Overberg Asset Management - Weekly report

Weekly report

27 February 2018

IN THIS WEEK’S BOTTOM LINE

  • While the Budget’s projections are a long way from those achieved under ex-Finance Minister Trevor Manuel’s tenure when a budget surplus facilitated tax cuts, credit rating upgrades and government-led infrastructure spending, the country’s finances have been put back onto the right path without prejudicing the country’s medium-term growth potential.

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SOUTH AFRICA ECONOMIC REVIEW

  • Following October’s poorly received Medium-Term Budget Policy Statement (MTBPS) the 2018 State Budget returned South Africa to the path of fiscal prudence. The budget deficit is projected to decline from 4.3% of GDP in 2017/18 to 3.6% in 2018/19 and 2019/20 and to 3.5% in 2020/21. Although falling short of the 2017 Budget projection of a 2.6% deficit by 2019/20 the 2018 Budget shows a marked improvement on the MTBPS projections. According to the Treasury, the combination of a narrower deficit, a stronger rand and lower borrowing costs will bring down the projected peak in gross government debt to 56.2% of GDP in 2021/22 and 2022/23. Although worse than the projected peak of 52.9% in 2018/19 as tabled in the 2017 Budget it is far better than the projected peak of 63.3% in 2025/26 projected in the MTBPS. (See Bottom Line for further analysis).
  • The Treasury raised its revenue projection for the new fiscal year by R36 billion. The biggest contributors were from the 1% increase in value-added tax to 15%, contributing an additional R22.9 billion, and from restricted fiscal drag relief contributing an additional R6.8 billion. A Budget highlight is the planned reduction in government expenditure. At national, provincial and local government level, the government projects R85 billion in spending cuts over the next fiscal years. R26.3 billion in 2018/19, R28.8 billion in 2019/20 and R30.5 billion in 2020/21. The government expenditure cuts would be more than enough to cover the increased allocations to free higher education, national health insurance, social grants, drought relief and the contingency reserve. (See Bottom Line for further analysis).
  • Consumer price inflation (CPI) fell by more than expected from 4.7% year-on-year in December to 4.4% in January, below the 4.5% consensus forecast. CPI was assisted by the decline in food and non-alcoholic beverage inflation from 5.2% to 4.5% and the fall in housing and utilities inflation from 5.1% to 4.4%. The data confirms a broad-based disinflationary trend. Core CPI, excluding food and energy, reduced further from 4.2% to 4.1%. On a month-on-month basis, which strips out the base effect of year-ago comparative levels, CPI showed benign readings at both headline and core levels, rising by a moderate 0.3% and 0.2%, respectively. The benign outlook for inflation boosts the outlook for interest rate cuts. Amid an improving policy environment and a strengthening rand, the Reserve Bank is likely to cut the benchmark repo rate at its next policy meeting in March and perhaps in one or two additional increments by year-end.
  • The Reserve Bank composite leading business cycle indicator unexpectedly slipped in December to 104.6 from 105.2 in November. While disappointing, the trend remains positive. November’s reading, unchanged from October, was at its highest since 2013. December’s decline is attributed to the decrease in the 12-month percentage change in the number of new passenger vehicles sold and the average number of hours worked in the manufacturing sector. The drop in both categories was exacerbated by seasonal factors and likely to show a rebound in January and February. The largest positive contributions came from an increase in the number of residential building plans passed and an increase in the South African produced export commodity price index. The composite leading business cycle indicator, which signals economic activity over the next 6 to 9 months, points to a recovery in economic activity in the second half of 2018. 
  • A positive response to the 2018 Budget prompted a surge in foreign buying of South African bonds, reflected in net foreign investor inflows of R13.64 billion in the past week. Net foreign investor inflows into South Africa’s equity market gained by an additional R3.26 billion in the past week, lifting the month-to-date and year-to-date totals to R16.20 billion and R25.73 billion, respectively. The year-to-date bond inflows of R9.86 billion lifts the total year-to-date investor inflow to a healthy R35.58 billion. Bond and equity market inflows are expected to maintain their positive trend during the year amid rising financial market optimism and positive economic policy reforms.

