MARKET REVIEW… What happens in China does not stay in China…
- All I can say is thank goodness Q3 is behind us! In many ways the third quarter picked up many of the unresolved issues that we left behind in the Q2; that being an indecisive US Fed, a worrisome Chinese growth outlook and the impact of both on global growth, implicit or not, as well as picking up several new thorns (corporate scandals) which left risk assets battered and bruised. (The culmination of the 4 Cs = China, commodities, currencies and corporates).
- The MSCI South Africa index (measured in USD) was down 18.5%, similarly China lost 22.7%, Brazil -33.8%, Russia -14.4% and Turkey -19.5%. Developed markets fared only slightly better, however all losing ground.
- Volatility peaked in August, the VIX (volatility index) touching levels last seen in August 2011.
- From an asset allocation basis and In Rand terms, Income assets were the outright winners for the quarter – Global Bonds rallied 15.4%, Global Property rose 11.8% whilst SA Property rose 6.2%. Cash gave you 1.6%, the All Bond index managed +1.1% and Inflation-linked bonds +0.9%. Global equity returned 3.4% all thanks to Rand weakness, and worst performer being the JSE All Share which lost 2.1%.
- The Rand fell 12.1% against the USD over the quarter. The “fragile five” grew to the “troubled ten” = the major victims of yuan devaluation and vulnerability to China. Brazilian Real -21.4%, Russian Ruble -15.4%, Turkish Lira -11.4%.
- SA inflation eased from its July high of 5.0% to 4.6% in September.
- Data sourced from Bloombergs, total return calculated on Net Dividends reinvested
- Global Equity = MSCI AC World, Global Bonds = JPM GBI, Global Cash = JPM Cash, Global Property = MSCI World Real Estate Index
SA EQUITIES – Weighed down by Resources
- After touching record highs in the second quarter, the volatile global sell-off of risk assets left the JSE down 2.1% for the third quarter, although somewhat buffered by the weak rand.
- SA was particularly weighed down by Resources which were hindered by concerns of a hard landing in China. This left commodity prices reeling and the Resource Index fell by over 10% in the month of September alone, down some 17.9% for the quarter. Industrials outperformed, rising 0.8%, thanks largely to the 26% jump in SAB Miller on confirmation that AB Inbev had approached the company with intentions of a takeover. Financials fell 1.1%.
- Industrial counters gain traction in dominating the free float market cap weighted – FTSE/JSE All Share index. By the end of September the composition of the JSE All Share Index continued to shift towards Industrials, which now account for 65.7% of the index (from 55% a year ago), followed by Financials at 23.3% (from 20.2% in Q3 2014) and lastly Resources continue their slide, only contributing 11% to the index (from 24.4% a year ago).
- SABMiller (+25.6%) – post quarter end SAB Miller accepts AB Inbev’s $106bn (GBP 44/share) proposal to merge in the largest UK takeover deal to date and the third largest deal in global history.
- Rand hedged Industrial heavyweights British American Tobacco +15.9%, Reinet Investments +17%, Richemont +8.4% and Mondi +9.6% as the rand takes a tumble and investors scramble for defensive plays.
- Steinhoff International (+10.3%) – releases better than expected results with the highlights being dividends up 10%, cash flow up 26% and revenues growing by 15%. The acquisition of 10% of Pepkor was finalised end of March.
- Telkom (+3.8%) – issues a cautionary relating to its desire to acquire Cell C for a proposed sum of no more than R18bn
- Discovery (+8.8%) – 2015 earnings rose 16% with new business growing by 51% (boosted by the award of the Bankmed Medical Scheme) whilst core business grew 15%. RoE at 18%.
- AVI (+7.4%) – releases revenues up 9.5%, headline earnings +9.4% and dividends grew by 10.7%. Return on capital employed a healthy 28.3%.
- Glencore (-61%) – announces a fully committed proposed equity capital raising of up to $2.5bn alongside additional capital preservation / debt reduction measures, which taken together, have an aggregate value of up to $10.2bn. Further portfolio optimisation and cost reduction actions also proposed in order to reduce net debt to the low of $20bn by the end of 2016. Also announces its cutting final 2015 and H1 2016 dividends.
