Category: SA Financial Markets

Further consolation for the well-travelled South African with a taste for the more exotic is that some destinations have become significantly cheaper for them since June 2013, provided, and it is an important proviso,  prices are set in the local currency rather than in US dollars. Bali in Indonesia will appear a mere snip, with the Indonesian Rupiah having depreciated by about 12% against the rand since 1 June 2013. That never to be forgotten experience in the Istanbul Hamam could be about 8% cheaper and booking that Rio hotel for the World Cup should not be more expensive than it was six months ago – nor should the game changing visit to the Indian Ashram take more rands than it did six months ago. Bangkok or Pukhet might also appear something of a bargain buy. Mauritius, a favourite nearby destination for SA tourists, has proved remarkably exceptional in this regard. Its rupee has maintained its value against the US dollar and the euro.

These developments on the currency markets in 2013 illustrate the important forces that have influenced the foreign exchange value of the rand over the past 12 months.

The weakness in the rand across almost all currencies, including other emerging market currencies until June 2013, was SA specific in origin. It was caused by the failure of labour relations and the resort by the unions to strike action that disrupted production and especially exports from the mines and manufacturers. It became very apparent that export revenues and profits can only benefit from a weaker rand if output can be maintained or increased in response. This was not the case in SA in 2013. For want of exports, the trade and current account deficits remained large despite slow growth. This put sustained pressure on the rand from August 2012 until June 2013.

The weakness in the rand after June was much more a case of increased emerging market risks, rather than specific SA risks. The intention of the Fed to taper its injections of cash into the US financial system, first revealed in late May 2013, meant higher interest rates in the US and everywhere else. Capital tended to flow out of emerging market equity and bond markets into developed equity markets with very negative effects on most emerging market currencies. The “fragile five” emerging economies – Brazil, India, Indonesia, South Africa and Turkey – that ran current account deficits and therefore depended more heavily on foreign capital inflows proved particularly vulnerable.

Any recovery in emerging market currencies will depend upon renewed appetite for emerging market equities that have so underperformed in US dollar terms over the past two years.

Emerging equity markets and their currencies did not take at all well to the prospect and reality of higher interest rates in the US – notwithstanding the good news about the US economy that remains such an important part of the global economy. Clearly the state of most emerging market economies was not at all robust enough to tolerate higher interest rates. Their currencies, including the rand, weakened as funds flowed out of emerging equity and bond markets. While the local currency values of emerging market equities generally rose, as they did on the JSE, these price gains were not enough to compensate offshore investors for currency weakness.

In US dollar terms, the average emerging market equity went south rather than north in 2013, thus lagging well behind the trends registered on the developed equity markets (see below). Good news about the US economy did not translate into good news for emerging market economies.

Higher long interest rates in the US, that led to higher rates in emerging economies, including SA, put downward pressure on currencies and equities, when valued in US dollars. The one saving grace for interest rate sensitive economies and companies is that interest rate spreads between riskier bonds (including RSAs) and those issued by the US Treasury have tended to narrow recently, so moderating the impact of higher interest rates in the US (see below).

For now investors in emerging equity markets should hope that the expected recovery of the US economy is fully reflected in current long term bond yields. Indeed, economic disappointments (leading to lower bond yields) rather than surprisingly strong growth in the US (higher bond yields) would be greatly appreciated by emerging market equity and currency markets. Yet in any longer run view, a stronger US economy (given its large size) is good news for the global economy and especially for those emerging economies reliant on export flows to the developed world.

The better economic times seem more propitious for developed than for emerging markets and their valuations reflect this. In due course, the good economic news will spread to the emerging markets, their currencies and their equity and bond markets. For now developed equity markets, we think, continue to make the stronger case for equity investors than emerging equity markets, while equities generally make a much better case than bonds, given the risks of higher interest rates.

But a mixture of still more demanding valuations on developed equity markets and less demanding valuations on emerging markets, especially when measured in US dollars, could revive the case for emerging market equities and their currencies. At some point in time, the strong outperformance of developing equity markets and currencies will become the case for emerging markets that, after all, have the global economy in common. As they say, timing is everything.

We examine the models of 2013 Nobel laureate Robert Shiller and see what predictive role they have in the performance of the S&P 500.

The joys of receiving the 2013 Nobel Prize for economics – shared between Eugene Fama, Robert Shiller and Lars Peter Hansen – may well have been tempered. The ideas of Shiller and Fama on how financial markets behave are about as far apart as they get. Fama made his reputation exposing the economic logic, the efficiency of the market. Shiller made his attempting to prove the opposite.

We consider below just how useful price/earnings (PE) ratios are for market timing decisions. We ask whether the Shiller approach has merit – it continues to receive attention from market timers – or whether Shiller in his call that the S&P 500 market was greatly overvalued in 2000 (as it subsequently proved to be), was just lucky enough to be in the right place and time to draw favourable attention to his work.

Bubbles are good for some

Shiller’s analysis of an overbought stock market in 2000 was based on apparently unsustainably high price-earnings ratios for the S&P 500. He used a 120 month (10 year) moving average of real (CPI deflated) earnings as the denominator and real share prices, represented by the S&P 500 for which he derived data going back to 1871, as the initial starting point for the analysis. The Shiller PE is also described as the Cyclically Adjusted Price Earnings ratio (CAPE).

In the figure below, we compare the Shiller price/smoothed earnings multiple to the conventional measure using reported or what are often called trailing earnings. The two series differ most dramatically during the Global Financial Crisis (GFC) of 2008 when prices held up, even though reported earnings had collapsed. Shiller earnings, being a 120 month moving average, moderated this fall in earnings, so leading to a much lower multiple in 2008-09 and a much higher one therafter, given the recovery in trailing earnings. As may be seen in the chart below, the current Shiller PE multiple is now significantly more demanding than a multiple based on reported earnings.

The problem with a moving average when earnings collapse

The application of a 120 month moving average to estimate earnings means that the low level of reported bottom line S&P earnings in 2009-10 will continue to drag down Shiller earnings, relative to the much higher subsequent reported earnings, for 10 years thereafter. The current Shiller PE ratio is 24.42, while the conventional trailing PE is 19.43 (see Figure 2). The long term average (1871- 2013) monthly Shiller PE ratio is 16.5 and the conventional PE has a long run average of 15.83.

Incidentally, in contradiction to the Shiller notion that share prices are more variable than reported earnings – indicating some degree of irrationality in valuations – the opposite has been true since the late 19th century using the data suppled by Shiller. The average move in the real S&P has been 3.56% a year, calculated over 1578 months (over 131 years), while the average annual growth in real reported S&P earnings has been 6.86% over the same period.

