May started off with a bang, with several developed market indices such as the S&P 500 in the US and the FTSE 100 in the UK reaching all-time highs while Japan’s Nikkei 225 and Europe’s Stoxx Europe 600 indices also hit post-financial crisis highs.  However, a raft of negative news from increasing probability of the Federal Reserve ending quantitative easing to poor manufacturing data in China to rising bond yields in Japan led to an exhaustion of the rally.  MSCI World index actually ended down 0.3% for the month after being up 2.9% in April, 2.1% in March, flat for February, and up 5.0% in January (but is still up 10% for YTD).

Europe and China, buoyed by hopes that their economic slowdowns may have found a bottom, led the market rally with the US also chipping in with good gains.  But the weakness in the second half of May highlighted the main issue with markets currently, that quantitative easing has already pushed equity and bond prices to high levels while economic growth out of the financial crisis has remained relatively anaemic and profit growth is slowing.  Gold’s weakness continued, down another 5.2% and down 16.7% YTD (due in part to a strengthening US dollar and higher US interest rates), while other commodities were also weaker (Brent oil was down 1.9%).  US Treasury and German bund yields jumped to their highest point this year, 2.13% and 1.51%, respectively, as a potential “Great Rotation” by investors from bonds into equities may be beginning to take place.

The African Union turned 50 years old in May, and the leaders celebrated by accusing the International Criminal Court in The Hague of racism and “hunting” Africans, especially in pursuing Uhuru Kenyatta, Kenya’s new president, for inciting mass violence after the previous elections in 2007.  This is despite the transparent manner in which the court has conducted its proceedings.  However, overall the continent has benefited from the end to civil war in many regions and greater adherence to international standards, allowing entrepreneurship to take hold and greater foreign investment to come in.  Sub-Saharan markets such as Nigeria (up 13.0% for the month and 34.6% YTD) continue to reflect positive investor sentiment towards the continent.  If this momentum continues we may start questioning whether markets are a bit ahead of themselves.

South Africa, has been its laggard in terms of economic growth.  First quarter GDP growth was only 0.9%, so the government’s growth forecast of 2.8% for this year is perhaps a bit optimistic (and yet still lower than the 5% needed to cut into unemployment).  The Reserve Bank had to keep its benchmark rate at 5% to stem an alarming decline in the rand.  There were also wildcat strikes at some of the mines.  An upstart union, the Association of Mineworkers and Construction Union, has challenged the incumbent National Union of Mineworkers (NUM), which has been viewed by many constituents as too cosy with mine bosses, and attracted the majority of workers in some areas.  The NUM has responded by demanding 15-60% pay increases.  This has not helped foreign investor confidence and is partly the reason for the rand depreciation.  The currency depreciation helps South Africa’s competitiveness and the JSE All Share index was up 8.5% in May after being down in April.

The rand currency (and hence N$) has lost 10.8% vis-à-vis the US dollar and has now breached the 10 rand/dollar barrier.  We believe that this is now the single biggest factor facing South African and Namibian institutional investors, and is something we are actively discussing with our clients.

The US economy grew at an annualised rate of 2.5% in the first three months of 2013, despite the sequester (enforced budget cuts) agreed to at the beginning of the year, which subtracts about 1% from GDP.  Private sector GDP is growing at a healthy clip, led by a strong recovery in the housing market; many parts of the country are now experiencing housing shortages, causing median home prices to rise by 10.9% year over year (though prices are still 28% below their peak).  This has been coupled with a goldilocks situation of low inflation (producer price inflation is only 0.6% year over year) and a strengthening financial system; consumer confidence is now at a 5-year high as a result.

A more problematic issue is the revelation that tax authorities in the Obama administration had discriminated against opposition groups, an incrimination as good as treason in many gun-toting Americans’ eyes.  This has put a wrench into on-going budget negotiations; while most other issues have been resolved for this year, the federal debt ceiling still needs to be raised in the second half of this year.  The two sides are far apart in negotiations, and the tax scandal has hardened the position of opposition Republicans.  However, the more immediate impact on the market was the Federal Reserve’s signal that it will slow its quantitative easing programme, resulting in the yield on 10-year Treasuries rising to 2.13%.  This caused an immediate reversal in the stock market in the second half of May (though the S&P 500 index was still up 2.1% for the month).  As a result, many high profile hedge funds have incurred large losses.

