Author: Brian Kantor

Dangerous curves

The danger in the US is not rising interest rates themselves, but rises that surprise

US President Donald Trump, being the businessman he was (or is), woke up one recent morning worrying about interest rates and what the Fed might do to the US economy (or perhaps his real estate portfolio) with higher interest rates.

Being Trump, he immediately Tweeted his concerns to the world at large, so defying the convention that the Fed should be independent of political forces, causing predictable consternation. But with more reflection he might have noticed that the market place was doing the job for him: of actively restraining the upward march of interest rates expected in the future.

While short term rates, under the direct influence of the Fed, have been on the rise and are confidently expected to rise further over the next 12 months, the pace of further increases is expected to slow down to very gradual increases over the next three years. The current yield on a one-year US Treasury Bond is 2.42%. In a year’s time this yield is expected to be 2.87% but in three years’ time it is expected to be only a little higher, at 2.94%.

One can interpolate the expected rate of interest from the term structure of interest rates. Investing in a one year to maturity Treasury will yield 2.42%. A Treasury Bond with two years to run now offers little more, or 2.64%, and a three year Treasury Bond yields but 2.73%. An investor can secure 2.73% by committing to a three year investment, or alternatively invest for a year at 2.42% and then reinvest for a further year at what will be the one year rate in a year. The expected returns must therefore be very similar given the alternatives of investing for longer or shorter periods.

Given the alternative of investing for a longer period or a shorter period and then reinvesting the proceeds, the longer-term rates can be regarded as the (geometric – allowing for compounding of interest) average of the expected short term rates. The difference between the fixed yield on a two year bond and the fixed yield on a three year bond can be used to calculate the one year rate expected in three years’ time and so on for any one year period in the future. We have reported these expected one year rates above from a table provided by Bloomberg (The US Treasury Active Curve).

Thus the steeper the yield curve – the greater the difference between long and short term – the more short rates must be expected to rise. The flatter the yield curve – the smaller the difference between long and short rates – the smaller must be the expected increase in short rates. Should the yield curve turn negative, that is when short rates are above longer term rates, this means that short rates must be expected to decline in the future to provide average returns in line with the currently lower longer-term fixed rates.

Borrowers typically incur debts with extended repayment terms. So what is expected of interest rates (more than current interest rates) will influence current decisions to borrow and to spend. Such modest increases in the expected cost of servicing debts in the US is unlikely to be a deterrent to current borrowing and lending decisions undertaken by firms, households and banks or other suppliers of credit.

In the US, the gap between longer and shorter term interest has been narrowing sharply as we show below. Short-term rates have been rising much faster than long term rates – the yield curve has therefore flattened – giving rise to very modest further expected increases in short-term rates reported upon earlier. The difference between the fixed yield on a 10-year US Treasury Bond (2.93%) and a two-year bond (2.64%) is currently a mere 27 basis points (0.27 of a percentage point). The extra rewards for investing currently at a fixed rate for 30 years in a US Treasury Bond (3.05%) rather than 10 years is therefore a very scant 12 basis points. Clearly this reflects a very flat yield curve beyond two years and very limited expected increases in interest rates to come.

 

We therefore need to consider the causes as well as the effects of rising or falling interest rates. Short-term rates can be expected to rise with economic strength and the upswings in the business cycle and fall as economic activity slows down. A sharply positive yield curve implies faster growth and higher interest rates expected. And these higher interest rates can then be expected to slow down the pace of economic growth, hopefully to a rate of growth that can be sustained over the long term. A flat or negative yield implies slower growth to come and in turn lower interest rates to come; that is to help stimulate economic activity enough to enable the economy realise its long term growth potential without deflationary pressures.

The flattening of the US yield curve, while encouraging current spending by restraining the expected cost of debt service, may portend slower growth to come and therefore less reason for the Fed to raise short-term rates in the future and so act as the market expects it to act.

The danger to the US economy however does not come from higher or lower interest rates – provided that they behave as expected – and so move consistently with the expected state of the economy. If this were to happen, interest rates would have little real effect on borrowing, lending, spending and the economy. The danger is therefore not that interest rates may rise, but rather that they rise unexpectedly rapidly. This would disturb the economy and slow down growth unnecessarily rapidly. Trump might have noticed just how carefully the Fed has been to make its actions as predictable as possible, so aligning actual and expected interest rates. His and our concern as economy watchers should be about the danger of interest rate surprises – not interest rate levels. 26 July 2018

 

Is pessimism about the SA economy overdone?

