Author: Brian Kantor

A new optimistic message from the Reserve Bank

The new optimistic message from the Reserve Bank is welcome, but there are some reservations about the analysis and its implications for monetary policy and the SA economy.

The Monetary Policy Review recently published by the Reserve Bank (MPR) offers a full explanation of how the Bank thinks about its role and how it goes about realising the inflation target set for it. I offer a critique of the analysis that I hope can help prevent the errors of monetary policy that I believe have characterised monetary policy over the past few years.

The Reserve Bank Governor, Lesetja Kganyago, in introducing the MPR, sounded a clear call for a new, better future for the SA economy and the role of the Reserve Bank in helping realise this much more hopeful vision. To quote his introduction to the MPR:

“This Monetary Policy Review arrives at a moment economists would call ‘a structural break’ – a point where the behaviour of the numbers changes. In more everyday terms, we have witnessed the end of one chapter of South Africa’s history and we are starting a new one. This document represents an attempt to write the economic story of that chapter, or at least the first pages, in advance. Of course, this is a difficult enterprise, with a reasonable chance of substantial error. But monetary policy affects the economy with a lag of one to two years, so it must be forward-looking.”
(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)

When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:
“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”

(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)

When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:

“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”

This sense of economic opportunity is refreshing. I hope as much as the Governor that the next chapter in the monetary history of SA is a much happier one, characterised by less inflation and faster growth.  The transparency of the MPR is admirable and demands a full response. But if faster growth with lower inflation is to be sustained for the long run, it will in my considered opinion take a different frame of mind at the Reserve Bank. I indicate how I believe the Reserve Bank could better realise its objectives for inflation, without having to sacrifice growth.

A successful monetary policy is one that delivers low inflation in a way that encourages rather than inhibits the growth of an economy. An inflation targeting monetary policy regime should recognise that unpredictable supply side shocks that lead prices and inflation higher call for lower, not higher interest rates to help the better economy absorb the shock to prices and to the demands for goods and services produced domestically.

Only demand led inflation, more demand than the economy can hope to satisfy without higher prices, calls for higher rates. Higher interest rates then can slow down spending. But higher interest rates will harm growth when spending is already under pressure from rising prices that follow what is in effect reduced supplies of goods and services. What is described as a supply side shock to the economy is one that drives up prices and discourages spending.

Higher interest rates at times like this simply reduce spending further and growth slows more than it should.  Supply shocks can come in the form of a drought that reduces the supplies of staple foods and pushes up their prices. Another supply side shock on prices follows a sharp decline in the exchange rate described as an exchange rate shock. Then the supply of goods imported or in sold domestically in competition with exports comes with higher prices.

A decline in the exchange value of a currency may have nothing to do with the demand side of the economy – with demand running ahead of supply so forcing up the prices of goods and services and also the cost of foreign exchange. Currency weakness can have their cause in global events that influence the supply of foreign capital or local political events. To fears that worsen the outlook for the economy and lead to less capital flowing in and more out, enough to weaken the exchange rate that will then lead to subsequently higher prices.

Supply side shocks greatly disturbed the SA economy between 2014 and mid-2016. The drought and the weakness of the rand linked to the strength of the US dollar and weakened further by political developments in SA, were among the major shocks with which the economy had to cope. The Reserve Bank however between 2014 and 2016 resisted any distinction between supply side and demand side forces acting on prices in SA that should call for different interest rate reactions. It reacted to the increases in the CPI as if it was demand driven and so raised its repo rate to further inhibit spending and output growth that remained highly depressed over the period. The economy grew slower than it would have done had interest rates been lower and spending been more buoyant. My contention is that growth was sacrificed without any lower inflation than would have been the case with lower interest rates.

This MPR acknowledges correctly (see quote below) that the recent VAT increase is contractionary – not persistently inflationary – representing the equivalent of a supply side shock that will raise CPI inflation by about a half a per cent only over the next 12 months. After which, assuming no further VAT increase, it will fall out of the inflation numbers.

What is true of the temporary impact of a VAT increase was surely as true of the food price impact of a drought and of the exchange rate shocks that forced SA prices higher after 2014. These were temporary price shocks even reversible ones, that serve to contract spending and are best ignored by monetary policy settings. Indeed the more favourable inflation trends observed recently in SA represent the reversal of the price shocks – the rand and the drought – that raised the CPI between 2014 and mid-2016.  The demand side of the economy still remains repressed though lower inflation would appear in late 2016 to have helped lift the growth rates in household spending, particularly on durable and semi durable goods (clothing etc) whose prices would have benefitted from the recovery in the exchange value of the rand.

A further objection is that the forward looking monetary policy recommended by the Governor is only helpful when forecasts of inflation, interest rates and real growth fall within a narrow range. The forecasts of the Reserve Bank as indicated in the MPR qualify very poorly in this regard.

