Month: January 2015

The MPC says welcome to 2015. Will it say out with the old, in with the new?

The Monetary Policy Committee (MPC) of the Reserve Bank will be reporting back today on its first meeting of 2015.

The MPC did not have a good 2014. By the year end it had become clear that it had overestimated both SA inflation and growth in 2014 and beyond.

The estimates of inflation were overtaken by events outside SA, over which the Reserve Bank has no influence. These were events that moved global prices and interest rates markedly lower and the rand no weaker on a trade weighted basis, despite the strong US dollar. However the increases in the MPC short term repo rate in 2014, to 5.75%, by an initial 50 bp in January followed by a further 25bp in July, would have discouraged domestic spending to a degree. This was spending that in mid year gave every indication of slowing down even more rapidly than initially forecast. But the higher cost of credit had no discernible influence on inflation, dominated as it was by global price trends, especially that of oil and grains, and the exchange rate.

Hindsight would suggest that short term interest rates in SA should at worst have been kept on hold in 2014 and, better still, should have moved lower. Longer term rates certainly did, determined as they are by market forces, though they were market forces with an eye always on central bank action.

The Reserve Bank might be inclined to contest such an observation. It stressed in its statements released after its MPC meetings that fighting inflation was its primary task and moreover that it regarded its monetary policy as always accommodating, a reference to the unusually small gap between interest rates and inflation.

According to its statement in July 2014, when it raised short rates by a further 25bp:

“The MPC is also increasingly concerned about the inflation outlook, and the further upside risks to the forecast. Although the exchange rate remains a key factor in this regard, the possibility of a wage-price spiral should wage settlements well in excess of inflation and productivity growth become an economy-wide norm has increased. Although the inflation trajectory has not deteriorated markedly since the previous meeting, upside risks have increased, and it is expected to remain uncomfortably close to the upper end of the target range when it does eventually return to within the target. The upside risk factors make this trajectory highly vulnerable to any significant changes in inflation pressures.

“Although inflation expectations have remained relatively anchored, should inflation persist outside the target band, these expectations risk becoming dislodged.

“The MPC has decided to continue on its gradual normalisation path and raise the repurchase rate by 25 basis points to 5,75 per cent per annum, effective from Friday 18 July. Given the expected inflation trajectory, the real repurchase rate remains slightly negative and well below its longer term neutral level. The monetary policy stance remains supportive of the domestic economy, and, as before, any future moves will be gradual and highly data dependent.

“We would like to reiterate that monetary policy should not be seen as the growth engine of the economy. The sources of the below par growth performance are largely outside the realms of monetary policy.”

The lesson the Reserve Bank might however take from events in 2014 is that while it is true that the “the sources of the below par growth performance are largely outside the realms of monetary policy”, so is the inflation rate.

Inflation in 2015 will continue to be dominated by events beyond the influence of SA monetary policy and short term interest rate settings. For some obvious examples of only the known unknowns, the timing of the first US FED rate increase, June 2015 or later, will matter for global growth and inflation forecasts. So will the success or otherwise of European quantitative easing and how deflation in Europe presses down euro yields and hence the flow of funds both to the US and emerging markets (including SA) in search of higher yields. A possibly still stronger dollar might press further on the oil and other metal prices, meaning less inflation and possibly slower growth in the US. The economic recovery in the US, depending on its pace, may encourage tepid growth in emerging economies, adding to the attractions of their equities and currencies, including the rand. Such outcomes will in turn bring rate increases in the US either forward or back.

The MPC, as is clear from the statements it issued, worried a great deal in 2014 about the turbulence in global markets and economies and how it should react to the interest rate decisions of other central banks. As it turned out, the higher rates imposed by a number of emerging market central banks, including the SA Reserve Bank, were ill advised and are being reversed in the light of lower inflation.

The MPC will almost certainly keep its repo rate on hold today. Hopefully its future decisions will remain data dependent and not presume a so described normalisation of interest rates any time soon. Normalisation of (higher) interest rates presumes a normalisation of global economic circumstances that remain distinctly abnormal as deflation and QE in Europe confirm.

