Author Archives: RealFin Capital Partners

South Africa Retains Investment Grade

In a highly anticipated decision, S&P has elected to affirm South Africa’s credit rating on foreign currency denominated government debt at its current investment grade, just one notch above “junk”. This was considered the less likely option by economists that were surveyed by Bloomberg in November. The ratings agency did, however, cut the rating on South African local currency denominated government debt to two notches above junk.

The reasons cited include:

  • Political events transpiring which have been distracting the government from implementing reforms to enhance growth.
  • Low growth potentially having adverse consequences on the “public balance sheet”.

The immediate reaction of the currency is shown in the chart below, which displays intraday exchange rates. As at the time of writing, the Rand had gained 1.57% against the Dollar for the day.

Chart showing intraday performance of the South African Rand against the Dollar.

Source: Bloomberg

This decision comes after last week’s ratings action by Fitch, who also affirmed our foreign currency denominated government debt at investment grade, however they lowered their outlook to “Negative”. S&P’s affirmation today leaves the two agencies with the same rating and outlook. Moody’s did not issue a credit rating action last week, however they did publish a note on South African credit, citing political infighting, lack of structural reforms and protracted low business confidence as threats to the rating.

With S&P affirming the rating on foreign currency debt, South Africa has avoided what looked like the biggest threat to its investment-grade status. However, it has simply bought time until the next round of assessments halfway through next year. If growth, reform and politics do not improve in the next half-year or so, then South Africa will be back where it started - waiting anxiously on the word of international ratings agencies.

Abstract of financial data featuring line graph, bar graph and random numbers

Emerging Market Currencies Get “Trumpled”

In the wake of the largely unexpected election win by Donald Trump, markets have reacted in some interesting ways. The US market reacted initially with a sell-off, but then whip-sawed into a mild relief rally. Treasuries are selling off and yields are rising on the back of what commentators are suggesting is the Trump “regime change”. Why is this happening? Markets are expecting growth and inflation from Trump’s proposed spending plans which would likely be funded by government bond issuance.

Indeed the sell-off is being seen in other markets too, especially emerging market currencies and bonds. (Source for all charts: Bloomberg)

Chart showing performance of emerging market currencies

embi

Regarding specific currencies, the drops that have occurred in the Mexican Peso are easily understood: Trump’s rhetoric on the campaign trail was directed at the economic relationship between the US and Mexico, specifically he pledged to repeal NAFTA and renegotiate trade between the nations. But the sharp drops in the Rand are somewhat surprising. Indeed, in the two trading days since the election result was known, the Rand lost 7%. For comparison’s sake, over the same period the JP Morgan Emerging Market Currency Index (pictured above) lost 1.67%.

The market’s reaction is, in our opinion, based on three possible factors:

  • Trump’s Trade – Donald Trump campaigned on an anti-trade platform, which would be relatively bad news for trade-intensive emerging markets such as South Africa and could impact other emerging market currencies and assets.
  • Investor Uncertainty – With Donald Trump comes a number of questions: Which of his policies will be implemented? To what extent will the rhetoric match reality? This uncertainty tends to create demand for safer assets, reversing portfolio flows into South Africa.
  • The Fed – The market has begun to price in inflation again, and this should improve the probability of a rate hike. If markets continue to be optimistic, we think the Fed will more than likely raise rates.

The chart below displays the annualized volatility in the Rand since 2000. Since 2000, this year has been the second most volatile, after 2008.

Yearly Annualized Volatility in USD Rand

The chart below compares 1 month at-the-money implied volatilities for the Rand and the Peso (against the Dollar).

1 month implied volatility of the Rand and the Peso

With all of the political risk and credit downgrade fears swirling in South Africa this year, these charts could make sense. But it is still a bizarre result, considering the US is Mexico’s biggest trading partner and that they were holding an election, with one candidate from a major party essentially hostile to said trading relationship.

brexit EU cross roads road map

You Can, I Can, We All Can For Nissan

The recent decision by Nissan’s CEO, Carlos Ghosn, to locate production of the new Qashqai and X-Trail at the Sunderland plant in the UK provokes some thought. In particular, exactly what decisions are being made within the UK government, as well as exactly what was agreed when Ghosn met Theresa May at 10 Downing Street recently.

Hitting the Brakes

At the Paris Motor Show earlier this month, Mr Ghosn threatened to cut investment into Nissan’s Sunderland manufacturing plant if no compensation was given by the government for costs borne as a consequence of a hard Brexit (an exit from the Customs Union and Single Market). For instance, costs that would now be added to exports from the “independent” UK into the EU. With such a large proportion of production being exported to the EU (something on the order of 80%), some kind of compensation or guarantee would be required by any sensible Chief Executive.

