Over the past few months we have seen markets start to retreat, and the most recent turmoil is a more violent expression of this. While this may come as a surprise to many, we have believed for some time now that the elevated market levels are not sustainable. There has been an all too large disconnect between the underlying weak global economic environment and the valuations attached to equities.
Chinese growth is far weaker than reported
On the global front, the picture is not looking much rosier. China continues to print real GDP growth figures of 7%, but our analysis shows that the economy is actually contracting. Government has worked tirelessly to stimulate and avoid a hard landing, and has gone as far as suspending trading on half the Shanghai Composite Index. However, the reality of reduced infrastructure spend and a transition towards a consumption-led economy means that China will not be the driver of global growth. Investment, trade, output and sales growth remain sluggish, so it is unsurprising that China has recently engaged, at the margin, in currency devaluation. Unfortunately for our local economy, this means that the downward pressure on commodity prices may continue.
Is the US really recovering that well?
While many have been debating the timing of the first Fed rate hike on the back of a strengthening US economy, our analysis shows that the US economy is in fact intrinsically weaker than the reported numbers suggest. Growth and job creation over the last six years has been supported by the booming shale oil states, with the rest of the country still in decline.
With the count of shale oil rigs reducing as a result of lower oil prices, we are concerned that investors will not see the economic recovery that they are anticipating. We believe that this weakness will limit the extent to which the Fed will be able to raise rates, and that a normalisation of interest rates is highly unlikely.
Locally, the economy remains under threat. While imports have been on the rise as platinum production normalises, we are seeing slowing profit growth from local companies on the back of negatives volumes. The South African Reserve Bank (SARB) has become increasingly more hawkish due to inflation concerns and raised the repo rate to 6% at its most recent monetary policy committee meeting. Indeed, rising energy and food prices will result in inflation breaching the 6% inflation band ceiling at and peak at close to 7% in the first quarter of 2016. The SARB may have been mandated to contain inflation, but given the weak economy, we believe there is risk of a policy misstep in South Africa.
Importantly, local investors have become increasingly conservative, and foreign ownership of equities – after climbing rapidly between 2004 and 2011 – has stagnated at current levels (unsurprisingly given the flat returns in dollars and weak local environment).
Where do we see value?
We believe this market slowdown is set to continue, and there is no significant wall of cash waiting to drive them higher. We believe this is a very necessary correction to bring market valuations more in line with muted growth expectations.
We remain conservatively positioned (though not contrarian). There are significant risks to market expectations of inflation, economic growth and corporate profit growth. These heightened risks call for a balance of exposures in a portfolio that will ensure both value accretion, and hedging against the multitude of risks we currently face.
Therefore, we maintain exposures in our portfolios that will offer protection in a number of different investment environments. Bonds remain a cornerstone of our portfolios, as they offer superior real yields at lower risk than the overall equity market, and are appropriately priced for potential interest rate increases. We continue to hold select global equities with investments in companies with defensive business models offering sustainable earnings growth characteristics. These holdings supported our portfolios in previous times of market turmoil such as 2008 and in 2011, and we believe this will yet again be the case this time round.
Submitted by: Clyde Rossouw and Sumesh Chetty, portfolio managers at Investec Asset Management