SA resource sector performs dismally

Cape Town - The resource sector has performed dismally since the start of the year and prices are declining due to global over-supply, Overberg Asset Management said in its weekly overview of the SA economic landscape.

"At the same time that demand for resources is on the decline the cost of mining production is rising rapidly due to high wage demands, the rising cost of electricity and an uncertain regulatory environment," OAM said.

"Falling revenues and rising costs are not an equity investor’s best friends. There will be a tremendous profit squeeze and prospects of rising losses for the mining sector.

"Losses are likely to be especially pronounced over the short-term due to the equity market collapse in China."

According to OAM hedging demand from equity investors unable to short China-listed shares will add even further downside pressure on base metals prices and the JSE Resource 20 index in the months ahead.

South Africa economic review

• Following its strong +R4.9bn trade surplus in May the trade balance unexpectedly recorded a follow-up surplus of +R5.8bn in June well ahead of the –R1.5bn consensus forecast deficit. The cumulative deficit for the first half of 2015 is –R24.6bn compared with –R46.77bn for the same period last year. During the month of June exports increased by 12.9% year-on-year while imports increased 5%, and over the second quarter exports increased 12.3% on the year in contrast to a -0.3% decline in imports. Exports should maintain their positive momentum during the second half of the year as external demand from key developed markets continues to improve, although load shedding may affect local manufacturing and mining output. Lower commodity prices may also have a detrimental effect on mining exports although on the flipside the value of oil imports will be suppressed by the sharply lower oil price.

READ: Rand recovers from 14yr lows on trade surplus

• Foreign investors were net sellers of –R2.85bn worth of bonds and -R0.53bn worth of equities in the past week. While turning negative towards SA’s equity markets foreigners’ contribution to total equity market traded volume increased to 44.9% from 27.9% the previous week, above the year-to-date average of 39.1%. Foreign equity selling was concentrated in the financial sector followed by the property sector, while net buying was noted in the industrial sector followed by the resources sector. For the year-to-date foreign net buying of bonds and equities amounts to R15.9bn and R35.37bn respectively.

• Despite the SA Reserve Bank’s recent 25 basis point interest rate hike on the 23rd July the rand continued to depreciate in the past week, extending its losses against the US dollar to -9.5% since the start of the year and to -15.75% over the past 12 months. The rand is trading at its lowest against the US dollar in 14 years with further losses expected due to a combination of rising budget and current account deficits and heavy reliance on foreign portfolio inflows. The rand is especially vulnerable to any change in sentiment in foreign bond investors who currently own over 40% of SA’s sovereign bond issuance. The rand is expected to depreciate further in the lead-up to and following the Federal Reserve’s expected interest rate hike in September, as interest rate normalisation in the US lessens the attraction of higher emerging market yields.

READ: Cees Bruggemans looks ahead to 2018 and $1 = R22.50

• Producer price inflation (PPI) increased slightly from 3.6% year-on-year in May to 3.7% in June below the 3.9% consensus forecast. The more moderate than expected PPI increase is attributed to food manufacturing inflation which increased just slightly from 5.3% to 5.4% in spite of the drought-induced spike in maize prices. However, the lag between crop prices and food manufacturing inflation tends to be difficult to predict and may be longer than expected during the current cycle. As a result PPI is expected to accelerate in coming months feeding through to higher CPI, which is likely to breach the upper end of the SA Reserve Bank’s 3-6% target range by the end of the year.

• Growth in private sector credit extension (PSCE) decelerated from 9.4% year-on-year in May to 8.1% in June well below the 9.3% consensus forecast. The slowdown is attributed to corporate sector credit extension which slowed from 16% to 12.9% due primarily to a slowdown in the general loans and advances category which contributes about 45% of all corporate sector credit. On the other hand growth in household credit extension increased slightly from 3.2% to 3.5%. Growth in household general loans and advances which is comprised mainly of unsecured credit increased strongly from 3.2% to 4.9% the fastest rate since early 2014.

• The Quarterly Labour Force Survey (QLFS) reported that unemployment unexpectedly fell from 26.4% in the first quarter (Q1) to 25.0% in Q2. The 107 000 increase in the size of the labour force was outweighed by a 198 000 increase in employment with the formal sector adding 39 000 payrolls and the informal sector adding the bulk at 117 000. The agricultural sector lost -22 000 jobs. Although the labour report is encouraging it seems to contradict recent macroeconomic data which has been signaling an increase in unemployment over the quarter. Stats SA, which prepares the QLFS data, itself admitted reservations over the accuracy of the data due to the introduction of a new sampling methodology at the start of the year.

READ: Unemployment rate down, but big picture worrisome

• Vehicle sales have been slow since the start of the year with recent declines recorded in both passenger and commercial vehicles. The fall in new vehicle sales accelerated on a year-on-year basis from -4.8% in June to -6.1% in July attributed to the impact of rising interest rates and weakening consumer and business confidence. Passenger sales fell -8.8% marking the fifth straight annual decline despite most dealers offering sales incentives. Commercial vehicle sales fell by -0.1% with light commercial vehicles gaining 0.7% but medium and heavy commercial vehicles falling by -1.6% and -6.3%. The outlook for domestic vehicle sales remains clouded by slow economic growth, weak credit demand, high household indebtedness, and poor employment prospects. A bright spot is that total exports remained strong rising 24.4% on the year with passenger vehicle and commercial exports rising 52.7% and 11.7% respectively.

