Month: September 2009

We remain optimistic about equities generally, yet we do not expect JSE Resources to out- or under -perform the market generally.

JSE performance is often in the mix of resources vs other sectors

South African managers of balanced equity funds usually stand or fall by their judgments about the mix of resources, industrial or financial stocks in their portfolios. Resources can out or under perform by large orders of magnitudes as we show below.

JSE Resources Vs Industrials vs Financials (18 Sept 2008=100)

Source: I-Net Bridge and Investec Private Client Securities

Extreme relative moves were experienced in 2007-2008

Fifteen months ago, by mid 2008 when compared with a year before, the JSE Resource Index had outperformed the Financial Index of the JSE as much as 60% and had gained 40% on Industrials. Within a few short months, when the credit crisis was at its height and commodity prices collapsed, Resources had fallen more than twice as far as Industrials or Financials.

The JSE sectors have moved in line over the past twelve months

Over the past twelve months after the fall and with the strong recovery from March 2009 in commodity prices and emerging equity markets, all the major sub sectors of the JSE have performed more or less in line. The annual return on JSE Financials and Industrials have been about five per cent ahead of Resources and all sectors have moved into positive annual return territory.

Resources/Industrials and Resources/Financials (Sept 2008=100)

Source: I-Net Bridge and Investec Private Client Securities

What matters for relative and absolute JSE performance is not rand strength or weakness – but the causes of rand strength or weakness

The key to the out- or under-performance of the Resource sector is not simply, as many would be inclined to suggest, simply rand weakness or rand strength. Rand weakness will only be especially helpful to Resources and harmful to Financials and Industrials if the cause of rand weakness is South African specific. For example if some SA political development causes investors both locally and abroad to raise their risks of doing business in South Africa causing an outflow of funds and rand weakness, Resources will do better than Financials or Industrials. Vice versa if an improvement in sentiment causes the rand to strengthen, when the rand plays will outperform the rand hedges.

Mid 2006 to mid 2008 was an ideal time to be exposed to JSE resources

A combination of the kind of rand weakness experienced in 2006-08 coupled with stronger commodity markets represents ideal circumstances for JSE resource valuations. We show in the figure below how the rand weakened against the Aussie dollar (another commodity currency) in 2006-07 despite commodity price strength; and so Resources performed well absolutely and in a relative sense, outperforming handsomely the other JSE sectors. We also show how the rand recovered some of its losses and has held its own against the Aussie dollar over the past 15 months. Resource valuations came under particular pressure from the combination of weaker commodity prices and a relatively stable rand.

JSE Resources/Industrials, Commodity Price Index and the ZAR/AUD (Sept 2008=100)

Source: I-Net Bridge and Investec Private Client Securities

Rand strength for fundamental reasons is good for the JSE, but not especially good or bad for JSE Resources

When the source of rand strength or weakness is to be found outside South Africa, in the form of global economic strength which leads to stronger global commodity and emerging equity markets, there will be no reason to expect resources to out- or under-perform other sectors of the JSE. This has been the case recently. The rand has strengthened because of the recovery of the global economy led by emerging economies. The rand is stronger because of much firmer emerging equity and commodity markets.

The recent strength in commodity prices has been helpful for Resource company valuations on the JSE as well as those of the rand hedges (companies with a substantial part of their business outside South Africa). The strength in commodity and emerging equity markets has simultaneously boosted the rand and so the South African economy plays listed on the JSE have kept pace with the JSE generally.

The case for increasing exposure to the JSE equities at the expense of bonds must be based on a belief in rand strength for global reasons. What is good for the rand in the global economy will be good for the JSE, resources included. Rand weakness for global and SA specific reasons would be a reason for seeking less exposure to equities generally even though resources are likely to suffer less than average damage in such unhappy circumstances.

Our view is that the recovery in the global economy will continue to be helpful to JSE equities and the rand and so there are no SA specific reasons for strongly preferring resources over the other sectors or for reducing exposure to them. While continuing to overweight equities we would continue to recommend a broadly neutral mix of Resources, Industrials and Financials.

Presentation to Economic Society of South Africa

Biennial Conference, Sept 8th 2009

Brian Kantor, Professor Emeritus, University of Cape Town, Investment Strategist, Investec Private Client Securities.

and

Chris Holdsworth – Analyst, Investec Securities

Abstract

This study demonstrates with the aid of single equation regression analysis the role global capital markets play in determining the behaviour of the Johannesburg Stock Exchange (JSE ALSI) the Rand/ US dollar exchange rate (ZAR) and long term interest rates in South Africa on a daily basis represented by the All Bond Index (ALBI) or long term government bond yields represented by the R157. It will be shown that since 2005 the state of global equity markets, represented in the study by the MSCI Emerging Market Index (EM) has had a very powerful influence on the JSE. The EM Index is shown to have had a less powerful yet statistically significant influence on the ZAR while it is also demonstrated and that conditions in global capital markets, and the ZAR have had some weak but statistically significant influence on the direction of long term interest rates in South Africa. It will be demonstrated that movements in policy influenced short term interest rates, have had very little predictable influence on share prices, the ZAR or long term bond yields. The causes as well as the consequences of the ineffectiveness of policy determined interest rates for monetary policy are further analyse.

