As we enter the second quarter of 2024, market participants are throwing in the looming recession towel. The United States (US) economy is still rallying, and the anticipated US recession is nowhere in sight. Over the last few quarters, we have been talking about the canary in the coal mine, where economic indicators have been pointing to a possible global recession. However, when it comes to the US, there is a sense that the canary may have escaped its cage and turned into the soaring American eagle.
The reason for this is that while most global economies are already feeling the recessionary pinch, the US economy remains surprisingly strong. So, the question on everyone’s minds is, can this last? At Citadel, we believe the US eagle may well be about to catch a cold.
At the beginning of the year, consensus expectations were that central banks would start cutting rates as early as March, given the downward inflation trends. However, it didn’t take long for that view to change. Due to the stickiness of US core inflation, coupled with the resilience of the underlying economy, any potential rate cuts continue to be pushed back for later this year.
When it comes to the global economy, the US stands alone. Currently, it appears that its economy is immune to the impact of higher interest rates. Whereas, in the other regions, China, the European Union (EU) and the United Kingdom (UK), and here in South Africa, we see a very different story. These regions are seeing extremely weak activity and are facing several headwinds for both the consumer and business. And when the US starts to see a slowdown, it will be even tougher for these regions. Indeed, this brings to mind –the adage: “When America sneezes, the world catches a cold”.
The US – Don’t be fooled by the sentiment
While consumers may be feeling optimistic about the US economy at the moment, this is more a reflection of the current hype than what we believe is in the pipeline. Looking at current economic fundamentals, they certainly paint a less optimistic picture.
The better-than-expected economy is currently underpinning consumer sentiment. Consumer sentiment is what the consumer is feeling right now. It is being driven by the potential of interest rate cuts which will benefit consumers, as well as business and the economy. Consumer sentiment is also being buoyed by stronger-than-expected equity markets, which during the first quarter, reached new record highs – indicative of that soaring eagle. When we look at sentiment, we would be asking questions like: would you be prepared to buy a new fridge or TV right now? Strong sentiment sees people say yes, given the current buoyant environment.
Consumer confidence, however, looks to the future and asks whether people would be willing to make the same buying decisions six or 12 months down the line, for example, given the prospects for the economy and jobs. Consumer confidence is still very depressed and the gap between consumer sentiment and consumer confidence is widening. Low consumer confidence shows that the consumer is concerned about the future. So even though interest rates may decline, consumers are concerned that, in the future, there will be pressure on economic activity and job security.
US economic growth is still quite robust, and unemployment is low, but other employment trends are all pointing to a softer job market developing. Over the last six months, the low unemployment figures have been driven by part-time employment and by multiple job seekers – those people who are looking for a second or third job to make ends meet – while full-time employment has been flat. A recent survey indicated that 40% of American households rely on multiple jobs to make ends meet. This data shows that households are feeling the pressure. In addition, real-wage growth is also on a downward trend as inflation is getting softer. Last year, strong wage growth was helping consumers; this year, it has come to an end. Future hiring trends are down as companies are considering hiring fewer people going forward. In addition, job-quit rates are falling, which indicates that people are hanging onto their jobs because the job market is getting tighter. Currently, the US unemployment rate is at around 4%, which is still low compared to historical standards, but this can shift quickly if the economy moves into a slowdown phase. All of these trends point to US consumer confidence being tested.
Staying with the consumer, the higher interest rates are seeing US savings rates being depleted, meaning that any backup the consumer might have had to weather higher interest rates are disappearing. With this, we are seeing increased delinquencies on credit card debt, as well as vehicle loans and mortgages (to a lesser extent). The demand for consumer credit has increased by more than 5% over the last year, which is a clear sign that the consumer is not keeping up with the cost of living.
In summarising the US consumer’s predicament – savings are being depleted, they are borrowing more, they are struggling to repay their debt and 40% of consumers need a second or third job just to keep the lights on. We therefore see that it is not a story of a soaring eagle, but rather one of a consumer being pushed into a very tight corner.
On the back of this, retail sales are down year-on-year, also pointing to a struggling consumer. Consumer spending contributes around 70% to overall US economic activity – Given current developments we expect that consumer spending can turn into a headwind for overall economic activity over the next few quarters.
