Investment Note 22 August 2016 | Old Mutual Wealth
Emerging market equities hit their highest level in a year after the world’s two most important central banks most recent monetary policy meetings pointed to interest rates remaining low.
The MSCI Emerging Markets equity index has rallied 35% (in US dollars) from 21 January, when it hit the lowest level since the 2008 crisis, and has outperformed developed markets handsomely over this period.
However, the index is still 15% below where it traded two years ago and 25% lower than its post-crisis peak in 2011. Since it is measured in US dollars, the strength of the greenback has been a big determinant of the poor performance over this period (with the commodity collapse and slower economic growth also contributing).
However, the big dollar rally has run out of steam, as expectations for higher US interest rates have not materialised. The Federal Reserve (Fed) has only managed to get one hike under its belt in December 2015.
The minutes of the most recent meeting were more upbeat about the US economic outlook, but noted that most participants were not convinced that further gradual improvement in the labour market would lead to ‘an unwanted increase in inflationary pressures’.
Although the minutes also indicated divisions on the monetary policy body, with some members more eager to get going on a second hike, rates are likely to only rise gradually over time as the Fed will be careful not to choke the economy.
The market is still pricing in a 50% chance of a rate hike in December. US consumer inflation is showing no sign of rising rapidly and rose only 0.8% in July.
The minutes of the most recent European Central Bank (ECB) meeting show that participants were mulling an extension of the €80 billion per month quantitative easing programme beyond the current scheduled end date of March 2017. The ECB is not convinced that recent increases in inflation would persist and is also concerned that the Brexit vote could still negatively impact economic activity in Europe.
South African equities have surged in US dollar terms
While emerging market equities have done well this year, the performance of local equities seems relatively lacklustre. This is particularly because of the JSE All Share index still being below its 54 250 points peak for the year.
In fact, it has traded in a range of between roughly 47 000 to 55 000 points since early 2014. A couple of things need to be borne in mind though:
Firstly, the index level excludes dividends, which adds around 3% to returns annually.
Secondly, while the All Share Index is probably the better-known local equity index among the general investing public, the Shareholders Weighted Index (SWIX) is more widely used as a benchmark by equity managers (including ours).
The SWIX has outperformed the All Share by 4% year-to-date and the JSE Top 40 index by 8%. The All Share and the SWIX indices have the same constituents, but the latter excludes shares of local companies held by foreign investors.
In other words, the SWIX only includes the shares that are theoretically available to local investors and downweights dual-listed shares. The recent weak performance of SABMiller (down 20% year-to-date), which has a larger weight in the All Share, partly explains the difference.
Thirdly, the emerging markets benchmark is considered in US dollar and the local equity market has surged in dollars this year whether measured by the All Share or SWIX.
Despite this rally, local equities are only trading at 2010 levels in US dollars terms. In other words, from the perspective of foreign investors, there is a very obvious upside in South African equities and equity markets in general, even after the strong gains this year.
Flows into emerging market bond and equity markets have picked up strongly, and if this trend continues, the rand could hold onto its gains and appreciate even further.
What does the stronger rand mean for the broader economy? It is far too soon to determine the impact on South African economic data released to date, but it does change the outlook. For instance, last week’s retail sales data showed a decline between May and June.
However, the second quarter posted marginally positive growth, meaning the sector will contribute positively to second quarter gross domestic product (GDP) growth. Wholesale trade sales also posted positive second quarter growth.
Inflation outlook better
By lowering the inflation outlook, the stronger rand could give consumer spending a shot in the arm. As things stand, inflation might have already peaked in the first quarter, while not too long ago inflation was still expected to increase towards the end of the year.
With the economy wage bill still growing by around 7% - 8% per year, there is scope for real household income growth of 2% to 3% per year if inflation declines towards 5% next year, helped along by cheaper imports (including food, fuel and other goods).
South Africa is still battling the worst drought in decades, which forced the country to import both maize and wheat.
However, bumper crops in the US and Russia are putting global grain prices under pressure, which together with a stronger rand, means local food inflation will probably not rise as much as feared.
According to the local Agricultural Business Chamber, the expected arrival of the La Nina phenomenon from October onwards should bring decent rain (it also revealed that agricultural exports fell between 2014 and 2015 due to the drought, the first decline in a decade).
Although the oil price has increased rapidly over the past two weeks to return to $50 per barrel, there could be a moderate petrol price cut early next month as the average rand price for August is still below the average price recorded in July.
Interest rate outlook has also improved
An improved inflation outlook also means that further interest rate increases are less likely. Because of the 2% increase in the repo rate over the past 20 months, the average cost of making interest payments has increased from 8.5% to 9.5% of household disposable income over this period. If the Reserve Bank keeps interest rates unchanged, this debt servicing ratio should stabilise and improve moderately.
There are also signs that financially constrained consumers are changing their spending behaviour. For instance, new car sales are plunging, with a substantial percentage of new cars being imported and therefore more expensive due to the weak rand. Sales of used cars have picked up nicely (exports of new cars also continue to grow, with about half of all cars manufactured locally being exported).
In other words, while nothing points to a boom in consumer spending any time soon, there is scope for improvement. This is important as consumer spending accounts for two-thirds of South Africa’s overall economic activity.
Chart 1: The trade-weighted US dollar
Chart 2: Emerging market and South African equities in US dollars, rebased to 100
Chart 3: Value of used and new car sales
Caption: Izak Odendaal, Investment Analyst at Old Mutual Wealth
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