January 2014 – ZA Economist

Interest rates: Falling into the trap

The Reserve Bank raises rates modestly and falls into the trap set by other central banks. Too little by half to impress the markets – more than enough to damage the economy.

The Reserve Bank fell into the trap set for it by its central bank peers in Turkey and India (and Brazil and Indonesia which are already in a tightening mode) who raised short rates to defend their weaker exchange rates.

That this strong armed defence (including direct intervention in the foreign exchange markets) has failed to support the likes of the Turkish lira or the Brazilian real, might have given  pause to the Monetary Policy Committee (MPC). A minority of members voted against the increase, presumably because they know that higher interest rates have an unpredictable influence on exchange rates – particularly when global capital markets are under strain – while having a predictably negative influence on already weak domestic spending and therefore economic growth.

The Governor or the members of the MPC cannot explain how higher interest rates will reduce inflation rates, unless the exchange rate strengthens in response to higher rates, which it may or may not do. The immediate response to the 50bps increase has been a weaker rather than stronger rand. It may however be argued that the market expected a more hawkish response of at least a 100bp increase and sold the rand accordingly. In other words, so the argument goes, the MPC surprised the market not because it raised rates but because it did not raise them much further.

What the SA economy needed and did not get from the Reserve Bank was a vigorous analysis of the uselessness in current circumstances of capital market volatility of raising short term interest rates. A full explanation should have been provided, and would have explained why a 50bp increase would be irrelevant for the exchange rate and harmful to the economy and why any larger hike in interest rates, perhaps expected in the market place, was unthinkable given the weak domestic economy. Nor, it might have been pointed out, would an even larger increase in short rates have helped the rand anymore than it has helped the Turkish lira.

Such an argument will be as imperative the next time the MPC meets, should the rand not have gained strength by then and should the inflation outlook remain as unsatisfactory as it is now and the economy become even less well placed to tolerate a further increase in rates. Without such an argument the economy may well set off on a 1998 Chris Stals-like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.

We have been here before and we should remember how much better the Australians coped at that time with Aussie dollar weakness – by sitting on their interest rate hands and not reacting to the essentially temporary inflation danger presented by a (temporarily?) weaker exchange rate. The comparison between the success the Aussies had by doing nothing and the pain suffered for example by the SA, New Zealand and Chilean economies in the late nineties, where interest rates were increased aggressively in response to emerging and commodity market crisis-driven exchange rate weakness, makes  a most instructive case study.

The right response to a weaker exchange rate driven by forces beyond the control of the Reserve Bank is not to react at all. It should ride out the exchange rate weakness as best it can and focus on the requirements of the domestic economy. The MPC did not have the wisdom to do this and unfortunately made a modest concession, a mere 50bp concession, to poorly considered market expectations and poorly executed monetary policy reactions in other emerging markets.

We can only hope it does a much better job before and during the next MPC meeting of defending the SA economy against ill considered and unhelpful interest rate increases. Monetary policy needs to be not only data dependent, as the Governor has indicated following the Fed mantra, but accompanied by appropriate guidance for the market that makes good economic sense. That is why we will not be embarking on an interest rate spiral unless the domestic economy can justify it – which it is very unlikely to do anytime soon.

Emerging markets: Biter gets bitten

Emerging markets are now hurting developed economies – rather than the other way round.

The flavour of financial markets for much of the past 12 months has been a strong preference for equities over bonds and for developed equity markets over emerging markets (EMs). The developed equity markets, led by the S&P 500, performed well, even as US long term interest rates rose significantly and consistently between May and September 2013.

Higher interest rates in the US were a response to the first intimations that the US Fed would be reducing the scale of its Quantitative Easing (QE): that is, the rate at which it would be adding to its portfolio of government bonds and mortgage backed Paper and adding to the money base. In December the Fed announced its intention to “taper” its injections of cash from US$85bn a month to US$75bn. This action was well received by developed equity markets. It was interpreted as confirming the good news about the state of the US economy, thus helping the earnings outlook for US corporations and their market value.

