With global mar­kets soar­ing to new highs, some jit­tery an­a­lysts be­lieve that the bull’s days are num­bered. In South Africa, risks also abound, with the ANC’s elec­tive con­fer­ence loom­ing and an­other sov­er­eign credit rat­ing down­grade a pos­si­bil­ity. So which

Finweek English Edition - - Front Page - By Mar­cia Klein

b etween sky-high val­u­a­tions glob­ally, Don­ald Trump’s un­pre­dictable ac­tions in the US and Ja­cob Zuma’s dis­as­trous lead­er­ship re­sult­ing in po­lit­i­cal and eco­nomic crises in South Africa, it is prob­a­bly fair to say that the rest of 2017 holds sig­nif­i­cant risk for in­vestors.

In­creased risk and height­ened un­cer­tainty now come stan­dard with any in­vest­ment de­ci­sion, and the abil­ity of fund man­agers to adapt to these con­di­tions for long-term gain is ar­guably untested. Many fund man­agers con­tinue to ad­vise in­vestors to block out the pre­vail­ing “noise” and stick to long-term tar­gets. Un­for­tu­nately, the out­come of this ad­vice will only be ev­i­dent in the fu­ture.

But de­spite the tur­moil, eq­uity mar­kets re­main buoy­ant and eco­nomic growth and cor­po­rate earn­ings, par­tic­u­larly in de­vel­oped mar­kets, are on the rise.

Sit­ting in SA, it is hard to see through the noise, which is made all the more deaf­en­ing by our es­ca­lat­ing home-grown chal­lenges, which means any uptick else­where is only felt par­tially. Eq­ui­ties re­main rel­a­tively ro­bust, but cor­po­rate earn­ings in cer­tain sec­tors are un­der un­prece­dented pres­sure, and the econ­omy is, well, just about grow­ing.

Global eq­uity mar­kets are up with the S&P 500 reach­ing record highs in Septem­ber, driven largely by bet­ter eco­nomic growth prospects and in­vestor con­fi­dence, specif­i­cally in fast-grow­ing com­pa­nies like Face­book and Ama­zon and the rise of biotech and other dis­rup­tive busi­nesses.

The sus­tained bull run has given rise to skit­tish in­vestors fear­ing and an­tic­i­pat­ing the burst­ing of what some per­ceive to be a bub­ble. The Fi­nan­cial Times, among oth­ers, re­ports that fund man­agers are hoard­ing cash and try­ing to hedge against pos­si­ble crashes.

It must be said, how­ever, that fear of a crash and in­creas­ing share prices have been sit­ting com­fort­ably side by side for a num­ber of years. In­vestor con­fi­dence has won out, but that does not mean the risks are not for­mi­da­ble.

What are the risks? Glob­ally

Eq­uity val­u­a­tions are high. As Ash­bur­ton and FNB Se­cu­ri­ties point out, the S&P 500 reached “a new peak for the five-year long eq­uity bull mar­ket”. The bull mar­ket has, they say, co­in­cided with the rise of the FANG (Face­book, Ama­zon, Net­flix, and Google) stocks, which have been the mar­ket lead­ers so far this year, with Face­book up 48% by the end of Au­gust, Ama­zon 29%, Net­flix 41%, and Al­pha­bet 19%, against the S&P 500’s 10% rise.

The US Fed­eral Re­serve is end­ing quan­ti­ta­tive eas­ing, in­tro­duced through the ac­qui­si­tion of $4.5tr of bonds and as­sets to stim­u­late the US econ­omy fol­low­ing the global fi­nan­cial cri­sis nearly a decade ago – a move aimed at low­er­ing long-term in­ter­est rates and boost­ing the econ­omy and in­vest­ment. Al­though it has not bought as­sets since 2014, it will now be­gin to un­wind them, paving the way for fur­ther in­ter­est rate hikes, in­clud­ing one an­tic­i­pated in De­cem­ber. The Fed’s ac­tions may lead to some pres­sure on the US econ­omy, com­pany prof­its, bond yields and in­vestor sen­ti­ment in the US and, by de­fault, sim­i­lar reper­cus­sions in other mar­kets.

North Korea’s test­ing of nu­clear weapons and es­ca­lat­ing ten­sion be­tween it and the US is just one ex­am­ple of ris­ing ten­sions glob­ally, in­clud­ing the ef­fect of Brexit on the EU. Within some coun­tries ten­sions are ris­ing on the back of debt crises, ris­ing poverty lev­els, fear for jobs in the fu­ture, the ef­fect of im­mi­gra­tion and chal­lenges of in­fra­struc­ture and sus­tain­able re­sources. The spat be­tween North

Many fund man­agers con­tinue to ad­vise in­vestors to block out the pre­vail­ing “noise” and stick to long-term tar­gets.