Introduction

This study demonstrates the role global capital markets play in determining the behaviour of the Johannesburg Stock Exchange (JSE ALSI) the Rand US dollar exchange rate (ZAR) and long term interest rates in South Africa on a daily basis represented by the All Bond Index (ALBI) or long term government bond yields represented by the R157. It will be shown that since 2005 the state of global equity markets, represented in the study by the MSCI Emerging Market Index (EM) has had a very powerful influence on the JSE.

The EM Index is shown to have had a less powerful yet statistically significant influence on the ZAR while it is also demonstrated and that conditions in global capital markets, and the ZAR have had some weak but statistically significant influence on the direction of long term interest rates in South Africa. It will be demonstrated that movements in policy influenced short term interest rates, represented by daily changes in expected short term interest rates, represented by daily movements in the implicit JIBAR 3 month forward rate (Jib3f3) have had very little predictable influence on share prices, the ZAR or long term bond yields.

The MSCI EM Index may be regarded as a proxy for conditions in global capital markets that affect South Africa. JSE listed shares are included in the EM Index with a current weight of about 7%. The more abundant the capital available for emerging market capital raisers, that is to say the less risk aversion prevailing, the higher would be the level of the EM Index – and vice versa.

Changes in the forward JIBAR rate are used as our proxy for short term interest rates on the presumption that it is interest rates expected, rather than current actual interest rates that drive the value of shares, bonds and currencies and that therefore changes in expected short term rates rather than changes in actual rates- that may well have been anticipated – have significance for the financial markets.[1]

Exchange rates inflation and the implications for monetary policy

The implications of this finding for monetary policy are surely serious ones. It would strongly suggest that policy determined adjustments to short term interest rates, when unexpected, will not influence the exchange rate in any consistent way. If so adjustments to short term interest rates cannot be regarded as a reliable anti-inflationary tool, given the influence exchange rates have on measured inflation rates in SA. The feed back effect of the exchange rate on import export and domestic prices is clearly a very important influence on the measured rate of inflation

The case for interest rate changes as the principle instrument of monetary policy is furthermore not enhanced by the evidence that short term interest rates have not had any consistently important influence on the direction of long term interest rates in South Africa nor on the direction of share prices and therefore on these components of household wealth. However it would seem to be the case that movements in actual short term interest rates can have a significant influence on aggregate demand in South Africa and perhaps also on house prices without necessarily reducing inflation rates. These relationships between interest rates and aggregate demand are not tested here.

Estimation procedures

This study utilises daily data to model and estimate the behaviour of the JSE ALSI the rand/USD exchange rate and the RSA All Bond Index bond index or long dated RSA bond yields (between January 1st 2005 and August 31st 2009. The models using daily data are supplemented with similar models utilising month end data from the mid nineteen nineties to help confirm the strength of the hypotheses tested and to test for structural changes in the economy.

The models are single equation models of daily or monthly percentage movements in the ALSI, the ZAR and the ALBI or as an alternative to the ALBI of daily changes in long term interest rates represented by the long dated RSA 157. The estimation method applied is single equation least squares regression analysis.[2]

The data – represented in figures

The dependent and independent variables of the models are pictured below in level and daily percentage change form. It may be seen that daily changes in all the dependent and independent variables are highly random and that prices, exchange and interest rates they have drifted both higher and lower since 2005. It is also shown below how much more generally volatile share and bond prices and interest rates became during the financial crisis that reached its apogee in September 2008 with the collapse of the large investment bank Lehman Bros. We have measured the volatility of the variables in the form of a 30 day moving average of their Standard Deviations and present this information in graphical form. We demonstrate how similar has been the behaviour of volatility on the different markets. That risks appear so similar in the different markets is further evidence of the globalisation of capital markets. We show that the increased volatility did not materially influence the estimates of the coefficients of the models

Fig1. The JSE All Share Index Daily Levels and % changes 2005 – Aug 2009

Fig2. The ZAR Daily levels and % changes 2005 – Aug 2009

Fig3. The SA All Bond Total Return Index Daily levels and daily % changes data 2005-Aug 2009

We compare in figure 4 below the performance of the rand to both the USD and the AUD to indicate that the rand while holding its own against the weaker US dollar in 2006-07 lost significant ground against what may be considered other commodity and emerging market currencies.

Fig4. The rand Vs the USD and the AUD Daily data (Jan 1st 2009=100)

The independent variables

The explanatory variables considered for inclusion in the models comprise (surprising) daily or monthly movements in forward short term interest rates (JIB3f3) and daily or monthly percentage changes in the MSCI Emerging markets equity index (EM) or in the S&P 500 Index to represent share prices in New York, As shown below the correlation between daily moves in the EM and S&P 500 is very high and other than reporting this correlations with the S&P 500 we did not apply the S&P 500 in the models. Also considered and applied in the various models were percentage movements in global commodity prices in USD, represented by the commodity price index of the Commodity Research Bureau (CRB) and percentage moves in Australian/USD exchange rate (AUD) or (AUS$). The additional explanatory variable applied in the models were changes in US long dated 10 year treasury Bonds.

