CAPITAL MANAGEMENTblueqcm.com/.../2016/05/BQ-Quarterly-Review-1Q16.pdf · quarterly review q1 2016...

1QUARTERLY REVIEW Q1 2016BLUE QUADRANT

C A P I T A L M A N A G E M E N T

QUARTERLY REVIEWQ1 2016

BLUE QUADRANTC A P I T A L M A N A G E M E N T

FSP 42165

QUARTERLY REVIEW Q1 2016

Compiled between Apr 1 - 3, 2016




FINANCIAL MARKET AND GLOBAL ECONOMIC OVERVIEW

GLOBAL OUTLOOK

US GROWTH WILL REMAIN RESILIENT IN 2016 AS CONSUMER SPENDING SUPPORTS OVERALL GROWTH

US economic growth slowed further to an annualised growth

rate of 1.4% (q/q) in the fourth quarter of 2015 from the 2%

reported in the third. As in the prior quarter, the slowdown

was driven by a further contraction in private domestic

investment due to slowing non-residential fixed investment

growth and a reduction in inventory levels for the second

consecutive quarter.

The collapse in energy prices and a stronger US Dollar

have acted as key headwinds for the US economy, having

an adverse effect on the US manufacturing sector and

broader exports. A faster pace of inventory accumulation

and consequent de-stocking have also impacted

negatively, particularly in the latter half of 2015. The chart

below illustrates that inventory levels in nominal terms

have risen to the highest levels since the last recession.

Real Inventories/Sales Ratio

Nominal Inventory/Sales Ratio

1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.202000 2003 2006 2009

Dec

Nov

2012 2015

Nevertheless, despite these headwinds, the US economy still

managed to grow by 2.4% in 2015, an unchanged rate when

compared to 2014.

On the positive side, household consumption has remained

buoyant supported by strong job growth, historically low

debt servicing burdens and the further decline in energy

prices. Personal consumption expenditures grew by 3.1% in

2015, accelerating from a growth rate of 2.7% reported in

2014. Personal consumption contributed 2.11% out of 2.4%

of the annual growth recorded in 2015, increasing from a

contribution of 1.84% in the prior quarter. This largely offset

the increased negative contribution from the widening in the

US trade deficit, which subtracted 0.64% from calendar 2015

GDP, up from 0.18% in 2014.

As discussed in prior publications, sustained job growth and

accelerating wage growth amid a generally accommodative

monetary backdrop, are likely to remain key tailwinds for the

US consumer and the overall economy by implication. With

consumption accounting for over 70% of the US economy, a

recession without a retrenchment in consumer spending is a

very unlikely prospect.

More notably perhaps, recent data on the manufacturing

sector in the US has shown indications of an incipient recovery,

which could gain further traction as the year unfolds.

60

55

50

45

40

35

302006

(Inde

x)

ISM MANUFACTURING: PMI COMPOSITE INDEX

2008 2010 2012 2014 2016

reserach..stlouisfed.orgSource: Institute for supply Managementreserach..stlouisfed.org




The systemic risks created by the bursting of the US housing

bubble was mainly caused by the defaulting mortgage debt

as a % of bank and insurance capital being a multiple of

this capital figure and thus a real threat to the solvency of

important financial institutions. The systemic risk associated

with rising defaults in the US is almost zero pertaining to the

high yield and mining sectors.

The chart below shows how high yield bonds have already

staged a fairly significant recovery, with yields declining by

nearly 200bps since reaching a multi-year high in the final

quarter of 2015. This retracement in yields should ease some

of the strains placed on companies with higher debt levels in

their capital structure.

The US economy is set to adjust from the twin negative

shocks following the collapse in energy prices (impact on

the US shale energy industry) and the appreciation in the US

Dollar. The headwinds from these factors should dissipate

as the year unfolds and point to the potential for continued

robust growth in 2016 relative to other developed economies.

In the last quarterly publication, we noted the recent negative

development regarding the sharp rise in corporate bond yields

and specifically high-yield bonds issued by non-investment

grade companies. A large portion of the rise in yields was due

to a widening in the spread between high quality investment

grade bonds and lower quality bonds, specifically those

issued by energy and commodity companies.

We further noted how the rise in yields across other unrelated

sectors was probably an overreaction and partly related to

a ‘contagion’ effect spilling over into other sectors, due to

the attendant liquidity effects. Funds facing redemptions

are forced into selling more liquid bonds, even if the issuer

companies are at little risk of defaulting, in order to meet

redemption requests.

Outside of specific sectors such as energy and mining, default

rates remain near historically low levels, while the outlook

for growth in the US itself remains positive. It should be

remembered that low bond yields and favourable corporate

bond spreads have also allowed many corporates to extend

the redemption profile of their outstanding debt issues.

