May 2023 – ZA Economist

Why hedge using Gold when one can hedge using Gold share Options?

GDI Barr & BS Kantor

In a previous piece (What can help the Rand and the economy? – ZA Economist) we discussed how ever-changing probabilities make Financial Risk so hard to measure and that investment outcomes are dominated by the return received, with any notion of the past risk faced quickly fading from memory. Thus, if a successful share investment has yielded an excellent return, is the happy result either because the shareholder took on extra risk and got lucky , or because the savvy investor knew the share was undervalued and proved to be so, becomes irrelevant.

Knowing the downside, estimating how much of a loss any portfolio or balance sheet can take and survive a potential loss is an essential task for the risk taking investor. Deciding what is a good bet – improving the odds of success by improving expected returns for any presumed risk -or reducing risks of failure for any expected return -makes every good sense.

Holding gold or perhaps more realistically holding a claim on a stock of gold held in some very safe place, has long proved itself as a sensible way to protect wealth against disasters in the form of war or revolution or more prosaically against inflation and their impact on many other ways to conserve wealth. As the dangers of an economic calamity rise, so typically, as will be expected, the price of gold will move higher.

If so, as will a claim on gold bearing rocks in the ground, that will be gradually turned into gold on the surface by a gold mining company. A share in the expected profits of a gold mining company will then also provide very useful insurance against danger. The gold price and the share price will move in the same direction – but given all the potential gold in the ground, and the risks associate with bringing it to the surface – the share price will be far more variable, hence far riskier than the gold on the surface. The recent sharp upward movement in the gold price provides an appropriate example. The gold price has moved up 10% or so in dollars over the last year. If we take the example of the GoldFields (GFI) share price, this has moved up around 160% (a factor of 1.60times the Gold Price movement) over the same period.

But an investor seeking safety owning gold has still a further alternative. That is to buy an option to buy a share in a well traded gold mining company, at a pre-determined future date, at a price agreed to today. The options can be bought or sold at market determined prices until the expiry date of the option, after which that right or option becomes worthless.

Option prices therefore exhibit a still much greater level of variability (or risk) than the underlying metal or share prices . Because of this character they give investors an excellent opportunity to raise the expected return from an exposure to movements in the gold prices , with a much smaller risk of a loss should the gold price move lower. Give the option price volatility – the factor here

. The availability of gold shares and more so options on gold shares give investors, who want to speculate or to hedge a portfolio of gold bullion against a large contrary or unexpected movement in the gold price make for a very efficient vehicle to hedge the exposure while laying out significantly less capital or incurring expenses to improve the expected return- risk trade-off.

Graham- one needs protection against a fall in the gold price and/or the multiplied fall in the value of a share or an option. One hedges the gold bullion price position by selling (shorting) the shares or selling the option- the puts -to hedge the exposure to the share price. It is cheaper to sell the shares and cheaper still to put the shares. I have tried to spell this out but with difficulty as you will see. A portfolio of gold bullion. Gold price down 10% portfolio down 10%. Bullion price down 10% GFI down 100% – 10 times more. A short of how many GFI shares (1% of the portfolio) would give the bullion portfolio protection against a 10% fall in the gold price. A put option on GFI equivalent to 0.2% of the portfolio in gold would presumably protect against a 10% fall in the gold price.

In recent months a short duration Call Option on GFI, has moved up about 500% (a factor of 50 times greater than the move in the gold price) By agreeing to sell the share and more so an option on the share, one will have exposed (expensed) significantly less actual capital for the same hedging effect. Thatis protection against losses should the gold price move lower rather than higher – as was the expectation. If the gold price had fallen 10%, then one would have lost 10% of the portfolio capital if one had held gold coins (a ten percent fall for ten per cent of the portfolio), 1% of the portfolio for a short on the GFI shares but lost only 0.2% of the portfolio capital, if the outlay was in the form of a put on the GFI shares rather than a short. Therefore, one would have been be unambiguously better off to hold the gold share options (puts) (a 50th of the gold bullion loss). Thus for the portfolio manager who is a gold bull and is already committed to holding a large amount of bullion, he can turbo-boost his investment in gold, with little added risk, by making a relatively small purchase, risking relatively little capital on a highly geared Gold share options. The potential gain (retrun on capital invested in the option) will be very large should the gold price move higher- but the potential loss – compared to the losses incurred by investing the same amount of capital in gold or gold shares – should it all turn out badly – will be much smaller. The return- risk trade-off, calculated looking ahead rather than behind, will have been greatly improved.The fact that at any moment in time judged by observing the random daily nature of the gold price, the gold price has as much chance of rising or falling from its current market determined value, means that the gold bulls are always matched by the gold bears – at the market determined price, or share price, or option price on the shares. The profit seekers in a higher gold price– as in any other actively traded asset – will always be matched by the profit seekers – those who are cashing in on their positions, believing the price will go down. And they will be able to do so at a market clearing price that matches the amounts of bullion or share or options bought and sold. The market makers, including the option providers, will match buyers and sellers. They ideally from their perspective will be rewarded with a fee and not be exposed to the highly unpredictable move in the underlying metal or share prices.

