June 2021 Update

Making the News

During June, the US Federal Open Market Committee (FOMC) kept the benchmark rate at c. zero percent, as was expected. Similarly, the Fed’s 2021 inflation forecasts were revised higher, in line with expectations. Most market participants however did not anticipate that the Fed would signal potentially raising rates twice throughout the course of 2023. The hawkish announcement pushed forward the first-rate hike expectation from early 2024 to the third quarter of 2023 in the Fed’s dot plot estimates of future rates. At the post-meeting press conference, Fed Chair Jerome Powell indicated that initial discussions around when the Fed should talk about tapering bond purchases have now started.

In South Africa, the country continues to grapple with Covid-19 and its effects on unemployment and GDP growth. The country’s vaccine rollout, although delayed, is gaining momentum, with over 4 million people vaccinated thus far. The pace is expected to accelerate as vaccine supply increases over the following months, assisting the country to move to a more normal post Covid-19 world. Although South Africa faces difficult challenges in the months ahead, it is important to highlight the structural economic reforms being taken in the country so far during 2021:

1. Firstly, the announcement that private companies will be able to produce up to 100MW of power is a significant step towards mitigating the effects of load shedding and reducing the national reliance on Eskom,
2. Secondly, privatising SAA through a 51% sale will lessen the burden of state bailouts on the country’s fiscal position,
3. Thirdly, action has been taken on corruption accused persons such as ANC Secretary General Ace Magashule being suspended, Health Minister Zweli Mkhize being placed on special leave, as well as further steps towards extraditing the notorious Gupta brothers from the United Arab Emirates,
4. And lastly, the judicial system proving its efficacy and independence with the issuance of an arrest warrant for former president Zuma for contempt of court. At the time of writing, the former President Zuma has handed himself in to the police and will now spend 15 months in prison.

Markets Commentary

A downward shift in sentiment in the commodity market towards the end of quarter two (and a stronger dollar on the shift in tone by the Fed) saw commodity prices drop off their recent elevated levels, and the Rand weakened by 4.1% against the dollar in the month of June. Despite the pressure on the Rand, the local currency remains one of the few emerging market currencies that have posted material gains of 17.5% against the US Dollar year-to-date. Over the second quarter, the currency still strengthened by 3.3% against the Dollar, and commodity prices remain at high levels relative to their history.

The price of Brent crude oil rose by +8.6% in June as demand increases globally due to the economic recovery. This however was not shared by commodity prices across the board with platinum (-9.3%), gold (-7.0%) and copper (-8.6%) declining as monetary authorities give indications of becoming less accommodative due to looming inflation. This coupled with a rampant COVID-19 third wave led to the local equity market (FTSE/JSE All Share index) pulling back by -2.4% in June. On a look through basis, the resource and financial sectors fell by -6.6% and -2.6% respectively, while the industrial sector managed to buck the trend and delivered a modest return of +0.6%.

Despite the pull back, the FTSE-JSE All Share Index remains up +13.2% YTD and +25.1% over the last year. Additionally, it is worthwhile pointing out the stark difference in performance between domestic companies and foreign earners. For example, small cap and real estate companies are up strongly by +65.2% and +25.2% respectively over the last year, while the likes of Naspers for instance is down -1.7%.

On the global front, global equities initially took fright when the US Federal Reserve brought forward to 2023 the date by when it expected US interest rates would first rise. Markets subsequently settled as the Fed downplayed inflation, supported by positive economic data and the vaccination rollout. Developed market (DM) equities rose (up +5.6% in June) with the US benefitting from the $1 trillion infrastructure stimulus announcement and the gradual return to normalcy. Additionally, emerging markets (EM) rose (up +4.3% in June), benefitting by the strong oil price and led by oil exporters Brazil and Russia. Returns over the last year are robust for DM and EM equities however SA has outperformed over the period given the material strengthening of the Rand.

The All-Bond Index remained buoyant during June, gaining +1.1% as the longer dated maturities outperformed. The SA bond yield curve continued to flatten during the quarter, with stronger commodity prices and the related improvement in the fiscal outlook supporting longer dated yields. Bond yields have recovered from the weakness seen in March; however, we anticipate some volatility in global bond markets as the Fed starts to signal their intention to taper asset purchases at some point in the coming months. All considered, we remain constructive on bond valuations on the back of recent progress in reforms, and continued commitment to fiscal consolidation shown thus far by National Treasury.

