February 2020 – ZA Economist

Are the global markets right- about permanently low returns?

If we are to take seriously the signals from global bond markets- as we should- savers should expect a decade or more of very low returns. The decline in bond yields due to mature in 10 years or more accelerated dramatically during and after the Global Financial Crisis (GFC) (see below)

Less inflation expected is part of the explanation for these lower yields. But it is more than lower expected inflation at work. Yields on inflation protected securities – those that add realized inflation to a semi-annual payment – have declined to rates below zero. Before the GFC the US offered savers up to a risk free 3% p.a. return for 10 years, after inflation. The equivalent real yield today is a negative one of (-0.11% p.a). (see below)

Real Yields in the US 10 year Inflation Linked Bonds ( TIPS)

Source; Bloomberg and Investec Wealth and Investment

These low risk-free rates also mean that firms investing the capital of their shareholders have very low investment hurdles to clear to justify their investment decisions. A 6% internal rate of return would be enough to satisfy the average shareholder given the competition from fixed interest. Equity returns might also be expected to gravitate to these lower levels.

Another way to describe these capital market realities is that the rate at which the value of pension and retirement plans can be expected to compound is expected to be at a much slower one than they have been in the recent past. Savers will need to save significantly more of their incomes to realise the same post-retirement benefits.

The past decade has in fact been particularly good for global pension funds. In the ten years after 2010 the global equity index returned 10.5% p.a. on average while a 60-40 blend of global equities and global bonds returned an average 6.4% p.a. with less risk. US equities would have served investors even better, realizing average returns of 13.4% p.a, well ahead of US inflation of 1.8% p.a. over the period.

Total portfolio returns 2010-2019 (January 2010 =100)

Source; Bloomberg and Investec Wealth and Investment

Why then has global capital become so abundant and cheap over recent years? Many would think that Quantitative Easing (QE) the creation of money on a vast scale by the global central bankers, has driven up asset prices and depressed expected returns. An additional three and more trillion US dollars-worth has been added to the stock of cash since the GFC.

Global Money Creation

Source; Bloomberg and Investec Wealth and Investment

But almost all of this cash has been added to the cash reserves of banks- and not exchanged for financial securities or used to supply credit to businesses that could have stimulated extra spending. Bank credit growth has remained muted in the US and even more muted in Europe and Japan.

The supply of global savings has in fact held up rather better than the demand for them, helped by an extraordinary increase in the gross savings to GDP ratio in Germany. These savings have increased from about 22% of GDP in 2000 to 30% of GDP in 2018- while the investment ratio has remained at around 22% of GDP. Government budget surpluses have contributed to this surplus of savings in Germany. For advanced economies the share of government expenditure in GDP has fallen from 42% in 2010 to 38% in 2018 while the share of revenue has remained stable at about a lower 35% of GDP. This could be described as global fiscal austerity -post the confidence sapping GFC.

Germany – Gross Savings and Investment to GDP ratios

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

IMF – All Advanced Economies – Ratio of Government Expenditure and Revenue to GDP

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

Perhaps depressing the demand for capital may be the changing nature of business investment. Production of goods and more so of the services that command a growing share of GDP, may well have become capital light. Investment in R&D may not be counted as capital at all. Nor is intangible capital as easily leveraged.

Lower interest rates have their causes -they also have their effects. They are very likely to encourage more spending – by governments and firms and households. Mr.Trump does not practice fiscal austerity. Boris Johnson also appears eager to spend and borrow more. It would be surprising if firms and many more governments did not respond to the incentive to borrow and spend more and compete more actively for capital. Permanently low interest rates and returns and low inflation may be expected – but they are not inevitable. The cure for low interest rates (high asset prices) might well be low interest rates.

To grow or not to grow? – that is the question for the RSA and investors in it.

The RSA is currently offering its bond holders a real 3.8% a year for 10 year money. It is the lowest risk investment that can be made in rands over the next 10 years. One made without the risk of inflation reducing the purchasing power of your interest income and without risk of default. If you wished to invest in a US Treasury inflation protected security (a ten year TIPS) you would have to (pay) Uncle Sam 13.3 cents per $100 invested for the opportunity.

Thus investors willing to accept RSA risk are currently being compensated with an extra 4% real rand income each year for the next ten years. This real risk spread was a mere 2.3 % p.a. a year ago. Other possible measures of RSA risk are as unflattering. The RSA borrowing dollars for five years has to pay an extra 2.2% p.a more than the US Treasury for five year money making RSA debt already well into junk status where it has languished for some time not withstanding its fragile investment grade status with Moody’s. Our rating compared to other EM borrowers has deteriorated and the ZAR is expected to weaken at a faster rate (See figures below)

The real risk spread for SA assets

Source; Bloomberg and Investec Wealth and Investment

Measures of SA risk

Source; Bloomberg and Investec Wealth and Investment

It all makes for very expensive national debt that taxpayers have to fund and higher costs of capital for SA business. These higher real rates also raise the returns that SA businesses have to hurdle to justify capital expenditure. Ever fewer such opportunities are seen to be on offer. And so the best many SA economy facing businesses can now do for their share owners is to opt out of the race in ways that are not good for growth. That is to use the cash they generate to buy back shares or pay dividends rather than attempt to grow their businesses.

