Overberg Asset Management - Weekly report

IN THIS WEEK’S BOTTOM LINE

  • Over the past fifteen years (to 15th May) the growth in the JSE Top 40 Index has been an impressive 14.57% annualised. Yet the Mid-Cap Index has gained a superior 16.43% annualised and the Small-Cap Index the best return of all at 17.42% annualised.

SOUTH AFRICA ECONOMIC REVIEW

  • As expected the South African Reserve Bank kept its benchmark repo interest rate unchanged at 6.50%. The Reserve Bank Monetary Policy Committee (MPC) was unanimous in its decision. The MPC kept its GDP growth forecast for 2018 unchanged at 1.7% but lifted its 2019 forecast slightly from 1.5% to 1.7% noting positive global growth and improving domestic business and consumer confidence. While keeping its inflation forecast unchanged, with consumer price inflation peaking at 5.5% in the first quarter 2019, the MPC noted that risks to the inflation outlook are tilted to the upside due to the rising oil price, potential sharp increases in electricity prices and recent weakness in the rand. The rand has depreciated versus the US dollar by 6% since the MPC meeting in March and by 2.8% versus the trade-weighted currency basket. The Reserve Bank’s cycle of interest rate cuts is likely to be put on hold until the rand shows renewed stability.
  • Consumer price inflation (CPI) increased sharply in April to 4.5% year-on-year from 3.8% in March due to the impact of the VAT increase from 14% to 15% implemented on 1st April. However, the CPI gain was less than expected, below the consensus forecast of 4.7%. On a month-on-month basis CPI increased 0.8%, driven mainly by rising fuel prices with the transport category contributing 0.3 percentage points. The less volatile core CPI reading, excluding fuel and food prices, also accelerated although by less, from 4.1% to 4.5%. The 3.8% CPI reading in March is likely to have been the low point in the current cycle with inflation risks now titled to the upside amid residual effects of the VAT increase, recovering food prices and higher oil prices. CPI is expected to peak in the third quarter at around 5.3% before declining again to below 5% by year-end, although this projection could be undermined by potential rand volatility. Rising global risk aversion emanating from US interest rate concerns could continue to impact emerging market currencies, including the rand.
  • The South African Reserve Bank Leading Business Cycle Indicator dipped slightly in March from 108.3 to 107.4 its first decline since April 2017. While slightly disappointing some pullback had been expected given that the indicator had increased in February to its highest since June 2011. The leading business cycle indicator, a barometer for expected business conditions 6-9 months ahead, remains at elevated levels despite the slight decline, signalling a rebound in economic activity in the second half of the year and into 2019. Among the index sub-categories, positive contributors included new vehicles sold, rising job advertisements, increasing manufacturing orders and a pickup in the average leading indices of South Africa’s largest trade partners. Negative contributors included lower commodity prices, fewer hours worked in the manufacturing sector, a deceleration in broad money supply and a decline in residential building plans passed.
  • S&P Global Ratings affirmed South Africa’s sub-investment grade credit rating and kept its outlook stable. S&P noted that: “After the recent political transition, authorities are pursuing key economic and social reforms, but we consider the economic and social challenges the country faces as considerable.” According to the rating agency: “Our ratings on South Africa are constrained by the weak pace of economic growth, particularly on a per capita basis, as well as its large fiscal debt burden and sizeable contingent liabilities.” On the positive side, S&P said: “We could also take a positive rating action if policymakers were to introduce structural economic reforms that delivered improved competitiveness and employment.” In a veiled reference to land expropriation, S&P warned that: “We could also consider lowering the ratings if the rule of law, property rights, or enforcement of contracts were to weaken, undermining the investment and economic outlook.”

