IN THIS WEEK’S BOTTOM LINE

  • The JSE has suffered a torrid four years. In the four years from 25th June 2014 to 25th June 2018 the JSE All Share Index has increased from 50,350 to 56,116 a return of only 11.45%. If this is bad, consider that while the JSE All Share has lost 6% since the start of the year, more than half the investible shares on the market have dropped by 18% or more. Of these almost a fifth have fallen by over 50%. The equity market has been a minefield.

SOUTH AFRICA ECONOMIC REVIEW

  • The Reserve Bank will be relieved by the benign consumer price inflation (CPI) data. CPI unexpectedly slowed in May to 4.4% year-on-year from 4.5% in April considerably below the 4.7% consensus forecast. CPI had been expected to rise due to the lagged effect of the VAT increase and higher fuel prices. While the fuel price rose 3.6% month-on-month causing overall transport prices to rise 1.2%, the month-on-month gain in CPI was a modest 0.2%. Food price inflation eased from 3.9% on the year to 3.4%. Core CPI, which excludes food and energy prices due to their volatility, also eased from 4.5% to 4.4%. Despite the VAT increase, inflation for all goods and for all services remained unchanged at 3.5% and 5.3%. Inflation eased across the board for durable, semi-durable and non-durable goods, from 1.0% to 0.9%, from 1.2% to 1.1% and from 4.8% to 4.6%, respectively. While the Reserve Bank will be on the lookout for any second-round inflationary effects from the rand’s recent sharp depreciation, the inflation data so far remains more moderate than expected.
  • The current account deficit widened well beyond expectations in the first quarter (Q1) to 4.8% of GDP from 2.9% in Q4 last year versus a consensus forecast of 3.8%. The trade balance was the main culprit. It deteriorated from an annualised R74 billion surplus in Q4 to a deficit of R24.9 billion in Q1, attributed to the stronger rand which affected the country’s terms of trade. The terms of trade, the ratio of export prices to import prices, fell by 3.7% in Q1. On an annualised basis net portfolio inflows remained strong in Q1 at R73.8 billion although below the Q4 level of R108.8 billion. However, foreigners have been heavy net sellers of South African bonds and equities since the end of Q1, due to the global withdrawal from emerging markets generally. Foreigners have been net sellers of local assets since the start of Q2 to the tune of R69.3 billion annualised. Net direct investment remained negative in Q1 at R10 billion similar to the Q4 deficit of R10.3 billion, with offshore investments by South African entities continuing to exceed inbound investments. While disappointing, the current account deficit is expected to improve as the year progresses, helped by the beneficial impact of the weaker rand on the trade balance. For the year as a whole the current account deficit is likely to reduce to around 3% of GDP.
  • Household disposable income, net of inflation, increased in the first quarter (Q1) by just 0.2% quarter-on-quarter annualised sharply down from 2.7% in Q4, marking its weakest growth since Q1 2016. Weak income growth combined with an increase in household debt and household spending caused household finances to deteriorate over the quarter. The ratio of household debt to disposable income increased from 71.2% to 71.7% while the debt service ratio lifted from 9.1% to 9.2%. A sustained improvement in household finances depends on moderate inflation and interest rates, significant jobs growth and rising labour productivity.
  • After rising from 31 to 42 in the first quarter (Q1), the FNB/BER Building Confidence Index gave back all its gains for the year in Q2 slipping by 14 points to 29 its lowest score since Q2 2012. The index level indicates that more than 70% of survey respondents are dissatisfied with prevailing business conditions. Of the six survey sub-sectors, confidence of hardware retailers and of manufacturers of building materials suffered the worst declines, from 47 to 2 and from 45 to 13, respectively. More encouragingly, the decline in confidence of main building contractors was more subdued from 41 to 37. Confidence of non-residential building contractors increased for a second straight month, although John Loos, property economist at FNB cautioned that: “There is little macroeconomic evidence to suggest that the rise in non-residential building activity seen so far this year will be sustained.”
  • After rising from 31 to 42 in the first quarter (Q1), the FNB/BER Building Confidence Index gave back all its gains for the year in Q2 slipping by 14 points to 29 its lowest score since Q2 2012. The index level indicates that more than 70% of survey respondents are dissatisfied with prevailing business conditions. Of the six survey sub-sectors, confidence of hardware retailers and of manufacturers of building materials suffered the worst declines, from 47 to 2 and from 45 to 13, respectively. More encouragingly, the decline in confidence of main building contractors was more subdued from 41 to 37. Confidence of non-residential building contractors increased for a second straight month, although John Loos, property economist at FNB cautioned that: “There is little macroeconomic evidence to suggest that the rise in non-residential building activity seen so far this year will be sustained.”