By contrast EM equities did not react at all well to the news about tapering and higher US interest rates. At best EM equities tended to move sideways or lower in 2013 as long term interest rates on EM bonds followed US rates higher. Hence developed market equities significantly outperformed EM equities.

The outlook for EM economies was widely regarded as deteriorating in 2013, even as that of the US was improving, making higher interest rates for EM borrowers distinctly unwelcome. Not only did EM equity and bond markets weaken, but EM currencies came under pressure as funds rotated away from emerging to developed markets. The performance of the JSE and the rand proved no exception to the other EM markets and currencies.

Indeed the rand has been among the weaker of the EM currencies. Commodity based currencies, including the Australian and Canadian dollars, also weakened significantly in response to uncertainty and unease about the prospects for the Chinese economy, the leading EM economy that has such an important influence on demand for commodities like iron ore, copper and coal.

The comfort zone in developed market equities however became significantly smaller on Friday 24 January. The risks in emerging economies on the day infected developed markets. EM contagion became the order of the day. Long term interest rates fell sharply as investors sought safety in US bonds and US equities fell away as risk appetite waned. EM currencies came under particular pressure and while long term interest rates in the US fell those in EM currencies, including the rand rose. Risk spreads across the board, including US corporate spreads, rose rather than fell with lower US rates.

In this way EMs were subject to a risk off threat just as they had previously been subject to a risk on threat. All news has appeared as bad news for EMs. Both higher as well as lower US long term rates have proved unhelpful to EM equities, bonds and currencies.

It may be some consolation to know that a risk off threat to emerging markets, or indeed a risk on threat to emerging markets, should only be of limited duration. Should long term interest rates in the US continue to move lower, the search for higher yields will extend to EMs and reverse the flight of capital from EMs. If US economic growth is well sustained and interest rates rise to reflect the increased demands for real capital that accompany economic growth, the good news will eventually spread to the global economy, including emerging economies. Good news about the US economy will sooner or later translate into good news for EM economies and their markets.

Investors in EM markets, including those equity investors whose wealth is measured in rands, should wish for higher rather than lower US long term interest rates, that is for US economic strength rather than weakness. In the longer run what is good for US business will be good for EMs and SA business.

In the shorter run the challenge for EM economies, especially the SA economy, is to turn a much more competitive currency into export and import replacement led growth. Constructive labour relations and constructive government relations with SA business, in the form of encouraging tax policies and infrastructure roll out, are essential to this purpose. It will also be helpful if the Reserve Bank continues to leave interest rates on hold while leaving the exchange rate to help the economy adjust to higher costs of capital. The mantra for monetary policy should be to float with the tides rather than attempt, Canute like, to reverse them.

Developing economies including SA are up against it – what can we do to help ourselves?

The Wall Street Journal Online edition led on 23 January with the following report:

“Investors Flee Developing Countries Currencies in Many Emerging Markets Take a Pounding, Hit by Growth Fears

Investors dumped currencies in emerging markets, underscoring growing anxiety about the ability of developing nations to prop up their economies as they face uneven growth.

The Argentinian peso tumbled more than 15% against the dollar in early trading as the South American nation’s central bank stepped back from its efforts to protect the currency, forcing the bank to reverse course to stem the slide. The Turkish lira sank to a record low against the dollar for a ninth straight day. The Russian ruble and South African rand hit multiyear lows.

U.S. stocks tumbled as well, reflecting the world-wide pullback from riskier assets and continuing a weekslong struggle to regain the upward momentum seen at the end of 2013. The Dow Jones Industrial Average slid 175.99 points, or 1.1%, to 16197.35, the lowest close since Dec. 19.”

The Wall Street Journal (WSJ) indicated that the Turkish lira was the worst affected by the move out of emerging markets since 1 January, followed by the rand, down 3.54%, and the Russian ruble, also down 3.54%. Clearly emerging market economies (with a few exceptions, perhaps Mexico) are very much out of favour and may well stay out of favour if the current investor mood is sustained.

