Month: June 2015

Global interest rates: The prospect of a normal world

The prospects of higher interest rates in the US and Europe, indicating more normal economies, should be welcomed, not feared

It should be recognised that while the rand has been on a weakening path against the US dollar since 2010, so has the euro since the second quarter of last year. This dollar strength, coupled with euro weakness, has left the rand, weighted by the share of its foreign trade conducted in different currencies, largely unchanged since early 2014. The euro has the largest weight (29.26%) in this trade weighted rand, while the generally strong Chinese yuan has a 20.54% weight and the US dollar a much lower weight of 13.77%.

Thus there has been minimal pressure on the SA inflation rate (CPI) from higher prices for imported goods. If anything, especially when the rand price of oil and other imported commodities is taken into account, the impact has been one of imported deflation rather than inflation. And the CPI would be behaving much like the PPI is (PPI inflation is now about 3%) were it not for higher taxes levied on the fuel price and higher prices for Eskom – which is also a tax on energy consumers being asked to cough up for Eskom’s operational failures.

The rand weakened significantly against all currencies in the aftermath of the Marikana mining disaster of August 2012. The rand, on its exchange rate crosses, has not recovered these losses. However, since early 2013, the rand US dollar exchange rate has very largely reflected global rather than specifically SA influences, that is US dollar strength rather than rand weakness. The rand / US dollar on a daily basis (since 2013) can be fully explained by two variables only – by the Aussie / US dollar exchange rate, which has also consistently weakened over the period, and lower mineral and metal prices. The further statistically significant influence has been the spread between long term US interest rates and their higher RSA equivalents – this reflects SA risk, or expected rand weakness. The interest rate spread also consistently adds rand / US dollar weakness (or strength when the interest spread narrows). The ability of this model to predict the daily value of the rand / US dollar since January 2013 is shown below. The fit is a very good one. Moreover, the model displays a high degree of reversion to the mean. That is to say, an under or overvalued rand according to the model has quickly reverted to its predicted value. For now, or until SA specific risks enter the equation, for better or worse, the model presents itself as a good trading model. At present the rand, after a recent recovery, appears about one per cent ahead of its predicted value.
 

The future strength of the US dollar against all currencies or, equivalently, the weakness of the euro, will depend on the pace of economic recovery in the US and in Europe. The pace of recovery will be revealed by the direction of short and long term interest rates. If rates in the US increase ahead of euro rates, because the US recovery becomes more robust, the dollar is likely to strengthen, and vice versa should US growth disappoint. The question then is what might these higher rates in the US and in Europe mean for emerging equity and bond markets? Clearly higher rates in the US will ordinarily mean higher long bond yields in SA and in other emerging markets. This cannot in itself be regarded as helpful for bond and also equity values in the emerging world. However faster growth in the US and Europe would translate into faster global growth, upon which emerging market economies are so dependent. This could attract capital towards emerging markets, strengthen their currencies and narrow the interest rate spread between, for example, rand-denominated bonds and US bonds of similar duration.

It is striking how emerging market equities and currencies have underperformed the US equity markets since 2011. Measured in US dollars, the benchmark MSCI Emerging Market Index and the JSE have, at best, moved sideways while the S&P 500 has stormed ahead.

The weaknesses of the global economy over the past five years have proved to be a large drag on emerging market equities. Faster global growth, accompanied by higher interest rates, can only improve the outlook for emerging market equities and perhaps their currencies. The prospect of higher interest rates in the US to accompany faster growth should be welcomed by equity owners, especially emerging market shareholders, who have had such a rough time of it in recent years. Faster global growth, led by the US, is very likely to be good news for equity investors everywhere, and especially those in emerging markets.

Greek debt – whose problem is it?

There is the old saw about when you borrow money from a bank, paying interest and repaying the loans are your problem. But when you are unable to meet the terms of the loan it becomes the banks problem. If the bank had been more risk averse or done its sums better it would not have loaned as much and you might not have gone broke.

