By: Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist), Old Mutual Multi-Managers
The JSE was down sharply last week as scandal engulfed one of the biggest shares on the exchange. Steinhoff International shares plunged after the company’s auditors refused to sign off on its latest financial statements and its CEO resigned.
Before its collapse, Steinhoff was the seventh biggest company in the FTSE/JSE Shareholders Weighted Index (SWIX), the benchmark widely used by professional investors, with a 2.3% weight. A number of other listed companies closely associated with Steinhoff and Chairman Christo Wiese also suffered sharp declines.
It is not immediately clear if outright fraud is involved, but German prosecutors (the share is also listed in Frankfurt) said they are still investigating possible accounting irregularities and fraud. Either way, it is yet another blow to South Africa’s reputation for good corporate governance, coming so soon after allegations that a subsidiary of Naspers, the biggest company on the JSE, improperly influenced government policy. Meanwhile, listed technology group EOH also saw its share price collapse last week following a probe by the Independent Police Investigative Directorate (IPID) into subsidiaries that do business with Government. In a country where the popular view of big business is often very negative, also among some policymakers, these are unwelcome developments.
Global markets softer
The Steinhoff debacle occurred against the backdrop of a softer patch for global equities. It is perfectly normal for markets to pull back after a strong run (though it is never pleasant). The S&P 500 has been positive every month this year, an almost unheard of feat. Whether or not December is positive, global markets are still up substantially this year, supported by a healthy economic backdrop and good earnings growth.
In contrast to corrections, big market moves are usually shifts in perceptions about underlying fundamentals (large changes in sentiment) or changes in underlying fundamentals (like a recession). Recessions are notoriously difficult to forecast. All one can do is look for warning signs of overheating and build-up of imbalances. These include debt, particularly household debt, rising faster than incomes; accelerating wage growth and consumer inflation; large budget and current account deficits; and overvalued currencies. Unsustainably high commodity prices are another indicator for countries like South Africa. These warning signs are largely still absent, except perhaps in China, a risk area that is constantly highlighted. The other big risk is that central banks hike interest rates quickly, perhaps spooked by ‘financial stability’ worries (to take away the punchbowl before the party gets out of hand, in the famous phrase of a former Fed chair).
With Friday’s payrolls report showing 228 000 jobs created in November in the US, a Federal Reserve interest rate hike this week is a near certainty. The big question is really how quickly rates will rise next year, and how the US dollar responds. A strengthening dollar can cause havoc, putting emerging market currencies and commodities under pressure. The good news is that the Fed’s interest rate view is based on an improving economy. The fall-out for the rest of the world is minimal and in such a scenario, rate hikes send a positive signal. This was the case during the previous hiking cycle, which occurred against the backdrop of strong growth, and therefore had virtually no impact on financial markets.
Another positive quarter
Locally, the economic outlook is also improving. The economy grew faster than expected in the third quarter, with seasonally adjusted real gross domestic product increasing at an annual rate of 2% from the second quarter. The prior quarter’s growth rate was also adjusted upwards from 2.5% to 2.8%. Growth for the first nine months of the year compared to the same period last year is at 1%, a run rate that is ahead of most forecasts.
From a sector point of view, the third quarter benefited from a 44% jump in agriculture, a 6.6% increase in mining and a 4.3% rise in manufacturing. The services sectors saw slower but still positive growth of 0.3%, largely due to weak wholesale sales and declining government spending.
The post-drought rebound in agriculture – responsible for 0.9 percentage points of the quarter’s overall growth – is clearly not sustainable, but there are other signs that point to a more lasting but subdued upswing. Private fixed investment spending grew by 4.1% in the third quarter, up from an 8.4% decline in the second quarter (fixed investment by businesses has declined in seven of the past 10 quarters).
Household final consumption spending rose 2.6% in the third quarter, with spending on durable goods (cars and furniture) contributing almost half. Spending on these big ticket items tends to rise and fall with the economic cycle much more than on clothing and food.
Real income growth is supporting the outlook for household spending and is still almost two-thirds of economic activity in South Africa. The economy’s wage bill grew by 8.1% in the third quarter compared to the same quarter last year. This increase in employee compensation was fairly broadly spread across sectors. Unless wage bill growth slows materially, expected inflation around 5% over the next year implies further positive real income growth.
Could Steinhoff derail this mild economic upswing? There is no indication that any of the local businesses (mainly in retail) will close, leading to job losses. Importantly, there is also no sign that any of the domestic banks faces a loss that threatens its viability. A healthy banking system is crucial for a healthy economy. Therefore, the macroeconomic impact is determined by the so-called wealth effect – households responding to a decline in their asset values by adjusting spending. It is safe to say that, given its size, most equity portfolios in South Africa would have had some exposure to Steinhoff. But the exposure of the typical investor or pension fund member to Steinhoff is probably in the region of 1% to 2%, well within the range of market movements over the course of a few weeks or months. Therefore, the countrywide wealth effect is likely to be minimal. However, the market for high-end property, luxury vehicles and the like could certainly suffer in and around Stellenbosch, where the company is based.
It’s not all about Steinhoff
This is our final weekly market commentary for 2017. While the Steinhoff debacle means we are not ending the year on a high note, the overall outlook is fairly positive globally, while locally things also appear to be on the up. We spent much of this year warning against excessive pessimism, and despite political uncertainty, Cabinet reshuffles, credit ratings downgrades, a technical recession and a volatile exchange rate, South African investors have generally enjoyed a good year in terms of growth assets.
Local equities have returned 17% in 2017 despite a negative December. Listed property has delivered double digit returns. With the rand–dollar exchange rate basically flat this year, the rand has not detracted from global performance from the point of view of local investors. Global equities are therefore up 20% in rand. It is only domestic bonds that have disappointed, with the return on the All Bond Index of 5.5%.
The importance of diversification
We have also tried to highlight some of the key investment lessons along the way (for ourselves as much as our readers). While the local investment community was divided over Steinhoff’s aggressive debt-fuelled global expansion path, even the sceptics would have been shocked by the announcement regarding accounting irregularities. Ultimately, the only defence against such an unexpected event is diversification – a diversified portfolio would suffer a knock, but not a wipe-out. This forms the basis on which we run the strategy funds for our clients: diversification across securities (so no single share can wipe out the portfolio); diversification across regions (to benefit from a larger opportunity set and hedge against currency weakness); diversification across asset managers (to benefit from different views and investment styles); and diversification across asset classes (since the future is inherently uncertain).
Chart 1: Asset classes in 2017, rebased to 100
Chart 2: South Africa real gross domestic product growth