It would be wise for the Reserve Bank to realise that its influence over growth, inflation and inflation expectations is limited given the exposure of the SA economy to global forces.

There is however one feedback loop over which it has some influence. This is the loop from short term interest rates to domestic spending. Higher rates discourage such spending and lower rates can encourage it. This is the only channel of influence the Reserve Bank can rely upon to some degree.

It should therefore concentrate on ensuring that domestic demand neither adds to nor detracts from inflationary or deflationary pressures. Or, in other words, to attempt with its interest rate settings to match domestic spending (influenced as it will be by bank lending) to potential domestic production as closely as possible. If it succeeds in this, it will have done what little it can realistically hope to achieve in consistently low inflation in SA. Hoping to do more than this, especially in hoping to predict the course of global economic events, and then to react “correctly”, is beyond its limited powers. This was amply shown to be the case in 2014.

Domestic spending in SA has been running at what can be presumed to be well below normal levels and rates of growth. It can do with all the help it will be getting from lower inflation and lower fuel prices. Additional help from lower short term interest rates may well be called for in due course, if spending growth remains subdued.

A helping hand from Europe

How European Central Bank (ECB) Quantitative Easing (QE) moved the markets, including the rand and the RSA Yields. Is this good news for emerging market economies?

The unexpected scale of the intended QE in Europe announced on Thursday moved the markets. Most conspicuously it weakened the euro vs the US dollar. Such weakness must be good for European exporters and thus for growth prospects in Europe regardless of how much more lending European banks will do with their pumped up cash reserves. Some stimulus from a weaker euro will add something to the demand for bank credit, which has been as weak as the supply of bank credit from European banks – hence the case for QE.

US dollar strength and euro weakness was an entirely predictable response to what became a wider interest rate spread in favour of US Treasuries over Bunds.

The rand not only gained against the euro but also strengthened against the US dollar on the QE facts.

This strength was however not confined to the rand. It was also extended to many of the other emerging market currencies. The rand lost a little bit of ground against the Brazilian real and gained against the Turkish lira. It also held its own against the Mexican peso and Indian rupee as we also show below. Thus euro weakness vs the US dollar extended to emerging market currencies, including the rand.

The strength of the rand vs the euro was linked with further strength in the RSA bond market. We have alluded in previous notes to the recently strong relationship between the rand/euro and RSA long bond yields. This trend of declining RSA yields associated with rand/euro strength held up strongly over the past few days. It indicates that the lower euro interest rates and a wider spread in favour of RSA (and presumably other emerging market) bond yields also attracted flows of funds out of or away from Europe – enough to move emerging market bond yields lower.

It was not only emerging market bond markets that seemed to benefit from changes in flows of funds in response to ECB QE. Emerging market equity markets, including the JSE when measured in US dollars, also outperformed the S&P 500.

Lower interest rates and determined reflation in Europe have improved global growth prospects. It does appear that EM bond and currency markets have benefitted and that EM economies may grow faster in response to the sustained improvement in the US economy and now hopefully better growth prospects in Europe on which EM economies depend. So much can be read into market moves. As we have mentioned before it is hard to predict other than dollar strength Vs the Euro in the light of the sustained spread in the yields offered by US Treasuries over German Bunds. It seems that the wide spread between Euro yields and EM yields can help to protect EM currencies including the ZAR from dollar strength. This means less inflation as well as low long term rates. It can also mean lower short term rates that might help stimulate growth even as inflation comes down.

The lack of pricing power in SA and its favourable implications for the economy

The CPI in December 2014 was no higher than it was in August 2014. 

The Consumer Price Index (CPI – based to 100 in December 2012) reached the level of 111 in August. In December the CPI fell by 0.2 points and was back at the 111 level. In other words, on average, prices in SA have not changed in five months.

Headline inflation is measured as the year on year change in the CPI. Prices since December 2013 have risen 5.3%. However, if we measure the change in prices over a shorter three month period, this inflation rate is zero, way below headline inflation. If current trends continue and are extrapolated using a time series forecast, SA is heading for significantly lower inflation, perhaps below 4% by the end of 2015. Lower petrol and diesel prices in January may send the CPI still lower and reduce the forecast rates of inflation further, though it is highly likely that if the rand oil price stays where it is, the government will impose an additional excise tax on petrol, diesel and paraffin in its February Budget proposals.

