Emerging Markets – ZA Economist

Building Brics – opportunity beckons

The group of countries that will make up the enlarged BRICS, Argentina, Egypt, Ethiopia, Iran, Suadi Arabia and the UAE have little in common other than a deep suspicion of the motives of the US and its close allies. A state of mind also shared by left wing opinion everywhere including in the US itself. If the unlikely combination of kingdoms, autocracies and genuine democracies is to become more than a another talking shop with an anti-West bias, then it should take an important lesson from the economic development of the US and Europe.

What has been of great benefit to the US and to Europe, since it established a common European market and Euro are their highly significant common currency areas. The same money is used everywhere in the US and Europe as a medium of exchange and a unit of account. Thus unpredictable rates of exchange when buying or selling goods and services across frontiers are avoided, as are the direct costs of converting one currency into another- usually converting US dollars -into the domestic money.

Trade and financial flows between the states of the US and now of Europe is greatly encouraged by what is a fixed exchange rate regime within a common market, also free of protective of domestic industry tariffs or discrimination against foreign suppliers, by regulation. As it does incidentally when transactions of one kind or another take place within any country. The important trade between Gauteng and the Western Cape for example is facilitated by prices set in the rand common to both.

In the nineteenth century when which international trade and finance first flourished and economies came to benefit from wider markets for their goods and labour, and the ability to realise productivity and income enhancing economies of scale, currencies were mostly linked by fixed rates of exchange. The link was the ability to convert the different monies, if necessary, into gold at a fixed rate. And the issuers of different monies made sure to maintain convertibility by protecting their balance of payments through adjusting domestic interest rates. If gold generally flowed out interest rates could be raised to conserve and attract gold reserves and vice versa. Provided the commitment to currency convertibility was fully credible, the extra interest received would balance the payments by attracting or retaining capital.

A modified fixed exchange rate system was re-established after the second world war with the US dollar as the reserve currency- but dollars that could be converted into gold at the request of other central banks. This commitment was abandoned unilaterally by the US in 1971 and market determined exchange rates, with the still dominant US dollar, became the norm. Highly variable rather than predictably fixed exchange rates have become the unsatisfactory order of the day. The rates of exchange of other currencies with the dollar, both in money of the day terms and when adjusted for differences in inflation of different currencies have varied very significantly – and unpredictably- damaging volumes of international trade and real investments.

US Dollar Exchange Rate Index. Market Determined and Inflation Adjusted

Source; Bloomberg, Federal Reserve Bank of St.Louis and Investec Wealth and Investment

It has not been a case of exchange rate moves levelling the playing field for traders in goods and services- so maintaining purchasing power parity in the face of differences in inflation rates across trading partners. Rather the exchange rates have adjusted to equilibrate independent flows of capital – large and reversible flows – in search of better risk adjusted rates of return- to which inflation then responds. Weaker exchange rates lead to more inflation and vice versa. Without stable exchange rates, controlling inflation in the face of capital withdrawals and a suddenly weaker exchange rate with the US dollar can become a severe interest rate burden on the domestic economy – as South Africa demonstrates.

The enlarged BRICS could establish fixed exchange rates between each other to promote trade and investment. They might usefully adopt a Chinese standard- that is offer convertibility of their own currencies into Renminbi at fixed rates. And rely on the Bank of China to manage the float of the crucial rate of exchange of Renminbi into US dollars, as it now does.

Of liras and rands

Moves in emerging market currencies like the rand and Turkish lira show that countries that depend on foreign capital need to play by the rules governing international trade and flows of capital

Emerging market (EM) currencies have been caught up in the political and now financial crisis confronting the Turkish economy and its leader. But some EM exchange rates have suffered more than others. The rand, alas, has been one of the worst performers, especially on Wednesday (15 August). It is a trend that continued yesterday morning. The Turkish lira has re-gained some ground against the still strong US dollar and significantly more against the weaker rand.

At its worst this month, on 13 August, the lira had fallen from 4.99 to 6.88 against the US dollar – a decline of 37%. That same day the rand was about 9% weaker against the US dollar since 1 August and so 21% up on the lira. As I write at mid-morning on 16 August, the lira is now stronger than it was, at 5.81 to the dollar while the rand has weakened to R14.511 (see below).

The rand has now lost about 4.6% of its beginning of August US dollar value. This is not good news for the SA economy. It means more inflation and less spending power for hard pressed households and firms. Hopefully it will not lead to higher interest rates, which would depress domestic demand further.

The Turkish and SA economies have something in common: a continuing dependence on foreign capital to fund expenditure. But that is where the current similarities end. The Turkish economy has experienced a boom (over 7% real GDP growth in 2017) led by rapidly rising private sector capex funded increasingly with short-term borrowed dollars. This growth, accompanied by rapidly rising inflation and a widening ratio of current account deficit and so capital inflows to GDP. Interest rates lagged well behind inflation, now running about 16%.

The contrast with a depressed SA economy could not be greater. Our private sector capex cycle is even more depressed than household spending. Inflation (especially at retail level) remains well below interest rates and the current account deficit has stabilised at about 3.5% of GDP. The borrowing SA does is mostly by government and its agencies and is predominantly undertaken in rands.

Foreign lenders, rather than local borrowers, are exposed to the risk of the rand weakening, for which they collect a wide risk spread – of the order of 6% more than US dollar yields. SA business savings (cash retained) runs at about the same rate as stagnant or declining capital expenditure. Our fiscal deficits and the ratio of government debt to GDP are wider than those of Turkey – and may be getting wider, according to Moody’s. This is not an opinion helpful to the rand or the cost of borrowing dollars for five years: currently running at 2.17% above US five year yields. Turkish debt in US dollars is offering an extra 4.88% for five years – even more junky than RSA debt.