 

SOUTH AFRICA POLITICAL REVIEW

  • President Ramaphosa appointed close allies and respected leaders to the three key departments. The departments of Finance, Public Enterprises and Mineral Resources will be placed under the capable leadership of Nhlanhla Nene, Pravin Gordhan and Gwede Mantashe. While there is disappoint over the retention of Zuma stalwarts Bathabile Dlamini and Malusi Gigaba, albeit in different posts, both are likely to be forced from public office by impending court rulings. Ramaphosa might have wasted political capital by removing them himself. Of greater concern, David Mabusa, also a Zuma supporter, will wield substantial power as the Deputy President. However, his appointment reflects political reality. As he was appointed Deputy of the ANC at the elective conference his appointment as Deputy President was probably unavoidable.

 

SOUTH AFRICA: THE WEEK AHEAD

  • Private sector credit extension: Due Wednesday 28th February. Private sector credit extension (PSCE) is likely to have shown a slight lift in January from December’s 6.72% year-on-year growth, helped by the combination of recovering business and consumer demand and an easing in lending standards.
  • Producer price inflation: Due Wednesday 28th February. Producer price inflation is expected to have reduced from 5.2% year-on-year in December to 5.1% in January, pulled lower by the effect of a strengthening rand on imported prices.
  • Trade balance: Due Wednesday 28th February. The trade balance is expected to have returned to a deficit in January following the bumper R15.7 billion surplus in December. January is traditionally a poor month for the trade balance as importers re-stock their inventories post the December festive season.
  • New vehicle sales: Due Thursday 1st March. The year-on-year decline in new vehicle sales is likely to have slowed from 8.9% in January to 7.8% in February, according to consensus forecast, assisted by strong external demand and a recovery in domestic confidence.
  • Absa manufacturing purchasing managers’ index: Due Thursday 1st March. The Absa manufacturing purchasing managers’ index (PMI), after recovering strongly in January from 44.9 to 49.9 is expected to have posted a further gain in February, regaining the expansionary 50-level. The 50-level has eluded the PMI for eight straight months.

 

NORTH AMERICA

  • As reported by the Federal Reserve’s policy minutes: “A majority of participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate.” However, the Fed’s interest rate forecast for 2018 was left unchanged at three 25 basis-point rate hikes, rather than four as the financial markets had feared. While a number of participants noted that the effects of the tax cuts “might be somewhat larger in the near-term than previously thought” they also noted few signs of a broad-based pick-up in wage growth. Although the minutes were taken prior to the unexpectedly strong 2.9% increase in year-on-year earnings, Federal Reserve Bank of Minneapolis President Neel Kashkari played down the importance of the reading as just one months’ worth of data. Kashkari said: “Wall Street overreacts to everything. They overreact on the upside, they overreact on the downside.”
  • The US government is confident that its tax cuts will boost capital as well as consumer spending. The cut in corporate tax from 35% to 21% should lead to an upturn in business investment, which in turn would increase productivity and boost the economy’s potential growth rate. Labour productivity, measuring real economic output divided by the number of hours worked, is key to maintaining sustainable growth while keeping inflation in check. Recently appointed Federal Reserve Vice Chairman Randal Quarles said: “It might be early, but it is possible that the investment drought that has afflicted the US economy for the past five years may finally be breaking.” While US productivity grew in 2017 by just 1.2% well below its long-term average of 2% for a seventh straight year, Bart van Ark, chief economist at the Conference Board noted that: “We have seen a genuine acceleration in business investment in recent months, which we expect to gain more traction this year, driving higher productivity in the US.”
  • With the 10-year US Treasury bond yield nudging the 3% level, close to four year-highs, investors are anxious that any further yield increase could undermine the bull market in equities. The million-dollar question is at what point will the yield be negative for equities. While the yield level needs to be studied in real as well as in nominal terms, to factor-in the inflation rate, investment institutions have published their opinions on the nominal yield point at which equity markets will suffer. Bank of America Merrill Lynch thinks the “sweet spot” for shares is at a yield range of 1-3% with anxiety likely to set-in above 3%. Credit Suisse thinks anxiety would start at a yield of 3.5%. Goldman Sachs, which forecasts a 10-year treasury yield of 3.25% by year-end, forecasts a 25% plunge in the US equity markets if the yield hits 4.5%.
  • With the reporting season almost complete, companies have in aggregate increased earnings in the fourth quarter (Q4) by 15% year-on-year marking the third quarter in four in which earnings growth has exceeded 10%. Almost 75% of companies beat analysts’ forecasts, above the five-year average of 69%. More impressively, revenue growth increased by a solid 8.1%. Company executives are upbeat about future profit growth due to the accelerating economy and substantial corporate tax cut. Kate Moore, Blackrock’s chief equity strategist describes the fiscal stimulus as “supercharging US earnings expectations”, adding that “the fundamental story is the best it’s been, which is surprising given how far we are into this cycle.” Blackrock has upgraded its recommendation on US stocks from “neutral” to “overweight”.
  • Warren Buffet, in his annual newsletter to Berkshire Hathaway shareholders, admitted that pressure is mounting to deploy the company’s ballooning $116 billion cash pile. He said: “We will need to make one or more huge acquisitions.” Yet, while advising investors to stay with US stocks adding that “equity investors have the wind at their back” he lamented the lack of well-priced acquisition opportunities. Perhaps reflecting an increasingly cautious market outlook, Buffet motivated the allocation of Berkshire Hathaway’s cash pile to short-dated Treasury Bills, saying they would provide more liquidity during a market downturn. 
  • The Conference Board Leading Economic Index (LEI), a barometer for economic conditions in 6-9 months’ time, increased from 107.1 to 108.1 in January building on its gains over the previous two months. The LEI increased 0.6 points in December and 0.4 points in November. According to Ataman Ozyildirim, director of business cycles and growth research at the Conference Board: “The US LEI accelerated further in January and continues to point to robust economic growth in the first half of 2018.” He added that: “While the recent stock market volatility will not be reflected in the US LEI until next month, consumers’ and business’ outlook on the economy had been improving for several months and should not be greatly impacted.”