The bond market, where interest rate contracts between the government and pension funds can be written for 20 or more years, the risks of more or less inflation are fully reflected in long term interest rates. Inflation-protected bonds offered by the government enable lenders to avoid the risks of inflation turning out higher than expected and provide a riskless certain real return (provided governments measure inflation objectively and stand by the contract). The difference between the nominal and real yield on RSA bonds of similar duration (say 10 years) therefore represents compensation for bearing inflation risk and is an objective market-determined measure of expected inflation.

Less inflation in SA, linked to the accompanying stability of the rand on a trade weighted basis and lower oil and commodity prices (when expressed in the strong US dollar) has helped lead interest rates in SA lower. The gap between the yields on nominal inflation-exposed benchmark 10 year RSAs and their inflation-linked equivalents (RSA 212) has also narrowed recently and has followed headline inflation lower.

Less inflation leads to less inflation expected – the Reserve Bank is wrong to think it can go the other way round – there is no good evidence for the so-called second round effects (more inflation expected that are assumed to lead inflation higher). But it should also be appreciated that inflation compensation in SA is very sticky about the 6% level. It has stayed close to that level even as inflation came down sharply from high levels after the Global Financial Crisis and crept higher in the second quarter of last year. The Reserve Bank will have little influence on these inflation expectations – provided inflation behaves “normally” – and it should recognise that its policy targets can only be about inflation and also growth, not inflation expected.

It may take inflation well below 6% and sustained at that level over an extended period of time to reduce inflation compensation in the bond market well below the 6% level. RSA bond yields (lower or higher) will continue to take their cue from global interest rate trends – to be led by euro rates, as they have been led in 2014. It is the interest rates in Europe (reflecting fears of deflation and central bank reactions to deflation) followed by lower rates in the US, that have attracted flows from off shore into to the rand bond market causing SA interest rates to fall while helping the rand to strengthen. The stable to stronger rand has helped reduce inflation while having a much more subdued influence on inflation expected.

The importance of these trends, all well beyond Reserve Bank influence, will mean that the Reserve Bank is very unlikely to raise its repo rate this year and may even reduce it next year should the economy not pick up momentum. A mixture of less inflation with faster growth in SA, encouraged by stable interest rates, is the new welcome opportunity provided by global deflation for the SA economy to lift its growth rates. Such optimism is already being reflected in the buoyant recent performance of the interest rate sensitive stocks listed on the JSE: the retailers, banks and property companies.

More growth expected and the improved profitability associated with faster growth will attract more capital to SA, as it has been doing over the past few days. These flows support the rand and make faster growth with less inflation more likely. These are good reasons why the Reserve banks should focus its attentions on what it can do to assist growth in SA and leave inflation – over which it has little influence – to the global market forces that drive the rand and long term interest rates.

Point of View: The Uber test

My colleagues who get out a bit and would never ever drive and drink are wild about Uber, their preferred taxi service. The Uber taxi service is made possible by ever advancing information technology. The service could not be offered without the GPS enabled smart phone with its extraordinary advances in computing capabilities that Uber relies upon.

The service offers a number of advantages over its competition, however well connected or instructed by a call centre. The most decisive advantage is the flexibility and certainty of the service provided – you can call an Uber car and driver up precisely when you need it (something you may not wish to decide in advance) and know with a high degree of certainty that the call will be answered and punctually: a clear advantage that the alternative services, including those provided by a taxi allowed to roam, cannot offer with anything like the same predictability. Finding a cab on a busy street corner to take you quickly out of the rain cannot be predicted with any confidence.

There are other conveniences on offer to both the passenger and, as important, the driver who supplies the Uber service. No cash or credit card swipe is required. The reputation, not only of Uber but of the driver and passenger, is always on the line. It is in Uber’s interest to vet not only the competence of its drivers and the soundness of their vehicles but also the behaviour of their passengers. It is also in the interest of Uber to ensure that its drivers are not only competent but fully insured against accidents that may damage its passengers and therefore its reputation. Cars for hire understandably command higher insurance premiums than vehicles used only privately – they are more on than off the road and therefore are likely to suffer more accidents.

