Summary – 10 things to watch in 2024:
- Is value the place to be? – Battered valuations may offer opportunities.
- SA national elections – the potentially murky waters of a coalition government…
- Elections in the US – Is “The Don” making a comeback?
- The resilience of the US economy – A potential “soft-landing” implies a masterclass response to inflation by the US Fed.
- Interest rates and inflation – Hopefully inflation has fully abated … and interest rate hikes have come to an end!
- SA growth – Will Eskom and Transnet remain a binding constraint on SA growth?
- Elections everywhere – What does this mean for geopolitics?
- The resurgence of geopolitical realignment – Are Cold War-like conditions back?
- China economic stimulus – The scene is set for more pronounced fiscal action by the Chinese government.
- Regulations and protectionism – Regulatory scrutiny may increase over the coming years.
Looking back on a tumultuous year
2023 was a tumultuous year in many respects.
Inflation proved to be sticky, although it has trended towards central bank targets in developed markets and returned to central bank target ranges in the developing world. The aggressive hiking of interest rates by central banks seems to be over, with the US Fed holding rates steady at the final rate decision of the year.
China had been expected to hold up the world economy in 2023, if commentary at the beginning of the year was anything to go by. However, while the economic stimulus out of China was somewhat helpful, it was offset by the weakness of the property sector, which resulted in negative wealth effects for consumers. The current deflation in China indicates that there are significant demand-side pressures on the economy (discussed in detail below). This was particularly important from a South African export perspective, given our exposure to China, and the relative demand for our commodities thereof.
The US economy held up surprisingly well given the hiking cycle. We will see in 2024 if the lagged effects of the interest rate hiking cycle take hold and cause a recession or if the soft landing narrative comes to fruition. We continue to flag increasing risks of recession in the US and have kept a close eye on multiple leading and coincident indicators, of which most, apart from the labour market, suggest a recession is imminent. And if there is anything we can take from historical experiences, the strength of the labour market alone is not sufficient to assume continued resilience in the US economy. When the labour market unravels, it does so quickly.
That said, a soft landing would imply a masterclass outcome for the US Federal Reserve.
We went from one geopolitical event in 2022 (Russia-Ukraine) to another in 2023, with conflict erupting in the Middle East at the tail-end of the year. The consequences of the geopolitical upheaval remain to be seen but can have a fundamental impact on changing geopolitical alignments.
In terms of geopolitical formations, we saw the BRICS membership expand to include Saudi Arabia, the United Arab Emirates, Argentina, Egypt, Ethiopia and Iran. According to Visual Capitalist (link, 2024) The expanded BRICS is a significant player in global trade, particularly oil production (43% of world production) and agriculture, and makes up a significant portion of the global population (46%) and global GDP (almost 30%).
South Africa kept us on our toes. The economy held up well in our view, given the extent of the energy crisis and logistics constraints. But households and businesses alike acted to cushion themselves from the impact of loadshedding, as can be seen in the large increase in the imports of solar panels. We also saw South Africa narrowly avoid an axing from its AGOA status (though there are renewed concerns around our AGOA status given developments in the Middle East).
As we go into 2024, we will keep a close eye on the following 10 key themes in local and global equity markets:
Is value the place to be?
Later in this piece we go into detail about the performance of the US economy and its implications for relative positioning. The S&P 500 screens expensive relative to history (trading at a 29% premium to the historic mean on a 12-month forward price/earnings (P/E) basis), and perhaps from a US perspective, the value theme might not take hold on an aggregate level, although specific sectors may offer some opportunities. In the case of the US, it may be wiser to stick around defensives a little while longer (given their stickier earnings profile) as we enter a US interest rate cutting cycle but await to see the extent of the lagged effects of high interest rates on consumption in the US, and its implications for wage growth, employment and economic growth (discussed in detail below).
