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Getting the balance right

11 April 2013 Absa

A summary of quarter two global and South African economic outlook as well as equity markets commentary is summarised below.

Craig Pheiffer, Head: Absa Private Client Asset Management says:

While the countries of the world have different climates, languages and time zones, they all face similar economic challenges. The monetary and fiscal authorities of countries around the globe face the dilemma of how to grow their economies without letting inflation get out of control. It is not a new problem but the current challenge is that monetary authorities are throwing everything that they have at the problem (historically low interest rates and widespread asset buying) while the fiscal authorities are trying to rein in overly wide budget deficits. Central banks are doing all that they can to boost liquidity and stimulate economic activity and it appears that with the recent price declines in food and oil, inflation can largely be contained.

Consumer price inflation is running at elevated levels in many economies but given the soft nature of growth in those economies it is more of the cost-push type than the demand-pull type that requires tighter monetary policy. The key global challenge at present is how to reduce budget deficits without hurting growth prospects. Once again, the dilemma for policymakers is that in a low growth environment, tax revenues are lower and the only means of balancing the budget books or at least reducing budget deficits is by cutting back on government spending (that is tightening fiscal policy and hurting growth prospects). A lower budget deficit is crucial as it reduces the magnitude of borrowing required by a government and that in turn reduces government’s interest bill and allows more of the country’s income to be productively spent. It is all about finding the right balance between monetary and fiscal policy so that the right balance can be achieved between growth and inflation.

An added dimension to this ever-changing equation is politics. A stable regime is needed to ensure that policies are kept in place long enough to have the desired effect. That is easier said than done when the populace has reform fatigue and rejects salary cuts, higher retirement ages and reduced welfare spending. The frequent result, apart from mayhem in the streets, is that office bearers are replaced and the new incumbents embark on a fresh policy path. The odd earthquake or tsunami upsets the applecart even further.

Fine-tuning policy and getting the balance right does not happen overnight. It is also a continuing journey rather than a destination. South Africa’s fiscal and monetary authorities are currently in the same boat as their international counterparts and getting closer to historical trend levels of growth is going to be a long haul.

Global growth in 2013 is expected to be maintained at a fairly pedestrian 3,2% from 3,1% last year as advanced economies maintain a 1,2% growth rate and as emerging economies grow at a marginally faster pace of 5,3% (2012: 5,0%). US growth forecasts have been cut back to 2,1% this year from 2,2% in 2012 as budget spending cuts take effect.

Countering this to some degree will be the Federal Reserve’s continuing quantitative easing programme and commitment to low interest rates. The euro area economy was expected to exit its recession during the early part of this year to leave the economy flat in 2013 but that recovery has been pushed out and the prospect now is for a further contraction of 0,3% this year (2012: -0,6%).

In the UK a “triple dip” recession has been mooted but although the risks are to the downside, the economy there is forecast to grow at a modest 0,6% pace this year from 0,3% last year. The massive new fiscal and monetary policy package aimed at boosting the Japanese economy and getting inflation up to 2% in two years will likely have its greatest effect in 2014 as momentum grows but for this year a slower pace of growth of 1,1% is expected from 2,0% last year.

The Chinese economy is forecast to grow at close to 8,0% this year and next from 7,8% last year as the authorities in that country promote urbanisation and try to uplift household consumption and carefully reduce fixed asset investment in the largest of the Brazil Russia India China and South Africa (BRICS) countries. In contrast the South African economy, the smallest of the BRICS, is expected to grow at a 2,7% pace this year from 2,5% in 2012.

With slowing rates of household consumption, government consumption and fixed asset investment, the modest improvement in South Africa’s growth rate in 2013 is predicated upon a slightly higher rate of growth in exports (thanks to a weaker rand). The early forecasts for 2014 are slightly more upbeat across the board but improvements in growth rates will remain modest and below trend. Risks remain to the downside and it will be up to our policymakers to see us through these difficult times.

Christopher Gilmour, analyst at Absa Asset Management Private Clients, says:

Global equity markets remain elevated, with both the S&P 500 and the Dow Jones Industrial Average recently hitting new highs. Meanwhile global economic growth is still anaemic at best, with little hope of anything more meaningful on the horizon. South African equity market, which is to a very large extent influenced by global markets, continues to remain close to record levels.

But it is also important to get a sense of proportion into this debate; although at record highs, the S&P 500 has been a truly dismal performer during the past 13 years. At the current level, it is only marginally higher than where it was in 2000 and in real terms, it is almost 30% below that figure.
And in terms of its momentum, the fact that it has had a really strong run since the beginning of 2013, it should be noted that the index is quite far above its 200-day moving average. This suggests that the index could be due for a correction in the short term.

The rating of the S&P 500 is not especially high, either in historic terms or in relation to our market. Interestingly, the yield gap has begun widening again after almost closing earlier this year.
So, what is moving the S&P to new highs, even if these highs are not especially inspiring?
A number of factors are at play, such as record liquidity in the US financial system, caused by successive bouts of quantitative easing but also the realisation that US corporate earnings growth appears to be bottoming out and perhaps even turning upwards. After a long period of declining corporate earnings growth, the trend does appear to be turning, aided by improved US consumer demand and a nascent return of manufacturing from the far east back to the US. The resurgence of the US oil and gas industry may also be playing a part.

The joker in the pack as far as global equity markets are concerned is the Japanese market. After decades of deflation and virtually no growth, the Japanese economy is being resuscitated, primarily by a deliberate and sustained weakening of the yen. The Nikkei 225 index has responded very positively to this but needs to carry on much further to convincingly demonstrate that it has broken its very long-term downtrend.

If this happens, the world’s third largest equity market after the NYSE and the Nasdaq could help to improve sentiment on global equity markets generally, so the trend in the Nikkei 225 index should be watched carefully.

Locally, the JSE All Share Index (Alsi) remains at or near record levels, defying gravity in a sense, as the underlying economic fundamentals of the South African economy are tepid at best. But even though the market corrected sharply in the first week of April, the long term upwards trend is still very much intact, with earnings and dividend growth supporting the level of the index. Even in USD terms and after adjusting for inflation, the Alsi has still easily out-performed the S&P 500, which is probably one of the main reasons why foreign investors and speculators have been attracted to our market.

From a valuation perspective, the Alsi is in expensive territory, due in no small measure to the poor results from the heavily weighted diversified mining companies recently. The Financial & Industrial Index is even more expensive though at least here earnings growth of above 20% looks sustainable. There is a large disconnect between the level of the Alsi and its underlying earnings growth, though the earnings growth graph appears to be bottoming.

The retail sector has come under pressure since the start of the year as a number of trading updates from the major retail players failed to meet expectations. Retail sales growth, as proxied by the official figures from Statistics South Africa, appears to be faltering. But certain other consumer-oriented companies, such as City Lodge, Sun International and Tsogo Sun all have sustainable fundamental metrics and, with the exception of City Lodge, are relatively cheap.

The large industrial counters, such as BAT, SABMiller and Richemont all look good fundamentally and all have great rand hedge qualities. But none of them are cheap. Commodity stocks have taken a real beating in recent months and we are concerned about single-commodity resource counters such as Kumba, which do not have a “cushion” of diversity. While we believe that resources stocks still look good in the longer term, our short and medium term concerns currently hold sway.

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