This care for its customers will be taken because the value of Uber as a business, as is the value of almost every business enterprise, is completely dependent on attracting repeat business. Its reputation is its most valuable business asset of which its owners and managers will be fully aware because of their own economic dependence on its reputation and value.

Perhaps the most valuable innovation of the Uber system that could be scaled up very easily is its treatment of the peak pricing and loading problem. When demand peaks, fares rise to restrain demand. But the same higher level of demand instantaneously revealed by the system, with or without the inducements of higher Uber charges, encourages additional supply. Capacity responds immediately to revealed demands because it is in the interest of drivers and owners of vehicles to do so. The costs to their owners of cars standing idle becomes patently obvious when the state of demand and the income earning opportunity becomes so conspicuous.

Most cars however stand idle most of the day and are employed almost entirely at peak hours in the working week. Uber offers a very effective way to bring enough of them out of idle storage to meet peak demands. What if the Uber service offered for income and profit could be extended to car sharing to and from work from homes that is currently only encouraged as acts of charity by the car owners and users? Uber might well be able to get you to economically share a ride to or from work at a time to suit perfectly.

But while Uber is a potential boon to consumers of taxi like services it is a clear and obvious danger to the established taxi services and the economic interests associated with them. The right to run a taxi service in many cities is a valuable one because supplies of the service are artificially restricted by regulation of entry into the business. It can also become a tradable right as the valuable trade in New York City taxi medallions demonstrates. The licensing system is also valuable to the officials with licensing power who have their own jobs and benefits to thank the regulations for.
Competition through innovation from Uber is as much a threat to the jobs and benefits of the regulator as it could be to established suppliers. It will not be a threat to the drivers for whom remuneration will be determined by the supply and demand for drivers. The supply of drivers and the employment benefits they command will be influenced by the difficulty to qualify as a licensed driver. Drivers will surely be a lot keener on the opportunities presented by Uber than licensed taxi owners. Uber should be seen as high tech system helping job creation.

The revealed demand for the Uber service at the prices being charged for them is proof of its welfare adding capability for the society at large. The patterns of demand for and the supply of the Uber service is an outcome of competition at work. Competition of the most important kind- that is not merely price competition for an established good or service – but the transforming competition that comes with invention, innovation and capital put at risk as well as capital used more intensively and productively than it was before. It is this ‘creative destruction’ that has made the economic world the much more powerful productive system it has become over the past 300 years or so. Had the Luddites had their way this economic progress would not have been allowed to happen1.

The reaction to Uber illustrates the destructive power of established interests and especially those of regulators to limit competition. Growth happens when individuals are left largely free to pursue their own interests by competing with the established suppliers working hard, taking risks and constantly innovating to improve their own rewards. The hidden hand that converts private benefits into public gains is a work in constant progress.

Growth is frustrated when established interests are protected against competition, be they those of the King and his court or by formal religions to protect their own interest in the established order. Or when competition is frustrated and growth potential denied in order to protect the interests of regulators and politicians in the established ways of doing things.

The different reactions to the entry of Uber into the market place, relatively encouraging or discouraging and highly suspicious reveal that the forces of competition may be treated by the broad society as instinctively helpful or otherwise. That is as innocent and welcome until proven otherwise. Or, alternatively they may be presumed guilty of unwelcome interference, until the entrant can prove themselves (with great difficulty) innocent of the charge of not causing economic damage. It is those economies that welcome competition, that believe market forces in principle should be allowed their freedom, that will pass the Uber test to the great benefit of society, not only in the convenience of its taxi service, but in every sphere of economic activity, the future shape of which is unimaginable, given the power of innovation.

1The Luddites were 19th-century English textile artisans who protested against newly developed labour-replacing machinery from 1811 to 1817. The stocking frames, spinning frames and power looms introduced during the Industrial Revolution threatened to replace the artisans with less-skilled, low-wage labourers, leaving them without work. I would suggest labour saving- productivity enhancing inventions rather than labour replacing. The supply and demand for labour and real wages have risen consistently since then even as the machinery has become ever more labour saving and micro-processor assisted. (Source: Wikipedia)

Global rates: What they mean for SA assets

Whither interest rates: up, down or sideways?