Indeed, some kind of firm assurance is exactly what appears to have been granted. Mr Ghosn spoke yesterday (27 October 2016) of the assurances and support of the UK government to ensure the Sunderland plant remains competitive.

Some Scenarios

There are roughly four scenarios here:

  1. The UK Government will be compensating Nissan for tariffs which their exports to the EU will face as a result of the UK being out of the EU Customs Union and Single Market.
  2. The UK Government has provided assurances to Nissan that they will actually be retaining Single Market or perhaps Customs Union access, despite the current political noise.
  3. The UK Government has convinced Nissan that it can pull off a good deal which will protect their export interests.
  4. Even when factoring in the cost of tariffs, it would be profit-maximising to locate the plant in Sunderland.

The first scenario is possible and, while it would potentially be breaking EU rules on state aid, that wouldn’t matter as the UK would be safely out of the EU. It may, however, also contravene WTO rules on subsidies which means it is perhaps unlikely that this is the case, as countries could simply enact countervailing duties and make the exports uncompetitive again. However, in July, current Brexit Secretary David Davis noted that the UK could implement a range of measures to keep the industry competitive, including tax breaks and “research support”.  

The second scenario is the one which is of particular interest. While Theresa May’s rhetoric certainly suggests that the UK would like to retain Single Market access while still restricting immigration, it’s likely that this won’t pan out. For the EU, free movement of labour is a crucial pillar of the Single Market. Remaining a member of the Customs Union also seems unlikely – May has specifically set up a Trade Minister role in her cabinet, effectively signalling that she intends for the UK to negotiate their own trade agreements. In our view, some sort of select free-trade agreement will be negotiated with the EU. Considering the volume and value of vehicle imports from the EU into the UK, the UK certainly has leverage to negotiate a tariff-free agreement on vehicles.

The third scenario is relatively unlikely – as mentioned above it is doubtful that the Nissan Chief Executive would base his capital investment decision on a flimsy hope that the UK government will negotiate an excellent deal with the EU who, arguably, has an interest in making the deal as punitive as possible.

The fourth scenario is unlikely given Mr Ghosn’s own words about needing compensation, but is not impossible. Firstly, there may be internal factors and existing deals which simply mean that it would still make sense, from a business point-of-view, to invest in the Sunderland plant. Secondly, the weaker Pound (almost 15% weaker against the Euro since the Brexit referendum) might still mean that production is competitive.

Driving a Hard (Brexit) Bargain

In closing, perhaps the most likely scenario here is a bit of everything. Theresa May has spoken of an industrial strategy and perhaps this is it – negotiate a good free-trade deal with the EU in the sectors where they have the most leverage, provide tax incentives to industry (in the event that they do not secure a favourable deal) and bank on the weaker Pound keeping the export sector competitive. In our opinion, the take-away from this whole event is that the UK will not be a part of the Single Market or the Customs Union (unless significant concessions are made on the EU’s part) and that Theresa May is simply setting the negotiation bar high with her current rhetoric.

Saboteurs, Luddites and Automation

Automation, a buzzword one often comes across, is not new. Indeed, automation has been replacing jobs in industry for hundreds of years; a romanticised etymology of “saboteur” has it that workers who were displaced by mechanical looms would retaliate in anger by throwing a wooden shoe, or “sabot”, into the machinery, thereby “sabotaging” the factory’s output and showing management the error of their ways.

It was the automation and mechanization taking place in the textile industry in 19th century England that gave birth to the Luddite movement. Groups of workers who were put out of a job or under threat from machines, would burn and break machinery used by textile mills. Their actions and subsequent clashes with the British Army grew so intense that at one stage, there were more British soldiers fighting Luddites than there were fighting Napoleon’s armies in the Peninsular War! The British Parliament, in an attempt to stop the riots and clashes, eventually made it possible to be put to death for sabotaging these machines by signing into law the Frame Breaking Act of 1812. Modern-day references to “Luddism” typically mean something quite different - a general aversion to, and mistrust of, technology.

In the 21st century, with the advent of powerful computers, algorithms and industrial robots, the future of employment for many is itself at risk. This paper suggests that up to 47% of U.S jobs are in a high-risk category of being automated in “perhaps a decade or two”. Furthermore, unlike the manual labour tasks of yesteryear replaced with robotic arms, this phase of automation is hitting white-collar “knowledge workers” too. Machine learning and the rise of computing power has made it possible for machines to replace humans in more skilled jobs like radiology, paralegal services and journalism too.

