WALTER DE WET: US recession could mean an even weaker rand

The recently released minutes from the US Federal open market committee  meeting of May 3 and 4, during which the Federal Reserve (Fed) funds rate was increased by 50 basis points, suggested there was general agreement among committee members that another 50 basis point hike will be necessary at both the June and July committee meetings.

If these rate hikes materialise it will put the upper end of the Fed funds target rate at 2%. The minutes cited inflation that is too high amid a tight labour market as the main driver for this hawkish stance. At the same time the SA Reserve Bank raised the repo rate by 50 basis points at the May monetary policy committee meeting, in the face of what the Bank described as upside risk to its inflation forecast.

Fighting inflation is of primary concern for most central banks right now, and for good reason; growth concerns are secondary. In fact, central banks are hiking into a global growth slowdown, specifically in China and the US. Our own indicators suggest a recession in the US remains a real possibility in early 2023, partly driven by a market pricing in aggressive Fed tightening, falling US consumer confidence and high oil prices.

In China, Covid-19 lockdowns in big cities have knocked the growth outlook, and locally higher fuel prices are becoming a drag on growth. For SA we expect growth of 1.8% year on year in 2022, down from the forecast 2% at the start of the year, while the Bank expects annual GDP growth at 1.7%, revised down from 2% in March.

When global growth slows sharply and the US goes into recession it has implications for SA markets too. While local markets will not react exactly the same way to each slowdown, there is a general stylised blueprint that can be used as a starting point of what to expect.

Market moves tend to start with the currency. When global growth slows sharply emerging market currencies, including the rand, tend to experience weakness as risk aversion rises. Though we would associate some of the recent rand weakness and dollar strength with this slower global growth narrative, we believe the currency is not fully reflective of a US recession yet, and more weakness is likely should a recession materialise.

Furthermore, a weaker rand tends to see inflation higher, and a monetary policy response follows. This leads to a rise in short-term interest rates that extends beyond what was originally expected (this is different from the recession in 2020, where the complete collapse of economic activity because of lockdowns allowed central banks to ease as inflationary pressures collapsed overnight).

Bond yields

Bond yields also come under pressure, and initially the rise in longer-dated bond yields tends to be larger than the rise in shorter-dated yields, resulting in an initial bear steepening of the yield curve. Fortunately, all of these moves tend to reverse after a few months as market conditions settle and the growth outlook bottoms.

Is it possible that local markets will behave differently if the US goes into recession? We are reluctant to assume that this time is different, but that possibility exists. Already an obvious difference now compared to previous US recessions this century is that SA runs a current account surplus, which may protect the rand better from a sharp sell-off. This could also see bond yields react less.

That said, we remain cognisant that there was a strong belief that commodity prices will remain high in 2007, until a deep recession pushed commodity prices lower. This could turn a strong trade surplus into a deficit, especially if oil prices do not see a big decline. In fact, the oil price’s performance is noteworthy considering that part of the Chinese economy has been in lockdown, many other economies are seeing slower growth and the US has released substantial volumes of oil from its strategic reserves — and still oil is trading well above $100 a barrel.

Fortunately for SA, the higher inflation that is driven in part by higher oil and commodity prices has been positive for the country’s fiscal position. The new fiscal year has only recently started, but our estimates already suggest that despite weaker growth expectations for 2022 corporate income tax revenue is likely to exceed the estimate the National Treasury pencilled into the 2022 budget in February.

While precious metals are a key driver of the corporate tax revenue upside, higher energy prices are also likely to increase tax receipts. VAT revenue could also surprise on the upside as higher inflation expands the tax base at a faster pace than expected. The upside bias is likely to remain even if consumer spending comes under pressure from higher oil prices.

Our current estimates suggest that the main budget deficit may well be closer to 5.2% of GDP rather than the 6% projected for 2022/2023 in the budget. This could provide the Treasury with some much-needed fiscal flexibility to provide temporary relief measures such as a reduction in the fuel levy. Unfortunately, this fiscal flexibility remains limited and is likely to be temporary.

• De Wet is senior research strategist at Nedbank CIB Markets Research.