RealFin Capital Partners€¦ · Economic theory tells us a downward sloping or “inverted” yield curve is a recessionary predictor. We can measure the yield curve shape by examining

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RealFin Capital Partners Quarterly Investment Report

Dear Investor

General Market Overview

In a quarter that has been marked by higher levels of market volatility, the US market has outperformed its global peers over the quarter returning 6.5% in US Dollars. It was followed by the Japanese market which returned 3.0%. The French Index was flat while both the UK and German markets fell over the quarter, each returning -3.3%. All returns are presented in local currency.

Emerging markets have dominated the news over the last few months, Turkey, Argentina, Venezuela and South Africa in particular. We’ll cover these events in more detail in our coverage on the South African Rand.

Index Performance for the Quarter (Local Currency)

Source: Stock Rover

From an economic standpoint, the FOMC (Federal Open Market Committee) meeting minutes and the shape of the US yield curve are a key area of focus. Economic theory tells us a downward sloping or “inverted” yield curve is a recessionary predictor. We can measure the yield curve shape by examining the difference between the 10-year US Treasury Bond yield and the 2-year US Treasury Bond yield.

A flat yield curve means this difference will be close to zero, in other words, longer-dated 10-year treasuries are not yielding more than shorter-dated 2-year treasuries. Investors typically want to be compensated for duration risk (longer is riskier) through a higher yield which is part of the reason for a typical upward-sloping yield curve.


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US Yield Curve Slope (10yr – 2yr)

Source: Federal Reserve Bank of New York, NBER

As can be seen on the chart above, when the 10yr-2yr differential gets to zero, this has historically been followed by a recession (indicated by the grey bars). Government bond yields and the yield curve in general, provide a sense of what market participants believe is coming for the domestic economy.

A flattening yield curve implies that “the market” believes an economic slowdown which would be accompanied by the FOMC reversing their current hiking cycle and decreasing rates is possible. However, when we look at the Eurodollar Futures market, which provides a good estimate of the markets’ view on the Fed policy rate, the market seems to be expecting a continuation of the hiking cycle.

Path of 3-Month Average Policy Rates

Source: CME, Bloomberg

Using a combination of these views, together with other macroeconomic data which has been positive and supportive of the US economy, a recessionary environment seems unlikely. There are of course risks, the


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trade policy uncertainty being a key economic risk, but on a measured basis, we see continued economic growth and further Fed tightening in the medium term. While the US economic outlook may remain benign, there is not always a direct link between the economic backdrop and stock market performance. Another area of concern is the length of the current bull market. The chart below maps out the length of the current and 5 prior, post-WWII bull markets. While the 1990’s run produced greater overall returns, the current cycle which commenced in early 2009 has become the longest surviving. Market commentators and investors alike, tend to get nervous at milestones such as this! What is of interest, are the key drivers of the current cycle.

Bull Market Length (years)

Source: LPL Research, FactSet, CFRA

Just this year alone, Amazon, Netflix and Microsoft are responsible for 71% of the S&P 500’s returns. If treated as a collective, the FAANGs+ stocks (including Microsoft) would form a group that is bigger than the 11 sectors comprising the S&P 500. The similarity of the FAANG phenomenon with the tech bubble of the late 1990s is notable.

FAANG+! (Facebook, Apple, Amazon, Netflix, Google + Microsoft)

Source: The Irrelevant Investor


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Cyclical growth stocks, driven by the tech sector, have over this bull market significantly outperformed defensive stocks. The CAPE (Cyclically Adjusted Price Earnings) ratio is currently at 31 for the US market – at 1929 levels but below that seen in the late 1990’s. High CAPE ratios have historically indicated lower future returns, and attractive CAPE ratios tend to forecast higher subsequent returns.

The Relationship between Valuation and Long-term Stock Market Returns

Source: StarCapital AG

If we turn our attention to those geographic regions looking more attractive on a CAPE valuation basis, our focus would include Eastern Europe, some Southern Mediterranean countries and parts of South-East Asia. The US, Canada, Eurozone and Scandinavian markets all indicate a degree of overvaluation on a CAPE metric basis.

Stock Market Capitalisation as a % of GDP

Source: CEIC

Another interesting valuation metric is stock market capitalisation as a percentage of GDP. The ratio compares the value of all stocks at an aggregate level to the value of the country's total output and was popularised by Warren Buffett. It is quite staggering that for South Africa, the combined market cap of all the JSE-listed stocks is more than 3 times the size of the South African economy! It certainly points to a growing combination of both a market price and an economic mismatch which may not be sustainable, which again, supports our diversified international asset allocation view and investment offering.

Given the overvaluation in various pockets of the market, and the increasing risks due to Fed action, trade policy fall out and idiosyncratic EM risks, we expect market volatility to continue both in the domestic market and internationally as markets embark on a rotation away from cyclicals to more defensive plays.

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General Conclusion

US economic growth seems to be robust but increasingly, markets are starting to look overvalued. This is most notable in growth sectors like technology stocks and reinforces our decision to target more conservative equity sectors in our core equity allocation.

The reason for focussing on the US economy and market this quarter is to highlight the potential increasing impact that a change in US interest rates can have globally. If the US economy does remain in a growth phase, then the Fed has leeway to raise rates. Increasing US interest rates will have a ripple effect through global markets, particularly those markets with high sensitivity to fund flows.