Since 1960, the average real price move has remained at 3.6% a year while the average growth in earnings has been higher, at 11.6% a year. The standard deviation (SD) of real price moves, the conventional measure of volatility, has been 16.09% a year since 1960, while that of real earnings growth has been much greater, a staggering SD of 78.5% (influenced by the post GFC collapse in earnings and changes in accounting conventions that now discourage any protection of the bottom line that might have helped smooth earnings in the past).

The Shiller theory of value and the evidence – problems with a price earnings model that does not revert to some consistent long term average

The Shiller theory is that the Shiller price to smoothed earnings multiple will provide a superior method for recognising an over- or undervalued share market than the conventional measure of a price to earnings ratio. Or, in other words, comparing the Shiller PE to its long run average can assist market timing decisions. The problem for those using either measure is that neither of them can be regarded as reverting over time to their long term averages. The ability to revert (called mean reversion by econometricians) can be calculated – and it can be very clearly shown that these ratios do not converge to long term averages. These PE multiples can remain well above or well below their long term averages for long periods of time. There can thus be little confidence, based on the statistical evidence, that the PE multiple will consistently gravitate to some long term average within some operationally useful period of time for investors to time entry to or exit from the share market

Using either measure of the PE multiple, conventional or Shiller, the market appeared to be as significantly over valued long after Fed chairman at the time, Alan Greenspan, spoke memorably in 1996 of irrational exuberance. The S&P and the price to earnings multiples moved significantly higher for another four years.

It is expected earnings that drive value

It should be appreciated that investors use past performance, as represented by realised earnings, as a proxy or starting point for expected earnings when undertaking any valuation exercise. Future earnings will determine future valuations and the path of future earnings may well be expected to diverge from past earnings for any number of reasons – for example underlying economic growth can realistically be expected to gain or lose momentum for an extended period of time, adding to or subtracting from expected profits.

Unforeseen economic policy events, taxes, regulation or even natural events can alter the present value calculations that investors make. They may view the economic outlook with more or less confidence. The less their confidence, the more risk they will attempt to allow for when they buy or sell assets and so the higher or lower the discount rate or equity risk premium they would use to calculate a present value for a stream of benefits. The real cost of capital may well change as global and domestic propensities to save increase or decline, given degrees of capital mobility.

The future may well be different and investors can rationally hope to benefit from the difference. Most assets, including the real plant and equipment that corporations invest in, have a natural limited economic life. Earnings that might add value to an asset if it survives beyond a twenty year horizon cannot add much present value.

It can be demonstrated that small adjustments to two key influences on the price earnings multiple can drive the PE ratio dramatically lower or higher. These are in the required rate of return (or the cost of capital used to discount expected earnings) or in the expected growth rates in earnings themselves. Even small changes in the discount rate or the expected growth in earnings or dividends can have an explosive impact on the PE ratio.

Time will tell whether investors were too optimistic or too pessimistic about these forces that drive valuations. Market prices set in advance may be proved wrong by subsequent market moves – but this would not prove the valuation process as irrational. The unexpected might well prove the norm to which valuations adjust. This is a point Eugene Fama would no doubt make in response to accusations of market inefficiency – because markets may appear to change their collective minds and forecast poorly. It does suggest however that forecasting share prices is difficult to do successfully and also that using a simple metric like the price earnings multiple – compared to its long run average – is not the holy grail of share market valuations.

The growth in earnings and share prices

As an alternative to the PE ratio, we examine below the relationship between the annual growth in earnings and the annual growth in share prices. It seems reasonable to expect the relationship between the growth in earnings and prices, or between price moves and earnings moves, to cancel out over a period of time. Either prices catch up with faster earnings growth or, vice versa, earnings growth can catch up with higher share prices, so closing the gap between growth in prices and growth in earnings. If earnings fail to grow as expected, prices will then tend to retreat, thus closing the gap between price and earnings movements.

We examined the difference between annual price movements in the S&P Index and the simultaneous growth in earnings, both conventional and Shiller. The results of the exercise are pictured in Figure 4 below.

These differences in the annual growth in share prices and the growth in earnings do appear to revert to zero over time, though not necessarily in any regular way, either within the same year or even over the next few years. This suggests that it may well take a long time for the adjustment process of share prices to corporate performance or the other way round, to work out. The annual differences between the growth in share prices and earnings have an almost random, rather than persistent, character and so these differences in growth rates provide little notice of whether the current gap between the recent growth in prices and earnings will subsequently widen or narrow.

When we compare the growth in the S&P over 29 consecutive five year periods, with the growth in earnings over the same five years, we do get a somewhat better statistical fit. However the results are not convincing: even if we could successfully forecast earnings and earnings growth over the next five years we could not be confident that we would derive accurate predictions of the stock market . In the figure below, we show the results of such an exercise for the five year changes in the real S&P and real S&P reported earnings since 1871.

Connecting the level of the market to the level of earnings

While the PE ratio compared to its long run average provides little help in predicting the direction of the market , we may be able to gain some insight by comparing the level of the market with the level of earnings using regression analysis, especially if we add the influence of interest rates to the description of the level of the market relative to reported earnings. The difference between this approach and those of Shiller or conventional PE ratios to indicate an over- or undervalued market, is that it allows for a discount rate to be added to earnings or dividends as an additional explanation of value. The opportunity cost of holding equities in the form of interest income foregone surely influences the prices investors are willing to pay for a share in a listed company.

Adding long term US interest rates to both of these equations improves the fit of these models. The interest rate variable included in these models is the yield on a 10 year US Treasury Bond, for which data is also available back to 1871. The interest rate betas have the predicted negative association with share prices and are statistically significant.

The equation drawn, sometimes described as the Fed Model, with the natural log of the real S&P explained by the log of real S&P dividends and long term interest rates since 1880 and compared to actual values, is shown below. Judged by this model, the S&P 500 is currently about 9% undervalued.

By any conceivable measure of past performance, the S&P 500 was greatly overvalued in 2000

Utilising any of the variations of the Fed model, the US equity market was very demandingly valued in 2000. Using the Shiller definition of earnings as the explanatory variable without interest rates, a regression equation run over the period 1880-2000 indicates that the real value of the S&P was 2.7 times its value predicted by the Fed model with Shiller earnings in early 2000. Substituting reported earnings for Shiller earnings in this PE model indicates a market 2.2 times above that predicted by real earnings.

The problem for the investor utilising the Fed model is that in mid 1996 the S&P was already 1.9 times its value with Shiller earnings and 1.6 times its value, as predicted by reported earnings. Utilising either the Shiller earnings approach or reported earnings would have told essentially the same story. Yet the demanding valuations persisted for many years.

The case for dividends rather than earnings as the measure of past performance

It can be argued, especially taking into account the recent earnings turbulence, that real S&P dividends per share are a superior measure of past performance to reported S&P earnings. Definitions of bottom line earnings may change over the years as accountants revise their conventions. Dividends are much less complicated: they are simply cash in money of the day paid to shareholders. Buying back shares, subject to changes in financial fashion, serves the same purpose but does not show up immediately as dividends per share.

