The SA economy has lift-off! Or does it?
It would probably be fair to describe South African equity investors as a pretty despondent lot by now. Returns over the past three years have, after all, been disappointing, with the FTSE/JSE all-share index largely moving sideways within a fairly narrow range, and only recently breaking out of the channel in which it has found itself since 2015 to achieve new highs.
However, the question is whether this is the start of a new trend or whether it will turn out to be just another tentative blip in a continuing sideways movement. Can the equity market escape the doldrums in which the economy is stuck? Although the relationship between the performance of the stock market and that of the economy can at best be described as tenuous, in the long run, it can surely not be ignored.
The dismal growth performance of the South African economy over the past five years has to carry much of the blame for the stock market’s weak performance, while the negative political sentiment encouraged the downward re-rating of South African stocks. The extent to which South African equities under-performed compared to their emerging-market peers since "Nenegate" in December 2015 is particularly noteworthy.
The future outlook is not much better, with the potential growth rate of the economy having suffered a severe setback. Companies that depend on the South African economy for the bulk of their profits will be particularly hamstrung in growing their businesses.
However, one should of course acknowledge that South African companies increasingly earn more and more of their profits offshore, weakening the link between the performance of the domestic economy and local equity prices. More importantly, the fortunes of the JSE remain tied to those of international bourses and it is unlikely that South African equities can continue increasing if they are not supported by international trends, especially on Wall Street.
One should therefore not lose sight of the driving forces behind the sustained increase in, for instance, the S&P 500 index at the same time that the South African market disappointed.
Profits were temporarily boosted by cost-cutting, for example, and, more important, earnings per share were (artificially) increased by reducing the number of shares in issue through companies buying back their own shares. Insofar as the latter was financed through increased borrowing (encouraged by low interest rates), it makes perfect sense from a corporate finance perspective, but at the end of the day it is just another sign of a lack of profitable investment opportunities that would favour top-line growth.
The weak performance of the JSE therefore happened against a supportive international background that is now threatening to come to an end. Ample liquidity provided by developed countries’ central banks’ quantitative easing programmes, and the accompanying depressed bond yields, played an important role in investors turning a blind eye to risk in their reach for yield. However, central banks are now set on normalising monetary conditions.
The CBOE volatility index, euphemistically known as the financial markets’ "fear index", recently moved into single digits, a level last seen in 2007 prior to the international financial crisis.
Equity valuations on Wall Street, which remains the world’s trendsetter, have reached uncomfortably high levels, as exemplified by Robert Schiller’s cyclically adjusted price-earnings (CAPE) ratio breaching the 30-point level recently. The only two previous times (1929 and 2000) when this ratio broke through this level (in fact, exceeding 40 on the previous occasion), it was followed by a stock market collapse.
Investors therefore have a lot to consider from a purely financial cycle perspective. And the undeniable truth is that the upward leg of the cycle seems to be rather stretched with very little support for a further increase in share prices. Even if the Trump administration succeeds in delivering major tax reform benefiting the corporate sector, much of the potential benefits have already been discounted.
But perhaps there are more fundamental questions equity investors should be asking themselves that bear on the long-term future of the asset class. Was the great bull market that started in the 80s and came to an abrupt end at the time of the financial crisis an anomaly, or can we expect a repeat?
Stock market movements, both their direction and magnitude, are determined by change in the environment rather than the state of the environment. We should therefore ask ourselves what the direction and magnitude of future change is likely to be compared to where we have come from.
Stock market movements, both their direction and magnitude, are determined by change in the environment rather than the state of the environment
Forces at work
For the stock market to lose momentum would not require a complete reversal of the forces that propelled it since the 80s, but just for them to weaken. And that is indeed what is happening.
• Firstly, the neo-liberal era with its widespread de-regulation, creating all sorts of new profit opportunities and allowing profit margins to expand, has come to a standstill. The enthusiasm for tightening regulation after the financial crisis may have petered out and some reversal may even be in the offing, but support for a new push towards de-regulation is nowhere to be found.
• With that, the financialisation of the economy at a national as well as a global level has probably reached its peak. The push back against allowing financial interests to dominate still has a long way to go.
• The growth in demand that came from expanding indebtedness, public as well as private, has run its course and cannot be repeated. Rather, austerity and de-leveraging are the order of the day and the unwinding of the debt overhang will take a long time.
• The sustained increase in the share of capital in national income through the latter, rather than labour being able to claim the bulk of the benefits of increased productivity, has run its course. The relative shares of capital and labour move in long cycles and we may be approaching a turning point.
The relative shares of capital and labour move in long cycles and we may be approaching a turning point.
• The enthusiasm for increasing globalisation has stalled and at least a partial reversal is taking place. Global governance has been unsettled by the withdrawal of the US from its global leadership role while the much vaunted new multi-polar world has not yet dawned, increasing the riskiness of international capital flows.
The cross-border correlations between asset markets will probably diminish, especially if the global business cycle becomes less synchronised across national borders.
• The tolerance for greater inequality has reached its limit and the reaction of those societal groups who judge themselves to have been excluded from the benefits of growth has changed the political landscape. Should the world move onto a long-term lower growth trajectory as predicted (for example, by proponents of the secular stagnation thesis), it is bound to result in greater distributional conflict. Apart from the threat of political instability, the clamour for greater egalitarianism will affect the business environment, possibly suppressing profits.
• The positive re-rating of equity valuations played a big role in the previous bull market. However, this re-rating was made possible by the structural decline in inflation since the early 80s and the subsequent decline in interest rates. Inflation (and interest rates) has now reached a multi-decade low from which it can only rise, although it may remain at its current depressed level for some time. However, a repeat of the declines of the 80s and 90s can be ruled out.
• The ability of policy makers to guarantee macro-economic stability in the future has been markedly reduced with the shrinking in the room for counter-cyclical fiscal policy. The only meaningful policy-making power now resides in central banks, although the efficacy of monetary policy is also up for discussion.
The more central banks step into the void created by the absence of fiscal policy, the more their independence and lack of democratic accountability will be questioned, as is already happening. The ability of central banks to maintain financial stability as in the past is therefore not a given.
• The nature of technological development is undergoing a qualitative change and is heading to be as disruptive to the world of work as the first industrial revolution — for example the growing role of robots to accomplish tasks hitherto deemed the exclusive domain of humans. It is uncertain how this will balance out in terms of lower costs, lost employment opportunities, greater demands on the welfare state, and political stability.
Where does this leave us?
The bull market in developed-market equities is nearing its end and the odds are against it resuming any time soon. With SA having missed out on the positive sentiment towards equities as an asset class in the past three years, inter alia as a result of its domestic malfunctioning, it now faces the prospect of a transition to a deteriorating global backdrop without a solution to the domestic impasse yet on the horizon.
• Laubscher is a Sanlam economic adviser