The most important feature of global financial markets in 2014 was the significant decline in long term government bond yields. On 1 January 2014 the 10 year US Treasury was trading at a 3.03% yield and the German Bund offered 1.94%. On Friday 16 January 2015 these yields had fallen to 1.83% and 0.46% respectively. These developments, led by German yields, were a great surprise to a market that was expecting both rates to increase, judged by the upward slope of the yield curve a year ago.

The US 30 year Treasury bond offered 3.96% a year ago. It now yields 2.45%, still above the 10 year rate, thus revealing that the market still expects interest rates to rise, but by much less and more gradually. The 10 year US Treasury is priced, in the futures markets, to rise from the current 1.84% to 2.08% in a year and to only 2.86% in 10 years’ time.

Long term interest rates in SA moved in the same direction and this trend lower accelerated in January 2015. Not only did long rates fall but the gap between long and short rates has narrowed sharply. Short term rates in SA have held up and only very recently has the money market revised its view that short term rates would be rising in 2015. The market would now appear to have put off any expected increase in short rates to 2016 and now appears to expect short rates to rise by about 1%t (100bp) over the next three years.

These unexpected movements in SA interest rates, long and short, have had a significant influence on the share prices of those companies listed on the JSE whose performance is known to be very sensitive to interest rates, for example property companies, banks and credit retailers. Changes in interest rates influence not only their cost of doing business but also stimulate or restrain demands for their services and top line growth. Our index of large market cap interest rate-sensitive stocks on the JSE performed as well in 2014 as the JSE-listed Global Consumer Plays and the S&P 500 (in common currencies) – well ahead of almost all the major stock markets in 20141.

Clearly interest rate trends matter a great deal for equity valuation in SA and had a powerful influence on the JSE in 2014. What the does the future hold for interest rates in SA? In 2014 and to date in 2015, RSA yields moved very closely in line with the rand/euro exchange rate. As we show below, interest rates in SA fell as the rand gained value against the euro. This relationship has held up very well this year.

This relationship (which has not always been as strong as this), between the euro/rand and the RSA yields makes every sense. It is weak growth and the threat of deflation in Europe that has sent all interest rates lower, including those in SA. It is these lower rates that have widened the spread between euro and US dollar and RSA rates even as rates have declined, adding to the case for holding dollars and rands. The dollar is strong and the rand is stable, so improving the outlook for inflation in SA in a deflationary (at least in dollars or euros) world.

The direction of economic activity and inflation, and so the exchange value of the euro, will continue to hold the key to the direction of interest rates in SA. This week the European Central Bank (ECB) hopes to add quantitative easing (QE) to its repertoire of instruments designed to avoid deflation and stimulate growth in Europe. We wait to see how much QE will be undertaken and how it will affect interest rates in Europe. In and of itself, QE would lower interest rates. However if QE is thought capable of reviving the Eurozone economy, then this would counter expectations of slow growth and deflation and might limit the downside to euro interest and exchange rates. Our sense is that provided the spread between US and euro rates holds up (currently about 1.4%) a strong or at worst stable US dollar/euro rate should be expected. Interest rates in SA would then move sideways at worst and possibly lower, with long rates continuing to lead short rates. If the rand holds up on a trade weighted basis (weaker against the US dollar and stronger against the euro), then the chances of inflation in SA surprising on the downside improves. Less inflation and less inflation expected portend lower (not higher) interest rates in SA.

1The Interest plays are a market (JSE SWIX) weighted average of:

BGA FSR GRT INL INP IPL MSM NED RMH SBK TRU CCO CLS CPI FPT HYP NEP PIK RDF RES TFG WBO MPC WHL CPF ATT PSG RPL AEG FFA

The SA Industrials Index combines:

BVT IPL SHP TBS VOD BAW AVI LHC SPP NPK

While the Global Consumer Plays consist of a market weighted combination of:

APN BTI CFR MDC MTN NPN SAB SHF NTC ITU

Hard Number Index: December boost

The SA economy is looking up again, judged by December data releases.

