mid january 2016 market commentary - ffg€¦ · currently the vix is spiking higher and...

January 20, 2016 [Edition 1, Volume 1]

WORST START EVER 2016 is fast becoming the year of the Bear

January has seen some of the

largest liquidations in stocks that

we have ever seen for the first

month of the year in history, but is

it all a co-incidence? Or are

there greater forces at work?

“Animal Spirits” maybe? The

world is reeling from a greatly

depressed oil market which is

largely caused due to excess

supply in the market from key

players in OPEC, namely Saudi

Arabia who are targeting sales of

12 million barrels a day as well as

the fresh supply coming on line

from Iran who have been

released from the shackles of

international sanctions. We are

now seeing levels in oil not seen

since the 90’s and this creates

tremendous pressure on oil

producing countries to promote

growth, especially since

breakeven prices for production

are often at levels higher than

the current price of $28.8/Barrel

*below WTI Crude Futures

MASH-UP OF CHARTS AND MARKET COMMENTARY

MID JANUARY 2016 MARKET COMMENTARY

MARKETS YTD

JSE ALSI(-2.73%)

JSE FIN 15(-2.29%)

JSE RESI 10(-4.51%)

JSE IND 25(-2.60%)

JSE TOP 40(-2.94%)

JSE GOLD(+2.76%)

Data: moneyweb.co.za

“The problem with the oil

market is part of a far

greater issue with

commodities and

commodity producing

counties as a whole.”

M A S H - U P O F C H A R T S A N D M A R K E T C O M M E N T A R Y

“spreads are widening

and the banks who

supplied the capital to

these producers now sit

with a liability.”

This oil glut in the system is

wreaking havoc with many oil

exporting country’s currency

exchange rates. A clear

example of this currency

devaluation off the back of oil

deflation can be seen when

looking at the USD/CAD – Oil

represents one of Canada’s

primary export markets and

therefore we see that their

currency has also not been this

week in over a decade. The

next casualties of the Saudi

lead devaluation are smaller

and high cost producers, who

are currently being driven to

the brink of bankruptcy. Many

of them will fail and their assets

will be sold at fire sale prices.

The effect of this is currently

being seen in High Yield Energy

Green – USD/CAD

Black – WTI Crude Futures

Data: Tradingview

Credit (1) markets where spreads

are widening and the banks who

supplied the capital to these

producers now sit with a liability

on their balance sheet as much

of this high yield debt will default.

This event may possibly be the

catalyst to end this particular

credit cycle.

On the right we see a very

alarming chart illustrating the

yield spike on HY Energy Bonds

and startling, although not

surprising the ability for borrowers

to service their debt dropping to

levels lower than what it was

during the 2008 financial crisis.

(1)HY Credit Spreads

Data: Reuters

mash-up of charts and market commentary

“record prices in

late 2011 evaporate

into prices last seen

in the 1990’s”

The problem with the oil and

credit market is part of a far

greater issue with HY Credit and

commodity producing counties

as a whole(2).

We are possibly going to start

seeing some banks balance

sheets hemorrhage due to the

fact that producers can no

longer afford to pay the debt on

their loans – This will be an

important theme to watch as we

progress further on into the year.

The Commodity Super Cycle(3)

has seen record prices in late

2011 evaporate into prices last

seen in the 1990’s and with such

depressed prices, mining and

exploration companies(4) and

the countries that depend on

them for economic growth suffer.

The JSE: Resources Index is Down

54.98% from 5 years ago

World demand for commodities

has dropped thanks to the

slowing down of manufacturing

(5) Global PMI

Is nearing 50, which would

suggest that the global economy

should start to shrink if we go

below the 50 line.