Turning to the business side of the economy The NY Empire State Manufacturing Index, which looks at US manufacturing activity, has dropped to levels that were only surpassed during the COVID-19 pandemic, indicating that manufacturing is under pressure and that new orders and shipments are down significantly. This is because global trade is soft, and the US cannot escape what is happening around the world.
Current indicators suggest that business investment plans are down, meaning that businesses are not planning to invest in new projects. This can be attributed to the fact that manufacturing activity is weak, which is further highlighted in the ISM Manufacturing Survey, which looks at the strength of the production side of the economy. A number above 50 suggest the economy is expanding and below 50 indicates the economy is in a state of contraction. The last print was only 50.3. When we look at the components of that index, we see employment is at 45 and declining. All of these trends are not paining a rosy picture for the US economy.
What’s more, US trade, imports and exports are both negative compared to a year ago. This is not only a reflection of the state of the US economy, but the global economy as well. An interesting aside is that Mexico has now overtaken China as the US’s top import source in 20 years. This speaks to the ongoing themes of supply-chain diversification, the US trade war with China, and bringing production closer to home.
Turning to US inflation, given the current sticky components, it seems like inflation is finding a floor around 3% which is still more than the 2.5% US Federal Reserve (Fed) inflation target. It is for this reason that the Fed keeps delaying its decision to cut interest rates. We do expect it to get there eventually as the US economy slows further. However, with tensions in the Middle East escalating, shipping costs coupled with higher oil prices mean that inflation might remain higher for longer – which implies that we can expect fewer, and less interest rate cuts this year.
Our view remains that the US economy will continue to slow further and will struggle to deliver growth in excess of capacity. US real growth should average around 1.8% per annum over the next three years.
The European Union – Sitting with a bad case of flu
Across the Atlantic, the European Union (EU) is a bit of a mixed bag economically. The EU’s growth engines, Germany, France and the Netherlands, are all in recessionary territories, while the peripheral regions like Spain and Italy are still experiencing positive GDP numbers.
Germany, a major global exporter is struggling, which is always a reflection of what is happening in the rest of the world. German exports have fallen to their lowest levels since 2020, especially shipments to China and the US, which from a year ago, are down 12% and 10% respectively. These numbers reflect the weak state of the global economy, with Germany being the quintessential canary in the coal mine. Locally, factory output in Germany has been falling for the last six months running. This has been its longest downward cycle since 2008, when the world experienced the Financial Crisis and points to an extremely soft manufacturing environment, not only in Germany, but the entire EU, where manufacturing is down 6% compared to a year ago. In addition, the cost of doing business in Germany has increased, which is primarily energy related.
Beyond Germany, EU industrial production is also declining. While this has been the trend since 2022, the most recent data showed a fall of 6% year-on-year. On the back of this, the business climate index, which measures business sentiment, is also deteriorating, with no indication of it turning any time soon.
On the import and export side, new exports of goods and services continue to decline. Germany is down around 12% year-on-year, whereas the region has seen a drop of 3% year-on-year. On the import front, European imports have fallen 4.4% year-on-year, which indicates that Europe is struggling.
In looking at the EU consumer, we see that consumer confidence is starting to rebound on the hope of rate cuts. Yet, it remains below average levels seen over the past three years, meaning that it is not yet at a level that will support consumer spending. This is, therefore, having a direct impact on metrics like retail sales, which remain negative year-on-year, indicative of a struggling consumer. We are also seeing increased demand for credit and an increase in delinquencies on debt. Having said that, like in the US, the labour market is still robust and employment figures are strong. In fact, most EU countries are still experiencing historic-low unemployment numbers.
While EU inflation numbers are falling, they are not where the European Central Bank (ECB) wants them to be. In addition, unlike the US, EU inflation is coming off a weaker real economy, and it is more likely for the EU to have some downside surprises in its data related to the lag effects of higher interest rates. This makes the ECB’s interest rate decisions trickier. However, due to the weakness of their economy, we might see the ECB start cutting rates sooner than the US.
