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US interest rates crucial for SA markets

Cape Town - One of the most important influences on SA’s financial markets this year will be the reaction of US equity markets to the expected hike in US interest rates, says Overberg Asset Management is its weekly overview of the SA market landscape.

"When the US sneezes the rest of the world catches a cold. The Federal Reserve is widely expected to hike its benchmark Fed Funds interest rate sometime in the second half of the year, with the impact reverberating throughout global financial markets," says OAM.

According to OAM investors in SA will be keeping a close eye on the Fed.

Describing the contraction in US GDP in the first quarter as “transitory” Fed Chair Janet Yellen is clearly preparing financial markets for a rate hike, expected according to consensus forecast in either September or December.

Market overview

SA economic review

• Total vehicle sales fell in May by -3.2% year-on-year following a similar decline of -3.3% in April and worse than the consensus forecast for 0.2% growth. Although total vehicle sales increased 7.6% month-on-month this was due to the larger number of trading days compared to the previous month. The outlook for domestic vehicle sales remains uncertain due to weak consumer and business confidence. Passenger vehicle sales fell -5.4% on the year and commercial vehicle sales were also lackluster rising by just 1.2%. Vehicle exports offered a bright spot, rising in May by 114.2% on the year due to the base effect of low comparative figures.


• GDP growth slowed markedly from 4.1% quarter-on-quarter annualized in the fourth quarter (Q4) last year to just 1.3% in Q1 below the 1.6% consensus forecast. The culprits are manufacturing which contracted -2.4% annualized and agriculture which shrank by a surprisingly large -16.6%. The mining sector continued to recover providing some relief with growth of 10.2% and the “finance, real estate and business services” sector also grew a robust 3.8% on the quarter. While GDP growth is likely to recover slightly over the remainder of the year to around 2-2.5% for 2015 as a whole, the risk remains of further downward surprises amid power shortages, and weak consumer and investment confidence.

• The unemployment rate increased from 24.3% in the fourth quarter (Q4) last year to 26.4% in Q1 substantially above the 24.8% consensus forecast. While total payrolls increased during the quarter by 140,000 this was no match for the 766,000 increase in the labour force over the same period. However, the deterioration in unemployment is probably exaggerated by the shift in sampling from the 2001 Census to the 2011 Census. The increase in the labour force seems unnaturally large.

• The Kagiso manufacturing purchasing managers’ index increased sharply from 45.4 in April to 50.8 in May back above the expansionary 50 level for the first time since January and substantially above the 46.7 consensus forecast. Encouragingly the gain is attributed to the forward-looking new sales orders index which increased strongly from 42.3 to 52.2. The business activity index also gained strongly from 40.6 to 49.6. However, inflationary pressures were apparent with the input prices sub-index rising for a third straight month from 69.0 to 73.2 in response to rising global commodity prices. Meanwhile, the employment sub-index remained weak at 45.2 in sub-50 contractionary territory for a fourteenth straight month.

• Producer price inflation (PPI) unexpectedly decelerated from 3.1% year-on-year in March to 3.0% in April below the consensus forecast increase to 3.4%. On a month-on-month basis PPI registered 0.9% also well below the 1.3% consensus forecast. The below forecast PPI reading is attributed to an unexpected decline in food price inflation from 6.0% on the year to 5.4% in spite of the drought and its effect on maize prices. However, pipeline pressures appear to be increasing with electricity and water prices rising 4.7% on the month, followed by agriculture, forestry and fishing with a 4.5% increase. PPI data could spike higher in coming months especially if Eskom is awarded the 22% electricity tariff increase it is requesting.

• Despite weak GDP data and a lower than forecast producer price inflation reading expectations are growing that the SA Reserve Bank (SARB) will soon hike interest rates. The Forward Rate Agreement market is pricing-in a 75% probability of a 25 basis point rate hike at the July monetary policy meeting and an 80% probability of a further 25 basis point increase at the September meeting. In a speech following the release of the SARB’s annual bank supervision report SARB Deputy Governor Kuben Naidoo said the probability of rate hikes at the next few meetings is high.

• Growth in private sector credit extension increased more than expected from 8.7% year-on-year in March to 9.3% in April above the 8.9% consensus forecast. Growth in household credit extension slowed from 3.6% to 3.3% although mortgage advances growth strengthened slightly from 2.7% to 2.8% the highest in 14 months. However, credit growth to the corporate sector accelerated from 14.2% to 15.8%. The robust credit growth to companies seems at odds with the weak domestic business investment climate and is probably explained by investment into the rest of the continent.

• The trade deficit widened from a revised deficit of –R9 million in March to a –R2.51 billion deficit in April although less than the –R5.5 billion consensus forecast. The relatively mild trade deficit was assisted by strong exports of vehicles and equipment which increased by 41.0% year-on-year, and exports of precious and semi-precious stones which increased 33.8%. Imports of mineral products including crude oil fell by -36.7% on the year reflecting the benefit of lower oil prices. The last two trade balances have shown a steady improvement in SA’s external accounts reducing the cumulative trade deficit for the year-to-date to US$ 3.0 billion the lowest since 2012. The current account deficit is expected to benefit, likely to reduce from 5.1% of GDP in the fourth quarter (Q4) 2014 to around 4.6% in Q1.

