Category: SA Financial Markets

(From 13 January 2012)
SABMiller and the SA government have in recent days been able to take advantage of the appetite for fixed interest lending by borrowers with favourable credit ratings. The government was able to raise US$1.5bn of 12 year money at 4.665%. SABMiller plc was almost simultaneously able to raise over US$7bn in a variety of maturities at significantly better terms: $1bn maturing in 2015 at 1.85%; $2bn at 2.45% maturing in 2017; $2.5bn of 10 year money at 3.75% (compared with the 4.665% the government paid for 12 year money); and an additional $1.5bn of 2042 notes with a yield of 4.95%.

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Global bond markets 13 January 2012

The SA chances of an interest rate cut have improved markedly. Insuring against the risks of more inflation has also become more expensive. What does this mean for equities?

This week the Monetary Policy Committee (MPC) of the Reserve Bank will meet to set the Bank’s repurchase (repo) rate. Their deliberations were preceded last week by a very sharp downward shift in the Forward Rate Agreements (FRAs) set by the commercial banks. These rates, at which the banks are willing to lend for three months in three months’ time and beyond, indicate the direction of the repo rate to be set by the MPC.

With the bodily shift of the FRA curve lower and the negative tilt of the FRAs, the SA banks have significantly raised the prospect of a cut in short term interest rates in the near future. This probability can be inferred from the level and direction of the forward rates. As we show below the probability of a 50bps reduction in short term interest rates is about 20% this week, rising to over a 70% chance of a cut within six months.

We had judged that the MPC had come very close to cutting rates at its last meeting, having every good reason to do so, given that the economy had been operating well below its potential. But the MPC then blinked and passed on the opportunity. Since then the MPC would have noticed how the Australians and the Europeans have cut rates with a deteriorating global and European growth outlook.

However the rand has not regained the ground it was losing at the time of its last meeting and so the SA inflation outlook will not have improved. Our sense as we have reported from retail and vehicle sales and the growth in cash, is that the local economy has picked up some momentum, even as the global outlook has deteriorated. But any incipient recovery has not been rapid enough to suggest that the gap between actual and potential GDP growth will have closed in any significant way. The housing market in SA has not shown any signs of a recovery in demand or house prices – meaning accompanying weakness in bank lending and, more important, construction activity and the employment that comes with construction and the renovation of homes.

Thus the case for lowering the repo rate is as strong as it was. The question is whether the MPC have had time to gain courage and take the leap to lower interest rates. As indicated such a leap will not come as a complete surprise to the market place.

The outlook for interest rates over the longer term has also changed to a degree. Implicit in the term structure of interest rates is that one year rates will now be lower than previously thought until year five and to be higher thereafter. The yield curve is accordingly steeper – lower interest rates for now but higher over the long term.

This also indicates that the market expects inflation to rise rather than fall over the next 10 years. And so investors in SA, as elsewhere, are prepared to pay up for insurance against higher inflation in the form of accepting much lower (even negative) yields on medium dated inflation linked bonds. The yield on the key 10 year inflation linked US bonds (TIPS) has turned negative again while the benchmark inflation linked RSA bond (the R189) that matures in March 2013 now offers a minimal 5bps yield – meaning that investors are being offered an extra and seemingly attractive 6.5% a year to carry inflation risk over the next few years. The bond market in the US is indicating that over the long term inflation will average about 2% a year. Given all the cash pumped into the US monetary system, but now idle on the balance sheets of banks, and all the cash pumped into and still to be pumped into the European banks, there must be a wide distribution of possible inflation outcomes about this benign 2% average. Hence the low inflation linked yields and the high price of gold (and also by comparison with lower interest rates, both real and nominal, the relatively low costs of entry into equity markets).

Of the US economy

The US economy in the third quarter of 2011 grew at a 2.5% annual rate according to the first estimates released yesterday. Thus earlier fears of a recession have proved much exaggerated. Inventories rose at a slower rate in the quarter, enough to reduce the estimated growth rate by 1.1%. This must be regarded as good news – investment in inventories grew more slowly because final demand was unexpectedly high, implying that output and orders to come will be augmented by planned restocking. Final demands were hugely boosted by a 17.4% surge in spending on equipment and soft ware and spending on non-residential structures that were up by a 13.3% per annum rate in the quarter. US companies are drawing on their piles of cash to add capacity and competitiveness but remain reluctant to add to their numbers of employees.

Of banks everywhere

Banks in Europe were required to write off €100bn of Greek government debt. The banks, against their own wishes, have also been required to boost their impaired capital to 9% of the assets on their balance sheets. Where this capital is to be sourced is not fully known but the much augmented European Stability Facility may well be called upon in addition to shareholders. The upshot of the weekend action taken by European governments (still lacking in detail) was an enthusiastic response recorded in the markets, and in particular in the market for bank shares (and not only in Europe). By the close in New York the Bank of America share price was up 9.6%, Citibank had gained 9.7% and JPMorgan was up 8.3%.

The losses that banks have had to take on their books has been more than made up for in gains in market value. Which again indicates an important point, that raising equity capital (and diluting existing shareholders) can add to the market value of a banking (or any other) share when it serves to reduce meaningful bankruptcy risks. Private shareholders in banks, when called upon to subscribe additional capital in due course, might bear this win-win prospect in mind.

The Eurostoxx Index of Banking Stocks that had fallen by more than 50% between March and September is now about 16% up from these lows. Of the leading French banks, BNP gained 16.93% on the day, SocGen was up 22.5% and Barclays in London gained 17.6%, while our own Investec shares in London were up a more modest 6.4%.