Looking at it from another perspective, economists have a term for the (supposedly) mistaken fear of job loss from technological change – the Luddite fallacy. The argument basically boils down to the idea that the automation of jobs lowers the cost of production, which provides a benefit to the economy as a whole.

Such fears over the loss of jobs, it could be argued, led to the successful rise of Donald Trump’s presidential campaign. His view, however, is different in that he blames losses of manufacturing jobs, at least in part, on China. What his analysis doesn’t mention, is the benefits derived from lower-cost goods which U.S consumers could import from China. However this is not to say that the government couldn’t have done better; retraining displaced workers and giving them the skills to work in other areas of the economy may have been a sound policy.

The fact of the matter is, modern day automation is happening and will likely continue inexorably (at least in the absence of government intervention). It also comes at a time when there is clearly growing economic discontent; the Brexit vote and the rise of Trump are all economic on some level and reflect anger in society bubbling to the surface. In light of these two conflicting forces, it is perhaps only a matter of time before a violent neo-Luddite (in the proper sense of the word) movement begins, shutting down and sabotaging modern-day, digital incarnations of the original mechanical looms which first disrupted the world of work. History sometimes has a funny way of repeating itself.

 

Machine Learning

What’s the Fuss about Machine Learning?

One of the more exciting new fields in statistics and data analytics is that of machine learning. If you haven’t heard of it, you’ve almost definitely been affected by it. Companies and organisations from Netflix, Google, Apple, General Electric and even the NBA utilise and have used machine learning analysis to inform decision making. But, exactly what is machine learning, and why is everyone making such a fuss?

Arthur Samuel defined machine learning as the “Field of study that gives computers the ability to learn without being explicitly programmed.” Effectively, a machine learning program is one which improves its performance in the task it was programmed for, without the original programmer needing to do much more than write the initial algorithm. Applications are often in predicting changes with respect to a variety of variables, but there are many applications.

Machine learning tasks can be categorised into one of three groups:

  1. Supervised Learning
  2. Unsupervised Learning
  3. Reinforcement Learning

Supervised Learning

In this group of tasks, the computer is given a set of inputs and the desired output. For instance, a good example given here is the email Spam filter. A set of emails (the inputs) labelled as Spam by a user (the label is the desired output) are given to the computer. The machine learning program then processes the data set to determine, using a particular algorithm which was decided on beforehand by the programmer, what the relationship is between the input and the desired output. So, the computer will learn what you think Spam is and continuously improve. Put simply, this means fewer Nigerian 419 scams.

Unsupervised Learning

In this group of tasks, the computer isn’t told what the correct output is…that’s because the programmer doesn’t necessarily know! All they want to know is what would be a good way to group or “cluster” the data together, into groups that make sense. For example if you have a massive database of pictures, but no labels on them, you could feed the database through an unsupervised algorithm which would deduce common characteristics among pictures, and group them accordingly.

Of course, the computer wouldn’t know what to actually call the groups of common pictures, but a human could simply give the categories names afterwards.

Reinforcement Learning

This group of tasks was well summarised here as “learning by trial and error”. This type of task is well suited to computers, which can perform repetitive tasks at immense speed. The computer is allowed to interact with an environment and is “rewarded” (likely based on input provided by the programmer) - encouraging that approach.

For example: imagine that you wanted a robot that walked, but you didn’t have the time or were too lazy to spend hours pre-defining how it should walk (i.e that it needs to put one leg forward first, then the next). What you could do is let it “learn” by itself how to walk, and give it a “reward” for moving forward. In this way, it will work out for itself how to move forward, motivated by the reward. This video  is a great visual example of reinforcement learning in action.

In Closing

There are huge possibilities for machine learning in the field of Finance. For instance, consumer credit scores could be assigned based on machine learning algorithms’ results. For example, instead of a bank comparing the credit performance of its consumers based on factors that it chooses beforehand, it could simply let a machine learning algorithm loose in its massive database to decide for itself what the best variables are for assigning credit scores in the future.

Or, a firm could develop a high-frequency trading algorithm which utilises machine learning to uncover relationships between different stocks and economic variables which may not have been considered beforehand.

Finally, machine learning is not just being used for financial gain. The field of Medicine is yet another area where machine learning has value, with algorithms being used to aid diagnosis and even identify melanoma on the skin!

