Fears grow of ratings downgrade - OAM

Cape Town - There is a growing probability of a credit rating downgrade in December, cautioned Overberg Asset Management (OAM) in its weekly overview of the economic and political landscape in South Africa.

It noted that power struggles within government are likely to increase as the ANC nears its National Elective Conference in 2017.

This promises further rand volatility in the months ahead and a potential credit rating downgrade.

South Africa economic review

• The rand tumbled for a second straight week taking its losses over the past fortnight against the US dollar, euro and pound from R/$13.45 to 14.47, from R/€15.20 to 16.15, and from R/£17.57 to 19.26, percentage declines of -7.6%, -6.3% and -9.6%. In the past week total net foreign sales of domestic bonds and equities amounted to -R4.0bn and -R6.2bn. The combined -R10.2bn of net sales exceeded the -R8.0bn of net sales in the week after Nenegate in mid-December. Continued uncertainty over the fate of Finance Minister Pravin Gordhan undermined the positive sentiment towards the rand created by the smooth local elections and raised questions over governance in the country.  

• Futuregrowth Asset Management, which specialises in bond investments with around R150bn invested in SA’s domestic bonds and loans, announced that it would suspend all new lending to state-owned enterprises (SOEs). Andrew Canter, Futuregrowth chief investment officer, cited threats to the National Treasury amid the government’s persecution of Finance Minister Pravin Gordhan and concerns that President Zuma would take control of SOEs. Although the announcement applied to all SOEs Futuregrowth singled out the following as being of greatest concern: Eskom, Transnet, South African National Roads Agency, Land Bank, Industrial Development Corporation and the Development Bank of Southern Africa.

• The Barclays manufacturing purchasing managers’ index (PMI) fell sharply from 52.5 in July to 46.3 in August below the 51.0 consensus forecast and the weakest reading since January, under the crucial 50-level which signals contraction. Among the sub-indices, the business activity index fell from 49.5 to 44.8 and the forward-looking new orders index from 54.4 to 42.5. However, there were some bright spots. The employment index, although dropping from 52.6 to 50.6 stayed above the key 50-level while the prices index fell from 72.1 to 64.8 indicating a moderation in inflationary pressure. Encouragingly the expected business conditions index increased from 55.4 to 61.5, which suggests a PMI rebound in coming months. Given the inherent volatility in PMI readings and the contradictory signals among the sub-indices, manufacturing activity is likely to remain positive in the second half of the year although less strong than the second quarter’s 8.2% quarter-on-quarter annualised pace.

• Total vehicle sales increased in August by 2.8% month-on-month helping the year-on-year decline ease from -17.1% in July to -9.6%. Passenger vehicle sales increased 4.6% on the month with the year-on-year decline easing from -20.6% to -13.1%. While domestic sales remain depressed due to weak consumer confidence amid increasing unemployment, accelerating inflation and rising debt costs, vehicle exports surged. Total vehicle exports increased 22.7% on the month with the year-on-year increase rising from 2.4% in July to 26.7% in August.  

• The trade surplus narrowed from R12.5bn in June to R5.2bn in August. Imports fell -2.4% month-on-month while exports fell by a larger -9.0%. The cumulative trade balance for the first seven months of the year amounted to a surplus of R17.0bn a substantial improvement on the -R24.7bn trade deficit in the same period in 2015. The month-on-month decline in exports is attributed to precious metals and stones, and base metals which suffered falls of -22.0% and -11.0%. Imports were led lower by electrical equipment, and machinery and electronics with declines of -10.0% and -6.0% on the month. The improving trade data indicates export competitiveness is benefitting from the weaker rand signaling a decrease in the current account deficit from -4.4% of GDP in 2015 to -3.5-4.0% in 2016.

• According to data from the National Treasury net foreign buying of SA bonds for the year to end July amounted to R96bn well above the JSE’s initial estimate of R50bn. The inflow into SA bonds was sufficient to counter-balance the net foreign selling of equities over the same period, which amounted to around -R80bn. Total foreign ownership of SA’s bond market has increased from 32% at the start of the year to 37%. Although the increase is encouraging the high level of foreign ownership is a double-edged sword making domestic bond yields and the rand especially vulnerable to foreign investor sentiment.

The week ahead

• A Chamber of Commerce and Industry (SACCI) business confidence index: Due Wednesday 7th September. Following two straight monthly increases in June and July the SACCI index is expected to give up some if its recent gains in August due to uncertainty over the fate of Finance Minister Pravin Gordhan.

• RMB/BER business confidence index: Due Wednesday 7th September. The BER business confidence index, which fell by four points to 32 in the second quarter (Q2) is expected to show some recovery in Q3 supported by peaceful elections although any gains are likely to be tempered by infighting within the ANC.

