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the good, the bad and the ugly...
www.mitonoptimal.com
The 1966 Western? No... More like our current economic climate!
Who can remember Clint Eastwood’s role (‘Blondie’) in the movie The Good, the Bad and the Ugly? One of the famous quotes in the movie was that of Tuco:
“If you save your breath, I feel a man like you can manage it. And if you don't manage it, you'll die. Only slowly, very slowly, old friend”
The months of May and June reminded me of this movie title. When good news became ‘bad’ news for emerging market currencies and bonds as improved US economic conditions – and rumours of potential monetary tightening by the Fed - caused the US 10 year Treasury yield to spike. Within the space of two weeks a 60 basis point (bps) increase in US 10 year treasuries caused a 120 bps rise in Mexican yields and almost 200 bps in S.A.
Judging by these numbers it can be fair to say that SA specific factors have definitely played a (say 40%) role in the higher yield spike and weaker rand, but there has also been a general weakness in most emerging market currencies as a result of improved US economic prospects, a stronger US Dollar and a subsequent correction in US 10 year treasury yields.
This yield correction caused the prices of SA Fixed Rate and Inflation Linked Bonds to collapse between 7% (ILBI) and 9 % (ALBI) and 15% for SA Listed Property Equities. These three asset classes are instrumental in generating income to income orientated portfolios, and asset managers had to be almost contrarian to avoid a price correction under these circumstances. (‘Save your breath…’)
Although our Multi-Asset Income & Growth funds experienced some downside, our weighting to offshore assets did assist these funds to remain in line with CPI plus returns for the past quarter. Once again, diversification minimised the losses and made it possible for us to purchase higher yields at a better price in June. (‘I feel a man like you can manage it…’)
A number of factors within the SA Economy caused us to remain cautious and underweight SA risk assets during the quarter. These factors include:
■ The lack of increasing exports due to slowing commodity demand from China and economic contraction in Europe contributes to a trade deficit that swelled to R15.02bn in April and an ongoing SA current account deficit which reached 6.5% of GDP, which all contributes to pressure on government to attract foreign inflows to service the deficit.
■ Continued wild cat strikes and wage demand from the mining sector , which earnings potential is threatened by reduced commodity prices, higher manufacturing costs and low productivity
■ Slowing SA retail sales and credit demand all contributing to a slowing SA Economy
■ Expensive relative rating of SA equities and listed property measured against other emerging and developed market counterparts and developed.
I would say the message to the SA Economy and Government is ‘If you do not manage it, you’ll die…only very slowly…’
SA Interest rates, Inflation and the Rand: where to from here?
Considering slowing SA GDP and economic growth, the Monetary Policy Committee can consider cutting local rates. In contrast to this, a weaker rand at R9.50 - R10,00 to the US$, a potential breach of the upper inflation band of 6%, higher global and local bond yields and the need to attract foreign capital are reasons why the MPC may afford to hike rates. We believe that the MPC may not do either and keep interest rates on hold to avoid a potential policy error.
Moving on to inflation we remind readers that more than 33% of our inflation basket relies on external factors influencing oil and food prices. Therefore, recent rand weakness and a bond yield spike will add upward pressure to our inflation rate. On top of this, SA’s competitiveness has declined as export production costs has accelerated over the past 5 years due to annual increases in electricity costs (20.8% pa) and unit labour costs (8.6% pa). We are very exposed to external factors that may influence the value of the Rand and impact our inflation rate, which leads us to the US economy.
More attractive developed market bond yields may cause ongoing volatility within risk asset classes as global investors can potentially rotate their emerging market exposure for developed market assets due to the improved US economy. If, however, the US 10 year treasury yield stabilizes lower, it could introduce some calm in the markets for risky assets and may provide support for emerging market local currencies and the Rand.
Using a wide spread of models, the SA Rand is undervalued. History suggests that the Rand has a tendency to overshoot fair value, particularly on the downside. RMB reports that this risk is particularly high when one considers the potential of Fed tapering,
Local - South African On-shore Focus
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our current account deficit, our labour and electricity challenges and overall money flow and market sentiment. RMB’s research explains that if the Rand stabilizes near R10.00 to the US$, we can expect SA Inflation to be between 6% and 6.5% in the next year, while if we experience a larger blow out to R11.00 to the US$ an inflation rate of 7% is on the cards. This is not RMB’s base case scenario as they believe the Rand should stabilize closer to R9.50: US$ as it is undervalued relative to Developed and Emerging Market currencies.
