Author: Brian Kantor
Italy, Europe and beyond
Renewed volatility in bond and currency markets. Learning the lessons of monetary history.
Europe (especially Italy, but also Spain) rather than emerging markets (especially Turkey) has become the new focus of attention in financial markets. Bond yields in Italy and Spain have increased sharply in recent days. The two year Italian bond yield is up from zero a few days ago to the current 2.82% while the spread between 10 year Italian bonds and German Bund yields have risen from 1% to 2.87% in three days.
Rising US interest rates were the proximate cause of some earlier distress in emerging bond markets and now in the past few days have reversed course. From a recent high of 3.12% the yield on the key 10-year US Treasury Bond has fallen back to 2.83%. RSA bond yields have also receded in line with Treasury bond yields. Yesterday they were at 8.59% and about 28 basis points lower than their recent high of 8.87% on 21 May. However the risk spread with US Treasuries has widened marginally, from recent lows.
While long term interest rates in the US have fallen back, the US dollar has strengthened further against the euro and most currencies, including emerging market (EM) currencies like the rand. German Bunds are another safe haven and the 10-year Bund yield has also declined, from 0.64% earlier this month to the current 0.33%. This has allowed the spread between Treasuries and Bunds to widen further – to 2.6%, helping to add strength to the US dollar.
It should be appreciated that RSA bonds have held up well under increased pressure from US rates and now also some European interest rates. In figure 4 we compare RSA dollar denominated five year (Yankee) bond yields with those of five year dollar bonds issued Turkey and Brazil. While all the yields on these dollar denominated bonds have risen and also very recently have fallen back, the RSAs have performed relatively well.
The US dollar went through an extended period of weakness against its developed market peers and EM currencies between mid-2016 and the first quarter of 2018, after which the dollar gained renewed strength. Dollar strength can be a particular strength to EM currencies and the recent episode of dollar strength has proved no exception in this regard.
As we show below in figures 5 and 6, the rand performed significantly better than the EM Currency Index from December 2017 and has recently performed in line with the average EM currency vs the US dollar and much better than the Argentine peso and the Turkish lira recently. In figure 6 the declining ratio EM/ZAR indicates relative rand strength.
We may hope that the rand will not be subject to any crisis of confidence. So far so good. But were the rand to come under similarly severe pressure as has the Turkish lira, one would hope that the Reserve Bank would avoid the vain and expensive attempts to defend exchange rates that Argentina and Turkey have made. Throwing limited forex reserves and much higher short term interest rates at the problem can only do further harm to the real economy – and very little to stem an outflow of capital. As has been the latest case with Turkey and Argentina.
It was the mistake the Governor of the Reserve Bank Chris Stals made in 1998 when failing to defend the rand during that emerging market crisis. The best way to deal with a run on a currency – caused by exposure to a suddenly stronger dollar – is to ignore it. That is to let the exchange rate absorb the shock and live with the (temporary) consequences for inflation. Defending the currency provides speculators with a one way bet against the central bank attempting to defend the indefensible. It is much better to let them bet against each other and let the market find its own equilibrium. The renewed volatility in Europe, we may also hope, will continue to hold down US and RSA interest rates – and deflect attention from emerging markets. 30 May 2018
Recent Research
Much of my recent research output has been published in the Journal of Applied Corporate Finance, now published for Columbia Business School by Wiley. (See references below) Some earlier versions of this work may be found on the Blog- but copyright prevents me from posting the published versions.
Global Trade – Hostage to the Volatile US Dollar, Journal of Applied Corporate Finance, Volume 30, Number 1, Winter 2018
The Beliefs of Central Bankers about Inflation and the Business Cycle—and Some Reasons to Question the Faith, Journal of Applied Corporate Finance; Volume 28, Number 1, Winter 2016
A South African Success Story; Excellence in the Corporate use of capital and its Social Benefits with David Holland, Journal of Applied Corporate Finance, Volume 26, Number 2, Spring 2014
2013 Nobel Prize Revisited: Do Shiller’s Models Really Have Predictive Power? with Christopher Holdsworth, Journal of Applied Corporate Finance, Volume 26 Number 2 Spring 2014
Lessons from the Global Financial Crisis (Or Why Capital Structure Is Too Important to Be Left to Regulation) with Christopher Holdsworth, Journal of Applied Corporate Finance, Volume 22, Number 3, Summer 2010
Podcast: The case for looking beyond the large caps quoted on the JSE
Find below a link to a podcast with Barry Shamley, Portfolio Manager. Investec Wealth and Investment discuss the case for looking beyond the large caps quoted on the JSE . This is the first trail of a series of podcasts that I will be conducting and posting on the website.
Retail peaks and troughs
Retail spending has gathered momentum. Have we reached a (low) peak in the retail cycle?
The volume of retail sales in South Africa has gained momentum, off a very weak base. By March real sales were up 4.8% compared to a year before. Will this cyclical recovery in spending at retail level accelerate or fall back? The answer will depend on the future path of inflation in SA, to which short term interest rates and the cost of credit for households and firms are linked. The future path of the rand will be critical to the inflation outcomes, as we discuss below.
This growth in spending was stimulated by a sharp decline in retail inflation from early 2017 (see figure 1 below). Retail inflation in March 2016 was 7.4% and declined steadily to 1.6% in March 2018. Retail sales growth was a negative 1.7% in December 2016. Growth in sales a year later was over 5%. The real sales cycle was at a trough when the retail price cycle was at its peak in Q4 2016.
(Retail inflation is calculated as the annual change in the retail price deflator, being the ratio of retail sales at current prices to retail sales at constant prices. It has fallen far below headline CPI inflation that was 3.8% in March 2012.)
A large part of the answer to whether or not the retail recovery will accelerate or decelerate will depend on the direction of retail prices and on interest rates that will take their cue from the price trends. As may be seen in figure 1, the time series forecast is for a slowdown in sales growth from its peak and a modest pick-up in retail inflation from its recent trough. It will take rand strength to avoid these outcomes.
In figure 2 we show this clearly negative relationship (inflation up and sales growth down) over an extended period. It also shows how low the current rate of real sales growth is in comparison to the previous peak growth rates realised in 2006 and 2011. There would be little reason to regard the current rate of retail sales growth as representing a peak in the cycle – were it not for a concern that retail price inflation may have reached a cyclical trough.
The declining trend in retail and headline inflation since mid-2016 had much to do with the stronger rand. Another force acting particularly on food price inflation was the end of the drought in the eastern part of the country of 2016. The drought had pushed food price inflation to double digits. Food price inflation was 3.5% in March 2018. Inflation peaked after the USD/ZAR exchange rate had reached its weakest point in late 2015. And headline and retail inflation receded after the rand had come to strengthen on a year on year basis. Thus the future of inflation in SA will depend, as ever, on the exchange rate, given the openness of the economy to foreign trade. Exports and imports together add up to the equivalent of 60% of GDP.
We compare CPI (headline) inflation with retail price inflation in figure 3 below. We show the impact of the exchange rate on inflation in figure 4.
In figure 5 we compare the correlated movements in the USD/ZAR and trade-weighted rand. Both rand exchange rates are helpfully for inflation trends that still marginally stronger than they were a year ago, even after recent US dollar strength and rand weakness.
The key to the exchange value of the rand in the months to come (and so for the outlook for inflation) will be the behaviour of the US dollar. Dollar strength vs peers is likely to mean weakness in emerging market currencies, including the rand, as has been the case since mid-April. Dollar strength in 2014 was associated with emerging market currency weakness until mid-2016. A degree of dollar weakness, and rand and emerging market strength followed until very recently. It may be seen that since April 2018, renewed dollar strength vs the euro, yen, sterling and the Swiss franc has been associated predictably with emerging market and rand weakness.
The degree to which the rand moves independently of the other emerging market exchange rates as shown in the figures may be regarded as the additional SA-specific political events that can influence the exchange value of the rand. SA risks weakened the rand compared to other emerging market currencies in 2015 – and a diminished sense of SA-specific risks to investors strengthened the rand in a relative sense in 2016 and again in late 2017.
Thus it should be appreciated that most of what happens to the rand will reflect global forces acting on emerging market currencies generally, events over which SA has no influence. Nor are SA interest rates likely to influence the rand exchange rates in circumstances when global capital flows dominate exchange rate movements. In our view, with the Ramaphosa presidency now firmly in place, the exchange value of the rand in 2018 will be influenced largely by what happens to the US dollar and all emerging market currencies.
The recent strength of the US dollar is a clear danger to the rand and SA inflation. A stronger US dollar means rand weakness and more inflation in SA and at best stable short-term interest rates. More inflation and unchanged interest rates will hold back retail sales. A weaker dollar however would mean less inflation, possibly lower interest rates and continued strength in retail sales volumes.
The dollar strengthens when the US economy grows faster than other developed economies and vice versa. Relatively faster growth in the US means that US interest rates are likely to rise relatively to interest rates in Europe and Japan, so attracting flows into the dollar, as has been the case recently. More synchronised global growth is to be hoped for to restrain dollar strength and protect the rand and improve the outlook for inflation and growth in SA.
SA has little influence over the direction of the rand and hence inflation and the retail sales cycle. The best SA monetary policy can do in these circumstances is to let interest rates take their direction from the state of the economy and not the outlook for inflation – which is dominated by forces beyond interest rate influence. The danger to the economy comes from interest rate settings that react to the impact of a stronger US dollar on domestic inflation. 23 May 2018
Not so quiet on the interest rate front
Things became more active on the global interest rate front last week, led by an advance of US yields. The key 10-year US Treasury yield was below 3% earlier in the week, but was at 3.12% onThursday before pulling back to 3.05% on Friday (it was ar 3.07% this morning). Not only have yields moved higher, but the spread between US Treasury and German Bund yields have widened further, to 2.5%.
This may be thought to be enough of a carry (enough US dollar weakness priced in, that is) to attract funds to the US and restrain the upward march in US rates and the US dollar. The US dollar has gained not only against the euro and other developed market currencies, it has gained against emerging market (EM) currencies, like the rand, as is usual when the dollar rises against the euro, yen and sterling. A strong dollar is a particular threat to EM currencies. The JP Morgan EM exchange rate index is now at 66.1 while the the US vs developed market currencies index (DXY) is trading at 93.87.
The rand has been among the better EM performers in the face of the advancing dollar as we show in figures 4 and 5 below (all rates in these charts up to 18 May – though the rand did come under motre pressure than other EM currencies on Friday). The ratio of the USD/ZAR to our own construct of eight other EM currencies and their exchange rates with the US dollar, improved significantly between November 2017 and March 2018 and the USD/ZAR has maintained its rating since then. The story of the rand has once more become a story of the US dollar rather than of South African politics. And seems very likely to remain so.
This ratio was 0.917 on the Monday 14 May – it weakened to 0.934 by the Friday. The story of the rand has once more become a story of the US dollar rather than of South African politics, and seems very likely to remain so.
Interest rates in the US have risen (and the dollar has strengthened) because the acceleration in US growth has been confirmed by recent labour market trends and by the strength in retail sales volumes reported last week. The state of economies outside the US, in Europe and even in emerging markets however, appears less certain. Global growth appears, at least for now, less synchronised – making for fewer correlated movements in short- and long-term interest rates.
It is of interest to note that US shorter term interest rates have been rising faster than long rates. The spread between the 10 and two-year Treasury bond yields have narrowed further. This flatter yield curve indicates that the US may be getting closer to the end of the cycle of rising short rates. Or in other words the GDP growth rates that justify higher short rates may well have peaked and are slowing down- which if so will cause short rates to decline from higher levels in the not too distant future. (See figure 6 below)
It is of particular importance to note that the recent increase in US yields have not been a response to more inflation expected. Inflation-protected real yields offered by the Treasury (TIPS) have increased in line with vanilla bond yields. The spread between nominal and real 10-year treasury yields has remained largely unchanged around 2.2%. That is to say, the bond market continues to expect inflation to remain at the 2% level for the next 10 years. So what is driving nominal yields higher is more growth, rather than the expectation of more inflation, thus representing interest rate developments that are less dangerous to equity valuations than if it were only inflationary expectations that were driving yields higher. The more GDP (and so earnings growth) expected, the more it improves the numerator of any present value calculation, perhaps enough to compensate for higher discount rates.
South African bond yields, as well as the USD/ZAR, have moved higher in response to US yields. However the spread between RSA and Treasury yields has remained largely unchanged. The spread, which indicates by how much the rand is expected to weaken against the US dollar over the years, narrowed sharply after November 2017. In other words, as the political news out of South Africa improved. Figure 8 below shows the SA exchange rate risks and the more favourable trends in RSA and US long bond yields, and in exchange rate expectations since January 2017.
Conclusion: how best to react to dollar strength
A stronger US dollar is seldom good news for the growth prospects of emerging market economies, including South Africa. It puts upward pressure on prices and downward pressure on spending. It furthermore raises the danger of monetary policy errors of the kind Argentina has been making: raising interest rates to fight exchange rate weakness and the (temporarily) higher prices that follow. This then slows down economic growth further, without helping and maybe even harming the exchange rate. Slower growth drives capital away and interest rates, become less attractive when a still weaker exchange rate is expected.
The wise policy approach is to ignore of exchange rate weakness that is caused by dollar strength and not by excessive domestic spending. South Africa made such monetary policy errors during the last period of US dollar strength between 2011 and 2016. We may hope that such errors are not repeated. We may hope even that this period of dollar and US strength is a temporary one – and that growth outside the US resumes an upward trajectory. 21 May 2018
The Tencent effect
A good day for Naspers shareholders. Dare they hope for Tencent-like performance in the future?
