South African equity markets are currently undergoing the highest level of volatility on record, driven by global growth factors, domestic policy issues and uncertainty about the Chinese economy.
This is according to Head of Old Mutual Investment Group’s Macro Solutions boutique, Peter Brooke, who says that he expects the current situation to improve in 2017, but in the meantime the remainder of 2016 is going to be a challenge for investors.
Speaking at Old Mutual Investment Group’s second quarterly media briefing for 2016, Brooke explained that dispersion is responsible for the increased volatility that we are currently seeing in SA markets, and that he and his team have been looking at this as one of their major themes for some time. “The fascinating element is how our other three major investment themes all feed into and drive this volatility theme,” he says.
“Our ‘Purgatory’ theme is based on the fact that global growth is currently trapped as there is not enough growth to break out, but enough stimulus to avoid going into a recession,” he says. “Because the global economy is running at a lower level of growth, we are essentially much closer to the zero bound, or falling into recession. This is the issue that global markets are obsessing about, which is driving higher volatility as investors swing between fear and greed on the short-term ebb and flow of macro-economic data.”
His second key theme is ‘South Africa suffers’ which we have been seeing for some time now. “South African market volatility has shot up recently, driven by domestic political issues. However, this isn’t as likely to continue, given that SA has seen the error of its ways and has reversed some of its mistakes,” says Brooke. “This is therefore a theme that can actually recover somewhat, but has driven the volatility of our currency and bonds up sharply, which in turn exacerbates share volatility through interest rate sensitive stocks and currency plays.
“In addition, our third theme, “China in transition’ is based on slowing Chinese growth and how structurally there needs to be a shift from investment to consumption. However, managing the transition of the largest economy in the world is fraught with risk, exacerbated by the very high levels of corporate leverage. The recent slowdown in growth and the resultant aggressive stimulus exemplify this problem, while speculative flows exaggerate its impact.”
Brooke explains that the South African equity market is particularly vulnerable to these macro-economic themes. “As a small open economy with one of the most liquid emerging market currencies we are like a cork in the ocean. Worsening the volatility is the make-up of our market with a very large resource component and large locally listed global stocks. Even the gold shares have displayed moves of over 500%.
“A key point to note when talking about this extreme volatility is that it is actually cross-sectional dispersion, meaning the volatility between the different shares rather than the market as a whole,” he explains.
“This current situation has important implications for our market in terms of the allocation of capital,” says Brooke. “Because of higher volatility levels, investors need to be rewarded for risk. Based on our valuation work, we do not see this reward in SA equity and are looking for alternatives such as global equity, private equity and hedge funds.
“One of our major concerns is about South African corporate profitability. Inflation has gone up to 7%, with food inflation peaking around 15%, which is ultimately putting pressure on the consumer. This means spending power will come under pressure, and at the same time, the ability for companies to pass on cost increases has diminished, given that growth is under pressure based on higher interest rates.”
Brooke says that the good news is that we are already going through this process, with interest rates having already gone up and inflation accelerating. “As a result, we can start looking ahead to 2017 where things are expected to start improving, as inflation peaks and comes down again. With the South African economy starting to rebalance, exports growing and imports contracting, and the current account deficit narrowing, we’re starting to move towards a better place, but it is still too early to get there.
“This creates a better environment for the rand and bonds while still creating a tough environment for local profits.”
Consequently, Brooke and his team are overweight offshore equity, underweight South Africa equity, overweight South African interest-bearing assets and underweight offshore interest-bearing assets.
“This is based on where we see the best risk-adjusted returns. We’re seeing high yields in SA, but equities are going to be challenged by high volatility and multiples, while offshore equities are offering better yields than bonds and cash,” says Brooke. “We’re also running with more cash than we would normally hold, and are more positive on the rand than before.
“Overall, we’re looking for yield wherever we can find it, which is very much an absolute return mentality, without taking excessive risk.”