SOUTH AFRICA: THE WEEK AHEAD

  • Quarterly Employment Statistics: Due Tuesday 26th June. Some moderation is expected in the first quarter (Q1) following the creation of 81,000 jobs in Q4 last year, attributed to the reversal of the festive season’s seasonal hiring. Furthermore, the mining, manufacturing, construction and trade sectors provided little if any contribution to GDP growth during the quarter, indicating slow job creation.
  • Producer price inflation (PPI): Due Thursday 28th June. Producer price inflation (PPI) is expected to have slowed slightly in May from 4.4% year-on-year to 4.2% according to consensus forecast. Despite the lagged effects of the VAT increase and upward pressure in fuel prices, PPI will have continued to benefit from the sustained decline in manufactured food price inflation.
  • Private sector credit extension: Due Friday 29th June. Growth in private sector credit extension (PSCE), having slumped in April to 5.1% year-on-year, is expected to have recovered to 5.4% in May helped by a rebound in corporate credit growth and gradual improvement in household lending. PSCE, which remains modest despite the earlier spike in both business and consumer confidence, needs to show considerable improvement in order to provide a meaningful boost to GDP growth.
  • Trade balance: Due Friday 29th June. The trade balance, having narrowed sharply to a surplus of just R1 billion in April, is expected to have recovered to a R3 billion surplus in May according to consensus forecast. South Africa’s terms of trade and trade balance will have benefited from the rand’s sharp depreciation over the past two months.

GLOBAL

  • President Trump threatened a further $200 billion worth of Chinese imports will be subjected to 10% tariffs unless China abandons its retaliatory tariffs on $50 billion worth of US goods. Trump said: “China has no intention of changing its unfair practices related to the acquisition of US intellectual property and technology.” In response to the raised tariff threat, China’s commerce ministry said: “If the US suffers a loss of rationality and issues a list, China will have to adopt strong countermeasures, which will be comprehensive measures combining quantity and quality.” As China’s imports comprise a far lower proportion of the bilateral trade balance than US imports, its measures would have to involve qualitative policies such as targeting US corporate interests in China or engineering currency depreciation. Fed chairman Jay Powell said at the ECB central bankers’ conference in Portugal that: “Changes in trade policy could cause us to have to question the outlook.”
  • In a potential escalation of the trade dispute between the US and China, the Wall Street Journal reported President Trump was planning to block firms with 25% Chinese ownership from buying US companies with “industrially significant technology.” In addition, suggested export controls would prevent key technologies from being shipped to China. The initiatives are designed to frustrate China’s “Made in China 2025” policy aimed at making the nation a global leader in 10 areas of technology.

NORTH AMERICA

  • Speaking at the ECB annual central bankers’ policy conference in Portugal, Fed chairman Jay Powell said low unemployment was unlikely to precede an inflation spike as it had done in the 1970s due to rising education levels and lower inflation expectations. However, he admitted that there was little precedent for the current economic environment and cautioned that “a very tight labour market could lead to large, nonlinear effects” which means inflation could accelerate sharply at a certain tipping point. Powell noted that recent recessions were caused by excessive risk taking and leverage rather than inflation or an overheated economy.
  • The Fed’s annual bank stress test, which has been running since 2008, was passed by all of the country’s 35 largest banks, despite this year’s worst case scenario being the toughest so far. The test concluded that banks were “strongly capitalised” and that in the hypothetical scenario of unemployment rising to 10%, GDP shrinking by 7.5% and bank loan losses of $429 billion, they would still be healthy enough to continue lending.
  • One of the most reliable barometers of economic expansion is the yield curve, measuring the spread between 2-year and 10-year Treasury bond yields. A positive spread reliably predicts economic expansion whereas a negative spread or “inverted” yield curve has reliably predicted most recessions. The yield spread has reduced to less than 40 basis points its narrowest since 2007. While still marginally positive there is a danger that the yield spread will turn negative if the Fed lifts the fed funds rate two more time before the end of the year, as tabled by its policy members. The heavy weighting of short-dated US Treasury bonds in the JPMorgan Global Bond Index (GBI) combined with rising US interest rates has already caused the GBI to invert for the first time since 2007, placing some doubt over the durability of the synchronised global economic expansion.
  • Existing home sales fell in May by 0.4% month-on-month the second straight monthly decline. On a year-on-year basis, existing home sales fell 3% marking an annual decline for three consecutive months. The decline is attributed to a combination of low inventories, elevated home prices and rising mortgage interest rates. Inventories are at a low level of just 4.1 months’ supply at the current sales rate while home prices continue to scale new record highs. To compound the increased lack of affordability the average interest rate on a 30-year fixed rate mortgage has increased since the start of the year from 4.03% to 4.59%. By contrast, the number of new homes on which construction has started increased sharply in May by 5% on the month lifting the year-on-year growth rate to 20.3%. Reflecting the benefit of fiscal stimulus, housing starts in the Midwest region, which had hitherto been unaffected by the economic recovery, surged by 62.2% on the year.
  • The Conference Board Leading Economic Index (LEI), a barometer of expected business conditions 6-9 months ahead, maintained its upward momentum in May rising for a third straight month. However, the month-on-month gain slowed to 0.2% from 0.4% in April and 0.4% in March. The modest increase reflected positive contributions from 7 of the 10 sub-indices while negative contributions from building permits, average weekly manufacturing hours and average weekly initial jobless claims detracted from the overall reading. Ataman Ozyildirim, the Conference Board director of business cycles and growth research cautioned that: “The US LEI still points to solid growth but the current trend, which is moderating, indicates that economic activity is not likely to accelerate.”

