January 2017 – ZA Economist

The recent SA business cycle trends may have become friendlier

The SA economy appears to have gone through something of a cyclical trough, judged by the latest statistics for December 2016 (note issue, vehicle sales and CPI) and for retail sales for November 2016. Encouragingly, Reserve Bank notes in circulation at December month-end increased on a seasonally adjusted basis, enough to raise the annual year on year growth to 11.3%. If these trends continue, the note cycle, having pointed lower since Q3 2015, may well turn higher in Q2 2017.

As we show below, the note issue has proved a reliable indicator of retail sales, though the sales cycle may well lead rather than follow the money cycle. This is because the Reserve Bank accommodates the demand for cash that the economy exercises – via the banking system. It has no target for the supply of either cash (so called high powered money) or broader measures of money. Thus, the more households intend to spend and borrow from banks and the more cash that they will wish to hold, the more cash will be automatically supplied to them as the banks borrow the extra cash from the Reserve Bank.

The information supplied by the Reserve Bank on the note issue (available within a week of the month end) however precedes that of the retail values and volumes, so making it a useful leading indicator of retail activity. Retail volumes picked up in November and it is likely (judged by the demand for cash in December) that the better retail trend was sustained by the year end. The retailers themselves, through their trading updates, appear to support this contention of a marginally improved trend in sales under way.

When adjusted for consumer prices, the real money base cycle also appears to support the view that a cyclical trough in the money supply has been reached, or is about to be reached in the near future. If the past cyclical regularities can be relied upon, then the latest trends in the demand for and supply of cash indicate that real retail sales volumes may well increase from a very subdued pace of about 1% p.a. to a still subdued, but faster pace of about a real 2% p.a. by mid-2017. No reason to break out the Cap Classique nor for a stiff brandy and Coke.

As we reported earlier, the new vehicle cycle looks a lot happier if December 2016 unit sales (down over 15% on a year on year basis) are seasonally adjusted. On a seasonally adjusted basis, sales volumes, having declined sharply by mid-year, picked up by year end. Extrapolating these recent trends suggests that vehicle unit sales in SA could be growing (slowly) again by mid-year.

We combine the vehicle sales cycle with the cash cycle to establish our Hard Number Index (HNI) of the immediate state of the SA economy. Given the better news about both the cash and vehicle cycle, the HNI has picked up, reversing to some extent the declines in economic activity registered earlier, as may be seen in the figure below.

We also compare the HNI to the Reserve Bank coinciding business cycle indicator, updated only to September 2016. The HNI and the Reserve Bank may be regarded as well related over the long run. Therefore the HNI, which can be updated very soon after any month end, should be regarded as a good leading indicator of the SA business cycle; and one that appears to be turning up marginally rather than down. The HNI indicates that economic activity in SA in 2017 will show slow but positive growth, perhaps slightly improved on recent slow growth rates.

The HNI also appears to be doing a much better job of predicting the state of the SA economy than the Reserve Bank’s own leading indicator (updated to October 2016). This indicator has continued to turn down, until very recently, even as the economy made some progress. The role the JSE plays in accurately predicting the business cycle (included as a leading indicator by the Reserve Bank) may have changed as the JSE itself has become much less exposed to the SA economy and much more directly affected by global rather than SA economic forces.

The direction of commodity prices will remain important for the state of the SA economy. As may be seen below, the commodity price cycle, as reported by the Commodity Research Bureau in Chicago has recovered, when measured in US dollars, but has largely moved sideways when converted into rand, thanks to rand weakness and then a degree of rand strength enjoyed in 2016. As may also be seen, industrial metals have had a stronger recent run than commodities in general that include a large weighting (over 20%) in oil.

Higher commodity prices – the result of faster global growth – would translate into a stronger rand and inflows into emerging market equity and bond markets, as they have done in 2016. Less inflation and lower interest rates also become more likely with a stronger rand, a force clearly helpful for the SA economy plays, such as the banks and retailers listed on the JSE. Without lower interest rates, leading to a strong recovery in money supply and bank credit, a meaningful cyclical recovery – with GDP growth rates trending higher to above 4% p.a. – will not be possible.

