Month: August 2013

The Hard Number Index: Looking to export prices and volumes to revive the SA economy – held up by domestic spending

By Brian Kantor

There are at least two strong features of the SA economy, notably domestic unit vehicle sales and the supply of notes. Domestic vehicle sales in the 12 months to July are being sustained at 66 2000 units, close to the record sales of over 700 000 units in 2006-7 terms. The growth rate in vehicle sales has declined but remains positive at about 5%, helped by low financing costs and low rates of inflation of the prices of new vehicles.

The Reserve Bank note issue has grown by more than 12% over the past 12 months. Growth has held up strongly over the past three months to July, though the trend would appear to be in decline to about a 9% rate over 12 months.

 

The demand for new vehicle sales of all sizes comes largely from the formal sector of the economy – those with access to bank credit – while the growth in the note issue reflects less formal economic activity of those who prefer cash to credit or debit cards. Both sources of demand have been very welcome to an economy under pressure.

We combine both of these very up to date series to form our Hard Number Index (HNI) of the current state of the SA economy with the note issue, deflated by consumer prices. The results are shown below. The Hard Number Index has moved higher but appears to be peaking. Growth in economic activity, while still positive, is slowing down.

This latest indicator of the state of the SA economy, of sub-par growth subsiding, will not come as much of a surprise to economy watchers. Growth in domestic spending has probably held up better than many would have predicted and meant the economy could maintain some forward momentum, despite the weakness of exports and export prices. But the economy could do with all the further help it can get from stronger demands from world markets to boost local production and incomes.

Sustained output of minerals and metals, less disrupted by strikes and walkouts, would be a big plus for growth. Higher prices for commodities coupled with better export volumes and revenues would also help the rand. A stronger rand would mean less inflation to come and lead to lower interest rates that could help sustain domestic spending. The problems in mining have not only damaged output and employment in mining and manufacturing; they have kept up interest rates. The domestic economy has deserved the lower interest rates that an improved foreign trade account and better than expected labour relations could help deliver.

Economic policy: The solution for poor project management in SA is private ownership

When a private company grossly mismanages a project designed to add revenues and profits or mismanages the project such that its capital costs grossly exceed budget, the management takes the blame. They may lose their jobs as well as their reputations, and the shareholders who appointed them have to bear the burden of a lower return on the extra plant and equipment created. In extreme cases the overruns and the waste of capital incurred may bring the company down, causing shareholders to lose all and debt holders to salvage what they can out of the loss making wreck.

In the case of a government-owned and regulated monopoly the outcomes for the management and the company may not be so severe. Unlike the private company, the regulator may be persuaded to allow the company to charge more to maintain a regulated return on the extra capital employed. Unlike the private company facing competition and market determined prices, largely beyond its control, the public monopoly may be able to cover its cost overruns with higher prices. With little alternative, the consumer will have to pay up and hope to economise on the more expensive essential service. The consumers, not the company, then have to bear the consequences of what might well be very poor project management. And the international competitiveness of all those who use the now more expensive service suffers accordingly. Factories and mines will then become less profitable, especially in export markets, because they will not be able to pass on higher costs, so discouraging further investment in their enterprises. And households will see their real disposable incomes taxed further, discouraging consumption of other goods and services.

Making customers rather than owners carry the proverbial can for poor project management is not only unfair – it covers up for poor management so encouraging managers to become less responsible and efficient.

Price and return on capital-regulated state owned enterprises play a critical role in supplying the SA economy with essential infrastructure, such as new power stations (Medupi) and new pipelines (Transnet’s new pipeline from Durban to Gauteng). The problem is that the managers of these state owned enterprises are not making a very good fist of project management. These important projects are well behind time and well over original budget.

Fortunately for the consumers of electricity or pipelines, the regulator is adopting a more critical approach to the costs, both capital and operating, claimed by Eskom and Transnet to justify higher prices. A report (Businessday/BDlive, Razina Munshi, 2 August 2013) commented:

“The National Energy Regulator of South Africa (Nersa) is investigating the near doubling of the costs of Transnet’s new multiproduct fuel pipeline from Durban to Gauteng, in a move that could herald closer scrutiny of big cost overruns on state infrastructure projects. The outcome of the probe could also have implications for petroleum pipeline tariff hike requests in the future……. Transnet originally budgeted R12.7bn for the project, but this soon rose to R15.4bn, and it quickly became clear that even that was conservative. The final price tag of R23.4bn includes the cost of pump stations in Durban and Heidelberg, still under construction….”

