Category: SA Financial Markets

The member companies of the Chamber did much better in extracting gold bearing ore from their mines than in extracting gold as the second table shows. The tonnes of gold-bearing rock they milled actually increased in recent years. What has declined precipitously is the average amount of gold contained in each tonne of ore raised to the surface. Each tonne of rock extracted, expensively and dangerously, from the bowels of the earth now contain a miniscule average 2.9 grams per metric tonne. The loss of SA’s share in global mine production has much more to do with declining grades (from 4.56 grams per tonne in 2003) than it has to do with increased output elsewhere. Global gold output has increased by approximately 230 tones since 2003, while production from all SA mines fell by 208.6 tonnes over the same period. In other words, production outside SA has increased by a little more than SA production has declined.

An important further point worth making is that annual production of gold is a very small proportion of the gold ever produced. Almost all of this has survived and is held as a store of wealth. Therefore, as is surely apparent, the price of gold is little affected by current output – legal or illegal. The legitimate mines may lose potential output to thieves and the SA government is not able to collect income from illegal or informal miners, while the price is unaffected by illegal mining activity – equivalent to 5% to 10% of the legal production. Furthermore, if the gold has been extracted illegally from shafts that have been permanently abandoned, such output is incremental, not lost. The gold would have stayed in the ground and not helped produce any income at all. The costs of mining this otherwise abandoned gold is borne entirely by the workers themselves, including the risks of losing their lives to rock falls and their gold to gangsters preying on them.

Incidentally, the gold produced in SA in 2012 earned R73bn, well up from the R32.9bn realised in 2003 thanks to the higher rand gold price. 5% – 10% of this attributed to illegal gold miners is significantly more than the R2bn worth of illegal mining revenues reported by the WSJ and does not take account of other mining sales that altogether totaled R363.8bn in 2012. Such illegal mining activity, currently largely unrecorded, could add significantly to the SA GDP were it to be included in the national income accounts.

Yet while the recorded output of gold has declined and the numbers employed in gold mining has fallen from 198 465 employees in 2003 to 142 201 in 2012, average earnings of these workers have improved significantly over the same period. Total gold mining earnings amounted to R22.24bn in 2012 or R156 386 per employee, compared to approximately R63 900 earned by the average worker in 2003, or to R103 000 in 2012 (the equivalent when adjusted for CPI). In other words, the average employee in the gold mining industry, of whom there are now fewer, appears to be earning about 48% more in CPI adjusted terms in 2012 than they did in 2003.

These improved remuneration and employment trends are unlikely to be independent. The fewer surviving gold mine workers have become more productive, helped no doubt by more and better equipment per worker, judged by the volume of ore extracted rather than the gold produced. The industry would not have survived otherwise than by providing fewer jobs in exchange for what have become better paid and more productive workers. Operating margins for the Chamber member mines have improved rather than deteriorated over the years, as we show below, despite lower grades of gold mining ore.

The safety record of the industry, judged by fatality rates, has also improved as we show below. Thus the industry has provided better and safer jobs, but for regrettably fewer workers.

As the WSJ makes only too clear, the willingness of the illegal miners to undertake the hazardous and poorly remunerated work they engage in has much to do with the lack of alternative employment opportunities. To quote the article again:

”’If I could find a proper job, I would leave this,’” says Albert Khoza, 27, who says he started illegal prospecting eight years ago because he couldn’t find work and was desperate to send money to his family. On this day, outside an old mine about 60 miles from where Mr. Matjila mines, he has been handling mercury with his bare hands. His eyes are bloodshot and infected, as he stokes the fire with plastic containers”.

Or, as the other illegal miner interviewed, Mr. Matjila, is reported to have said: “’We’re not criminals, I don’t want to be doing this. But I need to make some money.’ Then he stood up to walk down the road to the hardware store to check on prices of new supplies. ‘We have to make a plan to find another hammer,’ he says.

The challenge to the SA economy is to resolve the inevitable trade-offs between better jobs for some workers and the very poor alternatives then open to those who are unable to gain access to what is described as ”decent jobs”. The formal SA labour market has not been allowed to match the supply of and demand for labour at anything like market-clearing employment benefits. And so we have the insiders, those with formal employment and willing to launch strike action to further improve their conditions of employment; and the outsiders who find it so difficult to gain entry to formal employment, of whom the illegal miners represent a numerically important group, as numerous, so we are told, as those formally employed in gold mining.