READ: June car sales down

• The BER manufacturing purchasing managers’ index (PMI) unexpectedly maintained its June level finishing unchanged in July at 51.4 above the key 50 level which demarcates expansion from contraction. The PMI reading is encouraging given the impact of severe electricity shortages during the month. However, while the output sub-index climbed strongly from 51.7 to 53.7 the forward-looking new orders index fell below the contractionary 50 level to 49.8 signaling a fall in both export and domestic orders.

Political review

• Parliament debated the controversial Expropriation Bill which will replace the Expropriation Act of 1975. The Bill drew strong criticism from the Cape Chamber of Commerce and the Banking Association of SA (Basa) on the grounds that it gives the state excessive powers to expropriate land and property without paying full market value compensation. Basa was especially critical of the clause that government is only required to pay 80% of a property’s market value, saying that this would expose mortgage bond debtors to substantial financial risk. However, law firm Webber Wentzel although reporting several shortfalls in the Bill also confirmed that these could be easily remedied through relatively small amendments.

READ: Expropriation bill will spook investors, banks say

• Gold producers made their final wage offer to the mining unions. As well as being well below the 150% increase being demanded by the Association of Mineworkers and Construction Union (Amcu) the wage offer also stipulates that in order to be validated it must be accepted collectively by all four of the representative unions. The collective stipulation is designed to prevent Amcu, which controls around 30% of membership across the sector, from disrupting the final wage agreement. While the sharp decline in the gold price may encourage Amcu to be more compliant there is a high probability that the union will reject the current offer, raising the likelihood of eventual strike activity.

READ: Amcu snubs higher wage offer

• Tourism is a vital component of the SA economy contributing around 10% of GDP in addition to providing substantial export revenue and employment opportunities. However, new visa regulations introduced by the Department of Home Affairs have caused a sharp decline in visitors especially from China where numbers have declined by -38% compared with last year. Tourism Minister Derek Hanekom publicly stated his concern over the impact of new visa regulations. The requirement for visitors to provide biometric data means visitors must apply for visas in person which is difficult in vast countries like China with only two visa processing centres. While the Home Affairs Minister has refuted Hanekom’s remarks it is hoped that there may be some softening in the biometric data requirement.

READ: SA tourism harmed by visa rules - Hanekom

The week ahead

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation. A break above the key “Fibonacci” level of R/$12.45 signals further depreciation in the rand to the R/$13.00 level.

• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.

• Despite the recent uptick in bond yields the long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.

• The US 10-year Treasury yield has broken above key resistance levels of 2% and 2.2%. However, there is unlikely to be a major bear trend in US bonds as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield is testing support at 8.15% and needs to break below resistance at 7.90% in order to resume its bull trend.

• The MSCI World Equity index is in the 5th and final wave of a rising-wedge formation. A rising-wedge formation is a typical trend-ending signal. European equities are set to outperform US markets. The Nikkei exhibits the most bullish pattern.  

• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle can be expected in the next year. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur around June 2016.

• The S&P 500 is breaking down from a rising wedge pattern, which is traditionally a trend-changing pattern. A break below the previous low of 2067 will confirm a trend reversal. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, has already broken down from its rising wedge.

• Brent crude’s break below the key $60 support level suggests a continuation of the weakening long-term trend. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the 2011 low of $6 500 and the key $5,500 support level suggesting further downside ahead.  

• Despite recent advances Gold is in a protracted bear market signalled by rapid declines through successive support levels at $1 300, $1 250 and $1 100. Gold’s next target is $1 000 which is likely to be breached before the bear market ends.  

• The All Share index has lost most of its gains since the start of the year. The All Share Index is testing the key support line which has been in place since 2009. A break below 50 000 would signal a sharp move lower to the October low of 47 000.

Bottom line

• The resource sector has performed dismally since the start of the year. The Resource 20 index has lost -13.82% compared with the +4.59% return of the All Share index. By contrast the Financial 15 and rand-hedge laden Industrial 25 indices have gained +8.96% and +8.56%.

• Resource prices are on the decline due to global over-supply and a slowdown in demand from the world’s largest resource market, China. Not only is China’s economy slowing, as evidenced by the latest manufacturing purchasing managers’ index (PMI) which fell to its lowest level in two years. China’s authorities are making a concerted effort at rebalancing the economy from industrial- and investment-led growth to consumer- and service-led growth, which will have a massive impact on China’s demand for resources.

READ: China July factory activity shrinks most in 2 years

• At the same time that demand for resources is on the decline the cost of mining production is rising rapidly due to high wage demands, the rising cost of electricity and an uncertain regulatory environment. Falling revenues and rising costs are not an equity investor’s best friends. There will be a tremendous profit squeeze and prospects of rising losses for the mining sector.

READ: Mining shares hammered as metal prices drop

• Losses are likely to be especially pronounced over the short-term due to the equity market collapse in China. China’s authorities have tried to prop-up the equity market through restrictions on short-selling. One of the only remaining hedging tools for China’s equity investors is through the commodities markets. Around 40% of global demand for base metals emanates from China which makes base metals an effective hedging tool against the country’s equity market declines. Hedging demand from equity investors unable to short China-listed shares will add even further downside pressure on base metals prices and the JSE Resource 20 index in the months ahead.

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* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.