The point? Expect to hear a lot more about machine learning in the future.

 

Why Negative Rates are Bearish for Banks

As developed economies grapple with the ever looming threat of deflation (which for France, Japan and Switzerland among others, is actually a reality), their respective central banks are turning to extreme measures to try and induce inflation. The measures? Breaking through the zero lower bound on interest rates and making them negative. Japan recently became the latest member of the negative rates1 club.

The rationale is quite simple really - set a lower interest rate to try and encourage borrowing and spending in an economy, with the end goal being to generate economic growth. However, commercial banks are taking strain because negative rates are changing the calculus.

Commercial banks, by and large, make their money on spreads. That is, there is a difference in the rate at which borrowers pay to loan money and the rate paid to depositors who lend banks money (with such deposits being used to fund the loans banks make). The positive difference between the rate charged to borrowers and the rate paid to depositors is in essence the bank’s margin.  Now, when negative rates are introduced by a central bank, this simply means that the central banks charge the commercial banks to hold their excess bank reserves with them. The implication is that banks would rather deposit their reserves with each other in the inter-bank market. But, this activity drives down inter-bank interest rates (JIBAR in South Africa, LIBOR in the U.K for example) to somewhere close to the rate set by the central bank.

These inter-bank rates feed through to longer-term rates and the rates which are offered on new loans to customers. Central banks hope that cheaper loan rates will incentivise borrowing and the financing of economic activity.

Now, on the other side of the coin, banks hold deposits for their customers and pay them a small rate of interest for this. Banks want to retain their spread on interest rates to stay profitable and keep shareholders happy. To do this, they need to reduce the rate they pay to bank customers on deposits. But what if this rate is already very low or zero? How do banks maintain their spread in this environment?

Banks could risk moving their interest rates on deposits to negative, in effect charging customers to hold their money. However, that may largely result in customers pulling their deposits out of banks and stuffing them under their mattresses. This mass withdrawal of funds from the banking sector would result in a very big problem for the financial sector and, ultimately, it would probably crimp economic growth.

Data

So banks have, by and large, stood by and taken the pain as margins have narrowed. This is why the Eurostoxx Banks Index, an index of European Bank stocks, has dropped 20.43% in Euro terms year-to-date (see figure above). Whether central banks will stick it out with negative rates is a difficult question; however if they do “normalise” in the future, it may present an opportunity to pick up a sector that has lost significant value.  

1By this we mean the rate earned on commercial banks’ deposits at the central bank

 

Is the Rand Really all that Leveraged to Commodities?

An oft-heard statement in financial media is something akin to the following:

“Emerging Market currencies, such as the South African Rand, are under pressure due to their reliance on commodities”

USDZAR – December 2015 Through March 2016 Performance

THE RAND

Source: Bloomberg

While this sentiment makes a bit more sense when considering South Africa’s stock market, the entirety of which (measured using the FTSE/JSE All Share Index) is composed of almost 14% in basic resources stocks, the same is not immediately true of the Rand. To exactly what extent does South Africa’s economy depend on the export of commodities?

Immediately the question may seem impossible to answer – an economy is a giant, interconnected system and attempting to quantify one particular aspect of it is always going to have some issues. That being said, this article will take a look at a couple of simple ratios to look deeper into how reliant we are on the export of raw commodities, where we will analyse the figures as a percentage of GDP as a proxy for “reliance”.

Data from the South African Reserve Bank’s Quarterly Bulletin indicates that about 84% of total goods exported from SA is physical, merchandise goods. The remaining is in services. The figure was roughly the same for 2014, at 85%. For imports, the proportions are approximately equal.

To gauge what proportion of those exports are in traditional hard commodities (i.e. precious metals, base metals, iron ore, steel etc.), data was obtained from the South African Revenue Service’s Trade Stats. These data overestimate the values if anything, as they are not granular enough to discriminate between “articles” of the commodity, and the raw commodity itself in this case. These commodities were highlighted specifically because they have been in the spotlight lately, dropping in value from what is likely a demand deficiency globally (specifically in China). For 2014, the proportion of export value made up of hard commodities was roughly 45%, and dropped to 43% in 2015. For imports of commodities, in 2014, the figure was 24%, falling to 17% in 2015.

The point of the above is to determine how SA would react to a decrease in commodity prices. Clearly when broad prices decrease, exports are worth less internationally (because most commodities are priced in U.S Dollars). However, imports are cheaper as well. In the absence of currency moves, if proportions of GDP are similar, one would expect a zero net impact on the economy.

