Last year delivered excellent returns in international and South African equity markets. South African bonds were also superb but most international bonds were only good for selling short!
There is a lot of common market wisdom that goes something like “What goes up must come down”. I’m sorry to say that is the source of frequent and serious harm to portfolios when people sell way too early.
It’s quite true that the “cheap rating plus recovery-from-the-bottom” stage of the equity markets has run, but valuations are not extended and the “trend-following” stage of a bull run is usually much more extended. I wrote extensively about this in IM in March 2024.
To help me grapple with the broad market, I’ve always been more interested in establishing whether equity ratings line up with the cost of capital. I focused on the US as it’s the biggest market by far. I rolled and recalculated Krolls’s calculation of equity risk premium (ERP) from June 2024 (5% then) to extrapolate a current estimate. Since then, the S&P 500 has jumped 10%, but FactSet’s earnings consensus still looks solid (albeit somewhat tempered into year-end), while short-term rates are substantially lower but 20-year rates are 0.5% higher. Net result: the US ERP slightly sagged from 5% to 4.5% now. That is a fairly reasonable real return.
Additionally, FactSet has the earnings growth of the Magnificent 7 more tempered (but still high) in the 20% range, but expected earnings growth for the remaining 493 companies on the S&P 500 is up from 4% in 2024 to 13% in 2025. That is a broadening of the market, and usually a very bullish signal. Cyclically adjusted p:e ratios are high, but that metric is useless for market timing purposes. If you must capitulate to bearish sentiment, rather be a cash chicken (or use guaranteed products) than a short-selling bear.
The US Federal Reserve’s rate cut note of December 18 shows dissent in the federal open market committee over how the US economy is doing, whether many more rate cuts are necessary and if US inflation is accelerating again. The statement and “dot plot” signalled that the Fed is pivoting from focusing on unemployment back to controlling inflation. The signals point to the Fed pausing after two more rate cuts in 2025 — down from the four rate cuts foreseen in the US central bank’s previous dot plot. Part of me wonders if this isn’t early Trump management by the Fed, though the US president has moderated his anti-Fed diatribes from Super to Regular.
Even after the last cut, South Africa’s real interest rate is still at the highest level in 18 years, so the Reserve Bank really could consider lowering borrowing costs further
I suspect that 2025 will be the year that the world resolves whether global inflation is structural or cyclical. The Fed in fact will need to cut rates more next year if collapsing interest rates in the eurozone put downward pressure on US bond yields in the second half of 2025.
The European Central Bank (ECB) will likely cut key interest rates four or five times in 2025 until rates are at 2%-1.75%. Recessionary conditions look sticky in Germany and France and both are mired in political crisis until new leadership emerges. The ECB has ditched its reference for the need to keep monetary policy “restrictive”. More rate cuts anyone?
Japan is very much alone in its rate-hiking cycle. China looks in need of fiscal stimulus and no doubt is not relishing the prospect of a trade punch-up with Trump. Similarly, the oil price is also not signalling inflation either; indeed, we hope that growth doesn’t faceplant too hard.
South African indices belied some of the (big) reratings experienced among South Africa Inc stocks. Which is just another way of saying that economically sensitive smaller caps whipped big caps 27% to 9%. Ouch. If ever there was going from a “bad to less bad” bull market, this was it. It would be good to see lower rates, no load-shedding and firmer political confidence actually drop through to GDP growth.
For South African institutions we have an environment of inflation stabilising at around 3%-4.5%, with the repo rate at 7.75% and both prime and 20-year bonds at 11.25%. These are huge real yields and on a risk-adjusted basis, 2025 will surely be the year of the bond in South Africa again.
Even after the last cut, South Africa’s real interest rate is still at the highest level in 18 years, so the Reserve Bank really could consider lowering borrowing costs further.
The bottom line is, apart from OECD bonds, risk assets can grow unless earnings faceplant or bond yields melt-up.
* Lucas is a Vunani private client portfolio manager
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