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Market correction an opportunity for investors to reset

Reflections on markets with Clyde Rossouw.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, where I speak to leading investment professionals. My guest today is Clyde Rossouw, he is a portfolio manager at Investec Asset Management, one of the more experienced asset managers, he’s been in the business for more than 20 years. Clyde, welcome to the show, we’ve seen a bit of volatility, especially downward volatility, on world markets this week and many markets have seen official corrections, which is declines of more than 10%, what is your take on what has happened this week?

CLYDE ROSSOUW: Thank you for the opportunity to talk to you today. I think investors often get into a sense of comfort when markets are on a steady upward trajectory and particularly this market that started in 2008/2009, if you go back quite a long period of time, is a fairly mature bull market and normally bull markets end with a bit of euphoria. So if you think about where we were at the end of December and going into January this year there was a lot of talk about a peaceful transition in South Africa, there was a little bit of enthusiasm with regard to markets and you had incredibly buoyant local and global stock markets, so that took us to significant highs and in some respects probably the market was pricing in too favourable an outcome on a whole host of fronts. So the fact that we’ve now had a, let’s call it, 10% correction in both local and offshore stocks is pretty healthy in my opinion and it’s a very good opportunity for investors to reset and just make sure that what they own, they own at reasonable prices. So from our perspective we don’t know whether this is going to be more than a correction, whether there is another leg down, that’s the joy of markets, you have no idea about what tomorrow holds but what you can do is ensure that the things you own you own for fundamental reasons rather than just because you are participating in trends in asset prices.

RYK VAN NIEKERK: As you’ve said, the market has performed excellently over the last nine years, it has been a long bull market, do you think this is the end of this bull run?

CLYDE ROSSOUW: The key things to observe are probably two things, the first one on the global side is you’ve had the Fed essentially being out of any influence in terms of monetary policy for almost two years now, so liquidity is not being contributed by the US Federal Reserve and, if anything, we have seen the opposite, so there’s been a significant withdrawal of liquidity from the US and interest rates have been rising for the last 18 months or so. So that normally is not particularly good in terms of buoying asset prices. What has kept the show going has been the European Central Bank and it has been continuing with significant injections of liquidity. In fact, the ECB’s balance sheet is now larger than the Fed’s, so they have definitely taken over the role. But we know that markets always take their cue from the US and, therefore, the key sign that we are looking for is to see whereabouts do US long-term interest rates, particularly ten-year interest rates in the US, stabilise. They are sitting at just under 3%, let’s call 2.85% today, and that materially up from where they were at just over 1% 18 months ago and because the world is still highly leveraged it doesn’t take very high interest rates to reach a tipping point. So for me the key determinant is going to be where to from here for the US bond market and that’s going to give us the cue around where stock prices are going to go because if bond yields go up and growth is not supportive of that then base economics just don’t work.

Mistrustful of the current economic cycle

RYK VAN NIEKERK: The tipping point you refer to, how much fat is still left before we reach that point?

CLYDE ROSSOUW: Again, another $1 million question. From our perspective we are very mindful and we’ve been slightly mistrustful of this upcycle and for what it’s worth we think we are probably slightly over the peak of the current economic cycle, so if you look across many indicators we have seen the copper price peak and decline, you’ve seen the oil price peak more recently and starting to decline, you’ve seen Chinese monetary supply growth peak and starting to decline, growth is tapering off there. So most of the cyclical indicators for us would suggest that we’ve almost seen the peak of the cycle and it seems very strange because when you look at where the Fed fund’s rate is at 1.75% it doesn’t seem like a top in global interest rates but coming back to the first point that I made, this cycle is going to see much less yield upside than the previous cycle saw and I would venture to say that we are probably close to that peak of that economic cycle and from here on out you’re going to have to tread with caution and make sure that whatever you hold, whether it’s companies or businesses or shares you hold, aren’t overly dependent on a big pickup or improvement in the economic cycle from here because I think that’s where the danger lies.

RYK VAN NIEKERK: On the S&P 500 the sectors that were hit hardest are financials, down more than 5%, healthcare, industrials, it’s across the board. Obviously many people think opportunity when there’s such a correction, which sectors do you think are the hardest hit and where do you think the opportunities may emerge?

