2014 MARKET REVIEW – Moderate returns; Plunging Oil Prices a late Game Changer
• Besides the macro and geo-political issues that played out over the course of the year, several themes shaped a volatile fourth quarter global market performance, that being: (1) the strong US dollar (2) the “surprise” rally in Treasuries (3), the late recovery in Chinese equities and lastly (4) the dramatic sell-off in Oil markets. This saw Global Equities returning 4.7% (in $- terms) in 2014, its twentieth year of positive returns in its 27 year history of data.
• Against this backdrop South Africa weathered the global volatility rather well, the JSE ended the year with a sobering 10.9% total return, somewhat sombre when compared to 2013’s = 21.4% and 2012’s = 26.7%; but in context of weak commodity prices, a weak Rand, and a very uncertain and tepid macro outlook.
• The MSCI South Africa index rose 5.7% in $ terms relative to the MSCI Emerging Markets index loss of 1.8%.
• Although almost 10% weaker, the Rand certainly wasn’t the most significant driver in 2014 like it had been in 2013 where it lost 19% of its value.
• Looking across the asset spectrum in 2014: SA listed Property trumped returns with a 26.6% gain, followed by Inflation-Linked Bonds with 11.2%, then the JSE All Share’s 10.9%, closely followed by the SA All Bond Index 10.2% and Cash returned almost 6% against average headline inflation of 6.2% for the year (cash currently offering negative real returns).
• Investing in Global Equity (MSCI AC World) in Rand terms gave you 15.1% (compared with 52% last year), Global Bonds (JPM GBI) returned 11.0% (relative to 18.2% in 2013) whilst Global Cash lost 1.3% (23.5% in 2013).
SA EQUITIES – Count your blessings, it could have been worse…
• Overall 2014 was no stellar year for investors on the JSE. The All Share index rose a mere 7.6% before dividends which is less than 2% above inflation. The total return with dividends reinvested is a slightly more comforting 10.9%.
• But in context, other Emerging Markets did not fare as well as South Africa, particularly in December. The MSCI Emerging Market index ended down 1.8% in 2014 (in $ terms) versus MSCI SA’s 5.7% gain, and underperforming Developed Markets by over 7% and the US by some 15%. The other commodity producing Emerging Markets performed shockingly – Russia lost 45.9% in value whilst Brazil fell 13.8%, but were plagued by numerous other macro and geo-political factors. China ended up 8.3%, India was a strong performer up 23.9% and Turkey rose 19%.
Volatile December Emerging Market returns (Local currency) – South Africa holds its own
South Africa outperforms the major global indices in 2014 North America trumps Regional returns
• Taking a longer term view SA Equities have given investors a whopping 18% compound annual average return over the last 10 years whilst SA Bonds have returned 8.5% over the 10 years.
• SA sector winners in 2014 tended to be more defensive groups with exposure to low interest rates, falling bond yields and/or a weaker rand. The Materials and Energy stocks bore the brunt of selling as commodity prices continued to collapse for a fourth straight year.
• The spread in returns from financials, industrials and resources was significant. Financials far outstripped the rest of the market, delivering a total return of 27.8%, whilst Industrials gave you a respectable 17.2%, however Resources lost you 15%.
• Financials outperformed, with banks reporting relatively stable earnings, although African Bank obviously blots this sector’s record in the third quarter. Non-life insurers were one of the sectors showing significant earnings upgrades particularly in this last quarter. Along with other yield plays, real estate stocks were a surprise star performer in 2014 with forecasts at the beginning of the year of approximately 5-6% returns, significantly below the 26.6% total return achieved. The Property sector also attracted the bulk of new listings on the JSE with 8 of the 23 new listings.
• Industrial counters were restrained by lacklustre earnings, particularly in the retail industrials. The SA consumer was noticeably under pressure earlier in the year, although the late fall in the oil price buoyed the sector sentiment in the fourth quarter. Construction and Material stocks remained out in the cold in 2014.
• Resource counters once again took a pounding in response to a confluence of reasons – fears over Chinese demand, a global oversupply with various new mines coming on line, while the surging US dollar further pressured commodity prices and oil’s fourth quarter demise was the last nail in the sector’s coffin. All the big diversified miners were out of favour, all losing more than a quarter of their value.
