Month: October 2009

The presentation of the Medium Term Budget Policy Statement in Parliament yesterday was unusually important for two reasons. It was the public baptism of the recently appointed Minister of Finance, Pravin Gordhan, who would be presenting the revised three year outlook for government spending and revenues in much changed economic circumstances.

The severity of the recession had made nonsense of the Government’s Revenue projections made in February this year. Gross tax revenues estimated for fiscal year 2009-10 have now been revised markedly lower by R70bn from the R659.3bn expected in February to R589bn, or from 26.6% to but 24.5% of a significantly lower expected GDP. Expenditures have been revised modestly upwards by about R16bn, so lifting the budget deficit from an estimated R95.6bn in February to the latest estimate of -R181.6bn and requiring additional, not previously planned, debt issues of R85.5bn. Government expenditures are now equivalent to an unhealthily large 35% of GDP. Unhealthy in normal circumstances but temporarily helpful in offsetting the sharp decline in private spending

The unknowns to be resolved yesterday were about style: how would the Minister present himself and be received, and about content, and how would the government address the much more difficult economic circumstances in its plans for revenue collection and spending?

Comfortably in command

On the question of appearance and reception the Minister was very well received. South Africa, one would suggest, has found a worthy successor to Trevor Manuel. The rookie Minister was comfortably in welcome command of his brief. Especially welcome since the content of his proposals and projections were eminently sensible and represented the continued commitment to fiscal conservatism of the SA government.

The immediate recessionary dangers facing the economy were well recognised – no pro cyclical increases in tax rates are proposed – and the extra borrowing requirement is to be wisely tolerated, given the strength of the balance sheet.

While, as was pointed out, the financial situation of the SA government has deteriorated more severely than almost anywhere else, the ratio of government debt can be allowed to increase from the currently low 23% of GDP to an estimated, much less comfortable 41% of GDP in 2012-13 when the economy will have recovered to a degree. The interest expense on the Budget will have risen by about R40bn or around R100bn a year. But importantly the plan thereafter is to reduce dependence on debt finance to reduce spending on interest and to restore the still highly valued balance sheet strength. This will allow spending on much more valuable other services to the hard pressed South African public. It should be appreciated that fiscal strains in the developed world will see government debt to GDP ratios rising above 100% within the next year or two – a much more difficult condition than that faced by South Africa.

A very conservative U-shaped recovery is predicted by the Treasury, though its forecasting credentials will not have been improved by the recent underestimates of economic activity. GDP is estimated to decline this year by 1.9% and to grow next year by only 1.5% and to then pick up to a still modest 3.2% rate of growth in 2012. Such an economic outlook, taken with the established and appropriately careful approach to issuing more debt, make for highly constrained plans for extra expenditure and revenue between now and fiscal year 2012/13.

The framework allows for government expenditure to grow at a compound average growth rate of 7.8% per annum and for revenues to grow faster, to partially close the deficit of 11.9% a year. The deficit is thus planned to decline from an estimated R183.8bn in 2009/10 to R131.5bn in 2012/13. Since inflation is expected to average around a still high 6% a year this will mean minimal growth in real government spending, though much faster growth in real government revenues is predicted.

The intention to reduce deficits and to contain real government expenditure is admirable. Whether such revenue estimates will prove consistent with macro-economic stability remains to be seen, especially if Eskom is allowed to tax the hard pressed consumer to the extent it has proposed. The Treasury has set its face against further debt issues by the central government and further guarantees of the debt issued by state enterprises including Eskom. Over R170bn of additional Eskom debt has already been guaranteed by the Treasury and we may hope that this will allow for electricity prices that make long run economic sense and do not damage the economy in its current fragile state. Perhaps in the strained circumstances actually selling off a power station or two, accompanied by an attractive enough price for the electricity to be fed to the grid, will seem like a good financial deal.

The strained financial conditions would also seem to have ruled out expensive health care innovations at least for the foreseeable future. They have also led to grave concerns about the size of and employment benefits of what has become an increasingly well paid government employee. The scope for further improvements in public sector conditions of employment are being recognised as very limited.

Hamlet without the Prince

The government in this Budget Review could not have been more frank about the large scale failures of its own administration and then the need to address its inability to service the community. To quote the Budget Statement: “The functioning of the public service requires fundamental reform to obtain better value for public money, to do more with less, and to build a culture of responsible stewardship so that citizens trust the institutions of service delivery…..”