CLYDE ROSSOUW: Normally what happens during these market setbacks is when equity prices come down you have bond yields rallying and interest rates fall as well, so lower interest rates are good for the slightly more interest rate-sensitive parts of the market like utilities, real estate, tobacco and consumer staples normally do well under that environment but what’s different about this market correction is the fact that, as I said, interest rates are not falling. So it’s very hard for the defensive companies, the consumer staples, tobacco, real estate, utilities, for those shares to outperform without getting interest rate support. So the key question is when do rates participate and when do they start falling? Outside of that it’s going to be very difficult to pick winners from a sectoral basis. For what it’s worth, from our perspective, we’re probably slightly more optimistic about the European defensive shares, particularly on the consumer staple side, so if you look at businesses like Roche or Nestlé, Novartis, these are pretty good companies, European interest rates are falling and there is, therefore, a lower risk of material underperformance, many of those share prices are stabilizing and look as though they probably should do well from here on out. So we would definitely prefer the European defensive shares or then we will just keep that portfolio in line with a couple of technology shares, where again the business fortune is not the high-flyers but they are companies that are still growing quite nicely and are determining their own fortunes. So that mix is appropriate at this stage. 

Political stability could lead to favourable interest rate environment

RYK VAN NIEKERK: Do you think it’s significant that the JSE did not fall as aggressively or as significantly as international markets, my calculations show about 8%, which is less than definitely the US and UK markets, is that significant or are there other reasons for that?

CLYDE ROSSOUW: It is interesting because, as you know, normally on a stock market decline all emerging markets tend to go down a little bit more than the downward trajectory of international markets, so whether it’s the US or global markets on that basis, so this has been slightly atypical. I think it’s too early to definitively say – the JSE has outperformed up until now – and the key reason for that is that the South African rand has been relatively resilient and what that is reflecting is a definite positive expectation around imminent political developments in South Africa. As we know, South Africa last year, despite the market being up 20-odd percent in rands, which was driven by a single stock, Naspers, and the market is definitely hopeful of a favourable political settlement, which could lead to potentially a more favourable interest rate environment in South Africa. As we know long-term interest rates, bond yields, are very high in South Africa and our short-term interest rates have not come down. So the market is, if you like, trying to price in that optimistic global scenario and, therefore, it’s holding out for some of that good news.

RYK VAN NIEKERK: If you look at the bond yields, the R186 dropped from 9.4% to 8.4% this year, well, currently and that’s from the middle of December, after Cyril Ramaphosa was elected, so it shows that ir can change actually quite quickly.

CLYDE ROSSOUW: Yes, it’s a fair point, although that 9.4% that we saw in November/December last year, if you look at South African yields they were some of the worst performing interest rate markets around the world, only possibly followed by Turkey, so we were really dancing to our own fundamentals, which were at that stage not going in the right direction. So the first correction we have seen or rally in long-term interest rates in South Africa is pricing out some of that specific risk that we brought onto ourselves. But I still think from here on out the spreads on South African emerging market debt is still higher than our commensurate peers and, therefore, there still is some scope for rates to fall further in the event that we can get beyond the politics.

RYK VAN NIEKERK: Let’s talk about the Investec Opportunity Fund, it’s the fund you manage, it’s a big fund, close to R45 billion under management, it’s the twentieth anniversary this year and it’s performed really well. If you put in R10 000 in 1997 into the fund you would today have around R113 000, while in the sector you would have had just under R80 000. It’s a big fund, it has performed really well, the size of the fund is always a question in South Africa, does that limit you in any way?

CLYDE ROSSOUW: No, I think if you look at our fund, yes, R45 billion is a big fund but if you look at some of our competitors and the peers that we have they run even more money than we do, so that’s the first point I would make. The second point is that increasingly a large part of the opportunity set is actually outside of South Africa, so if you look at the 25% that we’ve allocated offshore we’re very optimistic and excited about the opportunities that we can exploit, so I don’t want to say there’s no cap but there’s a lot of things that we can buy outside where there is no liquidity or size constraints involved on that side. Then we are probably also the biggest holder of South African government bonds in South Africa amongst our peers, again, where there are no issues around liquidity. So for us we don’t see the size of the fund as being a constraint and, as a result, we still think that if we do our job correctly we’ll be able to deliver the correct investment outcomes for clients.

