Trade war: Biggest risk to global financial markets

South Africa’s financial markets have had a tough year so far. At the close of trade on 12th October the JSE All Share Index had lost -10.14% year-to-date and the ZAR/$ had depreciated -14.74%, according to to Overberg Asset Management (OAM).

We are not alone.

In its weekly economic and market overview, OAM noted that the MS World Index lost -1.90% and the MS Emerging Market Index -15.40%.

"As the most liquid emerging market, our currency, equities and bonds ebb and flow in tune with global markets, this begs the question, what is driving global markets?"

According to a survey by the Bank of America Merrill Lynch, US fund managers indicates a sharp decline in investor confidence.

"60% of fund managers cited a trade war as the biggest risk to global financial markets, the highest allocation to any single risk since the Eurozone sovereign debt crisis in 2012."

As a result, the World Economic Outlook the IMF flagged increased risks to global growth posed by intensifying trade wars, leading it to cut its global growth forecast for this year from 3.9% to 3.7%. 

South Africa economic review

• Growth in manufacturing production slowed in August to 1.3% year-on-year from downwardly revised growth of 2.8% in July. On a month-on-month basis manufacturing production grew by a slender 0.1% compared with 1.4% in July, although July’s numbers were flattered by there being extra working days in the month. Besides the iron and steel sector where output growth increased from 1.1% on the year to 2.1%, there was a broad-based slowdown across manufacturing sectors.

The biggest culprits were motor vehicles where growth slowed from 8.2% to 1.3% on the year and the food and beverages sector, which slowed from 5.8% to 3.3%. Fortunately, the slowdown in manufacturing growth is not nearly as bad as indicated by the ABSA/BER manufacturing purchasing managers’ index (PMI), which fell in August from 43.4 to 43.2, deeper into sub-50 contractionary territory and its lowest since June 2017.

The PMI was likely affected by sentiment surrounding land expropriation rather than hard fundamentals. Given the positive contributions in July and August, manufacturing production would have to contract in September by at least 4.0% on the year, for the sector to make a negative contribution to GDP growth in the third quarter (Q3). This seems unlikely, which bodes well for the economy pulling out of recession in Q3.

The week ahead

• Retail sales: According to consensus forecast, retail sales growth is expected to have slowed in August to 0.5% year-on-year from 1.3% in July. While the public-sector wage settlement earlier in the year will have boosted household disposable income, consumer confidence is being undermined by weak jobs growth and rising fuel prices.

• Mining production: According to consensus forecast, mining production is expected to have contracted in August by 4.0% year-on-year. While a slight improvement on the 5.2% contraction in July, the mining industry has been beset by regulatory uncertainty, infrastructure bottlenecks and falling international commodity demand. However, the weaker rand would have helped to compensate for falling dollar-based commodity prices.  

Technical analysis  

• The spike in the rand/dollar rate to R15.50/$ in the first week of September may mark the peak in the currency’s recent decline.  

• The rally in the US dollar index has reached its medium-term goal suggesting a correction from current levels. The dollar remains below a major 30-year resistance line suggesting the bull run in the dollar may be over.

• The British pound has broken back below key resistance at £1.35/$ suggesting a trading range of £1.30/$ to £1.35/$. The £1.28/$ level is expected to provide strong resistance.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield has broken above resistance at 3.0% and 3.20%, paving the way for a new 3.20% to 3.30% trading range. However, any further move highly is likely to meet stiff resistance, especially at the key 3.50% level.  

• The benchmark R186 2025 SA Gilt yield has spiked higher to 9.30% but is expected to meet stiff resistance at this level, limiting any further likely upside. The R186 may retrace a portion of its upward move taking the yield back to the 8.80% level and thereafter 8.60%.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.  

• The Brent oil price has decisively broken above key resistance at $80 per barrel, opening-up the $100 level, which just two months ago seemed far-fetched. However, any spike higher to the $100 level is likely to be short-lived, a blip rather than the start of a sustainable trend higher.