It needs to be appreciated however that the JSE, when seen from offshore, has provided excellent recent US dollar returns since early 2016 – as have emerging equity markets generally.

The stronger rand has yet to lift the SA economy and the SA economy plays listed on the JSE. It will take a changed view on the interest outlook and stable commodity prices to lift the JSE meaningfully. For now however, the market still believes short rates are more likely to increase than decline. Further rand stability and lower food prices will reverse such expectations and in turn the direction the interest rate cycle itself. 24 January 2017

Brand Trump and the US Presidency

Being President can be very good (and honest) business

Donald Trump likes to remind us what a great businessman he is (or rather was). He may be right and perhaps his best business decision was to run for US President. It has greatly enhanced the value of his brand. As they like to say in Hollywood, there is no such thing as bad publicity.

Moreover he did not apparently have to spend much of his own wealth on his triumphant publicity campaign. A generally hostile media provided him with all the exposure he needed and did not have to pay much for. They thought, as did Hillary Clinton, that exposing his exceptionalism would be enough to put off potential voters. As we now know, they were wrong. The daily Trump tweets became the news events of the campaign (and, alas, continue to make the news) and were to his advantage at the polling booths. A tweeting President Trump, like much else of what he will now do and say, breaks the mold and we may well just have to get accustomed to his style (or lack of it).

What he does in office, with the help of his cabinet colleagues and many appointments, will matter more than his Tweets or intentions. The promise of a very different and more encouraging approach than that provided by the Obama administration to doing business in the US has resonated strongly with business – especially small business whose confidence levels are at record highs. Confidence in future income prospects is the most important ingredient in the recipe for more spending by households and firms that will raise US growth rates if it materialises.

Separation of US powers, between the House, the Senate, the states and the courts, is designed to complicate and constrain the realisation of any Presidential agenda or campaign promise. Tax reforms, of which much is expected, are initiated in Congress where much work has been done over the years by the Republican leaders in the House. We, as well as Trump, await with some anxiety the essential details. The implementation of a border tax, or rather a system where costs of imports may be disallowed as a deduction from taxable income, will deserve particular notice. The implications are vast – and not just in the US – and may well threaten the system of corporate taxing practiced everywhere else.

Taxing imports

This border or import tax will be intended to compensate the IRS for a lower corporate tax rate – given the excess of US imports over exports. The lower the corporate tax rate however, the less will any expenditure deduction matter for after-tax incomes. This includes the deduction for interest incurred or capital expenditure, both of which will be subject to debate and possible reform. It will be deemed protectionist by the World Trade Organisation and the US will argue otherwise but irrespectively. Net-net it may mean higher prices in the US but only if net-net taxes have risen for business enterprises in general. That will not be the intention though different businesses will be affected differently in ways that will be worth anticipating. It is effective after tax profits that influence the required returns on capital that have to be recovered in the prices that consumers or customers must pay if the firm is to succeed. Even income taxes find their way into prices.

Managing conflict

President Trump is not bound by the conflict of interest regulations that apply to all others responsible for government business. Trump however has elected to recuse himself fully from the Trump enterprise while President. His sons will run the business and manage the Trump brand. The cry from the anti-Trump brigade is that such arrangements, even should Trump stay fully uninvolved in the decisions made by Trump Enterprises, still represent a conflict of interest. In other words, the Trumps should abandon the Trump business and eliminate the brand, including presumably removing the Trump insignia that currently adorns buildings and merchandise – not a practical possibility. Selling the brand would not have eliminated the connection with the Presidency.

The Trump brand therefore lives on and understandably so given its value, calculated as the present value of the difference a Trump branding can make to rentals or prices that a Trump enterprise or franchisee can realise and pay royalties on. But this does not mean any conflict of interest. The better Trump does in discharging his responsibilities as President, the better his contributions will be appreciated by the public at large and the more valuable his brand will become. The economic interests in his brand and that of the US are well aligned, just as they were well aligned with the Obama brand. The lecture and consulting fees he will now be able to charge depend on the regard in which he is held.

