INVESTMENT NOTE AN INVESTOR-FRIENDLY BUDGET AGAINST A FAVOURABLE GLOBAL BACKDROP DAVE MOHR & IZAK ODENDAAL, OLD MUTUAL MULTI-MANAGERS
AN INVESTOR-FRIENDLY BUDGET AGAINST A FAVOURABLE GLOBAL BACKDROP There were more jitters on global markets last week as investors tried to price in the pace of interest rate increases, but most indices ended the week in positive territory. Minutes from the Federal Reserve s January monetary policy meeting released with a three-week lag show that the participants are currently comfortable with the US inflation outlook, but increasingly think US growth will surprise on the upside. The fear of many investors is that this would lead to interest rates rising faster than currently expected. The yield on the US 10-year Treasury, the global benchmark, has almost doubled from 1.6% in mid-2016 to close to 3% last week. Rising yields do not just imply higher borrowing costs for companies and governments, but also potentially make shares relatively less attractive, hence the renewed volatility on equity markets. In a quarterly outlook for monetary policy, Fed officials indicated in December that there were likely to be three hikes this year. Could the Fed instead hike four times? It still seems unlikely. The Fed did not overreact last year when inflation unexpectedly declined and stayed low. There is no reason to overreact now that growth is strong and inflation is rising, partly due to the low base set last year. Moreover, the Fed started hiking rates in December 2015 when there was no inflation in sight - precisely so that they wouldn t have to overreact when inflation did make a comeback, as forecasts suggested. The European Central Bank (ECB) also released minutes from its monetary policy meeting last week. It has been impressed by the robust and broad-based economic expansion in the Eurozone and is now more confident that inflation will eventually move up to its 2% target. However, the ECB is not in a hurry, especially as a strong euro could put downward pressure on prices and export revenues. The global backdrop therefore remains supportive for South Africa, with strong global economic growth, firmer commodity prices, inflation that is still mild (but rising) and central banks that are careful not to overreact. AN INVESTOR-FRIENDLY BUDGET While global markets were choppy last week, Wednesday s Budget is positive for local markets even though consumers will cough up more at the tills and petrol pumps. From the point of view of individual investors, the Budget is positive too. For one thing, there are no additional taxes on investment returns (in the form of capital gains tax or dividend withholding tax). The deficit for the current fiscal year is likely to be 4.3% of GDP, in line with the October Medium-Term Budget s revised projection. But unlike October, there is now a plan in place to narrow the deficit over time by cutting R85bn on the spending side over the next three years and raising additional revenue. An additional R36bn in revenue will be raised, mostly by hiking the Value-Added Tax (VAT) rate from 14% to 15%, the first such increase in 25 years. The VAT increase will raise an additional R22bn. Other indirect taxes such as the fuel levy and excise duties will add around R2bn. On the direct personal tax side, there is some fiscal drag relief (R7.3bn) but government will still get R6.8bn from the impact of inflation pushing taxpayers into higher tax brackets (fiscal drag). But there are no further increases in direct individual taxes. The budget deficit is therefore projected to decline to 3.6% in the subsequent two years, eventually settling at 3.5%. If this is achieved, the debt-to-gdp ratio can stabilise at 56% in 2022, an acceptable level in the global context, and much better than the 60% ratio predicted in October. The deficit projections are made on fairly conservative growth assumptions. National Treasury expects growth to increase from 1% in 2017 to 1.5% next year and 1.8% in 2019. It is the first time since 2012 that Treasury is upgrading its forecasts from the prior year s estimates, rather than cutting them. The persistent disappointment in growth over the past few years is the main reason why the deficit failed to narrow below 4% (though Treasury noted in the Budget review policy choices and high public sector wage increases also played a role). BUDGET SHOULD SUPPORT CURRENT RATING By putting state finances on a more sustainable path, the government should create a more accommodative overall investment climate. The Budget probably did enough to secure South Africa s current Moody s credit rating. Moody s is the last of the three main ratings agencies to still rate South African