Such self recognition is very welcome as a starting point to reforms that are essential to the purpose of a better South Africa. Also welcome is the recognition of the extreme gravity of the employment problem that is graphically illustrated in the Statement. South Africa’s ability to offer employment, that is to say its ability to absorb labour, appears weaker than almost anywhere else in the world with only 42% of the age group 15-64 in employment. To quote the government again, “creating jobs, particularly among millions of relatively unskilled South Africans, is the country’s greatest economic challenge….” A number of interesting innovations are proposed to this end, but a discussion of this issue without reference to the employment destructive role of unions – or how such employment objectives can be met without the essential services of labour brokers – is bit like Hamlet without the Prince.

Helpful to the goal of a stronger economy are the steps taken and intended that will enhance the flexibility of monetary policy. Also signalled by the Treasury was a more flexible approach to inflation targeting that took account of forces acting on inflation that was beyond the influence of monetary policy.

The significant exchange control reforms announced have been timed to counter an unwanted degree of rand strength. The Brazilians have imposed a tax on capital inflows to this purpose. More impressively South Africa has provided greater freedoms to move savings in and out. The currency market however did not react at all to the news – though the rand had responded earlier yesterday with weakness and again today to the downward pressure being exerted on emerging equity and commodity markets accompanied by the stronger US dollar. We show below how little reaction to the Budget statement made at 14h00 was observed in the currency market, while the market in RSA debt reacted favourably to the news.

R157 bond

Rand/US dollar

Graph sources: Bloomberg

Clear evidence that the government continues to budget conservatively and wisely under capable guidance is very welcome. Very welcome too is the recognition of its own failures to deliver services and employment opportunities as an essential starting point for reform. But the state of the economy remains very fragile and every effort will still have to be made to encourage domestic spending for the sake of incomes employment and government revenue.

By the end of this year, it will have been 20 years in which long dated bonds will have registered superior returns over equities in the US and South Africa. As may be seen in the tables below long dated government bonds have outperformed the equity index in the US and the RSA on both dimensions – they have provided significantly extra annual returns for less risk – as measured by the standard deviation of these returns.

Unexpectedly equities have failed to provide long term investors with a risk premium over long dated bonds. Equities and bonds have returned more than cash over the period though the competition from cash for equities in SA has been very strong over the past 20 years. Encouragingly all asset classes in both economies have provided in returns well ahead of inflation over the past 20 years. Especially so for SA investors (it was not as if equities performed poorly): in real terms they provided excellent average returns of over 5% pa. However, as may be seen, long dated bonds did even better for somewhat less risk.

Annual Returns Equities, bonds and cash calculated monthly 1990-2009

USA

Sample: 1990:01 2009:09
S&P 500	US 10 Y TBONDS	US SHORTS	US INFLATION
Mean	7.2	10.6	4.1	2.8
Median	11.1	12.9	4.7	2.8
Maximum	41.6	62.1	8.3	6.3
Minimum	-59.6	-30.4	0.3	-2.3
Std. Dev.	18.2	15.3	2.0	1.3
Observations	237.0	237.0	237.0	237.0

RSA

Sample: 1990:01 2009:09
JSE	SA LONG RSA	CASH	SA INFL
Mean	13.7	16.2	12.1	8.0
Median	14.8	18.7	11.7	7.7
Maximum	54.3	41.1	21.7	16.6
Minimum	-43.4	-18.8	6.8	0.1
Std. Dev.	19.2	12.2	3.4	3.9
Observations	237.0	237.0	237.0	237.0

Source: Investec Private Client Securities

The prices of long dated bonds generally rose over the 20 years as they benefited greatly from low inflation. Long dated interest rates fell back as less inflation was priced into their yields. Clearly the monetary and fiscal authorities consistently surprised the bond market in their ability to reduce inflation – and even more so in the US than in South Africa as we show below. Less inflation expected was good for equity returns and for the real returns from cash – but it turned out to be even better for investors in long dated bonds.