The fan charts provided by the MPR (see the chart below) indicate very conspicuously the lack of confidence policy makers should attach to the most likely outcomes as forecast by the model. For example, as shown below, the point forecast for the Repo rate is  7.5% in three years’ time, 125 basis points higher than the current repo rate – but with considerable uncertainty around this 7.5%. For example the chart indicates a high probability (15%) of the forecast being between 8.7% and 10%. And a similarly high probability (15%) of being much lower, between 5% and 6.3% A case of having to take your pick for the repo rate as anywhere between 5% and 10%.

Similar conclusions could be reached about the forecasts of GDP or inflation. In the case of GDP you can take a pick between a forecast of minus 1.2% and a booming 7% real growth in 2020. As for inflation the forecasts offer a pick between a 1.8% and near 9% in 2020.

If the economy turns out very differently to the forecast, delayed responses to interest rate changes made in advance can be damaging to the economy. This ability to accurately forecast the SA economy has been undermined by the series of shocks the rand has suffered. The impact of the drought on food prices as well as shocks to commodity, metal and oil prices have been additional largely unpredictable events to disturb the accuracy of past forecasts. The quality of these forecasts will not improve unless the shocks that have so affected the SA economy are of much diminished scale and range.

One can only hope with the Governor that this indeed will be the case. But if not, the MPC will have no option to think on its feet and to react to events as they occur, hopefully with good judgments about the causes and effects of inflation and the difference between supply side and demand shocks that call for very different reactions. And differences in responses that need to be well communicated to and understood by the economic agents affected by interest rates and inflation and the rate of growth of the economy, that they too will be trying to anticipate in a forward looking way. A different narrative from the Reserve Bank is called for to explain why the different causes of higher prices can call for different policy responses, responses that do not mean tolerating inflation more than makes sense.

The MPR contends that its interest rate settings in recent years have been accommodative rather than restrictive and will likely remain so (see figure below).

As the MPR states:

“Viewed through the lens of the South African Reserve Bank’s (SARB) Quarterly Projection Model (QPM), the policy stance will be expansionary over most of the forecast period, helped by the recent rate cut. The projected rise in near-term inflation, which lowers the real interest rate, is largely due to the VAT increase. This will reduce disposable income and is in this respect actually contractionary. The recent rate cut mitigates this effect, making policy more clearly accommodative through the rest of 2018 and 2019.”

And so if in fact inflation turns out as expected- around 5%, a lower repo rate appears as unlikely.

The MPR defines these interest rate settings as accommodative because interest rates have stayed below inflation. But evidence of demand running well below potential levels is overwhelming enough to conclude that interest rates were too high rather than too low in the circumstances of such weak spending propensities. The persistence of an output gap, a gap between actual and potential output that is the longest on record, according to the MPR, is strong evidence of too little spending and thus to be inferred as the result of contractionary rather than accommodating monetary policy (see figure below). Ideally monetary policy should help eliminate slack in the economy (negative or positive). The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low.

 

It is important for the supply side of the economy and the exchange rate that the Reserve Bank maintain its independence to conduct monetary policy as it sees fit. The Bank’s independence came under severe threat and it resisted this attack successfully to its eternal credit. But independence should ideally be accompanied by good judgments and not necessarily compromised by appropriate interest rates.

Further direct evidence of tight monetary policies comes with direction of the growth in money supply and bank credit. These growth rates have declined consistently over recent years but receive surprisingly little attention in the MPR.

I further question the notion, that inflationary expectations are self-fulfilling, much relied upon by the Reserve Bank over the years to justify its interest rate settings, that is the more inflation expected the more inflation realised, regardless of the slack in the economy. And that higher interest rates increases are required to prevent these so called second round effects from driving up prices whatever the initial cause of higher prices because higher prices mean more inflation expected and in turn more inflation realised.

The evidence for such persistent second round effects on inflation is very weak. Inflation in SA tends to lead and inflation expectations follow- with some regard for what are seen to be temporary forces that may have pushed up prices- for example a drought. If inflation comes down in South Africa- for good permanent reasons- inflation can be expected to decline. And if inflation rises because of supply side shocks these increases will be temporary and may even be reversed when the shock passes through. The recent decline in inflation in SA is mostly the result of the reversal of the forces that drove up inflation – the harvests have normalised and the rand has strengthened. Positive supply side shocks that have brought less inflation and stimulated a revival in household spending. The MPR appears to concede this point.

It remarks, in justification of reducing its repo rate recently, that:

“A second consideration was that lower inflation could be used to bring inflation expectations closer to the target midpoint of 4.5% over a shorter time frame. However, these factors do not preclude fine-tuning of the interest rate. The MPC is also not committing to a rate cutting cycle.”

Finally I would question the notion that deficits of the current account of the balance of payments represent danger rather than opportunity for the SA economy as the MPR appears to regard them. By definition the current account deficit is equivalent to the capital flows an economy is able to attract from abroad. Faster growth will mean larger current account deficits and larger capital inflows. Growth leads and foreign capital can follow the prospective faster growth and make it possible. I would argue that the opportunity to grow faster by attracting more capital should not be frustrated by higher interest rates for fear that capital flows can reverse when the news deteriorates.