Naspers (NPN) – a great story with an opportunity to add additional value for its shareholders

A brilliant success story

When the financial history of South Africa in the first two decades of the 21^st century comes to be written, the role played by Naspers (NPN) will surely be a prominent one. Its achievements reflect many of the important themes of our financial times- not only that of outstanding returns to share-holders that made NPN by far the most important contributor to the JSE – with a weight in the JSE market Indexes of about 17% and a market value that rose from R7b in 2003 to nearly R85b by the end of 2016. But as important and interesting is that the value added for shareholders came from participating in the new digital economy and by taking excellent advantage of South Africa’s newly acquired democratic credentials and consequent access to global markets in goods services and capital.

Fig.1; Naspers (NPN) Market Value and share of the JSE Swix Index

Source; Bloomberg, Investec Wealth and Investment

The most important decision made by NPN management was the decision taken in 2001 to purchase 46.5% of Tencent (a Chinese internet business listed in HongKong for USD34m.[1] This stake has since been reduced to a 34.33 per cent holding. As we show below the rand value of Tencent itself, when converted to ZAR at the current rates of exchange, is now over R3000b and the theoretical or potential worth of the NPN stake in Tencent to over R1000b.

Fig 2. Market Value R millions of Hong Kong listed Tencent and the theoretical value 34.33% NPN stake in it. 2007-2016. Month end data

Source; Bloomberg, Investec Wealth and Investment

The theoretical not actual value of the stake in Tencent

The theoretical nature of this estimate deserves emphasis. Firstly because its holding in Tencent is worth more than the value of NPN itself as we show in figure 3- some 22% or R216b less than its holding in Tencent. This implies that all the other assets of NPN in which it has made very large investments have a large negative value for shareholders of as much as R216b.

Fig 3; The market value of NPN and its stake in Tencent (Rm) (Month end data 2014-2016)

Source; Bloomberg, Investec Wealth and Investment

The link nevertheless between the share value of NPN and Tencent Holdings is very close – notwithstanding the fact that NPN now seems to be worth significantly less than its holding in Tencent. The correlation of the daily level of two share prices measured in ZAR is 0.99 indicating that almost all of the price level of NPN in ZAR can be attributed to its holding in Tencent and the current value of a Tencent share.

NPN is much more than a holding company for Tencent shares- but what is its other business worth?

NPN, as a business enterprise, however is much more than a holding company for its investment in Tencent, as its cash flow statement for the latest financial year to March 2016, demonstrates very fully. NPN reports dividend income in 2016 (mostly from Tencent) of USD146m compared to net cash utilised in investment activity by NPN in FY 2016 of USD1,384m. This investment activity in 2016 was facilitated by additional equity and debt raised in 2016 of USD4470m of which USD2270m was applied to repaying existing debts.

The implication often drawn by investment analysts when comparing the value of NPN to its sum of parts- including the Tencent holding – is that all this investment activity undertaken by NPN management destroys rather than adds significant value for its shareholders. But such a conclusion, or rather the scale of this presumed value destruction, is perhaps not nearly as obvious as it may seem on the surface.

It is firstly not at all clear that NPN would ever be willing or indeed able to dispose of its holding in Tencent. Even if NPN were willing sellers, such a disposal might well be subject to the approval of the Chinese authorities. These authorities would be concerned about who might acquire these rights to the revenue and income from NPN- for example US internet companies that have a dominant share of the global internet business that might not be welcome in China.

Thus valuing the NPN holding in Tencent, as if it could be easily disposed of a current market prices – or even unbundled to its NPN shareholders- may well be an invalid assumption. In reality the NPN stake in Tencent may well be more conservatively valued in the market place as an illiquid asset and so worth less than it appears on the surface- that is valued at less than the prevailing market value of Tencent- but exactly how much less would be a matter of judgment.

Moreover if there is no NPN intention or ability to dispose of its Tencent stake then its value to NPN shareholders will depend on the uses to which NPN puts the dividend income it receives from Tencent, and perhaps more important the borrowing capacity its stake in Tencent may give NPN and the debt capital it raises to fund investment expenditure.

The NPN cash flow statement for financial year indicates significant investment and financial activity as discussed above. The cash flow statement also refers to NPN dividend payments of USD254m in 2016. That is dividends paid to NPN shareholders in 2016 exceeded the dividends received from Tencent and other investments. Clearly these dividend payments are not valued as highly as dividends paid by Tencent a point to which we return below.

