It’s been a rocky start to the final quarter of the year as far as world equity markets are concerned. There is no shortage of conflicting signals, unease and uncertainties keeping investors up at night. The optimists and pessimists are slugging it out.
The big conflicting signal is that global bonds and equities are both up strongly for the year, even with last week’s wobbles.
At the end of September, the MSCI All Countries World Index returned 16% year to date, while the FTSE World Government Bond Index returned 6.5%, both in US dollars. The latter is astonishing since the yield on the index at the start of the year was only 1.7%. The returns therefore came from capital appreciation, not income.
Bonds rallied as investors priced in lower interest rates and the restart of unconventional policy from major central banks amid a weak global economy and stubbornly low inflation.
Equities, meanwhile, also rallied, not because of strong earnings growth or high dividend payments, but on higher price-earnings multiples. Markets are discounting the current weakness and looking forward to better times ahead.
Global listed property, which shares characteristics with both equities and bonds, has performed really well. The 2.5% return on the FTSE Epra/Nareit Developed Index in September means the year-to-date return increased to 20.7%. The one-year return of 14% is ahead of bonds and equities.
Chart 1: Global bonds, equities and property in 2019 (total return indices rebased to 100)
Squaring the circle
How can bonds and equities both be right, if bonds are rallying on expectations of a weaker economy and equities on prospects of improvement?
One way to square the circle is that bonds are pricing in lower central bank interest rates, which will boost economic growth and thus the earnings prospects for companies. The other way is that as bond yields decline, equities become increasingly attractive on a relative basis. At the end of the third quarter, equities were offering a higher current income than bonds (dividend yields were higher than bond yields, a highly unusual situation). The third point to remember is that not all investors are the same.
Many of those who piled into bonds – driving already-low yields lower and already-negative yields further into sub-zero territory – are clearly not sensitive to price. They have to own bonds for regulatory or other reasons. On the other hand, investors who need to achieve longer term growth targets realise that equities should outperform bonds over the next few years in all but the most dire economic scenarios.
The forward price-earnings ratio on the MSCI All Countries World Index increased from 12.8 at the start of the year to 15.3 at the end of September, slightly below its longer-term average.
Equities are therefore still priced to deliver reasonable returns, while bonds are historically expensive.
One should also remember that while global equities have had a strong 2019, this follows the deep slump in the final quarter of 2018. Therefore, in the 12 months to the end of September, the MSCI All Countries World Index returned only 2%, hardly anything to write home about.
In fact, some commentators are already wondering if last week’s volatility points to a repeat of last year’s fourth-quarter rout, given the combination of global growth fears and rising political uncertainty. One key element is missing, however: this time last year, the US Federal Reserve (the Fed) was still in hiking mode and was projecting significantly tighter monetary policy. After turning on its heels, the Fed has cut its policy interest rate twice and is expected to reduce it further, joining dozens of other central banks in the process.
Widespread rate cuts
Central banks, in turn, are cutting rates because of the widespread economic weakness, particularly in trade and manufacturing, low inflation, and the many policy and political unknowns. Chief of these is of course the US-China trade war.
Donald Trump’s chaotic presidency has taken a new turn with the impeachment inquiry. He is unlikely to be removed from office prematurely due to rock-solid Republican support in the senate, but the pressure seems to be building day by day. This might not have much of an impact on economic activity in the US, but how it influences his willingness to agree to a trade deal with China is an open question.
For the Fed specifically, the big question is the inverse of the old saying that “if America sneezes, the rest of the world catches a cold”: can a weak global economy throw sand in the cogs of the $16 trillion US consumption machine? So far, the evidence points to weak US manufacturing – the closely watched Institute of Supply Management (ISM) manufacturing index fell below 50 points – but consumption and services remains solid, supported by plentiful jobs, moderate wage growth and low inflation.
The US economy added fewer jobs than expected in September, but the 136 000 expansion in non-farm employment in the month is still in line with longer-term averages and does not ring alarm bells yet. The decline in the pace of job creation and wage growth (to 2.9% year on year) is consistent with an economy that has slowed from last year’s heady pace, but is still expanding at a solid but unexciting rate.