• Mining production: Due 8th September. The year-on-year decline in mining production is expected to moderate further from -2.5% in June to -1.4% in July helped by the base effect of year-ago comparative levels and a gradual recovery in production volumes.

• Manufacturing production: Due 8th September. Manufacturing production is expected to show continued growth although slowing from the 4.5% year-on-year pace in June to 3.4% in July according to consensus forecast.

Technical analysis

• The rand’s downward break past R/$14.20 opens a new target of 15.10 which is the support line of the appreciating trend that has been in place since January. A break of the R/$15.20 level would open-up a target of 17.00 marking the January low.

• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.

• Following the Brexit vote the British pound hit its weakest level against the US dollar since 1985. The £/$1.30 level provides key support, which if broken would open up a Fibonacci projected target of £/$1.20-1.24.

• The long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.

• The US 10-year Treasury yield has broken below key resistance levels of 1.6% confirming that the major bull trend in US bonds is likely to continue as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield has compressed to its lowest level since “Nenegate” last year falling below key resistance at 9.0%. The yield is now testing the bottom of the current consolidation channel at 8.5%, which if broken will target a yield of 8.0%.

• The MSCI World Equity index has broken downward from a rising trend-line which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1,400.

• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle is likely to have just occurred. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur between mid-2016 and mid-2017.

• The S&P 500 index has broken to new record highs but the rally is not being confirmed by momentum indicators, which suggests the market is overbought and in danger of correction. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is underperforming the broader index.

• Despite this year’s price rally Brent crude’s break below the key $30 support level in February suggests a continuation of the weakening long-term trend to a downside $25 target. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. Despite its recent rally the copper price broke below the key $4 500 support level in February suggesting further downside ahead.  

• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400 target level.

• The JSE All Share index is testing an important resistance line but if this remains unbroken the index is likely to move back below the 24-month moving average at 50,900 in turn opening a downside target of 45 000. A break above 54 200 on the JSE All Share index would project an upward move to 60 000 marking a new high for the JSE.

The bottom line

• South African equity market returns have been pedestrian over the past three years. The All Share index has increased 25.08%, which amounts to an annualised compound return (excluding dividends) of just 7.74%. This is lower than the return currently offered by most money market funds.

• With money market returns beating the three-year historic return on the All Share index should investors be switching from equities into money markets? The short answer is no. However, there is one caveat. Any investment portfolio should be diversified across the traditional asset classes and so should already comprise a healthy balance of cash/ money market exposure.

• Over time equities provide the best returns, by far, compared with all other asset classes. Although in the short-term cash and bonds are safer, in the long-term they provide lower returns and hence less protection against inflation. This means that for long-term investment, they are actually riskier in terms of maintaining real buying power, while equities are safer. Admittedly equities can suffer severe short-term losses. In the worst 12-month declines for the All Share Index over the past twenty years following market peaks in April 1998, May 2002 and June 2008, the All Share Index suffered respective losses of -39%, -30% and -38.5%. These would be enough to unnerve most investors. However, in each case patient investors would have been rewarded, outperforming money market returns on an annualised basis in less than four years after the initial decline.

• In SA, based on historical experience, the four main asset classes are likely to produce the following annualised real (adjusted for inflation) returns over the long-run: Cash (0-2%), Bonds (1-3%), Property (2-4%), Equities (7-9%). The statistics speak for themselves.

• It is a mistake to try and time the market. The market rarely performs as expected and so investors who try and time the market may lose out on periods of strong equity performance. The biggest pitfall for equity investors is impatience. As the old adage goes, time in the market is more important than timing the market. The patience required for successful long-term equity investing is assisted by diversification across asset classes. The panic of seeing equity markets decline is moderated by the stability of other asset classes in a diversified portfolio, including cash, preference shares, bonds and property. Exposure to these asset classes, which offer stability to an equity portfolio, will greatly reduce the temptation to mistakenly sell equities when they are underperforming. Leo Tolstoy once observed that: “The two most powerful warriors are patience and time.”

• There are concerns over the current high valuations of the All Share Index, trading on the lofty price to earnings (PE) multiple of 23.47x, which is well above the 14.87x long-term average. However, the index is distorted by the so-called Big-5 stocks namely British American Tobacco, Naspers, SABMiller, Richemont and BHP Billiton. If these Big-5 stocks are excluded, the market PE falls to a far lower 16.5x, which is just below the five-year mean.  

• Equity valuations are extremely compelling in certain sectors, for instance the Bank Index on a PE of 10.24x and the Construction and Materials Index on a PE of 9.53x. These domestically focussed sectors are cheap due to weak economic growth and considerable government policy uncertainty. The best time to invest is often when pessimism is at extreme levels. In the words of investment guru John Templeton: “The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.”

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.

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