Thematic view: What can governments do to support their economies in a slowdown?

Market and economic highlights:

• November was a strong month for equity markets in the US, with all three major indices closing the month at least 8% higher.
• There was a broad-based contraction in government bond yields during the month too. 10-year US Treasuries fell to around 4.35% at the end of the month.
• US inflation continued its downward trajectory towards the midpoint of the Fed’s target range (actual: 3.2%, survey: 3.3%). The same was true for core personal consumption expenditure (the Fed’s preferred gauge of consumer spending) which rose 3.5% (in line with estimates), down from 3.7% the month before. Global markets were boosted by the news, which fueled bets that the Fed is done with hiking interest rates, with FRAs suggesting the Fed could cut by as much as 50bps in the first half of next year. This would be a catalyst for consumption as consumer purses open up.
• And CPI is falling everywhere. The UK, which has been in the most precarious inflation environment in Europe, saw headline CPI fall to 4.6% (it was 11.1% a year ago). As inflationary pressures dissipate in the UK, so do worries around the Bank of England continuing to hike interest rates, a welcome reprieve for UK consumers.
• China announced a significant property sector-centric stimulus package, and we are of the view that additional fiscal stimulus in China could go a long way in boosting demand in China and commodity prices. An infrastructure-driven stimulus package would be particularly good for South Africa given the reliance of infrastructure on our commodities, with iron ore futures specifically popping up to reach their highest price levels since March on the back of the news. Industrial sector profit data out of China on 27 November showed slowing profits, indicating that the recovery story in China remains fragile.
• At the beginning of November, South Africa’s Minister of Finance presented the Mid-Term Budget Policy Statement (MTBPS). As a follow-through from the China comments above, the MTBPS illustrated the impact of lower commodity prices on SA’s economy, with lower tax revenues underpinning weaker growth expectations and a higher debt-to-GDP trajectory. That said, broadly speaking there were no surprises in the MTBPS and greater fiscal prudence underpinned relative strength in the rand/dollar exchange rate as well as lower government bond yields. (At the time of writing, Treasury will be providing some assistance to Transnet of +-R47 billion).
• South Africa successfully hosted the AGOA summit in the first week of November. South Africa’s AGOA status has been in question for the better part of 2023 following unsubstantiated allegations by a senior US diplomat that SA had sold weapons to Russia. An independent investigation commissioned by the government of South Africa found that no weapons had been sold. The successful hosting of the summit underpins our view of South Africa being relatively secure with its AGOA status and continues to play a central role in the US support of development in the broader African continent.

Thematic View: What can governments do to support their economies in a slowdown?

Tax revenues play a critical role in the ability of any government globally to provide basic services and invest in the productive capabilities of the state. Similarly, tax revenues determine the extent to which the state can provide support to the economy in the event of an economic downturn. Taxes tend to be a proxy for the overall performance of an economy and there is a contradiction between poorer economic performance and a relative ability of the state to support the economy, but that leads to the question of what enables continued expenditure in the event of lower taxes. That is fiscal debt, and the debt burden of the state similarly plays a critical role in the extent to which debt can fund government activities.

Our first analysis (see chart 1 below) looks at a select sample of Organisation for Economic Co-operation and Development (OECD) countries and attempts to answer the question, “Which taxes matter?” The taxes that tend to matter across this sample of OECD countries are individual taxes, consumption taxes and social taxes. In essence, taxes in OECD countries are sensitive to employment outcomes and wage dynamics across the countries. Corporate taxes are of less significance, but corporates play a central role in employment opportunities and wage growth and as such corporate tax trends are important.

Chart 1: OECD country tax composition

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, OECD, Tax Foundation

Individual taxes are of the most significance in the US out of the OECD sample of countries (see chart 2 below). This highlights the sensitivity of fiscal performance in the US to individual taxes. This also implies that wage growth dynamics and tax base dynamics would be of particular concern for the US federal government. Higher employment rates would indicate a saturated tax base while wage growth would determine the extent to which wages are keeping up with inflation and therefore, is the federal purse growing by inflation or more. Tax revenues are a nominal number, and the nominal growth should be ahead of inflation (to ensure real growth in taxes) for meaningful increases to government expenditure (government service provision and investment activities).