(2)HY Metals & Mining Vs Energy

Data: Bloomberg

(3)Bloomberg Commodity Index

Data: Bloomberg

(4)Orange - JSE: RESI Index

Blue – Bloomberg Commodity


(5)Global Manufacturing PMI

Data: JP Morgan & Markit

China is also struggling with

internal issues around its currency

peg to the US Dollar and the

impact of having to sell off its war

chest of US treasuries every

month in order to maintain this

artificial peg to the Greenback(6)

The initial “Shock Devaluation”

experienced by the market in

August 2015 of the Chinese Yuan,

left the markets in complete and

utter disarray and caused a great

amount of fear in the market and

general risk-off sentiment in stocks

China has since August slowly

continued to devalue its currency

in order to help its economy

transition into an economy that is

consumption driven rather than

production driven. This

devaluation is causing somewhat

of a capital flight from Chinese

Investors who are moving money

out of the country at record

amounts which is placing a stress

on its foreign reserves.

(5)View of Global

Manufacturing PMI’s

We note that the world is

producing less with

Emerging Market

Manufacturing actually

contracting in 2015

China also produced

much less in 2015 than in

2014

Only the Eurozone seems

to have ramped up

manufacturing

production in 2015

“Global PMI

Is nearing 50,

which would

suggest that

the global

economy

should start

to shrink.”

BELOW CHINESE CONSUMPTION

SHOWING CLEAR SIGNS OF GROWTH

(BLUE) RELATIVE TO NET EXPORTS (GREEN)

AND CAPITAL FORMATION (ORANGE)


Data: the Economist

The Left shows that China has lost

more than $700 Billion in foreign

FX reserves in order to maintain

their currency peg to the US

Dollar.

Data: Bloomberg

To the left we see how China is

fighting capital flight in its country

as investors buy Dollars to guard

themselves against a much more

muted Yuan devaluation

Date: Bloomberg

Note that the fact that China is

liquidating its reserves, does not

necessarily mean its dumping its

treasury holdings onto the

market, which would have very

adverse effects on US Sovereign

Bond Yields and the economy at

large.


THE STORY OF THE DOLLAR A new normal of monetary policy divergence

Mid December saw the US Federal Reserve adjust its guidance for its Federal Funds Rate upward by 25 bps,

which marks the end of an era of ultra-lose monetary policy from the US Central Bank; which until then had

been engaged in ZIRP (Zero Interest Rate Policy) as well as Quantitative Easing and Planned Open Market

Operations to manipulate the long end of the treasury yield curve lower, making servicing its debts cheaper.

Data: Tradingview

FED FUNDS (Blue) DXY Dollar Index (Green)

Now one would question whether or not 25 bps is sufficient to warrant a move to the upside in the US Dollar?

The correlations between these two indicators are striking and one would assume that eventually the Dollar

would rally further if demand for the Green Back is introduced into the system via stock market liquidations

(risk-off behavior) or demand for higher yielding US treasuries

A general gauge for bearish sentiment is the implied volatility measure of the S&P500 – AKA the VIX.

Currently the VIX is spiking higher and traditionally what happened since FED monetary stimulus efforts, was

that traders and investors would sell these VIX volatility spikes as a sure way to make money off of a dip in the

S&P500. This trade was however predicated on the fact that central banks (specifically the FED) were actively

involved in propping up financial markets via stimulus and would always come to the rescue of the market if

it fell. This created massive amounts of complacency in the financial system where investors falsely expect the

market to always go up.

We are currently seeing the lowest levels in the S&P500 that we have seen in over a year, the FED has for the

time being stopped all of its efforts to prop up the market and is now trying to engage in monetary tightening


“This created massive

amounts of complacency

in the financial system

where investors falsely

expect the market to

always go up.”

Data: Tradingview

S&P500 (Blue) VIX (Red)

Above we note the dips in the

S&P500 and corresponding VIX short

Vol trades that much of the last

decade have been about.