We maintain that although the currency is undervalued, the structural challenges SA face and a stronger US$, may lead the Rand to trade between R9.50–R11: US$ over the next 12 -18 months. The only reason we may face a stronger Rand may be due to increased foreign inflows into our capital markets if global central banks add monetary stimulus or due to attractive SA bond yields in the near term.
Domestic Asset Allocation viewsWe take into consideration both strategic and tactical decisions (overweight/neutral or underweight) within various asset classes in each of our multi- asset funds, according to an optimized portfolio profile per risk profile and investment horizon of each mandate. In that context, this quarterly piece deals with our views on our short term tactical calls; this may differ from our long term strategic views. We believe this is prudent practice, in a world dominated by debt de-leveraging and political interference. Buy and hold and static asset allocation are, in our opinion, philosophies that worked in a different era and are no longer best practice.
In true Clint Eastwood style, we will share our views in a ‘Good, Bad and Ugly’ overview per local asset class!
SA Equities (Underweight)
Good: A weaker Rand contributes to improved earnings potential for the many SA stocks. Between 60-70% of Top 40 earnings are generated offshore. Most Top 40 companies reflect healthy balance sheets and can gear up at low cost to increase earnings potential. There are pockets of value available, especially in the mining sector, which can bode well for SA Equities if global growth accelerates in the next 12 months. The relative valuation of SA stocks looks more interesting at present relative to developed market counterparts due to a weaker rand. If global economists are right on their call for global growth recovery in the second half of 2013, it would create a better environment for SA cyclical stocks and lend support to value styles.Bad:This year to date, SA equities have underperformed the Global Emerging Market Index and the MSCI World Index due to Rand weakness. The relative valuation of SA Rand hedge stocks remains expensive relative to their emerging market peer, which looks wrong considering a worsening SA macro environment. The US$ earnings of the MSCI SA have underperformed against global emerging market peers over the past 12 months as illustrated overleaf.
SA, Emerging Market and US 10 Year Bond Yields
Relative Currency Performance
RMB Inflation View
[Source: RMB]
014
For the SA Government to achieve a targeted 3.1% fiscal deficit in 2015/16, it would require not only the constrained growth of the public sector wage bill but also making some tough decisions on taxation. This does not bode well for SA company earnings relying on domestic spending.
Ugly:SA Equities relative earnings revisions were the worst of all EM countries across the EM Universe. Lower SA economic growth can put additional strain on fiscal revenue and any structural flow shift away from SA and other emerging markets can add to this pressure. The growth in domestic consumer spending may moderate in 2013 amid slower real income growth, higher inflation, elevated household debt levels and a potential slowdown in credit extension to consumers. These ‘environmental’ factors and the business confidence index falling to an all time low, may affect the earnings outlook of domestic stocks negatively.
SA Bonds (Underweight Long Duration, Overweight Inflation Linkers and Floating Rate Notes)
Good: The correction in long bond yields during May and June has made SA government bonds more attractive especially considering the weaker SA Rand. This may attract inflows from foreign investors, local pension funds and asset managers back into our bond market which now trades at the same level as in May 2012 when we learned of our inclusion in the World Government Bond Index. Any evidence of additional monetary stimulus by one of the big three Global Central Banks may see a return to the ‘search for yield’ trade and increase demand for SA Long Duration Government Bonds.
We use SA Inflation Linked Bonds (ILB’s) to match our long term CPI Plus mandates and increased exposure to ILB’s more recently when real rates followed fixed rate bond contraction. The 10-year modified duration real yield of ILB’s now trades at a coupon of 1% above CPI and serves as tail risk insurance against the ravages of inflation in our income & growth funds.
Floating rate notes served us well during the quarter and remain our largest exposure to bonds in our portfolios due to their positive correlation to cash, while providing cash plus returns.
Bad:The SA Government budget is planning to spend R847 billion to develop public infrastructure in our country. Although Government collects R800 billion in tax revenue, current expenses remain higher than their current income. Government may curb wage growth to limit expenses, but will need to issue Fixed rate and ILB long term bonds of approximately R135 billion per annum to fund proposed infrastructure development. Therefore SA’s fiscal status needs to be managed well to maintain inflows from foreign investors. A 5-6% current account deficit and an inflexible labour policy may negatively influence how SA is viewed by rating agencies.