The prospect of being hanged is said to concentrate the mind. Clearly the European leaders were concentrated very hard over the weekend to find a clear way out of the European debt and banking crisis. Also on hand were the leaders of the IMF and ECB. Full details of the plan to revive the credit of European governments and the banks threatened by the possibility of default will be released on Wednesday. But so far so good as far as the equity and bond markets are concerned. Investors understandably have great difficulty in valuing assets given a small probability of a catastrophic event (particularly when nothing like it has ever occurred), such as the failure of the euro experiment and all the financial commitments and contracts associated with the Euro. The markets before and after a fateful weekend in Brussels appear to have reduced the likelihood of catastrophe.

As we show below, some of the upward pressure on the yields of Spanish and Italian bonds has been relieved. When the market is convinced that 6% in euros from the Italian government is a good deal the crisis will be over and the Italians and Spanish governments can then come up with credible long term plans to further reduce their costs of finance.

The equity markets are well off their recent lows, with the S&P 500 leading the pack and up 10.6% off its recent low of 3 October. The JSE in US dollars (despite a weaker rand), has gained 7.8% since 3 October and the MSCI EM is up 8.8% from its low of 4 October.

The very much revised plans (from July 2011) to avoid disaster appear to have a few essential elements. Firstly a much larger write down of Greek debt (from a 30% write down to something more than 50%) appears to be in the wings. The banks suffering these losses therefore will need significant infusions of fresh capital. Clearly European governments – especially governments with fiscal strength – will be an important source for additional capital. However shareholders and sovereign wealth funds will also be called upon; though to what degree and will have to be revealed.

The market in all other vulnerable European government debt will be encouraged by the utilisation of the European Stability Fund. How best to leverage this fund of €440bn has been the subject of particularly intense debate between the French and the Germans. The French have been calling for what in broad terms would amount to unconstrained support (by European taxpayers in one way or another including interventions by the ECB) for all euro denominated European government debt. The Germans, while emotionally strongly committed to the symbolism of the euro have been reluctant to sign a blank cheque.

According to the Online addition of the Wall Street Journal this morning (24 October 2011):

Options for the fund, the European Financial Stability Facility, were narrowed to two after a meeting of euro-zone finance ministers Friday. One is an insurance plan that foresees the fund’s setting aside a pool of money that could be used to offset part of any losses suffered by purchasers of the debt of weak countries, such as Italy. That could entice buyers and keep Italy financed.

The other would be to create a special, separate fund. That fund would raise money from private investors and others, like sovereign-wealth funds, to buy debt of weak countries. The EFSF would also participate in the fund—but would suffer the first losses. Officials said the two options could be combined.

Meanwhile, in other parts of the world …

The markets woke up today on their good side following a strong close in New York. However not all the good news may have emanated from Brussels. It seems very clear now that the US economy grew satisfactorily in the third quarter with the initial growth estimate, to be released, expected to be at about a 3% rate. The US third quarter earnings updates are by now well in hand and the results appear highly satisfactory, with earnings per share estimates for calendar 2011 in the process of being revised upwards again to above $100 per share. According to the FT, reported third quarter earnings from US companies have been ‘remarkably upbeat’. The FT, quoting S&P Capital expects a “blended average of actual and forecast earnings for the S&P 500 to rise 14.6 per cent for the quarter from a year ago…That figure is up from 12.4 per cent a week ago but below the mid July estimate of 16.94 per cent..”

The outlook for the Chinese economy also appeared to have improved over the weekend with official statements indicating no need for additional stimulus or any change in the policy tack. Should the market decide that a solution for the European debt and banking crisis has been found (even as the outlook for minimal European growth remains largely unchanged) the focus of market concerns will revert to the outlook for Chinese and Emerging market growth, helped or hindered (as the case may be) by the outlook for US growth. Brian Kantor

The equity markets have reacted favourably to the G20 meeting over the weekend that promised a comprehensive solution to the European debt and banking crises. Stabilise the debt markets, recapitalise the banks and finally deal with Greece: these are all necessary to calm the markets and are now fully recognised in the highest European circles.

The equity markets over the past two weeks have recovered some of the ground lost in late August, so much so that (including dividend income), the S&P 500 is now about flat for the year. The emerging equity markets, including the JSE when valued in US dollars, continue to lag well behind the S&P 500.

When it strikes, risk aversion appears to infect emerging markets regardless of the sources of the dangers to the global economy that emanate from the developed world. Nonetheless, if the tolerance for risk improves further, the value implicit in emerging market companies and government bonds will attract renewed attention.

The US dollar value of the rand continued to follow the direction of the emerging market (EM) Index and the JSE (which are so closely connected). As we show below, the rand/US dollar exchange rate, while it continues to track the EM Index on a day to day basis may be regarded as somewhat undervalued relative to the EM Index. Fair value for the rand/US dollar (given the level of the EM Index on Friday 14 October) would have been close to R7.50 rather than the R7.80 at which the rand traded. Where the S&P 500 goes the EM Index, the JSE and the rand will follow if the recent past is anything of a guide to the future.

One of the features of the equity markets in recent months has been the extreme daily movements in the indices. It has been reported by the Wall Street Journal that the S&P 500 moved by more than 1% on 56 of the past 57 trading days.

As risks rise and fall, as reflected in daily price moves and the price of options, share prices move consistently in the opposite directions. Volatility is good for the bears but not the bulls in the market: we show below the strong negative relationship between daily percentage moves in the JSE All Share Index and daily moves in the SAVI (the volatility Index priced into options on the JSE). The correlation is -0.710 for the period since 1 July.

The SAVI and the VIX (the volatility Index for the S&P 500) show a similar pattern. The recent decline in the VIX and the SAVI to below 30 must be regarded as encouraging for equity investors. If this declining trend persists (consequent on any gathering belief that the Europeans will sort out their problems) the share markets will move higher. It is not risks that determine returns or returns that determine risk. It is degrees of uncertainty about the future that simultaneously drives risks and returns in the opposite direction as may be clearly seen in the markets on a daily basis.