Monetary policy should focus on stabilising the economy so to improve the case for investing in SA. Sustainably low inflation is helpful to that end. But monetary policy should not sacrifice growth when prices are rising for reasons beyond its control and beyond the influence of interest rates. The lessons from the history of recent monetary policy in South Africa is that such errors of policy that mean slower growth for no less inflation – can be avoided. 25 April 2018

What’s in a price?

What is in a price? And what does it all mean for our standard of living?

Automation, roboticisation and miniaturisation are changing wondrously the way we produce and consume goods and services, including the medical treatments that can keep us alive for longer and with much less morbidity. To which forces of change we could add the internet of things that connects us ever more effectively and commands so much more of our attention.

The benefits of this technological revolution that we can see and feel are not at all obvious however in the measures we use. We are informed that US productivity continues to grow very slowly. And real GDP is growing as slowly, as are wages and incomes adjusted for inflation. Apparently Americans are not getting better off at the pace they used to and are frustrated with their politicians they hold responsible.

Is our intuition at fault or the way we compare the prices of the goods and services we consume over time? All measures of output and incomes are determined in money of the day, calculated and agreed to in current prices. They are then converted to a real equivalent by dividing some sample of output or wages estimated at current prices, by a price index or a deflator. A price index measures the changes in the prices of some fixed “basket” of goods and services thought to represent the spending patterns of the average consumer. The deflator calculates the changes in the prices of the goods and services consumed or produced today, compared to what would have been paid for them a year before.

Both estimates attempt to make adjustments for changes in the quality of the goods and services we are assumed to consume. A car or a pain killer or cell phone we buy today on today’s terms may do more for us than it would have done at perhaps a lower price, or possibly a higher price (think dish washers or calculators) five or 10 years before. It is not the same thing we are making price comparisons with.

A piece of capital equipment today, robotically and digitally enhanced, is very likely to produce many more “widgets” today than a machine similarly described 10 years ago. And it may cost less in money of the day. It is a much more powerful machine and firms may well make do with fewer of them. Their expenditure on capex – relative to revenues – may well decline, indicating (wrongly perhaps) a degree of weakness in capital expenditure. The problem may not be a lack of willingness of firms to invest more, but how we measure the real volume of their investment expenditure – quality adjusted.

There is room for moving the rate at which a price index increases (what we call inflation) a per cent or two or three higher than they would be if quality changes were implied differently and more accurately. And if s,o GDP and productivity growth would appear as equivalently faster.

It is instructive that the US Fed targets 2% inflation – not zero inflation – because 2% inflation (quality adjusted) may not be inflation at all. And zero inflation may mean deflation (prices actually falling) enough to discourage spending now, to wait – unhelpfully for the state of the economy – for better terms tomorrow.

Over the past three months there have been no increases in prices at retail level in SA. The annual increase in retail prices (according to the retail deflator) fell below 2% in January 2018 and is far lower than headline inflation. (see below). The Reserve Bank would do well to recognise that the state of the economy – coupled with what the stronger rand provides businesses in SA – leaves both manufacturers and retailers with very little pricing power. Nominal borrowing costs – well above business inflation – are in reality applying a significant real burden for them. They could do with relief. 12 April 2019

Machines in a world of abundance

Will the intelligent machines ease us out of work as we understand it?

Where will all the workers go?

The pace of technological and scientific change is both rapid and accelerating. Robots with powerful computers have invaded the factory floor and the warehouses and distribution centres with great effectiveness. The number of workers employed in them have accordingly shrunk. Transistors, sensors and cameras will soon combine to eliminate the need for someone in the driver’s or pilot’s seat, and move us faster and more safely than now.

A common modern refrain in response to the challenge of the robots is where will all the workers go? Will it be into other jobs or into unemployment? And if the cohort of the unemployed is to become a much larger one for want of employment opportunity, how will society cope with the assumed failure of an economy to employ most of those who seek work?

Replacing workers with machines is not something new. Smashing the hand loom machines was not helpful

The advance of knowledge and its application to production – so improving the ratio of output to inputs of resources – of land, labour and capital is not something new. Economic progress, scientific advances accompanied, sometimes led, by the invention of ever more powerful machines, has been more or less continuous since the 17th century. The east, that once so lagged behind the west in economic and military prowess, is rapidly catching up in the economic and scientific stakes, applying much of the same proven recipe for economic progress.

The increased production of goods and services enhanced by ever more productive machinery of all kinds (medical equipment included) has been accompanied by consistent advances in the average standard of living and life expectancies and a rapid growth in population. The population of the world has more than doubled since 1970, increasing from 3 billion to more than 7 billion today. On average we are better supported today by higher levels of production of the essentials for life: food, shelter and medical care. And we are provided for with more of the luxuries of life, including more time off work.

We choose more leisure – not working – when we can afford to do so

A preference for more leisure has been exercised in greater volume as the average hours per week worked has declined. Leisure is a desired form of consumption for which income and other forms of consumption have been willingly sacrificed. Choices made by those who can afford to reduce hours at work, and some of the drudgery and dangers of work, have been eliminated with the aid of machines, helping to make work more pleasurable and less onerous. Nice work – if you can get it.