 

CHINA

  • China’s Communist Party announced it was seeking to end a constitutional provision that bars the head of state from serving more than two five-year terms. The constitutional limitation was put in place four decades ago by Deng Xiaoping, who sought to institutionalise peaceful transfers of power following Mao Zedong’s 30-year rule. A change in the constitution would allow President Xi Xinping to rule indefinitely, well beyond 2023 as currently mandated. While Xinping espouses market-friendly reforms, financial markets may review his increasingly authoritarian tendencies negatively.
  • The China Insurance Regulatory Commission (CIRC) announced it will take temporary control of Anbang Insurance group and prosecute its founder Wu Xiaohui for alleged fraud. The government’s takeover in control of Anbang suggests the company is deemed too large to fail and may pose systemic risk to the country’s financial sector and broader economy. Anbang is the third largest Chinese insurer with an estimated 9% market share, holding about $310 billion in assets and with 35 million customers. The CIRC reported that: “At present, business operations of the group are stable, and the interests of consumers and stakeholders have been protected.” The Angang developments, while reflecting the risk of over-indebtedness facing China’s economy also signals the ability of authorities to underwrite this risk.

 

JAPAN

  • Consumer price inflation (CPI) accelerated to 1.4% year-on-year in January from 1.0% in December, its highest since early 2015. The increase is attributed to sharply higher food prices. Core CPI, excluding fresh food prices, remained unchanged at 0.9% although better than the 0.8% consensus forecast while core-core CPI, excluding fresh food and energy prices, picked-up from 0.3% to 0.4% its highest since August 2016. Besides the strong increase in food prices the prices of clothing, medical care and entertainment also gained. While the Bank of Japan (BOJ) will be encouraged by the data, inflation remains far below its 2% target. The BOJ is therefore unlikely to be deterred from its substantial quantitative easing programme.
  • The Nikkei-Markit manufacturing purchasing managers’ index (PMI) slipped from 54.8 to 54.0 in February although some pullback had been expected after hitting the highest reading in four years in January. The PMI remains near the highest it has been since 2014, consistent with strong gains in industrial output. Although the new export orders sub-index fell sharply from 57.4 to 54.0 the reading remains consistent with solid export volume growth of around 10% per annum. The employment sub-index increased from 53.7 to 54.2 its highest since 2007. The output prices index slipped from 52.5 to 51.3 indicating price cuts by producers and a further headwind to consumer price inflation achieving the Bank of Japan’s 2% target.

