An optimal share portfolio is constructed around companies with a long-term competitive advantage and good corporate governance. While the valuation of the investment is a key factor, a sound balance sheet is essential. Strong balance sheets protect wealth.
Despite global concerns over rising trade tensions and geopolitical conflict, net investor inflows into South African financial markets remained positive in the week ended 13th April to the tune of R3.53 billion. While the bond market suffered a mild net outflow of R0.93 billion the equity market gained a net R4.46 billion. Net investor inflows have been well above the seasonal average since the start of the year. Year-to-date net foreign investor inflows into the South African equity and bond markets are extremely positive, measuring R33.29 billion and R22.64 billion, respectively, a total of R55.95 billion. The net equity inflow marks a substantial turnaround from the total net equity outflows of R43.1 billion in 2017, R124.8 billion in 2016 and R1.9 billion in 2015. The year-to-date equity inflow is almost level with the R36 billion inflow recorded in the whole of 2010, the year South Africa hosted the FIFA World Cup.
Mining production increased in February by a stronger than expected 3.1% year-on-year. Although up from 2.9% in January the improvement was not sufficient to arrest the 2.4% quarter-on-quarter decline in the 3 months to February. Nonetheless, the upturn is encouraging and should gain further momentum as the year progresses, supported by strong global demand and rising international commodity prices. Meanwhile, a more constructive dialogue between government and the private sector should contribute to increased investment in mining capacity. The production of diamonds increased 42.9% on the year contributing 2.0 percentage points to overall growth. Other contributors were iron ore, which grew 10.5%, coal 3.9% and other non-metallic minerals 16.5%, each contributing 1.5, 1.0 and 0.9 percentage points respectively to overall mining production growth. On a month-on-month basis mining production increased 0.9%.
Manufacturing production was surprisingly weak in February, falling by 2.4% month-on-month pulling the year-on-year growth rate down to 0.6% well below January’s 2.3% growth rate and the 2.6% consensus forecast. On an annual basis there were sharp declines in six of the ten major manufacturing categories. The “petroleum, chemicals, rubber and plastics” and “wood, paper, publishing and printing” categories showed the heaviest year-on-year declines, of 2.8% and 3.1%, respectively. On the plus side, the production of “food and beverages”, “glass and other non-metallic mineral products”, and “motor vehicles and other transport equipment” increased by 4.3%, 12.9% and 5.5%, respectively. On a quarter-on-quarter basis to end February manufacturing production increased just 0.2% signalling a negligible contribution to first quarter GDP growth. However, forward-looking sentiment indicators suggest manufacturing activity will show a gradual recovery over the course of the year aided by healthy export markets and improving domestic demand.
SOUTH AFRICA: THE WEEK AHEAD
Consumer price inflation: Due Wednesday 18th April. Consumer price inflation (CPI) is expected to have remained unchanged in March at 4.1% year-on-year according to consensus forecast. This will likely mark the trough in CPI as the next reading in April will include the inflationary effects of the VAT increase from 14% to 15%.
Retail sales: Due Wednesday 18th March. Retail sales are expected to have shown nil year-on-year growth in February according to consensus forecast, marking a slowdown from the 3.1% growth posted in January. The slowdown is due to the base effect of strengthening comparable readings last year. Over the course of 2018 retail sales growth should remain supported by improved consumer confidence, low inflation, falling interest rates and increased credit extension. The BER retail business confidence index, which measures the outlook for the retail, wholesale and motor trade sectors, increased sharply in the first quarter from 29 to 42, signalling a substantial improvement in retail trading conditions.
In the annual Boao Forum Asia (BFA), modelled on the World Economic Forum held annually in Davos, China’s President Xi Xinping gave a conciliatory speech aimed at defusing trade tensions with the US. Xinping promised to broaden market access to the country’s insurance and other financial sectors, greater protection for intellectual property, reduced limits on foreign investment in the automotive, shipbuilding and aviation sectors, and lower import tariffs. While the speech contained little detail or new measures which hadn’t already been tabled in Davos, financial markets responded favourably to the conciliatory tone. So far, the trade spat has resulted in $50 billion of punitive bilateral tariffs imposed by both the US and China with threats of a further $100 billion from the US. Encouragingly, Xinping’s speech suggests China is aiming for a negotiated settlement.
