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.
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.
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.
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.
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.
