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Wednesday, May 20, 2015 - 02:16
The long wait is over

For British investors, the 16-year drought is over. The FTSE 100 Index finally closed above its previous record of 6 950 index points, set in 1999, the end of February. Optimism that the Greece crisis has been resolved for now, and a better performance from resource heavyweights helped propel the FTSE last week.

“This provides an opportunity to remind ourselves of a number of important investment principles,” says Izak Odendaal, Investment Strategist at Old Mutual Wealth.”
Don’t read too much into an index number. Firstly, despite the hype, an index level is a fairly meaningless number, he says. This is important as the local JSE All Share Index is also trading at record high levels, as is the benchmark US S&P500 Index. Equities rise over time, so one should expect representative indices to constantly reach new record high levels. “What is remarkable about the FTSE is not that it is at a record high, it is that it took so long to get there.”
(For Japanese investors it is worse: the Nikkei 225 is also at 15-year highs, but still well below its all-time record set in 1990).
Secondly, an index represents nominal growth in share prices. If one subtracts inflation, the FTSE 100 index is 30% lower than in 1999.
“But it is not all that bad,” says Odendaal. “If you take into account the dividends generated over the past 15 years, the index is 60% higher than in 1999. By reinvesting dividends, investors would have benefited from compound growth (using dividends to buy more shares that paid out more dividends). At 3.5%, the dividend yield on the FTSE 100 is substantially higher than the yield available on the ten-year UK government bond.”
Thirdly, an equity index does not necessarily represent the economy. Like our own resource heavy All Share Index, the FTSE 100 is dominated by large-cap mining and oil companies, many of which have almost no operations in the UK (such as Anglo American, BHP Billiton and Rio Tinto). Other equity indices are more representative of the UK economy, which has picked up some positive momentum recently (certainly compared to other European countries – the UK grew 2.6% in 2014, the fastest rate in seven years). Not that a strong economy always matters: Russia’s market is one of the top performer year-to-date in local currency. And the JSE’s strong performance over the past seven years has come even as the South African economy has battled. “Part of the explanation is that large listed companies do business across the globe and profitability has improved worldwide,” he says.
Can lost decades be avoided?
The most important question is probably: how does one avoid 16 lost years on the market (25 years, in the case of Japan)? “Valuations matter,” he says. “For a start, the price: earnings ratio on the FTSE 100 was 30 in 1999, it is almost half that now at 15.7. This implies that earnings have almost doubled over this period. The problem is simply that after years of strong gains, and gripped by dotcom fever, investors were prepared to pay too much for earnings in 1999. High valuations imply lower subsequent returns, while extremely high valuations suggest very poor longer-term returns. Global equities currently aren’t historically cheap, but offer reasonable long-term returns. Valuations are still way more attractive than in 1999. Unlike 1999, there is no bubble in equities as investors still appear scarred by the 2008 crash. Retail investors have generally steered clear of equity markets.”
For many South African investors, the lagging FTSE is particularly painful, as they made use of the first relaxation of exchange controls in the late 1990s to invest in the booming FTSE. Diversifying offshore was not a bad idea. It is just that the timing was unfortunate. They bought at the time of extreme optimism about the UK economy, and extreme pessimism about South Africa, selling a cheap rand and cheap local assets to buy an expensive pound and expensive UK assets. Going with the herd turned out to be very painful. At Old Mutual Wealth, valuation is one of the pillars of our investment philosophy, preventing us from investing into such extreme valuations.
Chart 1: UK FTSE 100 equity index


