Month: May 2011

With reporting season behind us, some room for comfort in current valuations

The quarterly earnings reporting season is now almost behind us. As we show below the deep trough in earnings in 2009, coinciding with the global recession, is now more than a year behind us. JSE All Share earnings per share since May 2009 (smoothed) have grown by nearly 40% with the growth in Resource Sector earnings leading the other sectors by a very large margin. Financial Sector earnings reported to date are barely ahead of where they were a year ago while JSE Resource Sector earnings have grown by nearly 80% with Industrial Sector earnings up by about 20% on a year before.

The Resource counters have clearly benefited from the recovery in commodity prices that has contributed also to the strength of the rand. The industrial companies have gained from the recovery in the global economy and the recovery in the SA economy where growth is pacing that of global growth. Industrial companies, especially the domestic retailers and distributors of goods and services with high import content, benefit form rand strength. The banks might ordinarily have been expected to benefit from rand strength and the lower interest rates that follow lower inflation led by rand strength. However the demands for bank credit have stalled at only marginally positive growth rates. Until house prices and demands for mortgage loans pick up momentum the growth in bank revenues will remain subdued.

We compare reported JSE earnings, so called trailing earnings, with what we describe as normalised earnings. Normalised earnings are estimated using a 10 year rolling time trend. Trailing earnings are catching up with normalised earnings. If the past is a guide to the future then there would appear to be considerable scope for further earnings upside. The underlying trend in earnings growth also suggests as much. If the underlying trend in All Share earnings is extrapolated, the prediction is growth in All Share earnings of 30%, to be reported in 12 months’ time, led by growth in JSE Resource earnings of over 60%. Clearly such a time series forecast would be vitiated by any sharp reversal in commodity prices.

These underlying trends may be regarded as encouraging of higher valuations on the JSE. As we also show the JSE All Share price to trailing earnings is just under 16 times while the price to normalised earnings ratio is of the order of a below average 14 times. Clearly for the market to move ahead normalised earnings will have to materialise and most important world markets will have to be supportive.

Earnings and dividends from companies listed on the developed equity markets have also recovered strongly from crisis depressed levels of 2009. S&P reported earnings per share in the first quarter of 2011 have recovered to over US$81 compared to the barely US$7 of mid 2009. S&P earnings and dividends per share are now nearly back to their record pre financial crisis record levels.

It makes no sense to attempt to normalise S&P earnings given their extraordinary recent collapse. Consensus forecasts expect US dollar 100 of S&P earnings per share by year end, to be reported in Q1 2012. When we normalise S&P dividends that were much less severely damaged we find that reported dividends are still trailing well behind normalised dividends.

The S&P at 1331 has recovered strongly and outpaced Emerging markets over the past six months as we had suggested it would. When we calculate a dividend discount model for the S&P, discounting trailing dividends by long term interest rates going back to 1980, we find the S&P to be 24% undervalued for trailing dividends and 32% undervalued for normalised dividends. We therefore continue to be of the view that the least demandingly valued of the equity markets is the S&P 500.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 31 May: With reporting season behind us, some room for comfort in current valuations

The rand: Foundations still to be laid

This past month has not been a particularly good one for the rand. The rand lost about 7% against the Aussie dollar in May 2011 to date, while losing less about three per cent Vs the Brazilian real and the US dollar.

We have long watched the relationship between the rand and the Aussie dollar for signs of South African specific risks influencing the value of the rand rather than commodity prices that are common to both currencies. A combination of commodity price strength and rand weakness is a heady one for investors in Resource companies, quoted in rands, on the JSE.

However the current modest rand weakness would appear to have more to do with favourable Australian, rather than less favourable South African specifics. This view is supported by the better performance of the rand against the US dollar and the Brazilian currency.

The rand is more than a commodity currency. It is also very much an emerging market currency and actively traded as a proxy for other less liquid emerging market currencies. The beat to which the rand is moving this month has been day to day volatility on emerging equity markets. The rand has been getting weaker or stronger as emerging equity markets have been going down or up in a highly synchronised way. And the JSE remains a highly representative emerging equity market.

