By Reza Hendrickse, Portfolio Manager at PPS Investments.
Global economic expansion fell out of sync this year unlike the previous two years as global growth appeared to have plateaued. This is evident in Q3 where the performance has been less than spectacular.
Growth rates in Europe and Japan have settled at anaemic levels. In the US, tighter monetary policy has been offset by tax cuts and increased government spending, causing a mini boom.
The International Monetary Fund’s (IMF) latest World Economic Outlook trimmed its global growth forecasts for 2018 and 2019 to 3.7% respectively per annum. This is 0.2% lower than its previous estimate.
The IMF also cut its South African growth forecast for 2018 to 0.8% (from 1.5%) and trimmed its 2019 projection to 1.4% (from 1.7%). This echoes downward revisions by both the World Bank and the South African Reserve Bank (SARB), following two successive and unexpected weak quarters of negative gross domestic product (GDP) growth. With SA officially in a technical recession, the SARB now expects growth of 0.7% for 2018.
All of these occurred as prominent global themes from previous quarters – trade tensions, emerging market pressures and flashbacks of the Greek crisis – persisted.
Interestingly, it was also a decade ago when Lehman Brothers, the fourth-largest investment bank in the United States at the time, filed for bankruptcy in September 2008. This marked the start of the global financial crisis.
Some of the key highlights for Q3 2018 were:
- Global equities were the best performing asset class – the US’s strong performance resulted in developed markets strengthening 5.1% and outperforming emerging markets, which were down 0.9% for the period.
- South African stocks failed to participate in buoyant global equity market conditions with the FTSE/JSE Capped SWIX Index declining 1.7%. Financials and resources gained 4.2% and 4.6% respectively, however these were offset by the 8.2% fall in industrial stocks.
- Emerging market underperformance in recent months left many vulnerable. Rising US interest rates and the strengthening dollar also led to concerns.
- Industrial stocks fell significantly – Naspers fell 11.0% this quarter (tracking Tencent’s 18% decline) and weighed down on industrial stocks. MTN (-25%) and Aspen (-36%) also posted declines.
- Domestic interest-sensitive assets posted muted returns – the All Bond Index (ALBI) gained 0.8% and the SA Listed Property Index lost 1%. SA bonds strengthened in early Q3 but retreated during a broader emerging market selloff with the yield on the R186 (SA’s 10-year benchmark government bond) rising to a high of almost 9.5%. SA bonds (4.8%) have underperformed cash (5.1%) so far this year while SA Listed Property (-22.2% year to date) has yet to experience any material bounce since the steep Resilient-driven selloff earlier this year. It is still the worst performing asset class for the year to date.
- Offshore interest-sensitive asset classes delivered muted hard currency returns. Global listed property was roughly flat in dollar terms this quarter, but outperformed global bonds, which lost 1.2%. Dollar strength provided a further 3.2% boost to these returns when converted into rand. The yield on the US 10-year treasury climbed to 3.1% at quarter end. The higher long bond yield has created a pause in the flattening of the US treasury yield curve with the recent steepening potentially indicating continued resilience in the US economy.
- Domestic inflationary pressures in SA increased owing to the weaker rand, higher oil price, higher VAT rate, higher electricity prices as well as higher municipal rates. Fortunately, lower food price inflation has offered respite and as a result the consumer price index (CPI) remains contained with inflation at 4.9%. Inflation expectations are around 5.3% for 2018 and 5.6% for 2019/20.
- The SARB’s Monetary Policy Committee kept interest rates unchanged during the third quarter.
The resignation of Nhlanhla Nene as Finance Minister and former SARB governor, Tito Mboweni, taking over the reigns has seen the market responding favourably.
Mboweni’s Medium-Term Budget Policy Statement included stabilising and reducing government debt, which requires deferring current consumption and creating an environment that promotes investment to facilitate growth.
The Finance Ministry halved its SA growth forecast from 1.5% to 0.7% but expects growth to reach 2.3% in 2021. This pales in comparison to other developing countries where the growth rate is almost 5% per annum. For this reason, President Ramaphosa recently announced stimulus measures. The plan is not as bold as stimulus measures seen abroad, but it is a step in the right direction.
We anticipate that the global economy as well as South Africa will continue to muddle through.
Managing portfolios in an economy out of sync
During the quarter, we upgraded South African bonds to ‘neutral’ when the 10-year yield rose above 9% to a level not often seen during the past 15 years. With inflation currently around 5%, bonds offer a compelling real yield of roughly 4%. We have deliberately not advocated an ‘overweight’ position at this point as we’re cautious about the current interest rate cycle. In addition, there’s the lingering risk of a sovereign credit ratings downgrade. We would treat any significant selloff as an opportunity to upgrade bonds to ‘overweight’ at attractive real yields.
We remain negative on the outlook for global bonds. The multi-decade bond bull market has potentially ended, with US treasury yields having risen above 3%, and poised to continue rising over the coming years. Outside of the US, developed market bond yields and interest rates remain at unattractively low levels. Bonds could however temporarily regain some appeal in a global risk off event or a flight to safety. For now, we prefer to achieve global interest rate exposure via global listed property, a small amount of US cash, or a mix of the two.
We remain constructive on equities in our house view and maintain a preference toward global over local equity exposure. While the SA market is currently held back by weak demand and generally difficult macroeconomic conditions that do not bode well for above average earnings growth, we acknowledge that SA stocks have de-rated and become cheaper. Nevertheless, for now we still prefer to access the better prospects and wider opportunity set that offshore equity markets have to offer.
From a valuation perspective, global equities are currently less attractively priced than in SA – skewed by the US – which is one of the more expensive markets offshore. The US is however one of the few markets where growth remains robust and where a higher rating could perhaps be argued for (though cyclically high profit margins do pose a risk). Regardless, US stocks currently trade at around 16 times forward earnings and are roughly on par with their 10-year average, which at face value is not particularly excessive.
The current macroeconomic climate offshore remains supportive of global equities though risks have increased over the course of the year. Global growth is reaching a plateau and ultra-simulative policy is being scaled back with monetary conditions being guided toward more normal levels. This is creating some anxiety and increased volatility, which the market has needed to re-acquaint itself with after a prolonged period of extremely low volatility. Other risks include the trend towards economic protectionism and self-interest and the threat of a full-blown trade war, which poses a material threat to the global growth backdrop.
Taking all this into account, we have not yet been of the view that down-weighting equities is appropriate at this stage, but we remain flexible in our assessment. When called for, any down-weighting would be measured, as we will rarely underweight on equities recognising their importance in achieving meaningful long-term returns.
Looking ahead, we remain vigilant in navigating the current volatile and uncertain environment.
Our approach is to build well-diversified and sensibly constructed portfolios across asset classes and managers in combinations that are well-placed to achieve their stated objectives over time. This approach will no doubt continue to result in a rewarding experience for investors over the long term.