A new normal emerging?

David Crosoer: Executive: Research and Investments at PPS Investments
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Five years after the unprecedentedly loose monetary policy put in place after the global financial crisis, the global economy is slowly adjusting to a more normalised world. Although economic conditions are beginning to improve in developed markets, for investors the starting point of exceptionally low interest rates and stretched equity valuations place considerable headwinds on the ability of investment markets to deliver strong returns on their own.

After threatening to start tapering economic stimulus in May 2013, and partly backing-off in September, the US Federal Reserve finally committed in December to reduce its monthly purchases of US Treasuries and mortgages from $85 billion to $75 billion per month. Arguably (because the change is fairly nominal and because it is conceivable that this decision could be reversed should economic conditions not improve further), this signals the start of the end of the unprecedented monetary support that has affected global markets since the financial crisis in 2008.

The eventual re-pricing of risk (i.e. the normalisation of short-term interest rates) will have a profound impact on the pricing of assets across the globe. As markets are forward-looking machines, this re-pricing could occur before short-term rates actually rise (which in the case of the US could be as late as 2016).

The US 10-year bond re-priced aggressively in the latter half of 2013 to reflect a potential normalisation of short-term interest rates, and traded close to 3% at the end of December. While somewhat below its long-term average of around 4%, this was significantly higher than where it had traded before talk of tapering occurred. Similarly, South African bond yields traded higher in sympathy and ended the year trading at around 8%.

South African and global equities are also vulnerable to a re-pricing of risk. Both global developed market equities (in USD) and South African equities (in ZAR) delivered strong returns in 2013 in the absence of strong earnings growth. In fact, shares able to maintain earnings have been strongly re-rated. As a consequence of this, the South African equity market ended the year trading on a price-earnings multiple of over 18 times earnings, significantly higher both than where it started the year and than its long-term average of around 12. It is unlikely that earnings growth in aggregate will be sufficient to justify these lofty valuations, and a number of shares on such valuations are vulnerable to a re-pricing even if economic conditions continue to improve.

CPI inflation threatened to breach the upper limit of its 3% to 6% band for most of 2013 (exceeding it in July and August) and the rand has been under considerable pressure from South Africa’s significant current account and budget deficits. These deficits have been in place since the financial crisis and now look more difficult to finance in the presence of tapering from the United States.

The weakening of the rand (making our exports more competitive) and the recovery in developed market economies (increasing demand for our exports) should ultimately help to improve our economic fundamentals. The World Bank, for instance, states that the advantage from higher export growth for emerging economies should more than offset the reduction in capital flows that have allowed these economies to run large deficits. Of course, this fairly benign view rests on the assumption that the adjustment in capital flows will not be disorderly (which could have a very negative impact on the rand) and that South Africa will actually be in a position to export in its strike-prone export industries.

In line with market expectations that the South African Reserve Bank would raise interest rates in the first half of 2014, a repo rate hike of 50bp was announced on 29 January. The challenge facing the SARB is that the South African consumer remains in considerable distress, and there is no sign of excess demand in the economy. In fact, South African inflation has been remarkably well-behaved and in 2013 only briefly breached the upper 6% target band in July and August.

The adjustment to a more normalised world may still be some way off given the magnitude of the overleveraged mess left behind after the financial crisis. It will also not be without its challenges. In such uncertain times it is prudent to remain well-diversified across both strategies and managers who can take advantage of opportunities as and when they materialise.

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This edition

Issue 72