Chart 2: OECD individual tax contribution to overall tax collection

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, OECD, Tax Foundation

But wage growth in the US has been weak for a while, as illustrated in chart 3 below, which may bode negatively for individual tax receipts in the US. Higher wage growth is typically associated with a larger taxable income base, and wage growth which is above inflation typically indicates increasing spending power which is positive for consumption and can also be positive for sector-specific corporate profitability. Therefore, all components of tax collection benefit from wage growth.  In essence, wage growth trends are bad for tax collection holistically in the US.

Chart 3: US wage growth

Date sampled: 10 Aug 2023
Source: Investec Wealth & Investment, Bloomberg

Our (and consensus) expectations of weaker GDP growth in the US similarly imply that wage growth should continue to be weak (see chart 4 below). If we were to pencil in growth in the order of 1%, this would estimate nominal wage growth of around 2.15% next year. This implies no real wage growth in the US and continued diminishing of consumer spending power.

Chart 4: The relationship between nominal GDP growth and nominal wage growth

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, Atlanta Fed

According to the chart below, consumption taxes are of less significance in the US relative to other OECD countries but still make up around 16% of tax receipts. However, consumption makes up around 70% of GDP in the US and therefore consumption tax dynamics are scrutinised blow.

Chart 5: OECD consumption taxes contribution to overall tax collection

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, OECD, Tax Foundation

Wages are typically a leading indicator (six months) of the directionality of personal consumption expenditure. Weak wage growth therefore similarly implies weaker consumption, which may put consumption taxes under pressure. Given that consumption makes up 70% of US GDP, this is similarly negative for corporate profitability given the linkage between demand, production and profitability.

Chart 6: Wage growth and personal consumption expenditure

Date Sampled: 10 Nov 2023
Source: Investec Wealth & Investment, Bloomberg

Chart 7: Relationship between wage growth and PCE

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, Bloomberg

As illustrated in chart 8 below, corporate taxes are of less significance across countries and particularly the US, Germany and France. While corporate taxes may be of less significance, it is important to analyse the trends given the linkage between profitability and taxes, but also employment.

Chart 8: OECD corporate taxes as proportion of overall tax collection

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, OECD, Tax Foundation

Profitability is now under strain in the US, implying weaker corporate tax receipts. The year-on-year change in earnings before tax has been on a downward trend over the last two years, having peaked immediately after the general reopening of the US economy following the Covid-19 pandemic. Corporate profitability is similarly an indicator of the strength of the US economy, and weak earnings before tax is supportive of our in-house view of an impending recession in the US. It is a trend we will watch over the coming quarters, but, if the trend persists this may be negative for employment dynamics in the US.

Chart 9: Earnings before tax in the US (nominal dollars)

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, FRED

Why is this important? In the face of tax pressure, we ask ourselves the extent to which the federal government can support the economy in the event of an economic downturn. The two ways the federal government can spend are through tax collection and raising debt.

Chart 10 below illustrates the debt-to-GDP dynamics in the US, and this metric remains uncomfortably high, having breached 100% at the onset of the pandemic and remained above 100% (latest: 119%). Increasing debt in the face of falling taxes will only increase the debt-to-GDP ratio, which is a negative for the US’s fiscal position. Therefore, the current ratio implies limited scope for the federal government to support the economy in the event of an economic slowdown. We are cognizant of the fact that 2024 is an election year, which is atypical of fiscal austerity.

Chart 10: US debt-to-GDP since 1966

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, FRED

GDP growth is expected to slow over the coming months, as a recession potentially takes hold in the US and broader developed markets. Interest payments as a percentage of GDP should trend upward as GDP growth slows. We see in the chart below that interest outlays as a percentage of GDP are sitting at their highest levels in over 20 years. This supports the argument that the US federal government will not be able to provide fiscal support to the economy.

Chart 11: US interest outlays

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, FRED

US federal government interest expenditure is similarly high, which could be the final nail in the coffin as far as fiscal support is concerned. The debt dynamics covered over the last few illustrations are key reasons why Moody’s downgraded the US credit outlook from stable to negative recently.  US Treasuries, considered a safe haven asset, are at risk as the fiscal conditions in the US deteriorate, which puts credit pricing at risk holistically. Adjustments to the risk-free rate similarly will impact the valuations attached to companies globally, and the impact is more pronounced in the US where forward price-earnings ratios are trading at a premium.