Data: Pension Partners

To the left we see the major indices

of the World in their local currency

from highest to weakest YTD return

as well as their distance from their 52

week high and whether price lies

above or below the all-important

long term 200 day simple moving

average


So in the US we are seeing the start of tightening monetary policy when growth is tepid and inflation low

(which begs the question how long will it last?). The result of the loose monetary policy of the US Fed has

caused the Price to Earnings (PE) ratios of companies to become inflated. The higher PE ratios create a

market expectation of future profit growth, but because this inflation of companies stock prices has been

largely artificial due to the worldwide search of yield and that the stock market has pretty much been a one

way bet; Companies now face the very real risk of missing earnings estimates, due to the fact that the Fed

has removed the punch bowl, so to speak.

In the EU, China and Japan we are experiencing the exact opposite with each Central Bank engaged in

some form of stimulus or policy intervention in order to generate inflation in their economies and get

consumption up and the consumer spending. This further incentivized by historically low interest rates, and in

the EU even negative interest rates!

This policy divergence will facilitate an investment carry trade towards high yielding economies away from

low yielding economies, where investors borrow in a low interest and invest in an economy which can offer a

greater yield than what they have to pay on their borrowed money.

In a local context, South Africa has since 2009 enjoyed the benefits of this positive carry trade and with our

inclusion into the Citi world bond index in 2012, we have seen great inflows into our country as a direct result

of the kind of return investors could make on money borrowed at near zero rates and put to work in our local

economy, but more of that a little later.

The tightening of FED monetary policy also means that all interest payment on Dollar denominated debt is

increasing, due to the fact that the Dollar is currently very strong and getting stronger relative to most other

countries. Below we look at a study from the Bank of International Settlements to see which countries are

exposed to higher Dollar debt servicing costs.


“The tightening of FED monetary policy also means that all interest

payment on Dollar denominated debt is increasing, due to the fact

that the Dollar is currently very strong and getting stronger relative to

most other countries”

It is very encouraging to see that US Dollar denominated debt is not as large for South Africa as it is for many

of the other Emerging Economies, like China, Russia, Brazil and Turkey. So the current weakness of the Rand is

not necessarily placing an added strain on our economy in the form of debt repayment as it would be with

countries like Brazil and Russia, who have like South Africa also been battered by the current commodity rout.

Below we see the breakdown of Non-financial debt and we can see that where South Africa is concerned

most of our debt is for investment or hedging purposes in the form of debt securities, with very little in the form

of outright loans. Whereas Russia and Brazil are in a far worse situation with regards to their liabilities.


The previous 6 currency blocks (South Africa, Brazil, Russia, Turkey, Mexico and China) represent the Emerging

Markets (EM) Currency Exchange Rates relative to the US Dollar.

We can see that currently the strong Dollar is effecting massive pressure on domestic EM currencies and with

China continuing to devalue its currency to counter US Dollar strength since the FED began to tighten its

monetary policy by ending Quantitative Easing and raising interest rates. Such competitive devaluation helps

countries such as China who are net exporters of goods, but for countries like South Africa who do not

produce many finished products the weaker Rand is a curse, as the country now starts to import inflation via a

stronger Dollar.

Yesterday the Core CPI (Inflation numbers came out for South Africa) and we are already starting to see the

effects of the Rand weakness on our inflation numbers.

Consumer prices in South Africa went up 5.2 percent year-on-year in December of 2015, up from a 4.8

percent rise in the previous month and the biggest increase in a year. This due to the higher costs for food.

Factors that could further increase inflation in 2016 include Eskom tariff hikes and power shortages, the

Drought of the 2015 farming season, the weak Rand, higher costs of imported products including cars,

technology, broadband infrastructure, etc. We are getting some relief at the fuel pump in the coming

months due to the low oil price, but again Rand weakness makes this relief very muted.

The problem with inflation running away as it has been is that the South African Reserve Bank has as part of its

economic mandate the duty to guide inflation between the 3%-6% band and as inflation tracks higher the

SARB have little other choice but to hike the interbank repurchase rate or REPO rate higher in order to try and

stabilize our currency and credit markets, hopefully bringing inflation down.


