IN THIS WEEK’S BOTTOM LINE
- As the economy recovers, the J-curve effect will have a powerful impact on earnings growth. The J-curve explains why share price gains are always strongest in the early stages of a new economic cycle.
SOUTH AFRICA ECONOMIC REVIEW
- As expected the Reserve Bank refrained from cutting its benchmark repo interest rate, leaving it unchanged at 6.5% despite reducing its GDP forecast for 2018 from 1.7% to 1.2%. Its GDP forecast for 2019 was lifted slightly from 1.7% to 1.9% and for 2020 left unchanged at 2.0%. The Reserve Bank was spooked by an increase in inflation risk stemming from the rand’s weakness and a rising oil price. The rand has declined by 7.2% versus the US dollar and 6.2% versus the euro since the last monetary policy meeting in May and by 4.9% on a trade weighted basis. The Reserve Bank now expects consumer price inflation (CPI) to peak at 5.7% in the first half of 2019 up from its previous forecast of 5.5% in the first quarter 2019. The Reserve Bank also cited concerns over the impact of above-inflation wage settlements, especially in the public sector, which set a benchmark for the remainder of the economy. For now, the rate cutting cycle initiated in March with a 25 basis-point rate cut, appears to be on hold. At the same time a rate hike also seems unlikely at least until the second half of 2019.
- Retail sales grew in May by more than expected, rising by 1.1% month-on-month, lifting the year-on-year growth rate to 1.9% from 0.5% recorded in April. Among the retail categories, “household furniture, appliances, equipment” grew sales by 14.4% on the year, “textiles, clothing, footwear and leather” by 4.1%, and “pharmaceuticals, medical goods, cosmetics and toiletries” by 2.2%. In the three months to end May retail sales grew year-on-year by a resilient 2.4%, which bodes well for second quarter GDP growth. Consumer spending comprises around 60% of South Africa’s GDP. The improving outlook for consumer spending is underpinned by a rebound in consumer confidence stemming from the Reserve Bank’s interest rate cut in March, improved political and policy certainty, and benign inflation.
- The BER consumer confidence index slipped in the second quarter (Q2) to +22 from an all-time high of +26 in Q1. A greater decline had been expected considering the elevated base established in Q1 when the index surged to its highest since the 1980’s. For the first time since 2012, consumer confidence has registered two consecutive positive quarterly readings. By household category, confidence among middle income households declined sharply while confidence among lower income households increased sharply. Confidence among high income households remained broadly unchanged. Among confidence categories, survey respondents’ economic outlook and household financial prospects remained at elevated Q1 levels. However, expectations of the appropriateness to purchase durable goods declined, explaining the discrepancy between elevated consumer confidence and actual hard consumer spending numbers. Nonetheless, the consumer confidence numbers, if maintained at current levels bode well for a strong pick-up in domestic demand and GDP growth in the second half of the year and into 2019. Despite the slight decline in Q2, consumer confidence remains close to levels recorded in 2007 when GDP growth approached 6%.
SOUTH AFRICA: THE WEEK AHEAD
- Brics summit: Due Tuesday 24th July. The South African hosted Brics summit, lasting the full week, will be launched by Finance Minister Nhlanhla Nene with a conference in Sandton addressing the country’s key financial priorities. The Brics summit will be closely watched for potential investment commitments from South Africa’s Brics partners.
- Reserve Bank Composite Business Cycle Indicator: Due Tuesday 24th July. The Reserve Bank Composite Business Cycle Indicator for May will provide guidance on expected economic conditions 6-9 months ahead. Having jumped in February to 107.4 its highest since 2011 the leading indicator slipped slightly to 105.9 by April although near its multi-year high.
- Producer price inflation: Due Thursday 26th July. Producer price inflation (PPI), which increased from 4.4% year-on-year in April to a relatively subdued 4.6% in May despite the rand’s sharp depreciation and rising oil price, is likely to have gained just moderately in June. Expectations of subdued inflationary data are attributed to lacklustre economic activity and depressed domestic demand. PPI is closely watched for pipeline pressures that affect consumer price inflation.
- The Bank of America Merrill Lynch July fund manager survey indicates a sharp decline in investor confidence. A net 9% of fund managers surveyed expect global profits to remain the same or deteriorate over the next 12 months, the most negative view in 29 months. This contrasts with the prevailing view as recently as January when a net 44% of fund managers expected global profits to improve on a 12-month view. 60% of fund managers cited a trade war as the biggest risk to global financial markets, the highest allocation to any single risk since the Eurozone sovereign debt crisis in 2012. The survey found that the most “crowded” trade is the “FAANG and BAT” group of stocks (Facebook, Amazon, Apple, Netflix, Google and Baidu, Alibaba, Tencent). The next most crowded trade is the short position on emerging market equities.