Finally, the actual size of the high yield bond market is small

relative to other sectors of the capital market, both in an

absolute sense as well as and, importantly, relative to bank

and insurance capital.

Mortgage debt outstanding as share of total debt outstanding (ls)

Source: FRB, DB US Credit Strategy, Haver Analytics, DB Global Markets Research

0%

5%

30%

30% vs 2%

25%

20%

15%

10%

0%

-5%

-10%

-15%

-20%

-25%

-30%

2000 2002 2004 2006 2008 2010 2012 2014

HY bonds outstanding as share of total debt outstanding (rs)

TODAY IS VERY DIFFERENT FROM 2006

11

10

9

8

7

6

5

(Per

cent

)

BOFA MERRILL LYNCH US HIGH YIELD EFFECTIVE YIELD

2012-01-01

reserach..stlouisfed.orgSource: BofA Merrill Lynch

2013-01-01 2014-01-01 2015-01-01 2016-01-01




The general re-pricing of equity valuations, particularly in

these aforementioned companies was a likely key factor

driving the equity market sell-off in December and January.

The chart above reflects that outflows from equity funds

reached their highest levels in the first seven weeks of the year

since 2008. This data is also consistent with various market

sentiment indicators, which reached extremely oversold

levels in January and February and set the stage for the recent

rebound. Given that we do not expect a ‘2008-type’ economic

environment this year, the recent negativity and fund flows

away from risk assets should provide a reasonable platform

for further strength in equities. Their attraction as an asset

class is especially supported by the still very accommodative

monetary backdrop.

This backdrop received an additional boost in March, when

the ECB expanded both the size and scope of its current QE

program. The Federal Reserve further stepped back from prior plans to raise benchmark rates by 100bps this year.

Many now see the Fed only raising interest rates further in the second-half of the year and possibly by no more than 50bps

or in two equal increments of 25bps each.

As discussed, we expect positive real income growth to

continue to support overall consumer spending in 2016.

Buoyant activity in the housing market and the broader

construction sector will also lend some support to the overall

economy. Following several years of narrowing budget

deficits, the US budget deficit is expected to widen once again

in 2016. Fiscal consolidation at both the federal and state/

local levels have acted as a notable drag on US economic

performance since at least 2011. This dynamic will now shift

from a headwind to an additional tailwind from 2016 onwards.

BUDGET DEFICIT FORECAST W/NEW STIMULUS, $BN

2015-439Nominal-2.5%% of GDP -3.4% -3.9%

-634 -7502016 2017

-80

IN $BN. GLOBAL EQUITY FLOWS (MF +ETF) FOR THE FIRST SEVEN WEEKS OF THE YEAR.

Source: Bloomberg, ICI, J.P. Morgan.

-60

07-65

-19-8

-36

232319

3851

08 09 10 11 12 13 14 15 16

-40

-20

0

20

40

60

80

100

US GOVERNMENT SPENDING GROWTH HAS UPSIDE

US government consumption &investment, real, year-on-year

1996

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2000 2004 2008 2012 2016

Source: Soberlook




EUROPEAN OUTLOOK STILL POSITIVE, JAPAN BATTLES CHINA “GROWTH” HEADWINDS

Growth in the broader Eurozone, although likely to have

slowed somewhat in the first quarter of 2016, is expected to

have remained positive. Following a modest decline in activity

in the manufacturing sector, notably in France and Germany,

recent data for March is pointing to some stabilisation. The

European Manufacturing PMI for March ticked higher to 51.6

from 51.2 in February, which was a multi-month low.

Notably, PMI readings outside the two ‘core’ economies of France and Germany were actually much higher and in some cases continue to print at multi-month highs.

US economic growth appears set to remain fairly resilient

over the next 24 months. We detail below how the real

longer-term risk is an under-appreciation for a potential

acceleration in inflation during the year, rather than a return

to a deflationary ‘quagmire’.

The chart below further details how the potential for a further

acceleration in wage growth in the US remains a key upside

risk. Given that the labour force in the US is only growing by

around 100,000 to 125,000 per month, average job gains of

around 200,000, as has been the case in the past 5 years,

suggests that the unemployment rate will continue to

decline in 2016. This obviously creates the risk of a further,

perhaps meaningful acceleration in wage growth as the year

progresses.