Fixed Interest yields 1990-2009

Source: Investec Private Client Securities

The caveat – past performance is not necessarily a guide to future performance – may be particularly apt when we contemplate expected returns from bonds, equities and cash over the next 20 years. Equities will always be valued to realise an expected premium for the extra risks associated with them. The yield on long dated bonds will always carry a premium to cover expected inflation. But as always, markets may be surprised or disappointed as evidence changes the temporary beliefs captured in current valuations giving rise to unexpectedly good or poor returns.

There is no guarantee that over the next 20 years inflationary expectations will be revised generally downwards as they have been over the past two decades. Given the much deteriorated recent state of government finances in the developed world, the temptation will have risen to print money to finance government expenditure – rather than cut expenditure or raise taxes and or pay market interest rates for funds borrowed. The share of government tax revenues that will have to go to pay interest rather than used for much more popular spending will be rising inexorably over the next few years at least.

Yet the bond markets in the developed world remain highly sanguine about the inflation outlook. The yields on US and other developed country bonds are currently offering inflation compensation of less than two per cent per annum on bonds maturing in 15 or more years, that is nominal bonds issued by Uncle Sam are currently offering near record low yields (about 3.5% pa) and less than two per cent more than the inflation linked bonds that would secure investors a real return over the long run. Currently these long dated inflation linkers also yield less than a two per cent per annum real yield. In SA the bond market is compensating for expected inflation by offering more than six per cent more on vanilla government bonds over their inflation linked equivalents.

We would regard the vanilla government bonds in the US as dangerously exposed to a revival of inflationary expectations. Accordingly holding inflation linked US government bonds seem like the superior alternative for now. By contrast in SA the higher yields on RSA vanilla bonds do now offer more attractive compensation for inflation to come. An average rate of inflation of over 6% per annum now priced into the bond market may well again prove overly pessimistic about the ability of the SA government to contain inflation in the years to come. Perhaps the history of declining bond yields in SA over much of the past twenty years should encourage SA investors to pay more respect to long dated bonds as an asset class.

Very good for some

The strength of the rand has astonished many. The rand is now more than strong enough to bring down inflation, which it is helping to do. The stronger rand and the downward pressure it has put on prices in the shops and showrooms is providing some encouragement to still very depressed domestic spending.

Further rand strength would not be very welcome. The gains made by consumers in the stores are at the expense of domestic manufacturers and their employees competing for shelf space. Their rand costs, especially their wage costs, are still rising while their pricing power in rands is under pressure from cheaper imports. It would greatly help if the trade unions moderated their wage demands accordingly, but such assistance has been sadly lacking and job losses continue as the manufacturers and miners attempt to reduce their costs to counter the pressure on their operating margins caused by the strong rand.

It needs to be appreciated just how strong the rand is; why it is so strong and what implications for economic policy should be drawn from it. The rand, as we show below, has not only gained against the weak US dollar and the not-so-weak euro, but has held its own against the growing strength of the emerging market and commodity currencies represented below by the Brazilian real (BRL) and the Australian dollar (AUD). We show this below and also that rand strength this month against the US dollar and euro is accompanied by strength in emerging market and commodity currencies, of which the rand is clearly one.

The rand in 2009, daily data

Source: I-Net Bridge and Investec Private Client Securities

The rand in October 2009 (Sept 30=100), daily data

Source: I-Net Bridge and Investec Private Client Securities

Why the rand is so strong

The most obvious explanation for rand strength is the hugely increased flows out of the dollar and to emerging market and commodity fund managers, of which SA receives a consistent share. Citibank analysts report very large net flows into emerging markets of US$45.5bn this year, of which US$4bn flowed in the past week up to 14 October 2009.

The JSE offers very convenient exposure to emerging and commodity markets for offshore fund managers. It is exposed much more to the state of the global economy than the SA economy, which given the depressed state of the SA economy, is just as well. The correlation between moves in the benchmark MSCI Emerging Market Index and that of the JSE when converted into US dollars is very close (about one to one) as we show below.

The JSE ALSI (USD) vs the MSCI EM (January 2009=100), daily data

Source: I-Net Bridge and Investec Private Client Securities

The JSE ALSI (USD) vs The MSCI EM, September to October 2009 (October 2009=100), daily data

Source: I-Net Bridge and Investec Private Client Securities

What it means to be a global market

This correlation shown above as indicated is no co-incidence. It is because JSE listed companies are fully exposed to the expected and improving trends in the global economy and especially the emerging market share of it, which is growing and is expected to grow at well above average rates. Hence the demands for shares in companies exposed to this promising growth found on the JSE.

