Top down, bottom up

Izak Odendaal, Investment Analyst at Old Mutual Wealth.

Markets remain volatile and at the mercy of macro factors, including big swings in the oil price. Oil prices spiked after suggestions about a production cut between Russia and OPEC and then tumbled when they were denied. Better-than-expected data from China’s services sector has done little to calm fears of a hard landing. China announced a lower growth target range of 6.5% to 7% for the next year. The announcement was greeted with some scepticism, although Beijing had always managed to achieve its growth targets in the past.

The spread of the Zika virus from Brazil is also causing uncertainty. This mosquito-borne virus causes birth defects which are an obvious tragedy for the people whose babies are affected and could further add to Brazil’s woes if it discourages visitors to this year’s Olympic Games. However, such global outbreaks rarely have a prolonged impact on global financial markets.

Earnings disappointment

Apart from macroeconomic ‘top-down’ factors, investors now also have to contend with ‘bottom-up’ earnings updates, as reporting season for listed companies is well underway. The top-down is clearly affecting the bottom-up: 200 of the S&P500 companies reported earnings and the strong US dollar, tepid global growth and collapse in the oil price have knocked company profits. Some analysts are talking about an ‘earnings recession’, meaning falling profits although the overall economy is still growing.

To understand this, one needs to dig a big deeper into the numbers. According to JP Morgan, earnings reported so far for the fourth quarter is 3.1% lower than a year ago, but up 1.5% higher if the 40 listed energy firms are excluded. Similarly, sales growth is -2.2% but 1.5% excluding energy. Energy plays an outsized role in the S&P500 index, since the oil and gas industry only accounts for around 2.5% of US Gross Domestic Product (GDP). In the corporate bond market, energy plays an even bigger role, accounting for around 13% of the high yield bond market. Since oil firms borrowed heavily, and are now under immense financial strain, and corporate bond yields increased substantially, there is talk that this could be the next subprime crisis, referring to the mortgage-linked bonds that gummed-up global credit markets and contributed to the 2008 financial crisis. The obvious difference between now and then is that in 2008 most US families were exposed to falling house prices, while they now benefit from lower fuel prices.

Manufacturing lagging services

There is also a big divergence between manufacturing and services companies. This split is reflected in the difference between the latest Institute of Supply Management (ISM) purchasing managers’ indices. The ISM manufacturing index is at 48.2, with 50 being the level that separates growth and contraction, while the ISM services index is in positive territory at 53.5. While manufacturing is only 12% of US GDP, it has a larger representation in the S&P500 (194 firms). S&P500 firms have reported falling sales (-9.8%) and earnings (-9.4%). Services firms, in contrast, have reported 3.3% sales growth and 2.5% earnings growth compared to the fourth quarter of 2014.

Firms focused on the US economy are still doing well, with 10.1% sales growth and 4.1% earnings growth. It makes sense with a strong dollar and slow wage growth limiting input costs, while a decent economy supports sales growth. Multinationals, in contrast, reported a 8.7% decline in earnings on a decline of 11% in sales: the strong US dollar is clearly hurting.

The dollar link

The outlook for the US dollar is important. The Bank of Japan and the European Central Bank having implemented negative policy interest rates and upward pressure on the strong dollar could remain as investors search for higher yields in the US. The US 10-year yield is 2% while the German equivalent is 0.4% and Japan 0.14%. However, the US strong dollar reduces the likelihood of the Federal Reserve (Fed) hiking interest rates much further, given the impact on the US economy and inflation. A strong dollar effectively tightens monetary conditions in the US, the equivalent of higher interest rates, a point reiterated by two senior Fed officials in separate interviews last week. When the Fed hiked interest rates in December, it also said that it expected to hike four times in 2016. The markets are now pricing in a good chance that no hikes will take place this year and the US dollar suffered a sharp decline last week (giving commodities and emerging markets a boost). It is too soon to tell whether the dollar rally has run its course, but it seems the Fed was well ahead of the curve.

Chart 1: The trade-weighted US dollar

Source: Datastream

Is the weak rand hurting or helping?