The SA economy in December continued on a modest recovery path that we had identified in November 2014. Growth in economic activity would appear to be gaining rather than losing momentum, as appeared to be the somber case in mid-year.

Vehicle sales and notes in circulation in December, two hard numbers about the state of the SA economy with a very early release, reveal some more encouraging trends. Vehicle sales were particularly robust and the note issue, when adjusted for lower inflation, also maintained its helpful upward trajectory.

We combine these two series with equal weights to calculate our Hard Number Index (HNI) of the immediate state of the SA economy. It may be seen that the HNI, having dipped lower earlier in 2014, has risen to higher levels again and is extrapolated to sustain this forward momentum in 2015. Numbers above 100 for the HNI indicate that the economy is moving forward, that is growing at a positive rate. Such forward momentum is also confirmed by the Reserve Bank Coinciding Business Cycle Indicator with very similar turning points but which has only been updated to the September month end.

This forward momentum may be established by looking at the second derivative of the business cycle, that is the rate of change of the HNI itself. As may be seen below, the rate of change of the rate of change in economic activity, the forward speed of the economy, reached a top in 2010 as the economy recovered from the recession of 2009. But this speed slowed down consistently until late in 2014 when it appears to have turned up again. It must be hoped that these more favourable activity growth trends will be sustained in 2015.

It was a very good month for sales of new vehicles in December 2014. 51 461 units were delivered to the local market and 21 833 units were exported. Local sales were marginally up on November but December, with its holidays, is typically a well below average month for the motor dealers. On a seasonally adjusted (SA) basis therefore, unit sales were strongly ahead of November as we show below.

Sales on a seasonally adjusted basis have recovered strongly from what appears as something of a slow down after September 2014 that was also a very a strong month. September sales may well have been boosted by improved availability of vehicles after the strike in the manufacturing sector and perhaps was also influenced by some pre-emptive buying in the light of rand weakness. We show below that the new vehicle sales cycle has turned distinctly higher, following the slowdown in mid year. If current trends were to be maintained, the industry would realise a 10% growth rate in 2015 or sales of over 700 000 units, an outcome that would be regarded as highly satisfactory for the industry, especially if it were accompanied by good export volumes. Exports can run at about 50% of local volumes.

Particularly encouraging from the perspective of the wider economy and its longer term growth prospects, was the willingness of businesses to invest in new vehicles. Light commercial vehicle sales were 14.7% up on a year before while sales of the expensive, extra heavy commercial vehicles were up buy an especially robust 29.9% on December 2013.

The demand for and supply of notes also continued to grow faster at year end. Such demands indicate spending intentions and holiday sales reports from the major retailers – due in late January are likely to reveal a similar trend to those of the real note issue cycle. Significantly lower rates inflation realised over the past three months would also have helped the real money supply cycle.

As is well observed, faster or slower growth in economic activity tends to reinforce itself as economic actors react to the more or less favourable spending trends. Interest rate developments in 2015 will play a crucial role in adding reinforcement to growth prospects or detracting from them. In this regard global deflation and generally lower than expected interest rates have made any immediate rise in local interest rates much less likely than they were. The money and bond markets have revised their expectations of interest rate increases sharply lower in recent days and weeks. The money market appears now to expect a 50 basis point increase in short term interest rates over the next 12 months, in place of the earlier expectations that rates would rise by more than 1% by year end 2015. We would argue that even this revised expectation of higher interest rates will not be realised, and that interest rates in SA will stay on hold until domestic spending has gathered more strength than our modest growth forecasts suggest may be the case over the next 12 months. The case for lower interest rates, should inflation maintain its much slower recent pace, while spending growth rates remain positive but subdued, may well present itself for serious Reserve Bank attention by year end.

Equity markets: Keeping up with the S&P 500

The excellent performance of the S&P 500 in 2014 has been well matched by the Global Consumer Plays listed on the JSE

One of the features of the stock markets in 2014 was the outperformance of the New York-based S&P 500 against almost all other markets. This included the JSE and other emerging markets, with which the JSE kept close company as always.