Reported dividends per share held up much better than trailing earnings per share through the GFC. They therefore provide a much more realistic estimate of realised corporate performance and perhaps also the performance expected by management, than bottom line earnings that were so much affected by the write offs of financial institutions (see Figure 8 below).

Regression models of the real S&P 500 over the period 1960-2013, using either real trailing earnings, real Shiller earnings or real dividends as the explanatory variable, together with the 10 year Treasury yield, indicates that the S&P 500 is currently under rather than overvalued: by 13% using real Shiller earnings and long term interest rates; fairly valued using trailing real earnings and interest rates; and as much as 32% undervalued using real dividends per share, when combined with interest rates.

Statistical issues with these regression equations

The statistical issues with these linear regression models, using levels of earnings or dividends with interest rates to explain the market, is that, as with the Shiller or conventional PE, the under- or overvaluation identified by the models are persistent. One of the essential conditions for unbiased regression estimates is that the error term, that part of the dependent variable not explained by the model, should have an expected value of zero and be normally distributed about zero (that is the regression estimate should have the same probability of being above or below the estimated value).

This is not the case with these models, which reveal what statisticians would describe as serial correlation and therefore do not provide unbiased estimates of the relationships identified. When this persistence of errors occurs, the results of any linear regression analysis and the validity of the estimated coefficients are compromised. As we indicated earlier, this persistence of Shiller’s PE away from its long run average is subject to the same bias. Lars-Peter Hansen was awarded his share of the Nobel Prize for providing methods to overcome the serial correlation and many other problems caused when the data is compromised.

How to apply these models, with their statistical weaknesses recognised

It is best to regard these models not so much as helping time entry or exit from the market (trading models), but rather as a way to interrogate and perhaps understand the level of the market and the earnings and interest rate expectations implied by current market valuations. If the model suggests the market is significantly overvalued by its own standards, a degree of caution may be called for. And vice versa, if the market is deeply undervalued a degree of confidence in its future recovery may be encouraged by undemanding earnings expectations. Again, there should be no confidence that these identified valuation gaps will be closed rapidly. Earnings can catch up with prices or prices can catch up with earnings as the truth about underlying economic performance is revealed and this may take time.

Conclusion: The market proposes – economic reality disposes

The lesson to be drawn from this analysis is that in the long run, valuations will catch up with economic performance or performance will catch up with valuations. However predicting the direction of the market over the next month, year or five years (even knowing where earnings and dividends are going) is not easy to do.

Trading theories that rely on price/earnings ratios or the relationship between the level of earnings and prices may indicate degrees of investor exuberance or despondency by the standards of the past. But there can be no certainty that temporary exuberance or despondency will prove excessive or short lived.

There will always be more than earnings or dividends (or even expected earnings or dividends) at work in driving the market in one direction or another. The growth in expected earnings as well as the discount rate attached to them may be in a constant flux, making accurate predictions of market returns extremely difficult to make. Not only would it be necessary to predict earnings with accuracy, but also the direction of interest rates and the degree of risk aversion or tolerance that may emerge.

The direction of causation may well be from prices to earnings rather than from earnings or expected earnings to share prices. For example, the higher the share price, the more willing and able the company will be to expand its operations and increase its bottom line earnings. Market volatility furthermore provides no proof of market irrationality. It indicates only the difficulty in forecasting the behaviour of complex systems with feedback loops – in the case of the share market from performance to prices and also from share prices to the economic performance of a company.

It is instructive to recognise that this weakness in the real and the relative stability in the rand/real exchange rate have come despite very aggressive increases in Brazilian interest rates, imposed in response to the weaker real.

These increases have not helped the real while they have probably weakened the growth outlook for the Brazilian economy. The SA Reserve Bank is hopefully taking note: higher interest rates do not necessarily protect the currency while they almost certainly restrain domestic spending. It is the growth outlook more than the short term interest carry that drives capital flows, which in turn support a currency and improve the inflation outlook. Sustain growth rates and the currency will be supported. Weaken growth rates and foreign investors are more likely to take their capital elsewhere – even back to the developed world.

The Governor of the Reserve Bank, Gill Marcus, saw fit in her Q&A session after the Monetary Policy Committee (MPC) meeting to adopt a more hawkish tone about the direction of interest rates. This came after the MPC decided to leave short rates on hold.

Perhaps the MPC needs to be reminded that raising short term rates will not do anything useful for the inflation rate unless the rand responded favourably to such a move.

Judged by the relationship between daily changes in short rates and daily moves in the rand since 2007, there is in fact as much chance of the rand weakening as strengthening when short rates rise. This relationship since 2008 is shown below in a scatter plot and has a correlation of zero.

Higher rates however can be expected to slow down domestic spending that, as the Reserve Bank is well aware, is growing very slowly and is putting deflationary, rather than inflationary, pressure on prices. The risk is that higher rates will damage the economy without having any favourable impact on inflation or inflation expectations.

It is a risk not worth taking. The Reserve Bank should have lowered interest rates long ago but in current circumstances of “tapering” risk on US rates and the rand, the best approach the Reserve Bank could take is to do nothing at all. It almost appears, from the body language of the Governor, as if doing nothing about interest rates or the exchange rate is a hard act for the MPC. Doing nothing for now and until domestic demand has picked up momentum, which it shows no signs of doing, is highly recommended.

Just in case the Bank thought its tough talk had any favourable impact on the rand it should know that any strength in the rand on late Thursday and Friday was due to a favourable upward move in emerging equity markets that helped the rand as much as it did other emerging market currencies. Absent SA political risks (over which the Bank has no influence) the rand remains exposed to global economic forces for which emerging market (EM) equity and bond markets are a very good proxy. We show the links between the rand and the MSCI EM Equity Index and also those between EM credit spreads over US Treasuries and the rand below. Clearly global forces are driving the rand and will continue to do so – independently of short rates set by the Reserve Bank.

The recent Brazilian experience with hiking short rates – to which reference was made at the MPC meeting – should be salutary for the SA Reserve Bank. In response to dollar strength and weakness in the Brazilian real, the Brazilian central bank hiked short term rates aggressively in mid year. As we show below, such aggression) no doubt harmful to the domestic economy) has not has any favourable impact on the Brazilian real/rand exchange rate. The weak rand has more than held its own with the real without support from higher interest rates as we show below.

The reason that currencies weaken in the face of higher short rates is because higher interest rates can damage longer term growth prospects and frighten capital away.

The path to a stronger rand and lower inflation is faster SA growth – this will encourage portfolio inflows and foreign direct investment to SA. Slowing down growth can be highly counterproductive: by discouraging foreign capital, it can weaken the rand and lead to more, not less inflation. Such possibilities should give strong pause to thoughts of higher short term interest rates.