Greek debt, it now appears, is becoming less of a problem for the Greeks and much more of a problem for the IMF and the European governments (rather the European tax payers) via the ECB, the European Investment Bank and the European Financial Stability Mechanism, who have backed the Greek governments (that is Greek taxpayers) with over €300bn of credit repayable over the next 30 and more years, with about €25bn due this year. Both the Greeks and the lenders involved must be well aware of the problem that the banks have. Almost all of the outstanding Greek debt is now owed to governments and their agencies (that is their taxpayers) after successive bail outs that avoided default and converted private into publicly owned debt.

The problem for the lenders is how much of the debt that they can realistically hope to collect, were the Greeks to declare default. In other words, how many cents on the euro could they still hope to collect in the bankruptcy proceedings that must follow? Unless the Greek government is willing to isolate Greece not only from the European Monetary System but from international trade and finance, they will still have to come to formal terms with their creditors. In such negotiations that will follow, the creditors would still have to be realistic about the demands they could make on the Greek people and their representatives in current and future governments.

The costs of having to leave the euro and the European Union (EU) are bargaining chips to encourage the Greek government to spend less on their many supplicants and grow faster through growth encouraging reforms. This would mean more competition in Greece and could enable the creditors to collect more of the funds they supplied to Greek governments so negligently in the past. Throwing more good money after what is now obviously bad, has less appeal for the creditor governments than it did – given the unwillingness of the Greek government to do or even to be seen to do what is asked of them. But the opportunity to make as much of your debt problems the problem of your bankers, as the Greeks have attempted to do, may still prove to have been a useful strategy – if Greece comes to better terms and retains its status in Europe.

Opportunity for the Greek economy with a Greek exit (Grexit) may come in the form of a weak drachma. But any gain in competitiveness through a weaker exchange rate is surely likely to be quickly eroded by higher inflation. Not facing up to economic realities (without access to foreign or domestic credit) will surely mean money creation and inflation to come. Not reforming a pension system that so encourages early retirement will remain a drag on economic growth, as will retaining so many of the policies that have bankrupted Greece. Greece, given the apparent appeal of its leftist leaders, could well become the Venezuela of Europe should it exit the EU. If this happens, it may take a long period of time and persistent economic failures for economic realities to reestablish themselves in the Greek imagination: you cannot spend as a nation much more than you produce, unless you can persuade others to lend to you. The likelihood of such persuasion succeeding any time soon, in the absence of some kind of deal with the EU, seems remote.

European bond markets can clearly withstand a Grexit from the euro. ECB support for the bonds issued by Spain, Portugal and Italy has eliminated contagion from a Greek default. The state of the markets in other euro government bonds tells us as much. Yet there is still much to lose for Europe – the banks will still be left with the problem of what to do with Greek debt even should Greece have been punished with expulsion from the EU. Formally writing off much of the Greek debt, as will have to be done should Greece default, will not be a comfortable exercise. So, given the alternatives for both creditors and debtors, a deal might yet be struck. This would be a deal that allows the creditors to postpone for now any formal recognition of how much they have lost, while allowing the Greek government to claim a much better deal than offered earlier, including access to further financial support, with a frank recognition that the debt cannot ever be fully repaid, even under the most conceivably favourable assumptions about the Greek economy.

Point of View: The rationale behind wage demands

Explaining the actions of trade unions in SA. Why it is not irrational to go on strike for higher wages even when employment declines. What are the policy implications?

The season of outrageous demands for wage increases is upon us. And, more important, it is the season of wage agreements that appear to take little account of the hundreds of thousands of workers outside the mine and factory gates who would willingly accept employment for current benefits.

Even more unsettling will be the loss of jobs, as managers replace unskilled workers with machines and more skilled and experienced workers productive enough to justify their higher costs of hire. The losers will be the newly unemployed with little opportunity for alternative employment on anything like the same conditions.

How then can one make sense of this seemingly irrational behaviour by the unions making the demands? How they can not be aware, it will be asked, since their members will continue to be retrenched in large numbers. Why then do the unions do what they do? They are surely as well aware as any that higher real wages can lead to job losses in the sectors of the economy where they exercise the power to strike?