So what went wrong with Turkish economy that was so encouraged with abundant inflows of short term loans until recently and that were withdrawn so abruptly? The answer is fairly obvious – it is the result of a serious disagreement with the US about the arrest of a US pastor. He has possibly been imprisoned as a bargaining chip for President Ergodan’s public enemy number 1, Fethullah Gulen, who lives in the US, whose followers are accused of fomenting a coup. And so many thousands of whom are languishing in jail.

This indicates very clearly that countries that depend on foreign capital need to play by the rules (US inspired or enforced) that govern international trade and flows of capital and legal practice. This surely applies also to SA. By proclaiming upon the ANC’s intentions to expropriate farming land without compensation – definitely against the rules, and given the turmoil in the markets – ANC chairman Gwede Mantashe did SA and its growth prospects enormous harm. As Minister of Mineral Resources he could however immediately undo the damage. That is by signaling reforms of the mining charter that made mining in SA properly investor and owner-friendly. 17 August 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

Reading the share market – beyond market timing

27^th December 2017.

Every well traded market offers opportunity and danger. The opportunity is to buy low and sell high. The grave danger is that the investor/speculator does the opposite- sells at the bottom and buys at the top. The history of returns from equity markets reveals just how tempting it is to try and get the timing of entry into and exit from the market right; or, to put it more modestly, why it is important not to get the timing badly wrong.

The irregular pattern of past returns from equities

In figure 1 we show that since January 2000, the ups and downs of the S&P 500 Index of the largest companies listed on the New York Stock Exchange and the JSE All Share Index. With the benefit of hindsight, we can see that getting out of the New York market in early 2000 and re-entering in 2002, would have been very good for wealth creation. For investors on the JSE, timing would have called for even greater agility. It would have been best to have sold off somewhat later, in 2002, and then to have re-entered in 2003, so benefiting from the excellent returns available until the Global Financial Crisis (GFC) of 2008 caused so much damage to all equity markets.

Despite all the understandable gloom and doom of that unhappy episode in the history of capitalism, the GFC was followed by a period of strong and sustained value gains that continue to the present day (late 2017). It has been a rising equity tide that only briefly faltered in 2014. Those with strong beliefs in the essential strength of the global economic system and, more important, with faith in the capabilities of central bankers to come to the rescue, did well not to sell out in 2008 at what proved to be a deep bottom to share prices.

Figure 1: Annual returns on the S&P 500 Index (USD) and the JSE All Share Index (ZAR)

Source: Iress and Investec Wealth & Investment

These total share market returns (price changes and dividends received) have been calculated as gains or losses realised over the previous 12 months and calculated each month. The average annual return on the S&P 500 between January 2000 and November 2017, in US dollars, was 5.3% compared to 14.4% in rands generated on the JSE. The worst month for both markets was in late 2008, when both markets were down over 50% on the year before. The best year-on-year return on the S&P 500 over this period was 43%, realised in the 12 months to February 2010, while the best months for investors on the JSE were in late 2005 when annual returns peaked at over 50%. Adjusted for inflation in the US and SA, the S&P Index has provided about a real average 3% p.a return and the JSE an impressive 8% p.a. in real rands.

When measured in US dollars, the JSE also outperformed, having delivered close to 7.5 % p.a on average compared to the 5.3% p.a earned on the S&P 500. It may be seen in figure 2 below that the JSE provided superior US dollar returns between 2003 and 2007, but offered markedly inferior returns (in US dollars) compared to the S&P 500 since 2012. These high average returns over an extended period of time surely indicate the advantage of maintaining consistently high exposure to equities over the long run.

Figure 2: annual US dollar returns – S&P 500 Index and the JSE All Share Index

Source: Iress and Investec Wealth & Investment

While timing which market to favour over another – the JSE before 2008 and the S&P 500 after 2014 – can make an important difference to investment outcomes, it should also be noted that the returns on the S&P 500 and the JSE are quite highly correlated on average (close to 70%) in all the ways to measure performance.

The forces common to all equity markets around the world will often be directed from the US economy and its asset markets to the rest of the world – rather than the other way round – making an analysis of the state of the S&P 500 a very good starting point for analysing any equity market.

The essential question then arises. Is it possible to undertake value-adding or loss-avoiding equity market timing decisions with any degree of analytical conviction? Such market timing decisions are unavoidable for any fund manager or investment strategist with responsibilities for funds that are not all-equity funds. Any fund required by its investors to hold a balance in their portfolios of cash, fixed interest investments of various kinds as well as the many alternative asset classes that might feature in portfolios, would have to exercise judgements about the risk inherent in equity markets at any point in time.

The risk that the equity markets might, as they have in the past, melt down or even melt up – only then perhaps to melt down again – must therefore be uppermost in the minds of all fund managers having to decide on an appropriate allocation of assets. Even those running all equity funds have to decide how to time turning newly entrusted cash into equities and, more important still, which particular equities to buy and sell.

The broad direction of the equity or any other market can only be known after the event. From day to day, month to month or quarter to quarter, market prices and values are about as likely to go up as they are to go down. These short-term price moves therefore appear to observers as largely random, as the figure of monthly changes and daily moves in the S&P 500 Index shown below demonstrate. Note the still random (down/up, up/ down in no predictable order or magnitude) but very wide daily moves in the S&P 500 during 2008-2009 and during the euro bond crisis of 2011.