Fig.5 Emerging equity markets (MSCI EM) and the S&P 500; Daily levels and daily % movement 2005-2009

Fig.6 Expected short term interest rates (Jibar 3 month implicit forward rate) Daily levels and daily changes

Fig7. Commodity Prices and US TB yields. Levels and Daily or daily % changes

Fig8. The Australian/USD exchange rate Daily Levels and % changes. 2005-2009

Representing volatility in graphic form

Fig 9. Volatility of Share and commodity markets. 30 day moving average of the Standard Deviation (SD) of daily % movements

Fig 10. Exchange rate volatilities; 30 day moving average of the Standard Deviation (SD) of daily % movements

We show below the measures of implied option price volatility on the S&P represented by the Vix Index and on the JSE represented by the SAVI

Fig11. Implied volatility – The Vix (on the S&P) and Savi on the JSE Daily data 2005-2009

Volatility and share prices

The increase in the volatility of share prices globally, including on the JSE, that provide indicators of the risks in the markets appears to have had a very negative impact on share prices. The negative correlation between daily percentage moves in the Index of Implied Volatility on the S&P 500, the Vix and daily moves in the S&P 500 itself has been a high negative (-0.76) and between daily moves on the JSE and the SAVI an almost equally negative (-0.73) since May 2005. (See Table 1 below)

Statistics for the SAVI, the implied options price volatility indicator of the JSE, are only available since then. It is surely volatility that drives the share market up and down. It is a much more difficult task to explain and predict volatility. Volatility in share markets may be regarded as abnormally high before 2007 when the global glut of capital was holding down interest rates and encouraging risk tolerance. The financial crisis as we well know reversed all this and produced much higher degrees of risk aversion and volatility as the likelihood of defaults and bankruptcies increased so dramatically, especially after the failure of Lehman Bros.

Table 1. Correlation statistics of daily % changes in volatility indicators with the Share Markets (May 2005- August 2009)

Correlation Statistics and their interpretation

In the tables 2 and 3 below we present correlation statistics for the daily percentage movements in the dependent and independent variables of our models. The correlation statistics that we regard as of particular interest are highlighted in red. The correlation statistics provided a foundation for the model building exercises to be fully reported upon below.

It should be appreciated that these correlations apply to prices, interest and exchange rates at market closing. The different markets however do not share the same closing times. Thus relevant information and the price movements that respond to the “news” can occur after one or the other market is closed and are then only reflected when the closed market opens up again. Were the data collected at the point in time when all the markets were simultaneously open the correlations measured would undoubtedly be higher ones

Table 2. Correlation of daily movements. The dependent variables Shares, Bonds and the ZAR with short term interest rates

Table 3. Correlation of daily movements of the independent variables.

To be noticed are the high correlation between daily moves in the JSE ALSI measured in rands and the EM measured in USD (0.73) The correlation of the JSE with the CRB also measured in USD is lower but significantly positive (0.39) Daily movements in the JSE and the ZAR have been negatively correlated (-0.33) indicating that rand strength rather than rand weakness has been generally helpful to the JSE.

Also to be noted is the very low almost zero correlation of daily moves in the JSE with changes in forward short term interest rates (- 0.07) The correlation of movements in the share and all bond indexes is a low but correctly signed (0.19) The correlation between movements in the EM Index and the ALBI Index (0.27) should also be recognised as a further influence of global capital markets on long term interest rates in SA. Lower or higher interest rates would not appear to have been generally either helpful or harmful to the JSE over this period.

The high correlation between the AUD and the JSE does not have any obvious theoretical explanation and this must be attributed to the high correlation between the AUD with the EM Index (-0.64) shown in the following table. Clearly the global economic forces that drive the EM higher or lower strengthen or weaken the AUD/USD.

It should be noticed that the returns on the ALBI the All Bond Index (the higher the index the lower are interest rates) have been negatively correlated with the moves in the ZAR(-0.34). That is a weaker rand is associated with higher long term rates- presumably because a weaker rand is associated with more inflation to come.

Of further interest is that bond market returns have been only weekly correlated with movements in short rates (-0.16). The correlation, not reported in the tables, between long dated R157 yields and these short rates is a very similar (0.16). The movements in the ALBI Index and R157 yields are very highly negatively correlated as would have been predicted. The correlation of daily returns in the ALBI and daily changes in the R157 (not reported in the tables above) has been (-0.98) over the period.

The high correlations over (0.50) between movements in the ZAR and the global equity markets should be noted as should the positive correlation between moves in the ZAR and the CRB and AUD. He rand has behaved as an emerging equity market and commodity currency. The weak, near zero correlation, between the ZAR and short term interest rates should be worthy of particular notice (.06). The final column of low correlations between short term interest rates and the equity bond and currency markets indicates how little short term interest rate moves seem to matter for the share, bond and currency markets.

The Regression Results and their interpretation

The regression equations reported in the tables below indicate that we are able to find very good estimates for daily moves in the JSE relying on the strength of the EM effect. We back up the models of daily movements in the JSE with models of monthly movements that go back further. These monthly models confirm the growing influence of emerging equity markets on the JSE since 2003.