The answer must be that they are well aware of the economic circumstances and the trade off between wage gains and job losses, which they make for their own good reasons. We would suggest that, in fact, unions are not in the business of maximising employment or employment opportunities. Rather, unions are in the business of maximising the total wages paid to their members. The objective they quite rationally and self-interestedly attempt to achieve is the highest possible wage bill, not the number of wage earners or members of the union. It is the total wage bill agreed to by employers that forms the basis for collecting dues from members. Therefore (percentage) increases in employment benefits can more than compensate for fewer workers employed. And better paid members may be more willing and able to pay their dues.

It is theoretically and practically possible for the wage bill paid by firms to rise in both nominal and real terms even as employment drops away. This is precisely what has happened in the mining and other sectors of the SA economy. While employment has declined in recent years, total compensation paid to employees of all kinds has continued to increase, and so presumably have the dues paid to their unions (collected conveniently by the employers themselves).

To put these outcomes in terms familiar to the financial sector, the asset base of the unions and staff associations from which they collect their fee income, the wage bill, has continued to rise as the unemployment rate continues to remain damagingly high to the economy, but not necessarily to the unions. There is nothing ignorant or irrational in all this, just predictable self-interest at work. Such an explanation fits the facts of the economy and its labour market well.

The statistics help make the point. The SA economy may well have become less labour intensive – fewer worker hours employed per unit of GDP – but the share of total remuneration in GDP or total value added has changed very little. The wage bill (not numbers employed) has risen more or less in line with output as we show below. The share of owners and funders and rentiers in SA output peaked in 2008 (before the global financial crisis) and has been in decline since, as the share of employees, has been rising. That is despite or maybe because of slow growth that reduces the rewards for savings and the demands for labour – but not necessarily the rewards of those, the majority who hold on to their jobs.

A similar picture emerges for the mining sector. In the figures below we compare mining output in money of the day (R millions) with total compensation paid by the industry to its employees. The share of mining output accrued by employees has been rising in recent years. In other words, the unions appear to be successful if their objective is (as we infer) to increase the wage bill paid by the industry rather than the numbers employed.

While mining employment was at 2008 levels in 2013, average employment benefits per worker employed have risen consistently, at an over 11% average annual rate in money of the day terms , and equivalent to an average increase of 4.5% in real terms, using the GDP deflator to convert nominal into real growth of employment benefits or rather costs to owners. The average employee in the mining sector came with an average cost to employers of over R220 000 per employee in 2013. Not bad work if (big if) you can get it.

The data on compensation of employees supplied by Stats SA only goes back to 2005. It is however possible to view mining output and employment over a much longer period. In the figure below we graph mining output in volumes (tonnes of coal and iron ore, kilograms of gold and platinum produced) and numbers employed in mining going back to 1990. The mining work force declined dramatically in the 1990s from nearly 800 000 employees to about 400 000 by 2002, where after the number rose to over 500 000 in 2008. Volumes of mining output, having declined in the 1990s as metal prices came under pressure, increased significantly in the mid-naughties, only to fall away again after 2008. The producers of iron ore and coal produced significantly more during the commodity price super cycle that accompanied the Chinese thirst for raw materials. The big losses of output were suffered by the gold mines, as they ran out of profitable grade to extract.

But a focus on mining volumes rather than mining revenues (volumes times price) misses the driving forces in the industry. The SA mining industry had the advantage of rising prices, especially after 2000 and became significantly more profitable, profitable enough to hire more labour as well as offer significantly higher rewards to their employees between 2000 and 2008, after the savage job losses incurred in the 1990s.

A better sense of the environment for SA mines, for their owners, managers and workers can be gained from the figure below. Here we reduce mining revenues to their real equivalents by deflating current revenues by prices in general, represented by the GDP deflator, rather than by the index of the prices of the metals and minerals themselves, which rose much faster than prices in general to the advantage of the mines. Real mining revenues measured this way show a strong growth pattern until 2008 and explain the employment and wage trends much better than mining volumes that have remained almost constant over many years.

