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AN EVENTFUL QUARTER AT A GLANCE

David Crosoer, Executive: Research and Investments at PPS Investments

The last quarter was characterised by weakness in South African equity markets, after the All Share Index failed to hold onto the all-time highs reached in the previous quarter; weakness in both commodity and foreign exchange markets with the South African Rand testing levels not seen since January this year; and weakness in the credit markets with the knock-on effects of the micro-lender African Bank (ABIL) being placed under curatorship in August was felt across the market.
 
Despite this, when measured over twelve months, financial markets have delivered strong returns with international equities (up 25%) and local equities (up 18%), the stand out performers.  Over the quarter, South African property (up 7%) and international equities (up 4%) continued to perform strongly, while SA equities (down 0.5%) and SA resources (down 6%) in particular, fared poorly against the backdrop of falling commodity prices and a weak rand.
 
Households have repaired their balance sheets to some extent (household debt-to-income was 83% in the first quarter of 2009 and 73.5% in the second quarter of 2014), but household consumption expenditure has come under pressure recently. The demise of ABIL reflects deteriorating credit worthiness in the unsecured sector and its exposure to the protracted mining and manufacturing strikes.
 
In particular, the private sector has only created 162,900 of the 449,100 jobs it shed in 2008/9, with government being the major net contributor to employment over this period by creating 256,900 public sector jobs. Both the mining and manufacturing sectors are still shedding jobs, and the planned infrastructure spend (aimed to alleviate bottlenecks in the economy) is hardly off the ground. (The construction sector has added just 5000 jobs since the recession).
 
Unsurprisingly, given weak mining and manufacturing and a burgeoning public sector, the current account deficit (i.e. the difference between what we sell and what we buy as a country) has worsened again to more than 6% of gross domestic product (GDP). 
 
Government’s finances have also deteriorated. The budget deficit (which the government funds by issuing debt) is now 4.6% of GDP and debt levels are uncomfortably close to 50% of GDP if implicit state guarantees are taken into account.
 
A challenging economic outlook has resulted in the South African Reserve Bank (the Bank) cutting its economic growth forecast five times this year, and the Bank now expects the SA economy to grow only 1.5% in 2014.
The Monetary Policy Committee (MPC) of the Bank increased interest rates by 0.25% at its July meeting, but left rates unchanged in August. The Bank has raised interest rates by a cumulative 0.75% between January and November this year.
 
The slightly better-than-expected inflation outlook (inflation looks like it peaked in the second quarter of this year) has given the bank some legroom not to raise rates as aggressively as initially expected, and the market is pricing in another 1.0% in interest rate increases over the next 12 months.
 
South Africa’s weak economic recovery should be seen in the context of a global economic recovery that is also weaker than initially forecast. The International Monetary Fund (IMF) in October this year once again revised downwards its expectation for global growth in 2014 and 2015.
 
 The IMF now expects the global economy to grow by 3.3% this year (and emerging markets in aggregate by 4.4%), considerably less than its October 2013 World Economic Outlook forecast of 5.1% for the global economy (and 5.7% for emerging markets). South Africa’s 5% growth targets look very ambitious in this context unless profound structural reforms are initiated.
 
The US economy continues to be the one bright spot in the global economy. (Its growth rate for 2014 has been revised upwards to 2.2% by the IMF). However, the US dollar strength and the prospect that US short-term interest rates will increase next year, is having a negative impact on commodity prices, and making it harder for small open economies like South Africa to attract the necessary capital to fund their shortfalls.
 
In fact, as a group, the IMF argues emerging economies potential growth rates are probably 1.5% p.a. lower than prior to 2008, making them less attractive as an investment destination regardless of the path of US interest rates.
 
Given the above, we believe that financial markets are not yet adequately pricing in the risk that both US and SA short-term interest rates could rise significantly.  Consequently, we continue to remain overweight short-dated fixed interest instruments in all our portfolios, given the short-term volatility we anticipate will occur in financial markets, should US short-term rates normalise.
 
Across our portfolios, our biggest active positions are to underweight South African equities and overweight South African cash. This is not a decision we take lightly, given the importance of holding equities to generate inflation-beating returns for our investors. We are keenly aware of the need to move to a neutral position in equities should valuations become more supportive. The managers we have allocated local equity assets to have tended to overweight rand-hedge industrial shares, given their shared concern of the weakness of the South African economy, although certain managers have also established positions in attractively-priced resource counters. Where we have awarded mandates to managers that have the discretion and ability to invest outside the Top40 shares, in the current challenging environment managers are being very selective as to what they buy.
 
The portfolios have maintained a fully-invested offshore position, despite our assessment that the rand is significantly undervalued when measured on a medium-term basis, because we still see further weakness possible. The managers we have favoured here have a bias towards capital protection and generating real returns. As discussed last quarter, we are no longer overweight international equities relative to our strategic offshore allocation.
 
Within our fixed interest composites, we have continued to reduce our exposure to managers who are significantly exposed to credit, as we remain concerned that local economic conditions could deteriorate further. Following the ABIL default, it is clear that investors will demand greater compensation for holding credit than in the past, and our portfolios should eventually benefit from this additional compensation.
 
We have also persisted with a structural underweight to longer-dated fixed interest assets, given our view that SA fixed interest assets will be re-priced as US interest rates normalise. We will look to move to a more neutral position once we have greater confidence in the South African fiscal position and feel we are being adequately compensated for holding this debt.
 
Financial markets have been fairly well-behaved through a period of record-low interest rates, notwithstanding the recent turmoil caused by the ABIL default. The ABIL default is noteworthy in that it represents a permanent rather than temporary loss of capital for investors. Fortunately investors in our portfolios were across different managers, and this helped limit the loss from the ABIL default. Undoubtedly, the economic environment will remain challenging and our multi-managed portfolios need to remain diversified across managers and strategies to generate real returns for our investors.