The strength of the dollar – the trade-weighted dollar index hit a two-and-a-half year high last week – is both a consequence and a cause of the issues described above. A strong dollar tends to weigh on the global economy, since a substantial slice of global economic activity is financed, invoiced and priced in dollars. The weak global economy in turn means that the Fed’s rate cuts aren’t weakening the currency as textbooks suggest, since other central banks are also cutting. In general terms, the world turns to the mighty buck in times of uncertainty.
The strong dollar has in turn resulted in a weaker rand. The rand lost 7% against the dollar in the year to end September, and was still on the back foot in the first few days of October. The benefit of a weak rand is that it boosts the offshore returns of local investors. This is helpful at a time when returns from local growth assets have been disappointing. With the oil price selling off in recent days and ending the week below where it was prior to the attacks on Saudi Arabian oil installations, the inflation impact of the weaker rand will probably be muted.
Chart 2: Trade-weighted dollar index
Drawn and quartered
The third quarter was particularly tough for the JSE, and the first few days of October were no better.
The FTSE/JSE All Share Index was marginally positive in September, but was still 4.6% down for the third quarter. Year-to-date, it was still ahead of cash with a 7% return. However, it is the longer-term numbers that are disappointing. The one-year return is only 1.8%, and the five-year return 5.3% per year (mostly from dividends, not capital growth).
Among local assets, bonds have outperformed equities, cash and property in 2019. The All Bond Index returned 8.4% in the first three quarters of 2019, and 11.4% over the year to end September. This might seem somewhat surprising, given all the negativity around the deterioration in government’s finances and the risk of further downgrades. A budget update from National Treasury, the last before the Medium Term Budget Policy Statement, shows that tax revenues are likely to be well behind target for the current fiscal year. Meanwhile, spending is rising due to the additional bailouts for Eskom and other struggling state-owned entities.
It is safe to say that in a more unforgiving global environment, South African bonds would’ve been punished more. But since global bond yields have slumped, South Africa’s didn’t increase. Other emerging markets have seen substantial declines in their bond yields, but our 10-year government bond yield is a few basis points below where it started the year. The main return driver for the local bond market is simply that yields are so high investors can earn a decent return even if bond prices decline somewhat.
For bond prices to rise (and yields to fall) the market needs greater confidence that South Africa’s fiscal and economic growth problems are getting the right attention from policymakers.
The much-anticipated statement on economic growth from the ANC National Executive Committee did not contain anything new or exciting, but also nothing unsettling. It is broadly a step in the right direction, but not enough by itself. More clarity on Eskom and the broader energy sector is needed. And as always, implementation is key. There is no shortage of growth plans gathering dust on shelves in Tshwane.
The reality is that it is highly unlikely that any growth plan will please everybody.
But in simple terms the cost of doing business has to come down, since nominal economic growth has halved over the past five years. This immense pressure on top-line growth has squeezed margins and profitability, and created a disincentive to invest. Policy uncertainty has amplified this disincentive, but not caused it. It has also weighed on the performance of locally focused shares on the JSE.
Chart 3: Local bonds, equities and property in 2019 (total return indices rebased to 100)
A longer-term view
Slightly faster economic growth can kick-start a positive feedback loop of lower yields (borrowing costs), faster growth, higher company earnings, higher equity prices and higher levels of investment. This in turn means government tax revenues can increase and borrowing can decline, which should put further downward pressure on yields.
It is just not clear what spark can light such a fire, but it is possible. South Africa will recover but not overnight, so a longer-term view is as important now as ever before. For local investors it’s a case of ‘Is the glass half full or half empty?’. Local equity returns have been weak, but we have the benefit (not available in many other countries) of high interest rates. Global returns have been good this year, supported by a moderately weaker rand.
If things stay as they are, 2019 should be a much better year than 2018 for a typical balanced portfolio. Not great, but better. If nothing else, the importance of diversification has certainly been proven again.
Dave Mohr is chief investment strategist and Izak Odendaal an investment strategist from Old Mutual Wealth.