The solution to the general lack of formal employment opportunities appears as far away as ever. Strike action not only leads to higher real wages and reduced employment opportunities, but still greater incentives to substitute reliable machinery for more expensive and unreliable labour that makes continuous production very difficult to achieve. The unpredictable impact of strikes on production is perhaps as much an incentive to reduce complements of relatively unskilled workers as are higher real costs of their employment.

To encourage employment in the gold mining industry and everywhere else, it would be very helpful if workers were willing to share in the risks of production, as the illegal miners appear willing to do: that is to accept less by way of guaranteed pay and more by way of rewards linked to performance and profits. In other words, for workers to become, to a greater degree, owners of the enterprises they engage with. If pay went up and down with the gold price, the gold mining industry would surely be willing to bear the risks of hiring more workers.

The slow but more or less steady recovery of the US economy allowed the Fed to suggest in May 2013 that it would be tapering such injections of cash into the system and that by late 2014 it would hope to end QE. It has since followed through on this prospect. Monthly net purchases of these securities in the market have been tapered and the security purchase programme will be over soon. This announcement of a likely end to the Fed support of the fixed interest market led however to the “taper tantrum” of May 2013. Long bond yields rose significantly and equity values declined. Volatility, in the form of daily moves in equity markets, increased and emerging equity and bond markets – regarded as more risky than developed markets – were particularly affected.

Then, despite the Fed taper in 2014, the trend in long term interest rates reversed direction, markets calmed down and share markets recovered. Indeed, market volatilities as measured by the Volatility Index, the VIX (the so-called “fear index”), had fallen back to pre financial crisis levels by mid 2014 and the US equity markets has moved back to record high levels.

The danger of the VIX at such low levels was that volatility could spike higher and share markets accordingly retreat (given that they were regarded by many observers as, at worst, fairly valued by the standards of the past, as represented by conventional Price/earnings multiples).

It could be demonstrated by reference to past episodes of low volatility and demanding valuations that such a combination of low volatility and generously valued equities would need more than good earnings growth to provide good returns. In the past it appeared that only lower long term interest could overcome well valued equities and low volatility. Moreover, it was widely assumed that long term interest rates in the US, very low by the standards of the past, could only be expected to increase. The upwardly sloping US treasury yield curve indicated very clearly such expectations of higher interest rates to come and incidentally still does so.

To the surprise of the bond market and despite the Fed taper, long term interest rates in the US fell rather than rose in July and August 2014. It was lower interest rates in Europe, especially in Germany, that led global rates lower in July. Not only did German Bund yields fall, with US and other rates falling in sympathy, but the spread between lower European and US rates actually widened, surely adding to the appeal of US Treasuries. The Spanish government now pays less for 10 year money than Uncle Sam.

The Fed therefore is no longer the lead steer of the bond market herd. The danger of deflation in Europe is that it leads interest rates lower. And this deflation is all the more likely given quantitative tightening in Europe to date, rather than easing. Unlike the Fed or the Bank of Japan, the assets and liabilities of the ECB have been falling significantly rather than increasing. That the supply of European bank credit and broader measures of money has been falling is consistent with a lack of demand for ECB deposits.

These broad trends will have to be reversed if European deflation is to be avoided. The ECB will have to do what it takes to increase the supply of money and bank credit. QE action is called for and can be expected to continue to hold down global bond yields. Euro deflation trumps the risk of higher interest rates.

The figures below fully illustrate this story of falling interest rates, declining volatilities and higher share prices. We also show how the US dollar has strengthened in response to this improved spread in favour of the US and how developed and emerging equity markets (including the JSE) when are running together, when measured in US dollar terms.

Both the VIX and the SAVI may be understood as forward looking measures of volatility used to price options, but they appear to track actual volatility – measured as the standard deviation (SD) about average daily price moves – very closely. We compare the VIX this year to the 30 day rolling moving average of the SD of the S&P 500 below. Both measures of volatility have declined this year, indicating that investors generally have a much more sanguine view of the future prospects of the companies they invest in.

The stability of the global financial system appears well secured by QE in the US, while the Draghi pronouncement “to do what it takes” to shore up European sovereign credit has soothed the sometimes savage breast of Mr and Ms Market.