The European central bankers and finance ministers invited Timothy Geithner, the Secretary of the US Treasury to their weekend meeting in Poland, but did not take that kindly to the sense of urgency he tried to convey. Jean Claude Trichet, head of the ECB, was ungracious enough to indicate that the outlook for European governments’ fiscal deficits at a 4.5% average was significantly better than that of the US. This average however conceals a wide standard deviation about the average which is the European problem and especially the problem of European banks. The Europeans in turn urged the US to adopt its tax on financial transactions proposals that seem like an invisible way to raise revenue – but only if all financial regimes cooperate (something the Americans and British seem unwilling to do).

The markets did not at all like the news flow from across the Vistula River. Increased risk aversion drove equity markets lower. Emerging market equities were especially vulnerable and took the rand predictably lower with them.

As we show below the benchmark MSCI EM Index lost 3% by the close and the rand/US dollar was a little more than 3% weaker as investors hedged their EM bets in the market for rands.

Neither SA rand denominated bonds nor commodity markets escaped the downward draft. Rand denominated bonds are no longer acting as the safe haven they were earlier in the month. Commodity markets, despite yesterday’s declines, can still be regarded as holding up very well relative to the equity markets, helped presumably by superior growth still emanating from the emerging economies.

The shining light yesterday was predictably the higher rand price of gold and the still higher rand price of gold shares listed on the JSE. The gold shares even outperformed the gold price on the day.

The European financial leadership does not appear to take the threats to European banks nearly as seriously as investors in them do. The European banks, represented by the Eurostoxx bank index, has lost over 50% of its value since March. This Index lost about 5% yesterday. The numbers bandied about in IMF and other circles indicate that the Euro banks are undercapitalised by about EUR220bn. European governments do not, as yet, seem willing to assist such an infusion of capital into their banks that would not at all be beyond their financial capacity. Unless Greece does manage to step back from the default brink, such a capital raising exercise will indeed be as urgent as Geithner has been arguing. The Greek drama is surely now very close to its final scenes (one way or the other), in the form of a recue or hopefully orderly bankruptcy proceedings.

What Geithner knows very well, but apparently failed to convince the Europeans accordingly, is that the solution to Europe’s financial crisis is very similar to that of the US crisis – that is pump cash into the banking system without limits to provide liquidity – and also to pump capital into the banks without delay so that they can resume business more or less as usual. The solution to Europe’s and the US’s long term fiscal imbalances will take longer and require much more fundamental reforms that politicians will have to wrestle with.

The rand came under moderate pressure last week – it lost about 2.5% on a trade weighted basis. Compared to a year before, the rand is now about 9% weaker than a trade weighted basket of the currencies of its trading partners.

The rand/US dollar exchange rate has continued to follow very closely the direction given by emerging equity markets, represented by the MSCI EM equity Index. This we show below where the influence of the EM equity index on the rand can be seen very clearly. However, as may also be seen, the rand/US dollar has moved from being somewhat overvalued – relative to emerging equity markets – to marginally overvalued by this criteria. On Friday emerging equity markets moved higher and the rand/US dollar unusually moved marginally lower, indicating perhaps additional forces at work. As we had previously pointed out, foreign holders of RSA rand denominated bonds had sharply reduced their exposures to the rand earlier last week; though they had returned to the market as net buyers on Thursday and were only marginally net sellers on Friday.

Longer term interest rates in SA have reversed a declining trend. The four year R157 recently touched a 6.3% yield then moved higher early last week on these net foreign bond sales but then yields declined later in the week.

It is also of interest to note that emerging market US dollar bond spreads over US Treasuries also widened sharply in recent weeks as global risk appetite diminished in the wake of the European bond crisis. These wider spreads are also consistent with both weaker EM equity markets and a weaker rand (which acts as a proxy for emerging market currencies that are less easily traded and hedged).

The rand continues to be well explained by global economic and financial forces. It remains a play largely on global risk aversion that is well represented by emerging market bond spreads and emerging market equity valuations. These two series remain highly correlated on a day to day basis. As we show below, when risks rise equities fall and vice versa. The rand can be expected to recover its strength should global investors recover some of their appetite for risk. South African specific risks or even expected movements in short term interest rates do not appear to have added much (if anything) to an explanation of the recent direction of the rand.

Foreign investors significantly reduced their exposure to rand denominated RSA bonds over the past two days. They were net sellers of over R7bn on Tuesday and sold a further R2.55bn yesterday. This quarter foreign investors had become enthusiastic net buyers of rand and other local currency denominated emerging market bonds in response to the weakness and volatility in euro denominated bonds. Clearly what had added to rand strength and forced interest rates lower in July and August took something away from the rand over the past two days and reversed recent moves in longer term interest rates.

The term structure of SA interest rates has shifted out over the past few days with the yield curve becoming significantly steeper over the one to five year terms.

The yield on the benchmark four year R157 increased from 6.52% on 31 August to 6.94% on 14 September representing an increase of about 60bps since lows reached on 8 September. The impact of foreign sales can also be seen in the one year rates implicit in the yield curve.

The one year rate, as expected 12 months ahead, has increased from the 7.82% implied on 31 August to 8.15% yesterday. Further along the yield curve the implied shorter term rates are little changed. Further steepening in the yield curve might follow the meeting of the Monetary Policy Committee (MPC) of the Reserve Bank next week. The MPC may choose to clarify its intention to reduce the repo rate in due course. It may even cut rates next week but this must be regarded as unlikely. It should be said that if the case for cutting rates is a stronger one – given the weakness in the global and domestic economies – the case for cutting sooner rather than later will also be a strong one.

