The start of 2019 has delivered some relief for local investors. The JSE has now strung together three consecutive positive months.
From the start of December last year to the end of February, the FTSE JSE All Share Index was up 10.8%. That is the most sustained gain since the positive move that began midway through 2017.
There is still a long way to go before this translates into something significant for investors, since the market is still below the levels it reached in early 2018. However, it does suggest that the optimism that many local asset managers have been expressing lately may have some merit.
Despite the state of the South African economy, there is a quiet sense of positivity about how 2019 could turn out for both local equity and bond markets. As Clyde Rossouw, co-head of quality at Investec Asset Management, points out, this doesn’t mean that they are blind to the country’s challenges.
“There are a lot of reasons to be concerned from a macro perspective in South Africa,” Rossouw acknowledges. “Firstly we know that we have a reserve bank that is determined not to cut interest rates because it is trying to create that bastion of stability. We also have an election ahead of us, and we know economic fundamentals in the country are deteriorating. You see that in company results.”
However, they do see reasons to be positive about future returns, given current valuations.
The yield on 10-year government bonds was above 9% for most of 2018, and is still near that level. This is extremely attractive, at around 5% above inflation.
“Getting 9% from a South African government bond, which is not entirely risk free, but is risk free for most intents and purposes, is an extraordinarily large return hurdle to overcome,” Rossouw argues.
In addition, he believes there is plenty of room for these yields to come down, and therefore for investors to realise capital gains. This is because he expects local inflation to continue to come in below expectations.
“There is clear evidence in our minds that we have seen the peak in inflation,” Rossouw says. “I’m not saying that there aren’t areas where inflation is a little bit more stubborn, like municipal rates and education. But if you look at the broad basket, there are definite signs that inflation will continue to surprise on the lower end going forward.”
That being the case, the South African Reserve Bank (Sarb) will have room to cut the repo rate, which is currently 6.75%. That is nearly 3% above the most recently announced inflation rate of 4%.
“We do think that, ultimately, the Sarb cannot run monetary policy with a 3% real interest rate,” says Rossouw. “It’s too draconian.”
He believes there is scope for rates to be cut by more than 1.5% points. “We know that Lesetja Kganyago, the Sarb governor, is fairly hawkish. He wants to do the right thing from a macro perspective, and I have sympathy for that view. That was definitely the case when we had more question marks around governance. But now that we have a responsible finance minister, and a responsible budget, he no longer needs to carry the full can from a responsibility perspective, in which case his mandate needs to change.”
This is unlikely to happen before the May elections, but could take place soon thereafter. Already the market’s expectations of where the repo rate is headed have moderated substantially in just the last few months.
As the chart below from Granate Asset Management shows, the expectation towards the end of last year was that the Sarb would be hiking rates in 2019. Now, however, what is being priced in is that rates will, at most, be kept unchanged.
The stock market
It is however on the JSE that investors have felt the most pain in recent years. The period to the end of 2018 was just the sixth time since 1900 that the rolling five-year real return on the local stock market was below the real return from cash.
Source: Investec Asset Management
But it is worth remembering where this period began. Back in 2014, both equities and listed property had run hard since 2009 and were, overall, expensively priced. At that point, Investec Asset Management held the view that equity returns would come down, and that all asset classes were likely to deliver similar performance for half a decade.
That is indeed what has happened.
“If you look at five-year returns, all asset classes have been giving you something around the mid single-digit range, which we thought was a realistic outcome to expect given that shares were simply too expensive,” Rossouw says. “But now we’ve had the pain, we’ve had the underperformance, we’ve had the weak economy, and you have a much better setting in terms of valuation and prices. In simple terms, there is scope from this point going forward for returns to start diverging again.”
That doesn’t mean he’s expecting a smooth upward trajectory on the JSE.
“Financial markets are never an easy ride,” Rossouw says. “There will be ups and downs. But the difference in 2019, we think, is that last year you had a lot of volatility and a declining trend. This year you will probably have the same degree of volatility, but the trend is more likely to be upwards.”
Source: Investec Asset Management