It would appear that it is very much emerging market business as usual in the market for rands. If we run a model that uses the EM equity market Index to explain the rand/US dollar exchange rate using daily data since January 2008, the rand is trading almost exactly as the model predicts.

In the large market for the rand, with daily turnover of about US$20bn making it about the tenth largest foreign exchange market, three quarters of the transactions reported to the SA Reserve Bank are conducted between third parties with no direct link to SA foreign trade or capital movements. They trade the rand because they can trade the rand to hedge emerging market exposures.

The notion that the SA Reserve Bank could intervene effectively in such a market to move the exchange value of the rand in some preferred direction would seem a false premise. The Reserve Bank can buy foreign currency in this market to add to its reserves, as it has been doing, but such interventions could not easily be seen as market moving. The value of the rand continues to be dominated by global forces, particularly those that influence the outlook for the global economy and so emerging equity and bond markets. South African specifics seem to have had little influence on the exchange value of the rand in recent years and we expect global forces to continue to dominate the rand exchange rates.

The rand began the year at R6.61 per US dollar. It lost about 10% of this value by early February 2011 and then reclaimed its beginning of the year value in late April 2011. It has by now lost about 4% of its January 2011 value against the US dollar this year, while the Aussie and the real are about three percent stronger than they were at the beginning of the year.

While the volatility in the market for rands this year may be regarded as moderate by its own standards, the still unusual volatility in the rand must remain of concern to the authorities in SA. Without rand stability, predicting inflation and interest rates more than six months ahead with any degree of accuracy or confidence, remains a near impossible task. The foundations for genuinely stabilising monetary policy and interest rate settings in the form of a stable and predictable rand have still to be laid.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:
Daily View 27 May: The rand: Foundations still to be laid

SA markets: Did anyone offshore notice the SA elections?

To the extent that anyone offshore actually noticed SA political developments last week the reaction must be regarded as benign. The extra yield provided by SA government US dollar denominated (Yankee) bonds over the yield on similarly dated US Treasuries declined last week, leaving the SA Sovereign risk premium close to its historic lows and its lows of the past 12 months.

The rand had a good week, gaining about 2% on a trade weighted basis, which has left rand still well ahead of its year ago value. These credit ratings and exchange rate trends will be very helpful in restraining SA inflation and welcome to the Reserve Bank struggling to avoid having to raise interest rates.

The news on the exchange rate was well received in the bond market. The difference between the yield in rands on long dated RSA bonds and the long dated US Treasury Bonds (which may be regarded as the SA risk premium) also narrowed last week by about 20bps to about 5.20%. This yield gap has remained within the five to six per cent range over the past 12 months. It may be regarded as representing the rate at which the rand is expected to depreciate against the US dollar over the long run.

If the rand loses an average 5.2% a year over the next 10 years, investors in RSA and US Treasury Bonds will have broken even. If the purchasing power of the US dollar and the rand is thought to determine exchange rates in the long run, then this yield gap will also represent the difference between expected inflation in the two currency areas. The bond market offers explicit compensation for bearing inflation risk. Long dated RSA bond holders are receiving an extra 6.3% for holding vanilla bonds rather than their inflation linked alternative. This yield gap has remained persistently at this high level over the years though it declined by 15bp last week.

In the US the inflation compensation is currently 2.35%, indicating that inflation in SA is expected to average about 4% higher in SA than the US over the longer term.

The significant electoral swing recorded at the nationwide municipal elections to the DA was enough to encourage the opposition but was not enough to cause anything like panic in the ranks of the ANC. The true democratic credentials of the ANC will perhaps only be fully tested when it is in danger of losing power. This still seems a long way off and maybe for the market place and its state of mind this is just as well.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 23 May: SA markets: Did anyone offshore notice the SA elections?

After the MPC: Interest rate expectations and the rand

The money market has raised the probability of an early increase in short term interest rates (in three months’ time) following the meeting of the Reserve Bank’s Monetary Policy Committee (MPC) on Thursday that maintained the repo rate at 5.5%. The short term three month Forward Rate Agreement curve (FRA) of the banks moved higher by between 10 and 30bps across the range of forward rates beyond the next three months late last week.