 

For those with long memories or knowledge of SA financial history, that episode of very demanding valuation in the mid 1960s did not turn out well for shareholders who entered the market in 1965. As we show below, it took until 1995 for the JSE Industrial Index, adjusted for inflation, to regain its 1965 levels. Thereafter, as we also show below, real share prices on average fell back again and only decisively exceeded the average 1965 real valuations in 2005. Since then we have seen spectacular real increases. Between 2005 and 2013 the JSE Industrial the Index has increased by nearly six times in real value to reach its current record levels.

 

 

 

 

 

This time has been different – The explosion of share prices and earnings after 2005

These improvements in share market valuations since 2005 have been supported by almost equally strong advances in reported earnings, adjusted for inflation. While share prices have increased by six times in real terms since 2005, real index earnings have increased by nearly five times over the same period, with only one temporary set back associated with the global financial crisis. This very impressive growth, if sustained, would be well worth paying up for in higher share prices. In other words, it is economic fundamentals, not irrational exuberance, that can explain the market in JSE listed Industrials.

It should be noted that after a period of strong growth in real earnings between 1960 and 1980, real industrial earnings in 2004 were no higher than they had been in the mid 1970s. The surge in earnings and earnings growth, as with share prices, began in 2005 and has been sustained since then. It represented a sea change in the circumstances of SA industrial companies. What is to be observed is a remarkable transformation of the real profitability of JSE-listed industrial companies.

 

Since January 2011 the growth in real industrial earnings has averaged 12.9% a year, while real dividends have grown significantly faster – by nearly 30% a year on average. These, it will be appreciated, are very impressive recent real growth rates. As may also be seen below, while both growth rates have slowed down, a time series forecast predicts that the growth in real dividends will pick up momentum while the growth in real earnings will remain positive in real terms in 2014. But all of this will have to be proved and investors will be watching the earnings and dividend news particularly closely.

 

 

Industrial earnings dissected – global and SA economy plays

Among the large industrial companies listed on the JSE it is the group of the Industrial Hedges that have made the running on the JSE. These are companies that depend on the global economy rather than the SA economy. We have created an Index of these companies weighted by their SA share holdings. The Index is made up of British American Tobacco, Aspen, SABMiller, Naspers, Steinhoff, Richemont, MTN, Netcare and Medicilinic. This group of companies generated a total return of close to 50% over the 12 months to the end of October 2013, compared to 23% for the All Share Index and a 42% return for the Industrial Index (the latter includes the Industrial Hedges as well as the SA economy-dependent large industrial companies).

Unsurprisingly, the Industrial Hedges have also outperformed on the earnings growth front. Yet it should be noticed that in recent months the SA Industrials have increased their reported earnings, in money of the day rands, at about the same rate as the global group.

 

The state of the global economy will prove decisive for corporate performance

It will take good support from the global and SA economies to realise the growth in earnings required to justify current market valuations. The global economy plays will benefit directly from US growth. With faster US growth will come higher long term interest rates though. For now this makes US rates a bigger threat to emerging market economies, their currencies and their stock markets than to the US economy and US equities – as we observe from market reactions to higher and lower US long term rates. Rand weakness adds to the case for the global plays relative to the SA Industrials. Rand strength improves the case for industrials dependent on the SA economy.

 

In due course faster US growth should feed through to emerging market economies and the companies dependent on them – including the SA Industrials. In the long run good news about the US economy means good news for the global economy; but not necessarily immediately. For now the ideal scenario for emerging markets would be modest increases in long term US rates – as the US economy consistently gains momentum and drags global growth along with it. The more delayed and slower the tapering of the extra cash injected into the US economy, the better for emerging market equities, including the JSE.

 

If the rights to subscribe new equity capital are taken up by established shareholders in the same proportion they currently hold shares, their share of the company is unaltered. They will be entitled to exactly the same share of dividends or the company (if liquidated) as before. In the case of a rights issue, established shareholders may however elect to sell all or part of their rights to subscribe to additional shares should these rights prove valuable, in which case they are giving up a share of the company but are fully compensated for doing so.

The key questions for shareholders and the market place are the following:

How well will the extra capital raised be employed by the managers of the company raising additional capital? Will the capital raised from old or new shareholders earn a return in excess of its opportunity costs? Will it earn a return in excess of the returns shareholders or potential shareholders might expect from the same amount of capital they could invest in businesses with a similar risk character?

Doing the numbers for the ABL rights issue

In the case of the ABL rights issue, the essential judgment to be made by the market place is whether or ABL will be worth more than the extra R5.482bn shareholders will have subscribed for in additional share capital, after 6 December. ABL had a market value of R12.33bn on 5 August when the rights issue was first announced. It would need to enjoy a market value of more than R17.88bn on 6 December (R12.34bn + R5.482bn = R17.88bn).

Given that 15.01m shares will have been issued by then, (the sum of the 685.28m new shares plus the 815.811m shares previously issued) the break even share price for the established shareholders would have to be approximately R11.88. A share price of more than this would confirm the success of the rights issue when the process has been finally concluded.

It is possible to infer the value of the rights implicit in the current R17.29 share price. R17.29 multipled by the 815m shares in issue gives a value of R14.09bn. If we add the additional capital of R5.5bn to this, we get an implicit post rights issue value for the company of R19.59bn. Dividing the R19.59bn by the 1501m shares gives an implicit post rights issue share price of R13.05. This is R1.17 ahead of the break even of R11.88. Hence the ABL capital raising exercise value has been value adding for shareholders.

Another way of measuring the value add is to compare the post rights value of ABL at R13.05 per share (R19.58bn) with the pre-rights issue value of R12.33bn to which the R5.5bn capital injection must be added. This amounts to R17.83bn and so the value add is R19.59bn – R17.83bn = R1.76bn.

The dilution factor – best to be ignored

The common notion is that issuing additional shares will “dilute” the stake of established shareholders, because more shares in issue reduces earnings per share. This assumes implicitly that the additional capital raised will not be used productively enough to cover the costs of the capital raised or earn more than the required risk adjusted return. But this is not necessarily so. Additional capital can be productively employed and can add, rather than reduce, value for shareholders.

 

In the case where balance sheets have been impaired, the ability to raise additional capital from shareholders in a rights issue adds value to the company by reducing its default risk. This would appear to be the main factor adding value to ABL. It is up to established shareholders in the first instance to approve any rights issue, on the presumption that it will add value to the stake they have in the company. If they approve and are willing to invest more it will be over to the market place to decide whether the gain in market value exceeds or falls short of the value of the additional capital subscribed.

