March 2, 2018
The general themes identified in the second half of 2017 are broadly set to continue into 2018. The world is experiencing its most synchronised global growth since 1981 (the fewest percentage of countries in recession at the same time). This is feeding into positive earnings growth with global accommodative monetary policy giving further support to risk assets.
One of the key principles underlying the US Federal Reserve’s cautious approach of gradually raising interest rates, has been the relatively benign inflation environment. February saw a potential shift of this principle, when higher than anticipated US wage inflation triggered a global equity market correction. While we expected wage inflation to eventually push higher, given the very low unemployment rate, an important point is that this correction was isolated to the equity markets. The lack of cross asset volatility gives us confidence that the general view on an improving global growth environment has not changed and this was a healthy correction in what had become a very complacent market.
Looking back at the South African equity market in recent years, the chart below illustrates how it moved sideways in a narrow range for three years from mid- 2014 to mid-2017, underperforming cash. We believe this market decline in real terms for almost three years leading into 2017 created value in South African equities. This, combined with a stronger global backdrop and improved local political environment, led us to increase our equity exposure, as well as increasing exposure to SA-focused equities and local bonds leading into December’s ANC Elective Conference and post the victory for Cyril Ramaphosa. The equity market has subsequently turned up strongly and, despite the recent correction, has produced decent double digit returns that have fed into improved performance.
The good news for the world
Although not rampant, global growth is solid and geographically broad-based. The US unemployment
rate continues to decline and, although this has started to feed into upward wage pressure, inflation is still below the US Federal Reserve’s target level of 2%. With inflation rising gradually, the US Federal Reserve will continue to be cautious in raising interest rates not wanting to destroy all the good work they have done over the past decade.
With Europe and Japan still stimulating money supply, the net effect at a global level is still accommodative. These low and, in some cases, negative interest rates, with continued asset purchases by the European Central Bank and the Bank of Japan, remain supportive of risk assets as the search for yield continues to drive prices higher.
Politics remains a wild card, but President Donald Trump’s policy intentions of reduced tax rates, deregulation
and increased infrastructure spending, remain business friendly and are reflected in markedly higher and sustained business and consumer confidence numbers. These are likely to be followed by a pickup in investment and consumer spending. The US remains the largest and most important determinant of global growth.
From an SA perspective, the rand has staged a remarkable turnaround since mid-November. This started with the improved likelihood of a positive outcome from the
ANC Elective Conference in December. This continued with the victory for Ramaphosa and increased foreign flows into both local bonds and SA-focused equities. This has pushed the rand below R12 to the US dollar at the time of writing. We took advantage of the fear in the market, prior to the elective conference, to insure against potential rand strength. We protected around half of our offshore exposure utilising protective structures and have subsequently taken profits on this currency protection given the rand has strengthened beyond its fair value. It is worth mentioning that the insurance was relatively cheap.
We believe that despite the long-term structural issues facing South Africa, the continuous marginal improvement in both the rhetoric and policy by government will lead to an improving South African dynamic with sustained portfolio inflows. Brazil provides a recent case study for significant equity re-rating, together with currency and bond strength. This is despite Brazil going into recession after their credit rating downgrade to junk status. We believe, even though there will be some periods of volatility, the market will look through a SA downgrade, if this does transpire, focusing more on the potential improvement that can be achieved by a Ramaphosa-led government.
The bad news is long-term in nature
US equity valuations are extremely elevated on many long-term measures. While this is not the case in Europe, Japan and especially not in Emerging Markets, the US accounts for half of global equities and generally leads risk asset returns. The probability of a sustained P:E contraction outside of a recession, which seems unlikely in the near term, is low, but the risk of capital loss to our customers is material enough for us to have taken action to mitigate this risk.
We have used options to protect a portion of our local equity exposure against another market correction. This asymmetric profile protects us against losses should negative shocks occur, but allows us to participate in the upside at an affordable ‘insurance premium’.
Key risks in 2018
- Cross asset volatility
The recent equity market correction saw volatility gauges return to sustainably higher and healthier levels, reflective of reduced complacency. This event did not change our outlook and equity markets have broadly resumed an upward trajectory since then. We remain vigilant and are monitoring cross-asset volatility for signs of wider risk-off contagion that could be detrimental to return outcomes
There is a risk that growth surprises on the upside, excess capacity disappears and wage growth and inflation rear their ugly head faster than the market is anticipating. This will force central banks to raise rates more quickly, putting pressure on over-indebted consumers, corporates and governments and reversing the risk asset price appreciation we are experiencing.
- Chinese growth moderation
China stimulated its economy leading up to the 19th National Congress of the Communist Party of China held in October 2017. It will be unable to maintain this level of stimulus and the risk is that the withdrawal of the stimulus could cause Chinese growth to moderate faster than the market anticipates. China is a significant part of the global growth equation, and any weakness will permeate the globe.
Although the risks to the downside are far overshadowed by the strength of the current business cycle and earnings, we remain prudent as asset price valuations are not supportive of strong overweight unprotected exposures to risk assets. For this reason we retain a well-diversified balanced portfolio, with a strong growth bias, including downside protection through the use of options. We will monitor events carefully as they unfold and adjust exposures accordingly, to ensure our customers can experience robust growth within a risk- controlled framework.
Written by Robin Eagar, Head of Multi-Asset