Structuring such risk reducing strategies is complicated for the average private investor. But it may be straightforward for banks or others who provide structured products bought by retail investors. Constructs that trade off less upside gain for less downside risk of losses It should be possible to put together a blended product of say 90% gold bullion and 10% Gold share options of appropriate duration. Such a listed financial security registered for trade on the JSE would exhibit high gearing to the gold price upside but for lower risk of losing capital should the gold price move in the wrong direction, which it may well do. Over to the market place.

What can help the Rand and the economy?

Graham Barr and Brian Kantor

16th May 2023

In early 1980 the Rand reached a peak of 1.32 US$ to the Rand; yes, the Rand then bought more than one dollar! This was the time of a very high gold price of $820 per oz. when Russia invaded Afghanistan and WW3 looked like a real possibility. It was but 35 dollars an ounce in 1970. Things have not been as rosy on the exchange rate front since. The exchange rate is currently around 19.2 Rand to the $. This means that in purely nominal terms the Rand is currently 1/25th (against the dollar) of what it was in those heady days of 1980! If the ZAR merely adjusted for differences in SA and US inflation since 2000 the dollar would now cost less than R13. In a relative sense- the ratio of the market to the Purchasing Power Parity was only wider in 2002 when the ZAR was nearly 80% undervalued. At current exchange rates it is about 50% undervalued. Or in other words the rand buys roughly 50% less in NYC than it does in SA as SA visitors will testify. The great deals will now be realised by tourists to SA –until the rand sticker prices in the stores and on the menus are marked higher. See figure 1

Figure1. The USD/ZAR and its PPP equivalent.1 Monthly data to April 2023.

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

In the seventies as the gold price took off- more in USD than ZAR, SA was the largest gold producer in the world and gold mining was hugely lucrative for shareholders in the gold mines and for the SA government who collected much extra revenue from taxes, and royalties paid by the gold mines. Platinum mining was only then getting going and subsequently got a huge boost from the widespread use of catalytic converters in the exhausts of motor vehicles. Coal exports got going after the construction of the huge export terminal at Richard’s Bay, and the rich Sishen iron ore deposit was still to be exploited.

South Africa is now merely the eighth largest producer of gold in the world, producing but a sixth of the gold delivered in 1970. And gold production is now a relatively small part of the South African economy that in the seventies accounted for 60% of all exports from SA and about 16% of GDP. The link between the gold price and the exchange rate

is now correspondingly weak and has done little to save us from facing the second weakest Rand on record and ever higher long-term interest rates.

The strength of the Rand is still much influenced by the state of the commodity-price cycle, as South Africa remains a commodity-based and exporting economy. It is also determined in large part by perceptions of South Africa’s economic future and the associated safety of investing in SA. Foreign and local investors require a return that compensates for the perceived risk of investing in SA- including the risk of rand weakness. These perceived risks influence flows of capital to and from SA and can strongly influence the foreign exchange value of the ZAR, as they have this year. As an emerging market, South African risk generally follows the average emerging market risk, but SA specific risk has recently risen dramatically in the face of income destroying load shedding and more recently for reputation destroying toenadering with the reviled Russians. This year the rand has weakened by about 13% vs the Aussie dollar and 11% Vs the EM basket. Much of the relative weakness occurred in January and February in response to load shedding. With additional exchange and bond market weakness (higher yield spreads) on the 10th May in response to the Russian revelations. (see figures 2,3 and 4)

The ratio of the USD/ZAR exchange rate to the USD/Emerging Market (EM) average provides a useful indicator of SA risk. This ratio indicates that SA is again in economic crisis territory. The hope is that this time is not different- and the USD/EM ratio recovers to something like normal, as it has done after all the other crises that have damaged the ZAR and the SA economy. Relative to an average EM currency the ZAR has never been weaker than it is now. The outlook for the SA economy, judged by this ratio, has never been as bleak as it is now.

