To use the adage of old and call 2016 a rollercoaster year may be somewhat of an understatement. Investors globally but especially in the local environment have been subject to more twists and turns, more dramatic drops and rapid reversions and more panic-induced nausea than your average day at the funfair. We have seen a number of Black Swan (unexpected and unprepared for) events creep up which have led to spikes in volatility through investor hysteria, all of which have subsequently reverted back to normality as the mystical ‘market’ digests reality and reprices assets accordingly.
On the local front, entering 2016 we had the uncertainty tailwinds of the Finance Minister fiasco with President Jacob Zuma removing the widely respected Nhlanhla Nene, replacing him with little known back bencher Des van Rooyen, and subsequently reversing this decision on the back of extensive pressure from business leaders and investor public alike. This coupled with, in mid-December, the first hike in US interest rates in over eight years from 0.25% to 0.50% after an extended period of expansionary monetary policy led to a massive sell off in emerging market assets, from bonds to equities which saw currencies depreciate rapidly. We also saw safe assets like gold and the dollar attract large flows
All appeared to be doom and gloom. The rand peaked at 16.94 on a daily close to the US dollar. Outspoken market commentators had us believe the rand was destined for 20 by years’ end. January truly felt like Armageddon – Mzansi style.
However, in a fashion that has become synonymous with central-bank fueled investor psyche, sense prevailed and we saw a reversion back to levels at which the rand had recovered over 16% by the end of April. Emerging markets were in favour yet again, as the US continued to stall on further rate hikes through a ‘data driven’ decision tree and concerns over global growth. Just as we seemed to be safe from political blunders, the whispers of state capture began to filter through. Risk up, rand off. And with that the currency resumed its seemingly inevitable path towards perpetual depreciation. Within a period of less than three weeks we saw a weakening of 12% to 15.90 to the US dollar.
This would continue, amongst constant scaremongering by government agencies and legal units over a potential arrest of new Finance Minister Pravin Gordhan, first over a so-called rogue unit and then over an early retirement investigation which in the end yielded nothing. Throughout this period of political yo-yoing, the net effect on the rand was an eventual strengthening of yet another 16%. Enter Donald Trump.
Although we are terribly sensitized to local issues as the key driver of the value of the rand, the actual catalyst (some 70%) is what happens in global markets, and to that effect what happens in the USA. As recent expansionary central bank policy has led to a global market flush with excess liquidity there has been a far more volatile trading environment where mere murmurs or a single data release can lead to rapid movement of capital in and out of risky assets, especially emerging market (EM) currencies. As such, South Africa and some of its more capital control friendly EM counterparts have been the punching bags in the game of “When will the United States raise interest rates?”
With the shock of the Republican victory in the recent elections there was again a largescale sell off in developing nation assets as Mr Trump’s proposed fiscal spending may lead to an increased inflationary environment. The opportunity to raise rates the Fed has been waiting for has, arguably, presented itself. A hike in interest rates (as early as December) is now priced with an implied probability as high as 95%. We saw alongside this US ten-year treasury bond yields spike some 0.6% to above 2.3% and the US equity market reaching all-time highs.
What this means for the rand in the short term is further uncertainty and most likely continued volatility. As South Africa navigates through a structurally shifting political playing field and as markets remain subject to global central bankers we are likely to see hops and drops although on a long term trajectory of a weakening nature to the dollar, provided rates in the US increase in a predictable manner, as investors begin to find attractive real returns in a far more stable market.
At present forward markets are pricing in rates of 15.50, 16.50 and 20.20 in the 1; 2 and 5-year forward periods respectively.
(Source: Thomson Reuters/NFB Asset Management)
As with the rand, our local equity markets are beholden to the appetite and sentiment of global investors. As one of the most liquid EM countries in terms of foreign capital controls the JSE is often used as a proxy for EM exposure, with some 40% of local equities owned by foreigners. Therefore, whilst on paper when examining returns over shorter periods of year-to-date (0.8%); one year (-2%) and two years (0.5% annualized) one could be fooled into thinking markets have been stable, but the reality is far from what meets the eye.
If we look at the JSE All Share Index (ALSI) over the past ten years, after riding an extended bull market through to mid-2014 with treble factor growth in the index from the trough post the 2008 global financial crisis (GFC), where it seemed hibernation season would perpetuate for the bears, we began to see the first real signs of weakness. From this point to now (some twenty-four months) the market is effectively flat, trading in a range of between 46,000 and 55,500. A number of times the upper and lower limits have been tested only for another reversion to take place. With the range itself consisting 20% trending upwards and 18% on the way down its fair to say that this has been anything but a smooth ride. Entry and exit points during this period would have made a material difference to the returns an investor has enjoyed. This speaks to the benefits of rand cost averaging, which is so often correctly recommended by professional advisors, as single entry point investments would be subject to a matter of market timing, which has been proven to be near impossible to perfect.