Korea and the US caused a mo­men­tary blip in eq­uity mar­kets, and var­i­ous re­ports sug­gested that in­vestors ei­ther ex­pect a ra­tio­nal and be­nign out­come, or eq­uity mar­kets to just march ahead, no mat­ter what. Michele San­tan­gelo, port­fo­lio man­ager at

In­de­pen­dent Se­cu­ri­ties, says with el­e­vated val­u­a­tions in the US at the mo­ment, any cracks in out­look there will re­sult in a cor­rec­tion in US mar­kets, which will have a rip­ple ef­fect across the globe, al­though this does not look likely at the very mo­ment.

The end­ing of quan­ti­ta­tive eas­ing and the process whereby the Fed will re­duce the size of its bal­ance sheet also poses a risk, where his­tor­i­cally eq­uity mar­ket re­turns have been cor­re­lated to the change in size of the Fed's bal­ance sheet, San­tan­gelo says.

Ac­cord­ing to Mar­ket Watch, the global eq­uity rally has been driven by cor­po­rate earn­ings rather than cen­tral banks, in­di­cat­ing that a re­vi­sion of quan­ti­ta­tive eas­ing may not have a sig­nif­i­cant ef­fect on the mar­ket.

“The case for fur­ther rate hikes in the US is look­ing stronger and this could put a damper on US growth prospects,” San­tan­gelo says. “North

Korea could be one of those un­known po­ten­tial prob­lems which can cause mar­ket jit­ters and any es­ca­la­tions in the con­flict be­tween the US and North Korea could quickly put mar­kets in a risk off mode.”

Given all of the risks, com­men­ta­tors say fund man­agers are hoard­ing cash and look­ing at hedg­ing against tur­bu­lence and they warn that a ma­jor cor­rec­tion could be over­due.

Ge­orge Cipol­loni, a se­nior port­fo­lio man­ager at Chartwell In­vest­ment Part­ners in the US and Ned­group In­vest­ments Global Cau­tious Fund subin­vest­ment man­ager, says volatil­ity and un­rest in mar­kets cre­ate op­por­tu­ni­ties to find value, and that “good com­pa­nies, or im­prov­ing com­pa­nies with good fu­ture prospects, should be able to per­form well in any con­di­tions”.

Cipol­loni says eq­ui­ties re­acted pos­i­tively to Trump’s elec­tion, while the US Trea­sury mar­ket did not, and bond yields spiked. Trump’s pro­posed cor­po­rate tax cuts would be good for com­pa­nies, he says. High val­u­a­tions mean it is in­creas­ingly dif­fi­cult to find value – “but that doesn’t mean it’s not there”.

Franklin Tem­ple­ton Global Eq­uity Group’s Cindy Sweet­ing and An­to­nio Do­cal say mar­kets are show­ing “a some­what cau­tious, if not un­com­fort­able, op­ti­mism”.

“Ex­per­i­men­tal cen­tral bank mon­e­tary pol­icy across the globe has fu­elled global stock price ap­pre­ci­a­tion, but a dan­ger­ous de­pen­dency on stim­u­lus to gen­er­ate ever-higher mar­ket re­turns is a pos­si­ble side ef­fect. This could present chal­lenges for fu­ture eq­uity mar­ket per­for­mance as ma­jor cen­tral banks grad­u­ally move to nor­malise ex­traor­di­nar­ily sup­port­ive pol­icy mea­sures.” Franklin Tem­ple­ton raised some con­cerns for the rest of the year, in­clud­ing di­min­ish­ing in­vestor con­fi­dence in Trump’s abil­ity to en­act pro-busi­ness poli­cies and it is not sure that his plans to lower taxes or boost in­fra­struc­ture spend­ing will ma­te­ri­alise in leg­is­la­tion.

Euro­pean mar­kets, how­ever, have ben­e­fit­ted from “pos­i­tive eco­nomic growth, sup­port­ive mon­e­tary pol­icy and mar­ket-friendly elec­tion re­sults,” Euro­pean GDP growth has out­paced that of the US over the past year and cor­po­rate prof­its have been ac­cel­er­at­ing. Franklin Tem­ple­ton said that “cor­po­rate earn­ings and cash flow gen­er­a­tion will mat­ter most for eq­uity re­turns go­ing for­ward”, al­though cen­tral bank pol­icy will con­tinue to de­mand mar­ket at­ten­tion in the sec­ond half of the year.