Table 4 Regression Output

Commentary on regression equations 1- 15

The dominance of the Emerging Market effect on the ALSI is confirmed by the regression equations 1-4. The EM coefficients take values close to 0.70 in all the specifications tested. The influence of the CRB is statistically significant in all the models of the ALSI but is of lesser influence with coefficients that take values of the lesser order of 0.10. In equations 1-4 the returns of the ALSI are measured in rands while the returns of the emerging market index are measured in USD. If the currency had no effect beyond its translation, one would expect the rand beta to have a value of 1. The low rand coefficient (even after adjusting for multicollinearity through orthogonalisation) implies that that the rand has had an independent influence on the share market. For any rand weakness the market has on average increased by less than the rand has weakened. This implies that rand weakness leads to a lower rand value for of the ALSI and similarly a stronger rand leads to a higher rand value for the ALSI. The graphs of the variables revealed an increase in volatility towards the end of the period and after the credit crisis had reached its most serious condition in September 2008. The equations were tested for such volatility clustering in the form of a GARCH process. An examination of the squared residuals reveals a GARCH(1,1) process in the error terms. Including terms for the GARCH process had a minimal influence on the value of the coefficients.

An out of sample test of the ALSI model 1 for the period July 1st to August 31st 2009 estimated over the 1 year period from June 2008 to June 2009 reveals that nearly all of the recent volatility in the ALSI can be explained by the returns in the ALSI, the ZAR and commodity prices. The out of sample exercise is demonstrated in figure 12. The daily average absolute difference between the realised changes in the ALSI, dlog (ALSI) and the changes predicted by the model outside of the sample period was a minimal 0.34 percent.

Including a term for the change in expected short rates to equation (1) only marginally increases the R2 of this equation implying that either the information in short term expectations has already been accounted for (through the rand) or that short term rates are not important for the market as a whole. In equation 6 below we show the weak relationship between short rates and the rand, implying that short rates have little explanatory power for the share market as a whole.

Adding the yield to maturity of 10 year US government bonds to the ALSI models above provides a negligible increase in the R2, justifying its absence from model 1.

Given the problems with daily data (misaligned closing prices amongst others) we examined the influence of the variables above on a monthly basis over the extended period 1995- 2009. It should be noticed that the EM coefficient is very similar to that of the daily model with a value of 0.72. The rand coefficient is however much higher than in the daily model. The model was tested for a structural break in the coefficients in January 2003. The Chow test indicates a significant break in the structure. The test result very strongly rejects the null hypothesis of parameter stability. The break should be attributed to a changing relationship of the JSE with the rand rather than with the Emerging equity Markets. The rand coefficient in the monthly model is very different to that of the daily model while the EM coefficient retains its value.

Modelling the innovations in the ZAR

The short term innovations in the rand can be reasoned to be driven by emerging markets, commodity prices and interest rates. All of these terms are significant. It is interesting to note that the R2 of this relationship is much lower than that of the ALSI, implying greater noise (or the impact of missing variables).

It is important to confirm that the changes in short rates do not appear to have a consistent impact on the currency. The implication is that the link between the currency and interest rates happens at the long end of the yield curve, rather than the short. The low coefficient is not the result of mutlicollinearity; the correlation between changes in short and long end of the yield curve is fairly low.

The currency model can be reduced without adverse effects on the explanatory power The incremental explanation of interest rates once emerging markets, commodity prices and the Australian Dollar have been accounted for is minimal.

An out of sample test reveals that the recent moves of the currency can be nearly fully explained by the changes in EMs, commodity prices and the difference in nominal rates between the US and SA. (See figure 13 ) The absolute average error was 0.7 percent per day. The simple correlation statistics between the actual and predicted values out of sample was 0.56 over this period

Given the problems with daily data (misaligned closing prices amongst others) we examined the influence of the variables above on a monthly basis over the extended period 1995- 2009. It should be noticed that the EM coefficient takes a value of (-0.18) compared to the more negative values of the daily models. The EM coefficient retains its statistical significance in the monthly model.

A longer time period is not necessarily advantageous given the possibility of a structural change in the economy. The changing character of the rand linked to the increased demand for and supply of foreign capital after 2003 (see figure 14 below) led us to test if there was a breakpoint in the coefficients of equation 9 at the beginning of 2003 using a Chow breakpoint test. The test result very strongly rejects the null hypothesis of parameter stability. Re-estimation of the model since 2003 using daily data highlights the greater influence of emerging markets on the rand. In the case of the monthly model of the ZAR we substituted surprising changes in the NCD rates for the JIBAR rates. The two series are very highly correlated.

The variations of the ALBI are more difficult to explain than both the rand and the ALSI. While the emerging equity markets, the rand, short term rates and US rates clearly are important drivers the very low R2 is suggestive of other drivers of bond yields – including expected inflation.

Modelling the variation in long rates as aside from the ALBI results in a similarly low R2.

It appears that the low R2 in 12 can be partly attributable to the frequency of the data. Sampling at a monthly frequency (and increasing the sample period) results in a much improved R2.

The bond market however was also affected by the structural break mentioned in 10. A Chow test reveals a significant break in Jan 2003.

Fig 12. Daily move in ALSI (d log ALSI) Out of sample forecast 1st July 2009- 31st August 2009.