SOUTH AFRICA: THE WEEK AHEAD

  • Private sector credit extension: Due Wednesday 30th May. Growth in private sector credit extension (PSCE) will be closely watched for confirmation that the surge in consumer and business confidence is translating into actual demand for credit. An acceleration in PSCE would lead to a pick-up in GDP growth. According to consensus forecast PSCE is expected to have grown in April by 6.1% year-on-year up from 5.9% in March.
  • Producer price inflation: Due Thursday 31st May. Producer price inflation (PPI) is likely to have jumped in April due to the first-time inclusion of the VAT increase, which was implemented on 1st April. Since April’s consumer price inflation number increased by less than expected the PPI figure may also come in below the consensus forecast of 4.3% year-on-year, from 3.7% in March.
  • Trade balance: Due Thursday 31st May. The trade balance is expected to have remained in surplus in April to the tune of R5.0 billion according to consensus forecast, down slightly from the surplus of R9.5 billion achieved in March. The expected decline is attributed to a slight softening in global trade combined with rising domestic demand for imports in line with improving business and consumer confidence.
  • Absa manufacturing purchasing managers’ index: Due Friday 1st June. The Absa manufacturing purchasing managers’ index (PMI), having surged higher in April from 46.9 to 50.9, is expected to have held above the expansionary 50-level in May albeit showing a slight decline to 50.7 according to consensus forecast. The PMI may struggle to make further strong gains due to continued uncertainty over land expropriation and the disruptive effect of the general election in early 2019.
  • New vehicle sales: Due Friday 1st June. Helped by rising consumer and business confidence and moderate vehicle price inflation, year-on-year growth in new vehicle sales is expected to have remained positive in May at 3.2% according to consensus forecast. This would mark a slight reduction from 3.6% in April.

GLOBAL

  • The oil price has slumped by over 6% from its $80 per barrel peak last week following a meeting between Saudi Arabia’s energy minister Khalid al Falih and his Russian counterpart Alexander Novak during which they discussed raising oil production. The OPEC and Russian led production cut of 1.8 million barrels per day (bpd) implemented in 2017 could be adjusted to compensate for the loss in supply from Venezuela and from Iran once US sanctions are re-imposed. OPEC and Russia are expected to ratify a 1 million bpd increase in oil supply when they meet formally in Vienna on the 22nd June, around 1% of daily global oil demand. The production increase could lead to a further softening in oil prices in the near-term.

NORTH AMERICA

  • The latest Bank of America Merrill Lynch survey of institutional investors reveals that while over 40% believe equity markets will not peak until 2019 almost 20% thought January marked the top to the cycle and the other 40% believe it will occur during 2018. The survey indicates the bull market in equities may be close to the end despite record earnings growth in the first quarter. Investors cited the flattening yield curve, measuring the difference between short- and long-dated interest rates, which tends to precede a slowdown in economic growth. Investors also cited rising short-term interest rates with the yield on the 3-month Treasury bill exceeding the dividend yield on the S&P 500 index for the first time in 10 years. Meanwhile, mergers and acquisitions (M&A) have risen to new records, which typically marks the end of the cycle due to the negative impact they have on company balance sheets. Global M&A deals announced in the year-to-date total $2 trillion, 60% above the volume recorded in the same period last year and only marginally behind the annual record set in 2007.
  • Minutes from the Fed’s policy meeting on 2nd May reveal an increasingly “dovish” outlook suggesting the Fed would not necessarily speed-up the pace of interest rate hikes if inflation exceeds its 2% target. While preparing financial markets for a further 25 basis-point rate hike at its June meeting, the Fed had an initial discussion on whether to change its forward guidance, which financial markets interpreted as potentially signalling a plateauing in interest rates. As a result, US Treasury bonds enjoyed their best week in the past 12 months with the yield on the 10-year bond dropping from 3.10% to 2.89%. The big question is how far the Fed needs to raise the fed funds rate before it becomes neutral. An equilibrium or neutral fed funds rate is one which neither stimulates nor slows economic growth. While the Fed consensus view is that the neutral rate would be achieved at 2.90% San Francisco Fed President John Williams last week estimated that the neutral rate would be 2.50% not much above the current fed funds rate of 1.50-1.75%. His interpretation would suggest only three more 25 basis-point rate hikes in the current tightening cycle.
  • Durable goods orders fell sharply in April by 1.7% month-on-month undermining the 2.7% growth in March, attributed to concerns over higher import tariffs and trade tensions with China. However, a large part of the decline is explained by a 29% decline in orders in the volatile civilian aircraft segment. Encouragingly, non-defence capital goods order, a closely watched proxy for business investment, increased in April by 1% on the month reversing the 0.9% contraction in March. The data confirms that companies are responding favourably to new tax rules introduced to incentivise capital investment. Overall, durable goods orders remain favourable, showing a 9.6% year-on-year growth in the first four months of the year.
  • Existing home sales fell in April by 2.5% month-on-month and by 1.4% year-on-year. The home sales figures are especially disappointing given that around 40% of annual US home sales are normally concluded during spring. Lawrence Yun, chief economist at the National Association of Realtors said: “The economy has continued to show improvement, but the home sales are stuck and not breaking out.” The lack of momentum in home sales is attributed to higher mortgage rates and the impact of rising home prices on affordability. The average 30-year mortgage rate increased in the past week to 4.66% compared with 3.99% at the end of last year. The median home price increased in April by 8.7% on the year according to property website Zillow, marking the fastest home price growth since June 2006. Incomes have not kept up with home prices. Home prices, measured as a multiple of average annual incomes, are above their historical norms in over a third of the US.
  • The University of Michigan consumer confidence index was revised lower in May from its initial reading of 98.8 to 98.0 although remained at elevated levels close to the 14-year high of 101.4 recorded in March. The survey’s chief economist Richard Curtin said: “Consumers have remained focused on expected gains in jobs and incomes as well as anticipated increases in interest rates and inflation during the year ahead.” Consumers, whose spending contributes around two-thirds to US GDP, are increasingly concerned that wage gains may not be sufficient to offset rising interest rates and inflationary pressures. Consumers expect inflation to average 2.8% over the next year up from 2.6% the same time last year.

