Coffee table economics with Anchor

Anchor’s coffee table economics note by Casey Delport will be distributed intermittently and is a collection of Casey’s opinions on key economic factors and events shaping markets globally and in South Africa (SA). It is essentially Casey’s thoughts and perspectives on the multiple dynamics at play in the global and local economy.

Executive summary

In this week’s edition, we highlight the following:

  • The US Federal Reserve (Fed) and the European Central Bank (ECB): A tale of two cities? Central banks continue to dominate the global discourse, with the US Fed and the ECB hiking their respective key policy interest rates by 25 bps. However, whereas the Federal Open Market Committee (FOMC) gave the first signal that it was close to pausing the hiking cycle, commentary from the ECB suggested that further tightening is the most likely path ahead.
  • Regional US banks are seemingly toppling over quicker than the rhythm of Queen’s Another One Bites the Dust. US regulators recently seized First Republic Bank and sold most of its assets to JPMorgan Chase, the country’s largest bank. This particular US government-brokered acquisition is the latest in a series of bigger banks swallowing failing, smaller banks at a discount. At the end of the day, there is no easy solution to the current problems facing the US banking sector, which may explain why the likes of the Fed and other key regulatory institutions are reticent to push any particular plan or ‘solution’ thus far, other than providing banks access to Fed liquidity.
  • Time for Sub-Saharan Africa (SSA) to tighten the belt amid a funding squeeze: Like many other emerging market (EM) economies, SSA countries face a challenging global environment with sluggish growth and tightening global financial conditions. However, more specifically for the SSA region, the current boiling pot of higher global interest rates, high sovereign debt spreads, and exchange rate depreciations (amongst other factors) has created a ‘funding squeeze’ for many African economies.

 

 The US Fed and the ECB: A tale of two cities?

Central banks continue to dominate the global discourse, with the US Fed and the ECB hiking their respective key policy interest rates by 25 bps, matching market expectations. However, whereas the FOMC gave the first signal that it was close to pausing the hiking cycle, commentary from the ECB suggested that further tightening is the most likely path ahead. If we look at the Fed specifically, this latest hike forms the tenth interest rate hike in a little over a year. Moreover, the hike puts US interest rates above 5% for the first time since 2007, as stubborn inflation has prompted the Fed’s fastest series of rate increases since the 1980s. However, this particular tale may soon be coming to an end.

Contrary to previous post-meeting statements, this latest one did not mention that “additional policy firming may be appropriate,” as in previous statements. As such, economists and market participants alike are hopeful that this revision to the Fed’s language, coupled with recent slowdowns in inflation and hiring, may indicate an upcoming pause in rate hikes. Whilst eager investors typically read a lot into any minor update, this time, even Fed Chair Jerome Powell acknowledged it was a “meaningful change” when asked about it at a press conference. Still, it is not all sunshine and roses – Powell also made it clear that he will keep doing whatever he thinks is necessary to tame inflation. Therefore, for the Fed to change the narrative of this particular story, inflation needs to keep slowing. Furthermore, whilst the Fed noted that it considers the US banking sector stable, tighter credit conditions for households and businesses will likely weigh on economic activity. Indeed, economic growth appears to be showing some early signs of slowing. A preliminary estimate showed that US GDP expanded by 1.1% QoQ annualised in 1Q23, down from 2.6% in 4Q22 and below market expectations of 2% growth. Business investment growth also slowed, and inventories declined. Conversely, consumer spending rose by 3.7% QoQ, while net exports also contributed positively to GDP. In addition, despite slowing economic growth, the US labour market remains tight. In April, non-farm payroll employment rose by 253,000, well above market forecasts of a 180,000 gain. On the wage front, average hourly earnings rose by 0.5% MoM – the fastest pace in nine months. So, despite some tentative early signs that the US economy may be cooling, the average US consumer remains strong.

Across the Atlantic, the ECB’s latest rate hike of 25 bps was a notable slowdown following three consecutive 50 bps increases. However, in comparison to the Fed, ECB President Christine Lagarde stated that price pressures were still a concern and that, simply put, a pause in rate hikes would not happen anytime soon. It is also worth noting that some ECB policy committee members still favoured a 50 bps rate hike.

Inflation in the eurozone (EZ) is indeed proving somewhat sticky. A preliminary estimate showed that consumer inflation ticked up to 7% YoY in April. Core inflation (excluding the volatile categories of food and energy) edged down to a still-elevated 5.6% YoY after a record high of 5.7% YoY in March. On a monthly basis, consumer prices rose by 0.7%. From the ECB’s standpoint, at this stage, stubbornly high inflation is overshadowing concerns about slowing economic activity. No end on the horizon to this particular hiking saga, then.

