Investment Postcards from Cape Town

By Cees Bruggemans

With employment losses probably only now reaching their maximum pace in South Africa (though having peaked in the US), monthly data suggest a bottoming process in output.

Year-on-year data comparisons in many sectors still show the horrific nature of the decline this past year:

• passenger cars sales in May were 27% down

• commercial vehicle sales were still 43% down

• manufacturing production in April was 21% down. When excluding food and beverages, and electrical machinery (both only about 5% down), the remaining four-fifths of manufacturing was down 25%, with car production a whopping -50%.

• Mining production in April was down 10%.

• Electricity production in April was down 6%.

• Retail sales volumes in April were down nearly 7%.

• Residential building plans in April were 48% down.

So there was ample reason to feel depressed these last few months, yet we had a successful general election, with high voter turnout and only modest support loss for the ruling party. The large output declines were due to three major forces.

Firstly, a major commodity-led inflation surge and subsequent policy tightening hitting interest-rate sensitive sectors these past two years.

Secondly, global crisis hitting our industrial and mining export sectors from late last year, which were already distorted by electricity disruption.

Thirdly, all these forces and their resulting employment losses belatedly inviting household retail cutbacks.

Yet passenger cars sold per day were the same in May as in April. That is hardly really good news, as April was a badly distorted month, containing three holidays (Easter and Election), with many people probably taking holidays. May was not supposed to be a productivity disaster, yet it still was.

Even so, there comes a point where a sales contraction has gone exceedingly far. Cars seem to be in such a situation, bearing in mind interest rates have been cut by 4.5%, though bank credit criteria remained tight.

Manufacturing fell a further 2.5% in April compared to March, nearly twice the distance as in Europe (-1.4%), though year-on-year in both instances near -20%.

April offered distortions by way of three holidays. Losing three out of 22 working days is a very large bite, suggesting output in an underlying sense (daily) to have risen. We need May manufacturing data to confirm.

According to BER business opinion surveys, motor trade confidence lifted for the second quarter in a row, though still atrociously low. A swing seems underway. Globally, car sales have been lifting for some months, in part subsidy-supported (though hardly the full story).

Electricity production rose in April, as did mining output. Since early this year, both sectors are trending sideways to better after horrific declines in 2H2008.

Manufacturing would also have confirmed a sideways trend if it hadn’t been for April’s setback. If it was holiday distorted, with May the litmus test, our industrial cluster would confirm stabilisation.

The waiting is for global lift (in the works nearly everywhere according Purchasing Managers Indices), inventory adjustment ending and replacement duration shortening. This would come through both in domestic order levels and exports.

This is where policy activism comes into its own, as much the budgetary drift into deficit (probably by now representing a 6% of GDP swing, from 1% of GDP surplus to a deficit approaching 5% of GDP) as in monetary policy.

The SARB has by now cut interest by 4.5%, prime falling from 15.5% last December to 11% today, providing a comforting tailwind to the economy as debt servicing costs have fallen rapidly.

Yet tight bank credit criteria, demanding higher returns and less risk, along with a firming Rand, pushed by rising global risk appetite to test 8:$, are probably still offering important headwinds to interest rate-sensitive demand as well as making things difficult for many producers.

This year will probably see GDP fall by 1%, pushed lower by household weakness, falling private fixed investment and major inventory destocking, though bolstered by strong government spending and probably modestly supported by falling import volumes.

By next year, growth should be accelerating again towards or even beyond the 3% level, assisted by the ending of the inventory depressant and some lift in export volumes.

The interest-rate sensitive sectors will be importantly influenced by the level of interest rates and the availability of credit, whether through traditional bank channels or new intermediating ones.

Following a simple Taylor Rule estimate, assuming the present CPI inflation rate of 8.4% to still moderate to 5% by late 2010, and considering an output gap likely surpassing 5% by early next year, there remains scope for two interest rate cuts of 0.5% each.

Government spending will be an important support for the household sector, with infrastructure spending holding up well as we address national priorities, not least the 2010 World Cup Soccer.

Source: Cees Bruggemans, FNB, June 17, 2009.

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Investment managers of balanced portfolios use a myriad fundamental and technical indicators on which to base their decisions regarding their portfolios’ allocation between equities, bonds property and cash.

