The Federal Reserve has made it clear that more increases can be expected as it attempts to realign the rates with the strength of the economy. (Reuters)
While much of the world is down in the dumps, South Africa should be partying like it’s 1999, given that was the last time the country saw so many foreigners piling in at one time to buy up its assets.
Money has streamed out of emerging markets since 2013 in anticipation of the United States Federal Reserve stopping its quantitative easing programme and beginning a rate-rising cycle.
The fall-out over the Brexit vote, which saw the United Kingdom deciding to leave the European Union, has shaken global investor confidence and put the anticipated US’s rate-rising cycle on hold, sparking a flow of investment to emerging markets.
According to Reuters, foreign investors have been net buyers of South African assets so far this year, spending almost R115-billion on bonds and equities, almost double the tally a year ago.
The flows to emerging markets even shrugged off the failed coup attempt in Turkey last weekend.
Analysts say the flows are not necessarily about improving prospects in developing countries but rather that the outlook for the developed world has become increasingly worse.
This week, the International Monetary Fund cut its global growth outlook to 3.1% for this year, citing concerns over Brexit. Next year global growth is expected to improve to 3.4%.
It was feared South Africa would be one of the nations to suffer if the Brexit result led to an investor aversion to risk. But, at least for now, the reality appears to be quite the opposite.
“If you look at where the capital flows have been going since the beginning of the year until now, this is not just a South African story. It’s an emerging market-wide story,” said Isaah Mhlanga, an economist of Rand Merchant Bank.
The change in direction of the flow of money began earlier this year but has gained momentum since Brexit. The JSE, for example, experienced the longest streak of net buying of equities by foreigners since 1999 – 36 consecutive days up to July 15, according to Moneyweb – and in June there were record inflows of R63.8-billion.
Some analysts are arguing, too, that resource prices such as those of iron ore, platinum and oil have come off their lows and the markets are signalling an end to the commodity downturn.
But it doesn’t take much to out-perform the developing world the moment. According to Credit Suisse’s Emerging Market Quarterly, for the third quarter of 2016, about 40% of the Group of Ten (G10) government debt has negative yields because of deflationary risks in these economies. “Risky assets benefit from bonds being not just expensive but literally costly to own,” Credit Suisse said.
Neal Smith, the portfolio manager of Denker Capital’s Sanlam Investment Management Global Emerging Markets Fund, said longer term trends show that emerging markets do materially outperform the developed world, but come with volatility and are subject to cycles.
Black Rock, the world’s largest asset manager, with more than $4.6-trillion under management, this week said in a note that it is time for investors to warm up to emerging market risks. Black Rock said it saw emerging markets as now meeting the conditions needed to receive a “great migration” of money seeking to flee negative interest rates in the developed world.
Smith said sentiment over emerging markets has been “very, very negative” and resulted in valuations being very cheap.
“Currently emerging markets are outperforming the developed world by about 7% in dollar terms.”
It is speculated that developed economies could try to use so-called helicopter money as a measure to boost spending. The Bank of Japan, meeting at the end of July, could be the first.
Helicopter money, an alternative to quantitative easing, is likely to involve tax cuts or infrastructure projects to act as a monetary stimulus and lift inflation.
“Markets are very cynical of the developed world. Their experiments will fail to inflate themselves out of trouble. Longer term, there are real issues that they don’t know how to solve”, Smith said.
“The odds of an EU break-up are increasing and on the EU periphery some economies are really challenged. I wouldn’t be surprised if some of them fail,” said Smith.
The extent of the Italian banks’ crisis is not yet known, although it is clear they cannot tackle the problems related to capitalisation, profits and bad loans alone. Even in Germany, which has performed well relative to other nations, Deutsche Bank has come under pressure. On Tuesday, the global ratings agency Standard & Poor’s downgraded the outlook on the bank’s long-term credit ratings to negative.
US markets hit record highs this week. This makes perfect sense for investors who can get better returns from dividend yields on the stock market than from what the bond market is offering.
US treasuries reached a record low return of 1.318 on July 6, according to Bloomberg. Even so, “compared to Japan and Europe, it’s a no-brainer to go to the US”, said Smith.
“Emerging markets are in much better condition. They are small economies and need to attract significant capital inflows.”
Smith said South Africa is an expensive emerging market relative to others. To attract capital, emerging markets need to be investor friendly and, although many countries are instituting relevant reforms, South Africa is not.
But Momentum Asset Management’s Wayne McCurrie said South Africa has never been as attractive.