Tencent listed in Hong Kong is no ordinary company

The full nature of the holdings of NPN and other shareholders in Tencent Holdings in Hong Kong deserves full recognition. These holdings do not represent an ownership stake in the usual sense. Tencent Holdings in Hong Kong provide its shareholders with contractual rather than ownership rights. They only have rights to the revenues, earnings and dividends generated by the Chinese owned operating company provided by Tencent Holdings- not to the assets of the company in China that have to be owned by Chinese citizens. Accordingly these right holders have no claim on the assets of the company should they have to be liquidated, unless they are Chinese owners. The contractual right is only to a share of revenues earnings and most obviously to dividends- not to the assets of the company operating in China that is limited by law to Chinese citizens.

Foreign ownership of internet and media companies in China including Tencent is prohibited. These ownership restrictions were however overcome and access to foreign capital achieved by Chinese entrepreneurs, including those who founded and developed Tencent, through contractual arrangements known as Variable Interest Entities (VIE’s) of which Ten Cent Holdings listed in Hong Kong is but one of many such entities listed outside of China. The note from Reuters on Alibaba written in September 2016 – a large rival to Tencent Chinese owned internet company –more recently listed in New York –explains the nature of a VIE.

Report from Reuters on VIE’s September 2016

Sept 9 (Reuters) – When Alibaba Group Holding Ltd sells more than $20 billion in shares on the New York Stock Exchange next week, investors won’t be buying equity in China’s biggest e-commerce company. Instead, they will buy into a firm that owns the rights to participate in the revenue created by a handful of Alibaba’s e-commerce and advertising businesses.

* Alibaba Group is set up as a traditional variable interest entity (VIE) structure – an elaborate legal arrangement designed 14 years ago to help Chinese tech and financial companies that hold restricted government-issued domestic licenses raise money overseas.

* VIE structures allow offshore-listed companies to consolidate domestic Chinese firms in their financial statements by creating the appearance of ownership.

* Of the more than 200 Chinese companies listed on the New York Stock Exchange and the NASDAQ, 95 use a VIE structure and have audited financial filings for 2013, according to ChinaRAI, a Beijing-based business consultancy. They include China’s biggest internet companies, such as Baidu Inc and JD.com Inc.

* VIE structures typically involve offshore holding companies in the Cayman Islands and British Virgin Islands; Hong Kong subsidiary enterprises; Chinese wholly foreign-owned enterprises (WFOEs); and local operating companies. The Chinese operating companies that anchor the arrangement are called the VIEs and hold the Chinese licenses that are restricted to domestic companies – in Alibaba’s case, primarily internet content provider licenses.

* Alibaba’s VIE structure comprises five local operating companies, each of which is 80 percent-held by co-founder and executive chairman Jack Ma, and 20 percent by long-term executive Simon Xie – except for Zhejiang Taobao Network Co, which is 90 percent-held by Ma.

* A series of technical services, loan, exclusive call option, proxy, and equity pledge agreements bind the domestic firms to the WFOEs and create the “variable interest” – allowing offshore Alibaba Group shareholders the appearance of control of the local companies.

* The contracts also are meant to provide a legal framework of checks and balances to guarantee that the ultimate stakeholders of the local operating companies act in accordance with the wishes of the offshore listed company’s shareholders. On occasion, such contracts have been broken. In 2010, for example, Ma unwound the contracts for Alibaba’s Alipay unit, triggering a dispute with major shareholders, including Yahoo Inc.

* The VIE structure has never been tested by courts in China.

* In its pre-IPO filings, Alibaba cautions investors that it can’t guarantee its VIE shareholders “will always act in the best interests of our company”, and that if the Alibaba VIE shareholders breach their contracts, “we may have to incur substantial costs and expend additional resources to enforce such arrangements.” (Compiled by Matthew Miller; Editing by Ian Geoghegan)

Thus the value of these contractual right to the revenue, earnings and dividend streams generated by these VIE’s is subject to significant uncertainty that is surely recognised in the prices of their shares listed outside of China. Thus any negative impact on the value to the beneficiaries of these VIE’s arrangements will however also apply to the rights enjoyed by all owners in Tencent Holdings listed in Hong Kong- including those held by NPN. Any VIE discount attached to the rights in Tencent traded in Hong Kong would already be reflected in the Tencent share price.