Now may seem to be a Eureka moment to some investors saying “why sit in equity markets when I could sit in cash and wait for volatility to subside and a resurgent bull market to reemerge”. In this regard, we can examine a study created by Investec Asset Management. Post the 2008 GFC investors worldwide were spooked and, as classic behavioural science has identified, many decided to exit equity markets and sit in cash. The results are as follows for a R100,000 investment made on the first of December 2006:
- Had you decided to exit at the trough and not reenter the market until now – R124,678
- Exit, sit in cash for one year and then reenter – R204,118 (64% higher than cash)
- Stay invested – R279,142 (124% higher than cash)
(Source: Investec Asset Management)
We can repeat this exercise over numerous entry, exit and timing scenarios and the overwhelming average outcome will always be that remaining invested, over the long term will prove to be the most sensible but often not the most comfortable option. One simply cannot time the market with 100% accuracy and whilst you may get it right once, over a repeated number of trials you are very likely to end up in a less fortunate position.
Equities are, have been and will continue to be a volatile asset class, this is the nature of the beast. However, on a risk adjusted basis, over the long term (7 years plus), this asset class almost always presents the best investment opportunity.
Again due to the accessibility of South Africa’s financial markets, coupled with a global treasure hunt for anything that resembled a positive real yield, as well as the aforementioned political shenanigans, the country’s debt markets have themselves been a tricky playing field. Over a two-month period from mid October 2015 to the firing of ex-minister Nene yields on the 10-year government bond spiked from 8.1% to as high as 10.7%, leading bond prices to fall some 14%.
As is the common theme, the overreaction subsequently normalized fairly rapidly as investors took a deep breath, relaxed and rationally digested and applied the new information to correctly price the debt.
When contextualizing the return/risk profile of bonds as an asset class, one would never expect such dramatic swings in value, especially over such a short time period. However, as previously discussed, central bank policy has led to a situation in which asset valuations are largely, in the short term at least, driven by sentiment where a much larger, somewhat less sophisticated investing public has a material impact on trade flow, we then see these disconnections and often an increase in irrational behaviour appears.
A topic which has been extensively covered has been the potential downgrade of South Africa’s long term foreign denominated debt to junk status. In an effort to save an additional thousand words in this article, opinion and comment on the matter will be reserved. What is important to look at here is the potential impact of such a decision.
With the country’s debt already being priced at high yield (junk) status, with April’s issuance of $1.25 billion worth of ten-year debt at 3.35% over that of US treasuries, an asymmetric outcome tree develops. The view is that should South Africa be downgraded, the downside to bond prices is somewhat limited by the fact that this outcome is already priced in. However, should the country manage to stave off the agencies stamp of disapproval and emerge like a phoenix from the flames of forbidden investment territory the upside to bond prices is much larger.
With this in mind it is worth considering the relative value of South African government debt at current prices for the short to medium term.
With so much information and signals influencing asset prices and volatility it’s important to examine the key drivers in the market place and allow for rational thought to influence expectations of return going forward.
- Donald Trump and US interest rate policy
The movements of the US Federal Reserve with regards to their interest rate actions is perhaps the single most important macro indicator to watch. The movement of global capital in large part depends on the rate of US interest rate hikes. With Donald Trump signalling a change of tack from expansionary monetary policy to that of a fiscal nature (increased government spending; lower taxes) there has been an increased expectation of increasing inflation in the United States, an outcome monetary policy has failed to achieve globally. This will allow the Fed to then raise rates at next month’s meeting and continue on the planned path of a stable rate-hiking policy in order to a more natural interest rate environment.
- South African political sphere
Investors globally are scared, confused, on edge. If the country is able to avoid further blunders and allow for an increasing GDP growth rate to materialize we should see a return of capital to both bond and equity markets. Bonds offer great relative value; local equities are no longer just that with some 65% of the top 40’s earnings derived in foreign markets, which allows for an attractive proxy for a truly global earnings base through an emerging market conduit.
With all this in mind it is important to manage return expectations going forward. Markets cycle between bull and bear phase and the days of seemingly perpetual bull markets are, for the moment at least, over. Global growth remains fragile, populist uprisings are not helping this. Large scale expansionary monetary policy from the US to Europe to Japan hasn’t necessarily led to the intended uptick in aggregate demand but has rather led to a distortion in asset prices which will need to be corrected. As these strategies come to an end and interest rates normalize, as is the case in the US, we would expect to see modest returns in most asset classes with a view that at present global quality focused equities offer the best investment case, alongside local bonds. Remember although that the JSE does have a number of quality global businesses, so this does not preclude local equities. However, it is important to be able to selectively identify and invest in such businesses. This is where the benefit of active management both at a fund/security level, as well as holistic level comes to the foray.
The most important piece of advice one can get in times of uncertainty and volatility is to remain calm and re-examine the variables of the initial investment plan. If these remain unchanged then ignore the noise and remain invested. Markets are cyclical and at the moment we are at a point where investors will be uncomfortable. Don’t let that cloud your judgement. Stay rational and sanity will prevail. Chopping and changing investments will not add to the long term value of your portfolio. Speak to your trusted advisor for some much needed guidance and rationalization.
Whilst the past year has offered up a number of Black Swan events from Nene to Brexit to Trump, which has resulted in heightened volatility and has lowered returns, over time remaining invested and sticking to your initial plan is most likely to result in the best possible outcome for you and your family. For a point of reference below is a “smartie box” depiction of asset class returns, including local equity; bonds; property; cash; the rand/dollar as well as NFB’s risk profiled multimanager model portfolios. What you will notice is that over the very short terms asset class returns will be dispersed and inconsistent, however as you begin to extend the periods out risk assets will outperform cash materially and dynamic multi asset portfolios offer a constant less volatile return profile.