Notwithstanding a better appreciation of the SA mining environment it can still be asked about employment of workers in SA that is so desperately needed. A better understanding of the self-interested behaviour of the unions (in the quantum of dues collected) and the shareholders in mines attempting to improve returns on their capital, which have led to fewer better paid and skilled workers, should lead us to expect more of the same in the years to come. This would be a trade off of better jobs in the industry for fewer employment opportunities and more capital (robots) per unit of output.

What then can be usefully done to encourage employment in SA, especially of unskilled workers, of whom there is an abundance? The first step would be not to look to the established unions or firms as sources of employment gains. The right way to look for employment gains is to find ways to inject competition in the labour market. Competition for customers and workers and competition for work will help convert the pursuit of self-interest to better serve the broad interests of society; that is in more employment.

More competition for the established interests in the mining and every other sector of the SA (unions and firms) from labour intensive firms needs to be encouraged in every way possible. This means in practice rules and regulations that allow willing hirers and suppliers of labour to more easily agree to terms (they may well be low wage terms) without artificial barriers. These barriers to more competition in the labour market come particularly in the form of closed shop agreements that apply to all firms and workers wherever located or regulated. Less regulation and more competition is the solution to the employment problem. Higher employment benefits for the fortunate few with artificially enhanced bargaining powers will not reduce the unemployment rate any more than it has to date.

Presumably these risks of default decline as growth prospects improve. And improved growth prospects (lower risk) are well associated with higher share prices. In the figure below we show the relationship between the value of the MSCI Emerging Market Index benchmark and the JSE ALSI and the CDS risk spread over recent years. We show how the CDS spread for RSA five year US dollar-denominated debt and the JSE in US dollars have moved in consistently opposite directions.

These relationships would suggest that the threat to the JSE and the rand will not be higher rates in the US and Europe, provided they are accompanied by improved global growth prospects. The threat however to the rand, the RSA bond market and the SA economy plays might still come from SA specific factors. These include strikes, load shedding and higher short rates imposed by the Reserve Bank that prevent the SA economy from participating in a faster growing global economy. The objective of the SA economic policy makers is to avoid such pitfalls.

The SA economy in May 2015: Slow but steady forward momentum, for now

The course of the SA economy at the end of May 2015 appears largely unchanged since February. This is judged by the pace of new vehicle sales and demands for cash (adjusted for inflation) in May.

These two hard numbers, which are not dependent on surveys based on selected samples – released very soon after the economic events themselves – serve to make up our Hard Number Indicator (HNI) of the immediate state of the SA economy.

The HNI may be compared to the Reserve Bank’s Coinciding business cycle indicator, updated only to February 2015. Current readings well above 100 (2010=100) indicate that the economy has moved ahead at a more or less constant modest forward speed, and is forecast to continue to maintain this pace over the next 12 months. This impression is supported by comparison with the very similar readings taken a month before. The recent inflexion of the HNI is also supported by the Reserve Bank Indicator that has continued to point higher, at least until February 2015 the latest observation.

Unit vehicle sales, after a strong start to the year, however fell back in May 2015, especially when viewed on a seasonally adjusted basis. The trend in new vehicle sales on the local market is now pointing lower towards a pace of 45 000 units per month or an annual market of about 540 000 units in 12 months’ time.

The consolation for the automobile manufacturers and their suppliers in South Africa, the largest component of domestic manufacturing activity, facing a likely decline in sales volumes, is that exports in May rose very strongly to 33 411 units, enough to maintain very high volumes of overall activity in this important sector of the economy. Hopefully the unions will also recognise the long term benefits to them of sustained production and the export contracts that will flow from the SA plants being regarded as reliable partners in global manufacture.

