Category: Global Financial Markets

The S&P on Monday lost 4% by its close. The Dow had its largest one day loss in history, over 1000 points. In percentage terms it was the worst day for the New York markets since September 2011.

It is easier to understand what didn’t move the New York markets on Monday than what did. It was not any economic news, which was notably absent on the day. Nor was it interest rates. Interest rates moved the markets on Friday when they rose sharply in response to the impressive employment report. Both real and nominal bond yields closed sharply lower by the close on Monday and have maintained lower levels compared to Friday’s close on early Tuesday morning, even as the equity markets remained under pressure before the markets opened.

The most conspicuously unusual behaviour on markets was registered by the CBOE Volatility Index, the VIX. It closed 20 points higher at 37, the largest point and percentage change in this Index ever. And most of this increase took place in the last two hours of trading: it moved from 10 to over 30 in two hours. It appears that much of the price move and the huge volumes of trading activity associated with it was the result of special funds attempting to close out strategies based upon low volatility. Their attempts to do so forced up the Index and forced share prices lower.

The issue for market commentators before the market opened was how soon, as it is described, the systematic bid for volatility would subside. Judged by the strong recovery of the equity markets (S&P up one per cent as I write on Tuesday evening) in the first hour of trading the danger posed by rebalancing volatility strategies may have passed. Yet volatility – the form of minute to minute movements in share prices and Index averages of them – remains highly elevated. The VIX on 6 February continued to trade at these elevated levels as the market indices gyrate between positive and negative values.

Some economic realities

Perhaps in times when economic fundamentals appear irrelevant to company valuations, it is good to be reminded of just what has been happening at the economic coal face. Though coal is surely the wrong metaphor, the companies we refer to here are moving the frontier of economic activity – of how we work and consume that has changed so dramatically.

Some of the leading new economy companies reported their results for Q4 2017. The scale of their operations and the growth in their revenues is nothing less than very impressive. Apple for example reported quarterly sales of $88.29bn, up 13% on the same quarter in 2016. Amazon reported Q4 sales of $60.5bn, up no less than 38% on the same quarter a year before and up 31% for the year. Facebook grew sales in Q4 2017 to $12.97bn and by 47% and Alphabet generated revenues in Q4 of $32.32bn, up 24%. And Microsoft (in business for much longer) grew its sales in Q4 2017 by 12%, to $25.83bn.

All these companies that are thriving impressively and are being generously valued accordingly – described as the FAAGMS – have a competitive and a regulatory threat. Their success to date is as vulnerable to disruption by competitors – known and unknown – as they have proved to be to what were then established ways of doing business.

However their success and the market dominance it seems to create – of which their approving customers are the arbiters – is bound to attract the attention of regulators and tax collectors. That is of economic agents, with interests and powers of their own, who are philosophically unwilling to concede the race for dominance in a market place is to be determined by consumers and regulate accordingly. They would do well to accept that what constitutes the relevant market place is fluid and incapable of being usefully defined and confined. Competition for the budgets of households and of all the firms that ultimately compete for their favour remains highly intense, as the fast growing sales of the Apples, Amazons, Facebooks, Googles and Microsofts prove. Society should best leave the unpredictable outcomes to this competition. 7 February

Equity markets and interest rates in the US – will we avoid inflation surprises?

The equity markets in the US have had an outstanding run. The S&P 500 is up 26% since January 2017 and has advanced with unusually low volatility. Day to day movements in the Index have been very limited by the standards of the past. The fundamentals of the market have been supportive of higher valuations. High operating margins and rising earnings, with upward revisions of earnings to come, combined with still low interest rates, have attracted these higher valuations. The future of earnings and margins has been further enhanced by the income tax cuts for corporates, small businesses and individuals. The animal spirits of corporate leaders are stirring, promising a boost to the economy from a strong pick up in capital expenditure.

The concern is that unexpectedly higher interest rates can offset these benefits, as earnings are discounted to estimate present values. As we show below, US Treasury bond market yields have been rising this year – but from abnormally low levels. Nominal yields for 10-year money have increased this year from 2.45% to current levels of 2.72%. So have real yields – they have risen from a very low half a per cent in early 2018 to over 0.6% now. Furthermore, the gap between nominal and real inflation protected interest rates has increased from 2.45% at the start of 2018 to the current level of over 2.7%. This spread reveals the inflation rate predicted by the bond market. The bond market is anticipating and being compensated for slightly more inflation expected over the next 10 years.