As the chart below shows, the superior returns provided by the S&P 500 over the year were almost all earned after September. In October the S&P marched higher while the JSE (and the average emerging equity market), having kept up to a degree with the S&P 500 until then, fell back absolutely and relatively. By year end the S&P 500 had gained about 16% against the JSE. The JSE in 2014 delivered a negative total return (including dividends) in US dollar terms of approximately -2.5% while the S&P returned approximately 13.7%. Converted to rands, the JSE returned 10.7% and the S&P about 25.7% in 2014.

Not all sectors of the JSE lagged behind the S&P 500. The group of 10 JSE listed companies we describe as Global Consumer Plays (because their earnings and valuations are largely independent of the SA economy, including the direction of SA interest rates), have again fully matched the performance of the S&P 500 in 2014, as we show below.

Clearly this group of JSE listed companies provides South African investors with easy exposure to the global economy and diversification against the SA economy. We have shown before that the reason for the high correlation of returns from the Global Consumer Plays and the S&P is not coincidental but can be attributed to a highly comparable level of earnings when measured in a common currency. The earnings performance of the JSE-listed Global Consumer Plays is particularly impressive through the Global Financial Crisis, as may be seen in the chart below. It seems reasonable to predict that the earnings of Global Consumer Plays will continue to perform well in line with those of the S&P 500. It must be said though that with only 10 companies making up the index and also given the large weight accorded to Naspers (NPN) in the index the much less diversified and therefore more risky character of the Global Consumer Plays ,when compared to the S&P 500 needs to be recognised. The largest stock included in the S&P 500, Apple, accounts for less than 4% of this Index.

We have calculated a market cap weighted Index of these companies, the Global Consumer Play Index using their weights as in the SWIX Index calculated by the JSE, which accords index weights according to the proportion of shares issued by these companies held on the JSE register. This makes Naspers, with a weight of over 10% in the SWIX, the largest contributor to our Global Consumer Play Index with a weight of about 30%. The companies we include in the Index account for about 40% of the value of the JSE All Share Index. Other shares in this index are: Aspen, British American Tobacco, Richemont, Mediclinic, MTN, SABMiller, Steinhoff, Netcare and Intu.

We aggregate other components of the largest companies listed on the JSE as indices. These include the Commodity Price Plays, which have been distinct underperformers while the SA economy dependent industrial companies, which we combine in a further index, have performed somewhat better. Clearly the distinct outperformers on the JSE have been the Global Consumer Plays.

It seems reasonable to suggest that optimism or pessimism about the prospects for the S&P 500 should translate into similar prospects for the Global Consumer Plays on the JSE – whether valued in US dollars or in rands.

Financial markets: Risk off day

A risk off day in the markets – drawing some of the implications for inflation and growth

The markets yesterday must be regarded as having had a risk off day. Global government bond yields fell further (ie bond prices rose) while most equities, including those in the US, moved lower.

The US dollar, the safe haven currency, gained further strength against the euro, trading this morning at USD1.186. This dollar strength was also highly consistent with a further widening of the interest rate spread in favour of US Treasuries over equivalent German bunds. This morning the US 10 year Treasury has yielded 1.9487% compared to the 10 year German bund that offered a mere 0.446%. The gold price also rose, providing further proof of more risk aversion in the markets.

 

What exact form the additional risks took was perhaps not so obvious. The further decline in the oil price may well be the most likely suspect. A lower oil price clearly helps consumers and household spending and must be regarded as helpful to the growth outlook, given the important share of household spending in GDP, over 70% in the US and over 60% in SA. Yet while oil consumers stand to benefit, the rapid magnitude of the oil price decline must threaten those banks with exposure to the producers and service providers to the oil sector way beyond the US oil patch.

The full impact of such large shocks to the global economy, of the kind represented by these dramatic moves in the oil price, is hard to measure accurately with any degree of confidence. The extra risks priced into the bond and equity markets generally, understandably reflect some of this. More stable oil prices at these lower levels would help calm the markets and provide time for the full impact of a permanently lower oil price (if this is to be the case) to be better calculated and priced into bond and equity values.

