It’s the time of year when investment and economic commentators gaze into their crystal balls and come up with an outlook for the months ahead. While these forecasts can be both interesting and entertaining, they are too often wide off the mark, and the more precise they are, the more incorrect they tend to be. However, it has to be said that the general outlook at the start of 2018 appears healthier than it has been for a number of years.


But before we get into that, let’s do a quick recap of three important lessons from last year.

Don’t overreact to “noise”

After much gnashing of teeth, South Africa (SA) was downgraded to junk status following the firing of Finance Minister Gordhan in March. Another round of downgrades followed in November as a result of the mini-budget’s shocking projections. Interest rates, however, did not surge as many predicted, and the rand actually ended the year stronger against the US dollar. Why?

Markets respond to the factors that give rise to ratings changes—weak economic growth, rising government debt, financial challenges at Eskom— in real time, long before the ratings agencies do. Much of the bad news, including the downgrades, was priced in by the time the agencies made their official announcements. The international backdrop also helped, with foreign investors hungry for higher yields irrespective of credit rating. The muted market response to the downgrade reiterates that investors should not overreact to negative news headlines, and that international trends also need to be considered.

Stay invested

The FTSE/JSE All Share Index posted an excellent return of 20% in 2017, most of which came in the second half of the year. The blistering rally kicked off at a point in time when things were looking particularly bleak locally: SA had just been downgraded to junk status, was in a technical recession, and faced major political uncertainty.

While many investors would have been tempted to sit on the sidelines and wait for the “dust to settle”, such unexpected rallies are not uncommon, and highlight the difficulty of trying to time exit and entry points into the market. This demonstrates the importance of staying invested (“time in the market, not timing the market” is a cliché but no less true). After all, the All Share delivered almost three times more than cash in the bank in the second half of 2017.

Diversification is key

While the local investment community was divided over Steinhoff’s aggressive debt-fuelled global expansion path and exceptionally low tax rate, even the sceptics would have been shocked by the revelation of suspected accounting manipulation. Analysts, ratings agencies, regulators, banks, and crucially, independent auditors, have all seemingly had the wool pulled over their eyes.

While full details have yet to emerge, this proves that it is clearly possible to deliberately deceive even some of the sharpest minds in finance and auditing.

Passive investing would not have helped either as index trackers would have had to hold Steinhoff shares at benchmark weight, and it was one of the largest companies on the JSE. The real lesson is that the best defence against such an unexpected event is diversification. A diversified portfolio would have suffered a bit of a knock, but not a wipeout.

Looking ahead globally

The good news is that global growth ended 2017 on a high note, and this positive momentum looks set to carry over into the new year. All the major economies—including the US, Europe, Japan and China—are growing at the same time, constituting the first “synchronised” upswing since the end of the Global Financial Crisis in 2009.

It is not that global growth is historically strong now—it is pretty much in line with long-term average growth—but that over the past decade we’ve become so used to mediocre growth, not only because consumers gradually reduced debt and banks repaired their perilous finances following the GFC, but further shock waves tripped up various large economies. Think of the US fiscal cliff and Japanese tsunami in 2011, the Eurozone debt crisis which reached a crescendo in 2012, and the commodity price collapse that accelerated between 2013 and 2015 and pushed the likes of Russia and Brazil into deep recessions. Instead, we could very well now be at the early stages of a virtuous cycle of rising confidence, faster economic growth, job creation and fixed investment spending.

Favourable backdrop for markets

With stronger economic growth, companies can grow top line revenues. The bottom line is helped by the fact that financing costs (interest rates) are still very low and that wage costs are increasing very slowly. US companies have just been given a further gift of a massive corporate tax cut, from 35% to 21%. All of this is positive for shareholders. As the world economy returns to normal, interest rates should also rise, but with inflation still low around the world (but no longer so low that central banks are panicking about potential deflation), interest rate increases are expected to be gradual. All in all, it is what many commentators have called a “goldilocks” environment—not too hot (i.e. no overheating and runaway inflation) and not too cold (in terms of economic activity)—for financial markets.