Ugly:Foreigners own 40% of our SA fixed rate government bond market (not the case with ILB’s or corporate bonds) and if they decide to find value outside SA and taper their SA long duration bond holdings, our bond yields will spike and cause widespread price losses in bond markets and listed property equity.
SA vs. Global Emerging Markets: 12 month forward earnings (USD terms)
[Source: RMB Morgan Stanley Research]
SA, Emerging Market and US 10 Year Bond Yields
USD/ZAR and Repo Rate
015
SA Listed Property (Underweight)
Good: Listed Property prices corrected by nearly 15% as Listed Property’s positive correlation to long bond yields caused a price collapse during May and June. This correction has made SA Listed Property yields more attractive. The current income return of approximately 6.5% and the growth in distributions (also approximately 6.5%) can be predicted with a high degree of certainty, providing a strong underpin for the sector.Property fundamentals are still strong and sustainable, especially in the retail and industrial/warehousing sectors of the market. Low vacancy rates and acceptable loan to value ratios should provide additional comfort for investors. Listed Property companies are able to obtain funding at JIBAR plus 35 bps in the corporate bond market and can therefore acquire assets at an attractive cost.
Bad:What remains uncertain is what will happen to SA government bond yields. If they remain more or less where they are or go lower, domestic property should deliver a generous positive total return. Another uncertainty is the potential knock-on effect of slowing retail sales and how it may affect the listed property market in the longer term. Stronger earnings potential is expected from EM counterparts and local listed property continues to trade at a longer term premium relative to its history, leaving room for downside earnings surprises.The office sector, however, finds itself in a challenging environment due to slowing business confidence.
Ugly:Foreigners own 40% of our SA fixed rate government bond market and if they decide to find value outside SA and taper their SA long duration bond holdings, our bond yields will spike and cause widespread price losses in bond markets and listed property equity, due its correlation to long duration bonds.
SA Cash (Overweight)
Good:We are overweight cash (for tactical asset allocation reasons) by using short – duration corporate bonds. We expect short dated corporate issuance to increase, as Banks will make lending less attractive to Corporates due to Basel III liquidity requirements. We believe that Money Market rates will remain flat, but corporate instruments in the 1-3 year duration space may generate CPI plus 1-2% returns for investors.
Bad:We run the risk of exposing ourselves to an asset class that is currently yielding negative real returns.
Ugly:Ugly for some and Good for others may be raising interest rates in an environment where the MPC is forced to hike rates to combat inflation or to attract foreign investments.
Where do we invest with higher conviction in expectation of real returns?
The conditions that lifted global equities have not changed much recently. After collapsing in the 2009 recession, earnings reported by the S&P 500 companies have risen to record levels, but remain cheap historically as they trade between PEs of 14 and 16. As the US economy recovers, earnings growth may continue. When one considers that the S&P 500 has traded sideways in the past 12-13 years, the US equity market remains good value. Japan’s outlook has improved since the pro-growth Shinzo Abe took over as Prime Minister. Faster growth in US, Japan and China could lift global demand and help ease risks elsewhere - Europe’s fiscal and economic challenges for one. Using MSCI forecasts, emerging markets now look cheaper than developed markets, as the average PE Ratio derived from expected earnings (Forward PE) in these markets over the next 12 months is under 10. The forward PE for developed markets is more than 13. From an overall valuation perspective most global developed and emerging market equities are more attractively priced than their SA counterparts. We are overweight global assets in our local mandates and within the global asset allocation mix we remain neutral global equities and listed property while we remain underweight global bonds and are more comfortable with US$ cash relative to other developed market currencies. ConclusionWe acknowledge that SA asset classes are facing a lot of potential ‘bad’ and ‘ugly’ challenges, most of which is dependent on external global factors.
However, investor confidence, relative yields in a world of low-yield fixed interest instruments, limited alternatives and global capital flows could be even more important than economic fundamentals or equity valuations. Together these influences may well deliver ‘good’ favourable returns for risk assets in the next couple of years. We plead to investors and advisors to ignore past performance of asset classes as a measure for future returns – especially short term performance. We advise investors and advisors to ensure that client portfolios matches the appropriate risk profile, risk capacity and investment horizon so they are able to ‘hold their breath’ in an appropriate manner during periods of high volatility (as experienced in May and June) and avoid a ‘slow death’ by chasing short term performance. Professional money managers will need to manage portfolios ‘like real men’ over the long term!
roeloff horneDirector & Head of SA Portfolio Management
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