Wealth Intelligence Weekly - 3 June 2019
May's market mayhem
Another red week on world equity markets topped a red month as investors digested more nasty trade-related surprises. US President Trump threatened tariffs on Mexico to force it to halt illegal immigration into the US. While there were legitimate concerns behind Trump's stance on China, using tariffs to address an issue that has nothing to do with trade is something completely new. Meanwhile, China has hinted that it could block exports to the US of so-called ‘rare earth' metals widely used in the manufacturing of electronics.
After a strong start to the year, risk assets sold off heavily in May as Trump reignited his trade war, with negative implications for global growth. Markets tend to overreact, and rather than pricing in slower growth, talk of a global recession is mounting. The MSCI All Countries World Index lost 5.8% in May, dragging year-to-date returns down to 9.4% in US dollars. The index is back in the red over 12 months. Emerging markets were particularly hard hit, being more exposed to trade and investor sentiment. The stronger dollar also hurt. The MSCI Emerging Markets Index lost 7% in May in US dollars. This means the JSE's dollar return was similar to the broader emerging markets index. In rands, the JSE All Share Index lost 4.8% in the month, which reduced 2019 returns to 7.1%. This is still ahead of cash, but over one year local cash has beaten equities.
As investors fled to safety, developed market bonds rallied and yields declined (bond prices and yields move in opposite directions). German and Japanese long bond yields dipped deeper into negative territory to levels last seen in 2016. More ominously, as US bond yields declined, the yield on the 10-year Treasury fell below that of the three-month Treasury bill, known as an inversion of the yield curve. The former reflects longer-term growth, interest rate and inflation expectations, while the latter primarily reflects the Federal Reserve's current interest rate stance. An inverted yield curve has in the past been a reliable indicator of a looming recession, though with a lag of anything from one to 12 quarters. It is always dangerous to say "this time it's different", but it is hard to see what exactly will cause a recession in the US in the next year or so. Tariffs are unlikely to be the culprit by themselves (though they could weigh heavily on China as companies shift production elsewhere). But the uncertainty could result in US companies postponing hiring and investment decisions, which would slow growth. Potential price increases are unlikely to be high enough to derail consumer spending.
Consumer spending remains healthy in the US and Europe, benefiting from low unemployment, low inflation and modest wage growth. The 10% decline in oil prices in May will also help. Data on Friday showed consumer spending beating expectations in April, growing 4.2% from a year ago. Persistent weakness in trade of manufactured goods could drag consumer spending down if job losses spread - especially if supply chains crossing the Mexican border are disrupted - but it is more likely that consumer spending will eventually lead to rising manufacturing production. Manufacturing is relatively small as the US economy is dominated by services.
Crucially, the US Federal Reserve's shift in its interest rate stance means it is not going to squeeze the economy further. If the Fed becomes worried about a weaker economy and tightening financial conditions (with a strong dollar a notable culprit), it will cut. The market is betting that this will happen sooner rather than later. In a speech last week, Fed Vice Chair Richard Clarida stressed that while the central bank thought the US economy was in good shape, it was "very attuned to potential risks" to the outlook for the economy. Since home loans are linked to US long bond yields (unlike in South Africa where they are linked to the prime rate), consumers can refinance them at lower interest rates. For these rates, the market is cutting on behalf of the Fed.
China's policymakers also have plenty of tools to stimulate the economy should it slow significantly. Of all the major economies, Europe is most constrained. The European Central Bank did not raise interest rates so it can hardly cut. On the fiscal side, European authorities remain obsessed with reducing debt, so there is little appetite for stimulus. The attempts by the government of Italy to prop up its depressed economy with a bit more spending is facing serious resistance from the European Commission in Brussels.
For local markets, the global risk aversion was exacerbated by a delayed Cabinet announcement. When it was eventually made, the response was broadly positive. Continuity at the key finance and public enterprises as well as mining ministries will be reassuring to investors. However, the reduction in the number of ministries from 36 to 28, while welcome, hardly amounts to the radical reconfiguration and streamlining of government that many hoped for. The substantial number of deputy ministers confirms the fact that Cabinet appointments are as much about balancing the various interests in the ruling alliance as it is about getting the best team in place. President Ramaphosa's ambitious reform agenda will likely be constrained by the internal politics of the ANC alliance, but at least most ministers are known to be Ramaphosa backers.
The most urgent item on that agenda is Eskom, whose financial position appears more precarious by the day. There have been no further announcements on how the troubled utility will be restructured, while estimates of required financial support to manage its massive debt burden are increasing. Fortunately, there has been no further sustained load-shedding since March. As several commentators pointed out last week, Telkom's latest results show that a state-owned company can be turned around when a strong management team is allowed to make unpopular decisions.
The local economy should benefit from President Ramaphosa's rebuilding of state institutions, but the road to much stronger growth is a long one. With Eskom requiring support, there is no scope for fiscal stimulus. In fact, government spending will probably have to be cut further to make room for a bailout. Monetary policy — the SA Reserve Bank's interest rate stance — remains too tight. With inflation at 4.4%, the real prime rate is almost 6% (the actual average interest rate on household debt is 12.7% according to the Reserve Bank, 8% in real terms). Structural reforms to make it easier to do business and to crowd in the private sectors in some of the activities currently dominated by the state (such as electricity) is one of the few levers policymakers can pull. This requires putting political capital to work. The other lever is the far more nebulous concept of confidence. Giving business leaders greater certainty about policy developments will benefit the economy, particularly around reliable electricity supply and land reform. When they feel more optimistic about the future, they will start investing for the long term.
From a portfolio point of view, this does not matter nearly as much as most people think. While the political intrigue behind the Cabinet announcement contributed to currency volatility, it is ultimately a strong US dollar and global risk aversion that saw the rand lose 2% against the greenback.
A booming local economy is also not a prerequisite for the JSE to do well, as it is dominated by globally focused firms and benefits from a weaker rand. High prevailing interest rates are negative for growth, but a boon for investors, and counterweight to equity volatility in a diversified portfolio. The opposite is true of developed market bonds. Though it has benefited from investor angst, yields are even more unattractively priced to deliver longer-term returns. For global equities, volatility is likely to persist for some time until there is some clarity on the US-China trade war. But in the end, investors will probably recognise that in a world of moderate growth, low inflation and low interest rates, equities remains the best asset class.
With the benefit of hindsight, May was a very bad month for risk assets and the old adage "sell in May and go away" seems to apply on first glance, especially after April was such a strong month. The problem is that when they "go away" many investors never come back, or only come back after the market has run. Successfully timing the market is not something anyone can get right consistently and not something we attempt to do.