And following a 27,3% rally in domestic equity prices since the FTSE/JSE All Share Index hit a low of 18 121 on 3 March this year, the decision regarding whether to overweight or underweight equities has become somewhat more difficult, to say the least.

A method of trying to gauge whether equities are cheap or expensive is to compare their valuations with those of other asset classes. One such technical indicator that managers look at is where equities are trading relative to bonds. To do this, one can compare the earnings yield on equities with the current yield on long-term bonds.

The earnings yield on the FTSE/JSE All Share Index (see Graph A) has declined from 12,4% when the market reached a low on 3 March to the current level of 9,2%. This can be ascribed to the significant rise in share prices since 3 March, and despite the fact that this represents a significant decline, the current earnings yield is still significantly higher that the long-term average of 7,5% since 1989.

To compare the relative value of equities versus bonds, one should look at the difference or spread between the yield on the two asset classes (i.e. the yield on the BESA All Bond Index minus the earnings yield of the All Share Index). With the yield on the All Bond Index currently at 9,5%, the spread stands at 0,3% (i.e. 9,5% - 9,2%). Although the spread has narrowed significantly since the market reached a low on 3 March (see Graph B), when the spread stood at -3,0%, it is still a long way off the long-term average, which stands at 5,1% when measured from the beginning of 1989.

Despite the fact that long-term bond yields have ticked up since their low of 8,9% on 18 December 2008, the yield is still close to its lowest level in more than 20 years (see graph C).

So what can be concluded from this data? Bond yields are almost on par with the earnings yield of equities. However, the earnings yield of equities is still significantly higher than the long-term average, while bond yields are close to a low not seen in more than 20 years. It is hard to come to any conclusion other than that equities are still cheap compared to bonds. And even though the recent equity market rally may prove to be a case of too much too fast and a short-term pull-back may be on the cards, there are signs that the pace of the global economic meltdown is slowing and that some green shoots are appearing. Even at current levels there is good potential for capital growth from equities over the next few years.

I am of the opinion that bonds have already discounted a very gloomy economic picture and more interest rate cuts by the South African Reserve Bank. And then we still have inflation to contend with, which although on a declining trend, remains stubbornly high. I believe there is little chance of significant declines in long-term bond rates and the potential for any capital growth over the next year or two is therefore limited. In fact, with an expected mild improvement in the global economy during the second half of this year, leading to higher commodity prices and an improvement in the domestic economy, we may see long-term bond rates rising and bond prices declining.

Graph A

Graph B

Graph C

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The May edition of the Reuters South African Survey of Economists has just been published. (The Reuters Econometer is a measure of economic sentiment drawn from a monthly poll of forecasts by leading economists in South Africa and abroad and presented in the form an index). The weightings used in the index are: GDP growth - 25%; CPIX inflation - 20%; Producer Price Inflation - 5%; Prime Interest Rate - 20%; 10-year bond yield - 5%; Rand-Dollar Depreciation - 25%.

After  reaching  a  2-year  high  in  March,  the  Econometer  has  fallen  in  each  of  the  past  two  months.  The lingering weakness in the economy and concerns that the decline in inflation has not been as rapid as previously expected has resulted in the May Econometer falling further to 251,97.

With the confirmation of economic recession coming with the release of  Q1  GDP  growth  data  since  the  April  Econometer  was  published,  growth  forecasts  have  now  been  revised  further downwards. The economy is now seen contracting by 1,42% over 2009, a more bearish outlook than that published in April’s survey which saw a 0,5% contraction for 2009.

Sticky consumer inflation has caused the other major revision to expectations with CPI inflation now seen averaging above 7% for the year, before dipping into the top end of the target band mid-way through 2010. This is a material change to the April outlook which saw consumer inflation falling into the target range by Q3 2009. Eskom tarriff increases and higher spot oil prices will also contribute to stubborn consumer prices so a further upward revision in the June survey is not out of the question.

The local currency has been in the headlines over the past few weeks. After reaching a recent high of R7,87/$ in early June, the rand is now seen stabilizing in a range of R8,50/$ to R8,70/$ in the medium term and is expected to average R8,59/$ for the year before trending weaker throughout the balance of the forecast period.

Please click the thumbnail below for the full report.

Source: Sasfin, May 2009.

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By Cees Bruggemans

The green shoots are apparently reaching higher.