Lo­cal risks

Emerg­ing mar­kets have shown strong re­turns in 2017, and UBS Wealth Man­age­ment cited China, In­done­sia, Rus­sia, Thai­land and Turkey as in­vest­ment op­tions but snubbed SA due to ex­pen­sive val­u­a­tions, low earn­ings and po­lit­i­cal in­fight­ing.

“Our tra­jec­tory for in­vest­ment is veer­ing from other emerg­ing mar­kets and for South African in­vestors, the lo­cal risks add an­other layer of risk which are not en­cour­ag­ing.

“Lo­cally it is all a po­lit­i­cal story,” says San­tan­gelo. The ANC elec­tive con­fer­ence in De­cem­ber could be a turn­ing point for in­vest­ment, but this is un­likely given the ANC’s in­abil­ity to act against Zuma. If

deputy pres­i­dent Cyril Ramaphosa edges in, there could be a more in­vestor-friendly en­vi­ron­ment, but the odds are stacked in favour of con­tin­ued poor man­age­ment of the econ­omy, in­creas­ing poverty and un­em­ploy­ment as well as higher lev­els of cor­rup­tion and waste­ful ex­pen­di­ture, all of which scup­per eco­nomic growth and in­creased in­vest­ment po­ten­tial.

Fur­ther rat­ing agency down­grades still loom large for South Africa. Moody’s, which has a sov­er­eign credit rat­ing of one notch above junk sta­tus for the coun­try af­ter a down­grade in June, is ex­pected to give its next credit as­sess­ment in Novem­ber. It has in­di­cated that it is not see­ing pos­i­tive signs and com­mented specif­i­cally on rad­i­cal eco­nomic trans­for­ma­tion and its risks to growth and the un­der­min­ing of in­vestor con­fi­dence. Moody’s said that in the run-up to the elec­tions “the com­mit­ment to dif­fi­cult (and hence less pop­u­lar) re­forms aimed at pro­mot­ing growth and con­sol­i­dat­ing govern­ment

fi­nances has been weak­en­ing, such as the much talked about re­form of state-owned en­ter­prises which has stalled”.

SA may have come out of re­ces­sion, but there is lit­tle prospect of eco­nomic growth. The Re­serve Bank has fore­cast GDP growth of just 0.6% for 2017 and 1.2% in 2018. At these lev­els, in­vestors would be silly not to look else­where for de­cent re­turns.

Dif­fer­ences over whether lo­cal com­pa­nies are or aren’t hoard­ing cash do lit­tle to hide the fact that SA is not see­ing mean­ing­ful in­ward in­vest­ment, nor are most of its com­pa­nies in­vest­ing lo­cally. The fact that over 60% of JSE-listed com­pany earn­ings are de­rived off­shore in­di­cates the sea change in in­vest­ment de­ci­sions over the past decade.

For in­di­vid­ual in­vestors, the story is no dif­fer­ent. “Given all the risks, it is good to have a de­cent per­cent­age of your port­fo­lio off­shore,” says San­tan­gelo. De­spite some re­newed in­ter­est in emerg­ing mar­kets, “South Africa’s idio­syn­cratic is­sues sup­pressed in­vestor ap­petite”.

“The big­gest risk in the short term is the po­ten­tial down­grade by Moody’s in Novem­ber,” com­ments San­tan­gelo. “If we see a down­grade of lo­cal debt, in­vestors won’t be able to in­vest in the lo­cal bond mar­ket and lo­cal bonds won’t be able to be in­cluded in in­dices.”

Moody’s would be watch­ing the Medium-Term Bud­get Pol­icy State­ment, out to­wards the end of Oc­to­ber, care­fully, “but it would have to be ro­bust and mar­ket-friendly to at­tract in­vest­ment and it is likely not go­ing to be, es­pe­cially with talk of the nu­clear deal com­ing back”, he says. “It will be dif­fi­cult forTrea­sury to sway in­vestor sen­ti­ment.”

How to in­vest given the risk out­look

Fund man­agers con­tinue to en­cour­age South African in­vestors to in­vest glob­ally.

For lo­cal in­vestors, there are a lot more op­por­tu­nity sets off­shore, says San­tan­gelo. “There are a lot of strong-per­form­ing emerg­ing mar­kets to in­vest in as well as in­vest­ment themes glob­ally which are not avail­able in South Africa, like ro­bot­ics and the In­ter­net of Things.

“There is the op­por­tu­nity to in­vest in growth themes, whereas lo­cally in­vestors are go­ing to strug­gle to get re­turns,” he ex­plains.

