Category: Global Financial Markets

The rise of Naspers and its implications for the JSE; and why the main show for emerging markets remains the US economy, not Shanghai or Greece.

One of the important features of the JSE over the past few years has been the extraordinary rise of Naspers (NPN). As a result of this, NPN has become a very large share of the JSE indexes (some 11% of the JSE ALSI and Top 40 Indexes) and an even larger share of the SA component of the MSCI Emerging Market Index (MSCI SA) where it carries a weight of over 19%.

MSCI SA excludes all the companies on the JSE with primary listings elsewhere, including therefore the heavyweights, Anglo American, BHP Billiton, Glencore, SABMiller, British American Tobacco and Richemont that have primary listings elsewhere, so adding to the NPN weight. MSCI SA accounts for nearly 8% of the emerging market benchmark, giving NPN a 1.5% share in MSCI EM. Tencent, the Chinese internet firm in which NPN has a 34% shareholding, that accounts aso accounting for almost all of NPN’s market value, is the third largest company included in MSCI EM with a weight of 2.57%. The share of NPN in Tencent will not have been counted twice in the free floats that determine index weights, making the combined weight of NPN and Tencent equivalent to over 4% of the MSCI EM larger than the weight accorded to Samsung. The diagram and table below show these weightings.

Clearly the share prices of NPN and Tencent are significant influences on the direction taken by the EM Index, while EM trends (and index trackers) will in turn influence the market value of Tencent and NPN. And so in turn, via the weight of NPN in the JSE, these forces directly influence the direction of the JSE Indexes and through flows of capital will also affect the exchange value of the rand. As we show below, not only has the rising NPN share price increased its weight in the Indexes the trade in NPN shares now accounts (clearly not co-incidentally ) for a large percentage of the value of all shares traded on the JSE. On some days the trade in NPN has accounted for well over twenty per cent of all the shares traded on the JSE (See below).

The JSE therefore has become to an important extent a play on NPN. And NPN is in turn (almost) a proxy for Ten Cent that is a play on Chinese mobile applications, including games and payment systems. Ten Cent describes itself as an Internet Service Portal. This NPN-Ten cent connection to the JSE accounts in part for the close links between the JSE and the EM Indexes, when both are measured in a common currency. It will be noticed that the EM Index and the JSE in USD dollars are now below their levels of January 2014 making them distinct underperformers compared to the S&P 500.

A recent force acting on global markets, especially EM markets, has been the extraordinary behaviour of the Shanghai equity market. The volatility in Shanghai listed shares as well as the direction of the Shanghai Composite Index, up then down since late 2014 is indicated below.

We show below that the EM Index and NPN largely ignored the extreme behaviour of the Shanghai Index until this past week when the markets and the rand seemed to have become somewhat “Shanghaied”, following that market sharply up and down. This turbulence on the Shanghai share market has clearly influenced the value of EMs, NPN and Tencent, as well as the rand, in recent days. On Wednesday (8 July), NPN in US dollars and Shanghai both lost about 6% of their value, while recovering as much on the Thursday.

It will take a greater sense of calm in Shanghai to reduce risks and attract funds into EMs and provide support for their currencies, including the rand. But more important still for EM economies and their listed companies over the longer term, will be a recovery in the global economic outlook. Any sustained recovery in the US economy should be welcomed by investors in EM. Any increase in short term interest rates in the US, from abnormally low levels, should therefore also be welcomed and regarded as confirmation of a US economic recovery under way; an economic recovery that is likely to extend to the global economy in due course. Events in Greece and Shanghai will remain distracting side shows to the main event, the state of the US economy.

There is the old saw about when you borrow money from a bank, paying interest and repaying the loans are your problem. But when you are unable to meet the terms of the loan it becomes the banks problem. If the bank had been more risk averse or done its sums better it would not have loaned as much and you might not have gone broke.

Greek debt, it now appears, is becoming less of a problem for the Greeks and much more of a problem for the IMF and the European governments (rather the European tax payers) via the ECB, the European Investment Bank and the European Financial Stability Mechanism, who have backed the Greek governments (that is Greek taxpayers) with over €300bn of credit repayable over the next 30 and more years, with about €25bn due this year. Both the Greeks and the lenders involved must be well aware of the problem that the banks have. Almost all of the outstanding Greek debt is now owed to governments and their agencies (that is their taxpayers) after successive bail outs that avoided default and converted private into publicly owned debt.

The problem for the lenders is how much of the debt that they can realistically hope to collect, were the Greeks to declare default. In other words, how many cents on the euro could they still hope to collect in the bankruptcy proceedings that must follow? Unless the Greek government is willing to isolate Greece not only from the European Monetary System but from international trade and finance, they will still have to come to formal terms with their creditors. In such negotiations that will follow, the creditors would still have to be realistic about the demands they could make on the Greek people and their representatives in current and future governments.

The costs of having to leave the euro and the European Union (EU) are bargaining chips to encourage the Greek government to spend less on their many supplicants and grow faster through growth encouraging reforms. This would mean more competition in Greece and could enable the creditors to collect more of the funds they supplied to Greek governments so negligently in the past. Throwing more good money after what is now obviously bad, has less appeal for the creditor governments than it did – given the unwillingness of the Greek government to do or even to be seen to do what is asked of them. But the opportunity to make as much of your debt problems the problem of your bankers, as the Greeks have attempted to do, may still prove to have been a useful strategy – if Greece comes to better terms and retains its status in Europe.