 

In the case of a secondary issue of additional shares (rather than a rights issue) the answer is easily found by observing the share price after the capital raising. A gain in the share price would be evidence of a value adding capital raising exercise for both established shareholders who did not subscribe additional capital as well as for all those who did.

 

However to be a truly value adding exercise, these share price gains made after a secondary issue would have to be compared to market or sector wide gains or losses. If the share price gains were above market average, the success of the capital raising exercise would be unambiguous. 

 

Estimating the impact of a rights issue is complicated; a lower share price may be compensated for by more shares owned.

 

Estimating the value add in the case of a rights issue is more complicated. This is because the rights are typically priced at a large discount to the prevailing share price before the announcement. The share price after a rights issue is likely to go down, but this will be compensated for by the fact that the shareholders, subject to a lower share price, will have received more shares at a discounted price, in exchange for additional capital subscribed.

The reason for pricing the rights at a discount to the prevailing share price is to attract attention to the offer and by so doing, to make sure that the rights to subscribe additional capital will have market value and so will be followed and the additional capital secured.

 

Making the comparison with a sole owner of a business investing more capital in it.

 

For any sole owner of a business enterprise injecting more capital into his or her business, the nominal price attached to the shares in issue would be irrelevant. He or she still owns all the shares.

 

When a sole owner decides to add capital to the private unlisted business, the test over time will be whether or not the business comes to be worth more than the extra capital invested – to which an opportunity cost should be added. That is what the same capital might have realised in an equivalently risky alternative investment.

 

The same is true of a rights issue in a listed company except, that if the shares are actively traded, the judgment of the market place on the wisdom in raising additional capital is immediate and continuous. Shares in a rights issue are being issued to shareholders in the same proportion to which they own them. As with a 100% owner, they would be issuing shares to themselves and their share of the company, after the rights issue, will remain the same should they follow their rights.

 

The rights issue price therefore is largely irrelevant to the established shareholders. What matters is the amount of capital the shareholders are called upon to subscribe to and what this capital they have subscribed for will come to be worth, when the rights issue and the capital raising exercise is concluded.

 

Why a large discount to the prevailing share price can be helpful to the success of the rights issue

 

This capital intended to be raised can be divided into a larger or smaller number of shares by adjusting the price at which the rights are offered without any important consequence for current shareholders – other than those who are financially constrained and therefore unwilling to come up with additional capital. They therefore would prefer not to take up their rights and to sell part or all of their rights to subscribe additional capital, presuming these rights had a positive value.

 

The same would be true for any underwriter that presumably would prefer not to have to take up their rights. For the underwriter the larger the discount the better; the larger the discount the less likely they will be called upon. One wonders if the underwriting commission properly reflects this trade off (as it should). For the underwriter, as for any shareholders less willing to follow rights, the larger the discount (and so the more additional shares issued) the better. A large discount to the prevailing share price will ensure an active market for the rights they wish to give up.

 

Conclusion

 

So far so good for shareholders in ABL following their rights issue. By agreeing to support the rights issue they have added value to the shares they owned. The market, as well as the shareholders, have so far voted in favour of the rights issue. Had the shareholders decided not to support the rights issue and proved unwilling to risk additional capital, the future of the bank might well have been regarded as much less certain and the share price damaged even more than it was. The market would have regarded any failure to support a rights issue as negative for the future of the Bank. The decision by shareholders to re-capitalise the bank was their vote of confidence in the management to realise good returns on capital in the future, even though they may have blotted their copy book. Forgiveness can be divine – but also value adding.

The importance of the US economy for the SA economy and its financial markets was again demonstrated last week. Some good news about the state of the US economy came in the form of the Institute of Supply Managers’ (ISM) latest report on manufacturing activity. This indicated good underlying growth, sending US long term interest rates higher on Friday.

SA yields moved in the same upward direction. More importantly, the gap between SA and US yields widened on Friday 1 November (as we show in the chart below), indicating that more rand weakness is expected over the next 10 years than was expected the day before.

 

US 10 year bond yields rose from 2.48% to 2.62% on Friday. These long term rates had earlier approached 3% after news of possible Fed tapering entered the markets in late May 2013. By tapering we mean reducing the monthly Fed injections of cash into the banking system, now running at US$85bn a month.

The manufacturing sector indicator was better news for the US economy than for emerging market (EM) economies. The US economy may be in a position to withstand higher interest rates when the Fed eventually begins tapering its injection of additional cash into the system. But higher interest rates are not called for in most emerging market economies, including the SA economy (at least not for now).

In the figure below we show how the S&P 500 Index outperforms the JSE (and the MSCI EM Index, the emerging market benchmark) when the gap between US and SA (and other EMs) interest rates widens and vice versa when the yield differences narrow.

 

 

In due course any sustained strength in the US economy will percolate through to the rest of the world and its stock and currency markets. But until such dispersed economic strength is apparent, investors in emerging markets must hope for a slow, steady recovery in the US and for not significantly higher US long term rates. The chart below shows that the recent weakness in the rand was shared by other emerging market currencies.

Thus it seems clear that for now, the more the Fed delays tapering, the better for EM economies and their stock and currency markets.

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

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

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

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

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

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

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

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

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

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

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

The SA economy, according to our Hard Number Indicator (HNI) continued to move ahead in August 2013. Growth in economic activity remained positive in August. However the forward motion of the economy appears to be losing rather than gaining speed. Our very up to date business cycle indicator is based on two equally weighted hard numbers that are released very soon after the end of the previous month, unit vehicle sales and the note issue.

This Indicator, the HNI, has proved to be very relaible in recognising the turning points in the offcial business cycle, the coinciding business cycle indicator published by the S.A Reserve Bank, that is based on a larger number of economic indicators derived mostly based on sample surveys, not hard numbers, and therefore is only published at best two or three months later than the HNI.

As we show the HNI appears to have reached a plateau suggesting that the forward momentum of the economy that has picked up speed strongly since the recession of 2008-09 has now stabilised. The forecast also suggests that the economy may not grow any faster over the next twelve months. (See below)

The Hard Number Indicator of the Current State of the SA economy.

The components of the HNI are shown below. As may be seen the supply of and demand for cash continued to grow at a rapid rate in August 2013 in both nominal and inflation adjusted terms. The trend in the extra cash supplied by the Reserve Bank to the economy remains above a 10% p.a. rate though the trend appears to be declining. Adjusted for rising inflation the real growth rates remain above 4% p.a as may be seen. This growth must be attributed in good measure to underestimated informal economic activity that is cash intensive.

The cash cycle- rowth in the supply of Reserve Bank Notes

New unit vehicle sales, that have been such a source of strength for the economy over the past two years, appears to be losing momentum, as we show below. On a seasonally adjusted basis August unit vehicle sales on the domestic market were well down on July sales and suggest that new vehicle sales are unlikely to increase over the next twelve months. Yet if sales volumes can be maintained at current seasonally adjusted levels, such outcomes, in the light of the history of the sector would be regarded as satisfactory. Significant increases in exports of new vehicles, labour relations permitting, could add to motor manufacturing activity.