The bottom line

For the ECB, relative to March, this latest interest rate decision was taken under calmer circumstances, the banking sector turmoil having (so far at least) not spilt over into eurozone banking institutions. Growth has matched expectations; the labour market has stayed strong; underlying inflation is still elevated; and although ‘forceful’ transmission of the ECB’s tightening was seen in terms of higher interest rates for households and firms, the ‘real economy’ response to that (i.e., the second leg of transmission) was yet to be seen, despite some signals of lower loan demand in the latest bank lending survey. Although the policy is now restrictive, the ECB has not yet deemed it ‘sufficiently’ so. For now, there are more rate hikes on the cards.

For the US, the unemployment rate remains low, and job growth remains positive. However, labour costs, in terms of wages and benefits, continue to grow, and whilst inflation is still above the Fed’s 2% target, it has slowed over the past year. Furthermore, inflation will likely keep coming down with all the rate hikes the Fed has already implemented (not to mention the recent failures of three US banks, which forced financial institutions to raise their lending standards). Nonetheless, the Fed will still have to keep a close eye on the labour market as it tries to bring down prices without creating a recession. Looking ahead, if current trends continue, we may have seen the last interest rate hike for now. However, the story has not quite reached its conclusion – Powell made it clear that it is too soon to start thinking about rate cuts.

 

Another one bites the dust.

Regional US banks are seemingly toppling over quicker than the rhythm of Queen’s Another One Bites the Dust. US authorities recently seized First Republic Bank and sold most of its assets to JPMorgan Chase, the country’s largest bank. First Republic Bank’s collapse marks the second-biggest banking failure in US history, topping Silicon Valley Bank’s (SVB) collapse in March. Like SVB, First Republic is a mid-sized California-based lender with a specific client base (in this case, wealthy individuals) that exposed it to the shockwaves of the recent banking turmoil. First Republic tried to weather the storm itself, but after customers withdrew more than US$100bn in deposits in 1Q23 – sending its share price down yonder- the US government was forced to step in. Nevertheless, by quickly finding a willing buyer, the government managed to avoid the costly tactic it had to deploy for SVB – protecting deposits over the federally insured cap of US$250,000. JPMorgan said it would assume First Republic’s US$92bn in deposits, which is a welcome outcome since SVB depositors cost the Federal Deposit Insurance Corporation’s (FDIC) deposit insurance fund about US$20bn.

The downfall of several regional US banks so far has probably been seen by most as a consequence of bad management and swift deposit flight. There are, of course, other theories surrounding their difficulties – some crazier than others. Regardless, we are still a world away from the global financial crisis (GFC) of 2008. Back then, wholesale funding was a problem for the firms that went under, such as Bear Stearns and Lehman Brothers. Today, rapid deposit flight is creating much of the funding strain. In 2008 the solution was to make investment banks ‘real’ banks so that they could get access to the Fed’s lender-of-last-resort facilities. But this does not apply now as regional banks already have access, helped by the Fed’s latest Bank Term Funding Program (BTFP).

The question is, then, what solutions are currently being drummed around? The latest beat seems to be blanket deposit insurance on either a temporary or permanent basis. However, there is a big moral hazard problem in guaranteeing deposits. Many investors will argue that the banks that have failed so far had already shown signs of recklessness, not borne from the insurance of all deposits, of course, but rather the easier regulatory environment for many in recent years and the fact that banks have been artificially flush with deposits (these have risen sharply during the period of the Fed’s quantitative easing). In other words, some banks have already shown signs that moral hazard issues could be problematic under a blanket guarantee of all deposits. Better supervision and stricter regulation are other potential solutions, but that is more of a long-term play.

The bottom line

This particular US government-brokered acquisition is the latest in a series of bigger banks swallowing failing, smaller banks at a discount. First Citizens Bank collected the scraps of SVB, New York Community Bank snatched up assets of Signature Bank, and UBS absorbed crosstown rival Credit Suisse. At the end of the day, there is no real easy solution to the current problems facing the US banking sector, which may explain why the likes of the Fed and other key regulatory figures are reticent to push any particular plan or ‘solution’ thus far, other than providing banks access to Fed liquidity. However, as more regional banks continue to metaphorically bite the dust, it has become clear that the rhythm of recovery needs to change, with regulators and policymakers stepping in to ensure a stronger and more resilient banking sector for the future.