There are some op­por­tu­ni­ties for in­vest­ment in

some good lo­cal mid-cap stocks, which have been ham­mered lately and are set to re­cover. Lester Davids, trad­ing desk an­a­lyst at Unum Cap­i­tal, says he favours Corona­tion Fund Man­agers, a for­mer JSE high-flyer that has lagged the mar­ket over the past few years be­cause of its ex­po­sure to re­sources and slower growth in as­sets un­der man­age­ment off an in­creas­ingly high base.

But the re­sources sec­tor is re­cov­er­ing, and Corona­tion in­di­cated that it had re-opened some of its in­sti­tu­tional funds, which “should re-ac­cel­er­ate in­flows go­ing for­ward”.

Unum Cap­i­tal also holds a num­ber of other mid-caps in­clud­ing Blue La­bel, Clicks Group, Im­pala Plat­inum, Pi­o­neer Foods and Syg­nia, and has both Dis­tell and Corona­tion on its radar.

Mean­while, Black­Rock re­cently said it re­mains neu­tral on US stocks and over­weight on emerg­ing mar­ket eq­ui­ties, favour­ing Asian stocks. The MSCI Emerg­ing Mar­kets In­dex’s rise of close to 30% this year has been fu­elled by the per­for­mance of com­pa­nies like Sam­sung, Alibaba and Ten­cent.

Ash­bur­ton In­vest­ments port­fo­lio man­ager Jan Botha and in­vest­ment an­a­lyst at FNB Wealth

Chan­tal Marx said there is a grow­ing in­ter­est in dis­rup­tive tech­nol­ogy un­der­pinned by strong cash flows and good prof­itabil­ity.

Com­par­ing new tech­nol­ogy com­pa­nies to those in the dot-com bub­ble at the turn of the cen­tury, FANG bal­ance sheets are more ro­bust with large amounts of cash on hand, free cash flow mar­gins are bet­ter and – most im­por­tantly – they are prof­itable and trad­ing at rea­son­able multiples rel­a­tive to growth.

They said Face­book beat earn­ings ex­pec­ta­tions in the sec­ond quar­ter with rev­enue growth of 45% and profit growth of 71% and progress with In­sta­gram, which was ex­pand­ing rapidly, ex­pec­ta­tions that What­sApp and Mes­sen­ger will mon­e­tise in 2018 and the in­te­gra­tion of AI.

Ama­zon grew rev­enue 26% and, de­spite its size, there are sig­nif­i­cant growth op­por­tu­ni­ties. They said sales growth is an­tic­i­pated to re­main ro­bust and it has recog­nised the con­straints of on­line gro­cery shop­ping by in­vest­ing in a brick-and-mor­tar foot­print. Ama­zon Prime is ex­pected to con­tinue grow­ing top-line and the type of in­come it pro­vides (sub­scrip­tion based/ an­nu­ity) is at­trac­tive, they said. The Whole Foods ac­qui­si­tion of­fers dis­tri­bu­tion ca­pa­bil­ity for Ama­zon’s other busi­nesses.

Com­men­ta­tors say fund man­agers are hoard­ing cash and look­ing at hedg­ing against tur­bu­lence and they warn that a ma­jor cor­rec­tion could be over­due.

“If we see a down­grade of lo­cal debt, some global in­vestors won’t be

able to in­vest in the lo­cal bond mar­ket and lo­cal bonds won’t be able

to be in­cluded in in­dices.”

“Vir­tual and aug­mented re­al­ity could be a gamechanger for on­line re­tail, es­pe­cially in cloth­ing,” they said, and it could have a strong im­pact on pur­chase rates and lower re­turn rates. They warn, how­ever, that on­go­ing in­vest­ments in ful­fil­ment and new busi­ness lines will be at the ex­pense of near-term mar­gins.

Net­flix grew rev­enue 32.3% as it added

5.2m sub­scribers, 2m more than ex­pected. The en­ter­tain­ment com­pany may be los­ing con­tent from its most im­por­tant sup­plier in Dis­ney, but its strat­egy to pivot to orig­i­nals, build its own global con­tent brand (30% of to­tal spend), and ver­ti­cally in­te­grate into self-pro­duc­tion mit­i­gate this loss. This loss of Dis­ney­branded films will not im­pact the ser­vice un­til the sec­ond half of 2019.

Al­pha­bet rev­enue was up 21% and is in a mar­ketlead­ing po­si­tion in search and video, al­though it is trad­ing at an all-time high and has strug­gled to break into so­cial me­dia and mes­sag­ing.