Fig13. ZAR – out of sample actual and predicted values

Further concluding comment on the regression results

Our models of the JSE ALSI may be regarded as very satisfactory with explanations of daily moves with the EM again providing the major impetus for the rand. Our models of monthly movements in the ZAR indicate that the EM influence has also become stronger providing for much better fits for the models in recent years. The goodness of fit of the bond market model is poor though the influence of short term interest rate surprises on long term rates, while of small impact, is statistically significant. The influence of US bond yields on RSA yields is also small but also of statistical significance.

The global flows of capital that move the EM equity index higher or lower also move the SA bond market higher or lower. However the coefficients of these models of the RSA bond market while statistically significant do not provide any thing like a full explanation of movements in long term interest rates in SA. Clearly other forces – especially inflationary expectations are at work in the bond market.

Conclusion; Identifying structural change in SA and drawing the implications for monetary policy

Figure 14. The Current account deficit and capital inflows 1990-2008

It must be asked why the global capital markets have become much more important for the JSE and the ZAR in recent years. The answer must lie in the structural change that occurred in South Africa after 2003 as growth in household consumption spending picked up strongly to drive the growth rates higher. This faster sustained growth was made possible by attracting foreign capital on a scale not earlier available to South Africa- at least not since the early eighties as we show in figure 14 below.

The ability to attract capital to finance growth in SA needs to be fully taken account of when setting interest rates that influence the level of demand in the economy even though they do not have an obvious influence on inflation. The feed back loop from faster growth to more foreign capital provided needs to be well understood and nurtured by the monetary authorities. It offers the rare opportunity to achieve faster growth with less rather than more inflation.

Higher short term interest rates in SA may attract capital through the attractions of a higher carry. They appear just as likely to frighten capital away if higher interest rates are assumed to threaten the growth prospects of the economy. If so higher policy determined interest rates are as likely to bring a weaker rand and more inflation than the opposite. Higher interest rates are however very likely to slow down growth. The instrument of short term interest used to manage inflation in SA appears to have been particularly blunt and potentially dangerous to the health of the economy as they appear to have been lately.

Global share markets have been running hard and in synch this quarter and especially this month as we show below. There is a natural inclination to think that this is all too much too soon and a lightening of equity exposures is called for. The lead steer of the global herd is clearly the S&P 500. Where New York goes other markets follow. However the S&P 500 is much more than a play on the US economy – about 40% of S&P 500 revenues and earnings come form outside the US (just as the JSE ALSI is much more than play on the SA economy). Stock markets list global companies whose fortunes and valuations depend upon the global economy.

The JSE EM and S&P 500 1 July 2009=100

Source: I-Net Bridge and Investec Private Securities

Fundamental analysis of the relationship between dividend yields on the S&P 500 and US Treasury bond yields indicates that the S&P 500 is far from being exuberantly valued. The indication is that the market has moved higher from a position of extreme undervaluation of dividends relative to long term interest rates to less undervalued, but still significantly undervalued.

In the figure below we show the output of a regression equation that explains the level of the S&P 500 with dividends declared (a positive influence on valuations and US T bond yields, though a negative influence normally). The current dividend yield on the S&P 500 is a respectable 2.2% and the 10 year bond yield a low 3.398%.

As may be seen in the difference between the lower actual value of the S&P 500 and its higher value predicted by the model, is still of the order of 30% having been as much as 83% earlier in the year.

Under or overvaluation is indicated in percentage terms in the residual – that is the difference between actual and predicted values in log terms. The value of the S&P 500 Index as predicted by the model is as heady a number of 1435 as we show in a further figure. The model should be treated as no more than an indication of fundamental value – provided dividends are maintained and interest rates do not shoot higher – the New York market does appear to still offer value.

The dividend discount model of the S&P 500

Source: I-Net Bridge and Investec Private Securities

The actual and predicted by dividend discount model of the S&P 500

Source: I-Net Bridge and Investec Private Securities

When a similar modelling technique is applied to the JSE FINDI, the FINDI is explained by the level of the Emerging Market (EM) Index. FINDI reported earnings and short term interest rates in SA show that the FINDI appears fully valued. Or in other words the FINDI, as is readily apparent, has kept pace with its global peers. Further strength in the FINDI therefore depends on further advances in the S&P 500, which the EMs are bound to follow. The chances of further advances in the S&P 500 should not be discounted, as we have suggested.

The model of the JSE Findi – full valuation indicated

Source: I-Net Bridge and Investec Private Securities

Actual Vs Predicted value of the JSE FINDI

Source: I-Net Bridge and Investec Private Securities

Listening to the experts

A foreign expert, Gabriel Palma of Cambridge University, has advised SA to “curb the inflows of foreign capital to beat recession”, according to a report from Business Day yesterday. Palma was quoted as saying that “capital controls were needed to address the erratic volatile and uncertain capital flows that could be expected in SA and that would bring a great deal of uncertainty into the domestic economy…..”

The new new thing – foreign capital abundance

In fact capital flows to SA since 2003 have flowed in large and highly consistent volume to fund the current account deficit that grew rapidly as the economy picked up momentum. Without the growth the foreign capital would not have been forthcoming – there would have been no demand for foreign capital nor any supply of it. But without supplies of foreign capital the growth could not have materialised. This year SA economic growth unfortunately has slowed down sharply and the capital inflows have more than halved, both in rands and as a percentage of GDP.