The rand is off its lowest levels but still trading around R16 against the US dollar. The negative impact of a weak currency is pretty obvious since the price of imported items tend to rise. Importantly, the extent of “pass-through” from a weak rand to local consumer prices has been low relative to previous episodes of rand weakness. In a tough economic environment, local firms have been reluctant to pass on higher input costs to consumers. Another positive is that the oil price has fallen faster than the rand over the past 18 months. This has reduced upward pressure on consumer prices, which in turn has decreased upward pressure on interest rates. Despite the steep rate hike two weeks ago, the South African Reserve Bank has increased rates very gradually so far compared to previous cycles. The lower oil price has also been a big help in containing the trade deficit. According to SARS, last year’s import bill for oil was R147 billion compared to R257 billion in 2014 - a saving of R110 billion!

Is the weak currency good for the local economy? A weak currency normally supports an economy in three ways: Firstly, it should boost exports by making locally produced goods and services cheaper in foreign markets. Secondly, it should support domestic production by making imported goods and services more expensive. Thirdly, individuals and firms who own foreign assets or earn an income from foreign operations should benefit from higher local currency values (provided these stay the same or increase in foreign currency terms).

Weak rand boosts offshore investments

South African firms have been investing in offshore operations in record amounts over the past three years and are reaping the benefits. More than half of the JSE’s profits are generated outside of South Africa and have increased as the rand weakens. Similarly, local individual and institutional investors (such as pension funds) have seen the rand value of foreign investments increase although global markets have been tepid over the past year. In fact, Alexander Forbes Large Manager Watch data shows that the 12 largest asset managers were already fully allocated offshore (the maximum allowed by Regulation 28) by early 2011 and therefore benefited from the weak rand since then.

Ambiguous benefits

The benefit in terms of the first two factors mentioned is ambiguous for a number of reasons. As a commodity producer, the collapse in the US dollar prices of our main exports has until recently outweighed the fall in the rand. This situation has turned around over the past few months. The gold price is up 10% in rands this year (and the JSE Gold Mining Index is up 39%).

Despite a weak rand, South Africa still recorded a R48 billion trade deficit in 2015. While export volumes are growing, it is not enough to help the sector benefit from an export boost: local manufacturing is still in the doldrums. The Barclays manufacturing purchasing managers’ index (PMI) fell by 2 index points to 43.4 in January. The average index level for 2015 was 48. None of the sub-components were encouraging and the sub-index measuring expected business conditions fell to a seven-year low. Inventories rose faster than sales, indicating that manufacturers don’t have an incentive to ramp up output in the short term. Part of the problem is that global demand is weak and currency weakness is not enough. At 50.9 index points, the latest global manufacturing PMI points to barely positive growth. Meanwhile, higher import costs are eroding margins.

It takes time, effort and money for local firms to source export contracts. A new World Bank report on the local economy pointed out that the top five percent of South Africa’s exporting firms account for more than 90% of exports. Many firms appear unable or unwilling to penetrate export markets.

Another problem is that some items are just not made locally and simply have to be imported at a higher cost due to the weaker exchange rate. South Africa’s import bill for machinery has been soaring; much of this linked to Eskom and Transnet upgrading their infrastructure.

Finally, South Africa is not the only country whose currency has been battered by foreign exchange markets. Most of our competitors have suffered a similar fate, while deliberately engineering currency weakness.

What about tourism?

A weak rand should make South Africa a more attractive destination and it should also convince many South Africans to holiday domestically instead of going overseas. The official visitor’s data (for November) show a 7.7% year-on-year increase in the number of tourists from Europe, North America and Asia. Even if visitor numbers haven’t picked up sharply, tourists might be spending more per head with the weak rand.

In other words, other factors appear to be overwhelming the positive impact of the weak rand. But things might have been worse without it. The standout example remains Greece. Faced with capital outflows, a lack of competitiveness and a collapse in business and consumer confidence but without a currency adjustment (because Greece uses the euro), the economy has contracted by 25% since 2008, a dramatic decline in living standards.

Chart 2: The trade-weighted South African rand

Source: Datastream