Indeed, when calculating Net Exports of Commodities (exports of commodities less imports of commodities) and representing it as a proportion of GDP, one gets a figure of 6.38% for 2014 and 7.72% for 2015. To put this into perspective, The Economist magazine estimated the same metric for a number of other countries, averaged over the period from 2010 to 2013. Brazil, Russia, Canada and Australia all had a greater net commodities dependence.

This figure is not huge – and that is good because it means that the commodity price drop, while having a definite impact on the economy, was perhaps muted by the commensurate cheapness of commodity imports. As to why the reliance increased in 2015; that was perhaps driven at least in part by the significant weakening of the Rand. The idea here is that cheaper imports were offset by the weaker exchange rate, meaning they weren’t all that cheap in the end.

In conclusion, in evaluating the original claim that Rand weakness was the result of gut instinct by traders shorting a country reliant on a crumbling commodity market, the above analysis suggests this is not the true reason at all.

Moreover, it seems more likely that other factors were at play in the weakening. Namely, high unemployment and a drought which is increasing basic food prices (and therefore the inflationary outlook). Finally, all of these factors amplified by the stark increase in political risk, on the back of the firing of South Africa’s well-regarded former Finance Minister, Nhlanhla Nene, which occurred on 9 December 2015 and saw the Rand lose almost 9% in 3 days.

 

Buy and Hold – The Simplest Investment Strategy

To time the market or not to time the market, that is the question which plagues investment professionals the world over. There is something intrinsically (at first) appealing to the idea of timing the market (and eschewing the buy and hold strategy) – consider the following scenario.

The market has dropped 2.2% and there is some fear-mongering on the financial news channels. You reckon that if the market turns down another 2% tomorrow then you’ll avoid the bloodbath, switch your equity investments into cash and wait out the storm. Things go somewhat your way, the market does take a knock and you are self-satisfied at your prescience. It’s been a week, the market has dropped further and today the market rallies 3%. This is what you have been waiting for! You place your trades, high five your colleagues and sleep well.

The next day the market drops another 3% in what is known as a “dead cat bounce” and the rout continues. You switch out again, all the while incurring costly brokerage fees and say you’ll wait much longer this time before jumping back in.

The above scenario can play out in a number of different ways, but the one truth is that in the very short-term, equity markets are nigh unpredictable.

To attach some hard evidence to the above example, consider that the performance (read: gains) of the S&P 500 since December 1959 to 29 February 2016 can be condensed into approximately 51 of the best days of trading. That’s slightly longer than 2 and a half months of investing. Furthermore, out of the 14 148 trading days between mid-December 1959 and end February 2016, roughly 53% have posted gains and roughly 47% have posted losses. The point here is that being out of the market for even a few of those critical days could have hurt your long-term performance considerably. The chart below shows this:

The S&P 500 Without its 5 and 10 Best Trading Days

Buy and Hold

Source: Bloomberg

In terms that are more comprehendible, the standard S&P 500 has had a compound annual growth rate of 6.41% annually since 1959. Excluding the best 5 days pushes this down to 6.05% and excluding the best 10 days pushes it down to 5.74%. Over just more than 56 years, this is a return of 3181% for the S&P 500, 2619% without the best 5 days and 2198% without the 10 best. This means that those 10 days in isolation, when considered over the whole holding period, multiplied an investor’s money by about 10.

While one could keep coming up with new, fun ways to present this information, the moral at the end of this story is that the long-term opportunity costs of trying to time the market could be massive. The point? Buy and hold for the long-term.

And, just for fun, if you had managed to foresee the 10 worst days for the S&P500 since 1959 (which there is no way you could!) you would have returned 4261% (6.95% CAGR)!

S.A Income Tax Rules and Foreign Investment

Flag_of_South_Africa.svg

Income Tax Rules are “Acting” Up. 

The allure of foreign markets gleams ever brighter in the turbulent market conditions facing the ordinary South African investor. Considering that since December the JSE All Share Index has lost 4.22% and dropped (at its worst) 10.19%, and that the Rand has lost 10.93%, investors may look to diversify their investments internationally and invest in a more stable currency as an inflation hedge.

How could the ordinary investor access such an investment? There are at least 3 possibilities:

  • Local Unit Trust funds invested in foreign markets;
  • Locally listed ETFs giving exposure to foreign indices and currencies;
  • Offshore funds, ETFs and securities utilising a local institution’s foreign investment allowance (unlimited) or through the use of a tax clearance (R10,000,000 per taxpayer per year).