Quits Rate (LHS)

Source: Haver Analytics, Renaissance Macro Research

17.0

WHEN QUITS RISE, WAGE GROWTH TENDS TO FOLLOW

15.0

11.0

9.0

7.0

5.095 97 99 01 03 05 07 09 11 13 15

Average Hourly Earnings (RHS)

13.0 3.5%

4.5%

4.0%

3.0%

2.5%

2.0%

1.5%

Unit Labour Costs

6

US UNIT LABOUR COSTS RIDING MORE QUICKLY THAN OUTPUT PRICES

5544

33

22

1100

-1-1

-2-2

-3-3

-4-496 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

6corporate output prices

Source: Soberlook

Eurozone Manufacturing PMI, sa, 50 = no change

65

60

1998

55

50

45

40

35

30

MANUFACTURING PMI (OVERALL BUSINESS CONDITIONS)

Source: Markit

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

COUNTRIES RANKED BY MANUFACTURING PMI : MAR.

Ireland 8-month high

5-month high3-month high

3-month low5-month high

2-month high7-month low

2-month high

Netherlands

Italy

Spain

Australia

GermanyFrance

Greece 49.0

49.6 (flash: 49.6)50.7 (flash: 50.4)

52.853.4

53.5

53.6

54.9




France is still battling the headwinds created by the election

of the more socialist Hollande government and a lack of

serious reform. In Germany, growth remains very sensitive

to export developments and this economy with its large

manufacturing sector has been negatively affected by the

decline in global fixed investment. The weakness in emerging

market economies also impacted as they have become an

important export market for Germany over the past decade.

With evidence of some stabilisation in key emerging

economies such as China, accommodative central bank policy

and rising German property prices, growth in this economy

will possibly remain positive in 2016. As improved conditions

in the periphery feed through into the core over the course of

the year, an acceleration is a realistic expectation.

In particular, the recent underperformance of European

equities relative to US equities has created an opportunity for

some geographical re-balancing in investment portfolios.

More notably, given the renewed decline in European bond

yields and the German 10-year yield trading back below 20bps,

there is some emerging evidence that inflation in Europe may

actually surprise to the upside during 2016. Although headline

inflation in Europe and the US remains close to zero, inflation

gauges continue to be pulled lower by the transitory effect of

the decline in oil and broader commodity prices in 2015.

Core inflation, although currently lower than the 2.3%y/y in

US at present, has accelerated in recent months to reach 1% y/y.

Should oil and commodity prices stabilize or rebound to

some extent this year, overall inflation in Europe is likely to

accelerate markedly in tandem with a general rise in headline

inflation in developed economies. This is a negative for global

bond yields, particularly those in Europe, which remain well

below corresponding yields for US bonds across similar

durations.

Recent data from Japan has disappointed to the downside.

The manufacturing PMI for March showed a renewed decline

to below the key 50 level and suggests a renewed contraction

in the Japanese manufacturing sector. Like Germany, the

Japanese economy remains far more sensitive to export

demand. In this case, Japan has severely felt the slowdown in

China and other regional Asian emerging economies.

1.7

1.5

1.3

1.1

0.9

0.7

0.5‘49 ‘52 ‘55 ‘58 ‘61 ‘64 ‘67 ‘70 ‘73 ‘76 ‘79 ‘82 ‘85 ‘88 ‘91 ‘94 ‘97 ‘00 ‘03 ‘06 ‘09 ‘12 ‘15 ‘18

US/Europe, relative price perf (USD)

+1 St Dev

-1 St Dev

US VS EUROPEAN EQUITIES, RELATIVE PRICE PERFORMANCE (USD)

Monthly data. GFD Europe index & reconstituresnthe MSCI Europe estimate pre-1970,includes a 12% UK weighing until 1970, after is actual MSCI Europe weighings; latest UK weight is approx. 31%Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg, Global Financial Data (GFD)

Apr ‘09 Oct ‘10 Apr‘12 Apr‘15 Jan‘160.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Oct‘13 Jul‘14

EUROZONE CORE CONSUMER PRICE INDEX (CPI) YOY

Actual1.0%

Forecast0.9%

Source: Trading Economics




There nevertheless remains a strong likelihood that the Japanese economy will still show positive growth this year, driven by resilient or improving growth in the US and Europe. Further contributory factors are a prospective rebound in China and a stabilisation in other key emerging economies such as Russia and Brazil.

STIMULUS EFFORTS IN CHINA GAIN TRACTION, POINTING TO REACCELERATION IN GROWTH

The slowdown in Chinese growth has inevitably prompted the

local authorities to embark on more aggressive policy stimulus.

The chart below outlines that the central government fiscal

deficit has widened significantly over the past year and could

reach 4% of GDP this year. This positive fiscal impulse should

support overall growth, at least over the short-term.

In fact, the most recent PMI data for March is already showing

signs of a potential recovery in the country’s manufacturing

sector.

As Chinese property prices are far more impactful than

any movement in Chinese equity prices, it is perhaps more

encouraging to note that the former has also shown some

signs of stabilization and evolving upward price trends.