The current account deficit is by definition approximately equal to net capital inflows. The small balancing item that equalises capital flows and the current account deficit are flows into or out of foreign exchange reserves held by the banks and the Reserve Bank. These reserves have been increasing, making capital inflows larger than the excess of imports, net debt and dividend service over exports and net foreign income receipts.

Foreign capital sets the limits to growth – the more growth the more capital – the more foreign capital the better

Clearly the SA economy cannot grow at more than a pedestrian 3% rate without infusions of foreign capital. Our domestic savings rate has declined to about 15% of GDP and cannot finance the growth in the capital stock, the real investment that is necessary to support faster growth. And so we come to a very different conclusion. SA must come out of its recession and grow faster to attract the extra foreign capital that has proved to be available to fund our growth. Unless SA is resigned to the 3% or less growth experienced before 2003 that did not require nor attract foreign capital, the case for encouraging as much foreign capital as we can remains as strong as ever.

Ignoring the new more favourable realities does SA a disservice

Palma and those who think like him do South Africans a grave disservice. They would inhibit the growth in living standards and the improved returns on capital invested that come with growth and which provide the essential attractions for foreign investment. The ability to attract capital to fund faster growth in SA is a relatively recent phenomenon as our figure shows. In the uncertain past the very risky SA economy would soon run up against the limits of its foreign credit. And these limits we would suggest were but 3% pa growth, constrained by domestic savings.

Testing the limits

Just how much capital SA could now attract before foreign lenders would be discouraged for fear of a balance of payments crisis is not known – there is too little evidence to make such judgments with any degree of confidence. SA should do all it can to encourage growth and test the limits set by the global capital markets. The economy is far from testing these limits now. The sooner it does so the better. Fear of foreign capital should be the last thing on our collective minds.

SA: Gross Savings Ratio and the Current Account Deficit

Source: I-Net Bridge and Investec Private Client Securities

Moreover the rand has strengthened this year against the US dollar and the euro. It has furthermore maintained its value against the other much stronger emerging and commodity currencies despite the highly unsettled state of global capital markets and the presumed vulnerability of the SA economy given its dependence on capital inflows (see below). This vulnerability is presumed rather than proved and the strength of the rand in potentially very difficult circumstances proves otherwise. However rand strength, to the degree experienced recently, is not especially welcome to our miners and manufacturers. Perhaps if the economy had grown faster and the current account deficits were sustained at their previous levels, the rand might not have been quite as strong as it has been. If we are to worry about rand strength then let us do it for the right rather than wrong reasons, reasons to encourage rather than discourage growth.

The rand vs the US dollar, the Brazilian real and the Australian dollar (Jan 2009=100)

Source: I-Net Bridge and Investec Private Client Securities

The strength of the rand this month has been a case of US dollar weakness and emerging market and commodity currency strength. The rand continues to perform in line with the Brazilian real and the Australian dollar as we show below and as such has gained significantly this year against both the US dollar and the euro. The rand has gained 20% this year vs the US dollar and about 18% vs the euro. The dollar this week also lost some ground against the euro.

The exchange value of the ZAR; Jan 2009=100 (Lower numbers indicate strength)

Source: I-Net Bridge and Investec Private Client Securities

The US dollar vs the euro (Lower numbers indicate strength)

Source: I-Net Bridge and Investec Private Client Securities

The reasons for emerging currency strength is the growing risk tolerance that has accompanied the recovery of credit markets and the evidence that the fastest growing regions of the world are best represented in emerging equity markets. Capital has flowed out of safe havens into emerging equity markets. The JSE has continued to receive its share of these flows, adding strength to the rand and the JSE. The JSE ALSI when measured in US dollar has held its own against the bench market Emerging Market Index as we show below.

The JSE vs the MSCI EM 2009=100

Source: I-Net Bridge and Investec Private Client Securities

This comparable and very strong performance of the JSE in US dollar as well as in stronger emerging market (EM) currencies is despite the fact that the SA economy is lagging well behind its emerging economy peers. Yet it should be appreciated that the JSE – especially its large cap representatives are more exposed to the global economy than they are on the SA economy.

Ordinarily a strong rand would be very encouraging to domestic consumers. The prices of imported goods become ever more attractive in times of rand strength. Also inflation comes down and interest rates follow to further encourage consumption. This encouragement is not yet at all obvious. Also CPI inflation is lagging well behind import price inflation. Households remain reluctant to borrow and banks remain reluctant to lend.

Yet it should be appreciated that the fundamentals for a revival of consumer spending are improving. The strength of the stock market itself should help reverse some of the negative wealth effects on spending that accompanied the collapse in equity prices in 2008. And lower interest rates will help the housing market to stabilise and perhaps even recover. Equity in homes is another important source of wealth for SA households and any recovery in the value of homes to their owners will be helpful to balance sheets as well as confidence and willingness to borrow.