Figure 3: S&P 500 monthly returns (percent)

Source: Iress and Investec Wealth & Investment

Figure 4: S&P 500 daily returns (2005-2017)

Source: Iress and Investec Wealth & Investment

But these daily or monthly movements may reveal a broad drift in either direction, more up than down, or the other way round, measured over longer period of time. So when daily and monthly moves are converted into annual changes, observers will get the drift (after the event) and a persistent statistically smoothed trend in returns, that peaks and troughs in some more regular way, will be registered, as shown in figures one and two above. These phases, from top to bottom in annual returns, are defined as either a bull or bear market or something in between, depending on the depth or height of the following trough or peak, but can only be identified with hindsight.

Understanding how assets are valued

This does not mean that nothing meaningful can ever be said about the state of a market after it has moved higher or lower. With observation of the past we can understand the forces that have driven the value of any company higher or lower and so the average of them represented by a stock market index and therefore recognise the forces that might drive them higher or lower in the future, if past performance can be relied upon.

Successful, more profitable companies – those that earn a high return on the capital shareholders provide their managers – after all command higher values than less successful ones. And part of their success or failure will also have to do with the environment in which they operate. The laws and regulations, including the taxes their shareholders are subject to, will influence their ability to generate revenues and reduce costs, as will fiscal and monetary policies. The more certainty about these forces in the future, the less (more) risk to be discounted in the prices paid and the more (less) valuable will be the future flows of revenues and costs in which owners will share.

These market wide forces that determine the value of a share market index are in principle not difficult to identify. In practice they raise many unresolved issues about how best to give effect to the underlying theory. The economic caravan always moves on making it impossible to prove the superiority of one valuation approach over another. Holding other things equal is only possible in the laboratory, not in the economy.

The market can be thought of as conducting a continuous net present value (NPV) calculation, estimating a flow of benefits from share ownership over time, the numerator of the equation. That can be calculated as earnings (profits) or dividends or net (free after-capital expenditure) cash flow expected. The calculations of these are highly correlated when measured for an aggregate of all the firms that make up the Index. This expected performance of the market is then assumed to be discounted by a rate that reflects the required risk-adjusted rate of return set by the market.

The cost of owning shares rather than other assets, is given effect in the applied discount rate. It represents the opportunity foregone to own other assets, for example government or private bonds or cash, that offer pre-determined interest rate rewards with less default risk. In addition shareholders will, it is assumed, expect some additional reward, described as an equity risk premium (ERP) for the extra risks incurred in share ownership that offer no predetermined income. Hence a higher discount rate when the ERP is added to benchmark, default risk free fixed interest rates as provided by securities issued by a government. Such risks can be measured by the variability of the value of the share index from day to day, as shown above, a process of price determination that makes share prices more variable and less predictable than those of almost all other relevant asset classes.

These share prices will go up or down as the discount rate rises or falls with changes in interest rates. And with circumstances that cause investors to attach more uncertainty to the flow of benefits they expect from share ownership. The price of the shares goes lower or higher to compensate for these extra or reduced risks to the outlook for the economy and the companies who contribute to it.

The numerator of the NPV equation that summarises the expected flow of benefits to owners may be regarded (for reasons of simplicity) as (relatively) stable. A lower (higher) share price reconciles this given outlook with the required risk adjusted return that makes owning a share seem worthwhile. So when discount rates go up (down) – valuations (share prices) move in the opposite direction to improve (reduce) the expected returns from share ownership. Lower prices, other things being equal including expectations of profits to come, mean higher expected returns and vice versa.

Understanding and taking issue with the market consensus

One of the essential questions with which to interrogate the market, is to judge whether current market-determined interest rates are likely to move higher or lower or the environment that companies will operate in is going to become more or less helpful to their profitability. By definition, what surprises the market moves in interest rates or tax rates or risk premiums, will move valuations in the opposite direction. You may believe that the marketplace has misread the true state of affairs, such as the outlook for interest rates and risk premiums, and so has mispriced the share market, overvaluing or undervaluing it enough to encourage additional selling or buying.

The market consensus (revealed by the current level of the Index) will also have incorporated its expectations of performance to come by the companies represented in the Index. This consensus may also prove fallible. Earnings may be about to accelerate or decelerate in surprising ways. Operating profit margins may stay higher or lower for longer than expected. The economy itself may be about to enter an extended period of well-above past growth rates. If so, and you will have your own reasons for believing so, this would provide good reason to reduce or increase exposure.

Such contrarian opinions, if acted upon will add to or reduce exposure to equities. The market consensus is determined by its participants, all with the same incentive to understand it better, as you have, and is studied by many with great analytical skills and vast experience. Consensus has every reason to be the consensus. And when the consensus changes – as we have shown it so often changes – it will do so for good and well-informed reasons. Beating the market – that is getting market timing right – is a formidable task, so humility is advised.

While perfectly timing market entry or exit is not a task given to ordinary mortals, we can draw some helpful inferences about the condition of the market place, given this sense of what has driven past performance. We are in a position to judge how appropriately valued a market is at a point in time and therefore what would be required of the wider economic forces at work to take the market higher- or prevent it from going lower. We will attempt to recognise what is being assumed of the equity market – what assumptions are reflected in the prices paid for shares – and whether or not you can agree or differ from what is at all times the market consensus.

Our valuation exercises

We judge whether the equity market is demandingly or un-demandingly valued in the following way. We determine how current valuations are more or less demanding of additional dividends. Why dividends? Because they have the same meaning today as always: cash paid out to shareholders rather than retained by the enterprise. They are not subject to changing accounting conventions, such as the nature of capital expenditure and research and development expenditure that may or may not be fully expensed to reduce earnings. What may appear as an overvalued market would need a strong flow of dividends to justify current values and expectations. An undervalued market would be pricing in a slow-down in dividend payments. Good or poor dividend flows can take the market higher or lower.

