Op-Ed: Difficult year almost over

PUBLISHED: Tue, 13 Dec 2016 10:23:56 GMT

It is almost time to say goodbye and perhaps even good riddance to 2016. Aside from the political drama here and abroad (including Brexit, Trump, State capture and SARS wars), investment returns have been disappointing. The JSE All Share Index had a positive week, but the year-to-date return for local equities is only 3%, including dividends. (This number hides a wide divergence, with resources up 33%, industrials down 7% and financials struggling with a 4.7% return.) Listed property returned 6% over this period, while cash achieved around 7%. Bonds have been the best performing local asset class with a 15% year-to-date return. The looming threat of downgrades – thankfully postponed for now – probably dissuaded a lot of managers from investing in bonds.

Some global markets have performed better this year, with the S&P 500 at record levels and a 12% year-to-date return. The FTSE 100 benefited from a weak pound and returned 15% in 2016, but Eurozone markets are flat in euros. The MSCI Emerging Markets Index returned 13% in US dollars. The problem for South African investors, though, is that the rand has gained 11% against the greenback, 13% against the euro and 24% against sterling. Therefore, translating global returns into rands results in negative returns. The stronger rand this year is also a factor behind the disappointing returns of local equities, given that the majority of earnings of JSE-listed companies are earned abroad.

Disappointing returns

According to Morningstar, the average retail balanced fund returned only 0.7% year-to-date to end November. The range of returns over this period is very wide, with the top fund returning 20% and the worst fund -8%. This is a fitting testament to the difficult environment, particularly the sharp reversal in January of the trends that persisted in the previous three years (a weakening rand, falling commodity prices, negative emerging market sentiment). However, the longer-term picture looks better, with the average balanced fund achieving an annualised 6.6% return over three years and 10.5% per annum over five years.

Third quarter growth disappoints

South Africa’s economy grew at a slower pace than expected in the third quarter – by a seasonally-adjusted and annualised 0.2% – after 3.5% growth in the second quarter. The economy contracted in the first quarter, leading to real growth of only 0.4% for the first nine months of 2016. Gross domestic product (GDP) grew by 0.7% in the third quarter of 2015.

Clearly this snails-pace rate of growth means the country is getting poorer in real per capita terms, but what matters now is to watch out for signs of improvement. Turning points are, however, difficult to spot as data is usually mixed while sentiment remains negative.

The biggest contributor to the disappointing quarterly growth rate was a 26% quarter-on-quarter drop in exports, followed by a 1% decline in real fixed investment spending (gross fixed capital formation).

The sharp decline in exports was due to a drop in both volume and export prices during the quarter. However, Transnet reported strong growth in export cargo volumes at its ports in November. Meanwhile, global trade conditions appear to be improving. The composite Global Purchasing Managers’ Index hit an 11-month high in November, pointing to the strongest global growth in a year. China’s latest import numbers surprised to the upside, showing positive growth after two years of declines.

Higher inflation

A big part of depressed real growth locally is higher inflation. The GDP deflator, a broad measure of inflation at all levels of the economy, increased 6.6% year-on-year in the third quarter. To gauge the earnings ability of companies operating in the local economy, one needs to look at nominal growth. The economy grew by 7.5% in the year to the end of the third quarter, a rebound from nominal growth of only 4 – 5% at the end of last year. Private sector gross operating surplus, a rough proxy for the profits of listed and unlisted companies, grew by 6.6% year-on-year in the third quarter while there was virtually no growth at the end of 2015.

Real income growth still positive

Employee compensation (the wage bill) is still growing at 8% per year, despite high unemployment. With inflation expected to decline next year, helped along by a firmer rand, it implies positive overall real income growth for households in total, supporting their spending ability. While debt constrains this ability, it has been easing. The cost of servicing debt fell slightly to 9.6% of disposable income in the third quarter. Consumer confidence has already improved. The FNB/BER Consumer Confidence Index has rebounded from a recession-like 11 index points to -3 index points in the third quarter. On balance, consumers are still pessimistic, but much less so than during the low levels earlier in the year. Household debt levels remain high, but have steadily declined over the past seven years, standing at 74% of disposable income in the third quarter.

Household consumption spending grew by 2.6% quarter-on-quarter in the third quarter, but would have been 3.2% if the decline in transport spending (mainly vehicle purchases) hadn’t happened. However, new car sales have already increased by 6% compared to the third quarter.

Although fixed investment spending contracted in the third quarter (for the fourth consecutive quarter), the pace of contraction slowed to only 1%, compared to -10% in the second quarter. The investment recession might be close to an end.

Is there light at the end of the tunnel?

Economic conditions on the ground appear to be improving globally and locally (at the very least they are not deteriorating). Market valuations are generally good signs of the prospects of future investment returns. The valuation signals on local equities are mixed: forward price to earnings ratio on the local market of 14 is above the long-term average, but the dividend yield and price-to-book ratios are in line. There is also a large divergence on a sector level, creating opportunities for active management to outperform. Local property fundamentals remain challenging, but the sector is offering more value after its 10% decline. Assuming distribution grows in line with inflation and a starting yield of 6%, listed property can deliver low single-digit returns. An improved domestic interest rate outlook should benefit property too, but also shows that there is little upside to money market investments. Moving up the yield curve improves the attractiveness of fixed income assets, with the 10-year bond still yielding 8.8% despite the good run this year.

Despite the rout on global bond markets in November, developed market bond yields are not attractive. Global equity valuations are slightly above long-term averages, with US equities more expensive than European equities. These valuations suggest global equity returns could be broadly in line with long-term averages. Emerging markets are cheap compared to developed markets and offer attractive long-term returns. Returns from global assets will clearly depend on where the rand goes. With our large current account deficit (4.1% of GDP in the third quarter), the rand is vulnerable to shifts in global risk appetite and capital outflows, which in turn are likely to be influenced by the expected path of US interest rates. Nonetheless, the big drivers of the rand – the US dollar, commodity prices and sentiment towards emerging markets – are already close to historically extreme levels. From this angle, substantial declines in the rand are unlikely. However, global diversification is prudent, irrespective of what the short-term outlook for the exchange rate is.

Return prospects muted but not dismal

Investors have become accustomed to excellent returns over the past decade. For instance, domestic equity returns averaged 10% per year in real terms between 2000 and 2015. Compared to this, current return expectations are therefore muted. But they are not dismal and an appropriately diversified portfolio should still be able to beat inflation over the longer term. The key for investors is to remain focused on their long-term financial plans. 2016 was full of surprises and 2017 will probably also be. Don’t get side-tracked by the headlines, surprises and unexpected developments that are bound to happen. You will experience potholes, speed-bumps and delays on any long journey. The key is to stick to your goals and focus on your long-term plan.  

Chart 1: Rolling real ten-year local equity returns. 2000 to 2015

Source: Datastream

Chart 2: South African gross domestic product growth

Source: Datastream

Authors: Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist), Old Mutual Multi-Managers

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