CHINA

  • In response to the potential destabilising effect of US trade restrictions the People’s Bank of China (PBOC) lowered the reserve requirement ratio (RRR) by 50 basis points for both large and small banks taking the RRR to 16% and 14% respectively. The cuts in the RRR will reduce the amount of reserves that banks are required to keep at the PBOC, freeing up the equivalent of $77 billion for large banks and $23 billion for small banks. Large banks will be required to use the freed-up capital to fund debt-for-equity swaps whereby debt is written off in return for equity in companies with stretched balance sheets. Smaller banks will be encouraged to extend funding to small- and medium-sized enterprises. The PBOC’s initiative indicates China is cautiously embarking on a monetary easing cycle.

JAPAN

  • The IHS Markit/ Nikkei manufacturing purchasing managers’ index (PMI) increased by more than expected in June from 52.8 to 53.1 above the neutral 50-level, which signals expansion, for a 22nd consecutive month. However, among the sub-indices new export orders fell from 51.1 to a slightly contractionary 49.5 confirming the negative impact of rising trade protectionism and the strengthening yen. The yen, which attracts safe-haven inflows during periods of rising global uncertainty, has appreciated around 3% against the US dollar since the start of the year. Nonetheless, IHS Markit economist Joe Hayes concluded that: “The final PMI reading of the second quarter revealed a quickening pace of growth across the Japanese manufacturing economy.” The PMI reading is consistent with a rebound in GDP growth in the second quarter (Q2) following its contraction in Q1.

EUROPE

  • At the ECB’s annual central bankers’ conference in Sintra, Portugal, ECB President Mario Draghi appeared to back-pedal on the central bank’s policy announcement the prior week that it would end its asset purchase programme by end December.At the conference Draghi said that those policy plans were “subject to incoming data confirming the medium-term inflation outlook” and that: “What is undeniable is that uncertainty surrounding the growth outlook has recently increased.” He cited a series of threats to the Eurozone economy including trade conflicts, rising oil prices, Italy’s populist government and financial market volatility.
  • The Bundesbank, Germany’s central bank, cut its country’s economic growth forecast for 2018 from 2.5% to 2.0%. The Bundesbank cited trade protectionism and rising political uncertainty in some Eurozone countries, a reference to Italy’s populist government. The forecast downgrade follows the decline last week of the ZEW forward-looking economic sentiment index to its lowest level since 2012. Germany’s IHS Markit manufacturing purchasing managers’ index (PMI) fell in June from 56.9 to 55.9, which although still above the neutral 50-level marks its lowest reading this year. Phil Smith, principal economist at IHS Markit called the PMI reading a “big disappointment”, noting that: “A worrying slide in export order growth seen since the start of the year continued into June.”
  • The Swiss National Bank (SNB) left its benchmark interest rate at -0.75% unchanged since January 2015 despite unemployment falling to just 2.4% in May and the SNB’s forecast that GDP will grow in 2018 by a robust 2.4%. Moreover, the SNB has expressed concern over a potential residential property bubble and the effect of negative interest rates on bank earnings. However, the SNB is loath to tighten monetary policy ahead of the ECB with the Eurozone being Switzerland’s main trading partner. The Swiss franc has already strengthened significantly against the euro due to safe-haven demand related to rising global financial risk aversion and Italy’s newly elected populist government. The SNB said it was willing to intervene in the currency markets if necessary.
  • In what is hailed as a “historic” agreement, Greece negotiated with its Eurozone bailout creditors that around 40% of its debt (€96 billion) would benefit from a maturity extension. The repayment of the bailout loans including interest would be pushed back by 10 years from 2023 to 2033 leaving the country with negligible debt repayments until after 2030. Greece has undergone three bailout programmes since 2010. A condition for the debt relief is that Greece must maintain a primary budget surplus, excluding debt repayments, of 3.5% of GDP until 2022 with a longer-term budget surplus target of 2.2% of GDP.