Furthermore, we judge whether the market is more or less complacent about the discount rates that will be attached to these dividends to come. In this we are also aware that the interest rates we observe and that the market expects, as revealed by the level of long term interest rates and the slope of the yield curve, may be abnormally low or high – but might normalise to some degree in the near future.

We utilise regression equations that compare the current level of the leading equity index the S&P 500 to the level predicted by trailing dividends and long-term interest rates. The results of such an exercise are shown below. The model equation predicts a significantly higher S&P 500 than is the case today, some 40% higher. By this standard the S&P is currently undervalued.

The model provides a very good fit and both explanatory variables easily pass the test for statistical significance and accord well with economic theory. It explains past market behaviour well.

Figure 5: Regression model* of the S&P 500 (1970-2017)

Source: Iress and Investec Wealth & Investment

*Representation:

LOG(SP) = -1.80463655704 + 1.18059721064*LOG(SPDIV) – 0.0727779346562*USGB10

We can back test the model. If the model was run with data only up to November 2014 when the S&P began its new upward momentum we would have received a very helpful signal that the S&P was in fact very undervalued at that time. This signal would have encouraged investors at that point in time to have maintained high equity weight in portfolios- or what is described as a risk-on position.

Similarly had we applied the model in early 2000, just before the so called Dot.com bubble burst, the model would have registered that the S&P 500 Index was then greatly overvalued for prevailing dividend flows and interest rates Reducing exposure to equities at that point in time would have been very much the right approach to have taken – as we soon came to find out. We should add however that the model would also have registered a high degree of overvaluation as many as three years before the market fell away from its high peak. Even irrational exuberance, as Alan Greenspan memorably described it in 1997, perhaps relying on a similar approach to value determination, or its reverse undue pessimism, can persist for an extended period of time, making our model or any such valuation exercise based on historical performance unhelpful as a short-term trading model, but still valuable as a basis with which to interrogate market consensus.

In our models we regard the value of the S&P 500 as representing the present value of a flow of dividends (the performance measure) discounted by its opportunity cost, represented by the interest rate (the expected return) on offer from a 10-year US bond yield. An alternative approach would be to compare the value of the Index to the expected economic performance of the companies included in the Index, and then to infer the discount rate that could equalise price and expected performance in the NPV equation.

The Holt system[1] undertakes this calculation. It estimates the free cash flow return on capital realised by and expected from all listed companies (CFROI) real cash flow return on real cash invested using the same algorithms applied to all the companies covered by the system and its data base. This analysis can be used to derive a market discount rate for any Index that equalises the value of an Index, for example the S&P 500, to the cash flows expected from it.

In the figure below we compare this nominal Holt discount rate for the S&P 500 to US long term interest rates. These discount rates have receded with long-term interest rates, as theory would predict. Note also that both interest and the Holt discount rate are at very low levels, implying higher share prices for any given flow of dividends.

Of greater importance perhaps for share prices than discount and interest rates is the spread between them. This spread, the extra risk premium for holding equities rather than bonds, has widened in recent years. While the discount rate may have declined, it has maintained and even increased the distance between it and interest rates, so encouraging demand for equities.

When we replace interest rates with this risk premium in our dividend discount model we get a very similar signal of a currently undervalued S&P 500 (see below).[2]

Figure 6: US Holt discount rates (nominal) US long bond yields (10 year) and risk spread

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 7: Real Holt discount rates and real interest rates and real risk spread

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 8: A model of the S&P 500 (explanatory variables, dividends and spread between discount rate and long term interest rates)*

*Representation of the equation:

LOG(SP) = -4.59846533561 + 1.51940769795*LOG(SPDIV) – 0.0501430590849*(CFROINOM-USGB10)

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Therefore we conclude that the S&P 500, despite its recent strong upward momentum, is undervalued for current dividends and interest rates or the risk spread. However some caution about the level of the S&P Index is called for by a sense that long-term interest rates are now very low and may well normalise. A further reason to be cautious about the current level of the S&P 500 is that the day-to-day volatility of the Index has been very low by comparison with the past. This indicates an unusual degree of comfort with the current state of the US share market. Were volatility to normalise, share prices would probably under pressure.

Hence our asset allocation advice has been to retain a neutral exposure to equities for now, with the next 18 months in mind. On a shorter term view (less than six months) however, we are of the view that upside strength is at least as likely as any move lower.

When we review the JSE applying a similar method of analysis, the rand values of the All Share Index appears as fairly valued for trailing dividends and US Interest rates. It also appears fairly valued when all the variables of the model are converted into US dollars. However when the (high) level of the S&P is included as an explanation of the USD value of the JSE in place of US interest rates the JSE appears as now attractively undervalued.

The S&P 500 is normally a rising tide that lifts all boats. But in the case of the JSE this has not been the recent case. Not only the JSE but emerging market equity indexes generally also lagged behind the S&P 500 after 2014 and until mid-2016. It will take less SA risk, which comes with an improved political dispensation, to focus global attention on the potential value in SA equities, particularly the companies heavily exposed to the SA economy. The SA political news has improved and the case for SA equities exposed to a potentially stronger SA economy, has also improved, making the case for a somewhat overweight exposure to this sector of the JSE.