A permanently lower oil price is on balance likely to be helpful for the global economy that has wanted for growth in household spending. It is likely to mean faster growth with less inflation, possibly accompanied by falling prices, that is deflation. If this happens, it will mean lower interest rates and so discount rates attached to income streams expected from oil and energy consuming businesses. They may well enjoy improved operating margins as production and distribution costs rise more slowly or, better still, decline when measured in money of the day. These trends, as they materialise, should show up in higher rather than lower values attached to most listed companies.

Yet while interest rates can be expected to decline with less inflation or even deflation expected, inflation linked interest rates offered by governments may well rise as growth picks up and demands for capital to invest by more profitable businesses also gains momentum. These real rates, highly indicative of the real cost of capital for all capital raisers, have been stable over the past year at low levels. Inflation expectations in the US, indicated by the difference between the yields on a vanilla bond exposed to inflation risk and the inflation protected equivalent (known as TIPS for Treasury Inflation Protected Securities), have declined also quite sharply in recent weeks (see below where we show the premium offered for bearing inflation risk in the US over the next ten years and the 10 year real TIPS yield).

However it is of interest to observe that yesterday, while nominal rates in the US fell away, the equivalent real yield actually rose. Perhaps this indicates that while less inflation is expected in the markets, growth expectations for the US may well have improved marginally on oil price trends.

We also graph the equivalent SA trends below. While the RSA 10 year yield, having risen sharply in January, has trended lower while the real 10 year yield has been stable, about the historically low 1.7% level. Of interest to note is that nominal RSA yields have declined sharply over the past two days, by about 30 basis points, from 7.82% on Monday to 7.51% this morning, the real rates have edged marginally higher. The markets in SA are now also pricing in less inflation expected and perhaps also stronger growth expected – in line with global trends.

 

Global interest rates and currencies: Making sense of surprises

A surprisingly strong US economy – a surprisingly weak euro. How will we be surprised in 2015?

Among the biggest surprises in 2014 was the decline in long term interest rates in Europe and the US. Another surprise for the market consensus in mid year was the strength of the US dollar and the weakness of the euro.

These two surprises were not unrelated. The decline in long term rates was led by European fears of deflation. US rates essentially followed the European lead lower, even as the US recovery gathered strength and expectations that the Fed would raise its target rate in 2015 firmed. But the decline in US rates lagged behind those in Europe and so the spread between these rates widened. We illustrate this in the charts below where we compare 10 year US Treasury and German Bund yields and show the generally widening spread between them.

Thus, despite persistent US dollar strength vs the euro and almost all other currencies from mid year, when the euro traded at close to US$1.40, the case for borrowing euros to lend dollars became ever stronger. Presumably the extra rewards for holding dollars rater than Euros added to the demand for, and the strength of, the US dollar.

The spread itself indicates that the market expects the US dollar to weaken against the euro, according to the theory of interest rate parity. Arbitrage makes the cost of forward cover equal to the difference in interest rates. If this were not the case riskless profits could be realised by simultaneously borrowing or lending in the one currency and buying or selling the currency in the market for forward exchange. The higher rates in the US are meant to compensate the lender of dollars and the borrower of euros for the expected weakness in the US dollar, thus making it a matter of indifference to a currency hedged borrower or lender in which currency a financial contract is written.

The recent strength of the US dollar, despite expected weakness, therefore represents an unambiguous surprise for the market. Yet it is difficult to predict a reversal of these exchange rate trends when the yield spread in favour of the US dollar remains as wide as it is or especially should it widen further. Unexpected strength in the US economy will help keep up US rates relatively to euro rates and the spread will encourage dollar strength, as has been the case in 2014. An unexpectedly weaker European economy will do the same: keep rates lower for longer in Europe as deflation takes hold and so add to US dollar strength and euro weakness.

The direction of the spread will tell us whether the market place has been too bullish or bearish about the US economy and too bearish or bullish about the outlook for the European economy. This key indicator will deserve the closest attention in the months ahead. If you believe the US economy will surprise on the upside, then buy dollars. If you believe Europe will surprise with better than expected growth, then sell the US dollar.