By Kevin Lings and Vaughan Henkel
In today’s interconnected, fast-changing world, you need deep investment insights to make the connections between many seemingly unconnected factors. Kevin Lings and Vaughan Henkel takes a look at a range of factors to help you make better investment decisions in 2017.
Since 2009 investors have witnessed one of the longest periods of global economic expansion in history. It may not seem like it though. Expansion has been weak and well below long-term average, but it has been expansion.
Between 1995 and 2005, the US economy produced an average rate of annual gross domestic product (GDP) growth of around 3,5%, regularly reaching over 4%. Since 2009, US GDP growth has averaged 1,5% per annum. This is despite significant stimulus from the US Federal Reserve through low interest rates and quantitative easing (QE). Other central banks, most notably the Bank of England, European Central Bank and Bank of Japan, have also pumped money into their economic systems.
South Africa’s economy has averaged growth of only 1,2% over the past three years, while the growth forecast for South Africa during 2016 remains modest at a mere 0,3%.
The question this raises is what happens next?
To understand where the markets may be headed, it’s worth reflecting on the current scenario. Market volatility, low global economic growth and global political uncertainty – from the US elections to Brexit – have made 2016 a rough and interesting ride.
In 2017 we can expect more of the same. But amid the volatility, there are signs of some stability and sustained growth.
The big five
The extensive and prolonged monetary policy response has not produced the rebound in global economic growth most analysts and central bankers anticipated, mainly due to five major factors.
First is increasing protectionism as a result of a backlash against the perceived negative effects of globalisation. Many countries have adopted more right-wing policies including protectionist measures to protect their trade.
G20 countries have more than tripled their number of trade restrictions since the global financial crisis, according to the World Trade Organisation. As there is a strong link between world trade and world growth, this has dampened economic growth.
Second, the cost of capital is at a historical low in developed markets, yet fixed investment activity has dwindled. Before the global financial crisis, fixed investment activity amounted to an average of 23,3% of GDP (from 1990 to 2008). Since then, the ratio has dropped to 20,3%, which equates to a significant USD1,3 trillion less spent on fixed investment.
Without sustained fixed investment expenditure, which includes infrastructure development, it is hard for most economies to gain traction in stimulating the economy through creating new jobs.
The third factor is the ageing population in the developed world. The average life expectancy was recently recorded as just over 70, whereas after the Second World War it was around 45 years. This in itself is not an issue, but having more people over the age of 65 dependent on others for an income is not ideal. This changes an economy’s growth outlook as more resources are diverted into supporting an elderly population.
This is not the case in South Africa, where we have a young, growing population.
Meanwhile, China is in the process of rebalancing its economy from predominantly fixed investment activity towards greater consumer household consumption. As a result, China’s demand for commodities is slowing, which has a negative knock-on effect on emerging commodity-producing countries.
If China is able to transition from an investment-based economy into one with a healthy mix of consumption and investment, it will easily become the largest economy in the world. In the meantime, it is undermining world economic growth in the short term.
Finally, on a global basis, the level of economic confidence is significantly lower now than before the global financial crisis. This is due to a combination of low economic growth, underpinned by a crisis of leadership in key Western countries, a growing wealth divide and rising levels of corruption.
The South African story
It is concerning that since the global financial market crisis in 2009, the rate of economic growth in South African has not been robust enough to lead to widespread job creation in the formal private sector.
Over the past year, the South African economy lost 112 000 jobs, mostly among lower-income groups. At the same time the official rate of unemployment has remained exceedingly high at 26,6%. The high rate of unemployment contributes to much of the country’s social tension, especially among the youth.
The current state of government finances includes higher levels of debt, a weakening tax base, the risk of a further credit rating downgrade, and the increasing demands for financial support from state-owned enterprises.
It seems clear that the public sector is unable to provide a significant additional economic stimulus in the form of government spending to boost the economy.
Instead, South Africa’s economic policy officials need to find a way to lift business confidence and encourage the private sector to play a bigger role in growing the economy. This is most likely to be achieved through targeted infrastructure development using private/public partnerships, as outlined by the Minister of Finance in 2016.
Where does this leave investors for 2017?
The economic backdrop locally and globally is not conducive to a strong earnings environment for equities while global bond yields are at 30-year lows. This limits the outlook for asset class returns, particularly when the past six years have delivered solid returns, in particular for rand-based investors.
With this in mind, it is worth highlighting that the most important goal of investing is to beat inflation. This is how you create real wealth.
The second most important consideration is time in the market. The power of compounding is best espoused by Albert Einstein (and although no one is quite sure if he said this, it is certainly good advice): ‘Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.’
So how do you choose how to allocate your investments between asset classes such as bonds, equities, property or cash in 2017?
Start by considering the key factors that drive markets.
South Africa’s economic outlook continues to be lower than average, coupled with lower levels of business and consumer confidence.
Investors may not agree on the best way to value asset classes, but it is worth considering that 90% of the expected returns in the S&P 500 (the proxy for global equity) on a 10-year view can be explained by the starting valuation level, that is the price to earnings ratio now. This ratio is used for valuing a company by measuring its current share price relative to its per-share earnings.
On a one-year view, the starting price to earnings ratio explains only 5% of the expected return and highlights the uncertainty inherent in a one-year forecast for 2017.
Other measures we look at indicate that we can expect lower returns on our investments than we have become used to. Consensus forecasts indicate company earnings will be in single digits while bond yields are already at 30-year lows.
For South African investors, the rand is an additional factor that has the potential to affect returns, as we have seen from the weakening in 2015 and strengthening in 2016. In a low-return world, currency forecasts become crucial.
Given this combination of factors, we think the most prudent strategy for 2017 is to adopt a cautious outlook.
Short-term forecasts contain a very high level of uncertainty. We prefer investing for the long term where our process and strategy offers a higher level of certainty on an expected outcome.
Our final point is that an investor’s risk profile, which is most easily explained by their age, will impact on the basic level of risk they are comfortable with.
Kevin Lings, STANLIB Chief Economist and Vaughan Henkel, STANLIB Investment Strategist
This article was originally published in the December/January 2017 edition of ASA.