Commenting on Eskom’s claim for higher prices, Business Report (12 July 2013 ) said: “The failure to push through big-enough price increases has created a 225 billion-rand cash-flow shortfall as the company struggles to meet the continent’s biggest economy’s electricity demands.”

This cash flow shortfall – the difference for Eskom revenues between a 16% per annum price increase over five years and the 8% per annum increase granted by Nersa – helps reinforce the important point. If the consumers cannot be forced to pay up for management failure, then the owners have to.

The owner of Eskom and Transnet is of course the Republic of South Africa, ie the citizens whom the government represents. To overcome the huge cost overruns they, the people, have to come up with the extra cash, that is the extra capital required to keep Eskom and Transnet going. They have to borrow the money and pay the extra interest on the additional debt, and/or impose additional taxes on themselves to cover up for poor project management. Even if some of the people believe that others, not themselves, will be stumping up it is clear that the funds so raised and the taxes paid could be put to better alternative uses, for example building homes, schools or hospitals.

It is not at all clear why the people of SA would wish to take on these risks of poor project management that they need not have to do. The assets and activities of Eskom and Transnet could be privatised, as they are in many economies, with the current plant and equipment sold off at market determined prices. The pipeline would fetch a pretty penny at current regulated prices. In this way not only would the debt levels and interest expense of the Republic be reduced significantly, the exposure of the SA citizen to huge cost overruns would be eliminated. Shareholders in privately owned utilities with highly predictable revenue streams would willingly bear those risks, especially if the regulator offers them a fair risk-adjusted return on capital. And the Republic would also collect its normal share (28%) of the profits earned by a privately owned utility and the dividends paid out.

Little sympathy should be accorded to Eskom having to raise the extra debt to cover their cost overruns. A recent positive response by a private company, Exxaro/GDF Suez Energy to a Department of Energy call for participation in electricity generation (13 June 2013);if accepted, will allow this private company to build a new coal fired power station producing a respectable 680MW of electricity, to be delivered to the grid at presumably current wholesale prices set by the regulator for Eskom – plus inflation.

This indicates that the price of electricity in SA is now more than high enough to encourage private owners to risk their capital to supply additional electricity. No doubt the company has built in high enough returns on the capital it intends to employ to make the project viable. Should it succeed SARS will be looking to its normal share of profits. And should it fail to produce a profit, or even go out of business, the shareholders will have to stand up and bear the loss. Some other group of owners would then take over the plant at what will be a distressed price and hope to manage it better.

SA citizens would surely find this a better prospect than having to bear the risks of owning assets over which they have very little control and their managers do not appear to do a very good job of managing.

Turning Income into Wealth – something not necessarily under the control of the saver

Earning an above average income does not make you well off or wealthy. The best one can do is to save and hope for the miracle of compound returns to give you the retirement you aspire to.

It is savings not income that makes you wealthy

Earning an above average income does not make you well off or wealthy. You might spend it all on the good things in life and have nothing left over when the income from work dries up – as it must at some point in time when age, infirmity or injury undermines your income earning capacity. It is not only the body but the creative mind that may give in prematurely. The profligate actor, artist, musician, writer or sports star may have a brief life in the fast lane and have nothing left to show for it other than some great stories, unless they put away some of their extraordinary earnings. Mick Jagger and his ever rolling stones would be a notable exception.

 

Save and hope for the miracle of compound returns to give you the retirement you aspire to

Wealth is gained by saving – consuming less than your income and by investing the savings in (hopefully) income earning assets and, most important , reinvesting rather than consuming this extra income your wealth is bringing (at least until you need it to sustain your life style in the hoped for accustomed manner). By accustomed we would mean being able to consume as much or almost as much  as you did when you could rely on a more or less regular income from your work. A rule of thumb is that your wealth or capital should be sufficient to allow you to continue to spend at the rate equivalent to 75% of the real goods and services consumed before retirement. (The pattern of spending may well alter with age but the real volume of spending will ideally be well sustained). Sustaining this pre-retirement standard of living might require gradually drawing down capital to support these consumption demands.

