Investment Summary October 2019 – Stephen Cloete & Associates

Politics and trade tensions were a big driver behind markets in October. A partial trade deal between US and China saw a bounce for riskier assets in local currency terms and developments in the Brexit saga were broadly viewed as positive by markets with the pound markedly stronger over the month. Also, for a third time this year, the US Federal Reserve (Fed) lowered interest rates by 0.25%, this was off the back of weaker economic data.

Locally, Tito Mboweni delivered a Medium-Term Budget Policy Statement that fell short of already low expectations. Moody’s followed this with a rating release that kept South Africa on the lowest investment grade credit rating but moved South Africa’s outlook from ‘stable’ to ‘negative’. Within the ratings release Moody’s signalled the real risk that the government will be unable to rein in expenditure and boost growth in order to arrest the increasingly slippery debt path the country is on. The budget speech, due in February next year, was specifically cited as an event that the ratings agency will be using to assess any plan that the Treasury may come up with. This leaves very little time for government to turn things around and present a credible plan that will be accepted by ratings agencies and the market alike.

With this in mind, it seems that most economists and commentators believe that Moody’s will downgrade the country’s credit rating to below investment grade sometime in 2020. In fact, many have questioned how Moody’s have held on to the investment grade rating for so long given that both Fitch and S&P downgraded the country over two years ago. Moody’s justifies its rating by stating that it reflects “South Africa’s deep, stable financial sector, resilience to a prolonged period of low growth, and a robust macroeconomic policy framework.”

Following the ratings release, bond yields and the currency strengthened slightly as a lot of the damage was done after the MTBPS a couple of days earlier. In the lead up to the events in October the South African bond market was the cheapest of the meaningful emerging market countries from a real yield perspective (yield above expected inflation). South Africa’s credit spread, as shown below, was also far higher than other countries with similar ratings as well as those countries that are further down the credit curve.

This implies that a lot of bad news was (and still is) already priced into the market. However, there seems to be some confusion as to what will happen should the event arise. Several articles have highlighted research reports written by analysts from international banks citing the pool of assets controlled by those investors that would become forced sellers once South Africa loses its investment grade status. The additional supply of bonds in the local market should negatively impact bond yields. However, it is not guaranteed that the event will result in persistent falling of South African asset prices. In fact, the mere certainty of the downgrade may do the opposite. Research of other countries that have gone through downgrades shows that generally markets tend to outperform in the years following the downgrade. Of course, this is dependent on the action that is taken by government to set the economy on a path to improving economic growth. There are several ills in the economy, but it seems we are acutely aware of what needs to be done. The question is whether the government has the political will to do what needs to be done.

In summary, there is no denying the difficult economic position the country is in. This is negative for the South Africa’s debt metrics and reflected to a large degree in the very high yields (cheapness) of the bond market. In an environment where 25% of the worlds bond markets have negative yields, there is a natural cap to how low we can go as the real yields available in South Africa remain attractive. Depending on

PERFORMANCE FEEDBACK – OCTOBER 2019

(Compiled by Nic Spicer and Brendan de Jongh)

October Overview

Economic data releases for South Africa were overshadowed by the all-important Medium-Term Budget Policy Statement (MTBPS) that was delivered towards the end of the month by finance minister, Tito Mboweni. The detail (in some instances the lack thereof) was not well received by the market and surprised to the downside for what were already low expectations. In the speech further fiscal slippage and under collection from a tax perspective contributed to poor forecasted debt metrics. Given the challenging environment growth forecasts were also revised down, further confirming the fragile state of the economy. Although vague on exactly where and how spending patterns would be improved the finance minister was clear that something needed to happen quite urgently in order to avoid a debt spiral. Most market participants would agree with this but the question now is whether the ruling party have the political will to make the tough decisions and tackle the “elephant in the room” being the public sector wage bill and continued bailouts of State Owned Enterprises (SOE’s).

Inflation remained in check at just over 4%. With the repo rate at 6.5% this means that real yields of 2.5% remain an attractive feature of South African fixed income markets.

The table below illustrates the movement in the South African currency over the last month:

During the month, Boris Johnson managed to agree a new deal with the EU which was eventually passed in principle by parliament. Parliament did not, however, vote to rush legislation through before the 31 October deadline. As a result, a Brexit extension was sought and granted by the EU until 31 January 2020. Rather than attempt to push through the legislation in a less hurried fashion, the Conservatives opted to push for a General Election which was eventually voted through by other parties with the date set for 12 December 2019. The pound strengthened significantly over the month as the chances of a messy Brexit on 31 October receded. Data showed that unemployment nudged up slightly to 3.9% in August, still remaining near record lows; and the latest readings for both consumer (CBI) and business confidence (GfK) showed noticeable decreases.

At the end of the month, the Fed cut rates by another 0.25%. This was widely expected given that the more recent datapoints have pointed towards a slowing economy. The ISM purchasing managers index (PMI) registered as 47.8 in September (in contraction) and consumer confidence showed a slight dip in October but quite a bit lower than expectations. Bearing this in mind, markets were, however given a fillip at the start of the month as a ‘Phase One Trade Deal’ was announced between the US and China, which was seen as a bit of a thawing of trade tensions. That being said, there was very little detail behind the deal and both sides are working on fleshing that out.

Economic data for Europe continued to be weak, particular in Germany – given global trade tensions and its dependency on exports. Germany’s flash manufacturing PMI in October remained firmly in contractionary territory at 41.9 – anything below 50 indicates contraction. In addition, German flash services PMI fell slightly to 51.2, the lowest level in over three years. Consumer’s aren’t really faring any better as the Euro Area consumer confidence index fell to -7.6 in October, a sharp drop from -6.5 in September.

Inflation in Japan fell again in September to 0.2%, well below the consensus expectation of 0.4%. Manufacturing PMI saw a decline in September to 48.9 and services PMI dipped slightly too. Yet again China’s GDP dipped down, and stood at 6.0% in Q3, from 6.2% in Q2. This is also impacting upon Chinese demand for imports, which have fallen 8.5% year-on-year in September. On a more positive note, industrial production and retail sales both picked-up in September.

Asset Classes

Global equity markets performed well over the month with strong outperformance within emerging market equities. The South African equity market benefitted from this which resulted in the local market comfortably outperforming SA cash and bonds. In an environment where bond yields generally increased, interest rate sensitive asset classes underperformed. Below is a summary of performance of the broader asset classes for the month:

GPS PERFORMANCE FEEDBACK – October 2019

GBP Asset Classes and Currency Performance

October generally saw some reasonably strong equity market performance in local currency. Unfortunately, for UK investors, the very strong pound meant that returns in sterling terms for international assets were all negative (including for the FTSE All Share which has the majority of its earning in foreign currencies).

Bond yields rose again slightly over the month; although shorter dated bond yields fell, partially due to the rate cut. The general yield increase resulted in longer duration bonds, especially inflation linked bonds, suffering. The more credit exposed fixed income asset classes fared better during the month, with investment grade and high yield bonds the relatively better performers, both up 0.3%.

The more internationally focused FTSE 100, thus also suffered as a result of a stronger pound returned -1.9%, whereas the more domestic focused FTSE 250 was up 0.6%.

GBP ASSET CLASS PERFORMANCE FOR THE MONTH