Source: Datastream
Weak growth: the difficult backdrop to the Budget Speech
Economic growth improved in South Africa in the fourth quarter of 2014. The local economy grew by 4.1% quarter-on-quarter after inflation and at an annualised rate from the third quarter’s 2.1%. However, despite the strong end to the year, growth was only 1.5% for 2014, down from 2.1% in 2013. This was well below the 2014 Budget Speech forecast of 2.7%. In fact, growth has disappointed the Treasury’s forecast every year since 2011. For 2015, they’ve pencilled in a more conservative 2%.
Mining and manufacturing rebounded off a low base
The growth rebound was led by manufacturing, which grew by 9.1% following three quarters of declines. Mining also jumped 15.2% after a weak start to the year. In both instances, much of the earlier weakness was strike-related, which poses an important question for 2015 growth: will labour relations be better this year? Agriculture also posted strong growth of 7.5% as farmers harvested healthy crops towards the end of last year. “Current drought conditions in maize farming areas limit potential further upside in agriculture,” he notes, “as the current maize harvest estimate is about a third smaller than last year. It could also result in some upward pressure on inflation later this year as maize prices have already risen sharply in response. South Africa is likely to go from a maize exporter to an importer this year.”
The largest sector in the economy, finance, real estate and business services (20% of total GDP) also gained momentum, growing by 3.5% up from 2.4% in the third quarter. The trade sector (wholesale, retail, motor sales, catering and accommodation) was the weakest, declining by 0.3%. Wholesale and motor sales dragged the overall performance down, as retail sales had a positive quarter.
Real incomes growth picking up speed. The economy-wide wage bill grew by 8% year-on-year in the fourth quarter. With inflation having fallen below 5%, real wage growth is now probably around 3% and should support household spending growth of a similar magnitude. A separate data release from the South African Reserve Bank on Friday showed that household credit is only growing by 3.5%, suggesting many households are using higher incomes to pay off debt.
In line with the Finance Minister’s promise to rein in state spending, growth in government services slowed to 1.2%. The GDP numbers show that the government’s wage bill was still growing at 7% year-on-year in the fourth quarter, slower than the rest of the economy.
Odendaal says the Budget could have been worse for consumers. “The Speech itself delivered few surprises, except for the steep 50c/l Road Accident Fund levy that will hit motorists but not help close the budget. Together with the 30.5c/l increase in the fuel levy, and the 130c/l current under-recovery, the petrol price is likely to jump sharply in March and April. If nothing else changes over the next two months, the petrol price will still be 8% lower than April 2014.” Increases in the fuel levy and the higher electricity levy should push inflation up by about 0.5%. However, it is still likely to fall further in the next few months, and would have fallen more without the levy shock.
The other surprise was that there was very little by way of net tax increases, after all the expectations. R16.8 billion in 2015/16, of which R9.4 billion comes from personal income taxes (with a 1% increase for all tax payers earning more than R181 900 per year). Sin taxes will also raise an additional R1.8 billion. This will, however, be offset by R8.5 billion in fiscal drag relief, and the once-off cap on Unemployment Insurance Fund will reduce contributions by R15 billion.
“Given the Minister’s commitment to a ‘structural’ increase in revenues, suggests that more tax increases might be ahead as the bulk of the fiscal consolidation is ‘back-loaded’ towards the end of the medium term forecast period,” says Odendaal. On the spending side, the Minister pretty much stuck to the lower expenditure ceiling announced in October last year. The Budget plans for a consolidated budget deficit (as a percentage of GDP) to be 3.9% in the coming fiscal year, 2.6% in 2016/17 and fall to 2.5% in 2017/18. Sticking to this deficit path is crucial to maintain credibility and avoid the perception that fiscal consolidation is pushed out yet again. If all goes according to plan, overall debt to GDP should peak at 43.7% in 2018, in line with internationally acceptable levels, and then drift downwards. However, there are no plans to substantially reduce the debt ratio, so the government will have to continue allocating around 10% of the Budget towards interest payments. This is money that could have been productively spent elsewhere.
Chart 2: Real economic growth forecast at the time of the Budget Speech and actual realised growth


Source: StatsSA/ National Treasury
 

Copyright © Insurance Times and Investments® Vol:28.5 1st May, 2015
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