The value theme may pick up in Europe over the next 12 months. Broadly speaking, most of the major equity markets in Europe are screening cheap when looking at 12-month forward price/earnings ratios, at a discount of at least 5%. Economic stagnation in Europe has taken hold over the last 12 months, in stark contrast to the US and this has filtered through into valuations. Europe is relatively poised for a cyclical recovery if the European Central Bank (ECB) begins to cut rates and boost consumption, although inflation (and the dispersion of inflation across Eurozone countries) and high interest rates continue to weigh on overall economic activity.
Within a South African context, the valuation theme has a more nuanced perspective. The JSE All Share in aggregate trades at a multiple of 13 times forward earnings, an 8% discount relative to history. Later in the note, we discuss the trajectory of Eskom and Transnet and the implications for economic performance, but the incremental improvements seen at Eskom and the emergence of alternative power solutions adopted by businesses imply that businesses have created a more conducive operating environment for themselves. Businesses thus might not be as susceptible to power rationing, while they are also becoming less reliant on expensive diesel-powered generators. However, power remains a key risk. Base case scenarios from Eskom paint a bleak picture for the permanence of loadshedding this year – this is negative for valuations. Additionally, high interest rates and depressed household final consumption expenditure will likely similarly continue to weight on economic activity and valuations. So, while incremental improvements at Eskom and Transnet may result in some cost pressures dissipation (through more persistent lower stages of loadshedding), top line growth might not be robust.
Currency value has been a key talking point over the last few months as investors digest the relative expensiveness of the US dollar against other currencies. The dollar recently broke parity with the euro. The currency value play may be a bit more pronounced against emerging market currencies. Another major currency seen as an opportunity is the Japanese yen, following its significant depreciation against the dollar. The decision by the Bank of Japan has had a major impact on the valuation of the yen, in an environment where the US has been hiking aggressively and offering better risk-adjusted returns in the form of government bonds. The rand has similarly depreciated against the dollar but for different reasons, and structural reform in South Africa would be the catalyst for rand performance.
SA national elections
These will take place sometime in the second quarter, but perhaps as late as August. It is arguably the most anticipated election since the start of democracy in South Africa in 1994. The ANC faces the task of trying to maintain its majority and ruling status, with many expecting the ANC to dip below 50% for the first time. Pollsters such as the Social Research Foundation see the ANC at between 41% and 45% nationally. We will watch this closely as we grapple with the prospects of entering the murky waters of coalition politics, which have proven to be problematic at a local government level.
New political formations add a new dimension to politics in South Africa, as well as the strategic formations of opposition parties such as the Multi-party Moonshot pact.
Kingmaker politics we have seen at a local level will probably be the new normal in national and provincial politics (particular risk areas include KZN and Gauteng). Unstable coalition politics may add more negativity to South African valuations.
With elections on the horizon, this presents some near-term risks to SA’s fiscal position. The government rarely records fiscal surpluses during election years, and the debt-to-GDP ratio is expected to worsen over the medium term before improving. The fiscal deterioration is primarily driven by rising debt (to cover tax revenue collection shortfalls) and slowing nominal GDP growth. A weaker economy and lower commodity prices similarly imply weaker tax collections, and this would be negative for service delivery and the servicing of debt.
Elections in the US
The presidential elections in the US at the tail end of the year will also be interesting as former President Donald Trump seeks re-election, having lost the last election in 2020. Trump currently has a lead over incumbent President Joe Biden, according to pollsters. PredictIt has “the Don” at around 48% and President Biden at 41%. Real Clear Politics has a narrower lead for Trump at 45.8% versus Biden at 44.7%.
However, “the Don” continues to be haunted by the insurrection at the US Capitol in 2021. The US Constitution bars people engaged in “insurrection or rebellion” from running for public office.
At the time of writing, Trump is challenging a decision by the Colorado Supreme Court disqualifying him from appearing on the state’s Republican primary ballot. This matter is currently before the Supreme Court and is expected to be a high-stakes legal showdown.
If the outcome is in favour of Trump, and he does appear on the Republican primary ballot, he is expected to win the Republican nomination for president and will in all likelihood face off against Biden.
