MARKET REVIEW – Markets pare early Quarter gains as Strong Dollar weighs late September:
The JSE All Share recorded its worst quarter in three years and shed 2.58% in the month of September alone.
For the Third Quarter, SA Listed Property was the star performer, returning 7.1%, the All Bond Index rose 2.2%, Cash gave you 1.5% whilst SA Equities lost 2.1%.
SA Listed Property surprisingly leads the year to date returns at 13.9%, whilst the All Share has given you 9.5%, All Bond Index 5.7% and Cash at 4.3% against CPI inflation of 6.4%.
External reasons for this weakness include: uncertain prospects out of China, worrisome economic reports from Europe prompting fears of the Eurozone dipping back into recession, and lastly commodity prices in particular being aggravated by the very sharp rally in the US dollar.
Add to this a weakening local outlook given a record August trade deficit of R16.3bn and signals from the Monetary Policy Committee of a tightening bias for local rates despite a weakening economic growth outlook. Our currency remains the key upside risk to inflation which continues to appear vulnerable given SAs deteriorating current account deficit, falling commodity prices and tenuous foreign portfolio flows funding the shortfall.
ASSET ALLOCATION – SA Equities capitulate, Global & Local Property take the lead
Q3 SECTOR PERFORMANCES – Broad-based weakness
On a sector view, weakness has been broad-based with all the major indices ending lower. Although marginally lower, Financials have outperformed, with insurers benefiting from a low claim season due to favourable weather, wealth managers reaping the benefits from positive returns, compounding effects and banks have reported relatively stable earnings. African Bank obviously blots the sector’s record, the demise of the micro-lender impacting many of SAs Money Market funds in particular.
Industrial counters have been pressured by lacklustre earnings, particularly in the retail industrials. The SA consumer is noticeably under pressure which is weighing on the SA retailers.
Resource counters have once again taken a pounding in response to a confluence of reasons – fears over Chinese demand while the surging US dollar further pressured commodity prices and the effects of the prolonged strike action filtering into the earnings reporting season.
Top sector performances came from Fixed Line Telecoms, Healthcare and Real Estate.
Bottom sector performances were from Platinum, Personal Goods, Golds, Auto and Industrial Transport.
CURRENCIES, COMMODITIES and EMERGING MARKETS – suffer the Strong Dollar & Over-Supply
The rand has depreciated 6.1% against a surging US dollar over the quarter, although held ground against a weak Euro, gaining 2.1%.
South Africa recorded a mixed quarter from foreign portfolio flows – a R10.7bn equity inflow was offset by R12.4bn of outflows from bonds.
The sharp rally in the dollar also translated into weak commodity prices, notably gold, platinum, iron ore and other metal prices, especially with more speculative investors dumping their exchange traded funds in the metals. This selling has more than offset any increase in demand from the global car industry which was just beginning to show signs of improvement.
The platinum price has slumped 12.4% in dollar terms in the last 3 months to a 5-year low and remains in this down-trend spiral that started in 2011 at $1915 compared to the current price around $1200, prices last seen in 2006/7.
The outlook for iron ore also appears jaded with BHP Billiton forecasting the increase in iron ore supply to continue to outstrip demand from the steel industry over the next 2 years, meaning the iron ore price could remain pressured, even after tumbling 41% in the year to date.
The oil price fell close on 16%, its biggest quarterly decline since 2012. Strong supply was the main culprit as North American and OPEC production surged and Libyan ports and oil fields were reopened.
SA has not been in isolation – the MSCI Emerging Markets Index fell 7.4% in September and places Developed equities back in the lead for 2014 on a return of 4.4% against the ytd MSCI Emerging Market return of 2.6%.
In US dollar terms, the worst quarter returns amongst the emerging markets came from Russia -15.1%, Turkey -11.8%, Brazil -8.4% and the South Africa -6.6%. Both India and China recorded small positive dollar returns in Q3.
Amongst developed markets, the S&P500 hit new closing highs in each month of the quarter and breached the 2000 mark in September before succumbing to profit taking late in September. The US performance certainly stands strong against the weak UK and European markets.
Commodity Prices and Emerging Market Currencies take a beating:
MAKING SENSE OF THE QUARTER AND LOOKING TO THE FUTURE – 2 Steps Forward, 1 Jump Back:
In developed markets we are beginning to see significant decoupling of business cycles and monetary policy prospects, with the US in particular approaching peak inflection point, the UK hot on its heels, while the Eurozone and Japan lag significantly behind.
Most fund managers continue to believe that the US offers the greatest opportunities with US earnings forecast to rise approximately 10% in 2014 and close to 15% in 2015. Earnings strength helps buffer shares against the worries about Fed tightening and possible geo-political issues that may arise. Another positive read from the US is that US corporates have bought back $338billion so far of their own shares in 2014, the most in 7 years.
