Surprise recession

We had the surprise announcement on Tuesday (4 September) that growth in the second quarter of this year was again negative (-0.7%). We use the word ‘again’, because the first quarter was also negative at -2.6%, with two successive quarters of negative growth triggering the term ‘recession’.

We had anticipated a marginally positive number on Tuesday with broad-based tepid growth being dragged down by agriculture and manufacturing. As it turns out, agriculture was a drag on growth but so too were the transport and telecoms sector and consumption – something we hadn’t anticipated and are investigating further.

So where does that leave South Africa?…

It is becoming clear, both through looking at the numbers and listening to our clients, colleagues and friends, that South Africa is feeling the after-effects of many years of policy mismanagement and corruption, at a time when the external environment has switched to one considerably more hostile to emerging markets. We would not put Tuesday’s release at the door of the “land expropriation without compensation” debate but would attribute it to a general lack of confidence in the country’s direction and therefore an unwillingness to consume and invest.

Furthermore, the poor state that the fiscus and state-owned enterprises (SOEs) find themselves in means that taxes have gone up and the government has quite rightly tightened the purse strings – adding a physical impediment to spending on top of the psychological barrier of poor sentiment.

Some positive factors to consider

The good news is that many of the factors that have resulted in these barriers to investing and spending are now being dismantled at a decent rate.

State institutions are being strengthened once more, SOE boards are being reconstituted and plans are being drawn and acted upon. There is an upcoming investment conference with palpable commitments to invest, while an agreement on the mining charter could soon be reached (removing years of uncertainty). And should we see a release of spectrum, that will kick-start elements of the gig economy that have been missing. Let’s not forget that we have one of the most credible central banks in the world keeping inflation under control, so our incomes are not being eroded excessively and the rates that our government borrows at are very reasonable by comparison to peers. This may seem a trivial point, but you need to look no further than Turkey with rates in the high twenties to see how quickly economic uncertainty turns to malaise without the pillar of a credible central bank. We also have our National Treasury which is committed to fiscal prudence and is innovative in ways to punch ourselves out of the current financial corner. Recent rand weakness will surely feed through to greater exports and tourism (get ready for sunburned Brits over Christmas!) The risks to this are clear, both locally and further afield.

Locally, the land debate is reaching fever pitch – it is a highly emotive topic that deserves the attention it gets. We believe under the current leadership of the country, this policy will be handled in a responsible manner that will ultimately unlock economic potential. However, it would be naïve of us not to recognise the risks to this policy, given remarks and actions in the build-up to next year’s election. As a result, we are keeping very close to the subject and are engaged with the main stakeholders – we will ensure our opinions are heard and will shift our views, and protect our investors, if required.

Emerging market headwinds

Further afield, emerging markets remain under pressure after the external environment turned more hostile in March of this year.

What started out as a strong dollar problem for emerging markets has evolved into a something a little more homegrown as policymakers across the globe stutter. Given the repricing that we have seen, emerging market assets now offer decent value to international investors.

Unfortunately, value is never something that turns a market; it always need a trigger. And the potential triggers needed to create more positive momentum could be developments such as tariff clarity from the US and China (not such an impossible thought into a US mid-term election), US data cooling off just enough to slow the US Federal Reserve’s tightening, or indeed China’s recent monetary and fiscal easing feeding through to aggregate demand and commodity prices.

How do we manage these uncertainties and risks in the Investec Diversified Income Fund?

We have been convinced for a while of the lack of inflation in the economy – the lack of local demand suppressing price pressures with the only inflationary aspects coming from administered prices and a weakening currency. We have expressed this view during the year through a combination of government bonds and listed property. However, we have been very concerned with the external backdrop and recognised the primary risk to inflation was a weaker rand.

As a result, we increased our offshore exposure in March and have oscillated between dollar exposure and other currencies depending on our view of where the emerging market risks lay. This offshore exposure did what it was designed to do and protected our bond position throughout the second quarter (when the bond market had the third worst quarter in a decade) and protected our bond position over the last week as the currency weakened close to 10% in the blink of an eye. We have also spoken for some time on how “managing volatility” will almost be a greater priority than “managing direction” this year, as the US Federal Reserve’s tightening will surely compound market moves as liquidity is withdrawn from global markets. What this means practically is that we have reduced our volatile exposures across the board (if the market is three times as volatile, you only need one-third of the position to extract the same return). We have often expressed our views in options, where you pay a fixed premium for certain outcomes (reducing portfolio downside when expressing a view).

From an income perspective, the fund’s net current yield is 7.8%,* a healthy return before one considers the capital opportunities that present themselves in times of flux such as now. We are confident that through the continued use of local and offshore exposures we can continue to participate in bond market upside or protect in the event of continued uncertainty. *As at 31.07.18

PETER KENT Co-Head of SA & Africa Fixed Income&MALCOM CHARLES Portfolio Manager Investec.

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