The rand however continues to be very well explained by global risk appetite, as fully reflected in the direction of the EM equity markets. Our model, which has successfully explained the rand/US dollar with the MSCI EM Index as the only explanatory variable, predicts the current value of the rand as R7.45.

Thus despite the influence of the bond market the rand is very well explained by the trends in equity markets and we presume will continue to do so. The risks in the EM equity markets are fully reflected in the spread offered by the EM dollar denominated bond index. As we show below, as the risks associated with the Eurozone debt and banking crisis increase (reflected by a widening yield spread over US Treasuries) the equity markets move in the opposite direction. And as EM equity markets go, the rand tends to move in the opposite direction.

The equity markets in New York appeared to gain some late afternoon relief yesterday from the Institute of Supply Management (ISM) survey of the state of nonmanufacturing activity (the NMI) in August. The survey is an influential and comprehensive one covering the very large proportion of economic activity in the US that is service rather than manufacturing based.

To quote the report:

“The NMI registered 53.3 percent in August, 0.6 percentage point higher than the 52.7 percent registered in July, and indicating continued growth at a slightly faster rate in the non-manufacturing sector. The Non-Manufacturing Business Activity Index decreased 0.5 percentage point to 55.6 percent, reflecting growth for the 25th consecutive month, but at a slower rate than in July. The New Orders Index increased by 1.1 percentage points to 52.8 percent. The Employment Index decreased 0.9 percentage point to 51.6 percent, indicating growth in employment for the 12th consecutive month, but at a slower rate than in July. The Prices Index increased 7.6 percentage points to 64.2 percent, indicating that prices increased at a faster rate in August when compared to July. According to the NMI, 10 non-manufacturing industries reported growth in August. Respondents’ comments remain mixed. There is a degree of uncertainty concerning business conditions for the balance of the year.”

Thus it may be presumed that the US economy is still growing but at a modest pace. ISM numbers above 50 indicate positive growth rates. In other words the US economy is not in recession which will have come as something of a relief to the increasingly bearish mood. The employment numbers and hiring intentions indicated in the survey however remain a continued source of economic weakness and uncertainty. The employment sub-index registered 51.6 – therefore also indicating growth but was down from the 52.5 level recorded for July 2011.

Clearly very weak employment growth is the Achilles heel of the US economy and presumably of the re-election ambitions of President Obama. He will address the combined houses of Congress on Friday – on his plans for the economy – but by all accounts expectations are not high about any immediate policy breakthroughs. What could do a great deal for business confidence in the US would be clear directions from the President and his administration that the long term fiscal and debt issues facing the US are being addressed in a serious and realistic way. The concern is that the focus of policy will be on additional short term stimulus measures unlikely to find approval in the House.

The European debt crisis continues to add uncertainty and volatility to the markets with the Spanish government (with the active support of its main opposition) leading the austerity stakes (including support for a constitutional amendment to entrench fiscal conservatism) and the Italian government trailing behind by a day or two – though seemingly able to push through its own austerity programme through the Italian Senate today.

The reactions in the bond market are shown below. As may be seen Spanish 10 year bond yields have now fallen below Italian yields, having traded well above them this year. Such are the rewards for fiscal realism. As may also be seen these yields have been kept under control with ECB support this month. That the key governments under market stress seem able and willing even to bite the austerity bullet will help the ECB to maintain its support. Perhaps it will also encourage Germany to support a Eurozone bond market and the euro in Parliament: the German Constitutional Court has just ruled that this is the responsibility of the Bundestag Budget Committee – so rejecting claims that such support would be unconstitutional.

JSE Index earnings per share in current prices have now regained the previous record levels attained before the global financial crisis and the subsequent global recession, which caused earnings to decline very sharply. As we show below, real JSE earnings, adjusted for rising consumer prices, have also recovered very strongly (though are not yet back to pre crisis levels). This should be regarded as a very encouraging signal about the quality of the companies listed on the JSE.

In the figures below we also compare these earnings to what we measure as cyclically adjusted earnings. These are earnings that attempt to look beyond current earnings and the current state of the economy to establish the long term trends that should drive long term valuations. In current price terms JSE earnings per share by end August 2011 have regained their long term trend (a trend that factors in the post financial crisis decline). In real terms JSE earnings per share have a little way to go to regain their long term trend but are well set to do so.

The real earnings series pictured above deserves close attention. It should be noticed that in real terms JSE real earnings per share only regained their 1980 levels as late as 2005. This recovery in real earnings that began only in 2000 and continued to 2008 represented an extended period of exceptional growth. It was a huge boom in earnings and dividends for shareholders, which was closely linked to higher metal and mineral prices that had suffered from an extended period of deflation since the early eighties. The role of Chinese and Asian growth in stimulating demand for commodities has been crucial for the surge in commodity prices and the earnings of resource companies that account for close to half of all JSE earnings.

The important question that was asked at the end of the earnings boom in 2008 was whether or not earnings in real terms could ever recover their 2008 levels. Or in other words, could the surge in JSE earnings between 2000 and 2008 (that extended to all sectors of the JSE) form a new base from which JSE earnings could grow further in real terms?

The recent recovery in real JSE earnings, that are now almost back to their previous record levels, provides impressive support for the view that JSE real earnings have indeed established a new higher base. This is testament to the global reach of the companies listed on the JSE that are much more exposed to the global economy than the SA economy.

The outlook for JSE earnings in real or US dollar denominated terms will continue to depend upon the global economy from which commodity prices, equity valuations and the rand itself will take their cue. The global economy has recovered from the recession of 2009 and commodity prices have recovered accordingly. We show below that global commodity prices suffered even more than did equities from the financial crisis. However recently commodity and metal prices have held up better than equities, helping to support the view that global growth will not turn markedly weaker.

