Emerging markets continue their upward march

Emerging markets continued their outperformance of developed markets in August. The MSCI Global Emerging Market Index gained 2.1% versus the MSCI World Index, which just managed to generate a positive return of 0.2%. Year-to-date the MSCI Global Emerging Market Index has delivered a dollar return of 28.6%, boosted by a strong performance from Asia.

South Africa’s equity market returns have been generated by very few shares The FTSE/JSE All Share Index (ALSI), buoyed by positive emerging market sentiment, added 2.6% for the month. The resources sector delivered the best performance for the month, returning 5.1% on the back of buoyant commodity prices. SA financial and industrial indices added 2.1% and 2.0% respectively. Superficially, while the 13.6% performance from the ALSI year-to-date appears impressive, this return has been generated by very few stocks i.e. the market breadth has been very narrow. Year-to-date Naspers, Richemont, BHP Billiton, Anglo American and Mondi have contributed 79% of the ALSI’s 13.6% return.

Locally, equities are the best performing asset class year-to-date Year-to-date the ALSI is up an impressive 13.6%, outperforming all other asset classes. By comparison the Listed Property Index, the All Bond and cash have delivered returns of 6.9%, 6.6% and 5% respectively.

Global growth remains robust, emerging market risk asset appetite remains high Despite the stronger global growth environment, developed market yields remain low as a consequence of a benign inflation outlook. This continues to feed foreign appetite for emerging markets risk assets, especially in the fixed income markets. This liquidity inflow has strengthened emerging market currencies and lowered their bond yields. The rand has been a significant beneficiary of this trade. This, however, creates more risk over the longer term if for whatever reason these inflows cease or even reverse.

South African economy exits technical recession, but concerns remain.

The South African economy moved out of a technical recession, following two quarters of negative growth. Annualised GDP growth improved to 2.5% quarteron- quarter, following the first quarter’s decline of 0.7%. The recovery in growth was off a very low base and was driven mainly by improved performances from the agriculture, forestry, fishing and mining industries.
Despite the second quarter recovery, growth expectations for the full year are still likely to be weak, with expected growth of less than 1.0%. Excluding the primary sectors, second quarter GDP growth would have been 1.5% off a weak base, which does not suggest a broad-based recovery in activity levels. Activity levels in the manufacturing, retail and finance sectors remain weak, and are vulnerable to a further potential confidence shock given the current uncertain socio-political environment.

Expect further interest rate cuts from the South African Reserve Bank (SARB)

The combination of a stronger rand and falling food inflation will see headline inflation well below the SARB’s targeted band. The SARB has already started cutting interest rates, and given the lower inflation outlook and weaker underlying economic momentum, we are likely to see a further 75 bps of rate cuts over the cycle.

South Africa facing higher budget deficits, big tax hikes to come

We have been highlighting our concern around the potential for a disappointment on government tax collections, given the weak local economic environment. July saw the government announce a record breaking fiscal deficit of R92bn, suggesting we could be facing a much larger fiscal deficit for the year. We expect the tax shortfall could be as much as R50bn for the year, which implies a much larger public sector borrowing requirement. As a result, we are likely to face further punitive tax hikes as government attempts to shore up its revenues. The Medium-Term Budget Policy Statement in October will give us more clarity on the extent of the potential shortfall.

Truffle Asset Management

The Trump election victory helped drive US 10-year treasuries up by 85 basis points to 2.44%, close to a two-year high. This affected global market bonds negatively (-8.2% on the JP Morgan Global Bond Index). The dollar strengthened against most currencies based on expectations of higher US interest rates. Locally, lower perceived political risk and maintaining our credit rating resulted in the rand holding its level with the dollar. The rand therefore also strengthened against most other currencies. This also explains the relative resilience of our bond market relative to other bond markets. The recent decision by S&P not to downgrade our foreign currency credit rating resulted in a resilient performance from the rand and bond market.

Despite this, S&P, Moody's and Fitch have a negative outlook on South Africa. Although the withdrawal of fraud charges against the Finance Minister was a welcome relief to investors and South African citizens, the risks associated with future leadership, persistently low GDP and state capture remain. Copper which increased 13.9% over the quarter rallied strongly after the Trump victory. Republican campaign promises of increased infrastructure spending and an improved global economic growth outlook helped this rise. It is important to note that the proposed infrastructure spending in the US is negligible compared to China's annual fixed investment requirement. The key driver to maintain current commodity prices is continued growth in Chinese fixed investment. This remained buoyant at 8.3% over the last year. However, China's rapid debt expansion over the last few years needs to slow down to at least levels of GDP growth. This process will likely involve a pullback in fixed asset investment and consequent commodity price reductions. At current commodity prices, most of the mining companies look extremely cheap and trade on double-digit free cash flow yields.

The key question is whether these prices are sustainable because they are, for most commodities, substantially higher than the costs of marginal producers. The Federal Reserve raised rates by 0.25% as well as its expectations for further increases. This can be attributed to unemployment levels which fell to a low of 4.6% and the expectation of a more stimulatory fiscal policy.
The expectation of higher rates (which increases the opportunity cost of holding gold) weighed on the gold price as it fell 12.8%. Platinum (-12.1%) and palladium (-5.5%) followed gold downwards. Given the depressed level of the platinum group metals relative to the cost of mining them, and the pickup in global economic activity; we would expect to see a recovery over the next year. Oil benefited from the Organisation of Oil Exporting Countries (OPEC) and non-OPEC members reaching an agreement to cut production by 1.8 million barrels a day. West Texas Intermediate (referred to as WTI, is a grade of crude oil used as a benchmark in oil pricing) prices increased by 11.4%. We continue to maintain a significant position in Sasol which is pricing in a negligible increase in the oil price. 'Bond proxies' include companies with stable earnings growth and an ability to pay generous dividends. In other words, shares with bond-like characteristics. A large portion of these are represented by FMCG (fast moving consumer goods) companies.

The price for British American Tobacco PLC(BTI), which sits firmly in this category, had already fallen during October due to its expected issue of shares to purchase R. J. Reynolds Tobacco. On a dividend yield of 4.5%, BTI offers reasonable value, however, a continued rise in US bond rates will result in further downward pressure on BTI's share price in the short term. Healthcare shares, which could fall under the bond proxy heading, have also been under pressure over the quarter (-13.3%). However, much of the underperformance has also been sector-specific. Netcare indicated further margin pressure going forward as medical schemes