The Fed’s target for inflation is 2% – a target that it is still to meet and is by no means certain of meeting any time soon. The Federal Open Market Committee, reporting this week (31 January 2018) still expects inflation to stabilise around its 2% objective over the medium term in its latest statement. It also repeated its view “that near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely…”

The most supportive scenario for the equity market will be one of rising real interest rates – indicating stronger growth in demands for capital – coupled with still very subdued expected inflation that will sustain low nominal interest rates. It is not higher real interest rates that represent danger to equity valuations. It is more inflation expected that would drive nominal interest rates higher that represent the threat to equity markets. Not only the Fed, but the markets, will be watching inflation developments closely. They will also be watching each other closely to avoid inflation surprises. Equity investors must hope that inflation does not surprise on the high side. Low inflation and strong real growth are what equity markets will thrive on, as they have done lately. 2 February 2018

SA is very open to international trade. The aggregate value of imports and exports in any year is equal to 50% of GDP. Yet all this great volume of trade across borders is subject to highly volatile exchange rates. This volatility adds considerable risks to exporters, importers and those who compete with imports and exports in the local market.

What matters for the operating margins of businesses is exchange rates adjusted for differences in inflation between trading partners. These are known as real exchange rates. An undervalued exchange rate will add to profit margins, while an overvalued one – should the exchange rate change by less than the differences in inflation – will depress margins.

When the offset is complete, or when what is gained or lost on the exchange rate is equal to the difference in inflation rates, purchasing power parity (PPP) exchange rates are said to hold. In such a case, the prices of common goods or services delivered in any market place will be about the same when expressed in any common currency. Real exchange rates above 100 indicate overvalued exchange rates while real exchange rates below 100 indicate the opposite: an undervalued or generally competitive exchange rate.

It is however changes in nominal exchange rates that are the predominant force behind changes in the real exchange rate. In SA and elsewhere, frequent shocks to the exchange rates lead the process and inflation rates follow.

However the SA experience with real exchange rate volatility is by no means unique. The trade-weighted real US dollar exchange rate has been even more variable than the real rand exchange rate. And those of Europe and the UK are similarly variable.

In figure 1 below we show the performance of the US dollar rate of exchange against its developed market peers (DXY). We also show the real dollar exchange rate against its major trading partners. The pattern has been a highly unstable and destabilising one for the global economy, which relies on the US dollar as a reserve currency and unit of account.

 

 

We compare below in figure 2 a variety of trade weighted real exchange rates for the period 1995- 2017. As may be seen, all these real exchange rates are highly variable. Not co-incidentally, the real trade-weighted rand moved in very much the opposite direction to the real US dollar. The real euro and real sterling have also been highly variable since 1995. A consistently overvalued, less competitive real sterling between 1996 and 2007 can be identified. More recently, with Brexit in sight, sterling has become much more competitive.

 

Moreover none of the real exchange rates considered above can pass a statistical test for mean reversion. The Chinese and Japanese real exchange rates trends shown below conspicuously do not revert to the theoretical PPP 100. The real yuan has had a distinct and persistently stronger trend (off what was a very undervalued base in the mid-90s) while the real yen moves persistently weaker off what was presumably a very overvalued base in 1995.

 

How should monetary policy react to exchange rate shocks?

This global nominal and real exchange rate volatility – as well as the lack of mean reversion to trade neutral purchasing power parity exchange rates – has greatly inconvenienced global trade. It has also greatly complicated the reactions of central banks.

We would argue the best approach central banks should adopt to exchange rate shocks is to ignore them. This is because such shocks are unpredictable and largely beyond their control. They have little to do with competitiveness in international trade and almost all to do with capital flows responding to changes in expected returns across different economies. If such exchange rate shocks are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should be recognised that dollar strength and other currency weakness in response to persistent capital flows can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness and also emerging market currency weakness observed between 2014 and mid-2016. Ditto the higher inflation rates that followed.

But to react to exchange rate shocks as if they threatened permanently higher inflation is to make monetary policy hostage to the unpredictable US dollar exchange rate. Monetary policy in the emerging market world would do better to moderate rather than exaggerate the shocks to spending intentions and confidence that may emanate from the market in foreign exchange.

Unfortunately the SA Reserve Bank, from early 2014, added higher interest rates to the contractionary forces emanating from a weaker exchange rate. We regard this as an error of monetary policy that unhelpfully further reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

Monetary policy in the US understandably does not react to the exchange value of the dollar. Thus when investing abroad (investments that always carry extra risks given exchange rate volatility) a bias in favour of US-based investing seems appropriate. Or, in other words, the risks posed by a volatile real and nominal US dollar to monetary policy and real economic activity everywhere else are best hedged by investing in the US rather than in more macro policy error prone economies. 9 November 2017

These are very good times for emerging market (EM) equities and currencies. The MSCI EM equity index continues to power ahead and has gained over 25% this year. This may be compared to a gain of about 10% for the S&P 500 and the average European equity. The JSE All Share Index has also had a good year and is up by about 16% in US dollars (see figure 1).

