April 2024 – ZA Economist

Wealth may matter more than income

The resilience of the US economy in the face of higher interest rates has surprised many. Members of the Fed Open Market Committee, having pencilled several cuts to interest rates to come this year, have seemingly reversed course. Their pivot was precipitate. The still highly satisfactory state of the US economy must take the credit- or the blame -depending on whether you a borrower or lender be including in SA. US GDP, that is total output, has grown by 3% year on year and by a below expected 1.6% annualised in Q1 2024. Retail sales, an all-important measure of the state of demand in the US, had a lively February and March. Yet sales had declined steadily for many months before and retail sales deflated by the CPI are still two percent below that of January 2023. This revived willingness of US households to spend more has occurred despite minimal growth in real personal disposable incomes. In February incomes were only 2% higher than they were in early 2023, despite very full employment. Tell that to the White House.

US Retail Sales and Real Disposable Incomes (January 2023=100) Monthly Data to March 2024

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

The good news about spending propensities with its implications for high interest rates for longer had a mixed reception in the financial markets. Given the new uncertainty about Fed action to come, stocks and bonds have fallen back this month.

This minor pull back has come after investors had enjoyed a full recovery from the significant declines in the valuations of stocks and bonds in 2022 when interest rates rose dramatically to deal with the inflation that had taken central banks and the markets by surprise. Yet it has all worked out rather well in the financial and housing markets. History tells us that it takes a financial crisis, to cause a recession, and the global financial system avoided one this time round.

The place to look for an explanation of US economic resilience is the behaviour of the US financial markets themselves. US wealth, consisting mostly of financial assets, stocks bonds and equity in homes, net of household debt, has been increasing dramatically since the Global Financial Crisis of 2010. And received a huge injection from the Covid relief payments and the strength of the financial markets in 2023. US household wealth, net of debts, is now of the order of 156 trillion dollars. That is about seven times Personal Disposable Incomes. It was but 110 trillion dollars in early 2020, and now worth 156 trillion. Up by approximately 40 trillion dollars since the Covid lockdowns. Personal Incomes after taxation have grown by a mere 45 billion dollars since then. (see charts below)

Changes in wealth are as much a source of additional spending and borrowing power as any other source of income. In aggregate unrealised wealth gains dominate changes in other sources of income. Changes in wealth, even if capital gains can reverse, can significantly influence current spending. .Though predicting the wealth effect on aggregate spending requires predicting wealth itself. Which is even more difficult than predicting the disposable income effect on spending. Success in predicting financial markets would be modern alchemy. Yet essential if economic forecasting is to have any scientific validity.

US Wealth, Personal Disposable Incomes and Wealth to Income Ratio

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

US Households. Annual Change in Net Wealth, Value of Financial Assets and Personal Disposable Incomes (USD Billions)

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

Household Wealth in South Africa is about 4.5 times larger than household incomes after taxation. This ratio increased markedly during the growth boom pf 2002-2008 and has largely stabilised since. (see charts below) The wealth of SA households is about to be challenged by a new dispensation. That is the right to easily draw down a third of their accumulated wealth held in pension funds and retirement annuities, the impending two pot system. The impact on spending, interest rates and on the financial and real estate markets in SA will be significant. The forecasters in and out of the Reserve Bank will be fully engaged in predicting the outcomes. Waiting to see what happens may be the only sensible option.

SA Households. Net Wealth and the Wealth to Disposable Income Ratio

Source; SA Reserve Bank Investec Wealth & Investment.

South African Households Annual Changes (R billion) in Net Wealth, Financial Assets and Debt.

Source; SA Reserve Bank Investec Wealth & Investment.

Private over public equity- a winning strategy?

March 31^st 2024

Over the past 20 years institutional fund allocators have fallen in love with high-fee paying, internally valued, and illiquid private investment strategies known as Private Equity (PE). The PE industry has evolved from a small cottage industry to a very important asset class. The PE partnerships that manage the process have gone the other way. Converting from small private partnerships to highly valued public companies. With their revenue and earnings and market value propelled by the ever-increasing inflow of assets they have captured from institutions. Supporting strategies that promise to ignore the “hated” and unavoidable volatility associated with owning listed stocks. Their founders are the new Titans of Wall Street.

These PE managers typically invest alongside their pension fund and endowment partners in the series of multiple separate funds (partnerships) they initiate and raise capital for. The largest the Blackstone Group Inc. has over $1 tr of assets under its management (AUM) and a stock-market value of $155b. Other prominent names in the category include KKR, the Carlyle Group, Apollo, Ares, Blackrock and Brookfield.

For privately owned operating companies sourcing capital from these private equity funds has clearly become an increasingly viable alternative to an initial public offering of their shares. The number of publicly listed companies traded on US exchanges has fallen dramatically from a peak in 1996 of 8,000 plus. Now only 3700 companies are listed in the US. Astonishingly there are now about five times as many private equity-backed firms in the US as there are publicly held companies according to the Wells-Fargo Bank.