How to capitalise on the opportunity presented by abundant capital

The question then is how best to take advantage of these inflows of capital that have brought with them rand strength. Or, to put it another way: what can and should be done to increase the demand for foreign exchange from SA, to perhaps hold back rand strength and in ways that will serve the economy and all those dependent on it?

Just grow faster and do all we can to encourage faster growth

The short answer is to use the opportunity presented by the abundant supplies of foreign capital behind rand strength to encourage the economy to grow much faster. The abundance of foreign capital and the strength of the rand scream out for faster SA growth. Faster growth might inhibit rand strength – though this is not certain given the influence of faster expected growth on the willingness to invest directly in SA. But even should faster growth not lead to a degree of accompanying rand weakness (due to the prospect of faster SA growth attracts more foreign direct investment), faster growth will surely be very welcome even if not accompanied by a degree of rand weakness.

Our call for policies to promote growth will not be surprising to our readers since we have been calling for such responses all year. We have called for urgent steps to be taken to revive household spending in the form of lower interest rates, accompanied by faster money supply growth: that is for quantitative easing to encourage the banks to lend more. The Reserve Bank therefore should be active in buying forex and by so doing adding cash to the system, and the extra cash should be accompanied by lower interest rates.

Perhaps one of the investments the Reserve Bank could usefully make with the dollars it buys in the market would be in foreign currency denominated RSA debt. This would improve both the government balance sheet and provide a very useful reserve for the time when SA government debt becomes less actively sought offshore

Encourage outward investment by institutional investors

The other steps to be taken to counter rand strength would be to encourage outward investment by SA fund managers. Listings of foreign companies on the JSE in which South African fund managers can invest freely – without limitation of foreign investment allowances – should get every encouragement. This is a very good time surely for the managers of SA retirement and pension funds to diversify some of the exposure to the SA economy of their clients. This will help build reserves in the form of offshore investments which can be drawn upon when circumstances in SA become less favourable. If such flows off shore help restrain rand strength for now, so much the better.

Updating the Hard Number Index

We have updated our indicator of the current state of the economy we call the Hard Number Index. It is based on hard numbers, namely vehicle sales and the Reserve Bank note issue adjusted for the Consumer Prices Index extrapolated for an extra month. The advantage in applying these hard numbers is that they are updated within a week of month end. All other published indicators of the state of the economy are as much as three or more months behind the times. Moreover the numbers that make up our very up-to-date Hard Number Index of Economic Conditions are actual accurate numbers not estimates based on sample surveys.

We have demonstrated that the Index tracks the business cycle represented by the coinciding business cycle indicator of the SA Reserve Bank very closely and the relationship has been an especially close one recently, as we show below. The Reserve Bank business cycle indicator however is only updated to June 2009 as is also shown.

Hard Number Index: Compared with the Reserve Bank Coinciding Business Cycle Indicator (2000=100)

Source: I-Net Bridge, SA Reserve Bank and Investec Private Client Securities

A closer inspection of the Hard Number Index and its annual rate of change (which should be regarded as the second derivative of the business cycle) indicate that the SA economy is now finally showing signs of a bottoming out. The Index itself, while still in decline, is now falling less rapidly. If present trends continue we can look to an actual increase in economic activity within the next month or two.

The Hard Number Index: The first and second derivates of economic activity

Source: I-Net Bridge, SA Reserve Bank and Investec Private Client Securities

A recovery despite further declines in the growth in Reserve Bank cash

This promised revival in economic activity owes little to the supplies of cash provided by the Reserve Bank to the system. No such assistance of the kind offered by many central banks has been made available to SA banks. The growth in the SA money base defined as the supply of notes issued by the Reserve Bank plus cash reserves banks held with the Reserve Bank, less required reserves, continues to slow down as we show below. But as we also show, the growth in the Real Money Base has stopped declining because the inflation rate has slowed down; and promises to slow further. Less inflation to come will add impetus to household spending in the months to come.

Real and nominal money supply growth

Source: I-Net Bridge, SA Reserve Bank and Investec Private Client Securities

The vehicle cycle has reached a deep bottom

Vehicle sales, having first turned negative in early 2007, now also appear to have bottomed out as we show below. What higher interest rates took away from vehicle sales, lower interest rates are very slowing adding something back, though if recent trends are to be extrapolated until year end 2010 the revival in sales will be a modest one (See below).

