Month: January 2016

How fares the SA economy? An update to December

With new vehicle sales and the Reserve Bank note issue for December to hand, we can update our Hard Number Indicator (HNI) of the state of the economy at year end. The economy maintained its sedate pace in December. The forecast is for more of the same in the year ahead, that is for slow but not negative growth in 2016. Our HNI serves as a useful leading indicator of the Reserve Bank Business Cycle Indicator updated only to September 2015.

The HNI and the Reserve Bank coinciding business cycle indicator measure the level of economic activity. When these are converted into rates of change, we show below that the growth rate in the HNI has been declining since 2010 and is currently barely positive and is forecast to remain barely so. It is of some consolation to notice that the weak growth outlook has not deteriorated and is forecast no to do so. The consistent way in which growth in the HNI leads the Reserve Bank cycle helps to confirm its usefulness. It has the advantage of being very up to date and based on hard numbers not sample surveys.

Sales of new vehicles of all sizes in the SA market (that make up half of the HNI) are shown below. While sales are 4% down on a year before, sales volumes, which have averaged over 50 000 units a month, must be regarded as very satisfactory, given the state of the overall economy, especially for the SA manufacturers who also delivered 337 748 units to foreign markets in 2015, 20.5% up on a year before.

The other half of the HNI is made up of the growth in the real supply of and demand for cash. These demands for cash have been growing at a real 4% p.a as we show below. However the cash cycle appears to have peaked earlier in 2015, helped by lower inflation. The demands for cash, to spend on holidays and presents, rise strongly in November and December, though growth slowed this December off a very high base established in December 2014. The growth in demands for cash in SA, despite the heavy and growing use of electronic alternatives to cash, speak eloquently of the important role the informal economy plays in SA – a role however that is not reflected in official estimates of the size of the informal sector, as about 5% only of GDP.

The outlook for domestic spending has deteriorated, with the collapse in the exchange value of the rand. Higher rand prices for goods with high import or import replacement content or export potential will further discourage spending by households. That the oil price in dollars has declined by even more than the dollar value of a rand has been a welcome source of relief for households and firms. The inflation outlook has therefore not deteriorated as much as it would ordinarily have done with a rand this heavily damaged.

Hopefully this lesser inflation outlook will help restrain the Reserve Bank from raising interest rates as much as they would otherwise have done. Higher interest rates will do little to help the rand; they have not helped the rand to date that has been driven by global and SA forces well beyond the influence of monetary policy and interest rates. However higher interest rates will be sure to add to the contractionary forces slowing the economy- and undermine further the case for investing in SA. Is it too much to hope for a sanguine Reserve Bank- one that will allow the exchange rate to absorb the economic shocks- and not to add to them? And to happily surprise the market accordingly.

From Shanghai to Johannesburg – More than the weak rand at work

The JSE has, over the years, become less a play on the SA economy and much more a play on the global economy. This degree of independence for investors from the ups and downs of the SA economy and the value of the rand is provided by an important group of companies listed on the JSE that we describe as global consumer plays (GCPs). They comprise principally Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI), Naspers (NPN), which has become largely a Chinese internet company through its 35% holding in Tencent, listed in Hong Kong, and MTN, which generates much of its revenues and incurs costs outside of South Africa. To these we added Steinhoff (SNR), Aspen (APN), Mediclinic( MDC), Netcare (NTC) and Intu (ITU), a London based property company.

We combine these companies into an Index, using their Swix weights (the proportion of their shares on the SA register) as the basis of their inclusion in our GCP Index. This gives NPN by far the largest weight in our Index. Foreign owners of NPN hold their shares in NPN on the JSE register because NPN shares are not listed on other exchanges. This is not the case when the shares are also primarily listed on other exchanges, as is the case with BTI, CFR and SAB, where only a small proportion of SA owners would be registered as such by the JSE.

Such independence is helpful to shareholders when the rand weakens. It is even more helpful when the rand weakens for particularly South African reasons, as it did in December 2015. In these circumstances the dollar value of these shares is likely to be little affected by events in SA and so their dollar values translate into rands at a higher USD/ZAR rate. When the rand weakens in line with all emerging market currencies, because of increased global risk aversion, the dollar value of these shares may well come under pressure, giving them less of a rand hedge quality. In such circumstances the rand can weaken by less than the decline in the dollar value of such shares, meaning that their rand value can go down even as the rand weakens. Nonetheless their rand values are likely to hold up better than the purer SA economy plays. Thus it is better to describe these shares as South African economy hedges than as rand hedges.