So far so very good. Lower volatility (less fear of the future and so less of a risk premium demanded of financial assets hence higher present values attached to expected earnings) has been accompanied, as it almost always is, by higher share values.

 

The relationship between share prices generally and volatility is consistently strong: when volatility is up, share prices move down and vice versa. The correlation of both the daily level of the VIX and the S&P 500 and percentage changes in both series since 2005 remains very high, of the order of (-0.60) or higher when levels are correlated and even higher (-0.74) when daily changes are correlated.

The good news about financial markets today is that volatilities are low and fear of some economic crisis apparently largely absent. The down side is literally that – if volatility is already so low can it go lower? and if not, can we expect share prices to go much higher? The answer is still perhaps so if the fear stays away. The markets may well continue to grind mostly higher as they have been doing recently. But the chances of a global event that would again frighten shareholders and their agents cannot ever be ignored.

It appears that markets are much more inclined to crash lower on bad news that may mean a change in the world as we know it, than to crash higher on good news. Good news seems to dribble in slowly, bad news can come crashing down on your head overnight. Let us hope that the flow of economic news continues to be mostly encouraging and volatility stays low and share prices grind higher.

Growth can more than make up for lower initial yields – something apparently not well understood in property circles

Reference will often be made to some acquisition or other being earnings “accretive”. Clearly an acquisition would hardly be made if it did not promise at least to add to earnings per share (EPS) and thus to the value of each share in issue. It may be thought, naively, that the simplest way for a listed company to accrete EPS would be to issue shares trading at a particular superior price/earnings (PE) multiple in exchange for another company trading at a lower PE ratio.

If it were so easy to add wealth by issuing relatively highly rated shares to buy lower rated shares, no recorded differences in PE multiples could survive such an obvious arbitrage. All earnings would then command the same price which obviously has not turned out to be the case.

The reason for the observed differences in PE multiples or earnings yields (the inverse of the PE ratio), or for matter dividend yields, is that an asset, particularly the bundle of assets and liabilities that make up a company, has a life of more than one year. A company may have an indeterminately long life given that company assets may be replaced or added to. Assets with economic lives of more than one year will be valued on their earnings and dividend growth prospects as well as their initial or first year yields.

The more growth in earnings expected over the life of an asset, the more investors will be prepared to pay for the asset. The faster the expected growth in benefits for shareholders, the higher the price paid per share and the lower the first year yield.

High initial yielding assets will be expected to have short lives and / or limited earnings, when compared to lower yielding assets or companies. If the market has correctly priced two assets in a similar sector of the economy and facing similar risks to their earnings potential, their expected returns will be the same, even though the initial earnings or dividend yields may be very different. Buying the company with a low PE ratio that is expected to grow its profits slowly, while selling a part of what is expected to be a fast growing company with a higher PE will not necessarily add value to the shareholders diluting their share of profits. What is gained in the form of the relatively low price paid for the asset will likely be lost in the form of the slower growth in earnings from the cheap asset – cheap for that reason.

Unless the assets bought can be transformed by better management or the value of the combined asset pool enhanced by economies of larger scale – the fabled synergies that may or may not justify an acquisition – two plus two cannot be worth more than four. Adding low PE assets to high PE assets must reduce the combined PE in line with a weighted average of the established assets and the newly acquired assets with different growth prospects.

There is a well known equation in the financial literature used to make this point, the so calledGordon growth model (see explanation at the end of this piece). This equation simplifies the standard Present Value (discounted cash flow) valuation model applied to any stream of expected operating profits that is discounted back to its present value by applying an appropriate risk adjusted discount rate to the flow of expected profits.

Parsing property returns

The model provides yet another example of the no free lunch principle in life. High yields imply short economic lives and vice versa – though one might think otherwise when listening to the managers of SA listed property companies and their shareholders who appear concerned, above all, to avoid yield dilution when acquiring assets. They appear fearful of buying assets that currently yield less than the current yield on their listed portfolio regardless of what may be differently better growth prospects.

Such observations are however made against a backdrop of extraordinarily good returns from listed SA property. Since May 2004 listed property has returned an average 20.7% a year, while the JSE All Share Index provided an annual average return, calculated monthly, of 18.14%. The All Government Bond Index, the ALBI, has generated an average total return, capital gains/losses plus dividend or interest income, of 8.86% a year over the same period.

