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JSE remains vulnerable to further declines, warns OAM

Cape Town - Although the JSE All Share index has dropped around 4.5% over the past fortnight it still remains vulnerable to further declines, warns Overberg Asset Management in its weekly overview of the economic and political landscape in South Africa.

The All Share index is up 12% from its lows in early January and appears dramatically over-priced on a price-earnings (PE) multiple of 21.2x, around 40% above its 14.8x long-term average, according to OAM.

"Some of the premium rating is explained by the high valuations of large multinational stocks such as Naspers, British American Tobacco and SABMiller, hence the 28.2x PE multiple of the Industrial 25 index."

OAM adds that part of the JSE’s high valuation is attributed to the jump in resource stocks. The Resources 20 index has gained 21% since the start of the year and trades on an excessive 23.8x PE ratio despite weak fundamentals.

South Africa economic review

• The SA Chamber of Commerce and Industry (SACCI) Business Confidence Index (BCI) edged higher from 81.2 in March to 82.5 in April marking the fourth straight monthly increase. However, the business confidence reading still remains close to its historic low of 79.6 reached after Nenegate in December last year. The largest positive contribution to the BCI came from the real value of building plans approved, while the largest detractors came from the rand exchange rate, export volumes, equity market prices and new vehicle sales.

• In a Bloomberg survey 12 out of 13 economists expect Standard & Poor’s (S&P) credit rating agency to cut SA’s sovereign debt rating to sub-investment grade (junk status) by the end of the year. Only four economists expect the rating downgrade at the upcoming meeting in June while the majority expect S&P to wait until December. It is expected that S&P will delay in order to see how the economy responds to a weaker currency and the lifting of the drought. In addition, the rating agency will want to see if the National Treasury can adhere to its deficit targets especially with regards to fiscal demands from state-owned enterprises. The upcoming local elections may also help resolve current political uncertainty and therefore support a delay in S&P’s key decision.

• Moody’s credit rating agency surprised the markets, which had expected a rating downgrade, by leaving SA’s sovereign debt rating unchanged at “Baa2”, a notch above the other agencies Standard & Poor’s and Fitch. Moody’s said the country was probably approaching a turning point after several years of slowing growth, that the latest budget and fiscal plan would likely stabilise and eventually reduce government debt, and that recent political developments, although disruptive testified to the underlying strength of SA’s institutions. In its statement Moody’s said economic growth would gradually strengthen as various supply-side shocks receded: “Specifically, the electricity supply is now more reliable, the drought is ending and the number of workdays lost to strikes has shrunk significantly.”

• Speaking in parliament Finance Minister Pravin Gordhan was confident that the government would be able to stick to its deficit targets despite weakness in economic growth. This years’ budget projected a state deficit of 3.2% of GDP in the current fiscal year declining to 2.4% in three years. According to Pravin Gordhan centralised government procurement through the Public Procurement Office, would be key to controlling state expenditure. The initiative which began in April, would enable more efficient purchasing saving around R25bn a year.

• On the conclusion of its visit to SA between 18 April and 4 May the IMF mission team gave an upbeat assessment of the country’s economic outlook. Laura Papi who headed the IMF mission forecast economic growth of 0.6% in 2016 but a gradual recovery from 2017. Papi said: “Risks to this outlook are tilted to the downside and include further shocks from China, heightened global financial volatility and sovereign credit rating downgrades. On the upside, the recent dialogue between government and social partners could catalyse reform implementation and invigorate growth.” The IMF report cited welcome progress in easing infrastructure bottlenecks with specific reference to electricity supply, commitment to reform of state-owned enterprises, and improvement in public procurement.

• The Barclays manufacturing purchasing managers’ index (PMI) surged higher from 50.5 in March to 54.9 in April well above the 50.2 consensus forecast, and the highest since August 2013 remaining well above the expansionary 50-level. All sub-indices were above the 50-level indicating a broad-based and sustainable improvement. The business activity index increased from 47.7 to 56.4, and the employment index increased from 48.4 to 50.5 above the 50-level for the first time since March 2014. The new sales orders index climbed from 53.1 to 58.4 signaling a robust improvement in the months ahead, with increased demand attributed to import substitution and rising exports. Meanwhile the input prices index fell from 87.8 to 77.7 reflecting an ebb in inflationary pressure in positive response to the recent strengthening in the rand. The overall data is encouraging suggesting the manufacturing sector may have turned the corner. The index measuring manufacturers’ expectations in six months’ time increased from 51.1 to 55.9.  