New Vehicle sales

Source: I-Net Bridge, SA Reserve Bank and Investec Private Client Securities

The sources of recovery are to be found outside of the Reserve Bank

The long awaited recovery in the SA economy will have little to thank monetary policy for, especially if the impulse of monetary policy is measured by the growth in money supply or bank credit rather than policy determined interest rates themselves. These have declined by 500bps since December 2008 but as yet lower interest rates, in the absence of quantitative easing, have not revived bank lending or the money supply. The economy has suffered a deep recession and the recovery prospects are for at best a slow recovery.

The recovery will be encouraged by the confidence that comes with the knowledge that the global credit crisis is over and the global economy is recovering. Relief of this kind also percolates through to SA business and their investment decisions while also encouraging the foreign demand for goods and services from SA. The improved global tolerance for risk has boosted values on emerging equity markets and the JSE, realising positive wealth effects. By boosting the value of the rand these improving trends have also helped lower inflation in SA and will continue to do so. We can look to lower inflation to boost the real money supply even if the Reserve Bank, unfortunately in our opinion, continues to resist doing so.

A most interesting article in the latest Barron’s by Michael Santoli (Leaving With the One Who Brought You, Barron’s Online, Monday 12 October) points to the opportunities and pitfalls provided by a highly receptive market for high grade corporate paper. Santoli observes:

Any CFO of a high-investment-grade large company who reaches for a phone to call his or her banker in the morning will have multiple hundred millions of cheap, no-strings debt financing offered up by bond-fund managers before happy hour. Or so it seems. Companies that really don’t need the money can – and are – selling bonds at will.

While the bond market is highly solicitous of new paper the share market can be very critical of the purposes to which this newly found balance sheet strength is being put.

To quote Santoli:

In the recent wavelet of M&A action, a particular sort of corporate transaction has been applauded. To specify: When large, self-financing, market-leading companies have deployed their balance sheets to opportunistically grab for unique and easily digested assets, investors have celebrated.

Moving from the warmth of the market’s hearth to its chilly woodshed, we can find the would-be acquirers swiftly punished by investors for the transgression of bidding generously for a business in an adjacent market and, in so doing, negating the reasons so many shareholders owned the shares in the first place.

Recent deals that have earned the strong disapproval of the market referred to were the moves made by Kraft Foods and Xerox, for Cadbury and Affiliated Computer Services respectively.

As Santoli opines: “In both cases, a shareholder base that owned the buyers’ stocks for their steady, cash-flow-generating attributes woke up in alarm as management opted to pay large premiums for companies that the shareholders could themselves have owned more cheaply the prior day, and whose integration might not be effortless.”

In other words shareholders have been rudely reminded that they do not control the free cash flow generated by the companies they invest in. These cash flows remain largely at the mercy of management who have their own interests to pursue that are not necessarily consistent with the interests of shareholders.

This reminds us of M&A activity on the JSE and in particular the attempt by MTN to buy a big chunk of Bharti, which was frustrated by regulatory issues. The deal falls decidedly into the category of free cash flows at risk. MTN is a company with a strong balance sheet and one presumably easily able to issue more debt. Its free cash flow from its current operations is growing rapidly and is expected to increase from an estimated R8.6bn at 2009 year end to over R16bn at year end 2011 (by Jonathan Kennedy Good of Investec Securities).

This improvement in free cash flow, absent of acquisitions, is estimated despite an ambitious accelerated programme of capital expenditure over the next few years designed to roll out its network in under serviced Nigeria and Iran. Capital expenditure would then be expected to taper off in the absence of acquisitions or, less likely, to till large new green fields for voice or data transmission.

It should be fully appreciated that MTN in its dealings with Bharti was decidedly on the trail of the utilisation of cash and borrowing facilities. While MTN planned to issue more equity to Bharti (issues of approximately R59bn of equity was proposed) MTN had additionally committed to pay cash of some US$2.9bn (approximately R22bn) for its stake in Bharti. Clearly additional MTN debt would have had to have been issued to this purpose and we understand negotiations had been entered into with banks to this purpose. Bharti, in its turn, proposed to exchange newly issued shares as well as cash with MTN shareholders for part of their stake in MTN.