Naspers had a very good day yesterday. It ended up over 5% in rands and almost as much in US dollars. It took the JSE higher with it thanks to its large size and share of the JSE by market value (approximately 20% of the All Share Index). Demand for Naspers shares from abroad may even have helped the rand recover on the day. The JSE All Share Index ended up by 15%. Naspers is now worth approximately R1.4 trillion.
The reason for this renewed enthusiasm for Naspers shares was a surprisingly good set of results from Hong Kong-based Tencent – reported after the Hong Kong market closed. Tencent is currently up by 6% in New York. Naspers has a 31.01% share of Tencent worth approximately R2 trillion at the close of trading on the JSE the day before. Naspers understandably rises and falls on a daily basis with the value of Tencent – though not necessarily to the same degree.
That is because there is more to Naspers than its stake in Tencent. We show in the figure below that the market value of Naspers has trailed behind that of Tencent, when both are measured in US dollars. Tencent is up 12 times since 2010 and Naspers has added (only!) about six times to its 2010 value.
Tencent and Naspers have also outperformed the S&P 500 Information Technology sector that includes all the big names in US technology stocks (the famous FAANGS) Facebook, Apple, Amazon Netflix, Google (Alphabet) to which Microsoft could be added, another superb IT company. On a day-to-day basis there is also a highly correlated movement between Tencent and the S&P Information Technology Index. Tencent and Naspers are high beta plays on global IT, but with significant alpha to add to returns.
Yet Naspers, while worth R1.4 trillion, is valued at significantly less than its stake in Tencent. Naspers furthermore has other assets – as well as debts and cash – that would add further to the difference between the sum of Naspers’ parts – its net asset value (NAV) and its market value. This difference between what Naspers would be worth if broken up and sold off and what it is worth as a going concern is a mammoth R700bn. Put another way, the Naspers management, while to be congratulated on their decision to invest in Tencent in the early 2000s, could possibly be accused of wealth destruction elsewhere. Everything else that it has done, other than invest in Tencent, has reduced the wealth of its shareholders.
Naspers conducts a very large investment programme, investing far more than the cash it has received as dividends from Tencent – US$248m in 2017. According to David Smith of Investec Securities, Naspers injected net cash into its ventures of US$3.43bn in 2014, US$1.43bn in 2015 and US$1.98bn in 2016. In 2017 it extracted cash (reduced debts) by US$1.8bn.
Recently Naspers enjoyed a major success when it sold its stake in Flipkart – an Indian internet company for US$2.2bn, realising a gain of US$1.6bn, or a rate of return of about 21% p.a. over six years and for about 30% or US$500m more than the market had thought it was worth. Clearly value adding but not as value adding as the 41% p.a. returns generated by its investment in Tencent over the same period.
The proceeds of this sale, as well as the R10bn received from reducing the Naspers share of Tencent to 31%, has since been added to the Naspers cash pile. Were investors of the view that this cash could produce cost of capital-beating returns of the Flipkart kind, the market value of Naspers would benefit and the gap between NAV and market value would narrow. Or equivalently, Naspers could then perform more closely in line with Tencent.
But this appears not to be the case. The market appears of the view that the stronger the Naspers balance sheet, the more its stake in Tencent is worth and the more cash it has to invest, the more it will be inclined to invest in ventures that destroy value for shareholders. That is to say, the cash invested by Naspers is expected to earn less than if the cash were returned to shareholders and invested by them. The large difference between NAV and the market value of a Naspers share reflects in part the losses expected to be incurred in the investment decisions the company will make in the future. The market value of Naspers is set lower to compensate shareholders for this danger that their capital will be wasted on a large scale. Only a lower Naspers share price can then offer market equaling returns; hence the gap between NAV and the market value.
A further reason why Naspers has lagged behind Tencent is that Naspers has issueda large number of shares. Shares have been issued not only to fund its investment programme but also to reward its managers. There were 290.6m Naspers N (low voting) shares in 2006. By 2017 this had grown to 431.5m shares in issue, an increase of 48%. Between 2012 and 2017, Naspers issued an extra 46.8m shares with 58% of the new issues going tp staff compensation. Tencent by contrast has issued very few shares over the years. Clearly the value of a Naspers share reflects in part the danger of further dilution of this order of magnitude.
Naspers could add market value and close the value gap by adopting a more disciplined approach to its investment and incentive programmes and convincing investors that it would do so. In other words, to quote its one time MD and now chairman, Koos Bekker, to throw less spaghetti at the wall so that perhaps more will stick. And to align the interests of managers and its shareholders by rewarding both in some proportion to a reduction in the absolute gap between the NAV and market value of Naspers.
Perhaps some progress in this regard is being made. This year the performance of Naspers and Tencent has been better aligned – as we show below and is reflected in a more stable ratio Naspers/Tencent over recent months. Shareholders in Naspers will hope for more of this more comparable performance. 17 May 2018
Dividing the JSE into its critical paths
Julius Caesar divided Gaul into three parts. To better understand the JSE (if not to conquer it) we would divide it into four parts: SA economy plays, global plays, resource companies and in an important category of its own, Naspers, that is a play on global information technology.
The first of these are the banks, retailers, some of the listed property counters and many of the small and mid-cap, which perform distinctly better when the rand strengthens, inflation and interest rates come down and spending by households and firms gather momentum. When the rand weakens and inflation and interest rates move higher, they perform poorly. They depend on the SA economy for sustenance.
The second part consists of the global consumer and property plays listed on the JSE. Their (foreign currency) earnings depend on the prevailing state of the global economy. They may have their primary listing and jurisdiction elsewhere, with a relatively small proportion of their shares held by South Africans. British American Tobacco and Richemont fall into this category. Their share prices are determined by investors offshore. Their US dollar or sterling share prices are then translated back into the rand equivalents on the JSE, at prevailing rates of exchange. Their rand values go up and down as the rand weakens or strengthens, for any given dollar value of their shares.
But their dollar value may also be changing at the same time. The better their expected performance (in dollars) the more valuable they become in dollars too, to be translated almost simultaneously into rand values (and vice versa). Higher dollar values for such stocks may well overcome rand strength and lower dollar values may even drag down their rand values even if the rand weakens at the same time. They may not in fact then act as a rand hedge at all.
When rand weakness or strength has its origins in SA political developments, the global consumer and property plays will act as a hedge against the SA-specific forces that can weaken or strengthen the rand. They then perform best in rands when rand weakness, for SA reasons, accompanies the good global growth that supports their dollar values. Their rand values will then rise for both reasons: a weaker rand and rising US dollar valuations. However when the rand strengthens as it did recently for SA reasons, the opposite may happen. Their rand values can decline. Thus they are thus better regarded as SA rather than rand hedges.
In the figure below we show how an equally weighted basket of 18 SA economy plays dramatically outperformed a basket of 13 equally weighted global plays (excluding Naspers) after January 2017 and until recently. The SA plays were benefitting from a strong rand, strong not only against the US dollar, but also against other emerging market currencies, for largely SA-specific reasons linked with the demise of the Zuma regime. The global plays, for partly the same SA-specific reasons, were moving strongly in the opposite direction. It should be noted that this included Steinhoff, with an equal weight in the basket of global plays, which lost almost all of its value for company specific reasons. This is always a danger to any portfolio and highlights the case for diversification.
Thus the JSE as a whole – subject to these opposite forces with about equal weights in the All Share Index, but then helped by the gains made by Naspers and resource companies – has gained about 14% since January 2017.
Which brings attention to the third part of the JSE: resource companies. Most of their revenue is earned on world markets in US dollars. Some of their production is carrried out in SA and in rands. A weak rand is helpful to their revenues and may even help widen their operating profit margins, when rand costs lag behind rand revenues in response to a weaker rand. But a weaker rand and weaker emerging market currencies may well be associated with weaker global growth and lower metal prices.
In these circumstances, as followed the end of the super commodity cycle in 2011 and lasted until mid 2016, the weaker rand could not make up for the lower US dollar values attached to resource companies worldwide. JSE-listed resource companies were not rand hedges: their rand values declined with the weaker rand. They are plays on the metal price cycle – not on the rand. However they will perform best – as will the global consumer plays – when the rand is weak for SA reasons and when global commodity prices are holding up.
The fourth part of the JSE is Naspers, with its large holding in Tencent, an extraordinarily successful Chinese technology company. The rand value of Naspers tracks the value of its Tencent shares enough to have made it the largest company listed on the JSE. It now accounts for about 20% of the JSE, from a mere 1.3% weight in 2009. Without Naspers the JSE as a whole would be worth no more today than in 2014. The JSE All Share Index has become a play on Naspers, though the additional investment and acquisition activity expected of Naspers as well as expected head office expenses have made Naspers less valuable than its stake in Tencent and its other valuable parts.
Naspers is itself a play on Tencent and Tencent is in part a play (a high beta play) on global technology. The recent weakness in Naspers and Tencent can be explained by declines in the values attached to global tech companies. On a day-to-day basis the direct link between the movements in the S&P IT Index and of Naspers and Tencent shares has become very obvious.
And so most companies listed on the JSE will do outstandingly well for investors when faced with a combination of the surprises of rand strength and strength in the global economy, associated with improvements in underlying metal prices that will add to the US dollar and rand values of the global and resource plays. That rand strength may take off some of the gloss off the rand value of share portfolios will be of little concern to SA rand investors and even less interest to foreign investors on the JSE. And the JSE will do even better should Tencent and global technology continue to surprise investors with their results. A further boost to Naspers shareholders would come should it be able to convince the market about the quality of its own ambitious investment programme.
The potential upside and the potential dangers should it not turn out so well for the rand, the global economy and IT call for active investors. The risks to investors on the JSE are too concentrated to justify a passive approach to the JSE as a whole. 10 May 2018
Time-series-based Financial Analysis led us down a blind alley – could Big Data Analysis repeat the same mistake?
Abstract
This paper considers the new thrust of Statistical Analysis and Operations Research in the area of so-called Big Data. It considers the general underlying principles of good statistical modelling, particularly from the perspective of Pidd (2009), and how some initiatives in the Big Data area may not have applied these principles correctly. In particular, it notes that demonstrations of applicable techniques, which are purported to be appropriate for Big Data, frequently use data sets of stock market share prices and derivatives because of the huge quantum of high frequency share price data which is available. The paper goes on to critique the frequent use of such historical stock market price data to forecast stock market prices using time series analysis and details the limitations of such practice, suggesting that a large volume of work done towards this end by statisticians and financial analysts should be treated with circumspection. It is seen as unfortunate that a large contingent of extremely able students are directed into areas that encourage time series modelling of stock market data with the promise of forecasting what is essentially unforecastable. The paper also considers which approaches may be appropriately applied to model and understand the process of share price determination, and discusses the contributions of the Nobel-prize winning economists Fama and Shiller.
The paper then concludes by suggesting that the Big Data initiative should be treated with some caution and further echoes the sentiments of Pidd; namely that the focus in Operations Research and Statistics should remain firmly on creative modelling, rather than on the singular pursuit of large amounts of data.
Read full paper here: Kantor 2018 – Big Data
Artificial intelligence, robots and a world of abundance
The pace of technological and scientific change is both rapid and accelerating. Robots controlled by powerful computers have invaded factory floors, warehouses and distribution centres with great effectiveness.
The number of workers employed in traditional occupations has, accordingly, shrunk. Transistors, sensors and cameras may soon combine to eliminate the need for someone in the driver’s or pilot’s seat, and move us about faster and more safely than before, while at the same time eliminating millions of jobs.
A common modern refrain in response to the challenge of the robots is: where will all the workers go? Will they go into other jobs or into unemployment? And, if the cohort of the unemployed is to become a much larger one, how will society cope with the assumed failure of an economy to employ most of those who seek work?
Replacing workers with machines is not something new
The advance of knowledge and its application to production – so improving the ratio of output to inputs of resources of land, labour and capital – is not something new. Economic progress, accompanying scientific advances and the invention of ever more powerful machines has been more or less continuous since the 17th century. It then accelerated in the 19th century with the growth in mechanised industry, which was described by historians as the (first) industrial revolution.
The increased production of goods and services enhanced by ever more productive machinery of all kinds (medical equipment included) has been accompanied by consistent advances in the average standard of living and life expectancy, as well as the rapid growth in population. The world’s population has more than doubled since 1970, increasing from 3 billion souls to more than 7 billion today. On average, we numerous humans are better supported today by higher levels of production of the essentials for life: food, shelter and medical care. We are provided for with more of the luxuries of life, including more time off work.
We choose more leisure – when we can afford to do so
A preference for more leisure has been exercised in ever greater volume as the average hours per week worked has declined. Leisure is a highly desired form of consumption for which income and other forms of consumption have been willingly sacrificed. Choices have been made by those who can afford to reduce hours at work. Some of the associated drudgery and dangers of work have been eliminated with the aid of machines, helping to make work less onerous and even pleasurable. Nice work – if you can get it.
Those who thrive with the help of robots are likely to choose more leisure and the services that accompany time off work.
This growth in population has been accompanied by a rapid (more or less) increase in workforce numbers. The increased number of humans surviving and employed today has been accompanied by a large reduction (billions fewer) of those having to merely survive in poverty. Absolute poverty is conventionally defined as those earning or consuming the equivalent of two US dollars per day. Most would describe these developments as progress, even if happiness, however defined, may remain as elusive as ever.
