Investing in a low-growth world

Dave Mohr & Izak Odendaal, Old Mutual Multi-Managers

Global growth continues to disappoint. The Organisation for Economic Co¬operation and Development (OECD), a club of the world’s most advanced economies, recently revised their global growth forecasts for 2016 and 2017 down to 2.9% and 3.2% respectively. The OECD joins other multi-lateral organisations (such as the International Monetary Fund, the World Bank and the World Trade Organisation), central banks and private sector economists in cutting forecasts. The actual global growth rate has remained resilient at around 3% per year since 2011, close to its longer-term average. The disappointment stems from the failure to accelerate beyond that rate. Every year, forecasters expect the next year to see much faster growth. This has rarely happened, but once again, 2017 is expected to be better than 2016. There are several potential culprits. One is the ageing of populations across the developed world and another is the collapse in commodity prices since 2011. A remarkable two decades of globalisation, during which trade grew twice as fast as global GDP, also appears to have come to an end. Political uncertainty, whether the Brexit vote, the US debt ceiling debacle, the Arab spring, Russia’s invasion of Crimea or the Eurozone debt crisis, also impacted the global economy at various points but never derailed growth.

With low growth and high uncertainty, where do you invest? The first thing to remember is that uncertainty is always high. Looking back through history, there were always geopolitical conflicts, policy uncertainty and natural disasters. Investors who sat on the sidelines until the “dust settled” have typically missed out. In fact, the most dangerous times to invest were when the future was looking particularly rosy and everyone was confident, such as in 2007 or 1999. These literally were the periods of calm before the storm. Secondly, faced with uncertainty, diversification appropriate to your own investment goals and time horizon is the best policy. This sounds like a cliché but take a simple example: the rand started 2015 at R 12 to the US dollar, weakened to R 16 per US dollar by early 2016 and is now closer to R14 per US dollar. Taking a one-way bet on the rand over this two-year period would have been costly. Having assets that benefit from rand weakness and rand strength and rebalancing between the two would have been beneficial. Thirdly, good companies can turn modest revenue (“top-line”) growth, which is largely linked to the performance of the economy, into meaningful earnings (“bottom-line”) growth through cost control, operational efficiencies, technological advances etc. Often, good companies thrive in tough economic climates because competitors fall by the wayside. Ultimately, when investing in equities, one buys into companies to share in the profit growth they generate which drives share prices up over time.

Different equity markets across the globe have delivered divergent performances since the global financial crisis. Among major markets, the US has had the longest uninterrupted economic expansion since 2009, which is reflected in the above average (but not excessive) valuation of its market. Part of the reason for the high valuation of the S&P 500 is that earnings declined in 2015 and haven’t grown this year. But this is largely because of the lower oil price and the strong US dollar. Both these factors are now in the base and their impact will fade, suggesting positive earnings growth heading into 2017.

Europe suffered a second recession in 2012 and 2013, and a lot of catch¬up needs to happen. The European economy is much healthier now, showing slow but steady growth but banks are still struggling. Deutsche Bank shares slumped to levels last seen three decades ago amid concerns that the government would not support Germany’s biggest bank, resulting in a possible rights issue, diluting existing shareholders. Like most European banks, Deutsche Bank is battling with increased regulation and capital requirements, a tepid business climate (especially in Southern Europe) and negative interest rates. Negative rates squeeze banks’ lending margins and lowers investment return. Unlike most other European banks, Deutsche Bank also faces billions of dollars in US fines for its role in the sub-prime crisis. While Deutsche is one of Germany’s (and Europe’s) most important companies and a systemically important bank, overall economic sentiment in Europe is still fairly good. The Ifo index of German business sentiment rose to a two-year high in September, after a Brexit-induced dip in July and August.

After the strong rally in early 2015 fizzled out, the broad Eurostoxx 600 index has been flat over the past two years, while the Eurostoxx Financials index lost 25% over this period. This long period of underperformance means European shares are generally cheap relative to the US market, but sustained growth is needed to unlock this value.