Impact on Our Portfolios

The CWM global models were beneficiaries of market developments in June (i.e. weaker Rand and stronger global equity and property markets). On the local front, CWM Income, Defensive and both regular income portfolios (RI-Growth and RI-Defensive) delivered positive growth between +0.3% and +0.8% during the month.

Local CWM models with a high weighting to growth assets, particularly local listed equity, were marginally negative during June. These models include CWM Balanced, Retirement Growth and Flexible which returns between -0.7% and -0.3% in the month. When measured over the last year, the returns generated by these models have compensated investors far in excess of inflation.

Overall, the first half of 2021 has been supportive to the CWM models and as a result, we are observing a pick-up in the five-year performance in the graph above. On the global side, our foreign house views continue to dominate performance given the weakening of the Rand coupled with the more robust offshore equity and property over the period.

Looking Forward

SA BONDS

As mentioned above, there have been several positive developments in SA during the first half of 2021. From a government finance perspective, a commodity-led export boom has resulted in the country recording a current account surplus of 5% of GDP in 1Q21, only surpassed by the surplus recorded in 3Q20 (5.9% of GDP); revenue collection is estimated to exceed the 2020 MTBPS projections by c.R100bn and there has been a moderation in the debt-to-GDP outlook over the medium term.

SA’s market-based inflation expectations also remain anchored around the SARB’s midpoint (i.e., 4.5%); our main trading partners are releasing improved leading business indicators; and our Constitutional Court has sent a strong anti-corruption message with its sentencing of former President Jacob Zuma. Despite all the positives, the South African local yield curve remains one of the steepest among EM nations. The SA 10-year bond offers an unmatched real yield spread of 7.2% relative to the US. Our view is that the risk premium embedded in the market is overdone. Below we outline our estimate of fair value, and the potential price return should there be a reversion to fair levels:

(As an aside, another argument in favour of bonds is the lack of a compelling alternative in listed property – the other local yielding asset class. The current real forward dividend yield of 0.85% p.a. does not compensate investors for the lingering uncertainty around the sector’s prospects and we remain underweight the asset class).

SA Equities

Two metrics that are closely monitored by economists and market analysts, but which often go unnoticed by the broader financial media, are the ABSA sponsored and Bureau of Economic Research compiled Purchasing Managers Index (PMI), and the South African Reserve Bank Composite Leading Business Cycle Indicator (CLI).

The PMI is released on the 1st business day of every month and provides timely updates regarding the level of overall activity in the local manufacturing sector. The factory sector is integral to the economy, as it provides inputs to the primary sector (agriculture and mining), while it is also exposed to the tertiary sector (e.g., wholesale and retail).

A PMI value above 50 indicates expansion and a sustained and rising level indicates an acceleration and broader diffusion of the expansion throughout the manufacturing sector. The average since inception in September 1999 has been 50.8. However, since August 2020, the index has not dipped into contraction territory (<50) and has averaged at an impressive 55.5. The data point is encouraging positive momentum in the engine room of the SA economy.

The SARB’s CLI looks at various economic data points that point to positive or negative momentum in the business cycle over the next 9-12 months (e.g. number of new building permits approved; order volumes in the manufacturing industry; number of passenger vehicles sold). Its usefulness lies in its timely release (well in advance of Stats SA’s official data) and its historical reliability in anticipating growth-cycle up/downturns.

Over the last 2 decades, the level of the index hovered around 100. Since August last year, however, the index level averaged 116. Key drivers for the uptick include improved terms of trade (measured by the Commodity Price Index for SA’s main export commodities); improving business conditions (as measured by the RMB/BER Business Confidence Index); and an acceleration in the number of job openings (as monitored in the Sunday Times).

While the PMI and CLI numbers seem to point to green shoots in the SA economy, viewed in isolation it fails to make out an investment case for SA equities. Valuation of the market at the point of entry remains the key determinant of prospective future returns. The graph below from Prudential Portfolio Managers looks at the Forward PE ratio for the SA Equity market over time.

The current multiple of 10x is in line with the 15-year average and suggests fair value. However, one needs to look towards the US market – which accounts for roughly 2/3rds of the global equity market cap – to appreciate the local opportunity. The S&P500 forward PE is currently at an imposing 21.5x (with a 25-year average of 16.7x). Put simply, the US market is double as expensive as the JSE and in our view warrants an underweight position in portfolios.