These increases in incomes and output represent impressive and consistent economic progress (compounding growth in output and incomes) made over the past 300 years. Yet there is much more to be done to raise average living standards to the levels now realised by those in the upper quintiles of income distribution in the most economically developed economies. This appears an attainable prospect given the record of past economic performance.
Only the (few) well off in their comfort zones might wish to halt economic progress
There is, therefore, every reason, out of concern for our fellow humans, to encourage the scientific revolution and make humans ever more productive and able to earn more than subsistence incomes.
Robots’ capabilities are bound to improve with developments in artificial intelligence (AI) that will make the machines less dependent on their human supervisors.
The numbers of workers employed designing, building, servicing and operating each robotically enhanced unit of equipment will also decline, aided in their efforts by AI. The robots, with enough enhanced artificial intelligence at their disposal, may be able to write their own operating instructions. Therefore, we may see the need for even fewer writers of the underlying computer code that provides the platform for their intelligence.
Output per person employed and, as a result, total output will rise with the application and utilisation of these new wondrously productive machines. Production – the output of goods and services produced with the aid of capital equipment, including what we now describe as robots of one kind or another – may grow even faster and more continuously than in the past.
This productivity provides society with opportunities and challenges. The challenge, as always, will be to maintain order and stability. A growing economy will surely provide the opportunity to satisfy competing interests, particularly those that come with unequal rewards – if only relatively.
Will machines become substitutes for, rather than complements to, human action?
So, will the pace of change now leave more behind, whose dissatisfaction may then become a source of violent instability for society? The less skilled may be more vulnerable than they have proved to be in the past, since they may be less able to compete directly with the robots for robotic-type work, which may be all that many humans undertake and are capable of.
The same displaced workers may be unable, for want of relevant skills, to find alternative employment building and servicing the ever more numerous robots. Or, they may be capable of providing service to those earning higher incomes from owning, designing, managing, building and maintaining the robots, given competition from the increasingly dexterous robots.
Humans will adapt, as they always do, to changing circumstances
All may not be about to be lost by human agents in the competition with machines. I am informed that while computers now exist that will always be able to beat a chess grandmaster, the master chess player, accompanied by a computer, can typically beat the same computer unaided. The highest incomes in the years to come may be earned by those who are best able to work with the robots.
Those who thrive with the help of robots are likely to choose more leisure and the services that accompany time off work. Empathetic humans may have great advantages, compared to inhuman robots, when supplying the services that accompany leisure. This could include, for example, walking the dogs and looking after the cats and birds of the affluent. In particular, if alternative employment and income earning opportunities in the production of goods (rather than services accompanying leisure) are lacking, humans may try harder to serve, and so help keep the robots at bay. Robots, it might be added, help avoid the drudgery and danger of many kinds of work that workers do not regard as any more than a means to the end of earning a living.
Humans, as we are well aware, are highly adaptable to changing circumstances. This is why we have become the pre-eminent species and there are so many more of us commanding the planet and consuming more.
We may have enough time to adapt to competition from robots and the opportunities they open up, including becoming more skilled teachers, with the aid of robots. Computers may (at last) help teachers become capable of adding rapidly to the skills of their students, as they have done for chess players, thereby improving their own skills, productivity and employment prospects as they improve the skills and employment prospects for their students.
The scope for redistributing what is produced more abundantly will increase
But empathetic humans can do more than compete more effectively. A growing volume of output, made possible by science and robots, coupled with the right mix of economic policies, provides even more opportunity to take from the more productive to give to the less productive, including the unemployed and those without the capacity to contribute much to the output of the economy. The past tells us that as GDP increases so does the size of government and the share of incomes (output or GDP) that is taxed and redistributed by governments.
This is a process that is strongly encouraged by the less economically advantaged, and to which their elected representatives will respond. The ability to respond materially and perhaps sufficiently to calm the disaffected will be governed by the growth in the economy. The more that is produced by the economy, the more that can be redistributed without seriously damaging the process of growth itself.
The relatively poor and the unemployed could thus continue to look to an improved standard of living if society is productive enough and the tax base large enough to make more welfare pending feasible. We can expect more of this compulsory taking and giving to happen should our economies become more productive and should not all share equally in its advance, as is bound to be the case.
The interdependence of welfare and work, and of income and its growth
Such generous welfare will have some of the (unintended?) consequences we can already easily observe. The wealthier the state, the greater have to be the employment benefits that make choosing work (sacrificing leisure) a sensible decision. As unemployment benefits increase, incentives to work will obviously deteriorate.
Thus, welfare benefits of all kinds will tend to reduce the supply of potential workers and, perhaps unintentionally, increase the employment benefits of those still in work. As technology continues to improve, as total output and the tax base of the economy rises, unemployment benefits are likely to improve compared to the wages offered to the less skilled. If so, fewer and fewer people will remain part of the workforce and they will be given welfare benefits to be at leisure.
A highly productive society will be able to afford to support the relatively poor and the unemployed generously. But will it do so generously enough to avoid violent resentments of the better off? Resentment and opinions may well lead to a set of policies that put a brake on invention and innovation and risk taking – the true source of economic progress.
Those not working because society can afford to support their leisure – given a lack of skills and adaptability – may create a whole other set of problems. Society, under pressure from increased structural levels of unemployment, will be required to find ways to make not working a psychologically meaningful state, and to make such arrangements acceptable to the fewer taxpayers as well as those receiving benefits.
Compulsory work, while perhaps helping less fortunate humans and improving the environment in exchange for welfare, may become a component of the adjustment to growing affluence made possible by the robots. Families may be prevented from having as many children as they might prefer as part solution to the problem of too many people and not enough work for them.
What if the robots delivered true economic abundance and solved the economic problem for us?
But what if we took the advance of the robots to its full logical conclusion, to an imaginary state of the world where robots, aided by superior AI, completely replaced all humans in the workplace? When[1] the robots, with enough AI at their command, completely replace their human managers and collaborators? Robots would be able to manage themselves with a single-minded purpose (programmed originally by humans) to produce more goods and services for humans to consume, and for whom the robots are the servants (perhaps better described as slaves) with no preferences of their own.
If robots replaced all workers, the only income earned would be from owning robots who produced all the goods and services supplied to an economy – that is to the people who make up the society. But there would be an overwhelming abundance of goods and services for humans to consume.
Since there would be no work for humans to engage in, there would be no income from work to be sacrificed for leisure or to be saved for consumption in the future.
It should be recognised that if and when the robots are enabled to take over all the work, the economic problem of scarcity will have been resolved. The difficulty of society having to determine what should be produced and who should benefit from the production would have been overcome by the advancement of the robots. Trade-offs between those who produce and others who also benefit from their production will no longer be relevant. The perhaps unimaginably productive robots will be providing more than enough goods and services so that no person will be short of anything to accompany their leisure.
It should be recognised that if and when the robots are enabled to take over all the work, the economic problem of scarcity will have been resolved. The difficulty of society having to determine what should be produced and who should benefit from the production would have been overcome by the advancement of the robots. Trade-offs between those who produce and others who also benefit from their production will no longer be relevant. The perhaps unimaginably productive robots will be providing more than enough goods and services so that no person will be short of anything to accompany their leisure.
Since there would be no work for humans to engage in, there would be no income from work to be sacrificed for leisure or to be saved for consumption in the future. The only source of capital to replace and produce new and better robots would then be the savings made out of income received from owning robots.
Abundance solves not only poverty but inequality of incomes as well
Therefore, given that there is no economic problem, the inequality problem can be solved very easily. As the robots gradually take over all the work, differences in income earned will be caused by owning robots in unequal amounts rather than through income from declining work. Inequality of economic outcomes could then be resolved by a similarly gradual process expropriating and nationalising the primary means of production – the super productive robots. Compensation for expropriation would be paid to avoid disrupting the process of robot accumulation.
Collective ownership of the means of production will take over from the individual wealth owners without any of the usual dire consequences, because incentives for individuals to produce and save more will have no further purpose. Permanent abundance will have been secured for all humans by the robots.
Adam Smith’s hidden hand that turns private interest into public benefits will have done its work. The unequal rewards that we now have to offer to talented, risk-loving humans so that they will deliver the goods will have become redundant.
Self-interest becomes irrelevant in the midst of abundance: everybody has more than enough of everything and has only to decide how to allocate their time. So, owning anything, aspiring to wealth through saving that is intended to be a source of future income, and encouraging wealth creation will make no sense. Protecting rights of ownership (property rights) to encourage savings and investment will also have served its function.
The now all-embracing collective – the state as owner of all the abundant means of production (the robots) would spread the equivalent of the abundant free cash flow generated by the robot-owning state-owned companies equally to all the population. That is, the state as owner would spread equally all the surplus (cash) around that has been generated by the productive robots – after capital has been reinvested in new and better robots and in the social infrastructure that supports the leisure of all not working.
For example, the supply of roads, swimming pools and sports stadiums has to be determined and the balance distributed as income to the population. It should be understood that in these circumstances of robot-supplied abundance, the robots would be programmed (by other robots) only to meet the full and satiable demands of the leisure class – that is, the entire population.
Robots will just do what other robots programmed by robots tell them to do and they will produce more than enough to keep us at comfortable leisure and out of work. They will be productive slaves without any preferences of their own to get in the way of maximising output. AI and robots will, therefore, have replaced intelligent humans in the production of everything. There would be no differential rewards of spending power to breed resentment. Full equality of incomes is a logical consequence of superabundance.
A different world would mean the evolution of a different species
That some people have a (natural) human capacity for greater enjoyment of leisure than others may then become a problem that will have to be addressed by the political process. Legislation against unequal utility might be called for with the required dose of pharmaceuticals (or implanting of genes) to make sure that all are rendered equal in consumption and happiness.
The economic logic of robot-supplied abundance that demands no sacrifices from humans in the form of work or saving, would be a very different world. It would be essentially inhuman as far as we understand the human condition. That is, the harsh world we now inhabit that demands sacrifice (work and savings) and the acceptance of unequal rewards for unequal effort and sacrifice.
This acceptance of inequality of outcomes as the means to increased abundance for all has proved very difficult for many, particularly intellectuals and academics whose rewards are not well correlated with their IQs.
It is the envy of the presumed undeserving but economically successful, who deliver mere stuff to the masses and even more to the boring bourgeoisie, that inspires so much of the postmodern critique of a productive system at work.
The attack from the critics of society after abundance and full equality of incomes has been achieved (despite their worst efforts to slow the process down) would presumably be on the failures of many to consume the finer things in life.
Instruction on the art of life itself, as Keynes put it, might become but another popular but entirely voluntary and charitable activity. A further benefit of abundance is that the taxpayers would no longer have to fund their critics who advocate their elimination. There would be no taxes to be paid and no stipends of any kind for writers or artists and musicians. They will all do what they love to do without monetary rewards.
Abundance, however, would require that humans evolve as a very different species. Humans would be back in the Garden of Eden. Perhaps then, as with the first time around, having to start all over again, learning about what became the unfortunate necessity of work and sacrifice. Perhaps abundance is a frightening, unwelcome prospect for many. But would it be wise to stop the advance of the robots that promise to eliminate poverty and therefore even work itself? Choosing abundance (or rejecting it) will be a collective decision made by those humans in the way of the marching robots.
[1] A possibility welcomed in inimitable style by the most famous economist of his time, John Maynard Keynes, in his essay Economic Possibilities for our Grandchildren, written in 1930 and published in his Essays in Persuasion, Macmillan and Company, London, 1931. The book is available as a Project Gutenberg Canada Ebook. www.gutenberg.ca
Keynes writes:
“I draw the conclusion that, assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not – if we look into the future – the permanent problem of the human race.”
And later
“Thus for the first time since his creation man will be faced his real, his permanent problem – how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.
“The strenuous purposeful money-makers may carry all of us along with them into the lap of economic abundance. But it will be those peoples, who can keep alive, and cultivate not a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.”
Reserve Bank may have to change its tune regarding forces acting on prices
When you have bravely repelled a dangerous gang that threatened your existence — as has Reserve Bank governor Lesetja Kganyago — you are fully justified in looking ahead with a renewed sense of hope and confidence in the future of SA. As he does in his introduction to the Monetary Policy Review: “This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it.”
We must hope with the governor that the next chapter in the monetary history of SA brings less inflation and faster growth. But it may take a different frame of mind than revealed by the review. Only more demand for goods and services than the economy can hope to satisfy without the help of higher prices calls for higher interest rates. But higher interest rates harm growth when spending is already under pressure from rising prices that follow effectively reduced supplies of goods and services, in response to a sharply weaker exchange rate or a drought, for example. Higher interest rates at times like these simply reduce spending further and growth slows more than it should, for want of demand.
Currency weakness can, however, have its cause in global events that influence the supply of foreign capital or local political events; a response to fears about the future of the economy that leads to less capital flowing in and more out, enough to weaken the exchange rate. This then leads to higher prices. These supply-side shocks greatly disturbed the South African economy from 2014 to mid-2016. The drought and the persistent weakness of the rand initially linked to the strength of the dollar and then weakened further by political developments in SA that threatened the stability of the economy, especially in late 2015, were among the shocks with which economic agents had to cope.
However, from 2014 to 2015 the Bank resisted any distinction between supply-side and demand-side forces acting on prices in SA. It raised its repo rate to further inhibit spending and output growth that remained highly depressed over the period. The economy thus grew slower than it would have done had interest rates been lower and spending more buoyant. The review acknowledges that the recent value-added tax (VAT) increase is contractionary — not persistently inflationary — representing the equivalent of a supply-side shock that will raise consumer price index (CPI) inflation by only about a half a percentage point over the next 12 months, after which, assuming no further VAT increase, it will fall out of the inflation numbers.