Interest rates expected over the longer term, beyond four years, have remained unaffected. The zero coupon yield curve implies that the one year government bond rate, currently around 6% per annum, will rise consistently to a level of about 9% in four years’ time and then stabilise at this level.

These expectations remain consistent with inflation compensation priced into the bond market in the form of the yield gap between conventional RSA bond yields and their inflation linked alternatives. This gap remains consistently above 6% regardless of the rate of inflation.

Our own interpretation of the MPC statement and the press conference is that the Governor and the MPC would be extremely reluctant to take any interest rate action before the economy has regained its potential growth, which it is still some way from attaining. However further increases in fuel and food prices and the headline inflation rate might force them in this direction for fear of second round effects on inflation itself. In other words, more inflation expected would lead in turn to still more inflation.

We have found comprehensive evidence that inflation in SA does to a small degree influence inflation expected, as measured for the Reserve Bank by surveys conducted by the Stellenbosch Bureau of Economic Research for business, trade unions and financial institutions. However, the reverse has not been true, although the Reserve Bank seems to believe otherwise.

Moreover it is clearly concerned to preserve its inflation fighting credentials even if this should mean having to raise rates. This is so even when it is clear that the inflation it is attacking is not under its control and when higher interest rates might lead to slower growth and a wider gap between actual and potential output and employment. The striking feature of inflation expectations in SA is just how stable they have been and how they remain above the inflation target band of 3% to 6%.

As we indicated in our first reactions to the MPC statement, the outlook for interest rates in SA will depend primarily (and unfortunately) on the rand price of oil and the continued upward direction of administered prices and not on the state of the economy that might be intolerant of higher interest rates. There should be a better way of running monetary policy in SA with more sensitivity to the state of the domestic economy and with the media and the financial markets well able to understand that a shock to the inflation rate does not imply permanently higher inflation. Keeping interest rates on hold in such circumstances when demand pressures are subdued does not mean being soft on inflation. This better way is indicated by the inflation targeting mandate itself, which does not demand adherence to inflation targets regardless of the causes of inflation and the consequences of higher interest rates for the economy, as is indicated explicitly and clearly in Paragraph 4 of the Mandate.

The rand has however weakened in recent days despite an earlier expected increase in interest rates. This again confirms that the influence of movements in interest rates on the value of the rand is not easily predicted. As we show below the rand lost about 4% of its trade weighted value last week.

Perhaps the market is being influenced to a degree by the unknown outcomes of the municipal elections in SA on Wednesday, which have become a test of the national government and its competence to govern. A small additional protest vote would probably be welcome as an incentive for the government to improve its delivery. An unexpectedly large vote for the opposition might be regarded as a serious longer term threat to the powers that be, and would perhaps have unpredictable outcomes for the ruling party, its leadership and its policies. As we know markets do not appreciate uncertainty.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 16 May: After the MPC: Interest rate expectations and the rand

Think beyond just inflation

The Reserve Bank, as expected, kept its repo rate steady despite raising its estimate of inflation to come, now seeing inflation as marginally above 6% by year end. However it also predicted to return to within the band in 2012. The explanation of this increase was “cost push” rather than demand forces, therefore not justifying higher interest rates (in the absence of “second round effects”).

Second round effects are defined as higher inflation caused by more inflation expected. This, according to the theory of monetary policy, might demand higher interest rates to fight inflation expected, even if this depressed the economy. This dilemma – the unhappy trade off between inflation and economic activity – is something the MPC would naturally prefer to avoid. The big question is will it continue to do so?

Our own work has unambiguously identified the absence of second round effects. Inflation in SA has influenced inflation expected, not the other way round. Thus we do not expect second round effects to show up. But the inflation outlook remains particularly uncertain given the uncertainty about the direction of the US dollar and the oil price in particular. And if the inflation rate rises and is expected to stay above the upper band of 6% this policy dilemma will become more acute, with or without measurable second round effects.

We notice again and welcome the willingness of the Reserve Bank to think beyond actual inflation to the causes of inflation and the recognition that monetary policy must also bear the outlook for economic and employment growth in mind. The revised mandate for the Reserve Bank makes this very clear.

