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Taking stock of 2019

12 February 2020 Reza Hendrickse, Portfolio Manager at PPS Investments
Reza Hendrickse, Portfolio Manager at PPS Investments

Reza Hendrickse, Portfolio Manager at PPS Investments

Global equities reversed 2018’s sharp sell-off, rallying to new all-time highs in 2019. The catalyst was a surprise shift in monetary policy, with central banks globally turning accommodative and lowering interest rates, in what came to be known as the “central bank pivot”.

In developed markets, the US maintained its overall relative economic strength this year, despite the ongoing trade war. Europe showed signs of stabilisation, and in the UK, Boris Johnson took over the difficult task of negotiating a withdrawal from the EU.

In emerging markets, stocks underperformed developed market counterparts, and economic growth was weaker than expected. Populist election outcomes in Brazil and India reflected a global trend this year. In addition to the trade war, China grappled with protests in Hong Kong, which are indicative of social dynamics in that region.

Back home, economic growth disappointed and load shedding ramped up. The elections turned out as expected, however the ANC lost support. Our fiscal debt position weakened further, and vulnerability increased due to Eskom. On a positive note, consumers benefitted from an interest rate cut, state capture was slowly tackled, and SA won the Rugby World Cup and Miss Universe crown.

The domestic growth environment remains tough, but technically speaking we are not yet in a recession. GDP contracted 0.6% in the third quarter, growing only 0.1% year-on-year. Growth forecasts have been progressively revised lower this year, but chances are we will undershoot even these with power outages having reached unprecedented stage 6 levels. At this rate, electricity disruption could cripple growth going forward.

Growth and inflation have fallen
Although growth and inflation have been muted, the SA Reserve Bank (SARB) has only cut rates once last year, compared to the US Fed which cut three times. The SARB Governor points to the fact that the US is trying to revive inflation, while SA on the other hand does not have an inflation problem, so our objectives differ. Secondly, the weak growth environment locally is considered structural, so the SARB sees limited scope to boost demand through lower rates. Lastly, a Moody’s downgrade could weaken the rand, impacting inflation, which concerns the SARB. Despite all of this, the market is pricing in lower rates this year.

SA equities improved
The equity risk premium (earnings yield less the 10-year bond yield), which represents the relative compensation for taking on equity risk remains high, suggesting that equities are still compelling compared to bonds. While certain parts of the equity market, like the US, are no longer attractively valued and appear to be trading at a premium, stocks outside the US are reasonably priced. Furthermore, non-US markets such as Europe and emerging markets are more sensitive to a pickup in global growth, with cyclicals making up a greater share of these indices.

From a valuation perspective, local stocks are cheaper than global, particularly companies geared to the performance of the domestic economy. A stronger local economy is however needed in order to improve the earnings prospects of these companies, and currently the risk to growth appears to be to the downside. Fortunately, given the large proportion of companies with significant offshore earnings listed on the JSE, slow economic growth locally does not necessarily mean that the index will flounder. There is in fact no strong correlation between overall JSE returns and domestic macro performance. Besides better valuations locally, it is possible that SA could benefit from renewed global growth, irrespective of domestic growth.

We are in the late stages of an aging bull market, but it is probably too soon to de-risk. History shows that bear markets and recessions usually overlap, so given our growth outlook, it is probably best to remain invested. The global economy is poised to accelerate in 2020, and historically stocks have outperformed bonds when the cycle turns up. Lastly, bull markets do not die of old age, but rather due to overly restrictive financial conditions (which are not an issue currently) or unforeseen global shocks (e.g. a full-blown war in the middle east).

Global bonds
Global bonds have performed better than expected, against the backdrop of renewed central bank easing. Even negative yielding government bonds, locking in a guaranteed negative return for the next decade have continued to be bought this year, which is nothing short of mind-boggling. Regardless, although bonds have shown continued strength, the risk to yields appears firmly to the upside (i.e. a decline in bond prices), particularly as global growth picks up. Global bonds are currently expensive, offering little compensation for the risk.

Prospects for local bonds
Domestic government bonds are offering compelling yields, with the support of falling rates and subdued inflation. The main concern however, is that government debt is heading towards unsustainable levels and a Moody’s downgrade appears highly likely. The extent of any ensuing volatility is unknown, and many have therefore preferred to adopt a wait-and-see approach, despite the attractive yields. The counter-argument is that a downgrade has already been fully priced-in, given that our bonds are already trading on par with other sub investment grade country bonds. Provided one is prepared to ride out any potential downgrade-induced volatility, SA bonds should deliver reasonable returns.

Looking ahead
Locally, the February National Budget Speech will be closely watched. It has implications for growth, confidence, state-owned enterprises (SOE’s), and Moody’s, who have already primed the market for a downgrade, with its recent outlook change. Eskom will probably continue to struggle to keep the lights on in 2020. On a more positive note, we look forward to continued strengthening of institutions such as the National Prosecuting Authority and the South African Revenue Service, further progress by the Zondo Commission, and perhaps even a rate cut.

Globally, much rests on the resumption of growth, so we anticipate follow-through from the upturn in activity. The extent to which this revives inflation, and a normalisation of monetary policy will be something to note, although inflation is a lagging indicator, often peaking only well into past recessions. The 2020 US elections will also draw keen interest.

Our generally positive outlook means we have remained overweight growth assets in the portfolios. Our modest equity overweight still favours global equity, with room to build on this should our house view become more constructive on either local or global equity in 2020. Although certain parts of the market are expensive, we mitigate this risk by drawing on managers prepared to construct portfolios differently to the benchmark.

In 2019 our main asset allocation decisions included adding to domestic bond exposure, while reducing domestic real estate exposure. The challenges faced by local property companies have been pervasive and the sector still faces headwinds. Domestic bonds on the other hand offer a safer yield without the capital risk. Global bonds still do not feature in the portfolios, given its extreme unattractiveness.

Looking ahead, although we anticipate that the environment for risk assets will remain constructive for now, we will continue to evaluate the prevailing risks, maintaining an objective and flexible view, while being prepared to adapt should the facts change or as new information emerges.

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