Figure 9: A model of the US dollar value of the JSE with dividends and US interest rates*

*Representation:

LOG(JSE USD ) = 1.3925529347 + 0.776827626347*LOG(DIVIDENDS USD ) – 0.127168505553*US 10 Y Bond Yields

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

[1] Credit-suisse.com/holtmethodolgy

“HOLT derives a market-implied discount rate by equating firm enterprise value to the net present value of free cash flow (FCFF). HOLTs FCFF is generated by a systematic process based on consensus earnings estimates, a growth forecast, and Fade. This process is similar to calculating a yield-to-maturity on a bond” See Holt Notes November 2012

[2] In order to undertake the analysis over an extended period of time we added US inflation to the real Holt discount rate for the US sample to establish a nominal discount rate to be compared with nominal interest rate. An equivalent series of US real interest rates (Tips) is only available from 1997

Explaining the strength in emerging equity markets

This year is proving a very good one for emerging markets (EM) after years of lagging behind the S&P 500 (see figure 1 below).

Capital flows being good for EM equities (and bonds) have also been helpful for EM currencies, including the rand, and so the JSE, while it usually performs in line with the EM when measured in US dollars, has offered well above average EM returns to the offshore investor on the JSE this year (see Figure 2 below). As we have explained in earlier reports, strength in EM equities and bonds has a consistently favourable influence on the exchange value of the rand and most other EM currencies.

The question then arises of why are EM capital markets attracting revived interest from global investors? Is it simply the search for yield in a low yield, low expected return world? Or is there more substance to the switches to EM investors are making in the form of improved economic outcomes and better growth in EM economies and earnings from EM-listed companies to come. We provide some answers below that indicate the substance behind the strength in EM equities, including those listed on the JSE.

The underperformance of EM equities since 2011 has been accompanied- by weak earnings – earnings per share that have lagged well behind those generated by the S&P 500 Index. As may be seen in figure 3, S&P 500 earnings measured in US dollars compared to EM or JSE earnings in early 2010 , are more than 80% ahead, when measured in US dollars. The underperformance of EM equities has been highly consistent with this underperformance, as has the strength of the S&P been consistent with the impressive recovery in S&P earnings.

It should however be noted below in Figure 4 that EM and JSE earnings, having suffered a severe decline in 2015 led by lower commodity prices, appear to have reached a cyclical trough and are now increasing from their low base, while S&P earnings are also now pointing higher, after declining since early 2015. This revival in average earnings must be regarded as helpful for equity valuations generally, especially in a world of very low interest rates. That EM and S&P share prices moves have been highly correlated in 2016 is consistent with a similarly higher trajectory for earnings, especially should recent trends be sustained, as has been indicated.

The similar path of JSE earnings and that of the EM average – of which the JSE contributes only a small part, about 8% – should be recognised. It goes a long way to explain the similar direction of the EM Index and that of the JSE, when measured in US dollars. The JSE behaves as an average EM equity market because JSE earnings compare very well with the EM average. This is because JSE-listed companies, including industrial companies, are highly exposed to the global economy, even more than the SA economy.

In figure 5 below, we compare the average prices investors have been paying for average earnings. As may be seen, investors in the S&P Index have enjoyed a significant increase in the average P/E multiples and seen the Index re-rate when compared to the multiples attached to EM earnings. Such reactions are entirely consistent with impressive past performance, especially when accompanied by low interest rates that surely add to the present value of future earnings or cash flows expected. But the fact that S&P earnings have become expensive by the standards of the past and EM earnings can be acquired significantly cheaper than S&P earnings, will have attracted interest in EM compnaies, especially when the global economic and earnings prospects appear to be improving.

One sign of an improved economic state can be found in the Citibank surprise Index calculated for the 10 largest economies. As we show below in figure 6, the high frequency economic data has become much more encouraging. Expectations are being surprised on the upside. These more positive surprises are clearly helping to lift the equity markets. The economic news has been improving, surprisingly so, and global equity markets are responding accordingly. The strength in equities is well explained by economic fundamentals, especially so when the threat of higher interest rates seems so distant. 15 August 2016

Global interest rates: The prospect of a normal world

The prospects of higher interest rates in the US and Europe, indicating more normal economies, should be welcomed, not feared

It should be recognised that while the rand has been on a weakening path against the US dollar since 2010, so has the euro since the second quarter of last year. This dollar strength, coupled with euro weakness, has left the rand, weighted by the share of its foreign trade conducted in different currencies, largely unchanged since early 2014. The euro has the largest weight (29.26%) in this trade weighted rand, while the generally strong Chinese yuan has a 20.54% weight and the US dollar a much lower weight of 13.77%.

Thus there has been minimal pressure on the SA inflation rate (CPI) from higher prices for imported goods. If anything, especially when the rand price of oil and other imported commodities is taken into account, the impact has been one of imported deflation rather than inflation. And the CPI would be behaving much like the PPI is (PPI inflation is now about 3%) were it not for higher taxes levied on the fuel price and higher prices for Eskom – which is also a tax on energy consumers being asked to cough up for Eskom’s operational failures.

The rand weakened significantly against all currencies in the aftermath of the Marikana mining disaster of August 2012. The rand, on its exchange rate crosses, has not recovered these losses. However, since early 2013, the rand US dollar exchange rate has very largely reflected global rather than specifically SA influences, that is US dollar strength rather than rand weakness. The rand / US dollar on a daily basis (since 2013) can be fully explained by two variables only – by the Aussie / US dollar exchange rate, which has also consistently weakened over the period, and lower mineral and metal prices. The further statistically significant influence has been the spread between long term US interest rates and their higher RSA equivalents – this reflects SA risk, or expected rand weakness. The interest rate spread also consistently adds rand / US dollar weakness (or strength when the interest spread narrows). The ability of this model to predict the daily value of the rand / US dollar since January 2013 is shown below. The fit is a very good one. Moreover, the model displays a high degree of reversion to the mean. That is to say, an under or overvalued rand according to the model has quickly reverted to its predicted value. For now, or until SA specific risks enter the equation, for better or worse, the model presents itself as a good trading model. At present the rand, after a recent recovery, appears about one per cent ahead of its predicted value.