local currency bonds as investment grade. A downgrade from Moody s would see government bonds fall out of the Citigroup World Government Bond Index, leading to forced selling by those foreign investors who track the index. However, the Budget on its own will not be enough to result in ratings upgrades. The ratings agencies will want to see, firstly, progress on achieving fiscal consolidation; and secondly, improved growth. Thirdly, they will want to see evidence that the financial risks at State-owned Enterprises are being reduced and that promises to introduce private sector participation are being translated into action. The renewed focus on fiscal consolidation should help push longer-term borrowing costs (bond yields) down further, supporting other asset classes in the process. The yield on the 10-year SA government bond fell below 8% for the first time since May 2015, as the bond market cheered the Budget speech. 2
MORE FREEDOM TO CHOOSE With the offshore allocation of balanced funds lifted from 25% to 30%, fund managers will have more freedom to allocate based on expected return and valuation. Institutional investors can also increase African exposure from 5% to 10%. This is probably the biggest surprise for local investors. The further easing of capital controls demonstrates government s confidence in the local economy and local assets. The experience of recent times (2011-2015) showed that it was useful to the domestic economy (and the fiscus) for South Africans to have substantial foreign assets in a declining rand environment, acting as a shock absorber. Changes to offshore exposure (currently at the maximum of 25% for most balanced funds, including ours) will need careful reconsideration. For one thing, the rand is probably in fair to slightly overvalued territory on a purchasing power parity (PPP) basis after the strong appreciation of the past two years. TIGHTER FISCAL POLICY ALLOWS FOR LOOSER MONETARY POLICY Last week s Budget also makes it easier for the Reserve Bank to focus on the inflation outlook, rather than playing a risk management role (being an anchor of institutional stability and independence during the turbulent recent past). Though the SARB s thinking has shifted towards a greater emphasis on getting inflation to the midpoint of the 3% - 6% target range, rather than simply within the range, there is scope for interest rate cuts. Local inflation eased to 4.4% in January from 4.7% in December. Food inflation declined to 4.6%, but meat inflation remains elevated at 13.4% (it is the only item in the consumer price index that posted double-digit gains on an annual basis). The petrol price fell by 1.3% in January, lowering annual inflation to 9.1%. The February petrol inflation should fall further to 3.7%, while a current over-recovery of 34 cents per litre should see March petrol inflation fall to 2.2%. However, a 22 cents per litre hike in the fuel levy and 30 cents per litre hike in the Road Accident Fund levy are effective from April. Core inflation, a measure that excludes volatile food and fuel inflation to isolate underlying price pressures, fell to 4.1% in January, the lowest level since December 2011. The increases in indirect taxes such as the fuel levy and the VAT rate will likely put some upward pressure on inflation, but won t materially change the positive inflation outlook. The VAT hike in particular is likely to be a once-off, and will roll out of the year-on-year inflation numbers within 12 months of taking effect. In other words, consumers will feel a bit of a pinch in the coming year as a result of the indirect tax increases. However, by taking this step towards restoring credibility in fiscal policymaking and putting state finances on a sounder footing, the Budget serves the longer-term interests of all South Africans, including investors. The prospects for decent investment returns from local assets have therefore improved over the past few days. CHART 1: SOUTH AFRICAN RAND AND BOND YIELD 17 16 15 14 13 12 11 Rand-us dollar exchange rate 2/19/2016 3/19/2016 4/19/2016 5/19/2016 6/19/2016 7/19/2016 8/19/2016 9/19/2016 10/19/2016 11/19/2016 12/19/2016 1/19/2017 2/19/2017 3/19/2017 4/19/2017 5/19/2017 6/19/2017 7/19/2017 8/19/2017 9/19/2017 10/19/2017 11/19/2017 12/19/2017 1/19/2018 2/19/2018 CHART 2: South Africa govt 10-year bond yield, % (rh scale) TREASURY ECONOMIC GROWTH FORECASTS VERSUS ACTUAL PERFORMANCE Projected real economic growth 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 10 9.5 9 8.5 8 7.5 Source: Datastream 2013 2014 2015 2016 2017 2018 2019 2020 2015 Feb Budget 2016 Feb Budget 2016 Oct MTBPS 2017 Feb Budget 2017 Oct MTBPS 2018 Feb Budget Actual GDP Growth CHART 3: HEADLINE AND CORE CONSUMER INFLATION 8 7 6 5 4 3 SA consumer inflation Source: National Treasury Consumer inflation excluding food, fuel & energy 2 Jan11 Jul11 Jan12 Jul12 Jan13 Jul13 Jan14 Jul14 Jan15 Jul15 Jan16 Jul16 Jan17 Jul17 Jan18 Source: StatsSA 3
