Investment Environment October 2018

09.11.18

International

At the end of August we released our Investment Environment around the excitement of the US equity markets making new highs. It can be seen from the graph of the S&P500 below that the last high was achieved in January but then markets retraced significantly and that high was only surpassed at the end of September, and 8 months later the same reasoning is coming to the fore and the new high has again been tested. The market is nervous of interest rate increases and the consequence of the US – China trade wars.

Regarding the trade wars, the US has reached tariff agreements with Mexico, Canada and is in negotiations with Europe so arguably the Trump modus operandi of getting the first blow in and then agreeing to a softer outcome might be possible with China as well. The problem is Investors hate the uncertainty that surrounds this and Trump’s rhetoric (be it on Twitter or otherwise) makes Investors even more nervous.

2018 has seen 3 increases of 0.25% in the FED Funds Rate (FFR) and this should not be a surprise as it was well broadcast in January by Powell. However, the market is fixated with is the treasury yields where at the long end the yield has risen above the 3% pivot indicated in the yield curves shown below. Arguably, if the long end continues to pivot at 3% as shown, this would act as a ceiling for the FED as they should be reluctant to invert the yield curve (sloping downward from left to right) as this would signal a recessionary environment. Currently the FED is probably caught between containing inflation at 2% and the yield of treasuries at the long end of the curve. If the yield curve moves up to the mid 3%at the long end, this will provide the treasury more room to raise rates.

Interest rates are a head wind to equity markets, but equally the propensity that the FED has to increase rates is a strong indicator of the underlying strength of the US economy. This is also supported by the PMIs shown above. A stronger economy is ultimately good for equities as it should reflect in corporate earnings. However, as shown in the graphs below, the consensus forecast for S&P500 profit growth is a slow down in the next 4 quarters. It is however important to remember that earnings are still expected to grow albeit at a slower pace. The graph showing the valuation retreat is the story of equity markets for 2018! Markets tested the high in January and again in September but on both occasions the projected times earnings (P/E ratio) has retreated back to the 16-17 range. This is a function of the belief in earnings growth and how high interest rates will move causing valuations to be tested.

Douglas Investments is reasonably confident that the US growth story is not yet over but it is undoubtedly being tested as interest rates normalize and become less accommodating and the rest of the world lags behind.

South Africa

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.

Ramaphosa’s SA Investment Conference, the first of which took place on Friday 26 October, was encouraging and elicited pledges of R290 billion. This might mean the target of R100 billion in five years could be achieved. The reality of turning a pledge into investment is vital.  

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.

The Medium Term Budget Statement was very disappointing, forecasting 2018 GDP of 0.7%. This 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!!

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

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 test investors in the short term and we will probably see no returns in 2018 in spite of a fundamentally good US economy.

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