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Surprise firings of key officials are not unique to our own head of state. US President Donald Trump axed the head of the FBI, begging the question whether it relates to the ongoing investigation of the Trump election campaign’s links to Russia. For investors, the pertinent question is how markets are impacted. The answer is that it is simply too soon to tell. Markets rallied strongly after Trump won the election in November, on the assumption that his policies will favour businesses by cutting tax rates, reducing regulation and spending on infrastructure. However, this ‘Trump bump’ had already seemingly run out steam as it became apparent that implementing his agenda faces many hurdles, not least of which are the constant self-created controversies. This is just the latest in a series.
The US 10-year government bond yield quickly jumped from 1.8% prior to the election to 2.6% in little over a month on the expectation of faster growth and higher inflation. Since the start of the year, it has drifted lower as inflation is still well behaved and Federal Reserve rate hikes are expected to be gradual.
Equities higher despite Trump slump
The US equity market has been more excitable, surging from 2 085 points prior to the election to 2 395 in four months, before pausing. This was driven by an expanding price: earnings multiple from 19 to 22 over this period, a sign that investor optimism increased substantially. Some of this was justified, given a better global growth outlook (irrespective of Trump’s policies) and recovery in corporate profits. Companies have reported strong growth in first quarter earnings over the past few weeks, and the multiple declined somewhat.
Global equity markets have picked up speed again, supported by receding political risk following the French election outcome. The MSCI World Index hit a record high level in US dollars, as did the S&P 500 and Nasdaq. Eurozone equities hit the highest level since late 2015. On a total return basis (including dividends), the JSE All Share Index also reached a new all-time high last week (excluding dividends, the index remains below the record high close of 55 188 points set in April 2015). Emerging-market equities are also surging ahead, even in dollar terms, but remain well below record levels.
Europe outlook better
Although investor optimism over policy changes in the US might be fading, it’s rising in Europe following the election of Emmanuel Macron as French president. Macron ran on a ticket of reforming France and the eurozone to achieve greater economic dynamism in the former and strengthen the latter. Macron won’t be the first person to attempt economic reforms in France. Previous efforts met mass demonstrations and the government’s massive 56% share of GDP has gone unchallenged (in South Africa, it is only around 30%). Global investors probably care more about the message on the eurozone and the single currency that came with the election. Despite talk during 2015 and 2016 on the euro falling to parity with the US dollar, based on fears of a break-up of the single currency and increasing interest rate differentials as the Fed hikes, the euro has in fact strengthened around €1.09 per US dollar this year. It helps that eurozone GDP growth rates have caught up with those of the US.
A perennial source of euro risk, Greece, has exited investor radar screens. Greek bond yields declined sharply over the last two weeks, as the deadlock with its international creditors over the terms of its bailout programme appears to have broken. This sets the scene for the release of the next tranche of funds and possibly debt relief. Greece never posed an existential risk to the euro, but Italy might. Italy has the largest debt pile in Europe (€2.2 trillion or 130% of GDP), its economy has not recovered to pre-crisis level and citizens are lukewarm about euro membership. Like South Africa, Italy is rated BBB- on its local currency debt by S&P.
Yet Italy’s bond yield is 2.1% and only 0.5% when inflation is subtracted. In contrast, South Africa’s bond yield is 8.8%, or around 3% after inflation (surprisingly Greece’s 10-year bond yields only 5.9%, but that is 4% in real terms). Why the difference when South African economic fundamentals are stronger? There is obviously more currency risk attached to the rand than the euro, but there is no risk of South Africa changing its currency (and redenominating its debt), while Italy still might. Clearly, there is an expectation that our local currency bonds will be downgraded further. The other factor is that the European Central Bank (ECB) is notoriously hawkish on inflation, often to the detriment of growth. The current negative interest rates are a consequence of premature hikes in 2011. South Africa’s Reserve Bank (SARB) is also quite hawkish, but less trusted. This explains its eagerness to display commitment to inflation targeting by not rushing to cut rates. However, within the emerging-market universe, the SARB is considered one of the strongest and most independent central banks. Key for the SARB will be how the rand reacts to gradual interest rate increases in the US, whether emerging markets remain in vogue with global investors and, of course, if the recent commodity price declines stabilise.
China still key for commodities
Commodity prices also responded favourably to Trump’s promises of an infrastructure spending boost. However, a broad range of commodity prices peaked at the start of the year and some, like iron ore, have pulled back sharply. Though the US is a much larger economy, China accounts for a greater share of global commodity demand. Chinese authorities are trying to clamp down on rapid credit growth through the so-called shadow banking system and curb financial speculation, as they periodically do. Market-based interest rates have increased meaningfully. It appears that the tighter credit conditions have impacted commodity prices. Mainland Chinese shares have also sold off. While this is likely to impact on economic activity, even with slower growth (closer to 6% than to 7% per year), demand for commodities should remain healthy. One sign is that the growth slowdown in China in 2015 and 2016 coincided with a weaker currency and capital outflows. This has stabilised and foreign exchange reserves, which declined by a trillion US dollars, are no longer falling.
The ‘Belt and Road’ initiative, which seeks to invest an estimated $150bn a year into rail, road and maritime infrastructure and links China with South East Asia and Western Europe, was formally launched this weekend. This will be a further source of longer-term demand. The question is just whether commodity prices have increased too quickly, which appears to be the case, and also if miners have expanded supply in response to higher prices (which could place further downward pressure on prices). But major downside to commodity prices is limited by the fact that real commodity prices are still historically low.
South African miners expanded production in the first quarter at an annualised rate of 14% from the fourth quarter of 2016, with sizable increases in platinum and iron ore output more than offsetting a slight decline in coal (the largest category). This implies a positive first quarter gross domestic product growth contribution from mining. However, while mining production has been volatile, it has essentially moved sideways since 2011.
Dave Mohr is chief investment strategist and Izak Odendaal is an investment strategist at Old Mutual Multi-Managers.
