Month: April 2019

The paradox of paid holidays

Looking forward to the (paid) Easter holidays? Despite appearances to the contrary, you are paying for it.

The Easter holidays are upon us. Many will be enthusiastically taking time off, believing they will be enjoying a “paid holiday”, in other words, enjoying a holiday paid for by their ever-obliging employers. They are wrong about this – especially if they work in the private sector. They will in fact be sacrificing salary or wages for the time they spend not working.

This is based on the simple assumption that there is a consistent relationship between the value they add for their employers and the hours or days spent working – and that therefore they are paid according to the contribution they are expected to make to the output and profitability of the firm. Wages are not typically charitable contributions.

It makes no sense for some employer, the owner of a business, with a natural concern for the bottom line, to pay you for time spent on holiday, or on weekends off or when sleeping or traveling to or from work. They are unlikely to survive the competition if they did not take into account the accompanying loss of production, revenue and profits incurred when their employees are not working.
Those known costs must mean salaries, wages and employment benefits given up by the worker. There are no paid holidays, any more than there are free lunches in the company canteen.

Those paid on an hourly basis and at the end of every day or week will be under no illusions about having to sacrifice income when not working. Many of them might well be willing to work on the Easter weekend if given the opportunity to do so. They may well prefer to consume goods and services other than leisure.

It is those who are paid on a pre-determined monthly basis who may be inclined to believe that they are being paid to go on holiday. They should appreciate that the more time they are expected to take off, or the larger the contributions the employer may be making to medical insurance or pension contributions, training levies and the like, the less they will inevitably be taking home in their monthly paycheque. They are sacrificing salaries so that their employers can better stay in business and offer them employment.

The same bottom line and hence a sense of sacrificing pay may not apply in anything like the same force in the public sector, where the taxpayer picks up the salary, pension and medical aid bill, regardless of its size; where measuring the output of the public employees is not nearly as easy and where performance measures are often strenuously resisted.

European workers typically take many more days off than their US or South African counterparts. It is a widening trend that has evolved only over the past 30 or so years. We are often surprised at how little time the typical US worker takes off. Why is it so that the average US worker consumes significantly less leisure, takes less time off, therefore sacrifices less pay for holidays and consumes proportionately more other stuff that they prefer to pay for?

Is it a cultural difference, or are US workers naturally more hard working than their European or South African cousins? Maybe, but if that’s the case, why have these differences in working behaviour become so much more pronounced in recent decades? (Incidentally, the average number of hours worked per day in Europe and the US does not differ much). The striking difference is in the average number of days worked.

It may be because US workers and their employers enjoy more freedom to choose pay over leisure. Perhaps the regulations that determine compulsory time off for holidays or festivals are by now less onerous on US than European employers (and on formal South African businesses).

Were maximising output and money income and employment the primary objective of policy, South Africa would be wise to adopt the US rather than the European practice: allow the number of days off to evolve (mostly) out of competition for workers, rather than be regulated for them and their employers. And have fewer “paid holidays”.

The market and the economy – not a certain relationship

Brian Kantor 3rd April 2019

The state of the US economy gets very close attention from investors in the stock market. The market moved sharply lower in late December on fears of a US slowdown. More recently it has bounced back strongly as the outlook became less threatening as the Fed came to share some of the market anxieties and indicated it would not now be raising short term interest rates.

This raises a question. Could you make a fortune buying or selling shares accurately forecasting US GDP growth rates over the next few years? The answer is a highly qualified yes.  It would take very surprising – to others – very fast growth to deliver well above average returns in the stock market or, as surprising to all but yourself, very slow growth to deliver unusually poor returns.

Such phases of very fast or very slow growth, that presumably could confound the forecasters and investors, have in fact been very rare events. Since 1967 there have only been seven recessions in the US.  There have been about the same number of so-called technical recessions – defined as two or more consecutive quarters when the real GDP declined.