A degree of perspective on these recently favourable equity trends is called for. As we show in figure 2 this EM outperformance has come after years of underperformance between 2011 and 2016, as is shown in figure 2. The EM comeback is still very much a partial one that dates from the first quarter of last year. Perhaps some encouragement can be taken from this perspective.

The EM equity comeback (measured in US dollars) can be attributed partly to a weaker US dollar and stronger EM exchange rates. In figure 3 below, we compare the performance of the US dollar vs other developed market exchange rates – mostly vs the euro. The US dollar has weakened significantly since January 2017, by about 8% according to the trade weighted (DXY) index, while the index of EM currencies vs the US dollar has shown a similar degree of strength. The EM Currency Index calculated by JP Morgan (JPMEMX) includes a small weight in the rand. The rand/US dollar exchange rate has performed in line with the average EM exchange rate. Note higher numbers in these figures indicate a more favourabe rate of exchange.

This strongly negative correlation between US dollar weakness vs its peers and EM currency strength vs the US dollar is of long standing, as we show in figure 4 below. The correlation coefficient is of the order of a negative (-0.83) using daily data.

Thus much of the recent strength in EM currencies, including the rand, reflects US dollar weakness vs its peers. As we will demonstrate further below, the recent strength of the rand is much more a tale of the US economy vs its developed market peers than of political and economic developments in SA. The rand has performed very much in line with its own EM peers against the USD,

EM economies and their equity and currency markets have clearly benefitted from a recovery in metal and commodity prices that are dependent on global demands. The global economy has grown faster and in a highly synchronised way in recent months. This news about the state of the global economy has become more encouraging for metal producers. The underperformance of EM currencies and equities since 2011 and their recent recovery is closely associated with the recovery in metal prices, as we show in figure 5 below. Metal prices bottomed out in mid-2016 and have enjoyed a strong move higher since mid-2017, as we show in figure 6.

We can recall the days when the BRICS, Brazil, Russia, India, China and, a later inclusion, South Africa, were the darlings of the commentators. Their growth prospects were fueled by the super-cycle of commodity prices and improved equity markets – until the global financial crisis of 2008 intervened.

Commodity prices and emerging market (EM) equities recovered strongly after the crisis, but then in 2011 fell away continuously, until mid-2016. This took down the exchange value of EM currencies, including the rand, with them and forced inflation and interest rates higher, so adding further to the BRIC misery.

The economic and political reports out of Brazil in recent days are particularly discouraging. Its current constitutional crisis and likely upcoming elections will make it more difficult to enact the economic reforms that could permanently improve the economic prospects for the country. The trajectory of its social security expenditures and lack of revenue from payroll taxes will take the social security funding deficit, currently 2.4% of GDP, to 14% by 2022, according to the IMF. But these fiscal problems are compounded by a recession that shows little sign of ending.

The disappointments of the BRICS moreover forced attention on the “Fragile Five” of Turkey, Brazil, India, South Africa and Indonesia. These are economies with twin deficits – fiscal and current account of the balance of deficits, that makes them especially vulnerable to capital flight. Some investors have found consolation in this slow growth. Slow growth has seen these current account deficit decline markedly. In the case of South Africa the current account deficit – the sum of exports less exports, plus the net flow of dividends and interest payments abroad – has declined markedly from near 7% of GDP in 2013 to less than 2% in Q4, 2016, and is likely to have fallen further since.

These trends have made the SA economy and its fragile peers appear less dependent on inflows of foreign capital, thus making the spread between the yield on its bonds and safe-haven bonds attractive enough to attract inflows of capital and provide support for the local currencies. In mid-2016 the declining trend in EM exchange rates and commodity prices (not co-incidentally) was reversed, as was the outlook for inflation.

These reactions however neglect the more important vulnerability of the SA and the Brazilian economies to persistently slow growth. That is the danger slow growth presents for social stability. The capital account inflows no more cause the current account deficits, than the other way round. The force driving both sides of an equation is an equality is the state of the domestic economy and its savings propensities. In the case of SA, Brazil or Turkey, should the growth rate pick up, so will the current account deficit and the rate at which capital flows in. If the capital proves expensive or unavailable, the exchange rate will weaken, inflation will rise, the prospective growth will not materialise and the current account deficit will remain a small one.

Were Brazil or South Africa to adopt a mix of policies that reduces risks and improves prospective returns on capital, the long-term growth outlook will improve and their economies will grow faster. And they will have no difficulty in attracting the capital to fund the growth. Growth could lead and capital will follow in a world of abundant capital.