The future strength of the US dollar against all currencies or, equivalently, the weakness of the euro, will depend on the pace of economic recovery in the US and in Europe. The pace of recovery will be revealed by the direction of short and long term interest rates. If rates in the US increase ahead of euro rates, because the US recovery becomes more robust, the dollar is likely to strengthen, and vice versa should US growth disappoint. The question then is what might these higher rates in the US and in Europe mean for emerging equity and bond markets? Clearly higher rates in the US will ordinarily mean higher long bond yields in SA and in other emerging markets. This cannot in itself be regarded as helpful for bond and also equity values in the emerging world. However faster growth in the US and Europe would translate into faster global growth, upon which emerging market economies are so dependent. This could attract capital towards emerging markets, strengthen their currencies and narrow the interest rate spread between, for example, rand-denominated bonds and US bonds of similar duration.

It is striking how emerging market equities and currencies have underperformed the US equity markets since 2011. Measured in US dollars, the benchmark MSCI Emerging Market Index and the JSE have, at best, moved sideways while the S&P 500 has stormed ahead.

The weaknesses of the global economy over the past five years have proved to be a large drag on emerging market equities. Faster global growth, accompanied by higher interest rates, can only improve the outlook for emerging market equities and perhaps their currencies. The prospect of higher interest rates in the US to accompany faster growth should be welcomed by equity owners, especially emerging market shareholders, who have had such a rough time of it in recent years. Faster global growth, led by the US, is very likely to be good news for equity investors everywhere, and especially those in emerging markets.

Developed or emerging markets? The JSE offers easy access to both

The JSE All Share Index, when converted into US dollars at current rates of exchange consistently tracks the benchmark MSCI Emerging Market (EM) Index, making the JSE a very good proxy for the average EM equity market.

This relationship, as we have often pointed out, is not co-incidental. It is the very similar earnings performance of the average JSE-listed company compared to that of the average EM company that presumably explains the closeness of the fit. We show below how closely the two earnings per index share series compare. Continue reading Developed or emerging markets? The JSE offers easy access to both

Rand and bond markets: Some very welcome relief from the global bond market

Emerging market (EM) stocks and bonds had suffered and developed market equities had flourished, since long term interest rates in the US began their ascent in May 2013, when the US Fed first signaled its intention to taper its support of the US bond market and reduce its injections of cash into the system.

The rand, in company with many other EM currencies took its cue – as it usually does – from the capital flows into and out of EM equities and bonds. The New Year brought no relief for EM markets and currencies, regardless of the direction of US long rates, that turned generally lower in 2014.

That is until last week, when EM markets and currencies ended the week on a stronger note. The key to this improvement was a narrowing spread between US and EM local currency bond yields, as exemplified by the performance of SA government bonds last week. The spread narrowed and the rand and the JSE, in US dollar terms, benefitted – as did other EM equities.

We may hope that this relief for EM markets is more than a straw in the wind and that the now significantly lower EM bond and equity prices have renewed appeal for global fund managers. Any sustained strength in EM currencies will help restrain EM central banks (including the SARB) from raising short term interest rates. The SA-US yield spread will deserve particularly close watching in the days and months ahead.

Emerging markets: Biter gets bitten

Emerging markets are now hurting developed economies – rather than the other way round.

The flavour of financial markets for much of the past 12 months has been a strong preference for equities over bonds and for developed equity markets over emerging markets (EMs). The developed equity markets, led by the S&P 500, performed well, even as US long term interest rates rose significantly and consistently between May and September 2013.

Higher interest rates in the US were a response to the first intimations that the US Fed would be reducing the scale of its Quantitative Easing (QE): that is, the rate at which it would be adding to its portfolio of government bonds and mortgage backed Paper and adding to the money base. In December the Fed announced its intention to “taper” its injections of cash from US$85bn a month to US$75bn. This action was well received by developed equity markets. It was interpreted as confirming the good news about the state of the US economy, thus helping the earnings outlook for US corporations and their market value.

By contrast EM equities did not react at all well to the news about tapering and higher US interest rates. At best EM equities tended to move sideways or lower in 2013 as long term interest rates on EM bonds followed US rates higher. Hence developed market equities significantly outperformed EM equities.

The outlook for EM economies was widely regarded as deteriorating in 2013, even as that of the US was improving, making higher interest rates for EM borrowers distinctly unwelcome. Not only did EM equity and bond markets weaken, but EM currencies came under pressure as funds rotated away from emerging to developed markets. The performance of the JSE and the rand proved no exception to the other EM markets and currencies.

Indeed the rand has been among the weaker of the EM currencies. Commodity based currencies, including the Australian and Canadian dollars, also weakened significantly in response to uncertainty and unease about the prospects for the Chinese economy, the leading EM economy that has such an important influence on demand for commodities like iron ore, copper and coal.

The comfort zone in developed market equities however became significantly smaller on Friday 24 January. The risks in emerging economies on the day infected developed markets. EM contagion became the order of the day. Long term interest rates fell sharply as investors sought safety in US bonds and US equities fell away as risk appetite waned. EM currencies came under particular pressure and while long term interest rates in the US fell those in EM currencies, including the rand rose. Risk spreads across the board, including US corporate spreads, rose rather than fell with lower US rates.

