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Equity markets off to a flying start for the year

But there is reason for caution.

Equity markets across the world have started 2018 on a very strong note. In the last two days both the S&P 500 and the FTSE/JSE All Share Index have breached new record highs.

As the table below shows, global markets are sharply higher across the board:

Market performance to January 23 2018
Index YTD performance
FTSE/JSE All Share Index 3.38%
S&P 500 5.96%
Nikkei 225 5.97%
Hang Seng Index 10.07%
Dax Index 4.99%
Euro Stoxx 50 4.88%
MSCI World Index 4.67%
MSCI Emerging Markets Index 7.66%

Source: Bloomberg

“The way we look at it, we are in the second of three phases of growth,” says Hannes van den Berg, from Investec Asset Management. “The first phase was when global markets rerated in anticipation of growth coming through, in an environment where interest rates were very low, and central banks were being very accommodative. In phase two, which I think we are in now, earnings are coming through and justifying those market levels.”

The backdrop to this is that the world appears to have entered a period of synchronised growth. The US economy continues to look strong, China is growing at above 6%, and Europe and Japan are now also delivering positive numbers.

That suggests investors can expect stronger company earnings over the next six to 12 months. This has been further boosted by tax reform in the US which should also lead to higher profits.

“That’s the second phase, and it leads to the third phase where confidence will start coming through and potentially drive further capital spending,” says Van den Berg.

The JSE

The local market has followed global equities higher, but there has also been the added driver of changes to the South African political landscape.

“On the domestic front, the last few years have been dominated by politics, and one of the consequences of that was that South Africa by and large missed out on the emerging market cycle that commenced in early 2016,” says PSG Asset Management’s Shaun le Roux. “We were tremendous laggards at a time when other emerging market equities were in very strong demand. But as the market realised that potentially there was a more optimistic political outcome on the horizon, we had very rapid repositioning in the rand and in domestic assets.”

This began in December last year and led to dropping bond yields, a strengthening currency, and a very sharp appreciation in the share prices of banks, retailers and other domestic companies. At the same time, a more supportive global environment for commodities has supported resource stocks.

Ryan Jamieson from Fairtree Capital anticipates that these trends will continue.

“The factors in favour of both resources stocks and SA Inc stocks are still in play,” he says. “We talk to clients about there being no breaks in the system. Monetary policy is accommodative, we hope that confidence will return at a business and consumer level, and there is the possibility of interest rates falling.”

This should lead to further positive returns from local equities.

“We had a few challenging years locally, so to get a 20% return in 2017 was fantastic,” says Jamieson. “We think we are looking at mid-double digits for this year as well.”

Van den Berg agrees that the local market is now presenting interesting opportunities.

“For the first time in many years we can look at local opportunities from an earnings perspective,” he says. “With sentiment having changed and confidence coming back, this will drive earnings growth.”

A strong rand is also leader to lower inflation, assisting South African consumers. If political reforms continue, Van den Berg believes we could see a very good 12 to 24 months for South African shares.

“The risk, however, would be that this happens slower than expected,” he says. “Then we might be too late in the cycle, global growth begins to slow and we get caught in that. But in the short term the stars are aligning for our economy to catch up.”

Complacency

Investors should however, be cautious of getting too caught up in positive sentiment. Global markets have already had an incredible run. The S&P 500 has now not seen a correction of 5% in more than a year-and-a-half.

“We think we are late in the cycle, but still constructive for where we are and this can continue for at least the next six months,” says Van den Berg. “We will have to reassess towards the second half of this year if earnings growth still justifies valuations. You just need one or two big misses from an earnings perspective for markets to starts questioning global growth.”

Le Roux says that PSG has been finding fewer opportunities offshore as valuations have risen. He believes there is reason for caution.

“Globally, it has been a very benign environment for equities,” Le Roux says. “That has coincided with extraordinarily low and sustained levels of volatility, which has almost certainly given rise to complacency. Nobody can predict how much further it can go, but there is a simple question one could be asking, which is what are your likely expected returns off of these valuation levels and do they adequately factor in some of the broader risks if you look a few years further down the road.

“We would come to the conclusion that this is an environment that favours a dialling back of risk and taking profits in some of the stocks that have enjoyed extremely strong returns,” Le Roux argues. “It’s not a time to be adding to risk. But if you look at market positioning, average cash levels and investor sentiment, the average participant in the market is doing the complete opposite. They are as keen to take on risk as they have effectively been for a very, very long time.”

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Insightful commentary from market managers.
Investors might be in for some additional return catch-up but on the other hand it also reminds of the old adage – if most is chasing the hype in the market, you know it’s going to become crazy and it becomes time to get out of the way of the herd stampede. Same applies to Bitcoin.

End of comments.

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