 

Property returns were on average less risky than shares, with a standard deviation (SD) of returns of 15.85% a year compared to a SD of share returns of 18.14%. Lower bond market returns were significantly less variable over this extended period than shares or property, with a SD of 5.16. The money market would have yielded about 7.34% a year over the same period, with still less variablity.

The chart below shows how the initial dividend yields have come down since 2008 in company with lower long term interest rates and declining growth in dividends paid. It may also be noticed that recently, while bond yields have moved higher, the initial dividend yield has moved in the other direction, meaning a recent rerating of the Property Index and improved recent returns from property compared to bonds.

The initial JSE Property Index dividend yield averaged 7.54% since 2004 compared to an average 2.75% for the JSE. The growth in JSE dividends has averaged 16.22% a year (despite the global financial crisis) compared to the steady average growth of 7.67% a year in dividends paid by the listed property companies.

 

Faster growth in dividends from all JSE equities has clearly compensated investors for initially lower dividend yields, when compared to property investors who started with much higher initial yields but were subject to slower growth in dividends received. The result has been similarly excellent total returns.

When we add the initial dividend yield to the growth in dividends realized, we get what may be regarded as an internal rate of return (IRR). The IRR for the JSE over the period 2004-2014 was an average 18.98% a year, while the IRR for SA Listed Property was 15.22%. However these realised returns from holding property rather than shares were significantly less variable in the light of the collapse in JSE ALSI dividends in 2009. The SD for the IRR of the property sector was 5.34 compared to 19.29 for listed shares. Clearly the income streams from property, if not as much their valuations (and total returns) have proved more consistent than JSE equities in general and such predictability of dividend streams must have helped to enhance their appeal.

Within the property sector itself, we tested the proposition that the highest yielding property companies can be expected to generate the highest returns. The method used was to rank all the components of the Index by their initial yield every month and to calculate and compare returns over the next 12 months. No such consistently positive relationship between initial yield and subsequent returns from the individual property companies was found. In fact, initial company yields have had no statistical power to explain differences in the returns realised by the different listed companies.

This result was consistent with the theory that what should matter for investors in property, is the combination of initial yield plus growth in dividends. Initial yield alone or apparent concerns about yield dilution should not be a focus of attention. What matters is the combination of initial yield and subsequent growth.

 

The Gordon growth model

The Gordon growth model makes the simplifying assumption that the expected growth in operating profits, earnings and dividends is a constant, permanent one. Thus the price(present value) to dividend ratio can be expressed as P/D= 1/(r-g) where r is the required risk adjusted return or cost of capital equivalent to the discount rate and g the permanent growth rate. The equation can be converted to an equivalent PE by assuming a constant ratio of earnings to dividends.

This equation can then be reformulated to infer the permanent dividend or earnings growth rate implicit in current share prices and dividend yields. That is the cost of capital r, is the sum of the interest rate available from a low risk long dated government bond , say of 8% p.a plus an appropriate risk premium. That is, an equity risk premium of an average 4 or 5 per cent per annum, to be added to the bond yield to give the required return. That is r is equal to say 8 (government bond yield) +5 (risk Premium) =13% p.a. Depending on the above or below average risks, the company faces this average risk premium can be added to or subtracted from.

The initial certain first year dividend yield (for example 3% a year) can then be subtracted from the 13% required long run return in our example to give the implied (permanent) growth in dividends necessary if the required return is to be realised over time. In this example g, the annual growth in dividends would have to be at a 10% annual rate to justify an initial yield of 3%. Clearly, the higher the initial yield the lower the expected growth rate in g required to satisfy r, the risk adjusted required returns. Vice- versa – low initial yields will be associated with higher expected growth rates in dividends or earnings.

 

The economy in April maintained a very modest forward momentum – but the outlook is deteriorating, not improving.

Early data releases for vehicle sales and notes in circulation indicate that the economy in April 2014 maintained the modest forward momentum of the previous month. Our updated Hard Number Index (HNI), as we show below, is largely unchanged from the month before and reveals a similar outlook for still slower, but positive, growth rates in the months ahead.

