The return of real returns

Dave Mohr, Chief Investment Strategist at Old Mutual Multi-Managers.

Izak Odendaal, Investment Strategis at Old Mutual Multi-Managers.

2017 is suddenly shaping up to be a very good year for investors. Global growth has picked up, and companies are reporting solid profit numbers as a result. At the same time, low global inflation suggests the world’s major economies are far from overheating, and therefore interest rates need to gradually rise to more normal levels. While the Bank of England hiked rates for the first time in a decade last week, it is unlikely to move much further given the uncertainty around Brexit. Jerome Powell’s appointment as successor to chair of the US Federal Reserve, Janet Yellen, also removes an element of monetary policy uncertainty. Powell is seen as pragmatic and likely to follow Yellen’s gradual and measured approach.

October positive

Global equities were positive in October. The MSCI All Countries World Index returned 2% in US dollars, lifting the 2017 return to a solid 17%. US equities are leading the pack among developed markets and the S&P 500 gained 2.2% in October, lifting its year-to-date return to 15%. The tech-heavy NASDAQ gained 3.5% in October and is up 25% in 2017.

Emerging markets returned 3.5% in US dollars in October, beating developed markets. The 2017 US dollar return of the MSCI Emerging Markets Index is at a staggering 29%.

Commodity prices rose on a broad front in October, despite the stronger US dollar (usually a headwind), as optimism over global growth has lifted. Copper was up 4.9%, aluminium increased by1.4% and nickel was 12% higher in October. The oil price jumped 7% to close above $60 per barrel as OPEC gears up to negotiate an extension of production cuts next year. Palladium continues to outshine platinum, gaining 4.5% in October and 45% year-to-date, while platinum was up 1% in October and only 1.9% in 2017. Gold ended October marginally lower at $1271 per ounce, capping the 2017 increase at 10%. Soft commodities were negative in October, with dollar prices of wheat and maize declining.

Local market up strongly

October was also a very strong month for local equities, despite elevated political uncertainty (following another Cabinet reshuffle) and a disappointing Medium Term Budget. The FTSE/JSE All Share (Alsi) Index followed global markets higher and benefited from a weak rand, returning 6.3% in October. Returns for the first ten months of the year is a very solid 19.6% (including dividends). In June the Alsi fell to 50 000 points, a level it first crossed three years earlier. Last week it almost hit 60 000 points.

The FTSE/JSE Shareholders Weighted Index (SWIX), the preferred benchmark for local fund managers, returned 6.5% in the month and 17.7% for the year so far. The Capped SWIX Index, which limits the Naspers weight to 10%, lagged behind, demonstrating Naspers’s incredible performance on the back of its shareholding in Chinese internet giant Tencent. Naspers has gained 71% in 2017, of which a staggering 17% came in October alone. Therefore, the Capped SWIX Index lagged with a 4.8% return in October and 13% year-to-date.

The strong local equity returns came entirely from large caps, in other words from the big global companies on the JSE, including Naspers, but also Richemont, British American Tobacco (BAT) and Anglo American. The Top 40 Index has returned 22% in 2017 but the Small-Cap Index only 1.8% while the Mid-Cap Index was flat.

Industrials led the way in October and returning 7.6% and 26% year-to-date respectively. Within the broad industrials sector there was quite a divergence between subsectors in 2017. Media (Naspers), personal goods (Richemont) and tobacco (BAT) delivered 71%, 45% and 21% respectively. However, healthcare is down 3% this year, while telecommunications is flat. General retailers are down 5% in 2017, but food and drug retailers are up 18%.

Resources had a strong month in October, returning 7% thanks to a 22% rebound in platinum miners and an 8% gain by the general miners. Forestry and paper were negative for the month. Year-to-date, resources have returned 20%.

Of the three broad sectors, financials have lagged this year returning only 6.5%. It is also the sector most negatively affected by political uncertainty, downgrades and a weak rand. Interestingly then, banks returned 2.8% in October despite the disappointing mini-Budget, while life insurers returned 3.4%. Financials returned 2.4% in the month.

Listed property is classified as part of the financials index but is treated by investors as a separate asset class. Listed property returned 1.9% in October to lift the year-to-date return to 10%, ahead of bonds but behind equities.

Bonds and rand weaker recently

Local bonds and the rand were already under pressure from mid-September as the dollar firmed up and US Treasury yields rose in anticipation of tax cuts in the US. The shock of much wider projected deficits in the Medium Term Budget only accelerated the selling. The All Bond Index (Albi) lost 2.5% as the yield curve steepened, with the R186 long bond yield kicking up 55 basis points during the month. This means the 5.3% return on the Albi for the first 10 months of the year lags cash.

The rand lost 4% against the US dollar, 3% against the pound and 2.7% against the euro during October. It was 2.8% weaker against the dollar over 12 months and this has boosted the returns from global markets for domestic investors (rather than subtracting from returns, as was the case earlier this year). The weak rand also supports the JSE, given that it is dominated by global companies.

Rising real returns

All in all, Morningstar data shows that the one-year return for the average retail balanced fund was 12.6% at the end of October (7% above inflation), while it was only 1.5% in June. Good short-term performance also lifts long-term numbers. The three-year annual return for the average balanced fund was 4.5% in June and below inflation, but 7.8% at the end of October, more than 2% ahead of inflation.

The decline in inflation from an average of 6% in the first quarter to 4.7% in the third quarter is another boost for real returns. While the softer rand and higher oil price over the past month or so will put further upward pressure on the petrol price, the overall outlook is for inflation to remain around 5%.

Lessons for investors

An important lesson from 2017 is that returns are lumpy. While the JSE is up strongly for the year, February (-3.1%), May (-0.4%), June (-3.5%) and September (-0.9%) were negative months. You have to sit through the negative months to benefit from months like October and July (+7%). Missing out on such strong short-term rallies can substantially reduce long-term returns from equities. Over time, the market trends up and there are more positive than negative months, but trying to time the market successfully and consistently is not possible.

The other lesson is that most investors sitting on the side lines wait for “the dust to settle” before getting back into the market. However, the JSE surged from July onwards despite there being little meaningful improvement in the political and economic situation in South Africa. October’s rally came despite a gloomy Medium Term Budget that could very well lead to further credit ratings downgrades. This is because the global backdrop matters more for the JSE than local developments, despite the fact that local investors often obsess about the latter. By the time the dust has settled, the market has already priced in the new reality and investors would have missed out.

Chart 1: JSE follows global markets higher

Source: Datastream

Chart 2: Main asset classes in rand, total returns, rebased to 100

Source: Datastream