Investment Environment May 2015

06.07.15

Global

The world needs two things to happen, being economic growth to kick in on a sustainable basis, and the USD to weaken, which should allow commodity prices to recover. 

The quarter just ended 31 May, was not ideal for risky assets as the environment reflected weaker economic growth, higher inflation expectations (mainly in the Euro zone), a stalemate between EU creditors and Greece, and the timing threat of a FED rate hike.

June started with government bond yields moving sharply higher, because inflation might be re-emerging and European deflation reversing.  This story is shown in the graph which highlights the soft economic performance of Europe.

The yield increase coincided with the ECB President, Mr Draghi, arguing that markets must expect higher volatility. Draghi seems to have been stating the obvious and it does not require a Central Banker or a statistician to explain the high levels of volatility have demonstrated the uncertainty that markets are broadcasting. It is not uncommon to see either the Dow or S&P move by more than 1% in a day. In fact as we enter June the Dow was down 2.2% from its 19th May record close and the S&P off 1.6% the 21st May closing high – these are big moves!

We also know that risky assets, such as equities, are on extended valuation criteria and that this is largely driven by the past and current QE (quantitative easing) programmes which have made money cheap and risk palatable. Unfortunately these valuations are not backed by economic growth with the US GDP 2015 Q1, contracting by - 0.9% (expected revision). The US is meant to be the pillar of world growth.

In 2015 the Chinese Shanghai market is up 59% and at a 7 year high in CNY. These valuations must be stretched but hopefully the bubble will not burst because of the risk of contagion to other markets. 

So what investors need to make markets less volatile is:

  •          The stalemate in Greece to end;
  •          Chinese economic fundamentals to catch up with the equity market;
  •          Bond yields to retrace to their low levels indicating interest rates will remain low for              longer;
  •          Sustainable economic growth, albeit at a slower pace;

And most of all;

  •          Clarity from the FED that interest rate increases could be postponed into 2016 – This          was the IMF’S Christine Lagarde’s request.

South Africa

Notwithstanding the fact that the saying “Sell in May…” has again proved correct for the JSE, the indices such as the ALSI and ALSI40 remain in high territory. The only reasonable explanation is that most of the heavily weighted stocks comprising these indices are internationally orientated and the ZAR is the shock absorber to the extent it weakens. However, on simple valuation criteria such as PE’s the graph below demonstrates that valuations of the ALSI and the FNDI have become extended whereas the RESI (Resources) has sustained its valuation notwithstanding the poor performance of commodities.

It is interesting to note that generally equity performance has been maintained. This is in spite of weak commodity prices, including oil, with the concomitant effect on resource stocks. This is the only cheap sector in the market. Even more surprising is the JSE retains most of its value in a negative political and social environment with failing infrastructure as demonstrated by load shedding.

Conclusion

Douglas Investments recognises that equities are stretched, but in the extremely low interest rate environment which might persist, a growth asset such as equity might be worth the risk! If share markets correct it must be viewed as an opportunity. Interest rates, led by the US, should only go up if there are indicators of economic growth being underpinned.  While this will cause a temporary setback for shares, it must be good in the long run.

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