Valuations – Stretched amongst heavyweight Industrials:
• From a valuation perspective, SA began the year on 1 year forward PE of 13.9x earnings which steadily crept up to around 15x by year end. Most of the increase in PE rating has come from the Industrial sectors – Media, Personal Goods, and Food & Drug Retailers. The biggest forward PE declines were seen in Platinum, Mobile Telecoms (MTN responding to the slump in the Naira) and General Mining.
• At year end the JSE All Share’s Market Capitalisation of all constituents was R9.85 trillion with Industrials making up 58.6%, Financials 22% and Resources the remaining 19.4%.
Foreign Flows – JSE Equity inflows support Current Account deficit:
• In 2014, foreigners ended the year Net Buyers of SA equities for the first time in 3 years. Foreigners bought a healthy R18.1bn worth of equities, reversing the trend of sales of approximately R160m in 2013, R3.4bn in 2012 and R17.2bn in 2011. This inflow is in sharp contrast to Emerging Market equity flows, which saw a massive $25bn outflow in 2014. In December alone, Emerging Market funds suffered severe outflows to the tune of $17bn in the month alone as the collapse in the Rouble and sharp sell-off in EM Forex and debt ultimately weighed on EM equities.
• However SA Bonds were sold by the foreigners, Bond outflows of R5.7bn were recorded in 2014.
CURRENCIES, COMMODITIES and EMERGING MARKETS – OPEC sends clear message to Oil Markets
Emerging Markets underperform Developed Equity but high dispersion:
• Emerging Market equity ended almost 2% lower in 2014 underperforming Developed Equity by over 7% and the US by 15%. Dispersion in market and sector performance was high. Egypt, Indonesia, Philippines and India were the best performers, all gaining in excess of 20% in $ terms. The bottom three markets were Russia, down a massive 46%, Greece off 40% and Hungary -27%.
• Interestingly analysts revised down EM 2014 and 2015 Earnings by 17% in the past 12 months, whilst Economists have revised down 2014 and 2015 GDP growth forecasts for all countries except Hungary, Malaysia and India. Russia had the biggest negative GDP revision from 2.65% to 0.05%.
OPEC defends Market Share and not Price – Oil price tumbles 50% in 2014:
• Oil markets slumped after the OPEC meeting on 27 November 2014 where Saudi Arabia surprised the globe by saying it would not cut back on production to support oil prices. As a reminder, the average price of Brent oil in 2014 was approximately $99/barrel, compare this to the current price of $50/bl. How did we get here?
• The November OPEC meeting was a significant event in Global Oil markets with Saudi Arabia opting to defend market share at the expense of price for the first time since the 1980s. This change in Saudi’s behaviour is a short term game-changer and far outweighs the demand weakness which is seen as more transitory. This new era of volatility is expected to result in spending and investment cuts, which should see OPEC’s intended slowdown from key non-OPEC producers: US Shale and Russia.
• The next OPEC meeting is scheduled for 5 June 2015, but an emergency meeting before this is a possibility. At $50/bl Brent oil is already well below the marginal supply cost for the industry. At this price, spending will be reduced, projects delayed and investment will fall. The marginal supply over the last three years has come from US shale, where the companies have begun announcing significant spending cuts for 2015 by on an average 25%-30%. (Investec estimates the marginal cost for US share to be around $75/bl).
• Russia also plays a role in Oil’s outlook with the effect of sanctions and underinvestment pulling Russia’s 2015 production materially lower, approximately 0.5 million bl/day. Other supply side risk events in 2015 include Saudi Arabian succession, Venezuelan debt default and Nigerian elections.
• Oil price forecasts for 2015 are wide ranging from $60-$77/bl, averaging around $65-$70 for the year.
Emerging Market Currencies weaker across the board in 2014
Emerging Market currencies weakened on the back of a strong US dollar and weaker commodity prices, weighing most notably on oil producer, Russia (as well as geo-political factors).
Relative to the other current account deficit candidates, i.e. “the Fragile Five”, the rand is the worst performer over the last two years. Only Brazil fared worse than SA in 2014.
MAKING SENSE OF THE YEAR AND LOOKING TO THE FUTURE – Challenging but Opportunities exist:
PLEASE NOTE THE VIEWS AND FORECASTS HEREIN ARE BASED ON CONSENSUS AND ANALYST REPORTS.