South Africa and Brazil have more in common than slow growth and fiscal challenges. They have similar degrees of political difficulty in adopting growth-enhancing reforms. The best they can now do, absent a credible growth agenda, would be to aggressively lower short term interest rates. This would improve the short term growth outlook and help attract capital and, if anything, help rather than harm the exchange rate. It remains for me a source of deep frustration that the SARB remains so reluctant to take the opportunity to improve growth rates, without any predictable impact on inflation. 26 May 2017

Overcoming the Trump shocks and drawing its implications for SA and Reserve Bank action

The Trump shock has been working its way through the markets. Expectations for US growth under Trump were revised upwards, which benefited US equities generally. Emerging market (EM) equities by contrast have suffered both absolutely and relatively, with the JSE in US dollars performing as it usually does, in line with the average emerging market, with both losing about 6% of their pre-Trump US dollar values.

The market and central bank governors have long feared the impact of higher bond yields in the US on EM currencies, inflation and interest rates. Long term RSA bond yields rose immediately, in sympathy with higher US bond yields. But recent interest rate trends in the RSA bond market have proved much more encouraging. Yields have receded as the spread between RSA and US Treasury bond yields have narrowed, leaving rates little changed from their pre-Trump levels. These are helpful trends and indicate that a feared “Trump tantrum” in the RSA bond markets has not materialised.

A related and similarly favourable reaction can be observed in the currency market. The rand weakened against the US dollar, along with other EM currencies, with the Trump election. But more recently the rand has regained its pre-Trump US dollar value and has performed better than the average EM currency since. More important is that the trade weighted rand has gained significant strength as we also show below. The trade weighted rand is now as much as 24% stronger than it was in mid-January 2016. This strength translates directly into lower import and export prices and so less inflation and less inflation expected.

Not all the recent economic news has been encouraging. The latest GDP release for the third quarter indicates that SA growth trends have deteriorated. Spending by households and the government is barely increasing while capital expenditure by private businesses and public corporations declined significantly. The GDP growth rate of a mere 0.2% in the third quarter can be attributed to an extraordinary growth in investment in Inventories in the third quarter that was enough to offset a very poor reading on net exports. A better net export performance in the fourth quarter and beyond may help compensate for a likely decline in inventories.

The economy will have to grow at a minimal 2-3% rate to cause the rating agencies to sustain our credit rating. It will take meaningful growth enhancing structural reforms to raise growth rates permanently to higher levels. These appear unfortunately unlikely and would take time to achieve results.

A cyclical recovery is however distinctly possible and could take GDP growth up to a 2-3% pace. Such a cyclical recovery would have to be led, as it always has to be led, by a significant pick-up in household spending propensities. Households have to spend more to encourage firms to invest more in equipment and people to meet their extra demands. Lower short term interest rates are essential to the all-important purpose of a cyclical recovery.

Inflation in SA is now very likely to recede below the upper band of the inflation targets. There is always a risk that these recently favourable trends may reverse. But there is a much greater probability that the economy will continue to stagnate dangerously, leading to political and economic stability for want of a stimulus to spending. Inflation is no self-fulfilling process in SA. The relevance of so-called second round dangers to inflation that may accompany inflation expectations is a theory for which there is no good evidence. Inflation expected is much more likely to follow than lead inflation as the evidence does reveal.

The Reserve Bank focus, narrative and action should respond accordingly by addressing the downside risks to the economy and lowering interest rates. And by recognising an improved outlook for inflation, rather than to focus further on inflation risks, over which they have no predictable influence. 8 December 2016

The market reacts to a surprising US election. Is more growth expected in the US consistent with less growth in emerging economies? Perhaps not.

Donald Trump’s ascension to the White House surprised the financial markets. The bond markets have recorded the largest surprises. A heavy dose of shock and awe was registered in the Treasury bond market and the shock waves were also felt in emerging bond markets, including the market for RSA bonds. US 10 year Treasury yields ended last week over 30bps higher (as we write on Monday 14 November, the yield is 2.21% p.a). The RSA 10 year also ended the week higher at 9.11% p.a (now 9.17%) or 44bps higher, meaning a slightly wider SA risk spread of 6.95% p.a. – equivalent to the average rate the rand is expected to depreciate against the US dollar over the next 10 years.

The higher rates in the US were not confined to vanilla bonds. Inflation linked yields (TIPS) also moved higher on Wednesday 9 November, revealing that the Trump presidency was expected by market participants to not only bring more inflation but also faster growth; faster growth that was expected to increase the competition for capital, so making capital more expensive in real terms.

RSA yields indicated that more SA inflation came to be expected as real bond yields remained largely unchanged through the week. This indicated that little change in the SA growth outlook was expected. The wider spread between nominal and real RSA bond yields indicated more inflation expected that was consistent with the faster rate at which the rand was expected to weaken. More rand weakness, other things equal, means higher rates of inflation in SA (See figures 1-4 below).

It is however not at all obvious why faster US growth should be associated with less growth expected fromemerging market economies; nor why strength in metal prices should be associated with a deteriorating outlook for emerging economies, including the SA economy. The opposite conclusion might have been drawn as appears to be the case for the Australian economy, which is highly dependent on metal exports.

