27four Investment Managers
16th March 2018
Monthly Global Market Overview | 4word
While local sentiment continued to ride on the renewed sense of optimism within the South African economy, the benefits of this continued to elude the local equity market with the overall market continuing to be weighed down by both by global uncertainty and volatility and also Rand strength as many investors adopt a wait and see approach regarding the delivery of earnings.
Notwithstanding this, pockets of the equity market (particularly those with a domestic bias) continued to witness significant re-ratings as the market began anticipating improved local economic growth and consequently earnings prospects from these sectors. If one considers the most obvious examples of such, Retailers and Banks continued to extend the strong gains from December and January into February. Eventually, the banking index ended the month up 9.47% with Retailers ending the month 3.45% in the green. This brought year to date gains for the banks to 7.77% and three month gains to 24.20% while the retail index has advanced 8.22% and 25.43% over the same respective periods. Given that the All Share Index delivered -1.87% and -2.20% over these periods provides some context as to the extent of pressure exerted on all Rand hedged stocks across multiple sectors.
The shifting narrative has been palpable and sectors which remained out of favour for the best part of two years have begun to re-rate aggressively in lieu of improved growth prospects on a forward looking basis. Further evidence of the shifting narrative outside of the large market capitalisation South African incorporated businesses can be found in what is being termed as the first wave of re-rating in a number of mid-cap opportunities. While it is still early days and there remains significant value yet to be unlocked from this segment of the market, one could consider the turnaround in fortunes at companies such as AECI as well as Italtile as clear examples of improving investor sentiment filtering through into interest in companies related in no way apart from size and perception of earnings base.
Since the rising optimism of shifting political winds within South Africa took a hold in early December, AECI has rallied an impressive 21.68% whilst Italtile has delivered a commendable 9.08% over this period. With both companies reporting results over the course of February, further evidence of the changing sentiment and outlooks for such companies was provided. AECI delivered creditable results growing headline earnings per share by 17%, profits by 21% and dividends by 10%. Perhaps most encouragingly, the group managed to do this at a time of very weak economic growth and subdued activity in the mining and manufacturing sectors which are the primary sources of business for its chemicals and explosives business. On another positive note, all numbers have been produced prior to the purchase and integration of Much Asphalt which would look to diversify the business’ earnings stream and generate many synergies to be exploited within the current business. While the results announcement was particularly impressive, there was no new material information to be obtained and analysts and the general market were already aware of AECI’s flexibility in navigating the business through a highly challenging economic backdrop. Despite this, until evidence of improved economic prospects emerged, a re-rating in the stock and the beginning of unlocking the potential returns eluded the share.
Italtile also managed to deliver an impressive earnings update for their last half year end to December 2017 with revenue growth of 22% over the prior period and operating profit ultimately growing by 21%. Perhaps more importantly, however, was the intent maintained by the company to continuously invest in new stores opening a further 10 stores during its second half bringing the total number of new stores opened to 22 in its current financial year. When adding to the equation the benefits of vertical integration to be brought in through the acquisition of Ceramic Industries which will extract considerable margin benefits, it appears the shifting backdrop and smart management are likely to hold the business in good stead on a forward looking basis.
While local equity managers continue to reposition their portfolios to capture the changing narrative filtering through and ultimately culminating into better growth and investment prospects within South Africa, it is arguable that a number of the domestic companies outside of the banking sector have been overdone and now perhaps exhibit excessive exuberance with regards to earnings growth prospects. Examples of such businesses re-rating prior to the delivery of earnings include Massmart (up 45% over a 3 month period) as well as Barloworld (up 15.45% over a 3 month period). While pockets of the banking sector continue to offer value (with Barclays Africa still only trading around 10X forward earnings on a dividend yield in excess of 5% and Standard Bank on around 12.5X forward earnings with a dividend yield of almost 4% and a stellar earnings release for the last financial year end), investors continue to remain cautious regarding the extent of the re-rating witnessed and continue to position their respective portfolios for the second wave of this re-rating. Reasoning seems to dictate that the quality mid-cap segment of the market presents the next best opportunity for investors to buy stable and improving earnings trajectories likely to benefit from an improving local economy. As such, a number of investment managers have shifted to this sector of the market hoping to catch a second leg to the “SA Inc” rally.
With economists across the board upgrading forecasts for economic growth in South Africa (with Goldman Sachs being the most bullish upgrading forecasts to 2.3% for 2018 and dubbing South Africa the emerging market story of 2018), it is critical that policy makers continue to capitalise on this great positivity and continue to take the right steps in a short window period to avoid ratings downgrades and continue to support improving business and consumer confidence so as to deliver the much required economic growth to tackle chronic unemployment. Having said this, the cabinet reshuffle that was announced bringing highly credible ministers Nhlanhla Nene and Pravin Gordhan back into the fold have been exceptionally positive developments. When coupled with the austere budget announced for the 2018/19 financial year implementing considerable tax increases in the way of higher fuel levies as well as a 1% increase in VAT a strong message of action has been signalled to ratings agencies with regards to tackling the concern of ballooning debt and has come at a critical time ahead of a vital update from ratings agency Moody’s. With the welcome news of economic growth numbers for the fourth quarter (and consequently for the year of 2017) coming in ahead of expectations (3.1% growth for the fourth quarter brining 2017 growth to 1.3%), the market has begun to price in no ratings downgrade from Moody’s at its March update.
On the global front, while markets remained exceptionally bullish on the prospects for the global economy and investment for 2018, the greatest threat to a stable and gradually rising global equity market remains the threat of spiralling inflation and consequent drastic tightening action from global central banks. The middle of February highlighted the dangers of increasing global volatility as over-subscribed leveraged equity products dependent on ongoing low volatility had to be unwound at considerable loss to investors. While the source of this increased volatility is speculated to be related to faster than expected increases in inflation driven by wage inflation out of the US, there are a number of factors which could increase such volatility at the margin given the historically low base it is coming off. While investors would be well cautioned to be aware of such spikes in volatility, we believe this is nothing to be overly concerned about for the time being. The global earnings base continues to improve off the back of corporate investment as evidenced by 2017 being yet another record year for US merger and acquisition activity closing the year with in excess of $3 trillion in concluded transactions.
Share buy backs continue to reduce at a drastic rate as corporates no longer need to support earnings per share through financial engineering by reducing the number of shares in issue and ultimately the 4th quarter proved to produce exceptionally robust earnings numbers with every major region in the world growing earnings at a 10% or greater rate. There is always, however, the ongoing threat of heightened geopolitical risk causing volatility along the way. The latest bout of this has been an election in Italy seeing a strong rise in popularity for right wing anti-Euro parties as well as the steel and aluminium import tariffs announced by President Trump which threatens retaliation from the European Union as well as China increasing the risk of a damaging trade war. Ultimately, asset prices have reacted to this increasing risk given the sharp derating in the month of February.