- In the update of its World Economic Outlook the IMF flagged increased risks to global growth posed by intensifying trade wars, geopolitical tensions, and a shift from accommodative monetary policy. Yet it kept its global GDP growth forecast for 2018 unchanged at a robust 3.9%. While acknowledging that trade tensions pose the greatest near-term threat to the world economy, the IMF’s chief economist Maurice Obstfeld said: “Trade actions to date, while they are indeed broadly negative, they frankly apply to a rather small range of exports.” While Trump has threatened tariffs on all $500 billion of imports from China actual tariffs implemented to date amount to just $34 billion on imported steel and aluminium, washing machines and solar panels. IMF Managing Director Christine Lagarde announced at last weekend’s G-20 summit that in a worst-case scenario a trade war would cost the world around 0.5% in GDP.
- Following four years of negotiation the EU and Japan, the world’s second and fourth largest trading blocs, held an official signing ceremony for a bilateral trade deal. The trade deal, which still needs to be approved by the EU and Japanese parliaments, creates the world’s largest free trade pact covering about a third of global GDP. The trade deal extracted significant concessions from both sides and comes as a welcome counterbalance to US growing US trade protectionism. The signatories at the signing ceremony declared themselves the “flag bearers of free trade”. Jean-Claude Juncker, European Commission president said: “Trade is about more than tariffs and barriers. It is about values… There is no protection in protectionism.”
- The copper price fell for a sixth straight week, taking its losses since its multi-year high in June to over 17%. The London Metals Exchange Index, comprising the six key industrial metals, has slumped by over 15%. The copper price is closely watched as a barometer for turning points in the economic cycle, due to its wide application across manufacturing and construction. The decline in copper and base metal prices is attributed to trade fears, debt deleveraging in China (which consumes around 50% of world supply), and a strengthening US dollar which makes dollar-based commodity prices less affordable for most buyers. In the copper market, the lack of scrap sales indicates that supply is running ahead of demand.
- At the semi-annual testimony to the Senate Banking Committee Fed chairman Jay Powell delivered an upbeat assessment of the economy. However, he hinted that the projected four rate hikes in 2018 and three in 2019 were not necessarily on auto-pilot. Powell said: “The Federal Open Market Committee believes, for now, the best way forward is to keep gradually raising the federal funds rate”. By including the qualifier “for now” he opened the door to a potential halt in rate tightening. Powell cautioned against the risk of the growing trade war acknowledging the rising chorus of concern from businesses. Trade tariffs have a mixed implication for Fed monetary policy. On the one hand they could slow economic growth forcing the Fed to pause its monetary tightening but alternatively could also push up inflation leading to a steeper hiking trajectory.
- The “yield curve” which measures the difference between 2- and 10-year treasury bond yields has narrowed sharply over the past year from 100 basis points to just 25. At the current pace of Fed interest rate hikes the yield curve will be inverted by the end of the year with the short-dated yield exceeding the longer-dated yield for the first time since 2006. An inversion of the yield curve is viewed as a warning signal for an impending recession. An inverted yield curve has preceded every economic recession over the past five decades. Minneapolis Federal Reserve Bank President Neel Kashkari noted that: “If the Fed continues raising rates, we risk not only inverting the yield curve, but also moving to a contractionary policy stance and putting the brakes on the economy, which the markets are indicating is at this point unnecessary.” However, former Fed chairman Ben Bernanke while acknowledging that an inverted yield curve is a good forecaster of economic downturns, noted that normal market signals have been distorted by regulatory changes and by unprecedented quantitative easing. Quantitative easing has brought down longer-dated rates to unusually low levels.
- The Conference Board US Leading Economic Index (LEI), which signals expected economic activity 6-9 months’ ahead, increased in June for the eighth straight month, rising by 0.5% month-on-month building on the 0.2% gain in May. Among the ten measures comprising the LEI, the biggest positive contributors were the Institute for Supply Management new orders index, better credit conditions and higher stock prices. Ataman Ozyildirim, Conference Board Director of Business Cycles and Growth Research, noted that the LEI is “pointing to continuing solid growth in the US economy.” He added that: “The widespread growth in leading indicators, with the exception of housing permits which declined once again, does not suggest any considerable growth slowdown in the short-term.”
- Industrial production recovered strongly in June, rising by 0.6% month-on-month reversing the 0.5% contraction in May.The improvement was driven by a sharp rebound in manufacturing output, which increased by 0.8% on the month following a 1.0% decline the previous month. The boost to manufacturing output is attributed to increased production of motor vehicles, machinery and electronics equipment. Industrial capacity utilisation increased to its second highest level of the year indicating improving momentum into the second half of the year.
