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A TOUGH YEAR AHEAD...

David Crosoer

Focus on your long-term goals
 
David Crosoer, our Executive: Research and Investments answers some pertinent questions about our investment perspectives for 2015 and what happened in 2014. He shares insight into the broader global economy, the local picture and just how PPS Investments has diversified its portfolios to minimise risk for clients and help to generate long-term wealth.
 
What were the primary economic themes last year?

2014 was dominated by weakness in the global economy, and downward pressure on commodity prices. This was largely as a result of investors reacting to the implications of the end of quantitative easing in the United States, and continued poor growth in most of the developed and emerging world. Consumer price inflation remained manageable, and South Africa ended the year within the three percent to six percent target band.

We saw mediocre growth in the SA economy in Q3 last year. Why?

Bottlenecks in infrastructure and adjusting to the strikes in the mining and manufacturing sector haven’t helped. But it’s been a weak recovery as consumers have been unable to take on additional debt. The private sector has been subdued and reluctant to hire, and employment creation has largely been driven by the public sector, which has seen a marked deterioration in its finances.

How did the various asset classes perform in 2014?

The Shareholder Weighted All Share Index (SWIX) was up 3.75% for the quarter and 15.42% for the year, with the financial sector performing particularly strongly (up 10.37% for the quarter, and 27.83% for the year). Investors in resource shares, however, had a torrid time with the resource sector down 19.81% for the quarter and down 15.01% for the year. This weak performance reflects poor growth prospects. Resource shares have now given negative annualised performance over one, three, five and seven years despite the broader equity market compounding at over six percent real over a similar period.

Fixed interest assets also performed strongly over the quarter with the All Bond Index (ALBI) delivering 4.25% over the quarter, and 10.15% over twelve months. Short-term cash rates were unchanged over the quarter, but have edged up slightly when measured over twelve months. The rand has remained under pressure, particularly against a strong dollar. It ended the year ten percent weaker from where it started.
Global equity markets underperformed South African equities over the quarter (up 1.93%), but gave broadly similar returns when measured over twelve months (up 15.42% in rands). International equity markets however have outperformed South African equities over two, three and five years with the United States equity market being the standout performer.

What are the market expectations for economic growth?

Market analysts now anticipate that South Africa might have grown by just 1.4% in 2014, and will be lucky to grow above two percent in 2015. In fact, our potential growth rate, given all our constraints, is probably closer to two percent per year than the five percent we need to start making a dent on unemployment - or the three percent we’ve typically grown at in the past. Worryingly, the International Monetary Fund (IMF) calculates that despite a challenging global context, South Africa should have grown two thirds of a percent faster per year since 2010.

What does SA need to do to avoid being downgraded by rating agencies?

Both Fitch and Standard & Poor have left our rating unchanged in December. Both stressed this was conditional on, firstly, South Africa improving its economic growth rate and, secondly, South Africa getting a handle on its government expenditure. Both conditions are challenging to implement, especially in a demand-deficient world where there is considerable political pressure to spend. Relative to other emerging markets, we’ve gone backwards over the past five years. We need to reverse this.

How will SA Treasury support growth and manage expenditure?

South Africa has limited room to manoeuvre. We’ve frequently commented on the unsustainability of our government expenditure (government debt as a percentage of GDP has increased from 27% pre-crisis to close to 50% today) and the gradual erosion of our economic competitiveness despite a weaker rand.
In his maiden Medium-Term Budget Policy Statement in October, incumbent Minister of Finance, Nhlanhla Nene stated Treasury would, among other things, need to raise additional revenue, freeze public sector headcount and wages in real terms, and ensure any support to state-owned enterprises was budget neutral. It is critical that he delivers on this in this February budget, as most market participants are anticipating US short-term interest rates will increase in 2015 on the back of an improving US economy. We also need to direct expenditure towards infrastructure spend rather than public sector salaries.

Will US interest rates change?

The unsynchronised global recovery puts great pressure on economies like South Africa. This is because we are reliant on record-low interest rates to stabilise consumer demand. Although the US Federal Reserve (Fed) released a less aggressive interest rate forecast than one quarter ago, the December minutes indicate that the median the governor expects the Fed Funds rate to be is one percent at the end of 2015, and 2.5% at the end of 2016 (from 0% currently). The first interest rate increase, and changes in market expectation as to when this will occur, is likely to mean significant volatility in the pricing of most financial assets.