 

Yet 75% of a low number may well remain a low number. Many would aspire to at least 75% of a large number rather than a small number. This means earning well, saving a good proportion of these earnings and perhaps, even more important, achieving very good returns on the savings made. High incomes, a consistently high savings rate and excellent returns on savings is the path to true wealth – it is a much steeper path than one that could lead to a comfortable retirement for the middle income earner.

 

How to get more than comfortable: that is, how to get rich

True riches, achieved by the relatively few, are when the wealth or capital that has been accumulated over a life time can provide for a very comfortable life style without the wealth owner having to consume any of that wealth. That is to say, a stock of capital that generates enough income to provide for both generous consumption demands and enable further savings to not only preserve, but indeed to add to the real value of the capital owned.

 

There are perhaps two obvious routes to conspicuous wealth (if not conspicuous consumption) for the self-made man or woman. The first is to establish and manage-own a very successful business. Success in this way will very likely mean not only the successful execution of a business model. It may require mortgaging the home to raise the initial funds to start the venture and then to sustain growth by reinvesting a high proportion of the cash flow generated by the enterprise. This process of saving income and reinvesting it in the successful business can realise a very high rate of return, making the owner manager very wealthy.

 

These returns on the capital invested will be measured by the increase in the market value (assets less debts) of the business plus the extra income earned that again may be mostly reinvested in the business. Such a high savings and investment plan by a owner-manager is inevitably highly risky – all the family eggs are in one basket and risk adjusted returns have to be high to justify the risks taken. When the value of the enterprise is well proven, the owner manager may wish to cash in by selling up or by selling a share in the company and by paying dividends that are then used to fund a more diversified portfolio of other assets.

Another path to riches may be climbing the slippery ladder of a well established stock exchange listed corporation. This would be one that enjoys growing appreciation from fund managers and is awarded a rising market value. Significant wealth for the top management will come with the increased value of their share options or the shares regularly awarded as part of remuneration and held by them. On retirement or resignation, these shares can be held or again exchanged for a more diversified, less risky portfolio of assets.

 

Options for the risk-averse family man or woman or professional.

The usually risk averse average salary man or woman and the highly successful partner or principal in a professional practice will typically take a different path to comfortable retirement or, possibly, great wealth if the income is high enough. They will have to save a proportion of their incomes and contribute to a pension or retirement fund. The tax advantages of such contractual savings schemes are considerable while there may also be opportunities for the higher income earners, the highly successful professional, to save and invest independently in the stock, bond or property markets.

 

It is investment returns more than the contribution rate that matters for the saver.

The more the salary man and professional save and the sooner they contribute to a savings plan, the more wealth they will accumulate. But as (or more) important will be the returns they earn on their investments. We will demonstrate and illustrate the differences it makes to the wealth outcomes between a low or higher real rate of return on a portfolio, especially when these returns are compounded over an extended period of time.

 

Doing the numbers – demonstrating the miracle of compound returns

In an earlier exercise of this kind published in our Daily View we considered a salaried individual aged 55 in SA in December 2001 expecting to retire 11 years later. By 2001 this individual was assumed to have accumulated assets of R5m and was earning a gross salary of R500 000 per annum and also assumed to contribute 15% of this gross salary  to a no fee no tax pension fund. We also assumed that the salary would grow at 8% per annum. The Pension was invested fairly conservatively in a constant mix: 60% in the JSE All Share Index, 30% in the All Bond Index and 10% in the money market. We calculated the performance of this fund using realised returns over the period to April 2013 some 137 months later.

The results of this savings plan would have been very good indeed. The salary would have grown at an 8% p.a. compound rate from R500 000 to R1 165 813 while the value of the portfolio, worth R5m at the beginning of the period, would have been worth R23.952m in April 2013. The ratio of wealth to salary that was 10 times in 2002 would have increased to 20 times the final salary earned in 2013. This individual would have been able to support a life style much better than the equivalent of 75% of final salary. Consuming at a mere 5% rate of this capital – a rate likely to preserve real capital – would yield R1.19m in year one – slightly more than the final salary. At current interest rates in SA R1m of capital, to be consumed, can buy you about R80 000 of more or less certain nominal annuity income per annum or about R35 000 of inflation linked income at 65, for as long as you or your spouse survive.