What is true of the temporary effect of a VAT increase was surely as true of the food price effect of a drought and the succession of exchange rate shocks that forced South African prices higher after 2014.
These were temporary price shocks, even reversible ones, that serve to contract spending and are best ignored by monetary policy settings. Indeed, the more favourable inflation trends observed recently in SA represent the reversal of the price shocks — the rand and the drought — that raised the CPI from 2014 to mid-2016. The demand side of the economy still remains repressed, although lower inflation recently helped lift the growth rate in household spending, particularly on goods with high import content.
A further objection is that since “monetary policy affects the economy with a lag of one to two years”, it must be forward-looking. Such interventions can only be helpful when forecasts of inflation, interest rates and real growth fall within a narrow range. The forecasts of the Bank as indicated in the review qualify very poorly in this regard.
The fan charts provided by the review indicate very conspicuously the lack of confidence policy makers should attach to the most likely outcomes forecast by the forecasting model. The point forecast for the repo rate, for example, is 7.5% per annum in three years, 125 basis points higher than the current repo rate but with considerable uncertainty around this figure. The chart, for example, vindicates a high probability (15%) of the forecast being between 8.7% and 10% and a similarly high probability (15%) of being much lower, between 5% and 6.3% — a case of having to take your pick for the repo rate as anywhere between 5% and 10%.
Similar conclusions could be reached about the forecasts of GDP or inflation. In the case of GDP, you can take a pick between a forecast of -1.2% per annum and a booming 7% real growth in 2020. As for inflation, the forecasts offer a pick between 1.8% and almost 9% per annum in 2020.
This inability to accurately forecast the economy has been undermined by the self-same shocks the economy and rand have suffered from. The quality of these forecasts will not improve unless the shocks that have so affected the economy are of much diminished scale and range. If the economy turns out very differently to the forecast, delayed responses to interest rate changes made in advance can be damaging to the economy.
The review contends that its interest rate settings in recent years have been accommodative rather than restrictive and will likely remain so. As the review states: “Viewed through the lens of the Reserve Bank’s quarterly projection model, the policy stance will be expansionary over most of the forecast period, helped by the recent rate cut. The projected rise in near-term inflation, which lowers the real interest rate, is largely due to the VAT increase. This will reduce disposable income and is in this respect actually contractionary. The recent rate cut mitigates this effect, making policy more clearly accommodative through the rest of 2018 and 2019.” If in fact inflation turns out as expected — about 5% per annum — a lower repo rate therefore appears unlikely.
Ideally monetary policy should help eliminate slack in the economy, negative or positive. The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low
Evidence of demand running well below potential levels is overwhelming enough to conclude that interest rates have been too high rather than too low in the circumstances of such weak spending propensities. The persistence of an output gap, a gap between actual and potential output that is the longest on record according to the review, is strong evidence of too little spending and thus to be inferred as the result of contractionary rather than accommodating monetary policy.
Ideally monetary policy should help eliminate slack in the economy, negative or positive. The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low. Further direct evidence of tight monetary policies comes with the direction of the growth in money supply and bank credit. These growth rates have declined consistently over recent years but receive surprisingly little attention in the review.
The notion, much relied upon by the Bank over the years to justify its interest rate settings, that inflationary expectations are self-fulfilling — that the more inflation is expected the more inflation is realised, regardless of the slack in the economy — is questionable. The evidence for such persistent second-round effects on inflation is very weak.
Inflation in SA tends to lead and inflation expectations follow — with some regard for what are seen to be temporary forces that may have pushed up prices. And if inflation rises because of supply-side shocks these increases will be temporary and may even be reversed when the shock passes through. The review appears to concede this point.
It remarks, in justification of reducing its repo rate in April by 25 basis points, that “a second consideration was that lower inflation could be used to bring inflation expectations closer to the target midpoint of 4.5% over a shorter time frame. However, these factors do not preclude fine-tuning of the interest rate. The MPC [monetary policy committee] is also not committing to a rate-cutting cycle.”
The notion that deficits on the current account of the balance of payments represent danger rather than opportunity for the economy, as the review appears to regard them, is questionable. By definition the current account deficit is equivalent to the capital flows an economy is able to attract from abroad. Faster growth will mean larger current account deficits and larger capital inflows. Growth leads and foreign capital can follow the prospective faster growth and make it possible.
The opportunity to grow faster by attracting more capital that funds an increased supply of goods and services, augmented by more imports and fewer exports, should not be prematurely frustrated by higher interest rates, for fear that capital flows may reverse. Growth itself boosts confidence and improves credit ratings and attracts capital, a virtuous cycle.
The Bank may have no option but to think on its feet and react to events as they occur. It is to be hoped it will do so with good judgment about the causes and effects of inflation, which may call for very different interest rate reactions.
A different narrative from the Bank is called for to explain why the different causes of higher prices can call for different policy responses, responses that do not have to mean being soft on inflation for politically convenient reasons
A new optimistic message from the Reserve Bank
The new optimistic message from the Reserve Bank is welcome, but there are some reservations about the analysis and its implications for monetary policy and the SA economy.
The Monetary Policy Review recently published by the Reserve Bank (MPR) offers a full explanation of how the Bank thinks about its role and how it goes about realising the inflation target set for it. I offer a critique of the analysis that I hope can help prevent the errors of monetary policy that I believe have characterised monetary policy over the past few years.
The Reserve Bank Governor, Lesetja Kganyago, in introducing the MPR, sounded a clear call for a new, better future for the SA economy and the role of the Reserve Bank in helping realise this much more hopeful vision. To quote his introduction to the MPR:
“This Monetary Policy Review arrives at a moment economists would call ‘a structural break’ – a point where the behaviour of the numbers changes. In more everyday terms, we have witnessed the end of one chapter of South Africa’s history and we are starting a new one. This document represents an attempt to write the economic story of that chapter, or at least the first pages, in advance. Of course, this is a difficult enterprise, with a reasonable chance of substantial error. But monetary policy affects the economy with a lag of one to two years, so it must be forward-looking.”
(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)
When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:
“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”
(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)
When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:
“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”
This sense of economic opportunity is refreshing. I hope as much as the Governor that the next chapter in the monetary history of SA is a much happier one, characterised by less inflation and faster growth. The transparency of the MPR is admirable and demands a full response. But if faster growth with lower inflation is to be sustained for the long run, it will in my considered opinion take a different frame of mind at the Reserve Bank. I indicate how I believe the Reserve Bank could better realise its objectives for inflation, without having to sacrifice growth.
A successful monetary policy is one that delivers low inflation in a way that encourages rather than inhibits the growth of an economy. An inflation targeting monetary policy regime should recognise that unpredictable supply side shocks that lead prices and inflation higher call for lower, not higher interest rates to help the better economy absorb the shock to prices and to the demands for goods and services produced domestically.
Only demand led inflation, more demand than the economy can hope to satisfy without higher prices, calls for higher rates. Higher interest rates then can slow down spending. But higher interest rates will harm growth when spending is already under pressure from rising prices that follow what is in effect reduced supplies of goods and services. What is described as a supply side shock to the economy is one that drives up prices and discourages spending.
Higher interest rates at times like this simply reduce spending further and growth slows more than it should. Supply shocks can come in the form of a drought that reduces the supplies of staple foods and pushes up their prices. Another supply side shock on prices follows a sharp decline in the exchange rate described as an exchange rate shock. Then the supply of goods imported or in sold domestically in competition with exports comes with higher prices.
A decline in the exchange value of a currency may have nothing to do with the demand side of the economy – with demand running ahead of supply so forcing up the prices of goods and services and also the cost of foreign exchange. Currency weakness can have their cause in global events that influence the supply of foreign capital or local political events. To fears that worsen the outlook for the economy and lead to less capital flowing in and more out, enough to weaken the exchange rate that will then lead to subsequently higher prices.
Supply side shocks greatly disturbed the SA economy between 2014 and mid-2016. The drought and the weakness of the rand linked to the strength of the US dollar and weakened further by political developments in SA, were among the major shocks with which the economy had to cope. The Reserve Bank however between 2014 and 2016 resisted any distinction between supply side and demand side forces acting on prices in SA that should call for different interest rate reactions. It reacted to the increases in the CPI as if it was demand driven and so raised its repo rate to further inhibit spending and output growth that remained highly depressed over the period. The economy grew slower than it would have done had interest rates been lower and spending been more buoyant. My contention is that growth was sacrificed without any lower inflation than would have been the case with lower interest rates.
This MPR acknowledges correctly (see quote below) that the recent VAT increase is contractionary – not persistently inflationary – representing the equivalent of a supply side shock that will raise CPI inflation by about a half a per cent only over the next 12 months. After which, assuming no further VAT increase, it will fall out of the inflation numbers.
What is true of the temporary impact of a VAT increase was surely as true of the food price impact of a drought and of the exchange rate shocks that forced SA prices higher after 2014. These were temporary price shocks even reversible ones, that serve to contract spending and are best ignored by monetary policy settings. Indeed the more favourable inflation trends observed recently in SA represent the reversal of the price shocks – the rand and the drought – that raised the CPI between 2014 and mid-2016. The demand side of the economy still remains repressed though lower inflation would appear in late 2016 to have helped lift the growth rates in household spending, particularly on durable and semi durable goods (clothing etc) whose prices would have benefitted from the recovery in the exchange value of the rand.
A further objection is that the forward looking monetary policy recommended by the Governor is only helpful when forecasts of inflation, interest rates and real growth fall within a narrow range. The forecasts of the Reserve Bank as indicated in the MPR qualify very poorly in this regard.
The fan charts provided by the MPR (see the chart below) indicate very conspicuously the lack of confidence policy makers should attach to the most likely outcomes as forecast by the model. For example, as shown below, the point forecast for the Repo rate is 7.5% in three years’ time, 125 basis points higher than the current repo rate – but with considerable uncertainty around this 7.5%. For example the chart indicates a high probability (15%) of the forecast being between 8.7% and 10%. And a similarly high probability (15%) of being much lower, between 5% and 6.3% A case of having to take your pick for the repo rate as anywhere between 5% and 10%.
Similar conclusions could be reached about the forecasts of GDP or inflation. In the case of GDP you can take a pick between a forecast of minus 1.2% and a booming 7% real growth in 2020. As for inflation the forecasts offer a pick between a 1.8% and near 9% in 2020.
If the economy turns out very differently to the forecast, delayed responses to interest rate changes made in advance can be damaging to the economy. This ability to accurately forecast the SA economy has been undermined by the series of shocks the rand has suffered. The impact of the drought on food prices as well as shocks to commodity, metal and oil prices have been additional largely unpredictable events to disturb the accuracy of past forecasts. The quality of these forecasts will not improve unless the shocks that have so affected the SA economy are of much diminished scale and range.
One can only hope with the Governor that this indeed will be the case. But if not, the MPC will have no option to think on its feet and to react to events as they occur, hopefully with good judgments about the causes and effects of inflation and the difference between supply side and demand shocks that call for very different reactions. And differences in responses that need to be well communicated to and understood by the economic agents affected by interest rates and inflation and the rate of growth of the economy, that they too will be trying to anticipate in a forward looking way. A different narrative from the Reserve Bank is called for to explain why the different causes of higher prices can call for different policy responses, responses that do not mean tolerating inflation more than makes sense.
The MPR contends that its interest rate settings in recent years have been accommodative rather than restrictive and will likely remain so (see figure below).
As the MPR states:
“Viewed through the lens of the South African Reserve Bank’s (SARB) Quarterly Projection Model (QPM), the policy stance will be expansionary over most of the forecast period, helped by the recent rate cut. The projected rise in near-term inflation, which lowers the real interest rate, is largely due to the VAT increase. This will reduce disposable income and is in this respect actually contractionary. The recent rate cut mitigates this effect, making policy more clearly accommodative through the rest of 2018 and 2019.”
And so if in fact inflation turns out as expected- around 5%, a lower repo rate appears as unlikely.
The MPR defines these interest rate settings as accommodative because interest rates have stayed below inflation. But evidence of demand running well below potential levels is overwhelming enough to conclude that interest rates were too high rather than too low in the circumstances of such weak spending propensities. The persistence of an output gap, a gap between actual and potential output that is the longest on record, according to the MPR, is strong evidence of too little spending and thus to be inferred as the result of contractionary rather than accommodating monetary policy (see figure below). Ideally monetary policy should help eliminate slack in the economy (negative or positive). The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low.
It is important for the supply side of the economy and the exchange rate that the Reserve Bank maintain its independence to conduct monetary policy as it sees fit. The Bank’s independence came under severe threat and it resisted this attack successfully to its eternal credit. But independence should ideally be accompanied by good judgments and not necessarily compromised by appropriate interest rates.
Further direct evidence of tight monetary policies comes with direction of the growth in money supply and bank credit. These growth rates have declined consistently over recent years but receive surprisingly little attention in the MPR.
I further question the notion, that inflationary expectations are self-fulfilling, much relied upon by the Reserve Bank over the years to justify its interest rate settings, that is the more inflation expected the more inflation realised, regardless of the slack in the economy. And that higher interest rates increases are required to prevent these so called second round effects from driving up prices whatever the initial cause of higher prices because higher prices mean more inflation expected and in turn more inflation realised.
