IJG Market Timing Tool

Timing Tool

By Rome Mostert

Our timing tool considers the market’s sentiment and valuation in order to estimate a probability that the market will be up over the next three months.

What we witnessed since early 2012 is that market sentiment was fairly upbeat, with more stocks trending higher than the long term average. At the same time we saw valuations moving into expensive territory and remaining expensive for most of 2013. Despite seemingly stretched valuations we have shared our view that we are not unduly concerned over market levels as long as earnings are up to expectations as expectations reflect a fair degree of growth.

The strong JSE earnings reports for December 2014 saw the PE multiples declining into the 7thdecile relative to historic averages. The valuation rating relative to the positive sentiment saw us issuing a very bullish view in April 2014.

Since the previous Elephant Book we saw the Top40 Index increasing 7.7%, coincidently taking the PE multiple back up to the seemingly expensive levels seen for the most part of 2013. The PE levels together with the continuing strong market breadth continue to predict positive market returns, with probability of 52.2% for positive returns going forward. However, the market is increasingly reliant on the upcoming earnings reports to justify the current levels. The Top40 is trading at 15.4x and 13.9x CY14 and CY15 earnings.

As a result, we are cautiously optimistic heading into the new quarter, awaiting JSE earnings report and should it meet expectations or beat, we will happily change gears with eyes on an end of year rally.

market_timing_tool

Recommendation

With our view that the global business cycle has entered the late expansion phase, we foresee that growth and inflation forecasts will start to see some upward revisions coming through (as opposed to a long streak of downward revisions) as global economic momentum starts gaining traction. Based on this we keep our recommended asset allocation unchanged with an underweight in bonds, neutral on cash and overweight equities.

We anticipate that bond yields will move gradually higher over the medium term as the market starts pricing in the probability of central banks tightening money supply. However, we do not foresee a significant spike/overshoot in bond yields as it is important for central banks to keep managing the trend in order to avoid the detrimental impact of higher finance charges to the global economy. South African bonds, however are expected to show increased volatility on account of the bearish rand sentiment. We recommend an underweight in bonds and income yielding instruments (with a limited growth profile). Within the bond asset allocation we do however prefer longer duration over shorter duration, based on the view that the yield curve has factored in the interest rate hiking cycle at the long end, with the shorter end set to react and be more sensitive to the actual increases.

We take a neutral view on cash. We do, however, prefer it over bonds, but prefer equities over both. We recommend tying a combination of floating rate notes and inflation linkers with the cash position to achieve some yield pickup.

Given our view that the late expansion is only commencing, we expect to see momentum in corporate earnings growth over the next 18 months, which in turn bodes well for equities. We recommend an overweight in equities with the view that the second half of the bull rally has only started and is likely to persist for at least another 12 to 24 months. We do, however, expect investor nervousness, on the back of increasing bond yields, to result in an increase in market volatility.

Our most and least preferred stocks are as follows:

most_and_least_preferred_stocksSource: IJG

 

IJG: Updated Macro Projections

Macroeconomic Backdrop

By Rowland Brown

Following the release of the IJG Economic Outlook in January 2014, we have revised our macro projections, including inflation, private sector credit extension, GDP growth and interest rate forecasts. As always, these forecasts are based on our various models, tempered by the views of the research team with regards to known and expected factors not generally accommodated for within the models.

National Accounts – Growth:

Our growth forecast revisions come after the release of rebased national accounts (base 2010 from base 2004), which rebasing naturally results in marginally higher growth figures for most categories in the National Accounts. Moreover, since the release of our previous projections, we have witnessed a number of changes within the local economy that have a material impact on growth, as detailed below.

First and foremost, the Government announced a major expansion in the National Budget, increasing planned expenditure for the 2014/15 financial year by 26 percent when compared to the 2013/14 financial year, and up nearly 25 percent when compared to the previous estimated figure announced for the 2014/15 financial year. Much of this expenditure increase is on account of increases in salaries and wages. A low marginal propensity to save in Namibia suggests that much of this increase will thus flow into the pockets of local retailers, or be leveraged upon for the purchase of property, vehicles and other consumer goods. Thus, from a growth perspective, we expect to see a strong expansion in both wholesale and retail trade, as well as public administration – both large weightings in the national accounts.

Secondly, the Bank of Namibia maintained interest rates at historically low levels for the first half of 2014 as expected (then hiking rates by 25 points in June), however, unprecedented increases in private sector credit extension (in absolute terms) witnessed over the period were above expectations. A large component of this credit extension covers mortgage loans, while around 15 percent represents instalment credit increases. This should further contribute to wholesale and retail trade growth.