In this way EMs were subject to a risk off threat just as they had previously been subject to a risk on threat. All news has appeared as bad news for EMs. Both higher as well as lower US long term rates have proved unhelpful to EM equities, bonds and currencies.

It may be some consolation to know that a risk off threat to emerging markets, or indeed a risk on threat to emerging markets, should only be of limited duration. Should long term interest rates in the US continue to move lower, the search for higher yields will extend to EMs and reverse the flight of capital from EMs. If US economic growth is well sustained and interest rates rise to reflect the increased demands for real capital that accompany economic growth, the good news will eventually spread to the global economy, including emerging economies. Good news about the US economy will sooner or later translate into good news for EM economies and their markets.

Investors in EM markets, including those equity investors whose wealth is measured in rands, should wish for higher rather than lower US long term interest rates, that is for US economic strength rather than weakness. In the longer run what is good for US business will be good for EMs and SA business.

In the shorter run the challenge for EM economies, especially the SA economy, is to turn a much more competitive currency into export and import replacement led growth. Constructive labour relations and constructive government relations with SA business, in the form of encouraging tax policies and infrastructure roll out, are essential to this purpose. It will also be helpful if the Reserve Bank continues to leave interest rates on hold while leaving the exchange rate to help the economy adjust to higher costs of capital. The mantra for monetary policy should be to float with the tides rather than attempt, Canute like, to reverse them.

Developing economies including SA are up against it – what can we do to help ourselves?

The Wall Street Journal Online edition led on 23 January with the following report:

“Investors Flee Developing Countries Currencies in Many Emerging Markets Take a Pounding, Hit by Growth Fears

Investors dumped currencies in emerging markets, underscoring growing anxiety about the ability of developing nations to prop up their economies as they face uneven growth.

The Argentinian peso tumbled more than 15% against the dollar in early trading as the South American nation’s central bank stepped back from its efforts to protect the currency, forcing the bank to reverse course to stem the slide. The Turkish lira sank to a record low against the dollar for a ninth straight day. The Russian ruble and South African rand hit multiyear lows.

U.S. stocks tumbled as well, reflecting the world-wide pullback from riskier assets and continuing a weekslong struggle to regain the upward momentum seen at the end of 2013. The Dow Jones Industrial Average slid 175.99 points, or 1.1%, to 16197.35, the lowest close since Dec. 19.”

The Wall Street Journal (WSJ) indicated that the Turkish lira was the worst affected by the move out of emerging markets since 1 January, followed by the rand, down 3.54%, and the Russian ruble, also down 3.54%. Clearly emerging market economies (with a few exceptions, perhaps Mexico) are very much out of favour and may well stay out of favour if the current investor mood is sustained.

It was in fact not only a bad day for emerging markets and currencies it was a risk off day in the US with, accordingly, equities prices down and bond prices up. The risk on threat to emerging markets and their currencies including the rand can be easily identified. That is more confidence in the US growth outlook (less risk attached to the prospects for the economy and the companies dependent upon it) leads to higher interest rates. These higher interest or discount rates have been mostly tolerated by the valuations attached to US equities, but unwelcome to emerging market equities as rising interest rates in emerging economies, led inevitably by the US rates, threaten the already unpromising growth outlook for emerging economies.

Clearly, as demonstrated yesterday, there is also a risk-off threat to emerging markets even as US rates move lower. The question then, to refer to the WSJ report, what can emerging market governments and central banks do to prop up their economies. Raising interest rates have done little to help support exchange rates. Intervening in the foreign exchange markets by selling US dollars has also not helped to stem the currency weakness. The global tide is flowing too strongly to be diverted and higher interest rates simply weaken domestic demand further. Higher interest rates put additional downward pressure on expected growth rates and undermine further the case for investing in the beleaguered emerging economies.

One sincerely hopes that the SA authorities have taken full notice of the unhappy experience of those emerging market central banks that, unwisely and unlike the SARB, have reacted in a highly activist way to the pressures in the currency and bond markets emanating from global investors and capital flows out of emerging economies and back to developed ones. Surely the best approach for an economy under stress is to allow a floating exchange rate to help absorb the pressures imposed by less sympathetic global investors; and to do what they can with monetary policy to help relieve some of the unwelcome pressure on domestic spending. While lowering short term interest rates in the circumstances of a sharp currency depreciation might be regarded as too sanguine an approach, leaving them on hold – that is doing nothing – would seem to be the best that can be done by a central bank in circumstances beyond the control of the monetary authorities.

For South Africa this means the mines, factories, hotels, restaurants and tour operators should stay open for business – or, better still, work overtime and double shifts where extra demands present themselves as they are doing most obviously for the SA hospitality industry where extra demand- encouraged by the weaker rand is leading to extra supply and the extra incomes and employment that comes with it.. The task for economic policy in SA is to make sure the export and import replacement-led growth happens and is encouraged. Sensibly reformed labour relations and policies for labour employed in mining and manufacturing, currently highly conspicuous by their absence, would be very helpful as would a highly supportive and well managed roll out of infrastructure; More success in these endeavours would be the best response to an increasingly sceptical global investor. Only faster growth or the prospect of faster growth will attract more capital to the businesses that drive the SA economy and would support the rand and by so doing also improve the outlook for inflation.

There is an important economic opportunity for the SA economy provided by the weaker real rand exchange rate (defined as an exchange rate that has moved significantly more than can be justified by relatively fast domestic inflation). The opportunity is for domestic producers, enjoying wider operating profit margins, to take a larger share of both the domestic market from importers and to increase their share of export markets through keener pricing on the local and foreign markets and increased output and employment Such responses raise growth rates and by so doing are the only know method likely to impress foreign investors.

