Eight months into a tumultuous 2018, investors may be forgiven for being sceptical about the prospects of a wide range of financial markets. We started the year with the Steinhoff saga fresh in our memories following that company’s share price collapse early in December 2017 – a result of fraudulent activities that triggered questions about the diligence and competency of professional investors.
The changing of the guard within the ANC leadership later the same month sparked renewed optimism, however, with the rand strengthening. The share prices of South African-focused companies appreciated materially on the back of this euphoria late in December and January. The positive sentiment also spilled over in a strong recovery in consumer confidence in the first quarter and economists adjusted their growth forecasts for 2018 on the assumption that the improved sentiment would be enough to boost actual economic activity.
Sadly, the euphoria has now petered out and the economic realities of the day are in stark contrast with the initial expectations. Also, financial markets – not only the equity market – have started to reflect these realities with pedestrian performances following the peaks recorded in mid-January.
US RATES CAUSE PAIN
From a macro perspective, our base case has always been that we’re in an advance stage of a global economic upswing and that we should expect the growth momentum to slow over the next two years. Economic upcycles usually end when interest rate shocks, normally inflation related, deflate the cycle, or an external shock, often an oil price upset, creates a hurdle for sustained economic growth. As growth in the US has matched expectations, the unemployment rate is at historically low levels. There are signs of higher inflation, and policy rates in the US are on the up.
Higher US interest rates have certainly not derailed economic growth in that country. However, they’ve caused pain in other areas. While the higher rates have supported the US dollar, they’ve conversely had a negative impact on emerging market currencies, and therefore in many cases the performance of both emerging market equities and government bonds.
For emerging economies struggling with structural economic issues, the pain has been more tangible, especially for Brazil and Turkey. Although South Africa doesn’t have the same structural issues, we’ve also became a victim as investors withdraw their money from the tainted emerging markets investment category in general.
Increased US interest rates have also leaned heavily on the share prices of so-called consumer staples internationally. Many of these were seen as proxies for interest-bearing investments in a low interest rate environment, and were trading at inflated valuations. With the higher rates, investors have switched out of these shares back into interest-bearing investments, with a resultant decline in share prices in this category. This is partly the reason why the share price of tobacco stocks like Philip Morris is down by 23% year-to-date and why British American Tobacco has suffered a similar fate on the London Stock Exchange.
TRADE WARS: A MAJOR RISK
As stated, shocks can bring an economic cycle to an end. As the word implies, it’s impossible to forecast a shock. However, a full-blown trade war – the beginnings of which are now in evidence – would certainly present a major risk to the longevity of the global economic cycle. The war of words – and initial actions – between US president Donald Trump and China’s Xi Jinping have clearly resulted in uncertainty in the performance of risky assets: equities, property and currencies.
Equity markets in particular have at times responded violently to the tit-for-tat trade battle between the various camps. Liberal trade arrangements have, since the 1950s, undoubtedly contributed positively to stronger global economic growth, and a reverse to this approach is likely to have the opposite effect.
OPERATIONAL PERFORMANCE
Investors globally have also responded harshly to disappointing operational performance. The biggest casualty has been Facebook. After the company came under scrutiny for its privacy policies, the share price started to reflect investor jitters during CEO Mark Zuckerberg’s testimony to the US Congress in March. It was Facebook’s disappointing results, however, that wiped 22% – or a massive US$136 billion – off its market capitalisation, in two trading sessions. This movement is astounding if one considers the amount of investment research done on this company – little wonder that many investors are questioning the value of research done by professional investors!
Closer to home, it wasn’t only the pedestrian economic growth rate that disappointed in the first six months of the year, relative to expectations. The narrative associated with the low growth rate was rather scary. We followed a cautious approach to investing in local government bonds, as we’d warned earlier about a deteriorating fiscal situation – partly as a result of mismanagement and corruption within state-owned enterprises in particular.
Our biggest concern remains Eskom. There seems to be no end in sight for this organisation’s financial woes while management and labour bizarrely persist in negotiating on wages when it’s obvious that productivity falls far short of any international standard. To top it all, a reliable supply of electricity is crucial for business, particularly for manufacturing – an economic sector rapidly losing ground against more productive nations.
WHEN THE TIDE GOES OUT
Corporate South Africa hasn’t been able to escape this tough economic backdrop. Two years ago, we warned that an oversupply of property and high valuations wouldn’t be sustainable when the tide goes out. Indeed, the Listed Property Index has lost 24% of its value since the start of the year.
The sharpest drop has been in the Resilient group of companies. Following accusations of foul play from local hedge fund managers, the counters within the group have fallen significantly and haven’t recovered since. There’s still an ongoing investigation by the Financial Sector Conduct Authority (FSCA) into possible price manipulation by both Resilient and Fortress, and the share price is unlikely to gain materially before this investigation has been concluded.
While the previously unpopular mining counters Anglo American and Billiton have advanced strongly year-to-date, former darlings have come under severe pressure. Curro Holdings traded 26% lower and the share price of its sister company Stadio halved over the period. These declines had very little to do with the operational performance of the companies but were simply a correction from extreme valuations. A few single-commodity resource counters moved from what some regarded as cheap, to even cheaper – precious metal producers Lonmin, Sibanye Gold, Northam Platinum and Impala Platinum all lost more than 30% of their value over the period.
INVESTMENT OPPORTUNITIES
Investment market uncertainty will always be with us to some degree – currently amplified by the advanced stage of the economic cycle and increased interference by authorities in the normal evolution of economic trends.
In our view, heightened uncertainty can be either positive or negative. It’s negative in the sense that although we’d like to craft portfolios that reflect high conviction, we’d caution against extreme views given the wide range of possible investment outcomes. But it’s also true that during times of uncertainty, investors act emotionally, and, from a longer-term perspective, price assets incorrectly. Such emotional behaviour invariably provides good investment opportunities for those skilful enough to identify them and patient enough to watch the long-term benefits unfold.