The SA economy: will it gain relief from a stronger rand and less inflation?

The SA economy (no surprise here) continues to move mostly sideways. Growth in economic activity is perhaps still slightly positive but remains subdued. Two hard numbers are now available for the June 2018 month end: for new vehicle sales and the real supply of cash – the notes in issue adjusted for prices that we combine to form our Hard Number Index (HNI) of economic activity. Because it is up to date, the HNI can be regarded as a leading indicator of economic activity that is still to be reported upon.

Its progress to date is shown below. It shows a falling off in activity in 2016 and a more recent stability at lower levels. It is compared to the Reserve Bank’s business cycle indicator based on a larger number of time series that continued to move higher in 2016-17 but has also levelled off in recent months. The problem with the Reserve Bank series is that it is only available up to the March month end for which GDP data is also available.

 

We show the growth in the HNI and the Reserve Bank cycle below with an extrapolation 12 months ahead. The HNI cycle suggests growth of about 1% in 2019 while the Reserve Bank cycle is pointing lower.

 

 

It is striking how well the real cash cycle (included in the HNI) can help predict the cycle of real retail sales. Retail sales volumes gathered momentum in late 2017 stimulated it would seem by an increasing supply of real cash. This momentum has however slowed more recently as inflation turned higher in the face of a weaker rand. Retail sales have been reported only to April 2018.

The key to any revival in domestic spending will be less SA inflation. And inflation will, as always, take much of its momentum from the exchange rate. The recent weakness in the rand has been a body blow for the SA consumer. It has little to do with events in SA and much to do with slower growth expected in emerging market economies, especially China. Where the dollar goes, driven higher by relatively stronger growth and higher interest rate prospects in the US, emerging market currencies, including the rand, move in the opposite direction.

The best hope for the rand and for the SA consumer is that the pessimism about emerging market growth has been overdone. If so some recovery in EM exchange rates can be expected – and that the rand will appreciate in line with capital flowing in rather than out of emerging markets. Some of these forces have been at work this week, helping the rand recover some of its losses and improving the outlook for inflation in SA. It may also if sustained even lead to lower interest rates in SA – essential if any cyclical recovery is to be had.

The importance of inflation for the business cycle is captured in this correlation table of key growth rates in SA. Inflation may be seen to be negatively correlated (and significantly so) with the growth in retail volumes and new vehicle sales. It is even more correlated (0.85) with the growth in the supply of real cash – that is in turn highly correlated with the growth in retail activity. And as may be seen, the growth in retail activity is also strongly correlated with growth the Reserve Bank’s cyclical indicator (Resbank) (0.80 correlated):

 

The problem for South Africa and the Reserve Bank that targets inflation, is that so little of the inflation experienced in SA is under its control. The exchange rate takes its own course – driven by global sentiment – so pushing prices higher or lower, that in turn drives spending lower or higher. Interest rates that may rise with more inflation and then fall with less inflation make monetary policy pro-cyclical rather than counter cyclical. 11 July 2018

Why China is so important to SA

The outlook for the SA economy depends on China

Emerging markets (EMs) and their currencies enjoyed a strong comeback in 2017, after years of underperformance when compared to the S&P 500. The JSE All Share Index kept pace with the S&P 500 in 2017 in US dollars. An EM benchmark-tracking stock would have returned over 40% in the 12 months to January 2018 while the S&P 500 delivered an impressive 26%, less than the 28% delivered to the dollar investor in a JSE tracker.

Investor enthusiasm for equity markets in general and for EM securities and currencies in particular however ended abruptly in January 2018 and waned further in April. The EM equity drawdowns since January have been depressingly large. The MSCI EM Index and the JSE have now lost about the same 16.5% of their end January US dollar values, while the S&P 500 was down by a mere 4% at June month-end.

