Making sense of the see-saw environment

Erik Nel, analyst at Atlantic Asset Management writes that markets remain in a state of flux as traders try to make sense of the risk on/risk off see-sawing environment.

Local markets also continue to be highly volatile, with R157 trading in an 8.15%/7.84% range month-to-date, while the Top40 has traded in a 10% (!) range of 23,050 and 25,210. Push vs. pull factors both globally, as well as on the local front remain finely balanced, with some of the following recent headlines ongoing cause for concern:
* Jobs are still being lost despite recovery
* Minister to review state-owned corporations after all
* Workers reject 8% Eskom offer but rule out strike

Here we have to add that what is alarming is the amount of conflicting signals being sent out by government lately – it appears completely rudderless to be brutally frank. Whether it is due to the fact that the entire nation is preoccupied with the World Cup only time will tell. Let’s hope that with Bafana Bafana now relegated to the stands, the focus will shift to the economy!)

We will comment further on wage settlements in the Fixed Income segment, but the cause for concern in the above headlines is that we are the country with the highest official unemployment rate in the world!

We came across the following speech made by Dallas Fed President Richard Fischer – note that it dates back to May 2008!

An excerpt : “I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words — “frightful storm” — deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets…”

The even more disturbing dark and dirty secret about deficits — especially when they career out of control — is that they create political pressure on central bankers to adopt looser monetary policy down the road…”

Fixed Income

On balance it would appear that the local recovery continues to gain traction, while cyclical disinflation still seems to have some legs left. Incoming data will not help make the SARB’s decision any easier at the July MPC meeting, with 1Q10 unemployment data in particular a cause for concern. Instructive though is comments made by SARB governor Marcus some time back that the SARB’s role was not to correct structural misalignments in the economy. We can think of few better examples than unemployment.

While the latest update from the BER inflations expectations survey showed a continuation in the improving trend for lower inflation for both 2010 and 2011 (2012 remains unchanged at 6.8%), the survey still sees inflation averaging above the target band in both years, with business’ expectations in particular a concern given the ongoing battle with labour to contain wage increases. This appears to be a classic case of passing the buck with the consumer to only lose in the end. This concern is highlighted in the wage expectations section of the survey which rose to 9.0% (8.4% in Q1), while remaining unchanged at 8.5% in 2011.

Local rates are benefiting from ongoing demand by offshore investors. After at least one severe risk-off round in May, investors will be well advised to treat this demand with a healthy dose of skepticism. While we remain constructive on rates in general in a global disinflationary/deflationary environment, Fed President Fischer’s warnings deserve all our attention.

Global

While China’s announcement that it will resume its 2005 policy of de-pegging the Yuan has taken centre-stage over the past few trading sessions, a story covered less well is the discovery that the 15-25 year age group in the most populated country on the planet has been overstated by 31 million.  With worker strikes (and even reports of suicides) on the increase, it would appear that the era of exporting deflation from China may be coming to an end.

With regards to the revaluation, as Northern Trust’s Paul Kasriel put it, Beijing has plenty of concerns at home that will not benefit from a stronger Yuan, and managing higher wages, lower export competitiveness and perhaps a slower economy will not be easy.  If these problems become more than policymakers want to handle, it is likely that a change in the Yuan's valuation will be the first corrective measure taken. Such a move may not be palatable to China's trading partners, but Beijing now has covered itself for just such an event.

Finally, we came across the following statistics regarding the BP Gulf oil spill disaster. While we are just as concerned about the environmental impact as everyone else, we could not help to notice some clearly alarming trends in these stats that are just not sustainable (our emphasis):

1.33 million barrels are estimated to have been released into the Gulf thus far. Consider a few facts and figures, from Boston University Professor Cutler Cleveland, describing how much energy 1m barrels of oil can generate:

* Supply your house with power until the year 83286.
* Drive a Toyota Prius to the sun and back – 34 times.
* Fly Tony Hayward on a private jet from Louisiana to London -- 263,808 times.
* Power all US auto traffic for 3.9 hours.
* Power total world energy use for 8 minutes.
* Power the country of Ghana for 20 days.
* Meet yearly energy needs for 130,968 Chinese.
* Meet yearly energy need for 22,890 Americans.
* Generate $280,488,692 of GDP in China.
* Generate $989,481,786 of GDP in America.

One look at the above statistics and the graphic below illustrates how important it is to find sustainable alternative energy sources and become less dependent and more efficient users.

When bearing in mind that US state finances are not only in a state of disarray, but appearing to be falling apart, it is important to recognise the fragility of this great nation and the implications that a further deterioration in its economy could have on world finance. (A report from the US Center on Budget and Policy Priorities issued last month estimates that in fiscal 2010 the US states collectively posted a $200bn-odd budget shortfall, equivalent to 30% of all state budgets.

Last year, that pain was partly eased by Obama's stimulus packages. But that spending splurge is now fading away. And in fiscal 2011 and 2012, the states are expected to face another combined budget deficit of $260bn, with the 2011 shortfall in places such as New Jersey, Illinois, Nevada and Arizona projected to be more than 35% of last year's budget).

Foreign Exchange

Alas there is a silver lining... Despite all the negativity that continues to surround the announcements of European austerity measures (the UK the latest in this regard with a truly monumental cutback to almost flat by 2015, lowering its issuance profile dramatically in the process – although the proof is in the pudding!), the Rand remains one of the strongest currencies on the planet.

On a trade-weighted basis the unit continues to hover around best levels seen in 2010, and above levels experienced at the March MPC meeting, where it appeared that authorities were trying to weaken the Rand through a surprise interest rate cut.

A recently published research piece by Pimco perhaps supports our maiden Quarterly article in the sense that it speaks to the ongoing change in demographics across developing nations. While South Africa is not specifically mentioned in this document, most of the arguments hold true for us also, and at the margin it is a Rand positive one. (Although we would argue that consumption and credit extension in South Africa is probably already closer to developed nation standards than that of emerging markets, and we can actually do with increasing savings.)

Rising domestic consumption in emerging markets looks good for global investors. An extract : “Second, emerging economies should expand their service sector, including wholesale and retail distribution, domestics, transportation, logistics, healthcare and education. Ultimately, this would allow several emerging market countries – and mainly the ones that are heavy exporters, such as China – to become less dependent on labor-intensive manufacturing and more on labor-intensive services.” 

While the Rand appears to be holding up well at present, both its outperformance against peers, as well as the tipping over of our leading macro-economic indicators point to a potential move to the topside soon.