Local outlook also better

The outlook for SA is also (and quite suddenly) better. To understand why, it is important to realise why things were so dire to begin with. Between 2013 and 2017, the global environment was extremely unfavourable towards SA: commodity prices collapsed, capital flowed out of the country (and other emerging markets) and the rand fell sharply, putting upward pressure on inflation and interest rates.

The country also experienced the worst drought in a century, which not only hurt the farming community, but also resulted in a food price shock. And then there were the “own goals”, including load-shedding, restrictive new visa rules, surprise cabinet reshuffles and political uncertainty in general.

In terms of the global environment, things are now much more favourable towards us. The global economy is finally firing on all cylinders, and SA—as a small and open economy—tends to follow the global cycle with a bit of a lag. Commodity prices have firmed up and capital has been flowing into emerging markets.

It also looks like we’ll see fewer own goals being scored this year. Specifically, sentiment around the political situation has improved substantially following the ANC’s December elective conference at Nasrec. Since winning the ANC presidency in a tight race, Cyril Ramaphosa has made all the right noises in terms of focusing on economic growth, investor confidence, combatting corruption and fixed state owned enterprises specifically. The latter is crucial, because though Eskom is no longer crippling the economy with rolling blackouts, it risks doing so with its debt burden. It is too early to tell to what extent he can walk the walk, since there are a number of constraints on his ability to implement wholesale reforms.

The rand roared ahead when it became apparent that Ramaphosa would win. The 10% rally against major currencies gives an idea of the kind of risk premium foreign investors attached to SA because of political uncertainty. A stronger currency improves the inflation outlook, which means that the real income growth of South Africans can improve. Since South Africans tend to spend what they earn, real income growth is the main determinant of consumer spending, which in turn accounts for around 60% of economic activity.

SA households have also not been borrowing to spend, and have instead reduced debt relative to income over the past decade. A bit of borrowing growth could lift spending further. The other benefit of lower inflation is that it gives the Reserve Bank some room to potentially cut rates once or twice later this year.

The big potential headwind for consumers will come at the February Budget. The SA government needs to stop the unsustainable growth in its debt level, but its tax revenues have grown disapprovingly slow. At the same time, the ability to cut spending is limited and the announcement of free higher education for low income students just adds to the long list of spending needs. Tax rate increases are therefore likely, possibly even an increase in the VAT rate.

If the economy surprises on the upside – if we also have a virtuous cycle of sentiment, growth and investment, all of which are low and with plenty of room for improvement – tax revenue collection should also improve and limit the need for tax rate hikes. This is the tricky balancing act the Minister of Finance (whoever he or she will be in February) will have to follow: hike taxes too much and you might hurt the economy and end up getting even less tax revenue.

Investment implications

Regarding the investment implications, the current environment is clearly a positive backdrop for local bonds—the one local asset class that offers clear value. Despite the recent rally, however, bond yields are still higher than average and well above expected inflation. For equities, companies that focus on the domestic economy, and which have understandably been under some pressure in recent years, have the ability to improve earnings growth.

The JSE, however, is dominated by companies that do business globally, and while they should benefit from stronger global growth and firmer commodity prices, these shares are impacted in the opposite direction by the rand exchange rate than domestically-focused shares.

This makes things tricky in the short term. If the rand strengthens, it could drag down the JSE at an index level but some sectors will do very well. Because of these global players listed on the JSE, the overall local market also never became cheap, even as the domestic economy struggled. However, bear in mind that it is a handful of global shares—Naspers, Richemont, British American Tobacco, and the mining giants —that drive the headline index. Though they offer exposure to global growth and protection against a weak rand, and do so without running into the complications of capital controls, where possible it is better to get these benefits in a less concentrated manner. In other words, through a broad basket of global equities.

One final thing to consider when thinking about the year ahead

Humans like to categorise things in precise boxes like calendar years, which is why each year starts with an investment outlook and ends with a review. But markets are not bound by such distinctions. Good periods will necessarily be interspersed with periods of mediocre or downright negative returns, without sticking to a schedule. What matters then is that investors benefit from the strong months and years as they come along, which has resulted in historically good real returns over time. To do so requires the patience to sit through periods of disappointing returns, as the experience of 2017 again highlighted. 

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