HOW TO CRASH-PROOF YOUR INVESTMENTS
After a magnificent seven-year run for local equities, storm clouds are gathering. The South African economy is virtually stalled, and the US – like South Africa – is expected to enter a cycle of rising interest rates, which raises borrowing costs for com
The JSE All Share Index (Alsi) i s up 248% i n t he l ast 10 years. That’s a growth of 13.25% a year, more t han double the average inf lation rate for the period.
SO WHY WORRY?
Because several of the engines powering this growth are stalling. Two major factors foreshadowing darker days for equity investors are the Chinese economic slowdown, which has already knocked nearly 40% off the Global Base Metals Index over the last year, and the end of the era of low interest rates.
Looming over the local market is the outlook for the rand, which is down 9% against the US dollar this year, and more than 40% since 2011. Several market analysts believe the rand is heavily oversold and could strengthen over the next year, which would take some of the froth off rand hedge stocks.
The heav y weights of t he JSE have i noculated t hemselves against sluggish domestic growth by investing abroad. Fifteen of the biggest companies on the JSE now earn more than half their revenue offshore. These include MTN, Bidvest, Steinhoff, Naspers, SABMiller, British American Tobacco, Glencore and BHP Billiton. The dominance of these hard currency earners in the index helps explain the outsize performance of the JSE at a time when the domestic economy is at a virtual standstill.
A weak rand may be good for the Alsi, but little else. It benefits exporters and companies with foreign businesses, but also fuels inflation and spreads poverty. Over the past 20 years, South Africans have become 6% poorer each year when measured in US dollar terms, according to David Shapiro, deputy chairman at Sasfin Securities.
Playing the rand hedge game has been a dominant theme among investors in recent years. And rightly so. But what if the rand were to return to R10 to the US dollar? While there is nothing on the horizon to suggest a reversal, Warren Ingram, director at Galileo Capital, believes the rand at R12.70 to the dollar is horribly oversold.
“There is a strong correlation between the rand and the commodity cycle, which has
been weakening in recent years. I don’t see much advantage in sending a lot of money out of SA at this stage,” says Ingram.
“If we look back at the early 2000s, we get a sense of what can happen. At that time the rand fell to about R12 to the US dollar and then clawed its way back to around R6. If you send money out at R12.70 to the US dollar, and the rand strengthens from here, you are looking at a certain loss.”
THE CHINA FACTOR
Another development worrying local investment managers is the slowdown in the Chinese economy, which has already knocked about 40% to 50% off commodity prices for copper, i ron ore, coa l a nd gold. This, coupled with r ising labour and input costs as well as electricity supply disruptions, has devastated t he resources sector which now accounts for just 23% of the JSE’s market capitalisation, compared to 43% i n 1994. The commodities super cycle, fuelled by China’s massive i nvestment i n manufacturing, pushed t he Metals index up four-fold between 2001 and 2007. It has been in steady decline since 2011. Equity prices have been buttressed by low interest rates for much of the last decade. In June the Reserve Bank hiked its key repo rate by 0.25% to 6%, signalling what may turn out to be the end of the era of sustained low interest rates. This had little effect on the JSE, but any further increases in rates will almost certainly take some of the shine off equities as an asset class.
In a recent report Shaun le Roux, portfol i o manager at PSG Asset Management, says that although the JSE Alsi seems to be undergoing a mild correction, having fa l len 7% from its peak in April this year, in US dollar terms the index has lost about 18% over the past year.
“The more popular parts of t he market, perceived to be of higher quality or producing more consistent prof it growth, have been on a tear over the past year – with several of the popular names posting year-on-year gains in excess of 50%,” says Le Roux. “On the other side of the performance charts, resource counters have had a torrid time over the past year. At an index level share prices have declined by 43%,” he says.
The one ray of light in all this gloom is the 50% drop in the price of crude oil over the past year, which has helped keep inflation under control. But that benefit has all been wiped out by the decline in metals and minerals prices on which we depend for export earnings. And while rand weakness in the past has helped boost export competitiveness, that advantage has disappeared due to lack of electricity supply and labour unrest.