The growth prospects for the SA economy would not have been improved by the changed outlook for short term interest rates. As we show below, the short term yield curve, as reflected in the Forward Rate Agreements (FRAs) offered by the banks, moved sharply higher last week. The money market, having much reduced the chances of higher short term rates earlier, has reversed course. The market is now expecting a further 75bp increase in the Reserve Bank repo rate. Such increases, where they to be imposed on the already hard-pressed SA economy, would eliminate almost any possibility of a recovery in household spending, a necessary condition for a cyclical recovery. The bond market is expecting more inflation to come and the weaker rand expected is consistent with such a view.

Yet the USD/ZAR, while now weaker, is stronger than it was in early 2016, indicating stable import prices. Furthermore the outlook for much lower food price inflation should see headline inflation and Reserve Bank forecasts of inflation recede well below the upper band of the inflation target in 2017. The case for higher policy-determined interest rates, given a further slowdown in the economy, is even weaker than it has been, even though the market may now believe otherwise of the Reserve Bank.

Lower inflation, should it materialise, will lead inflation expected in the same lower direction. The causation runs from inflation to inflation expected and not the other way round as the Reserve Bank has argued. Inflation takes its cue from the exchange rate and is much affected by the weather and the actions of the President. These are forces over which interest rates and the Reserve Bank have no predictable influence. The Reserve Bank should concentrate on what it can do to assist the growth prospects of the economy and that is to lower interest rates. Inflation is beyond its control; a fact of economic life in SA that is overdue official recognition but may yet receive it. 15 November 2016

The punditry not only greatly underestimated the presidential chances of Donald Trump, they also misread the implications of the known election outcomes for the financial markets. Far from the predicted rush for safety in the US dollar, US Treasuries and defensive stocks, the market, when given the opportunity, pushed US bond yields higher, indicating that faster growth and more inflation was to be expected post Trump (the 10 year Treasury yield initially increased from 1.85% to 2.08%, though it closed at 2%).

Further evidence of positive expectations of faster growth came with the outperformance of resource companies, including those listed on the JSE. The performance of the 12 sectors that make up the S&P 500 is shown below. Financials and Healthcare (expected to benefit from less obtrusive regulation and executive action) as well as Materials ( to benefit from growth and investment in infrastructure) were outperformers while sectors that offered protection against a weaker economy, including Consumer Discretionary and Staples underperformed as did interest rate sensitive sectors of the New York stock market.

 

Emerging markets, a risk off trade, did come under initial pressure, led by the Mexican peso, a currency especially vulnerable to any protection provided for US manufacturers, lost 8.8% of its US dollar value on the day. The rand ended 1.8% weaker while the Brazilian real was 2% weaker. The 10 year RSA yield moved higher, from 8.64% to 8.78%, leaving the risk premium vs US bonds at an unchanged and recently improved 6.79%. The MSCI Emerging Market (EM) benchmark in US dollars ended 2.5% weaker on the day, compared to the JSE that was 1.3% weaker in US dollars and 0.5% up in rands.

These outcomes must be regarded as satisfactory for EM financial markets, including those measured in rands. The exchange value of the rand has held up more than well enough to sustain a forecast of lower inflation and interest rates to come- essential for faster growth in SA.

What the pundits missed is that while Hillary Clinton represented business as usual for the US and its allies, business as usual under Obama had become increasingly less friendly to business. US and global business have come under increasing suspicion and hostility from more ambitious and obstructive officials emboldened with ever greater executive powers. The Trump administration, with the aid of a friendly Congress, could achieve some quick wins for US business by annulling or at least amending financial and environmental legislation and practice, as Trump had promised to do. The grossly dysfunctional US corporate tax system is an obvious target for a complete restructuring in ways that would be helpful to the owners of business in general and to the economy at large – though these are not necessarily synonymous.

Free trade for example (against which Trump argued and which helped him bring in the vote on the rust belt) is very good for consumers and their standard of living. Cheaper and better air conditioners produced in China have made living in the US South a lot more comfortable, for example. But they have not been helpful to the owners of air conditioning factories in the US or to the employment benefits of their employees. Protection unfortunately can be good politics and good for business owners, but not necessarily for their customers. Though if free traders are seeking consolation they may find it in the prospect of freer trade in services, with a far larger role in the economy (including the SA economy) than manufacturers. Exchanges conducted not over the waters but over the internet and are much more difficult to tax.

