Month: October 2013

Demanding valuations on the JSE: Sentiment or fundamentals?

Market watchers are well aware that share prices on the JSE have run faster than earnings. The price over earnings multiples have increased to their highest levels since January 2000. Is this rerating of the market irrational exuberance as many fear or has it a more fundamental explanation?

The rerating of the market owes much to the increased values attached to the leading industrial companies listed on the JSE. Their values have been rising significantly faster than their earnings and are now trading at close to 24 times reported headline earnings per share.

By contrast, the prices of resource companies have held up much better than their earnings, which have declined significantly, but are clearly expected to recover strongly. Reported JSE Resource Index earnings per share are more than 22% below their levels of a year ago. Financial companies on the JSE have not rerated. Their price to earnings multiples remained largely unchanged and remain undemanding of earnings growth.

While the share prices of the major companies included in the JSE Industrial Index have risen faster than earnings, it is perhaps less apparent just how well these companies have performed on the earnings front. We show below the progress of JSE Industrial Index earnings per share since 2003 when these earnings first took off after a long period of stagnation, especially when measured in real terms.

Earnings grew very rapidly until interrupted by the Global Financial crisis of 2008-09. The decline in these earnings was modest and temporary and then resumed an upward path about as steep as that realised between 2004 and 2008. This observation needs emphasis. Despite what will be regarded as well below par global and SA economic growth since 2009, JSE Industrial Index earnings per share have been growing as rapidly as they did during the boom years of 2003-2008.

In the figure below, we convert recent industrial earnings growth into real terms. Real industrial earnings growth has averaged about 9% per annum, or 15% in nominal terms, with little sign to date of a slow-down in the pace of growth. Indeed the pace of growth appears to be remarkably stable as well as strong.

Investors, it may be concluded, are paying up, not only for earnings but for strong and stable earnings growth. The question to be answered therefore is not so much as to why the market has rerated JSE industrial earnings – they surely deserve such a rerating based on past performance – but whether or not the impressive consistent pace of earnings growth can be sustained. Future performance will depend not only on the capabilities of managers, who have proved capable of growing earnings and realising consistently high returns on shareholder capital employed in what have been tough times, but also on a recovery in the pace of SA and global economic growth.

Good news for SA – US bond yields are at three month lows

With the US government back to its spending and borrowing ways until at least January 2014, long dated  US Treasury yields fell yesterday to their lowest levels  in four months three months. RSA yields followed suit also reaching their lowest levels since July. (See below)

 

RSA and USA 10 year bond yields (daily data)

Source; I-net Bridge and Investec Wealth and Investment

The difference between these yields may be regarded as the RSA risk premium or equivalently the average rate at which the ZAR/USD exchange rate is expected to depreciate over the next ten years. As may be seen this risk premium too has narrowed significantly since reaching its recent peak of over 5.5% p.a. in late August 2013. This was when US and RSA rates were at their recent highs on fears of QE tapering that have since been allayed. ( See below)

 The RSA risk premium (daily data)

 

Source; I-net Bridge and Investec Wealth and Investment

We have pointed to the key role played in global financial markets by US treasury yields. Emerging market equity, bond and currencies (of which SA is such a conspicuous component) are particularly exposed to higher US rates. As we suggested while rising yields might be good news about the improving state of the US economy rising yields in SA and other emerging market economies would not be at all helpful given that growth rates have been slowing down rather than picking up. For emerging markets, at least for now, the lower the US rates the better.

And so it has been proved. The decline in US rates has been very good news for the rand, the rand bond markets and also the JSE in rand  and USD.  In USD the JSE All Share Index has recovered strongly from its mid year lows and is now worth almost as much in USD as it was in January 2013. (See below)

 

US 10 year bond yields and the JSE (USD value)

Source; I-net Bridge and Investec Wealth and Investment

Again conventional wisdom about the rand has been proved wrong. It is a strong rather than a week rand that is good for the JSE. The factors that move the rand weaker or stronger- both for global and domestic reasons that encourage or discourage risk taking- are either harmful or helpful to the rand and simultaneously harmful or helpful to the USD as well as the rand value of SA listed assets.

Lower interest rates in the US have been good news for the rand and rand denominated stocks and bonds. The value of almost all financial assets measured in rands and dollars have moved move in the opposite direction to the rand cost of a dollar. Or if preferred, have moved in the same direction as the US dollar cost of a rand. Companies with predominantly dollar based revenues- are not in fact rand hedges- they do not gain value when the rand weakens – they simply lose less of their rand value than do the SA economy plays- when the rand weakens. They may also gain less rand and USD value when the rand strengthens. It would be better to regard companies listed on the JSE, whose operations are largely independent of the SA economy, as SA economy hedges rather than rand hedges.

