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Economic Update

TRIPPED UP BY TRADE TREPIDATIONS
DAVE MOHR & IZAK ODENDAAL, OLD MUTUAL MULTI-MANAGERS2

Only in its fourth month, 2018 is already an eventful year. As investors
digest their first quarter statements, the contrast between the general
sense of optimism on the streets and around the braai fires and the
disappointing short-term investment returns couldn’t be more stark.

Economic sentiment in South Africa has turned for the better and is
benefiting from three tailwinds. The first is obviously the prospect (with
some initial evidence) of improved governance and the return of sensible
policy-making under President Ramaphosa. Secondly, the global
economy is humming along nicely and South Africa, as a small open
economy, tends to follow the global cycle with a bit of a lag. Thirdly,
local consumers are already benefiting from lower inflation boosting
real incomes and spending power. The recent interest rate cut in March
will also help. This is a huge improvement from a year ago, when we
suffered downgrades, a technical recession and huge political uncertainty.
Moody’s has recognised this, announcing that they are maintaining
South Africa’s investment grade credit rating and upgrading the outlook
to stable.

Economic data often lags what is happening on the ground. One of
the more recent indicators, the Standard Bank Purchasing Managers’
Index, remained above 50 points in March, indicating that the private
sector is growing. The Reserve Bank’s forward-looking composite
leading indicator is at its highest level since March 2012.

RETURN OF VOLATILITY

Compared to this fairly happy picture, global equity markets have
experienced a torrid time in the first quarter as volatility returned after
a long, quiet stretch in 2017. The JSE has followed global markets
lower.

In the past two months, global investors’ optimism, fuelled by tax cuts
in the US and strong global growth, has made way to three broad
concerns. Firstly, the worry that strong growth and tightening labour
markets will lead to inflation jumping and central banks – particularly
the US Federal Reserve – slamming on the brakes. Equities and bonds
sold off in early February on rising interest rate expectations as data
showed a jump in US wage growth in January. That number has since
been revised lower, while the same wage growth indicator for March,
released on Friday, came in as expected at 2.7% year-on-year. This
hardly points to runaway wage and price inflation even as unemployment
hovers around a 17-year low. The 10-year Treasury yield has declined
to 2.8% since spiking to almost 3% in February.

Secondly, the high-lying technology sector has come under sudden
pressure as investors fear a regulatory backlash against dominant
companies like Facebook and Amazon. Naspers, the biggest share
on the JSE, also had a rough ride as global tech sold off. These shares
traded at high valuations after a strong run and were vulnerable to
reversal, but there is no evidence yet that their business models are
fundamentally threatened.

TRADE SPAT

Thirdly, and perhaps most significantly, has been the concern that the
world’s two largest economies are heading toward a trade war after
US President Trump announced tariffs on Chinese goods and China
retaliated with tariffs on mostly agricultural imports from the US. The
background is firstly long-standing complaints that China is pilfering
US intellectual property, but more recently that the US trade deficit has
ballooned to record (in nominal terms) levels. However, the trade deficit
is not a sign of the weakness of the US economy, but rather its strength
as improving domestic demand draws in more imports. US exports
are also at record-high levels. Trump’s fiscal policy is likely to further
stimulate the economy and increase imports, irrespective of tariff levels.

We live in a globally integrated world where almost no piece of
machinery, equipment or consumer product is made in a single country
in its entirety. Parts are typically sourced from several places and even
assembly can happen in different locations. The same good can cross
borders a number of times before it is finalised. Detangling these
complex supply chains can be like unscrambling an egg. Another layer
of complexity is that companies from one country often export to another
from a third; the two biggest exporters of cars made in the US to China
are German (BMW and Mercedes). This also means that if you try to
block imports from China, there is a good chance that imports from
India or Vietnam will surge, doing nothing to reduce the deficit.

Markets tend to sell first and ask questions later, but it really does
appear too soon to argue that a full-on trade war is looming. There is
still plenty of time for the two sides to iron out an agreement (President
Trump – whose autobiography is called The Art of the Deal – loves to
burnish his credentials as a master negotiator). Within each country,
there are also powerful interest groups who would want to maintain
the status quo. Last week saw encouraging comments from both sides,
but also another shoot-from-the-hip threat from President Trump on
Thursday. While both sides have now announced, or are contemplating,
tariffs on some $200 billion in traded goods, the decline in market
value of global equities has been in excess of $1trillion since the tariff
spat began, clearly an overreaction. Looking ahead, with each
successive tariff announcement, the surprise factor will be less and
market response should be milder.

GLOBAL MACROECONOMIC BACKDROP STILL HEALTHY

However, it is safe to say that uncertainty is back on markets, particularly
regarding the unpredictable US president, and markets never like
uncertainty. But looking beyond this, the global economic picture is
still healthy. Growth is solid, inflation remains low and central banks
accommodative. After all, even though the US Federal Reserve is hiking
rates, they are still negative in real terms. In Japan and Europe, they
are negative in nominal terms. Companies are generating strong profit
growth. Major bear markets have historically only occurred during US
recessions (1987 was a notable exception), and there is no sign of a
looming recession in the US or any other major economy.
Therefore, investors who follow a considered approach, grounded by
a proper financial plan, can avoid a knee-jerk reaction to market
turbulence. After all, while corrections are always unpleasant, they are
also fairly common, especially after a strong run-up in equities.

NO PAIN, NO GAIN

To benefit from the superior long-term real returns from equities, you
have to be prepared to experience some short-term distress. An
appropriately diversified portfolio – like our Strategy Funds – will reduce
this discomfort, because not all asset classes have struggled. Buoyed
by lower inflation, a rate cut and the Moody’s reprieve, bonds have
delivered 8% returns year-to-date. But the discomfort can never be
eliminated completely in funds that aim to generate above-inflation
returns, since no one can time these ups and downs consistently.
It is also worth considering that a portion of most balanced funds –
usually around a quarter – is exposed to global markets directly and
the rand’s 14% appreciation against the dollar is a further dampener
on these returns. Should the rand depreciate in the near future – and
remember not too long ago many thought it impossible for the rand to
do anything but depreciate – this situation will reverse itself. The
importance of diversification is precisely that we do not know exactly
what the future holds, and therefore need to be prepared for a range
of outcomes.

SIT TIGHT, DON’T FIGHT OR FLIGHT

For investors, it is hardly comforting to hear that they should “sit tight”
or “focus on the long term” when faced with dramatic headlines and
disappointing returns. Instead, the fight-or-flight response tends to kick
in. This is normal. But remember that the fight-or-flight response evolved
in a very different set of circumstances, certainly before we were able
to do proper financial planning. When looking at markets, we should
do our best to ignore our instinctive reptilian brains and engage the
more reflective mammalian parts. One way is to remind ourselves of
the general principle that financial plans should be amended in response
to changes in your personal circumstances, but not in response to
changes on financial markets.

 

Details

Date

April 10, 2018

Author

The Wealth Room

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