Investment Environment August 2015

21.09.15

Towards the end of August markets entered a correction (defined as >10% decline) and the S&P500 index experienced some of the most volatile days in history closing on 25 August at 11% below its May high. Other markets have had similar drops and there have been “snap back” days. Such volatility is a good indication that market participants are confused. The explanation at the time seemed to be a delayed reaction to China’s market correction plus the threat that the FED will increase Interest rates in September. None of this was new news and it feels like last week markets woke up to what was always apparent!

The correction should be seen as an adjustment of markets from the distorted economics since the global financial crisis (GFC), driven by a low or no interest rate environment. As interest rates normalise investors are going to have to re-prioritise their risk return expectations. Usually bear markets are always shorter and sharper than bull markets and therefore any cash available should be held with the expectation of an opportunity to invest at much better prices. Such markets call for investor patience and courage.

A brief economic explanation affecting markets is as follows:

The US is producing economic indicators showing that a sustained GDP growth of 2–2.5% pa is likely and while this is below the 3% prior to the GFC, it is argued that this trend of growth is the new normal. This provides the Federal Open Market Committee (FOMC) and Yellen the opportunity to consider raising interest rates in order to end the era where risk takers benefit from a free cost of capital. The period of near zero interest rates and quantitative easing has undoubtedly pushed up asset prices and in particular equities. It is not new news that US interest rates are likely to increase but it will undoubtedly be gradual and while the expected September increase might not materialise (due to recent market actions), one should expect an increase in October or December.

The Euro area has certainly been affected by the noise around Greece but one needs to appreciate that Greece only comprises 1.7% of Europe’s GDP. Greece will not go away until such time as it is provided debt forgiveness or exits the Euro but the EUR 86 billion bail out has delayed this event. If Greece is set aside, Europe is not performing too badly by most economic measures and it is expected that the GDP index will now exceed pre GFC levels.

Possibly, the Chinese market “bubble burst” as the Shanghai Equity Index corrected severely, was a catalyst to extreme volatility in developed and emerging markets. The Shanghai market is domestic and has been used by the Chinese authorities to improve the Chinese consumer wealth, but should largely be regarded as a “casino”, albeit that it has unsettled world markets. What is of more relevance is that Chinese year on year industrial production has been slowing from a growth rate of approximately 13% (2012) to the current rate of approximately 6%. This has been driven by the lack of Chinese exports and the concomitant effect on imports. The natural reaction of the Chinese authorities to devalue the RMB (-3.9%) and reduce interest rates in order to allow the Chinese economy to be more competitive has been cumbersome and frightened world markets. However, the devaluation was necessary as the RMB/USD has appreciated considerably over the last decade making China less competitive and was a suitable economic lever to help maintain Chinese GDP growth at 6-7%.

South Africa is behaving like most emerging markets, but is severely affected as a resource emerging market. The fears of a slowing Chinese economy and a USD well supported by higher interest rates are well founded. Unfortunately, the South African government has few tools at its disposal to support the economy and continues to run twin deficits (fiscal and current account) which have contributed to the debt : GDP ratio ballooning to 50% from a low of 27% at the end of the Trevor Manual era. It would appear that South Africa’s best outcome would be to maintain consumer confidence and encourage business to follow suit in order that the large cash piles held on corporate balance sheets are released. The political environment combined with the infrastructure woes (electricity, water etc), make this a tall ask, but only the private sector by using its large cash resources can put SA back on the growth path.

The above comments probably encourage investors to exit SA and therefore a comment on the ZAR is warranted. The ZAR, which is a very liquid emerging market currency and often used as a proxy for other emerging markets, has demonstrated severe pressure and is thus excessively affected as emerging markets sell off. Furthermore, as there is no GDP growth premium being demonstrated by emerging markets, investors are naturally attracted to harder currencies as they disinvest from all securities (equities and bonds), and these proceeds need to be exchanged to USD or other currencies. It is probably fair to say that the existing weakness of the Rand (>R13/USD) has been exacerbated and that when the market rout is over a recovery to the low R12’s/USD would not be undue.

While the current market volatility and corrections are obviously painful, these are necessary for a normalisation of the underlying economies which are fundamental drivers of listed equities. Therefore, while a correction should provide a buying opportunity, it should also be seen in the longer term as providing risk assets, such as equities, with better fundamental underpins going forward.

South African portfolios should continue to be invested in counters where the predominance of their business is international or clients should consider using the Foreign Investment Allowance to expatriate funds, but hopefully on a ZAR/USD recovery. International portfolios valued in USD should concentrate on large market capitalisation equities, predominantly in the US and take advantage of price dips which cause better valuation criteria. It is likely that as the world normalises, particularly the US and core European markets will benefit from the low input cost of oil and other commodities.

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