- Implats (-29.2%) – on full year results and the announcement of no dividend for the year. Headline earnings fell 58%. Propose a capital raising up to R4bn through the sale of new Implats shares using an accelerated bookbuild process.
- Naspers (-8.7%) – Former CEO Koos Bekker reduces his shareholding to 4.69m shares from 16.4m shares the previous year, disposed at a value of approximately R20.4bn.
- MTN (-22.2%) – reports underwhelming results and increasingly tougher operating conditions in Nigeria. On the positive side MTN concludes a deal in September with Multichoice to acquire Smart Village, which will accelerate the mobile operator’s fibre to the home strategy (targeting approximately 200,000 homes.)
- Aspen Pharmacare (-18.3%) – results fell short of expectations due to unfavourable currency swings.
- Aveng (-37.4%) – Proceeds of R1.127bn from the disposal of 70% of Dimopoint to be used to strengthen the financial position of the Group and reduce overall debt.
- Sasol (-13.9%) – headline earnings fell 17% on a 33% decline in the oil price.
- Mr Price (-23%) – releases a disappointing trading update with total sales up 9%, impacted by low levels of consumer confidence, some poor fashion calls as well as the late onset of winter.
- Datatec (-3.9%) – warns that headline earnings will be lower by 25% and foreign exchange losses of $10.6bn.
- Sanlam (-9.9%) and Firstrand (-7.8%) – report results that miss analyst expectations.
- SA equities saw small inflows of R3.1bn in the third quarter (despite a R3.8bn outflow in the last month), offset by outflows of R5.5bn from SA bonds.
- Year-to-date SA portfolios have attracted foreign inflows of R35.3bn (R34.6bn into SA equities and R0.7bn into SA bonds).
Graph sourced from RMB
- Over the quarter the JSE All Share earnings were downgraded by 3.9%, led by Resources (-14.9%) and Financials (trimmed by 0.3%). Once again the Platinum stocks suffered the greatest earnings declines, analysts cutting forecasts by 46% whilst Gold miners had their earnings trimmed by 27%. Upgrades to earnings were prevalent in Forestry by 18.5%, Personal Goods by 12.7%, Tobacco 8% and Beverages by 7.6%.
- Meanwhile the JSE All Share 12 month forward PE de-rated to 15.2x at the end of September, led by Financials (-7.8%) then Industrials (-4.4%) and Resources (-2.6%).
The JSE’s low beta set to be challenged as earnings downgrades persist
• For the quarter Developed Equity Markets outperformed riskier Emerging Markets by almost 10%, the worst relative performance since 2008. The biggest drag on EM performance was Brazil (-36%) and China (-23%). Greece (-36%), Indonesia (-24%), Colombia (-24%) and Peru (-21%).
SA BOND MARKET … finds late support
- Local bonds gained support into the quarter end and in a bull-flattening move the 10 year rallied from the year to date peak at 8.60% to below 8.2% in the ensuing weeks, although still 17bpls higher than at the start of the year. The yield at quarter end was 8.4%, and outperformed India, Indonesia, Brazil and Turkey in the last month of September.
- Positioning in bonds remains tricky in SA. On the one hand the market is expecting further risk-premia on the back of markets shifting the hiking cycle further out, and in addition the recent forex weakness should translate into higher medium-term inflation expectations also leading to a steeper yield curve. Furthermore, downgrade risks will continue to dampen sentiment in particular for the foreign investor. But contrary to this, the SA investor base remains strong and a spread of over 200bps vs short-end funding while limited near-term external risk-factors and low spot inflation should provide some support.
COMMODITIES… suffer pain and more pain
- Commodity prices remained under pressure as concerns about global growth countered any benefit from a temporary weaker dollar. Brent crude was relatively stable for the quarter, oscillating around $48/bbl. The platinum price came under notable pressure not only from weakening Chinese demand, but also from the Volkswagen scandal.