EUROPE

  • While some pullback had been expected in the European Commission’s Eurozone consumer sentiment index from January’s level of 1.4, its highest in 17 years, the eventual decline to 0.1 was bigger than any analysts had predicted. The decline is attributed to sharp declines in global equity markets at the beginning of February, lingering uncertainty over Italian elections and difficulties in forming a German government. However, the consumer sentiment index remains well above the long-term average of -12. Despite last month’s decline the Eurozone consumer sentiment index is consistent with robust household spending growth of as high as 3% per annum exceeding the 1.6% growth recorded in the fourth quarter last year.
  • Germany’s Ifo business climate index fell in February from 117.6 to 115.4 a 5-month low. The decline is attributed to the effect of a strengthening euro on exports, concerns over US protectionist trade tendencies and the increased influence of the centre-left Social Democrats in Germany’s coalition government. While retreating from January’s multi-year peak Ifo president Clemens Fuest noted that: “The indicator was at its second highest level since 1991” and that: “This signals economic growth of 0.7% in the first quarter”. The projected growth rate would mark a slight pick-up on Germany’s 0.6% growth achieved in the fourth quarter last year.

 

UNITED KINGDOM

  • The original estimate for fourth quarter (Q4) GDP growth was revised lower to 0.4% quarter-on-quarter from an original 0.5%. Growth for the full year in 2017 was revised lower from 1.8% to 1.7% its weakest growth rate since 2012. The UK showed the lowest growth among the G7 group of most advanced economies, underperforming the US, Japan, Germany, France, Italy and Canada. GDP growth is being undermined by uncertainty over Brexit, causing the UK to miss out on the full benefits of synchronised global expansion. Over the quarter, a decline in exports and increase in imports caused net trade to subtract 0.5 percentage points from total growth. The service sector remained strong, expanding by 0.6% in Q4 and contributing 0.4 percentage points to total growth. Manufacturing output was also solid, increasing by 1.3% on the quarter and contributing 0.1 percentage points to total growth.
  • Bank of England (BOE) chief economist Andy Haldane commented that the long-awaited increase in wages “is starting to take root.” The probability, as measured by interest rate futures, of a rate hike at the BOE’s policy meeting in May increased following Haldene’s comments to 84%. BOE Deputy Governor Dave Ramsden, who was an opponent of a rate hike at the November policy meeting, also raised the chance of a rate hike by turning more hawkish. Ramsden said in a Sunday Times interview that an acceleration in wage growth suggests swifter rate increases are now required.
  • The unemployment rate unexpectedly increased in the fourth quarter (Q4) from 4.3% to 4.4% marking the first increase since the three months to end February 2016. While employment increased in Q4 by 88,000 the workforce increased by a greater amount at 109,000. Wage growth accelerated to 2.5% year-on-year up from 2.3% in the three months to end November. However, increased productivity should stem the inflationary impact of rising wage growth. The combination of lower hours worked and increased output contributed to output per hour rising in Q4 by 0.8% on the quarter, following-on from a solid 0.9% increase in Q3.

 

