Month: September 2015

How well is the equity market reading the Fed?

 

The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.

While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.

Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?

We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.

The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.

The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.

The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.

It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders

Taking stock of GDP

The SA economy in Q2 2015 was not as it appeared – after taking an inventory

According to the first readings of gross domestic output (GDP), in real terms for Q2 2015, the SA economy performed very poorly. It is estimated by Stats SA to have shrunk by 1.3% on a seasonally adjusted annual rate in the quarter.

(All figures are taken from the Quarterly Bulletin of the SA Reserve Bank, September 2015.)

 

On a second reading for the second quarter of figures provided by the SA Reserve Bank, which include estimates of the demand side of the economy, the outcomes, on the face of it things. seem even worse. Gross Domestic Expenditure (GDE) is estimated to have declined by as much as a 7.2% rate in the quarter. The outcomes were not nearly as dire as might be inferred from either the GDP or GDE estimates. Final demand, the sum of spending by households, firms and the government sector, actually grew by about 1%. That final demands continued to grow at a very modest pace is consistent with our own measures of economic activity. What turned final demands into very weak GDE growth rates was a dramatic decline in inventories. Inventories in Q1 grew by R8.8bn on a seasonally adjusted annual rate. In Q2 they declined by the equivalent rate of over R38bn. This decline in inventories was enough to reduce real GDP in the quarter by as much as 6.2%.

Much of the action is attributable to the large seasonal adjustment factor interpolated to the estimates of inventories, the consistency of which may well be questioned. It is normally the case that the second and third quarters are periods when inventories are built up and the fourth and first quarters are normally associated with a general run down in inventories. But as the Reserve Bank comments, inventory events in Q2 were anything but normal in the mining and oil sectors. To quote the Economic Review of the Reserve Bank for Q2 2015:

Following a modest build-up in inventories in the first quarter of 2015, real inventory levels declined significantly at an annualised pace of R38,9 billion (at 2010 prices) in the second quarter. The rundown of real inventories in the second quarter of 2015 was mainly due to the destocking in the mining and manufacturing sectors, partly reflecting subdued business confidence levels and a decline in import volumes.

In the mining sector, inventory levels at platinum mines in particular contracted during the period on account of a significant increase in the exports of platinum in order to fulfil offshore export obligations. The rundown of inventories in the manufacturing sector partly reflected lower crude oil import volumes due to scheduled maintenance shutdowns at major oil refineries over the period. Consistent with a slower pace of increase in retail trade sales, the level of real inventories in the commerce sector rose in the second quarter. Industrial and commercial inventories as a percentage of the non-agricultural GDP remained unchanged at 13,8 per cent in the first and second quarters of 2015.

Inventories can run down because firms lacking confidence in future sales plan for a reduction in goods held on the shelves or in warehouses. They may also run down in an unplanned way because firms are surprised by the actual sales they were able to make. The planned reduction in inventories can represent bad news for the economy as orders decline. The unplanned reduction can mean better news should firms attempt to rebuild inventories. Similarly, a planned increase in inventories can reflect a more confident outlook for sales to come. An unplanned build-up of inventories may also reflect unexpectedly poor current sales volumes, and so fewer orders to come in the quarters ahead. Making the distinction between planned and unplanned inventory accumulation will be all important for any forecast of economic growth. In the case of the SA economy in Q2, it seems clear from the Reserve Bank statement that the run down in inventories in Q2 was for largely idiosyncratic reasons, making the application of seasonal adjustments particularly subject to error.

Judged by the estimated growth in final demand, the economy did not deteriorate in Q2 as the statistics on the pure face of it may suggest. In our judgment of the National Income Accounts released for Q2, the economy continues on its unsatisfactorily slow growth path as other indicators of the economic activity, included our own Hard Number Index, have revealed. The economy is growing slowly and not shrinking, nor is it about to do so. There is moreover at least one silver lining to be found in the latest statistics. As much as inventories subtracted from the growth rate, net exports added as much, due to the growth in export volumes and the stagnation of import volumes. The trade balance went into surplus and the current account deficit declined thanks to the weaker rand and the relative absence of strike action.

Another development this year, essential to lessening the tax burden on the productive part of South Africa, and so increasing potential growth, is the further decline in public sector employment in Q1 noted by the Reserve Bank. Lower tax rates and less spent on employment benefits for a bloated public sector, also lower interest rates, will help stimulate a recovery in the all-important household spending that is essential for faster, sustained growth over the longer run.

A combination of export growth and a stronger trade balance combined with a smaller budget deficit, accompanying fewer expensive public officials, of the kind revealed in Q2 2015, is some of the right stuff necessary to recalibrate the SA economy in the collective mind of the global capital market from a fragile to a resilient economy.