 

 

 

Toll charges are not the problem, the way they have been determined is the problem

The SA National Roads Agency (SANRAL) very clearly misjudged its pricing power when setting the original tolls for the Gauteng commuter belt. Toll road charging is as much about politics as economics, as the Agency now knows only too well.

But what are the economic principles that inform SANRAL tolls? I trawled through the SANRAL website for answers and find very little by way of guidance. How “the right price” for a new road to be built and tolled is determined appears to receive very little attention or analysis in the documentation presented to the SA public by SANRAL.

There are some clues that indicate the tolling pricing philosophy. SANRAL pays close attention to the volume of traffic on its roads. To quote its Strategy: “Traffic data forms the basis of planning in SANRAL. Because it is important for SANRAL to have accurate traffic data for the entire national road network, it is covered by strategically positioned traffic counters.” Source: SANRAL Strategic Plan

SANRAL is also naturally well aware of its credit ratings and the strength of its balance sheets. Debt management would appear to play an important role in its tolling determinations , according to its Strategy Document:

“SANRAL has historically sought to reduce its dependence on transfers from the fiscus, using the strength of its balance sheet to finance the toll road programme…….. to allow it to continue its borrowing programme efficiently to fund the toll roads. The aim is to maintain the credit ratings at sovereign equivalent levels at all times. But the recent uncertainty around the implementation of electronic tolling on the GFIP has caused nervousness among investors. The rating agency has placed SANRAL‟s ratings on review for a possible downgrade.”

Not all of the extensive road network, for which the agency is responsible, is suitable for tolling, due to the lack of sufficient traffic to cover even the costs of collecting the tolls. But the costs of maintaining and extending the road network are formidable and for meeting this responsibility, the revenue from tolls (where they do cover their costs of collection) are for SANRAL a more helpful alternative source of finance than grants from the National Treasury.

The Toll Budget proposed in 2012-13 illustrates the financial objectives for SANRAL, presuming it got its way with tolls. Income from tolls were proposed to increase from R3.69bn in 2012-13 to R6.34bn in 2014-15. Expenditure on operations was to rise much more slowly, from R2.42bn to 2.84bn over the same period. That is to say, operating profits would rise from R1.27bn in 2012-13 to R3.5bn in 2014-15.

This improvement would go some way to meeting the growing finance charges associated with a massive increase in capital expenditure on roads to be tolled, that occurred between 2008-9 and 2011-12, as well as the extra debt associated with this capital expenditure programme. Capex of R25.37bn was incurred over these years and funded largely with debt. This burst of capex on toll roads according to the Toll Budget will slow down to R2.24bn in 2012-13, R1.45bn in 2013-14 and R1.58bn in 2015-16. This mixture of rising operating profits and declining capex and debt issues would clearly improve the SANRAL balance sheet.

The strong indication is that, with these balance sheet objectives very much in mind, the guiding principle in determining the tolls charged is based largely upon what the expected, closely monitored, traffic will bear. In other words, the tolls are set to maximise revenue. The more traffic, the more essential the route to be travelled, the stronger the demand and so the higher the tolls, would seem to be the modus operandi. In other words the tolls are set independently of the costs of building and maintaining the roads, with the most popular routes producing the largest operating surpluses.

The transport engineers might call this a pure congestion charge. It is not a user charge system but a system for cross subsidising users.

It is good economics to apply user charges as an alternative to general taxation, from which the taxpayer may receive very little benefit. The Gauteng commuter, not the Cape Town commuter, should pay for Gauteng roads. Nor should the Cape Town or Gauteng motorist be expected to pay for the costs of using the little used road from Calvinia to Upington.

But then how much should the Gauteng commuter be expected to pay? Not surely as much as the Gauteng traffic could bear. Given the lack of alternative routes and transport this could be a very high price indeed – as SANRAL originally intended.

The right price for a new toll road would be a toll that could be expected to generate enough revenue and operating surplus to cover all costs of building the road, including the opportunity cost of the capital employed. It would be inflation protected. If, in applying this principle, the right price can be expected to be generated over the estimated life of the asset (say 20 years), providing revenues sufficient to cover all costs, including a (low) risk adjusted return on capital, then the road should be built. If this condition cannot be met, either the road should not be constructed at all, or some explicit subsidy from the taxpayer would have to be in the budget for the road, using the same pricing principles. This economically sensible “right price” for a new road, for which there would be good demand, as for example an improved Gauteng road network, would surely be far lower than a “what the traffic can bear” charge.