- Housing starts fell sharply in June by 12.3% month-on-month to an adjusted annualised rate of 1.173 million, marking the largest monthly decline since November 2016. The decline was broad-based in all regions of the US across all types of housing. Residential building permits, which signal how much housing construction is in the pipeline, also unexpectedly declined by 2.2% on the month. However, housing starts and building permit data are notoriously volatile, and prone to strong reversions. On a year-on-year basis the numbers remain positive. Housing starts increased in the first six months of the year by a solid 7.8% on the year. The National Association of Home Builders (NAHB) housing market index remained unchanged at 68 in July, which although below the recent peak of 74 recorded in December, remains in strongly positive territory. Readings above 50 indicate growth. The slight decline in NAHB confidence since December is attributed to rising costs associated with tariffs on steel and aluminium and increasing lumber and labour costs.
- The People’s Bank of China (PBOC) injected the equivalent of US $74 billion into the banking system through its Medium-Term Lending Facility (MLF), marking the largest MLF inflow since the facility was introduced in 2014. The PBOC reportedly asked lenders to invest in lower-grade corporate bonds in exchange for the funds. The MLF expansion in money supply follows two cuts this year to the banks’ required reserve ratio, indicating the PBOC is moving closer to shifting from its current official neutral policy to an official accommodative monetary policy. The shift to monetary accommodation would be premised mainly on the successful clampdown on the shadow banking sector, which has left many smaller businesses without their traditional source of credit funding. In addition, the US-China trade war is affecting the economic growth outlook.
- Confounding expectations of a slowdown emanating from global trade protectionism, Japan’s exports increased in June at a robust pace, rising 6.7% year-on-year marking the 19th straight year-on-year increase. Exports were driven by increased shipments of auto-parts, electronic equipment and power generating equipment. Imports also gained, by 2.5% on the year marking the third consecutive year-on-year increase, signalling a recovery in domestic demand following the soft patch during the first quarter.
- A Reuters report indicated the Bank of Japan (BOJ) is moving closer to adjusting its quantitative and qualitative easing programme. The programme was last adjusted in September 2016 when the BOJ introduced “yield curve control”, a commitment to keep the longer-dated 10-year government bond yield at 0% through the purchase of bonds. There is a growing debate within the BOJ over unwelcome side effects of continued yield curve control, which some policy members say is affecting bank capital, bank profit margins and consequently credit extension. The BOJ’s next policy meeting, concluding on 31st July, is likely to postpone its target for achieving 2% inflation until 2020 or 2021, while also shifting the parameters of its yield curve control programme to make it more sustainable. This may entail applying the yield controls to the 5-year government bond yield rather than the 10-year yield, allowing for a steepening in the yield curve. The shorter dated the bonds the easier it would be for the BOJ to control the yield, requiring fewer bond purchases.
- Eurozone consumer price inflation (CPI) nudged higher in June to 2.0% year-on-year from 1.9% in May. The inflation data is good news for the ECB, which targets an inflation rate of below but close to 2%, and will strengthen the central bank’s resolve in unwinding its asset purchase programme as planned near the end of the year. However, most of the pick-up in inflation is attributed to the 8% increase in energy prices which contributed 0.8 percentage points to the headline CPI reading. Core CPI, which excludes energy and food prices due to their volatility, fell in June to 1.3% from 1.4% the previous month. By country, Ireland’s inflation rate was the lowest at 0.7% followed by Greece and Denmark at 1.0% and 1.1%. At the other end of the spectrum, inflation in Germany, France, Spain, Austria and Luxembourg is at or above the ECB’s 2% target.
- Consumer price inflation (CPI) remained at 2.4% year-on-year in June unchanged from the previous month despite an 11.6% annual rise in fuel price inflation. The inflationary pressure from rising fuel prices was mitigated by heavy discounting in early summer sales, which pushed down clothing and footwear prices by 2.1% on the month, the largest June decline since 2012. Core CPI, excluding energy and food prices, fell from 2.1% to 1.9% a 15-month low. While producer price inflation (PPI) edged higher from 9.6% to 10.2%, indicating potential pipeline inflationary pressures ahead, the benign CPI data suggests the Bank of England (BOE) may delay in hiking interest rates at its upcoming meeting on 2nd August. CPI has exceeded the BOE’s 2% target for 16 straight months but the latest CPI reading of 2.4% came in below its forecast of 2.5%. Meanwhile, wage growth has been slower than expected over the past four months.