The Index is based upon 2010 values. Index values above 100 indicate forward momentum. As we show, according to the HNI, the economy began a period of positive growth in 2004 that has continued since, but for a brief move backwards after the Global Financial Crisis broke in 2008 when the rand weakened and interest rates rose.

In the figure below we compare the HNI to the Reserve Bank’s coinciding business cycle indicator, also with a 2010 base, that has only been updated to January 2014 (with a value of 118). The Reserve Bank’s Indicator was still pointing higher in January 2014 while the HNI had turned lower in Q3 2013. The HNI has generally been a good timely leading indicator for the broader business cycle.

The performance of unit vehicle sales and the note issue is shown below. The outcomes are better than the raw numbers on a seasonally adjusted basis. But for Easter coming later this year than in 2013, such seasonal adjustments, as well as the raw numbers, need to be treated with caution.

If current trends persist, vehicle sales are heading lower, from a smoothed rate of 52 000 units per month, to about 50 000 units, equivalent to an annual rate of 600 000 units by April 2015. The local industry sold 647 217 units in 2013. Trends in the note issue suggest that the cash cycle may bottom out in Q4 2014. If this turns out to be the case, this modest recovery would be very welcome.

Hopefully for the state of the economy, the recent strength in the rand and a significantly lower maize price will have reduced the Reserve Bank’s forecast inflation rate as well as reduced the danger to the economy of higher short term interest rates that would undermine the prospects of any cyclical recovery.

The Reserve Bank fortunately (in a close call) did not raise interest rates in March when the rand was much weaker and long term interest rates significantly higher. It is therefore difficult to see how the Monetary Policy Committee could argue this week for anything but maintaining interest rates at their current levels for a while longer.

A still weaker level of demand and the still fewer jobs associated with higher interest rates would be an unacceptable price for the economy to pay and the Reserve Bank might be persuaded that higher interest rates are not appropriate given the trade offs in the form of slower growth. Furthermore, as we show in our next chart, there is evidence that higher short term interest rates may be associated with a weaker rand, so the outlook for inflation, despite the lower levels of domestic spending, could deteriorate rather than improve with higher rates. Yet the market still expects the Reserve Bank to think and act otherwise. Our view is that should the output gap threaten to widen further, the Reserve Bank might think again about raising interest rates even if its inflation forecasts have not declined.

Questioning the structure of the Reserve Bank econometric model

One of our issues with the structure of the Reserve Bank econometric model is the assumption, incorporated in the multi equation model, that higher inflation leads to increases in wage inflation and in disposable incomes, adding impetus to household spending and helping to close the output gap.

This presumed relationship – more inflation and so temporarily faster and perhaps unsustainable growth – however relies on a demand side explanation of inflation. In other words, high rates of inflation reveal a state of excess demand in the economy that needs to be restrained. This, as we have indicated, is very far from an explanation of current inflation in SA.

The model also assumes that inflation expectations can be self-fulfilling and lead to higher prices even though demand pressures may be weak. There is no evidence of this. Inflation in SA leads inflation expectations, which remain very stable at about 6%. There is no statistically significant feedback loop from inflation expected to inflation.

Higher consumer prices can alternatively be attributed to reduced, or more expensive, supplies of goods and services, the result of the weaker rand as well as for electricity and other administratively set prices. Such supply side driven increases reduce rather than add to real disposable incomes and spending power, especially when formal employment is in decline or growing very slowly. A weak rand is bad news for the purchasing power of SA households. It becomes even worse news for them when accompanied by higher interest rates. Furthermore, households account for over 60% of all spending and the incentive private firms have to add to their plant and equipment – which accounts for another 15% of GDP – is derived from the spending actions of households. A return to SA GDP growth rates of a mere 3.5% pa will have to be accompanied by an increase in household consumption growth rates.

A combination of a stable rand with stable interest rates is essential for this important purpose. A lift in exports, labour relations permitting, could help stimulate more GDP growth, but would have to be followed up by a recovery in household spending growth rates.

The further dilemma for the monetary authorities is that, even if the output gap were to widen further, it is quite possible that the inflation outlook could worsen rather than improve. It would worsen if the rand were to weaken further and the so-called pass through effect of the weaker rand pick up strength. There is no predictable relationship between SA interest rate moves and the value of the rand, as Holdsworth has again confirmed (see the chart below).