So locally with Inflation expectation set to rise, and interest rate increases being initiated by the SARB in order

to bring inflation under control. Unless the SARB change its inflation target mandate and move towards more

accommodative monetary policy in the aid of economic growth whilst ignoring inflation remains to be seen

We also have the looming worry of a possible credit rating downgrade of our sovereign bond market this

year, which would effectively drop us from Investment Grade into Junk bond status and out of the coveted

Citi World Bond Index. This event would wreak havoc on our bond and currency markets much like the

carnage witnessed in Brazil when they got junked in Sep 2015 by S&P

All the above issues are predicated by a strong Dollar and weak demand for raw materials. We have seen

Rand Hedge stocks outperform local counters and so far this year it has been the Gold Miners who have been

relishing the limelight. The thesis around this meteoric rise in gold stocks has been very simple. Rand weakness

causes the price of Gold in Rand terms to be higher and those miners who have little exposure to offshore

mining operations benefit directly from enhanced earnings in Rand terms as the price of Gold remains flat

and the Rand weakens. However if gold were to rise then these Mining stocks may come to the rescue for

South Africa and the Rand.

Another thought of note is that in a high interest rate environment we should see pressure exerted on bonds

and on our local property markets.

There are many analysts that suggest the Dollar may not strengthen further and that EM currencies are

currently greatly undervalued but it is still early days to be calling a bottom in the Rand, although that may be

the trade of the decade if one could accurately get it right.


Our saving grace at the moment for our economy is consumer spending which is seeing quarterly increases

although this will come under threat if inflation rears its ugly head.

Above we see consumer spending take a dip when inflation breaks out of the 6% band

SUMMARY

The world is not in a happy place at the moment, and South Africa has little or no effect on the world

economy at all, so we are going along for the ride.

There are great systemic risks in the market brought about by asset bubbles that have formed through the

attempts of Central Banks to artificially prop up financial markets through unprecedented monetary policy.

The problem is that as we saw with Sub-prime defaults in the USA, that the world markets are so correlated

and intertwined that it makes it very difficult to hedge against these risks that seem so far away.

The safest way to save money in troubled times has always been cash and with interest rates on the rise, it

opens up new opportunities for money market rates to improve and possibly match or beat inflation, if the

SARB gets it right.

The long term prospect for local stocks is looking grim, but it is in such times that asset managers show their

true value in creating alpha in falling markets through tactical asset allocations and portfolio diversification

Over the long term the global markets should stabilize and find a floor and continue to grow especially if the

Asian consumer comes online, the Fed may abandon their current forward guidance and opt for more QE in

order to save the market again, but this remains to be seen and is not something one should be betting on

the short term.

Locally we are at risk of a credit rating downgrade, but this can be averted with prudent fiscal and monetary

policy. We await our new budget to see what direction treasury will take to tackle our domestic issues.

In the long term emerging markets still offer significant value for investors with a stomach for volatility and

patience.


Markets are cyclical, and we can’t expect them to always go up, we are definitely entering a new market

landscape of prolonged lower growth and possible recession

Investors sticking to a tried and tested investment strategy that looks to produce inflation beating returns over

the long term and not selling in a panic when markets drop, need coaching on matching their expectations

to the new returns reality that we are moving towards.

Fees will come into focus and its best to opt for solutions that save investors in fees and reward investors for

good investment behavior; like investing through the cycle.

Start becoming more self-sufficient; capture rain water, maintain a veggie garden, go solar, go green and

invest in your children’s future

The Document has been prepared solely for informational purposes, and is not an offer to buy or sell or a solicitation of

an offer to buy or sell any security, product, service or investment. The opinions expressed in this Document do not

constitute investment advice and independent advice should be sought where appropriate.

mid january 2016 market commentary - ffg€¦ · currently the vix is spiking higher and...

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