- Retail sales growth eased sharply in June to 2.9% year-on-year from 4.1% in May. On a month-on-month basis, retail sales fell in June by 0.5% after rising 1.4% in May and 1.3% in April. The decline in June is attributed to a slump in non-food sales, especially textiles, clothing and footwear. Internet sales fell on the month. On a year-on-year basis, non-food store sales grew by just 0.7%. Blame for the slowdown in retail sales is levelled at the impact on consumer confidence from Brexit uncertainties and concerns over rising trade protectionism. More positively, gradually falling inflation should provide support for consumer confidence in coming months.
FAR EAST AND EMERGING MARKETS
- Singapore’s non-oil domestic export growth slowed sharply in June, to 1.1% year-on-year compared with 15.5% in May and well below the 7.6% consensus forecast expansion. The slowdown reflects declining electronics exports, which fell 7.9% on the year following a 7.8% decline in May. As a key trading hub, Singapore’s export figures also reflect the disruptive impact of the US-China trade war on regional supply chains. Similar weak export readings have been recorded in other traditional trading hubs, most notably South Korea. Export figures from Singapore and South Korea are canaries in the coalmine, providing early warning signals for any deterioration in global trade.
- Australia’s economy added a massive 50,900 jobs in June far exceeding the consensus forecast of 17,000. Encouragingly, there was a notable shift in the labour market which recently has been dominated by growth in part-time employment. Full-time jobs increased by 41,200 the largest increase in 8 months and a strong turnaround from the decline of 19,900 in May. The recovery in labour demand raises the prospects for increased wage growth and the likelihood of the Reserve Bank of Australia hiking interest rates.
KEY MARKET INDICATORS (YEAR TO DATE %)
|JSE All Share
|JSE Fini 15
|JSE Indi 25
|JSE Resi 20
- The rand has broken decisively through key resistance at R/$13.35 indicating further weakness to the R/$14.00 level. However, the rand is deeply oversold at current levels, which suggests a trading range of R/$13.00-13.50 is more likely.
- 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 back below key resistance at £/$1.35 suggesting a trading range of £/$1.30-1.35. The £/$1.30 level is expected to provide strong resistance.
- 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 above key support levels of 8.6%% and 9.0% indicating a new target trading range of 9.0-9.5%.
- 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.
- The J-curve effect is a common phenomenon, not only in business, but also in other fields, like farming. It takes three years for a newly planted vine to produce its first grapes. After that the vine can keep on producing grapes for the next 100 years. Just like the vine, a business must first build a strong “root system”, or infrastructure, before it can produce profits. Once a company survives the gravity and risks of the dangerous valley of the J-Curve, blue skies await. This may take at least three years, often more. The “overnight success” is a myth. It takes many years to become an “overnight success”.
- Leverage: To survive the gravity and risks of the J-curve valley, a business needs a winning strategy. Small strategic adjustments can result in strong growth. These strategies are called leverage, also known as multipliers, power points or core competences. Power points can trigger exponential growth. They are often remarkably simple concepts. Einstein said, “simplicity is the ultimate genius”.
- Metair: Metair is a vehicle component and battery manufacturer. In June 2017 Metair reported an increase in revenue of 0.01% - an unspectacular performance by any measure. But the multiplier effect exponentially lifted the operating profit by 111%! A spectacular multiplier of over 1000.
- Dis-Chem: Dis-Chem operates a chain of 130 pharmacies. Over the next five years, from 2019 to 2023, Dis-Chem plans to roll out 100 new pharmacies – nearly two pharmacies every month. The pharmacies are serviced by a network of strategically located warehouses. Warehouses are the “roots” that feed the pharmacies. The existing warehouses have enough spare capacity to service an additional 100 new pharmacies. Dis-Chem doesn’t need to build a single new warehouse before 2023. At Dis-Chem, existing spare capacity can support (leverage) a near doubling in new pharmacies. The cost savings should be substantial. If the strategy plays out right, Dis-Chem’s price graph will take the shape of a J-curve.
- How does the J-curve affect you? The J-curve examples of Dis-Chem and Metair may be replicated across the JSE. The J-curve of your private share portfolio will be a composite of the potential J-curves of each of the 20-odd shares in your portfolio.
- When to Buy? Buy at the beginning of the growth phase, which starts just after the valley of the J-curve. For the equity market as a whole, this will typically be after a protracted period of lacklustre economic growth and weak share price performance, as experienced over the past four years on the JSE.
- As the economy recovers, the J-curve effect will have a powerful impact on earnings growth. The J-curve explains why share price gains are always strongest in the early stages of a new economic cycle.