It was in fact not only a bad day for emerging markets and currencies it was a risk off day in the US with, accordingly, equities prices down and bond prices up. The risk on threat to emerging markets and their currencies including the rand can be easily identified. That is more confidence in the US growth outlook (less risk attached to the prospects for the economy and the companies dependent upon it) leads to higher interest rates. These higher interest or discount rates have been mostly tolerated by the valuations attached to US equities, but unwelcome to emerging market equities as rising interest rates in emerging economies, led inevitably by the US rates, threaten the already unpromising growth outlook for emerging economies.

Clearly, as demonstrated yesterday, there is also a risk-off threat to emerging markets even as US rates move lower. The question then, to refer to the WSJ report, what can emerging market governments and central banks do to prop up their economies. Raising interest rates have done little to help support exchange rates. Intervening in the foreign exchange markets by selling US dollars has also not helped to stem the currency weakness. The global tide is flowing too strongly to be diverted and higher interest rates simply weaken domestic demand further. Higher interest rates put additional downward pressure on expected growth rates and undermine further the case for investing in the beleaguered emerging economies.

One sincerely hopes that the SA authorities have taken full notice of the unhappy experience of those emerging market central banks that, unwisely and unlike the SARB, have reacted in a highly activist way to the pressures in the currency and bond markets emanating from global investors and capital flows out of emerging economies and back to developed ones. Surely the best approach for an economy under stress is to allow a floating exchange rate to help absorb the pressures imposed by less sympathetic global investors; and to do what they can with monetary policy to help relieve some of the unwelcome pressure on domestic spending. While lowering short term interest rates in the circumstances of a sharp currency depreciation might be regarded as too sanguine an approach, leaving them on hold – that is doing nothing – would seem to be the best that can be done by a central bank in circumstances beyond the control of the monetary authorities.

For South Africa this means the mines, factories, hotels, restaurants and tour operators should stay open for business – or, better still, work overtime and double shifts where extra demands present themselves as they are doing most obviously for the SA hospitality industry where extra demand- encouraged by the weaker rand is leading to extra supply and the extra incomes and employment that comes with it.. The task for economic policy in SA is to make sure the export and import replacement-led growth happens and is encouraged. Sensibly reformed labour relations and policies for labour employed in mining and manufacturing, currently highly conspicuous by their absence, would be very helpful as would a highly supportive and well managed roll out of infrastructure; More success in these endeavours would be the best response to an increasingly sceptical global investor. Only faster growth or the prospect of faster growth will attract more capital to the businesses that drive the SA economy and would support the rand and by so doing also improve the outlook for inflation.

There is an important economic opportunity for the SA economy provided by the weaker real rand exchange rate (defined as an exchange rate that has moved significantly more than can be justified by relatively fast domestic inflation). The opportunity is for domestic producers, enjoying wider operating profit margins, to take a larger share of both the domestic market from importers and to increase their share of export markets through keener pricing on the local and foreign markets and increased output and employment Such responses raise growth rates and by so doing are the only know method likely to impress foreign investors.

An Overview on Asset Allocation for Balanced SA Pension Funds in 2014

Taking on equity risk was well rewarded in 2013. It was especially so for shareholders in companies listed on the developed market exchanges led by the New York benchmark, the S&P 500, that returned an extraordinary near 30% annual return. Shareholders in the average Emerging Market (EM) company did not do nearly as well, having seen the USD value of their shares decline. However when measured in depreciated local currencies, strongly positive returns may have been earned on equities, as were provided for the rand investor on the JSE. Furthermore for local EM currency investors equities are likely to have performed much better than local currency bonds or cash as was decidedly the case for rand investors. Even long dated US Treasury Bonds did not provide positive returns in rands given rising long term rates in the US.