A lower underlying trend in the headline inflation rate has helped support the growth in the demand for and supply of cash. But this favourable trend appears likely to be reversed in the months ahead, according to our time series based forecast. The prediction of higher inflation to come in the months ahead would be well supported by other forecasts, including those made with the Reserve Bank forecasting model. This model predicts that headline inflation, off its low base of early 2015, will breach the 6% upper band of its inflation targets in early 2016 but fall back within it later in the year.

There might be some relief that the SA economy has not slowed down faster in 2015 and has been able to sustain a modest rate of growth, equivalent to GDP growth of about 2% a year. The biggest threat to sustaining a mere 2% a year growth in output would be higher inflation itself- particularly the sort of inflation that has been inflicting the SA economy in the form of higher taxes and higher electricity prices (taxes by another name), as well as poorer harvests that push maize and food prices in SA higher. Higher prices forced by the supply side of the economy, extract from the purchasing power of households and depress the real incomes of households and the volume of spending they wish to undertake, which constitutes such a large component of total spending (over 60% of the total of spending). Without a recovery in household spending growth the economy will not grow faster than it is now doing. Businesses will only wish to add significantly more to their capacity in response to stronger demands from their ultimate customers, the household spender.

A weaker rand imposes the same risk of higher prices to come and would act as a further drain on household spending power and propensities. In the 12 months to date the rand has held its trade weighted value rather well (despite the stronger dollar) and could not be regarded as contributing to higher inflation to come. Without higher excise tax rates, on what is now a lower rand price for oil compared to a year ago, the inflation rate would have been significantly lower and so would have eliminated, at least for now, any argument for higher interest rates, given the state of demand.

The further and imminent danger to the growth prospects of the economy is the pronounced intention of the Reserve Bank to raise interest rates, apparently regardless of the state of the economy or the unpredictability of the impact of higher short rates on the exchange value of the rand and inflation. The hope for the SA economy and for a firmer rand must be an improved outlook for the global economy and especially emerging market economies that encourage flows of funds to emerging market equities and bonds that will support emerging market currencies. A stronger, not weaker, rand might then accompany a gradual normalization of global growth and global interest rates.

Until then emerging market central banks, including the SA Reserve Bank, would be wise to do nothing to harm their own growth prospects with tighter monetary policies in response to a gradual normalisation of interest rates in the developed world. The tool to help their economies adjust to possible volatility in global capital markets should be exchange rate flexibility, not higher interest rates.

Will the Reserve Bank prove data or path dependent?

The members of the Federal Open Markets Committee (FOMC), while contemplating an increase in their key Fed Funds rate from an abnormal zero per cent to a slightly less abnormal 0.25%, are at pains to emphasise that such decisions remain “data dependent”.

Most recently chair Janet Yellen indicated that if the data on the US economy confirm their forecasts of an economic recovery well under way, then interest rates in the US will rise this year – this after spending all the while since 2009 at about zero. One would hope that their counterparts on the Monetary Policy Committee (MPC) of the SA Reserve Bank remain equally data dependent.

The danger is that the MPC has become path dependent – it has signaled its firm intention to raise rates this year regardless of the state of the SA economy, the state of which (if anything) has deteriorated in recent months as household spending on goods and services has slowed down. The MPC might believe that not raising rates (independent of data) would be interpreted as being soft on inflation – a most unfortunate state of path dependence if that becomes the case. Travelling down this path to still higher short term rates would be a grave error of judgment, even if the market place regards such interest rate developments as inevitable. The MPC needs to step off this path it has mapped out for itself.

It has to be pointed out that any further increases in its repo rate have been postponed ever since June 2014, presumably because of the weak economic data. The SA inflation to date has had nothing to do with excess demand that would usually call for restraint in the form of higher borrowing costs. Spending by firms, households and recently by the government itself (practising a degree of austerity) have grown even more slowly than even energy-repressed supply. Higher observed prices have almost everything to do with higher taxes on expenditure – on petrol and diesel and on electricity charged by Eskom and municipalities – with the prospect of further increases to come. Absent of these tax events the inflation rate would have been about the three per cent rate it reached in February 2015 – between August 2014 and February 2015 the CPI itself hardly rose at all – indicating a very subdued underlying trend in inflation before higher taxes kicked in. The firm rand in a world of deflation was a very helpful contributor to these trends. Despite the strong US dollar and because of the weak euro, with the largest weight in our foreign trade, the trade weighted rand is little changed from its exchange value 12 months ago. See below, where strength is indicated by higher numbers:

