Economic & Market Commentary : November 2017

Posted on


Although less than robust, global economic growth remains healthy with key measures indicating some momentum in the recovery are very strong. The manufacturing PMI lead indicators have been particularly strong: the ISM indicator in the US rose to its highest level since 2004, the Chinese official PMI is the highest since 2012, and the same holds for the euro area measure. Global trade growth has also been impressive and appears poised to soon peak, although it should remain solidly in positive territory.

For much of the world, deflation fears have been put aside and the continued low global inflation has enabled central banks to maintain hyper-accommodative monetary policy despite the healthy growth mentioned above. Low inflation has supported asset prices (both bonds and equities) and has boosted balanced portfolio returns. The relationship between growth, employment and core inflation is less clear than in the past. Headline and core inflation in the US and Eurozone remain below target in spite of historically low levels of unemployment. Our view remains that inflation risks are to the upside. The danger for bonds is that very marginal increases (as little as 0.10%) in the monthly core PCE Index in the US could quickly raise Federal Reserve rate expectations.

Speaking of the Fed, President Trump nominated Jerome H. Powell to chair the Federal Reserve when Janet Yellen’s term runs out in February 2018. Yellen was available for a second term, but Trump turned to a replacement who is expected to stay the course on monetary policy if the US economy continues its steady growth. Across the pond, the Bank of England’s governor, Mark Carney, announced the first increase in their official bank rate in ten years when seven out of the nine members of the monetary policy committee voted for a 0.25% increase to 0.5%. Looking ahead, monetary policy will continue to provide support for the global economy, but there will be less of a tailwind for asset prices.

South Africa

Some good news is that during the second quarter of 2017, the South African economy exited its first recession since 2009 as household consumption and agriculture rebounded sharply. Despite recovering on a quarterly basis, when measured over a year-on-year basis, both the trade and manufacturing sectors remain in contraction.

South Africa’s PMI as compiled by the Bureau for Economic Research (BER) remained below 50 for the fourth consecutive month in September at a level of 44 and the third quarter average of 44 is the lowest in eight years. This does not indicate any significant recovery in the local economy.

The 2017 medium term budget policy statement (MTBPS) enjoyed far more coverage than in prior years. It had as much to do with it being Minister Gigaba’s first official budget speech as it had with the sorry state of South Africa’s fiscus. It painted a bleaker picture than most market analysts expected. The minister’s message was frank, direct and a clear call for action, but sadly none of this was offered. The significant increase in the budget deficit for the next three years and the poor economic growth outlook paint a picture of debt to GDP rapidly rising to unsustainable levels. The silver lining was perhaps that, for the first time in a few years, the economic assumptions used in the projections contained in the policy statement are possibly overly pessimistic providing room for a positive surprise.

According to Granate Asset Management, the significantly worse MTBPS outlook clearly increases the risk of a rating downgrade in November. However, they believe that at least one of Moody’s or S&P will wait for the ruling party’s elective conference before deciding. While their base case is for a downgrade in 2018, they believe that a positive political outcome in December might save South Africa from it.

Market performance

For the twelve-month period ending 31 October, growth assets (property and equity) continued their strong performance.  In October, the JSE All Share Index ended 6.3% higher, taking the rolling twelve-month performance to over 20%. This performance was driven by a few very large shares (including Naspers, Anglo American, BHP Billiton and Richemont). Many investment funds would not have participated in the full market growth as some of these large cap multinational companies look expensive on a variety of fundamental valuation measures.

Interestingly enough, retail bank deposits in South Africa have risen from a little over R700 million in March 2015 to over R1 trillion in April this year. It’s likely that many investors who have switched from some form of equity and bond market exposure to cash during the last two years are still invested in the money market and have therefore foregone these good returns.

Global equities continued to perform particularly well in both US dollar terms (MSCI AC World up 24% over the year) as well as local currency as it delivered nearly 30% to rand based investors. Emerging markets outpaced their developed market counterparts as it ended the year 33% higher (in rand terms). With a generally weak local currency over twelve months, even global bonds boosted absolute returns.


Market indices 31 October 2017
(All returns in rand) 3 months 12 months
SA Equities (JSE All Share Index) 8.1% 20.1%
SA Property (SAPY) 4.0% 11.1%
SA Bonds (SA All Bond Index) -0.2% 5.0%
SA Cash (STeFI) 1.8% 7.6%
Global Developed Equities (MSCI World Index) 11.9% 29.5%
Emerging Market Equities (MSCI Emerging Market Index) 13.0% 33.1%
Global Bonds (Barclays Global Aggregate) 6.9% 6.1%
Rand/Dollar 7.2% 4.9%
Rand/Sterling 8.0% 14.1%
Rand/Euro 5.9% 11.5%


Commentary – The Size Effect

Market returns over a number of periods have featured highly in our conversations with clients recently, with the past year being most noteworthy. For the first time in quite a while, investors in more risky assets have been rewarded for the additional risk taken. Both South African and global equities and property outpaced bonds and cash when measured over the past twelve months. One year is however, a short time in investments. The fact remains that over much longer periods, equity investors typically still enjoy a larger reward (a.k.a. risk premium) for exposing their capital to higher levels of short-term uncertainty.

An asset class which may have been overlooked in recent years, certainly from a South African investor’s point of view, is small cap shares. Over long enough time periods, this asset class has outpaced large caps in our local equity market by more than 1% per annum. This is a significant premium for long-term growth oriented investors and a meaningful contribution to wealth accumulation. In the twelve months to the end of October, large cap shares gained 23% with small caps up a miserly 4%. It may be true that small caps are mainly exposed to the local economy (which is far from booming) and as a result reflect the lack of expected growth in South Africa. It is however more useful to turn to academic research to investigate the existence of a small cap risk premium over the full investment cycle.

In a recent paper (“The Size Effect”) by Dr Hamish Macalister of Firth Investment Management in Singapore, he extensively reviews academic literature on this matter. Dr Macalister comes to the conclusion that it highlights significant evidence for superior risk-adjusted returns amongst small, low liquidity firms that have been ignored by market participants (little to no analyst coverage, no media attention, etc.). The literature also provides evidence of premium returns for investors with local expertise in such stocks, relative to offshore investors, particularly in emerging markets. Critically, recent academic research highlights the importance of distinguishing between low-quality and high-quality stocks. There is robust evidence that the size effect is both large and statistically significant for high quality small firms and insignificant (or negative) for low quality small firms.

While at face value there is arguably evidence that the size premium does not exist, this result is completely reversed when stock quality is considered. Low quality small firms (of which there are proportionately more than low quality large firms) effectively reduce the size premium to statistically insignificant levels. There is robust evidence of a substantial size premium when low quality small firms are distinguished from high quality small firms. Asness et al (2017) find these results are consistent with liquidity-based explanations for a size premium, and neither with risk-based nor behavioural explanations.

Overall, their research indicates the size premium is alive and well for high quality small firms. This implies that quality considerations are very important for portfolio managers’ stock selection in the small firm sector. As professional investors, our interest is always awakened by the underperformance of an asset class. The recent performance woes of South African small cap shares may just be an opportunity for the sensible (and brave) investor. As long as you plan to remain invested for a long enough period, now may be a good time to capitalise on the “size effect”.

Please be advised that as in the past, no monthly statements and newsletters will be sent out at the end of December 2017.  Our offices will be closed from the 22nd of December and will be re-opened on the 3rd of January 2018.

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 festive season and a prosperous 2018. Please be assured that we shall continue to manage your investments with due care and responsibility.

God Bless.