Read the full piece here: An overview on Asset Allocation for 2014

US interest rates: What they mean for SA and emerging markets

The unexpectedly poor new jobs number for the US released on Friday 10 January, some 70 000 jobs added in December compared to about 200 000 expected, sent long term interest rates in the US sharply lower. The yields on the vanilla as well as the inflation linked varieties all fell on a revised view of the underlying strength of the US economy. Yesterday these yields remained at the lower levels.

SA interest rates predictably also fell, though the yield spread widened, namely the difference between long dated RSAs and US Treasuries marginally:

The news about the possibly diminished strength of the US economy suggested by the labour market surveys, implies that the extra cash injected into the US financial system through asset purchases by the US Fed (QE) will proceed at a slower rather than faster rate – hence more demand for US Bonds and lower long term interest rates.

This move in US rates provided relief for emerging market currencies and their equity markets. The rand behaved entirely consistently on Friday 10 January – moving in the opposite direction to the Emerging Market Index, as it had been doing for most of 2013. However late on Monday in New York the rand came under renewed pressure (also felt to a smaller degree by the Turkish lira) while some emerging market currencies, including the Indonesian ruppiah strengthened markedly. The rand perhaps attracted selling pressure on Monday evening after Amcu gave notice that it was proceeding with strike action at Impala Platinum. Emerging equity markets were holding up well as the S&P 500 fell away by more than 1%.

These developments confirm once more that the most important indicator for emerging market equities and currencies will be the direction of long term US interest rates. For now, good news about the US economy (that translates into higher long term interest rates and is treated as good news for US equities and the US dollar), is simultaneously bad news for emerging market equities and currencies, as interest rate increases spread. Also, as we saw on Friday, when interest rates fall in the US, emerging market currencies and equities gather strength.

The rand is mostly a play on emerging market equities – the rand benefits from foreign capital that flows in when the JSE appears offers to offer value. This it does when US interest rates fall. If the recent past is to be our guide to the future, higher US interest rates are a threat to the rand and lower US rates a benefit. This will be so until good news about the US economy spreads to emerging market economies and higher interest rates can be more easily tolerated.

For now, those concerned about the poor health of the SA economy must hope that the US economy does less well than previously expected, that long term US rates decline rather than increase and that emerging market equities rise rather than fall to support the rand. This would reduce the danger of more SA inflation and damagingly higher interest rates.

The rand: Where to holiday in 2014

By Brian Kantor

A recommendation to take your holidays at home, or failing that, try Indonesia, Turkey, India or Thailand in more or less that order.

South Africans, especially those with the taste for foreign holidays and the wealth to indulge this taste, will not have to be reminded that a number of the destinations they may have in mind will cost them significantly more rands than it would have done six months to a year ago.

There may be some consolation in the knowledge that while the US dollar now costs South African residents about 28% more and the euro 31% more than it did on 1 January 2013, an Australian dollar can be had for only approximately 9% and the yen a mere 5% more compared to a year ago and are now worth roughly the same number of rands they would have in June 2013. Sydney and Tokyo may still appear expensive cities for the SA visitor but not much more expensive than they were a year or six months ago.

Further consolation for the well-travelled South African with a taste for the more exotic is that some destinations have become significantly cheaper for them since June 2013, provided, and it is an important proviso,  prices are set in the local currency rather than in US dollars. Bali in Indonesia will appear a mere snip, with the Indonesian Rupiah having depreciated by about 12% against the rand since 1 June 2013. That never to be forgotten experience in the Istanbul Hamam could be about 8% cheaper and booking that Rio hotel for the World Cup should not be more expensive than it was six months ago – nor should the game changing visit to the Indian Ashram take more rands than it did six months ago. Bangkok or Pukhet might also appear something of a bargain buy. Mauritius, a favourite nearby destination for SA tourists, has proved remarkably exceptional in this regard. Its rupee has maintained its value against the US dollar and the euro.

These developments on the currency markets in 2013 illustrate the important forces that have influenced the foreign exchange value of the rand over the past 12 months.

