SA banks performing well despite downgrades

Cape Town - South Africa’s banks have been virtually recession proof, delivering robust earnings growth and return on equity despite the turbulent economic and political environment.

Led by strong management teams, SA banks have successfully navigated through the turbulence of political and policy uncertainty and the rating downgrade to junk status.

History has shown that emerging market bank shares have tended to produce strong returns following a credit rating downgrade. This stems from management anticipating and discounting negative outcomes before they occur.

This is the view of Overberg Asset Management in this week's overview of the economic landscape.

South Africa economic review

• June manufacturing and mining production confirm both sectors of the economy posted positive contributions to GDP growth in the second quarter (Q2).

While mining production fell in June by 2.6% month-on-month and 0.8% year-on-year strong production in April and May helped overall output grow 2.6% quarter-on-quarter (q/q) annualised in Q2.

Manufacturing output, while declining in June by 2.3% on the year, grew in Q2 by 6.1% q/q annualised following three consecutive quarters of contraction, helped by low statistical base factors.

The Q2 manufacturing and mining production data are consistent with positive GDP growth in the quarter putting an end to the technical recession that ensued after two straight quarters of contraction in Q4 last year and Q1. Assuming 25% q/q annualised growth in agriculture in Q2 and flat output in the services sector GDP should grow by around 1.5% q/q annualised in Q2.

• The South African Chamber of Commerce and Industry (SACCI) business confidence index increased in July for a fourth straight month rising to 95.3 from 94.9 in June.

The business confidence index is at its highest since February and above its 2016 year-end level of 93.8. The main contributors to July’s improvement came from increased vehicle sales, more building plans passed, lower inflation, and higher share prices. The largest detractors were lower export and import volumes and the rand exchange rate.

The SACCI report cites the World Economic Forum’s 2016-2017 Global Competitiveness Report. Although falling to 47th position overall, South Africa ranked 10th in the world for the efficiency of its legal framework for challenging regulations, 16th for judicial independence and 14th for the strength of investor protection. South Africa ranked second in the world for the soundness of its banks.

• Escalating tensions between North Korea and the US and uncertainty surrounding the motion of no confidence caused foreign investors to retreat from the South African bond market in the past week.

Foreign investors sold a net R2.83bn of domestic bonds in the week ended 13th August partly reversing the R8.10bn inflow during July. For the year-to-date net bond inflows total R35.06bn. By contrast foreign investors have been net sellers of domestic equities since the start of the year amounting to R61.41bn, building on the total net outflow of R124.83bn in 2016.

However, there is an indication that the trend may be turning. Although foreign investors sold a net R86m of equities in the past week net inflows of R10.77bn were recorded in July.

The week ahead

• Retail sales: Due on Wednesday 16 August. Retail sales are expected to maintain their positive upturn in June with year-on-year growth of 2.4% according to consensus forecast up from 1.7% in May, helped by low statistical base factors.

Retail sales will have shown positive year-on-year growth in each month of the second quarter (Q2) contributing positively to the quarter’s GDP growth, in sharp contrast to Q1 when retail sales contracted by 3.5% quarter-on-quarter annualised.

The outlook for retail sales is helped by falling inflation and the prospect for further interest rate cuts.

Technical analysis

• The rand is testing key resistance at R13.00/$, which if broken would target further gains to R12.50/$ and thereafter R12.00/$.

• The US dollar index has tried but failed to break through a major 30-year resistance line suggesting the three-year bull run in the dollar may be over.

• Following the announcement of the snap election the British pound has broken above key resistance at £1.30/$ which has now become a key support level and should promote further near-term currency gains.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield has failed to break below key resistance at 2.0% raising the probability that the multi-year bull trend in US bonds is over.

• The benchmark R186 2025 SA Gilt yield is trading in a tight trading range of 8.5% to 9.0%. A break above 9.0% is required for the yield to move decisively higher towards the 10.5% target level.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.

• The Brent oil price has broken above key resistance at $50 and likely to remain in a trading range of $50 to $60 over the foreseeable future. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $6 000 per ton.

• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400 target level.

• The break above 54 200 on the JSE All Share index projects an upward move to 60 000 marking a new high for the JSE.

Bottom line

• Emerging market currencies have rallied since the start of the year in line with a falling dollar and rising global risk appetite. Despite domestic political and policy uncertainty the rand is likely to correlate closely with the strengthening trend in emerging market currencies.

Given the constructive environment for the rand equity investors should reduce the relative weighting of rand hedge shares in their portfolios in favour of domestically focused shares. The bank sector is a compelling candidate.

• Historically the bank sector has provided investors with market beating performance delivering superior earnings growth and a higher dividend yield over the long-term.

Despite its excellent track record the bank sector trades at a substantial discount to the broader market on a price-earnings multiple of 11.27x versus 19.99x for the All Share Index. The dividend yield also compares favourably at 4.82% versus 2.75%.

• South Africa’s banks, led by strong management teams, have successfully navigated through the turbulence of political and policy uncertainty and the rating downgrade to junk status.

• Impressively, bank debts have trended lower despite the economic recession. Debt counselling by distressed consumers and orderly court-sanctioned re-negotiation of debt terms has contributed to significantly lower than usual bad debts in the current economic downturn.

• Following the anaemic economic environment of the past two years’ bank clients are less indebted, making space for healthy credit growth in the next economic upswing.

• Conservative provisioning and increased regulatory restrictions have led banks to build robust capital buffers. The total capital adequacy ratio of the major banks has strengthened to 16%, substantially above the South African regulatory minimum of 9.75%.

• Bank penetration is still at low levels creating extremely favourable long-term growth prospects. An estimated 65% of transactions in South Africa are still cash-based, while only 58% of South Africans hold bank accounts and only 14% borrow from banking institutions.

• The initiation of the interest rate cutting cycle in July and likely easing in political and policy uncertainty after the ANC’s elective conference in December should lead to an upswing in aggregate credit demand across household and business sectors, in turn boosting bank earnings.

While the bank index has gained just under 11% over the past month it has only gained 1.4% since the start of the year and its returns over three years are modest at 15.5% suggesting substantial upside from current levels.