That’s more like it

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

Global equity markets have surged ahead. This is despite there being no resolution to the recent North Korea stand-off. The main US equity indices – the large-cap Dow Jones Industrial, the broader S&P 500, the tech-heavy Nasdaq and the small cap Russell 2000 – all hit new record highs after a streak of successive positive days. American-listed companies account for around half the major global indices.

Supportive global backdrop for equities
The catalyst for the recent surge in global markets appears to be a renewed push for tax reform in the US that would see companies pay less tax. But the underlying driver of rising equity prices is that the global environment is favourable for companies, allowing them to generate strong profit growth.

Global economic activity has picked up and for the first time in a decade none of the major economies are in a recession. At the same time, inflation is low, implying that interest rates will remain accommodative for some time still. Low borrowing costs help companies remain profitable, reducing interest costs and making it cheap to acquire other firms. It also means equity is an attractive asset class relative to interest-bearing assets.

The dividend yield on the S&P 500 is 2%, more than the yield on a five-year government bond. Persistently low inflation suggests reduced corporate pricing power (companies cannot easily charge consumers more and raise revenue growth) but wage growth across the developed world is also very low despite a rapid decline in unemployment. Companies are simply squeezing suppliers and workers. Reported earnings of S&P 500 companies are expected to be 9.6% higher in 2017 compared to 2016, according to Factset (this after two years of virtually no growth).

The future path of monetary policy is therefore important not just for bond markets, but also for equity markets. US bond yields have increased in anticipation of tighter monetary policy (higher interest rates) and looser fiscal policy (tax cuts) but the 10-year Treasury yield at 2.3% is still below where US Federal Reserve officials expect their policy interest rate will eventually settle (around 2.8%). In other words, the market does not believe the Fed will hike as much as it thinks it will, and with good reason, given persistently low inflation.

Valuations not juicy
Though earnings are growing nicely, expectations for future earnings are high and investors are prepared to pay more for each dollar of earnings. In other words, price-earnings (PE) ratios have increased. The forward PE ratio of the S&P 500 is at 18 and above its longer-term average. European and emerging markets are more reasonably valued and therefore the forward PE of the MSCI All Countries World Index (ACWI) is at 16, in line with its long-term average. This suggests longer-term return expectations from global equities in US dollars are average or somewhat below average. But for now, returns are welcome. The S&P 500 is up 14% in 2017 and the MSCI ACWI 16% in dollars. Emerging market equities are up 28% in dollars.

Weaker rand good for investors
Rather unusual in a risk-on environment, the rand has depreciated over the past three weeks in line with other emerging markets as the dollar rebounded somewhat. The softer rand, together with a higher oil price, mean motorists can expect more pain at the pump, but this doesn’t by itself mean a large change to the favourable inflation outlook over the next year or two. Unless the rand weakens much further, the current inflation outlook still calls for lower interest rates. Fuel is only 4.6% of the consumer price index basket (with public transport another 2.3%). Moreover, in a weak economic environment, companies have to think twice about passing higher transport costs on to consumers and risk losing market share. But the weaker rand has been good for local investors, directly and indirectly.

Since the rand is flat against the dollar year-to-date and over 12 months, this means local investors can fully participate in global equity performance (the direct impact).

The indirect impact is that the JSE generally benefits from a weaker rand since most of its earnings come from outside South Africa. While this rand-hedge component traditionally came from the miners and global companies like Richemont and British American Tobacco that have secondary listings on the JSE, companies with a domestic focus are increasingly expanding abroad in search of growth. The list spans retailers, healthcare, logistics, construction and financial services and grows by the day. If this trend continues, there will be very few “pure play” South African shares left.

JSE also at record high
The JSE had a negative month in September but regained these losses in the first week of October on the way to a new record high close for the FTSE/JSE All Share Index (Alsi). Interestingly, the choice of benchmark has been significant this year. While the All Share is the best-known and most widely quoted in the media, most professional investors track the FTSE/JSE Shareholder Weighted Index (Swix). But since the weight of Naspers in the Swix has climbed above 20%, this introduces single-stock risk. It also makes it virtually impossible to be overweight on Naspers for those managers that are bullish on the stock. Many are now shifting to a capped version of the Swix where the Naspers weight is limited. The year-to-date return on the Alsi is 16% and 13% on the Swix (including dividends). The JSE also trades above its long-term average PE ratio, but in line with global markets (which makes sense given the increasingly global nature of the local bourse).

With inflation below 5%, investors are finally getting decent real returns from local and global equities after a prolonged period where local equities underperformed, while global returns were limited by rand appreciation since January 2016. Good short-term returns also drag longer-term numbers up: the three-year annual total return of local equities has climbed to 8%.

Other asset classes are also delivering real returns. The FTSE/JSE SA Listed Property Index had a strong third quarter and returns for 2017 to date are 8%. Over 12 months, listed property has returned only 9%.

In line with higher global bond yields and a softer rand, local bonds have sold off since mid-September. The yield on the 10-year SA government bond increased from 8.4% to 8.6% over the past three weeks (bond yields rise as prices fall). It started the year at 8.9%. The All Bond Index has returned 7% in 2017 and is ahead of cash.

What a difference a month can make
At the end of June, the three-year annual return on the All Share was only 3%, coming almost entirely from dividends. Moreover, at that point the rand was 10% stronger than a year ago, mostly wiping out the benefit of holding offshore assets. Many investors were wondering whether it was worth it at all, and if it wouldn’t be better to just leave the money in the bank. But then in July, the JSE market delivered a year’s worth of bank deposit returns (7%) in a single month.

What is the lesson? Nobody can predict whether the next month will be a June (with markets deeply in the red) or a July (with markets buoyant). We know that after a month like June, the temptation is to give up. But we also know that the market trends up over time, so there must be more months like July than months like June. The trick is that one has to remain invested to benefit from this long-term trend. Timing entry and exit into the market is extremely difficult, as you have to get both the exit and the re-entering calls spot-on to benefit from it.

Chart 1: Three-year rolling annual returns of local and global equities (in rand terms)

Chart 2: US and South African 10-year government bond yields

Source: Datastream