Investment Environment August 2018

04.09.18

International

We are taking the opportunity to compose our quarterly article early, as the US equity markets make new highs! It can be seen in the graph below this high is relative to that achieved in January this year, but what is most relevant is in January the PE of the S&P500 was 25, but is now 20 historic and 15 looking forward on analysts’ forecasts. The reason for the failure and subsequent correction in January was couched by Investors fearing interest rate increases, as broadcast by Powell (Chairman of the FED), and the beginning of Trump rhetoric on trade wars. In reality DI believes Investors used the interest rate hikes and trade wars as an excuse to take the S&P500 down 10% because of the scary valuation criteria relating to equities – simply put, the market got ahead of itself.

The graph shows the S&P500 regaining the high, closely followed by the Dow Jones (that is yet to achieve the high). This is seven months later after the first two quarters of earnings surprising on the upside, two interest rate increases of 0.25% and the day the market hit the new high it is no surprise that the US closed a bilateral trade deal with Mexico.

Maybe the trade deal with Mexico is indicative that the same is possible with China which might mean the impact of such tariffs is less than expected. Both the US and China have demonstrated the strong underlying economics in their purchasing managers’ index (PMI) as shown in the graph  which demonstrates the resilience of the underlying economies.

The headwind to equity markets, in particular the US, is interest rates that have been increasing at the short end, as shown in the yield curve. The thesis is that the FED can adjust the FED funds rate (FFR) up to this 3% mark which will then mean that the yield curve is flat and might be a ceiling as to how far the FFR can increase, if the long end holds at 3%. Beyond that, an inverse yield curve could potentially cause a recessionary environment. The FED would want to avoid this and therefore maybe the interest rate increases are a limited threat to equity values. Interest rates are the big unknown and obviously very difficult to forecast, but what is relevant this time is the US market is underpinned by strong economic growth which consequently is causing corporates to show good earnings which are generally exceeding analysts’ forecasts.

Unfortunately DI believes that South Africa is at a T junction from a market perspective.

If SA goes right (in every sense of the word) and Ramaphosa consolidates his position and that of the ANC going into the 2019 election, virtually securing his victory, there will be a good period of “Ramaphoria”. What this would mean for SA is a good bout of business confidence which will hopefully release the cash balances held by corporate SA to be appropriately invested domestically. These funds are very significant, as shown in the graph below, and would support economic growth which in turn would translate into consumer confidence.

As difficult as it is to predict turning right, it is impossible to forecast what would happen going left!

What we do know however, is if left means indiscriminate land grabs, massive social upheaval, higher taxation on an already strained base etc, this does not bode well for foreign Investor confidence and SA will probably be amongst the least supported of the emerging market economies. While Trump tweets are usually wholly inappropriate and inaccurate the recent tweet on SA land reforms is indicative of the message that the rest of the world sees. Fortunately, while the left scenario is doomsday, it is the less likely as Ramaphosa is currently in power and is hopefully on track.

2Q2018 GDP surprised on the downside coming out at negative 0.7%. This by definition puts the South African economy into recession and increases the threat of further Rating Agency debt downgrades which certainly won’t help the ZAR. The Consumer has probably never been under such pressure with increasing tax burdens through higher rates across all fronts (marginal and VAT) and record high petrol prices that also embody a tax!!

SA portfolios need to be invested with a significant ZAR hedge component and balanced with what has become known as “SA Inc” shares that are extremely cheap and would benefit from the right scenario. Internationally, the US is the preferred investment region and for portfolios that are USD denominated it looks likely that equity markets will continue to “climb a wall of worry” but we should see some returns in 2018 (having had muted returns so far) from what is fundamentally a good US market.

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