Headwinds for the incumbent include falling approval ratings across both sides of the aisle, with his handling of international crises in the spotlight.
The outcome of the US presidential election is important insofar as federal policy is concerned, from issues ranging from tax policy, to trade policy and welfare policy – all of which have a material impact on the US economy and geopolitical alignments.
The performance of the US economy in 2024 will be important for the global economy. As we have mentioned, many recession indicators suggest a recession is imminent in the US. Later in this article, we discuss the China stimulus package, but in the case of the US, there is little room for the government to rescue the economy in the event of an economic slowdown. We looked at a range of indicators that suggest tax revenue growth may be weak due to lower consumption, lower earnings before tax, and the linkage between weak consumption growth and its negative impact on growth, wages, taxes and employment.
At the end of 2023, we saw wage growth falling, which is a negative signal for the direction of employment in the US. This is because wage growth and unemployment in the US are inversely related. Lower wage growth is typically associated with higher unemployment. Consumption is a leading indicator of wage growth, and weaker consumption implies weaker wage growth which in turn implies weaker employment in the US. In our view, consumption, and wage growth trends will be an important gauge for the performance of the US economy in 2024. Consumption and consumer confidence are also linked, and as inflation expectations anchor lower, consumer confidence should pick up and so too should consumption.
Growth remains a key catalyst for equity returns (US equities are expensive on a forward price/earnings basis relative to the 15-year median).
Inflation and interest rates. The beast of inflation appears to have been contained across the world. As mentioned above, inflation in developed markets is trending towards the 2% central bank target and is broadly within target across emerging markets. These will be key determinants of the extent and pace of interest rate cuts in developed markets, particularly the US. The Fed’s preferred gauge of inflation, core personal consumption expenditure (PCE) prices, surprised to the downside in November and the December reading will be of key interest (bearing in mind seasonal aspects of consumption). The US Fed is, at the time of writing, expected to cut rates by around 175bps (1.75 percentage points) in 2024 (seven cuts of 25bps each) this year. This will be significant for the US economy as the cutting of rates has a material impact on consumption expenditure and the profitability of US companies. Fixed-income securities are set to benefit materially from interest rate cuts. The effect of the cutting cycle will have a material impact on US growth outcomes, particularly if consumption picks up and holds up the economy when the government can’t. The key mover of the needle will be the direction of wages and the relative compensation provided against inflation. Improving consumption should also enable company earnings to hold up, taking into account that earnings in the US continue to appear elevated despite some form of an economic slowdown expected.
If inflation expectations are anchored lower, we should also see consumer and business confidence picking up.
We have noted some reliance on the services economy in the US (although services inflation is falling) which has underpinned the soft-landing narrative. Looking at data from the year 2000 it has been typical for services inflation to be above core inflation, implying downward pressure on inflation is typically driven by goods. It is worth mentioning that the federal funds rate is also restrictive on services. This may imply sufficiently restrictive monetary policy in the US so far as containing services inflation is concerned, providing room for the Fed to cut.
At the back of our minds however is the point that the Fed doesn’t typically cut when the US is at full employment, which it currently is. We also highlight the risks of escalating tensions globally that pose risks to supply chains. This will certainly be a hot topic for the Fed and may impact the direction of interest rates (i.e. boost the higher-for-longer narrative). The federal funds rate would not have a material impact on exogenous factors such as global supply chain issues, but rather unduly suppress demand. The demand destruction may in a sense contain inflation in the face of rising fuel costs, but would have extensive material impacts on firms struggling with higher input costs and suppressed demand.
The wheels of inflation and interest rates are turning quickly.
The Fed cutting cycle will be important from a South African perspective. There is scope for the SA Reserve Bank (SARB) to cut rates before the Fed does, bearing in mind that the SARB started hiking rates before the US. However, what is of key importance is the relative attractiveness of our domestic assets, and cutting rates too soon could lead to foreign capital outflows as investors seek to be compensated for risk in South Africa.
