US rate hike hasn’t derailed the Rand

20 June 2017 | Investments | General | Dave Mohr, Izak Odendaal, Old Mutual

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

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

The US Federal Reserve (the Fed, as it is commonly known) increased its target interest rate last week as expected by 0.25%. The fourth increase since the start of the historically gradual hiking cycle in December 2015, it takes the fed funds rate target range to a range of 1% - 1.25%. (We pay close attention to US markets and interest rates since they set the tone for global markets and by implication, South African markets.) The Fed also spelled out plans to reduce its $4.5 trillion balance sheet, which ballooned after three rounds of quantitative easing between 2008 and 2014.

Dollar weaker, not stronger

Rising US short-term rates should in theory result in a stronger US dollar and higher long-term market rates (the yield on government and corporate bonds). Instead, the opposite has happened. The dollar has softened this year, but it did rally strongly in anticipation of higher rates from 2011 onwards. The yield on the 10-year US Treasury jumped from 1.8% to 2.6% after the presidential election in November as the market expected faster growth and higher inflation. But at the end of last week (and three Fed hikes later) the yield was 2.1%. This appears to be a return of the “conundrum” former Fed Chair Alan Greenspan spoke about in 2005, after bond yields moved sideways despite 150 basis points of interest rate hikes.

Greenspan’s successor, Ben Bernanke, identified a ‘global savings glut’ as the main reason why. China and other large current account surplus countries, together with the oil producers, were recycling their dollars back into the US bond market (pushing prices up and yields down) instead of investing domestically. This was partly to prevent their currencies from appreciating too much.

The savings glut thesis is less relevant today: oil producers clearly have less spare cash, while China is much less dependent on exports (the export share of GDP has halved over the past decade) and more on domestic consumption. These days, the low yields seem to reflect investors’ appetite for safe, liquid assets, still scarred by the financial crisis, as well as their expectation of verylow inflation remaining. In fact, inflation has been falling over the past few months.

The participants on the Fed’s monetary policy committee (the FOMC) produced their quarterly projection of how the hiking cycle is likely to unfold. This hasn’t shifted, and the Fed still expects the fed funds rate to eventually settle at 3%, i.e. three hikes per year for 2017 and the subsequent two years. The market clearly doesn’t believe this will happen.

While the US bond market is still reflecting a view of low growth and low inflation, US stocks are still close to record highs. Despite the fumbling of the Trump presidency, corporate tax cuts are still expected to be delivered by the Republican-controlled Congress within the next year or so. A weaker dollar and stronger global growth have supported companies that do business outside the US. Finally, global technology giants (like Facebook, Amazon, Apple, Microsoft and Google) have been at the forefront of the recent rally.

Favourable backdrop for the Rand

The combination of a weaker dollar, lower yields in the developed world (European and Japanese central banks are still buying bonds) and faster global growth has been supportive of emerging markets, including South Africa. The rand rallied after the Fed’s announcement of the best level against the dollar in four months, before pulling back on the release of the new mining charter. The 10-year government bond yield has fallen from 9% to 8.4% this year.

The stronger rand should put further downward pressure on inflation. For instance, the current over-recovery of 60 cents per litre points to a petrol price cut of similar magnitude next month. In turn, lower inflation provides scope for the Reserve Bank to cut rates. In fact, with inflation falling, real interest rates are rising, so the SARB risks falling behind the curve as the economic recovery struggles to take root. Sticking to a traditional view, the SARB has been hugely concerned that Fed hikes would lead the dollar higher, and has maintained relatively high rates as a result. But clearly this is not happening, nor has a string of downgrades derailed the currency.

Silver lining for the domestic economic

Lower inflation and potentially lower rates is the silver lining for the domestic economy at the moment amid bad news piling up. The BER/RMB Business Confidence Index slumped to its lowest level since 2009 in the second quarter, with a reading of 29 index points (with 50 being the cut-off between net positive and net negative). This long-standing survey of business sentiment has only been lower in 41 out of 171 quarters. All five sub-indices - covering the cyclically sensitive sectors of manufacturing, retail, wholesale, motor trade and construction - declined during the quarter (this has happened only 12 times before) and are in net negative territory. According to the Bureau for Economic Research, the fall in the index does not only represent political uncertainty following the Cabinet reshuffle and downgrades, but also tough operating conditions. Specifically, businesses are hamstrung by weak consumer demand. However, the other notable economic data release from last week was better: StatsSA reported that real retail sales grew by 1.5% year-on-year in April, ahead of economists’ expectations. The April number is also better than the first quarter average.

Local equities struggling

In contrast to global markets, the JSE All Share Index has moved sideways over the past three years and pulled back sharply over the past three weeks. Part of this story is obviously the weak economy, which has hurt the prospects for domestic-focused companies. The other part is the stronger rand which has weighed on the returns of rand-hedge shares, whose revenues are more than half the JSE total.

Unlike in rand terms, the JSE All Share has more than kept up with global markets in US dollar terms in the past year, returning 20% compared to the MSCI World’s 18%. There have also been stock-specific issues pulling the index down. These include Naspers, the biggest share in the index, pulling back from its staggering run in line with other global tech giants, Sasol declining on the lower rand oil price, Steinhoff picking up problems with its acquisition streak and MTN’s troubles with regulators in several markets. Mining shares, under pressure from lower commodity prices, fell back further after the Minister of Mineral Resources announced a new mining charter that requires 30% black ownership within a year, and other stringent conditions that surprised the market.

What are the asset allocation implications?

The net result of the above has been disappointing returns for investors. Local equities, where the bulk of most balanced funds invest in, have given below inflation returns over the past year. Global equities have performed well in dollars but are flat in rands. Within the global universe, emerging market equities have delivered positive returns in rands over the past year. Only bonds have delivered solid inflation-beating returns.

From an asset allocation point of view, the correct call has been to be underweight in local equities and overweight in local bonds. An overweight in global equities has not paid off hugely due to the stronger rand, but the diversification case is strong, particularly given domestic uncertainties. Should the Reserve Bank cut rates (and they should), bonds will be even more attractive relative to cash.

The current challenge for investors is that they are faced with a double-whammy of disappointing returns from most asset classes and ongoing bad news about the local economic and political landscape. The temptation to “do something” to address the situation and switch and alter portfolios is large. One can only hear “be patient” and “focus on the long term” so many times before you stop believing it. But history tells us that the biggest risk at a time like this, for someone in an appropriately diversified portfolio, is not sitting tight. The good returns of the past were always lumpy, with the fat years interspersed with lean years. But since nobody can consistently predict what the next 12 or 24 months will hold, sticking to the plan is the only realistic option. Over time
there have been more good years than bad years.

Chart 1: US 10 YEAR TREASURY YIELD %