UNITED KINGDOM

  • While leaving its benchmark interest rate unchanged the Bank of England (BOE) adopted a more “hawkish” bias raising the likelihood of an interest rate hike at its next policy meeting in August. Of the nine-member monetary policy committee, the number voting for a rate hike increased from two to three with BOE chief economist Andy Haldane joining the other two dissenters for the first time. Haldane has traditionally argued against tightening monetary policy. Moreover, the BOE stated that it would begin reducing the size of its balance sheet once its interest rate has reached 1.5%. The interest rate threshold had previously been set at 2.0%. Following the BOE policy meeting the probability, implied by interest rate futures, of an interest rate hike in August lifted from around 50% to 70%.

FAR EAST AND EMERGING MARKETS

  • JPMorgan’s emerging foreign exchange index, which covers a basket of emerging market currencies, has dropped against the US dollar by over 10% in the past two months. According to Fitch Ratings: “US monetary tightening, divergent global monetary policies, and potential market volatility remain key challenges for emerging markets.” Growing trade conflicts combined with the decline in economic momentum in the Eurozone and China add further prompts for an emerging market pullback. In addition, Trump’s tax reform to encourage US companies to repatriate dollars held overseas aggravates the global dollar liquidity shortage, piling increased pressure on emerging market currencies. The silver lining is that value in emerging markets has increased amid the general selloff. The estimated cyclically adjusted price-earnings multiple of emerging equity markets, taking into account a ten-year profit cycle, measures 17x compared with 30x for the US S&P 500 Index.
  • In a snap election brought forward by 18 months, Turkey’s President Recep Erdogan was elected as President while his Justice and Development Party won a clear majority in parliament. Although the clear election victories remove any uncertainty of second round polls concerns remain over Erdogan’s dictatorial leadership. The country has been under a state of emergency since the attempted coup in July 2016. The lira has been one the worst performing currencies since the start of the year, losing around 20% versus the US dollar. Following GDP growth of 7.4% in 2017 growth is at risk of falling into recession in the second half of this year. The greatest risk stems from the likelihood of much looser fiscal and monetary policy. Erdogan has said that he would personally take a more active role in guiding monetary policy, undermining the independence of the country’s central bank. He has described high interest rates as “the mother and father of all evils.”
  • By unanimous decision Brazil’s central bank left its benchmark Selic interest rate unchanged at its record low of 6.5% despite expectations that rates might be lifted in order to stabilise the recent sharp depreciation in the real. The real has lost around 12% versus the dollar since the start of the year. The central bank acknowledged that: “The global outlook remained more challenging and showed volatility. The evolution of risks associated, to a large extent, with normalisation of interest rates in some advanced economies led to adjustments in international financial markets. As a result, risk appetite towards emerging economies has diminished.” Nonetheless, the central bank governor Ilan Goldfain stressed that monetary policy would not be used to manage the currency.

KEY MARKET INDICATORS (YEAR TO DATE %)

JSE All Share - 06.08
JSE Fini 15 - 10.41
JSE Indi 25 - 07.91
JSE Resi 20 + 09.44
R/$ - 08.64
R/€ - 06.20
R/£ - 06.97
S&P 500 + 01.63
Nikkei - 01.87
Hang Seng - 03.20
FTSE 100 - 02.31
DAX - 05.01
CAC 40 - 00.54
MSCI Emerging - 07.54
MSCI World - 00.85
Gold - 02.26
Platinum - 06.00
Brent oil + 12.64

TECHNICAL ANALYSIS

  • 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.