It should be pointed out though that, in answer to a question, this point about a broader focus than a focus on inflation only was not made by the governor. The governor, like all governors of central banks, would hate to be interpreted as being soft on inflation, particularly when inflation is expected to rise above the target band and even when there is very good reason to ignore “cost push” pressures. And so anti-inflationary vigilance must always be stressed by central bankers, for fear that their lack of monetary action being misinterpreted as evidence of a lack of anti-inflationary conviction by the market place.

However, as was made clear by the MPC, the state of the economy does not support higher interest rates. As we have previously indicated the Reserve Bank is also of the view that economic activity may have decelerated rather than accelerated recently. And so, until the economy does pick up significant momentum, accompanied by significantly faster growth in bank credit the Reserve Bank will prefer to keep interest rates on hold. Yet it might feel obliged to raise rates despite the weakness of aggregate demand (wrongly in our view) should the actual inflation outlook deteriorate even if such higher inflation is beyond the control of the Bank itself.

The oil price remains the big unknown for inflation to come. It was remarked at the Q&A session that food price inflation may have peaked according to the Bank. The consolation is that higher commodity prices will very likely be accompanied by a stronger rand. If the rand price of oil remains unchanged or falls, the danger of higher interest rates will be averted for perhaps up to a further 12 months, that is until the economy gains real traction, which it will if the rand remains stable and the oil price does not detract further from household spending.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 13 May: Think Beyond Just Inflation

Bank credit and vehicle sales: No room for complacency

The bank credit statistics updated by the Reserve Bank to March 2011 indicate that weak growth in the supply of bank credit to the SA economy may be slowing down rather than gaining momentum. As we show below, our calculation of the underlying trend in the supply of extra bank credit to the private sector, suggests as much. Year on year growth appears to have stabilised at just over 5% (about a very modest 1% after adjusting for inflation) while the underlying trend growth has declined to a just over a 4% rate.

Behind this weakness in the supply of and demand for bank credit is the housing market and so the demand for mortgage loans. Mortgage loans have become an ever more important asset of the SA banks and now account for about 50% of all bank lending to the private sector.

House price inflation understandably leads mortgage lending as we also show below. The more valuable the house the larger the mortgage loan provided to secure it. Moreover house price inflation encourages home ownership. House prices are however not providing much encouragement to home owners, potential home owners or the banks. Clearly bank lending and money supply growth are not contributing any impetus to the SA economy. By implication therefore interest rates in SA are too high rather than too low: a point that will be taken account of when the Monetary Policy Committee (MPC) of the Reserve Bank meets next week.

The market for new and by implication used vehicles in South Africa has been the most conspicuous benefactor of lower interest rates and a stronger rand. However sales statistics for new units sold in April indicate that the growth momentum has slowed down. April with its many public holidays is typically a very slow month for vehicle sales, as slow as December for similar holiday reasons. April 2011 saw more than the usual numbers of days off and so April vehicle sales will need to be treated with more than usual caution. For the record, unit sales adjusted for seasonal factors (as far as we can measure them accurately) declined from 49 003 units in March 2011 to 42 830 units in April.

Furthermore the ripples from the Japanese Tsunami are still to be felt in the supply chains (including SA plants). In the months ahead new vehicle sales may well be inhibited by a want of supply rather than a lack of demand, making this leading indicator temporarily less helpful than usual.

The recent credit and vehicle sales statistics justify the caution expressed at the last MPC meeting about the state of the SA economy and the risks to the growth outlook. The credit and money numbers state very clearly that there is no pressure from the demand side of the economy on output, employment or prices.

The food and energy prices that have risen have their sources well beyond the influence of monetary policy in SA. They nevertheless help slow down rather than speed up the local economy.

These facts of economic life in SA should continue to give the MPC pause. There is no case for higher interest rates in SA. Indeed there is a much better case for lower rather than higher interest rates to add momentum to money supply and credit growth, which are too slow rather than too rapid for the good of the economy.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:Bank credit and vehicle sales: No room for complacency

Natural gas: Economic development vs the status quo

More than a year ago we indicated the potential of natural gas extracted from shale rock and that the SA Karoo basin covered in shale rock might contain a great deal of this new source of energy. In a report in the Calgary Herald, of 18 April, Peter Terzakian referred to a very recent assessment of shale gas potential in 48 basins in 32 countries released by the US Energy Information Agency.

