Global Investing

South African equities hit record highs, doomsayers left waiting

Earlier this year it seemed that an increase in global bullishness meant the end of the road for risk-off investment strategies and, by extension, the rise in South African equities. However, 6 months later, the band is still playing, and the ship is refusing to go down.

South African equities have flourished in the face of the doomsayers, with returns this year doubling the emerging market benchmark equity performance. Both the all-shares index and the top-40 share have hit fresh all time highs this week, and prophecies of gloom for South African stocks appear to have missed the mark somewhat.

Part of the reason for this is that, when it comes to risk attitudes, much of the song remains the same. South Africa has certainly benefitted from its continued attractiveness to risk-off investors, as global bullishness has receded from whence it came. For instance, as it is relatively well sheltered from euro zone turmoil, and as major gold exporter, firms based in the gold sector are ostensibly an attractive investment for the globally cautious.

However, while ongoing uncertainty in the euro zone has meant that global sentiment has not recovered to a consistently risk-on position, there is more to South Africa’s performance than just a reliance on safe-haven gold. This is demonstrated by the highly fluctuating performance of gold during 2012, adding 3 percent to its value in total in 2012 and dropping in value over the second quarter. By contrast, South African equities have grown in value consistently over the year, adding ten percent thus far.

Indeed, according to John Paul Smith of Deutsche Bank, it’s not because of the country’s natural resources but despite them that equities have hit fresh highs. Resources have notably underperformed in South Africa this year, and other sectors such as financials, consumer stocks and telecommunications have been supporting the rise.

Russia: a hawk among central bank doves?

This week has the potential to bring an interesting twist to emerging markets monetary policy. Peru, South Korea and Indonesia are likely to leave interest rates unchanged on Thursday but there is a chance of a rate rise in Russia. A rise would stand out at a time when  central banks across the world are easing monetary policy as fast as possible.

First the others. Rate rises in Indonesia and Peru can be ruled out. Peru grew at a solid  5.4 percent pace in the previous quarter and inflation is within target. Indonesian data too shows buoyant growth, with the economy expanding 6.4 percent from a year earlier. And the central bank is likely to be mindful of the rupiah’s weakness this year — it has been one of the worst performing emerging currencies of 2012.

Korea is a tougher call. The Bank of Korea stunned markets with a rate cut last month, its first in three years. Since then, data has shown that the economy is slowing even further after first quarter growth eased to 2008-2009 lows. Exports are falling at the fastest pace in three years. But most analysts expect it to wait it out in August and then cut rates in September. Markets on the other hand are bracing for a rate cut as yields on 3-year Korean bonds have fallen well under the central bank’s main 7-day policy rate.

Will Poland have an “ECB moment”?

When Poland stunned markets in May with a quarter-point rate rise, analysts at Capital Economics predicted that the central bank would have an “ECB moment” before the year was over, a reference to the European Central Bank’s decision to cut interest rates last year, just months after it hiked them. A slew of weak economic data, from industrial output to retail sales and employment, indicates the ECB moment could arrive sooner than expected. PMI readings today shows the manufacturing business climate deteriorated for the fourth straight month, remaining in contraction territory.

With central banks all around intent on cutting rates, markets, unsurprisingly, are betting on easing in Poland as well. A 25 bps cut is priced for September and 75 bps for the next 12 months, encouraged by dovish comments from a couple of board members (one of whom had backed May’s decision to raise rates). Bond yields have fallen by 60-80 basis points.

Marcin Mrowiec, chief economist at Bank Pekao says:

The market should continue to expect that the (central bank) will unwind the rate hike delivered in May.

India, a hawk among central bank doves

So India has not joined emerging central banks’ rate-cutting spree .  After recent rate cuts in Brazil, South Korea, South Africa, Philippines and Colombia, and others signalling their worries over the state of economic growth,  hawks are in short supply among the world’s increasingly dovish central banks. But the Reserve Bank of India is one.

With GDP growth slowing to  10-year lows, the RBI would dearly love to follow other central banks in cutting rates.  But its pointed warning on inflation on the eve of today’s policy meeting practically sealed the meeting’s outcome. Interest rates have duly been kept on hold, though in a nod to the tough conditions, the RBI did ease banks’ statutory liquidity ratio. The move will free up some more cash for lending.

What is more significant is that the RBI has revised up its inflation forecast for the coming year by half a  percentage point, and in a post-meeting statement said rate cuts at this stage would do little to boost flagging growth. That, to many analysts, is a signal the bank will provide little monetary accommodation in coming months. and may force  markets to pedal back on their expectation of 100 basis points of rate cuts in the next 12 months.  Anubhuti Sahay at Standard Chartered in Mumbai says:

Mrs Watanabe in Istanbul

Japanese mom-and-pop investors’ penchant for seeking high-yield investments overseas is well known. Mrs Watanabe (as the canny player of currency and exchange rate arbitrage has come to be known) invests billions of yen overseas every year via  so-called uridashi bonds, debt denominated in currencies with high yields.  Data shows the lira has suddenly become the red-hot favourite with uridashi investors this year.