This growth in population has been accompanied by a rapid (more or less) increase in the numbers employed (that is in the work force). The greater number of humans surviving and employed today has also been accompanied by a large reduction (billions fewer) of those who survive despite absolute poverty. Absolute poverty is conventionally defined as those earning or consuming the equivalent of US$2 per day. Most would describe these developments as progress even if happiness – whatever this means – may be as elusive as ever.

These increases in incomes and output represent impressive and consistent economic progress (compounding growth in output and incomes) made over the past 300 years. Yet there is more to be done to raise average living standards to the levels now realised by those in the upper quintiles of the distribution of incomes in the most economically developed economies. Surely this is an economic state to be preferred and aspired to by all who lack this degree of material comfort and the choices it brings with it – including time spent not toiling? And if past performance is anything to go by, it is a realistic prospect. After all, incomes double every 20 years if they grow at 3% a year.

Only the (few) well off in their comfort zones would wish to halt economic progress

There is therefore every reason out of concern for our fellow humans to encourage the scientific revolution that will make humans and the machines who complement their efforts, ever more productive. The capabilities of the robots are bound to improve with developments in artificial intelligence (AI) that will make the machines less dependent on their human supervisors. The numbers of workers employed designing, building, servicing and operating each robotically enhanced unit of equipment, will also decline, also aided in their efforts by AI and digitilisation. The robots, with enough enhanced artificial intelligence at their disposal, may be able to write their own operating instructions. Therefore fewer writers of code for them will be called for.

Output per person employed will rise accordingly with the application and utilisation of these new wondrous machines. Economists describe this process as an increase in the ratio of capital to labour in the production process. It rose in the past when machines first replaced animal and human power and production became mechanised before being automated to an ever greater degree. Production – the output of goods and services produced with the aid of capital equipment – including what we now describe as robots of one kind or another, will grow as it has in the past, aided by ever more superior equipment. And perhaps the output of goods and services produced, with the aid of capital, will increase even more rapidly than before.

Will machines become substitutes for, rather than complements to, human action?

But will the pace of change now leave many more behind? Unable to find useful work and so effectively replaced by the machines, rather than able to earn more, because of the equipment they work with, the less skilled today may be more vulnerable than they have proved to be in the past, less able to compete directly with the robots, for robotic type work, which may be all many humans undertake and are capable of.

And the same displaced workers may be unable, for want of relevant skills, to find alternative employment, building and servicing the ever more numerous robots. Or capable of providing service to those earning higher incomes from owning, designing, managing, building and maintaining the robots.

All may not be about to be lost by human agents in the competition with machines. I am informed that while a modern computer can now always beat a chess grand master. The master chess player accompanied by a computer will beat the computer unaided. The highest incomes in the years to come may be earned by those best able to work with the robots.

Those who thrive with the help of robots are likely to choose more leisure and the services that accompany time off work. Empathetic humans may have great advantages, compared to inhuman robots, when supplying the services that accompany leisure including, walking the dogs and looking after the cats and birds of the affluent. Particularly should alternative employment and income earning opportunities in the production of goods (rather than services accompanying leisure) be lacking. Humans may try harder to serve and so help keep the robots at bay.

Humans, as we are well aware, are highly adaptable to changing circumstances. This is why we have become the pre-eminent species and there are so many more of us commanding the planet. We may have enough time to adapt to the competition from robots and the opportunities they open up, including becoming more skilled teachers, with the aid of robots. Computers may (at last) be productive in adding to the skills of their students as they have done for chess players. So improving their own skills, productivity and employment prospects as they improve the skills and employment prospects for their students.

The scope for redistributing what is produced more abundantly will increase

But empathetic humans can do more than compete more effectively. A growing volume of output made possible by science, technology and robots provides more opportunity to take from the more productive to give to the less productive, including the unemployed and those without capacity to contribute much to the output of the economy. The past tells us that as GDP increases, so does the size of government and the share of incomes (output or GDP) that is taxed and redistributed by governments exercising their power to do so. This is a process that is strongly encouraged by the less economically advantaged and to which their elected representatives will respond. The ability to respond to the collective will and impulse, will be governed by the growth in the economy. The more that is produced the more that can be redistributed.

The relatively poor and the unemployed too will thus continue to look to an improved standard of living if the society is productive enough and the tax base large enough to make more welfare spending feasible. We can expect more of this compulsory taking and giving should our economies become more productive and not all share equally in its advance, as is bound to be the case. This is if fast exponential growth continues over many years because the incentives to innovate and invent, the true drivers of economic progress, are encouraged enough by economic policy.

