After a strong start to the year, global investors have been spooked by a diverse combination of developments, including a slowdown in global economic activity, the threat of trade wars and uncertainty about the consequences of further rate hikes in the United States. The risk that these could tip the world into recession is of serious concern to emerging markets such as South Africa. Sandy McGregor makes sense of it all.
The first quarter of this year was characterised by a loss of momentum in economic growth almost everywhere. It is uncanny the extent to which regionally distinct economies acted seemingly in concert. The trend was more pronounced in some countries than in others, and there were few exceptions, notably India. However, comparing growth in the first quarter with the previous 12 months, the United States slowed from 2.8% to 2.2%, the euro area from 2.5% to 1.5%, Japan from 1.1% to -0.6% and China from 6.8% to 5.7%. After surging in the last quarter of 2017, South Africa’s economy contracted at an annualised 2.2%.
Subsequently growth in South Africa has accelerated again and predictions for the full year are more optimistic than the gloomy outcome of the first quarter. The US expansion also seems to be back on track. Such slowdowns are typical of any growth cycle and should not in themselves be a major reason for concern. However, this latest episode has served to remind investors that sooner or later all expansionary phases come to an end. Such concerns have been reinforced by other developments, which may disrupt the international economic order, seriously damaging business conditions.
The global trade framework
The century-long global expansion, which ended with the outbreak of World War I in 1914, was in part a triumph of free trade. Efforts to recreate the old order in the 1920s failed, and rising tariff barriers were among the most important causes of the Great Depression that followed. World trade contracted massively, and with the outbreak of World War II, almost ground to a halt. Serious efforts to re-establish a more rational and orderly trade system resumed in the 1960s. The outcome has been a triumph of international cooperation, especially after China joined the World Trade Organization in the early years of the last decade.
Increasing integration of the global economy has created general prosperity and an environment in which billions of people in emerging markets have escaped from poverty. While the process followed in constructing the framework of agreements which control global trade is cumbersome, and some countries have benefited more than others, a highly integrated global supply chain has been created. Multinational companies have dispersed manufacturing all over the world to optimally manage costs. As economic growth is largely a matter of making things cheaper, the outcome has been a widespread improvement in the standard of living conditions.
The advent of President Trump
US President Donald Trump now threatens this system. Whereas changes previously happened at a pace that allowed businesses to evolve without massive disruption, Trump wants big changes to take place immediately. To this end, he has bypassed established multilateral institutions in favour of bilateral negotiations, which seek to promote American interests alone. His negotiating tactic is premised on the proposition that it is unacceptable that some nations have significant trade surpluses with the US. These countries have been confronted with demands that they remedy the situation, and failing immediate compliance, their exports to the US are to be selectively subjected to additional tariffs of between 15% and 25%. Among the specific targets of his anger are Mexico and Canada, the US’s biggest trading partners and fellow members of the North American Free Trade Agreement (NAFTA). Trump wishes to rewrite NAFTA agreements, which he claims disadvantage the US.
Other targets are Europe and China. In the most recent 12-month period, Chinese exports to the US were worth US$446bn, while US sales to China were only US$133bn. The US current account deficit is US$466bn – equivalent to 2.6% of GDP, of which the Chinese trade deficit accounts for US$313bn. However, China’s aggregate current account surplus with all nations for the same period was US$121bn, or 1.1% of its GDP. With the rest of the world, it is in deficit. Of the major economic blocs, China’s trade with the rest of the world is closest to being in balance.
The euro area is running a current account surplus of US$486bn, but much of this is due to exports to Asia and other developing countries. There is a circular flow: The Chinese pay for imports from Europe through exports to the US. Global trade is truly integrated, which means disruptions at one point will have repercussions elsewhere.
The response of America’s trading partners
The initial response of the Chinese and Europeans to Trump’s demands has been to try to negotiate. However, they are finding that his unwillingness to compromise and talk rationally makes it hard to resolve issues. It is difficult to dismantle a global trade structure assembled over decades. Non-American manufacturing capacity established to supply the US market would be forced to close. The disruption will be compounded by the fact that the US lacks the capacity to rapidly redirect its domestic manufacturers to replace current imports.