We show below that the JSE earnings cycle by end August 2011 (with many of the first half earnings reported) has realised growth rates to date of about 40%. As may also be seen the trends in this growth rate has not declined but appears to have stabilised at these levels. Thus if recent trends are maintained, helped essentially by stability in commodity prices, further growth can be expected. When we extrapolate recent trends it suggests that significant further growth in earnings per share may well be realised.

If this were to be the case for JSE earnings per share (as mentioned such earnings outcomes would have to be supported by sustained growth in the global economy) the JSE would be very well and further supported by very good earnings fundamentals.

The JSE has continued to take its cue from global equity markets as has the rand. In recent days emerging market equities have lagged behind the S&P 500, with the weaker rand adding some rand value to the JSE.

The rand itself has continued to closely follow the direction provided by the emerging equity market Index. As we show below, the rand, if anything, is a little stronger rather than weaker than might have been predicted, given the level of emerging equity markets.

The relationship however between equity and commodity markets has not proved so regular over the past few weeks. As we show below commodity prices have held up much better than equity markets. The anxieties that infected equity and debt markets have not damaged commodity markets to anything like the same extent as occurred during the financial crisis of 2008. As we also show below, commodity prices and equity values have tracked each other closely since 2008 as both sets of prices reflect the growth in global economies. These unusual recent trends in commodity prices relative to equities hopefully indicate that the outlook for global growth has not deteriorated as much as feared by equity investors. If so, the demand for equities may also come to be encouraged, as the demand for metals and commodities has been, by extraordinarily low interest rates.

What explains the recent ascent of the gold price to record levels? Is this a sign of extreme anxiety about the state of the world – the end of the world as we know it – or perhaps something else, more easily explained by economic fundamentals?

The performance of gold since 2007 has been impressive indeed. The price of gold has risen almost uninterruptedly since early 2007, by about four times since then, with rather low volatility from day to day. Good returns with low risk are a very attractive combination very likely to attract investor interest. More impressive still is that the price of gold was hardly affected by the global financial crisis of 2008-09 when other commodities and metals (and also equities) fell away so dramatically.

The times have become more uncertain, as is revealed by the indicators of risk and volatility in the form of the volatility priced into options on the S&P 500 (The VIX) as well as the risk spread offered by emerging market (EM) government bonds over the yield on US Treasuries. But as we show below, while these risks have increased significantly lately driving down equity and EM bond prices, they are a far cry from the risks priced into markets at the height of the financial crisis. This is especially true of the emerging market bond spreads which are far below those crisis levels. There may well be a crisis of confidence in global financial markets but, so far at least, it is one far lower on the financial Richter scale than was the crisis of 2008.

How then to explain the much higher price of gold and its more or less continuous ascent? The cost of holding gold is interest income foregone. Perhaps more relevant as an opportunity cost of holding gold is real, after inflation interest rates foregone. As we show below the price of gold has gone up as real interest rates have fallen. The relationship between the falling real yield on a US 10 year inflation linked bond (TIPS) and the US dollar price of gold over recent years an almost perfectly negative one: the correlation statistic is (-0.90).

Gold has gone up as real interest rates have fallen, in a highly consistent way, with the yield on a 10 year Tips now a negative one. Investors are paying up for the right to an inflation linked yield.

Holding cash at even a zero (not negative) yield would seem to offer a superior return. However holding cash is usually in the form of deposits in a bank, which (so some fear) may not to be able to pay the cash back at full face value. This anxiety about the future of banks and uncertainty about future inflation (which may flare up again), may be part of the explanation for negative real interest rates and so the higher price of gold.

However the lack of demand for capital to invest, combined with abundant supplies of savings emanating from China in particular, is a further part of the explanation for very cheap capital and so very low costs of owning gold. These low costs of ownership apply also to other commodities and for that matter equities that pay more or less inflation linked dividends. That gold and other commodities should have so dramatically outperformed equities recently is perhaps the bigger mystery than the price of gold.

The latest twist to the euro debt crisis has come in the form of US money market funds withdrawing cash from European banks. However the European Central Bank (ECB) can print all the cash the banks may require – in exchange for collateral (including European government’s sovereign debt) provided by banks – to replace the deposits lost by the European Banks. This process is well under way.

The ECB in its latest August Monthly Review editorial said that there was “ample liquidity” in the system; enough to keep the ECB still explicitly worried about inflation (amazingly so). Besides indicating its almost ritual concerns about inflation, the editorial also discusses the liquidity supplementing actions under way. To quote the editorial: “While the monetary analysis indicates that the underlying pace of monetary expansion is still moderate, monetary liquidity remains ample and may facilitate the accommodation of price pressures.”

Reference is also made in the editorial to the large and unusual steps that are being taken to add liquidity to the system. To quote the ECB again: “As stated on previous occasions, the provision of liquidity and the allotment modes for refinancing operations will be adjusted when appropriate, taking into account the fact that all the non-standard measures taken during the period of acute financial market tensions are, by construction, temporary in nature…”.

A primary task of any central bank is to save the financial system from imploding for want of liquidity (cash) – caused by a run on the banks – by providing liquidity that it can create without any cost. The withdrawal of US money market funds from Euro banks may be regarded as such a run which could engulf all European banks if it is allowed to degenerate into some kind of panic. This would affect even those banks with strong balance sheets.