Thirdly, the country’s external position has continued to weaken on account of unprecedented fiscal and monetary stimulus, a boom in construction and weakening export earnings on account of falling commodity prices for minerals. First quarter figures show the largest current account deficit (in absolute terms) in the history of the country following the receipt of vast levels of imports, largely for the construction of the Husab, Otjikoto and Tschudi mines. This current account weakness was not offset by a positive balance in the capital and financial account, and as such the overall balance of payments, and thus the change in reserves, was negative, with a net outflow of approximately N$1.06 billion. Preliminary data for the 3rd quarter shows a further worsening of the external position, as revised April trade figures showed the largest ever level of imports for the country, at N$11.8 billion, and the lowest level of import to reserve coverage since 2007, at 1.5 months, half of the benchmark level.

Namibia_Reserves
Source: IJG Research

Namibia_BOPSource: IJG Research

Fourth, a major rebound in agriculture is expected in the National Accounts, on account of base effects. Following a drought in Namibia in 2013, a major sell-off of the national herd was witnessed, and the livestock farming category of the national accounts contracted by a whopping 39.2 percent. In 2014, we have seen the start of the rebuilding of the national herd, and as a result, some of the lowest cattle marketed numbers in over a decade. However, this growth in the national herd should be recorded as a positive in the national accounts, and as such we are expecting a rebound in growth, to 28 percent in real terms. These lower sales figures are expected to impact on meat processing and manufacturing, which is expected to contract by as much as 15 percent in 2014.

Namibia_Cattle_MarketedSource: IJG Research

Namibia_Cum_Cattle_MarketedSource: IJG Research

Fifth, we have revised up our construction figures for 2014, despite the vast base set by the 35.2 percent growth seen in 2013. This expansion is based on the construction figures that we have seen coming through from the various municipalities to date in 2014, as well as the on-going construction of the three new mines, the major increase in the national budget, and the abnormally large import figures seen for the year to date. As such, we are now looking at growth of 27.3 percent in 2014, after which we believe growth will slow. In late 2016 and 2017 we expect to experience a contraction in construction, as mine construction for two of the three new mines come to completion.

Finally, we have revised down our uranium production expectations on the back of Rossing Uranium radically reducing production in 2014 and 2015, as the uranium spot price fell to U$28/lb, a half decade low. On account of the change in production profile for Rossing, we are looking at a 26.2 percent contraction in the category, which has a notable effect on overall mining production and thus real growth.

On account of these changes, our growth projections for 2014 have seen a major upward revision, from 5.2 percent in January, to 6.9 percent. For 2015, we are looking at growth of 4.5 percent, largely on account of base effects and a slowing of growth in the categories of wholesale and retail trade and construction, as the high base of 2014 dampens new growth levels.

Namibia_GDP_Projection_2014_2015

Source: IJG Research

Inflation:

Namibia_NCPI_ForecastSource: IJG Research

Inflation for 2014 has broadly surprised to the upside, driven by increasing food and fuel prices in Namibia Dollar terms, both on the back of a weakening/weaker currency and global US dollar prices for these commodities. Moreover, the strong growth seen and expected in the country appears to be instigating some demand-side inflation. This is particularly apparent where administered and housing prices are concerned. Large increases in the cost of utilities, school fees, rental prices and transport prices have been seen and/or are expected going forwards.

Additionally, cost push factors are expected to have a further negative effect on inflation, particularly should the Namibia Dollar/Rand remain weak or weaken versus major currencies. Local meat prices are expected to continue rising on account of lower livestock sales volumes at the beginning of the year. This is a result of abnormally high sales volumes in 2013, which were a result of the drought last year. Additionally, we are expecting to see an up-tick in bread and cereal inflation, on account of a rise in global food prices in Namibian Dollar terms. Ukraine, the world’s sixth-largest wheat exporter, is a strong contributor to rising wheat prices due to uncertainty about future production in the country as a result of the on-going political turmoil. Finally, we expect to see a pickup in transport inflation driven mainly by the rise in the cost of operating personal vehicles. This rise is largely attributed to fuel prices increasing around the world, with forecasts predicting that they will continue rising.