 

The carnage was widespread across the EM universe. The SA component of the EM Index, with a weight of 6.5%, has been an averagely poor EM performer in 2018, as shown in the figure below. Turkey is the worst performer in 2018, down nearly 30% in US dollars in the year to June. The All China component of the EM benchmark, with a large weight of 31.7%, has lost about 12% over the same period, with much of this loss suffered since March, including a large 7% decline in June. The Brazil Index has suffered a heavy 27% decline in its US dollar value in the past quarter.

 

 

The capital that had flooded into EMs and their currencies in 2017 has rushed out even more rapidly, presumably back to the US, so driving the US dollar higher and other currencies, especially emerging market currencies (including the rand) weaker. The rand has traded mostly in line with its peers in 2018, though it has lost ground to them recently.

 

 

It should also be recognised that the similar flows of dividends and earnings from the JSE and EMs over many years, in US dollars shown in the figure above, is not some co-incidence. It is the result of the similar economic performance of the companies represented in the two indices.

The JSE has been well representative of the EM universe taken as a whole, when measured in US dollars. Naspers, with a 20% weight in the JSE All Share Index and a close to 30% weight in the SA component of the EM benchmark, is largely a Chinese IT company. Naspers is riding on the coattails of its subsidiary Tencent, and this helps account the similar behaviour of the respective indices.

In the long run, it is past performance reflected by earnings, dividends and return on capital invested that drives equity valuations, not sentiment. Reported dividends, discounted by prevailing interest rates, do a very good fundamental job in explaining the level of an equity index over time. In the short run, expectations of future performance (sentiment), will move markets one way or another, as they have moved equity markets in the past.

The sell-off in EM equity markets is not explained by their recent performance, which has benefited from synchronised global growth. It reflects uncertainty about the prospective growth in dividends and earnings and therefore global growth rates to come. We may hope that pessimism is being overdone.

The impact of the performance of companies that operate in China, on the outcomes for EMs generally (including SA), cannot be overestimated. Not only is the direct weight of China in the equity and currency indices a large one, but China is an important trading partner for all other emerging market economies.

Therefore the ability of China to maintain its growth and trading relationships successfully and manage its exchange rate predictably and responsibly will be a vital contributor to the prospects for all EMs. Realised global growth, including growth in the US, Europe and China, will determine the outcomes for EM equity and bond markets and exchange rates. The performance of the global economy and the companies dependent upon it are as good or better than they were a year ago.

The performance of the SA economy would be assisted by a stronger rand and damaged by a weaker rand that moves inflation, interest rates and spending faster or slower. Exchange rate and inflation trends in SA are bound to follow the direction taken in all EM economies, especially China. We must hope that renewed respect for growth in China will make this happen. Our immediate economic future depends more on what happens in Beijing than in Pretoria. 5 July 2018

The mining charter- its true purpose

Version published in Business Day 23rd June 2018

 

There is much to be gained from a thriving mining sector. Its promise for growing incomes is as great- perhaps greater than any other sector of the SA economy- given the opportunity. There would be extra income to be earned on the mines and rigs and additional taxes paid by many more workers. There would be more jobs gained and increased incomes earned supplying goods and services to additional mining enterprises.

 

Exports would grow and the balance of payments would benefit from inflows of permanent mining capital. The exchange value of the rand would become less vulnerable to outflows of portfolio capital – to the advantage of all businesses and their customers in our economy.

 

The recipe to stimulate rapid growth in mining activity is simple It is to make the rules and regulations applied to the owners of mining companies at least as attractive as anywhere in the world.. Applied to capital that realistically can only be expected from well-established, well-diversified global mining companies with the appetite for taking on mining risks and the balance sheets and borrowing capacity to do so.

 

And wouldn’t it be a game changer for exploration activity were ownership of the rights to the potential value below the surface be transferred from the state to the owner of the land above. Including to communities with traditional rights to graze or plant land that could be far more valuable than they can possibly know before exploration. Rights ceded in exchange for a significant betterment tax should ownership be transferred to a mining company received on transfer from the buyer.

 

However the newly proposed and amended mining charter informs us very clearly that this more competitive landscape for mining is not about to happen. The intention is to put onerous constraints on the powers of owners to manage a mine as best they might. Owners will be required to contract with suppliers, directors and managers and partners with preferred legal status rather than chosen on merit. It imposes further controls on how they have to share the benefits of ownership and the capital they will have put at risk. With partners not necessarily of their own choosing or on terms chosen by them should the mine prove successful.

