Central banks will be satisfied with their progress in controlling inflation whilst maintaining employment and economic stability. Although central bank execution risk of taming inflation without causing recessions certainly persists, as the US economy cools, we remain optimistic about the outlook for financial markets. The current combination of lower inflation, partly due to reduced oil prices and normalised supply chains, robust consumption fuelled by real (after inflation) wage increases, declining interest rates, and strong balance sheets across both households and corporations, leads us to be constructive on markets, recognising that there are increasing chances of a “soft landing” being delivered.

At the recent FOMC meeting in September, the Fed opted for a 50-basis points (bps) cut instead of the anticipated 25- bps. The most important takeaway for investors was the Fed’s assessment of the economy. “The decision reflects the Fed’s growing confidence that, with an appropriate recalibration of policy, strength in the labor market can be maintained alongside moderate growth and inflation moving sustainably down to 2%. This recalibration aims to maintain economic and labor market strength while enabling further progress on inflation as the Fed moves toward a more neutral stance.”

It was crucial for the Fed to emphasise economic strength to avoid any perception of panic with the 50-bps cut. Fed Chair Jerome Powell clarified that this move is not the new norm but a pre-emptive measure to signal the Fed’s commitment to staying ahead of economic challenges. The Fed believes the economy is in good shape, with growth expected to decelerate to around 2%, consistent with the US’s potential growth. Growth forecasts for 2024 were revised down slightly, with no changes from 2025 onwards. The Fed indicated a further 50-bps of cuts in 2024, followed by quarterly 25-bps moves, reflecting a gradual cutting cycle during 2025. Importantly, Mr. Powell reiterated that the Fed is prepared to act decisively if the economy deteriorates more than expected, reassuring investors that policy responses will be strong, thereby reducing the likelihood of significant sell-offs in risk assets.

However, it should be noted that the Fed’s outlook hinges on two main assumptions: that inflation remains under control and that the labour market does not deteriorate significantly. Like the Fed, we will continue to monitor these developments and stand ready to adjust our views if conditions change.

Recently, however, there has been a shift in policy aimed at providing much-needed support to the Chinese economy by boosting domestic economic activity, stabilising the real estate market, and supporting equity market prices and consumer confidence. China announced a stimulus package to inject one trillion yuan into the economy, along with accommodative measures such as cutting lending rates, mortgage rates, and down payments on property, and supporting share buybacks for domestic equities. The Chinese currency, equities, and commodity markets have all responded positively to these proposed policy reforms, with aggressive short covering further propelling these markets higher.

The government’s renewed urgency has captured market interest, as the extensive stimulus measures across all facets of the economy are perceived as a “whatever it takes” approach to revitalise China.

While these measures are positive from a liquidity perspective, especially with global central banks cutting rates, the sustainability of the recent aggressive rally remains in question. Economic improvement will not happen overnight, as the stimulus measures take time to take effect, and the government works through elevated property market inventory. Following the Politburo meeting, key execution points to monitor in the coming months include controlling new property supply, optimising housing inventory and quality, and implementing supportive measures for idle land.

However, it is crucial to distinguish between environments where monetary easing was necessitated by financial dislocations or imbalances—such as asset bubbles (dotcom era), stretched balance sheets and reckless lending practices (Global Financial Crisis), excess capacity following aggressive capital formation or employment growth, and unexpected events like wars or oil shocks (1987) — and periods when interest rates are reduced due to disinflation, as we are currently experiencing. The latter tends to be positive for both equities and bonds, and from the current level of interest rates the Fed has plenty of ammunition to support the economy if required.

Additionally, job cut announcements are down from a year ago despite sizeable layoff announcements in tech and finance this year. We are also relatively optimistic on the outlook for layoffs since we have not seen significant over-hiring in this cycle.

We are closely monitoring these trends for any signs of weakness, as aggressive layoffs could disrupt the benign outlook for economic growth due to the negative feedback loop between weakening consumption and a weakening labour market.

Despite the trends within the labour market, economic data and final demand remain resilient, allowing us to maintain a positive outlook on financial markets. The global environment of synchronised declining interest rates is expected to support consumption, investment spending, and liquidity. Coupled with lower oil prices, reduced inflation, and positive corporate earnings revisions, this bodes well for equity markets, justifying our tactical overweight position in this asset class.

As we approach the 60th US presidential election, increased volatility is anticipated as candidates vie for the presidency. This is not unusual and may present opportunities for patient, long-term investors. At Melville Douglas, our portfolios are well-diversified across various asset classes, sectors and stocks ensuring they are well-positioned to navigate any outcome.