The weakness in the rand across almost all currencies, including other emerging market currencies until June 2013, was SA specific in origin. It was caused by the failure of labour relations and the resort by the unions to strike action that disrupted production and especially exports from the mines and manufacturers. It became very apparent that export revenues and profits can only benefit from a weaker rand if output can be maintained or increased in response. This was not the case in SA in 2013. For want of exports, the trade and current account deficits remained large despite slow growth. This put sustained pressure on the rand from August 2012 until June 2013.

The weakness in the rand after June was much more a case of increased emerging market risks, rather than specific SA risks. The intention of the Fed to taper its injections of cash into the US financial system, first revealed in late May 2013, meant higher interest rates in the US and everywhere else. Capital tended to flow out of emerging market equity and bond markets into developed equity markets with very negative effects on most emerging market currencies. The “fragile five” emerging economies – Brazil, India, Indonesia, South Africa and Turkey – that ran current account deficits and therefore depended more heavily on foreign capital inflows proved particularly vulnerable.

Any recovery in emerging market currencies will depend upon renewed appetite for emerging market equities that have so underperformed in US dollar terms over the past two years.

Hard Number Index: A mildly encouraging December

The first indicators on the state of the SA economy at the end of December 2013 are now available in the form of unit vehicle sales and the currency issued. These two hard numbers provide a very accurate and up to date estimate of spending by households and firms.

The news on spending in December is mildly encouraging when account is taken of seasonal influences on the sales of vehicles and the demand for notes. December, for obvious holiday reasons, is a very strong month for the notes held in wallets, purses and ATMs. It is also a weak month for vehicle sales, as holiday makers do not typically visit motor show rooms.

Yet while actual new vehicle sales fell from 50 806 units in November 2013 to 46 501 units in December, on a seasonally adjusted basis unit vehicle sales in December were well up on November sales, by some 3 605 units, or a monthly gain of some 6.9%. If the latest trends in new vehicle sales are extrapolated forward, using a time series forecast, the sector could be looking for sales in 2014 of 626 000 units. This would represent a minimal annual decline in sales volumes of some 2.36%, an outcome the industry would gladly settle for.

The manufacturing arm of the sector can hope to benefit further from much higher levels of exported units in 2014, after the disruptions caused by strike action in 2013. The National Association of Automobile Manufacturers in SA (Naamsa) indicated that exports of 275 822 units, though a record number, were some 61 000 units fewer than expected.

The money supply numbers at end December showed a somewhat similar improvement compared to November when seasonal influences are factored in. In the figure below we adjust the nominal note issue for the CPI and show that, on a seasonally adjusted basis, the real money base (supply of cash) picked up momentum in December 2013. When the latest statistics are used for a time series forecast, the real money base is predicted to have increased by 2.7% by year end 2014 – equivalent to nominal growth in the note issue of some 8% and consistent with an estimated inflation rate of about 6% in 2014. This is consistent with a predicted modest aggregate spending growth of about the same magnitude, of less than 3%.

What can be concluded from the latest economic news is that the SA economy has not, as may have been feared by some, fallen on its face. Rather, it seems able to sustain a modest forward momentum that, in the circumstances of disrupted production and a depreciated exchange rate that helps sustain high rates of inflation, may perhaps be consoling.

We combine the two hard numbers, unit vehicle sales and the real supply of cash in equal weights to form our Hard Number Index (HNI) of economic activity. We have previously shown that the turning points in the HNI – pointing to a pick up or slow down in the mostly forward pace of economic activity – track the Reserve Bank’s Coinciding Business Cycle Indicator Index very well. The distinct advantage of the HNI is that it is available within a week of the end of the previous month, rather than only three or more months later (as the Reserve Bank indicator is). The updated HNI is shown below. It shows that the SA economy is still growing and can be expected to continue to move forward at the current slow speed. The December data has helped to keep the HNI on this modestly faster track.

