25 Oct Boom & Gloom: September 2016
OUR VIEW OF THE INVESTMENT MARKETS
This table reflects our view of the relevant assets, based on expected performance.
When evaluating market valuations the ultra-low interest rates in some markets, due to extreme monetary policy, need to be considered. We constantly hear that the market has extreme price earnings ratios (PEs), but is this a fair statement? In a low growth environment, very few investors feel comfortable to pay above average PE for below average growth. In this latest quarter’s review of the global investment markets, we look at some of the influences of low interest on fundamental valuation measures.
- Interest rates generally find their way into valuation models via discount factors or the cost of equity (COE).
- When calculating the equity risk premium (ERP) for a country or region, we historically compare the spread that the market demanded over the long-term real risk free rate (RRFR), to compensate the equity investor for the additional risk taken.
- The earnings yield, which is the inverse of the price earnings ratio (PE), is generally used as the rate of return of the market which can be compared to a real bond yield. Therefore, the spread between the average long-term historical earnings yield and the average real long-term historical bond yield, is the premium received for investing in a higher risk equity over time.
- At the same time, we can define the cost of equity (COE) as the RRFR plus ERP for a market. On a single share one would adjust the RRFR by multiplying it by the stock beta. In conclusion, the COE is the same as the earnings yield over the long-term and thus the inverse of the PE.
As an input variable, valuation models generally use either the current risk free rate (RFR) or the expected RFR over the medium-term. A simple example is the way you can calculate the fair price to book (PB) value of an asset. Assume the asset is expected to generate a return on equity of 17% over the long-term and have a sustainable growth rate (SGR) of 6%, the market ERP is 5%, the only factor left is the long term risk free rate (RFR) to calculate the COE.
Expectations are for international long-term RFRs to be lower for longer, thus lower COE can result in higher PB values. We see this in the price of domestic banks when ratings downgrade fairs elevate, and expectations of higher interest rates result in prices dropping. The same goes for the PE or the economic PE, as the PB increases so will the economical PE.
In general, both PE and economic PE are above long-term averages driven by cheap capital. For the PE to normalise to the long-term mean, either PB needs to drop or ROE needs to increase. Even though the ROEs across the major international indices are trading below long-term means, the probability to normalise is being held back by subdued global growth. This makes the risk of a derating in global PE and PB high.
NOW LET’S LOOK AT THE GLOBAL MARKETS
The chart below plots the historical PE, economical PE (using historical ROE and historical PB) and the long-term average economical PE.
When evaluating the potential relative return of global equity indices, we incorporate the valuation level, potential margin expansion and the potential ROE expansion. As can be seen in the table below, very few regions score well in more than one area. MSCI Emerging Markets (EM), MSCI AC Asia ex Japan and MSCI EM Eur, Middle East (ME) & Africa score well in more than one area. The latter has liquidity problems, so we prefer the first two regions.
On an absolute basis Japan is priced just below fair value on both a PE and PB basis. Asia ex Japan and South Africa are well priced on a PB basis, but the South African PE is 1.17 standard deviations above the mean, Asia ex Japan PE is more attractive at 0.55 standard deviation above the mean. One might question how this relates to total return, which brings earnings expectations into the equation.
The graph below plots the normalised historic and forward earnings per share (EPS) of the universe. Consensus expects some of the indices’ EPS to recover dramatically, especially Europe and Latin America.
In the first scenario below, when calculating total returns, we assume that the PE mean reverts. We then apply the PE to the expected twelve month rolled earnings to get an exit price twelve months forward to calculate the capital return, then the dividend yield is added to get a total return.
Returns look more subdued if the PE`s revert to the economic PE long-term mean. In both scenarios Japan looks attractive, however, regional allocation will consider other asset classes as well.
We see that global industrial production will start expanding due to growth in the tradable goods sector resuming for the first time since 2014. The drag from the mining sector has ended and commodity prices have stabilised. The household sector is displaying fairly good growth, driven by a strong consumer in the US and Europe with access to easy financial conditions. Risk appetite is strong which is reflected in the unresponsive behaviour of developed market interest rates to growth. Geopolitics remains a major risk that will cause volatility and could impact consumer and business confidence.
We see continued monetary stimulus being pumped into the system by the European central bank and the Japanese authorities over the next year which supports the search for yield. We expect the US to lift interest rates in December 2016 and maintain a dovish stance for 2017 allowing for limited impact on growth. We also expect that the stability and slight improvement in commodity prices will stabilise the currencies of commodity producing nations. The improvement in global trade and thus industrial production will be supporting commodity producers and other emerging markets.
We expect the South African Rand to stabilise around ZAR 14 and trade in a volatile broad band between ZAR 13.5 to ZAR 14.5. The currency can overshoot as the political circus plays itself out and the potential downgrade of our credit rating materialises, or doesn’t. The graph below plots various emerging market’s credit default swap spreads (CDS) and their respective credit scores (ratings). The South African CDS is trading close to the Brazilian, Russian and Turkish CDS, both Russia and Brazil are rated non-investment grade, Turkey is rated no investment grade by two of the three major rating agencies. We believe a downgrade is priced into the currency and bonds. A downgrade will most probably see a further spike in the currency and bonds yield but should normalise over time. We have a fundamentally driven stronger Rand bias.
We believe the R186, the current 10 year bond proxy, is trading close to fair value. However, the flat yield curve does not encourage us to take risk on the long-end of the yield curve as the one yield is at 8.5%. A 1% premium does not justify the duration risk. We will consider longer duration as the R186 yield moves above 9.5% with an exit yield of 9%, allowing for a total return over a one year period of 12.1% with breakeven being at 11.3%. We retain the neutral allocation to South African bonds.
We expect South African inflation to start falling in 2017, allowing the Reserve bank to consider reducing the repo rate toward the middle of 2017 if the currency behaves reasonably well. This will allow for reasonable performance in the property sector. We retain our Buy allocation to South African property.
The global and domestic geopolitical risk, potential interest rate hikes in the US and choppy growth in China, will cause market volatility. We stick with our Buy on precious metals as a hedge to diversify the portfolio.
DOMESTIC ECONOMIC ACTIVITY
Manufacturing production growth climbed by 2.2% year on year (YoY) in August but slipped by 1% month on month (MoM). Mining production declined 0.21% YoY, an improvement from the -5.4% in July. Iron ore production improved 11.7% YoY but gold production declined 7% YoY.
Retail sales slowed to a growth rate of 0.2% YoY for August, down from a revised 1.2% YoY in July. Supermarket sales are sharply down to 1.2% YoY. Retailers in pharmaceutical and medical goods, cosmetics and toiletries grew 6.6%.
Offshore investors sold R1.2bn in bonds and sold R15.6bn in equity in September. Year to date offshore investors bought R68.7bn in bonds and sold R99.5bn in equities, resulting in a net outflow of R30.8bn.
Inflation printed a lower than expected 6.1% YoY in September driven by softer fuel deflation and vehicle prices grew by 9.4%.
Total return to 30/9/2016, in domestic currency
Total return to 30/9/2016
TOP 10 JSE EQUITY PERFORMERS
TOP 10 JSE EQUITY DETRACTORS
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Sources: Bloomberg LP, Credit Suisse, RMB, BNP Paribas
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