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As investors we tend to have the propensity to react to changes in the investment landscape in which we operate after the fact.
In truth, most of the analysis that we use in order to determine the metrics by which we measure the quality of a potential investment comes in the form of backward-looking methodologies that evaluate what has taken place. We attempt to affix a future value on the assumption that things will continue to fare as they have over the period during which we measured the inputs.
Said more plainly, we use historic data and make assumptions about trends in that data continuing. Then we use fancy mathematics in order to pin a value on our assumptions, and then of course we decide whether or not we are willing to invest in whatever it is that we have evaluated. The fact, though, is that things change very quickly.
Why start off with this giant disclaimer, you might wonder? In fact, it is not as much a disclaimer as an acknowledgement that the environment in which we currently find ourselves is very fragile and that there are a number of things that could change the dynamics at any moment.
This was illustrated by the sudden market reaction following reports on 23 August (after this article was originally written) that finance minister Pravin Gordhan faces arrest. At the time of going to print, the rand had weakened more than 5%, or 70c, against the dollar, based on INET BFA data.
If we acknowledge that things can change, and change very quickly, we will be better equipped to make our investment decisions with this openness to change in mind and therefore either invest in a more flexible, or more considered – and likely risk averse – manner.
Take for example the beginning of the year. The FTSE/JSE All Share Index was under tremendous pressure, as was the rand. This had every market commentator (including myself), investment manager, holding company and their donkey chanting, “It’s time to invest offshore!” A strategy that worked, for a while.
Since then, though, we have seen massive risk-on sentiment dominate the market, with the rand strengthening considerably against most major developed market currencies, which of course leads to offshore investments coming under pressure. This does not mean that the market commentators, investment managers, holding companies and donkeys (myself included) were wrong. They were right at the time. Market conditions have changed though, and now so must our approach.
The overarching risks that face our economy have not disappeared. South Africa still faces the potential of being downgraded by ratings agencies later this year and, most notably, there is still a chance that the US Federal Reserve will raise interest rates before the end of the year. For the moment though, we have been cushioned by dovish commentary coming out of the Fed minutes released in August, increased monetary stimulus coming from the UK, continued accommodative monetary policy in Europe and Asia, and a steady stream of inflows into emerging markets.
The search for yield
So it seems that emerging markets are in favour as offshore investors are looking to emerging markets for investment return.
According to an August research note by Capital Economics, emerging-market (EM) industry is finally starting to turn the corner. They measure EM industrial production growth picking up to 2.4% year-on-year in June from 2.2% in May, and note that this is the second month in a row of accelerating growth. They note also that EM GDP growth is accelerating its pace of recovery, especially the GDP growth of those economies that are commodity producers.
This does not come as a great surprise. We have seen a tremendous recovery coming from oil this year, which has led other commodity prices higher. Therefore, it is only logical that as the prices of commodities rise, so will the GDPs of those countries that produce the commodities.
SA has not been sharing in the above observation, though, as our GDP has contracted by 1.2% in the first quarter of 2016. This is because we have been dealing with stubbornly high inflation, partly due to our weak currency, as well as with the impact of the drought on food prices.
Our weak currency has been strengthening considerably over the past few months (at least until the latest shenanigans by the Hawks), and if logic follows, this should lead to first a recovery of our GDP growth rate and then probably an acceleration in GDP growth. In other words, we are lagging because our currency has been weak, but if it firms up again against major developed-market (DM) currencies, we should start seeing a similar result to the rest of the EM world.
Rand outlook
It is important to understand what has been driving the recent strength in the rand in order to speculate on whether or not it will remain strong and thus whether or not we can expect our economy to benefit from it. Post-Brexit we have seen actions taken by DM central banks to support their economies in the form of further stimulus from the UK, and continued accommodative monetary policy from the EU, Asia and the US.
The expectation is that the US will keep interest rates low for the remainder of the year, with the possibility of an interest rate hike only at the end of 2016. This means that international investors have resorted to taking on excess risk in a search for yield as most of the DM bonds are currently offering negative yield. So to get any return on investment, fund managers are forced to seek out higher yielding investments, and those are found in the EM world, and thus we see inflows into South Africa and the strengthening rand.
In a strengthening rand scenario, the negative effects of above target band inflation will eventually subside (along with inflation) and our GDP should start to grow again.
EM economies are also, on aggregate, mostly in a loosening monetary policy cycle (as indicated above). Again, with the exception of SA and a few others who are struggling with high inflation due to historic currency weakness, and again subject to change if things keep going the way they are now.
In other words, there is light at the end of the tunnel for EM, at least from my perspective. So assuming that the light at the end of this tunnel is not an oncoming train, how can we position ourselves to take advantage of a prolonged global bull market and a recovery of EM economies? I believe there is opportunity to invest locally again. But remember, things can change quickly.
This is a shortened version of the cover story that originally appeared in the 1 September edition of finweek. Buy and download the magazine here.