A reduction in US Dollar liquidity will see “hot money” washing out of higher yielding and more risky assets, which when coupled with economic fragility (as seen in select emerging market economies including South Africa) will exacerbate FX, market and economic woes for these regions.

There is likely to be turbulence ahead.

Rand Overview

The Rand has weakened significantly over the quarter for a combination of reasons. There is undoubtedly US Dollar strength following rising US interest rates which is pressuring the Rand and other “carry-trade currencies” due to the Dollar-liquidity squeeze. However, there has also been a significant degree of Emerging Market FX weakness, driven by Turkey and Argentina which, coupled with South Africa-specific political and economic issues has led to a fragile domestic currency.

Rand-US Dollar (12 Months)

Source: Share Data

The Turkish Lira started 2018 at 3.79 Lira to the Dollar. It’s now trading at 6.73 – a 44% depreciation. The Argentinian Peso was at 19.08 to the Dollar and is now at 38.73 – a 51% depreciation. The South African Rand has depreciated by 16% against the Dollar over 2018.


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Currency Devaluation (Indexed)

Source: Google Finance

In Turkey, foreign-currency denominated debt is accumulating rapidly, and domestic borrowing costs have spiked. Turkish President Recep Tayyip Erdogan has alarmed markets with his unorthodox economic policies and political decisions. Inflation in Turkey is now running above 15% year-on-year and with an economy heavily reliant on oil imports, this is likely to accelerate. Given that oil must be paid for in US Dollars, Turkey’s foreign currency reserves have been shrinking, and according to the IMF, its financial position is precarious.

Turkish Foreign Currency Reserves Current Account Balance as % of GDP

Source: FactSet, WSJ

One of the key weaknesses is the Current Account (CA) balance as a percentage of GDP. A CA deficit means that the Turkish economy needs foreign monetary inflows to sustain itself. When we review Turkey’s CA position, we note the South African and Argentinian situation is not dissimilar on this measure. Using World Bank 2017 statistics, Turkey has an external debt (foreign currency denominated debt owed by companies, government and households) to GDP of 53.4%. A close second in the EM peer group is South Africa with external debt to GDP of 49.6%. Argentinian foreign currency debt is forecast by Moody’s to reach 70% of GDP in 2019.

Argentinian President Mauricio Macri has asked the IMF to speed up delivery of a $50 billion bailout package which prompted markets to question whether the Government had “insider information” and knows that the situation

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on the ground is, in fact, worse than global participants believe. The Government has also raised interest rates to 60% to try to (unsuccessfully) slow the currency’s fall. Inflation could reach 32% this year and if inflation rises faster than wages Argentine citizens will struggle to make their debt payments.

In South Africa, Government debt as a percentage of GDP has now reached its highest level of 53%, excluding State-Owned Enterprises (SOEs). If we include Government’s guarantees to SOEs, then the debt to GDP ratio rises to 58%, and if the full value of SOE outstanding debt is included, then this relationship rises to 70%.

So, while Turkey and Argentina may have focussed market attention on the fragility of some EM economies, South Africa also has diminishing FX reserves, a current account deficit, a high reliance on external debt and an over-indebted government balance sheet. Economically, South Africa’s position is poor.

South African Government Debt as % of GDP

Source: Economists.co.za

On the 15th of August, Moody’s Investor Services announced the following on their assessment of South Africa: “Growth this year is expected to be lower than the government's own estimates, weighing on tax revenues, while the public sector wage agreement in June also brings extra, unbudgeted costs.”

SARB Governor Lesetja Kganyago has said growth projections were “worrying,” and hinted policymakers aren’t about to raise rates. On an annualised basis, South African GDP fell by 2.2% in 1Q18 – an economic contraction, with the biggest downward contributions, came from mining, manufacturing and agriculture.

South Africa GDP (quarterly, annualised)

Source: Stats SA, Trading Economics


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Of course, adding fuel to the “EM sell-off fire” is Venezuela. Inflation has now breached 82 thousand per cent (82,766%) year-on-year, a figure inconceivable to anyone except those who have lived through hyperinflation. The economy has shrunk 70% since 2011 and 7% of the population (2.3 million people) have left the country in the wake of severe food and medicine shortages. Therefore, it is worrying when the South African political leadership seem to step towards increasingly socialist policies.

Expropriation without Compensation (EWC), NHI and a mining charter that is definitely not pro-business are all worrying signs that political and economic policy geared towards economic growth and foreign investment is being all but abandoned in order to pursue a populist agenda. The undermining of property rights has serious implications for South Africa and in June, the IMF warned that the uncertainty created by the land debate and EWC is dissuading potential investors from considering South Africa as an investment destination.

The Absa Purchasing Managers’ Index (PMI) declined in August to 43.4, this is the lowest level in over a year. The fall was driven by a decline in new sales as respondents indicated concern about domestic demand for goods.

Absa PMI South Africa

Source: BER, Absa

Although it feels like a pessimist outlook, a weakening Rand might be the very factor that “saves” our export industries (mining, agriculture and tourism), helps create jobs and adds to tax revenues. It is, however, a real Catch-22 and there are likely to be economically difficult times ahead.

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RealFin Capital Partners€¦ · Economic theory tells us a downward sloping or “inverted” yield curve is a recessionary predictor. We can measure the yield curve shape by examining