Economics, politics and your portfolio

By portfolio manager Melville du Plessis

Let’s first reflect on what macroeconomic policy is about: economic growth, price stability, employment and viable external accounts. These are important considerations when evaluating the potential outcomes of an investment decision:

• Bonds – the impact of unexpected inflation
• Companies – the economic growth outlook and consumer spending power
• Foreign exchange rates – inflation differentials, balance of payments imbalances and the terms of trade

But how does this fit together in practice?

Relative importance of policies

Macroeconomic policies are typically implemented through a combination of fiscal policy (budget balance between government expenditure and tax revenue) and monetary policy (interest rates and the supply of money).

Since the global financial crisis (2007-2009) policy makers’ focus has shifted between fiscal policy dominating at times and monetary policy at others. Large fiscal stimulus packages were implemented to mitigate the risks of prolonged recessions – with accompanying budget deficits and increasing debt levels. Unconventional monetary policy measures such as quantitative easing and negative interest rates have been used. This has renewed interest in coordination considerations of monetary and fiscal policies.

In South Africa, the SA Reserve Bank’s Monetary Policy Committee is responsible for monetary policy, while the National Budget (fiscal policy) is formulated by National Treasury. As we shall see next, the credibility and independence of these institutions are of critical importance for the country’s prospects – and investment returns.

Credibility and independence

Both the policy frameworks and implementing institutions need to maintain their credibility and independence to be successful. The less successful one component, the more pressure on the other to achieve the overarching macroeconomic goals. For example, a loss of confidence in monetary policy could result in a self-fulfilling prophecy: if inflation expectations are not successfully managed then this could lead to inflation spiralling out of control resulting in higher interest rates, which in turn makes financing the fiscal budget deficit more expensive.

The political environment and actions are also important: in December 2015 when South Africa’s Finance Minister was unexpectedly replaced it led to a sell-off in financial assets, including substantial losses on the country’s currency and government bonds. In fact, December 2015 was one of the worst months on record for local bonds while the rand weakened to previously unseen levels.

The loss of investor confidence has not yet been restored, with government bond yields trading 130 basis points higher so far during 2016 compared to the previous three years leading up to the event. Monetary policy actions for 2016 were also influenced – with two policy rate hikes -as the weaker currency resulted in additional inflationary concerns.

The events during December 2015 were interpreted as a loss of fiscal credibility by the markets. It puts further pressure on government finances: according to National Treasury’s February 2016 Budget Review the forecasted increase in debt service costs has risen further on the back of the December events to R15.3 billion for the following two years.

This means that government has less room to spend on items that support the economy in the long run, such as education. It affects the longer-term prospects in the country, as well as the outlook for bonds and the potential returns on equities and property.

But the question that interests investors is: how is my portfolio exposed to all of this?

Your portfolio

Investors can take some comfort in the fact that South African assets are already pricing in some of the political uncertainty and the potential for South African credit rating downgrades. Further weakness in government bonds and monetary policy tightening is possible, but there is a margin of safety priced in.

Looking at local companies, almost half of the of the larger shares listed on the Johannesburg Stock Exchange are dual listed shares with local share prices thus tied to the exchange rate, while another quarter are rand hedge shares. These share prices are somewhat insulated from negative sentiment and accompanied currency weakness. With almost two thirds of locally listed company earnings generated abroad, the ones left most vulnerable are locally orientated companies and interest rate sensitive sectors. This includes financials, as well as retailers and industrials whose earnings are sensitive to the performance of the local economy – however these sectors are already trading at a discount.

Listed property has been one of the best performing asset classes and its continued strength has made this asset class more vulnerable – as has been highlighted by the increased volatility lately. The sector has diversified offshore over the last few years, but remains sensitive to local interest rate moves. An increase in bond yields combined with negative investor sentiment would lead to weakness in listed property counters.

What do we need at this point?

The political decisions taken and macroeconomic policies implemented need to create a supportive environment which is conducive to economic stability. One could only hope that the looming threat of South African credit rating downgrades would create even greater urgency among the public and private sector to address the legitimate concerns that credit rating agencies are highlighting, bearing in mind that the factors that are important for long-term economic trends aren’t necessarily the same as those that are important in the short to medium term.

The implementation of credible and successful policies that stimulate broad-based economic growth is necessary to reduce rising tensions and are also key considerations when assessing the potential return on any investment in the country.