Only the ECB has the power to print euros to support the system (the other national central banks tied to the euro no longer have this power). If these other central banks were not constrained by fixed exchange rates to the euro they would be printing money to save their own banks; and if they could there would be no sovereign debt crisis, only an inflation danger. Yet despite QE1 and QE2 and vast amounts of cash injected into the US financial system (that saved it from imploding) the danger of US inflation remains a very distant one, as indicated by very low yields on US Treasury Bonds. The low yields on German bonds indicate the same and make the ECB’s concerns with inflation given the current uncertainties seem otiose. It should be encouraging to those anxious about the future of European banks, their sovereigns and the euro that current spreads on Italian and Spanish government bonds have declined from well over 6% and stabilised around the 5% level. Any downward move in these yields would be comforting; any significant move higher would add to anxieties.

The ample liquidity that the ECB refers to is taking the form of increases in the deposits the Euro banks are holding with their central banks. Like their US counterparts the banks in Europe are holding cash in excess of their legal reserve requirements though, as in the US, not enough cash to prevent the European money supply, broadly defined, from growing. Though, as we show in the chart below, this money supply growth may be slowing down in Europe while picking up in the US. This pick up in money supply growth rates, despite little growth in bank lending, is very welcome and not consistent with a recession.

The question is asked as to why European banks are now valued at considerably less than the value of their books. The answer is that it is only partly to do with the crisis of confidence in the survival prospects of the banks themselves. The quality of the assets on the books of the banks, including sovereign debt, is suspect. Also, the banks are holding more cash earning very little or no interest income, implying lower earnings to come. Furthermore, of perhaps greater significance for the value of banks, the European banks will have to or be required to raise additional capital to secure their futures. The capital may come from the market or, if shareholders are not forthcoming, from their governments. The earnings outlook for European banks is not promising. They will survive – but may not be able to generate returns on capital that justify any premium to book value.

In the midst of market turbulence it may prove helpful to focus on earnings rather than prices. Index weighted earnings per share reported by the Resource companies listed on the JSE over the past 12 months have risen very sharply.

These earnings per share in rands have grown by about 80% over the past 12 months (given rand stability the growth rates in rands have been very similar to growth recorded in US dollars). Resource companies have significantly outperformed other sectors of the JSE on the earnings front. Yet when valuations are considered, JSE Resources have proved distinct underperformers since the beginning of the year. JSE resources, when compared to the Financial and Industrial Index, are about 20% weaker than in early 2011.

Clearly the share market must be expecting a very sharp decline in resources earnings from current levels to have derated the sector as much as it has. As we show below, the peaks in the resource earnings cycle have often been associated with declines in the price to earnings ratios established for the sector. This relationship – a peak in the price to earnings multiple and a trough in the earnings cycle – appears particularly obvious over the past 12 months. The earnings cycle is approaching a very high peak while the price to earnings multiple has headed sharply in the other direction.

The valuations therefore seem to be predicting the impact of a global recession on underlying metal and mineral prices and therefore in turn on resource earnings.

Commodity prices have however have held up over the past and in recent turbulent weeks rather better than equity valuations, as we show below. Recession fears – especially for the global economy – may be overdone. If so commodity prices may remain resilient and current resource valuations will then prove very undemanding.

The equity markets late yesterday in Europe and also late in the New York day made a spectacle of themselves and it was not a pretty sight at all, especially when the futures on the DJ Industrials and S&P 500 moved sharply higher after the close. The biggest losers (on a day that saw the major markets down by more than 4%, having been up by the same percentage more or less the day before) were the European and US banks.

SocGen, a major French bank, was down over 26% by the close of the trading day on rumours, soon denied, that French sovereign debt was about to be downgraded by the rating agencies. BNP Paribas lost 11% on the day and Credit Agricole almost 15% off. On the other side of the Atlantic, Bank of America was down another 10.9% while Citi and Goldman Sachs both lost 10.5% on the day. JPMorgan escaped relatively lightly with a 5.6% loss and Wells Fargo was down 7.7% on the day.

We have pointed out before that no national bank can hope to survive the default of its sovereign, or even in some senses, the serious expectation of its default if it were forced to revalue its assets at their reduced market value. This is because the presumed safest part of the banks’ balance sheets are committed and required by banking rules to be invested in significant proportions in sovereign debt.

The way governments and their banks usually avoid notional default on their debts is by printing money. This may mean more inflation, but also avoids banking failure since the banks’ assets and their liabilities also inflate more or less to the same degree.

The European Central Bank (ECB) is the only central bank in the euro system with the power to print euros. It continues to demonstrate a degree of reluctance to do so, out of fear (or perhaps German fears) of providing an easy way for European governments to get out of their fiscal crises and so avoid the necessity of cutting spending. The reality is that the ECB will have no alternative but to buy the bonds of threatened European governments if a banking crisis is to be avoided; or to indicate that it would be prepared to do so aggressively if called upon. Such unambiguous intentions might in themselves be more than enough to put the bond and bank short sellers to flight. The primary purpose of any central bank is to avoid a financial crisis and to use its considerable (and essential) power to print money without limits in order to prevent crisis. Further, when circumstances permit, they have the power to take the cash back again, usually with the profits that come with crisis resolution. The actions taken by the US Fed to pump money into the US financial system not only saved the system but did so at a profit to taxpayers. The ECB no doubt is well aware of this responsibility. Exercising it with vigour is well overdue. After all, financial instability is a threat not only to the financial system but to the real economy.

It is of interest to note that the emerging equity and the commodity markets (and so the rand) after having been engulfed by global fears on Monday, actually ended yesterday higher rather than lower. The volatility yesterday was clearly a crisis of confidence in European banks and in the willingness of the ECB to deal with it rather than new fears about the global economy. Commodity markets in general, as represented by the Reuters CRB Index can be regarded as having survived rather well the recent revival of risk aversion

The world as reflected in equity markets has become a riskier environment. Day to day and even intraday, share price movements have become more pronounced (volatility or risks rising) with an inevitable and distinct downward bias. The outlook for the global economy has become more uncertain and this uncertainty has been demonstrated in the form of lower and more volatile valuations. In the figure below we show how much daily percentage moves in the S&P volatility indicator, the VIX, and daily per cent moves in the S&P 500 have increased over the past week.