CHINA

  • China’s attempts at reducing debt in the economy appear to be succeeding. Upon his appointment to a second term President Xi Jinping pledged to make financial deleveraging a priority to stabilise China’s economy.  Total social financing (TSF), which includes traditional lending and lending from the shadow banking sector, fell in the first four months of the year by 14% year-on-year, while shadow banking has dropped by 64% over the same period. The shadow banking sector’s contribution to TSF has dropped to 15% from a peak of 50% at the start of Xi’s first presidential term in 2013. The decline in shadow banking has been achieved largely by clamping down on the repackaging of high risk credit investments and reducing the hidden inter-dependencies between financial institutions. The newly created Banking and Insurance Regulatory Commission is eliminating the arbitrage opportunities across the banking and insurance sectors. While a clampdown on China’s TSF and its shadow banking sector is encouraging it may have implications for global liquidity, in turn affecting global financial risk appetite.
  • China’s Ministry of Finance announced that from 1st July the import tariff on passenger vehicles would be reduced from 25% to 15% and tariffs on auto parts would also be reduced to 6% down from a range of 8-25%. While foreign vehicle manufacturers typically build their vehicles locally to evade import duties China imported 1.2 million passenger vehicles in 2017 around 4% of the total market. The US greeted the positive news by suspending threatened tariffs on an estimated $50 billion worth of trade. US Treasury Secretary Steven Mnuchin reported that “meaningful progress” had been made with China.

JAPAN

  • Despite GDP shrinking by 0.2% quarter-on-quarter in the first quarter (Q1) marking the first economic contraction in nine quarters, the government kept its overall economic assessment unchanged in May for a fifth consecutive month. The government described the economy as “recovering moderately”, private consumption and exports as “picking up” and business investment and factory output as “increasing moderately”. The government’s economic assessment maintained an upbeat outlook for economic prospects in the months ahead citing fiscal stimulus and improving wage growth. Wages increased in Q1 by 3.2% quarter-on-quarter annualised the fastest growth in over 20 years.