The evidence for such persistent second round effects on inflation is very weak. Inflation in SA tends to lead and inflation expectations follow- with some regard for what are seen to be temporary forces that may have pushed up prices- for example a drought. If inflation comes down in South Africa- for good permanent reasons- inflation can be expected to decline. And if inflation rises because of supply side shocks these increases will be temporary and may even be reversed when the shock passes through. The recent decline in inflation in SA is mostly the result of the reversal of the forces that drove up inflation – the harvests have normalised and the rand has strengthened. Positive supply side shocks that have brought less inflation and stimulated a revival in household spending. The MPR appears to concede this point.
It remarks, in justification of reducing its repo rate recently, that:
“A second consideration was that lower inflation could be used to bring inflation expectations closer to the target midpoint of 4.5% over a shorter time frame. However, these factors do not preclude fine-tuning of the interest rate. The MPC is also not committing to a rate cutting cycle.”
Finally I would question the notion that deficits of the current account of the balance of payments represent danger rather than opportunity for the SA economy as the MPR appears to regard them. By definition the current account deficit is equivalent to the capital flows an economy is able to attract from abroad. Faster growth will mean larger current account deficits and larger capital inflows. Growth leads and foreign capital can follow the prospective faster growth and make it possible. I would argue that the opportunity to grow faster by attracting more capital should not be frustrated by higher interest rates for fear that capital flows can reverse when the news deteriorates.
Monetary policy should focus on stabilising the economy so to improve the case for investing in SA. Sustainably low inflation is helpful to that end. But monetary policy should not sacrifice growth when prices are rising for reasons beyond its control and beyond the influence of interest rates. The lessons from the history of recent monetary policy in South Africa is that such errors of policy that mean slower growth for no less inflation – can be avoided. 25 April 2018
What’s in a price?
What is in a price? And what does it all mean for our standard of living?
Automation, roboticisation and miniaturisation are changing wondrously the way we produce and consume goods and services, including the medical treatments that can keep us alive for longer and with much less morbidity. To which forces of change we could add the internet of things that connects us ever more effectively and commands so much more of our attention.
The benefits of this technological revolution that we can see and feel are not at all obvious however in the measures we use. We are informed that US productivity continues to grow very slowly. And real GDP is growing as slowly, as are wages and incomes adjusted for inflation. Apparently Americans are not getting better off at the pace they used to and are frustrated with their politicians they hold responsible.
Is our intuition at fault or the way we compare the prices of the goods and services we consume over time? All measures of output and incomes are determined in money of the day, calculated and agreed to in current prices. They are then converted to a real equivalent by dividing some sample of output or wages estimated at current prices, by a price index or a deflator. A price index measures the changes in the prices of some fixed “basket” of goods and services thought to represent the spending patterns of the average consumer. The deflator calculates the changes in the prices of the goods and services consumed or produced today, compared to what would have been paid for them a year before.
Both estimates attempt to make adjustments for changes in the quality of the goods and services we are assumed to consume. A car or a pain killer or cell phone we buy today on today’s terms may do more for us than it would have done at perhaps a lower price, or possibly a higher price (think dish washers or calculators) five or 10 years before. It is not the same thing we are making price comparisons with.
A piece of capital equipment today, robotically and digitally enhanced, is very likely to produce many more “widgets” today than a machine similarly described 10 years ago. And it may cost less in money of the day. It is a much more powerful machine and firms may well make do with fewer of them. Their expenditure on capex – relative to revenues – may well decline, indicating (wrongly perhaps) a degree of weakness in capital expenditure. The problem may not be a lack of willingness of firms to invest more, but how we measure the real volume of their investment expenditure – quality adjusted.
There is room for moving the rate at which a price index increases (what we call inflation) a per cent or two or three higher than they would be if quality changes were implied differently and more accurately. And if s,o GDP and productivity growth would appear as equivalently faster.
It is instructive that the US Fed targets 2% inflation – not zero inflation – because 2% inflation (quality adjusted) may not be inflation at all. And zero inflation may mean deflation (prices actually falling) enough to discourage spending now, to wait – unhelpfully for the state of the economy – for better terms tomorrow.
Over the past three months there have been no increases in prices at retail level in SA. The annual increase in retail prices (according to the retail deflator) fell below 2% in January 2018 and is far lower than headline inflation. (see below). The Reserve Bank would do well to recognise that the state of the economy – coupled with what the stronger rand provides businesses in SA – leaves both manufacturers and retailers with very little pricing power. Nominal borrowing costs – well above business inflation – are in reality applying a significant real burden for them. They could do with relief. 12 April 2019
Machines in a world of abundance
Will the intelligent machines ease us out of work as we understand it?
Where will all the workers go?
The pace of technological and scientific change is both rapid and accelerating. Robots with powerful computers have invaded the factory floor and the warehouses and distribution centres with great effectiveness. The number of workers employed in them have accordingly shrunk. Transistors, sensors and cameras will soon combine to eliminate the need for someone in the driver’s or pilot’s seat, and move us faster and more safely than now.
A common modern refrain in response to the challenge of the robots is where will all the workers go? Will it be into other jobs or into unemployment? And if the cohort of the unemployed is to become a much larger one for want of employment opportunity, how will society cope with the assumed failure of an economy to employ most of those who seek work?
Replacing workers with machines is not something new. Smashing the hand loom machines was not helpful
The advance of knowledge and its application to production – so improving the ratio of output to inputs of resources – of land, labour and capital is not something new. Economic progress, scientific advances accompanied, sometimes led, by the invention of ever more powerful machines, has been more or less continuous since the 17th century. The east, that once so lagged behind the west in economic and military prowess, is rapidly catching up in the economic and scientific stakes, applying much of the same proven recipe for economic progress.
The increased production of goods and services enhanced by ever more productive machinery of all kinds (medical equipment included) has been accompanied by consistent advances in the average standard of living and life expectancies and a rapid growth in population. The population of the world has more than doubled since 1970, increasing from 3 billion to more than 7 billion today. On average we are better supported today by higher levels of production of the essentials for life: food, shelter and medical care. And we are provided for with more of the luxuries of life, including more time off work.
We choose more leisure – not working – when we can afford to do so
A preference for more leisure has been exercised in greater volume as the average hours per week worked has declined. Leisure is a desired form of consumption for which income and other forms of consumption have been willingly sacrificed. Choices made by those who can afford to reduce hours at work, and some of the drudgery and dangers of work, have been eliminated with the aid of machines, helping to make work more pleasurable and less onerous. Nice work – if you can get it.
This growth in population has been accompanied by a rapid (more or less) increase in the numbers employed (that is in the work force). The greater number of humans surviving and employed today has also been accompanied by a large reduction (billions fewer) of those who survive despite absolute poverty. Absolute poverty is conventionally defined as those earning or consuming the equivalent of US$2 per day. Most would describe these developments as progress even if happiness – whatever this means – may be as elusive as ever.
These increases in incomes and output represent impressive and consistent economic progress (compounding growth in output and incomes) made over the past 300 years. Yet there is more to be done to raise average living standards to the levels now realised by those in the upper quintiles of the distribution of incomes in the most economically developed economies. Surely this is an economic state to be preferred and aspired to by all who lack this degree of material comfort and the choices it brings with it – including time spent not toiling? And if past performance is anything to go by, it is a realistic prospect. After all, incomes double every 20 years if they grow at 3% a year.
Only the (few) well off in their comfort zones would wish to halt economic progress
There is therefore every reason out of concern for our fellow humans to encourage the scientific revolution that will make humans and the machines who complement their efforts, ever more productive. The capabilities of the robots are bound to improve with developments in artificial intelligence (AI) that will make the machines less dependent on their human supervisors. The numbers of workers employed designing, building, servicing and operating each robotically enhanced unit of equipment, will also decline, also aided in their efforts by AI and digitilisation. The robots, with enough enhanced artificial intelligence at their disposal, may be able to write their own operating instructions. Therefore fewer writers of code for them will be called for.
Output per person employed will rise accordingly with the application and utilisation of these new wondrous machines. Economists describe this process as an increase in the ratio of capital to labour in the production process. It rose in the past when machines first replaced animal and human power and production became mechanised before being automated to an ever greater degree. Production – the output of goods and services produced with the aid of capital equipment – including what we now describe as robots of one kind or another, will grow as it has in the past, aided by ever more superior equipment. And perhaps the output of goods and services produced, with the aid of capital, will increase even more rapidly than before.
Will machines become substitutes for, rather than complements to, human action?
But will the pace of change now leave many more behind? Unable to find useful work and so effectively replaced by the machines, rather than able to earn more, because of the equipment they work with, the less skilled today may be more vulnerable than they have proved to be in the past, less able to compete directly with the robots, for robotic type work, which may be all many humans undertake and are capable of.
And the same displaced workers may be unable, for want of relevant skills, to find alternative employment, building and servicing the ever more numerous robots. Or capable of providing service to those earning higher incomes from owning, designing, managing, building and maintaining the robots.
All may not be about to be lost by human agents in the competition with machines. I am informed that while a modern computer can now always beat a chess grand master. The master chess player accompanied by a computer will beat the computer unaided. The highest incomes in the years to come may be earned by those best able to work with the robots.
Those who thrive with the help of robots are likely to choose more leisure and the services that accompany time off work. Empathetic humans may have great advantages, compared to inhuman robots, when supplying the services that accompany leisure including, walking the dogs and looking after the cats and birds of the affluent. Particularly should alternative employment and income earning opportunities in the production of goods (rather than services accompanying leisure) be lacking. Humans may try harder to serve and so help keep the robots at bay.
Humans, as we are well aware, are highly adaptable to changing circumstances. This is why we have become the pre-eminent species and there are so many more of us commanding the planet. We may have enough time to adapt to the competition from robots and the opportunities they open up, including becoming more skilled teachers, with the aid of robots. Computers may (at last) be productive in adding to the skills of their students as they have done for chess players. So improving their own skills, productivity and employment prospects as they improve the skills and employment prospects for their students.
The scope for redistributing what is produced more abundantly will increase
But empathetic humans can do more than compete more effectively. A growing volume of output made possible by science, technology and robots provides more opportunity to take from the more productive to give to the less productive, including the unemployed and those without capacity to contribute much to the output of the economy. The past tells us that as GDP increases, so does the size of government and the share of incomes (output or GDP) that is taxed and redistributed by governments exercising their power to do so. This is a process that is strongly encouraged by the less economically advantaged and to which their elected representatives will respond. The ability to respond to the collective will and impulse, will be governed by the growth in the economy. The more that is produced the more that can be redistributed.
The relatively poor and the unemployed too will thus continue to look to an improved standard of living if the society is productive enough and the tax base large enough to make more welfare spending feasible. We can expect more of this compulsory taking and giving should our economies become more productive and not all share equally in its advance, as is bound to be the case. This is if fast exponential growth continues over many years because the incentives to innovate and invent, the true drivers of economic progress, are encouraged enough by economic policy.
The interdependence of welfare and work – and of employment benefits and employment opportunities – and of income and its growth
Such generous welfare will have some of the consequences we can already observe. The better the state – that is other people – provide for the unemployed – those willing and able to work –the greater has to be the employment benefits that make choosing work – sacrificing leisure – a sensible decision. And the less skilled are less likely to command rewards from work that exceeds improved benefits available to them when not working. Their reservation wage – the employment benefits that make sense working for – may be too high for some to choose work. For them, without the skills that command higher more attractive rewards from employers, leisure is the rational alternative to work. They will choose more of it if employment prospects deteriorate.
Thus welfare benefits of all kinds will tend to reduce the supply of potential workers and, perhaps unintentionally, increase the employment benefits of those in work. Decent work is likely to become ever more decent as the economy grows and welfare becomes more generous to the relatively poor. But as these employment benefits improve and the cost of hiring rises, employers will be encouraged to further substitute machines (capital) for labour. In doing so they perhaps leave a greater proportion of the adult population not working or even seeking work. They choose leisure – because in a sense they can afford it.
A productive society may well be able to afford to support the relatively poor and the unemployed generously. But will it do so generously enough to avoid resentment of the better off? Resentment that given political consequences may well lead to policies that disrupt the economy and its progress. The process of economic growth depends on society accepting – at least to some degree – unequal rewards for unequal contributions. Is not acceptance of those forces of invention and innovation that will drive the development of robots and AI essential to the purpose of economic progress? Invention and innovation and risk taking generally are the true source of economic progress and need to be given the right encouragement. The economic problem of not enough to go around is only resolved by permitting a degree of unequal rewards for unequal effort and outcomes. Inhibiting the rewards for economic success may well prevent it occurring.
People not working on a larger scale because the society can afford to support their leisure – given a lack of skills and adaptability – may create a whole set of problems for the more or less permanently non-working. Society may be required to find ways to make not working psychologically meaningful and acceptable to the tax payers. Compulsory work, perhaps by helping less fortunate humans and work improving the environment, in exchange for welfare, may become a component of the adjustment to growing affluence made possible by the robots (robots it might be added who can help avoid the drudgery and danger of many kinds of work that workers do not regard as any more than a means to the end of consumption).
What if the robots delivered true economic abundance and solved the economic problem for us?
But what if we took the advance of the robots to its full logical conclusion? An imaginary state of the world when robots aided by superior AI completely replaced all humans in the work place1. The robots with enough AI may completely replace their human managers and collaborators. They may be able to manage themselves with a single minded purpose (programmed originally by humans) to produce more goods and services for humans to consume, and for whom the robots are the servants (perhaps better described as slaves) with no preferences of their own.
If robots replaced all workers the only income earned would be earned owning robots who produced all the goods and services supplied to an economy, that is to the people who make up the society. And there would be an overwhelming abundance of goods and services for humans to consume. It should be recognised that if and when the robots take over, all the work the economic problem of scarcity will have been resolved. The difficulty of society having to determine what should be produced and who should benefit from the production would have been overcome by the advance of the robots. Trade-offs between who produces and who benefits from production will no longer be relevant. The perhaps unimaginably productive robots will be providing more than enough goods and services so that no person will be short of anything to accompany their leisure.