In a clearly riskier environment such as this, a degree of rand weakness might have been expected. In fact the rand has held up very well against not only the US dollar and the euro, but also the Aussie dollar and the Brazilian real.

The explanation for these unusual currency events – the rand strengthening in a riskier environment – deserves an explanation. The explanation is to be found in the behaviour of emerging equity markets from which the JSE and the rand take their cue. Emerging equity markets have held up better than the US market. It may be seen that this quarter and particularly this week, the emerging market (EM) Index has declined less than has the S&P 500. The average EM market by the close on 2 August was off by a mere one and a half per cent compared with 30 June. The S&P 500 had lost nearly 5% over this period and the JSE about 3% in US dollars.

Moreover the emerging markets have not been as volatile as the New York equity markets. The volatility priced into options traded on the JSE represented by the SAVI is now less than that of volatility priced into the S&P 500, as represented by the VIX that.

And so when we run our model (utilising daily data since January 2009) to explain the rand/US dollar exchange rate with the EM Equity Index, the model predicts a rand/US dollar rate of R6.90 compared with an actual R6.80 on 2 August.

The enhanced risks therefore may be recognised as more uncertainty about the outlook for the US economy than anxiety about the prospects for emerging market economies (as well as the companies that serve them, including those listed on the JSE). This makes every sense. It is the developed world that needs to get its fiscal house in order, not the emerging economies that are mostly in comparatively good economic and fiscal shape.

Perhaps the agitated state of the developed equity markets indicates that there is now even less confidence in the ability of the Obama administration to sustain faster US growth, given the shenanigans that accompanied the lifting of the US debt ceiling. It was not the President’s nor his party’s finest hour.

It is surely up to President Obama to prove that the market is misjudging him. But he has little time to prove the market wrong before facing the US electorate in November 2012. To build the confidence that would revive spending plans of firms and households and employment, he would need to convince Americans that he can implement a realistic long term plan to deal with the US deficit without raising tax rates. Faster economic growth is essential to this purpose. Such a plan would have to include critical features like reining in the threatened runaway government spending on medical benefits under Obama care. This will not come easily.

The recent strength of the rand should not have come as a surprise. The rand has continued to follow very closely the day to day the direction provided by emerging equity and bond markets.

A simple regression equation linking emerging equity markets (represented by the benchmark MSCI EM Index) to the rand explains over 95% of the daily value of the rand as we show below. This model predicted a value of R6.80 on Wednesday 27 July, slightly weaker than the R6.70 at which the rand traded that day.

This relationship seems obvious and persistent enough and very likely to continue: where emerging market (EM) equity markets go and where global growth and risk appetite take them, the rand will follow.

The explanation for the strength of the relationship is perhaps less than obvious. That the JSE All Share Index, especially when converted to US dollar, also follows the EM Index very closely, is part of the explanation. This connection that makes the JSE so highly representative of the average EM is by no means accidental. As we have pointed out, JSE earnings in US dollars follows average EM Index earnings as closely as does the Index. This is because the major companies listed on the JSE have a global and emerging market economy reach, rather than being dependent on the SA economy. And so capital tends to flow into and out of the JSE and the SA bond market, depending on the simultaneous direction being taken by the EM equity and bond markets generally.

It should moreover be recognised that the market in rands is a large, active and liquid global market. Each day up to US$20bn worth of rands is now being traded according the SA Reserve Bank. Much of this trade is conducted between third parties not directly engaged in SA trade or finance; they are presumably trading the rand because they can easily do so and are doing so because presumably the buying and selling of rands enables traders and investors to hedge exposure to Emerging Markets and their currencies that cannot be traded as easily.

This makes the rand much more of an emerging equity market currency and much less influenced by the direction of SA foreign trade and the implications that inflation differences, or purchasing power parity (PPP), can have for this trade. Exports are encouraged when the rand is undervalued – that is exchanged for the US dollar at a lower rate than its PPP equivalent; while imports are encouraged when the US dollar is cheaper and can be bought for less than its PPP equivalent value.

It all depends on where you start

The history of the rand relative to its PPP value, that is, its value explained by the difference between higher SA inflation and lower US inflation alone is shown below. In the decade of the 1990s the rand stayed close to PPP until 1995. Thereafter it depreciated at a much faster rate than PPP until the rand blew out in 2001. By then the rand was substantially undervalued relative to PPP. However by 2011, the rand was back to its 1990 PPP equivalent.

Thus if we begin the calculation of PPP in 2000 and carry it forward until now, the picture becomes very different. By 2011 the rand, compared with its PPP value, is substantially overvalued compared to its undervalued position in 2000 and 2001. The PPP value for the rand today (with January 2000 taken as the starting point) would be about R9 to the US dollar. But the strength of the rand over the last decade was due to the recoveries from two major shocks: the 2001 shock was almost completely domestic in origin – it was linked to the initiation of the asset swap facility. The shock in 2008 and the recovery thereafter represent the impact almost entirely of global forces (that is the impact of the global financial crisis on all emerging market currencies) including the rand and the subsequent recovery from this crisis.

As indicated, the rand cannot be well explained by PPP. Capital flows explain these differences from PPP and will continue to do so whatever the SA Reserve Bank might hope or try to do about this by interventions in the currency market. The market is just too big for the Bank to hope to muscle in one or other preferred direction.