60

55

50

45

40

30

30

25

Source: Nikkei, Market

2002 2003 2004 2005 2006 2007 2008 2009 2010

Increasing rate of contraction

Increasing rate of expantion50 = no change on previous month, S. Adj.

NIKKEI JAPAN MANUFACTURING PMI

2011 2012 2013 2014 2015

Jul-0

9

Jul-1

0

Jul-1

1

Jul-1

2

Jul-1

3

Jul-1

4

Jul-1

5

Source: Bloomberg

48 50

52

54

56

58

50

52

54

56

China PMI ManufacturingChina PMI Non-Manufacturing (RHS)

CHINA PMI MANUFACTURING & PMI NON-MANUFACTURING

100-CITY AVERAGE PROPERTY PRICE MOM CHANGE (SA)

2.0% 2.0%

1.5% 1.5%

1.0% 1.0%

1.0% 1.0%

0.0% 0.0%

-0.5% -0.5%

-1.0% -1.0%

-1.5%Jan-12 Jan-13 Jan-14 Jan-15Jul-12 Jul-13 Jul-14 Jul-15 Jan-16

-1.5%

Source: Goldman

0% 0%0.5%1%

2009 2010 2011China Annual Fiscal Budget Deficit (RHS)

China Annual GDP Growth Rate

Source: Bloomberg and iFast Compilations; data as of 23 March 2016

2012 2013 2014 2015 2016

1.5%2%2.5%3%3% E3.5%

2%

4%

6%

8%

10%

CHINA ANNUAL FISCAL BUDGET DEFICIT VSCHINA ANNUAL ECONOMY GROWTH (%)12%




Chinese private sector credit growth of loans extended by the

Chinese financial system further accelerated to 15.3% y/y in

January from 14.3% in December. This is the highest rate of

credit growth recorded since early 2013 and provides another

indication that a ‘hard landing’ in the Chinese economy is an

unlikely scenario for 2016.

Central Bank 1-year lending rates of around 4.5% also have

room to move lower, while reserve requirement ratios are

also far higher than the statutory ratios prevalent prior to

the global financial crisis in 2008. Given that the central

government also still has substantial room for fiscal stimulus,

the tools available to Chinese policymakers to avoid a hard-

landing in the short-term are substantial. A return to the

double-digit growth rates recorded over the past decade is

also unlikely, but the Chinese economy will possibly continue

to grow overall, supported by stimulus and consumption

growth.

There nevertheless remain substantial longer-term risks.

China’s now ageing demography suggests that the total

number of employed workers in the economy is likely to

remain flat going forward, while scope for the kind of robust

wage growth seen over the past decade also appears limited.

China has lost substantial competiveness as wages increased

and its currency, which is nominally pegged to the US Dollar,

gained when compared to regional competitors.

The major risk for China is stagnant job and wage growth,

along with a political system that is unsustainable in the long-

term, at least if China wishes to move to even higher levels

of income per capita. As USD liquidity continues to tighten

over the next few years, the Chinese currency will possibly be

forced to further devalue before the end of the decade.

At present, China still has a large trade surplus and foreign

exchange holdings, so it is probable that policymakers will be

able to control the exchange rate for some time to come. At

some point before the end of the decade, not likely this year,

Chinese growth will weaken or slow further. When coupled

with possible rising social and political tensions, the risk of

an acceleration in capital outflows could ultimately lead to

an even more pronounced devaluation in the currency at

some point. This will be the key or pivotal moment for China,

related financial markets and regional economies as regards

specific event risks.

We have noted in past publications that one of the major

‘fault lines’ that would be exposed to a hard-landing in China

is Hong Kong. Hong Kong has experienced an enormous

property bubble and prices have risen significantly in recent

years, partly driven by investment from Mainland Chinese

investors.

Hong Kong as a banking centre is additionally at risk, given the

large growth in loans to mainland China entities from Hong

Kong. Hong Kong banks also rely on cross-border funding

in order to sustain their own foreign currency denominated

lending activities.

Source: www.tradeeconomics.com / peoples bank of china

2012 2014 201612

14

16

18

20

CHINA OUTSTANDING LOAN GROWTH

CHINA CASH REVERSE RATIO BIG BANKS

2006 2008 2010 2012 2014 20166

8

10

12

14

16

percent

18

20

22

Source: www.tradeeconomics.com / peoples bank of china




true of the oil market which has been influenced by the rapid increase in US oil supply since 2011. Lower prices will eventually result in some kind rebalancing as new supply growth stalls or even contracts. In certain segments of the commodity market where the lead time to new production is shorter, this rebalancing may happen quicker.