The Reserve Bank – will it undergo an economic reality check?

Changes in short term interest rates may therefore help hit or miss inflation targets even as changes in interest rates have the opposite impact on the growth in domestic spending and output. This leaves the Reserve Bank with uncomfortable trade offs between inflation and growth, which may encourage the MPC to take little or no action on interest rates, as has been its inclination recently.

The MPC may recognise the inadvisability of raising interest rates in current circumstances, having seen how the rand weakened further as interest rates rose in January and strengthened after the March meeting of the MPC when the rates were left on hold.

Global forces will drive the rand and the SA markets

The inflation rate outcomes for SA will be determined mostly by the direction taken by the rand, independent of SA interest rate settings. The global forces that influence the exchange value of the rand are the state of emerging market bond and equity markets. This pattern is highly consistent. These developments in emerging bond, equity and currency markets, in turn reflect the appetite for risk by global investors and the outlook for the global and emerging market economies. The better the outlook for emerging market economies, the more upside for commodity prices, emerging market equities and their currencies.

These helpful trends for emerging markets and currencies, led by lower long term interest rates in the US were a notable feature of the markets in March 2014, when the MSCI Emerging Market Index gained nearly 3% in the month. In January 2014, the Index lost nearly 7% of its value, before adding over 3% in February followed by another strong month in March 2014.

As we show below, these trends were especially helpful to the SA economy plays on the JSE in March 2014. In Q1 2014, we calculate that our grouping of SA Industrials and, to a degree, overlapping SA Interest Rate Plays in March, provided returns of over 9%, the Global Consumer Plays generated negative returns of about 1% and the Commodity Price Plays returned 1.5%. Were the rand to surprise on the upside again, a similar pattern of outperformance by SA economy plays is likely.

The forces that could drive emerging markets higher

Over the next six months, investors in emerging markets, including the JSE, should hope for minimal pressure from US and other developed market interest rates, especially from long bond yields. They should hope that Fed governor Janet Yellen and ECB president Mario Draghi continue to emphasise deflation rather than inflation until the prospect of stronger global growth is fully confirmed. This dovish approach seems a likely one and its realisation will be to the advantage of emerging market economies and the companies dependent on them. Over the longer term, faster growth in developed economies will bring higher interest rates, as demand for global capital improves and when faster growth in emerging markets can compensate for the higher costs of finance that should follow.

Breaking up the JSE by dependence on global or domestic economic forces

The large listed companies that dominate the JSE can be broken down by the degrees of dependence on global or domestic economic forces as indicated in the figure above. There are the Commodity Price Plays, made up of resource companies that depend on the US dollar prices of metals and minerals. This category of JSE-listed companies best excludes the gold mining companies that dance to the sometimes very different rhythms of the gold price. The Commodity Price Plays include the large diversified mining companies Anglo American (AGL), BHP Billiton (BIL) and Sasol (SOL), as well as the platinum, iron ore and coal mining companies.

Then there are the SA Interest Rate Plays: the banks, the credit retailers, property companies etc whose valuations are dependent on the direction of SA interest rates. They include the major banks like Standard Bank (SBK) and insurers like Sanlam (SLM).

A further category of SA economy plays are the less interest rate-exposed SA Industrials, including the cash retailers.

The other important category of Industrial companies listed on the JSE are those clear plays on the global economy. These include Naspers (NPN), Aspen (APN), Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI) and MTN, whose fortunes and valuation depend mostly on the profitability of their activities outside SA. We describe them them as Global Consumer Plays or as industrial hedges since they are hedged against the SA economy and the rand.

About 60% of the JSE All Share Index weighted by SA shareholders (the SWIX) is accounted for by a mere 10 companies, of whom only three companies may be described as heavily exposed to the SA economy: Standard Bank and Sanlam, both interest rate sensitive companies; and Sasol, a resource company, which generates much of its revenues and costs in SA but whose revenue is closely linked to the global US dollar price of oil.