The interdependence of welfare and work – and of employment benefits and employment opportunities – and of income and its growth

Such generous welfare will have some of the consequences we can already observe. The better the state – that is other people – provide for the unemployed – those willing and able to work –the greater has to be the employment benefits that make choosing work – sacrificing leisure – a sensible decision. And the less skilled are less likely to command rewards from work that exceeds improved benefits available to them when not working. Their reservation wage – the employment benefits that make sense working for – may be too high for some to choose work. For them, without the skills that command higher more attractive rewards from employers, leisure is the rational alternative to work. They will choose more of it if employment prospects deteriorate.

Thus welfare benefits of all kinds will tend to reduce the supply of potential workers and, perhaps unintentionally, increase the employment benefits of those in work. Decent work is likely to become ever more decent as the economy grows and welfare becomes more generous to the relatively poor. But as these employment benefits improve and the cost of hiring rises, employers will be encouraged to further substitute machines (capital) for labour. In doing so they perhaps leave a greater proportion of the adult population not working or even seeking work. They choose leisure – because in a sense they can afford it.

A productive society may well be able to afford to support the relatively poor and the unemployed generously. But will it do so generously enough to avoid resentment of the better off? Resentment that given political consequences may well lead to policies that disrupt the economy and its progress. The process of economic growth depends on society accepting – at least to some degree – unequal rewards for unequal contributions. Is not acceptance of those forces of invention and innovation that will drive the development of robots and AI essential to the purpose of economic progress? Invention and innovation and risk taking generally are the true source of economic progress and need to be given the right encouragement. The economic problem of not enough to go around is only resolved by permitting a degree of unequal rewards for unequal effort and outcomes. Inhibiting the rewards for economic success may well prevent it occurring.

People not working on a larger scale because the society can afford to support their leisure – given a lack of skills and adaptability – may create a whole set of problems for the more or less permanently non-working. Society may be required to find ways to make not working psychologically meaningful and acceptable to the tax payers. Compulsory work, perhaps by helping less fortunate humans and work improving the environment, in exchange for welfare, may become a component of the adjustment to growing affluence made possible by the robots (robots it might be added who can help avoid the drudgery and danger of many kinds of work that workers do not regard as any more than a means to the end of consumption).

What if the robots delivered true economic abundance and solved the economic problem for us?

But what if we took the advance of the robots to its full logical conclusion? An imaginary state of the world when robots aided by superior AI completely replaced all humans in the work place1. The robots with enough AI may completely replace their human managers and collaborators. They may be able to manage themselves with a single minded purpose (programmed originally by humans) to produce more goods and services for humans to consume, and for whom the robots are the servants (perhaps better described as slaves) with no preferences of their own.

If robots replaced all workers the only income earned would be earned owning robots who produced all the goods and services supplied to an economy, that is to the people who make up the society. And there would be an overwhelming abundance of goods and services for humans to consume. It should be recognised that if and when the robots take over, all the work the economic problem of scarcity will have been resolved. The difficulty of society having to determine what should be produced and who should benefit from the production would have been overcome by the advance of the robots. Trade-offs between who produces and who benefits from production will no longer be relevant. The perhaps unimaginably productive robots will be providing more than enough goods and services so that no person will be short of anything to accompany their leisure.

Since there would be no work for humans to engage in there would be no income from work to be sacrificed for leisure or to be saved to be consumed in the future. The only source of capital to replace and produce new and better robots would then be the savings made out of income received owning robots.

Abundance solves not only poverty but inequality of incomes as well

Given that there is no economic problem, the inequality problem (derived increasingly over time by owning robots in unequal amounts) would be solved by expropriating and nationalising the primary means of production – the super productive robots. The collective will take over from the individual without any of the usual dire consequences when the economic problem exists and demands resolution.

The now all embracing collective, the state as owner of all the abundant means of production – the robots – would spread the equivalent of the abundant free cash flow generated by the robot owning state-owned firms equally to all the population. That is the state as owner would spread equally all the surplus (cash) around that has been generated by the productive robots, after capital reinvested in new and better robots and in the social infrastructure that supports the leisure of all not working.

For example, the supply of roads and swimming pools and sports stadiums has to be determined and the balance distributed as income to the population. Intelligent robots will manage the state-owned companies and issue the tenders and welfare checks in response to the instructions of the politicians, elected by the people at leisure

It should be understood that in these circumstances of robot-supplied abundance, the robots would be programmed (by other robots) only to meet the full and satiable demands of the leisure class – that is the entire population. These robots will not require any of the incentives that are now necessary to get humans to work well by appealing to their self-interest.

Adam Smith’s hidden hand that turns private interest into public benefits will have done its work. The unequal rewards that we now have to offer to talented humans so that they will deliver the goods will have become redundant. Self-interest becomes irrelevant in the midst of abundance: everybody has more than enough of everything and have only to decide how to allocate their time. Hence owning anything will make no sense and protecting rights of ownership (property rights) will have served their function.

Robots will just do what other robots programmed by robots tell them to do and they will produce more than enough to keep us at comfortable leisure and out of work. They will be productive slaves without any preferences of their own to get in the way of maximising output. AI therefore will have replaced intelligent humans in the production of everything – produced abundantly by robots for all humans to consume in as much quantity as they might desire. There would be no differential rewards to breed resentment. Full equality of incomes is a logical consequence of super abundance.