• The Christmas break has seemingly done very little to calm investor nervousness about the global and local economy, and especially concerns surrounding the Eurozone. The volatility seen in recent weeks suggests investors remain unsure how to position against the heightened concerns of deflation in light of the dramatic fall in oil, vacillating and unsynchronised global growth and the will-they-won’t-they debate about the future European Central Bank (ECB) Quantitative Easing (QE) policy. The head of the ECB, Mario Draghi, has committed to the purchasing on assets (bonds) to the value of 60 Billion Euro’s per month in order to stimulate inflation and Economic Drive within the European Union. Furthermore a looming Greek parliamentary election (Jan 25th) also has the potential to unsettle markets that could possibly see an austerity/euro party to power.
• From a Macroeconomic point of view, South Africa was in a state of stagflation in 2014 (accelerating inflation and declining GDP growth), which typically favours a higher allocation to Bonds (both local and foreign) according to BNP Paribas. However, in the face of the declining oil price and a possible concomitant pickup in consumer activity transitioning SA into a possible recovery in 2015, this phase favours Equity (both local and foreign), but it also allows for a higher Cash weighting, due to a typically lower inflation-based hurdle (for mandates that have inflation-based targets).
• History has shown the Resource sector is the most positively geared to the economic cycle, whilst Financials the least and therefore fared the best during periods of declining GDP growth, like that seen in 2014. If the consensus is for a pickup in GDP growth into 2015 and 2016 then history suggests that the Resource sector should outperform. Consensus forecasts also show the Resource sector with the largest number of Buy recommendations whilst Financials show the largest number of negative recommendations. BUT herein lies the dilemma that has many fund managers grappling with answers – is it time to switch into Resources (“The Great Rotation Debate”)? Views are widely divided with some analysts basing their investment cases around valuation. However over the past decade earnings growth has been the key driver of the Resource sector performance. Earnings growth is largely driven by commodity prices, which in turn are influenced by global demand, supply, speculative positions and currency dynamics. Thus in view of current events, namely oil, plus a slowing Chinese economy, the strong US dollar and poor European outlook the likelihood of a significant pickup in commodity prices is poor, according to Analysts.
• On the upside, Analysts expect SA GDP growth to rebound to 2.3% in 2015 after a significantly labour-impacted 2014, but will remain muted with possible downside risks in the wake of electricity constraints, public sector wage negotiations in Q1, inter-union rivalry and the ANC’s National General Council in June to add to political risk events.
• Also the consumer price inflation is expected to moderate from pushing against the 6% upper limit of the target range to about 4.5% in mid-2015 easing the pressure on the South African Reserve Bank’s Monetary Policy committee to raise the key interest rate to quell inflation. This is largely as a result of the lower oil price, this however is expected within the hear ahead to trade between the $60 and $70 per barrel range, so do not get comfortable with your home bond repayments not rising, I would recommend that you willingly request your bank to marginally increase your payments in expectations of the rising REPO rate. This will result in you not being “caught off guard” when the interest rates do rise.
• The current account deficit should also shift from a worrying 6% of GDP, to a more palatable 4% of GDP, which should lift some of the pressure off the rand. In addition, on a purchasing power parity basis, the rand remains fundamentally cheap and attractive. But for this to translate into economic reality, SA needs more robust growth and a stable economic environment. Without a rise in productivity and a more disciplined fiscal setting, the rand is set to remain weak.
• The attractiveness of bonds will only likely improve on the expectations of an easing interest rate environment. We are not there yet. And whilst the budget deficit remains wide (4.1% of GDP) and tax revenue remains under pressure and demands on the fiscus continue to grow, the bond market is not expected to rally any time soon.
• The property market will benefit from an improved economic growth outlook, the lower oil price, moderate price inflation and a stable interest rate environment. But, the caveat here is the proliferation of property listings on the JSE over the last year. Investors need to be mindful of the nature and quality of the property assets in which they invest – not all the assets are of equal attractiveness.
• According to consensus, the JSE All Share Index appears relatively fully priced and not a hugely compelling investment. Using just about any valuation metric – SA ranks towards the bottom of the table relative to global markets. However, it is critical to keep in mind that the index is exactly that – an index. There are pockets of value to be found, which are masked by the All Share Index composition.