Since there would be no work for humans to engage in there would be no income from work to be sacrificed for leisure or to be saved to be consumed in the future. The only source of capital to replace and produce new and better robots would then be the savings made out of income received owning robots.
Abundance solves not only poverty but inequality of incomes as well
Given that there is no economic problem, the inequality problem (derived increasingly over time by owning robots in unequal amounts) would be solved by expropriating and nationalising the primary means of production – the super productive robots. The collective will take over from the individual without any of the usual dire consequences when the economic problem exists and demands resolution.
The now all embracing collective, the state as owner of all the abundant means of production – the robots – would spread the equivalent of the abundant free cash flow generated by the robot owning state-owned firms equally to all the population. That is the state as owner would spread equally all the surplus (cash) around that has been generated by the productive robots, after capital reinvested in new and better robots and in the social infrastructure that supports the leisure of all not working.
For example, the supply of roads and swimming pools and sports stadiums has to be determined and the balance distributed as income to the population. Intelligent robots will manage the state-owned companies and issue the tenders and welfare checks in response to the instructions of the politicians, elected by the people at leisure
It should be understood that in these circumstances of robot-supplied abundance, the robots would be programmed (by other robots) only to meet the full and satiable demands of the leisure class – that is the entire population. These robots will not require any of the incentives that are now necessary to get humans to work well by appealing to their self-interest.
Adam Smith’s hidden hand that turns private interest into public benefits will have done its work. The unequal rewards that we now have to offer to talented humans so that they will deliver the goods will have become redundant. Self-interest becomes irrelevant in the midst of abundance: everybody has more than enough of everything and have only to decide how to allocate their time. Hence owning anything will make no sense and protecting rights of ownership (property rights) will have served their function.
Robots will just do what other robots programmed by robots tell them to do and they will produce more than enough to keep us at comfortable leisure and out of work. They will be productive slaves without any preferences of their own to get in the way of maximising output. AI therefore will have replaced intelligent humans in the production of everything – produced abundantly by robots for all humans to consume in as much quantity as they might desire. There would be no differential rewards to breed resentment. Full equality of incomes is a logical consequence of super abundance.
A different world would mean the evolution of a different species
That some people have a (natural) human capacity for greater enjoyment of leisure than others may then become a problem that will have to be addressed by the political process. Legislation against unequal utility might be called for, with the required dose of pharmaceuticals (or implanting of genes) to make sure that all are rendered equal in consumption and happiness.
The economic logic of robot-supplied abundance that demands no sacrifices from humans in the form of work or saving, would be a very different world. It would be essentially inhuman as far as we understand the human condition. That is the harsh one we inhabit that demands sacrifice (work and savings) and the acceptance (very difficult for many particularly intellectuals and academics whose rewards are no well correlated with their IQs) of unequal rewards for unequal effort and sacrifice.
Abundance would require that humans evolve as a very different species. Humans would be back in the Garden of Eden, perhaps then as the first time having to start all over again learning about the necessity of work and sacrifice. Perhaps abundance is a frightening prospect to many. But even if it is, would it be wise to stop the advance of the robots that promises to eliminate poverty and so even work itself? Choosing abundance (or rejecting it) will be a collective one made by those in the way of the marching robots. 19 March 2018
1A possibility welcomed in inimitable style by the most famous economist of his time John Maynard Keynes in his essay Economic Possibilities for our Grandchildren written in1930 and published in his Essays in Persuasion, Macmillan and Company, London, 1931. The book is available as a Project Gutenberg Canada Ebook. www.gutenberg.ca
Keynes writes “….I draw the conclusion that, assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not – if we look into the future – the permanent problem of the human race……..”
And later
“……Thus for the first time since his creation man will be faced his real, his permanent problem- how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.
The strenuous purposeful money-makers may carry all of us along with them into the lap of of economic abundance. But it will be those peoples, who can keep alive, and cultivate into a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.”
The political economy of SA – promise and hoped for delivery
It is possible to get very rich from politics in an honest and old-fashioned way. Recent SA political and economic events prove so. Had you predicted that Cyril Ramaphosa would win the ANC election in December and ascend to the presidency of SA, and bought the rand and the shares and bonds that benefit from a strong rand, you would have done very well. And you’d have done even better if you had sold those securities (including the US dollar or euro) that weaken when the rand responds to good news about SA.
The USD/ZAR reached a recent low of R14.46 on 15 November. It is now R11.77, an improvement of about 20%. The rand has also gained 24% against the JPMorgan Index of emerging market exchange rates (FXJPEMCS), since then indicating it was South African-specific surprises rather than global forces that has driven the rand recently.
The cost to the taxpayer of issuing rand-denominated debt has fallen significantly. The yield on five year RSA bonds has fallen from 8.69% on15 November to 7.38% on 12 March that is by 1.31% or equivalent to a 16% decline in the cost of issuing new government debt of this duration. This even as US interest rates were moving in the opposite direction.
The extra yield SA has to offer investors in US Treasury bonds for five year money (the sovereign risk premium) has fallen from 206 to 139 basis points. Over the same period, enough to bring SA debt well within investment grade quality. A one per cent per annum saving on interest, given the volume of government debt to be serviced and rolled over, is worth about R6bn to the SA taxpayer (hopefully) or the recipient of extra government spending (alas more realistically).
A stronger rand means less inflation and encourages households (who do more than 60% of all spending in SA) to spend more on the goods and services to be supplied to them by SA business. And the more profitable firms in turn will then hire more workers and equipment to service their growing custom. And less inflation may bring a lower repo rate and mortgage payments to further encourage spending. Enough extra spending to at last spark a recovery in the economy that has been growing much too slowly for far too long.
These implications of the stronger rand has therefore been dramatically registered in the share market. Companies with revenues and earnings generated in SA, banks and retailers for example, have become more valuable. While companies listed on the JSE, whose main line of business is generated offshore, have lost value. An equally weighted group of 14 large offshore plays has lost about 20% of its rand value since mid-November (see figures 4 and 5 below).
By contrast the rand value of a group of 18 equally weighted large SA economy plays on the JSE has increased by about 25% over the same short period. Buying SA and selling the world on a Ramaphosa victory would have been very value adding. Simply buying the JSE – with its mix of global and SA plays would – as an exchange traded fund would do, would have been to miss the value adding bus. It is in surprising turbulent times like this that active managers earn their fees.
The government led by Ramaphosa could provide much more of the good stuff for the SA economy by delivering on the promise of better government. Better still for the economy and its growth would be less government. Officials should intervene less in the economy – and show more respect for business and market forces as the critical drivers of the economy. Government should tax business income at lower rates and avoid subsidising other businesses that survive only with government aid.
Less intrusive government and consequently lower compliance costs would allow small businesses to compete with large businesses. And, more important, to free up the market for workers that leaves so many unemployed.
Government should also show a genuine willingness to sell off rather than add capital to the companies it owns: firms that survive to protect their employees from the performance indicators that private owners would demand of them – and reward accordingly.
The cabinet should recognise that its current set of economic policies of high spending and tax – ever more intervening government – has been a primary cause of the debilitating slow growth realised in recent years. A mix of all of the above policy recommendations would deliver economic growth and votes. A still weak economy could lose the ANC the next election in 2019. 15 March 2018
Retail therapy
The SA economy is being helped along by lower inflation at the retail level
The SA economy did surprisingly well in the fourth quarter of last year. GDP grew at an annual rate of over 3%. The demand side of the economy did just as well, growing at the same rate as supply, which was augmented by a strong seasonal recovery in agricultural output. Demands from households, which account for 60% of all spending, increased by an annualised 3.6% in the quarter, well above recent trends, while expenditure on capital goods increased even more robustly by 7.4% annualised. Imports increased significantly faster than exports, so reducing GDP growth, but found their way into increased holdings of inventories – enough to offset the impact of the growth in imports (up 23%) and the negative trade deficit on GDP. Imports add to supply – the increase in inventories adds to demand.
The strength in household spending – essential to any cyclical recovery – was reflected in a strong recovery in retail sales volumes. These were growing at close to a 6% annual rate in the fourth quarter. Such growth was assisted by low rates of retail price inflation. The prices of goods and services at retail level were largely unchanged in the fourth quarter; hence sales in constant prices were rising as rapidly as were sales measured in prices of the day. Clearly consumers were getting the benefit of the end of the drought (lower food prices) and the stronger rand and presumably strong price competition at retail level.
The figures below tell the story of price competition and its effects. Extrapolating recent trends suggests that prices at retail level will be rising at a very slow rate in the months to come. The recent strength in the rand will be adding to these disinflationary, if not deflationary pressures in the months to come and will help to stimulate household spending. A time-series forecast of retail volumes indicates that they could retain a brisk growth pace of around 6% over the next 12 months.
Retail sales and price statistics are available only up to December 2017. Two more up-to-date hard numbers have been printed for the February 2018 month end, that is for vehicle sales and the cash (notes and coin in circulation) supplied by the Reserve Bank. We combine these indicators into a Hard Number Index (HNI) of economic activity in SA. As shown below, this index may be regarded as a good leading indicator of the business cycle in SA (itself only updated to November 2017).
As we show in figures four and five, according to the HNI, the economy has picked up some positive, though modest momentum, consistent with the 3% GDP growth realised in the fourth quarter.
The growth in the components of the HNI are shown below. As may be seen both the vehicle and the real cash cycles have recovered from their low points of mid-2017. However the impetus for the economy provided by cash in circulation and vehicle sales volumes is forecast to wane somewhat in the months ahead – absent any stimulation from lower interest rates.
The real cash cycle (notes/consumer prices) provides a consistently helpful predictor of the trends in retail volumes, and had been doing so recently, as we show below in figure 8. Were we to use retail prices rather than consumer price inflation to deflate the supply of cash, we might derive a better indicator of retail sales volumes. The divergence between CPI and retail inflation has become unusually large. It reflects the intense competition for strained household budgets. It surely provides a better measure of the lack of demand-side pressures on prices and supply side forces (exchange rates and drought) acting on prices in SA. The CPI is more exposed to administered prices and tax rates. The Reserve Bank would do well to acknowledge how low business inflation is in SA and lower interest rates accordingly to encourage households to spend more for the sake of a much desired economic recovery – with low inflation. 13 March 2018
Waiting for Godot – and the Reserve Bank
The Ramaphosa ascension has been very well received by the capital and currency markets. The political risk premium attached to SA-domiciled assets has declined sharply. The yield spread between RSA bonds denominated in US dollars that carry risks of default and US Treasury bonds narrowed sharply after November when it became more likely that the Zuma list would not be voted in at the ANC Congress in December. This sovereign risk spread – the extra yield investors receive on five year RSA debt to compensate for extra risk – declined from over 2% in November to about 1.4%. SA debt now trades as (low) investment grade.
The rate at which the rand is expected to depreciate has also declined sharply as long-term interest rates in SA have declined and US rates increased. These differences in yields, expressed in different currencies, is known as the carry and is also the percentage difference between the spot and forward rates of exchange maintained through arbitrage exercises in the money and currency markets. The cost of securing a US dollar for delivery in the future therefore increases by the per annum interest rate spread. This spread for five year debt denominated in rands was 6.7% in mid-November and has declined to current levels of about 4.9% a decline of about 1.8% (See figures 1 and 2 below).
This decline in interest rates and less rand weakness expected portends lower SA inflation. Less inflation has also come to be expected by the capital market. These expectations are represented by the spread between the yields on vanilla bonds that carry the risk of inflation eroding the purchasing power of interest income, and the inflation linked variety that offer complete protection against higher inflation. As may be seen below, the bond market is pricing in about 60 basis points (0.6 percentage points) of less inflation to come in over the next five and 10 years.
These sovereign risks are also represented in the real yields on inflation-linked bonds issued in different currencies. The inflation link, especially on long-dated bonds, offers protection against the exchange rate weakness associated with more inflation. The real spread must therefore be attributed to factors other than the exchange rate risks the market is factoring in with nominal rates. Of interest is that this spread between long-dated RSA inflation-linked debt and US Treasury Inflation Protected Securities (TIPS) has narrowed sharply in recent months by more than 100 basis points (one percentage point). (See below)
It should also be recognised that real government bond rates in the US, while having increased marginally in recent months, remain well below normal. They indicate a continued global abundance of saving over capital expenditure and continued pressure on prospective real returns from all asset classes.
The better news about the future of SA has also been well reflected in the share market. Since December 2017, those listed companies with strong exposure to the SA economy have dramatically outperformed those companies that generate almost all of their revenues and earnings outside SA. The JSE All Share Index – with at least half the companies represented in the index highly dependent on offshore economies – has returned very little since 1 November. The total returns from Banks and Retailers since then by strong contrast have been over 30%. (See below)
The offshore businesses listed on the JSE are best described as SA political hedges rather than rand hedges. The rand/US dollar exchange rate reflects two forces: global and SA-specific forces drive the markets in the rand and rand denominated securities. Global economic forces can act to strengthen or weaken emerging market economies and their exchange rates against the US dollar. The rand is very much an emerging market currency and will move with emerging market exchange rates – with an import overlay of SA political risks. When the rand strengthens for SA reasons, as it has done recently , the SA hedges listed on the JSE (British American Tobacco, Richemont and Naspers, for example) are likely to lose value when expressed in rands. Their US dollar value may remain unchanged while their rand value falls with a stronger rand. The earnings of SA economy-exposed stocks benefit from a stronger rand whatever its provenance; hence their recent outperformance can be attributed to a stronger rand because of less SA risk priced into the markets and an improved outlook for the SA economy.
