Pound falls as Hard Brexit looms

Dave Mohr & Izak Odendaal, Old Mutual Multi-Managers

US gross domestic product growth has slowed substantially over the past year to 1.3% year-on-year in the second quarter. In its latest round of global forecasts, the International Monetary Fund (IMF) cut its outlook for US growth for 2016 from 2.2% to 1.6% and 2017’s forecast from 2.5% to 2.2%. Consumer spending is the main engine of growth, supported by low inflation and decent job growth. Headline inflation is below 1% and core inflation, which excluded volatile food and energy prices, is below 2%.

Declines in business investment, partly due to the low oil price, are largely to blame for the slower growth. Against this backdrop, it seems a bit strange to be considering interest rate increases. Yet several Fed officials, including previously dovish ones, have in the past few weeks argued the case for a rate increase later this year. They are somewhat supported by US economic data including the ISM indices that rebounded in September after August’s decline.

US job growth below expectations but still decent
The key data points in the interest rate debate remain job and wage growth, the theory being that lower unemployment leads to higher wages causing higher consumer prices. The US economy added 156 000 jobs in September, below Reuters’ consensus forecast of 172 000. This follows an upwardly revised 167 000 rise in August. The unemployment rate rose to 5% as more people re-entered the labour force (increasing the labour participation rate). The annual rate of job creation has slowed down over the past year from 2.3% at the beginning of 2015 to 1.7% now. Wage growth increased over this period. This means that the overall household income growth (wage growth plus job growth) has remained more or less steady.  But with labour productivity growth stagnant, and wage costs increasing, there is a strong possibility that companies will slow hiring to maintain margins. Therefore, while 156 000 jobs added last month still points to a labour market that is reasonably healthy, there is enough weakness to prevent rates from rising by much over the next year or so. 

There are two monetary policy meetings left this year, scheduled for November and December. The November meeting is seen by many to be too close to the Presidential election to hike, but not hiking could also lead to accusations of bias. The European Central Bank (ECB) denied reports of considering scaling back its €80 billion a month bond buying programme, but this was coming soon after the September policy meeting which failed to deliver a widely expected extension beyond March 2017. Inflation, both current and expected, remains well below the 2% target.

With possible US interest rate increases in December and the ECB potentially taking its foot off the pedal, the rand and other emerging market currencies lost some shine last week. The gold price - also sensitive to global interest rate expectations - fell to the lowest level since the Brexit referendum. In rand terms, the gold price is 12% higher than a year ago. (Looking at South Africa’s other main export items, platinum is 9% higher than a year ago and iron ore 3%. The coal price is 30% higher in rand terms.)

Sterling pounded
Speaking of Brexit, sentiment in the UK has generally been remarkably upbeat since the vote, but the honeymoon phase might be over. Friday morning saw a ‘flash crash’ in the UK pound when its value slumped by 6% in Asian trading to $1.18 before rebounding two minutes later to $1.24. Other currencies – including the rand – reacted negatively too. It is unclear whether a technical glitch or human error was behind the sharp slump, but the pound had already been falling for most of the week after Prime Minister Theresa May outlined her government’s intentions regarding its future relationship with the European Union. It included curbs on immigration that would go against the EU’s key principles of free movement of goods, services, people and capital and therefore could see restricted access for UK companies to the European single market. Such an outcome has been termed a “hard Brexit”. May said she intends triggering Article 50 of the Treaty of Lisbon by March 2017, which would set the process of leaving the EU in motion.

On the positive side, there are increasing signs that May’s government will lean to infrastructure spending as a way to support the economy during the potentially turbulent years ahead, instead of just relying on the Bank of England to do the heavy lifting. This would represent a marked break with the austerity policies of her fellow-Conservative predecessor David Cameron. It could also act as an example for other governments to use low borrowing costs – the UK government can borrow at only 1.4% per year for 30 years - to fund investments that would lift productivity and growth. The IMF has been calling for this for years now. The IMF forecast for the UK this year is 1.8% and 1.1% for 2017, but there is considerable uncertainty over this outlook since no one knows exactly how Brexit negotiations will play.Buoyed by the weaker currency, the FTSE 100 surged above 7 000 points, the highest level in a year. Much like the JSE, the London bourse is dominated by global companies whose revenues rise as the pound falls.

South Africa losing jobs
Unlike the US, South Africa has been shedding jobs. StatsSA reported last week that 67 000 formal jobs were lost in the second quarter. Most of these appear to be part-time jobs related to preparations for the elections. The beleaguered mining sector lost 1 000 jobs in the quarter, surprisingly few, but lost 32 000 jobs over the previous four quarters. The manufacturing sector lost 7 000 jobs in the second quarter and 16 000 over the previous year.

A key factor impacting the performance of the mining and manufacturing sectors over the past two years has been electricity supply disruptions. These appear to be a thing of the past and StatsSA reported that electricity generation increased by 3.8% year-on-year in August.

Some positive signs
The Barclays manufacturing purchasing managers’ index (PMI) unexpectedly slumped from 52.5 index points in July to 46.3 in August (with 50 index points separating growth from contraction). This was surprising, given that the PMI remained above the neutral level for the preceding five months. The PMI rebounded somewhat to 49.5 in September, but the average reading in the third quarter was below the second quarter average. On a positive note, expectations for business conditions in six months’ time increased for the third straight month and are now at the highest level since early 2015.

The Standard Bank PMI, which covers the entire private sector (not just manufacturing), also showed a positive signal. The PMI rose above 50 index points for the first time since April last year, driven by an increase in new orders. Some parts of the economy are clearly still weak and will take time to recover. Consumers are clearly shying away from expensive purchases, with September new passenger car sales down 15% year-on-year. The IMF’s forecast is for the domestic economy to grow by only 0.1% this year and 0.8% next year. This is much better than its outlook for fellow emerging market commodity producer Brazil, which is expected to contract by 3.3% this year but return to modest growth of 0.5% next year. However, it is probably on the pessimistic side.