Reasons To Be Cheerful: Outlook 2020
Financial market performance in 2019
The 2019 investment returns of the major asset classes in which retirement funds invest were as follows:
With the exception of property, all major asset classes generated inflation-beating returns in 2019.
Despite the rand/USD exchange rate strengthening in 2019, global shares produced an investment return of 24.2% in rands. The FTSE/JSE All Share Index achieved a return of 12.1% for the year, but the Capped Shareholder Weighted Index (often used for retirement funds) gained only 6.8%. Domestic bonds generated an investment return of 10.3%. Bonds in the 7-12 year maturity bucket produced the best investment return for the year (+12.0%) while bonds in the 3-7 year maturity bucket produced 11.5%. Resources shares gained 28.5% for the year, shares listed in the financial sector gained only 0.6% and industrial shares lost 8.9% for the year. All the standout winners for the year were resources shares, with especially platinum and gold mining shares performing exceptionally well.
Balanced funds produced returns of approximately 12% in 2019, which is roughly 2% better than the target of inflation plus 5.5% after fees.
Economy and environment
The outlook for 2020 is overshadowed by the following domestic issues:
- Eskom electricity generation issues
- Impending junk status
- Lethargic economic growth and investment
- Land expropriation
- Prescribed assets and labour policies and other red tape
- Asset allocation limits; and
- Domestic political risk.
In addition, some important global issues are:
- Geopolitical tension (in the Middle East, and don’t forget North Korea)
- Presidential elections in the US
- Trade agreements globally; and
- Slower economic growth.
The extent to which these issues have been discounted by share prices, interest rates and exchange rates is not clear. If the risk factors have been discounted fully, investments should not perform poorly in the event that any combination of the risks materialises. If the risk factors have not been discounted fully, investment performance can be affected adversely should some of the risk factors materialise. The barometers for global risk factors are the US dollar exchange rate and commodity prices while the barometer for domestic risk factors is the rand exchange rate. Fundamental to the current investment environment is the impact of US yields, which rose sharply in September 2019 because of liquidity constraints when repurchase transactions (“repo trades”) were unwound over quarter-end. Responding to the sharp spike in yields, the US Federal Reserve (“the Fed”) increased liquidity in the US.
The recent positive performance in financial markets follows increased liquidity of some US$400 billion created by the US Federal Reserve (Figure 1).
The increased liquidity created pressure on yields in the US relative to major economic zones, e.g. Europe. The positive spread of US bonds over other sovereign bonds narrowed (Figure 2).
As US yields narrowed, the US dollar exchange rate lost some of its attraction. The greenback has experienced some weakness since September 2019 (Figure 3).
The weaker US dollar and increased liquidity resulted in risk-on positions where exposure was allocated to emerging markets (Figure 4).
Will the Fed maintain the higher level of liquidity, will the US dollar exchange rate continue to weaken and will the stronger performance from emerging markets since September 2019 continue? On the other hand, will the numerous domestic risk factors overwhelm financial markets in South Africa?
As things stand, several of these domestic risk factors can materialise.
In its planning Eskom provided for an Unplanned Outage Assumption of 9500 MW (mostly from its coal fleet), but recent evidence suggests that the power utility frequently experiences unplanned outages at its newer generation coal units. The unplanned outages result in rolling blackouts (demand management measures referred to as load shedding). The impact on domestic economic growth is severe. The World Bank has reduced its forecast for economic growth in South Africa to 0.5% for 2020.
Rolling blackouts, lethargic economic growth and Government’s inability to implement common sense economic policy shifts are all factors that contribute to the impending downgrade of South Africa’s sovereign credit rating to a sub-investment grade rating.
Currently, 46% of government revenue is spent on civil service salaries – which, together with social grants and interest payments, already account for more than 70% of government revenue. South Africa faces a fiscal cliff once these commitments reach 75% of government revenue. A fiscal cliff is reached when expenditure on these commitments grows faster than government revenue, which means government revenue will not be enough to provide for civil service salaries, social grants and interest payments. The encroaching fiscal cliff and continuing bailouts to Eskom and other state-owned enterprises (SOEs) leave Government with very little room to manoeuvre, as it can either increase taxes, reduce expenditure or take steps to accelerate economic growth. However, it is unlikely that economic growth will accelerate or that Government will reduce expenditure.
In the present environment, it is difficult to understand:
- The impact that land expropriation may have on the economy
- How the NHI initiative will proceed
- State participation in exploration and mining
- The effect of further state-owned banks, and
- How the debate about prescribed assets can be avoided.
Reasons to be cheerful – part 3
Share prices in developed markets have increased by 12.4% p.a. (in US dollars) since 2012 to outperform emerging markets (5.4% p.a. in US dollars).
US$100 invested in the developed markets in 2012 has increased in value to US$254 in 2019 (Figure 5), while in emerging markets it has increased to US$152. In South Africa, it has increased to a mere US$118.
Rational investors increased exposure to shares in developed markets and avoided allocating capital to emerging markets, and to South African shares in particular, during this period. We know that global investors sold South African shares to the value of US$22 billion in the period from 2012 (Figure 6).