Accordingly, America’s trading partners are left with only one response: Match US punitive tariffs with equivalent measures of their own in the hope that this will promote a more favourable negotiated settlement. General indignation has created an environment in which tit-for-tat retaliation could easily get out of control, with far-reaching adverse consequences. In surveys of US chief executives, 95% say that their biggest concern is the potential damage arising from trade wars. The equity markets are also reflecting these worries.
globalisation is probably too powerful a phenomenon to be derailed permanently by any one nation, even the United States
The inflation risk
The US has chosen a bad time to embark on a trade war. Its economy is operating at full capacity and wages are increasing significantly. It will find it difficult to rapidly replace imports with domestically produced goods. The likely outcome is that import volumes will remain largely unchanged, but will be priced upwards to compensate for higher tariffs.
The cost of the trade war will be borne by the US consumer. This is already being seen in aluminium and steel, which were the first targets of the Trump administration’s new tariffs. The US produces only 14% of its aluminium requirements domestically. Smelters in the Pacific Northwest have closed because it is more profitable to sell hydroelectricity, on which they were based, into the national grid. Almost half of the US’s aluminium requirements are supplied by Canada, which has abundant hydropower. There is no way that existing domestic smelters can close this gap. The premium at which aluminium trades in the US relative to the rest of the world has increased by about US$100. This cost flows through to the final buyers of a large number of products. The situation for steel is identical. As more and more tariffs are imposed, there will be a widespread rise in prices.
The monetary policy response
The US Federal Reserve’s Monetary Policy Committee is already concerned about the inflationary impact of an economy operating at full capacity. It is widely accepted that short-term interest rates of 2% are too low and will have to rise to about 3% over the next year. However, this projection is predicated on the assumption that inflation will be fairly well behaved. Anything such as a trade war, which sets off a major inflationary spiral, could put the Fed in an unenviable position. It will either have to put up rates much more than it plans, which could have seriously adverse consequences for housing and the bond market, or leave them too low, which will stoke the inflationary fires. This disruption could trigger a US recession that would spill over to the rest of the world.
Anxiety about these risks inevitably has an impact on the market prices of equities and bonds. The Trump administration dismisses such worries, but it is worth considering that the last time the unemployment rate was at its current level of 3.8% was in 1969, when the failure of the Fed to increase interest rates appropriately in an economy operating at or beyond full capacity set off an inflationary spiral, which lasted for a decade and was only brought to an end by the severe recession between 1980 and 1982. The forces of globalisation played a critical role in bringing inflation under control. The retreat of globalisation sought by President Trump could have the opposite effect.
President Cyril Ramaphosa has correctly identified foreign investment as a key component of any programme to getting the economy going again.
South Africa in an uncertain world
South Africa is a bystander which cannot influence these events, but for whom their outcome is profoundly important. Our major industrial export success, motor vehicles, is dependent on the continuation of the existing framework of global trade agreements. More immediately, concerns about trade and interest rates have caused significant selling by global investors of emerging market bonds and equities. This largely accounts for the current weakness of the rand. A further rise in US interest rates will reinforce these pressures. However, globalisation is probably too powerful a phenomenon to be derailed permanently by any one nation, even the United States, which, after all, only constitutes 22% of the global economy.
President Cyril Ramaphosa has correctly identified foreign investment as a key component of any programme to getting the economy going again. An internationally focused business sector, promoting activities such as trade with Africa, agriculture and tourism, offers the most hopeful immediate opportunities.
The failure of our economy to gain any traction from the considerable improvement in business confidence following the outcome of the December 2017 ANC conference is concerning and speaks to the severity of the challenges the country faces. In particular, the outcome of the current debate within the ANC on land reform will be a critically important determinant of whether, in an increasingly uncertain world, there will be sufficient confidence to make the investments required to put South Africa on a sustainable growth path.