Those looking for low-cost exposure and convenience may pick one of the first two options, however as we will see below, this may prove more costly when considering the tax impact.

Paragraph 43, subsection 1 of the South African Income Tax Act provides the following guidance:

“43.        Assets disposed of or acquired in foreign currency

(1)        Where, during any year of assessment, a person that is a natural person or a trust that is not carrying on a trade disposes of an asset for proceeds in a foreign currency after having incurred expenditure in respect of that asset in the same currency, that person must determine the capital gain or capital loss on the disposal in that currency and that capital gain or capital loss must be translated to the local currency by applying the average exchange rate for the year of assessment in which that asset was disposed of or by applying the spot rate on the date of disposal of that asset.”

Therefore, investors who acquire offshore investments in hard currency will not be subject to any taxation on the increase in capital value in Rand terms due to currency depreciation.  For investors who gain foreign exposure through local investments, this is not the case.

Now, the implication of this definition will be shown through two simple examples:

Example 1:

The investor invests in a locally listed ETF tracking the S&P 500. Since October 2015, the S&P 500 has lost 2.28% and so, should an investor wish to redeem their investment today, they assume they would not be subject to Capital Gains Tax. However, the Rand has depreciated against the Dollar by 15.12% since October 2015, meaning that in terms of the Act, the investor has had a capital gain of 12.84% and is subject to taxation (which is really a loss on the investment in U.S Dollar terms).

Example 2:

The investor utilises their Foreign Investment Allowance or Tax Allowance and purchases an offshore listed S&P 500 ETF on 1 October 2015.  Should the investor in this instance sell their investment today, they will not have realised a capital gain for tax purposes.  They repatriate their money and pick up a tax free return of 12.84% on the conversion – unlike the investor in Example 1 who would be liable for Capital Gains Tax (up to 14% for individuals and 27% for trusts).

Of course, the shrewd reader may note that the Rand doesn’t always lose 15% against the Dollar in a manner of months and that it may even strengthen against the Dollar, reducing the tax bill (if indeed there is a Capital Gain in foreign currency terms).

However, if one has balanced the risks and rewards of an investment and believes that exposure to a foreign market, e.g. the U.S, will be beneficial then a rational investor should invest in a vehicle which will reduce the expected tax bill. Through the local option, there may be tax levied even if there is a capital loss (due to an exchange rate depreciation), while the same is not true of the direct foreign approach. Even if there is a capital gain in foreign terms, if the Rand depreciates then one would incur more tax.

Further, it is likely that the Rand will continue to depreciate over the long term. Why? Economic theory suggests that a country’s currency will always depreciate against another currency when its inflation rate is greater - South Africa’s inflation rate is far higher than that of developed markets. Therefore, it is safe to assume that a portion of the Rand return would most likely be attributed to the weakening Rand.  As such, it makes sense to shelter this return from tax wherever possible.

Although, in our view, the taxation impact of gaining offshore exposure through local vehicles makes it far less efficient than acquiring investment in hard currency, other factors such as costs should always be examined prior to investing.

Investment Outlook: 2016

Macroeconomic Outlook

Central Bank Policies

Following Mario Draghi’s statement made at the December meeting of the ECB, the global macroeconomic environment should be dominated by a dichotomy of central bank policy this year. On the one hand, the December 2015 rate rise by the U.S Federal Reserve and 2016 rate hike schedule should tighten conditions in the world’s largest economy; one that had been at near zero rates of lending for almost a decade. In addition, the United Kingdom’s Central Bank governor, Mark Carney, has suggested that British consumers should expect a rate rise at some stage owing to a period of solid economic conditions and firm wage growth.

On the other hand, loose monetary policy in Japan and the Eurozone are fending off the threat of deflation and hoping to stimulate growth in these stagnating economies. The clearest sign of these policies has been observed in the forex and bond markets, hopefully supporting the export markets in these countries and keeping borrowing costs very low (and negative in a number of circumstances!). Furthermore, China has also kept its monetary policy very loose, in the wake of weak growth. We don’t see this policy reversing in 2016 as the full effects of the policy changes work their way through the economy.

Government Borrowing Costs (10 Year Bond Yield) – Increasing Order of Perceived Risk

Borrowing CostsSource: Bloomberg

Growth Estimates

 

The growth story this year should come largely from economies which rely on domestic demand and the export of services to advanced economies. Commodity countries can expect tough headwinds as the demand for their product subsides. This is covered in more depth in the ‘Commodities’ section.