Opportunity for the Greek economy with a Greek exit (Grexit) may come in the form of a weak drachma. But any gain in competitiveness through a weaker exchange rate is surely likely to be quickly eroded by higher inflation. Not facing up to economic realities (without access to foreign or domestic credit) will surely mean money creation and inflation to come. Not reforming a pension system that so encourages early retirement will remain a drag on economic growth, as will retaining so many of the policies that have bankrupted Greece. Greece, given the apparent appeal of its leftist leaders, could well become the Venezuela of Europe should it exit the EU. If this happens, it may take a long period of time and persistent economic failures for economic realities to reestablish themselves in the Greek imagination: you cannot spend as a nation much more than you produce, unless you can persuade others to lend to you. The likelihood of such persuasion succeeding any time soon, in the absence of some kind of deal with the EU, seems remote.

European bond markets can clearly withstand a Grexit from the euro. ECB support for the bonds issued by Spain, Portugal and Italy has eliminated contagion from a Greek default. The state of the markets in other euro government bonds tells us as much. Yet there is still much to lose for Europe – the banks will still be left with the problem of what to do with Greek debt even should Greece have been punished with expulsion from the EU. Formally writing off much of the Greek debt, as will have to be done should Greece default, will not be a comfortable exercise. So, given the alternatives for both creditors and debtors, a deal might yet be struck. This would be a deal that allows the creditors to postpone for now any formal recognition of how much they have lost, while allowing the Greek government to claim a much better deal than offered earlier, including access to further financial support, with a frank recognition that the debt cannot ever be fully repaid, even under the most conceivably favourable assumptions about the Greek economy.

There is a latter day curse victimizing financial institutions. That is to be recognized by the regulator as a “Systematically Important Financial Institution” (SIFI) In other words one regarded by the regulators as being “too-big-to-fail”. Hence the requirement by regulators of any SIFI of very strong balance sheets that ensure against failure. This translates into ample highly liquid assets on the asset side of the balance sheet that yield minimum income for the bank. Such safe assets will have to be accompanied by secure funding in the form very long dated liabilities that may be expensive to raise. It may be required that such debt be converted at very short notice- to be given by the regulator- into equity – should solvency come under serious threat. Such unfavourable terms for debt holders would add further to the cost of such funding . Furthermore short term liabilities that can be withdrawn at the whim of lenders, for example deposit liabilities,do not qualify as desirable secure forms of funding. Regulators then require of banks good cover in the form of capital and holdings of cash or near cash to be acceptable sources of bank funding. These requirements make short term deposits a much more expensive source of funding for banks.

The problem with such safe guards and fail-safes is that they must all come with reduced returns on the capital subscribed by shareholders in any SIFI. Less risk forced upon borrowers and lenders (higher costs of raising funds and lower rewards for allocating them) translates inevitably into less profitable financial businesses with diminished prospects for growth. These lesser prospects for shareholders immediately subtract from the long term value of any bank or financial business to its shareholders. Such is the curse on shareholders. It is also a curse on potential borrowers from a financial institution. It means less appetite by banks to lend even at higher charges and to much slower or negative growth in their loan portfolios.

South African banks are also having to face up to additional constraints on both sides of their balance sheets imposed by the international bank regulation convention known as Basle 3. This means significantly increased costs for banks raising funds and reduced returns on shareholder capital they risk. It must also mean both more expensive bank loans and fewer borrowers qualifying for them. It is not a formula designed to facilitate economic growth for which bank credit is an essential ingredient.

One way to break the spell over the SIFI is to reduce the scale of your financial activities – that is for a financial institution to become as systemically unimportant as possible- something shareholders will welcome and the regulators cannot easily stop, as General Electric (GE) is now in the process of doing. GE announced the disposal of USD26b of its real estate assets and property lending to the Blackstone Group and Wells Fargo last week, the first steps in winding down its Financial Division. GE’s intention is to dispose of USD200b of property and financial assets and associated liabilities under its control. GE Capital accounted for 57% of GE earnings in 2007- pre the Financial Crisis – and this contribution is planned to decline to 10% of earnings in 2018. GE has also announced that ; USD50b of the asset sale proceeds will be used to buy back shares equivalent to about 17% of its current market value while it intends to maintain its dividend –another means to return excess cash to shareholders.

The share market reacted very favourably to the news, adding nearly 14% GE’s share price and as much as USD37b dollars to its market value almost overnight. (See below) Perhaps also worth noting is that despite the recent jump, a GE share is worth but half of what it was in 2002.

How European Central Bank (ECB) Quantitative Easing (QE) moved the markets, including the rand and the RSA Yields. Is this good news for emerging market economies?

The unexpected scale of the intended QE in Europe announced on Thursday moved the markets. Most conspicuously it weakened the euro vs the US dollar. Such weakness must be good for European exporters and thus for growth prospects in Europe regardless of how much more lending European banks will do with their pumped up cash reserves. Some stimulus from a weaker euro will add something to the demand for bank credit, which has been as weak as the supply of bank credit from European banks – hence the case for QE.

US dollar strength and euro weakness was an entirely predictable response to what became a wider interest rate spread in favour of US Treasuries over Bunds.

The rand not only gained against the euro but also strengthened against the US dollar on the QE facts.

This strength was however not confined to the rand. It was also extended to many of the other emerging market currencies. The rand lost a little bit of ground against the Brazilian real and gained against the Turkish lira. It also held its own against the Mexican peso and Indian rupee as we also show below. Thus euro weakness vs the US dollar extended to emerging market currencies, including the rand.

For a while now – since 19 September to be precise – the markets have stopped worrying about what US growth might do to interest rates (threatening equity valuations) and began to worry about growth itself.

News of deflation in Europe had fed these fears and helped force bond yields everywhere (including RSA yields) lower. Yesterday morning a weak US retail number, announced before the market opened in New York, was more than enough to encourage a dramatic sell off of leading equities and an equally dramatic rush to the apparent safety of bonds. We show the intraday moves in the bond markets below.

Continue reading An extraordinary day in the markets