In a note entitled Welcome Mrs Watanabe, Barclays analysts estimate $2 billion in lira-based uridashi issuance this year, ahead of old favourite, the  Australian dollar.

So far, Japan’s exposure to Turkey is negligible at just 1.2 percent of their emerging market portfolio investments (Brazil is 4 percent, Korea 3 percent and Mexico 2 percent).  But Turkey’s high yields (almost 8 percent on one-year bonds) and the lira’s resilience mean the figure could rise to $5-$6 billion a year. That is almost half of total portfolio flows to Turkey in 2011, Barclays says.

Emerging debt default rates on the rise

Times are tough and unsurprisingly, default rates among emerging market companies are rising.

David Spegel, ING Bank’s head of emerging debt, has a note out, calculating that there have been $8.271 billion worth of defaults by 19 emerging market issuers so far this year — nearly double the total $4.28 billion witnessed during the whole of 2011.

And there is more to come — 208 bonds worth $75.7 billion are currently trading at yield levels classed as distressed (above 1000 basis points), Spegel says, while another 120 bonds worth $45 billion are at “stressed” levels (yields between 700 and 999 bps).   Over half of the “distressed” bonds are in Latin America (see graphic below).  His list suggests there could be $2.4 billion worth of additional defaults in 2012 which would bring the 2012 total to $10.7 billion. Spegel adds however that defaults would drop next year to $6.8 billion.

Risks loom for South Africa’s bond rally

Investors are wondering how much longer the rally in South Africa’s local bond markets will last.

The market has received inflows of over $7.5 billion year-to-date, having benefited hugely from Citi’s April announcement that it would include South Africa in its elite World Government Bond Index (WGBI).  But like many other emerging markets, South Africa has also gained from international investors’ hunger for higher-yielding bonds. And the central bank’s surprise rate cut last week was the icing on the cake, sending 5-year yields plunging another 30 basis points.

There are some headwinds however. First positioning. Around a third of government bonds are already estimated to be in foreigners’ hands. Second, markets may be pricing in too much policy easing (Forward rate agreements are assigning a 77  percent probability of another 50 bps rate cut within the next six months).  That’s especially so given local wheat and maize prices have been hitting record highs in recent weeks.

South Africa’s joins the rate cutting spree

Another central bank has caved in and cut interest rates — South Africa lowered its key rate to a record low of 5 percent at Thursday’s meeting. In doing so, the central bank noted growth was slowing further. ”Negative spillover effects (from the global economy)  likely to intensify,” it said.

Very few analysts had predicted this outcome, reckoning the central bank (or SARB as it’s known) would hold fire until its next meeting due to concerns over the currency and inflation.  But in fact, forward markets had guessed a cut was coming, especially after June inflation was lower than expected. And after all, even the conservative Bank of Korea cut rates last week to buck up domestic growth and compensate for slumping exports.  There have also been some policy easing in Taiwan and Philippines in the past week while earlier on Thursday, Turkey’s central bank unleashed more liquidity into the banking system. Kevin Lings, chief economist at Stanlib in Johannesburg says:

(South Africa’s rate cut) would suggest that the Reserve Bank feels they are a little bit behind the curve when they look at interest rate movements in other countries and hence the decision.

Yield-hungry funds lend $2bln to Ukraine

Investors just cannot get enough of emerging market bonds. Ukraine, possibly one of the weakest of the big economies in the developing world, this week returned to global capital markets for the first time in a year , selling $2 billion in 5-year dollar bonds.  Investors placed orders for seven times that amount, lured doubtless by the 9.25 percent yield on offer.

Ukraine’s problems are well known, with fears even that the country could default on debt this year.  The $2 billion will therefore come as a relief. But the dangers are not over yet, which might make its success on bond markets look all the more surprising.

Perhaps not. Emerging dollar debt is this year’s hot-ticket item, generating returns of over 10 percent so far in 2012. Yields in the so-called safe markets such as Germany and United States are negligible; short-term yields are even negative.  So a 9.25 percent yield may look too good to resist.

Doves to rule the roost in emerging markets

Interest rate meetings are coming up this week in Turkey,  South Africa and Mexico.  Most analysts expect no change to interest rates in any of the three countries.  But chances are, the worsening global growth picture will force policymakers to soften their tone from previous months; indeed forwards markets are actually pricing an 18-20 basis-point interest rate cut in South Africa.

Doves in South Africa will have been encouraged by today’s lower-than-expected inflation print, coming soon after data showing a growth deceleration in the second quarter of the year. Investors have flooded the bond markets, betting on rate cuts in coming months. In Turkey and Mexico, no policy change is priced but a few reckon the former, reliant on a policy of day-to-day tinkering with liquidity, may narrow the interest rate corridor in a nod to slowing growth.

For now, all three banks could be constrained from cutting rates by fear of currency volatility and the potential knock-on effect on inflation. Of South Africa, analysts at TD Securities write: