November marked one of the most decisive shifts for global financial markets in recent years, with a number of asset classes — from bank stocks, emerging-market bonds to hard commodities — staging sharp price swings in the space of a mere three weeks. Bloomberg reports that investors appear to think that the unexpected victory of Donald Trump will lead to a regime shift for the global economy, marked by trade protectionism, a stronger US inflation outlook, and a higher US fiscal deficit. A stronger dollar, an increase in US growth expectations and fears of a more protectionist Trump-led administration have led to a steeper US yield curve that has put some fixed-income investments out of favour, thereby stoking fears that the 35-year old US bond market bull-run is coming to an abrupt end. That signals a reversal of the perverse investment strategy in the first half of the year to snap up equities for yield, and bonds for capital gain. November was the worst month ever for the Bloomberg Barclays Aggregate Total Return Index, which staged a 4% loss, as yields on US 10-year Treasuries climbed from 1.8% to 2.4% in swings reminiscent of 2013’s taper tantrum.
“The US election result just over 3 weeks ago sparked a huge divergence across asset classes and also between developed and emerging markets,” Jim Reid, Deutsche Bank AG strategist, wrote in a note to clients early in December. “In years to come markets may well look back at the month just passed as one of the most pivotal in recent memory.” Most asset classes were in a relatively stable trading range in the first 8 months of the year. All that changed in the month after the Trump victory. With the prospect of regulatory relief from a Trump administration, the S&P 500 Financials Index returned 13.9% in November, while copper gained 18.9% — its best monthly gain in a decade — driven, in part, by Trump’s campaign pledge to turbocharge infrastructure spending.
By contrast, emerging-market local-currency bonds had their worst month of 2016, with Latin American debt, tracked by IHS Markit, shedding 7%. The drop in local currencies erased returns for equity and debt investors in dollar terms. The sharp appreciation of the dollar — and associated liquidity fears for emerging markets next year — has challenged leveraged fixed-income trades that rely on cheap dollar funding, with the cost to borrow dollars in Japan rising. November saw credit and interest rate markets also taking a hit, while developed equity markets led the gains. “Analysts have been criticized for suggesting beforehand that a Trump victory would instigate a selloff in assets but the reality is that of the 39 global assets we cover (excluding currencies) only 11 are up in November in dollar terms with most being US assets,” Reid wrote. It wasn’t bad news for all emerging markets, however. Russia’s benchmark Micex index of equities gained 4% in dollar terms, underscoring expectations of a thawing of tensions between Washington and Moscow next year.
The rationale behind November’s memorable, market-moving month — investors are positioning for a game-changing shift in US fiscal and monetary policies — is largely backed by Wall Street strategists. A bevy of analysts, from Goldman Sachs Group Inc, JPMorgan Chase & Co, and Societe Generale SA, have upgraded their index forecasts for the S&P 500 over the next two years, citing the prospect of tax reform, regulatory relief and higher government spending, while downgrading their outlook for emerging markets.
Back at home, news from global ratings agencies late in November and early in December suggests that South Africa’s chances of repeating its escape from a non-investment grade credit rating in 2017 are in the balance as focus intensifies on tepid economic growth and simmering political tensions.
Bloomberg also reports that Standard & Poor’s (S&P) Global Ratings kept its assessment of the nation’s foreign-currency debt at BBB-, one level above non-investment grade, with a negative outlook on December 2, while cutting the local-currency rating by a step to BBB. S&P’s decision follows that of Fitch Ratings Ltd a week earlier, which also left South Africa’s foreign-currency assessment at one level above junk, while Moody’s Investors Service’s rating is one step higher. The reprieve may be short-lived if the government doesn’t take steps to accelerate economic growth, according to Piotr Matys, an emerging-market currency strategist at Rabobank in London. “Comments from S&P imply that it is absolutely crucial for South Africa to accelerate the pace of implementing structural reforms to avoid a downgrade in the coming months,” Matys said. “Prolonged political infighting may delay an implementation of reforms, which would increase the odds that S&P may downgrade South Africa to junk,” he said.
The view from offshore is that political turmoil here in South Africa (Africa’s most-industrialized economy), including an investigation into Finance Minister Pravin Gordhan, has overshadowed the state’s efforts to boost investor and business confidence, such as recent proposals to stabilize the labour market. The slowest output growth this year since a 2009 recession will complicate Mr Gordhan’s pledge to narrow the budget deficit to 2.5% of gross domestic product by 2020, from a projected 3.4% this year, and to limit government debt. S&P said political events have distracted from growth-enhancing reforms and slow output growth continues to affect the nation’s fiscal performance and overall debt levels, and is a ratings weakness. While the government has identified important reforms and supply bottlenecks in the economy, “delivery has been piecemeal,” the company said. S&P gave South Africa the benefit of the doubt, said Peter Attard Montalto, a London-based economist at Nomura International Plc. “This can’t continue forever and the downgrade of the local-currency rating is a crystallized view of increasing risk in the eyes of S&P from politics, the poor growth outlook and the slow implementation of reforms,” he said.
