Economic & Market Overview - September
Equity markets around the globe had a tough August against a backdrop of economic and socio-political news flow, which reflected slowing global trade, as well as uncertainty with regards to political policy. According to Tantalum Capital, the G7-summit provided few noteworthy developments, other than a chance for President Trump to further his “America First” agenda. The US-China “eye for an eye” trade conflict did not do investors (other than those holding US Treasuries and gold) any favours. Despite some attempts by the Trump administration to allude that a deal is still possible, the latest tariff announcements from the US, followed by retaliation by their Chinese counterparts, represent a significant escalation in the trade war. The very nature of the uncertainty around how tensions may further escalate is becoming a great concern for economists, heightening risks of a reduction of investment due to a drop-in business confidence. As if this is not enough to upset the global equity apple cart, Prime Minister Boris Johnson announced the suspension of the British Parliament, from the second week in September to the middle of October, in a move which critics argued is an attempt to hinder members of parliament to block a no-deal Brexit.
As a result of the slowdown in worldwide trade, global manufacturing is slowing down at an alarming pace too. According to the World Bank, this sector of the economy makes up 15% of global GDP, and a contraction in manufacturing does not bode well for future growth expectations. In contrast to the rest of the world, the US economy seems to hold up reasonably well… for the moment at the very least. The release of the July meeting minutes of the Federal Reserve’s Open Market Committee, highlighted a divided view among its members and suggested that further easing in US monetary policy may be more muted and delayed relative to market expectation (and to the chagrin of President Trump). With retail sales, employment and manufacturing data in the US still showing decent growth, core inflation in the US is now back at 2.2%, a little above the Federal Reserve’s target of 2%. This explains why there is a strong argument for the Fed to overlook economic weakness in the rest of the world and maintain positive real US interest rates for a bit longer. This would support the current US Dollar strength against its trade basket – another development which will have President Trump up in arms.
South African markets struggled, not only against a gloomy global outlook, but also against weak local economic data, Moody’s rating concerns, a delay in the restructuring of Eskom and political discontent – particularly about the possible implementation of prescribed assets for pension funds and developments around the latest National Health Insurance (NHI) proposals.
Towards the end of the month, there was a silver lining though as Finance Minister Tito Mboweni published an economic strategy for South Africa. It is a comprehensive, detailed strategy and generally pragmatic. Most of the ideas have featured in policy proposals before, though some of the proposed (micro) interventions are fresh. Most importantly, this brings together the entire range of policy proposals and creates a sense of policy coordination and a holistic view of the required interventions (mostly from government, but in many areas, it acknowledges that private sector contributions are not only required, but extremely helpful). The immediate response of financial markets illustrated that it was viewed in a positive light.
The general emphasis of the plan is on improving SA’s competitiveness, making it easier to do business, and easing growth constraints; it also aims to create much needed policy certainty. To boost growth, the strategy focusses on:
• improving network industries to improve competitiveness,
• lowering the barriers to entry to stimulate new business formation,
• prioritising labour-intensive growth to boost wage growth,
• creating more focused and flexible industrial and trade policy, and
• improving export competitiveness and regional trade
It’s early days for this initiative but it holds promise in terms of both business and consumer confidence. Just imagine what could happen if the Springboks manage to hold the Webb Ellis Cup on 2 November – coupled with Treasury’s plan - it could be the catalyst for a significant boost to the local economy.
Except for bonds and some precious metals (gold in particular), most global and local asset classes retreated during August. Global equities (measured in US Dollars) ended the month 2.3% down while emerging market equities gave up nearly 5%.
The yield on the US 10-year US Treasury bond had a sharp decline from 2% at the end of July to around 1.5% at the end of August on the back of a deteriorating global growth outlook. South African bond yields also ended the month broadly lower, leading to a 1% gain in the All Bond Index.
South African equities continued to struggle in August after a similarly tough July, and the broad FTSE/JSE All Share index again ended the month 2.4% lower. Financial and industrial stocks gave up in excess of 3%, with resource counters shedding only 0.2%. The Rand’s weakening trend against the US Dollar continued as it gave up more 6% during the month. It was not the only emerging market currency to struggle though – the US Dollar managed gains against most developing currencies during August.
Commentary – Diversification remains the one free lunch
We’re all familiar with adage saying that “there is no such thing as a free lunch” meaning that it is impossible to get something for nothing. It has its roots in the tradition of saloons in the United States’ Wild West which offered a free lunch (made up of foods with a high salt content) to each customer that bought at least one drink. Once the salt did its trick the margin on increased liquor sales more than made up for the cost price of the lunch. So clearly the lunch was not for free.
In the 3rd Millennium BC, Chinese merchants’ approach to risk management would have challenged the concept that there is no such thing as a free lunch.
These merchants, travelling treacherous river rapids, would redistribute their wares across many vessels to limit the loss to any one merchant due to any single vessel's capsizing. They understood what it meant to not put all your eggs in one basket.
Because there is no cost (or only a marginal cost) to distributing your goods over more than one vessel, the merchants did indeed get a free lunch – a reduced risk of losing everything. This is true for investments also. An important consideration in constructing an investment portfolio is how much return investors could expect for the extent of risk that they’re willing to take.
Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximise returns by investing in different areas that would each react differently to the same event.
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimising risk. Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is a risk that investors must accept.
The second type of risk is diversifiable. This risk is also known as unsystematic (or idiosyncratic) risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.
Let's say you have a portfolio of only gold mining stocks. If it is announced that gold miners are going on an indefinite strike and that all mining operations are halted, share prices of gold mining companies could drop. That means your portfolio will experience a noticeable drop in value.
If, however, you counterbalanced the gold miner stocks with a few platinum stocks, only part of your portfolio would be affected. In fact, there is a good chance the platinum stock prices would climb, as consumers turn to platinum as an alternative base for luxury jewellery.
You could diversify even further because there are many risks that affect both gold and platinum mining. An event that negatively impacts any form of mining hurts both types of companies. Statisticians, for example, would say that gold and platinum stocks have a strong correlation.
Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your share price movements are, the better. It's also important to diversify among different asset classes. Different assets such as bonds and equities will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio's sensitivity to market swings. Generally, bond and stock markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.
Finally, don't forget location, location, location. Diversification also means you should look for investment opportunities beyond your own geographical borders. After all, volatility in the South African stock market may not affect stocks and bonds in developed markets such as the United States and Europe, so investing in that part of the world may minimise and offset the risks of investing in South Africa only.
Most South African based balanced portfolios aim to achieve these diversification objectives. Diversification can help an investor manage risk and reduce the volatility of an asset's price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely. Your fund manager can reduce the risk associated with individual stocks and bonds, but general market risks affect nearly every holding in the portfolio. The key is to invest in a portfolio that finds a happy medium between the risk you’re willing to take and its expected return over the investment term. This ensures you can achieve your financial goals, while still getting a good night's rest.
During the following month communication will go out to all clients currently invested in the APS Suit of Funds.
The purpose of this is to announce our change from fund of funds to "clean pricing" funds as it is the direction of the industry as a whole.
The change-over will result in a reduction of total investment charges and greater flexibility in the funds. You are kindly requested to support the change by completing the one-page ballot form and vote in favour of the change-over. More information will follow in due course.
Source : APS Monthly Economic Commentary