²In this breakdown of the JSE we have combine the individual stocks into their various categories as follows:

Interest Rate Plays:
ABL, ASA, DSY, FSR, GRT, INL, INP, NED, RMH, SBK, SLM, BVT, IPL, MMI, MSM, PIK, SHP, TFG, TRU, WHL,

Commodity Plays:
AGL, AMS, ARI, BIL, IMP, LON, SOL, ACL, KIO

Industrial Hedges / Global Consumer Plays:
BTI, APN, SAB, NPN, SHF, CFR

S A Industrials:
BVT, IPL, SHP, TBS, VOD, BAW, LHC, AVI, SPP NPK

The case for SA economy plays – at current prices

The key question we now address is whether or not the JSE, taken as a whole, can be thought to offer the prospect of good returns for investors, at current valuations. The further issue is the valuation currently attached to the SA economy plays. Can they be considered demandingly valued at current valuations that incorporate the expectation that SA interest rates will rise over the next 24 months? Clearly there is upside for this class of shares should interest rates not rise as expected.

Yet a consideration of the downside risks to this class of shares needs consideration, as well as upside risks. Risks to the JSE All Share and SWIX Indexes, positive or negative, will impact to a lesser or greater degree on any subset of the market, including the SA economy plays.

Holdsworth shows that the JSE All Share Index is currently priced within the norms established since 1995. Cyclically adjusted or normalised earnings suggest an even less demanding rating for the market than do reported earnings. This is because the earnings from the Resource companies listed on the JSE are currently in only partial recovery mode from a deep, cyclical decline in normal earnings.

It would seem accurate to conclude that, by the standards of the recent past, the JSE was not demandingly valued at March 2014 month end, relative to trailing earnings (provided earnings from the Resource companies do in fact return to their cyclically adjusted norms). Clearly, such valuations also depend on the current state of emerging markets generally.

In our valuation models, we allow for an emerging market influence on the US dollar value of the JSE All Share Index and Financial & Industrial Index, in addition to factoring in the level of JSE earnings in US dollars and the interest rate spread between SA and the US. These valuation models, which have provided a good long run explanation of market value, suggest that the All Share Index is between 10 and 20% above the valuation predicted by the model.

Using a similar approach to valuing the S&P 500 indicates, by contrast, a high degree of undervaluation, 20% or so. This suggests that the better value for shareholders is for now still to be found in developed rather than emerging equity markets.

These currently stretched valuations of the JSE have been encouraged by the above long term average growth (of 10% pa) in Financial and Industrial rand earnings in recent years. This recent strong and predictable growth has been augmented by the exceptionally good earnings growth reported by the Global Consumer Plays. The SA Plays have also performed very well on the earnings front, especially in recent years.

Looking at Price/earnings ratios

In the figure below, we show the very different ratings enjoyed by these sub-sectors of the JSE. Global Consumer Plays now enjoy a much improved and exalted price/earnings rating compared to the other sectors.

While Naspers accounts for the largest share, 12.5% of the Top 40 companies included in the SWIX, its share of the Global Consumer Play sub-category is as high as 29%. Almost all of the value of Naspers can be attributed to its large shareholding in Tencent, a Hong Kong listed internet company. Without Naspers, which has recently traded at 65 times reported earnings, the Global Consumer Plays, taken together at SWIX weightings, would enjoy a still demanding 19 times earnings rating compared to the more demanding 24 times multiple when Naspers is included.

While the earnings performance of the SA Industrials has compared well with those of the Global Consumer Plays, these SA economy-dependent companies realise a significantly lower rating in the market. The Global Consumer Plays must be considered as growth companies while the group made up of SA Industrials and SA Interest Rate Plays can be considered as value stocks with much less demanding valuations.

Holdsworth has estimated that the trend earnings growth is 14% pa for the Commodity Price Plays, 9% p.a for the SA Interest rate plays, 15% pa for the Global Consumer Plays, 11% pa for the SA Industrials. The volatility of these earnings growth trends has been lowest for the SA Industrials at 17%, compared to 19% for the Global Consumer Plays, 23% for the SA Interest rate plays, 61% for the Commodity Price Plays and an extraordinarily high 158% for the Gold Mining Companies. Part of the case for the SA Industrials is thus their lower risk character. If these growth trends in earnings are sustained, current valuations of the SA economy plays cannot be regarded as demanding.

It may be argued therefore that, based on valuation metrics and given that the impact of higher interest rates is already factored into the valuations of the SA Industrials and Interest rate sensitive counters, the downside for these SA economy-dependent stocks is more limited than that of the Resource stocks or the Global Consumer Plays.

