What to expect in 2014

"The current shape and slope of the US yield curve is a result of artificially low interest rates applied by the US Federal Reserve Bank as well as central banks throughout the world. At the front end of the curve, i.e. short-term interest rates, the Fed has stated repeatedly that it intends to keep its lending rates zero-bound at least until late 2015. As a result, banks, life assurers and asset managers will thus derive a negative return on cash investments in relation to the prevailing inflation rate. This monetary policy that has been in place for five years has forced short-term capital to seek higher - but riskier - returns elsewhere.

Global short-term rates are unlikely to begin to normalise (increase) in 2014. The South African Reserve Bank will therefore be under no immediate pressure to begin the cycle of interest rate increases, which under normal conditions may be necessary to defend the rand against further depreciation. This is a positive factor for the JSE, as rising rates would provide an undesired headwind to a market that is not cheaply priced.

Longer-term interest rates (bond yields), have also been managed downward artificially. The US Fed and Treasury have worked in tandem using their national balance sheet to acquire US Treasuries and other agency securities in a strategy dubbed quantitative easing (QE). The key outcome of quantitative easing has been to prevent market forces from pushing yields on these government and quasi government securities upwards in an uncontrolled fashion. This exercise has avoided large potential capital losses for the holders of these securities, especially banks, life insurers and pension funds.

The gradual removal of QE (so-called tapering) will signal a time when normal market forces will again begin to drive bond yields and prices. The key point is to what level US bond yields will be allowed to adjust upwards. Rising bond yields always imply capital loss for investors, so the Fed would prefer a slow and gradual increase in bond yields. But once the taper commences, it may be difficult for the Fed to keep control over market forces without reintroducing QE, a direction it would likely avoid at all costs, as it would signify that it misjudged the situation.

This decision will impact bond yields all over the world. The trend in global bond yields is almost certain to be upward in 2014, but by how much is the question. This adjustment process will leave markets very uncertain as we navigate 2014. A larger than anticipated increase in the US 10-year yield – to above 3%, for example – will push South African yields higher (for example, to between 9% and 10% on the 10-year) and this would be negative for local equities, bonds and real estate securities.

Emerging market (EM) economies have been cooling somewhat of late due to falling commodity prices and generally subdued economic growth in the developed world. China’s GDP grew perennially at 9% to 10% in the decade to 2011 and slowed to 7.6% in 2013. It is forecast to grow at 7.4% in 2014. By and large, the EM economies are still growing at a much higher rate than the developed world, which is still hamstrung by high debt levels, weak consumers and cautious corporate sectors. This is especially true of the Eurozone and Japanese economies.

Conventional thinking has it that when US tapering commences, massive sums of capital will be sucked out of higher yielding EM assets and currencies back into US denominated assets, causing a severe depreciation in EM currencies in relation to the US dollar. This will be paired with a severe spike in EM bond and equity yields, implying big capital losses in the process.

Whilst this outcome is feasible, it could just as easily be argued that the largest proportion of the hot money has ended up in US bonds and not EM assets as suggested. Besides, a removal of QE is only possible because economics are gradually recovering. In the medium to longer term, EM economies appear to offer better demographics, growth rates and lower debt levels, whilst EM interest rates are higher and closer to delivering real returns. We would therefore be very wary about betting the house on a large and sustained devaluation of EM assets as the centrepiece of one’s investment strategy.

A devaluing rand will be broadly positive for the JSE as a growing proportion of JSE profits are being derived from non-South African sources, namely Africa and the rest of the world. The largest benefactor will be the resources sector, which has lagged the financial and industrial sectors for several years now and will benefit from the tailwind offered by a devaluing rand and more stable commodity prices.

It is unlikely that South African GDP grew beyond 2% in 2013 and it may reach around 2.8% in 2014. The South African corporate sector has, however, been very responsive to the situation. Agile management teams have applied capital to expansions into sub-Saharan Africa. Many JSE-listed companies have taken advantage of the higher growth rates on offer in Africa. Since many of these economies are US-dollar based too, they have a natural rand hedge component implied in their earnings.

The result is that diversified South African companies with growing income streams from non-South African sources are likely to deliver inflation-beating returns in 2014 and beyond.

The South African economy is a disappointment for several reasons. With policy instability and a lack of cohesion between government and business leaders, the local economy is underperforming its potential. The one issue that is uncomfortable to raise, but impossible to ignore in 2014, is the political climate going into the general election planned for May 2014. For the first time since 1994, the political temperature during the elections is likely to be elevated on a national basis.

Whilst it will not admit to it at this time, the ANC is under pressure. The party’s response will probably be to become more defensive that in previous elections. Increasing evidence of corruption and maladministration in the ANC has provided a platform for several new political formations to organise themselves. The potential for flashpoints to develop has been heightened. Expect the political rhetoric leading up to the elections to be divisive.

The world will be watching closely to see how the ANC leadership deals with these pressures and how it responds to the process of democracy in action. We would expect some weakness in asset prices leading into the election period, especially if acute conflict develops in certain highly contested areas.”