Growth in new unit vehicle sales to the SA market.

SA Unit Vehicle Sales. Annualised and Forecast.

The National Income Accounts released on August 27th estimated that GDP grew at an improved seasonally adjusted 3% rate in Q2 2013. However GDP in Q2 2013 was only 2% higher than year before. These growth rates must be regarded as highly unsatisfactory given the potential for faster growth. Such GDP outcomes would ordinarily call for lower interest rates. Unfortunately the times cannot be regarded as ordinary with the foreign exchange value of the rand, in company with other foreign capital dependent economies, under so much pressure form higher long term interest rates in the US.

The inflationary implications of a weaker rand therefore make lower short term interest rates less likely. Lower rates would be very helpful for not only vehicle sales but housing prices and employment creating residential construction activity. Were mortgage rates closer to five per cent than ten per cent a lively housing market and many more new houses would surrely follow.

Higher short term interest rates, incluinding the rates charged for mortgage or car loans would further slow down the SA economy and hopefully will be avoided. The weaker rand and the higher prices to be charged domestuic consumers will anayway be taking their toll of domestic spending. Already subdued domestic spending will be under enough additional downward from higher prices, particularly from higher petrol and diesel prices. Spending does not need further discouragement from still higher interest rates.

Higher rand prices for exported goods should however encourage the mining and agricultural sectors to produce more. Manufacturing activity should also benefit from incentives to export more and also as domestic producers compete with now more expensive imported goods for space on the shelves of retailers. But extra output and incomes can only be realised if the mines and factories stay open for business.

The rand is not only a play on US interest rates. It is a play on SA labour relations that deteriorated so badly a year and more ago at the Marikana platinum mine that saw the ZAR perform so poorly not only against the USD but also against other Emerging Market currencies.

An unexpected recent degree of realism about wage demands appears now to be influencing the SA labour market. The outlook for mining and manufacturing output has improved accordingly and the rand has benefitted to a degree from this. In recent weeks and days the ZAR has been a relatively strong EM currency and the Indian Rupee particularly weak, as we show below.

The foreign currency cost of a rand

This small degree of rand strength has been accompanied by some relief for long term interest rates in South Africa. These rates as they did throughout the EM world followed higher yields in the US higher after warnings of the tapering of Quantitative Easing entered the global financial markets in late May 2013. In recent days the gap between RSA and USA yields has also narrowed indicating a lower cost of forward cover and somewhat less rand depreciation expected over the next ten years. (See below)

Long term interest rates; RSA and USA

The interest rate yield premium. (RSA-USA ten year bond yields)

More of the same – that is SA specific reasons for a stronger rand linked to more production on the mines and in the factories –especially if accompanied by lower rather than higher US bond yields – would be especially welcome news for the SA economy. It would improve the outlook for inflation and perhaps allow for lower rather than higher short term interest.

But in the absence of such favourable forces the right monetary policy response to higher US rates and a stronger dollar would be to continue to leave the adjustment process to a fully market determined ZAR and to keep short term interest rates where they are .

Ratio of Wealth to Income

 

Source: Investec Wealth & Investment

 

Scenario 2 is much less favourable for the saver. With the same inflation and real salary growth assumption and despite a higher constant 20% contribution rate,  the assumption of an average 3% real return on the portfolio means that the portfolio would be worth a mere R29.3m after 40 years of contributions, or only 7.8 times the same final salary. Retirement in these circumstances would call for a much reduced standard of living.

 

Scenario 2: Low returns – high contribution rate

 

Source: Investec Wealth & Investment

 

Scenario 3 is hopefully more realistic. It assumes an average 6% p.a. real return and a 15% constant contribution rate. The results as shown below may be regarded as satisfactory. The final wealth to income ratio would be 10.4 times.

 

Scenario 3: Satisfactory returns – 15% contribution rate

 

In Figure 3 we show the links between US bond yields and the S&P 500 Index. The good news that drove up interest rates was good news for the equity market on the Thursday. The initial reaction to the less good news on the Friday morning was to weaken the equity markets. But then through the Friday, the S&P 500 recovered its losses to end the day where it had started. This demonstrated a rather robust state of mind of equity investors. Perhaps the underlying fundamentals in the form of earnings reports and the outlook for them is proving supportive.

Of further interest, in Figure 4, is that the JSE followed the S&P 500 very closely throughout this period. We show this relationship through the index futures that offer more overlap than the spot indices.

QE: An exchange of bonds held by the public for cash issued by the Fed

QE easing may be regarded as an exchange of bonds for cash. The Fed holds more bonds and the banks hold more cash in the form of a Fed deposit. If the balance sheets of the US Fed and the Treasury were consolidated (as they should be since both are agencies of Uncle Sam) the consolidated US government balance sheet after QE is of the order of $2.4 trillion. It now shows lower liabilities to the public in the form of bonds that pay relatively high rates of interest, about 2.6% p.a for 10 year loans, and much larger liabilities in the form of bank deposits with the Fed (some $3.2 trillion) that pay much lower rates of interest, 0.25% p.a.

That these Fed deposits earn anything at all is something of an anomaly – something paid out of the goodness of the heart of Ben Bernanke to the shareholders of banks. It improves their income line and probably (controversially) makes the banks less reluctant to hold on to cash rather than lend it out.

But cash for bonds is likely to cause interest rates to fall and reversing the process – bonds exchanged for cash, as must eventually happen – should cause interest rates to rise. The market understands this very well. What it struggles with is the timing of this reversal, which will be dependent on the state of the US economy. And that is especially hard to predict.

Source: I-Net Bridge and Investec Wealth & Investment

For the year to the end of June, the S&P 500 was up about 12.6% while the MSCI EM Index had lost 10.9% of its 1 January value and the JSE in US dollars was down about 14.2% (see below). The JSE in US dollars usually behaves very much like your average EM market, for good fundamental economic reasons as we will demonstrate. It has suffered an extra degree of rand weakness against the US dollar, compared to other EM currencies, and so the JSE in US dollars has lagged behind its EM peers.

The S&P 500 vs MSCI EM vs JSE (January 2013 = 100), daily data, US dollars

Source: I-Net Bridge and Investec Wealth & Investment

We can provide a good economic rather than sentiment-driven explanation for this recent outperformance by the S&P 500. We show below how S&P 500 earnings and dividends per share have moved higher since 2011 – while EM and JSE earnings have declined from their recent peaks.