To quote the Calgary Herald: “ The numbers are staggering: over a six-fold increase in the 1,001 trillion cubic feet (Tcf) of natural gas that was previously known to be “proven” reserves. According to the EIA report, over 6,600 Tcf of shale gas resources are estimated to be technically recoverable”. As the Calgary Herald explains “……..To put this in perspective, 1,000 Tcf of natural gas contains the equivalent energy to 166 billion barrels of oil – a staggering amount considering that the discovery of 10 billion barrels of conventional oil these days is a rare occurrence….”

We might add by way of comparison that the annual global consumption of oil is of the order of 87m barrels per day of which SA consumes about approximately 555 000 barrels per day.

The Calgary Herald produced a table of the largest 15 such shale gas reserves to point to the vast recoverable resource in China. But as may be seen below the estimate of the technically recoverable resource in South Africa at 500 TCF (none yet proven) is no small potatoes either- it is the fifth largest such resource and equivalent to 83billion barrels.

Were this potential output of natural gas, estimated as recoverable by the US EIA, to be captured from the Karoo shale it would be very large potatoes indeed. It would be the equivalent to about 400 years of SA consumption of oil at current rates: 365*550 00 = 202.575m per annum; (83000mb/202.575mbpa) = 402 years

These numbers derived from estimates that are as objective and scientific as any should help concentrate minds at the SA Department of Mineral Resources that has placed a freeze on rights to explore for natural gas in SA until it has formulated a policy. The benefits of discoveries of natural gas in SA of anything like this order of magnitude would very obviously be transformational for the SA economy. It would offer the prospect of much faster growth in national output and in incomes, including the incomes to be received by the SA government and of the poor to whom it may be hoped a good portion of the extra income would be distributed.

There might well be damage to the environment to be traded off for these great potential benefits. Such tradeoffs can presumably be calculated and compensation offered if necessary to those negatively affected. There is too much at stake for any other approach to be adopted.

How much actual damage to be caused will continue to be disputed. However what should be borne in mind is that the damage to the environment caused by extracting other sources of energy in SA especially open cast or even deep level coal mining, would need to be brought into the calculation. Or in other words, less damage to the Waterberg traded off for damage to the Karoo

In many countries the prospects of shale gas have been greeted like the proverbial manna from heaven. Technically recoverable gas is being converted into proven reserves and actual output at a rapid rate. The economics of shale gas are rapidly transforming the energy equation in the US. But in SA the green movement seemed to have sounded an alarm that has deafened any account of the potential benefits. That the Karoo farmers have (recently) been denied any direct benefits from the gas under their land has no doubt added to the cacophony of protest.

Shell Oil, which appears to be well ahead in the race for Karoo gas, has argued (Business Report May 3 2011 p 17) to the contrary, that the process of extracting gas from shale “can be done without significant environmental damage”. That Shell has an interest in such arguments does not make the argument invalid. Furthermore the actual experience of damage to the environment in shale basins where gas is already being extracted in significant volumes will provide very important evidence.

The negative external effects of extraction or of any minerals in the ground do not remove the necessity to actually calculate the relevant tradeoffs as best as science will allow. Without such calculations and tradeoffs, economic development itself becomes much more difficult to realise. This is a fact of economic life well enough known to the greens who have no taste for the rising incomes and especially the rising consumption power of the masses.

Such an environmental assessment would then enable full compensation to be actually paid out to those damaged directly. The great potential extra income to be generated from natural gas potentially available deep under the Karoo shale rock is very likely to greatly exceed the damage caused to neighbours. If this is not the case then the project should not be allowed to go ahead.

