Patrice Rassou: Is sentiment the new fundamental?

Patrice Rassou

Patrice Rassou, head of equities at Sanlam Investment Management, explains the role that sentiment (fear and greed) plays in market movements.

As we pass the halfway mark of yet another turbulent year, we reflect on the paradoxical nature of markets. For the first half of the year, global equity returns have been very good and 2017 has delivered the strongest half-year performance from global equities since the 2009 rebound that followed the financial crisis. Events such as the election of Trump were greeted with a return of animal spirits in the US as business and consumer confidence surged. The concern remains that the liquidity punchbowl is soon to be taken away and the era of record-low interest rates will start to normalise. But prices – which are sentiment-driven in shorter timeframes – are saying something else. Both the S&P 500 price index and the total return index have been hitting all-time record highs in 2017, buoyed by positive sentiment.

On the other hand, South African investors have had a comparatively tough time, facing the double-whammy of subdued performance from the JSE and returns from international markets muted by a stronger rand. Business pessimism can be ascribed to heightened uncertainty following a cabinet reshuffle, and subsequent sovereign credit rating downgrades by the international rating agencies.

But then unexpectedly, on 31 July the JSE hit another all-time record high. The All Share Index was 0.63% higher, improving on its previous high in April 2015, putting the market again at the level it was on 27 months ago. Once again, the fundamentals render this completely unfounded. First-quarter GDP growth for SA was the sum of all fears at a dismal -0.7%, plunging the economy into a technical recession. The business cycle downturn has now been running for 46 months and business sentiment has never been lower. Is it possible that prices are anticipating actual economic improvement that simply hasn’t manifested itself in the data yet?

“Fundamentals are not giving anyone much of a clue as far as the current trend. In the absence of a trend, sentiment becomes the new fundamental… It’s like a delusion of a delusion” (Source: The Informed Broker, Joshua M Brown).

Says Rassou, it’s important to remind ourselves that anomalies and gyrations such as those we’re currently seeing in financial markets are dominated by the fear and greed cycle. Looking back to 2016, the patterns are evident. After the election of Donald Trump as US president, we saw an almighty rally in commodity prices in 2016 (greed), supported by Chinese nominal GDP which improved to 12% in 2017, and banks up 27%.

But in 2017, fear reinstated its grip on markets as anti-trade and anti-globalisation concerns raised their ugly heads again. Commodities pulled back with iron ore retracing violently by a third as concerns about a credit crunch in China, the world’s biggest commodities consumer, took hold of markets. The Chinese regulator was unhappy that banks funnelled funds to non-banking financial institutions (accounting for a quarter of total loans). And with the creation of wealth management products (aggregating to 40% of Chinese GDP), this led to a boom in the shadow banking sector and a retail-driven asset bubble in commodities. To make matters worse, there have been doubts whether OPEC supply cuts would reduce excess stockpiles, driving the Brent oil price down 14% to US$49/barrel – officially entering bear market territory in the second quarter of the year, and back to 2004 levels! Resources stocks were down 6% in Q2.

Locally, at the beginning of April, credit ratings agency S&P downgraded SA local currency debt to junk and by mid-June, Moody’s followed by downgrading our local debt to one notch above junk status. If both S&P and Moody’s downgrade our local currency debt to junk, this would lead to our exclusion from the World Government Bond Index, possibly leading to capital flight of over R100 billion. The rand, which had followed most emerging market currencies stronger in 2016 and early 2017, sold off after the news of the Cabinet reshuffle but regained some ground during the quarter. Financials fell 9% with Banks down 15% after the reshuffle but ended the second quarter slightly down (Fear).

In complete contrast, the US recovery manifested itself via IT stocks, with the NASDAQ up 13% in the first half of 2017. A bout of ransomware attacks on leading institutions globally further accentuated the importance of technology in our everyday lives. The appetite for growth assets appears to be whetted by low US bond yields. After rising from record lows of below 1.5% last year to 2.6% at the end of the first quarter of 2017, the US bond market is once again pricing borrowing costs below 2% as Fed tightening is seen as less of a threat. This has slain the VIX ‘fear index’ to 25-year lows and driven the S&P 500 Index to hit record highs above the 2 430 level in June. The threat of populism also receded as the Dutch elected a mainstream candidate, and Emmanuel Macron swept to victory in the French presidential elections, driving the CAC 40 Index to its highest levels since 2008. The threat of an unhinging of the European Union (EU) has been postponed despite the UK elections, unexpectedly yielding a hung parliament and fears that the Five Star Movement in Italy could also win the polls next year. European stocks were up 10% in 2017, with the euro gaining 7% against the US dollar (greed).

Locally, the third draft of the Mining Charter caused much consternation in June. Furthermore, a deadline of 12 months had been set for compliance with onerous new requirements. In an industry which has shed an estimated 70 000 jobs, the uncertainty and court challenge around the Charter is unlikely to foster much investment, furthering the rate of decline of deep level mines. There is a 1% revenue royalty proposed to be paid to BEE owners. This would amount to some R6 billion, which is equivalent to the total dividend paid to shareholders last year, denting future pay-outs (fear).

That said, demand for emerging market equities remains high. Despite the rollercoaster of emotions, global equities hit record highs during the past quarter. Greed is winning and the fear index (the VIX in the US) and similar indices in other countries are at decade lows. Meanwhile, a series of obstacles have beleaguered the JSE this year and the economy remains at the mercy of another downgrade by credit rating agencies, which would increase the cost of financing our budget deficit.

Political pronouncements will keep making the headlines and this will have an inevitable feedback loop into our markets and on business confidence. The credit ratings agencies will continue assessing the strength of our institutions with the discretion to send our economy into a further tailspin by relegating our local sovereign debt to junk status like a virus holding a PC to ransom.

So how do you invest in this rollercoaster cycle of repeated stock market anomalies?

Says Rassou, you can’t go wrong with a robust investment process, one that is geared to assess risks and invest in companies that have resilient business models, and able to withstand adverse macro circumstances in the long term. As value investors, our focus remains on being contrarian and capitalising on opportunities as they arise. An aggressive stock-picking capability such as SIM’s Top Choice is made up of the very best ideas of the equity portfolio managers at Sanlam Investment Management (SIM). We are keenly aware of the fear and greed cycle and the behavioural and cognitive biases that accompany it, and we have robust processes in place to counter this.

Over the past ten years, this capability has shown extreme resilience during volatile cycles, navigating both the lows of the global financial crisis and the euphoria of quantitative easing. (Source: Morningstar, December 2016). This is testimony to a sound pragmatic value investing philosophy as well as the ability of a diverse team of investment professionals to unearth great stocks even when times look bleak.

The capability is a concentrated portfolio of insights of both generalist and sector specialists, in one fund that is also non benchmark-cognisant and also counter-cyclical, in that it maintains exposure to some stocks that are occasionally out of favour, capitalising on their value when markets turn. The objective of a concentrated fund such as this is to ensure that stock specific risk is NOT diversified away, as a broader portfolio of stocks would normally attempt to do. This kind of portfolio should allow the stock picking skills of superior portfolio managers to come to the fore, regardless of macro-economic conditions.



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