At the start of 2013 we warned that South African growth has been fuelled by debt over recent years. Consumers, faced with slowing income growth, have been happy to continue to consume and borrow. Lenders have been happy to lend as well, not only to keep their loan books growing, but these consumer instalment loans also carry much higher interest rates, on average 24% but at times in excess of 40%. This loan growth has therefore mainly taken place in the unsecured lending market.
We warned that on the surface, creditors may appear to be the beneficiaries, but they in fact are facing an adverse “selection dilemma” as it is mostly high-risk debtors that tend to borrow money in such an environment. Therefore an expectation for significant spikes in bad debts was highlighted. Bad loans as a share of total loans are already high. As at the end of September 2012, only 78% of unsecured loans were reported as “current” by lenders, implying that 22% were already a problem. Although bond yields in South Africa have fallen a lot, household debt servicing has not really eased. The reason is that at 76% of disposable income, the household debt/income ratio is the second highest in emerging economies after Korea, and the latest surge in high-cost consumer credit has considerably increased the burden of debt servicing.
During the first week of April, the first signs of a crack in this sector emerged. African Bank Investments, South Africa’s biggest unsecured lender, shed R4bn of its market capitalisation in one trading day after a trading update forecast a double-digit decline in earnings and higher provisioning for bad debts. The Bank said they expect a fall of 25%-28% in interim earnings for the period to March. It also announced that it had written off additional nonperforming loans in March and had experienced an increase in bad debts, especially on the furniture credit portfolio. It expected bad debts to remain high for the rest of the year.
We believe this is just the first signs of more to come. Rising consumer debt levels would not be a problem to service if consumers’ disposable income was also expanding briskly. However, household income growth has not been robust, especially in real terms and the growth that has occurred has stemmed from government transfers and public employment rather than the private sector.
Moreover, recent economic data echoes the deteriorating spending power of the consumer:
Chart 1: FNB/BER Consumer Confidence index
The FNB/BER Consumer Confidence index (chart 1) dropped a further 3 points in Q1 of 2013 to a 9 year low. Consumers’ rating of the outlook for the national economy, their own financial prospects and the appropriateness of the present time to buy durable goods all deteriorated notably.
Not even at the height of the global financial crisis in 2008 were consumers as downbeat about the country’s economic prospects and their household finances as they are now. Combined with a slowdown in household income growth and credit extension, low consumer confidence levels foreshadow subdued growth in household consumption expenditure going forward.
The slump in consumer sentiment also corresponds with the deterioration in the business confidence levels of retailers and the substantial slowdown in retail sales growth recorded in recent months. Apart from the decline in consumers’ willingness to spend, their ability to spend will further be constrained by rising inflation, high debt levels, a likely forced slowdown in the growth of unsecured lending and the changes in government spending announced in the February 2013 budget.
A further blow to the consumer is muted job creation. The official unemployment rate in South Africa is now back above 25% at 25.2%. This is extremely high by global and emerging market standards (chart 2.) Importantly, 70% of SA’s unemployed are younger than 35, while the unemployment rate among people aged less than 25 is around 50%.
Chart 2: SA unemployment rate versus emerging markets
The growth in consumer spending was the mainstay behind the domestic economic recovery between 2010 and 2012, the growth in consumer spending is expected to be subdued and much less supportive of economic growth in 2013.
A weak consumer, combined with a lacklustre manufacturing sector points to a weak economic environment. This is expected to result in continued negative pressure on the Rand as capital flows are reallocated to countries with more attractive fundamental outlooks. It should also result in relative underperformance by the South African equity market of both the broader emerging markets and developed markets.
We noted last month that we believe the outlook for risk assets remains favourable. However, we cautioned that short term events may lead to increased market volatility and possibly a near-term correction. Catalysts for such volatility or even correction could be multiple, but the most likely are the developments in the euro area and the current economic slowdown plaguing most of the globe.
Weaker Global Growth
In its most recent World Economic Outlook released, the IMF trimmed its estimate for global growth in 2013 to 3.25%, down from its projection of 3.6% made last October and last April’s projection of 4%. Chart 1 shows that the Economic Surprise indices in the major economies have turned negative, therefore, more numbers released are negative surprises currently than on target or positive surprises.