The outlook for base metals prices is less certain after the copper price retreated sharply from the key $7000 per ton level. A decisive break below $6 000 per ton would herald a bear market in copper and base metals’ prices.

• Gold has developed an inverse “head and shoulders” pattern, which indicates a price recovery and a test of the $1 400 target level.

• Despite the consolidation since the start of the year the break in the JSE All Share index above the key resistance level of 60 000 in December signals the early stages of a new bull market.

Bottom line 

• South Africa’s financial markets have had a tough year so far. At the close of trade on 12th October the JSE All Share Index had lost -10.14% year-to-date and the ZAR/$ had depreciated -14.74%. We are not alone. The MS World Index lost -1.90% and the MS Emerging Market Index -15.40%. As the most liquid emerging market, our currency, equities and bonds ebb and flow in tune with global markets. This begs the question, what is driving global markets?

• A Bank of America Merrill Lynch survey of US fund managers indicates a sharp decline in investor confidence. 60% of fund managers cited a trade war as the biggest risk to global financial markets, the highest allocation to any single risk since the Eurozone sovereign debt crisis in 2012.

In the update of its World Economic Outlook the IMF flagged increased risks to global growth posed by intensifying trade wars, leading it to cut its global growth forecast for this year from 3.9% to 3.7%.

• The IMF forecasts total global trade volume will grow by 4.2% this year and 4.0% next year, down from its previous respective forecasts of 4.8% and 4.5%. These are still heady growth rates though. It appears the fundamentals are not nearly as bad as the souring in sentiment would suggest. Let’s look at the fundamentals.

So far, the US has raised tariffs on around half of all Chinese imports. China has retaliated. However, since it imports less from the US than it exports it will have to resort to other measures if, in the worst-case scenario, the US raises tariffs on all Chinese imports. China is likely to restrict sales of materials, equipment and other components which are key to US manufacturers’ supply chains. China may also punish the US indirectly by reducing tariffs on imports from its other trading partners.

• The US-China trade war headlines may be dramatic but the expected impact on aggregate global demand for goods will be minimal. The price elasticity of demand for much of China’s trade with the US is quite high. This means the quantity demanded is likely to adjust by less than the adjustment in price.

In any event, if buyers are put off by the resulting price increase, they will look elsewhere. Trade will be redirected. Besides, the yuan’s 10% depreciation versus the dollar since its peak earlier in the year largely mitigates much of the price adjustment.

• Fortunately, despite the US-China trade war, trade elsewhere is steadily becoming freer. Following four years of negotiation the EU and Japan, the world’s second and fourth largest trading blocs, concluded a historic bilateral trade deal in July. The trade deal creates the world’s largest free trade pact covering about a third of global GDP. The trade deal extracted significant concessions from both sides and comes as a welcome counterbalance to growing US trade protectionism.

Encouragingly, the NAFTA agreement has been successfully renegotiated with minimal increase in protectionism. The biggest change appears to be in the name, now known as the United States-Mexico-Canada Agreement (USMCA).

Meanwhile, President Trump and European Commission President Jean-Claude Juncker have pledged to work together to negotiate towards a broad reduction of tariffs. The temporary trade truce between the US and EU signals a de-escalation of the trade conflict amid broadening resistance from US businesses and Republican politicians.

• Provided the trade war does not spread beyond the US and China, which seems unlikely given positive developments elsewhere, the effect on global trade and global GDP will be negligible. The effect on China and the US will also be mild.

With steady growth in domestic demand, China depends less on exports for its GDP than it used to, now less than 20% of GDP compared with around 50% as little as 20 years ago. China’s exports to the US account for an estimated 2.5% of its GDP while US exports to China account for as little as 1% of its GDP.

• Although certain industrial sectors will undoubtedly be impacted the global macro-economic effect will be far less than indicated by prevailing negative sentiment. The risks are exaggerated and over-priced, creating an attractive buying opportunity. Fundamentals always reassert themselves. 

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* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

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