A different world would mean the evolution of a different species

That some people have a (natural) human capacity for greater enjoyment of leisure than others may then become a problem that will have to be addressed by the political process. Legislation against unequal utility might be called for, with the required dose of pharmaceuticals (or implanting of genes) to make sure that all are rendered equal in consumption and happiness.

The economic logic of robot-supplied abundance that demands no sacrifices from humans in the form of work or saving, would be a very different world. It would be essentially inhuman as far as we understand the human condition. That is the harsh one we inhabit that demands sacrifice (work and savings) and the acceptance (very difficult for many particularly intellectuals and academics whose rewards are no well correlated with their IQs) of unequal rewards for unequal effort and sacrifice.

Abundance would require that humans evolve as a very different species. Humans would be back in the Garden of Eden, perhaps then as the first time having to start all over again learning about the necessity of work and sacrifice. Perhaps abundance is a frightening prospect to many. But even if it is, would it be wise to stop the advance of the robots that promises to eliminate poverty and so even work itself? Choosing abundance (or rejecting it) will be a collective one made by those in the way of the marching robots. 19 March 2018

1A possibility welcomed in inimitable style by the most famous economist of his time John Maynard Keynes in his essay Economic Possibilities for our Grandchildren written in1930 and published in his Essays in Persuasion, Macmillan and Company, London, 1931. The book is available as a Project Gutenberg Canada Ebook. www.gutenberg.ca

Keynes writes “….I draw the conclusion that, assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not – if we look into the future – the permanent problem of the human race……..”

And later

“……Thus for the first time since his creation man will be faced his real, his permanent problem- how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.

The strenuous purposeful money-makers may carry all of us along with them into the lap of of economic abundance. But it will be those peoples, who can keep alive, and cultivate into a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.”

The political economy of SA – promise and hoped for delivery

It is possible to get very rich from politics in an honest and old-fashioned way. Recent SA political and economic events prove so. Had you predicted that Cyril Ramaphosa would win the ANC election in December and ascend to the presidency of SA, and bought the rand and the shares and bonds that benefit from a strong rand, you would have done very well. And you’d have done even better if you had sold those securities (including the US dollar or euro) that weaken when the rand responds to good news about SA.

The USD/ZAR reached a recent low of R14.46 on 15 November. It is now R11.77, an improvement of about 20%. The rand has also gained 24% against the JPMorgan Index of emerging market exchange rates (FXJPEMCS), since then indicating it was South African-specific surprises rather than global forces that has driven the rand recently.

The cost to the taxpayer of issuing rand-denominated debt has fallen significantly. The yield on five year RSA bonds has fallen from 8.69% on15 November to 7.38% on 12 March that is by 1.31% or equivalent to a 16% decline in the cost of issuing new government debt of this duration. This even as US interest rates were moving in the opposite direction.

The extra yield SA has to offer investors in US Treasury bonds for five year money (the sovereign risk premium) has fallen from 206 to 139 basis points. Over the same period, enough to bring SA debt well within investment grade quality. A one per cent per annum saving on interest, given the volume of government debt to be serviced and rolled over, is worth about R6bn to the SA taxpayer (hopefully) or the recipient of extra government spending (alas more realistically).

 

A stronger rand means less inflation and encourages households (who do more than 60% of all spending in SA) to spend more on the goods and services to be supplied to them by SA business. And the more profitable firms in turn will then hire more workers and equipment to service their growing custom. And less inflation may bring a lower repo rate and mortgage payments to further encourage spending. Enough extra spending to at last spark a recovery in the economy that has been growing much too slowly for far too long.

These implications of the stronger rand has therefore been dramatically registered in the share market. Companies with revenues and earnings generated in SA, banks and retailers for example, have become more valuable. While companies listed on the JSE, whose main line of business is generated offshore, have lost value. An equally weighted group of 14 large offshore plays has lost about 20% of its rand value since mid-November (see figures 4 and 5 below).

By contrast the rand value of a group of 18 equally weighted large SA economy plays on the JSE has increased by about 25% over the same short period. Buying SA and selling the world on a Ramaphosa victory would have been very value adding. Simply buying the JSE – with its mix of global and SA plays would – as an exchange traded fund would do, would have been to miss the value adding bus. It is in surprising turbulent times like this that active managers earn their fees.

 

The government led by Ramaphosa could provide much more of the good stuff for the SA economy by delivering on the promise of better government. Better still for the economy and its growth would be less government. Officials should intervene less in the economy – and show more respect for business and market forces as the critical drivers of the economy. Government should tax business income at lower rates and avoid subsidising other businesses that survive only with government aid.

Less intrusive government and consequently lower compliance costs would allow small businesses to compete with large businesses. And, more important, to free up the market for workers that leaves so many unemployed.

Government should also show a genuine willingness to sell off rather than add capital to the companies it owns: firms that survive to protect their employees from the performance indicators that private owners would demand of them – and reward accordingly.