The Trump triumph, it should be appreciated, represents a successful attack on the conventional wisdoms and actions that have guided social and economic policies in the US and Europe. How wise and fair this consensus actually is, is a matter of very divided opinion as the US election has demonstrated. Given the opportunity provided by the highly unorthodox Trump, large numbers of Americans voted in effect against the comforts of the ruling establishments inside and their supporters outside Washington DC. Their discomfort in recent events is understandable and clearly geo-political risks are enhanced. Perhaps even the risks to the environment have increased. But the risks to doing business in the US and its growth prospects have as clearly declined, as the market has told us. 10 November 2016

Brexit is now seemingly a non-event for the global economy and its financial markets. A move to less quality in financial markets may be under way.

Brexit came as a large shock to the markets – but within two days of extra anxiety and an equity sell off – the Brexit effect came to be almost immediately reversed. Stock markets are now well ahead of where they ended on 24 June and are ahead of levels reached on 30 May. The benchmark MSCI Emerging Market Index on 14 July was 7.5% up on its 30 May level, fully accompanied by the JSE All Share that had lost over 12% per cent of its 30 May value (in US dollars) in the immediate aftermath of Brexit. The key S&P 500 Index has also recovered strongly. A feature of the equity markets in 2016 has been how unusually closely the developed and emerging stock market indexes have been correlated with each other when measured in US dollars (see figure 1 below).

 

The VIX Index that measures share price volatility on the S&P 500, simultaneously and consistently moved strongly in the opposite direction, while volatility on the JSE measured by the SAVI has remained elevated, consistent with the sideways move in the JSE when measured in rands rather than in US dollars. The volatility of the stronger USD/ZAR exchange rate has remained elevated as has, to a smaller degree, the realised volatility of the USD/EUR (see figures 2 and 3 below).

With renewed strength in emerging market equity and (especially) bond markets, emerging market currencies have shown strength against the US dollar, as we show below. We also show that the rand has performed better than the average emerging market currency, represented as an unweighted average of nine other emerging market currencies, excluding the rand and the Chinese yuan, as well as the Korean won and the Singapore dollar that enjoy a somewhat different status to the representative emerging market. The rand has gained about 10% against the US dollar and about 6% against the emerging market average since 30 May, as may be seen in figure 4.

 

A more risk-tolerant market place in the aftermath of Brexit has not only been helpful to emerging markets generally, but it has proved particularly helpful to the rand and the market in RSA bonds. As shown below, default risk spreads have receded for emerging market bonds, including RSA US dollar-denominated bonds. Judged by the spread between RSA yields and those of the high risk EM Bond Index, SA’s relative credit rating has improved recently as shown in figure 6.

 

A further important spread, that between RSA 10 year rand yields and US Treasury 10 year bond yields, has also narrowed as long term interest rates in developed markets and in emerging markets receded in the wake of Brexit. This spread represents the rate at which the rand is expected to weaken against the US dollar over the next 10 years (see figure 7 below).

The fact that most government long term bond yields declined further and immediately in the wake of Brexit – including gilt yields in the UK – indicated that Brexit was not regarded as a financial crisis, but rather as an indicator of slower global growth and less inflation to come. This conclusion was also evident in the decline in inflation-linked bond yields to very low levels.

This decline in the cost of funding government expenditure (especially in the form of negative costs of borrowing for up to 10 years for some governments) can be expected to encourage governments (not only the UK government) to borrow more to spend more and to attempt to reverse the austerity forced on them by the Global Financial Crisis of 2008 and the subsequent Euro bond crises, that were such a particularly expensive burden for European taxpayers. That burden of having to meet ever larger interest rate commitments has become something of a bonanza for European governments, faced as they are with a fractious electorate.

The sense that less austerity is now more firmly in prospect may have led investors to price in less risk when valuing equities. We have argued that a high equity risk premium is reflected in the value of the S&P 500 Index when valuation models that discount S&P earnings and especially dividends with prevailing very low interest rates. Still lower discount rates after Brexit may help explain the higher equity values. A search for yield in emerging bond markets, driving emerging market discount rates lower, may explain why more risky emerging market equities have also added value.

The very recent economic news moreover has been surprisingly good, rather than disappointing. The trends in the US economy have been particularly encouraging. The Citibank Economic Surprise Index for the US has moved significantly higher with the stronger S&P (revealing more data releases ahead of rather than behind consensus forecasts) (See figure 8 below).

The very recent news from China is that stimulus there has been working to stabilise GDP growth rates. Such more positive indicators of global growth will also have helped to modify what was already a high degree of global risk aversion before the UK referendum. Commodity prices, of particular importance for emerging economies and emerging equity markets, have recovered from depressed levels in January and have stabilised recently after Brexit (see figure 9 below).

