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Wednesday, June 24, 2015 - 02:16
Inflation twitch

The local equity market had a buoyant April, in stark contrast to the gloom caused by the widespread load-shedding and xenophobic violence in the country. The JSE All Share gained 4% in April so far, for example, and 10% for the year-to-date. Although South Africa’s international reputation has taken a huge knock, it hasn’t stopped foreigners from buying our shares – a net of R14.2 billion so far this year. That is more than the previous four years combined. Net foreign purchases of bonds are around R15 billion, which is lower than most of the previous six years, except for 2014, when there were net outflows from the bond market.

Valuation risks

“There are, at an asset class level, two kinds of risks to future equity returns. One is valuation-based and the other relates to a macro shock,” explains Izak Odendaal, Investment Analyst at Old Mutual Wealth.
The JSE All Share trades on a price-earnings (PE) ratio of 19, well above the average of 12, since 1960. “One could argue that only the average since 1994, when South Africa started re-integrating in global finance, should be considered. However, that average is 15 leading to the current PE remaining higher,” he notes. One of the main reasons that South African valuations seem high compared to its own history and emerging market is that the biggest companies on the JSE are also listed in developed markets and trade in line with peers on those markets. Naspers’ sky-high PE ratio and massive market cap are as a result of its stake in the Chinese internet company, Tencent.
Other valuations metrics look more reasonable: the All Share dividend yield of 2.8% is in line with the average of the past 20 years. JSE All Share companies increased dividend payments by 20% per year over the past five years.
Buying shares at above-average valuations have previously resulted in below-average longer-term returns - with the historic long-term average return being 7% per year after inflation. “But PE ratios say very little about what is likely to happen in the shorter term. For that, we need to consider broader global, economic and political factors that could cause a significant loss of capital and not just a market correction.”
For instance, the JSE PE was average on the eve of the 2008 crash, while it was already historically low before the 2002/3 bear market. In both instances, US market movements set the pace. On the eve of the 1998 crash, the PE was very high, but even from a lower PE the market would have fallen due to the EM crisis.

What are some of the big macro risks?

Ultimately, it comes down to the ability of companies to generate earnings. Perhaps the biggest concern is that when US interest rates start to rise, it will kill the six-year long equity bull market. There is little historical evidence to support this view, since markets usually don’t crash at the beginning of the hiking cycle, but rather at the end. The Fed did its best to signal its intentions, but some volatility at the time of the first hike is likely. There is, however, no reason it should fundamentally derail the market. The more pertinent question is whether real interest rates will rise to a level that can cause a recession.
Could the strong dollar cause an earnings collapse for US companies? The dollar certainly has reduced reported profits for several listed US companies, but none have reported losses. The dollar is already historically expensive on a trade-weighted basis, so it is an open question how much further it can gain.
The potential fall-out from the dollar-borrowing binge of emerging market companies over the past five or so years is also related to the above-mentioned point. While developed market investors ‘searched for yield’ in emerging markets, emerging market companies did the opposite, borrowing in dollars at low rates. The surging dollar and weaker EM growth outlook place these firms at risk. Recently, Kaisa Group became the first Chinese property developer to default on its dollar-denominated bonds. “How these chickens come home to roost will depend on how far the dollar moves, how well these companies have hedged currency exposure and whether they have any dollar-based revenues. South African companies, having learnt some expensive lessons, have comparatively low levels of foreign currency denominated debt,” says Odendaal.
The most immediate concern on markets is probably that ‘Grexit’ could happen: a Greek debt default and exit from the Eurozone. Greece is running out of cash fast and still faces significant repayments over the next few months. The key questions are if missing a payment will necessarily lead to an immediate Greek exit from the euro; to what extent such an outcome has been priced in and the degree of contagion to other weak links in the Eurozone. Grexit has been compared to the Lehman Brothers collapse in 2008, but the latter was unexpected. Greece has been a big concern for the past five years: a lot of bad news has surely been priced in already.
Finally, a big rand move in either direction also poses a risk to the JSE. A sharply weaker rand would potentially harm interest-rate sensitive shares (which have been flying) and companies that have significant import bills. But a sharply stronger rand – perhaps due to a renewed search for yield if US interest rate hikes don’t materialise as expected - will likely hurt industrial rand-hedges that are currently trading at elevated ratings, and miners.
Chart 1: FTSE/ JSE All Share Index

Inflation ticks up in March

The inflation cycle seems to have bottomed, he says. Consumer inflation rose to 4% year-on-year from 3.9% year-on-year in February, slightly less than market expectations. The consumer price index (CPI) was 1.4% higher in March compared to February.

Food inflation is still falling, but for how long?

Food and non-alcoholic beverage inflation declined further from 6.4% in February to 5.8%. Most categories of food prices showed slower growth on an annual basis, but further increases on a monthly basis. “Therefore annual food inflation should start rising again especially because of a substantially smaller anticipated maize harvest in 2015 compared to 2014,” says Odendaal. “That said, global dollar agricultural prices are falling, meaning that as long as the rand behaves, upward pressure on food prices could be limited.” Alcoholic beverages and tobacco prices jumped 2.7% during the month as the annual ‘sin tax’ increases kicked in. Year-on-year inflation in this category accelerated to 9%.
Annual petrol inflation was -21% in March, from -27% in February, but petrol prices were 9% higher month-on-month. Annual petrol inflation should shrink further in April (to around -10%) after the substantial petrol price increase. There is currently an average over-recovery of 11c/l on the fuel price, but this is falling as the oil price rebounded to above $60/barrel. This means year-on-year petrol inflation should remain around -10% in May.
The cost of buying a vehicle rose 5.4% year-on-year as falling used car prices appear to be capping price rises for new vehicles.
Electricity inflation was 7% year-on-year. Electricity constitutes 4.18% of the CPI basket, and if the mooted 25% tariff increase materializes, this could place substantial upward pressure on consumer inflation in the second half of the year.
March is a survey month for housing and education in annual inflation. Education inflation increased to 9.3% year-on-year from 8.7% and continues to be above the headline inflation rate as has been the case for many years. Actual rentals and owners’ equivalent rents together constitute 15% of the CPI basket. Actual rents rose by 5.3% year-on-year from 5% while equivalent rents rose 4.9% from 4.7%. Both are indicative of a still sluggish residential rental market.

Impact on monetary policy

The SA Reserve Bank’s most recent monetary policy statement concluded that there was less ‘scope to pause’ on hiking rates. “These inflation numbers suggest that they can pause a while longer,” says Odendaal. Core inflation – excluding food and energy prices – dipped to 5.7%, and inflation expectations remain well anchored. While the rand has lost around 14% against the dollar over the past year, it has gained against the euro and remained broadly stable on a trade-weighted basis. While the risks to the inflation outlook – from the rand, electricity tariffs and maize price – are all to the upside, the risks to the growth outlook are to the downside. The current repo rate has turned positive in real terms, meaning that part of the rate normalisation process that the SARB wanted to get underway before the US Federal Reserve starts hiking rates, has taken place automatically. Meanwhile, while all the focus has been on when the Fed rate will hike, 20 other central banks have eased policy so far this year, with China being the most recent. However, the SARB’s tone of late has been very hawkish and markets are pricing in interest rate hikes later this year.

Chart 2: Headline, core and food inflation

Source: StatsSA

Copyright © Insurance Times and Investments® Vol:28.6 1st June, 2015
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