These flows and their influence on the rand were severely restricted by exchange controls before 1995. Capital flows were captured within the financial rand pool and the financial rand exchange rate insulated the (commercial) rand. These controls were lifted for foreign investors in 1995 and gradually for SA investors ever since. The relief of the exchange control log jam after 1995 and panic demand for asset swaps by individuals in 2001 explains most of the persistent weakness of the rand between 1995 and 2001 (just as the global financial crisis explained the weakness and recovery in 2008-2010). By 2002 global forces had taken over the exchange value of the ZAR.

It should be appreciated that with the almost complete lifting of exchange controls and the trading appetite for rands abroad, the rand is no longer a one way bet. It is much more a bet on emerging markets. Those who like to believe that rand weakness (given higher SA inflation) is a fact of economic life should think again. And they should also appreciate that a stable rand helps to reduce inflation pressures in SA.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 29 July

The JSE and emerging equity markets (as measured by the MSCI EM Index) have moved sideways this year. However, in something that is consistent with the now very well established pattern, the two markets indices have moved closely together day to day and month to month. Furthermore the rand, confirming another well established relationship, has continued to move closely in line with the emerging market Index.

Our model of the rand/US dollar (which includes only the MSCI EM Index as its explanation) indicates that fair value for the rand/US dollar on 12 July (given the level of the EM Index) was R6.90 compared to a closing value that day of R6.85. The fit of this model run with daily data since 1 January 2009 is extraordinarily good.

The strength of the association between the value of the MSCI EM and the JSE is explained only in small part by the fact that JSE listed shares constitute 8% of the EM Index itself and therefore attract the interest of emerging market (EM) fund managers. The relationship is more fundamentally explained by the fact that the stream of JSE All Share Index earnings per share, in US dollars, approximates very closely those of the earnings per share generated by the EM universe itself. Thus the values attached to these expected streams of earnings, by global portfolio managers, are highly comparable.

Investec Securities has created its own large market cap EM Index of about 190 individual EM companies and aggregated their earnings per share to derive both an Index called the IBICEMI and its associated Index earnings per share. As may be seen below, the IBICEMI tracks the benchmark MSCI EM Index very closely and may be considered fully representative of benchmark earnings per share.

It may also be seen how closely JSE earnings per share and EM earnings per share have been related over the years. Both earnings series demonstrated extraordinarily rapid growth in earnings measured in US dollar through the boom years of 2002-2007 before the onset of the global financial crisis in 2008. Moreover EM and JSE earnings survived the crisis in much better shape than the S&P 500 and earnings per share now exceed their pre-crisis peak levels in US dollars. The JSE Index in US dollars is now above its pre crisis peak values while the MSCI EM has still to reach pre crisis levels. This re-rating of the JSE relative to the EM ( values rising ahead of earnings ) may be seen below with the JSE trading at a 14.85 times reported earnings and the IBICEMI EM Index trading at a lower 11.21 times trailing earnings.

This rerating of the JSE may be explained by the respective earnings cycles. JSE earnings per share, while following a similar path, have grown significantly faster over the past 12 months than EM earnings represented by their large caps. JSE earnings per share measured in US dollars grew by about 46% in the 12 months to June 2011 while EM earnings growth was a less robust 26% over the same period. Clearly the relatively greater dependence of the JSE on Resource companies and their earnings has served the JSE very well as metal and commodity prices moved ahead of their year ago levels.

It can be confidently predicted that the values attached to Emerging Markets and the JSE will continue to be strongly influenced by earnings reported and expected. It can also be predicted, though perhaps somewhat less confidently, that the foreign exchange value of the rand will continue to be determined in large measure by the state of emerging equity markets. The JSE, the EM equity Indexes and the rand can be confidently predicted to remain highly responsive to the outlook for the global economy, to which emerging market economies contribute most of the growth.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 15 July 2011: The JSE, rand and emerging markets: Following the same path

The benchmark Emerging Equity Index lost a further 2.2% last week in response to the uncertainties associated with the ongoing Greek debt saga. The New York indexes held their ground as the news about the state of the US economy improved marginally.

The SA component of this index, the MSCI SA, as may be noticed, did better than the average emerging market thanks to a rand that held up very well in the circumstances of the increased risks being priced into global markets. Both the volatility priced into options on the S&P 500, the VIX index and the emerging market bond spread reflected the lesser appetite for risk late last week.

The trade weighted value of the rand last week was only fractionally weaker by the weekend which in the circumstances of elevated global risk must be regarded as a surprisingly good outcome. The rand/US dollar exchange rate can be very well explained by the emerging market equity index and on this basis the rand can be regarded as very marginally overvalued, to the order of about 3.5%. In the figure below we show the results of this model that predicts the value of the rand/US dollar using the MSCI Index as its only explanation. The fit of this model using daily data since early 2009 has been exceptionally good, as may be seen.

It seems to us that the equity markets are well supported by undemanding valuations relative to earnings and dividends. The fixed interest markets continue to offer very little competition for savings and seem unlikely to do so within the next 12 months. It seems to us also that despite the crisis in Europe, the outlook for the global economy, US weakness taken into account, remains satisfactory enough to make further good growth in earnings from globally focused companies a very likely reality. Currently lower oil prices will help materially to this end.

The future of the euro, or rather, the continued participation of Greece in the Eurozone remains uncertain. How far the German and French leaders are prepared to go to avoid what appears unthinkable to them, and that is a breakup of the euro, and how much help they will be getting from the Greeks to this ideological end, remains unresolved. The likelihood of Europe (that is, Northern European taxpayers) footing ever more of the bill for European unity seems to us somewhat more, rather than less, likely post this weekend’s deliberations. The equity markets would surely like confirmation of their willingness to pay the price for the failure to date of Europe to co-ordinate fiscal and monetary policy. It is a failure that will have to be addressed with or without the active commitment of Greece

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 20 June: The rand: Remarkably unaffected by global risk aversion