- On the platinum price, the construction of automobile catalytic converters accounts for around 50% of global platinum and palladium demand. Due to their different properties, platinum is more appropriate for diesel engines and palladium is better for gasoline vehicles. If the VW case results in a significant increase in consumers’ (and regulators’) preference for gasoline engines, at the expense of diesel, then demand for palladium is likely to increase at the expense of platinum, as should their respective prices. Although SA is a major producer of both platinum and palladium, platinum is much more important, producing some 70-75% of world platinum output and only 33%-37% of palladium output.
CURRENCIES … Commodity and Current Account Deficit Currencies hit the hardest
• During the quarter the rand weakened 12.1% against the USD, in response to the global risk-off move that hit all high-risk high-yield and commodity linked currencies.
• Post quarter end, the Rand is currently benefitting from the expected delay in Fed hikes, commodities rebound and the general risk-on sentiment. However the medium-term view remains bearish on the weak fundamental picture and lack of room to defend the currency via rate hikes or via forex interventions (forex reserves remain low). External factors will also continue to hold the Rand ransom – potentially weak growth in China is negative for the Rand. South Africa has the largest trade exposure to China within EMEA – nearly 16% of its exports are directed to China. Further, given SA’s dependence on commodity exports, the Rand is particularly vulnerable to weak global growth and its bearish implications from commodity prices.
SA MACROECONOMICS IN Q3… Picture remains bleak
• The fundamental picture in SA remains a bleak one. GDP is growing at its slowest pace since 2009, manufacturing data remains in contractionary territory and business confidence is low. Neither the business cycle nor structural factors are likely to provide much support to growth in the coming quarters. SA is estimated to be 6 – 12 months into a down-cycle which raises concerns over a looming recession, while structural issues (electricity shortages and labour strikes) persist.
• Monetary Policy: In a unanimous and expected decision, the SARB kept rates on hold at 6% in September “for now”, (after July’s pre-emptive 25bps hike) due to domestic economy weakness and tame inflation. The Reserve Bank did however indicate that it remains on a gradual path of policy normalisation should inflation pick up (for example on rand weakness). The Governor highlighted that the Monetary Policy Committee will not have to move rates in tandem with the Fed as domestic conditions differed, although the resultant impact on the Rand would be closely monitored.
• By the time the MPC next meets, on 17-19 November, CPI data for September and October would have been published. Consensus estimates indicate that headline inflation will still print below 5% yoy in September (4.6% in August) and marginally above 5% in October.
• A few economists believe that the Reserve Bank will likely raise interest rates by 25bps on 19 November.
• GDP Growth: the SA economy contracted by an annualised 1.3% in the second quarter over the previous quarter. Manufacturing contributed the most to the contraction, declining for the second straight quarter by 6.3% due to lower production of basic iron and steel, non-ferrous metal products, metals and machinery, petroleum, chemicals and plastic products.
• GDP growth downgrades persist and forecasts range a little above the 1% mark to 1.5% for both 2015 and 2016.
• Inflation remains contained for now. CPI dropped to 4.6% year on year in August (from 5% in July), lower than market expectations and well within the SARBs 3-6% target band. The data suggest that the forex pass-through to inflation remains low, while weakness in fuel prices and consumer demand are weighing on inflation. Inflation is now expected to peak at around 6.7% in 1Q16 with the 2016 projections around 6.2%.
• The current account deficit narrowed to 3.1% of GDP to its smallest gap in nearly 3 years (from 4.7% in Q1), as a rise in the trade balance more than offset a larger gap on the net services and income account. The trade balance improved on the back of stronger exports which benefitted from the weaker rand, whilst the subdued growth in the value of imports also contributed to the improved trade balance. The improvement is expected to be short-lived particularly given SA’s reliance on short-term financing flows.
• Domestic demand remains soft with household spending growth slowing to 1.2% q/q in line with lower disposable income growth. Households continue to delever with outstanding debt easing to 77.8% of disposable income, from 78.7% in the first quarter. Fixed investment spending remained lacklustre, mainly driven by spending by government, and flat in the private sector.