 

They will be required to pay taxes and royalties and declare dividends based on cash flows, not on normal accounting principles. For fear – not doubt legitimate – that taxable income might be minimised by transfer pricing – reducing revenues and raising costs. Or by exaggerating the interest paid on loans provided by holding companies residing in no tax or low tax jurisdictions. Interest payments (expensed for tax purposes) that are intentionally more like capital repaid.

 

Eliminating tax avoidance and applying the complex regulations will take a costly to taxpayers and owners army of competent officials on both sides of the fence to hopefully ensure compliance.

 

It would be much more sensible if mining companies in SA were not subject to any income taxes at all. This would eliminate all attempts to minimise tax payments and protect the tax base. All income distributed by companies as employment benefits, rents, interest dividends or capital repayments can instead be taxed in the hands of the receivers- reported by the company making the payments. Compliance becomes much less onerous and the case for investing much improved – to the great advantage of mining output.

 

It should be very clear therefore that the intentions of the mining charter are not to stimulate mining output and employment. Its primary purpose is to redistribute its benefits. The mining charter is symptomatic of this approach to economic development in South Africa. Redistribution at the expense of potential growth. The consequential sacrifice of growth, so balefully apparent, should not be regarded as unintended.

Looking at the hard numbers

Our review of the state of the SA economy indicates a modest but welcome pick-up in economic activity. This was driven by lower levels of inflation particularly at retail level where even some lower prices helped spur spending by households.

Unfortunately the suddenly weak rand will reverse inflation trends and slow down spending all over again. As Mike Tyson said, everybody has a plan in the ring until they get hit in the face. Consumers have had to take another punch in the form of a weaker rand that will soon show up at the stores. They will depend on the Reserve Bank rolling with the punch: leaving interest rates unchanged to soften the blow of higher prices. The real danger is that the Bank will do the opposite and raise rates, doing nothing for the rand and only depressing spending further.

We have updated our index of the current state of the SA economy with data released for May 2018. We call it the Hard Number Index (HNI) because it relies on two hard numbers that are provided very close to the month end. The data we rely upon and combine to form our Index are new vehicle sales, provided by the National Association of Vehicle Manufacturers (NAAMSA) and the cash (notes) in circulation issued by the Reserve Bank. The note issue is a liability on the Reserve Bank balance sheet, reported soon after each month end.

These are hard numbers and not the result of sample surveys that inevitably take time to collect and estimate. A further advantage in the May releases is that they are less likely to be influenced by the Easter effect that comes at different times in March or April, and so always makes seasonal adjustments very difficult to claculate accurately for those months. The seasons of the year do make a difference to vehicle sales and even more so on demands for cash that tend to rise as consumers intend to spend more on holidays, especially at Easter and Christmas.

The current state of the economy, according to the HNI, as of the May month end, is shown in the chart below (Figure 1). The HNI is compared with the Reserve Bank Business Cycle Indicator that has only been updated to February 2018 (an especially out of date measure given that disappointing first quarter GDP estimates have already been released). The disappoinment was that in the first quarter GDP, declined at a 2.2% annual rate. the economy will have moved on – hopefully forward.

The HNI may be regarded as a leading indicator of the SA business cycle and has served very well in this regard as may be seen in figures one and two. However the two series parted company to a degree after 2016. The HNI has pointed to lower levels of activity than the Reserve Bank Indicator. However in late 2017 the HNI stabilised and picked up some momentum. These trends, when extrapolated, suggest that the economy will stabilise at its current pedestrian pace for the next 12 months.

We show the second derivative of the business cycle in figure 2, the growth in the economic indicators. As may be seen the growth in the Reserve Bank activity indicator has been slow but persistently slow in 2017 and 2018. The HNI has recently turned from negative to positive growth.

The components of the HNI have shown a different direction. Supply (and demand) for cash, adjusted for prices, has shown a welcome upward direction, and is forecast to be sustained over the next 12 months. However vehicle sales, while they have shown a modest recovery in 2017, are pointing marginally lower: down from their current annual rate of about 546 000 new passenger cars sold, to a marginally lower rate of sales of 535 000 cars forecast to be sold this time next year. See figures 3 and 4.