The cause of this deteriorating credit rating and the higher discount rates applied to SA earnings is obvious enough. The RSA appears increasingly unlikely to manage its public finances with any degree of competence. The 2020-21 Budget has to cover an extra R50b to hold the fiscal line drawn as recently as last October. It is the result of less revenue than expected as growth has slowed and rapidly growing government expenditure on failed state-owned enterprises. A growing interest rate bill on ever more government debt is a further growing strain on the Budget .

There are however alternatives to raising taxes or borrowing more. That is to raid the SA pension and retirement funds. That is to compel them to hold more RSA debt of one kind or another on less favourable terms than have currently to be provided. Such forms of EWC have one major advantage for the politicians imposing them. Their full consequences will not become obvious for many years. That is in the form of lower than otherwise returns for pension funds and depleted pension payments. Including the bill ultimately to be presented to taxpayers for underfunded defined benefits owed to public sector employees- and largely incalculable today.

Swapping most of the debts and interest payments of SOE’s for equity without guaranteed returns has however one major potential upside. It could mean the effective transfer of ownership and rights of ownership from government to the private sector. This would bring greater efficiency and the avoidance of further losses for SA taxpayers and consumers of essential services. Such a step would bring down real interest rates and encourage private sector investment.

It would moreover indicate something much more fundamental to investors in SA. That is when accompanied by credible controls on the size of the government payroll it would clearly signal something all important for investors. And that is the primary purpose of the SA government is not to provide a growing flow of real benefits for those employed by government. This is the essential question that the Budget, we must just hope, will answer in the affirmative.

The narrow corridor of success

A new book by Harvard economists Daron Acemoglu and James A Robinson sheds light on what success looks like for nations. An empowered and critical civil society is crucial.

The achievements of a few highly successful economies are admirable and conspicuous. Consistent growth in incomes and output over many decades has eliminated poverty. The growth has been accompanied by rising tax revenues that are easily collected, without much disturbing the engines of growth.

These are then redistributed in cash and kind to provide a measure of security for all its citizens against the accidents to which individuals and their families are always vulnerable. Growth provides the means to fight crime, protect borders, provide roads, sewers and vaccinations, of equal value to all. The caveat is that this historically unprecedented abundance is not as appreciated or as popular as it should be. Continued success can never be taken for granted.

Open access to markets for all goods and services and for the resources – labour, capital and natural resources – with which to compete for custom, is a critical ingredient for success. Innovation threatens established interests and must be recognised as a force for good. Rights that protect wealth and persons against fraud, theft or violent assault, supported by predictable laws and transparent regulations, are essential for success.

Competent and responsive government agencies are essential. A society that is critical of government action, aware and unafraid of what a powerful government might arbitrarily do to them, makes for good government.

Harvard economists Daron Acemoglu and James A Robinson have followed up on their influential book “Why Nations Fail” with the excellent “The Narrow Corridor: States, Societies and the Fate of Liberty” (Penguin-Viking, 2019). It explains in fascinating detail why it has been so difficult for nations to do what it takes to enter and stay in the narrow corridor that leads to economic success.

They explain the advantages of the so-called “shackled Leviathan”. This is when the potential abuse of state power is effectively constrained by an empowered and critical civil society. This is unlike the “despotic Leviathan” that maintains essential order but does so at huge cost to a cowed and vulnerable people. China, old and new, is cited as one such example.

Another alternative may well be the “paper Leviathan”. This describes an expensive and incompetent government. South America provides more than a few hapless cases of governments that serve only the people on their payrolls.

In all the many cases of national failure there is an elite who have a powerful interest in the stagnant status quo – and who resist the obvious reforms that would stimulate and sustain faster growth. Zimbabwe comes to mind as an example.

The authors also examine the potentially suffocating role of the “cage of norms” – well-entrenched customs that stultify access to markets and inhibit competitive forces. The caste system in India is still such an inhibitor of economic progress. Traditional land rights are a serious obstruction to producing more in South Africa.

Acemoglu and Robinson regard BEE as helpful to economic success because it broadened the political interest in established enterprises and business practice, enough to help protect them and the economy against destructive expropriation. Cultivating a new elite into business success was necessary for stability and growth.

One wonders how Acemoglu and Robinson might now react to the revelations about state capture and corruption; and to the failures of the South African state to deliver satisfactory outcomes for the resources made available to it.

The next question is: will the highly transformed South African elite act in the general interest and encourage the invigorating forces of meritocratic competition for resources and customers? Or will they act to protect their gains and privileges?

The new elite should be aware that a failing economy will not be politically acceptable and any elite dependent on it will be highly vulnerable. They should be encouraged by our open and critical society to take the steps to get South Africa back into the narrow corridor that leads to economic success.