• SA’s macro mix remains unfavourable from an equity market perspective – weak growth, rising inflation, challenging twin deficits, weakening currency, uncertainty over monetary policy, lower commodity prices, depressed business and consumer confidence, and structural issues all weigh on the prospects of the economy and the outlook for equities. The uncertainty around China’s growth outlook is another major impediment for the SA economy and its equity market.
• Furthermore the currency seems likely to remain under medium-term pressure due to both external factors and the challenging cyclical and structural backdrop.
• Lastly a look to valuations sadly does not provide the buffer against the macro backdrop. SA’s 12 month forward PE relative to other Emerging Markets is close to a 20% premium to the ratio’s five-year historical average. This makes SA the second most expensive market within the Emerging Market universe. Even after adjusting for the sector biases (by using a sector neutral PE), SA is trading quite richly compared with other EMs.
• In absolute terms, select SA banks, retailers and industrials are seen as slightly more defensive. Banks dividend yields are healthy and the banks over-capitalised. Loan growth, while slowing is still resilient, nor is credit quality under the kinds of pressure that macro factors might superficially suggest. Select industrial plays – particularly those offshore – are worth emphasising.
THE INVESTMENT CASE FOR EMERGING MARKETS BEING TESTED… requires clarity
- The long-term case for Emerging Market equities rests on both credible Chinese reflation and clarity on the US rate trajectory. It is too early to position for this, thus defensive themes remain at play.
- GEM equities are clearly having a torrid time at present. The two prime impediments to their performance relate to US monetary policy and the Chinese growth outlook, and the market’s focus has progressively shifted from the former to the latter (although the two are relatively interlinked).
- Even if one has a benign view on both of these factors, clarity is required to allow EM equities to perform. While there is a long-term case for the asset class, it is too early for medium-term investors to position for this.
- The problem for investors is that determining when the right time has come may not be straightforward – however, it will almost certainly stem from the world’s main central banks affirmation to a normalising of monetary policy.
- In terms of why EM growth is generally faltering, one can identify five drivers – a weak global trade cycle, falling EM competitiveness, slowing domestic demand growth, trade exposure to China and a slump in commodity prices. Cyclical developments in most EMs are under pressure. Since most EMs are, through commodity and other trade linkages, heavily tied into the Chinese growth cycle, the only plausible way in which the EM growth cycle turns positive is if China itself sees cyclical stabilisation. Policy levers and the domestic credit cycle are generally unlikely – with the exception of India possibly – to be sufficient to create much domestic growth momentum for most EM economies.
- To conclude, EM equities, as an asset class, need the “China anchor to right the EM ship”.
- US Interest Rates
- Whether the Fed hikes rates in December or holds into early in 2016, this is surely the most telegraphed hike in history. Yet, the problem for EM equities is not so much the timing of the first rate hike, as clarity on where peak interest rates lie. Until this can be discerned, higher US rates are likely to be an ongoing drag on the asset class. One could even suggest that the uncertainty associated with monetary tightening is far worse than the rate hikes themselves. Thus the sooner there is this clarity about peak US interest rates, the better the performance of EM equities will be.
• Like beach balls held underwater, risky assets should rise harder and faster under these conditions when the relief rally comes. Nevertheless, risks of powerful structural forces dragging risky assets even further underwater remain. Slower global growth would raise difficult questions about the efficacy of QE, and perhaps trigger a paradigm shift in investor expectations of monetary policy at the zero lower bound. Even if liquidity eases and sentiment improves, growth will still be the largest determinant of longer-term solvency and valuations.
LET’S NOT COMPLETELY FORGET ABOUT THE U.S. …
• With the US Q3 earnings season about to commence, a quick review of the Q2 reported results provides insight into trends and shape to what happened to global markets in the third quarter.
• Overall the basic headline reporting stats were solid in Q2 with Sales and EPS beat rates (results beating expectations) were a bit stronger than for Q1 for all of the major size indices.