Given these challenges we do expect the EU to grow below capacity over the next three years.
The United Kingdom – Going nowhere slowly
The United Kingdom (UK) is stuck in a state of stagnation. Last year, the country had to deal with the “flu” when it went into a technical recession. While it is seeing some improvement this year, this is coming off an extremely low base and it therefore will not experience any real growth. However, this slight recovery is improving household incomes somewhat and together with the potential for interest rate cuts, we should see an easing of credit conditions, which will further fuel consumption. Like the US, the UK’s recovery is currently service-driven, with its construction and manufacturing sectors remaining weak.
The UK’s long-term growth outlook, at 1%, is not cause for celebration. The economy is navigating the impact of the global geopolitical risks, as well as battling with the impact of Brexit as it no longer has all the trade benefits associated with belonging to the EU. This trade friction could hamper investment plans, which will pose additional headwinds for the economy. In addition, the UK is currently dealing with a unique issue. Its unemployment numbers are still good at around 4%, but youth unemployment is much higher at 12%. This will put additional social pressure on the national budget, which is already operating under tight conditions.
UK exports are down 9% compared to a year ago, reflecting slower demand around the world. Imports are down by 2%, meaning that net trade is negative, reflecting the UK’s struggles. Like its peers, the UK is dealing with sticky inflation. But given the weak state of its economy, the Bank of England, like the ECB, may start to cut interest rates ahead of the US.
China – Unwarranted optimism
Yolanda Naude has written a comprehensive analysis of the Chinese economy in this edition of Citation. In brief, the Chinese government is hoping for economic growth of 5% and inflation of 3% for 2024. However, given the current state of the economy, which is experiencing a deflationary (falling prices) environment, a property sector in deep recession, a manufacturing sector which is sitting with severe over capacity, high local-government debt levels and weak consumer confidence, we do not think that China is going to achieve these goals without targeted stimulus.
The headwinds the Chinese economy is facing reflect the soft global economic environment, a lack of demand due to weak consumer and business confidence, and local structural issues, which will not be easily remedied.
South Africa – Stuck in a gridlock
Locally, 2024 has been and will remain a gridlocked year. This is the result of a number of challenges. The first are the structural issues the country is dealing with, as well as the budget being unable to provide more financial support to the economy and its citizens. There is also no movement in the implementation of policies because government’s focus is now on the elections, scheduled for 29 May 2024.
As we all know, life on the ground in South Africa is more than just about the economic numbers and indicators. On a daily basis, we have experienced loadshedding, water issues, and potholes, never mind what we see on our news feeds each day. But if we do look at the numbers, we will remember 2023 to be a disaster in terms of our cumulative loadshedding. Given the alternative energy sources being adopted, 2024 has seen a much better power situation. But just as the country started getting to grips with its power problems, another gale-force headwind raised its head, in the form of Transnet, which had a major impact on the country’s ability to import and export towards the end of last year. Now as South Africa starts to address this issue, we have a looming water crisis that is threatening to put another level of pressure onto our beleaguered economy and population. We can be forgiven for feeling like we are lurching from one infrastructural failure to the next.
If you look at South Africa since 2021, the numbers seem to back up our despair. We have seen a 20% drop in the country’s cumulative electricity production and a very similar decline in the total cargo being handled by South African ports. However, despite these declines in power and shipping, the country has still managed to grow, albeit by a disappointing 1%. This growth, though, is not from sectors that are creating meaningful economic growth or employment. It is coming from sectors that are less energy and port intensive like financial services, general government services, and personal services (including domestic workers). While the performance of these sectors did not shoot the lights out, they have at least contributed positively to South Africa’s growth.
The industries that need a consistent supply of power, ports to import and export and which require reliable water sources – mining, manufacturing, construction and agriculture – and are the industries that will really boost the economy, have experienced no growth and are facing a rather bleak outlook. This shows a glaring imbalance in the country’s growth due to structural challenges.
To illustrate the dire state of growth in South Africa, the economy is only R8 billion bigger than it was just before the COVID-19 pandemic. Although this sounds like a lot, it is not a big enough increment to cover goods and services to compensate for the employment needed owing to our current population growth figures. This has resulted in the government being pushed into a corner, as there is the snowball effect of more people, fewer jobs, and a greater need for social support, while there are lower revenue collections, due to falling tax collection on the back of a flat economy.