For exporters the strong rand takes away from the recovery in commodity prices and in export volumes. But they should appreciate the rand is strong because of a global recovery reflected in higher spot prices. For domestic manufacturers having to compete with imports, the strong rand means there is little consolation to be found. For them extreme discomfort follows these trends in diminished pricing power that add to the woes caused by still reluctant consumers.

The Reserve Bank continues to leave the rand to be determined by market forces and to stay out of the currency market. It also shows no appetite for quantitative easing to encourage the banks to lend more. The monetary policy committee however will have become more willing in current circumstances to further reduce short term interest rates. This is probably all the domestic producers of goods and services can hope for from monetary policy for now.

The recovery in the domestic economy will depend upon the strength of the global recovery and export led growth. Lower interest rates and improvements in household balance sheets, as well as more favourable prices in the stores, will help spending growth as will the continued buoyancy of government spending. The economy is closer to a recovery in domestic spending given the global trends and the stronger rand. Firms dependent on the SA economy have hunkered down – they have run down their inventories, reduced their borrowings and strengthened their balance sheets. They have probably experienced the worst the economy could throw at them. They should expect gradual improvement in the economic environment.

Presentation to Economic Society of South Africa

Biennial Conference, Sept 8th 2009

Brian Kantor,

Professor Emeritus, University of Cape Town, Investment Strategist, Investec Private Client Securities.

Please treat this as a preliminary draft to accompany the Power Point Presentation made to the conference. A version complete with figures and tables properly integrated will be made available for public comment on my blog after the conference.
http://zaeconomist.wordpress.com/

This study demonstrates the role global capital markets play in determining the behaviour of the Johannesburg Stock Exchange (JSE Alsi) the Rand US dollar exchange rate (ZAR) and long term interest rates in South Africa on a daily basis (Albi or R157). It will be shown that since 2005 the state of global equity markets, represented in the study by the MSCI Emerging Market Index (EM) has had a very powerful influence on the JSE, a less powerful yet statistically significant influence on the ZAR and that the ZAR has had some consistent influence on the direction of long term interest rates in South Africa.

The EM may be regarded as a proxy for conditions in global capital markets that affect South Africa. JSE listed shares are included in the EM Index with a current weight of about 7%. The more abundant the capital available for emerging market capital raisers, that is to say the less risk aversion prevailing, the higher would be the level of the EM Index – and of course vice versa.

It will be shown moreover that movements in policy influenced short term interest rates, represented by daily changes in expected short term interest rates, represented by daily movements in the implicit JIBAR 3 month forward rate (Jib3f3) have had very little predictable influence on share prices, the ZAR or long term bond yields. Changes in the forward JIBAR rate are used as our proxy for short term interest rates on the presumption that it is interest rates expected, rather than current actual interest rates that drive the value of shares, bonds and currencies and that therefore changes in expected short term rates rather than changes in actual rates- that may well have been anticipated – have significance for the financial markets.1

The implications of this finding for monetary policy are surely serious ones. It would strongly suggest that policy determined adjustments to short term interest rates, when unexpected, because they do not influence the exchange rate in any consistent way, cannot therefore be regarded as a reliable anti-inflationary tool. We will attempt to explain why higher short term rates have not generally added rand strength and why lower interest rates have not meant rand weakness. The feed back effect of the exchange rate on import export and domestic prices is clearly a very important influence on the measured rate of inflation.

The case for interest rate changes as the principle instrument of monetary policy is furthermore not enhanced by the evidence that short term interest rates have not had any consistently important influence on the direction of long term interest rates in South Africa nor on the direction of share prices. However it would seem to be the case that movements in actual short term interest rates can have a significant influence on aggregate demand in South Africa and perhaps also on house prices. These relationships are not tested here and daily data would not be readily useful in such tests.

This study utilises daily data to model and estimate the behaviour of the JSE All Share Index (ALSI) the rand/USD exchange rate (ZAR) and the RSA bond index or long dated RSA bond yields (ALBI or R157) between January 1st 2005 and August 31st 2009 . The models are single equation models of daily percentage movements in the ALSI, the ZAR and the ALBI or of daily changes in long term interest rates in the case of the R157 The estimation method is single equation least squares regression analysis.2 A few additional equations using monthly data, going back to 1995 in some instances, were run for evidence of structural change in the economy.

The explanatory variables considered for inclusion in the models in addition to the movements in forward short term interest rates (JIB3f3) and the emerging markets (EM) are daily moves in the S&P 500 Index representing share prices in New York, The daily percentage movements in global commodity prices in USD (CRB) the daily moves in Australian/USD exchange rate (AUD) or AUS$) and the changes in US long dated 10 year treasury Bonds.

The character of the dependent variables is demonstrated in figures three to six. We compare the performance of the rand to both the USD and the AUD to indicate that the rand lost significant ground against what may be considered other commodity and emerging market currencies in 2006 as the USD weakened against most currencies in 2006 – 2007.

