Economic & Market Overview – January 2019

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2018, will be marked down by most as a tough year for investment markets. Being conservatively positioned and not losing serious money was the name of the game; to this point global equities were hit hard recently – the S&P500 for example, declined a significant 15% between December 1st and the 26th alone).  In 2018, the South African equity market (as measured by the FTSE/JSE All Share Index) reached a peak of 61 777 versus a low of 50 033 points. The index ended 2018 down 8.5%, its first negative calendar year since the 2008 crisis.    After adjusting for inflation, only bonds and money market recorded positive returns over the last 1, 3 and 5 years.  This poor performance has been disheartening for investors who have not been rewarded for taking on extra risk. It is therefore only natural to consider moving into cash (which is less risky and has been outperforming recently).  This (although it feels like the obvious, more comfortable choice) has proven to be an unsuccessful strategy time and again.  

Global

Global equities deteriorated even further in December (to end the fourth quarter of 2018 down 13% in dollar terms). Continued concerns over trade war tariffs as well as slowing economic growth in Europe and China saw investors shy away from risky assets. This risk aversion was demonstrated by the decrease in US Bond yields (result of investors fleeing to save-haven asset classes) as well as the strengthening of the US Dollar and Japanese Yen (which are also often seen as “safe-havens” in times of extreme uncertainty). These global factors also weighed on Emerging markets, particularly emerging market equities. The MSCI Emerging Markets Index ended the year down 14.2% (in dollar terms).

After raising US rates again in December on continued stability in economic data, US Federal Reserve chairman (Jerome Powell) sounded slightly more dovish as he revised expected rises in 2019 from three down to two.  Last week the larger US companies started to issue warnings about the health of their businesses which validated the investors’ concerns over growth. Apple reduced their revenue expectations for the first time in 16 years citing weak iPhone sales in China. Following this announcement, Delta Air Lines said its fare revenue would be falling short of earlier forecasts.

The latest wage report indicated that the average US employee is starting to see an increase in their wages. This could put further pressure on companies’ margins if they elect to absorb the cost of increasing wages as opposed to increasing prices.

In the UK, the ongoing uncertainty surrounding Brexit negotiations continued to weigh on both business and consumer confidence as fears of a “no deal” Brexit continue to loom.

The Oil price plunged even further in December to end the 4th quarter 35% down from its previous quarter end. This sharp decline comes mainly as a result of increasing US shale production which saw rising supply catch up with demand. Although the lower oil price might hurt producers, consumers will benefit which could boost growth and provide a surprise on the upside.

Timing the market

The success of moving one’s investment into cash depends upon the investor being able to successfully time market corrections. Is this a reasonable assumption? Likely not. According to modern investment theory,  when  there  is  maximum  uncertainty  about  the  future, securities are priced to offer investors higher returns otherwise, investors will not invest. When there is less uncertainty, securities are priced to offer investors lower returns because investors perceive the risks to be less risk. The net effect is that when movements into cash are caused by feelings of uncertainty, and movements back into the market occur when the uncertainty has dissipated, the investor is “out of the market” when returns are most likely to be high, and “in the market” when returns are most likely to be low.  Just as important, in order to accurately time the market, the investor must make two decisions correctly in the following order: first, the investor must correctly decide when to move into cash. Secondly, the investor must also correctly decide when to move back into the market. The dilemma is that, even if the investor is correct about when to make the first decision, it may not do the investor any good unless the second decision is accurately executed.

“Thinking, Fast and Slow” and herd mentality

In his book “Thinking, Fast and Slow”, Daniel Kahneman talks about two main systems that humans use to make decisions. The first system is our immediate reaction. This is our fast, intuitive, mostly unconscious decision-making system. The second is our slow, more deliberate, analytical and conscious reasoning system.  Kahneman notes that while it is possible for system two (the logical, analytical system) to override the suggestions made by system one (the impulsive, emotional system), it takes effort. He notes that system two is “lazy” to do just that, and that its default is to simply accept what system one tells it – “system one usually wins the race”. Modern investment decisions can be fuelled as much by emotion as logic, (perhaps even more than we are willing to admit or aware of). In addition, Kahneman quotes Jonathan Haidt as saying, “The emotional tail often wags the rational dog”.  

Looking ahead 

Overall, it seems like 2019 is going to be yet another challenging year for financial markets with a lot of geopolitical, economic and regulatory questions that could cause investor concern.  In South Africa, the elections will dominate the first half of 2019 together with the State of the Nation address, the National Budget, the release of sovereign ratings and of course the continued challenges of Eskom.  With a long-term view however, now is an opportune time for investors, as future returns are determined by current valuations, valuations are far more attractive after the recent sell off versus a year ago.   Investors have an opportunity to purchase great companies at a discount.  Many of the local asset managers are excited about the opportunities in local asset classes as well as some specific local shares (some of which are trading at very attractive valuations). British American Tobacco is a prime example; an investor can get British American Tobacco now with a dividend of close to 7%, very similar to what an investor can earn in the bank, with the added benefit of earning this yield in a tax efficient manner. Is moving to cash then really an optimal choice?  Investing in South Africa with its struggling economy and the pervasive pessimism will feel uncomfortable to many but this pessimism feels familiar. It wasn’t long ago when we were investing in commodity companies that were priced for Armageddon, an investment which turned out to be very rewarding. Local investments will require time and patience, but we don’t think it is impossible that with a bit of growth and improvement in sentiment surrounding our country, share prices of some of the businesses we are buying today could double.  The best approach investors can follow now is to stay on track with their investment strategy and not make any emotional decisions (even when the latter feels a lot more comfortable). It’s the rational investor that will come through this period with far fewer scars.

Source- APS Monthly Economic Commentary