Fig.2: Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1

Higher ratios indicate relative rand weakness

Source; Bloomberg and Investec Wealth and Investment.

Fig.3; Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 15th May 2023. Higher numbers indicate relative rand weakness.

Fig.4; Rand Weakness, Inflation expected and the RSA Sovereign Risk Premium. 5 year yield spreads. Daily Data 2023 to May 16th 2023.

Source; Bloomberg Investec Wealth and Investment

In response to this exchange rate shock – for reasons specific to SA – the SA rate of inflation is very likely to trend higher, independently of by how much the Reserve Bank raises short-term interest rates to further reduce spending pressures on prices. Yet raising short-term rates is almost certainly negative for growth in incomes and employment of which the SA economy is already so sorely lacking, given load shedding and a general loss of confidence in the competence of the SA government. The forces that have given us this latest exchange rate shock are completely out of the Reserve Bank’s control. The

Governor needs to recognise this and do little additional harm to the economy and its growth prospects- by not reacting to the exchange rate shock.

It seems evident that the surging rand prices for our mineral exports may not help the Rand this time. A working Transnet to ship the metals and goods out the country would help – as even more important would be a consistent supply of electricity. But it is hard to be optimistic about such immediate responses and investors shared this pessimism earlier in the year and well before our damaging Russian connection came to light to add further to relative rand weakness.

Unfortunately, we do seem saddled for now with a weak Rand and a near-term uptick in inflation. Yet the weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices for their production. Their extra rand costs of production will lag higher rand revenues until local inflation catches up with the inflation of the rand prices, they will be able to charge on foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers) listed on the JSE. Sectors of the JSE that face abroad can provide a very good hedge against rand weakness that occurs for SA specific reasons, as they are predictably doing.

The rand cost of petrol and diesel will play an important role in influencing the inflation rate in the months to come. A saving grace for the inflation outlook is that the dollar price of oil and gas has fallen away- by more than the ZAR has weakened against the USD. (see figure 5)

Fig.5; Brent Oil price – per barrel in USD and ZAR

Source; Bloomberg and Investec Wealth and Investment

The biggest danger to the local economy is that the Reserve Bank will raise interest rates further (the money market already expects increases of over 100b.p. in the next few months) The most recent attempt to support the ZAR raising interest rates by 50 b.p. at the last Monetary Policy has been a conspicuous failure. It has not helped, could not support the rand in the circumstances, but has further depressed spending and the growth outlook. And helped push long term interest rates and the cost of capital higher.

The best approach to rand shocks – that have nothing to do with monetary policy settings- is surely to ignore them – and let the inflation work itself out without higher interest rates. One has long hoped that SA had learned the lesson to not interfere with the currency market. Interest rates can have little impact on the ZAR in current circumstances. The best support for the rand will come from faster economic growth that raises incomes and tax revenues for the state.

Long term interest rates in SA are now punishingly higher than they were last week and the rand is now expected to weaken at an even more accelerated rate than was the case a week ago. This is because SA remains at greater risk – given the even more depressed outlook for growth – of not easily balancing its fiscal books. The expectation of even slower growth to follow still higher borrowing costs, as is widely expected, has added to these risks.

The only way out of the mess SA has got itself into is to surprise investors by delivering surprisingly faster growth- even an extra one percent higher GDP would be helpful. The Reserve Bank has a crucial role to play in this by ignoring the exchange rate shock. Eliminating load shedding and delivering more exports are even more important to improve the growth outlook and reduce SA risks.

A shock to the system- and getting over it

The latest shock to the SA currency and bond markets is of a large scale, similar to those of 2001, and of 2008-9, that was linked to the Global Financial Crisis, also to the Zuma-Nenegate shock of 2015-16, and the Covid shock of 2020. This shock is entirely of our own making. It is the punishing result of a failure to keep the lights on and choose our friends more carefully. We can assert this not only by reference to the abruptly higher rand costs of a USD or Euro, but by the poor performance of the ZAR against other emerging market (EM) and commodity currencies. A weakness that was pronounced earlier in the year as load shedding increasingly hurt the growth prospects of the economy and that was accentuated on the news of our arms business with Russia. The ZAR this year to the 24th of May, after a further burst of weakness on the 10th May, is about 10% weaker Vs the Aussie dollar and 12% weaker Vs the JPMorgan Index of EM exchange rates.