The value of the dividends paid by Tencent- valuing dividends to recognise value destruction- and the value add opportunity.

The direct benefits to NPN shareholders have come in the form of dividends received from Tencent. These as may be seen have grown spectacularly both in USD and even more so in ZAR. By year end 2016 the .3433 per cent of the dividends flowing to NPN would have been of the order of USD200m or R2700m at current exchange rates. These dividends have grown spectacularly- at an average annual compound rate of about 42% p.a. in USD and 51% p.a when measured in ZAR since 2017. (See below)

Fig 4. Tencent dividend and earnings flows to shareholders. (2007-2016)

Source; Bloomberg, Investec Wealth and Investment

These growth rates and the expectation they would be sustained, have been reflected in the values attached to shares in Tencent Holdings. As we show below the Tencent shares as at December 31^st 2016 traded at 42.1 times reported earnings and an even more spectacular 403.6 times reported dividends. (see figure 5 and 6 below where we show the trailing Tencent earnings and dividend yields and multiples.) The dividend yield (D/P) as at end December 2016 was 0.247 and the earnings yield (E/P) 2.37.

Fig 5; Tencent Holdings; Earnings and Dividend Yields Daily (Data 2007-2016)

Source; Bloomberg, Investec Wealth and Investment

Fig 6; Tencent Holdings; Price/Dividends and Price/Earnings Ratios (Daily data 2007-2016)

Source; Bloomberg, Investec Wealth and Investment

Were the dividends received from Tencent by NPN shareholders accorded the same price multiples as those accorded to Tencent shareholders themselves this .3433 share of the dividends paid by Tencent would command a value of about USD79b or ZAR1,085b, at prevailing exchange rates, that is well ahead of the ZAR850b of NPN market value recorded at year end 2016. Another way of putting this would be to say that the dividend stream paid by Tencent to its shareholders would now be worth R200b more if NPN shareholders could receive these dividends directly rather than via NPN. As indicated earlier unbundling these shares is not a choice NPN is likely to make- nor may it be a feasible option given Chinese sensitivities. What however might well be possible would be for NPN to create a Tracking Stock to track its Tencent Holding[2]. It could in other words further contract with its shareholders to pay out all the dividends it receives from Tencent directly to them and that these rights to the Tencent dividends could be traded separately in the market place. NPN would continue to own its Tencent rights so no change in control would have occurred and such ownership rights as before would be reflected on its balance sheet. The NPN, Tencent tracking stock would then presumably be a pure clone of Tencent itself and so command the same value- that is 400 times the dividends paid out. NPN shareholders would then be about ZAR200b better off.

Furthermore the shareholders and NPN managers would then know very precisely the value added or lost by the investment activity undertaken by NPN. The rump of NPN- net of the explicit value of its Tracking Stock – would very objectively measure how much the other assets of NPN – in which it has invested so heavily – are actually worth to shareholders. The case for adding to such assets- including raising debt to the purpose – would then presumably have to be a good one. In addition, with dividends flowing through the tracking stock, NPN could make the case for reducing its own dividend payments- and investing the cash. That is if NPN could realistically expect returns that would exceed its cost of capital, above required risk adjusted returns, and so add value for shareholders.

In line with much market commentary, is it unfair to suggest, that the complications inherent in valuing the Tencent stake in NPN has encouraged poor capital management by NPN? The large difference, approximately R200b between the value of the Tencent dividends received by NPN and the value of NPN itself strongly suggests that NPN is not expected to add value for its shareholders through its investment activity.

Recognising objectively the value of the Tencent stake through the market value of its tracking stock will help expose the significant other business of NPN to the essential disciplines that should govern the use of shareholder capital. This surely would be good for NPN shareholders.

Conclusion

For all its past success the management and directors of NPN have a very large problem with investors. The market reveals that NPN would be worth much more to its shareholders if it sold off all its assets and paid off its debts. The assets it has invested so heavily in (in addition to its investment in Tencent) would have significant positive value in other hands- surely many hundred of billions of rands. But such sales or unbundling of assets is regarded as a very unlikely event hence the lower sum of parts value attached to NPN.

