As we move into the last quarter of 2018, we are comfortable that the latest developments in global financial markets validate our investment approach. Though there has been some turbulence in the year to date, we have seen strong growth in developed world equity markets which have delivered robust returns.
Right now, we are seeing a wide divergence between the performance of the US dollar and emerging market currencies and between US equity markets and non-US stock markets—particularly, but not exclusively emerging market equities.
Leading commentator and businessman, Mohamed A. El-Erian, succinctly sums up why we can expect the US markets to continue to outperform in the medium term:
- Economics: The year started with a consensus among traders that we were in a period of synchronised global growth. However, the US is currently outperforming most other markets and appears to be one of the few major economies benefitting from pro-growth policies.
- Liquidity: Following from the US’s strong economic performance, the Fed remains in a tightening cycle, in turn soaking up liquidity from global markets. If the ECB in the Eurozone is able to end its bond-buying programme by the end of the year, liquidity will recede even further.
- Technical: A combination of index products and flighty investors increases the risk of technical contagion. Though we at Dynasty are not strong proponents of technical analysis, it is worth taking note that receding liquidity and growing risk aversion is highlighting the difference between the technical robustness of emerging markets and US markets.
- Operating environment: With US President Donald Trump ratcheting up his trade war rhetoric, aversion to risk is growing in international markets.
US equity indexes have performed reasonably well this year (some pullbacks notwithstanding), and we expect to see 22% earnings growth in the companies that comprise the S&P500 index over the year to come. As such, we remain biased towards developed world equities, particularly the US market, and underweight on bonds and property.
Focusing on quality
In line with our established approach, we continue to focus on quality and predictable earnings from equity investments. We have also identified a few potential new fund managers that can add value to our clients’ portfolios for inclusion in our offshore solutions.
As the commentary above suggests, the South African rand and equity markets are largely at the mercy of international market movements. We continue to believe that as much as 70% of the rand’s movement up or down against the US dollar is about international factors beyond the control of the country’s government or the reserve bank.
That said, we do not expect the South African markets and currency to produce any major positivity for the rest of 2018. Markets are sceptical about the stimulus package government has announced to kick-start growth in the country’s stuttering economy, and we expect negative news based on weak economic conditions in the Finance Minister’s Medium-Term Budget Policy Statement (MTBPS) in October.
Policy uncertainty to continue
Many of the policy uncertainties will persist until after the next general election, particularly around the emotive land debate, the need to recapitalise and restructure state-owned enterprises, and the capacity of the state to effectively deliver on both existing as well as on new policies, for example on land reform and economic stimulus. When it comes to the JSE, investors have also had some unpleasant surprises from stalwart blue-chips such as Steinhoff, Capitec, MTN, Naspers and Aspen.
Calling the direction for South African equities is challenging. However, it is possible that much of the bad news is already priced in. Performance, we suspect, will be dictated by the rand. If it strengthens, banks and retailers will perform well. If not, the traditional rand hedges will be the performers unless there are adverse company-specific issues.
We therefore have a substantial bias towards an ALSI weighting within our local equity allocation. Our goal is to balance the risks of further rand weakness against the possibility of a pullback and strengthening of the rand against the US dollar. As we all know, the rand is volatile and unpredictable. South African bonds are looking relatively attractive with a real yield in excess of 4%, but remain at the mercy of their tight correlation to the rand.
Dynasty continues to maintain a local portfolio positioning in line with our view of conviction – overweight offshore, underweight bonds and property. This aligns with factors I have outlined above, due to a larger and more attractive opportunity set in offshore markets and also as a risk management mechanism.