This brings us to the next important facet of our outlook, what happens at Transnet and Eskom. Transnet and Eskom remain a binding constraint on economic growth in South Africa. It is perhaps for this reason that the JSE All Share trades on a 13 times forward P/E ratio, a discount to history and implying the JSE in aggregate is cheap. We saw glimpses of improving energy supply from Eskom over the final months of 2023, but the durability of it remains to be seen. Businesses continue to shield themselves from the impact of loadshedding, but improved energy security will be positive across the economy, including small and medium enterprises that cannot necessarily afford alternative power solutions.
As I wrote in a Business Day article recently:
“The SA business environment could go through a structural shift in the coming year or two thanks to the investment in alternative sources of power. Businesses have, to some extent, resuscitated and created a more conducive operating environment, improving their prospects for enhanced profitability. The reduced burden of diesel costs, for example, could act as a cost-containment mechanism, implying that the markets may have unduly punished JSE-listed companies, for what may turn out to have been a once-off cost.
If energy-related risks dissipate, so too can government bond yields, which is the risk-free rate, which would be positive for valuations. This therefore implies that there is upside potential for SA Inc.
Alternative sources of energy are cheaper over the longer term, meaning that production costs and producer inflation should both fall. The SARB is also traversing a new plain, in which it may soon have to decide when to cut interest rates. A combination of falling rates and falling risk premia is a net positive for SA Inc. Additionally, this would support household consumption expenditure (i.e. demand). This is important because consumer-sensitive sectors like retail contracted in the second quarter.“ (Business Day, 5 December 2023)
The problems at Transnet came to the fore in the second half of last year, and logistics constraints will hurt the economy irrespective of improvements at Eskom. What we produce also has to be moved, particularly those commodities that we export. Agriculture and mining, our leading labour-intensive industries, are particularly vulnerable to problems at our ports. Likewise, problems at Transnet present an upside risk to inflation (it does not appear material at this stage, but is still an important consideration).
There are important elections for many other leading geopolitical actors. About 40% of the world’s population is due to go to the polls this year. The first event on the elections calendar are the presidential elections in Russia, in which incumbent President Vladimir Putin is expected to get another term. This may imply further instability in the region, as the Eastern European conflict persists, dampening hope of a ceasefire anytime soon. Continued expansion of NATO is negative for any resolution of the conflict. Ukrainian President Zelenskyy is also set for an election, but given that Ukraine is under martial law and wartime conditions, Zelenskyy has been quoted as saying it would be “utterly irresponsible” to hold elections.
There are elections expected in the UK before the end of 2024. The UK has faced a volatile political landscape since the Brexit vote and especially after the Covid-19 pandemic. Whatever the outcome, the UK is not expected to move materially on its geopolitical alignment.
India is another big election on the cards, as well as Iran.
Conflict to the fore
The Middle East conflict has brought to the fore the fragility and potential re-forming of geopolitical alliances. Although the responses to the conflict by individual countries in Europe have varied (we see this through the voting in the United Nations on resolutions on the conflict), this does set the stage for a different geopolitical landscape. Europe experienced the brunt of the pain when aligning with Ukraine and the aftermath of energy insecurity in Europe given the region’s reliance on Russian gas.
The conflict similarly presents some risks to the oil trade, which again presents an upside risk to inflation. However, we have not seen oil prices react with the same magnitude as they did to the Eastern European conflict. Conflicts in the Middle East have generally had a benign impact on oil prices, with prices driven mainly by demand-supply dynamics.
But importantly, we have seen the impact of the Middle East conflict on the Suez Canal in the Red Sea, an important global trade route. This presents an upside risk to inflation if there is greater contagion on the route, depending on the severity of the supply chain impact. An oil spill for example would have wide-reaching consequences on the movement of vessels. Tesla recently announced plans to shut down a production plant in Germany as a consequence of a shortage of parts as a result of supply issues in the Red Sea.
