Month: January 2018

SA – back in the emerging market fold

The South African economy has recently re-joined the world of emerging markets. The JSE, measured in US dollars, has caught up dramatically after having lagged well behind the surging MSCI Emerging Market Index. The JSE, in US dollars, and the SA component of the emerging market (EM) Index have gained over 40% since January 2017 as we show below in figure 1.

These EM and JSE gains have come after an extended period of underperformance when compared to the S&P 500. The S&P 500 has been making new highs so consistently over the past year. The EM Index and the JSE, in US dollars, have still to be worth more dollars than in 2011.

This JSE catch-up has come with the burst of rand strength that accompanied the defeat of President Jacob Zuma and his faction at the ANC electoral congress in December 201, a defeat that promised a new direction for the SA economy. The rand had weakened by about 11% compared to our basket of equally weighted other EM currencies by November. It is now about 4% stronger than the basket of EM peers (see figure 2).

Rand and EM currency strength has come with a noticeably weaker US dollar. The US dollar index (DXY) lost about 12% of its exchange value against other developed market currencies since early 2017 while the index of EM currencies has gained about 10% on the dollar, with the rand up by over 15% over the year.

A weak US dollar is good news for EM economies and especially their consumers. It brings currency strength and lower inflation – particularly of imported goods – and lower interest rates. It is very hard to see how the SA Reserve Bank can fail to respond to these trends with lower interest rates in due course.

The renewed hopes for the SA economy have extended to the bond market and to the risk premiums attached to SA government debt. Both inflationary expectations – measured as the spread between a vanilla 10 year RSA bond and its inflation linked equivalent – have declined sharply, from over 7% in November to about 6% currently. The spread between the RSA 10 year yield and its US Treasury bond of similar duration, that represents the expected depreciation of the ZAR/USD (the interest carry), has also declined by a similar degree. Yet both spreads remain quite elevated by the standards of the past. The belief in permanently lower inflation or a stronger rand is still lacking (See figure 3).

The cost of insuring RSA US dollar-denominated debt has also responded well to the new dispensation in SA. After many years of trading as junk – ever since Zuma sacked finance minister Nene in December 2015 – RSA debt is now competing again on investment grade yields.

Further support for the rand and EM currencies has come from higher commodity and metal prices. As we show below, industrial metal prices have performed better than commodity prices indices (that includes a heavy 27% weighting in oil). The London Metal Exchange Index is up 30% in US dollars since early 2017 (see figure 5). A stronger global economy combined with a weaker US dollar is helpful to EM economies including SA with their dependence on exporting minerals and metals.

The politics as well as the economics of SA are now in a much healthier state as the market place confirms. And the global economy is offering much more encouragement for SA exporters. But as indicated in our figures, there is room for further improvement. Inflation and interest rates can recede and the exchange rate and sovereign risk spreads have room to narrow further. The opportunity presented to SA is to stop the rot (developments to date have been well appreciated in the market place) and then to follow through with wealth creating and poverty reduction initiatives. 29 January 2018

US earnings and tax rates – a temporary conundrum

You may think that cutting company tax rates in the US from 35% to 21% of their earnings would boost after-tax earnings. But not so fast – while the longer run impact of the lower taxes will clearly benefit shareholders and employees, the immediate impact of a lower tax rate can significantly reduce, rather than improve the bottom line. This is the case with a number of the very large US banks reporting or about to report their latest results.

Citibank, according to the Wall Street Journal, is about to report a large loss for the final quarter of 2017. It will be making enough of a tax charge to its earnings – as much as US$20bn – for the bank to become loss making in 2017. Some of the other major US banks, for example JPMorgan, will also be deducting large sums (in its case $2.4bn) from its earnings as a once-off adjustment for lower tax rates to come. Wells Fargo by contrast was able to add $3.35bn to its earnings, as was another large bank, PNC, which added about 9c to its reported earnings of $4.18 a share.

The banks and firms that are able to immediately boost earnings have net deferred liabilities, some $2.37bn worth in the case of PNC. In the past, these provisions against future tax liabilities had been deducted from earnings. Now with lower tax rates, this reserve can be reduced and added back to earnings. JPMorgan and Citibank, by contrast, have on balance accumulated tax assets rather than liabilities. They include tax benefits to be realised in the future as an asset on their balance sheets. The accumulation of such potential benefits has boosted earnings over the years. At a lower tax rate, these assets are worth less when they are written off against current earnings.

Incidentally, the Journal article while commenting on the generally very favourable operating performance of the bank as a whole also reports a further charge to JPMorgan earnings, as follows:

“JPMorgan’s corporate and investment banking unit was weighed down by weak trading, slumping 17% to $3.37 billion after stripping out the tax-overhaul impact. It also was hit with losses as high as $273 million related to client Steinhoff International Holdings NV, which is dealing with a wide-ranging accounting probe that is expected to also dig into other large banks’ results.” (WSJ, Peter Rudegeair)

These important recent developments on the earnings front raise the issue about the usefulness for investors or operating managers of these heavily and frequently adjusted bottom-line earnings. Quarterly reported earnings cannot be regarded as a reliable measure of the long run potential of the companies reporting. Nor, since the definition of earnings has changed so much over the years, can these reported earnings be helpfully compared to earnings in the past, nor to historic share prices, in the hope that price earnings ratios will revert to some long run average.

But there is one measure of the performance of a company or of a stock market that has the same meaning and significance today that it has today as it did 50 or 100 years ago. That is the cash paid out to shareholders as dividends. Companies do not easily pay away real cash unless they are confident they can maintain such payments. As such their dividend payments constitute a very real measure of normalised earnings.

A comparison between S&P 500 Index earnings and dividends makes the point. As we show in figure 1 below, dividend flows are far smoother than earnings; smooth enough to be regarded statistically as well as for economic reasons as a normalised measure of earnings.

Of particular significance is that dividends survived the financial crisis of 2008 far better than earnings, as may be seen. Earnings in that period collapsed dramatically as all the failed loans and less valuable assets of the banks and financial institutions were written off earnings. Dividends held up relatively to earnings to reflect the future of US business rather than its immediate past.

And share prices since the crisis are much better explained by the flow of dividends than the flow of earnings. As may also be seen in figures 2 and 3, dividends payments by S&P 500 companies grew steadily between 2014 and 2016, even as earnings fell away sharply in 2014. This helped to support further improving share prices.

S&P Index dividends moreover have continued their steady advance even as earnings have rebounded very strongly, as the figure shows. Dividends since 2012, a period when the S&P Index gained an average 13% p.a., have grown on average by 10.5% p.a, while earnings grew by 3.5% p.a on average, with twice as much volatility. It would appear investors bidding up share prices were taking more notice of normalised than actual earnings, that is of the consistent growth in dividends.

As we show below the quite stable dividend yield on the S&P 500 is very much in line with its post-2000 average. This does not appear to indicate an overvalued market, especially when this dividend yield is compared to interest income which is the alternative to dividends. And lower tax rates will surely encourage US businesses to raise their dividend payments. 16 January 2018