Presumably shareholders in MTN are not surprised by MTN’s appetite for acquisitions, especially in the light of much improved credit market conditions. Shareholders in MTN would have even less reason than those of Kraft or Xerox for believing that the cash flows that emerge from maturing operations will increasingly flow their way.

The big issue for shareholders in MTN is not whether or not they will control the free cash flow emanating from MTN, but rather how much return on capital they should expect from management exercising their ambitions. Will the assets they buy prove “opportunistically cheap and easily integrated” or will MTN overpay “for businesses in adjacent markets that shareholders could access cheaply on their own”.

MTN’s great value added for its shareholders by rolling out operations in South Africa, Nigeria and Iran could be regarded as of the first kind of investment. But the scope to exploit virgin telecom territory is increasingly limited. The Investcon acquisition, an investment in adjacent markets, might well be regarded as value destroying, judging by the returns so far realised on the extra capital employed.

Shareholders in MTN should seek good answers to this question of prospective return on debt and equity capital when MTN management comes around again, as they are most likely to do, to seek approval for an acquisition that would commit a large proportion of the potential cash flows from operations. Strong balance sheets that comfort debt holders are always a powerful temptation for managers – they allow managers to raise and invest capital both internally and externally derived – with often unfortunate consequences for shareholders.

Growth in earning that comes with the expectation of improved returns on capital at risk is the magic that drives share prices higher. Growth in earnings that promises to reduce the return on shareholders capital below its opportunity cost clearly punishes the value of a company to its shareholders, though not necessarily its managers.

MTN has made great value adding investments that shareholders have applauded. MTN may well be embarking on a growth course through acquisition that will realise below cost of capital rewards. This fear is presumably holding back its share price.

The MTN’s share price does not appear to carry any optimistic forecasts of improved flows of cash to shareholders. What would happily surprise the market would be an indication that MTN would not be making major acquisitions, and or that it intends to be much more demanding of a high return on capital from any acquisition it might make – including that of Bharti shares.

Ideally for shareholders, MTN would announce it is no longer interested in acquiring other established telecom companies and that it intends to focus entirely on realising the organic growth or green field opportunities that still present themselves. Then shareholders could anticipate a very healthy flow of cash over the next few years that they could hope to deploy in cost of capital beating ways should MTN be unable to do so.

Gold price records are being broken

The gold price is at record levels when measured in US dollars. When measured in the mighty rand it is however well below its record levels of November 2008. Part of the strength of gold is the weakness of the US dollar.

The gold price in US dollar and rands; Daily data

Source: I-Net Bridge and Investec Private Client Securities

But gold lately is not exceptional

In recent months the gold price in US dollars has not behaved exceptionally: it has closely tracked commodity prices in general as the dollar weakened and the signs of a global economic recovery were read (See below).

Gold Price vs All Commodity Prices CRB Index (January 2009=100), Daily data

Source: I-Net Bridge and Investec Private Client Securities

Gold was very special a year ago

Gold was special when the credit crisis reached its apogee with the failure of Lehmans in September 2008, when it showed admirable defensive qualities and performed very much as a safe haven.

Gold vs Commodity prices 2008-2009 (Jan 2009=100), Daily data

Source: I-Net Bridge and Investec Private Client Securities

History tells us that gold, that barbarous relic (as Keynes described it with characteristic intellectual scorn), is more than just another commodity – it has always been a special store of value and is especially useful when the value of all other assets is threatened by war or financial crises, as has again been proved.

It took very special events to prove that gold is special

But as we show below, a sharp divergence between the trend in gold and other commodity prices, as occurred between September 2008 and March 2009, has been a unique occurrence over the past 30 years. It took the fear of a melt down of the banking and credit system to lead to a rush to gold and a liquidation of other commodities. Mere inflation fears, if that were the driver, would be common to precious and ordinary metals and minerals.

The gold price and the commodity price index (CRB) (Jan 2009=100), month-end data

Source: I-Net Bridge and Investec Private Client Securities

In ordinary times gold is very likely to behave in line with other metals and minerals

The state of the global economy and the balance between the real demand and supply of commodities will be a primary driver of real (after adjusting for inflation) commodity prices. However all asset prices, including especially hard assets in the form of gold and other metals and minerals that can easily be stored, are influenced by inflationary expectations, or more particularly by the prices of these commodities that are expected to prevail in the months and years ahead.