• Some 50% of the index is made up of the large industrial companies which are on very expensive multiples and continued to rise through 2014. Momentum works very successfully – until it stops working. Rather than rely on sector momentum, investors will have to look beyond the big names and identify some hidden smaller to mid-cap counters for intrinsic value.
• All-in-all, South Africa goes into 2015 in a better state than in 2014, with some positives on the horizon. But once again, investors need to exercise caution in making investment decisions and focus more on the robustness of each particular business than any blue sky potential that may (or may not) exist. Yield will remain an important factor of total return and should not be ignored. On the equity side, consensus forecasts 5-6% earnings growth for the All Share with a 3% yield bringing the total expected return to between 8% and 9%, but caveat that risks are to the downside.
• Below is a range of both global and SA Analyst forecast Asset returns for 2015, (note the disparity in SA Bond forecast).
• From a Global perspective 2014 brought many surprises for financial markets with the biggest probably being the rally in bonds and the decline in energy sectors. These two were related to the extent that global demand weakness induced investors to reassess the outlook for both interest rates and oil prices. In fact the two were self-reinforcing with lower oil prices exacerbating market’s assessment about deflation risks and thus lowering expectations about the future path of policy rates.
• Global growth is expected to languish in the mid-3% range in 2015. The dichotomy between those central banks that are now beginning to normalise their policy rates (US and UK) and those that are expanding their balance sheets (Europe and Japan) suggests a volatile year (evident by the first couple weeks trading). China is slowing and may be weaker than it looks. USD strength and weaker-than-expected Chinese demand threaten commodity exporters like SA.
• The expectation that Fed policy rates will rise around mid-2015, coupled with the end of US QE, should continue to drive the US dollar higher and US yield curve flatter. As is in 1990s, when Japan and Europe were flailing and Emerging Markets were in financial crisis, the US dollar and US Treasuries were the safe haven assets. In this environment, US equities outperformed on a strong US economy, while inflation fell and bond yields remained low. There are a number of similarities today with the US emerging as a growth leader in a world of softer growth and low inflation – Europe and Japan are struggling with weak growth and risks of deflation, and emerging economies are being constrained by weak commodities, tight monetary policy and deteriorating growth.
• In light of this, capital flows into the more risky assets or vulnerable emerging market economies, like South Africa, will no doubt come under some pressure when US tightening finally kicks offs, though the balance sheet expansion in Europe and Japan could limit the sell-off.
THE CHARTS SET TO SHAPE THE FUTURE
SA MACROECONOMIC REVIEW OF 2014:
South African Macro highlights in the Fourth Quarter 2014:
o The MPC kept rates on hold at 5.75% in November although the tone turned decidedly dovish. Furthermore the SARB lowered its GDP and CPI forecasts and the Governor also made reference to possible delays in the US Fed’s decision to raise interest rates, due to a more benign outlook for global inflation. The next MPC meeting is scheduled for 27-29 January 2015.
o Stats SA this week confirmed that the consumer price inflation dropped to 5.3% in December 2014 from 5.8% in November. Inflation is expected to moderate in 2015 to average approximately 5.2% (from 6.1% in 2014)
o South Africa’s current account deficit narrowed somewhat to 6.0% of GDP in 3Q14, from a revised 6.3% of GDP (6.2% before revisions) in 2Q14.
o For the fifth consecutive quarter, export volumes grew faster than imports, but better terms-of-trade made the real difference. Despite July’s strike in the metals and engineering sector and a platinum sector that is still ramping up production (after a six-month stoppage in 1H14), export volumes still performed marginally better(+3.3%) than imports (+3.2%), in part benefitting from a pickup in vehicle exports (as a new model comes into production), but mainly reflecting weakness in domestic demand. However, the key driver of trade improvement was the price of Brent, which represents around a quarter of South Africa’s imports.
o The credible fiscal consolidation message in the MTBPS saved South Africa from a downgrade this time around. Fitch said that the government’s MTBPS commitment to reduce the deficit rather than delay consolidation supports creditworthiness. However, execution will be challenging. In 2015, the challenging growth outlook and difficult wage bill growth targets, will likely weigh on fiscal performance, further delaying fiscal consolidation, which, may imply a downgrade of Fitch’s rating to BBB-, in line with S&P’s.