Speaking at the University of Hong IMF managing director Christine Lagarde issued a stern warning against the growing threats of trade war: “The multilateral trade system has transformed our world over the past generation. But that system of rules and shared responsibility is now in danger of being torn apart. This would be an inexcusable, collective policy failure.” While not mentioning any countries, Lagarde’s criticism was aimed at China as well as the US, arguing that necessary trade reform “includes better protecting intellectual property, and reducing the distortions of policies that favour state enterprises.” In a veiled swipe at the US trade position, Lagarde stated that trade deficits and surpluses were not necessarily indicators of unfair trade practices but rather caused by countries spending more than their income allowed. She added that trade deficits and surpluses should be tackled with structural reform and fiscal policy.
The Brookings-FT Tracking Index for the Global Economic Recovery indicates that economic momentum may have peaked. Professor Eswar Prasad of the Brookings Institute said: “The world economy’s growth momentum remains strong but is levelling off as the winds of trade war, geopolitical risks, domestic political fractures, and debt-related risks loom, with financial markets already reflecting mounting vulnerabilities.” Prasad continued: “The US is engaged in a perilous macroeconomic experiment, with the injection of a significant fiscal stimulus even as the economy appears to be operating at or above its potential.” He cited the Markit composite global purchasing managers’ index (PMI), measuring conditions in both manufacturing and services sectors. The global composite PMI fell in March to its lowest since December 2016 although at 53.3 is still comfortably above the key 50-level which demarcates expansion from contraction.
The oil price surged to its highest level since December 2014 pushed higher by a combination of geopolitical risks, falling OPEC supply and strengthening global demand. The Brent oil price exceeded the $70 a barrel level for the first time in over three years. Geopolitical risks to supply include the escalation in conflict in Syria, the prospect of renewed sanctions against Iran and a collapse in production in Venezuela. The US oil rig count has bounced back in response to rising oil prices, bringing the total to 815 in the past week the highest since March 2015. The US Energy Information Administration forecasts annual US production will rise to a record high 10.7 million barrels per day (bpd) in 2018 and 11.4 million bpd in 2019 up from 9.3 million bpd in 2017. However, rising global demand is absorbing increased US production. The International Energy Agency reported that global inventories of petroleum fell to just 53 million barrels above the five-year average at the end of January, down sharply from the 302 million-barrel excess a year earlier.
According to the minutes from the Federal Reserve (Fed) policy meeting in March: “All participants agreed that the outlook for the economy beyond the current quarter had strengthened in recent months” and that “all participants expected inflation on a 12-month basis to move up in coming months.” The Fed minutes suggest a steeper trajectory for interest rate hikes than had been previously expected by policy makers with some warning that rates could eventually be lifted to deliberately restrict growth. The change in outlook is attributed to the US tax plan and increased fiscal spending. However, “a strong majority” saw the prospect of retaliatory trade actions by other countries as a risk for the US economy. Fed officials described the loss in economic momentum in the first quarter as “transitory”, attributed to seasonal factors.
Federal Reserve Bank of Boston President Eric Rosengren, while optimistic about the outlook for the US economy, cautioned that current tax cuts and increased fiscal spending will reduce government’s capacity to address the next cyclical economic downturn. Rosengren said: “By using up so much fiscal capacity now, by which I mean the ability to lower tax rates or boost federal spending to offset economic weakness, the country risks not having sufficient fiscal capacity in the future when it might be needed.” He also cautioned that as interest rates may not rise as much as they did in the past there would be less scope to reduce them. Rosengren alluded to the use of quantitative easing and less conventional monetary policy measures if they should be needed.
The yield spread between the 2-year and 10-year US Treasury bonds has declined to just 47 basis points its lowest since 2007. The so-called “yield curve” is a barometer for the economic outlook. A flat yield curve is traditionally viewed as a signal of weakening growth while an inverted yield curve usually presages a recession. While the 10-year yield has dropped back due to trade-related risks to the long-term economic outlook the 2-year yield has risen sharply in response to an increasingly “hawkish” Federal Reserve. The flattening in the yield curve may have been exacerbated by the government’s deficit spending and associated glut in short-dated bond issuance. However, it is a concern that has been flagged by Federal Reserve Bank of Dallas President Robert Kaplan: “I, for one, am going to be watching this yield curve very carefully… I do not want to knowingly tighten into a flat or inverted yield curve.”