At a recent JPMorgan conference, analysts were asked which emerging market country offered the biggest investment opportunity over the next two years. Not a single analyst named SA, according to a recent report by Coronation Fund Managers. They named Brazil as the top opportunity, followed by India, Russia and Mexico.
ArcelorMittal ’s i nterim results published i n July summed up t he domestic environment: “Locally, the economy is nearly at a standstill due to electricity constraints, infrastructure development delays and the low spending in the mining sector.”
“South African companies have now opted to focus on investments that increase productivity to compensate for salary increases rather than invest in growth projects,” it stated.
Shapiro says SA’s growth for the next three years is likely to range between 2% and 2.6%, which is a good percentage point below the forecast global mean of 3.3% to 3.6%. That means we are likely to underperform not only other developing economies, but developed economies such as the US and UK.
“Our growth is likely to be lower than our developing country peers and even developed economies such as the US and UK. The downward shift in commodity prices poses a major threat to growth and social order. Lower commodity prices will benefit consumer countries, particularly Europe and the US. Falling oil prices should provide some relief,” he explains.
Also disconcerting is the divergence
be t ween t he J SE a nd busi ne ss c onf i dence ( se e g r aph on le f t). Confidence is at the lowest level it’s been in a decade, the result of a laundry list of ills according to Shapiro, including Eskom outages, overregulation of the economy, strained labour relations and threats to private property.
The dispa ri t y bet ween equit y prices and a deteriorating economic environment makes little sense until one starts to unpack the components of the Alsi. Says Ingram: “The JSE is hiding massive disparity between five to eight glamour shares which are very expensive, versus the entire resources sector, which is cheap. So looking at the index on its own does not [provide] the full picture.”
BEARISH ON SA
Foreign analysts have turned negative on SA and emerging countries in general. Stephen Meintjes of Imara SP Reid told Finweek this negativity creates attractive opportunities on the JSE. “An increasing number of foreign investors realise that not only do emerging market economies differ widely in many areas – including corporate governance in the private sector – but the JSE, while by no means i ndependent of t he South African GDP, is relatively resilient,” he says. “This is due to the need, over many decades, to diversify outside the local economy due to limited growth prospects. Needless to say, the school fees were high over the years but many are getting it right.”
The diversif ication by SA Inc provides JSE investors a natural hedge against rand weakness, but buying the index alone may not be diversification enough. Investors will have to hunt harder for value stocks capable of smoothing any turbulence ahead.
In a recent report to investors, Coronation Fund Managers says global f inancial markets continue to be i mpac te d b y the now extended period of extraordinary accommodative monetary policy a ppl ie d i n most of t he major economies around the world. “While European, Japanese and Chinese authorities have become even more accommodating, markets have started to discount a slow normalisation in interest rates in the US. This has resulted in a period of significant US dollar strength, with most currencies remaining under pressure.”
We are now in the seventh year of a bull market supported by low interest rates, which have come to be accepted by investors as the norm. The result is exaggerated valuations for most asset classes, particularly high-quality companies that have historically paid reliable dividend yields. “This is due to these businesses increasingly being seen as proxies for bonds that are producing record-low yields. This, as a broad simplification, has led to an environment where investors have to venture further down the quality curve to f ind attractive valuations,” according to Coronation.
While the timing of the f irst interest rate hike in the US may be uncertain, a normalisation of abnormal monetary policy remains inevitable.
The US economic recovery is on track, and the f irst real signs of inf lation pressure are emerging as wages start to climb in a tightening labour market.
For retirees reliant on stable mont hl y i nc ome, t he se ar e challenging times. Corporate bonds in well-funded institutions can be attractive, as are some preference shares, but these are often highly illiquid. Fixed property similarly offers a stable yield, but there is the risk of tenants defaulting as we head into the economic downturn.
Doug Turvey, private cl ient portfolio manager at Cannon Asset Managers, says stable i ncomeseeking investors will need to be patient, realistic and tempered in their expectations.
“The excitement and opportunity probably lie in the equity-centric yields, corporate bonds, l isted property and preference shares for now,” he says.
SOUTH AFRICAN COMPANIES HAVE NOW OPTED TO FOCUS ON INVESTMENTS THAT INCREASE PRODUCTIVITY TO COMPENSATE FOR SALARY INCREASES RATHER THAN INVEST IN