In times like these it is most important to stick to a disciplined and diversified investment process.
South African growth assets materially underperformed both their emerging and developed market counterparts over the second quarter.
Market unease around political developments and generally lacklustre economic growth in South Africa have lowered market sentiment.
On the global front, the economy is still battling with the effects of the financial crisis, even though we are now in the ninth year of economic recovery.
So far, however, investor flows have continued into higher-yielding assets and passive strategies, despite the potential catalyst of higher US interest rates and potentially overly-optimistic expectations around global economic growth.
In this context, South Africa has continued to benefit from a benign global environment, despite significantly deteriorating local fundamentals. These deteriorating fundamentals have been well documented in the media and the investor community. The country’s foreign currency debt is now rated below investment grade by two ratings agencies (Standard & Poor’s and Fitch), with Standard & Poor’s and Moody’s placing SA on a negative watch. Consequently, South Africa is already excluded from one emerging market bond index and will be excluded from others should other ratings agencies downgrade our local currency debt further.
Such a downgrade is not impossible to contemplate. According to an annual review by the International Monetary Fund SA’s government debt (excluding contingent state-owned enterprise (SOE) liabilities) will comfortably exceed 50percent of gross domestic product (GDP) by the end of the fiscal year, a level previous studies have suggested makes emerging markets significantly more vulnerable to funding crises. This could be 14percent higher should economic growth be 1percent per annum less than expected in the 2018-2022 period.
Similarly, contingent liabilities now amount to 18percent of GDP (of which 10percent is SOE debt) and the realisation of these liabilities, in an adverse scenario, could also increase government debt to above 65percent of GDP. Despite credible finance ministers in the past, the state has still spent on average 1.2percent of GDP each year on recapitalising dysfunctional entities.
Following the downgrades, the South African economy is far less resilient today than it was in the build-up to the 2008 financial crisis to withstand a global recession. It experienced a technical recession, with two consecutive quarters (quarter 4 2016 & quarter 1 2017) of negative GDP growth. Even the subdued 1percent per annum growth expectation for 2017 is possibly too optimistic.
According to the recent Stats SA Quarterly Labour Force Survey, 11.1million South Africans out of a potential 37million between the ages of 15 and 64 years are in formal non-agricultural employment (and 27.8percent are unemployed), while an unsustainable 50.8percent of youth between the ages of 20 and 24 are not in education, training or employment.
In addition, South African business and consumer confidence have both plumbed post 1994 lows earlier this year.
Unlike in the past, low-points in confidence have not been marked by equivalent attractive valuation-based entry points into the local equity market. This difference can partly be explained by the dominance that internationally based equities now exert on the local market, and the fact that these shares continue to trade at lofty valuations. Unlike in previous cycles where our equity market traded on a PE ratio below 10 times earnings at times of depressed consumer and business confidence, today the market trades on a PE closer to 20 times earnings.
In light of the current investment climate appearing especially uncertain, it is unclear how strong the global synchronised economic recovery will be and whether South Africa will be able to benefit from it by decisively putting its political uncertainty to bed.
In such a context it is important to construct portfolios that are not beholden to any one particular outcome, but are sensibly managed to specific risk.
David Crosoer is Executive: Research and Investments at PPS Investments.