Economic and financial markets review

“Economic activity in South Africa mainly followed global developments. After a surprisingly buoyant first quarter, emulating the sharp recovery in the global manufacturing sector, economic growth slowed markedly in the second and third quarters with the Soccer World Cup providing only a brief spurt in spending.” 


The past year was somewhat of a roller-coaster ride, with assessments of the outlook for the global and domestic economies being repeatedly revised. Sentiment fluctuated between optimism and pessimism, depending on whether the news flow at the time was positive or negative. Unfortunately the future remains as unpredictable as it was 12 months ago, inter alia because so much depends on decisions to be taken by politicians and policymakers, which are difficult to predict.

One should nevertheless not overlook the progress that has been made in coming to grips with the international financial crisis, although its consequences will remain with us for many years to come. Perhaps, more importantly, the financial markets have been on a steep learning curve in analysing and interpreting the crisis, and they have now reached a point of greater balance and calm in assessing risk. Although this does not make the issues at stake less serious, markets now have better insight into the willingness and ability of political and policy institutions to deal with them, even if in an imperfect way. 
The difference in the response of financial markets to the Greek sovereign debt crisis in May and the recent Irish crisis, in spite of much more serious contagion possibilities in the case of the latter, is striking. While markets reacted sharply negatively in May, with world equity prices declining by approximately 16% from peak to trough in the second quarter and the VIX volatility index shooting up from 15 to 45 index points, the increased risk appetite that has become evident since mid-year has hardly been dented. On the face of it, markets appear to have become more confident regarding the outlook for economic growth, with US equity prices returning to their pre-crisis level in November.

The core event of 2010 was the developing sovereign debt crisis in the Euro zone periphery, bringing with it the possibility of a second leg to the global banking crisis emanating from European banks' exposure to credit-impaired sovereign bonds. Policy steps by European governments and the ECB initially allayed the fears regarding a possible Greek debt default, and the results of stress tests conducted on European banks helped to confirm confidence in the European banking system. However, the subsequent problems in Irish banks that had previously passed the stress tests have confirmed the initial scepticism regarding the stringency of the tests. The European policy response has unfortunately been characterised by doing too little too late.

The high probability of sovereign debt restructuring in some of the peripheral countries in the near future, resulting in substantial losses for the holders of the affected government bonds, implies that it is too soon to become complacent. However, if the bonds in question have been marked-to-market by their holders, the recent sharp increase in their yields should mean that a large part of the losses will already have been priced in.

The latter half of 2010 also witnessed increased international tension around the problem of unresolved imbalances in the global economy, with some countries being accused of being involved in so-called "currency wars". The tit-for-tat between the US and China as to who is manipulating its currency remains unresolved, with the US objecting to China's policy of aggressive foreign reserve accumulation and China in turn expressing its dissatisfaction with the US's announcement on further quantitative easing. Other emerging market currencies, including the rand, appreciated sharply in response to increased capital flows to emerging markets. The inability of the G20 to resolve the issue of global imbalances has resulted in increasing risk of the adoption of protectionist measures that would set back global growth prospects.

The sharp fall in global economic activity after the breaking of the financial crisis has been followed by an equally sharp rebound, although not back to previous levels. A protracted period of "muddling through" probably still lies ahead in the developed world while the extensive set of legacy issues from the financial crisis is being dealt with. Although the possibility of a so-called "double dip", i.e. a second recession following close on the heels of the first one, gained some support after the initial recovery in economic activity started losing momentum, it remains unlikely.

Emerging-market countries have continued to perform strongly and in some cases had to start tightening policy to counter inflationary pressures. They stand to outperform developed countries for a prolonged period, and risk perceptions have been turned on their head by their obviously better economic fundamentals.

Economic activity in South Africa mainly followed global developments. After a surprisingly buoyant first quarter, emulating the sharp recovery in the global manufacturing sector, economic growth slowed markedly in the second and third quarters with the Soccer World Cup providing only a brief spurt in spending. Industrial action played an important role in cutting back growth in the secondary and tertiary sectors in the third quarter. However, it will not prevent the economy from recording 2,8% growth for the calendar year due to a low base in 2009, with real final consumption expenditure by households making the biggest contribution.

In spite of heavy job losses due to the economic downturn, the trend in real disposable income has turned positive, with relatively high wage and salary settlements supporting a year-on-year increase of approximately 4,5%. Other supporting factors for household finances have been the recovery in net wealth, the decline in debt service costs in the wake of further reductions in the Reserve Bank's repo rate, and declining inflation that slowed the erosion of real purchasing power. However, household debt levels remained elevated, unlike during previous downturns when households sharply reduced debt.

The exchange rate of the rand received a boost from increased capital flows to emerging markets. Unlike on previous occasions, there are indications that these flows are of a sustainable nature rather than being pure "hot money" flows. The support the exchange rate has received from strong commodity prices, and therefore improving terms of trade, should also not be underestimated.

The persistent strength in the exchange rate of the rand (the nominal effective exchange rate appreciated by 12% during 2010) has played an important role in lowering inflation from 6,3% at the start of the year to a low of 3,2% in September, measured by the consumer price index, in spite of rising unit labour costs. This has enabled the Reserve Bank to take greater cognisance of the sluggishness of the economic recovery, reducing its repo rate by a further 1,5 percentage points during the course of the year to its lowest level in 30 years in response to repeated positive surprises on inflation. However, inflation is likely to have bottomed for now. Apart from the effect of rand strength fading, food inflation poses the risk of accelerating in 2011 from a low base. It is likewise likely that the repo rate has reached its lowest turning point, in addition to fiscal policy becoming less expansionary.

Long-term bond yields followed inflation and the repo rate downwards, with the 10-year generic government bond yield declining by approximately 1 percentage point to 8,25%, in line with global trends. The JSE All Share Index was by and large range-bound up to August, fluctuating between 26 000 and 29 000 index points. However, it subsequently caught on to the improvement in global risk appetite, displaying an 18% jump in line with the increase in the global emerging market index. At current levels it is deemed to be fully valued.

The year 2011 should see a further improvement in growth to 3,5% with household consumption leading the ongoing recovery, followed by a turnaround in capital spending by the business sector. A gradual worsening in the current account deficit is therefore to be expected, which could help to bring the rising trend in the exchange rate to an end.

Although not buoyant, business conditions for financial services promise to be underpinned by a steadily improving economic and financial background in 2011.