What the market is telling NPN management is that its impressive investment programme is expected to destroy many billions of shareholder value. That is the cash to be invested, by NPN, is thought to be worth many billions more than the value of the extra assets the company will come to own and manage. This investment programme is a very ambitious one. In FY 2016 the company reported development expenditure of USD961m and M&A activity of USD1495m.

Clearly the NPN directors and management must believe differently, that the cash it intends to invest on such a large scale will add value for shareholders- that is return more than the cost of this capital- that is achieve an internal return of at least 8% p.a when measured in USD or 14% p.a in rands. If it achieves such returns it will add rather than destroy value for shareholders.

But there is room for an important compromise between sceptical investors and confident managers. And that is to separate the Tencent investment from the rest of the business. If NPN established a tracking stock that passed on the dividends directly to its shareholders this tracking stock would be valued at approximately 400*R2.7b, or approximately R1080b – about 200b rand more than the current market value of NPN itself. This tracking stock would be a pure clone of Tencent- perhaps also listed in Hong Kong and can be expected to trade on the same dividend generating basis as Tencent itself.

Shareholders would surely greatly appreciate an immediate R200b plus value add – and the growing dividend flows from Tencent- via NPN. And the quality of NPN management could then be measured much more clearly without the complications and comfort of its Tencent stake.

[1] The listing in HK on the Hang Seng exchange is abbreviated as 700HK

[2] For a full analysis of Tracking Stocks and their feasibility see

J Castle and B Kantor, Tracking stocks – an alternative to unbundling for the South African group, The Investment Analysts Journal, 2001 51(4), also to be found on the website www.zaeconomist.co, Research Archive.

The rand may be telling us something about SA politics

The rand weakened with the market rally and stronger dollar (and higher interest rates) that followed the US election result. Since then the rand has recovered, as some of the Trump impact on interest rates in the US and the US dollar moderated in mid-December. On a trade weighted basis, the rand has gained about 7% from its weakened immediate post Trump level.

The rand has also outperformed a basket of 11 equally weighted leading emerging market (EM) currencies after the Trump surprise. This basket includes the Turkish lira and the Mexican peso, which have been noticeably weak for their own specific reasons, such as the Trump threat to Mexican exports to the US. The rand moreover had gained strength relative to other EM currencies before the Trump election, relative strength that has continued since, as represented by the rand/EM exchange rate ratio.

The rand moreover has also strengthened against the developed market currencies as well as the US dollar after the initial Trump trade. It has also enjoyed a degree of strength vs the Aussie dollar, which can be regarded as a commodity currency.

It may be concluded that the rand has enjoyed a degree of strength for SA specific reasons. It is hard not to conclude that the rand has benefited from the assumption that President Jacob Zuma has become less likely to intervene in economic policy making. Perhaps this is the hopeful message to be read from the behaviour of the rand.

Trump and the SA economy – so far mostly good news

The Trump growth rally that began with his election success appeared to run out of steam in late December 2016. Real bond yields in the US, represented by the yield on a 10 year inflation-linked Treasury Bond reached a recent peak on about the 19 December. These real yields reflect the real cost of capital- the risk free required rate of return to which a premium must be added to compensate for investing in any asset or project with more risk to the expected return. Real rates have been exceptionally low in recent times as world-wide demand for capital to invest in extra capacity shrunk away and as global savings rose. The Trump-inspired increase in real rates portended faster economic growth in the US and the extra demands for capital that can be expected to accompany faster growth.

As may be seen in the figure below, real US rates for 10 year bonds have declined from 0.7% to the current 0.4% yield. This is still significantly higher than the negative real rates investors were accepting in early October. Thus the growth outlook for the US can be assumed to be more promising than it was in October but perhaps not as promising as it appeared in mid-December.

The Trump administration has to deliver on its promises to deregulate and lower taxes and also to bring jobs home. These are prospects that have received particular favour from small business in the US, whose confidence levels have reached record highs, as well as from the customers of the leading banks that apparently are now willing to borrow more. This was noted by bank CEOs reporting earnings on Friday – accompanying generally more favourable operating conditions.