Interest Rates

Namibia_Interest_Rate_ForecastSource: IJG Research

In our January Outlook, we called interest rate hikes in the third quarter of 2014, and like most analysts were taken by surprise when the SARB hiked rates in January. The Bank of Namibia then further surprised us by failing to follow the SARB hike in February, deciding only to hike in June. Nevertheless, as the interest rate differential between Namibia and South Africa has now been closed, we expect to see Namibia and South Africa to continue to hike rates in unison.

We maintain, however, that given the strong positive state of the Namibian economy, the growth in private sector credit extension, and the weakening external position, that higher rates are warranted in Namibia than in South Africa, but recognise the Bank of Namibia’s concern with regards to rapidly increasing interest rates on account of high household debt.

Private Sector Credit Extension

Namibia_PSCE_Growth_ForecastSource: IJG Research

Despite increasing interest rates in Namibia and South Africa, we continue to forecast strong growth in demand for private sector credit extension for the next 18 months. This is partly due to the relatively slow transmission of monetary policy changes to the market, but also due to the relatively large increases in domestic disposable income (wealth effects) on the back of strong domestic growth. On the back of these wealth effects of growth, we expect to see a fair amount of household leverage, for the purpose of property and vehicle up-grading, particularly. Additionally, increasing property prices due to undersupply in the domestic market, and increasing vehicle and consumer electronics prices on the back of a weakened and weakening Namibia Dollar, are further expected to increase credit demand by households.

Following a spike in credit demand by corporates in mid-2014, we expect to see a slowing of growth to around 10 percent by end 2015, from current levels of over 16 percent. This is largely on account of our broad expectation of lower growth in 2015 than 2014, as an unprecedented construction boom starts to slow. The multipliers of this boom and subsequent slowing, are thought to have driven major increases in demand for credit by corporates over the past 18 months, however this demand should dampen with construction growth going forward.

As such, we are forecasting growth in total private sector credit extension of N$15.8 billion over the next 18 months, broken down into N$11.0 billion to households, and N$4.8 billion to corporates.

Macroeconomists market view

By Rowland Brown

Over recent months, those involved in regional and international equity markets have had to endure an ever increasing online propaganda battle between bulls and bears, and with the tempo now reaching fever pitch, I have decided to weigh in with my views, from the perspective of a macroeconomist.

As a macroeconomist, obviously, I am looking at fundamentals rather than technicals, however it must be said that am coming round to both. I believe however, that while technical signals are handy in the short term when it comes to timing trades, in the long term they are overpowered by fundamentals. And it must be said that barring a few uncertainties, the fundamental outlook is positive.

From an equities perspective, what matters, ultimately, is earnings. As one is in effect buying a share in a company, in simple terms, if the company is making money, you are making money. So in this light, one must treat macro news with the view of whether it will increase earnings, or not.

 The Global Perspective

From a global perspective, the IMF World Economic Outlook (April 2014) highlights an improved growth prospectus for the coming two years, driven by both emerging and advanced economies. This growth should be positive for markets on a number of fronts, including:

  • Increasing economic activity, by nature, implies increased gross output in an economy. Increased gross output implies increased value added (i.e. companies that are not profitable will not continue to operate in the long term). Increased value added generally implies increased company earnings.
  • Increased economic activity should result in increases in total wages, as employment picks up from current lows. Increases in total wages can be expected to result in increased consumer expenditure, which in-turn can be expected to drive increases in company earnings, through first or second round demand for goods and/or services.
  • Increased growth usually accompanies increases in inflation, as various direct or indirect stimuli increase aggregate demand above long trend levels, driving demand side inflation. Inflation, however, should disincentivise saving, as the real value of savings declines more rapidly the higher the level of inflation. This too should increase company earnings, as the marginal propensity to consume increases over the propensity to save[1].

This increase in aggregate demand will of course come with the downside risk of increased interest rates. As aggregate demand increases through increased economic activity and value added, global central banks can be expected to start to wind in monetary policy. This tightening will look to normalise aggregate demand without overshooting long term trend levels and causing inflation. However, should central banks either over or undershoot, economic growth and company earnings, or earning quality, could be adversely affected.

Additionally, it should be noted that irrespective of whether increased wages are saved or consumed, it should be beneficial to equity markets, as in absolute terms, either: people save (invest), increasing demand for and the price of equities and other instruments, or they spend, in which case earnings multiples will decline as earning rise over price. In reality, a combination of these factors is likely, so both spending and saving will drive up equity markets, and multiples should remain manageable.

Global_Growth_Outlook

The point, however, is that the global outlook for fundamentals remains strong and coming off a low base after the macroeconomic capitulation seen over recent years.