The opportunity for the economy to pick up momentum in 2014 will have to be led by exports and replacement of imported goods and services by domestic suppliers. The weaker rand can help promote exports and discourage imports, provided that the mines and factories stay open as do the restaurants, shops, hotels and B&Bs catering to foreign tourists.

A stronger pick up in the global economy, led by the US, will be helpful for exporters and the US dollar prices they receive. The scope for a domestic demand led stimulus for the economy is limited, given the state of global capital markets that are revealing a greater preference for developed rather than emerging market assets. The danger to the economy is not that domestic spending will pick up – but that it can slow down further under the pressures of higher prices and higher interest rates.

We must hope that the Reserve Bank does not attempt to fight higher inflation, since it has no influence whatsoever over inflation given the sources of higher prices: the exchange rate, a possible drought in the maize producing areas, as well as relentlessly higher taxes in the form of higher municipal charges for electricity and toll roads.

Higher interest rates can only reduce domestic demand without influencing prices very much, so slowing down growth and, by doing so, probably frightening away rather than attracting foreign capital. Slower growth may well mean even more rand weakness and more inflation.

An emerging question

In the global village developed market equities and currencies continue to make the running. But for how much longer?

Good news about the US economy has led to the tapering that was first hinted at in May 2013 and became a reality late in the year. The Federal Open Market Committee announced on 18 December 2013 that it would begin reducing (tapering) the extra cash it injects into the US financial system through its bond and mortgage backed paper buying programme, for now from US$85bn per month to US$75bn.

The Fed also made it very clear that it did not expect to have to raise short term interest rates anytime soon and that all it might do by way of further tapering would remain US economic data dependent.

Long term interest rates in the US, and everywhere else, responded dramatically in May 2013 to the prospect of less support for bond prices and yields have remained on a generally upward path since then. The US equity markets were largely unruffled by the reality of higher interest rates. Good news about the US economy, as revealed by tapering intentions and action, was taken to mean better prospects for US corporations, despite higher interest rates. And so share prices rose further, especially in late December, as we show below.

Emerging equity markets and their currencies did not take at all well to the prospect and reality of higher interest rates in the US – notwithstanding the good news about the US economy that remains such an important part of the global economy. Clearly the state of most emerging market economies was not at all robust enough to tolerate higher interest rates. Their currencies, including the rand, weakened as funds flowed out of emerging equity and bond markets. While the local currency values of emerging market equities generally rose, as they did on the JSE, these price gains were not enough to compensate offshore investors for currency weakness.

In US dollar terms, the average emerging market equity went south rather than north in 2013, thus lagging well behind the trends registered on the developed equity markets (see below). Good news about the US economy did not translate into good news for emerging market economies.

Higher long interest rates in the US, that led to higher rates in emerging economies, including SA, put downward pressure on currencies and equities, when valued in US dollars. The one saving grace for interest rate sensitive economies and companies is that interest rate spreads between riskier bonds (including RSAs) and those issued by the US Treasury have tended to narrow recently, so moderating the impact of higher interest rates in the US (see below).

For now investors in emerging equity markets should hope that the expected recovery of the US economy is fully reflected in current long term bond yields. Indeed, economic disappointments (leading to lower bond yields) rather than surprisingly strong growth in the US (higher bond yields) would be greatly appreciated by emerging market equity and currency markets. Yet in any longer run view, a stronger US economy (given its large size) is good news for the global economy and especially for those emerging economies reliant on export flows to the developed world.

The better economic times seem more propitious for developed than for emerging markets and their valuations reflect this. In due course, the good economic news will spread to the emerging markets, their currencies and their equity and bond markets. For now developed equity markets, we think, continue to make the stronger case for equity investors than emerging equity markets, while equities generally make a much better case than bonds, given the risks of higher interest rates.

But a mixture of still more demanding valuations on developed equity markets and less demanding valuations on emerging markets, especially when measured in US dollars, could revive the case for emerging market equities and their currencies. At some point in time, the strong outperformance of developing equity markets and currencies will become the case for emerging markets that, after all, have the global economy in common. As they say, timing is everything.