The energy sector at the margin now has an increasingly shorter lead time than in the past. US energy producers exploiting unconventional shale reserves can now drill and bring new oil wells to production in a matter of weeks. This timeframe is in contrast to the lengthy lead times normally associated with major oil projects in the past. As the US energy sector increasingly becomes the worlds swing producer, oil production may respond more quickly to price changes than was previously the case.

There exists a scope for a general recovery in commodity prices over the next two years, but it is our opinion that it will be more nuanced and narrowed than was the case in the great commodity bull market of the last decade. Despite the potential for a temporary recovery in Chinese investment spending, that economy remains substantially unbalanced as investment spending still accounts for nearly 50% of overall GDP.

There thus remains significant downside risk in respect of Chinese investment spending growth over the next five years. The demand for commodities more sensitive to fixed investment or infrastructure spending, such as iron ore and

copper, will also be affected by implication.

Recent data has shown a notable weakening in the Hong Kong

economy, as evidenced by the sharp decline in retail sales in

recent months.

A temporary or cyclical recovery in the Chinese economy

should however also lend some support to the Hong Kong

economy over the near-term. With property prices already

having dropped somewhat from the recent peak reached in

2015, developments in this important region will be worth

monitoring as the year unfolds.

COMMODITY MARKET REBALANCING LIKELY TO BEGIN IN EARNEST IN 2016

We believe that the large-scale price declines in a range of

mining and resource companies are creating opportunities

in these sectors. As already highlighted, there remains scope

for a renewed cyclical upturn in Chinese investment spending

and the associated demand for various commodities. Volume

data from China in fact shows little if any real decline over the

past year, with the exception of coal volumes, in spite of the

recent fall in commodity prices.

This suggests that the weakening in commodity prices over the past few years have mainly been driven by increased supply rather than collapsing demand. This is particularly

2008 2009 2010 2011 2012 2013 2014 2015 2016-30

-20

-10

0

10

20

30

40

HONG KONG RETAIL SALES YOY

400 000350 000300 000250 000200 000150 000100 000 50 000 0210 000180 000150 000120 000 90 000 60 000 30 000

400 000350 000300 000250 000200 000150 000100 000 50 0000210 000180 000150 000120 000 90 000 60 000 30 000

STOCKS OF COPPER AND COPPER WARRANTS IN CHINA

31-12-99 31-12-01 31-12-03 31-12-05 31-12-07 31-12-09 31-12-11 31-12-13 31-12-15

Data Source: Wind Info

Clothing Stock on Warrant CopperStock Subtotal Copper. Closing Stock on Warrant Copper

Stock Subtotal Copper: Total

Source: Soberlook




The chart below shows how inventory levels of copper in

China have reached their highest recorded levels, despite the

recent recovery in copper prices.

On the other hand, demand for commodities more tied to consumption such as oil and also possibly metals such as platinum and aluminium may fare somewhat better. The large reduction in oil sector capital investment over the past year will limit oil supply growth over the medium-term. The outlined shorter lead time associated with US energy production could also lead to a much faster rebalancing in this market than is generally anticipated at present.

As previously detailed ,oil is in many ways a unique commodity, given the inherent natural decline in production rates that most oil fields exhibit over time. When a specific oilfield is first tapped, the pressure in the field is obviously very high. As the resource is depleted by outflows from the trapped reservoir, the pressure decrease causes the rate of flow out of the field to taper off.

This decline rate can vary depending on the type of field but the rate is very steep for shale fields. The rate of production from a typical shale oil well can fall by as much as 50% in one year. The industry consequently has to invest an enormous amount of capital annually in order to bring new fields or resources on stream. This is necessary to maintain global supply at existing levels, let alone increase production. At oil prices below $50 and certainly below $40, new investment simply does not make economic sense. As a result the industry has sharply reduced capital expenditures over the past two years or in some cases players have been forced smaller to stay afloat. These levels are not sufficient to address the natural declining rate of all oil fields currently in global production.

The International Energy Association (IEA) reported in its most recent monthly Oil Market Report (OMR) for February, that global oil supply declined by 180,000 barrels per day (b/d) in February to 96.5mn b/d. More notably, the IEA also said that preliminary data for February suggested that OECD commercial inventories had declined during the month, marking the first such decline in just over a year. The IEA said

that it expected total non-OPEC supply to decline by 750,000 b/d in 2016, chiefly driven by a decline of 530,000 b/d in the

US market.