The cost of storing gold and metals is very important for speculators

These price expectations have to be compared with the cost of storing metals and minerals which in the case of precious metals largely comes in the form of financing costs. The cost of storing precious metals – unlike the cases of copper, coal, iron ore or even oil – is almost all financing costs, given the high value to size ratio that determines the cost of storage.

Financing costs rise with inflation too

Financing costs, that is interest rates, however also rise with more inflation expected, so increasing the costs of storage and discouraging the demand to hold commodities. Thus there has to be more to a rising price of gold and other commodity prices than inflationary expectations. The price of gold, to make it worth buying at current spot prices, has to be expected to rise faster than the costs of owning gold in the form of interest rates paid or foregone. Or in other words, the price in the future must be expected to rise faster than the costs of financing that is explicit in the ratio of the spot and future price of gold.

It is real interest rates, not inflationary expectations, that matter

Thus a key determinant of the current price of gold will be the relationship between inflationary expectations and interest rates – that is to say real interest rates. Real interest rates have fallen to very low levels in recent years and months. They are at half the levels prevailing in the early years of this century. These real rates are best measured explicitly in the yields on offer from government bonds that come with complete cover against inflation – the inflation linkers – known as TIPS in the US, for Treasury Inflation Protected Securities (See below).

The purchasing power of the fixed coupon payments to be made to the owner of a conventional bond will be fully diluted by inflation. Thus inflation exposed bonds have to offer compensation for expected inflation. Thus the yield gap between the lower yield on inflation linkers and the higher yields on long dated conventional bonds is explicitly the compensation on offer for bearing inflation risk.

The bond market is very complacent about inflation to come

This compensation currently on offer to the holder of a 30 year US Treasury Bond is but an extra 2% pa. Thus it may be said that investors in 30 year bonds are highly vulnerable to losses should inflation in the US average more than 2% pa over the next 30 years – that is to say there is very little inflation expected or little cover against higher inflation currently on offer in the conventional government bond market as we also show below. Thus there is very little inflation expected in the bond market where the fear of deflation rather than inflation is dominant. That the idea that the gold price is being driven by inflationary expectations that are absent in the bond market, does not seem at all consistent.

US government bond yields and inflation compensation, month-end data

Source: Federal Reserve Bank of St. Louis, I-Net Bridge and Investec Private Client Securities

A consistent explanation for the rising gold and other metal prices

It would be far more consistent to conclude that the gold price, as with other commodity prices, is being driven by a global recovery and low real interest rates, that is abnormally low costs of storing gold and other commodities. The evidence in the relationship between the gold price and real interest rates in the US, represented by the yield on 30 year US TIPS is very supportive of this explanation. The gold price rose consistently with the equally persistent decline in real interest rates after 2000. It may also be seen that the gold price fell away as real yields rose temporarily as deflation fears gripped the markets in 2008 and then recovered as real interest rates fell back again.

Real interest rates and the Gold price 2000-2009; Month end data

Source: Federal Reserve Bank of St. Louis, I-Net Bridge and Investec Private Client Securities

A better case for gold in portfolios

The case for gold cannot be based on inflationary expectations alone. If inflation rises unexpectedly, interest rates and so the financing costs in owning gold will also rise, taking the gloss off gold and other metals. Thus it will take lower real rates – or interest rates lagging well behind actual inflation – to drive the price of gold and other metal prices higher. Unexpectedly strong global growth especially when coupled with relatively low real interest rates will be especially helpful to the gold price as it will be to all commodity prices. Gold may not prove special in a world of rising commodity prices as real demand presses against real supplies but yet well worth holding.

The case for an insurance premium for gold

But the recent evidence that gold can still provide insurance against calamity is surely reason to keep more gold in portfolios than before as insurance against true calamity. The experience of the defensive quality of gold in 2008 when gold held up while the price of all other metals fell away could add to its long term attractions so adding a little special lustre compared to the more prosaic other metals. Global portfolios still contain but a sliver of gold – should portfolio managers decide that a little gold may provide useful insurance as it did in 2008 – the gold price could move permanently higher relative to other metals and minerals and maintain such a premium. Brian Kantor