This strength in emerging markets may be regarded as something of a reversal of the move to quality in equity markets that has so dominated equity market trends in recent years. A marked preference has been exercised for shares with bond-like qualities, revealed in the form of predictably defensive earnings flows, accompanied by relatively low share price volatility. These are qualities more easily found in developed markets but capable of adding to well above average price earnings multiples to favoured companies in emerging markets, including on the JSE. The JSE, by market value, has come to be dominated by relatively few companies with a global rather than a SA economy footprint. And the price-to-earnings ratios of these companies has risen markedly, dragging up the multiples for the JSE as a whole. We have described this class of shares that are well hedged against the rand and SA economy risks, as Global Consumer Plays.Chris Holdsworth in his Q3 Strategy Review for Investec Securities, published on 13 July has identified these trends – a preference for quality in response to lower interest rates that have left the average share price to earnings ratios well behind the elevated few (see figures from Investec Securities below).

Any further move away from quality will be very welcome to emerging market currencies, bonds and equities. It would be very helpful to the exchange value of the rand and the outlook for inflation and interest rates. It would be especially helpful to the SA economy plays that have so lagged the high quality Global Consumer Plays in recent years. Rand strength for global as well as SA-specific reasons could reverse such relative performance. Less quality may come to offer better value should global risk tolerance, even though justifiably elevated, continue to improve as it has done since Brexit.

Is the best measure of past performance on the S&P 500 Index earnings or dividends per share? It can make a big difference

Our recent report on S&P 500 earnings per share indicated that, adjusted for very low interest rates, the S&P 500 Index at June month end could not be regarded as optimistically valued, even though earnings had been falling and the ratio of the Index level to trailing earnings was well above average. Since then, the Index has marched on to record levels (helped by still lower long-term interest rates) to support this proposition of a market that was not very optimistic about forward earnings.

The case for regarding the key US equity market as risk averse rather than risk tolerant would be enhanced, should S&P 500 dividends rather than S&P 500 earnings be regarded as a superior measure of how companies have performed for their shareholders in recent years. As we show below, S&P 500 dividends per share have continued to increase even as earnings per share have declined, while the growth in dividends declared has remained strongly positive even as the growth rate has declined (figures 1 and 2 below).

Clearly the average listed US large cap company has been paying out relatively more of the cash it has generated (and borrowed) in dividends – rather than adding to its plant and equipment. The pay-out ratio (that of earnings to dividends) has declined from the over three level in 2011 to less than two times earnings recently (see figure 3). This, presumably, is more of a problem for the economy than for shareholders, especially when interest income has come under such pressure.

The twin concerns (global growth and US rates) are not independent of each other. Faster growth would normally lead to higher interest rates and higher rates might then be regarded as a welcome indicator of faster growth under way. Slower growth would ordinarily lead to lower rates. In a normal environment, good economic news could mean higher interest rates, but also increased revenues and profits for listed companies, so would therefore be well received in financial markets.

But the times are not normal. The developed economies (apart possibly from the US) appear to be suffering from growth that is too low for comfort and inflation rates that are too low for the comfort of central banks. The emerging economies, particularly the commodity producers, are suffering from slow growth as well as weak demand and lower prices for their exports – leading to pressure on their exchange rates. Devaluation of emerging market currencies brings higher rather than lower prices in its wake and possibly (and ill advisedly), higher interest rates that in turn would reduce growth rates further. The emerging market policy makers would prefer faster growth in the developed economies they supply and lower interest rates to take pressure off their currencies and inflation rates.

Ideally, lower interest rates designed to stimulate faster growth in the high income world, would be broadly welcome in the financial markets. There is however the problem that interest rates, more particularly real, after-inflation interest rates, are already at historically low levels. How much further can they be made to fall? There are, for practical and theoretical reasons, lower bounds to interest rates.

Quantitative easing (QE) may become the only tool available to central banks when fighting deflation, has become their primary objective and when interest rates are very low, perhaps even below zero. But even supplying more cash to the banking system may not work if the banks prefer to hold the extra cash, in the form of extra deposits with the central bank, rather than put them to work funding additional loans and overdrafts. QE may have saved the financial system, but the rate of growth in bank credit has remained very weak in Europe while somewhat more robust in the US.

In a world where prices are falling, it might take interest rates well below zero, that is well below the rate of deflation, to stimulate more borrowing and spending; that is to effectively reduce the real costs of borrowing and repaying loans that rise as prices fall. Deflation is helpful to lenders and harmful to borrowers. Inflation does the opposite, which is why expected inflation and / or deflation would always be reflected in the terms lenders and borrowers could agree upon.

Expected inflation brings higher interest rates and expected deflation would result in lower rates, even negative market-determined interest rates. In other words, you could be paid by lenders to issue debt (at negative rates of interest) as governments in Europe are being paid to do. The German government now to offers a positive rate of interest for Bunds that mature only after 2021. Recently the US Treasury has issued three month bills at a zero rate of interest, a record low.