Eskom can overcome challenges

RYK VAN NIEKERK: Do you hold Eskom bonds?

CLYDE ROSSOUW: No we don’t.

RYK VAN NIEKERK: Can I ask why not? How do you evaluate the bond market and the risks associated with it?

CLYDE ROSSOUW: Well, there are two things here, if you look at Eskom, firstly Eskom is a systemically important institution for South Africa, you can’t take a national electricity generator out of the equation. Essentially if you think back to the financial crisis in 2008/2009 in the US there were so many ‘too big to fail’ institutions and many of the banks were labelled as such. Eskom is South Africa’s ‘too big to fail’ institution, so the government has to underwrite that potential liability in some shape, manner or form. I think the actions and the course we have taken on Eskom are definitely positive. So, firstly, reconstituting the board was a big positive and the day that that was announced in January we saw the yields Eskom bonds come in by more than 65 basis points, so already the market is taking note of that. I think more work needs to be done around solving both the liquidity issues of Eskom and potentially the balance sheet issues of Eskom and part of the solution is possibly a better tariff increase. So the reason why we don’t own the debt is because we still think there is some road to be run on that basis and we also believe that the South African bond market, if you look at government yields with the government potentially underwriting that risk, that is priced into nominal government bonds, not priced into the lower inflation scenario that we think is likely to occur in 2018. So in simple terms we think you are getting a better credit spread in SA bonds, you’d have lower specific systemic risk on that front and we do think that there’s a good chance that with credibility from the board that Eskom may be able to access finance in the market again and probably also negotiate a slightly higher tariff increase. You’ll remember that Nersa, the National Energy Regulator, in December only agreed to a 5.5% tariff increase for Eskom, which is clearly not enough to make their revenue targets or to create the cash flow that they need to make good on the capex that they’ve spent in terms of developing extra power stations. So Eskom has some challenges, we think they can overcome them, we don’t want to invest in the teeth of the risk and we think we have got some optionality if that risk has to transfer to the government we think the bond market is reflecting that. So we’d rather act on that basis.

RYK VAN NIEKERK: I don’t see in your top shareholding Capitec or Steinhoff, I don’t know if you own shares in those companies but what is your opinion about this whole Viceroy report and the impact it had on the market? Obviously shorting is not a new thing, it’s a very accepted business or investment principle but did you think the market overreacted?

CLYDE ROSSOUW: Firstly, clearly Steinhoff was somewhat disastrous in terms of the events of late December and Viceroy probably earned a bit of credibility from the timing of the report that came out the day that Markus Jooste, the chief executive of Steinhoff, resigned. So we could argue that they were maybe a bit lucky with their timing but clearly they built up a bit of credibility on that front. With regard to your question on Capitec, we don’t own Capitec but at the same time we don’t believe that the points that were made in the Viceroy report where they have questioned some of the business practices of Capitec, we wouldn’t agree with those assessments at all. We think that Capitec is very well managed; we think that the provisioning policy is conservative and we also think that they are very well capitalised. So we don’t share the concerns, from our perspective the biggest risk to Capitec probably earlier this year was purely a valuation issue. In other words, it’s quite an expensive bank trading on more than six times book. So it’s just really a function of the share price being a little bit too high relative to the fundamentals. But if you are asking if there is something wrong with Capitec, is the business model defunct, no, not at all. We see no issues around that and quite possibly Viceroy may have picked the wrong target to issue a short-selling report on. As a result of that belief and a lower Capitec share price we have initiated a position in PSG, which owns more than 55% of the value in Capitec, we can access some of that at a bit of a discount. So although we don’t own Capitec directly, we have a small indirect stake in Capitec through PSG.

RYK VAN NIEKERK: Thank you for your time today and hopefully this correction is just temporary.

CLYDE ROSSOUW: Yes, let’s see but with corrections there are always opportunities that emerge and if you are a buyer of assets it’s always better to be buying into weakness, rather than chasing strength because that’s often a tougher way to try and make an existence. When markets are buoyant everyone looks like a genius, when markets are tough that’s when we can differentiate ourselves.

RYK VAN NIEKERK: Thank you, Clyde. That was Clyde Rossouw, he is a portfolio manager at Investec Asset Management.

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