The upside is that the rand will be stronger than expected and interest rates lower than expected. All these sectors of the JSE will benefit from stronger global growth and strength in emerging market equities and commodity markets that would accompany any renewed appetite for bearing risks in emerging markets. But the SA economy plays as a group stand to benefit most from a strong rand and all that will follow a stronger rand, especially lower interest rates.

We show in the figures below how these developments on the JSE – a poor January followed by a recovery since – are strongly associated with movements in the bond markets. In January, long dated US Treasury yields were falling while SA yields in rands (unusually) were rising. In February, US yields moved sideways while SA yields fell. Hence the yield spread between SA bonds and US Treasuries widened sharply in January and narrowed in February, to the advantage of the JSE (in rands and US dollars) and the rand. These relationships between interest rates, the rand and the JSE developments are not coincidental. They are causal.

 

The yield spread is the risk premium attached to SA assets. The wider the risk premium, the higher the discount rate attached to rand income, and the lower the value of the rand and the US dollar value of SA assets. In the figures below we show how the rand/US dollar exchange rate and emerging market (EM) equities responded to the yield spread in 2014. The rand responds to capital flows into and out of the SA bond market and the JSE.

If we could accurately predict the direction of US interest rates and the risk premium, we would be able to accurately predict the direction of the rand and the JSE.

In the figures below we demonstrate these relationships since January 2013, using daily data. The S&P 500 has been an outperformer over this period and the JSE in US dollars consistently tracks the EM average very closely. This relationship is not coincidental either. JSE earnings and dividends in US dollars track the EM average closely because JSE earnings are more dependent on the state of the world than on the SA economy – as is the case for most EM listed companies. The JSE and EMs generally have performed better relative to the S&P 500 recently after lagging behind badly in 2013.

 

The patterns may be more or less regular, but predicting the direction of US rates and the yield spread is anything less than obvious. We can however suggest alternative scenarios and their implications, and assign our sense of the probabilities.

Four possible scenarios for the US economy:
+ = above expected growth or inflation
– = unexpectedly low growth and inflation.

1. Growth + Inflation – The triumph of Bernanke

2. Growth – Inflation + The scourge of Stagflation stalks the land

3. Growth – Inflation – More of the recent same?

4. Growth + Inflation + Punchbowl not removed in time

 

Scenario 1: Unexpectedly strong growth with no more inflation. This implies higher US nominal and real interest rates and will call for an early reversal of quantitative easing (QE)

Implications: Good for US equities and cash but bad for long dated bonds, yield plays, inflation linkers and EM. Good for the US dollar. EM currencies will come under pressure. Risk spreads may decline, helping higher yield credit, including EM credit, given less default risk. The preference then would be for developed market equities over EM equities since they are more able to win the tug of war against the higher cost of capital (though in due course EM equities will also benefit from a stronger global economy).

Assigned probability: 30%

Scenario 2: Stagflation – slow growth with more inflation

This implies low real interest rates with a steep yield curve as higher expected inflation gets priced into the long end of the bond market. This is ideal for inflation linkers: risk spreads widen and more inflation will be better for equities than bonds, though not good for either. Stagflation will be better for EM equities that offer more growth at lower real discount rates. Cash will have appeal if short rates stay above inflation. Fears will enter the markets of not only inflation but also of inflation fighting responses that will further reduce the US and global growth outlook. Bad for the US dollar, good for precious metals.

Probability: 10%

Scenario 3: More of the recent same. Below par growth – below par inflation

More QE will mean low real and nominal rates (the failure of QE will raise policy issues and encourage more direct intervention in markets, adding risk and volatility). Bonds to be preferred over equities – EM equities and currencies will be preferred to developed markets and currencies and defensive stocks may be worth paying up for. Gold will have appeal given low real rates and danger of intervention.

Probability: 25%

Scenario 4: Punchbowl not removed in time; QE overshoots, meaning above par growth with above par inflation

Real and nominal interest rates will kick up. Equities will be preferred over all bonds – credit may offer equity like returns. Developed market equities will be preferred over emerging markets. Cash will be better than bonds – high real interest rates will counter inflation expected in the gold price. Real estate with rental growth prospects will have strong appeal as an inflation hedge.

Probability: 35%

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.