From a top-down perspective, again the US appears to be the global beacon of hope with respect to global growth although credit creation in the US is still well below average. Consumers continue to pay down their debt, even though mortgage yields have fallen to record lows.
Unleveraged growth means the developed world is unlikely to spring into boom times and we’re likely to make slow yet irregular progress.
The world economies are still feeling the effects of excessive debt and commentators believe that the deleveraging will take longer and possibly see negative real rates (inflation higher than official interest rates).
The breather seen across global equities in the last couple weeks has been welcomed whilst the long term bull market trend, albeit temporarily hindered, remains intact. We caution however that market commentators believe there may be more pain to follow across equities but the consensus call is to stick with equities over bonds.
The consensus outlook in US Treasuries is fairly neutral with the risk of a significant sell-off relatively low given the world of overabundant savings. When faced with an over-savings scenario, bond yields traditionally fall to stimulate spending. Excess savings in Europe remain large and growing. Meanwhile the strong US dollar will dampen the pricing power of the US economy, drive down inflation expectations and compress bond yields even lower.
The outlook for China remains worrisome and described as “two steps forward, one step back” as authorities try to juggle both reform and growth at the same time. In Japan, the spurt of nominal growth has stalled and another dose of stimulus is needed to sustain reflationary momentum. Furthermore, Japan’s demographics remain poor with the labour force contracting at 0.5% per year.
Europe is the other big worry and seems headed for stagnation as credit growth continues to contract. Banks are reluctant to lend and businesses and consumers are loathe to borrow.
Economists are also warning that an ongoing strong US dollar will possibly reverse the strong capital flows into Emerging Markets – another cause for concern across local equities.
For South Africa there is significant cause for concern and most fund managers are expecting some Fourth Quarter weakness. Valuations amongst the Top40 heavyweights, in particular amongst the consumer industrials, are stretched and we are beginning to see a noticeable search for value amongst the smaller and mid-caps. This trend is likely to continue into Q4.
On the PE basis, the JSE All Share is trading just below 17x earnings down from its peak of over 19x in June. The current level is the lowest since July 2013 but still above the long term average of 14.7x. Again the disparity is evident amongst the industrial conglomerates with the likes of SAB trading on a PE of 29x and Naspers a massive 85x.
JSE PE Ratings – Industrials appear stretched
South African Macro highlights for the Third Quarter and month of September remain weak:
The MPC kept rates on hold although continued to signal a tightening bias.
The SARB marked down the growth outlook to 1.5% (from 1.7%) for 2014 and 2.8% (from 2.9%) in 2015 with risks skewed to the downside. The inflation outlook was lowered to 6.2% and 6.3% for the next 2 years on a more benign food inflation trajectory. However, the MPC did single out the currency as a key upside risk to inflation although also highlighted concerns around a wage-price spiral and elevated wage demands.
Governor Gill Marcus announced that she is stepping down as her term expires ahead of the October MPC meeting. The deputy governor, Lesetja Kganyago was announced as her successor.
Headline inflation unexpectedly ticked higher in August as food inflation picked up and core inflation also rose. The August report disappointed as food inflation climbed to 9.5% driven mainly by a 1% rise in meat prices (meat inflation at 10.1%) and a 1.5% gain in dairy products (dairy annual inflation at 12.7%).
Core inflation rose to 5.8% partly due to base effects, but also a rise in vehicle and personal care costs.
SA’s current account deficit widened to 6.2% in 2Q14 from 4.5% in the first quarter, and attributed to the impact of the platinum strikes. Weak domestic demand will continue to limit growth while the removal of supply side constraints should favour export growth and hopefully see a slight improvement in the current account deficit in the third and fourth quarters.
The trade deficit widened to 2.8% of GDP, from 2.1% previously, due to the impact of the platinum strikes filtering through the system as well as weak external demand.
The Purchasers Managers Index recovered to 50.7 in September from 49 in August, rising above 50 for the first time in the past five months, indicating a slight improvement in manufacturing activity.
A slowdown in Consumer Spending was reflected in the SARB’s 2Q Bulletin, as well as a concerning drop in fixed investment. Household spending softened further as real disposable income growth fell to just 1.3% partly due to wages lost during the strikes as well as more modest real wage gains in most sectors.
It was announced that Medupi is likely to cost the state R35bn more than original estimates placing the final figure now over R105bn, according the Public Enterprises Minister Lynne Brown. The first unit of Medupi is expected to be synchronised to the grid by December and come into full operation in 1H15.
In corporate news, the SARB put African Bank into curatorship and begins restructuring the ailing business. It undertook R17bn of the bank’s bad loans at a cost of 41% of face value. This left R26bn of good loans (after provisioning) which is to be recapitalised by way of a R10bn rights issue underwritten by
7 major financial institutions – Firstrand, Std Bank, Nedbank, Absa, Investec, Capitec and the PIC. African Bank JSE listed instruments, debt and equity were suspended on August 11th, and the good bank holding company will list in due course.