In the figure below, we compare the performance of the GCP Index with that of the S&P 500, also measured in rands. The comparison was highly favourable to the GCPs until this year. It has become very unfavourable in January 2016 as the chart shows. The S&P 500, in devalued rands, continues to move ahead while the GCP Index has gone backwards.

The main reason for this recent underperformance has been the NPN share price. As we show below, NPN outperformed the S&P 500 over a long period, but this has not been the case since mid-2015. The Shanghai market weakness would appear to have extended to Tencent and so to NPN. The links between Shanghai and other global equity markets has become much stronger recently and NPN is clearly affected by this.

Some of the other important components of our GCP Index have done significantly worse than NPN, as we show below where we compare total returns over the past 12 months to 15 January 2016. The distinct underperformers are APN and MTN and the distinct outperformer SAB. Clearly as with any company, firm specific risks as well as market risks including risks to the rand can greatly affect performance – as they have done with APN and MTN in 2015.

In the figure below we compare the performance of other sectors of the JSE with that of the GCP Index. Both the group of Top 40 SA Industrials and the SA interest rate plays have also had a very poor January. The commodity price plays (excluding the gold mines) continue to underperform both absolutely and relatively. The weak rand and the higher interest rates that are expected to follow a weaker rand are unhelpful market forces for SA economy plays.

The one consolation in all this JSE weakness across the board is that the oil price has fallen by more than the rand (see below). Thus the inflationary pressures that usually follow a weaker rand and usually higher fuel and transport costs, are not present. This means less inflation to come. Interest rates in SA may not rise as much as they are expected to rise. If this turns out to be the case, the depressed SA plays may well offer value over the next 12 months.

Monetary policy and the MPC: Recognising the facts

The members of the Monetary Policy Committee (MPC) of the Reserve Bank will be even more perturbed about the behaviour of the rand than the rest of us. However they have had (and will have) as little influence over its direction as you or me. The link between short term interest rates that they control and the USD/ZAR exchange rate is shown in the chart below. As may be seen, they began a rate hiking cycle in January 2014 and since then, the higher the rates, the weaker the rand has been. It is very hard to argue that the rand would have been any weaker than it now is had interest rates remained on hold over this period.

There is no good reason to believe that this relationship between interest rates and the rand will be any more predictable in the year ahead than it has been. What is predictable is the impact of interest rates on spending and so GDP growth. Higher interest rates have served to slow the economy down over the past 24 months. Still higher rates will mean even slower growth – without necessarily supporting the rand – and perhaps might even encourage further rand weakness. The slower the growth, the less reason foreign and domestic owners or managers of capital have to invest in South Africa. Growth expected leads the capital flows that determine the value of the rand.

The sooner the members of the MPC fully recognise these facts of SA economic life, the less likely they are to damage the growth prospects of the economy. The exchange value of the rand and so the inflation rate and the expectation of inflation (that take their cue from the exchange rate, for good reasons also incorporated into the Reserve Bank forecasts of inflation) is beyond their influence. Raising interest rates at a time like this because it may support the rand makes no sense at all. The rand may or may not strengthen – for altogether other reasons – especially sentiment about the investment case for emerging markets generally.

More global risk tolerance will mean a stronger rand and vice versa as usual. But the rand has not behaved as usual since President Jacob Zuma intervened so dramatically in SA’s fiscal affairs last month. Without such intervention, the rand, given global risk appetites, would have been much closer to 14 to the US dollar than 17. Zuma’s actions caused financial markets to raise significantly the doubts it has about SA’s ability and willingness to fund its government expenditure without printing money – and so causing inflation.

Hence not only did the rand weaken dramatically, but the expected value of the rand weakened even further. The spread between RSA and US Treasury bond yields, that indicate the compensation for expected rand weakness in the bond market, widened with rand weakness. A weaker rand has resulted in an even weaker rand to come- expected to lose value vs the US dollar at an over 7% p.a rate on average over the next 10 years.

Furthermore the risks of default on SA’s dollar denominated debt widened significantly – enough to take SA dollar bond yields into junk territory. SA dollar-denominated interest rates have risen ahead of equivalent junk-rated Russian debt but are still below those on even more vulnerable Brazilian foreign currency denominated debt.

