The impact of market uncertainty on investment strategies

David Crosoer, Executive of Research and Investments at PPS Investments.

Both local and global markets have been particularly unpredictable so far this year. In the face of uncertainty, it is often difficult to stick to an investment strategy as investors can get swayed by short-term news flow and emotion. However, in times like these it is most important to stick to a disciplined and diversified investment process.

South African (SA) growth assets materially underperformed both their emerging and developed market counterparts over the second quarter. Market unease around political developments and generally lacklustre economic growth in South Africa have lowered market sentiment.

On the global front, the global economy is still battling with the effects of the global financial crisis, even though we are now in the ninth year of the global economic recovery. While there has been an upturn in global growth expectations (although recent data, especially from the United States, has been less encouraging), global interest rates still remain abnormally low and the ‘search for yield’ theme continues to bedevil financial markets.

So far, however, investor flows have continued into higher-yielding assets and passive strategies, despite the potential catalyst of higher US interest rates (the US Federal Reserve raised rates again in the second quarter) and potentially overly-optimistic expectations around global economic growth. In this context, South Africa has continued to benefit from a benign global environment, despite significantly deteriorating local fundamentals.

These deteriorating fundamentals have been well documented in the media and the investor community. South Africa’s foreign currency debt is now rated below investment grade by two ratings agencies (Standard & Poor’s and Fitch), with both Standard & Poor’s and Moody’s placing SA on a negative watch. In addition to this, local currency debt is rated below investment grade by Fitch, with both Standard & Poor’s and Moody’s placing SA on a negative watch. Consequently, South Africa is already excluded from one emerging market bond index (JP Morgan GBI-EM GD IG Index) and will be excluded from others should other ratings agencies downgrade our local currency debt further.

Such a downgrade is not impossible to contemplate. According to an annual review by the International Monetary Fund (IMF) SA’s government debt (excluding contingent SOE liabilities) will comfortably exceed 50% of GDP by the end of the fiscal year, a level previous studies have suggested makes emerging markets significantly more vulnerable to funding crises, and could be 14% higher should economic growth be 1% p.a. less than expected in the 2018-2022 period.

Similarly, contingent liabilities now amount to 18% of GDP (of which 10% is SOE debt) and the realisation of these liabilities, in an adverse scenario, could also increase government debt to above 65% of GDP. In addition, despite credible finance ministers in the past, the state has still spent on average 1.2% of GDP each year on recapitalising these dysfunctional entities.

Following the downgrades, the South African economy is far less resilient today than it was in the build-up to the 2008 financial crisis to withstand a global recession. The South African economy experienced a technical recession, with two consecutive quarters (quarter 4 2016 & quarter 1 2017) of negative GDP growth. Even the subdued 1% p.a. growth expectation for 2017 is possibly too optimistic.

According to the recent Stats SA Quarterly Labour Force Survey, 11.1 million South Africans out of a potential 37 million between the ages of 15 and 64 years are in formal non-agricultural employment (and 27.8% unemployed), while an unsustainable 50.8% of youth between the ages of 20 and 24 are not in education, training or employment.

In addition, South African business and consumer confidence have both plumbed post 1994 lows earlier this year and remain depressed. The South African Chamber of Commerce Business Confidence Indicator (BCI) is at 95.3 for July but still lower than July 2016. Measures of consumer confidence are lower today than in 2008 and close to levels previously experienced in the 1998 emerging market crisis and the transition to democracy in 1994.

Unlike in the past, low-points in confidence have not been marked by equivalent attractive valuation-based entry points into the local equity market. This difference can partly be explained by the dominance that internationally based equities now exert on the local market, and the fact that these shares continue to trade at lofty valuations. Unlike in previous cycles where our equity market traded on a PE ratio below 10 times earnings at times of depressed consumer and business confidence, today the market trades on a PE closer to 20 times earnings.

In light of the current investment climate appearing especially uncertain, it is unclear how strong the global synchronised economic recovery will be and whether South Africa will be able to benefit from it by decisively putting its political uncertainty to bed. In such a context it is important to construct portfolios so that they are not beholden to any one particular outcome, but that they are sensibly managed to specific risk.