These SA economy plays could benefit further should the SA economy grow faster than expected. The additional confidence to spend that comes with a happier state of political affairs will help the economy along. The lower inflation rates that follow a stronger rand will also encourage the spending that SA-exposed companies can benefit from. Lower short-term interest rates would be an additional stimulus to the economy. Lower inflation and expectations of lower inflation should encourage the Reserve Bank to lower its key lending rates.
The money market however, while no longer expecting short-term interest rates to rise over the next 12 months, according to the forward rate agreements, does not (yet) expect short-term rates to decline. The case for lower interest rates is a very strong one, given the state of the domestic economy and lesser uncertainty attached to its political future. An austere 2018 Budget, with government revenues estimated to rise significantly faster than government expenditure, is a further reason to ease monetary policy. The SA economy plays might well continue to outperform the SA hedges were the Reserve Bank to focus on the risks to growth rather than the risks to the exchange rate and inflation. 5 March 2018
The reality of state-owned companies in SA
The Budget Review for 2018-19 informs us that “in cases where state owned companies are making large investments in infrastructure, capital expenditure reduces profitability. Even after these investments are paid for, profitability is unlikely to match private-sector profit rates because these entities often provide public goods and services below the cost of production to enable economic activity……”
Capital expenditure whenever properly managed should be a source of improved profitability and returns rather than of additional waste. Moreover, the requirement a government might make on any enterprise to subsidise some of its customers can be paid for directly and transparently by the government, that is taxpayers. There is an obvious distinction between public enterprises able to charge for their services and public works – as in supplying rural roads – where charges cannot be levied in any realistic way to cover costs.
The Review goes on to tell us (that) “in many cases, however, falling profitability reflects mismanagement, operational inefficiencies and rising financing costs. Over the medium term, state-owned companies need to raise their returns to generate value, and to reduce their reliance on debt and injections from the fiscus”. (2018 Budget Review p 96)
A combined balance sheet of state-owned companies provided in Table 8.2 of the Review indicates how poor the financial performance has become over the years. The combined total assets of these companies totalled R1 225.2bn in 2016-7. Total liabilities (debts) were R869bn. The net asset value or equity of the companies fell by 1.5% in the last financial year and the average return on equity was a mere 0.3% or about R10m. Adding back interest on the liabilities, at say 10% a year, would give them earnings before interest and taxes (also paid to the state) of approximately R97m and so a return on assets of less than 8%, less than the interest cost.
This begs the question as to why they are publicly funded in the first place. It is not because they may provide public goods. They might have been founded – backed by the taxable capacity of the nation – because at the time private capital (correctly so) would not have been willing to undertake the risks involved. There may have been strategic or nationalistic objectives that taxpayers had to accept. Such constraints on the availability of private capital sourced globally to fund SA infrastructure have long since gone. Private capital would fund the essential SA infrastructure on favourable, market-determined terms provided they could be satisfied with the terms and conditions.
This could take the form of government (taxpayer) guarantees for well ring-fenced projects with clearly earmarked revenue streams, as with the so intended infrastructure bonds. A much better deal for the tax payers of SA guaranteeing the leasing charges would be private ownership and management of these assets, with these companies broken up and sold off. Ports and pipelines can be separated from railways and compete with each other and the generation of electricity by a number of independent power producers could be separated from its distribution. Partial private ownership or private-public partnerships of various proportions might also attract private capital. But without private sector control of the performance of the managers, workers and their remuneration, the efficiency with which the infrastructure is operated and expanded is unlikely to improve.
The reason for the state-owned companies to remain state-owned has little to do with efficiency. It is the political influence of the managers and workers that have kept them so. The have been able to defend their superior employment benefits at the expense of taxpayers and customers. This largesse has brought the system into disrepute and strained the ability of taxpayers to keep the gravy train running. We must hope for reforms of the essential kind that change the goal of the managers of these companies from serving themselves to serving their owners. By doing so they would relieve taxpayers from the risks they now carry and help their customers for whom they would compete, and help the economy to grow faster. 1 March 2018
The Investment Holding Company. How to understand the value it adds or destroys for its shareholders and how to align the interests of its managers and shareholders.
This report has been written with the managers of Remgro, an important Investment Holding Company listed on the JSE, very much in mind. Their managers having received a less than enthusiastic response of their shareholders to their remuneration policies, the company engaged with shareholders on the issue. An action to engage with shareholders that is to be much welcomed.
I have given much thought and written many words explaining why investment holding companies usually worth less than the value of their assets less debt they owned, why in fact they sell at a discount to their Net Asset Value. It occurred to me, as a Remgro shareholder in response to the invitation from the Remgro managers, that my approach could be used to properly align the behaviour of the managers of Remgro with their shareholders. I then engaged with other shareholders in a Remgro webcast and offered to extend my analysis- an offer that was respectfully accepted. This is the result
Applying the logic of the capital market to the managers of companies that invest in other companies
The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds –should be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.
The managers of a listed investment holding company, for example a Remgro, a PSG, a Naspers in South Africa or a Berkshire-Hathaway, the most successful of all Investment Holding Companies listed in New York, unlike the managers of a Unit Trust or Mutual Fund, are endowed with permanent capital by shareholders. Capital that cannot be recalled should shareholders become disillusioned with the capabilities of the managers of the holding company. This allows the managers of the HC to invest capital in operating companies for the long run, without regard to the danger that their shareholders will withdraw the funds invested with them- as can be the case with a Unit Trust.
A Unit Trust always trades at values almost identical to the value of the assets it owns, whether funds are flowing in or out or its value per unit has declined or increased- of great relevance to unit holders. This is because these assets can and may have to be liquidated for what they can fetch in the market place.
This is not the case with an Investment Holding Company (HC) The HC cannot be forced to liquidate assets if its shareholders lose confidence in the ability of its managers to beat the market or meet the expectations of shareholders. Therefore the value of the HC shares will go down or up depending on how well or poorly the shares of the holding company are expected to perform relative to the other opportunities available to investors in the share market.
The price of a HC share will be set and reset continuously to satisfy the required risk adjusted returns of potential investors. A lower share price will, other things equal, compensate for any expected failure of the HC to achieve market beating returns through its holdings of assets and its ongoing investment programme. Vice versa a higher HC share price can turn what are expected to be excellent judgments made by the HC, into merely normal risk adjusted returns. In this way through changes in share prices that anticipate the future, the outstanding managers of any company, be it an operating company or a HC that invests in operating companies, that is capable of earning internal rates of return that exceed their costs of capital, will only provide their shareholders with market related returns. Successful companies expected to maintain their excellence charge a high entry price in the form of a demanding share price. Less successful companies charge in effect much less to enter their share registers. Expected returns adjusted for risks therefore tend to be very similar across the board of investment opportunities.
This makes the market place a very hard task master for the managers of a company to have to satisfy. Managing only as well as the market expects the firm to be managed will only provide market average returns for shareholders. And so the direction of the market will have a large influence on share price movements over which managers have little immediate influence. Better therefore to judge the capabilities of a management team by the internal returns realised on the capital they deploy – not market returns.
The managers of the holding company must expect that the operating companies they invest in, are capable of realising (internal) returns on the capital they invest that exceed the cost of capital provided them. That is capable of realising returns that exceed their required risk adjusted returns.
These potentially successful investments may be described as those with positive Net Present Value or NPV. If indeed this proves so, and the managers of subsidiary companies succeed in their tasks, the managers of the HC must hope that the share market comes to share this optimism in their ability to find cost of capital beating investment opportunities. This would add value to the HC whose shares will reflect the prospect of better returns to come from the capital allocated to subsidiary companies in their portfolio. Other things equal, the more valuable their subsidiary companies become over time , the greater will be the value of the HC.
Past performance may only be a partial guide to future performance
Past performance, even a good track record, a record of having found cost of capital beating investment opportunities, may only be a partial guide to future success. The capabilities of the holding companies’ managers to add further value by the additional investment decisions they are expected will be under continuous assessment by potential investors in its shares.
Therefore the market’s estimate of the Net Present Value of the investment programme of the holding company can have a very significant influence on its market value. This value will depend on the scale of the additional investments expected to be undertaken by the HC , as well as the expected ability these investments to realise returns – internal rates of return on capital invested, (irr)– in excess of their costs of capital or required risk adjusted returns.
These expectations will determine the market’s assessment of the NPV of the investment programme. If the irr from the investment programme is expected (by the market place) to fall short of the cost of capital, then the NPV will have a negative value- a negative value that will be in proportion to the value destroying scale of the investment programme. If so the investment programme will reduce rather than add to the market value of the holding company.
The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect, we argue, mostly this pessimism about the expected value of their future investment decisions. A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns.
How managers of the holding company can add to its market value
That an investment holding company may be worth less than the value of the assets it owns is a reproach that the managers of holding companies should always attempt to overcome. They can attempt to do this by making better investment decisions, positive NPV decisions, and convince potential shareholders that they are capable of doing so. They can also add to their value for shareholders by exercising supervision and control over the managers of the subsidiary companies, listed and unlisted, they hold significant stakes in and therefore carry influence over.
They may be able to add to their market value by converting unlisted assets, whose true market value can only be estimated, into potentially higher valued listed assets with an objectively determined market price. They may also succeed in adding value for their shareholders by unbundling listed assets to shareholders when these investments have matured. This would mean reducing the market value (MV) of the holding company but also its NAV and so possibly narrow the absolute gap between its MV and NAV.
Increases in the market value of the listed assets of the holding company adds strength to its balance sheet. Such strength may encourage the managers of the holding company to raise more debt to invest in an expanded investment programme. This extra debt raised to fund a more ambitious investment programme can only be expected to add market value if the returns internal to the holding company exceed its cost of capital. If it is not expected to do so, these investments and the debt raised to fund them will reduce rather than add to NPV. The influence of the NPV estimates on the value of the holding company will however depend on scale of new investment activity compared to the size of the established portfolio. The greater the risks additional acquisitions imply for the balance sheet, the greater will be the influence of the NPV calculation.
A further influence on the value of a holding company will be the costs of maintaining its head office and complement of managers employed at head office. Clearly the net expenses of head office- costs less fees earned from subsidiary companies will reduce the value of the HC.
Our view is that the difference between the value of the holding company and the assets it has invested shareholders capital in is the correct measure of the contribution of managers to shareholder welfare. Hence improvements in the difference between the market value of the holding company and the market value of the assets it has invested in (it may be a negative number) should form the basis with which their managers should be evaluated and remunerated.
A little mathematics to help make the points
In the analysis offered below we support these propositions by identifying, using the logic of algebra, the forces that influence the market value MV as well as the NAV of an investment holding company and the differences between them.
A conventional calculation is made of the Net Asset Value (NAV) of the holding company as the sum of its parts- the sum of the market value of its assets less its net debts.
The NAV of a holding company is defined as
NAV = ML+ MU- NDt …………………. (1)
Where ML is the market value of its listed assets, MU the assumed market value of its unlisted assets less its net debt – debts-cash (NDt) held at holding company level. MU will be an estimate provided by either the holding company itself or independently by an analysis making comparisons of the market value of the holding company with its sum of parts, its NAV. Any difference between the valuation of unlisted assets included in NAV and the market value accorded to such assets by investors in the holding company (a valuation that cannot be made explicit) will have consequences as will be identified below.
The market value (MV) of the listed holding company is established on the stock exchange and can be assumed to be the sum of the following forces acting on its share price and market value
MV=ML+MUm-NDt+HO+NPV………………………… (2)
Where ML is again, as in equation 1, the explicit market value of the listed assets, MUm is the market’s estimate of the value of the unlisted assets that may or may not have a value close to that of the MU included in NAV in equation 1. NDt is the sum of the holding company debt less cash, also as in equation 1, recorded on the balance sheet of the holding company. HO is the cost or benefit to holding company shareholders of head office expenses, including the remuneration of head office management and other employees, less any fees paid to head office by the subsidiary companies for services rendered. HO would usually be a net cost for shareholders in the holding company and if so would reduce the market value of the holding company.
The final force in determining the market value of any holding company is NPV as discussed previously. NPV is defined as the present value attached by the share market to the investment programme the holding company is expected to undertake in the future. The more active this expected investment programme and the larger the programme – relative to the current composition and size of the holding company balance sheet, the more important will be the value attached to NPV. Furthermore it should be recognised from equation 2 that the scale of the investment programme, relative to the size of the established portfolio of listed and unlisted assets will determine how much the dial, so to speak of market value, moves in response to NPV.
Were the holding company managers be expected to undertake investments, be they acquisitions or greenfield projects, that returned more than their cost of capital, this would reflect in a positive NPV. That is to say the greater the (expected) spread between realised and required risk adjusted returns, the greater will be the value attached to NPV for any given (estimated) monetary value attached to the investment programme. However, as discussed previously, the holding company may be expected to be unable to find cost of capital beating investment opportunities. If so NPV would have a negative value and the more the holding company were expected to invest in new projects, the larger would be the negative value that will be attached to NPV. A negative value accorded to NPV would clearly reduce the market value MV of the holding company as per equation 2.
The success or otherwise of the ability of the holding company to add value for its shareholders can be measured as the difference between NAV, net asset value, the sum of parts, and the market value (MV) of the listed holding company or
Value Add= NAV-MV …………………. (3)
It should be noted in the formulation of equation 3, that NAV is presumed to be larger than MV. This is a usual feature of holding companies that are usually worth less than their sum of parts. This negative value is often expressed as a percentage discount of NAV to its market value- as defined below in equation 5.