The Department of Mineral Resources should however be well aware when establishing its policy that not only will natural gas discoveries on this potential scale be transformational for the SA economy, it will prove even more transforming of the energy sector of the economy. The Department should know that transformation of this order of magnitude will naturally not only be resisted by those directly in the path of discovery. Resistance would also come from those who think they may lose the race for supremacy for natural gas from SA sources because they have been slow out the blocks. The national interest in economic growth will count for little when opposed by vested interests.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Natural gas: Economic development vs the status quo

Financial markets in April: From Pennsylvania Ave to Pretoria

Many South Africans who took an extended break from work celebrating Easter, Freedom Day and the Bolshevik Revolution (more or less in that order), were no doubt comforted by the largely false notion that somebody else was paying for their time off and foregone output (other than those paid by the hour, who know much better). The rest of the world carried on producing and earning more or less as usual for most of the time (notwithstanding the Bin Laden news).

On returning to work today however, South Africans (those who follow such things) will discover that April was a very good month for offshore investors in SA stocks. Had they invested in the SA component of the emerging market index their return in US dollars in April would have been as much as 5.3%, well ahead of the monthly return for the EM Index, the S&P 500 and the US small caps. In the still mighty rand the returns would have been less impressive with JSE industrials leading the way.

In the US it is proving an exceptionally good quarterly earnings reporting season, still to be concluded. The S&P 500 has ended higher four out of the last five months, has been well supported by better earnings and has not (yet) benefitted from a re-rating.

It was not so much rand strength that accounted for these differences in returns, but the weak dollar. The US Fed at its April Open Market Committee meeting in April and at its very first press conference held thereafter, made it clear that it still regarded unemployment and slow growth, rather than inflation, as its major challenge. With the European Central Bank indicating the reverse sense of priorities, the US dollar weakened in line with an expected widening of the Euro-US dollar yield gap.

The rand accordingly gained against the US dollar in April and, after some mid month weakness, held its own by month end against the basket of other currencies with which SA trades, weighted by their share of exports from and imports into SA. Against a basket of other Emerging Market (EM) currencies the rand made a modest gain in April 2011, even as it weakened marginally againsts the Aussie dollar.

The fundamentals of the rand as a commodity currency that takes its cue from the Aussie dollar, was reaffirmed in April – though with the Aussie dollar trading at close to 109 US cents, a small degree of rand weakness vs the Aussie dollar was perhaps understandable.

Commodity prices were lifted by the weaker US dollar with gold leading the way and the US dollar oil price ending the month a little below its peak levels of earlier in the month. Any weakness in the oil price would be very welcome to central bankers everywhere, especially Mr Bernanke, who is on record as suggesting the spike in commodity and food prices will reverse this year.

The benefits of rand strength that mostly accompanies higher commodity prices will surely be appreciated in Church Street, Pretoria, as helping to contain SA inflation. We can hope that in Church Street, as on Pennsylvania Ave Washington, the fragility of the domestic economic revival, remains of greater concern than an inflation rate, over which the SA Reserve Bank can have no influence, other than not to stand in the way of currency strength.

The rand oil price, after its spike to R840 per barrel early in the month (caused by higher oil prices in US dollars and a temporarily weaker rand is now close to R820), has come off since then, a trend we can hope will lead to lower prices at the pump.

The stable rand, it would appear, has had a modest influence on interest rate expectations. Longer term interest rates that had moved higher in March 2011, moved lower last month, as we show below. The SA money market is still factoring in an increase in short rates within six months. Our view is that this would not be called for and will be resisted by the Reserve Bank, leaving short term rates on hold in 2011.

Perhaps the most notable move in financial markets in April 2011 was the decline in real interest rates in the US. While vanilla bond yields declined modestly, the real yield on the 10 year Inflation protected bonds (TIPS) declined by about 20bps. Inflation protected 10 year yields fell from a minimal 0.96% at the start of month to barely over 0.70% by month end.

Clearly the real cost of capital remains exceptionally low in the US and globally, the lack of demand for capital and abundant supplies of global savings being the primary explanation for this. Nevertheless, investors are seemingly willing to pay up for insurance against higher inflation that remains decisively a long term rather than an immediate threat. The case for the US maintaining its highly accommodative stance seems unanswerable for now. If this means a weaker US dollar so be it; the Fed will not be deflected from its task of assisting economic recovery rather than resisting inflation. Brian Kantor

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:Financial markets in April: From Pennsylvania Ave to Pretoria