This said, trailing valuations appear expensive, however, going forward we expect to see strong earnings growth in both the US and South African markets. Talk of divergence between the markets and the high street is clearly overdone, as illustrated by the results of the current earnings season in the US, where we have seen a number of surprises on the upside with regards to positive earnings growth. Should this trend continue, market valuations in the world’s largest economy can be expected to come down dramatically. As such, in little over a months’ time, we could be looking at a very different valuation picture. Moreover, as the outlook continues to improve for coming years, forward earnings multiples can be expected to sustain reasonable increases in market prices.

JALSH_SPX_PE

The South African Picture

While the global picture is fairly rosy in my view, some uncertainty exists for South Africa. This uncertainty features in four major areas, as follows:

Firstly, and most obviously, China. Over recent years the outlook for China has deteriorated from a growth perspective, on the back of the bursting of a real estate bubble in 2011 and more recently an apparent looming debt crisis. However, these corrections are coming off an abnormally high base by global standards, and while lower growth is forecast, it is growth nonetheless. While slowing in percent change terms, in absolute terms china’s real GDP is forecast to increase by 1.35 trillion Yuan (US$220 billion) in 2014, compared to 1.28 trillion in 2013 (US$210 billion). In nominal terms, this increase in GDP is comparable to two and a half new South Africa’s, or 69 new Namibia’s based on these country’s GDPs in 2013. Recent growth figures further suggest that the extent of the soft landing expected has been overplayed, and it looks like while slowing, China’s growth may in fact, surprise on the upside.

China Growth

Secondly, QE unwinding in the US could have a negative impact on South African bonds and equities. Following the introduction of QE1 in the US in 2008/2009, South Africa saw a notable increase in the stock of foreign funds in SA bonds and equities, in late 2010, this was further exacerbated by the announcement of QE2, and again by the QE3 announcement in late 2012. The simple mention of an unwinding of QE expansion, as well as the actual slowing of the monetary injection into the US and thus global economies, has seen a reversal in this flow of funds, with net selling by foreigners in South Africa in both bonds and equity. With this reduced demand for South African instruments in favour of offshore, prices too can be expected to decline as per a simple demand-price dynamic. However, should South African listed companies see strong earnings (much of which are actually earned offshore), these flows are unlikely to be excessively dramatic, and price-earnings multiples should remain or become, favourable.

Foreign_Bond_Equity_Buying

Thirdly, and in close relation to point two, downside earnings surprises present a risk to the market outlook. Should we see earnings surprising on the downside on account of failing macroeconomic fundamentals, current valuations will be shown up to be excessive, and a market correction can be expected. Globally, this looks unlikely, and as earnings are revealed in the US, the country’s market outlook remains positive. However, the macro picture in South Africa may not be quite so positive. Waves of social unrest, major production declines in key industries and wage settlements above productivity gains, are likely to dampen the earnings of South African companies, and should these earning declines have been underestimated, down-side surprises on earnings could shake the market. This divergence between the South African and US markets could further exacerbate the outflow of funds mentioned in point two, however, as much of the South African market earnings are derived in jurisdictions with fewer social issues, the markets should generally remain supported to some extent in this eventuality.

The final concern relates extensively and directly to the previous three, being the broad macro outlook for South Africa. Weak and weakening growth outlooks, coupled with increasing inflation signal a possibility of stagflation, an undoubted negative for the local market. However, as mentioned previously, much of the local market earnings are derived elsewhere, and a better than expected out-turn in China and recovery in Europe and the US can be expected to both bolster global aggregate demand, and demand for South African manufactured and mineral products. Thus, while the outlook for 2014 remains poor, the year may prove to be an inflection point, with output recovery coming in 2015 and beyond, bringing with it jobs and increased consumer activity.

Conclusion

In short, the macro picture remains relatively positive from a global perspective, while local developments may suggest that the worst is over for South Africa. As such, macro fundamentals should win out, and while technical traders shout about corrections and recessions, fundamentals will continue to drive the market higher over the medium to long term. In the short term, however, we could see some retracement, but fundamentals would suggest that this is nothing but a good buying opportunity. However, a close eye should be kept on earnings, both in the US and South Africa, and downside surprise should excite caution.

[1] Of course, from a market perspective increased inflation could erode the quality of earnings, reducing the “acceptable” level of P/E, however as we are not expecting exorbitantly high inflation, merely higher than inflation of recent years, we do not see this as a major concern.