Fig.1 Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 24th May 2023. (2023=100) Higher numbers indicate relative rand weakness.

The ZAR compared to a basket of seven EM currencies – the ZAR/EM ratio – has never been weaker than it is now. The ratio very easily identifies the periodic shocks to flows of capital to and from SA since 1995. One can only hope that this time will not be different and that the ZAR bounces back- at least relative to our peers.

Fig.2. Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1 to 15th May 2023

Higher ratios indicate relative rand weakness

Source; Bloomberg and Investec Wealth and Investment.

The RSA bond market could not escape similar punishment. Yields on long dated RSA Rand and USD denominated debt rose by about 60 b.p. between the 9th and 15th of May having all tracked higher through much of 2023. The case for investing more in SA plant and equipment has become that much harder to make. And the rand -judged by the wider carry- the difference between interest rates in SA and the USA- is now expected to weaken at an even faster rate- despite recent rand weakness. All bad news for our economy

Fig.3 Interest rate movements in 2023. Daily Data to 24th May

Source; Bloomberg and Investec Wealth and Investment.

The weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices. Their extra rand costs of production will lag higher rand revenues and until local inflation catches up with the higher rand prices they will be able to charge on

foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers or the International Mining Houses) listed on the JSE and who account for more than half its market value. The JSE is not in shock- it is well hedged against SA specific shocks.

How quickly inflation rises in the months to come will depend on the rand price of imported oil. A saving grace for the inflation outlook is that the dollar price of oil has fallen by more than the rand- hence a lower rand price of a barrel of oil.

Fig.4; Brent Oil price – per barrel in USD and ZAR

Source; Bloomberg and Investec Wealth and Investment

The interest rates set by the Reserve Bank will make no difference to the rand or the inflation rate. Hopefully they will react to an exchange rate shock by not reacting to one. And do what little they can not to slow down growth any further.

The Treasury could help –by keeping the peak loading generators on for longer. And pay for the extra diesel or LPG. Every hour of load shedding not only means less income and output generally – it means lower tax collections. Every rand spent on diesel by the public or on replacing Eskom means less tax revenue in proportion to the company and personal income tax rates and the conversion to solar

allowances. Spending taxpayers rands on diesel will pay for itself. And possibly produce the growth surprise that could turn, only can turn around the rand.

Banks are different

Banks are different to other financial intermediaries. They do more than borrow and lend. They manage the payments system without which any modern economy could not function. The payments system cannot be allowed to fail and banks deserve support should their stability come into question. Which, as was apparent in the US recently, cannot be taken for granted.

Banks maintain the payments system by supplying deposits to their clients and transmitting many of them on demand. They bear the operating costs of doing so – which are considerable. They have to remain viable businesses, so they have to cover their operating costs with transactions fees and more importantly by lending long and borrowing short- realizing net interest income, essential to their profits and survival. Banks, competing with each other, are forced to operate with very limited cash reserves. They hold very limited reserves of equity- that is owner’s capital – and are highly leveraged for the same profit seeking purpose. The dangers come with the territory.

A margin of safety for them is to be found in their holdings of other liquid assets, mostly debt issued by the government, with varying maturities and interest rates, that the central bank will almost always repurchase for cash when asked to do so. In SA the cash to demand deposit ratio is less than three percent and the liquid assets to deposits ratio is now equivalent to about 40%.

SA Bank Deposits withdrawable on demand and Cash and Liquid Asset Reserves. January 2023

Source; SA Reserve Bank and Investec Wealth and Investment

Bankers everywhere must surely be considering attaching a longer notice period to their deposits and to reduce their dependence on transactions accounts – with interest rate incentives to do so. Giving them more time to call for a rescue from the authorities or other banks should their deposits drain away suddenly.

The relationship between the US Fed and its member banks changed in an important way after 2008. To rescue the banking system the Fed injected cash into the financial system on a very large scale through purchases of Government Securities from the banks and their customers in exchange for bank deposits with the Fed. A process of money creation described euphemistically as quantitative easing. (QE) Ever since then US banks have continued to hold large cash reserves despite short phases of quantitative tightening (QT) to reduce the supply of cash as is the case now- or at least before the banks ran into cash withdrawal problems

US Banks Deposits with the Fed

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

The policy determined interest rate is now the rate the Fed offers the banks on deposit rather than the rate charged them for cash borrowed. The SARB decided it too would no longer attempt to keep banks short of cash. SA banks since 2022 can now hold excess cash reserves and earn interest on them. Reserve Bank lending to the banks has fallen away sharply recently.