Finance Minister Gordhan has been leading efforts to avoid a downgrade to non-investment status with meetings between the government, business and labour and by talking to foreign investors. However, a standoff between him and President Jacob Zuma over control of the Treasury and state-owned companies, delays in passing new mining and anti-money laundering laws and a failed attempt by senior African National Congress officials last week to oust Zuma have fuelled perceptions of political turmoil and policy uncertainty. The National Treasury recognizes what needs to be done and is committed to implement the reforms needed, it said in a statement after S&P’s announcement. “We can celebrate for a few hours, come Monday we must roll up our sleeves and get down to work and do what is necessary to make sure that come six months’ time we will not be panicking,” Lungisa Fuzile, the head of the Treasury, said on December 2.
Another recent Bloomberg report suggests that Donald Trump’s electoral triumph has stoked expectations for a fiscal stimulus that will propel U.S. economic growth and spread to the rest of the world. For emerging markets, though, the report says that his presidency ends a long party. For some of them, it’s about time economic reality hit home. For others, the future looks a bit brighter. While the post-election resurgent US Dollar would seem to help emerging markets by boosting their exports, that is more than offset by other negatives, such as rising interest rates that are sucking money out of those economies. Trump’s America First protectionist plans may soon add to the pain. He has promised to abandon the tariff-cutting Trans Pacific Partnership (TPP) trade agreement between the U.S. and most Asian nations. He may force changes in the North American Free Trade Agreement (NAFTA) that will hurt America’s southern neighbour, Mexico. On the campaign trail, he branded China as a currency manipulator and talked of a 45% duty on Chinese imports. Even though he has toned down that rhetoric, investors are wary.
But not all emerging markets are equally vulnerable. Those that can weather a protectionist storm and higher interest rates are those with current-account surpluses, including the Philippines, South Korea, Malaysia, Taiwan, China and Poland. Their foreign-currency reserves provide the money to fund any outflows of hot money without provoking a collapse in their own currencies.
The losers are those emerging markets without that crucial buffer such as Brazil, India, South Africa, Argentina, Egypt, Indonesia, Mexico and Turkey. These countries have current-account deficits, so are importing capital to fill the gaps and have to take stringent measures as foreign money flees. Their foreign-exchange reserves tend to be slim, about half the size of those of the first group in relation to gross domestic product. In contrast to the healthier emerging market economies, the deficit countries have currencies that have been falling against the dollar for the past five or six years, spectacularly so in chaotic Argentina. Economic growth among the deficit economies has also been weak except for India, which may in time join the healthy group if Prime Minister Narendra Modi succeeds in curbing corruption, eliminating economy-distorting subsidies and reducing business-retarding regulations. With inefficient economies, slow growth and more entrenched corruption, the deficit economies also have much higher inflation levels than the surplus economies. And, with inflation problems and pressure to support their currencies, all except India have seen central bank rate hikes in recent years, in contrast to rate declines in the healthier group.
So, although political instability and the threat it poses to economic policy-making and to public finances in South Africa looms large as a concern for all three ratings agencies, they clearly seem to have given us more time, again, in the hope that the political warfare could end well. Hilary Joffe, in an opinion article for Business Day, points out that the big risk is that it could end badly, and the ratings agencies will be quick to act, for example, on any sign of political interference in strong institutions such as the Reserve Bank or the courts, or an investor-unfriendly cabinet reshuffle.
They will surely be watching very closely to see if recent small signs of reform turn into anything more substantial and if SA can begin to deliver on its promises of reform. SA has been given the benefit of the doubt in 2016: it won’t be given the benefit of the doubt in 2017, particularly if a post-Trump victory world order turns out to be a rather challenging environment for the more vulnerable emerging market economies.
Please be advised that as in the past, no monthly statements and newsletters will be sent out at the end of December 2016. Our offices will be closed from the 23rd of December and will be re-opened on the 3rd of January 2017.
The Boards of Directors of Pentagon Financial Solutions and Associated Portfolio Solutions would like to take the opportunity to wish all our clients a blessed Christmas and a prosperous 2017. Please be assured that we shall continue to manage your investments with due care.