One of the major contributing factors to the high levels of inflation seen over the last two years was supply chain bottlenecks driven by the zero-Covid policy in China (abrupt closure of cities and ports) as well as the pent-up demand globally, which led to excessive demand following the relaxation of Covid-19 regulations across the world. A deterioration in global supply chains would unwind progress made by central banks to contain inflation and would materially impact interest rate expectations despite our view that interest rate adjustments do little to influence supply-side pressures.
A key, final question is “will we see more regional conflicts this year?”. Last year we saw coups in Africa, which resulted in the upheaval of Western influence in some countries. Africa is a fierce ground of contestation for dominance between the West and the East. We have also seen some signs of rising tensions in the South China Sea, between China and the Philippines, and China and Taiwan. Geopolitical tensions are also important as far as alignment of the US with some of those contesting China’s dominance in the South China Sea. Both the previous and present Speaker of the House of Representative have met high-level Taiwanese officials over the last two years, a provocation in the view of China.
Will China stimulate its economy?
The extent of Chinese stimulus was a little disappointing in 2023, and as such we saw mining shares come under pressure from both a demand and pricing perspective. Given that China is in deflation, the scene is set for increased stimulus to spur demand and consumer spending, and result in the resurgence of inflation. Chinese authorities are increasingly worried that the economy may enter a deflationary spiral. Demand is low in China despite low interest rates and this presents a conundrum for authorities given that low interest rates have not yet spurred demand, a situation known as a liquidity trap. Domestic demand is a major facet of the Chinese economy, and without it, growth expectations would remain positive (relative to average growth of around 8.5% over the last 20 or so years). The rescuing of the property market and economic stimulus will go a long way in resuscitating demand in China.
Around Christmas time we saw Naspers and Tencent tumble due to regulatory uncertainty in China. Chinese authorities sought to increase regulation related to online gaming, though this is not a new or surprising development. However, the global and local regulatory environments are things to keep an eye on. This is premised on the increasing scrutiny of activities in areas such as environment, society and governance (ESG) within firms and countries, and how seriously sustainability is being taken. Rising temperatures and increasing weather-related hazards, among other effects, will impact how governments respond to the regulatory environment. ESG is increasingly becoming a cornerstone of future planning, and the ever-evolving ESG landscape can have a material impact on how companies operate. Similarly, from a local perspective, we have seen the South African government move forward with the National Health Insurance (NHI) plan, and we have seen increasing scrutiny of anti-competitive behaviour to protect consumers and producers, and one would expect an ever-increasing focus on ESG.
Another important aspect of regulations lies within the crypto market and the artificial intelligence (AI) realm. AI has its benefits but also its risks. Recently it was reported a Tesla AI robot attacked a Tesla employee, highlighting the risks of developing AI too quickly in a way that outsmart humans. The European Union recently agreed on the Artificial Intelligence Act, one example of governments putting into place specific regulations around the development of AI. The Act still needs to be ratified by member states.
AI is also being protected in the US. The bans on the export of chips to China show the seriousness of AI capability, particularly from a military-defence perspective, but also highlight the measures to be taken to protect intellectual property (IP) rights. Former President Trump was far more aggressive in his posture on trade policy and IP protection.
Protectionism more broadly could also resurge to the fore, and this is particularly pronounced for the US if Trump is elected. Protectionism regained appeal just after the Covid-19 pandemic when governments around the world sought to protect domestic industry. This is designed, through trade policy (tariff regimes) to protect domestic industry. Africa, for example, has embarked on the Africa Free Continental Trade Agreement to enhance domestic trade and reduce trade barriers within the continent. There is a rising use of industrial policy to enhance domestic industry, create employment opportunities and enhance economic activity. The relative strength of the US dollar has added to the narrative as goods priced in dollars remain expensive and contribute towards imported inflation.
If inflation trends are negatively impacted by issues in the Middle East and other geopolitical fragmentations lead to higher inflation (and by virtue high interest rates for longer), it could create further impetus for protectionist industrial policy.
It is going to be an interesting year, as have been the last few. Enjoy the ride!
For a comprehensive summary on our views for the next quarter, please look out for our Global Investment View compiled by Chief Investment Strategist Chris Holdsworth.
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