It is essentially this pricing principle that the energy regulator has used to determine the price that Eskom, with its monopoly power, is allowed to charge its customers. Nor did NERSA allow debt management considerations to influence its price determination. As with a new power station, a new road, bridge or flyover is fully justified when the price charged is sufficient to generate enough revenue to cover all costs and to provide an appropriate return on capital. And using debt to fund infrastructure also makes sense, providing the returns justify the capital expenditure. Debt management should not be allowed to influence prices.

Roads are highly productive. Building new roads or access to them can make every economic sense when the right price is charged to their users. An active road building programme for the SA economy is urgently called for, especially where demand for roads is most intense, as it is around Gauteng or Cape Town. Yet the right price to be charged to justify this programme should not be seen as a congestion charge designed to force the use of alternative transport – or as a way of cross subsidising the building of roads that cannot cover their costs.

It calls for a user charge sufficient to cover costs of building and maintaining roads, wherever possible and no more; or for an explicit subsidy that the tax payer will be called upon to supplement user charges when revenues from practically feasible user charges would fall short of the requirement to cover all costs.

These – economic return on capital – pricing principles have not guided SANRAL. That the originally intended Gauteng toll charges proved politically impossible has unfortunately made sensible toll charging of the right kind indicated less likely. It is likely to have a negative impact on productive road building in SA.

SA equities: Foreigners buy when the locals sell – this can be good news for the rand

For every foreign buyer on the JSE there is an equal and opposite domestic seller. The question therefore is what should make local institutions wish to sell when foreigners are keen to buy? Or, put another way, what would make foreign investors think prices on the JSE were too low (hence the buy decision) and domestic portfolio managers simultaneously think them too high (hence their sale)?

The answer may have something to do with the constraints faced by fund managers. For South African funds these come in the form of regulations limiting their exposure to equities in general. No more than 75% of a retirement fund can be held in equities and not more than 25% of the portfolio can be held abroad. Hence, when share prices run (especially when the rand weakens) they may well exceed these limits and be forced to rebalance their portfolios. Foreign investors, by contrast, are typically underweight exposure to SA and can easily add to SA weights, should they wish to do so.

Chris Holdsworth in his latest October Quantitative Strategy Report for Investec Securities published on 10 October shows how SA institutions, given strong performance by equities both here and abroad, are currently heavily weighted in equities:

He also shows that the SA institutions react to strongly to equities outperforming bonds, as they have done recently by reducing exposure to equities, that is selling equities to buy bonds, as shown below:

Hence they are now likely to be selling equities to them, likely to be buying bonds, at least to some extent, from them and also likely to be gradually repatriating funds from abroad to satisfy the 25% limit.

Holdsworth calculates that should equities outperform bonds by 12% over the next 12 months, SA institutions could sell up to R100bn of equities in rebalancing portfolio switches. If so the large current account deficit and the rand will receive considerable support from inflows into the equity market. A strong rand however improves the case for the bond market by inhibiting any thought of higher short term interest rates. The SA interest plays, property, banks and retailers – that benefit from low interest rates – become particularly attractive when interest rates become more likely to go down rather than up.

Expectations of rand strength (and lower interest rates) is not a consensus view in the market place and so there is clearly room for a rand and interest rate surprise. Any strength in emerging equity markets generally will support both the JSE and the rand and further encourage SA fund managers to reduce exposure to JSE listed securities encouraging foreigners to buy. That the rand is an emerging market equity play is no accident. It is partly also a result of regulation of portfolios.

The Hard Number Index: The current state of the SA economy

Information for September 2013 on new vehicle sales and the supply and demand for notes issued by the Reserve Bank has been released. These two very up-to-date hard numbers make up our Hard Number Index (HNI) of the immediate state of the SA business cycle.

These indicate that the pace of the economy is little changed from that of the previous month. The SA economy, according to the HNI, is still growing but the pace of its forward momentum, modest enough as it is, has stalled.

Vehicle sales of 54 281 new units in September were nearly 2000 units fewer than those of August 2013; but when measured on a seasonally adjusted basis sales declined by a lesser 700 units. A time series forecast indicates that by this time next year, the industry will be supplying units to the SA market at an annual rate of 632 390 units, slightly down on the current annualised rate of 649 400 units. The strike action in the motor industry in September appears to have affected export volumes – these were down sharply from the previous month, more than sales made at retail level. No doubt inventories, supplemented by imports, kept sales going with the influence of any supply disruptions postponed.

