A TOUGH YEAR AHEAD FOR SA…BUT WE’RE ON IT!
David Crosoer, PPS Investment Executive, answers some pertinent questions about his investment perspectives for 2015 and over the past quarter. He shares insight into the broader global economy, the local picture and just how PPS Investments has diversified its portfolios to minimise risk for clients and help them generate long term wealth.
What Were The Primary Economic Themes We Saw Last Year?
2014 was dominated by weakness in the global economy, and downward pressure on commodity prices. This was largely as a result of investors reacting to the implications of the end of quantitative easing in the United States, and continued poor growth in most of the developed and emerging world. Consumer price inflation remained manageable, and South Africa ended the year within the 3% to 6% target band.
We Saw Mediocre Growth In The SA Economy In Q3 Last Year. Why?
Bottlenecks in infrastructure and adjusting to the strikes in the mining and manufacturing sector haven’t helped. But it’s been a weak recovery as consumers have been unable to take on additional debt. The private sector has been subdued and reluctant to hire, and employment creation has largely been driven by the public sector, which has seen a marked deterioration in its finances.
How Did The Various Asset Classes Perform In 2014?
The Shareholder Weighted All Share Index (SWIX) was up 3.75% for the quarter and 15.42% for the year, with the financial sector performing particularly strongly (up 10.37% for the quarter, and 27.83% for the year). Investors in resource shares, however, had a torrid time with the resource sector down 19.81% for the quarter and down 15.01% for the year. This weak performance reflects poor growth prospects. Resource shares have now given negative annualised performances over one, three, five and seven years despite the broader equity market compounding at over 6% (real) over a similar period.
Fixed interest assets also performed strongly over the quarter with the All Bond Index (ALBI) delivering 4.25% over the quarter, and 10.15% over twelve months. Short-term cash rates were unchanged over the quarter, but have edged up slightly when measured over twelve months. The rand has remained under pressure, particularly against a strong dollar. It ended the year 10% weaker from where it started.
Global equity markets underperformed South African equities over the quarter (up 1.93%), but gave broadly similar returns when measured over twelve months (up 15.42% in rands). International equity markets however have outperformed South African equities over two, three and five years with the United States equity market being the standout performer.
And The PPS Portfolios?
The portfolios under our care have held up relatively well, despite our significant resource overweight, given our diversified exposure across all asset classes including international and fixed interest assets, with even our local equity managers delivering a positive return for the quarter.
Our managers have a mandate to make investment decisions with a long-term time horizon in mind, and we remain of the view that this is the most appropriate means to generate long-term wealth for our clients.
What are the Market Expectations for Economic Growth?
Market analysts now anticipate that South Africa might have grown by just 1.4% in 2014, and will be lucky to grow above 2% in 2015. In fact, our potential growth rate, given all our constraints, is probably closer to 2% p.a. than the 5% we need to start making a dent on unemployment - or the 3% we’ve typically grown at in the past. Worryingly, the International Monetary Fund (IMF) calculates that despite a challenging global context, South Africa should have grown two thirds of a percent faster p.a. since 2010.
What Does SA Need to Do to Avoid Being Downgraded by Rating Agencies?
Both Fitch and Standard & Poor have left our rating unchanged in December. Both stressed this was conditional on, firstly, South Africa improving its economic growth rate and, secondly, South Africa getting a handle on its government expenditure. Both conditions are challenging to implement, especially in a demand-deficient world where there is considerable political pressure to spend. Relative to other emerging markets, we’ve gone backwards over the past five years. We need to reverse this.
How Will SA Treasury Support Growth and Manage Expenditure?
South African has limited room to manoeuvre. We’ve frequently commented on the unsustainability of our government expenditure (government debt as a percentage of GDP has increased from 27% pre-crisis to close to 50% today) and the gradual erosion of our economic competitiveness, despite a weaker rand.