We also show that the growth in EM earnings and JSE earnings in US dollars have been significantly negative – but appear to be coming less negative, while S&P dividends per share have remained positive, though may be trending lower. We provide a time series forecast of both series to mid 2014. Bottom up estimates of S&P 500 company earnings as well as an extrapolation of recent aggregate trends indicate that S&P earnings and dividends will rise further over the next 12 months from their current record levels. The time series forecasts of EM and JSE earnings also point higher, but only well into 2014.

Index earnings and dividends per share in US dollars (2000 = 100)

Source: I-Net Bridge and Investec Wealth & Investment

The earnings and dividend cycles (2010-2014)

Source: I-Net Bridge and Investec Wealth & Investment

Not only have the S&P 500-listed companies performed better than their EM rivals, but we would also suggest that the S&P 500-listed companies have delivered better than expected bottom lines while EM equities and the JSE have delivered disappointing earnings. We will use our valuation models to make this point.

 

We use S&P 500 dividends rather than earnings as our measure of the economic performance of the S&P 500 because of the complete collapse of earnings in 2008-09. This extraordinary decline in earnings largely reflected the impact of the Global Financial Crisis on the earnings of financial institutions that had to write off so much of their failed lending books. The decline in S&P 500 dividends was less severe and can be regarded as more reflective of the underlying economic conditions.

 

Our valuation models can be described as earnings or dividend discount models. We run a linear regression equation to explain the level of the respective indexes. We use the level of reported earnings or dividends and long term interest rates as explanations. The models reveal a highly significant positive and consistent relationship over time between the index and earnings or dividends and a negative relationship with interest rates, just as basic valuation theory would predict. These models can be regarded as price to earnings (PE) or dividend ratio predictors of the market levels, with these multiples adjusted for by the prevailing level of long term interest rates. These interest rates represent the rate at which earnings are presumed to be discounted to establish the present value of reported earnings. The long term interest rate acts in the model as a proxy for the required returns of equity investors, or the opportunity cost of capital.

 

The dividend or earnings discount models do a very good statistical job predicting the value of the different indexes, as we show below. When however market values, as predicted by the model, exceed current market values (i.e. the model suggests an overvalued index), we can describe the level of the market as being demandingly valued and vice versa as undemandingly valued, when the current level of a market is well below its predicted value. These predictions are based on past performance.  

 

When a market is demandingly valued, that is when current market values are well above predicted or “fair value” according to the model, it is so because earnings are expected to grow strongly and vice versa. Subsequent events will either confirm or refute these optimistic predictions. If earnings do grow as strongly as expected, the index will be supported. If earnings disappoint, the index is very likely to fall away to fall in line with lower earnings. Similarly, when the index seems undemandingly valued – that is, it stands well below its value as predicted by the model – then this may well be confirmed by subsequently poor reported earnings. Then, if earnings subsequently turn out stronger than expectations, share prices and the index will gather strength. The degree to which the predicted values fall above or below predicted values – indicating optimism or pessimism about the economic and earnings outlook – may also be regarded as a measure of risk aversion or risk tolerance.

 

The observer may then wish to take issue with the collective consensus views that are revealed by market prices. The market might be thought to be too optimistic about the outlook for earnings – too risk tolerant in other words. This would encourage the sceptical active investor to reduce exposure to equities. Or, if the market is judged too pessimistic, or too risk averse by an active portfolio manager, this would encourage a greater exposure to risky equities in the view that economic events and growth in earnings, will turn out stronger than the market expects.

 

The predictive power of this approach can be back tested by using the models. This will show whether the signals provided by the model to buy or sell more equities would have been justified by subsequent market moves.

 

Such a model of the S&P 500 run in October 2010 – using data going back to 1980 – would have suggested a deeply undervalued, risk averse market at that time (understandably so with the memory of the global crisis still very fresh in the memory). The degree of undervaluation was of the order of 50%. In other words, the S&P 500 was 50% weaker than would have been predicted, on the basis of the relationship till then between earnings, interest rates and the market. The same approach would have revealed an especially very overvalued or risk tolerant market in early 2000 – just before the Dot.com bubble burst.

 

Using the same valuation method for the JSE, with all variables measured in US dollars, and using the difference between RSA and US long term rates as the interest rate influence on valuations, the JSE in October 2010 appeared as significantly, or some 28%, overvalued. Subsequent strength in the S&P 500 and weakness in the JSE, when measured in US dollars, provide good support for the validity of the dividend discount model.

 

The JSE vs the S&P 500, US dollar values (2011- 2013)

 

Source: I-Net Bridge and Investec Wealth & Investment

We do not have index levels and index earnings data for emerging markets that go back to 1980. However a model of the MSCI EM, using monthly data estimated for the period 1997 to 2010, provides very good statistical fits and estimates. This indicates that emerging markets were fairly valued (not over or undervalued) in late 2010 as per the predictions of the earnings discount model.

For discount rates in this model we have used the spread on EM bonds. It would seem that investors in EM equities in late 2010 were anticipating further increases in earnings from the average EM company. That this performance did not materialize was surely disappointing to investors, leading to a decline in the EM equity markets. By contrast, the subsequent strength of S&P 500 earnings, given its undemanding valuations of that time, early in 2011, was surprisingly good and able to lift the S&P 500 higher.

Updating the model and drawing conclusions about relative performance of developed and emerging markets

We can apply the same approach to the equity markets today. According to the dividend discount model, the S&P 500 today, supported by strong dividend flows, is still significantly undervalued for reported dividends adjusted for long term interest rates, judged by past performance. The model suggests fair value for the S&P 500 as almost 2500 compared to the 1630 levels prevailing recently.

The market and predicted value of the S&P 500, using the dividend discount model

Source: I-Net Bridge and Investec Wealth & Investment

The JSE measured in US dollars in June 2013 remains overvalued by about 22%, according to the model. Applying the model of the JSE measured in rands and using long term interest rates as the discount factor however, suggests that the JSE is not much more than fairly valued. The earnings discount model applied to the EM Index also suggests that this market is in fair value territory.

Thus one can conclude, with the aid of the earnings or dividend discount models, that the markets today are in a similar state to that of early 2011. The S&P 500 valuations appear still undemanding, while the emerging markets are in something like an equilibrium “fair value” state. On this basis, the S&P 500 and developed markets in general would seem much more defensive than the emerging markets and the JSE: the emerging markets remain more dependent on a good recovery in earnings than the S&P 500. Yet the outlook for earnings growth seems more promising in the developed than the emerging world – with the latter’s greater dependence on resource producing companies.

The state of the global economy will depend to an important degree on the future state of the US and Chinese economies. The developed markets will take their cue mostly from the US and the emerging markets mostly from China. One could say the same about commodity prices and the economies more dependent on them. Yet strength in the US, still a very large part of the global economy, will provide impetus to growth everywhere else including in Europe. The most direct beneficiaries of faster US growth will be the companies listed on the S&P 500. In a way it might also be said that China depends more on the US than the other way round.