Given the recent stability of the rand, though at lower levels, it may be presumed that sales aimed at pre-empting expected price increases would have been less of an influence. Low financial charges by banks eager to lend, secured by the vehicles themselves, no doubt remained a positive influence on sales volumes.

The most important influence on sales over the next 12 months will be the direction of interest rates. Clearly the showrooms, as much as all retailers, would appreciate lower, not higher, interest rates that the weak state of the economy surely justifies. As somebody told me many years ago when asked about the determination of the price of a new car: “How long is a piece of string?” What you pay for a new vehicle is a mixture of financing charges, estimated residual values as well as the prices on the lists in car magazines. The pricing of a cell phone call and the telephones used to make them – subject to regulation of some of the charges cell phone companies levy on each other – are as difficult to understand and predict. The presumption that a reduction in some regulated charge made by cell phone companies will lead to an equivalent reduction in company revenue, is much too simplified a view of price-setting behaviour.

The supply and demand for Reserve Bank cash (the other half of the HNI) continues to grow at a strong but also declining growth rate, as we show below. This demand for cash reflects in part informal economic activity. The forecast of real growth of slightly below year on year 4% this time next year is again consistent with stable, but unsatisfactorily slow growth in household spending. On this evidence there is no case at all for an interest rate increase in SA. An increase would slow down growth further and would have no discernable influence on the inflation rate that will take its cue from the exchange rate that, as we have often argued, is beyond the control of the Reserve Bank. Rather, an interest rate cut is called for to sustain growth in spending and such growth is likely to attract foreign capital to support the rand and improve the outlook for inflation.

 

The SA economy needs help – and not just from foreign investors

In 2003 the SA economy took off and the current account deficit of the balance of payments (exports minus imports of goods and services plus the difference between interest and dividends earned from offshore investments and paid out for them) increased very significantly.

From an unsatisfactory period of slow growth and a minimal current account between 1995 and 2002, after 2003 faster growth in SA was understandably financed in greater measure with the foreign savings the economy was able to attract to help fund economic growth. Given the low rate of domestic savings, the limits to SA growth are set in part by the willingness of foreigners to invest in SA debt and SA business. Without these foreign savings, the growth potential of the economy would be seriously constrained. Foreign capital makes the difference between a rate of capital formation of an unsatisfactory 14% to 15% of GDP to a more helpful possible 20% rate of additional investment in plant and equipment.

Growth, or rather expected growth (of a business, or an economy that is the aggregation of business and government activity) attracts extra capital and the failure to grow repels capital and investment. Economic growth, supported by capital inflows, is much to be welcomed. The current account deficit indicates the supply of foreign capital, to which a highly positive connotation can be given. It also measures the demand for foreign capital by domestic economic agents – a demand that indicates vulnerability to the possibility that such demands may not be met.

As we show below, the pace of economic growth in SA was disrupted by the Global Financial Crisis of 2008 and the deficits fell away. However since 2011, the growth rates have been very subdued and yet the deficit has remained very large. Clearly economic growth rates have remained unsatisfactorily low, as has the domestic savings rate, itself in part a casualty of slower growth in incomes and higher taxes on them, while the dependence on foreign capital (represented by the current account deficits) has remained very large.

The ability of SA to continue to attract foreign capital is welcome. Without it the economy could not grow even as slowly as it has done. Without it, the exchange rate would be weaker still, the outlook for inflation worse and the danger of higher interest rates greater – all of which would further diminish growth rates and the prospects for growth.

But attracting foreign capital is no free lunch for the economy. It is equivalent to having to sell the family silver to keep food on the table. The family silver sold is measured by the difference between income paid to foreigners in the form of dividends, interest and income received from them. The deficit on the debt and asset service account of the balance of payments has been widening as more of SA business is owned by foreigners and more debt issued to them. Income from capital invested abroad by South Africans made abroad has also increased but not nearly as rapidly as income paid out. This foreign income deficit is responsible for a large proportion of the current account deficit: about a third of it, or 2% of GDP in 2013, which is down marginally on recent years because of less profitable SA business paying out less in the form of dividends to offshore owners.

The objective for SA economic policy in these unsatisfactory circumstances of slow growth and higher inflation should be to make every effort to increase output, employment and savings. Two obvious initiatives would make a very large difference. The urgent call is for reforms that would encourage the demand for and supply of potentially abundant less skilled labour by repealing closed shop and minimum wage laws. Imposing secret ballots on strike proposals by union leaders would surely help sustain production in the factories and mines, which has been so disrupted recently.

The other clear route to higher savings and investment output and employment is to reduce income taxes on all business in exchange for more capital invested and more jobs created. A bias towards taxes on consumption rather than income is as urgently called for as labour market reforms.