A cyclical gear change is underway, in which 2Q2009 will show much less of a GDP decline than 1Q2009. Either 3Q2009 or 4Q2009 will probably show the first cyclical uptick in our output, heralding renewed expansion.

In the US, the May non-farm payrolls gave their first positive surprise, declining by ‘only’ 345 000 jobs. The market had expected a decline of 550 000, which would have been a more modest improvement from the 660 000 average declines these past six months.

The April payroll decline was simultaneously revised down by 25 000, reinforcing the perception of reducing job losses. As job losses are a lagging indicator, these changes reinforce the view of the US economy stabilizing and shortly (3Q2009) coming out of recession.

US unemployment in May still jumped to 9.4% from 8.9% in April, with 780 000 more people recorded as unemployed.

But less than half this unemployment increase was due to people actually losing their jobs in May. More than half the change was due to people previously retired from the labour force or simply not participating re-entering it out of necessity in search of work, possibly because of reduced wealth no longer underwriting their retirement plans adequately.

In South Africa, our forward-looking gauges are also increasingly picking up favourable changes in intended output even as actual data keeps reinforcing the stabilization theme.

Electricity production for April increased, lessening the year-on-year decline to -5.7% compared to -6% in March and -11% in February. Industrially, we are no longer falling off a cliff, as also reflected in actual manufacturing and mining output data.

The renamed Kasigo Purchasing Managers Index showed its first uptick since October, rising to 37.3. With the sub-index asking about business conditions six months out rising above 50, the signal is getting louder about 4Q2009 growth revival.

As is the case overseas, this is primarily at first an inventory phenomenon, as the reduction of inventories slows down and becomes less of a drag on output, allowing the latter to rise.

Simultaneously government spending globally is supporting consumer demand and substituting private fixed investment by boosting infrastructure.

Also important, but difficult to quantify, the shock reactions to global bank crisis conditions last September through December were probably overdone. With central banks and governments preventing ultimate collapse and engineering stabilization and repair, perceptions have swung around quite dramatically.

This can be observed in the greater risk appetite in equity markets as investors are gradually starting to vacate safe havens, but it is probably already going beyond this.

In the US there is speculation about consumer saving rates falling anew, never mind steadily rising further to much higher levels. Though it is early days, the composition of forces driving activity appears to be changing steadily, away from abrupt and severe decline, favouring stabilization and eventually new growth.

As to why, there are various explanations.

If one ceases to panic, defensive cutbacks to spending lose their vigour. Many such cutbacks were more in the way of postponements than actual permanent cancellations.

Cars still need to be replaced as they get older. One can temporarily delay replacement but not indefinitely, unless switching to another mode of transportation. World car demand in recent months has started rising again (even if subsidy-assisted in parts).

An important part of the industrial and export cutback in 4Q2008 was probably considerable overreaction tied to just-in-time business models. If a business is finely meshed with other suppliers and customers, any sudden change in conditions can set in motion a chain reaction.

If final customers get cold feet (many did in October), the entire global production chain experiences cardiac arrest as nobody wants to sit with unsold output (rising inventories), which is dead capital that needs servicing even as banks increased the cost of credit while reducing access thereto.

With the worst not happening, perceptions have moderated once again, stabilizing activity levels and in certain instances starting recovery. The operational cutbacks in many instances reduced reliance on bank credit.

Three important stimulants operated throughout.

Commodity prices collapsed last year (oil alone injecting the equivalent of a $350bn annualized tax cut in the US).

Government spending stabilizers and tax cuts kicked in, while the Fed engineered a 1.5% drop in mortgage rates which allowed many households to refinance mortgages more cheaply, improving their cash flow.

Technological innovation did not cease, improving productivity by 2.5% annually, as new knowledge allowed things to be done at lower cost or creating things that added to the force of creative destruction (consumers and businesses wanting or needing such items).

If one ends the panic withdrawal, stabilization comes first but ere long renewed expansion follows, given the spending and income forces aligning anew.

South Africa is closely following in the global slipstream, with the US, Japan and China in the lead.

Though we are currently still experiencing the worst of times, stabilization is already months underway and the first general uptick in GDP is very close, even if the data will take time divulging its mysterious secrets.

Source: Cees Bruggemans, FNB, June 8, 2009.

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