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JOHANNESBUGH (Capital Markets in Africa) – There are three big themes that we believe will dominate markets in the year ahead. These are Keynes is King, Reflation and South Africa Stabilises. The first two themes are about an improving world and better global growth, while the third theme is South Africa specific and has the biggest impact on the local asset classes in which we invest.
Keynes is King
The world has shifted. The big bond bull market is over and there is a move away from monetary policy stimulus to using fiscal stimulus to revive economic growth. Monetary policy (specifically low interest rates and quantitative easing) has gone as far as it can go in its effectiveness in boosting growth. The next step is fiscal stimulus − increasing government spending and/or lowering taxes to stimulate demand (an approach favoured by economist John Keynes). A more expansionary fiscal programme in the US will support growth and should result in global earnings going up in 2017. That is good for equities relative to bonds and within equities, it is good for value-style investing over growth-oriented shares and for cyclical over defensive shares.
With stimulus gaining some traction and global growth finally picking up, we are starting to see reflation – something developed market central banks have been trying to achieve for years. Reflation is primarily being propelled by US wage growth, which is driving increased consumer spending, and hence inflation. A rise in spending means increased demand, which will translate into better profits. While in the global equity bull market we’ve had multiple expansions, the thing that has been missing is profits. With the better growth, we think that earnings will come through and we believe earnings have the potential to surprise on the upside.
South Africa Stabilises
The other big theme for 2017 is “South Africa stabilises”. Effectively, South Africa had a disastrous 2016, but we expect conditions to improve in 2017. There are a couple of one-off factors that should facilitate a better year ahead.
The biggest factor is rain. The drought has broken and that will mean a good agricultural harvest. This, in turn, will bring food prices down and the consumer will have more disposable income.
Another supporting factor is inflation. While it recently hit an annual rate of 6.8%, we believe this is the peak and expect inflation to start coming down. A falling inflation rate will mean that we can expect the South African Reserve Bank to start cutting interest rates. Other factors supporting a stabilising SA are an improving global economic environment and the end of the commodity price collapse. This all translates into slightly better growth prospects for SA. After a tough period in terms of returns, with most investors making very little money in 2016, we think things will start improving in 2017.
Better earnings mean better returns, lower cash yields means cash is less attractive and lower inflation means we can get better real returns. Hence, our outlook is a bit more positive and that comes through in our expected returns over the next five years, which are higher in real terms.
Taking those expected returns on a basket basis for a balanced fund, our expected real return has increased to 4% a year over the next five years (up from our previously expected 3.5% a year). If we can get some alpha on top of that, we will be well placed to reach our target of 5% annual real returns for a balanced fund over the longer term.
Within our funds, we have shifted from defence to offence – investing cash into growth assets. For instance, at the beginning of 2016 the Old Mutual Balanced Fund had 25% in cash and today it has 7%.
This active asset allocation materially increases the chance of us delivering to our clients’ long-term return expectations.
Within the different asset classes, our return expectations are as follows:
South African Equities: We have increased our expected real return to 5% a year over the next five years, up from 4.5%. The market is cheaper, driven by the derating of some shares and strong earnings growth coming through from resources. The main headwind for the equity market is the strength of the currency, but following its strength last year, we expect a more stable rand this year.
South African Property: We have increased our expected longer-term real return for local property to 5.5% a year. However, this applies specifically to South Africa-oriented property companies. Those companies that have diversified into real estate overseas will have to contend with a rising cost of capital (as global interest rates rise) and a stronger rand. Conversely, the locally orientated companies will benefit from a falling cost of capital (on the back of expected interest rate cuts).
South African Bonds: We expect a real return of 3% a year from local bonds and our preference is for nominal bonds over inflation-linked bonds, as inflation has peaked and should come down.
South African Cash: Cash has been an attractive asset class over the last year, beating equity, but it is not a long-term option. With the economy on its knees and inflation falling, we expect rate cuts despite US rates rising.
Global Equity: Despite the reasonably high valuations, we’re optimistic that global equity will have a decent 2017. This will be driven by the improved macroeconomic environment flowing through into company earnings, especially where margins are depressed. As a result, we have an overweight position in value-orientated shares instead of growth shares.
Global Bonds: The expected returns on global bonds are actually improving as yields rise. However, we remain secular bears and continue to avoid the asset class.
Global Cash: Cash yields remain derisory, although the world will have to adjust to rising US interest rates.
This article is featured in the March 2017 edition of INTO AFRICA Magazine, Africa’s Lions: Trust in Fundamentals.
Peter Brooke, Head of MacroSolutions, Old Mutual Investment Group. Peter joined Old Mutual in May 2005 and has been the Head of Macro Solutions since 2007. He has specific responsibility for the dynamic funds − the higher return funds within the Macro Solutions range. These include institutional funds, such as the Profile Edge 28 Portfolio, and unit trust funds: Old Mutual Maximum Return Fund of Funds and Old Mutual Flexible Fund.
Having analysed countries and companies, Peter integrates top-down and bottom-up drivers and valuations to create an optimal portfolio. He has won a Raging Bull award for the best risk-adjusted fund in the overall prudential asset allocation category.
Peter is an award-winning analyst who has extensive experience in the investment arena. Prior to joining Old Mutual, he worked at a stockbroker for 10 years, as an analyst and equity strategist, and was the Head of Research and Head of Equities for Cazenove South Africa.