EUROPE

  • The Eurozone composite purchasing managers’ index (PMI), measuring activity across both manufacturing and service sectors, fell for a fourth consecutive month in May from 55.1 to 54.1 its lowest reading in 18 months. The decline is attributed to a shortage of skilled workers, concerns over a possible trade conflict with the US and a weakening in consumer confidence. The weaker than expected PMI data may prompt the ECB to delay the termination of its asset purchase programme to December from September, which had been the previous market consensus. However, Chris Williamson, chief business economist at IHS Markit, which compiles the PMI data, cautioned that: “Despite the headline PMI dropping to an 18-month low, the survey remains at a level consistent with the Eurozone economy growing at a reasonably solid rate of just over 0.4% in the second quarter.”
  • Italy faced political turmoil after its President Sergio Mattarella vetoed the appointment of Paolo Savona as minister of the economy. In turn, leaders of the anti-establishment 5-Star Movement and League coalition partners, which had recommended Savona’s appointment, called for President Mattarella’s impeachment. Mattarella has meanwhile called on former IMF official Carlo Cottarelli to form a transition government. Cottarelli is unlikely to receive the necessary endorsement from parliament which means another general election is likely to be called, potentially as early as July. Italy’s likely election would potentially centre on the country’s continued membership of the Eurozone, which put Italian government bond yields under substantial pressure. The Italian 10-year government bond yield surged from 2.36% to 2.63% on the day while the yield spread over the same maturity German government bond spiked higher by 22 basis points to 2.22%.

UNITED KINGDOM

  • In its revised second estimate the Office for National Statistics (ONS) maintained that GDP shrank in the first quarter (Q1) by 0.1% quarter-on-quarter unchanged from the first estimate, marking the slowest growth since Q4 2012. The unchanged reading confounded the Bank of England, which felt the impact from heavy snowfall in late February and early March had been overblown. Rob Kent-Smith of the ONS, which observed a longer-term pattern of slowing growth, said: “Overall, the economy performed poorly in the first quarter, with manufacturing growth slowing and weak consumer-facing services.” The slowdown is attributed to weakness in private consumption, gross fixed capital formation and net exports. The revised GDP data signals deteriorating growth amid continued uncertainty ahead of the UK’s exit from the EU in 2019.
  • Consumer price inflation (CPI) fell further in April to 2.4% year-on-year from 2.5% in March, marking its lowest reading since March 2017. The less volatile core CPI reading, excluding food and energy prices, decelerated from 2.3% to 2.1% also its lowest since March 2017. While remaining above the Bank of England’s (BOE) 2.0% target for the fourteenth consecutive month, CPI has been falling more rapidly than expected. However, higher oil prices caused producer price inflation (PPI) to accelerate sharply from 4.4% to 5.3% in April. Rising input prices may keep CPI elevated over the medium-term. Speaking to the Treasury select committee, BOE governor Mark Carney said: “Interest rates are more likely to go up than not, but at a gentle rate.”

FAR EAST AND EMERGING MARKETS

  • Fitch credit rating agency warned that Turkey’s sovereign credit rating could be burdened if the central bank’s independence is curtailed after President Erdogan’s expected re-election in June. Erdogan has signalled his intention to take control of monetary policy. Fitch said: “Comments from the Turkish president raise the possibility that discretionary policymaking and policy predictability will come under pressure after June’s election.” A 5% decline in the Turkish lira last Wednesday versus the US dollar prompted the central bank to hike its benchmark interest rate from 13.5% to 16.5% in a move to protect the currency and quell inflation. The lira has depreciated versus the US dollar by over 20% since the start of the year and inflation has accelerated to nearly 11%. Meanwhile, the current account deficit is expected to exceed 6% of GDP in the near-term, leaving the currency open to further downside risk.