The other area on equity markets where there is value is in emerging markets (EM). EM equities have outperformed this year, after several years of lagging developed markets. EM equities have the benefit of a few tailwinds. Over the course of the previous four years, several emerging markets were hit by a negative feedback loop of slower growth, capital outflows, weaker currencies and rising inflation and interest rates. For commodity producers (like Russia, Brazil and South Africa) the problems were compounded. But now we are seeing the early stages of a reversal, with firmer commodity prices, appreciating currencies, lower inflation and potentially falling interest rates. Nonetheless, emerging market equities are still much more attractively valued compared to developed markets, and bonds offer much higher yields. In fact, emerging market bonds are in many cases trading at higher yields than American corporate junk bonds, despite better underlying fundamentals.
However, EM are clearly not without risk. Turkey was recently downgraded by Moody’s, meaning two of the big three now have the country at sub-investment grade (junk) status, after S&P Global cut its rating in the immediate aftermath of the coup attempt in July. With two junk ratings, Turkey loses eligibility for inclusion in some of the world’s main bond indices, meaning that investors who track these indices (such as the Barclays Aggregate) would have to sell. So far, however, the selling has been subdued, with slight declines in the lira and the country’s bonds. Moody’s pointed to political risks and institutional weaknesses in Turkey that have deteriorated after the coup, despite the economic growth rate being fairly robust. South Africa’s problem is the opposite: our growth rate is too slow, but Moody’s rates our institutional strength highly. The Philippines saw its currency slumped to levels against the US dollar last seen in 2009, as investors worry over the implications of maverick president Duterte. Mexico’s currency has weakened against the US dollar over concerns that Donald Trump might win the November 8 election, but his poor performance in last week’s presidential debate seems to have put many investors at ease that he will not be elected. Mexico is one of the few countries that hiked interest rates recently, doing so again last week. Other emerging market currencies rallied, suggesting that the market views a Trump presidency as negative.

Locally, the JSE All Share Index remains in its trading range of the past two years and lost 1% in September. It has suffered a substantial earnings decline over the past year. This is largely due to the collapse in commodity prices which hit the earnings of mining companies. However, earnings of some industrial and financial companies are also off their peaks. For the mining companies, share price clearly reflects an expectation of higher commodity prices. For financials, the outlook for the local economy matters. Some industrial sectors like retail and construction should also grow earnings if the economy improves. But the largest industrial companies are global in nature (BAT, Naspers, Richemont, Steinhoff) and would suffer from a stronger rand. Indeed, with the majority of JSE All Share revenues now coming from outside South Africa, there is an increased need to be mindful of the impact of a potentially stronger rand on equity returns. A widespread pessimism around South Africa’s economic prospects has seen individuals, businesses and asset managers increase foreign exposure. Even the local listed property sector has fundamentally changed in the space of the past five years, to the extent that almost 40% of the assets of the benchmark index (the SAPY) is now derived from outside South Africa. When one includes the UK real estate companies listed on the JSE but not included in the index, the number rises to close to 60%.

The level and direction of the rand are therefore important and on balance still support South Africa’s external position. Although there was a surprise deficit in August due to a drop in precious metals exports, the first eight months of the year saw a surplus of R7 billion compared to a R35 billion deficit over the same period last year. Exports have grown more than inflation over this period.

In the same week that Capitec announced a jump of 44% in overdue loans in the half week to August, new Reserve Bank data showed a slowdown in household borrowing to only 1.4% year-on-year (3.7% if adjusted for African Bank). Corporate borrowing also slowed, but remains in double-digit territory. To an extent this means that further interest rate increases – which aim to slow borrowing – are unnecessary since there is a slowdown. Coupled with a more favourable inflation outlook, this points to a peak in the rate hiking cycle. Food inflation has been the big thorn in the monetary policy committee’s (MPC) side, but there is evidence that farm-level inflation is slowing markedly, which should filter through to consumers eventually. Global food prices have also been falling since June. One snag is that oil is trading above $50 per barrel again after major oil producers in the OPEC cartel surprised the market by agreeing on production cuts to support the price. Nonetheless, local real interest rates are still positive and high by global standards. Eventually, rate cuts should therefore come into view. This should be supportive of banks, retailers, bonds and domestic property companies on the JSE.