Ever since the global financial crisis of 2008, the world’s advanced economies, which led the way into the mess, have struggled to get back to their pre-predicament performances.
The South African economy showed uneasy growth in 2013, slipping to just 0.7% in the third quarter on an annualised basis. But the signs are pointing to a modest recovery in 2014 in the domestic and global economies. But it is not yet time to celebrate.
The United States and Japanese economies should see modest growth of 1% to 2% and, adding Europe’s anaemic growth into the equation, the “rich world” as a whole will likely achieve growth of some 1.5% in 2014.
Although insipid, the outlook for these economies collectively is healthier than it’s been since 2007.
They will still have to address structural issues, however, such as demographic decay, debt levels that translate into government bankruptcy and despair among the youth.
By contrast, the emerging economies are generally in better shape.
Widely divergent economic growth expected
Although we expect widely divergent economic growth among emerging economies, we can expect an average rise of roughly 5% from them. This will support the rise in new consumer markets in the “poor world”.
Given that the emerging economies now account for a little more than half of the world’s gross domestic product (GDP), this should translate into global growth of 3% to 3.5% this year.
With an open economy, South Africa is positioned to achieve economic growth in line with the global average, but with risks to the downside.
We will face several headwinds in 2014: a general election that is expected increase in market anxiety; ongoing frustration over a lack of infrastructure capacity; and a hangover from the wage settlements of 2013.
The difficulty of doing business in South Africa is exemplified in the loss of business competitiveness — especially in the export market — and a failure to attract adequate foreign direct investment that creates new enterprises and employment.
In addition, administered price inflation could shave as much as 1% off South Africa’s economic growth rate, so 2.5% growth is possibly in store for the country.
On the positive side, tailwinds come in the form of the accelerated implementation of infrastructure projects and local companies making some headway in finding and benefiting from regional opportunities.
We expect that the structural transformation that the region has undergone in the past 15 years, which helped sustain economic growth, could be comfortably in excess of 5% this year.
New business relationships need to be forged. South Africa’s exports to sub-Saharan Africa grew by just 20% over the past year, and its exports to the rest of the world grew by just over 2%.
Geography is key
Investors need to be aware of the specifics of geography and underlying fundamentals when making investment decisions.
Some global markets are priced to perfection on demanding multiples, the high prices being partly explained by easy money as well as the rise in risk-on appetite.
Nowhere is this more apparent than in the US, where the S&P 500 gained 31% in 2013 compared with a gain of just 6% in earnings.
Other regions, where investors have become cautious, demonstrate much keener pricing. Here, the standout regions are Western and Eastern Europe.
In Western Europe, although the economies remain weak, companies are profiting from their global exposure. The German-based BMW is a case in point.
Although the company is priced on relatively depressed European multiples, it is likely to achieve record sales in 2014 on the back of surging emerging market growth, led by new vehicle demand in the Southeast Asian economies.
From “expensive” to ”outrageously expensive”
The need to examine company fundamentals is no more true than in South Africa. In the two decades that I have been in the money management business, I have never experienced such levels of irrationality in valuations as I see now.
Over the past two years, I have watched as companies have moved from being “expensive” to being ”outrageously expensive”.
The irony is that investors believe that by buying blue-chip companies they are mitigating risk. Sadly, the opposite is true. As prices and valuations rise, so does investment risk.
That said, beyond the large-cap firms — call them the “loved 50” —there are 400 more listed companies that make up a rich basket of businesses at good prices.
By investing in these firms, and exercising the principles of discipline and patience, one would not have to do much to realise an excellent return.
For example, if we take a company on a 10 times price-to-earnings ratio with earnings growing at 20% a year and paying a 3% dividend yield (there are many companies that look like this), you do not need a rerating for the business to provide an annualised return of 23% — in effect doubling your capital every three years.
Sovereign versus corporate
Pinnacle Technology Holdings, Trencor, Value Group, Sasfin Holdings and ELB Group are good examples of this argument.
With bonds, it’s a case of sovereign versus corporate. By far the largest bond market in the world is in advanced economy government bonds. Although this market is big, I wouldn’t touch it with a barge pole.
Buying debt from bankrupt governments, despite the somewhat higher yields prevailing since the middle of 2013, leaves investors inadequately compensated for the risk involved.
Clearly, there are some exceptions to this argument. The strongest government balance sheets lie in the emerging countries and most of these are in sub-Saharan Africa and Southeast Asia. In looking for places to allocate capital to government bond markets, these are the regions on which to focus.
The South African government bond market began 2013 richly priced. Although some of that value has been relinquished, the pullback is insufficient to make a convincing investment case.
The domestic market is also complicated by the fact that South Africa runs a budget deficit that outstrips the country’s economic growth rate — this is not sustainable.
Balance sheet remains strong
Thus, although the local balance sheet remains reasonably strong, it is moving in the wrong direction.
By contrast, corporate bonds provide a better home for a bond investor. With corporate bonds priced at higher yields, we see the market as acting irrationally because, as an aggregate, the corporate sector is in much better shape than the government bond sector.
In our current environment, investors need to focus their efforts on equities, commodities and corporate bonds. Within these asset classes, they need to be mindful of geographies and industries, giving particular attention to prices and valuations.