The combination of US equity market declines since the start of the year and rapidly rising earnings forecasts has sharply lowered the valuation of the S&P 500 index. The estimated 12-month forward price-earnings multiple has reduced from 18.6x at the end of February to 16.3x its level in 2014. Although still above the long-term average of 15.5x it appears that value has been restored in US equity markets. First quarter (Q1) earnings could provide the catalyst for a lift in equity markets. Around 80% of gains in the S&P 500 index since 2013 have come during earnings reporting seasons. However, there is a danger that because expectations are so high they are more prone to disappointment. The rolling forecast for 12-month forward earnings has increased by a massive 11% since the start of the year, due mainly to US tax cuts. Earnings are expected to increase in Q1 by a substantial 18.4% year-on-year, according to Reuters consensus forecasts, posing a high bar for earnings “beats”.
Consumer price inflation (CPI) accelerated to 2.4% year-on-year in March from 2.2% in February, driven higher by food, alcohol, medical products and services prices. Core CPI, excluding energy and food, accelerated even more sharply from 1.8% to 2.1%. This is the strongest reading since February 2017. Core CPI is now well above the 1.8% average for the past ten years and above the Federal Reserve’s (Fed) 2% target. The Fed’s preferred measure, personal consumption expenditure (PCE) remains below the 2% target at 1.8% with core PCE at 1.6% but there are indications of rising inflation. Higher oil prices and the weaker dollar are likely to exacerbate the inflation outlook. Pipeline pricing pressure is evident in the producer price inflation (PPI) data. PPI increased in March by 0.3% month-on-month. Food PPI increased by a whopping 2.2% on the month, the largest increase in four years. Services PPI increased on a month-on-month basis for a third straight month lifting the year-on-year rate to 2.9% its highest in almost eight years.
US commercial and industrial loan balances increased in March by a substantial 9.3% year-on-year to a record $2.13 trillion, marking the fastest rate of growth since President Trump’s election in 2016. This indicates a significant acceleration from the first quarter growth rate of 5%. The tax plan is prompting a recovery in corporate credit extension, which has been conspicuously absent in the economic recovery so far. Corporate credit extension bodes well for capital investment spending, a key prerequisite for much needed productivity improvement.
China posted an unexpected trade deficit of $4.98 billion in March its first trade deficit since February 2017. Imports increased 14.4% year-on-year while exports contracted 2.7%. The sharp increase in imports is attributed to inventory replenishment after the week-long Lunar New Year holidays. However, the decline in exports may signal a slowdown in global demand. While China’s overall trade surplus fell in the first quarter (Q1) by around 20% on the year to $48.39 billion the trade surplus with the US increased over the same period by 19.4% to $58.25 billion. The surplus trend with the US appears to be unique suggesting a broader explanation than unfair trade practices. Fiscal stimulus in the US contrasts with restrictive economic policy in China. Due to policy divergence, it is inevitable that the US will import more while China will import less.
Consumer price inflation (CPI) fell sharply in March to 2.1% year-on-year from February’s four-year high of 2.9%. The steep decline is attributed to the return to normality after the Lunar New Year holidays, which pushed up food and service prices. Food price inflation fell in March to just 2.0% after rising to 3.6% in February. Meanwhile, producer price inflation (PPI) slowed for a fifth straight month, falling to 3.1% from 3.7% in February, reflecting a decline in input costs of mining products, raw materials, manufactured items and consumer goods. The benign outlook at the producer level suggests CPI will remain on a downward trajectory over the medium-term. The favourable inflation backdrop did not deter the People’s Bank of China from raising its 14-day reverse repo interest rate from 2.65% to 2.70%, matching a similar hike to its benchmark reverse repo lending rate from 2.50% to 2.55% on 22nd March. Monetary tightening is aimed less at quelling inflation than at further deleveraging in the economy.
Core private sector machinery orders, excluding volatile orders for ships and utilities, unexpectedly increased for a second straight month, rising in February by 2.1% month-on-month, confounding analyst forecasts for a pullback after the 8.2% increase in January. The government’s Cabinet Office maintained its assessment that “machinery orders are showing signs of a pickup.” Marcel Thielant, senior Japan economist at Capital Economics said: “Firms are facing the most severe capacity shortages since the early 1990s and business confidence remains strong. The upshot is that business investment should remain one of the key growth drivers this year.”
