24 May Boom & Gloom: April 2016
Our View of the Investment Markets
This table reflects our view of the relevant assets, based on expected performance.
Asset Class Overview
South African equities, on an index level, trade at high multiples. From a quality prospective, return on equity (ROE) and earnings before interest, taxes, depreciation and amortization (EBITDA) margins are below the long term average, so there is potential for it to revert to average. Operating profits are above the long term average, making margin expansion less probable.
Our view is that the US interest rate hike will follow a placid path. China is stabilising, commodity prices are bottoming out and emerging market assets are generally attractively priced – which allows for a “hold” view on South African equities on an absolute basis. However we see more value on a relative basis in other equity markets, reflected in our underweight view.
South African bonds are being driven by three factors: US long bond rate expectations; emerging market risk (Risk on/off) and domestic risk, especially political risk.
We use the JP Morgan Emerging Market Currency Index as a proxy for the Risk on/off trade as well as the JP Morgan EMBI plus sovereign spread as a relative pricing indicator to US treasuries. We see a reasonable probability of some relief in emerging market currencies, resulting in some strength with a bit more stability over the medium term.
The weaker US dollar, as measured by the US Trade Weighted Dollar Index, brought some relief in the US interest rate markets. The US long bonds rallied to near record lows, due to a lack of inflation expectations. We do not foresee a dramatic increase in US growth and inflation over the next year, and expect the US 10 year bond to sell off to around 2.36% over the next year.
Domestic politics will strengthen in the run up to the local municipal elections, which will cause a negative bias on domestic bonds over the short term.
The South African domestic 10 year bond is trading close to Russia and Turkey (which each have their own challenges) but higher than India and Indonesia which have similar credit ratings.
Our South African 10 year bond macro model, prices the one year forward fair yield at 9.5% while the US 10 year implied model expects a 9.51% yield. The domestic bonds could rally a bit more if we see further rand strengthening, which will drive inflation expectations down. Our current one year South African inflation view is 6.4% increase over the next 12 months. If the rand’s strength maintains its momentum and settles around R13.50 – 14 to the US dollar, CPI could be 0.5% lower which will translate to a 9% fair value for the R186.
The current real short term interest rate is +1.1% (3 month Jibar is 7.3% and CPI is 6.2%). The South African Reserve Bank will manage the real short term interest rate over the long term around +3%. Given the weak growth fundamentals, one will expect the SARB to aim way below the long term average, but the risk of elevated inflation justifies the current level. We see the short end of the yield curve (around one year) as attractive, relative to other domestic asset classes.
We use the SARB composite business cycle indicator, SA Government Bond Index and inflation to model a macro view of the FTSE/JSE Property Index. One year return expectations is 4.4%, the market is currently 3% over-valued resulting in an underweight allocation.
Global equity markets
The table below illustrates the major regional equity indices valuation, ROE’s and margins. We favour Asian emerging markets and Europe from a growth, quality and valuation perspective.
AC – All Country; EU – Europe; EM – Emerging Markets; ME – Middle East
Total return to 30/4/2016, in domestic currency
Total return to 30/4/2016
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