The problem with negative interest rates imposed upon central banks is that negative rates of interest on bank deposits or other rewards for lending provided by financial institutions generally, would have to compete with cash in portfolios. Cash, or rather the notes issued by central banks as well as their deposits, will maintain their money value despite deflation, providing a highly competitive zero rate of interest, when other safe haven rates fall below zero. For wealth owners, holding cash rather than lending or spending it will not help an economy grow faster. Such problems for central banks are exacerbated when deflation is accompanied by a recession.

It is the problem with deflation, rather than inflation, that is occupying the central banks’ minds in the US and Europe. The target for the US Federal Reserve (Fed) is 2% inflation. Anything less than 2% would therefore call for lower interest rates for fear of what deflation could do to spending and economic growth.

The problem for the Fed and Fed watchers is that the Fed has strongly signaled that it will be increasing its key short term interest rates this year. But while such an increase might make sense for the US, given the economic recovery to date, it will not be helpful outside the US. It also makes less sense for the US if it leads to deflation, accompanied as it is likely to be by a stronger dollar and so more deflationary pressures inside and outside the US. There is moreover a more general concern that US growth may disappoint anyway and that any interest rate increase will not be called for.

These considerations, especially the explicit Fed concerns expressed about the state of the global economy, convinced the Fed to postpone any increase in short rates at the Federal Open Markets Committee meeting of 23 September. This decision at first was poorly received in the market place. Fed vacillation appeared to add something to the risk premium attached to equities and currencies. More recently, a weaker employment number for the US, that strengthened the case for a postponement of an interest rate increase, saw the risk premiums decline with a much better tone on the equity and currency markets, especially for emerging market currencies.

It seems clear that the developed equity markets would welcome a mixture of stable (or even lower than previously expected) interest rates in the US. The outlook for global economic growth has also been revised lower by the International Monetary Fund and other forecasters, including other central banks, making the case for lower, not higher, interest rates in the US.

Most important for portfolio selections, developed equity markets appear rather pessimistic about economic and earnings prospects. They appear to be already valued for very slow growth. Goldman Sachs, in a recent report on European equities, given an equity risk premium of 5% (that is expected returns from equities 5% above the risk free rate that is close to zero) infers that the Stoxx 600 index for European equities is priced for zero growth in earnings per share, compared to the long term average of 5.1% p.a.

If we apply the same 5% p.a equity risk premium to the S&P 500 Index, using the implied growth in earnings per share as the risk free rate, represented by the 10 year bond yield (currently about 2.10% p.a) plus 5%, less the S&P current earnings yield of 4.93%, we derive an implied permanent growth in earnings per share of about 2% p.a. This is well below the average annual growth rate realised since 1990. With 10 year US inflation-protected bonds currently offering a very low 0.55% p.a, and nominal 10 year US Treasury trading at 2.09% p.a, the compensation for bearing the risks of inflation, or inflation expected by the bond market, over the next 10 years is currently about 1.54% p.a. Thus the implied real growth in S&P earnings per share is less than 0.5% p.a. This confirms that US equities, like European equities, are currently priced for very slow growth.

It would appear that the market is expecting secular stagnation of the developed economies rather than any normalisation of growth rates. A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market.

Conclusion – our view is different

Our own view is somewhat different. While aware of what is a somewhat confused market place, we are still expecting a further gradual move to economic normalisation. This is a process that followed the global financial crisis of 2008. This will be reflected in a gradual increase in the willingness of households in developed economies to borrow to spend and of banks to lend to them. Household debt to income ratios are in continuous decline, as are household debt to debt service ratios. A decline in these debt ratios points to normalisation of household spending propensities. This process is essential, if aggregate demand is to grow at something like normal rates, given the importance of household spending for GDP in the developed world.

It seems to us that the global economic problem is one of too little demand rather than too little being produced or capable of being produced. The supply potential of developed economies is being continuously enhanced by innovation and improved technology. Addressing the problem of under spending, after the global financial crisis, we appreciate, has taken longer than normal and required very unconventional monetary policy. This may well have had something of a negative impact on business confidence and so slower growth in capital expenditure by firms that has held back economic growth. But if households came to spend more of their incomes and firms exercise more of their capital equipment, they would normally be inclined to add to their plant and machinery and perhaps also their labour forces. Capex, rather than buying back shares or engaging in acquisitions, would then make more economic sense.

Equity markets in the developed world appear undemandingly valued for current interest rates. Interest rate increases, we think, are unlikely to threaten these valuations. Any sense that the developed markets will not slip into recession or secular stagnation will be helpful for equity values. The emerging market economies, where GDP growth and particularly earnings growth, remain under pressure from lower commodity prices, may take longer to normalise. Their progress will depend on the same improved sentiment about global growth that would mean normalisation of developed economies rather than secular stagnation. Our recommendation therefore for the composition of balanced portfolios, those that mix equities, bonds, property and cash, is for a continued modest bias in favour of risk-on, rather than insurance assets.