In his maiden Medium Term Budget Speech in October, incumbent Minister of Finance, Nhlanhla Nene stated Treasury would, among other things, need to raise additional revenue, freeze public sector headcount and wages in real terms, and ensure any support to state-owned enterprises was budget neutral. It is critical that he delivers on this in this February budget as most market participants are anticipating US short-term interest rates will increase in 2015 on the back of an improving US economy.
We also need to direct expenditure towards infrastructure spend rather than public sector salaries – something the G20 in Brisbane committed to trying to achieve in principle, but we need to see it implemented in practice.
Will US Interest Rates Change?
The unsynchronised global recovery puts great pressure on economies like South Africa. This is because we are reliant on record-low interest rates to stabilise consumer demand. Although the US Federal Reserve (Fed) released a less aggressive interest rate forecast than one quarter ago, the December minutes indicate that the median governor expects the Fed Funds rate to be 1% at the end of 2015, and 2.5% at the end of 2016 (from 0% currently). The first interest rate increase, and changes in market expectation as to when this will occur, is likely to mean significant volatility on the pricing of most financial assets. This is especially due to the key role the US plays in the global financial system.
Why do We Think SA Might Have to Raise Rates Significantly?
So far the South African Reserve Bank has only raised interest rates by 0.75%, and the market is not pricing in an aggressive interest rate cycle in South Africa in 2015, with the Monetary Policy Committee (MPC) expecting to leave interest rates unchanged later this month.
This subdued cycle is however dependent on South Africa retaining the confidence of investors, and the United States (US) not raising rates aggressively itself. We can expect far higher interest rates cycles if the current cycle resembles anything like we’ve had in the past.
And if our fundamentals deteriorate further, we may find ourselves in a similar position to Turkey and Russia in 2014 who were forced to aggressively raise rates as investors focused on their unsustainable economic fundamentals. These aggressive interest rate responses (Russia hiked rates from 7% to 17.5% in one day last December) can have devastating implications for consumers and the pricing of financial assets.
Has There Been Any Good News for South Africa?
The drastic drop in the oil price to under $50 a barrel is positive for consumers and inflation. If it persists, it is likely to stimulate global growth by as much as an additional percentage point. This is significant in an economic context where the World Bank expects the global economy to grow by just 3% in 2015. The MTBS announced by Minister Nene sound promising and he now needs to deliver. Delays in US interest rate increases may also give South Africa more breathing space and keep interest rates lower for longer. However, unless economies like South Africa can introduce the necessary structural reforms, it’s unlikely that, outside the US, the global economy will hold any pleasant surprises. We need to get the private sector creating jobs again.
How is PPS Positioning Itself for These Themes In 2015?
Our base case scenario is that 2015 will be a challenging one for investors - with tighter global conditions, an uneven and uncertain recovery, and reduced policy space. Since we expect the themes of 2014 to continue in 2015, our portfolios will continue to invest heavily in international assets. Asset managers we believe have the ability to offer some protection in difficult markets will be used. We also have a lower weighting to South African assets, with the only exception being the cash which also featured quite prominently in our portfolios. So in a nutshell, we continue to motivate underweighting South African equity and fixed interest assets, and remain overweight in SA cash and international assets as a means of protecting capital.
How are Your Portfolios Positioned to Minimise Risk for Clients?
We continue to believe that the normalisation of US interest rates from record lows is the greatest risk facing South African investors. We also remain sceptical about the ability of South Africa to initiate much needed structural reforms. However, we’ve ensured our portfolios are sufficiently diversified across asset classes and managers to perform adequately should these scenarios not materialise, especially because the local equities our managers are holding should benefit from an improvement in sentiment towards South African assets.
You will need to prepare yourself for a challenging year. 2015 is likely to be characterised by a lot of volatility as the world readjusts to increasing US interest rates. The budget could also hit consumers in the pocket.
In such an environment, it is doubly important for you to stay focused on your long-term goals and not get swayed by short-term sentiment.