On the negative side, total oil inventories remain high. Despite

the improving dynamics reported by the IEA in February, there

remains a gap between existing demand and supply. The IEA

estimates place global oil demand for Q1 2016 at around

94.7mn to 95mn b/d, which is still some 1.5mn b/d below

current supply levels. However, Q1 2016 saw seasonally lower

demand for oil. Based on the IEA’s estimate for an increase

in global demand of 1.2mn b/d in 2016, total demand should

rise above 96mn b/d by the second-half of the year. Based

on the current rate of decline and assuming 100,000 b/d per

month, supply will also have declined to around 96mn b/d

by this time. This would suggest that the oil market could in

fact rebalance well ahead of recent consensus expectations

and may partly explain the recent rebound in oil prices from

below the $30 mark reached in January.

WORLD OIL DEMAND

1Q201385

90

95

87.5

92.5

97.5

mb/

d

3Q2013 1Q2014 3Q2014 1Q2015 3Q2015 1Q2016 3Q2016

Source: IEA




SOUTH AFRICA OUTLOOKRecent data covering the manufacturing and mining sectors as well as new vehicle sales all suggest that the economy slowed further in the first quarter of 2016. This is not unexpected given the headwinds faced by the local mining sector after the slump in international commodity prices. More recently

the further increase in domestic interest rates have also had an impact.

The SARB has now increased its key benchmark lending rate by 200bps since the first hike in the current cycle in January 2014. The hike from 5% to 7% takes the prime lending rate to 10.5%. This is the highest level for short-term lending rates since early 2010 and not unsurprisingly, the economy will struggle to gain any meaningful traction in this environment. Consensus growth estimates for 2016 have been revised lower to just 0.5%.

The key question for many local investors is whether further rate hikes are likely and at what point will the level of interest rates finally lead to a recession in consumer spending and the broader economy by implication. After the reappointment of Pravin Gordhan as finance minister, political uncertainty eased. Terms of trade have improved as the prices of precious metals outperform that of oil. When coupled with a possible recovery in sentiment towards emerging market currencies, these factors could pave the way for the SARB to consider pausing its current tightening cycle, despite inflation projected to remain elevated for the rest of the year. Despite the poor economic backdrop and recent increase in interest rates, South African households generally still appear to be in reasonably healthy shape, particularly those in the middle to high income groups. Elevated wage and salary growth and waning demand for credit has helped keep nominal growth in disposable incomes above that of household indebtedness since the last recession in 2008/9.

This trend has been particularly noticeable as regards

outstanding residential mortgage debt. Demand for mortgage

credit has only recently picked up, following several years of

sluggish growth in the aftermath of the 2008/9 recession. The ratio of household sector mortgage credit outstanding

relative to disposable income has declined further in recent

quarters, from a peak of 49.2% in Q1 2008 to 34.8% in Q4

2015. Household mortgage advances grew rapidly from a

trough of just below 30% of household disposable income in

2002/3 while residential property prices rose to a peak level

of 49.2% in Q1 2008. The ratio had declined mainly due to

sluggish household mortgage credit growth and elevated

nominal, not specifically real, wage growth since 2008.

As interest rates still remain below prior historical highs, one could advocate that the scope for severe stress in the residential mortgage sector remains limited at this time. Despite the poor economic backdrop, a sharp rise in delinquency rates may not occur. A reflection of this is the fact that the household sector debt service ratio remains lower than the prior peak levels associated with a sharp rise in delinquency rates. According to FNB data, the number of residential property sellers due to financial pressure remains at or near a decade-low of around 14% as opposed to the 34% high experienced in 2008.

Household Mortgage Debt-to-disposable Income Ratio (Left Axis)

Household Sector Debt -to-Disposable Income Ratio

HOUSEHOLD MORTGAGE DEBT TO DISPOSABLE INCOME RATIO

1994 1997 2000 2003 2006 2009 2012 2015 10% 20% 30% 40% 50% 60% 70% 80%

90% 88.80%

77.8%

31.85%

49.20%

34.8%

18%

15%

12%

9%

6%

3%

0%2008 2010 2012 2014

Household Disposable Income-year-on -year % change

Household Sector Debt -year-on-year % change

HOUSEHOLD SECTOR DISPOSABLE INCOME VS DEBT

Source: FNB

Source: FNB




The Q4 SARB bulletin reports that the latest debt service ratio

stood at 9.7% of disposable income. This is higher than the

recent cyclical trough of 8.5% recorded in 2012/1, but still

somewhat lower than the 2008 peak of 14.4%.

All of this suggests that, should the SARB indeed opt to pause

its tightening cycle, conceivably at its next meeting in May,

consumer spending growth should remain positive. The

broader economy should consequently avoid a technical

recession this year. With latent political uncertainty and the

prospect of a rebound in international oil prices, inflation will

remain a key risk. As such, the outlook for further interest

rate hikes remains quite good over the longer term, beyond

2016.

The sharp rise in electricity and associated administered

prices since 2008 suggests that available disposable is

probably much lower than generally thought. After adjusting

for these items and including the more the recent food prices

hikes, income and therefore the debt service obligation ratio

as a % of disposable income, is probably much higher than

that reflected in the official data.

