Investment Environment May 2018

15.06.18

As reported on 8 May, equities have not done much in 2018, albeit that markets have been highly volatile indicating Investor uncertainty. After a very good start in January, the US market corrected as much as 10% in February after Trump introduced the idea of trade tariffs targeting China who in turn countered with their own set of tariffs. This was combined with the FED chairman, Powell, indicating that interest rates were likely to rise four times in 2018. The double whammy of increased cost and higher interest rates tested market valuations such as the PE multiples. Since February the situation seems to have normalised to some extent with the S&P500 up 1.8% YTD on a historic PE of 20.8.

The recovery from a February low has been driven by Investors being less concerned about interest rate increases which, while being a reality, are unlikely to be dramatic. However, the world is moving from a place of no interest rates since 2008 to increasing interest rates which in some cases will be real (ie exceed inflation). As can be seen in the graph, in the week ended 25 May there was a sharp pull back in the yield of the 10 year Government Bond. This could be considered a normalisation as yields had been over extended in the quick run up YTD. It is interesting to observe the inverse correlation to the S&P500 index, ie higher yields suppress equity prices and vice versa. Interest rates test the values of equities on two fronts, being the higher implicit discount rate used to calculate values and the alternative of a return without taking equity risk.

In the second last week of May the price of Brent Crude oil spiked above USD 80/bbl. To some extent this diverted the US focus from trade wars etc and elicited a typical Donald Trump Tweet “Looks like OPEC is at it again. With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!”. Trump’s comments have the support of US industry and other countries consuming oil which has rallied from USD30 in 2016. The reason for the rally was the dramatic fall in inventories, largely due to OPEC successfully curtailing its output as shown above. Unlike 2016, both Russian and Saudi Energy Ministers signaled that OPEC would gradually raise oil production in the latter half of 2018. It is too soon to tell whether these statements were lip service to appease consumer concerns about high prices, or whether in reality the market will normalize.

The US equity market is currently balancing the following factors:

The reality of a US / China trade war

The effect of rising interest rates providing a risk free alternative return

The growth of corporate earnings in the US which in 1Q2018 was 25% reflecting the boost from Trump tax cuts. This exceeded expectations but the question remains can this be repeated in 2Q2018

The effect of high oil prices on economies such as the US that are significant consumers and have to absorb this input cost.

At the current time US (and Western markets generally) equities reflect these factors and are fairly priced and Douglas Investments believes there appears to be some upside but Investors should temper their expectations after a very good 2017.

South Africa

The SA equity market remains largely driven by the ZAR as shown in the graph which reflects the changes in sentiment.

ZAR weakness to some extent is as a result of the USD strengthening slightly which has in turn focused on all emerging market currencies. Unfortunately South Africa amongst its peer group remains vulnerable as shown in the graph.

The same circumstances relating to the SA economy were endorsed by the S&P affirming a stable outlook on the rating but this remains two levels below investment grade. The rating agency did give the new Ramaphosa administration credit for implementing economic and social reforms, but SA will have to wait until the end of the year to see if this is enough to boost economic growth and repair public finances, allowing the S&P to restore SA to investment grade.

So while SA prospects look better, the upbeat political mood post the ANC election in December 2017 has now depleted as people seek clarity moving to 2019 elections. It can be politically justified that land redistribution is necessary as a political bridge post apartheid. But, depending on the form it takes, it is the bed rock of the economy and if expropriation without compensation becomes a reality this will undoubtedly cause foreign Investors to find emerging market returns elsewhere and will frighten both the business and banking sectors in South Africa. Furthermore, the noise ex ANC of “nationalising” the Reserve Bank might collect votes, but a politically driven central bank will scare foreign Investors.

Until clarity is reached equity Investors will use the ZAR as a barometer of the political and economic status.

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