• In the Institute of Management Development (IMD) annual world competitiveness ranking SA dropped from 53 last year to 52, out of 61 economies. The IMD cited SA’s electricity infrastructure issues ranking the economy in last place on this category. In addition the IMD cited poor performance in terms of education and health, as well as labour regulations. The country’s ranking has fallen sharply since 2012 when it was placed 37.

• Foreign investors bought R0.8 billion worth of SA bonds and R3.4 billion worth of equities in the past week. Foreigners bought over R3 billion worth of equities on Friday alone attributed to the second quarter rebalancing of the MSCI World Index. Over the month of May foreign investors sold R0.8 billion worth of bonds and bought R5.0 billion worth of equities, while for the year-to-date foreign investors bought R8.5 billion and R22.9 billion worth of SA bonds and equities respectively. However, data shows that non-resident percentage ownership of SA government bonds has dropped to its lowest level in 18 months indicating some loss of appetite ahead of the Fed’s expected interest rate hike.

SA political review

• Speaking at the launch of the Transnet Hub Development acting Eskom CEO Brian Molefe said there would be no more load shedding over the winter season. Molefe tweeted: “No planned loadshedding this winter. Limited maintenance will be done during this period as most work was done in summer.” Molefe also announced that Unit 1 of the Koeberg Power Station will be returned to service this weekend following a three-month planned shutdown. Eskom also announced that Unit 6 at the newly built Medupi Power Station reached a new record output of 800 megawatts this week, providing further stability to the power grid.

The week ahead

• Fitch credit rating review: Due Friday 5th June. The Fitch credit rating agency will release its review of SA’s credit rating. Fitch has SA on a “Negative Outlook” which raises the chances of a credit rating downgrade from the current BBB to BBB-. However, Fitch may defer any downgrade until it sees the final costing of the public sector wage bill and the outcome of wage talks in the gold and coal sectors. The current BBB rating is two notches above speculative grade.

• Gross reserves: Due Thursday 4th June. Gross reserves are expected to decline slightly from $47.04 billion in April to $46.29 billion in May.

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation. A break above the key “Fibonacci” level of R/$12.15 would open up a further depreciation in the rand to the R/$13.00 level.

• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.

• The long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.

• The US 10-year Treasury yield has broken below key resistance levels of 2.40% and 2.0% indicating a trading range of 1.70-2.2% over the medium-term. There is unlikely to be a major bear trend in US bonds as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield is testing support at 8.15% and needs to break below resistance at 7.90% in order to resume its bull trend.

• The MSCI World Equity index is in the 5th and final wave of a rising-wedge formation. A rising-wedge formation is a typical trend-ending signal. European equities are set to outperform US markets. The Nikkei exhibits the most bullish pattern.

• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle can be expected in the next year. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur around June 2016.

• In the meantime the S&P 500 is displaying a bullish short-term pattern. The index is moving into an advanced triangle pattern which normally signals the continuation of an upward trend. This view is corroborated by the “downward flag” of the Dow Jones index, which is also associated with an upward break-out.

• Although enjoying a temporary respite Brent crude’s previous break below key support levels at $60 and $50 suggesting a continuation of the weakening long-term trend. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the 2011 low of $6,500 suggesting a further downside move to $5,500.

• Despite recent advances Gold is in a protracted bear market signalled by rapid declines through successive support levels at $1400, $1300 and $1250. Gold’s next target is $1100 and is likely to breach $1000 before the bear market ends.

• The All Share index has broken to new highs exceeding the 55,000 level for the first time indicating a continuation of the long-term upward trend.

Bottom line

• One of the most important influences on SA’s financial markets this year will be the reaction of US equity markets to the expected hike in US interest rates…. When the US sneezes the rest of the world catches a cold. The Federal Reserve is widely expected to hike its benchmark Fed Funds interest rate sometime in the second half of the year, with the impact reverberating throughout global financial markets. Investors in SA will be keeping a close eye on the Fed. Describing the contraction in US GDP in the first quarter as “transitory” Fed Chair Janet Yellen is clearly preparing financial markets for a rate hike, expected according to consensus forecast in either September or December.

• Although the commencement of the Fed’s interest rate tightening cycle is bound to prompt a correction in US and global stocks, the correction is likely to be sufficiently mild for long-term investors not be deterred. Long-term investors should remain invested rather than trying to time the market. Previous Fed tightening cycles in 1994 and 2004 which coincided with similar improving economic outlooks as today, were accompanied by equity market corrections of less than -10%.

• Although Fed tightening cycles are associated with a de-rating in US equities (a decline in the price-earnings multiple) the impact on share prices will be mitigated in the current improving economic environment by rising company earnings. US earnings forecasts are so low due to the recent economic slowdown that they could likely surprise on the upside even with a mild improvement in GDP prospects.

• Furthermore, it is highly likely that once it starts the Fed will raise interest rates very gradually. Inflation remains very low and there is a sizeable “output gap” between the economy’s full capacity and actual capacity utilisation. The Fed is likely to move as soon as it can but very slowly thereafter. The risk to the Fed of raising rates too slowly is far less than the risk of raising rates too fast. If inflation jumps the Fed has ample room to raise rates. However, if inflation falls further and employment growth slows the Fed will have little recourse other than a QE4 programme, a scenario which the Fed is keen to avoid at all costs.

• Flat inflation gives the Fed significant room for manoeuvre and should keep a cap on bond yields, a winning recipe for US and global equity markets even after the initial Fed rate hike.

For the full report, including a look at international markets, click here.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.

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