It is this additional confidence of households and business that will influence their willingness to spend and borrow more. Balance sheets of US households have greatly strengthened in recent years, with more saved and more equity in their homes, while lower interest rates have reduced their interest expenses; similarly for business borrowers. It is not balance sheets that will stand in their way of increased spending, but the relative lack of confidence in income prospects.

It will also be of interest to note just how consistent has been the recent behaviour of the gold price in response to real interest rates. Real interest rates represent the opportunity cost of holding gold. The more expensive it is to own gold, the lower its price.

The difference between the lower yield on an inflation-linked bond and that of its vanilla equivalent bond of similar duration (that offers a higher running yield), represents the compensation to investors for taking on the risk that in inflation will prove higher than expected. By doing so it drive up interest rates to compensate for the now more inflation expected. In doing so it reduces the value of the conventional bond. In the figure below we show these recent yield differences, representing inflation expected, over the next 10 years in the US and SA bond markets. Inflation expected in the US has risen consistently before and after the Trump election to about 2% per annum. Real yields in the US have reversed course in the US recently. Inflation expected has continued to increase. The US Fed regards 2% inflation as one of its objectives for monetary policy.

The Trump election raised inflation expectations in SA to over 7%. Very recently, as the Trump rally faded, inflation expected in SA over the next 10 years, as revealed in the RSA bond market, has receded sharply to below 6.5%. This must be regarded as helpful for the SA economy. The Reserve Bank has a highly exaggerated view of the influence of inflation expectations on inflation itself. This retreat in inflation expectations as well as a much improved outlook for inflation itself may encourage the Reserve Bank to reverse the course of short term interest rates – an essential requirement if growth in SA is to pick up momentum.

The improved outlook for inflation in SA is also reflected in the declining SA risk premium, the difference in yields offered by a RSA 10 year bond and a 10 year US Treasury bond. This spread in 2017 has narrowed sharply, indicating that the rand is now expected to depreciate against the US dollar at a slower rate, close to 6.4% p.a. and thus consistent with less inflation priced into the bond market.

This better news about the outlook for the rand and so inflation in SA has come naturally enough with a stronger rand. The figure below indicates the trade weighted exchange rate since September. After initially weakening in response to the Trump election, the rand has benefitted from a strong recovery of about 7% since November. Clearly the extra growth and higher US interest rates associated with a Trump administration have neither raised long term rates in SA nor weakened the rand. Indeed the opposite has happened. This should encourage the Reserve Bank to focus on the downside risks to economic growth in SA rather than the upside risks to inflation. These surely have declined, both with the stronger rand and the prospects of lower food prices. The case for lower interest rates in SA has strengthened with the Trump election so that SA too can look forward to faster growth.

New vehicle sales: A closer look

What’s in a (growth) number? Vehicle sales volumes in December 2016 deserve a closer look.

Recently reported new vehicle sales of 41 639 units sold in in December 2016, some 15.35% fewer than sold a year ago, were greeted with general disappointment. The implication drawn was that the decline in sales volumes recorded in 2016 had accelerated.

But is this the right conclusion to be drawn about the most recent data release? A year can be a very long time in economic life and what has happened to vehicle sales in the months between December 2015 and December 2016 can tell a very different story about the underlying trends.

The data, when adjusted for predictable seasonal influences on monthly sales, indicate that while monthly sales volumes took a turn for the worse in the fourth quarter of 2015, by the fourth quarter of 2016, sales were in fact recovering from their lows of midyear 2016, when monthly sales are adjusted for seasonal influences, as we show below.

The important feature of the vehicle market is that unlike for other retailers, December is a typically well below average month for motor dealers. Holidays mean closed dealerships and so are not usually a good time to deal for an expensive new vehicle.

But a year ago in December 2015, with which sales comparisons are being made, was not a typical month for the motor dealers. The rand, it will be remembered, collapsed that month, portending higher vehicle prices, given their import content. And consequently buying ahead of the expected price increases seemed like a good enough idea to lift sales in December 2015 markedly, especially when seasonally adjusted. Actual sales in December 2015 were 49 158 units and had held up very well compared to November 2015 sales volumes of 51 338 – making December 2015 a very high base with which to compare sales a year later.