Lower commodity prices reflect more subdued growth in China and expectations of growth there. However lower commodity prices, while harmful to the commodity producing economies, Australia, Brazil and SA among others, are very helpful to consumers everywhere and especially in the developed economies that account for much of consumer demand. This divergence would apply even more were the oil price also to give way, more than it has to date, to slower growth in China.

The conclusion one is inclined to come to is that, in the absence of a resurgence of growth in China and the other BRICs, and given the positioning of the different markets, the best value in equity markets over the next 12 months may well still be found in the developed rather than the emerging market space.

The realisation of these higher values will be threatened by abruptly higher movements in long term interest rates, of the kind that roiled all markets after the last meeting of the Fed. Faster economic growth in the US will lead to higher interest rates in due course. But faster growth means faster growth in earnings. This may be more than sufficient to overcome higher interest and discount rates in the market valuations attached to the companies delivering these higher earnings and dividends.

Last week this pressure eased, as long dated US Treasury Bond yields, both the standard fixed interest variety and (perhaps of greater significance) the inflation linked variety declined significantly, as we show below.

The relief for EM equities, bonds, real estate and currencies was palpable and very welcome. The best news for emerging markets will be a modestly improving economic outlook in the US – modest enough to keep long term interest rates on hold and, better still, to move them lower. Higher US equity valuations, in the absence of higher interest rates, will do no harm to EM equities. They may even help support them as they did last week. Brian Kantor

It was a good week for emerging markets (the MSCI EM up 4.4%) and the rand (which gained nearly 4% on a trade weighted basis) last week. It was an even better week for off shore investors in the SA component of the EM benchmark (MSCI SA) that had returned as much as 8% in US dollars by the weekend. On a trade weighted basis the rand is now about 18% down on its value of a year ago.

The response of the RSA bond market to the stronger rand was also consistently favourable. The yield gap between conventional RSA bonds and their inflation-linked alternatives narrowed to 6.1%, indicating less inflation expected, while the yield gap between RSA 10 year bond yields and the US 10 year Treasury bond also narrowed to below 4.9%, indicating a slower rate at which the rand is priced to weaken over the next 10 years. This breakeven exchange rate weakness may be regarded as a measure of the SA risk premium. It would take an extra 4.9% in rand income to justify an investment in rand denominated assets of equivalent risk, rather than US assets.

The rand and the rand bond market benefited last week from strength in emerging market equity and bond markets as US bond yields retreated from their fear of the end of QE spike last week. It should be appreciated that the bond market moves the week before in the US and elsewhere were of an extraordinary dimension –an apparent overreaction to a promised return to something like normal in the fixed interest space.

The partial recovery of the rand portends less inflation and the developments in the RSA fixed interest markets were consistent with this. Any further strength of this kind would convert premature fears of higher short term rates in SA into expectations of lower short term interest rates. The SA economy deserves lower borrowing costs and a stronger rand would make this possible. Better still for the rand would be less disruption of output on the mines than is currently expected (and priced into the rand).

The precipitating force adding to yields and global bond market volatility has been the further sharply higher move in US long dated Treasury Bond yields. The financial markets are struggling to cope with the initial steps in what may well be a return to something like normal yields on US Treasuries. How long this will take and where higher interest rates will come to rest are important matters of conjecture. With higher yields promised by the safest bonds, the search for riskier yield elsewhere loses some of its urgency: hence the move away not only from higher yielding emerging market bonds but also from higher yielding utilities and property companies. Another dampener for the higher yield market has been significantly higher long bond yields in Japan – despite QE – and a stronger yen.

But of particular interest is that higher yields on vanilla bonds in the US have been accompanied by higher yields on the inflation linked variety. The yields on long dated US TIPS (inflation protected bonds) have moved higher, fully in line with the inflation-exposed bonds. The TIPS are now offering a positive real rate of return – the real yields until recently were negative. Thus the difference in these yields – the extra yield on the vanilla bonds being compensation for bearing the risks that unexpectedly high inflation will erode the value of interest income – has not altered much at all. It is therefore expectations of stronger sustainable future economic growth rates and therefore increases in the real demand for capital, that are driving real returns higher.

Higher real returns on capital is surely good news about the US and the global economy because it implies improved growth prospects. Faster growth should augment operating profits, cash flow, earnings and dividends of globally focused companies. The improved bottom lines may well be expected to compensate for the higher costs of capital (or required returns) as interest rates rise.

However this was not the case yesterday. Global equity markets were in strong retreat. The JSE, in rands, lost over 3% of its opening value (though less in US dollars). What was also of interest was that the sharp turnaround in the value of the rand after midday had no easily observable impact on the JSE or the sectors that make it up – it was a deep red colour where ever you looked.

The global companies listed on the JSE, the SABMillers, Richemonts and BATs of this world, did not act as rand hedges either before or after noon. The interest rate sensitive sectors on the JSE – property, banks and retailers – also bled through the day even as the rand strengthened.

A comparison of the price performance of the different sectors of the SA financial markets this year is made below. The increase in long dated interest rates in SA, as reflected by the All Bond Index (ALBI) and its inflation linked equivalent (ILBI) has dragged down the Property Loan Stock Index from a near 20% gain in mid May to a mere 4% up on Monday. Bonds have suffered more than property while equities had done about as well as property by Monday’s close. Using month end data and the JSE at the close on 10 June, we show how the S&P 500 in rands has provided excellent returns this year, over 40% if dividends are included. The global plays on the JSE (the Industrial Hedges) have performed nearly as well while the resource companies, the commodity plays, and the interest rates sensitive SA plays have all lagged. These two groups of companies – those sensitive to interest rates or commodity prices – have both lost about 5% of their rand value since 1 January 2013. The weak rand has, perhaps surprisingly, not helped the commodity plays while, as would have been expected, it has damaged the prospects for the SA economy-dependent plays.

Conclusion

The outlook for the rand, the JSE and emerging markets will be determined by the usual mixture of global forces and SA political specifics (in SA’s case). The recent volatility in financial markets can be attributed to global forces. But the rand is off a much weaker base for SA reasons. The global tug of war between higher interest rates and better growth prospects appears to be under way. Our sense is that the growth team will win this tug of war over moderately higher interest rates in the US, to the advantage of the S&P 500.

The rand and other emerging market currencies, including the weak rand, may well benefit from strength in global equity markets – though not as easily from bond markets. The SA specifics wil lalso continue to influence the value of the rand. Any sense that the mining sector wil not be as severley disrupted by strike action than expected, could bring a degree of rand strength. Even a modest recovery in the rand and bond market will make it easier for the the Reserve Bank to keep its repo rate on hold. It should do so regardless of the exchange value of the rand that is beyond the influence of SA monetary policy – as should be apparent to all.