 

Excellent past performance is not guranteed

The reason for these highly favourable outcomes for the saver retiring about now, was the excellent real returns realised by the equity, bond and money markets over the period. The JSE delivered an average 15.58% p.a. return over the period, the All Bond Index 10.55% p.a. and the money market 8.22% p.a. on average. Combining these asset classes in the proportion 60, 30, 10 would have given an average annual return of 13.3% p.a. over the period, well ahead of inflation that averaged 5.9% p.a. This average real return of 7.4% p.a. was well ahead of the growth in salary of 8% p.a. equivalent to a real inflation adjusted 2.1% p.a. Hence the increase in the ratio of wealth to salary from 10 to 20 times. Incidentally, had this salary earner in 2002 decided not to save any more of his or her salary after 2001,  the outcomes would still have been highly satisfactory. The portfolio would have grown to R21.291m through the effect of compounding high returns and reinvesting income.

It would be unrealistic to expect real returns of this kind over the next 10 years.

 

A simulation exercise to guide future savings plans

We will show in a simulation exercise what might apply to future contributors to SA savings plans. We will demonstrate that the rate of compounding real after inflation returns – higher or lower – especially when sustained over a long period – will overwhelm the impact of higher or lower savings rates. The Excel spread sheet attached to this report can be used to demonstrate this point. It allows for a great variety of savings options and real return and inflation assumptions that readers, with Excel at their command can try out for themselves.

 

The model and the scenarios

The model assumes a starting monthly salary of R10000 and a working life of 40 years. This working life is broken into three stages: a 10 year phase followed by a further 20 year phase with a final phase of 10 years to allow for different assumptions about real salary growth, percentage of salary invested and real returns through the phases. The simulation exercise also allows for different constant rates of inflation over the 40 year period. Given the emphasis on real growth, the assumed inflation rate has very little influence on the real outcomes though it will affect the nominal rand values as will be shown.

 

Let us then demonstrate a few outcomes to help make the essential points.

Scenario 1 may be regarded as highly, unrealistically favourable to the long term saver, assuming equity like returns of the kind realised by the JSE over the past 10 years, that is average real returns of 10%. It assumes a contribution rate of 15% over the full 40 year period and real, above inflation salary growth of 2% p.a. for the first 10 years of working life, 4% pa. for the next 20 years and 2% p.a. real growth over the final 10 years of employment. The assumed inflation rate is 6% p.a.

 

The results are shown below in two figures. The first tracks the salary and portfolio in money of the day (assuming 6% p.a inflation) and the second tracks the important ratio of wealth to final salary. A ratio of above 10 can be regarded as highly satisfactory with retirement in prospect. As may be seen, Scenario 1 leads to some very large numbers after 40 years: a final salary of R3.7m and a portfolio worth R92.7m – a highly satisfactory wealth to income ratio of 24.65 times.

 

Scenario 1: High returns

 

Ratio of Wealth to Income

 

Source: Investec Wealth & Investment

 

Scenario 2 is much less favourable for the saver. With the same inflation and real salary growth assumption and despite a higher constant 20% contribution rate,  the assumption of an average 3% real return on the portfolio means that the portfolio would be worth a mere R29.3m after 40 years of contributions, or only 7.8 times the same final salary. Retirement in these circumstances would call for a much reduced standard of living.

 

Scenario 2: Low returns – high contribution rate

 

Source: Investec Wealth & Investment

 

Scenario 3 is hopefully more realistic. It assumes an average 6% p.a. real return and a 15% constant contribution rate. The results as shown below may be regarded as satisfactory. The final wealth to income ratio would be 10.4 times.

 

Scenario 3: Satisfactory returns – 15% contribution rate

 

Source: Investec Wealth & Investment

Were the saver in Scenario 3 to only contribute a modest 7% of salary for the first 10 years to the pension plan yielding a satisfactory 6% real return, the final portfolio would have grown to R32.055m in 40 years or 8.5 times compared to the 10.4 times or R39.299m that would have been available had the initial contributions been at the 15% rate.

The implication of this analysis is that achieving a satisfactory wealth to final income ratio of 10 times is no gimme – even with the most favourable savings outcomes. Consistently saving 20% of gross salary for 40 years might not get you there unless real returns were well north of a real 3% p.a. These essential higher real returns are by no means guaranteed even if equity risk were taken on in large measure.