As we show in our table of seasonal factors below November is an average month for motor dealers, while December sales average about 13% below average monthly sales. By contrast for retailers generally, December sales volumes average as much as 36% above average monthly volumes.

Or in other words, to gain a full impression of trading trends in December 2016, retail volumes when recorded and reported should be scaled down (divided) by a factor of 1.36 while vehicle sales should be scaled up by a factor of approximately (0.87). Hence vehicle sales in December 2016 of 41639 units should be scaled up by (0.866476) to register the 48 055 sales seasonally adjusted indicated in the figures, and so well ahead of the much weaker, seasonally adjusted sales of 42 501 unit sales, recorded in July 2016.

In the figure below we compare growth rates in vehicle sales on an annual basis with growth calculated over consecutive 3 moth periods using seasonally adjusted monthly data. It may be seen that while annual growth rates are negative and in retreat, the quarterly numbers tell a more positive story.

Of interest is that the recent share price performance of two JSE listed motor dealers, Combined Motor Holdings (JSE code – CMH) and Imperial (IPL) seems to accord better with the more encouraging seasonally adjusted sales numbers than with the raw data (see below).

Lessons from the success of the Western Cape

The success the governments of the Western Cape have had in competing for resources with the rest of South Africa is highly evident in the building activity under way in the more expensive parts of the region. Any number of ordinarily valuable buildings are clearly worth more dead than alive – they are worth demolishing so that they can be replaced by more valuable structures, valuable enough to more than recover the costs of demolishing what stood before.

The demand for these expensive new residential structures has come mostly from migrants from other parts of South Africa where local government has proved much less competent in delivering services so essential to the quality of life, such waste removal, water and electricity supplies, easy access to homes, work and recreation as well as protection against fire, noise and criminals.

The more valuable the stock of buildings, the larger the tax base upon which the local authority can draw to fund service delivery, including in the more deprived parts of town. Moreover current revenues can be used to justify the raising of debt to fund a large capital expenditure programme in order to sustain and enhance the infrastructure that supports effective service delivery. This includes funding the additional roads and bridges and sewage works that support and make viable green field housing developments.

The extra tax these developments will generate over time can more than fund and repay the additional debt incurred. Bridges and new roads that improve access to undeveloped (often wastefully used land owned by government authorities) can prove highly profitable investments. They can be funded with tolls that can then pay off debt incurred in the building – no more or less than a user charge – rather than used to tax users as has wrongly been the case with most toll roads in the country, giving them their well-deserved notoriety.

A criticism one can make of the management of City of Cape Town is its reluctance to raise more debt to fund capital expenditure, that is to put its financial strength supported by ever rising values in the buildings and especially the land it services, to better and more immediate use.

Clearly regional economic development can become a highly virtuous circle of increased revenues and financial strength that leads to useful additional expenditure on improved service delivery that helps attract migrants to the region, rich and poor, that reinforces the growth under way.

It should however be fully appreciated (as perhaps it is appreciated in Cape Town), that the resource critical for faster growth and for which the competition is most intense (not only nationally but also internationally) are the skills, enterprise and wealth embodied in the high income earners of any community. Their contribution to economic development is indispensable for the incomes and the prospects of their poor neighbours. Moreover, providing this mobile resource with a globally competitive quality of local government service at a reasonable charge is essential to the purpose of economic growth. It is also essential to the incomes of the poor who will wish to migrate to the regions that promise better income opportunities.

Hence the relationship between the expensive real estate in a city that is demanded by the affluent and economically successful and the less expensive real estate, that is consistent with much lower earnings and less affordability, is a mutually supportive one. Improved competitive local government service delivery is very encouraging to the high income earners who deliver so much to an economy – including tax revenues – and so symbiotically also very valuable to the poor, who can expect improved services as well as improved income prospects.
If South Africa or any region of it is to succeed in the global competition for the all-important scarce resources that high income earners provide an economy, it will need to continue to offer them competitively priced and efficient services that local governments deliver. South Africa will also need to provide them and their children with competitively priced educational services and also competitive and competitively priced medical services. The role played in education by private suppliers of education and medical service is an obviously important one in these regards. Such quality service delivery will need to be nurtured and encouraged if South Africa is to succeed in overcoming poverty.