Chart 12: US nominal interest expenditure

Date sampled: 10 Nov 2023
Source: Investec Wealth & Investment, FRED

Cognisant of the constraints that may be faced by the US federal government over the next year, it is important to highlight similar dynamics from a state and municipal funding perspective in the US. Chart 13 below shows the revenue split for municipal and state funding in the US, and the relative exposure to federal transfers (just over 25%).

Chart 13: State and local government revenue composition

Date sampled: 17 Nov 2023
Source: Investec Wealth & Investment, US Census

In reference to chart 13, when looking at revenues from “own sources”, chart 14 below then highlights that the vast majority of said revenue is from taxes. Chart 14 highlights the different tax sources from a state and municipal perspective. The sources that move the needle the most, like federal taxes, are property taxes, sales and gross receipts (mainly consumption taxes), and individual income taxes. We made the points above related to the risks from a consumption and individual taxes perspective given trends in wage growth and personal consumption expenditure. Risks around elevated property prices will similarly have an impact.

Chart 14: Composition of municipal and state tax revenues

Date sampled: 20 Nov 2023
Source: Investec Wealth & Investment, US Census Bureu

To highlight the risks to property specifically, we looked at the S&P Global housing affordability index which illustrates that housing affordability has been weak for at least the last six months. This is negative for housing prices in the US.

Chart 15: Housing affordability in the US

Date sampled: 17 Nov 2023
Source: Investec Wealth & Investment, FRED

Housing inventory is trending upwards again and it is at its highest level since the tail end of 2020, and trending towards the mean inventory level since 2017. Surplus inventory (over-supply) would be an additional headwind for property prices in the US. This would have a wealth effect, which is typically associated with additional downward pressure on consumption expenditure in the US.

Chart 16: Housing inventory in the US

Date sampled: 17 Nov 2023
Source: Investec Wealth & Investment, FRED

The labour market is similarly starting to show signs of stress. Chart 17 shows that continuing claims (unemployment benefits) in the US have reached their highest level since the end of 2021. This implies that employment is coming under pressure. A weakened labour market would have extensive consequences for consumption in the US, and economic activity more broadly.

Chart 17: Continuing claims in the US

Date sampled: 17 Nov 2023
Source: Investec Wealth & Investment, FRED

Municipal bonds have been weak, as proxied by the municipal bond index (chart 18). Weakness in bonds implies idiosyncratic risks with the municipal bond market, which may be linked to the fiscal challenges beginning to manifest in the system. That said, we still see a significant margin of safety in sovereign bonds in the US despite the headwinds from a funding perspective.

Chart 18: Municipal bond index

Date sampled: 17 Nov 2023
Source: Investec Wealth & Investment, S&P

For South Africa, the key sources for tax are similar (see chart 19). Personal taxes and consumption taxes account for most tax collections. SA is slightly different when it comes to corporate taxes, which are the third biggest component. Therefore, in the SA context, individual incomes, consumption and corporate profitability are of greater significance.

Chart 19: SA tax composition

Date sampled: 25 Oct 2023
Source: Investec Wealth & Investment, National Treasury

SA real household final consumption expenditure has been trending lower for the last six quarters or so. This implies that the consumer is under increasing pressure as inflation-adjusted consumption is near zero. Consumption plays a key role within the South African economy as a key contributor to overall GDP, but similarly, as consumption falls this is negative for overall company profitability. This is therefore negative for overall corporate tax collection as companies struggle either to a) push through price or b) push through volumes as consumers or under strain.

Chart 20: Household consumption trends in SA

Date sampled: 15 Nov 2023
Source: Investec Wealth & Investment, SARB

Therefore, from a South African perspective, the composition of taxes has become more geared to personal and corporate taxes (see chart 21 below). This implies limited scope for the government to increase value-added taxes beyond the current 15% level. Particularly in the current economic environment with high interest rates and falling household consumption.

Chart 21: Tax composition percentile rank in SA

Date sampled: 25 Oct 2023
Source: Investec Wealth & Investment, National Treasury

In conclusion, the US and South Africa are not too dissimilar in their current experiences of the implications of tax collection headwinds, and the extent to which the respective governments can support the respective economies. The trends we see support the view that we will see a significant economic slowdown in the US. The depth and duration of a recession in the US remains to be seen, but anecdotal evidence of falling consumption expenditure, weakening wage growth, and elevated property prices may have a material impact on the US economy.

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