Forecasting in financial markets is dangerous

Ian Scott, Fund Manager at PSG Asset Management.

2017, at this point at least, seems to promise more positivity for the investment world than last year did.

At the outset of 2016, amidst political fears, negative sentiment gripped local markets. Market pundits painted a grim outlook for the year and it would have been very hard to find an economist or any conversation suggesting positives for the future of the South African economy. 

It’s understandable that most people will feel sceptical of any optimism about 2017 but there are some key factors that we believe should make 2017 slightly more tolerable for investors and their nerves.

The trouble with 2016

It was widely predicted that we would again replace our finance minister (Minister Pravin Gordhan), be unable to produce a credible fiscal budget and would face an imminent downgrade to below investment grade. The rand was predicted to spike to R20/$, inflation to rise sharply above the 7% target and the South Africa Reserve Bank (SARB) to be forced to hike interest rates significantly – a very unfriendly environment for local fixed income markets.

However, events unfolded very differently. The rand/$ exchange rate instead of weakening, strengthened 12% over 2016 and inflation expectations significantly reduced as food inflation worked itself out of the system. The market is now starting to look towards inflation falling below the 6% target of the SARB. South Africa, albeit in a fluid situation, has managed to avoid a downgrade to below investment grade status, whilst maintaining the independence of National Treasury. 2016 therefore taught lessons about the risk of forecasting based on binary events, and the implications of positioning portfolios for a one-sided outcome.

The upside to 2016

The fruition of the above forecast would have resulted in significant losses for investors. It was therefore more important than ever to remain focused on the fundamental drivers of local rates, specifically the outlook for inflation. This allowed some to see the opportunity presented in the NCD (Negotiable Certificate of Deposit) market, a compelling opportunity for PSG’s Money Market fund, where we have been able to take advantage of the negative sentiment and forecasts of excessive inflation. With rating agency decisions scheduled for December 2016, NCD rates remained elevated throughout the year, offering real yields in excess of 2% at headline inflation of 6.4% (November 2016).

While certain risks mentioned above remain, we prefer not to focus on predicting the outcomes of ratings announcements and political events, instead focusing our attention on better understanding the pressures on inflation and growth into 2017. We therefore look to position our portfolios for a range of outcomes, but towards a greater position in fixed rate exposure (this would benefit investors should inflation expectations normalize). Headline inflation pressures eased with a stronger rand, improved wage negotiations and lower food inflation expected going forward.

There is reasonable basis to believe that inflation should be more comfortable for the SARB going forward, a very positive outcome with real yields in excess of 2% already locked in for our investors looking for real income growth capital preservation over the short term.