An increasingly cloudy investment environment
Mark Appleton, South Africa Strategist at Ashburton Investments.
Global risk assets have experienced a torrid start to the year. Consensus global economic growth forecasts have been downgraded and it has become increasingly clear that the outlook contains considerable uncertainties and risks.
China remains a significant source of concern for global investors not only because economic indicators reflect an on-going slow down but also because investors are not clear as to how the authorities plan to manage the path forward. There has been considerable capital outflow on the back of a lack of confidence in that economy while the management of the currency (which has been allowed to depreciate slightly) is also unclear. On-going support of the currency seems to be at odds with a desire to stem capital outflows. While prevailing economic growth estimates suggest a gradual slowdown the risk to these forecasts are to the downside.
In the US while employment and home sales are relatively strong, a number of other economic indicators have been fairly soft. Furthermore, GDP grew at a muted 0.7% annualized pace in the final quarter of the year, retail sales growth in 2015 was at its slowest pace since 2009, and the manufacturing sector contracted for a fourth straight month in a row in January. Investors now appear to be anticipating a more gradual and shallow Fed hiking cycle than was previously the case. The Fed will have to consider the increasing economic risks globally and the threat that this poses to the domestic economy and may become increasingly hesitant to lift interest rates again in the near term.
Purchasing managers indices out of the Eurozone also point to a slowing of economic momentum in that area. The Eurozone PMI eased to 52.3 in January from 53.2 in December as five of the underlying economies reflected a deterioration in conditions. Comments out of the ECB suggested that further quantitative easing is likely. It is anticipated an extended and expanded raft of monetary easing measures to be announced in March.
In Japan the inflation outlook was cut and the Bank of Japan cut interest rates on excess deposits in current accounts to a negative 0.1%. That economy is by no means out of the woods as evidenced by negative GDP growth in the final quarter of the year.
Challenges on the local front are even more formidable. SA faces rising inflation and interest rates in the face of a slowing economy. Overall the economy remains bedevilled by a lack of confidence and we anticipate that economic growth could be as low as 0.5% on the back of subdued household spending, a fiscally constrained government sector and low levels of private fixed investment spending. The need for capital inflow to fund a large current account deficit also remains significant at a time when global investor sentiment towards SA is poor. All of this combined with increased policy uncertainty and the threat of credit rating downgrades has served to dampen the investment outlook.
On a more positive note the Government appears to be aware of these headwinds with the SA Budget reflecting a planned reduction in spending and a hike in taxes. This puts less pressure on fiscal borrowing requirements and serves to dampen demand from an inflation perspective. Are planned measures sufficient to alleviate risks of a credit rating downgrade? It all boils down to growth, and implementation credibility and this remains to be seen.
We anticipate that asset class volatility will remain elevated in 2016. From a global equity perspective the asset price reflationary impact of easy monetary policy is starting to wane. Interest rates are already exceptionally low and the scope to go materially lower is very limited. Easy money will no longer therefore play as much of a “shock absorbing” role as before. This means that as various events unfold, the impact on markets will be more direct which in turn means more volatility.
From a return perspective the global investment environment is anticipated to be challenging on a number of fronts with returns from most asset classes likely to be relatively subdued. While global equities have over the past number of years been well supported by low interest rates, equity performance will need to increasingly rely on the potential for profit growth which in and of itself does not appear to be particularly robust at present. Positive performance is nevertheless expected from this asset class in 2016. From a global bond perspective we anticipate that currently easy monetary conditions and gradual economic growth will eventually lead to slightly higher inflation and gradually rising bond yields. This will serve to keep returns from this asset class at relatively low levels.
From a South African perspective, notwithstanding a weak equity market of late, valuations still appear demanding compared to risk free yields relative to historical averages. Domestically sensitive corporates will also likely experience earnings headwinds. This together with a sub-par economic environment could prove a headwind for near-term equity performance.
Bond yields have declined from what appeared to be oversold levels at the beginning of the year. Yields however still remain at elevated levels which reflect credit rating downgrade risk. Current bond yields represent fair value given the anchoring effect a subpar economic environment will likely have on long term inflation levels.
While listed property will face increasing vacancy and rental growth challenges posed by a constrained economic environment this appears to have already been largely reflected in the price.
The rand is likely to remain a relatively fragile currency as it represents a fragile economy. In the short term however, it appears that the trade account is beginning to respond positively to the weak rand although the improvement is stemming mainly from a fall-off in imports. This suggests that the currency may have weakened enough to limit any further downside in the short term.