US interest rates: What they mean for SA and emerging markets

The unexpectedly poor new jobs number for the US released on Friday 10 January, some 70 000 jobs added in December compared to about 200 000 expected, sent long term interest rates in the US sharply lower. The yields on the vanilla as well as the inflation linked varieties all fell on a revised view of the underlying strength of the US economy. Yesterday these yields remained at the lower levels.

SA interest rates predictably also fell, though the yield spread widened, namely the difference between long dated RSAs and US Treasuries marginally:

The news about the possibly diminished strength of the US economy suggested by the labour market surveys, implies that the extra cash injected into the US financial system through asset purchases by the US Fed (QE) will proceed at a slower rather than faster rate – hence more demand for US Bonds and lower long term interest rates.

This move in US rates provided relief for emerging market currencies and their equity markets. The rand behaved entirely consistently on Friday 10 January – moving in the opposite direction to the Emerging Market Index, as it had been doing for most of 2013. However late on Monday in New York the rand came under renewed pressure (also felt to a smaller degree by the Turkish lira) while some emerging market currencies, including the Indonesian ruppiah strengthened markedly. The rand perhaps attracted selling pressure on Monday evening after Amcu gave notice that it was proceeding with strike action at Impala Platinum. Emerging equity markets were holding up well as the S&P 500 fell away by more than 1%.

These developments confirm once more that the most important indicator for emerging market equities and currencies will be the direction of long term US interest rates. For now, good news about the US economy (that translates into higher long term interest rates and is treated as good news for US equities and the US dollar), is simultaneously bad news for emerging market equities and currencies, as interest rate increases spread. Also, as we saw on Friday, when interest rates fall in the US, emerging market currencies and equities gather strength.

The rand is mostly a play on emerging market equities – the rand benefits from foreign capital that flows in when the JSE appears offers to offer value. This it does when US interest rates fall. If the recent past is to be our guide to the future, higher US interest rates are a threat to the rand and lower US rates a benefit. This will be so until good news about the US economy spreads to emerging market economies and higher interest rates can be more easily tolerated.

For now, those concerned about the poor health of the SA economy must hope that the US economy does less well than previously expected, that long term US rates decline rather than increase and that emerging market equities rise rather than fall to support the rand. This would reduce the danger of more SA inflation and damagingly higher interest rates.

The rand and emerging markets: It all makes consistently good sense

(From 6 February 2012)
The rand has strengthened in recent weeks in response to global equity markets and in particular to the recovery in emerging market (EM) equity markets. Such responses are entirely consistent with the patterns of the exchange value of the rand since 2008. As we have often pointed out, the rand is an emerging equity market currency: where emerging equity markets go, so too goes the rand and this year is no exception.
Click here for the full report: The rand and emerging markets

Earnings are growing strongly in Europe – despite slow growth

Alexis Xydias and Adria Cimino report for Bloomberg today that

“Net income for companies in the Stoxx Europe 600 Index will rise by 10.5 percent in 2012 after increasing 11 percent this year, led by carmakers such as Porsche SE and retailers including Burberry Group Plc, according to more than 12,000 analyst estimates compiled by Bloomberg. The gauge is headed for four straight years of income growth exceeding 10 percent, the longest streak since 1998, data show”, and that European profit growth

“….. will exceed the 10.1 percent estimated for U.S. companies, even though the economy in the 17-nation euro zone is expanding at one-third the pace….”

The reason that profits are growing much faster than nominal GDP in Europe and the US is that the dominant European and US companies increasingly depend on revenues and profits generated globally. Emerging market economies are doing much better and growing much faster than developed economies. They are playing catch up adopting proven technologies and through the absorption of labour from low productivity employment in agriculture to much more productive engagements in factories that fully participate in global supply chains without push back from trade unions protecting established workers. Yet wages are rising rapidly as competition for workers builds up. And these fast growing economies have not yet made promises of welfare benefits funded by taxpayers that are now proving impossible to fulfil. The cloud on their economic horizons is a meltdown in demands from Europe and perhaps the US- where the economic outlook now looks a lot more promising than a few months ago. The opportunity these rapidly emerging economies have is to rely much more on domestic rather than foreign consumers.

It is these same consumers in the emerging economies that are already proving so helpful to the profits of companies listed in Europe and the US. The willingness of these profitable global companies to add productive capacity and to employment in their home economies would be greatly assisted by a sense that their own governments are coming to grips with the necessity to spend less so as to grow faster and in this way overcome their debt problems

Turbulence on the Nile – ripples elsewhere

The likely fall of an Egyptian Pharaoh, after a very long reign, added uncertainty to global markets last week. Exposure to equities was reduced and share markets retreated with most of the weakness experienced on the Friday. A weaker rand made the JSE an underperforming Emerging Market in USD. The weak rand furthermore did not spare the Resource stocks that are regarded as riskier than most. (See below)

Global Equity markets Weekly USD returns; January 23rd= 100

JSE Weekly Rand returns; January 23rd= 100

Continue reading Turbulence on the Nile – ripples elsewhere

The dollar is weak, emerging and commodity markets are buoyant – a sign of growing normality

The dollar is weak and the rand is holding its own

It is not so much that the rand is so strong; rather it is that the US dollar that is so weak against emerging market and commodity currencies. This year the US dollar has lost as much as 20% against the Brazilian Real (BRL) and the rand and is almost 16% weaker versus the Australian dollar. By contrast the US dollar has lost a mere one per cent versus the euro this year (See below). US dollar weakness is thus a distinctly emerging and commodity market affair.

Currencies vs the US dollar 1 January 2009=100

USD weakness against emerging and commodity currencies