The pick-up in the real cash cycle was assisted by less inflation in 2017. Figure 5 compares the growth in the value of notes issued (at face value) with the slower inflation adjusted rate of growth.

The increase in prices at retail level has been unusually lower than headline inflation in recent months. In March 2018, retail inflation was running at 1.6% compared to headline inflation that month of 3.8% that increased to 4.5% in April. This pick up in what are spending intentions, hence demands for cash, would be faster if prices were measured at retail rather than headline inflation.

Lower levels of retail inflation in 2017 owed much to the end of the drought, the recovery of the rand and the weakness of spending at retail level that gave retailers very little pricing power. The consequently lower inflation rates at retail level – sometimes deflation – undoubtedly helped stimulate extra spending at retail level in late 2017. The real money cycle is almost always closely linked to the cycle of retail sales volumes as we show in figure 6.

As we show in figure 7, measuring the increases in the real supply of cash using retail prices rather than the CPI accords better with the faster pace of retail sales volumes in recent months.

It may also be seen in figure 8 that the forecast for both is for slower growth over the next 12 months. Both the growth rates in real cash and real retail sales are forecast to slow towards a three per cent per annum pace by early 2019.

The recent weakness in the rand will not be helpful in this regard. It will mean more inflation and so more pressure on the spending power of households. We may hope that the Reserve Bank will not be adding to this depressing effect on spending by raising interest rates and also doing nothing to help the rand while only slowing down economic growth further. 13 June 2018

Keep Cities Connected

A successful city is pro- rich and pro-poor. It budgets for growth to serve all who live there.

Cities bring people together in what becomes very crowded space. They come together to make better connections: helping employees connect with employers and helping customers and clients to connect with the suppliers of important services. The physicians are helped to connect with their essential patients. Lawyers, accountants, consultants of great variety, can connect with their clients who rely on their skills and experience for which they willingly pay and make practice possible. Restaurateurs, with their chefs and waitrons, connect the many who they feed and amuse. And artists of all kinds connect with the audiences they may only find in the large city, to mutual delight.

Cities offer valuable choices to all their citizens, rich and poor and those in between, that are not available outside. We complement each other and we combine together to make as sure as we can that our crowded space can serve our purpose to connect. And so we establish and maintain a grid of one kind or another to deliver essential services – water, energy, roads and other forms of transport – more cost effectively than if we somehow had to do it for ourselves, off grid so to speak.

The essential purpose of local government is to maintain and improve the quality of the vital connections by providing the grid efficiently. Elected civic leaders should compete on this basis for the votes that elect them to office. Successful cities will attract migrants from outside to join in and share in the success. They manage the growth well enough to preserve the advantages of city life for all who choose to live there, including the poor who cannot or will not pay enough to be connected to the grid. Yet it is essential to keep them well connected, for the sake of the city and all including the well-off who live nearby. Making these connections possible is not charity – it is good sense.

And the South African city would surely do better if it were given fuller responsibility for policing, schooling and securing the bulk supplies of water and energy for their grids – that has proved not nearly secure or capable enough when provided by the central government or by proxy provincial governments.

City success will be revealed in the value attached to the buildings of the city, the houses, offices, factories and warehouses that make up the city. More accurately it is revealed in the value of the land under the buildings and the vacant land that can be put to more valuable uses over time. Development and re-development increase the supply of buildings, helping hold down land values and the rentals attached to them. They help keep more people flowing in rather than out of the city.

There is a virtuous civic circle to be sustained. The better the city delivers, the more its land will be worth and the more revenue it can collect to maintain and improve its connections and grid. And failure to deliver soon shows up in deteriorating property values and increasing financial strain, harming all, perhaps especially the poor.

Cape Town has been the success story of SA cities, judged by the flow of migrants to it (rich and poor) and by the growing value of real estate that is so supportive of its balance sheet and income. The city borrows very little and its net interest bill, after investment income, is very small compared to its revenue and expenditure.