The exogenous variables of the modelling exercise are shown in figures 9 to 12. It may be seen that daily changes in the variables are highly random and that they have drifted both higher and lower since 2005. We also measure the volatility of the variables in the form of a 30 day moving average of their Standard Deviations. It is shown how much more generally volatile price and interest rate became during the financial crisis and also how similar has been the behaviour of volatility on the different markets. That risks appear so similar in the different markets is further evidence of the globalisation of capital markets. ( See figures 7, 13, 14, 15 and 16)

The increase in the volatility of share prices globally, including on the JSE , has had a very negative impact on share prices. The negative correlation between daily percentage moves in the Index of Implied Volatility on the S&P 500, the Vix and daily moves in the S&P 500 itself has been a high negative (-0.76) and between daily moves on the JSE and the SAVI an almost equally negative (-0.73) since May 2005.

Statistics for the SAVI, the implied volatility indicator of the JSE, are only available since then. It is surely volatility that drives the share market up and down. It is a much more difficult task to explain and predict volatility. Volatility in share markets may be regarded as abnormally high before 2007 when the global glut of capital was holding down interest rates and encouraging risk tolerance. The financial crisis as we well know reversed all this and produced much higher degrees of risk aversion and volatility as the likelihood of defaults and bankruptcies increased so dramatically, especially after the failure of Lehman Bros in September 2008. (See figure 17)

In figures 18 and 19 we present two tables of simple correlation statistics for the daily percentage movements in the dependent and independent variables of our models. The correlation statistics that we regard as of particular interest are highlighted in red. The correlation statistics provide essential support for the statements made earlier. To be noticed are the high correlation between the JSE in rands and the EM in USD (0.73) The correlation of the JSE with the CRB also in USD is lower but significantly positive (0.39) Daily movements in the JSE and the ZAR have been negatively correlated (-0.33) indicating that rand strength rather than rand weakness is generally helpful to the JSE.

Also to be noted is the very low almost zero correlation of daily moves in the JSE with changes in forward short term interest rates (- 0.07) The correlation of movements in the share and all bond indexes is a low but correctly signed (0.19) Lower or higher interest rates generally would not appear to have been especially helpful or harmful to the JSE over this period.

The high correlation between the AUD and the JSE does not have any obvious theoretical explanation and this must be attributed to the high correlation between the AUD with the EM Index (-0.64) shown in the following table. Clearly the global economic forces that drive the EM higher or lower strengthen or weaken the AUD/USD.

It should be noticed that the returns on the ALBI the All Bond Index (the higher the index the lower are interest rates) have been negatively correlated with the moves in the ZAR(-0.34). That is a weaker rand is associated with higher long term rates- presumably because a weaker rand is associated with more inflation to come. Of further interest is that bond market returns have been only weekly correlated with movements in short rates (-0.16). The correlation, not reported in the tables, between long dated R157 yields and these short rates is a very similar (0.16).

The high correlations over (0.50) between movements in the ZAR and the global equity markets should be noted as should the positive correlation between moves in the ZAR and the CRB and AUD. He rand has behaved as an emerging equity market and commodity currency. The weak, near zero correlation, between the ZAR and short term interest rates should be of particularly concern (.06). The final column of low correlations between short term interest rates and the equity bond and currency markets indicates how little short term interest rate moves seem to matter for the markets generally.

The regression equations reported indicate that we are able to find very good estimates for daily moves in the JSE relying on the strength of the EM effect. We back up the models of daily movements in the JSE with models of monthly movements that go back further. These monthly models confirm the growing influence of emerging equity markets on the JSE since 2003.

Our models of the rand may be regarded as very satisfactory with explanations of daily moves with the EM again providing the major impetus for the rand. Our models of monthly movements in the ZAR indicate that the EM influence has also become stronger providing for much better fits for the models in recent years.

The regression estimates for the bond market confirm the observations made before. The most consistent influence on changes in long term interest rates are movements in the ZAR. Movements in the ZAR are negatively related to moves in interest rates in an apparently statistically significant way – the weaker the rand the higher are interest rates. However the sign on the ZAR co-efficient on interest rates is reversed as the ZAR is made orthogonal to the EM influence on the ZAR. In other words the EM influence on the ZAR is first extracted to leave a pure net of EM ZAR.

The goodness of fit of the bond market model is poor though the influence of short term interest rate surprises on long term rates, while of small impact, is statistically significant. The influence of US bond yields on RSA yields is also small but also of statistical significance. Clearly other forces – especially inflationary expectations are at work in the bond market.

It must be asked why the global capital markets have become much more important for the JSE and the ZAR in recent years. The answer must lie in the structural change that occurred in South Africa after 2003 as growth in household consumption spending picked up strongly to drive the growth rates higher. This faster sustained growth was made possible by attracting foreign capital on a scale not earlier available to South Africa- at least not since the early eighties as we show in figures 38 to 40. The ability to attract capital to finance growth in SA needs to be fully taken account of when setting interest rates. The feed back loop from faster growth to more foreign capital provided needs to be well understood and nurtured. It offers the rare opportunity to achieve faster growth with less rather than more inflation.

Higher short term interest rates in SA may attract capital through the attractions of a higher carry. They appear just as likely to frighten capital away if higher interest rates are assumed to threaten the growth prospects of the economy. If so higher policy determined interest rates are as likely to bring a weaker rand and more inflation than the opposite. Higher interest rates are however very likely to slow down growth. The instrument of short term interest used to manage inflation in SA appears to have been particularly blunt and potentially dangerous to the health of the economy as they appear to have been lately.