This is especially due to the key role the US plays in the global financial system. Further, the market does look like it has got ahead of itself in not expecting any US rate hikes. At its January meeting, the Fed once again indicated that the US economy was still on track to endure increasing interest rates, notwithstanding the deflationary impact of the oil shock.

Why do we think SA might have to raise rates significantly?

The South African Monetary Policy Committee (MPC) left interest rates unchanged at its January meeting, after having raised rates by just 0.75% in 2014. Although the market has started pricing in a potential rate cut, the Governor was at pains to point out that this was highly unlikely. We continue to believe that the market is underestimating the possibility of further rate hikes, despite the oil price drop, given our poor fundamentals and the prospect of US policy normalisation.

The consensus view of a subdued interest rate cycle is however dependent on South Africa retaining the confidence of investors, and the US not raising rates aggressively. We can expect far higher interest rates cycles if the current cycle resembles anything we’ve had in the past.

If our fundamentals deteriorate further, we may find ourselves in a similar position to Turkey and Russia in 2014 who were forced to aggressively raise rates as investors focused on their unsustainable economic fundamentals. These aggressive interest rate responses can have implications for consumers and the pricing of financial assets.

Has there been any good news for South Africa?

The drastic drop in the oil price to under $50 a barrel is positive for consumers and inflation. If it persists, it is likely to stimulate global growth by as much as an additional percentage point. This is significant in an economic context where the World Bank expects the global economy to grow by just three percent in 2015.
The Medium-Term Budget Policy Statement announced by Minister Nene sounds promising and he now needs to deliver. Delays in US interest rate increases may also give South Africa more breathing space and keep interest rates lower for longer. However, unless economies like South Africa can introduce the necessary structural reforms it’s unlikely that, outside the US, the global economy will hold any pleasant surprises. We need to get the private sector to create jobs again.

Are PPS Portfolios still appropriately positioned?

We have diversified exposure across all asset classes including international and fixed interest assets. Our inflation-targeting portfolios target at least a three-year time horizon, and consequently are positioned for increasing US interest rates. We believe this view remains appropriate over the investment time horizon of these portfolios to generate long-term wealth for our clients.

Our international exposure is predominately invested in the shares of companies that can generate strong cash flows and the inflation-linked bonds of the governments of developed countries. The local fixed interest assets we are invested in should benefit from increasing interest rates.

We also hold South African equities.  They don’t look inexpensive, and our managers are being fairly selective in what they purchase. The top overweight positions in the PPS Equity Fund were Standard Bank, Anglo American and The Foschini Group, while our managers continue to avoid shares like Aspen and Sanlam, which they believe appear fully valued.

How is PPS positioning itself for these themes in 2015?

Our base case scenario is that 2015 will be a challenging one for investors - with tighter global conditions, an uneven and uncertain recovery, and reduced policy space. Since we expect the themes of 2014 to continue in 2015, our portfolios will continue to invest heavily in international assets using asset managers we believe have the ability to offer some protection in difficult markets. We also have a lower weighting to South African assets, with the only exception being cash which features quite prominently in our portfolios. So in a nutshell, we continue to motivate underweighting South African equity and fixed interest assets, and remain overweight in SA cash and international assets as a means of protecting capital.

How are our portfolios positioned to minimise risk for clients?

We continue to believe that the normalisation of US interest rates from record lows is the greatest risk facing South African investors. We also remain sceptical about the ability of South Africa to initiate much needed structural reforms. However, we’ve ensured our portfolios are sufficiently diversified across asset classes and managers to perform adequately should these scenarios not materialise, especially because the local equities our managers are holding should benefit from an improvement in sentiment towards South African assets.

You’ve recently had a mandate enhancement. What does this mean?

Investors in the PPS Managed Flexible FoF agreed to allow this fund to invest more than 25% offshore to deliver on its CPI+6% p.a. return objective. This change will enable us to use additional opportunities to deliver on our return objective. We anticipate increasing the offshore allocation in this portfolio over time as we make greater use of active international managers to deliver on our return objectives. Our other portfolios are all fully utilising the international allocation available to them.

You will need to prepare yourself for a challenging year. 2015 is likely to be characterised by a lot of volatility as the world readjusts to increasing US interest rates. The budget could also hit consumers in the pocket.

In such an environment, it is doubly important for you to remain focused on your long-term goals and not get swayed by short-term sentiment.