Investment and economic update
23 November 2017
Even before Finance Minister, Malusi Gigaba, tabled his rather sombre Medium-Term Budget Policy Statement (MTBPS) on 25 October, it was already evident that the economy was in a fix. His speech merely served to confirm this and unfortunately missed an opportunity to table concrete plans by the government to address the economy’s shortcomings. In reality, the speech was merely a call to action and not a convincing plan at all.
With the consolidated budget deficit now projected to widen to 4.3% of gross domestic product (GDP) in 2017/18 against a 2017 budget target of 3.1%, the speech has left credit ratings agencies more concerned about the health of the economy. In fact, Moody’s has now joined the other two main credit rating agencies (Fitch and Standard & Poor’s) in sharply criticising the MTBPS as a “marked credit-negative departure from previous consolidation efforts,” noting that it is the first fiscal policy document over the past few years that does not explicitly aim for fiscal consolidation.
Of course the task before Minister Gigaba was never one easy. He is dealing with an economy that continues to lose momentum and an unemployment rate that is still stuck at historic highs. This is a conundrum that is now expected to cut tax revenues by R50.8 billion in the current year, the largest downward revision since the 2009 recession. At the same time, the third quarter unemployment rate remained unchanged at 27.7%, as reported by Statistics SA – a marked deterioration from the 27.1% recorded over the same period in 2016. More worrying about this jobs data is the youth unemployment rate, which also remains unchanged at 38.6% for people aged between 15 and 34. Unemployment in this segment is the highest (at 32.6%) among people who have less than a matric-level education.
Unemployment is but one of the many challenges that the Minister failed to address adequately in his MTBPS, as had been widely expected. Instead, he placed emphasis on the 14-point plan that he had unveiled in July this year to revive the domestic economy – further detail of which we can only assume will be unveiled in the main Budget Speech in February 2018. Until then it appears South Africa continues to have great intentions to revive its faltering economy but unfortunately, no concrete action plan is in place – to the disappointment of international credit ratings agencies.
Given the current economic and investment environment, the importance of receiving and implementing professional advice from your financial adviser is paramount to ensure that your investments are sufficiently diversified to withstand market fluctuations and maintenance of your long-term holistic financial plan.
Local economic outlook
During the October 2017 Medium-Term Budget Policy Statement (MTBPS), South Africa’s Finance Minister, Malusi Gigaba, demonstrated less than satisfactory policy guidelines in balancing fiscal discipline and resuscitating economic activity. To this end, markets have swiftly begun pricing in a benign economic trajectory, with an expectation of suboptimal expansion rates over the next three years.
Undershooting economic growth targets while indicating low levels of commitment toward fiscal consolidation, is a condition likely to induce more struggles in fending off further credit rating downgrades. Due to low levels of economic activity along with high unemployment rates, the local government still expects challenges in collecting adequate tax revenue to simultaneously reduce the debt deficit and engage in expansionary fiscal policies, which is necessary for economic growth and development.
The grim reality is that in the presence of a financially squeezed middle-income household, the South African government is now forced to resort to raising sin and price-insensitive product taxes (i.e. fuel), selling portions of equity stakes in state-owned enterprises and increase borrowing from the global debt market. The latter stance unfortunately bears ill-intended consequences such as higher borrowing costs, a weaker rand and increasing pass-through inflationary headwinds (from a depreciating currency).
Notwithstanding potential rand weaknesses, the South African Reserve Bank (SARB) further cited high meat price inflation, upward pressure in global oil prices and expected increases in administered costs to be joint catalysts to the current inflationary outlook. On the balance of these risks, the Monetary Policy Committee (MPC) of the SARB opted to pause the easing cycle during their September 2017 meeting. The SARB is currently forecasting range-bound inflation print over the next 18 months, with the market completely discounting possibilities of rate cuts over the same time period.
Local market outlook
Even though yields at the short end are unlikely to rise faster than longer dated yields in response to a potential credit rating downgrade, the mid area of the yield curve should achieve better risk-adjusted returns due to attractive coupons and limited upside in yields. A narrow room for easing the repo rate and a poor economic outlook create a bias for taking a duration neutral strategy.
A duration neutral strategy would suggest an overweight in the R204 and an underweight in the 2023. From a break-even perspective, SA inflation-protected securities still remain relatively expensive in comparison with nominal debt and emerging market peers. Limited demand-pull inflationary headwinds is yet another reason why we remain reluctant to overweight inflation-linked securities at current levels.
From an asset allocation perspective, we have remained relatively bearish rand-denominated paper mainly due to a benign economic outlook and threats of further credit rating downgrades. Our local bond exposure across our balanced fund strategies ranges between 12% and 5%, pricing in effects of potential duration risks from the normalisation of long-term yields.
Valuations within the equity market also indicate the absence of a strong earnings catalyst in maintaining the recent run of the all share and Top 40 index. Sub-5% projected global GDP growth rates and lofty price-earnings multiples (spot and forward) still suggest caution towards the local equity bourse. A risk-off trade on the back of currency weakness and subdued bond returns has largely driven the market to surprise on the upside. According to our intrinsic value estimate, the all share index currently trades at a 4.6% premium, with an expected three-year annualised return of approximately 12% nominal.
