Financial news was dominated over the past week by the run-up to the meeting between the presidents of China and the USA at the G20 summit in Japan. Presidents Xi Jinping and Donald Trump agreed to allow negotiations to resume, but tariffs remain in place for now. It is clear that the relationship between the world’s two largest economies, which has shaped the global economy in many ways over the past three decades, is changing permanently. It’s too soon to tell how much, but for now, investors are a bit more relaxed.
The reshaping of global supply chains, with multinationals shifting production out of China, is likely to accelerate irrespective of the outcome of trade talks. This partly reflects a trend, which predates the Trump administration, that saw rising labour costs making China increasingly unattractive. China won’t necessarily mind this as it does not want to be the world’s manufacturer of cheap basic goods forever. It prefers to continue its climb up the value chain and become a leader in cutting-edge technology, especially in the emerging fields of artificial intelligence, 5G and electric vehicles. It’s doing this so well that alarm bells are ringing in Washington.
Although Trump has made a lot of noise about the US trade deficit with China, lurking in the background is a seeming desire to limit China’s rise as a strategic competitor. The decision – now suspended – to block China’s Huawei from using US technologies, including microchips, should be seen in that light. China’s biggest weakness is its dependence on the import of microchips and other electronics, as well as oil. The two leaders called a similar truce in December after meeting on the sidelines of the G20 summit in Argentina. Negotiations seemed to be proceeding well in the following months, until early May when Trump accused China of backtracking on some of its commitments and introduced new tariffs. This brought discussions back to square one and sparked a market sell-off. The sell-off was fairly brief as major central banks indicated that interest rates were headed lower.
Here’s to the 22nd century
Tucked away in the headlines was a report in the Financial Times that the Austrian Republic, a country that only came into its modern existence a century ago following the collapse of the Austrian-Hungarian Empire, would issue its second 100-year bond. Long-lived investors holding the bond to maturity will earn only 1.17% per year in euros. This is well below the European Central Bank (ECB) stated inflation target of 2% per year, and the European Union and the single currency might not even be around in a few decades’ time. Since investors have a hard time predicting what will happen in the next year, never mind the next century, they should demand extra yield for the uncertainty of holding longer-term assets (known as the term premium). However, term premiums have all but disappeared as investors scramble for yield in developed market bonds. In the case of Europe, the ECB’s purchase of the safest government bonds has greatly contributed to this disappearance. As expectations of future interest rates and inflation fell, bond yields tumbled further in the month of June. The global benchmark US 10-year Treasury yield fell from 2.16% to 2% – below the current Federal Reserve funds rate – having started the year at 2.5%. Germany’s equivalent yield hit new record lows at -0.3%, while Austria’s turned negative for the first time ever.
10-year government bond yields
A hundred years of default
On the other side of the world, the other country famous (or rather infamous) for issuing a 100-year bond is Argentina. Issued in June 2017 at a dollar yield of 8%, it was snapped up by investors despite Argentina having defaulted on its debt six times in the past 100 years, most recently in 2001. On its second anniversary, the bond was trading at 72 cents to the dollar, a significant capital loss. Amid a tumbling currency, and deep recession, Argentina received a record bail-out from the International Monetary Fund (IMF) last year. The country, which heads to the polls in October, is a clear example of what we don’t want to become. Its basic problems include lack of access to domestic capital, having completely destroyed the trust of domestic investors through a history of hyperinflation, capital controls, bank closures and forced redenomination. (Zimbabwe’s reintroduction of the Zim dollar will face a similar lack of credibility and seems doomed to fail.) The Argentinian government is therefore forced to turn to global capital markets, has paid a high yield to do so, and takes on considerable exchange rate risk in the process.
Lack of growth
South Africa’s big problem is a lack of economic growth, not a lack of capital. The weak economy and Eskom bailouts are likely to push the budget deficit – the difference between tax revenue and spending – to around 6%, rather than the 4% projected in the February budget. But the government can comfortably borrow in local currency in the local market, and a return to the prescribed asset regime of the late 20th century is therefore not necessary. To underscore how weak the economy is, the SA Reserve Bank noted in its Quarterly Bulletin that the current downward phase of the business cycle that started in December 2013 is now the longest since the bank started keeping tabs in 1947. The Reserve Bank doesn’t officially distinguish between expansions and recessions, unlike the US where a committee of greybeards at the National Bureau for Economic Research officially dates the business cycle, usually months after the fact. The bank rather distinguishes between upward and downward phases of the business cycle.
What could cause the South African cycle to turn?
The elusive increase in business confidence, leading to higher investment is one factor, but will require a much greater shift towards business-friendly policies on the part of government. Ultimately, local economic activity is dominated by consumer spending, and with wage growth running at around 4% annually (depending how you measure it), there is precious little real income growth to sustain spending. One measure – growth in remuneration per worker paid – dropped to 4.7% in 2018, the lowest since the Reserve Bank began collecting the data in 1971.
The stock market is not the economy
The weak local economy has not held the JSE back this year, and nor should it, since it has become more global over time. Shares of companies that primarily sell to local customers have tended to struggle, but should benefit the most when the economy eventually turns. However, the JSE is dominated by companies that earn revenues in the global economy. The rand benefitted from a softer US dollar, gaining 3% against the greenback during the month to close at R14.10 per dollar. This means the rand is about 2% stronger than at the start of 2019, and only 2% weaker than a year ago. The stronger rand is a double-edged sword for investors, since it boosts returns from interest-rate-sensitive assets (including bonds, bank and retail shares and listed property) but is a drag on the return from rand-hedge shares and direct offshore exposure.
Rand-US dollar exchange rate
Despite being dominated by rand hedges, local equities performed well. The FTSE/JSE All Share Index returned 4.8%, pushing 2019 returns back into double-digit territory. The return over one year was ahead of inflation at 7.8%. In US dollar terms, the JSE All Share gained almost 8% in the month, ahead of the MSCI All Countries World Index, which covers developed and developing markets. It returned 6.5% in June and 16% year to date in US dollars. Over one year, however, this broad benchmark of global equities only returned 7%, including dividends, and is still below its all-time high, set in January 2018. Resources led the JSE, returning 10% in the month, lifting one-year returns to 21%, most of which were made in 2019. Gold shares predictably led the rally in resources as the dollar gold price jumped 8% in the month to a six-year high of $1 412 per ounce. Since gold does not pay any income, it benefits from declining US interest rates. Local bonds also rallied in June and outperformed cash over six and 12 months (with a 7% and 12% return respectively). The yield on the 10-year local currency bond fell to 8.1%, but remains attractively high in a global context.
Main sectors on the JSE
In other words, asset class returns were positive across the board in the first half of 2019, in contrast to the last half of 2018, and despite considerable local and global uncertainty. One wonders how many investors responded to dismal 2018 returns by getting out of the market when the fight-or-flight instinct kicked in. They would have missed out on the subsequent rebound. Timing the markets is about as difficult as predicting Trump’s next tweet. Rather focus on the things you can control and stick to your financial plan.
Dave Mohr is chief investment strategist & Izak Odendaal an investment strategist at Old Mutual Multi-Managers