They ex­pect that over the next 12 months Face­book would grow earn­ings by 48%, Ama­zon’s earn­ings would drop 22%, while Net­flix would grow 166% and Al­pha­bet 9%.

This was against ex­pec­ta­tions of a 16% growth in the JSE All Share In­dex and 6% in the S&P 500. At for­ward price-to-earn­ings multiples (P/Es) of 24.4, 60.9, 70.6 and 20.3 re­spec­tively, their val­u­a­tions are rich, but “top-line growth is ex­pected to re­main ro­bust and over time the in­vest­ment in rev­enue will fil­ter through to the com­pa­nies’ re­spec­tive bot­tom lines”.

Chartwell looks for busi­nesses that “are trad­ing at a dis­count, but have im­prov­ing re­turn on cap­i­tal, healthy bal­ance sheets, strong com­pet­i­tive po­si­tions and (new) man­age­ment teams with good track records of turn­ing com­pa­nies around”. These com­pa­nies can do well un­der any con­di­tions, says Cipol­loni, who likes

Nin­tendo, Nokia and Eric­s­son. Or­bis In­vest­ments di­rec­tor Dan Brock­le­bank says this is a good time to be in­vest­ing in stocks “that are be­ing shunned due to pre­vail­ing mar­ket sen­ti­ment”.

“We in­vest where the big­gest dis­counts to in­trin­sic value lie. Some­times whole in­dus­tries are cheap and some­times just a few com­pa­nies. In gen­eral we find that there are in­ter­est­ing val­u­a­tion dis­crep­an­cies in most in­dus­tries at the mo­ment, re­sult­ing in a num­ber of idio­syn­cratic in­vest­ment op­por­tu­ni­ties,” he says. Glob­ally, Or­bis likes in China and Mer­cadoLi­bre in Latin Amer­ica.

Franklin Tem­ple­ton says it is avoid­ing the bank­ing sec­tor, state-owned en­ter­prises and in­dus­tri­als and prefers com­pa­nies in health­care, in­sur­ance and in­for­ma­tion tech­nol­ogy.

Ac­cord­ing to Franklin Tem­ple­ton, the UK has had a tougher time than broader Europe but it re­mains a rel­a­tively at­trac­tive eq­uity mar­ket. The FTSE 100 In­dex of­fers the high­est div­i­dend yield of any ma­jor re­gion (mea­sured by the MSCI World In­dex), it said.

Old Mu­tual Edge28 Fund co-man­ager Arthur Karas says his fund is po­si­tioned for rate cuts, with in­creased hold­ings “in SA bonds, SA listed prop­erty, SA banks and credit sen­si­tive re­tail­ers while re­duc­ing cash ex­po­sure”.

“Any in­vest­ment de­ci­sion with a long-term in­vest­ment hori­zon be­comes chal­leng­ing when fo­cused on a po­ten­tially bi­nary po­lit­i­cal out­come. Our dis­cus­sions with do­mes­tic banks con­firm that both large cor­po­rates, smaller busi­nesses and in­di­vid­u­als are all be­hav­ing in a sim­i­lar fash­ion, cur­tail­ing new cap­i­tal in­vest­ment, hoard­ing cash or in­vest­ing off­shore,” he ex­plains.

This en­vi­ron­ment is not en­cour­ag­ing for fu­ture profit growth, he adds. “Com­bined with other du­bi­ous poli­cies, such as a Min­ing Char­ter that is very dis­cour­ag­ing of new min­ing in­vest­ment, it’s hardly sur­pris­ing that for­eign­ers have been sell­ing South African shares.”

The South African bond mar­ket, on the other hand, has seen steady in­flows. “Yield-hun­gry global in­vestors seek to ex­ploit the large spread be­tween SA bonds and sov­er­eign yields avail­able else­where. These in­vestors must be­lieve that our po­lit­i­cal and eco­nomic woes are suf­fi­ciently dis­counted into our 8.5% yields.”

North Korea's Korean Peo­ple's Army launches four bal­lis­tic mis­siles dur­ing a mil­i­tary drill in March at an undis­closed lo­ca­tion.

Michele San­tan­gelo Port­fo­lio man­ager at In­de­pen­dent Se­cu­ri­ties

Lester Davids Trad­ing desk an­a­lyst at Unum Cap­i­tal

Cyril Ramaphosa Deputy pres­i­dent

Jan Botha Port­fo­lio man­ager at Ash­bur­ton In­vest­ments

Chan­tal Marx In­vest­ment an­a­lyst at FNB Wealth

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