BOTTOM LINE

  • The JSE has suffered a torrid four years. In the four years from 25th June 2014 to 25th June 2018 the JSE All Share Index has increased from 50,350 to 56,116 a return of only 11.45%. If this is bad, consider that while the JSE All Share has lost 6% since the start of the year, more than half the investible shares on the market have dropped by 18% or more. Of these almost a fifth have fallen by over 50%. The equity market has been a minefield.
  • On a compounded annualised basis the JSE All Share Index has gained just 2.75% per year well below the return on money markets. After four years of almost non-existent returns, share investors are considering throwing in the towel but this would be a mistake. Although returns have been extremely disappointing, over time, equities provide the best returns, by far, compared with all other asset classes. Bonds and cash are safer in the short-term. However, in the long-term they provide lower returns and hence less protection against inflation. Admittedly, equities can suffer extended bouts of underperformance. They can also suffer severe short-term losses, as in the 12-month periods following market peaks in April 1998, May 2002 and June 2008, when the All Share Index suffered losses of -39%, -30% and -38.5%. In each case, patient investors who stuck it out were rewarded, outperforming money market returns on an annualised basis in less than four years after the initial decline.
  • The equity market rarely performs as expected and so investors who try and time the market may lose out on periods of strong performance. Around 80% of the equity market’s gains occur in just 20% of the time. Time in the market is more important than timing the market. In the past fifty years, there has never been a period longer than five years in which South African equities have not outperformed cash. Excluding dividends, the JSE All Share Index has gained an annualised return of just 2.75% over the past four years, less than money markets, but over the past five years the annualised return is 8.06%, marginally better than money markets, especially once dividends are included. Will the track record remain intact? To keep the track record intact, the JSE would have to rise over the next twelve months by around 45%.
  • This seems a stretch. However, it is not unheard of. Share price gains are always strongest in the early stages of a new economic cycle. Research by professors Elroy Dimson, Paul Marsh and Mike Staunton, published in the Credit Suisse Global Investment Returns Yearbook 2018, confirms that since 1900 the South African equity market has produced the best annualised returns worldwide. Since 1900 the real compounded annualised return, net of inflation is a world-leading 7.2%.
  • Why, despite South Africa’s New Dawn, has the JSE continued to disappoint, unable to build on the stellar returns enjoyed in December last year? Much of the blame is placed on the first quarter (Q1) GDP numbers. GDP fell in Q1 by 2.2% quarter-on-quarter. Put in context, the figure is not so bad. It is an annualised figure. The actual quarter-on-quarter contraction was 0.54% and some pullback had been expected following the substantial 0.76% GDP expansion in the prior quarter. On a year-on-year basis GDP grew by a more respectable 1.5%. Yet, forward-looking surveys point to a far brighter outlook. The FNB/BER Consumer Confidence Index, surged from -7 to an all-time high of +26 in Q1, exceeding its previous record of +23 reached in Q1 2007. The dramatic improvement signals a considerable recovery in consumers’ willingness to spend. Put in context, this is the first reading since Q2 2014 that has been above “0”. The Reserve Bank (SARB) Leading Business Cycle Indicator dipped slightly in March from 108.3 to 107.4 its first decline since April 2017 but some easing had been expected given the increase in February to its highest level since June 2011. The SARB leading business cycle indicator, a barometer for expected business conditions 6-9 months ahead, remains close to multi-year highs signalling, together with other independent forward-looking business and consumer surveys, a rebound in economic activity in the second half of the year.
  • Policy certainty in South Africa has improved greatly under Ramaphosa, with positive news emanating from the State Budget, credit rating agencies, cabinet appointments, corruption court hearings and the re-capture of state-owned enterprises. Financial market anxiety over the ANC’s resolution to support land expropriation without compensation is misplaced. In its final set of resolutions, the ANC clearly emphasised the need to accelerate the rollout of title deeds to “black South Africans in order to guarantee their security of tenure and to provide them with instruments of financial collateral.” The ANC resolution stressed its focus on the “redistribution of vacant, unused and under-utilised state land.” The most likely target for land expropriation will be the former homelands and government-owned land, around 30% of South Africa’s landmass and home to an estimated 17 million people. The land expropriation that is envisaged would provide a massive boost to the country’s GDP growth rate.
  • The level of optimism on the JSE is rock-bottom, which is at odds with the brightening outlook. It is worth heeding the advice of investment guru John Templeton: “The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.” Warren Buffet, one of the greatest investment geniuses of our time, reiterated the same message with his now famous words: “Be fearful when others are greedy, be greedy when others are fearful.”