By Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth
If you thought political uncertainty was unique to South Africa or other emerging markets, think again. Last week saw the world’s two oldest democracies gripped by constitutional convulsions. In the US, the Democrat-controlled House of Representatives has formally launched an impeachment inquiry against President Donald Trump following allegations that he pressured the President of Ukraine to investigate the son of Joe Biden, a likely opponent in next year’s presidential election. Impeachment means the House will draw up charges and investigate these, but it is the Senate that has to vote on whether the President is guilty of these charges and should be removed from office. Since it is widely expected that the Republican-controlled Senate would rule in favour of Trump, the next few months are likely to see an increase in political grandstanding, and this while election campaigning is kicking up a gear.
What are the implications for investors in South Africa? The fact that local equities and the rand sold off because of a political crisis in the US is a reminder of the outsized role of that country in global markets. Similar episodes from the past may not tell us much about what lies ahead though. President Bill Clinton was impeached by the House but acquitted in the Senate in 1999. The roaring 1990’s bull market was hardly noticed. President Nixon resigned before he could be formally impeached, but the Watergate scandal took place against the backdrop of a 45% drop in the S&P 500 between 1972 and 1974 as the global economy tumbled into recession.
In simple terms, markets don’t like uncertainty, and this is likely to drag out for many months. It is hard to say what would be a ‘good’ or a ‘bad’ outcome for investors. When Trump was elected, equity markets were briefly stunned, before staging a massive rally. Trump was seen as business-friendly and his corporate tax cuts certainly provided a boost to companies’ bottom lines. However, over the past 18 months, Trump’s erratic pursuit of a new trade agreement with China has seen him introduce steep tariffs on Chinese imports. This has caused tremendous uncertainty among businesses and investors alike at a point in time when the global economy was slowing down anyway. Over the longer term, Trump’s willingness to up-end the global trading system that has created so much prosperity around the world, especially for investors in the multinational giants, is likely to offset the positive boost from tax cuts. And of course, those tax cuts still have to be paid for, as they were financed by borrowing. Though with interest rates close to historic lows, that is less of a concern for the moment.
Chart 1: S&P 500 since Donald Trump’s election.
Source: Refinitv Datastream
At the same time, getting rid of Trump is no panacea for the investors. The Democrat candidates for the Presidency are not free-traders, though they are likely to adopt a more reliable negotiating style with China. They also tend to favour interventions that shore up workers’ share of the spoils. This is not a bad thing, but it will come at the expense of shareholders. Interestingly though, even the CEOs of America’s largest companies (through the Business Roundtable) recently announced a shift in focus from shareholder to ‘stakeholder’ value. An admission perhaps that inequality in the US is getting out of hand, and short-term profits should not be made at the expense of the long-term sustainability of businesses.
Trade talks take time
Ultimately, what matters most for markets is not political intrigue per se, but whether politics interferes with the functioning of the economy. Normally, life carries on and people continue to go about their business irrespective of who is in charge. At the moment, politics and economics intersect in the trade war between the US and China, which if not resolved, could have real negative impacts, not just for market sentiment but also activity on the ground. It is an open question whether the impeachment proceedings will cause President Trump to double down on his hard-line stance on China. Speaking at the United Nations, Trump said he wouldn’t accept a “bad” trade deal with China, but a day later he said a deal could be struck “sooner than you think”. His political troubles at home could push him to do a deal and claim a win before the elections. Who knows? Unfortunately, the world economy is now to a degree hostage to the political (and legal) calculations of a single individual. Investors need to be prepared for all possible outcomes.
Boris’ Brexit blues
In the UK, Boris Johnson’s short stint as Prime Minister has seen one setback after another. First Parliament voted to block a no-deal or “hard” Brexit – the UK crashing out of the European Union without an agreement on the future economic relationship. Johnson has argued that he needs the threat of a hard Brexit as a bargaining chip to get concessions from European leaders. Parliament also voted to prevent Johnson from calling an early election. Last week the UK’s Supreme Court ruled that Johnson’s earlier five-week suspension of Parliament until next month was unlawful. The next important milestone is a gathering of European leaders in mid-October. Parliament has legislated that the Prime Minister must request an extension of the 31 October deadline if no Brexit deal is agreed at that summit. An election is likely to follow, dragging out uncertainty not only over the UK’s status in Europe, but also who would be responsible for negotiating it.
The pound tells the story of Brexit better than any other asset class. Since a no-deal exit would result in short-term economic chaos, and possible long-term damage, the pound rises and falls with the likelihood of it happening. At $1.23, it is still close to 30-year lows and signals that there is still much uncertainty.
Chart 2: How many US dollars a UK pound buys
Source: Refinitiv Datastream
Brexit does not matter as much to the world as the US-China trade talks or the US Federal Reserve’s monetary policy stance. However, it does matter to the UK and Europe, especially now that the latter is experiencing economic weakness. After stabilising for a few months, the IHS Markit Composite Eurozone Purchasing Managers’ Index plunged in September to 50.4 index points. This survey of businesses is one of the timeliest economic indicators around and shows the Eurozone economy at stall speed, since 50 is the level that separates contraction from expansion. The US equivalent picked up in September and there is still no indication that a US recession looms, contrary to the widespread narrative that has taken hold. However, US growth has slowed over the past year and profit growth has grounded to a halt.
Chart 3: US dollar bond yield versus US equivalent
Source: Refinitiv Datastream
South Africans can respond to all this political theatre with a wry smile, as it feels familiar. Political uncertainty is not going to disappear here anytime soon. Yet our emotional attachment to our home country can cloud our judgement of local asset classes when things go well, and when they are struggling, as is currently the case. Foreign investors tend to look at our markets in a much more clear-eyed fashion, though it must be said that they often lack a nuanced view. While the sale of $5 billion in hard-currency bonds last week was not quite the ringing endorsement of South Africa as National Treasury claimed, it was a clear indication that these investors are not shunning South Africa either. The sale was 2.7 times oversubscribed, but at yields of 300 and 360 basis points above similar 10 and 30- year US bonds, no wonder. The chart above shows an older dollar bond against its US equivalent, and the divergence in yields this year is striking. At these yields, the country’s well known fiscal risks are fully accounted for
Therefore, when thinking about all the risks and uncertainties in local and global markets, it is important not to focus on the latest breaking news, but rather to suss out what markets had priced in. Amid all the gloom about South Africa, it is also worth remembering that the grass is not always greener on the other side and other countries also have problems. This is not a statement of misguided patriotism, just acknowledging the fact that appropriately diversified portfolios should contain local and global assets.