These more favourable exchange rate and demand side influences on prices in general have been well reflected Producer Price Inflation, prices charged at the factory and mine gates, that was 3% in April 2015. The mines and factories are not exercising much pricing power- the markets they serve are not proving very accommodating to higher prices they are being charged for their inputs- for tax and trade union reasons. The notion that real interest rates in SA- measured conventionally and unhelpfully as the difference between overdraft rates and CPI inflation is not a burden on producers – is belied by the fact that producers are not achieving anything like average consumer price increases in the prices they are able to charge their customers. Costs may rise, including the costs of hiring labour, but profit margins may well have to give way to economic realities, as will employment opportunities- even as may be observed – in the public sector.

The Reserve Bank would have to argue that inflation in SA would have been higher and would be higher if it did not raise its rates. Their argument is that expected inflation drives prices and inflation. The evidence for such a feedback loop from inflation expected to inflation is very unconvincing. Indeed the rate of inflation expected by the bond market has remained remarkably stable around the 6% p.a rate, the upper end of the inflation target range, indicating very little change in observed inflation could have come from that constant quarter. If anything actual inflation leads inflation expected. Inflation comes down and less is expected – inflation goes up and more inflation is priced into long term interest rates- not the other way round. See below where we show inflation compensation- the difference yields on 10 year RSA’s and their inflation linked equivalentsyields over the past 12 months. Inflation compensation moved lower with less inflation and has since moved higher as it became apparent that he receiver of revenue would tax much of the gains from lower oil prices.

The Reserve Bank must argue that without its actions and narrative, inflation expected would now be higher and inflation even higher. It is impossible to refute such a counterfactual. To know what would have happened had interest rates not been raised last year and had the Reserve Bank not suggested that further rate increases were to be expected, remains an unknown. But we would argue that there is something very wrong with a narrative that suggests interest rates must rise regardless of the state of the economy, especially if it cannot be known with any degree of confidence, that higher interest rates can reliably influence the rate of inflation itself.

The link between higher interest rates and the exchange value of the rand and therefore on inflation to come, is particularly difficult to establish, given all the other influences on the rand. Especially the impact on emerging market currencies generally of a highly variable and unpredictable global taste for risk and so the flows into emerging market equities and bonds and their currencies. However it can be predicted, with a much higher degree of confidence, that higher rates will depress domestic demand and GDP growth rates. As the rating agencies constantly remind us, the biggest risk to SA and its credit rating is slow growth. Sacrificing growth for whatever reason is a risky strategy, especially if its impact on inflation is unpredictable. In fact stronger growth can lead to less inflation if growth attracts foreign capital and supports the rand. And vice versa when the prospect of slower growth drives capital away from SA and weakens the rand

The major uncertainty facing the markets in the near future will be the reaction to the Fed rate increase. The impact of this widely expected move on emerging market currencies will be very hard to predict with accuracy. In the past, rising US rates that accompanied faster US growth rates have usually had a favourable impact on emerging markets. This is because US growth implies faster global growth, from which emerging market economies and their financial markets and currencies stand to benefit. It makes little sense for the Reserve Bank to talk up local interest rates for fear that higher rates in the US will weaken the rand and cause inflation in SA to increase. Higher interest rates will do nothing to counter such a shock, should it occur.

The right policy response to any currency shock is to ignore it and allow exchange rate flexibility to help the economy recover from such a shock. Higher inflation that follows a supply side shock of the exchange rate or tax kind itself depresses domestic spending. Interest rate increases in such circumstances are not called for – despite higher inflation. This should be the Reserve Bank narrative, not its vain pursuit of inflation targets, regardless of the causes or consequences of inflation. Policy actions above all should be data dependent and not predetermined.