FAR EAST AND EMERGING MARKETS

  • Jeremy Grantham, the 79-year-old investor who correctly predicted in 2000 that US stocks would lose ground over the following decade, and is known for his bearish market outlook, said: “What I would own is as much emerging-market equity as your career or business can tolerate.” He recommended that his own children invest more than half their retirement money in the asset class. Grantham’s bullish view on emerging market equities, is echoed by other asset management firms. Peter Oppenheimer, chief global equity strategist at Goldman Sachs, who correctly predicted the equity market retreat in early February, said stocks should rally this year led by emerging markets. Barbara Reinhard, head of asset allocation at Voya Investment Management, managing $224 billion in assets, said: “Emerging markets are the place you want to be over the next five years.” Emerging markets are expected to grow GDP by double the rate of developed economies over the next two years and yet equity valuations are trading at a discount of around 30%.
  • Russia’s sovereign credit rating was upgraded by S&P Global ratings for the first time since 2006 restoring the sovereign’s investment grade rating. S&P Global cited Russia’s economic policy and its commitment to fiscal restraint, while highlighting the recovery in private sector credit growth. S&P Global downgraded Russia’s credit rating to “junk” in 2015 amid a slump in oil prices and international sanctions, which pushed the economy into recession. In the past year the economy has emerged from recession helped by a rapid decline in inflation and interest rates. In the meantime, the US has held-off from imposing additional sanctions. Russia now has an investment grade credit rating from two rating agencies, S&P Global and Fitch, which may prompt inflows from funds that track emerging-market bond indices.

 

KEY MARKET INDICATORS (YEAR TO DATE %)

JSE All Share - 01.07
JSE Fini 15 + 03.70
JSE Indi 25 - 02.39
JSE Resi 20 - 00.96
R/$ + 07.10
R/€ + 04.44
R/£ + 03.75
S&P 500 + 03.96
Nikkei - 02.69
Hang Seng + 05.28
FTSE 100 - 05.18
DAX - 03.02
CAC 40 - 00.60
MSCI Emerging + 05.41
MSCI World + 02.67
Gold + 03.19
Platinum + 08.03
Brent oil + 01.53

TECHNICAL ANALYSIS

  • Having broken key resistance levels at R/$12.50 and R/$11.70 , the rand has returned to its appreciating trend, targeting a break below R/$11.00 over coming months.
  • The US dollar index has tried but failed to break through a major 30-year resistance line suggesting the three-year 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 2.5%, targeting the next key resistance level at 3.0%. 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 $60 and likely to remain in a trading range of $60-70 over the foreseeable future. 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 further upward momentum and a test of the $1400 target level.
  • The break in the JSE All Share index above key resistance levels at 56,000 and 60,000 signal the early stages of a new bull market.

 

BOTTOM LINE

  • The Budget’s moderate fiscal consolidation should be enough to avert a Moody’s credit rating downgrade. By averting a Moody’s downgrade, South Africa will avoid exclusion from the World Government Bond Index. While Fitch and S&P Global have South Africa’s local and foreign currency credit ratings at non-investment grade, Moody’s is still one notch above non-investment grade. Moody’s has already cited positive credit-related developments since the ANC elective conference in December. Its rating decision is expected on or before 23rd March.
  • However, averting further credit rating downgrades over the longer-term will require a sustained economic recovery. Despite limited fiscal leeway the Budget managed to preserve a growth bias.
  • The Davis Tax Committee assessed that although the VAT increase would lift inflation over the near-term, it is less damaging to economic growth over the longer-term than increases in personal income tax and corporate tax rates. Inflation may increase by around 0.1 percentage points over the next four quarters but not by enough to deter the Reserve Bank from cutting interest rates. South Africa’s corporate tax at 28% is already high by international standards. The UK has cut its corporate tax rate from 30% to 19% and the US from 35% to 21%.
  • The Budget announced the pending approval of six special economic zones (SEZs). These SEZs would attract investment through additional tax incentives. 
  • The Budget assumes the public-sector wage bill will rise at an annual average rate of 7.3% over the next three years. A more moderate public-sector wage increase after the expiry of the current wage agreement in March 2018 would boost the economy’s growth potential by facilitating a shift away from consumption towards capital investment.
  • Effective implementation of structural reforms could increase potential GDP growth from 1.5% to around 4%, according to the Budget.
  • President Ramaphosa pledged in the State of the Nation Address to “intervene decisively to stabilise and revitalise state-owned enterprises (SOEs).” The Budget highlighted recent interventions at SOEs, noting that some SOEs could be restructured via equity investments.
  • While the Budget’s projections are a long way from those achieved under ex-Finance Minister Trevor Manuel’s tenure when a budget surplus facilitated tax cuts, credit rating upgrades and government-led infrastructure spending, the country’s finances have been put back onto the right path without prejudicing the country’s medium-term growth potential.