01 Jul Q3 2014
Currency markets have featured in the recent past. The trade-weighted dollar is up 9% since the beginning of May, advancing against all other major currencies to a 4-year high [CHART 1]. Reasons include the more robust growth in the US, and the benefit to its trade deficit of its rapidly rising oil production. But, also, because it has become the new ‘high’ yield play. The US 10-year Treasury now offers 2.5% against just 0.9% on the German 10-year Bund [CHART 2]. It seems astonishing that anyone would choose the Bund over the dollar given its much lower return, but more particularly as it is denominated in the weakening Euro rather than the buoyant dollar!
Although the dollar is clearly overbought in the short term (it has risen for 11 consecutive weeks – the longest run in over four decades), it appears likely to continue advancing (with periodic corrections) for some time yet. Apart from the stronger economic growth dynamic there will soon be another reason to buy the dollar when the Fed starts hiking rates.
Commodity prices, and the currencies of commodity countries, have been hard hit by the rampant dollar. Oil prices have fallen to their lowest in two years, gold is at a ninemonth trough and copper is down to a three-month low. Soft commodities have extended their already steep declines: the CRB grains index is down 10% since May. The silver lining of these falls is, of course, the benefit to world growth.
We have been downright sceptical of the widely-held views that the rand would remain relatively stable through 2014 and 2015. Consensus forecasts for the rand:dollar rate at the beginning of the year were R10.74 for end 2014 and R10.94 for end 2015. Several forecasters were predicting a below R10 rate at the end of 2015. We took the view that commentators were not taking sufficient cognizance of the dollar’s very positive outlook when forecasting the rate for the rand. Thus, even without allowing for SA’s anaemic growth and its huge budget and trade deficits, it was difficult to assume that the rand would hold steady over this period. The recent dollar strength has sent the rand tumbling back to its January low of R11.27 [CHART 3].
Although we are likely to see a short term correction from this level, there is little prospect of a meaningful recovery in our twin deficits. In addition, we are particularly vulnerable to the inevitable Fed rate hikes, especially with 37% of our local sovereign bonds held by offshore investors.
In keeping with our view of currency vulnerability, we remained steadfast in our belief that our heavy offshore exposure should be maintained. In all our funds we retained the maximum offshore permitted by regulation or our fund mandates, where applicable.
But it was not just the currency concerns which motivated this: our view of the prospects for the local bond and equity markets was a major additional factor. The SA equity market is expensive under any scenario, let alone under the bleak outlook we now face. The forward p/e is the highest in well over 10 years. Currently it is just on 15 times the next 12 months estimated earnings – significantly above the 10-year average of 11 times [CHART 4].
By contrast, in the US (where the greater part of our investment has been directed), the forward 12-month p/e is a little higher at 15.9 times, but with a significantly better outlook. This rating is also above its 10-year average (of 14.1) but this 13% premium compares with SA’s 35%.
Along with the US, most other major markets currently have forward PE ratios above their long term averages and are thus no longer cheap. But, given the unattractive alternatives of bonds (which are extremely vulnerable to Fed tightening) and cash (which offers pitifully low returns), the higher ratings are probably sustainable for now.
However, further expansion of PE ratios is difficult to justify, so future market advances could well be limited to earnings growth. Fortunately, with the gradual improvement in global economies and continuing accomodative monetary policies the outlook for corporate profits is still quite positive.