SA Banks; Actual, Required and Borrowed Cash Reserves.

Source; SA Reserve Bank and Investec Wealth and Investment

But will central banks be able to exercise good control over the supply of money (mostly bank deposits) and bank credit? The supply of bank deposits and supply of bank credit depends in part on the cash reserves supplied to them by the central bank. More cash supplied by the central bank leads to more bank lending and higher levels of deposits (M3) and vice versa. But this money multiplier (Deposits/Cash Reserves) can now rise or fall depending on how much cash the banks choose to hold, rather than on the extra cash supplied them by a central bank. One bank’s extra lending becomes another bank’s extra deposits. If the banks prefer to hold more cash and lend less, the supply of deposits and the money supply will shrink and vice versa. Therefore, the money supply will tend to grow faster during the booms when demand for bank credit is buoyant, and then grow slower when demands for bank credit is weak- as is now the case in the US – making a recession more likely. Ideally central banks can contain inflation and help smooth the business cycle by controlling the supply of money and credit. The current dispensation for banks with excess cash makes this less likely.

The impact of more equity and less debt for a growth company

Mpact a South African paper and packaging company has recently reported highly satisfactory results. It has a rare attribute for a SA based industrial company. It appears to have very good growth prospects linked to good export prospects for SA agriculture as highlighted in BD on May 2nd.

And Mpact seems very willing to invest in the growth opportunity and to raise capital from internal and external sources to fund the growth opportunities. It speaks of a 20% internal rate of return on these projects which would be well above the 15% p.a. that could be regarded as the opportunity cost of the capital it raises.

But the Mpact story is complicated by its shareholding. Caxton an apparently less than friendly shareholder unwilling to raise its 34.9% stake to the point where it has to make an offer to all other shareholders. It prefers to merge its operations with Mpact, a prospect the Mpact board is actively discouraging.

Caxton however argues that Mpact has raised too much debt for its comfort. It may have in mind using its own cash pile to fund the capex after a merger. It may nevertheless have a generally valid point. Mpact might be better advised to fund its growth raising more additional equity capital and less extra debt. This might not suit Caxton but would be a less risky strategy. And there is not good reason that SA pension funds with their typical 60% equity – 40% debt would not welcome the opportunity to contribute additional equity capital that promises good returns.

It is a strategy to be recommended to any growing company. Any equity capital raised that beats its cost of capital will very likely add value for its shareholders old and new. The value of the firm will increase by more than extra capital raised- adding wealth for shareholders with a smaller (diluted) share of what will have become a larger cake. Dilution can take place for good growth reasons- and not only to save off the bankruptcy – that always comes with too much debt.

The temptation always offered by interest rates below what prospective internal rates of return on capex is to raise debt to improve the return on shareholder’s equity. When the internal rates of return have in fact exceeded the costs of finance, hindsight tells us more debt, would and should have been the obviously preferred source of capital. But in an uncertain world such favourable outcomes cannot be known in advance.

The savings in taxes paid, because interest payments are deducted from taxable income, that is equal in value to the tax rate multiplied by the interest paid, may be presumed to reduce the “weighted average cost of capital’ – and so perhaps reduce the target internal rate of return required to justify an investment decision. I would counsel against such an approach. Expected return on all the capital put to work, however funded, should be the initial critical consideration independent of tax to be paid. If the expected returns are attractive, the appropriate financial structure can then be considered. Debt is not necessarily cheaper than equity – because it is more risky – and the firm may well have to pay up for the financial risk it has taken on, usually when it is least convenient to do so.

When the source of any reported growth in earnings appears to be financial engineering, and is largely debt financed, it should be treated with suspicion by actual or potential investors in the shares of such a company. Returns on all capital invested needs to be greater than the interest rate on debt raised and in addition need to at least meet the returns required by shareholders who have alternative investment opportunities. How best to fund the growth should be a secondary consideration after the favourable return on all capital invested can be assumed with confidence.

MPact should be strongly encouraged by its shareholders and South Africans more generally to realise all the projects that can confidently earn 20% p.a. And raising extra equity rather than only debt capital will help ease their way down their apparently long runway -should the 20% materialise.