Advanced economies with loose monetary policy can expect a pickup in consumer expenditure as the low to negative interest rates incentivises consumers to spend instead of save. Exports should also experience a net increase due to weaker exchange rates, however this is predicated on the assumption that their trading partners come to the table with a demand for these goods. Regarding this, the major trading partners for Europe and Japan are the United States and China, which are both set to grow this year, albeit at a slower rate than previously for China.

We don’t think that 2016 will be the year of the developing country, however certain countries within this broad group that are not reliant on the export of commodities should continue to grow at a healthy pace. India should outpace China next year as the fastest growing large economy as they are well positioned for the forthcoming economic climate.

Net Commodity Exports as % of total GDP (2010-13 Average)

Net CommoditiesSource: The Economist

Commodities

 

The huge amount of supply in the market combined with flat to decreasing commodities demand has resulted in a sell-off in the commodities market. As of writing, the Bloomberg Commodity Index had hit its lowest level in 16 years. We expect that 2016 shouldn’t be much better for commodities, as producers adjust their capital expenditure while producing as much as possible from existing plants in an attempt to maximise revenue. This is effectively what is prolonging the slump at this stage and we expect this to persist at least until the end of this year.

Bloomberg Commodity Index - 16 Year Performance

Bloomberg Commodity IndexSource: Bloomberg

The impact of cheaper commodities serves to reduce the input price in goods, reducing their cost. This is one of the key causes of the ultra-low inflation environments in Europe and Japan.

Furthermore, the price of oil has continued its decline lately, as more and more production enters the market. We suspect that the global oil market should continue to be oversupplied this year. OPEC recently elected to abandon their previous production target, instead producing more in a desperate attempt to put U.S Shale out of business. On that score, while rig counts have been dropping and prospective capital expenditure cancelled, the efficiencies that have been achieved in shale oil production mean that production has been increasing and the marginal cost falling. Therefore it is still in the best interests of existing producers to maximise revenue by continuing to pump oil. For this reason, we do not expect a change in the oil market in 2016, at least from the supply side.

A key risk to this assessment is, however, geopolitical instability in the Middle East. Most recently, with the execution by Saudi Arabia of a prominent Shiite cleric (and the subsequent cutting of diplomatic ties between Iran and Saudi Arabia) fanning the flames of tension between Sunni and Shia Muslims. The situation could degrade significantly, prompting worries about supply from OPEC’s largest producer.

On the demand side, China’s November demand did increase by 11%, however this could be largely attributed to strategic reserve building by the National Petroleum Reserve. The IMF predicts that the world economy will grow at 3.6% this year, half a percent greater than 2015. This should support demand for oil somewhat, but in our view the supply side is the key driver.

Exchange Rates

 

We suspect that the U.S Dollar is overvalued and may well begin to decline in strength on a trade-weighted basis starting in the second half of 2016. This view is based upon the real effective exchange rate for the Dollar which is overvalued by historical standards. Commodity currencies can expect to remain weak, in the absence of further central bank actions. The Yen and Yuan should continue to be weak currencies this year as the stimulus measures persist and the Yuan gradually moves to free float against the U.S Dollar.

The Euro’s path is not so clear-cut, however to the extent that the European Central Bank ramps up their Quantitative Easing Programme to try and stimulate inflation more than the market expects, we expect the Euro to weaken on a trade-weighted basis. On the other hand, the market does discount their future expectations; if economic conditions in Europe surprise to the upside then the Euro should strengthen.

Euro vs USD – 5 Year Performance

EURUSD

Source: Bloomberg

Market Outlook

Global Equities

 

While U.S equities had a turbulent 2015, we suspect that they may once again stay flattish in the year ahead due to their already ambitious valuations and the impact of a gradual monetary policy tightening cycle for 2016. A bizarre aspect of this turbulence is that a large contributor was the steadily falling oil price. However, economic theory would suggest that a decrease in the oil price would serve to increase the disposable income of the average household and therefore have a net positive impact on the economy. Even after removing energy stocks from the S&P 500, performance was still flat. To the extent that the rout in the oil market was demand driven, then this situation would make sense as lower demand means less growth. However, as mentioned in the section titled “Commodities”, we feel that the oil market drop is supply-driven.

As growth picks up in the U.S and unemployment falls even further, we expect slight inflationary pressure moving up to the Fed’s target of 2% over the medium term.