In the first quarter of the year, we saw the impact this low growth is having on the fiscus. In February’s national budget, we saw that with no growth in the economy, tax-revenue collection is down while government borrowing has not slowed down. This is unsustainable. The country’s interest payments are already 20% of the total budget, and they are growing every day. This highlights the urgency of fixing structural issues so that the economy can be kickstarted and grow our tax revenue. Fortunately, Treasury is trying to address this issue, having attempted to show how serious it is about reducing its borrowing in this year’s budget. Treasury has tapped into the country’s gold and foreign reserves, which although a hotly debated move, will allow the government to reduce the debt-to-GDP by about 2% over the budget framework. So, where we were expecting the debt-to-GDP ratio to rise to about 78%, with this move, it will peak at around 75%.
The issue around this move is that South Africa’s gold and foreign reserves account acts as a buffer to the South African Reserve Bank (SARB) for a rainy day. It was valued at around R500 billion, until Treasury drew down this reserve by R150 billion, still leaving a healthy sum for emergencies. The concern many analysts have, however, is that this account should not be tapped into if no long-term investments are being made to fix the economy. Otherwise, it is simply a temporary plug for a leaking budget. And this is what many feel it is. While this was not a populous budget, especially in an election year, this money is still going to fund the public sector wage increases, to make provisions for a Transnet bailout, and plaster over a few other issues. This means that if we are not growing the economy, there will be another need to dip into the piggy bank, once again, in the near future.
These issues, however, will not be addressed as we move into the second quarter of 2024, because it is the election quarter. In addition, the polls are suggesting that this election will see South Africa being governed by a number of smaller parties banding together in coalitions. This will more than likely add to the current gridlock the country is facing, due to ideology stalemates and policy paralysis. So, our current idling mode will continue, meaning a delay in the implementation of important policies, and indicating that we will continue to kick the proverbial can down the road when it comes to kickstarting the economy.
The good news, however, is that business is actively involved with government and progress is being made with the help of the private sector. The proposed railway bill will open up doors for private participation in the rail industry, which analysts are suggesting will result in a rail boom. The electricity diversification drive is continuing, despite the solar boom running out of steam, due to tax benefits on solar only being offered for two years. Fixed capital investment is improving, and we are again closer to 15% of GDP, after it bottomed close to 12% of GDP during the Zuma years. But we need to get that number closer to 20% or 25% to really make a difference. These initiatives will take time but without it the future is bleak; with it we could see the economy return to above capacity growth over the next three to five years.
From a consumer perspective, the South African consumer is not in a position to help drive the economy. South Africans are dealing with massive youth unemployment, high interest rates, and sticky inflation which is hovering closer to the upper end of the SARB’s target. The Experian Consumer Default Index revealed just how much pressure is on South African consumers, when it found that there has been an 18% increase in consumers defaulting on home, vehicle and personal credit. So, not only is the manufacturing and industrial side of the economy struggling, but the consumer is unable to add meaningfully to aid South Africa’s economic growth.
South Africa is also battling with sticky inflation, meaning that SARB is going to keep rates higher for longer. The local interest rate cycle will most likely be integrated with what is happening in the US, so when the Fed starts to cut rates, SARB will likely, only then, follow suit as our economy is directly impacted by global trends in addition to local occurrences.
Outlook in summary
The rest of 2024 will be filled with much uncertainty and volatility. There will be a number of headwinds to content with, before we start to see some light at the end of the tunnel. Geopolitical risks, contentious elections and the economic challenges discussed in this article are all going to impact markets this year.
Having said that, the turnaround in the global economic cycle is approaching. The question however, is how long will it take for the US economy to slow down, and what will the impact be on their trading partners across the globe? We believe a US slowdown remains in the pipeline. Only then will the outlook start getting better as these headwinds turn to tailwinds.
From an economic fundamental point of view, Citadel is still cautious, and coupled with current market valuations all our solutions remain defensively positioned.