I count 20 quarters since 1967 when growth in the US was less than 1% per annum. Average annual returns on the S&P over these low growth quarters was a negative 11.8%. The worst quarter for shareholders was Q1 2009 when the market was down 47% on the same quarter a year before. However slow growth was not always bad news for investors. In Q2 1981, when growth fell at a 2.9% rate, the S&P 500 Index was up by 19.4% on a year before. Yet the statistical relationship between growth and returns over these low growth quarters was a generally very weak one with a simple positive correlation of only 0.07- not nearly enough  regularity to rely upon as an investment policy.

 

Slow growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

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Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

 

I have also identified 98 quarters when growth in the US was a strong over 3% p.a. On average over these quarters the annual returns averaged an impressive 14.7% p.a. But this high average came with a great deal of variability around this average. The best annual return of 46.7% came in Q3 1982 and the worst -17.7% in Q4 1973. The statistical relationship between strong quarterly growth and annual returns is also very weak with a correlation close to zero.

 

Fast growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

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Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

 

The statistical relationship between quarterly growth and returns over the entire period 1967-2018 is altogether a very weak one. Linear regression equations that explain annual index returns with quarterly growth rates have very little explanatory power. Using smoother annual GDP growth rates in the equation do little better. R squares of no more than 0.16 indicate that there is much more than growth determining annual or even more variable quarterly returns. Generally accurate forecasts of GDP growth are simply not going to cut the returns mustard.

The problem for any reliance on patterns of past performance is that the markets are always forward looking. The well-considered, forecasts of the economy and of the companies dependent on it, will already have helped determine the current value of any company and of any Index average of them. Hence only economic surprises- indeed only large surprises in the GDP numbers can move the market.  But anticipating these surprises is largely beyond the capabilities of the collective of forecasters – who will employ similar methods evaluating the widely available data that anticipates and makes up the GDP itself. Any surprises are going to surprise the forecasters as much as the market

However as recent developments on the share market indicate- down and up with not so much the GDP itself – but with expectations of it- what matters over any short period of time in the markets is not so much the forecasts themselves, but the confidence held in such forecasts. These will never be in a constant state. Any additional uncertainty about the state of the economy (less confidence in the forecasts) adds volatility to the market. That is wider daily moves in the market up and down. And when the market moves through a wider daily range share prices will move in the opposite direction in a statistically very consistent way.

 

The impact of risk (changes in the VIX) on S&P returns 2016-2019; Daily Data. Correlation (-0.74)

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Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

 

Such changes in sentiment are not easily forecast. If they could be reliably anticipated this would undoubtedly be wealth enhancing to the forecaster or rather the sage. They are however best ignored by long term investors in favour of as good a forecast of the economy over the long run, as you can hope to make or receive.

 

Finding our way out of the debt trap demands more than monetary policy can offer

The interest payable on the national debt is surely a burden on taxpayers. But it is also as clearly a benefit to those who receive the interest. 

 When the national debt is owned by nationals, the interest paid and the interest earned cancels out, as do the liabilities of the taxpayers and the assets of the SA pension funds, insurance companies banks and South African citizens who have invested in SA government debt. The true burden on the SA taxpayer is the SA government debt held by foreigners.

Foreign investors owned 37% of all rand-denominated debt, R923bn  worth of the R2.49 trillion issued in 2018-19. They also owned all the foreign currency debt issued by the government in 2018, valued at R320bn.  Thus, foreigners own about 50% of all government debt issued (see figure below, taken form the Budget Review 2019 as is the further table that provides detail on the composition of RSA national debt).
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As the table above shows, there is a heavy load for South Africans to have to carry, especially when there is little to show for the debts incurred. This includes productive infrastructure that would add to GDP and incomes to be taxed and would make borrowing worthwhile, should the returns on the capital raised exceed the interest cost of the debt incurred, which has not been the case.  Much of the debt incurred by the government has been used, given insufficient tax revenue, to fund the employment benefits of public-sector employees and other goods and services consumed by government agencies. In essence, it has been raising expensive debt to fund consumption rather than capital accumulation.