• 73% of the S&P500 companies, 69% of Russell Mid Cap companies and 61% of Russell 2000 companies beat consensus EPS estimates, whilst 50% of S&P500 companies, 49% of Russell Mid Cap companies and 52% of Russell 2000 companies beat revenue estimates in Q2.
• There was a skew to sales beats as results for large cap Financials – more domestically focused sectors – were consistently strong, while those for more cyclical and globally exposed sectors were weaker (Consumer Discretionary, Industrials and Materials).
- Guidance was a primary point of concern which indicated a softer patch ahead, specifically for Industrials and Materials.
- On a bottom up basis, EPS growth is expected to trough in the third quarter (2% for the S&P500 large caps) and to re-accelerate through into 2016. At a sector level, Q3 EPS growth is expected to be highest for Consumer Discretionary, Telecom Services and lowest for Energy, Materials, large cap Staples and large cap Industrials. While international companies have dragged down EPS growth expectations, a slowdown is also expected for those with low or no international revenue exposure.
CURRENT MARKET THOUGHTS … Institutional Client Perspectives
Comments and perspectives taken from a Credit Suisse Strategist roadshow
- Confusion: Institutional investors have very seldom been this confused with what’s happening in markets and are sitting in high cash positions. US investors are particularly cautious. Whilst European and especially Asian investors are a little more constructive.
- Reasons for the bearishness: The following were the reasons given for the bearish sentiment – faltering global growth, China, QE running out of steam, the rise in non-energy high yield credit spreads, the risk of the Fed policy mistake (most clients believing that a December rate rise would be a policy mistake and see Yellen’s communication as being poor), US equities being expensive on normalised earnings and the earnings revisions falling close to a 4 year low.
- Growth pessimism: The pessimism on global growth is close to the highest on record and risk appetite is at 12 year lows. China and emerging markets were identified as the main source of growth weakness. Investors are concerned about secular stagnation and a low growth/low inflation environment, owing to China’s slowdown, end of the commodity super-cycle, credit overhang and demographics which they believe will result in permanently lower trend growth. Contra to these sentiments, global PMI new orders (a lead indicator) have not fallen in the past 5 months.
- China concerns: China remains the number one topic. The currency and PMIs are seen as key barometers. Clients agree that “real” data (even on the consumer side) are consistent with just 3-4% GDP growth. China has never faced a downturn when it has been this large (15% of global GDP, 32% of global GDP growth and approx 30% of global capex) and has had such excess in investment, credit and real estate.
- QE not working and has run out of steam: This view was a consensus. Interestingly most brokers would disagree on this on both counts, but agree that a move to QE to finance infrastructure would require more of a growth shock (and is most likely in countries where central banks’ mandates can be most easily changed, ie BoJ, BoE)
- Two new concerns cropped up: (i) the $0.5trn decline in global FX reserves, with this being likened to monetary tightening. (ii) the rising political tide against profits (living wage in the UK, and tax planning strategies that exploit the gaps and mismatches in tax rules across borders).
- Regional views: Pessimism on Emerging Market equities is extreme, except in Asia. Investors are happy to stick with Europe (growth, low margins, QE-friendly ECB, but have largely capitulated on Japan (too exposed to China).
- Recent rotations have hurt the majority of investors: Investors remain dollar bulls.
- What was not mentioned: Eurozone politics, US debt ceiling, Russia’s involvement in Syria or the UK referendum on the EU.
Two words summarize how investors are feeling about markets right now – “lost” and “bearish”. Investors are focused more on risks, which are abnormally high, rather than reward, which is also high, with the Equity Risk Premium for example at 5.8%. However it remains evident that visibility is abnormally low.
PortfolioMetrix (Pty) Ltd is an Authorised Financial Services Provider in South Africa. The information contained is given for information purposes only and is not intended to constitute financial, legal, tax, investment or other professional advice and should not be relied upon as such. Investments can go down as well as up and past performance is not a guide to the future.