Staying or going private works because the private co-owners and managers of their business operations are very likely to focus narrowly on realising a cost of capital beating return on the capital at risk, including their own capital. The controllers of the private equity funds are aware of the advantages of appropriately incentivised owner-managers. They design their contracts with the private companies they oversee accordingly. And the private companies that the funds invest in will also be encouraged to raise debt to improve returns on less equity capital.

Regular fund valuations and annual returns on the funds however are conveniently based on internal calculations of net asset value. Reporting smoother annual returns, so calculated, than provided by listed equity plays well in the annual performance reports provided to trustees of pension funds and endowments. Moreover, if returns on equity generally exceed the costs of finance over the long run, as expected, the case for leveraging returns on equity capital with more debt is a powerful one. And lenders also like smoother, predictable returns, especially when secured by the pre-commitments to subscribe funds when called. The longer the call for capital by the funds can be delayed, the higher will be the returns on the lesser equity capital invested.

A further advantage is that their private companies supplied with capital will be given time –five to up to ten years – to prove their business case – before the funds have to be liquidated. Perhaps via an initial public offering of shares (IPO) public market conditions permitting. Or a sale of assets to another PE fund. Perhaps even rolled over to a new fund raised by the same fund manager. The performance fees paid to the private equity firms themselves (perhaps 20% of the capital gain) will be realised on the final liquidation of a fund. Management fees of typically 1-1.5% p.a. on AUM will also be collected. These performance fees account for a large proportion of the fund manager’s revenue.

Yet paradoxically it would have been an even better idea to have become a General rather than a Limited partner in these burgeoning private equity funds. That is owning the shares of the listed private equity managers as an alternative to subscribing to one of their funds. The shares of six of the largest listed PE managers – yes volatile and market-related – have SIGNIFICANTLY outpaced the excellent performance of the S&P 500 Index itself. And PARADOXICALLY outperformed most of the funds they have managed. Taking more risk in PE investments has had its reward. (see below)

Listed Private Equity Companies; Market Cap weighted value of six large listed PE managers. (2014=100) Month End Data.

Source; Bloomberg, Investec Wealth and Investment International

What will be the catalyst for South African growth?

Private sector involvement in South Africa’s key capital expenditure (capex) projects could be the catalyst to set off a virtuous cycle of investment and growth.

The Covid-19 lockdowns led to some unusual economic developments. Among them was that gross savings in South Africa came to exceed all declining expenditures on capital goods (new plant and equipment, new houses and apartments, etc). Thus, a “capital light” South Africa became an exporter of our scarce savings.

Last year normal service was resumed, capex increased by more than savings and South Africa became a net importer of foreign capital again. This “back to normal” state also meant that incomes fell short of all spending in 2023 and that the current account of the balance of payments went into deficit. All these deficits were equivalent to a modest 1.6% of GDP (see below).

SA national income and balance of payments – measured as a share of GDP

Source: SA Reserve Bank (national income and balance of payments accounts) and Investec Wealth & Investment, 09/04/2024

Is this good or bad news? Clearly, the more capital South Africa can attract from foreign savers – particularly if it were used to fund productivity and income-advancing plant and equipment, and R&D – the better the economy would perform in the short and long run. Or to put in another way, the higher the levels of gross spending, relative to current incomes, the larger the capital inflows and the larger the current account deficits.

Yet both savings and capex have fallen to low proportions of total incomes. The savings and capex rates, now around 15% of GDP, have been in decline. Compare this with the strong growth years between 2002 and 2008, when capex again surged, the savings rate remained subdued, and foreign capital flowed in to realise faster growth (see below).

Gross capex and gross savings as a percentage of GDP

Source: SA Reserve Bank (national income and balance of payments accounts) and Investec Wealth & Investment, 09/04/2024

To achieve faster growth in incomes and expenditure, you need higher levels of capex. You also need South African households to spend more on the goods and services supplied by the local producers. Without support from interest-rate dependent household spending (now decidedly lacking), private businesses will not invest enough. Thus, any immediate increase in the savings rate (less spent) would neither be welcome nor realistic.

SA distribution of gross savings (R millions)

Source: SA Reserve Bank (production, distribution and accumulation accounts) and Investec Wealth & Investment, 09/04/2024

The extra debt raised by households to fund their homes, cars, furniture and appliances, largely cancels out their significant contributions to pension and retirement funds. This is why business savings (cash retained out of earnings) account for all of gross savings in South Africa. In the interest of faster growth for SA we would prefer businesses to spend more, to rely less on their own free cash flow, and augment their capex by raising debt or equity capital, including from abroad, as they did between 2002 and 2008. Negative free cash flow would be good for business and economic growth. As it was between 2002 and 2008 (see below)

But what would it take to set off for a virtuous cycle of more household spending and more profitable businesses, willing to raise their capex and labour forces, to then generate higher incomes for their workers?

