The Road Ahead

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LOCAL OUTLOOK

Rezco Asset Management continues to maintain a cautious market outlook. While there is some overlap locally and internationally, we believe that there are predominantly different forces at play. Preserving capital* and creating wealth continues to form the bedrock of our investment philosophy

The high local risk-free rate in fixed income instruments means that we can earn a competitive return whilst waiting for better equity valuations. The fixed income portion of our portfolios can earn an above inflation amount of 8.3% with almost no credit risk. Furthermore, due to the short duration of these instruments, the risk of capital loss is reduced if interest rates begin to rise. This enables us to strategically position our funds towards High Quality Defensive instruments until equity valuations more accurately reflect local economic conditions.

We are of the opinion that South Africa is stuck in a low growth scenario and will be for some time to come. The reality is in all likelihood worse, namely that we are slipping into a recession. It is of great concern that this economic slowdown is akin to a leaking tire: it is a broad-based slowdown for a myriad of reasons, predominantly economic mismanagement. It is this structural lack of economic growth and mismanagement that the credit rating agencies are flagging as areas of great concern. We will almost certainly be downgraded at the end of the year. Our view is that this is not fully discounted into asset prices.

One of the pillars of our economic growth over the past couple of years has been increasing government spending associated with staffing costs. This has begun to stall due to the level of government debt becoming unsustainable in the minds of international investors and credit rating agencies alike. The red line on the graph below illustrates the Price Earnings ratio (P/E) of the Johannesburg Stock Exchange (JSE), excluding mining shares and the large dual-listed shares such as Naspers, SABMiller, Compagnie Financière Richemont and British American Tobacco. The black line shows the declining Gross Domestic Product (GDP) growth rate. This illustrates that there is a clear disconnect between how expensive our market is and the local economic fundamentals.

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We are of the opinion that the political landscape will get worse before it can improve. Currently, the ‘rent-seeking’ Zuma camp seems to be firmly in the driving seat. This precludes any decisive policy initiatives that can assist in turning around our ailing economy. To make matters worse, the Zuma camp is driving disaffected ANC supporters into the hands of the ultra-socialist EFF. Large EFF gains in the municipal elections have the potential to unsettle both local and foreign investors.

The great international commodities super-cycle is now firmly a thing of the past. The prices of industrial commodities, excluding oil, are unlikely to rally much from current levels. Even when inputting commodity prices into our investment models that are far higher than current levels, we do not find value in commodity shares, other than Sasol.

At present, the local market is overvalued. One potential reason is the notion that, ‘everything is expensive, but we need to be invested’. Research shows that entry P/E is a large determinant of future returns – buying an expensive market is always going to disappoint. This can be exacerbated by the slow down in the local economy, leading to lower corporate earnings. Our largest holding is Redefine International, a foreign locally listed property counter, consisting of top quality British and German property, yielding about 7% in hard currency.

The graph below shows the South African Market P/E (red) compared to the Developed Market P/E (blue) and the Emerging Market P/E (black). Clearly, when compared to our emerging market peers, our market is expensive. Foreigners own over 40% of the JSE, so comparisons to other emerging markets are important, especially when considering potential corrections in the market. We have historically traded at P/E multiples closer to other emerging markets. Even when stripping out the impact of our large dual-listed shares, our market is still too expensive.

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INTERNATIONAL OUTLOOK

Our Rezco Global Fund is approximately 50% invested in equities. Though not as cautious as our local view, we see some difficult-to-quantify risks in the international market. Some of our main concerns are highlighted below.

China has, in our opinion, about a 30% probability of entering into a major crisis, mainly due to its excessive corporate debt levels that have been building up over the last few years. As alarming as this may sound, China will most likely muddle through but not be a major source of world economic growth. The downside risks are substantial and are a concern for equity markets.

We remain apprehensive that the markets have become complacent to the possibility of a faster than expected interest rate hiking cycle in the USA. The extremely poor May ‘new jobs created’ numbers could possibly be an outlier in that the US economy is actually at full employment and companies are finding it hard to fill vacant positions. Other important employment statistics paint a different picture to the ‘new jobs created’ numbers, which could leave the market with room to be disappointed.

It is our view that inflation numbers could surprise on the upside. This is due to the collapse in the oil price working its way out of the system. This could cause more uncertainty for an already anxious market. Permanently low interest rates are being hard-coded into economic assumptions. We believe this is extremely dangerous, as the fallout of this assumption being re-priced could lead to large drawdowns in asset prices.

Britain leaving the European Union should be manageable. However, this could lead to a domino effect that may be the beginning of the end for the Euro Zone. In the short term, markets will continue to be volatile as a result of the Brexit vote. The bull market is 7 years old, values are stretched and it is difficult to find corporate earnings growth numbers to justify equity valuations.

FIXED INCOME

We continue to avoid duration and credit risk, as we feel that our clients are not being paid for the potential risks. Locally, an extremely flat yield curve does not compensate for the increased volatility that potentially lies ahead due to the ratings downgrade. Internationally, the exceptionally low interest rates offer investors little to no chance of capital appreciation and a significant chance of incurring losses.

CONCLUSION

The low equity exposure of our balanced funds reflects our cautious views. The Rezco Stable Fund, Rezco Value Trend Fund and Rezco Managed Plus Fund are 16%, 21% and 27% invested in local equities, respectively. When we include foreign equities, our three balanced funds are 25%, 33% and 40% invested, respectively.

With no new corporate earnings drivers, the market is stuck in a range bound pattern. It is more likely to hit the lower boundary of the range than to move to significant new highs, as indicated by the graph below:

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Source │ Morningstar. Rezco Collective Investments Ltd is an FSB approved Manager of Collective Investment Schemes. Disclaimer : Nothing contained in this newsletter constitutes a solicitation, recommendation, endorsement or offer by Rezco, but shall merely be deemed to be an invitation to do business.

* While the portfolio manager will attempt to minimise risk, it is possible that the investor could incur losses, including the loss of principal invested.