The outlook for the SA economy depends on China
Emerging markets (EMs) and their currencies enjoyed a strong comeback in 2017, after years of underperformance when compared to the S&P 500. The JSE All Share Index kept pace with the S&P 500 in 2017 in US dollars. An EM benchmark-tracking stock would have returned over 40% in the 12 months to January 2018 while the S&P 500 delivered an impressive 26%, less than the 28% delivered to the dollar investor in a JSE tracker.
Investor enthusiasm for equity markets in general and for EM securities and currencies in particular however ended abruptly in January 2018 and waned further in April. The EM equity drawdowns since January have been depressingly large. The MSCI EM Index and the JSE have now lost about the same 16.5% of their end January US dollar values, while the S&P 500 was down by a mere 4% at June month-end.
The carnage was widespread across the EM universe. The SA component of the EM Index, with a weight of 6.5%, has been an averagely poor EM performer in 2018, as shown in the figure below. Turkey is the worst performer in 2018, down nearly 30% in US dollars in the year to June. The All China component of the EM benchmark, with a large weight of 31.7%, has lost about 12% over the same period, with much of this loss suffered since March, including a large 7% decline in June. The Brazil Index has suffered a heavy 27% decline in its US dollar value in the past quarter.
The capital that had flooded into EMs and their currencies in 2017 has rushed out even more rapidly, presumably back to the US, so driving the US dollar higher and other currencies, especially emerging market currencies (including the rand) weaker. The rand has traded mostly in line with its peers in 2018, though it has lost ground to them recently.
It should also be recognised that the similar flows of dividends and earnings from the JSE and EMs over many years, in US dollars shown in the figure above, is not some co-incidence. It is the result of the similar economic performance of the companies represented in the two indices.
The JSE has been well representative of the EM universe taken as a whole, when measured in US dollars. Naspers, with a 20% weight in the JSE All Share Index and a close to 30% weight in the SA component of the EM benchmark, is largely a Chinese IT company. Naspers is riding on the coattails of its subsidiary Tencent, and this helps account the similar behaviour of the respective indices.
In the long run, it is past performance reflected by earnings, dividends and return on capital invested that drives equity valuations, not sentiment. Reported dividends, discounted by prevailing interest rates, do a very good fundamental job in explaining the level of an equity index over time. In the short run, expectations of future performance (sentiment), will move markets one way or another, as they have moved equity markets in the past.
The sell-off in EM equity markets is not explained by their recent performance, which has benefited from synchronised global growth. It reflects uncertainty about the prospective growth in dividends and earnings and therefore global growth rates to come. We may hope that pessimism is being overdone.
The impact of the performance of companies that operate in China, on the outcomes for EMs generally (including SA), cannot be overestimated. Not only is the direct weight of China in the equity and currency indices a large one, but China is an important trading partner for all other emerging market economies.
Therefore the ability of China to maintain its growth and trading relationships successfully and manage its exchange rate predictably and responsibly will be a vital contributor to the prospects for all EMs. Realised global growth, including growth in the US, Europe and China, will determine the outcomes for EM equity and bond markets and exchange rates. The performance of the global economy and the companies dependent upon it are as good or better than they were a year ago.
The performance of the SA economy would be assisted by a stronger rand and damaged by a weaker rand that moves inflation, interest rates and spending faster or slower. Exchange rate and inflation trends in SA are bound to follow the direction taken in all EM economies, especially China. We must hope that renewed respect for growth in China will make this happen. Our immediate economic future depends more on what happens in Beijing than in Pretoria. 5 July 2018