Yet the city budget proposes to fund the significant capital expenditure needed to guarantee sufficient water with permanently higher tariffs. Lower tariffs would serve the city much better by helping to preserve on-grid demands. It would also generate enough extra revenue to pay the extra interest and repay the loans. This would be possible with more borrowing that in no way would threaten financial stability. Rather it will help by improving the growth potential of the city that depends upon its grid – especially so when competitively priced.

Making sense of the earnings and dividend cycle

The JSE earnings and dividend cycles – a May 2018 update. What the market may be telling us

The growth in reported JSE All Share Index earnings per share appear to have peaked. The year on year growth in earnings have fallen back from the 30% rate realised in late 2017 to the current rate of 10% realised by the May 2018 month end. Index dividends per JSE share were growing at a 20% annual rate at the May month end. A time series forecast of both earnings and dividends suggests that their growth will slow down to less than 5% in the next 12 months.

 

The resource companies listed on the JSE have grown their earnings and dividends more rapidly than the other sectors over the past year – off a lower base. Resource earnings in January 2017 were 34% down on earnings the year before, while All Share Index earnings were 15% lower in January 2017 than in January 2016.

We show some of the trends in sectoral earnings growth rates in figure 2 below. Industrial Index earnings were trending higher at a 19% a year rate by May 2018, Banks at a 7% rate while the General Retail Index earnings per share were declining at a 3% rate. Resource earnings were trending at a 34% rate in May 2018 – though well down on the peaks of 80% growth realiised in late 2017.

 

When calculating an earnings cycle the base effects- what happened a year before – is important for current growth. It is much easier (more difficult) to realise high (low) rates of growth when growth was subdued (or buoyant) in the same month the year before. Perhaps it is more helpful when interpreting the performance of listed companies and the values attached to them to examine the level of rather reported earnings.

Perhaps even more illuminating about the state of play on the JSE would be to examine the level of earnings or dividends in constant prices, as we do in figure 3 below.

 

 

Real dividends have outpaced real earnings – they are now close to peak real dividends of 2014, while real earnings are still well below real earnings realised before the global financial crisis and recessions of 2009. This is surely a very sobering statistic- it shows that the real earnings front of the JSE have moved backwards since 2006.

The movement of the JSE since 2000 therefore appears to be better explained by dividends than earnings. Were it not for the stellar performance of Naspers, a play on Chinese internet firm Tencent the JSE All Share Index, in which Naspers has comprised an ever more important weight, would have fallen back.

It would appear that JSE-listed companies have performed better than the SA economy. They have accordingly returned relatively more cash to shareholders, presumably for want of investment opportunities. A corollary is that had they invested more of their cash in South Africa, the economy would have performed better. However it is unrealistic to expect capital expenditure of business enterprises to lead household spending (accounting for 60% of all spending in SA) that has remained consistently depressed by the standards of the past.

In figure 3 above we compare real JSE Index earnings and dividends with the real value of the JSE. The All Share Index seems better explained by the upward trend in real dividends than the sideways move in real earnings. We can confirm this by regression analysis. An equation that links the nominal value of the JSE All Share Index with the contemporaneous level of reported dividends and short term interest rates provides a good statistical fit. Indeed the current level of the JSE is almost precisely as would be predicted by this valuation model. When we add the rand value of emerging markets (EM) generally as an additional explanation of the level of the JSE – we get an even better fit. The R squared rises from 94% to 99% with all the explanatory variables attaining highly significant and plausible values.

 

This provides for the conclusion that the JSE may be slightly undervalued by the standards of the past, given the level of the EM benchmark that the JSE has lagged behind. Perhaps giving a degree of safety to the JSE at current levels. Yet as before, the strength of the JSE will depend upon the flow of dividends, interest rates, the value of the rand and the level of the EM benchmark that the JSE always tracks closely.

We could add as a further important influence the value of Information Technology stocks worldwide that Naspers will follow closely. Perhaps it is easier to be confident about the supportive role to be played by the EM benchmarks and the role of IT within them, than the benefits a stronger rand and accompanying lower interest rates could bring to the flow of dividends and earnings from the JSE All Share Index. The strong dollar and therefore the weaker rand and the more inflation that will follow it has become a headwind for the SA economy and the companies dependent on it. 5 June 2018

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.

https://investecam.kuluvalley.com/view/kTdb9BFjT4H#/

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.

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