The cabinet should recognise that its current set of economic policies of high spending and tax – ever more intervening government – has been a primary cause of the debilitating slow growth realised in recent years. A mix of all of the above policy recommendations would deliver economic growth and votes. A still weak economy could lose the ANC the next election in 2019. 15 March 2018

Retail therapy

The SA economy is being helped along by lower inflation at the retail level

The SA economy did surprisingly well in the fourth quarter of last year. GDP grew at an annual rate of over 3%. The demand side of the economy did just as well, growing at the same rate as supply, which was augmented by a strong seasonal recovery in agricultural output. Demands from households, which account for 60% of all spending, increased by an annualised 3.6% in the quarter, well above recent trends, while expenditure on capital goods increased even more robustly by 7.4% annualised. Imports increased significantly faster than exports, so reducing GDP growth, but found their way into increased holdings of inventories – enough to offset the impact of the growth in imports (up 23%) and the negative trade deficit on GDP. Imports add to supply – the increase in inventories adds to demand.

The strength in household spending – essential to any cyclical recovery – was reflected in a strong recovery in retail sales volumes. These were growing at close to a 6% annual rate in the fourth quarter. Such growth was assisted by low rates of retail price inflation. The prices of goods and services at retail level were largely unchanged in the fourth quarter; hence sales in constant prices were rising as rapidly as were sales measured in prices of the day. Clearly consumers were getting the benefit of the end of the drought (lower food prices) and the stronger rand and presumably strong price competition at retail level.

The figures below tell the story of price competition and its effects. Extrapolating recent trends suggests that prices at retail level will be rising at a very slow rate in the months to come. The recent strength in the rand will be adding to these disinflationary, if not deflationary pressures in the months to come and will help to stimulate household spending. A time-series forecast of retail volumes indicates that they could retain a brisk growth pace of around 6% over the next 12 months.

 

Retail sales and price statistics are available only up to December 2017. Two more up-to-date hard numbers have been printed for the February 2018 month end, that is for vehicle sales and the cash (notes and coin in circulation) supplied by the Reserve Bank. We combine these indicators into a Hard Number Index (HNI) of economic activity in SA. As shown below, this index may be regarded as a good leading indicator of the business cycle in SA (itself only updated to November 2017).

As we show in figures four and five, according to the HNI, the economy has picked up some positive, though modest momentum, consistent with the 3% GDP growth realised in the fourth quarter.

 

The growth in the components of the HNI are shown below. As may be seen both the vehicle and the real cash cycles have recovered from their low points of mid-2017. However the impetus for the economy provided by cash in circulation and vehicle sales volumes is forecast to wane somewhat in the months ahead – absent any stimulation from lower interest rates.

The real cash cycle (notes/consumer prices) provides a consistently helpful predictor of the trends in retail volumes, and had been doing so recently, as we show below in figure 8. Were we to use retail prices rather than consumer price inflation to deflate the supply of cash, we might derive a better indicator of retail sales volumes. The divergence between CPI and retail inflation has become unusually large. It reflects the intense competition for strained household budgets. It surely provides a better measure of the lack of demand-side pressures on prices and supply side forces (exchange rates and drought) acting on prices in SA. The CPI is more exposed to administered prices and tax rates. The Reserve Bank would do well to acknowledge how low business inflation is in SA and lower interest rates accordingly to encourage households to spend more for the sake of a much desired economic recovery – with low inflation. 13 March 2018

Waiting for Godot – and the Reserve Bank

The Ramaphosa ascension has been very well received by the capital and currency markets. The political risk premium attached to SA-domiciled assets has declined sharply. The yield spread between RSA bonds denominated in US dollars that carry risks of default and US Treasury bonds narrowed sharply after November when it became more likely that the Zuma list would not be voted in at the ANC Congress in December. This sovereign risk spread – the extra yield investors receive on five year RSA debt to compensate for extra risk – declined from over 2% in November to about 1.4%. SA debt now trades as (low) investment grade.

The rate at which the rand is expected to depreciate has also declined sharply as long-term interest rates in SA have declined and US rates increased. These differences in yields, expressed in different currencies, is known as the carry and is also the percentage difference between the spot and forward rates of exchange maintained through arbitrage exercises in the money and currency markets. The cost of securing a US dollar for delivery in the future therefore increases by the per annum interest rate spread. This spread for five year debt denominated in rands was 6.7% in mid-November and has declined to current levels of about 4.9% a decline of about 1.8% (See figures 1 and 2 below).

This decline in interest rates and less rand weakness expected portends lower SA inflation. Less inflation has also come to be expected by the capital market. These expectations are represented by the spread between the yields on vanilla bonds that carry the risk of inflation eroding the purchasing power of interest income, and the inflation linked variety that offer complete protection against higher inflation. As may be seen below, the bond market is pricing in about 60 basis points (0.6 percentage points) of less inflation to come in over the next five and 10 years.