 

Time for Sub-Saharan Africa to tighten the belt amid a funding squeeze

Like many other EM economies, SSA* countries face a challenging global environment with sluggish global growth and tightening global financial conditions. However, more specifically for the SSA region, the current boiling pot of higher global interest rates, high sovereign debt spreads, and exchange rate depreciations (amongst other factors) has created a ‘funding squeeze’ for many African economies. This challenge comes in addition to the still present policy strains stemming from the ramifications of the COVID-19 pandemic and the cost-of-living crisis amid a heightened global inflationary environment.

Furthermore, uncertainty and general volatility surrounding the continent have been steadily pushing higher since the onset of the global COVID-19 pandemic and Russia’s war on Ukraine. This, in turn, has led to risk repricing, disproportionately affecting SSA countries due to lower credit ratings, cutting off virtually all frontier markets from international market access since 2H22. Unsurprisingly, eurobond issuances for the SSA region declined from US$14bn in 2021 to US$6bn in 1Q22. As a result, there has been a drastic and pro-cyclical tightening of financing conditions, which has exacerbated underlying vulnerabilities. Furthermore, borrowing costs have increased significantly over the past decade, with interest payments as a share of revenue doubling over the same period. At 11% of revenues (excluding grants) for the median SSA country in 2022, interest payments are about triple those of the median advanced economy. Structural shifts behind this increase in borrowing costs include a decline in aid budgets to the region, leading some countries to turn to market-based finance, which is generally more expensive. In addition, inflows from China (an important source of financing for many SAA countries in recent years) have started to decline markedly.

This ‘financing squeeze’ comes at a difficult time for the SSA region, as it faces various elevated economic imbalances. In the wake of the COVID-19 pandemic and Russia’s war on Ukraine, macroeconomic imbalances have again risen to the forefront as a critical challenge for most African economies – pushing some close to the edge. An elevated and volatile inflationary environment is one of the key culprits – the median inflation rate in the region was c. 10% in February 2023, more than doubling since the start of the pandemic. Furthermore, aside from registering double-digit headline inflation in roughly half of the countries in the region, about 80% are also experiencing double-digit food inflation. However, positively, fuel price pressures have decelerated recently off the back of more muted international prices. This should, in turn, provide some relief for the region. According to the IMF, around half of the countries in SSA have reported a deceleration in inflation over recent months. Nevertheless, there are some resurgences along with some economies phasing out some subsidies on fuel and food prices this year (i.e., Cameroon, Ethiopia, Senegal). As a result, we believe inflation across the region will likely remain volatile for the remainder of 2023.

The bottom line

 Policymakers and investors in SSA face another challenging year, with tighter financing conditions on top of the ongoing repercussions from various economic multi-year shocks. It is common knowledge that fiscal policy anchored in debt sustainability can help fight inflation. Thus, for most SSA economies reducing fiscal and debt sustainability risks via domestic resource mobilisation and greater spending efficiency can help cool aggregate demand and inflation. This includes measures to increase and diversify the tax base, improve tax administration and enhance the targeting of social protection programmes. In addition, reforms to strengthen public investment management systems (i.e., increasing transparency in appraisal, selection, and approval of investment projects) and repurposing government spending toward high-value investments remain key. Furthermore, accelerating debt reduction and restructuring debt is critical to shore up stability for growth. If anything, the past few years have shown that the international community needs permanent, comprehensive, and credible mechanisms to address sovereign debt crises when they occur.

The G20 Common Framework for Debt Treatments (CF) is the closest said framework for debt resolution. So far, four countries in the SSA region are seeking debt restructuring via the CF – Chad, Ethiopia, Zambia, and, more recently, Ghana. Chad is the only country that has negotiated an agreement with its creditors under this initiative, albeit without an actual debt reduction. Overall, leveraging concessional financing remains critical for Africa amid a challenging external environment, high debt levels, limited capacity to mobilise domestic resources and weak public investment management systems. Given the continent’s rising investment needs (including climate financing for adaptation), private and non-concessional lending will be needed to close the financing gap.

*SSA countries are Angola, Benin, Botswana, Burkina Faso, Burundi, Cameroon, Cape Verde, Central African Republic, Chad, Comoros, Congo, the Democratic Republic of the Congo, Côte d’Ivoire, Djibouti, Equatorial Guinea, Eritrea, Kingdom of Eswatini, Ethiopia, Gabon, Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mauritius, Mayotte, Mozambique, Namibia, Niger, Nigeria, Rwanda, São Tomé and Príncipe, Senegal, Seychelles, Sierra Leone, Somalia, South Africa, South Sudan, Sudan, Tanzania, Togo, Uganda, Zambia, Zimbabwe.

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