In our previous market commentary report to end March 2017, we outlined a cautious but optimistic stance towards our local equity market. The good news we had hoped for has unfortunately been pushed further out and may potentially only play out during the next quarter.
Our political leadership battles and continued negative headlines such as the recent headlines around the institutional mandate of the South African Reserve Bank, the radical proposals to the Mining Charter and the material State Capture allegations has not helped our markets’ cause.
Furthermore, South Africa has now also effectively entered a technical recession i.e. two consecutive quarters of negative economic growth. Our growth rate has now been one of the slowest in the world over the past year and as a result business confidence remains low.
The All Share Index lost ground over the past 3 months ending June 2017 losing 0.39%. Money market assets continued to be the best performing asset class and yielded 1.85% followed by local nominal bonds which returned 1.49% and listed property yielded 0.91%. Resources shares were the worst performer over the quarter losing 7.05%, the sector now shows a negative return for the past 10 years.
YOU MUST UNDERSTAND THE SMALL PIECES WHICH MAKE UP THE BIG PICTURE.
Except for offshore equities, other offshore asset classes produced negative returns in Rand terms over the quarter. Offshore equities returned 1.57% in Rand terms whilst offshore cash (-2.33%), offshore hedge funds (-1.55%), offshore bonds (-0.06%) and offshore property (-0.07%) all produced negative results.
Over the longer term i.e. the past 12 months, growth assets such as local equities and property which typically produces real returns continued to struggle and returned 1.69% and 2.82% respectively which has not even matched inflation. Money market assets and nominal bonds were the best performers and yielded 7.63% and 7.93%. The Rand appreciated by 11.14% against the US Dollar and as a result only offshore equities produced a positive result of 5.55% in local currency. Offshore cash (-10.45%), offshore bonds (-13.07%) and offshore listed property (-11.28%) were all negatively impacted by the Rand’s strength.
OUR GROWTH RATE HAS NOW BEEN ONE OF THE SLOWEST IN THE WORLD OVER THE PAST YEAR AND AS A RESLUT BUSINESS CONFIDENCE REMAINS LOW.
Global growth is projected to accelerate to above 3% this year, which would be the best performance since 2014. Such growth should support risk assets for the remainder of the year. Global political risks also seem to be less than before as the risk of a Euro break up has reduced.
Domestic deflationary economic conditions motivate a rate cut as such will help to ease some of the pressure on the household and business sectors. A falling inflation rate bodes well for our bond markets which offer among the highest local currency real yields in emerging markets. Our government bonds currently offer yields around 8.5% while inflation is moving down from 6.5% last year to levels of around 5% this year. This is particularly attractive to offshore investors given the low real returns available in offshore equity markets, as well as offshore bond markets. Unfortunately, political event risk in South Africa is part of the volatile local investment landscape and it may not be long before we are downgraded to junk by all three credit agencies and between R100 to R200 billion of monies may leave the country. It is this asset allocation balance, which will need to be managed very dynamically in the months to come. For now we remain underweight South African bonds as we rather opt to be cautious and weary of our political uncertainties. Should yields move above 9% would we look to allocate further to bonds.
If looking at our local equity market, so many shares have taken an absolute beating over the past 3 years. A cut in interest rates is typically good for our equity markets (particularly industrial shares). Further, our market valuations are now fairer. We think it is a good time to start accumulating more local equity exposure and we have moved to a marginally overweight position again.
On the currency front, the US dollar rally since 2011 has potentially matured and it’s not a given that our Rand will continue depreciate over the near term irrespective of all the negative local macro and political news. We do however remain cognizant that a reversal of flows out of emerging markets should a risk off scenario unveil will make the Rand suffer. Where the Rand trades above R14 to the Dollar do we believe investors should be hedging against Rand strength and when the currency trades below R12.50 to the Dollar it will be an opportunity to increase offshore exposure again.
For now we are not fully exposed to offshore assets as we believe the Rand may strengthen from current levels of R13.50 to even lower than R13. As noted, we will be increasing our offshore exposure when we see adequate Rand strength.
As Benjamin Graham (the father of value investing) once noted –
“…THE ESSENCE OF INVESTMENT MANAGEMENT IS THE MANAGEMENT OF RISK, NOT THE MANAGEMENT OF RETURNS.”
When markets become expensive we advise our clients to hedge such exposures. The US stock market currently appears to be overvalued. The current bull market is the second longest bull market in history. Since March 2009, the S&P 500 index has gained more than 250%. Unfortunately nobody rings a bell to let us know when a bull market like this ends.
The graph below indicates the Shiller CAPE Ratio of the S&P500, which is a valuation measure to gauge whether the market is cheap, fair or expensive. The graph indicates that the S&P500 has only been at the current high valuation levels twice before in history. Despite the high valuation could global equity markets could still rally due to various factors but specifically due the current abnormally low global interest rate environment.
So, the key question is whether the party in the S&P 500 will continue or will it come to an end? Let’s look at some statistics –
- Historically there has been a close correlation between the performance of the S&P 500 and the earnings of the companies which constitutes the index. The earnings on the S&P 500 has grown by 3% annualized over the past 5 years whilst the market has returned about 11%. The market has therefore had a run beyond which the earnings of the underlying companies has shown.
- Nobel Prize winner and economist Robert Shiller recently noted that the Shiller Cape Ratio (a valuation ratio for the market) has risen to alarming heights – the ratio is now almost 30. It has only been higher in 1929 when it reached 33 and around 2000 when it reached 44.
- The US equity market has avoided a correction exceeding 10% since 2009. Typically the market has experienced such a 10% decline over any 10 year rolling period if assessed over the past 50 years. If history repeats itself we will see another 10% drawdown sometime in the next 2 years.
- As equity markets have risen so has volatility fallen. The 5-year volatility number (standard deviation) of the market has reached its third lowest level since 1949 at approximately 10%. It’s not clear what has driven this reduced level and whether such is a sign of complacency but we do get worried when markets are just ticking along irrespective of major economic and external risks.
WHAT WE DO KNOW
- Gravity always wins eventually, it will win this time too.
- Markets tend to revert to the mean over time.
- Excesses in one direction leads to an excess in the opposite direction.
We also know that the exponentially rapid rising or falling markets usually go further than we all think it should go and as Peter Lynch once said –
“…FAR MORE MONEY HAS BEEN LOST BY INVESTORS PREPARING FOR CORRECTIONS, OR TRYING TO ANTICIPATE CORRECTIONS, THAN HAS BEEN LOST IN THE CORRECTIONS THEMSELVES.”
From our perspective, we are cognizant that the S&P 500 could rise higher but we also believe that implementing a form of protection here makes sense and to tranche such protection into our client portfolios as the markets continues to hits new highs. It makes even more sense as the cost of protection is at all time lows when assessed over the past 20 years whilst uncertainty is at all time highs. With markets being pricey but the cost of protection cheap we prefer to hedge albeit that it is only a portion of our client’s US assets.
We have therefore started implementing equity hedging strategies on the S&P 500 in small tranches as the US markets continue to rise to provide us with protection should it experience a major drawdown in the next 6 months. We believe such an approach is prudent.
Furthermore, as part of our active advisory and wealth management approach have we started to advise our clients to reduce their offshore passive or tracker fund mandates for more active investment management mandates. Active investment mandates should produce some downside protection if the markets fall albeit only marginal. Together with the S&P 500 hedges are we suitably protected for any material drawdown in US equity markets.
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