Equity valuations

On the face of it, equity valuations are not particularly attractive, primarily due to the high value assigned to high earnings growth sectors and stocks in the US. However, outside the US, valuations are in line with long-term averages and the US market appears fairly priced on a price-to-free-cash-flow basis. We expect valuation multiples to de-rate over the medium term, but in the short term, given declining interest rates, they could remain elevated. Historically, equity valuations have only contracted during recessions and short-term equity returns are more linked to earnings growth momentum than valuations, hence our tactical overweight position in the asset class.

Attributing the recovery of the local currency and domestic financial markets solely to the positive political backdrop would be inaccurate. The recovery has also been driven by benign inflation and interest rate outlooks, as well as the actions of central banks. With the synchronised global interest rate cutting cycle underway, the South African Reserve Bank followed suit with a 25bps decrease in the repo rate after inflation printed below the target midpoint of 4.5% for the first time in over three years.

One of the most encouraging aspects since the formation of the GNU, has been the improvement in confidence among consumers, business and the construction industry. Something which has been lacking for some time and if sustained will assist in moving the economy onto a different growth trajectory alongside the implementation of government’s growth and reform initiatives.

President Ramaphosa’s near-term growth ambitions for the economy may not be as far-fetched as some believe. The President has called to turn South Africa “into a construction site” to rebuild the country’s infrastructure after years of neglect. With collaboration from the private sector, the economy could achieve a 3.3% growth rate by the end of 2025.

In a recent report titled “What we need to jump-start economic success” the Bureau for Economic Research (BER) indicated that while their base case is for the SA economy to grow by 2.2% in 2025, 3.3% GDP growth is achievable if the economic reforms are implemented immediately, by prioritising the following areas:

• Electricity reforms
• Port and rail reforms
• Water
• Crime, corruption, governance, and other reforms

According to their analysis this package will lead to:

• Growth of over 3% by 2025 and a sustained increase in growth to 2029
• More than 130 000 additional new jobs every year (job growth increases by 2.1% a year)
• Nearly 1m additional new jobs by 2029
• Favourable inflation impacts from lower electricity and transport prices, support a repo rate cut

An improvement in the country’s growth fortunes will have a material effect on South Africa’s fiscal health, with Debt-to- GDP expected to decline, reducing government borrowing costs (10-year government bond) to below 9% by 2026/27 as the country’s sovereign risk premium narrows to levels last experienced during 2014-2016.

Asset prices stand to benefit from these developments, given that growth and the discount rate (required rate of return) are the two most important inputs in valuing assets. While we are starting to see positive revisions to corporate earnings from consensus, we believe more is in store, given that the earnings growth to real GDP multiplier for South African equities has historically been between 4-5x.

Domestic asset allocation

Domestic Equity - Overweight

The favourable and market-friendly outcome from the South African elections with the formation of the Government of National Unity is expected to unlock value for shareholders as growth reforms are implemented through various initiatives and greater public/private sector partnerships. Emerging Market investors currently hold an underweight position to South Africa, however, we expect a shift in this allocation due to the improved economic outlook. This could result in an uptick in valuations, given that South Africa is currently trading at an unusual discount to the MSCI Emerging Market peer group.

Our strategy remains to invest in high-quality businesses with strong balance sheets and robust cash flow streams. With that in mind, valuations remain supportive, and we expect an improvement in earnings growth momentum over the next year, underpinned by favourable base effects, lower interest rates, and an improvement in economic activity as confidence improves.

Global Equity – Neutral

The global economic backdrop remains resilient, though some softness is emerging in the labour market. The outlook for the global economy is unchanged, with the baseline view that global growth over the short to medium term will align with trend growth, supported by monetary accommodation as inflationary pressures subside. The no-recession view is critical for the global equity outlook. If rates are cut due to disinflation, positive returns should be expected.

Earnings growth is expected to broaden out to other sectors. Base effects are favourable and operating cost pressures are expected to subside as labour costs moderate in line with lower inflation and as the job market cools off after a period of unusually strong growth in developed markets. In addition, global earnings revisions have once again turned positive.

Valuations however are not as attractive compared to history, but this is predominantly a function of the value assigned to high earnings growth sectors/stocks in the US. Outside of the US, valuations are in line with long term averages.

We have a neutral exposure to Global Equity in domestic portfolios due to our tactical overweight position to SA assets.