Investment Environment November 2017

13.12.17

Equities in general have performed extremely well in the last year as shown in the graph of indices.

The fundamental reason for the equity performance is the world is demonstrating synchronised GDP growth clustered around 2%. The exception is China which continues to grow at a steady pace of >6.5% but this also creates market jitters whenever its growth is threatened. Furthermore, the equity prices have largely been driven by improved earnings rather than an expansion of PE multiples as shown below. This is obviously a much healthier scenario.

Equities are further supported by the continued passive interest rate environment which in developed markets is only expected to change as inflation emerges. The US is showing the highest probability of an interest rate hike of 25bp in December which would take the FED funds rate to 1.375%. This is hardly daunting! The outgoing FED Chair, Janet Yellen, continues to caution that if inflation remains weak and interest rates are raised too quickly, this could snuff out inflation going forward which in turn would put US GDP growth under threat. This introduces a contradiction in investors’ minds as an increase in US interest rates signals growth is on the way, yet generally lower interest rates are good for equities.

On balance, Douglas Investments believes that interest rates are sufficiently low and global synchronised growth remains predicted into 2018 at GDP rates around 2% excluding China and up to 3.5% including China which bodes well for equities.

The soft interest rate environment is a result of QE (quantitative easing) – a policy that “saved the world” from the Global Financial Crisis of 2008. There is some risk resulting from the change of central bankers around the world which are:

  •          Yellen / Powell                  February 2018                   Federal Reserve Bank
  •          Kuroda                              April 2018                          Bank of Japan
  •          Corney                              June 2019                          Bank of England
  •          Draghi                               October 2019                     European Central Bank

The successors are referred to as “the children of QE” and it will be in their hands to unwind the process which at its peak resulted in 40% of GDP being spent on bonds accumulated by central banks. If unwinding this position is too aggressive asset prices could be threatened, but let’s hope the world has learnt its lesson.

Therefore, it probably requires an event extraneous to security markets, to change the status quo of “risk on” and steady demand for equities. There is also a statistical argument to stay in the market and it is interesting to see the consequence of missing the up days as demonstrated by HSBC.

South Africa

We have recently had the benefit of a very honest medium term budget Policy Statement by Minister Gigaba which highlighted two key facts:

  •          Eskom is a significant risk to the economy as a whole
  •         GDP growth is likely to be 0.7% at best and the revenue shortfall for fiscal 2018 will               be R50 billion causing the deficit to expand significantly.

Unfortunately the Minister did not propose any concrete solutions, and these circumstances, combined with the political uncertainty, which is not good for South African economics and markets in general. Standard & Poor's rating agency adjusted down their SA debt rating for both foreign (rated BB having previously been BB+) and local  currency ZAR debt  (rated BB+ from BBB-) tipping both classifications into "junk" status. Prior to this only the foreign currency debt was "junk" and the downgrading of local currency debt has far greater consequences being bulk of Government borrowings. Moody's Investor Services, another agency, did not change their rating but signaled caution and put SA on 90 day notice for a downgrade review. While not all agencies have rated SA debt as "junk" the trend is bad and will have the consequence of a weakening ZAR and make government debt issuances, which will be used the bridge the ever widening deficit, more expensive as investors demand better returns for the risk of "junk"!

The JSE indices have also performed well in the last year but this is largely due to the ZAR hedge bias of the listed companies. This is further demonstrated in the ALSI40 outperforming the ALSI, as it holds the larger capitalisation stocks that are all ZAR hedges. Douglas Investments continues to maintain a strong ZAR hedge position in all portfolios. This could be tested in the event of a Rhamaposa victory at the ANC elective conference in December, but the change and promise of new hope would be a great compensation for being wrongly positioned relative to the ZAR. Furthermore, the economic problems are so endemic that any political change will take some time to fix the situation. 

There have been enquiries about crypto currencies and in particular the Bitcoin. At this stage Douglas Investments is accumulating as much information as possible and trying to understand crypto currencies but is struggling with valuation criteria. It is also possible that these currencies are experiencing a bubble market as shown in the graph below. However, this is not to say that they won’t exist in the future and serve a worthwhile commercial purpose and we will continue to watch this space!

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