EQUITIES - GLOBAL Global MSCI World US$ 2 117.0-0.98% -4.34% 0.67% 14.74% United States S&P 500 US$ 2 747.0 0.55% -2.73% 2.73% 16.20% Europe MSCI Europe US$ 1 799.0-1.05% -4.97% 0.11% 18.28% Britain FTSE 100 US$ 10 120.0-1.14% -5.54% -2.70% 10.87% Germany DAX US$ 1 449.0-0.69% -5.91% -3.82% 25.78% Japan Nikkei 225 US$ 204.8 0.25% -3.20% 1.37% 18.80% Emerging Markets MSCI Emerging Markets US$ 1 201.0 0.08% -4.30% 3.71% 26.16% Brazil MSCI Brazil US$ 2 332.0 1.52% -1.27% 15.27% 17.90% China MSCI China US$ 94.4 0.69% -5.18% 6.66% 42.94% India MSCI India US$ 583.5-2.03% -7.68% -4.51% 18.11% South Africa MSCI South Africa US$ 628.0-1.88% 1.13% 3.80% 26.87% EQUITIES - SOUTH AFRICA (TR UNLESS INDICATED OTHERWISE) All Share (Capital Only) All Share (Capital Index) Rand 58 715.0-0.69% -1.33% -1.33% 12.52% All Share All Share (Total Return) Rand 8 346.0-0.69% -1.34% -1.23% 15.85% TOP 40/Large Caps Top 40 Rand 7 340.0-0.70% -1.65% -1.45% 17.99% Mid Caps Mid Cap Rand 17 062.0-1.21% 0.61% 0.51% 4.88% Small Companies Small Cap Rand 20 960.0-0.75% -0.01% -0.29% -2.18% Resources Resource 20 Rand 2 226.5-2.96% -6.04% -2.61% 10.66% Industrials Industrial 25 Rand 14 802.0-0.74% -2.29% -2.08% 17.94% Financials Financial 15 Rand 10 086.0 1.38% 6.37% 3.90% 28.94% Listed Property SA Listed Property Rand 2 015.7-0.15% -9.20% -18.20% -6.29% FIXED INTEREST - GLOBAL Global Government Bonds Citi Group WGBI US$ 958.9-0.31% -0.51% 1.14% 8.44% FIXED INTEREST - SOUTH AFRICA All Bond BESA ALBI Rand 627.1 1.30% 4.72% 6.71% 14.30% Government Bonds BESA GOVI Rand 624.0 1.14% 4.42% 6.43% 14.18% Corporate Bonds SB JSE Credit Indices Rand 129.3 0.27% 1.32% 2.44% -12.07% Inflation Linked Bonds BESA CILI Rand 252.9 1.19% 1.46% 0.11% 1.21% Cash STEFI Composite Rand 387.1 0.14% 0.45% 1.09% 7.49% COMMODITIES Brent Crude Oil Brent Crude ICE US$ 66.2 2.13% -4.00% -1.13% 16.21% Gold Gold Spot US$ 1 328.0-1.41% -1.12% 2.39% 6.33% Platinum Platinum Spot US$ 995.0-0.90% -0.80% 6.99% -1.58% CURRENCIES ZAR/Dollar ZAR/USD Rand 11.55 0.72% 2.82% 7.21% 11.46% ZAR/Pound ZAR/GBP Rand 16.14 1.12% 4.58% 3.72% 0.06% ZAR/Euro ZAR/EUR Rand 14.21 1.57% 4.11% 4.60% -4.13% Dollar/Euro USD/EUR US$ 1.23 0.81% 1.30% -2.36% -13.82% Dollar/Pound USD/GBP US$ 1.40 0.46% 1.65% -3.36% -9.81% Dollar/Yen USD/JPY US$ 0.01 0.55% -2.08% -5.13% -4.87% Source: I-Net, figures as at 23 February 2018 4
THE WEEK AHEAD SOUTH AFRICA Credit growth Trade balance Producer inflation Absa Manufacturing Purchasing Managers Index US Federal Reserve Chair testimony to Congress Vehicle sales House prices New and pending home sales ISM Manufacturing Index Personal income and spending EUROPE Eurozone consumer inflation first estimate Eurozone loan growth Eurozone economic sentiment Eurozone unemployment CHINA Purchasing Managers Indices JAPAN Leading economic index Retail sales The Old Mutual Wealth Investment Note is published on a weekly basis to keep our clients and financial planners informed of what is happening in financial markets and the economy and to share our insights. Markets are often very volatile in the short term and similarly, economic data releases or central bank actions may cause concerns for investors. This does not mean that investors should take action based on the most recent events. It is better to be disciplined and remain invested in well-diversified portfolios that are designed to achieve long-term objectives. Our Strategy Funds are actively managed, with asset allocation changes based on valuations and in anticipation of future real returns, and not in response to the most recent market noise. The future is always uncertain and that is why our Strategy Funds are diversified and managed with a long-term focus. Old Mutual Wealth is brought to you through several authorised Financial Services Providers in the Old Mutual Group who make up the elite service offering. This document is for information purposes only and does not constitute financial advice in any way or form. It is important to consult a financial planner to receive financial advice before acting on any information contained herein. Old Mutual Wealth and its directors, officers and employees shall not be responsible and disclaims all liability for any loss, damage (whether direct, indirect, special or consequential) and/or expense of any nature whatsoever, which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of, or reliance upon any information contained in this document. 5