In December 2018 the average prudential balanced portfolio returned 0.74% (November 2018: -1.73%). Top performer is Momentum (2.33%); while Namibia Asset Management (-0.56%) takes the bottom spot. For the 3-month period, Momentum takes top spot, outperforming the ‘average’ by roughly 1.74%. On the other end of the scale Namibia Asset Management underperformed the ‘average’ by 2.50%.
Can you currently invest anywhere but in cash?
In this month’s commentary we continue the discussion on the US repo rate and its implications for global financial markets and therefore on investment decisions. What is the risk of investing anywhere other than cash now and in which asset class can you otherwise invest? We have in last month’s commentary shown how closely correlated the SA interest rates and the JSE is to its US equivalents. Fiscal policy is driven primarily by the state of the economy which drives inflation and the tools used to drive policy are interest rates and the supply of money to the market. If the economy overheats inflation rises and this will result in the lifting of the Fedrate (or repo rate in SA). If the economy is moving into recession, the Fed will attempt to stimulate it by dropping its policy rate. Inflation will follow the decline in the economy.
When the global financial crisis struck at the end of 2007, the US economy turned into recession. The Federal Reserve responded by lowering its policy rate from 5.25% in July 2007 to 0.25% in December 2008, and by flooding the market with money, in order to support the economy. GDP did recover rapidly out of negative territory up until the middle of 2009 to peak at just below 6% in quarter 2 of 2014. Since then it has declined steeply to steady at around 2% barring a blip taking it to just over 4% in the middle of 2018, probably the result of changes to US tax laws (refer graph 1).
Read part 6 of the Monthly Review of Portfolio Performance to 31 December 2018 to find out what our investment views are.
It’s the dog that wags the tail - how the US economy impacts SA (and Namibia)
For those readers who may have overlooked our monthly investment commentary in last month’s Performance Review as at 30 November 2018, we present this here once again.
The US Repo rate is currently 2.25%.While the US annual CPI has steadily been creeping up from around 0% in January 2015 to 2.95% at the end of July, it has been on the decline again since then, contrary to the Fed’s expectation, to reach 2.18% at the end of November. This means that any US citizen investing in US treasuries is now for the first time since November 2015, earning a positive real interest rate. If this trend continues, the appetite of US investors for equities is likely to wane, removing the underpin of equities in the US and globally.
The declining inflation in the US is probably also at least part of the reason why the Fed has no raised the repo rate at its last sitting, contrary to a general expectation that it would. The US needs inflation to deflate its huge debt burden and expected quantitative easing to do this job. It seems though that this strategy has not worked and the risk of deflation is on the rise. This may present major structural challenges and may result in us treading a very uncertain path and in increased market volatility.
A negative real interest rate is clearly not sustainable and is the cause of artificial imbalances in asset valuations that are due to correct once the situation returns to normal as we are starting to see now. The US repo rate should be around 1.5% higher than US CPI, going by historic evidence stretching back to 1988 and up to the onset of the global financial crisis.
Based on current US CPI of 2.2%, the US repo rate should be around 4%. Once the repo rate offers a real return of 1.5% or reaches 4% under current inflationary conditions, it would indicate a normalised interest rate environment. At the more recent rate of upward adjustment of the US repo rate and the state of the global economy we are once again looking at around 3 to 4 years now until we reach this point given that we saw 6 increases of 0.25% each over the past 4 years. This of course assumes that the global economy will pick up at the speed it has over the past 4 years, whereas at the moment it could go in either direction. So where will this leave SA?
Graph 1
Graph 1 above shows how closely correlated the SA and the US repo rates have been over the past 30 years plus, the SA repo (measured on the left vertical axis) generally lagging the movement of the US repo (measured on the right vertical axis). With an expectation that the Fed is unlikely to raise its repo rate given the current state of affairs, the SA Reserve Bank is unlikely to lift its repo further any time soon unless forced to do so because of a declining positive differential between US and SA real repo rates.
Graph 2
Since one would expect the interest rate to impact the exchange rate an interesting question is whether this is indeed the case. Graph 2 above measures the differential between the US and the SA real repo rate, i.e. the nominal repo rate minus annual inflation (the red line measured on the left vertical axis) and the Rand: US Dollar exchange rate (the blue line measured on the right vertical axis). Tracking the red line against the blue line, one will note a fairly distinct decline in the real repo rate differential (i.e. SA offers a higher real repo rate than the US) up until around 1994, coincidentally the time of the democratization of SA, despite a growing gap in real repo rates in favour of SA. There is hardly any correlation between these two lines over this initial period. Over this period the Rand weakened steadily against the US Dollar. From the beginning of 1999 up until about 2012 a relatively higher real repo rate in the US is accompanied by a weakening of the Rand and vise-versa, and we see much closer correlation between the red line and the blue line. Since 2012 the real repo differential hovered between minus 4% and 0% in favour of SA while the Rand continued to weaken significantly against the US Dollar from about 9 to its current level of around 14. It would be interesting to overlay political events in SA onto this graph such as the election of president Zuma and the end of his term. This graph does indicate that the Rand is currently excessively weak relative to the real repo rate differential between the US and SA, possibly for political reasons. This is also borne out by graph 5.1 in paragraph 5 above. Looking at the last few months, the real repo rate differential is closing in favour of the US and we simultaneously see a weakening of the Rand. This indicates that SA will be under pressure to raise its repo rate if the US inflation continues to drop or if the US lifts its repo rate.
Graph 3
As illustrated in graph 3 above, both the S&P 500 and the ALSI have grown strongly in real terms since the beginning of 1987. While the current S&P 500 price: earnings ratio at 18.9 is well below its 30 year average of 22.3, the current ALSI price: earnings ratio of 14.9 is now on its 30 year average of 14.7.
Graph 4
However looking at graph 4 above, the S&P 500 CPI adjusted earnings (measured on the left vertical axis) of currently 145 are twice its 30 year average of 71. The ALSI CPI adjusted earnings (measured on the right vertical axis) of currently 3,411 are 40% higher than is 30 year average of 2,400. This also indicates a risk of earnings declining to more normal levels and a consequent risk of equity markets adjusting downward.
With these expectations, the Rand and local interest rates will remain under pressure for the next 2 to 3 years and this will also impact negatively on local inflation. Equity markets are exposed to the risk of a downward adjustment. Low returns on equities and rising interest rates will also impact negatively on the consumer. On the flipside, a weak Rand should promote exports and support Rand hedge shares that benefit from the weak Rand and should promote local manufacturing and exports which should eventually create jobs and lead to improved consumer sentiment.