The Recovery is a Rally Not a New Trend

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FUND POSITIONING

Over the last quarter we have leaned more towards the “Preserving Capital” side of our “Preserving Capital – Creating Wealth” philosophy. We held cash at levels that were deliberately very high to insulate our portfolios from expected market disturbances. As a result, our clients experienced very little of the market volatility that was the characteristic of this third quarter of the year. The main reasons for the high volatility in the markets over the last quarter are as follows:

The prevailing investor view changed, almost instantly, from China being a perpetual high growth story to the thinking that China is now facing a significant slowdown in economic growth, which is likely to have a seriously negative impact on the rest of the global economy.

Large oil producing countries’ sovereign wealth funds, such as Saudi Arabia, were reported to have been very significant sellers over this period, resulting in share prices being driven down sharply.

The general perception of investors has continued to move strongly against emerging markets holdings. This is in stark contrast to the previous view, which held emerging market holdings to be an indispensable portion of an investment portfolio.

The markets started adjusting to the reality that the commodity super-cycle has ended and that the adjustments needed to balance supply and demand going forward might be long and painful.

The very large intraday fall on 24 August had an element of an electronic flash crash. The Federal Reserve of the United States needs to begin raising interest rates soon.

THE RECOVERY IS A RALLY NOT A NEW TREND

The rather depressing list above caused the market to move to a uniformly negative outlook and to become extremely oversold. This, combined with the United States Federal Reserve passing up on the opportunity to increase rates in September, gave the markets all the ingredients needed for a substantial rally. South African markets were helped by about 3% due to the take-over of South African Breweries by AB Inbev.

THE ROAD AHEAD

We have been suggesting for some time now that growth was not as rosy in China as the official numbers were stating, and as the market had previously believed. We are, however, not buying into the current “China in collapse!” thinking. China is a competitive country with close to $4 trillion in foreign reserves and a trade surplus of $600 billion a year. The Chinese authorities do, however, face a difficult and painful period of adjustment as they move towards an economy that is less dependent on investment and more focused on consumption.

We remain very concerned that the Federal Reserve is actually behind the curve in increasing interest rates in the USA. We track a wide range of indicators and almost all of these indicate that the US economy is very strong. This has possible severe implications for asset markets. Currently, our thinking seems to be going against the grain, with consensus in the popular press being that the USA is sliding back into recession. However, we are not so sure that this is what the smart money is thinking right now.

Interestingly, a recent fund manager survey by Merrill Lynch stated that 30% of fund managers in the USA think that the economy is in the late stages of economic expansion. This is compared to the 60% that think the economy is in the mid-stage of an economic expansion. The notion that the Federal Reserve should have already increased rates is important, as the financial markets have already factored in a “low interest rates for longer scenario”. US interest rates will set the trend for markets around the world, with higher US rates likely to have a negative effect on emerging market currencies, equity and bond markets. Financial markets can be extremely volatile when caught wrong-footed.

One of the features of the equity bull market in the US has been that operating margins have seen considerable expansion, mostly due to negligible wage inflation and low interest rates. More and more, we are seeing US corporates now identifying an increase in labour costs as a headwind to future earnings growth. As a result, corporate bond rates have already started to increase even if the Federal Reserve has not yet raised interest rates. This combination presents a large headwind for US equity prices.

Europe is in the early stages of an economic recovery but the sustainability of the recovery needs to be questioned.

International fund managers have become disillusioned by the emerging market “EM” theme and have become large net sellers of EM equities, including South African counters. The concerning thing for the world economy is that, since much of the international growth was being generated by emerging markets, forecasts of world growth prospects are now significantly reduced. This is of concern to South Africa as foreigners own about half our market. Our local economy continues to display signs of weakness and economic fundamentals do not justify the fact that it is trading at a Price to Earnings Ratio similar to the USA, where the underlying economy is much stronger.

That being said, we remain cautious going into the final quarter of the year and as a result are maintaining our exposure to risk assets at low percentage levels.

Download a copy of this commentary here: Rezco Asset Management – Fund Commentary – 20151023