“We will continue to attract foreign money. We are one of the most liquid emerging markets in the world. Our bond market is way larger than our peers’ [such as Turkey’s]”, he said. “Going back to 1988, the difference in yield between a South African bond and a US treasury bond is as high as what we have ever seen, even when our inflation was 16% and not around 6%, like it is now.
“Everything else considered, South Africa is not a bad place for investors to be … I would rather invest here than in Russia, Brazil or India.”
Mhlanga said JP Morgan’s bond market spread for South Africa shows that its country risk declined to levels that they were before finance minister Nhlanhla Nene was removed and replaced by a parliamentary backbencher, and its risk premium is lower compared to its emerging market peers.
The reasons, Mhlanga said, are that fears of a ratings downgrade have taken a back seat and the coming together of the government, labour and business on investor road shows have been positive.
Also, South Africa has deep capital markets, which allow people to invest and withdraw money easily.
McCurrie said, with the JSE so internationalised, and many of its listings earning money outside of South Africa, investment in the country can be seen in the purchase of resource shares, banks and retailers.
Foreign equity inflows have helped the rand strengthen to about R14.30 to the dollar this week. “The rand is probably a bit cheap at the moment,” McCurrie said.
The past weekend’s coup in Turkey was over before it started. It has seen its benchmark 10-year bond yield – a key indicator of how risky investors view a government – rise from nearly 9% before to almost 10% on Wednesday. South Africa’s 10-year bond yield was about 8.8% this week.
The Turkish lira has also weakened against the dollar.
In the past, such an event in an emerging market would have affected sentiment about all of them. “Unfortunately, the world is in such a state, [these sorts of events] have become so normal that it doesn’t actually make a difference anymore, quite frankly”, said McCurrie.
Turkey, Smith said, was contained pretty quickly. “We invest in Turkey. It was really localised, and there is very limited risk of contagion.”
An emerging markets analyst at Nomura, Peter Attard Montalto, said investors are taking Turkish events in their stride “surprisingly well”, with investors’ focus on growth potential and fiscal tightening still in place for now.
“For now, as long as the [US] Fed is not hiking, G10 rates remain lower and further easing is expected to come from the Bank of England and the European Central Bank, investors want to remain very close to benchmark and not very currency hedged,” he said.
“As a result, underweights like South Africa, which have been trimmed, will remain supported regardless of what went on in Turkey. Indeed, this is why we saw the rand-dollar exchange rate trade back so fast on Monday”.
Attard Montalto said this support will remain until the local elections on August 3, when the political noise and risk will rise and investors will focus more on the lack of reform and progress.
“Until then, there is not much that suggests it’s worthwhile standing in the way of the global wall of money,” he said.
Markets seem to have largely ignored the political noise in general, Mhlanga said, noting that despite the controversial Donald Trump being elected this week as the Republican candidate to run for the US presidency, the S&P 500 and other US markets also reached record highs.
“If you are in the markets, the political noise doesn’t matter”, Mhlanga said. “Something is happening in every other country, so where else do you go? You accept it as the status quo”.
But he warned that the money was not in South Africa to stay. “It is hot money. These are cross-over investors. They are people that ordinarily invest in developed markets.
“If sentiment changes – say, if the US Federal Reserve surprises markets by being hawkish – the risk of outflow from emerging markets is quite real.”
Mhlanga said he thought the inflows might continue for another 18 months and the consequent outflows will leave emerging markets with ever-wider current account deficits.
Credit Suisse expects the next rate hike by the Fed in 2017.
Another reason for emerging markets gaining popularity again is because the resource cycle appears to be turning in their favour, said McCurrie. Over time, commodity prices essentially track global industrial production. But prices were too low in December and January.
“Even though industrial production was not falling, a collapse in resources opened up the biggest negative prices virtually ever … it’s wrong because the world is actually growing,” he said, noting that the gap has closed quite significantly and the prices of many resources have returned to more or less their “right level” when compared to industrial production.
“So we will see inflows into South Africa purely because of resources,” said McCurrie, who said the resource index was up strongly this year.
Mhlanga also thought the pickup in commodity prices, although slight, given that oil remains under $50 a barrel, will further support growth. Additionally, mining activity has been supported by a softer-than-expected landing in China.
But Mamokgethi Molopyane, a mining and labour analyst at Creative Voodoo Consulting, said she didn’t believe the resources cycle had turned around.
Some commodity prices, such as those of platinum and gold, have done well but others such as coal and copper have not. Iron ore prices have improved since China increased its demand for steel, although it is probably because of some fiscal stimulus rather than a genuine demand.
Edgy investors moving into gold have seen the metal price flourish since Brexit. But things could take a turn for the worse, because wage negotiations in South Africa, which often result in strikes, are due to take place at a number of mines this year, Molopyane said.