This would suggest that although mortgage debt and in

general household debt serviceability remains reasonable at

present, it would likely take a smaller rise in interest rates to

recreate the same level of consumer stress. Rates would not

specifically have to rise back to the levels seen in 2008 and

the late 1990s in order for delinquency rates to increase. It

is worth noting that the prime rate reached a level of 15% in

2008 compared to its current level of 10.5%.

Sellers downselling due to financial pressure - % of total sellers

Trendline

Q1-20080%0%

10%15%20%

25%

30%

35%40%

34%

% o

f Tot

al H

ome

Sal

es

% of R

ental Tenants in good G

ood Standing

40%

50%

14%

Q1-2010 Q1-2012 Q1-2014

DOWNSCALING DUE TO FINANCIAL PRESSURE

Source: FNB

% o

f Dis

posa

l Inc

ome

HOUSEHOLD SECTOR DEBT-SERVICE RATIO VS INTEREST RATES

19950%

10%

5%7%9%

11%13%

9.7% 15%17%19%21%23%25%20%

1998 2001 2004 2007 2010 2013 2016

Prime Rate - Right AxisHousehold Sector Debt-Service Ratio (Interest Only)

Average Interest Rate on Household Debt

8.5%10.3%12.5%

Source: FNB




MAJOR INVESTMENT THEMESBlue Quadrant Capital Management clients invested in one

or more funds listed below can refer to the client portal at

www.blueqcm.com for more detail regarding each major

investment theme listed in this publication.

US DOLLAR TO OUTPERFORM AS GLOBAL YIELD TRADE UNWINDS

SUMMARY

• US current account deficit will narrow and possibly move

to surplus as US energy production and net imports

decrease.

• Accelerating US economic growth will lead to gradual rate

normalization. Coupled with less global dollar liquidity

and a smaller US current account deficit, the fundamental

underpin for the global ‘carry’ yield trade will become

progressively less favourable.

• These dynamics will attract capital flows back to the US,

supporting sustained US Dollar bull market.

IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING

• Avoid asset classes such as fixed-income and higher risk

yield-bearing counters and securities that have benefited

from this trade.

• Remain overweight in the US Dollar in respect of our

overall currency exposure.

THE CASE FOR A SECULAR BEAR MARKET IN FIXED INCOME

SUMMARY

• Current consensus expects continued disinflation in the global economy. US and global labour market dynamics do, however, point to a threat of the return of sustained wage inflation over the next 5 to 10 years.

• Additional potential risks to the medium-term inflation outlook could include:1 Fundamental dynamics such as lack of infrastructure investment in major developed economies.2 The end of ‘Moore’s’ law and geopolitical-induced disruption to global energy supplies.

• Memories of the 2008 financial crisis create the risk that policymakers will be slow to react and respond to a return

to elevated global inflation.


• Avoid asset classes such as fixed-income and higher risk yield-bearing asset classes, where rising interest rates and yields erode capital principal.

• Remain overweight the US Dollar in terms of overall currency exposure, which will benefit from rising long-term US bond yields

• Build and maintain an exposure to physical gold and specific gold producers as a form of portfolio insurance.




NEGATIVE ON OUTLOOK FOR SOUTH AFRICAN ECONOMY AND FINANCIAL ASSETS

SUMMARY

• Supply-side structural constraints, such as a persistent power deficit and a fractious labour environment, will constrain the country’s ability to expand export capacity

• Current government policy favours substantial state involvement in the economy. This will continue to result in substantial capital misallocation.

• These dynamics will ensure that the country’s two key economic imbalances, namely the fiscal and current account deficits, will remain large and entrenched as a feature of the country’s economic fundamentals.

• A depressed commodity price environment, with possible exception of gold, will lead to a deterioration in terms of trade, and create additional external headwinds for the economy.

• Rising global interest rates and a reduction in US Dollar liquidity will make it difficult for South Africa to fund its current account deficit resulting in a sustained depreciation

in the currency.


• Avoid domestic asset classes such as fixed-income and higher risk yield-bearing asset classes, particularly commercial property.

• Retain a large offshore exposure and minimize Rand currency risk in portfolios.

• Retain a minimal exposure towards interest-rate sensitive domestic sectors.

• Seek to invest in companies that are able to generate

export revenues or will benefit from import substitution

NEGATIVE ON OUTLOOK FOR CHINESE ECONOMY, FIXED INVESTMENT AND GLOBAL LINKAGES

SUMMARY

• The large growth in credit over the past five years has led to a massive capital misallocation. There exists widespread evidence of a significant capital stock surplus in certain sectors, such as residential- and commercial property.