Emerging market share prices have strengthened since August 2019, outperforming developed markets despite the strong share prices in those developed markets (Figure 7).
Rational investors now consider reallocating some exposure to emerging market shares.
Should the Fed maintain the increased levels of liquidity injected into the financial system since August 2019 (Figure 1), it is reasonable to expect the reallocation of capital from developed markets to emerging market shares and debt. Should the increased liquidity be curtailed, the switch from developed markets to emerging markets may be less pronounced than expected.
South Africa has underperformed other emerging markets consistently since 2015 (Figure 8) and it is difficult to see how a global switch into emerging markets will not accentuate this trend. For global investors looking for emerging market exposure, the e-commerce and technology opportunities provided by South and Southeast Asia (e.g. Taiwan, South Korea, China) are much more attractive and, in some cases, without the political risk exposure that South Africa presents.
Since 2016, there has been some positive movement in the price of precious metals, particularly gold and PGM metals (platinum, palladium and rhodium) (Figure 9). The improved metal prices are reflected in the performance of gold and platinum shares listed on the JSE in 2019.
The Dow Jones Industrial Index/gold ratio (Figure 10) shows that the prices of precious metals are likely to outperform shares. South African retirement funds have the opportunity to invest 10% of the market value of their assets directly in commodities. Precious metal prices may outperform other share prices, so investment managers who include commodities (precious metals) in their portfolios may produce better results than their peers
The FTSE/JSE Resources Index has improved by more than 23% p.a. since 2016 (Figure 11). As the prices of precious metals and even base metals improve, this trend of outperformance may continue into 2020.
Despite running hard recently (Impala Platinum +291%, Sibanye Gold +258% and Anglo American Platinum +128% in 2019) (Figure 12), the prices of some South African commodity shares remain attractive to US dollar-based investors. These investors may increase their exposure to South African commodity producers while reallocating capital from developed markets to emerging markets in 2020. This will have a significant impact on these share prices, which in US dollars are already considered cheap.
Apart from the precious metal miners, industrial and financial shares listed on the JSE are cheap. Industrial shares were down 8.9% in 2019 already. In addition to this, financial shares may experience similar headwinds in 2020 as bank share prices are expected to be affected by the impending downgrade. It is difficult to see how these shares will improve in a meaningful way in 2020 considering the fact that personal consumption expenditure remains under pressure. The result is that the TOPI 40 Index could outperform the Capped SWIX Index in 2020.
As the impending downgrade of South Africa’s sovereign credit rating looms, the yield to maturity on South African bonds is expected to increase to reward investors for the higher level of assessed risk (leading to a possible reduction of the value of existing exposure). The yield to maturity on the R2030 closed at 9.02% on 31 December 2019 (Figure 13) and can be expected to increase as foreign investors sell off domestic bonds pursuant to a downgrade. We expect global high yield bond investors to pay attention to South African bonds as the yields to maturity increase. Considering that inflation remains low (expected at 3.8% for December 2019), domestic bonds provide an attractive investment opportunity at higher yields (e.g. 9.60% for R2030, 9.80% on R2032 and 10.40% on R2037). The risk to South African bonds is the volume of bonds that continues to be issued on a weekly basis.
The inflation outlook for South Africa is muted. Administered prices may increase appreciably (electricity), but demand-pull inflation is expected to remain low. As a result, the risk of increased inflation is low. Nominal bonds are likely to perform better than inflation-linked bonds.
In the years since 2012, the rand weakened from R7.50 to the US dollar (early in 2012) to R16.97 during Nenegate (January 2017), before settling in a broad band ranging between R13.50 and R15.00 to the US dollar. Interestingly, since 2018, the movement of the US dollar exchange rate has explained what is happening to the rand.
It is possible that the rand will remain relatively strong (Figure 14) if we see greater levels of liquidity prevailing in the US (Figure 1) and a reallocation of capital to emerging markets (Figure 7), with some consideration for the continued strong performance of South African precious metal miners (Figure 12) and the more than 5% real yields from domestic bonds.
However, should liquidity contract in the US, the switch from developed markets to emerging markets will be much more muted than anticipated, the US dollar will not weaken as expected and the rand will lose ground, domestic bond yields will kick up more than expected, and the prices of South African precious metal miners may taper out.
Despite a positive outlook on emerging markets, commodities (precious metals) and the expected opportunity to purchase bonds at attractive yields, one should be careful not to expect exuberant investment returns in 2020. The risks for the year remain substantial.
The US Federal Reserve announced in January 2020 that the repo liquidity that has been created would be reduced gradually. It will be interesting to see how the Federal Reserve will constrain liquidity, considering the liquidity premium that has been front-loaded in share prices in a US election year.
In spite of the many challenges in the year ahead, the target return of 5.5% above inflation after fees is not out of reach. To use a golf analogy, 2020 will be a year in which to keep one’s head down and swing through!
Ultimately, the key to 2020 is the liquidity in the US financial system.