In Europe, sentiment has significantly improved in Ireland and Greece, signalling that the painful restructuring that has taken place in those countries over the past few years is finally bearing fruit.  Greece is pushing forward with its privatisation programme, led by a recapitalisation of its banking sector, which should help ease tight credit conditions, while Ireland is now able to regularly access credit markets and has recapitalised its banking sector.  Both countries, as well as Spain (despite its 27% unemployment rate) and to a lesser extent Portugal, have rapidly closed their current account deficits and their labour cost differential to Germany, increasing the likelihood of their ability to remain in the Euro currency regime.  As tail risk fears have eased, the UK, German, and French markets were all up strongly, 2.4%, 5.5%, and 2.4%, respectively (and are still cheap relative to the US market).  Nevertheless, the restructuring process has exacted its cost; the Eurozone’s GDP shrank for the sixth straight quarter (falling 0.2% in the first quarter), with 9 of 17 countries in recession, France now experiencing a double-dip recession, and Germany posting an anaemic 0.1% GDP growth.  The European Central Bank (ECB) cut its main refinancing rate by 0.25%, though its efforts at monetary stimulus have paled in comparison to the US Federal Reserve’s.

China’s government has been accused by the US of targeting American government computers with a cyber-espionage campaign.  The accusations highlight China’s increasing military assertiveness as well as its willingness to continue stealing others’ technologies.  China is going through a difficult transition to a more liberalised, consumer-oriented economy while becoming a strong military power without causing conflict.  However, its economic slowdown seems to have eased, and the Shanghai Composite rallied 5.6% during the month.

Australia’s central bank has shaved a quarter point off its benchmark rate to 2.75%.  The country’s economy is slowing rapidly, and the market declined 5.1% during the month.  Australia has been one of the main beneficiaries of the China-induced commodities boom but is now struggling with what seems to be the peak in the commodities cycle.

In Japan, Prime Minister Abe’s economic strategy of quantitative easing, currency devaluation, and fiscal stimulus is starting to have a significant impact on corporate bottom lines.  Toyota announced that a weaker yen was a significant contributor to its net profit almost tripling in the first quarter of the year, while Sony posted its first profit in five years.  However, Japan’s market suffered its largest single day drop, 7.3%, since the Fukushima earthquake, followed by another 5% drop a few days later.  The market ended down 0.6% for the month after a dramatic up and down rollercoaster.  This has been due to the sharp rise in yields of government bonds despite the central bank’s purchases.  Though current measures have so far led to improvements in sentiment and economic activity, the central bank will likely have to come up with a solution to arrest rising bond yields to prevent higher interest rates from crippling the recovery.

In India, the two largest political parties both suffered humiliations.  The main opposition Bharatiya Janata Party was voted out of office in the southern state of Karnataka after five years of incompetent government.  The ruling Congress Party suffered two more bouts of scandal over bribery and abuse of power in allocating coal-mining licences.  Still, after underperforming for much of the year to date, the SENSEX index was up 1.3% in May.

Brazil’s economy grew by a paltry 0.6% in the first quarter despite a raft of government measures to boost growth.  Unfortunately, Brazil’s myriad of complex legislation means that economic liberalisation to improve productivity is very difficult.  This has been highlighted by the severe delays in preparations for next year’s World Cup.  It has already spent 3 times as much on stadiums as South Africa did.  Brazil has been the worst performing major market so far this year, down 4.3% for the month and 12.2% YTD.

There are two big elephants in the room.  One is rising bond yields in the US and Germany.  Whereas the US’s yield increases are a reflection of the country’s return to strong economy growth, rising German yields are a reflection of a risk-on trade away from the safety of German government bonds.  Neither is helpful for a global economy that is slowly recovering.

The other elephant is the needed restructuring of the French and Italian economies.  Whereas Greece, Ireland, Portugal and Spain have accepted the restructuring process and have strong government mandates to push through reforms, France and Italy are still in denial about the need for reforms at all.  Francois Hollande in France addressed none of the critical issues in his presidential election campaign, while Italy’s newly formed grand coalition government under Prime Minister Enrico Letta barely has a mandate to stay in power much less make any reforms.  It is likely that Hollande will not make any meaningful reforms until bond markets and credit rating agencies force his hand.

The market correction in the latter half of May was expected, however, many of the potential downside catalysts have been withdrawn from the market; the US fiscal cliff is largely resolved (and the federal deficit is declining quickly), peripheral Eurozone countries are adjusting their economies to become more competitive, and China’s economy seems to be finding a happy medium around 7-7.5% annual growth.