• Chinese fixed investment has averaged 50% of GDP over the past five years, an unprecedented level relative to other economies both past and present.

• Chinese fixed investment spending has been a major driver of global demand for industrial commodities, particularly steel and iron-ore. A substantial slowing in Chinese fixed investment spending creates substantial downside risks for industrial metals

• Low global interest rates and access to cheap US Dollar funding has led to large-scale use of cheap US Dollar funding to finance risky investment projects in China. Unwind of this trade could lead to systemic risks in certain key banking centres, such as Hong Kong and Singapore and Australia by association. All three banking centres

remain heavily reliant on wholesale funding.


• Avoid those economies which have benefited from both elevated commodity prices and ample global liquidity, such as Australia. Substantial risks over the next several years to commodity-sensitive currencies that have also benefited from the global ‘yield’ trade.

• Build and maintain a short exposure in commodity or

‘yield’ currencies, as well as the financial assets of these

economies. • Avoid exposure to industrial metals and also mining

companies focused on the production of commodities tied to fixed investment or infrastructure, particularly

steel and iron ore.




THE US ENERGY REVOLUTION – IMPLICATIONS AND THE SCOPE FOR ENERGY PRICE VOLATILITY

SUMMARY

• US oil and gas production is expected to increase

significantly over the next five years due to the use of new

technologies able to unlock vast previously inaccessible oil

and gas (shale) reserve formations

• Increasing US energy production and decreasing net

energy imports have important implications for global US

dollar liquidity going forward.

• Increasing US oil and gas production may depress

global energy prices, creating substantial risks for major

‘petrostates’. Inherent political vulnerabilities may be

exposed, leading to heightened geopolitical risks and risk

of major energy supply disruptions.

• The current disparity in pricing between US natural gas

prices and global gas- and oil prices will gradually be

narrowed.


• Avoid major energy companies, particularly those with operations in geopolitical regions with heightened risks.

• Focus on maintaining an exposure to US-centric energy companies, and in particular companies focused on natural gas production, with substantial gas and liquids reserves. The inevitable narrowing in US gas prices relative to global oil and gas prices will favour these companies.

• Focus and maintain an exposure to companies that will benefit from rising US oil and gas production as a second derivative of this dynamic. Energy infrastructure companies able to remove logistical bottleneck and take advantage of existing energy price differentials will benefit.

THE CASE FOR A NEW GROWTH CYCYLE IN US FIXED INVESTMENT

SUMMARY

• US fixed investment expenditures (as % of GDP) have

declined to a multi-decade low in the aftermath of the

Great Recession in 2007 to 2009

• The US capital stock and in particular public infrastructure

is ageing and will require renewal or productivity will

continue to lag, creating upside risks to the medium-term

inflation outlook

• An upturn in the US housing market and sustained job

and income growth will boost federal, state and local

taxes, which coupled with reduced military spending, will

create fiscal space for an increase in public investment

expenditures.

• As the “millennials”, the largest demographic generation by

number enter the key 34 to 44 age segment, they will drive

household formation and demand for housing

• The rise of the millennials will drive inflation higher, as

demand for credit increases in the context of significant

supply-side and productivity challenges


• Avoid asset classes such as fixed-income and higher risk yield-bearing asset classes, where rising interest rates (as inflation trends upwards) and yields erode capital principal.

• Remain overweight the US Dollar in terms of overall currency exposure, which will benefit from rising long-term US bond yields and relative growth outperformance

• Build and maintain an exposure to equities expected to benefit from an upturn in US fixed investment spending as well as a general upward trend in housing activity, prices

and mortgage demand.




This report and its contents are confidential, privileged and

only for the information of the intended recipient. Please

destroy this document if you have received it in error.

Blue Quadrant Capital Management make no representation

or warranties in respect of this report or its content and will

not be liable for any loss or damage of any nature arising from

the unauthorised use of this report, the contents thereof, or

any electronic viruses associated therewith. This report is

proprietary to Blue Quadrant Capital Management and may

not be copied or distributed without the prior written consent

of Blue Quadrant Capital Management.

EMAIL [email protected]

LANDLINE +27 (21) 672 4744

FAX +27 (21) 672 4701

ADDRESS Unit C

Clareview Business Park

236 Imam Haron Road

Claremont, 7700

www.blueqcm.com

DISCL AIMER

CONTACT DETAILS

CAPITAL MANAGEMENTblueqcm.com/.../2016/05/BQ-Quarterly-Review-1Q16.pdf · quarterly review q1 2016...

Documents

Transcript of CAPITAL MANAGEMENTblueqcm.com/.../2016/05/BQ-Quarterly-Review-1Q16.pdf · quarterly review q1 2016...