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Storms come and go

17 September 2019 Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth

As we enter springtime in the southern hemisphere, things seem calmer on global markets after a very stormy August. But the weekend’s attack on a Saudi Arabian oil refinery suggests it is not yet time to pack the umbrellas away.

Tweeting up a storm
The market chaos that started with a Donald Trump tweet at the beginning of August also receded with a Trump tweet. In an attempt to ease tensions, Trump postponed the imposition of a fresh set of tariffs by two weeks to not coincide with the 1 October celebration of the founding of the People’s Republic of China. Trade talks between the US and China have also resumed, while China exempted some US items from its retaliatory tariffs. This follows a by-now standard pattern where Trump escalates his trade war when US equities are strong, and backs off when the markets are spooked.

Chart 1: US S&P 500 since the start of the trade war

Source: Refinitiv Datastream

While this latest thawing in relations between the two economic superpowers has been cheered by markets, it does nothing to ease the uncertainty of businesses that have to plan months ahead, and still don’t know what tariff levels will be. In fact, all this zig-zagging on tariffs only increases uncertainty. Even if no agreement is reached between the US and China, moving production to a third country, such as Vietnam, could be risky as there is no guarantee that Trump won’t target it next. Or even turn his attention to traditional allies in Europe and Japan.

The global manufacturing sector, which is most exposed to trade wars and also structural challenges in the auto sector, remains very weak. So far, this has not spilled over to the healthy services sector, but the risk that it could do so exists. The Eurozone economy is particularly exposed, given that it is more dependent on manufacturing and global trade than the US.

Geopolitical risks ebb and flow
The attack in Saudi Arabia potentially affects up to 5% of global oil output. Predictably, the oil price spiked around 10% when Asian markets opened on Monday. This is a knee-jerk reaction and it will take a day or two for the price to settle at a level that reflects the new realities. On the one hand, the sluggish global economy and record US output means that there was probably an oversupply of global oil. On the other hand, the price will probably now reflect a larger risk premium as investors worry about the vulnerability of oil infrastructure in the Middle East, and the potential for conflict to escalate. Ironically, this happened just as it seemed that the prospects for conflict in the Middle East were easing somewhat following the firing of Trump’s bellicose national security adviser, John Bolton.

Other geopolitical risks do seem to have receded. In the UK, Parliament voted to block a no-deal Brexit and an early election, in a blow to Prime Minister Boris Johnson. This does not mean we know how the Brexit debacle will unfold – the 31 October deadline has not been extended yet – but the likelihood of an extreme outcome has receded. In Italy, a new coalition government has been formed without the populist League party, which paves the way for better relations between Rome and the European Commission in Brussels. Italy’s problems run very deep, and this does nothing to address them, but here too the risk of an extreme outcome, namely Italy abandoning the euro, has been reduced.

Bonds down, shares up
All this has seen a jump in equities and a sell-off in bonds (leading to rising bond yields) over the last two weeks. Other safe havens such as the Japanese yen and gold are also weaker. However, bond yields are still lower than at the start of August, and we are in a declining global interest rate environment as central banks continue to ease policy.

Chart: Developed market 10-year government bond yields, local currency

Source: Refinitiv Datastream

QEnfinity
In what is seen as the first of a set of easing moves, the People’s Bank of China recently reduced the amount of funds banks have to hold in reserve, potentially freeing up billions of dollars of new loans. Last week, the European Central Bank (ECB) cut its deposit rate by 10 basis points to -0.5% and re-launched a €20 billion monthly bond buying (quantitative easing or QE) programme. It also introduced a tiered system to avoid the negative impact of sub-zero rates on banks. Notably, for the first time, the ECB said it will maintain QE and negative interest rates until such time as inflation “robustly” converges on its 2% target. Both negative rates and QE are now open-ended.

Whether this will help the struggling Eurozone economy is another matter. If negative interest rates did not spur economic activity up to now, slightly more negative rates are unlikely to do the trick in the future. On the QE side, the problem is that the ECB could run out of bonds to buy within a year, since the largest economy in the bloc, Germany, runs a budget surplus and therefore the outstanding stock of German bonds is declining. Germany’s tight fiscal policy is therefore not only holding back growth on its own, but also impeding monetary policy. This has not gone unnoticed at the ECB. Both Mario Draghi and his successor as ECB President, Christine Lagarde, have called on easier fiscal policy (more spending by governments) to do the heavy lifting of preventing a recession in the Eurozone.

This week, all eyes will turn to the US Federal Reserve (the Fed), which is expected to cut rates by 25 basis points on Wednesday. The SA Reserve Bank’s Monetary Policy Committee will announce the outcome of its meeting the following day. The odds of a local rate cut have increased somewhat, but the oil price spike complicates matters. However, in both rand and dollar terms, the oil price is below where it was a year ago. Central banks here and abroad are unlikely to respond to the jump in the oil price, but if it increases further and remains elevated, they will have to reassess their inflation forecasts. Having said that, the bigger risk is probably to growth, as a fragile global economy will struggle to handle much higher fuel costs. A sustained increase in oil prices could therefore be deflationary, not inflationary. Time will tell.

Ratings reprieve
One bit of good news came from ratings agency Moody’s, the last ratings agency with an investment grade rating on local currency bonds. At a conference in Johannesburg, Moody’s analyst for South Africa noted that a downgrade in November was unlikely. It has a stable outlook on its rating, and would first cut its outlook to negative before downgrading the rating. This means government still has time to reassure Moody’s by implementing reforms.

Once again, Moody’s voiced concern over the rapid increase in government debt (the absolute level is not very high), but noted the importance of our strong institutions in supporting our rating. The independent Reserve Bank is particularly important. Sorting out Eskom is important too, but ultimately to protect our credit ratings, we need faster economic growth. Moody’s now expects growth of only 0.7% this year. Faster growth should result in higher tax revenues for the state, and less borrowing. Since the bond market is already pricing in a dire fiscal situation and downgrades, there is a chance for a positive surprise. Yields remain very high relative to inflation and what is available anywhere else.

Local equities up
Local equities followed the rest of the world higher, despite more gloomy news on the local economy. The JSE is ultimately influenced more by global markets than local economic conditions. Business confidence declined to a 20-year low of 21 index points in the third quarter, according to the Bureau for Economic Research’s long-running survey. Confidence declined in four of the five cyclically sensitive sectors that constitute the survey (wholesalers, retailers, building contractors and manufacturers). Dealers of new vehicles were only slightly less pessimistic than in the second quarter. Stats SA data on mining and manufacturing production signalled a weak start to the third quarter after the second quarter bounce.

Chart 3: South African Business Confidence

Source: Refinitiv Datastream

Things can change quickly
The rand is now stronger against the US dollar than a year ago, and this will drag on the returns of global equities. It is ironic and frustrating that as soon as local asset returns pick up, global returns dip. That is why diversification is important, especially as there is so much uncertainty globally and locally. But there is always uncertainty, as the events of the weekend demonstrated again. The trick is to manage exposures through proper diversification and to manage our behaviour by sticking to a plan.

The other important lesson is just how quickly things can turn around on markets. Markets always price in all available information. If new information comes along that is only marginally more pessimistic or optimistic than what was thought, it could lead to a substantial market movement. So while we don’t know how long the September equity rally will last, investors who sold out in a panic in August have missed out. Markets move up over time in such fits and starts, it is never a smooth ride up. Unfortunately, missing out on such upward lurches will greatly reduce long-term returns from equity markets.

 

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