More sadly, some of the national debt that has been incurred and used to fund state-owned companies, mostly Eskom, has not even covered its interest rate costs. The Treasury calculates that the difference between the book value of assets of these companies (over R1.2 trillion) and their debts (over R800bn) means their equity capital earned a negative amount in 2017/18. In other words this investment by taxpayers (assets minus liabilities) is now worth nothing at all. Selling off their assets for what they could fetch in the market place would, at worst, reduce the current and future national debt burden. At best, they would provide a superior service to users of these essential services. These private companies, if profitable, could then provide an additional source of tax revenue.

What was paid for the assets is economically irrelevant. The only  relevance is their market value that may or may not exceed the value of the debt incurred. Still, less national debt is better than more.

So, what can be done to reduce the burden of SA’s national debt and the dangers of a debt trap that SA has entered?  One obvious answer would be for the government to borrow at lower interest rates. However, it is not lower inflation that would necessarily reduce the interest paid on conventional government debt.; only lower expected inflation could do this. Lenders demand compensation in the form of higher interest rates for taking on the risk that inflation poses to the purchasing power of their interest income and the market value of their debt. The more inflation that is expected, the higher interest rates will be.

The Governor of the Reserve Bank believes that lower inflation – the result of realising the Bank’s inflation target – will lead to lower inflation expectations and bring down interest rates with it. But the link between realised inflation and expected inflation is not nearly as direct or obvious as the recent behaviour of the bond market and interest rates confirms.  In recent years, inflation compensation in the bond market, the difference in yields offered by a conventional bond exposed to the danger of unexpectedly high inflation, and an inflation-proofed bond of the same duration that offers a real yield, has remained stubbornly high. It has been at about 6%, a number that has not declined in line with lower inflation, which is currently at 4%.

Long-term interest rates, inflation compensation and inflation in SA

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The problem for the Governor is that the Reserve Bank is only partially able to control the inflation rate, which is dominated by forces beyond its influence.

The exchange value of the rand, which has a large influence on inflation in SA, follows a course that is independent of Reserve Bank reactions. It is influenced by the sayings and actions of SA politicians. The rand also responds directly to global capital flows that drive the US dollar and emerging market currencies. Prices in SA respond directly to the price of imported oil and the taxes levied on it. The weather, food prices and the Eskom tariff are among other forces that always act on prices, to which the Bank can only react but not influence.

The interest rate reactions of the bank can only influence the demand side of the price equation. Reducing demand with higher interest rates, in the hope of countering the supply side shocks to prices, can depress demand in the economy.

The trouble with slow growth is that it raises the risk that SA may abandon its fiscal conservatism and elect to inflate its way out of its debt, which becomes ever more burdensome with slower growth. Paradoxically perhaps, it’s a burden that also rises with lower inflation. When nominal GDP growth (real growth plus inflation) falls below interest rates, the burden of debt (debt/GDP) increases.

Long-term interest rates and growth in nominal GDP
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SA can only hope to reduce the costs of funding its debt and escape the threatening debt trap by convincing the market place that it will not abandon fiscal conservatism. It will take even more than raising taxes or reducing the trajectory of government expenditure to reduce long-term interest rates meaningfully, which are both austere actions that in themselves hold back growth in the short run.

A commitment to the privatisation, rather than the reform, of our failed public enterprises is called for. This will reduce risks to lenders, bring down interest rates and permanently raise the growth rate. It will support the rand and reduce inflation by attracting additional foreign investment and capital.

Without such a change of mind and actions to back them up, the risks of us, sooner or later, inflating our way out of the debt trap will remain. Absent such reforms, our problems will continue to be exacerbated by permanently slow growth, for which the failed public enterprises will bear a large responsibility. Any failure to take this obvious action will keep up the high cost of funding borrowings.