Eurozone industrial production fell in February by 0.8% month-on-month marking the third consecutive monthly decline following declines of 0.6% in January and 0.1% in December. On a year-on-year basis industrial production growth slowed to 2.9% down from 3.7% in January and 5.2% in December. By industrial category, intermediate, capital, and consumer goods production all suffered declines on the month. Capital goods production fell the most by 3.6%. However, energy production increased 6.8% on the month, helped by cold weather. By country, Germany’s industrial production growth halved to 2.5% on the year, although this was made up by a sharp increase in production in Spain, France and the Netherlands. While the loss in momentum is disappointing, industrial production in the region remains generally upbeat.
The Eurozone trade surplus widened in February to €21 billion from €20.2 billion in January. While providing an added boost to first quarter GDP, the increased trade surplus is a result of falling imports stemming from slowing domestic business and consumer demand rather than rising export growth. Exports fell 2.3% on the month while imports fell even more rapidly by 3.1%. Exports, which were a key driver of the Eurozone’s strong economic recovery in 2017, are at risk from rising global trade tensions and the impact of a strong euro on trade competitiveness. In the minutes of its latest monetary policy meeting the ECB cited the risk posed by a strengthening euro: “Developments in foreign exchange markets continued to be a significant source of uncertainty and a risk that needed monitoring.”
Industrial production increased by less than expected in February, indicating underlying weakness in the economy in the first quarter of the year. Industrial production increased 0.1% on the month and 2.2% on the year below respective consensus forecasts of 0.4% and 2.9%. Had it not been for cold weather, which lifted electricity and gas output by 3.7% on the month, contributing 0.43 percentage points to industrial production growth, the slowdown would have been even more pronounced. Manufacturing output fell 0.2% on the month, the first decline since March 2017, attributed to a 3.9% decrease in the output of machinery and equipment. Construction output fell 1.6% on the month with infrastructure spending slumping by 9.4%. The data suggests manufacturing, which contributed to the UK’s resilience last year, may finally be succumbing to weak domestic demand while the stronger pound is beginning to affect export competitiveness.
Ian McCafferty, a member of the Bank of England (BOE) Monetary Policy Committee and one of two members who voted for an interest rate hike at the policy meeting in March, said: “We shouldn’t dally when it comes to tightening policy modestly.” McCafferty, a key BOE member, and former chief economic adviser to the Confederation of British Industry, argued that wage growth might prove stronger than most of his policy colleagues expect. He cited unemployment at its lowest level since 1975. McCafferty also said the “jury is still out” on whether inflation, which was forced higher by sterling’s post-Brexit slump, will ease back as the currency recovers. Financial markets forecast a 25 basis-point rate hike in May and a further rate hike before year-end followed by two rate hikes in 2019, lifting the benchmark interest rate to 1.5% by end 2019.
FAR EAST AND EMERGING MARKETS
The US imposed sanctions on Russia citing a “range of malign activity” including the occupation of Ukraine’s Crimea, aiding Syria’s Bashar Assad, interfering in US elections and more. The sanctions involve the blacklisting of selected Russian oligarchs, government officials and companies. The order freezes assets subject to US jurisdiction and prohibits Americans from dealing with the individuals and companies. The Russian sanctions caused the rouble to decline 4% on the day, Russia’s main stock index to plummet 8% and Russia’s 10-year government bond to fall 50 basis points from 6.75% to 7.25%. Prior to the selloff Russia had been the best performing market in the MSCI Emerging Market Index, helped by a rising oil price, falling inflation and declining interest rates. While financial conditions may have tightened following the sanctions they are only back to where they were at the start of the year. Over the long-term the most accurate barometer for the rouble is the oil price, which continues to climb higher, suggesting the currency and interest rates may revert to their favourable trends. Russian equities are even cheaper after last week’s steep decline, now trading on an estimated 12-month forward price-earnings multiple of 6.5x half the rating of the MSCI Emerging Market Index.
Brazil’s consumer price inflation (CPI) fell from 0.32% month-on-month in February to 0.09% in March taking the year-on-year rate down to 2.68% the lowest since the mid-1990s and well below the central bank’s target range of 4.5% plus or minus 1.5 percentage points. The low inflation reading signals a further cut in the central bank’s benchmark Selic interest rate. The central bank’s monetary policy committee, known as Copom, which has cut the Selic rate by 12 times in less than 18 months to a record low 6.5% guided at its policy meeting last month for a further rate cut. The next rate cut may be the last prior to the expected increase in political uncertainty ahead of upcoming general elections in October.
