- SA's looming fiscal cliff and debt issues are likely to be reflected in its asset classes, says the chief economist at Citadel.
- Investors need to look for exposure to those companies that offer some immunity against the local environment.
- The first bump in the road for SA will be the February Budget, which is likely to remind investors of the country's poor local economic fundamentals.
It is important to recognise that South Africa is currently lagging behind its peer group economically, and once the risk-on rally has faded and markets look past global drivers, SA's looming fiscal cliff and debt issues are likely to be reflected in its asset classes.
This is the view of Maarten Ackerman, chief economist at Citadel. He explains that the majority of earnings produced by JSE-listed companies are generated outside of South Africa. However, headwinds in the global environment could filter through to the local exchange as well, while a deteriorating fiscal situation and structural economic issues could hamper the prospects of those companies which operate only in South Africa.
Investors thus need to look for exposure to those companies that offer some immunity against the local environment.
"Investors should also bear in mind that, where the JSE in the past has acted as a useful proxy for emerging markets, as more and more emerging markets become Asia-Pacific focused, they should consider adding other emerging market exposure to achieve true diversification," says Ackerman.
"It is also worth noting that, while the local bond market is one of the few in the world that may generate positive returns for investors in 2021, this should be treated with caution and investors should rather consider taking profits or even go underweight."
Bond yields were trading around 9% in March 2020 and, following the Moody's downgrade to sub-investment grade, these yields went to 13% to compensate investors for the higher risk of government default.
"Since then, however, yields have returned to 9%, seemingly indifferent to the fact that our fiscal situation has significantly deteriorated due to the pandemic, and that our budget deficit will be twice the size anticipated at the start of 2020. In light of this, it is highly unlikely that the local bond market will continue to trade at current levels indefinitely," he adds.
Prospects for the rand
The rand trading below R15/$ clearly reflects international factors such as the US election outcome, vaccine developments and an abundance of liquidity, in his view.
"The first bump in the road, however, will be the February Budget speech, which is likely to remind investors of our poor local economic fundamentals. Eventually, as investors wake to South Africa's economic reality, the rand will come under some pressure again," he says.
"So, while the rand is currently enjoying the benefit of global tailwinds, it is likely to weaken during the course of the year. However, the extent of this weakening will ultimately depend on government’s progress on fiscal reforms, without which we could see the local currency head north of R18/$."
"So far, foreign investor support from the local bond market together with the IMF's loan have kept the country from feeling the worst effects of the pandemic's devastation. But the holiday will eventually end, and government will need to tighten its belt significantly at the end of the three-year fiscal framework, or towards the end of 2022 and moving into 2023 – especially as its first IMF loan repayment will come due."
He points out that even before Covid-19 hit, South Africa had travelled a long way down the road towards a fiscal cliff on the back of an unsustainable and unhealthy government budget.
"The pandemic simply accelerated the journey to the precipice. If we are to avoid a sovereign debt crisis or the risk of defaulting on our loans, government will urgently need to implement long-awaited structural economic reforms, and markets will be watching for evidence of action rather than simply more talk over the next 12 months," says Ackerman.
Global view Investors should not allow themselves to be "carried away" by the current more upbeat markets at the start of the new year, cautions Ackerman.
"Markets seem to have forgotten that the pandemic and its consequences are not yet behind us. Globally, there is a clear disconnect between market cheer and the economic situation on the ground, as many businesses and households remain under pressure while the global economic recovery slowly grinds forward," he says.
"Unemployment levels have risen worldwide, placing pressure on consumer income which will, in turn, impact on businesses and corporate profitability. Additionally, many companies and consumers will come under intensified pressure following a second wave of lockdowns."
At the same time, he points out that monetary and fiscal stimulus continue to underpin markets, buoying sentiment and valuations. Joe Biden's presidential win in the US has been seen as market positive, particularly in terms of global trade relations. Furthermore, though the speed with which Covid-19 vaccines have been developed and are being rolled-out are not an immediate cure for the global economy, their availability has boosted hope for a swifter-than-expected return to normality, in his view.
Where can investors turn?
Despite the many headwinds still facing markets, he says it is important for investors to keep in mind that the Covid-19 "reset" means the start of the upswing of a new business cycle.
"Although the road to recovery may be long, this is a positive for global equity markets, as companies usually only make sustainable losses during extended recessions or depressions. Furthermore, Biden is expected to borrow heavily to extend support for the US' social programmes, resulting in a softer dollar, which should in turn support riskier assets," says Ackerman.
"And with interest rates and the discount rate pushed to historic lows, cash and bonds hold little attraction for investors seeking growth, thus stimulating further demand and adding support to equity markets." He says to understand this trend, it's important to note that in a world of negative real rates, leaving money in cash in the bank is no longer "safe" in terms of achieving above-inflation growth.
Given the amount of debt currently in the financial system, it is highly unlikely that central banks will normalise rates over the course of 2021, in his view. Instead, central banks are more likely to keep manipulating the short-end of yield curves, or to keep interest rates below inflation or close to 0%, in order to afford the debt generated by unprecedented fiscal stimulus.
"With cash and bonds providing neither investment protection nor safety, investors need to consider alternatives that offer some protection while still providing cash-beating returns. The Swiss franc and Japanese yen represent some attractive options, as do gold and potentially cryptocurrencies.
Additionally, given the lack of alternatives, having a core allocation in global equity markets still makes sense at current valuations in order to achieve portfolio growth in excess of inflation," says Ackerman.
Understanding the risks
He cautions that equity investments are not without their risks, especially as many companies will face a challenge to earnings in the coming months, placing pressure on dividends and share prices. Perhaps the biggest risk is that central banks will withdraw stimulus before companies are able to generate reasonable profit numbers.
"Picking quality, fairly valued companies with a low risk of default or going bankrupt will therefore be particularly important in this tough economic environment. Additionally, investors need to look for companies that are well positioned for a post-pandemic world, and that are also well positioned for a world in which the fourth industrial revolution is gathering momentum – companies that can innovate, add new technologies and potentially act as disruptors," he says.