SA corporation savings (cash retained) over disposable incomes (earnings after taxes)

Source: SA Reserve Bank (production, distribution and accumulation accounts) and Investec Wealth & Investment, 09/04/2024

Much of the capex (over 70%) in South Africa is undertaken by private business enterprises. The share of the public corporations and the government in all capex has fallen away in recent years, (now 28%) after rising to well over 30% ten years ago. The Medupi and Kusile power plants and the Chinese locomotives were expensive projects that did not add to electricity generated or tonnes carried. It’s not enough to spend more on essential infrastructure, it must be capital well spent, to ensure the private sector can thrive.

SA gross capital expenditures (R millions) and share of private business in total capex (RHS)

Source: SA Reserve Bank and Investec Wealth & Investment, 09/04/2024

Eskom and Transnet have clearly failed the key economic survival test of earning a positive return on capital, as the government now recognises. The privately managed alternative is very much in prospect and the economic case for investing in South African infrastructure remains strong.

The private capital to fund such capex would be readily available from local and foreign sources. Private equity managers with access to institutional capital would be eager participants and the right terms to attract capital would not be onerous. These terms would have to guarantee inflation-linked utility charges, based on a realistic risk-adjusted return on the capital invested. Private business or private-public partnership so engaged would also need to be left largely free to sign their own procurement contracts. In this way, the virtuous circle would be set in motion.

The Shoprite Story. How impressive is it really?

Shoprite is an outstandingly successful South African business as its interim results to December 2023 confirm. It has grown rand revenues and volumes by taking an increased share of the retail market. The return on the capital invested in the business remains impressively high. Post Covid returns on capital invested has encouragingly picked up again.

R100 invested in SHP shares in 2015, with dividends reinvested in SHP, would have grown to R231 by March 2024. Earnings per share have grown by 55% since January 2015. (see below) The same R100 invested in the JSE All Share Index would have grown to a similar R198 over the same period. (see below) Though SHP bottom earnings per share seemed to have something of a recent plateau – load shedding and the associated costs of keeping the lights on have raised costs.

SHP Total Returns and Earnings (2015=100)

Source; Bloomberg and Investec Wealth and Investment

But earnings and returns for shareholders in rands of the day that consistently lose purchasing power need an adjustment for inflation. The performance of SHP in real deflated rands or in USD dollars has not been nearly as imposing. Recent earnings when deflated by the CPI or when converted into USD are still marginally below levels of January 2015 and well below real or dollar earnings that peaked in 2017. (see below) The average annual returns for a USD investor in SHP since 2015 would have been about 6% p.a. compared to 10.6% p.a. on average for the Rand investor. SHP earnings in US dollars are now 6% below their levels of 2015.

Shoprite Earnings in Rands, Real Rands and US dollars (2015=100)

Source; Bloomberg and Investec Wealth and Investment

Shoprite- performance in USD (2015=100)

Source; Bloomberg and Investec Wealth and Investment

The SHP returns realised for shareholders compare closely with those of the JSE All Share Index but have lagged well behind the rand returns realised on the S&P 500 Index. (see below) Even a great SA business has not rewarded investors very well when compared to returns realised in New York. It would have taken a great business encouraged by a growing economy to have done so.

The depressingly slow growth rates realised and expected are implicit in very undemanding valuations of SA economy facing enterprises. The investment case for SHP and every SA economy facing business, at current valuations would have to be made on the possibility of SA GDP growth rates surprising on the upside.

It will take structural supply side reforms to surprise on the upside. Of the kind indeed offered by the Treasury in its 2024 Budget and Review. The Treasury makes the case for less government spending and a lesser tax burden to raise SA’s growth potential. It makes the right noises and calls for public – private partnerships and “crowding in private capital”. The help for the economy would come all the sooner in the form of lower interest rates, less rand weakness expected and less inflation, were these proposals regarded as credible. With more growth expected fiscal sustainability would become much more likely. Long term interest rates would decline as the appetite for RSA debt improved. And lower discount rates attached to SA earnings would command more market value.

Lower long term interest rates (after inflation) would reduce the high real cost of capital that SA businesses have now to hurdle over. Whichever fewer businesses are understandably attempting to do. Without expected growth in the demand for their goods and services, businesses will not invest much in additional plant or people. SHF perhaps excepted. The current lack of business capex severely undermines the growth potential of the SA economy over the long term.

Yet SA suffers not only from a supply side problem. The economy also suffers from a lack of demand for goods and services. Demand leads supply as much as supply constrains incomes and demands for goods and services. The case for significantly lower short term interest rates to immediately stimulate more spending by households – seems incontestable- outside perhaps of the Reserve Bank.