Source: GI&S Africa, October 2017
House view summary
|Growth||The economy of South Africa is likely to expand at less than full potential over the next three years. Sub-investment ratings, a volatile currency and poor corporate profitability levels, are expected to increase the cost of servicing debt, where companies will be forced to either cut capital spending, undergo debt stress or reduce labour force. We therefore expect unemployment rates to remain stubbornly above 25% over the foreseeable future.||Prospects for the world economy seem a bit brighter compared to last year, as evidenced by the pickup in business confidence surveys across major economies. The more visible decline in unemployment figures suggests that demand pressures are already on an upward trajectory. Global economic activity is now expected to expand by 3.7% and 3.8% over the next two years.|
|Inflation||Challenges to CPI moderation or even a low and stable inflation print continue to linger. These challenges stem from the low supply in meat and meat-related products, increases in administered prices and pass through inflationary threats from appreciating oil prices. We therefore expect inflation to remain uncomfortably range bound over the medium term, with strong upside limitations from benign consumption propensities.||We anticipate that the world’s major central banks will find a 2% inflation target very difficult to achieve, let alone maintain over the next half a decade. Even though a gradual path of inflation towards 2% is more important than overshooting the target, we currently expect that mild deflation and easy monetary policy will remain the global economic order until recovery is firmly established.|
|Exchange rates||Although the rand is still undervalued against the dollar from a purchasing power parity perspective, faltering growth and a high inflation differential with our trading partners, make it unlikely for the currency to strengthen above the ZAR10 level again. We are currently pricing in a rand depreciation that is broadly in line with inflation differentials between SA and G10 markets.||Fed policy normalisation is set to accelerate the strength of the dollar, while accommodative monetary policy in Europe, the UK and China point towards a renewed weakness in the euro, pound and yuan respectively. It is therefore envisaged that the rand’s nominal effective exchange rate (NEER) could weaken conservatively over the short to medium term.|
Source: GI&S Africa, October 2017
Strategic asset allocation
Source: GI&S Africa, October 2017
House view matrix
|Asset class||Short-term view||Medium-term view||Rationale|
|SA Equities||Neutral||Neutral||The absence of a strong earnings catalyst with a number of counters already trading above fair value mutes short-term appetite. We favour rand-hedged stocks on the back of surging G10 currencies to improve the medium-term return outlook.|
|SA Property||Bullish||Neutral||Interest rate-geared earnings and currency-hedged growth continues to justify a long SA REIT position. Sluggish economic growth rates will conversely lead to increasing vacancy space over the medium term.|
|SA Bonds||Neutral||Bearish||Weak economic activity and falling inflation expectations favour a duration neutral strategy. High budget deficits and heightened threats of credit rating downgrades are conversely prone to bid yields high in the medium term.|
|SA Cash||Neutral||Bearish||The risk-reward profile of cash and short-term maturity bonds appears fundamentally strong relative to other asset classes in the short term. However, range-bound inflation and a flat policy regime are expected to bolster the premium of risky asset classes.|
|Commodities||Bearish||Bearish||US monetary policy normalisation and shifts from industrialisation to consumption led economic policies in China are set to keep the commodity risk premium unattractive for extended time periods. Increased exposure towards energy commodities may be justified by smaller than expected oil surpluses.|
|DM Equities||Bullish||Neutral||A strengthening dollar is expected to undermine US equity earnings while the ongoing pickup in global inflation should lead to better pricing power and attractive nominal returns for developed market equities. Long developed market equities relative to emerging market counterparts.|
|DM Bonds||Bearish||Bearish||Valuations indicate that these securities are currently trading at a significant premium, where real returns appear to be particularly stretched on the back of increasing inflation expectations.|
|DM Property||Neutral||Bearish||Due to low diversification benefits, this asset class remains a tactical call as it carries a high level of systematic risk relative to the DM equity index. Limited room for yield compression anchors yet another reason we remain bearish offshore REITS over the medium term.|
Source: GI&S Africa, October 2017
We maintain a strategic asset allocation for five risk profiles, based on our outlook for each asset class. Our asset allocation committee, made up of senior investment strategists and portfolio managers, regularly assesses the need for strategic and tactical adjustments to pre-existing allocations, based on our short- to medium-term risk and return expectations. Here, we share our latest thinking on shifts in market and economic cycles that can present both threats and opportunities to your investment portfolio. Non-quantifiable threats such as unstable global political backdrops are set to remain noisy, but investors will be best served by tuning much of this out and focusing on the fundamental benefits of asset allocation, which largely insulate extreme cases of volatility from your multi-asset portfolio.
Disclaimer: The advice contained on this blog is for general purposes only and does not take into account individual circumstances, objectives or financial needs. Accordingly, readers are advised to seek appropriate advice from licensed professionals prior to making any investment, or taking up a financial product or service.