Chart 1: Economic surprise indices
Reflecting this development, global cyclical stocks have sharply underperformed defensives and commodity prices have come under pressure pushing the CRB Commodity Index down 12% from its high last year and 23% from early 2011. Although the precipitous decline in the gold price has grabbed most newspaper headlines, the commodity selloff has been broad-based, with gold, silver, base metals and crude oil seeing significant selling pressure.
Details on the slowdown
Almost all the latest economic releases out of the U.S. have fallen short of expectations, including retail sales, consumer confidence, durable goods orders, housing starts, existing home sales, and homebuilder confidence, as well as both the manufacturing and non-manufacturing reports. As disappointing as such a slowdown may be it needs to be put in the proper context. A faster pace of inventory accumulation significantly boosted Q1 growth, but will subtract from growth in Q2. In addition, Hurricane Sandy shifted some spending from Q4 to Q1, lifting growth by roughly half a point in the first quarter. Thus, it is not surprising that the latest data show a decline in growth from the first to the second quarter. That said, some of the slowdown appears to be driven by fundamental factors. The impact of the sequester (federal budget cuts) and the lagged effect from tax hikes earlier this year are starting to take their toll on economic activity. Personal consumption held up reasonably well in the first quarter, but this was largely at the expense of a falling saving rate, which now stands at a mere 2.6%. Efforts by households to rebuild savings are thus likely to dampen growth over the coming months.
Looking beyond 2013, however, the picture brightens considerably. While the fiscal drag due to the sequester this year is likely to average a bit over 2% of GDP, it should fall to around 0.5% of GDP in 2014, allowing GDP growth to accelerate to potentially over 3%. A recovery in the housing market and a revival in capex spending should also help lift growth. In addition, household finances are improving, as evidenced by the fact that the ratio of household debt-to- personal disposable income has fallen to where it was a decade ago and the debt-service ratio is back to where it was in the early 1980s (see chart 2).
Chart 2: U.S. household debt-service payments as % of disposable income
As in the U.S., the latest data from the euro area leaves much to be desired. Economic activity indices for the region continue to contract, even the German economy has lost some momentum. This implies that real GDP in the euro area is still declining. Going forward, growth in Germany is expected to improve over the course of 2013, but France and the Netherlands will remain under pressure, largely due to the deterioration in their housing markets.
Many risks remain in the euro area. The ratio of net government debt-to-GDP is likely to exceed 100% in Italy, Spain, Greece and Portugal at least until the end of the decade (based on the IMF’s forecasts). This means that the periphery will remain highly dependent on ECB support for many years to come.
Recent economic data in the U.K. have been poor. This is partly due to the exposure that many U.K. companies have to continental Europe; but much of the weakness can be attributed to tighter fiscal policy. Conditions are likely to remain weak in the U.K for the foreseeable future.
Recent data out of China have come in below expectations. GDP growth, retail sales, industrial production and fixed-asset investment have all disappointed. Most critically for commodities, imports of crude and industrial metals have sagged noticeably. We have for some time highlighted the risks building in China as growth has been mainly fuelled by credit expansion. Now at critical debt levels, we question the sustainability of lofty growth numbers going forward. We believe this is part of the greater adjustment for China to a more normalised growth rate of 4-5%.
Lastly, developments in Japan could lead to it being the star performer for 2013. The centrepiece of Japan’s new economic strategy is the “2-2-2” plan, consisting of a 2% inflation target, a projected two-fold increase in the monetary base, and 2% of GDP in fiscal stimulus. The government’s policy actions should accelerate the exit from deflation. This expectation is being priced into market yields. Although nominal rates have moved down only modestly, real rates have plunged as inflation expectations have risen. The decline in real yields has boosted Japanese equity prices, both because low real rates will help stimulate growth and because a decline in real rates increases the present value of a given stream of cash flows that shareholders in Japanese companies can expect to receive. Crucially, the market has not yet fully discounted a move to 2% inflation. It has only priced in a move closer to 1%, thus, there is plenty of scope for expectations to increase further from this level.
The key question is whether the latest wave of growth disappointments is just another soft patch on the road to a lasting recovery, or whether it is the start of a protracted downturn. Our sense is that it is the former, although we have taken some insurance by reducing our overweight equity position to a more modest overweight in anticipation of the traditionally weak "sell in May and go away" period.