If we substitute equations 1 and 2 into equation 3 the forces common to the determination of market value (MV)and NAV in equations 2 and 3 that is MU, Net Debt, Debt less cash, cancel out and we can conveniently write the difference between NAV and MV as simply
(NAV-MV) = – (NPV+HO- (MU-MUm))…………………… (4)
It will be noticed that the higher the absolute value of NPV the smaller the difference between NAV and MV. Were however the NPV to attract a negative value the variables on the right hand side of equation 4 would (other things held constant) take on a positive value and increase the difference between NAV and MV. Other forces remaining unchanged, head office expenses and differences between the estimate of the value of the unlisted assets included in NAV and its “true” unobservable value will also narrow the difference between NAV and MV.
The net costs of head office (HO) as mentioned, is likely to have a negative value for shareholders, as would any overestimate of the value of the unlisted assets. If so, to have MV exceed NAV and so for the holding company to stand at a premium rather than a discount to its NAV, the NPV would have to attain enough of a positive value to overtake these other negative forces acting on MV.
A further value add indicated in equation 4 would be to narrow any difference between the value of the unlisted assets included in NAV and its true market value, which cannot be directly observed. Listing these subsidiary companies may well serve this purpose. It will provide them with an objectively determined value that may well exceed its lower implicit value as unlisted companies. If so this can add market value to the holding company.
It would seem clear from this formulation (equation 4) that for those holding companies with an active investment programme, the key to value destruction or creation, the difference between NAV and MV, will be the expected value of its investment programme (NPV) It would seem entirely appropriate for shareholders in the holding company to incentivise the managers of the holding company by their proven ability to narrow this difference and improve VA. Positive changes in VA- that is less of a difference between NAV and MV –that would take an absolute money value that can be calculated continuously – could form the basis by which the performance of the managers of the holding company are evaluated.
We have shown that much of any such improvement in the market value of the holding company and its ability to add value for shareholders should be attributed to improvements in NPV, a variable very much under the control of the managers of the holding company. The reduction of head office costs, or better debt management, or some reassessment of the value in the unlisted portfolio, is perhaps unlikely to significantly move the market value of the holding company.
Were the managers of the holding company able to make better investment decisions and more important perhaps, were expected to make better investment decisions, the market place would reward the shareholders in the holding company accordingly. Though further any contribution they might make to increase the market value of listed companies under their influence or control, could also help reduce the difference between NAV and MV, as we will demonstrate further.
Investment analysts give particular attention to the discount to NAV of the holding company. The notion is that there is will be some mean reversion of this discount and so an above average discount may indicate a buying opportunity and the converse for a below average discount. This discount is defined as
(NAV-MV)/NAV % …………………………………………… (5)
This notion of a (normal) positive discount is also consistent with the notion as indicated previously that the NAV usually exceeds MV. If we divide both sides of equation 4 by NAV and substitute the components of NAV in the denominator we derive the positive discount to NAV as
Disc%=- (H0+NPV-(MU-MUm))/(ML+MU-NDt) …… (6)
As may be seen in equation 6, if the combined value of the numerator is a positive number, then the discount attains a negative value- that is the market value of the holding company would stand at a premium to the sum of its parts – Berkshire Hathaway might be an example.
Clearly any change that reduces the scale of the numerator (top line) or increases the denominator (bottom line) of this ratio will reduce the discount. Thus a less expensive head office (HO) or an increase (less negative) in the value of future business (NPV) will reduce the discount. (These forces represented in the numerator of equation 6 are preceded by a negative sign. As per the denominator, any increase in ML or MU or a reduction in net debt will reduce the discount.
However while reducing the discount is unambiguously helpful to shareholders and will be accompanied by an improvement in NPV, this will not always or necessarily be the result of action taken at holding company level. Any increase for example in the market value of the listed ML or unlisted investments MU will help increase the absolute value of the denominator of equation 6 and reduce the discount and add NPV. But such favourable developments may have everything to do with market wide developments that influence ML or MU and have little to do with the contributions made by the management team at holding company level.
Thus it is the performance of the established portfolio relative to some relevant peer group rather than the absolute performance of the established portfolio should be of greater relevance when the performance of the managers are evaluated. These influences on the value add might be positive or negative for the value add for which management should not be penalised or rewarded.
It would therefore be best to measure the contribution of management by a focus on the underlying drivers of NPV seen as independent of the other forces acting on the market value of the holding company. Furthermore the focus of the managers of the holding company and their remuneration committees should be on recent changes in the absolute difference between NAV and MV and not on the ratio between them.
Unbundling may prove a value added activity – the interdependence of the balance sheet and the investment programme- for which the algebra cannot illuminate.
Unbundling listed assets to shareholders might well be a value adding exercise. It would simultaneously reduce both NAV and MV, but possibly reduce the absolute gap between them. Because such action could illustrate a willingness of the management of the holding company to rely less on past success and to focus more on the merits of its on-going investment programme. Reducing the size and strength of the holding company balance sheet may make the holding company less able and so less likely to undertake value destroying investments. An improvement in (expected) NPV and so a narrowing of the difference between NAV and MV might well follow such an unbundling exercises to the advantage of shareholders. That is helpful to shareholders because even as the absolute size of the holding company’s NAV and MV decline, the difference between them may become less negative- even become positive should MV exceed NAV
Conclusion
We would reiterate that the purpose of the managers of the holding company should be to serve their shareholders by reducing the absolute difference between NAV and MV and be rewarded for doing so. A focus on this difference, hopefully turning a negative number into a (large positive one) would be highly appropriate to this purpose.
Appendix
Remgro: chart reflecting estimated difference between the market value of Remgro and our calculation of its net asset value
Source: Investec Wealth & Investment analyst model
Naspers: chart reflecting estimated difference between the market value of Naspers and our calculation of its net asset value
Source: Investec Wealth & Investment analyst model
Global savings and interest rates- will we see normalisation?
What the world needs now is more than love- there is also too little spending. [1]More of that would also be very welcome. Particularly welcome would be extra spending by business enterprises on capital equipment. This lack of demand, combined with a rising global savings rate, has created an abundance of saving that explains the exceptionally low interest rate rewards for saving in developed economies. This glut of savings followed the global financial crisis (GFC) of 2008-09 that made managers more fearful to spend or lend while additional regulations restricted their freedom to do so.
The story of the global glut of savings can be told in a few pictures provided by the World Bank shown below. When will then consider how the bond market in the US may be indicating some incipient revival of the animal spirits of US corporations. Encouraged, as they attest, by lower tax rates and much more sympathetic regulators.
Figure 1 charts gross global savings as a per cent of gross global incomes. (GNI) As may be seen share of savings of income has been rising steadily over the years. The GFC hit savings even harder than incomes (upon which savings depend) but since then savings have made an ever larger claim on incomes (26% in 2015). The global savings rate was only about 21% of incomes in the fast growing and higher interest rate world of the mid-nineties. It has been on a generally upward trend since, as may be seen.
Gross savings – (savings before amortisation of capital that turns gross into net savings) are dominated by the cash retained by corporations. Households may save – but other households over the same period may be large borrowers and reduce the net contribution households make to the capital market. And most governments are net borrowers- borrowing even more than they spend on infrastructure that is counted as saving.
Fig 1; Gross savings as per cent of Gross Global Income
As we show below in figure 2, the rate at which real capital – plant and infrastructure – has been accumulated has been trending in very much the opposite lower direction. There was a brief surge in the rate of capital formation in 2005 – a boom year for the global economy – but this was not sustained and was but 24% of global incomes in 2016- compared to a higher global savings rate of 26%.
Fig.2; Gross Capital Formation (% of GDP)
Source; World Bank
In the case of South Africa, with a lower gross savings rate of less than 18% of GDP, the cash retained by the corporate sector (including state owned enterprises) accounts for more than 100% of all gross savings. The household sector’s net contribution to gross savings flows is barely positive and the government sector is a net dis-saver. We show the trends in the SA savings rate below. The profits from the gold booms of the seventies and early eighties were responsible for the very high savings rates then.
Fig 3; South Africa – Gross Savings Rate
Source; World Bank
South Africa cannot realistically hope to raise its savings rate significantly. It can however hope to raise the rate at which capital expenditure is undertaken. That is by reducing the risks of investing in SA- and growing faster and attracting the savings to fund more rapid growth. That would be freely available from the large pool of global savings anxiously seeking better returns- given the right incentives and protections to do so. There is, as indicated, no global shortage of capital – only of attractive investment opportunities that SA could be offering.
The current rate of capital formation currently in SA is only slightly higher than the low savings rate – hence the small net inflows of foreign capital. The difference between any nation’s gross savings and capital formation is approximately equal to the net capital inflow and so the current account deficit on the balance of payments. The item that balances the current account deficit (exports-imports +debt service) – is the change in forex reserves- usually a comparatively small number.
South Africa could do with much faster growth that would encourage more capital formation and attract the foreign savings to fund this growth. And higher corporate incomes would mean more corporate savings. It is slow growth that is at the core of SA’s economic issues. Not the lack of savings. If we grew faster both the current account deficit and the capital inflows would be larger and the rate of capital formation higher. And a larger capital stock would bring more employment and higher incomes for a more productive labour force.
The US despite a relatively low and fairly stable savings rate (currently also around 18% of GNI as in South Africa) is, given the scale of its economy, still a large saver on the global stage. Though the US economy is the largest by far drawer on the global capital market to fund its spending as we show below in figure 8. While the US has been saving absolutely more recently, Chinese savings have now far overtaken US savings in absolute magnitude. Germany is another large saver, adding significantly to global savings in recent years, as we show below.
Fig. 4; Global Savings Rates
Source; World Bank
Fig.5; Gross savings (current US dollars) by economy
Source; World Bank
The Chinese are not only the largest contributor to global savings, saving an extraordinary 45% of their GNI – a rate that as may be seen has been declining from above 50%- they are also undertaking by far the largest share of global capital formation. They created plant and equipment – real capital – worth over USD 5 trillion in 2016 or at a rate equivalent to 45% of GNI, similar to the investment rate- meaning that most of the Chinese savings were utilised domestically.
Fig.6; China Gross Capital Formation (% GDP)
Source; World Bank
But this raises a very important issue for the Chinese. Given the rate at which they save and invest in real capital the realised growth in Chinese incomes must be regarded as disappointingly poor- even when about a 7 per cent p.a rate. It suggests that much of the capital formed is still unproductively utilised. The full discipline of western style capital markets is surely something still to be introduced to China to improve returns on savings. But for all the relative inefficiency of Chines capital, the sheer volume of Chinese capital formation has made it the dominant force in the market for minerals and metals that are used to create capital goods.
Fig.7; Gross capital formation by economy – current US dollars
Source; World Bank
In figure 8 below we show how The US dominates the demand side of the flows through global capital market- and the thrifty Europeans – the supply side. As may be seen these trends that made US economic actors the dominant utilisers of global capital are predominatly a post 2000 development.
It is these capital flows that drive the US dollar exchange rate – and by implication all other exchange rates. Trade flows react to exchange rates- rather than the other way round. This is also the case for SA. With one important difference- foreign trade for the US economy is equivalent to about 25% of GDP. In SA imports and exports – valued at unpredictable exchange rates are equal to about 50% of GDP.
Fig. 8, Net Financial Flows from Europe and to the US. Current US dollars
Source; World Bank
The flows of savings and flows into the US have not only moved the dollar they have moved interest rates. Perhaps the best measure of the global rewards for saving are found in the direction of the real rates of interest offered by an inflation linked bond issued by the US Treasury. Such a bond may be regarded as free of default as well as inflation risk. The risks of inflation are reflected in the yield on a vanilla bond. In the figure 9 below we compare the yield on a 10 Year US Treasury Bond and its inflation protected alternative with the same duration. As may be seen the nominal and real yields have both trended lower. The vanilla treasury bond was offering over 5% p.a in 2005- now the yield for a ten year loan provided the US is about 2.7% p.a. Real yields were over 2%. p.a. in 2005-06. They are now about a half of one per cent p.a. – after a period of negative returns in 2012-2013.
More important these yields have been rising in 2018 indicating some small degree of greater demands for capital. The real and nominal yields however remain very low by historic standards as will be appreciated. Normality – that is any sustained higher global growth rates, must mean much higher real yields. Higher nominal yields will also depend on how much inflation comes to be added to real yields.
Fig. 9; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2005- 2018)
Source; Bloomberg and Investec Wealth and Investment
Fig. 10; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2018)
Source; Bloomberg and Investec Wealth and Investment
In figure 11 below we show the difference between these nominal and real interest rates. These differences represent the extra compensation bond investors receive for taking on inflation risk. It may be regarded as a highly objective measure of inflationary expectations. The more inflation expected the wider must be the spread between nominal and real yields. As may be seen- excluding the impact of the GFC this spread or inflation expected has remained between two and three per cent per annum. It is important to recognise that these inflationary expectations remain very subdued despite a recent increase. Equity investors as well as bond investors must hope that inflation expectations remain subdued enough to hold down nominal interest rates even as real yields rise to reflect a stronger global economy and a revival of capital formation. Low inflation with faster growth is an especially favourable scenario for equity markets.
Fig.11; Inflation compensation in the US Treasury Bond Market – spread between nominal and real 10 year US Treasury Bond Yields
Source; Bloomberg and Investec Wealth and Investment
[1] With acknowledgement to Burt Bacharach