U.S Unemployment Rate Since 2009

US Unemployment Rate

Source: Bloomberg

European equities should perform well in local currency terms this year as the Eurozone economy gains growth traction and the effect of cheaper commodities transmitting to the price of goods ideally stimulates demand. There is no guarantee the Euro will weaken further this year, as its value may reflect the effects of monetary policy already and it is likely too weak against the dollar currently. Our view is that the Dollar’s strength is out of line and should weaken over the coming years.

Asian and Asia Pacific equities should be led by India in 2016. Accommodative monetary policies should buoy growth and reduce the risks of hard landings. With China being a major consumer of Japanese, South Korean, Hong Kong and Australian exports, these countries are likely to feel the pinch somewhat. However, to the extent that the Chinese consumer is strong in 2016, many of these countries (barring Australia as a commodity exporter) may fair quite well. India derives a mere 5% of export demand from China and the rest primarily from the European Union and the U.S. We suspect that with monetary easing in the one and a very high purchasing power in the other, Indian exports should do well this year.

U.S Real Estate will likely continue to strengthen this year, as growth continues. There should be a muted impact from a rate rise as it is a very small increment (1/4 of a per cent). Furthermore, the reducing unemployment and strengthening wage levels in the U.S bodes well for growth in rentals. Internationally, Real Estate should generally benefit from very low interest rates, particularly in the Eurozone. The influx of migrants may prove to have an upward effect on property demand, and the low mortgage rates should entice buying. Commercial Real Estate may see some pick-up from the low rates and favourable expansion opportunities, as well as weakening exchange rates and hopefully increased economic activity.

In terms of distressed equity, Greece looks to be a very compelling long-term holding. The first review of the bailout programme, where the creditors will evaluate the progress Greece has made in implementing the bailout package reforms, should be completed by the end of February. The completion of this first major hurdle is likely to increase confidence and allow the go-ahead for further reforms and bailout funds. By mid-2016, the market can expect a lifting of the financial sector capital controls and a return to normality for banking operations. The long-term outlook will then be a return of Greek equities to their fair value as the (over-estimated) political risk subsides.

Global Trends

 

If the climate change summit that recently took place in Paris has told us anything, it is that world leaders are starting to unanimously worry about their reliance on carbon. While renewable energies are certainly receiving a lot of attention, the dialogue is increasingly focussing on nuclear strategies. While a few countries are very much anti-nuclear, the general consensus appears to be that nuclear energy is a necessity as it does not produce carbon emissions and is also a reliable source of baseload energy. The global sentiment change toward nuclear as a realistic, environmentally conscious form of power should continue to gather momentum this year.

Carbon Dioxide Measurements – 2005 to Present

Carbon Dioxide

Source: NASA

The rise of the Chinese consumer began in 2015 as the world took notice of China’s economic transition from investment-led growth to domestic consumption-led growth. Furthermore, with the recent abandonment of the one-child policy, China’s demographics will be supportive of increased consumer spending in the coming years. The key variable underlying Chinese demographics will be the fertility rate in China, which the government is officially attempting to boost.

The growth in the Indian economy is one of the major stories for 2016, as the world looks to the country that has overtaken China as the fastest growing large economy. With further economic reforms in the pipeline, strong demographics and favourable geographic trade compositions, Indian services may prove to be an excellent investment; comprising 35% of total exports. In addition, with the government focus on infrastructure investment for 2016, Indian construction could also provide significant upside.

With healthcare outperforming all other sectors in the U.S for the past 5 years, the question is whether this will persist throughout 2016. One of the important determinants of healthcare demand is demographics – the older the population, the more demand we expect there to be for healthcare. With the steady aging of the baby-boomers, the United States’ demand for healthcare should continue to grow. Healthcare is a very touchy subject in the U.S due to its extreme cost and lack of public provision; the question for investors is whether government policy will have a downward impact on healthcare companies. Investors largely judged Obamacare as being very positive for healthcare companies, as the spectacular growth coincided with the policy’s enactment. Taking less of a focussed approach, a good investment may be in global healthcare, as demand continues to come from aging populations.

Conclusion

 

In conclusion, we expect that 2016 may deliver slightly positive returns from global equities as underlying fundamentals catch up to market valuations. The commodity market rout, including the oil market, should persist as the slow moving supply-side attempts to adjust to the market conditions. In light of this, volatility may be a lot more prevalent than it has been in the past few years, with several wild sell-offs already being experienced on the Chinese stock exchanges. However, pockets of opportunity will present themselves as solid and dependable industries are sold off amid the fear. We expect the big themes of climate change, the Chinese consumer and Indian economic growth to gain momentum