KEY MARKET INDICATORS (YEAR TO DATE %)

JSE All Share - 04.45
JSE Fini 15 - 05.90
JSE Indi 25 - 06.05
JSE Resi 20 + 06.88
R/$ - 00.72
R/€ + 02.59
R/£ + 00.89
S&P 500 + 01.78
Nikkei - 01.25
Hang Seng + 02.92
FTSE 100 + 00.55
DAX - 00.42
CAC 40 + 03.70
MSCI Emerging - 01.85
MSCI World + 00.18
Gold + 00.04
Platinum - 02.66
Brent oil + 13.14

TECHNICAL ANALYSIS

  • Having broken the key resistance level at R/$12.50, the rand has returned to its appreciating trend, targeting a break below R/$11.00 over coming months.
  • The rally in the US dollar index has reached its medium-term goal suggesting a correction from current levels. The dollar remains below a major 30-year resistance line suggesting the bull run in the dollar may be over.
  • The British pound has broken above key resistance at £/$1.35 promoting further near-term currency gains to a target range of £/$1.40-1.50.
  • The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.
  • The US 10-year Treasury yield has broken decisively above key resistance at 3.0%, targeting the next key resistance level at 3.6%. A break above long-term resistance at 3.6% would indicate an end to the multi-decade bull market in bonds.
  • The benchmark R186 2025 SA Gilt yield has broken below key resistance at 8.6%% indicating a new target trading range of 8.0-8.5%.
  • Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.
  • The Brent oil price has broken above key resistance at $75 indicating a new trading range of $75-85 per barrel. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $7000 per ton.
  • Gold has developed an inverse “head and shoulders” pattern, which indicates a price recovery and a test of the $1400 target level.
  • Despite the consolidation since the start of the year the break in the JSE All Share index above key resistance levels at 56,000 and 60,000 in December signals the early stages of a new bull market.

BOTTOM LINE

  • Buffett famously stated that: “A fat wallet is the enemy of high investment returns.” Joel Greenblatt explains his meaning succinctly: “As his wealth has grown, his investment options have narrowed. There are now only a relatively few investment opportunities that are large enough to make a difference to the overall investment returns of his portfolio. His choices are generally limited to well-known companies, where he must compete with thousands of large institutional investors to find investment bargains.” Joel Greenblatt is the founder of Gotham Capital, an investment partnership that achieved 40 percent annualised returns for the twenty years after its founding in 1985, and professor on the adjunct faculty of Columbia Business School.
  • Small companies are generally too small for the large unit trusts or other institutional funds to buy. With restrictions on the ownership stake in individual companies and due to liquidity constraints, any holding in a small company could seldom have more than a negligible impact on their overall investment performance.
  • Institutional research does not usually cover smaller companies. Their shares do not trade in the volumes necessary to generate the stock brokerage commission that covers the cost of generating research. Less research means there are many more undervalued and mispriced opportunities among small companies, creating the opportunity to invest in under-priced investment bargains.
  • Small companies provide better investment returns than large companies over the long-term. With less available research and less competition from large investment institutions there are likely to be more bargains among small companies. In addition, prospects for earnings growth in small companies is greater as it is being generated from a smaller base. Small companies tend to benefit from greater management ownership and a more entrepreneurial culture. Being less constrained by shareholder demands for quarterly performance management also has greater freedom in taking a longer-term view.
  • Over the past fifteen years (to 15th May) the growth in the JSE Top 40 Index has been an impressive 14.57% annualised. Yet the Mid-Cap Index has gained a superior 16.43% annualised and the Small-Cap Index the best return of all at 17.42% annualised.
  • Shares are categorised as small, medium or large depending on their market capitalisation. On the JSE the companies comprising the Top 40 Index are considered large-caps and the Mid-Cap index comprises companies ranked 41-100 in terms of market capitalisation. The Small-Cap index comprises companies which rank 101 and below. In terms of market capitalisation companies sized R10 billion and over tend to be large-cap, companies from R2.5 billion to R10 billion tend to be mid-cap and anything less than R2.5 billion is considered small-cap.
  • Today’s small-caps will become tomorrow’s large caps. Being small does not necessarily equate to higher risk. Numerous small companies boast sound business models, established management teams, defensive balance sheets and a record of quality earnings growth.
  • A measured exposure to small companies can deliver an asymmetric risk-return profile, which means there is more upside than downside, delivering either a huge success on the one hand but only a small failure on the other.