The newly appointed Minister of Finance, Pravin Gordhan, has committed himself and the country to fiscal sustainability. The market place should believe him, in my judgment. But the market as yet is not giving him the benefit of their doubts. They are going to take a great deal of convincing that SA can live within its means by sticking to the strict limits on government spending that it has set for itself. The role the Reserve Bank can play in this is a limited one. Monetary policy settings will not make much of a difference to perceptions of fiscal policy. They can make a difference to the state of the economy with their interest rate settings. Slower growth makes the task of funding the fiscal deficits even more difficult. They will not be doing Gordhan or you and me any favours hiking interest rates.

SA markets: The Zuma shock wave has not passed through

The Zuma shock wave of Wednesday 9 December 2015, when Nhlanhla Nene was replaced by the little-known David van Rooyen, only to be replaced that weekend by Pravin Gordhan, has had time to be absorbed by the markets.

As we show below, some recovery from the events of that day have been registered on the share, bond and currency markets. As may be seen below, the JSE All Share Index has recovered best: at one point in late December it was almost back to its month end November levels. The RSA bond market, represented by the All Bond Index, with a duration of about six years, was the most deeply affected at the time, but then recovered and is now trading at about 94% of its 1 December value. The trade weighted rand is worth about 8% less than it was on 1 December.

That the Zuma intervention in our fiscal affairs is not regarded by the market as a temporary aberration but more as a permanent danger, is fully reflected in the extra costs of insuring against a RSA default of its obligations on its foreign currency denominated debt. The five year Credit Default Swap (CDS) spreads on RSA debt widened sharply on 9 December and have remained at a highly elevated level of over 350bps. This spread has also increased sharply when compared to the spread on the Emerging Market Bond Index (EMBI – indicated by a narrower difference between the EMBI and RSA spreads) and also when compared to Russian spreads. SA is now regarded as more likely to default than Russia and Brazil. Our credit rating in the market place is thus of junk status. It appears to be only a matter of time before the credit rating agencies catch up with the market place.

Unless the SA government can convince the market place very soon that SA’s fiscal intentions have not changed permanently for the worse, the Zuma shock will prove very expensive for SA’s taxpayers who have to service significantly more expensive debts to come as current debts are matured. Nkandla is very small change compared to this potential bill. The market place will need assurance that SA’s tax base can withstand the higher interest expenses incurred. Evidence that the growth in government expenditure, especially the growth in spending on government sector employment benefits, is slowing down sharply, would be helpful to this end. More important still is any indication and that the growth outlook for SA is improving to help generate more tax revenue to ease the pain of higher taxes rates. The chances of more fiscal discipline seem better than a meaningful pick up in GDP growth. Though the dramatically more competitive rand could and should be helpful to this end, strikes and unhelpful policy interventions permitting. The Barmy Cricket Army are an advance tourist guard doing their best to improve export earnings.

The spread between the RSA 10 year bond yield and the yield on a 10 year US Treasury also widened sharply, to over 8% on the fateful day and has since narrowed to about 7.2% as may be seen in figure 5. This spread indicates that the rand is expected to depreciate by about 7.2% a year, on average, over the next 10 years.

The reactions in the market place to date indicate that the rand continues to respond to the usual daily forces, but off a significantly weaker base. The weaker emerging equity and bond markets are, the weaker the USD/ZAR exchange rate will be and vice versa. Commodity price trends will also be an influence on exchange rates. But these forces are acting off a weaker base, as we show below. The rand is now much weaker than would have been predicted before December 2015 using the Aussie / US dollar exchange rate and the EMBI spread as predictors. A value closer to R13 than R16 might have seemed more reasonable before 9 December. The question then arises: can we confidently expect the base value of the USD/ZAR to improve any time soon?

The answer appears to be an unfortunately negative one, absent an equally dramatic development on the political and economic policy fronts. It does not take much to imagine what that would have to be. The government however will be under few illusions that SA’s dependence on foreign capital remains as heavy as ever. Given the currently low base and highly depressed expectations of SA, the benefits of surprising the markets with good news could have an unusual upside. Good, credible news about fiscal sustainability and more market respecting (business friendly) dispositions- maybe even some privatisation of publicly owned assets to reduce public debt and improve economic efficiency, could much improve the mood. Call them public private partnerships if you have to. But actions and better intentions towards market forces, both inside and outside the country, are urgently called for.