THE GLOBAL MACRO ENVIRONMENT – US the “Global Beacon of Hope”:
The US Fed reduced its asset purchases by $10bn in each month over the quarter with “QE” set to conclude in October.
The focus of this quarter turned to the timing of a Fed rate hike, though FOMC commentary continued to look for a “considerable period” between the end of QE and the first hike.
2Q14 GDP expanded at an annual rate of 4.6% quarter on quarter, the highest rate since 2006 as growth bounced back from a 1Q contraction of -2.1% caused by poor weather conditions.
Nonfarm payrolls underwhelmed and the unemployment rate was unchanged at 6.1%, whilst the participation rate held steady at 62.8%.
Consumer confidence firmed over the quarter with the Univ of Michigan survey rising to a 14 month high of 84.6 in September, up from 82.5 in June.
Purchasers Managers Indices also rose sharply, the Manufacturing PMI rose to 59.0 in September from 55.3 in June, whilst the non-Manufacturing Index rose to 59.6 from 56.0.
China’s Central Bank announced in September that it would provide RMB500bn of liquidity to five major banks for a period of three months.
Housing conditions continued to deteriorate over the quarter with house price declines reported across most Chinese cities.
GDP growth in 2Q14 was 7.5%, up slightly from 7.4% in 1Q14.
CPI inflation eased to 2.0% year on year in August compared to 2.3% in June. PPI deflation continued, running at -1.2% year on year in August from -1.1% in June.
The Manufacturing PMI fell over the quarter to 50.2 in September from June’s read of 50.7.
Credit data was soft over the quarter with new bank loans totalling 703bn yuan in August compared to 1079bn yuan in June.
The UK economy remains in expansion mode, growing by 0.8% in 2Q14. A more balanced growth profile looks set to be underpinned by a solid housing market, strengthening corporate confidence and investment and a slowly improving export performance, as indicated by the quarter’s business surveys.
However official wage figures remain alarming and the BoE is cautious on the economy’s ability to withstand rate increases. Comments by the UK governor of the BoE, Mark Carney, caused investors to push back their anticipated timing of interest rate hikes.
Europe & Japan
Economic reports across Europe were weak over this past quarter. Both Italian and German GDP shrank in 2Q14, with Italy returning to recession. France’s economy also failed to return to growth over the period. Germany however, surprised with record employment figures and rising wages.
Consider this: An economic region where GDP growth is stagnating, retail sales are weak, unemployment is floundering at 11.5% and industrial output is sluggish. Worst of all, the region’s inflation rate has declined throughout the first half of 2014 to a mere 0.3% in August, its lowest level since 2009 and well below the target rate of 2%.
The response from Eurozone bond investors becomes more positive the worse the news gets – short term government bonds have drifted into negative yield territory, the 10year German Bund yield moving firmly below the 1% mark. As Europe stagnates and the risk of deflation increases investors are becoming more and more confident that the ECB will be forced to intervene and undertake further quantitative easing action to counter the weak inflation and aid the region’s recovery.
Following the subdued inflation prints and stubbornly high unemployment, the ECB President, Mario Draghi, finally announced a much anticipated 10bp reduction in the interest rate corridor and confirmed that purchases of asset-backed securities will begin in October.
Japan’s economy is also under threat, and recorded a contraction of 1.7% in 2Q14. The Japanese current account fell into deficit for the first time in five months in June.
- Eurozone deflates
A WORD FROM THE WISE… Guide to CGT
Capital Gains Tax (CGT) is triggered when an asset is sold at a higher value than that of its base cost. When an investor rebalances their portfolio back to a strategic weight, in order to ensure consistency of risk in their portfolio, CGT may be triggered resulting in lower returns. If one were to compare the effects of realising capital gains on an annual basis as opposed to ‘once off’ at the end of the investment term, it is found that the difference is dependent on client circumstances, time horizon, size of investment and expected capital return.
In Conclusion Capital gains and the tax associated with it is inevitable for taxable portfolios. In our opinion, the risk control and higher risk adjusted returns associated with regular rebalancing compensate the client for the tax paid over time. Triggering capital gains associated with rebalancing in order to meet long term objectives at a higher probability and lower risk is good investment practice. This also adjusts your base cost going forward which lowers the Rand value of CGT payable in the future. However, we would prefer to be able to make fund switches within structures that will not trigger CGT where possible. If an existing investment already has substantial capital gains, this should not deter the investor from making the correct investment decisions (i.e. switching into a more efficient portfolio). CGT will ultimately have to be paid somewhere along the line and it is important to remember that a portion of your investment will always be owned by the government. Realising CGT on an ongoing basis is often favourable particularly if the exclusion is available.