Singapore’s GDP growth accelerated in the first quarter (Q1) to 4.3% year-on-year up from 3.6% in Q4 2017 and 3.6% for 2017 as a whole. The pickup in economic momentum is attributed to the manufacturing sector, which grew in Q1 by a massive 10.1% on the year up from 4.8% in Q4. Services output growth also gained from 3.5% to 3.8%. Due to its high dependence on trade Singapore’s economic data is closely followed as a barometer for global economic and trade conditions. The data, which appears to contradict the view that global growth may have peaked, bodes well for global economic prospects.
KEY MARKET INDICATORS (YEAR TO DATE %)
JSE All Share
JSE Fini 15
JSE Indi 25
JSE Resi 20
Having broken the key resistance levels at R/$12.50, the rand has returned to its appreciating trend, targeting a break below R/$11.00 over coming months.
The US dollar index has tried but failed to break through a major 30-year resistance line suggesting the three-year bull run in the dollar may be over.
The British pound has broken above key resistance at £/$1.35 promoting further near-term currency gains to a target range of £/$1.40-1.50.
The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.
The US 10-year Treasury yield has broken decisively above key resistance at 2.5%, targeting the next key resistance level at 3.0%. A break above long-term resistance at 3.6% would indicate an end to the multi-decade bull market in bonds.
The benchmark R186 2025 SA Gilt yield has broken below key resistance at 8.6%% indicating a new target trading range of 8.0-8.5%.
Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.
The Brent oil price has broken above key resistance at $60 and likely to remain in a trading range of $60-70 over the foreseeable future. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $7000 per ton.
Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1400 target level.
The break in the JSE All Share index above key resistance levels at 56,000 and 60,000 signal the early stages of a new bull market.
An optimal share portfolio is constructed around companies with a long-term competitive advantage and good corporate governance. While the valuation of the investment is a key factor, a sound balance sheet is essential. Strong balance sheets protect wealth.
When dark clouds appeared, Steinhoff was brought down overnight by a weak balance sheet. On the other hand, despite negative reporting from Viceroy and substantial attention from short-sellers Capitec, with a strong balance sheet, held its own.
When is a balance sheet strong? The golden thread running through strong financial statements is CASH. Cash is king! The three crucial figures in a balance sheet health check are the level of debt and of cash on the balance sheet and the level of cash flow in the income statement.
First, a strong balance sheet has more assets than debt, the more the better. Second, if a large portion of the assets is held in cash, this is better still. Third, a strong balance sheet is supported by a strong income statement. A company should have the ability to generate strong cash flows from its operations. The cash will flow from the income statement to the balance sheet.
The five companies with the strongest balance sheets in the world are Berkshire Hathaway, led and founded by Warren Buffett, Apple, Alphabet (formerly Google), Microsoft and Tencent, one third owned by Naspers.
Let’s look at Apple. To say that the three crucial figures for Apple are strong, is a massive understatement. First, it has $269 billion in cash. Second, it has “only” $97 billion of debt. Third, Apple generates annual cash flows of $51 billion. The company’s debt of $97 billion can easily be settled within two years from the strong cash flows. Or it can simply “pay back its debts” from the cash in the bank. A war chest of cash is a great asset.
Closer to home, a company with a strong balance sheet is Mr. Price. First, cash in the bank is a healthy R1.8 billion. Second, debt is low at a comparatively negligible R50 million. Third, the annual cash flow is R427 million (2017). Mr. Price can use cash flow to settle its entire debt within just two months! This is faster than Apple’s two years. At Mr. Price, cash is king.
When dark clouds gather, it is vital to own companies with strong balance sheets. These companies will have several strategies to not only manage and survive but also to benefit from economic downturns. In the end, they are in the enviable position of being able to “bleed” their competition out of business or to buy them out at bargain prices.
Overberg Asset Management specialises in the management of private share portfolios. Our philosophy ensures a secure long-term relationship with our valued clients, built on trust, service, value and performance. At the cutting edge of investing, Overberg has a proven track record in Global and Domestic South African markets.