The advice to new entrants to the labour force would be to start saving early in a working life and hope for high real returns. Unfortunately what is in your control, raising your savings rate, will not compensate for low real returns. This conclusion suggests very strongly that the long term saver should have a strong bias in favour of risky equities from which higher returns can be legitimately expected. But such higher returns that might compensate for more equity risk cannot be guaranteed any more than can the returns on bonds or cash be estimated with any certainty.

Saving in addition to the pension plan

It would therefore be highly advisable to supplement a pension plan with home ownership. Paying off a mortgage bond over 30 years is a savings scheme that will give you an effective real rental return of the order of 5% p.a. It will give you the choice of consuming accommodation service in the style to which you are accustomed, that is by staying on in the house you own. Or by offering the choice of scaling down your consumption of house, moving to the smaller apartment or less expensive home in the country town, and converting some of the remaining home equity into other income producing assets. What should be strongly resisted is converting home equity into consumption before retirement. Forced contractual saving in the form of paying off the bond is a constraint worth accepting for the long run.

A further form of saving is early membership of a medical aid scheme. Initial early contributions to medical insurance cover more than the risks – later contributions by the older member typically do not provide cover. The excess premiums paid by the younger worker are a form of saving to be cashed in when old. Carrying full medical insurance is a very good way to save up for the medical bills that form such a large proportion of post retirement spending.

Please note that the attached spread sheet is based on an Investec Wealth & Investment model, according to the assumptions explained in the article: Click here to access spreadsheet

 

 

Global markets: The essential patterns

By Brian Kantor

We have suggested that the most important indicator of the state of global financial markets, of which SA is very much a part, is the direction of US long bond yields. Thursday and Friday last week provided a further demonstration of their importance for the markets and why they do what they do – and that is to respond the expected state of the US economy.

The better the economic news, the sooner the tapering of Fed injections of cash through additional purchases of US bonds and mortgage backed paper, currently running at USD85b per month, and so the higher the US long bond yields and yields everywhere else, including on SA government bonds.

The backdrop to these interest rate movements were reports on the US labour market. On Thursday afternoon (morning on the US East Coast, or 08h30), it was announced that initial claims for unemployment benefits had declined unexpectedly. This was good news about the US economy and so interest rates went up. On Friday at the same time the employment gains were announced: these were well below expectations – not good news at all.

The reactions in the markets are shown below. US Treasury bond yields went up on Thursday and down on Friday and the RSAs follow very closely (Figure 1). In Figure 2 it is shown how US Treasury bond yields go up and down in similar order and the rand/US dollar exchange rate follows in very close order as capital flows to and from emerging market bond markets responded to the higher then lower US Treasuries.

In Figure 3 we show the links between US bond yields and the S&P 500 Index. The good news that drove up interest rates was good news for the equity market on the Thursday. The initial reaction to the less good news on the Friday morning was to weaken the equity markets. But then through the Friday, the S&P 500 recovered its losses to end the day where it had started. This demonstrated a rather robust state of mind of equity investors. Perhaps the underlying fundamentals in the form of earnings reports and the outlook for them is proving supportive.

Of further interest, in Figure 4, is that the JSE followed the S&P 500 very closely throughout this period. We show this relationship through the index futures that offer more overlap than the spot indices.

QE: An exchange of bonds held by the public for cash issued by the Fed

QE easing may be regarded as an exchange of bonds for cash. The Fed holds more bonds and the banks hold more cash in the form of a Fed deposit. If the balance sheets of the US Fed and the Treasury were consolidated (as they should be since both are agencies of Uncle Sam) the consolidated US government balance sheet after QE is of the order of $2.4 trillion. It now shows lower liabilities to the public in the form of bonds that pay relatively high rates of interest, about 2.6% p.a for 10 year loans, and much larger liabilities in the form of bank deposits with the Fed (some $3.2 trillion) that pay much lower rates of interest, 0.25% p.a.

That these Fed deposits earn anything at all is something of an anomaly – something paid out of the goodness of the heart of Ben Bernanke to the shareholders of banks. It improves their income line and probably (controversially) makes the banks less reluctant to hold on to cash rather than lend it out.

But cash for bonds is likely to cause interest rates to fall and reversing the process – bonds exchanged for cash, as must eventually happen – should cause interest rates to rise. The market understands this very well. What it struggles with is the timing of this reversal, which will be dependent on the state of the US economy. And that is especially hard to predict.