• According to the Labour Force Survey the unemployment rate jumped from 24.5% in the fourth quarter (Q4) last year to 26.7% in Q1 the highest rate since the new data series was initiated in 2008. Employment declined by 355 000 jobs during the quarter with the formal sector shedding 217 000 jobs and the informal non-agricultural sector shedding 111 000. Meanwhile the number of unemployed people increased by 521 000 as new entrants joined the jobs market. Eight out of the ten economic sectors recorded job losses led by the trade and manufacturing sectors with losses of 119 000 and 100 000 jobs, while the mining sector lost 10 000 jobs. By contrast the community and social services sector created 52 000 jobs mostly in the public sector, and surprisingly the agricultural sector created 16 000 in spite of the drought. The dismal employment data makes the SA Reserve Bank’s (SARB) job extremely difficult. Stuck in a classic stagflation environment with rising inflation despite rising unemployment the SARB may refrain from hiking interest rates at the upcoming policy meeting on 17-19 May.

• Although the decline in total vehicle sales decelerated from -14.3% year-on-year in March to -9.2% in April the monthly volume fell to the lowest since December 2010. The drop in passenger vehicle sales improved slightly from -13.7% to -13.2% with a more pronounced improvement for commercial vehicle sales from -15.1% to -0.9%. Total vehicle exports grew a robust 18.6% month-on-month helped by the base effect of fewer Easter-related trading days in March. On a year-on-year basis total exports grew 39.2% recovering from the phasing out of some high-volume models over previous months.  While export figures are encouraging domestic sales reflect weakness in both consumer and business confidence amid subdued economic growth, rising inflation and tight lending criteria.

The week ahead

• SA first quarter (Q1) unemployment was released on Tuesday, 10 May. The unemployment rate increased to 26.7% from 24.5% in Q4 as a result of the economy shedding seasonal jobs created over the festive season and due to new entrants entering the jobs market. Employment declined by 355 000 jobs during the quarter with the formal sector shedding 217 000 jobs and the informal non-agricultural sector shedding 111 000. With economic growth at less than 1% the prospects for jobs growth are slim.

• Mining production: Due Thursday, 12 May. The year-on-year contraction in mining production is expected to deepen from -8.7% in February to -11.2% in March according to consensus forecast, a substantial deterioration from the -5.5% decline in January. The mining industry is being affected by low commodity prices and weak demand from China, as well as rising input costs especially the cost of labour.

• Manufacturing production. Due Thursday, 12 May. Having improved from a -2.6% year-on-year contraction in January to 1.9% growth in February manufacturing production is expected to fall -1.0% in March according to consensus forecast. Although the Barclays manufacturing purchasing managers’ index increased to 50.5 in March above the expansionary 50-level for the first time since July last year, the base effect of year-ago comparative data will contribute to a negative reading.

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation.

• 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.

• Despite the recent uptick in bond yields 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 above key resistance levels of 1.8% and 2.0%. However, 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 broke out of its long-term bull trend as a result of “Nenegate”. The new bear trend for the R186 is underpinned by resistance at 9.0% with a risk of further upside to 10.50%. While SA bond yields may fall in line with global bonds they are unlikely to return to the bull trend.

• The MSCI World Equity index has broken downward from a rising trendline which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1,400.

• 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 is likely to have just occurred. 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.

• The S&P 500 index has broken downward from a rising wedge pattern, which is traditionally a trend-changing pattern. The downward trend is likely to remain intact unless the index decisively regains the 2 070 level. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is leading the broader market lower on the downside.

• Despite the recent price rally Brent crude’s break below the key $30 support level in February suggests a continuation of the weakening long-term trend to a downside $25 target. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. Despite its recent rally the copper price broke below the key $4 500 support level in February suggesting further downside ahead.  

• Gold has broken its recent downtrend by rising decisively above the $1 100 resistance level. An extended break above $1 250 is needed to confirm the end of gold’s bear market.

• The JSE All Share index is testing an important resistance line but if this remains unbroken the index is likely to move back below the 24-month moving average at 50 700 in turn opening a downside target of 45 000 and an ultimate target of 43 000.

Bottom line

• Resource companies are suffering balance sheet stress exacerbated by dwindling cash flow and rising interest rates. Although commodity prices have increased over the past month this has a lot to do with the weaker dollar. The dollar may soon reassert its strength. The Federal Reserve appears to be preparing for an interest rate increase, which is more likely to be in June than September to avoid overlap with the presidential election.


• China buys over half the world’s supply of raw materials and is therefore the price setter for resources. Although there have been signs over the past three months that China’s economy has stabilised the outlook is still fragile. A dangerous pattern of debt and deflation is evolving.

• The property sector appears to be bottoming out but inflation, capital spending and industrial indicators remain in a downtrend. China’s company debt to GDP has surged since the massive 2009 stimulus programme and currently stands at 215% of GDP. Moreover, the debt overhang is centered on the industrial, construction and property sectors, which are the traditional consumers of raw materials.

• Debt and deflation contagion from China is probably a far greater risk to equity markets than weakening oil prices, or Fed interest rate hikes. As China’s rate of economic growth slows down there will be growing evidence of bad debts and insolvent banks, which will renew the downward pressure on commodity prices and the JSE Resource sector.

• Declines in the All Share index are likely to be led by the resources sector. Recent price action in resource stocks may lead us to believe that the sector is turning the corner. However, the fundamental outlook remains extremely uncertain.

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

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

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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