These sovereign risks are also represented in the real yields on inflation-linked bonds issued in different currencies. The inflation link, especially on long-dated bonds, offers protection against the exchange rate weakness associated with more inflation. The real spread must therefore be attributed to factors other than the exchange rate risks the market is factoring in with nominal rates. Of interest is that this spread between long-dated RSA inflation-linked debt and US Treasury Inflation Protected Securities (TIPS) has narrowed sharply in recent months by more than 100 basis points (one percentage point). (See below)

It should also be recognised that real government bond rates in the US, while having increased marginally in recent months, remain well below normal. They indicate a continued global abundance of saving over capital expenditure and continued pressure on prospective real returns from all asset classes.

The better news about the future of SA has also been well reflected in the share market. Since December 2017, those listed companies with strong exposure to the SA economy have dramatically outperformed those companies that generate almost all of their revenues and earnings outside SA. The JSE All Share Index – with at least half the companies represented in the index highly dependent on offshore economies – has returned very little since 1 November. The total returns from Banks and Retailers since then by strong contrast have been over 30%. (See below)

The offshore businesses listed on the JSE are best described as SA political hedges rather than rand hedges. The rand/US dollar exchange rate reflects two forces: global and SA-specific forces drive the markets in the rand and rand denominated securities. Global economic forces can act to strengthen or weaken emerging market economies and their exchange rates against the US dollar. The rand is very much an emerging market currency and will move with emerging market exchange rates – with an import overlay of SA political risks. When the rand strengthens for SA reasons, as it has done recently , the SA hedges listed on the JSE (British American Tobacco, Richemont and Naspers, for example) are likely to lose value when expressed in rands. Their US dollar value may remain unchanged while their rand value falls with a stronger rand. The earnings of SA economy-exposed stocks benefit from a stronger rand whatever its provenance; hence their recent outperformance can be attributed to a stronger rand because of less SA risk priced into the markets and an improved outlook for the SA economy.

These SA economy plays could benefit further should the SA economy grow faster than expected. The additional confidence to spend that comes with a happier state of political affairs will help the economy along. The lower inflation rates that follow a stronger rand will also encourage the spending that SA-exposed companies can benefit from. Lower short-term interest rates would be an additional stimulus to the economy. Lower inflation and expectations of lower inflation should encourage the Reserve Bank to lower its key lending rates.

The money market however, while no longer expecting short-term interest rates to rise over the next 12 months, according to the forward rate agreements, does not (yet) expect short-term rates to decline. The case for lower interest rates is a very strong one, given the state of the domestic economy and lesser uncertainty attached to its political future. An austere 2018 Budget, with government revenues estimated to rise significantly faster than government expenditure, is a further reason to ease monetary policy. The SA economy plays might well continue to outperform the SA hedges were the Reserve Bank to focus on the risks to growth rather than the risks to the exchange rate and inflation. 5 March 2018

The reality of state-owned companies in SA

The Budget Review for 2018-19 informs us that “in cases where state owned companies are making large investments in infrastructure, capital expenditure reduces profitability. Even after these investments are paid for, profitability is unlikely to match private-sector profit rates because these entities often provide public goods and services below the cost of production to enable economic activity……”

Capital expenditure whenever properly managed should be a source of improved profitability and returns rather than of additional waste. Moreover, the requirement a government might make on any enterprise to subsidise some of its customers can be paid for directly and transparently by the government, that is taxpayers. There is an obvious distinction between public enterprises able to charge for their services and public works – as in supplying rural roads – where charges cannot be levied in any realistic way to cover costs.

The Review goes on to tell us (that) “in many cases, however, falling profitability reflects mismanagement, operational inefficiencies and rising financing costs. Over the medium term, state-owned companies need to raise their returns to generate value, and to reduce their reliance on debt and injections from the fiscus”. (2018 Budget Review p 96)

A combined balance sheet of state-owned companies provided in Table 8.2 of the Review indicates how poor the financial performance has become over the years. The combined total assets of these companies totalled R1 225.2bn in 2016-7. Total liabilities (debts) were R869bn. The net asset value or equity of the companies fell by 1.5% in the last financial year and the average return on equity was a mere 0.3% or about R10m. Adding back interest on the liabilities, at say 10% a year, would give them earnings before interest and taxes (also paid to the state) of approximately R97m and so a return on assets of less than 8%, less than the interest cost.

This begs the question as to why they are publicly funded in the first place. It is not because they may provide public goods. They might have been founded – backed by the taxable capacity of the nation – because at the time private capital (correctly so) would not have been willing to undertake the risks involved. There may have been strategic or nationalistic objectives that taxpayers had to accept. Such constraints on the availability of private capital sourced globally to fund SA infrastructure have long since gone. Private capital would fund the essential SA infrastructure on favourable, market-determined terms provided they could be satisfied with the terms and conditions.

This could take the form of government (taxpayer) guarantees for well ring-fenced projects with clearly earmarked revenue streams, as with the so intended infrastructure bonds. A much better deal for the tax payers of SA guaranteeing the leasing charges would be private ownership and management of these assets, with these companies broken up and sold off. Ports and pipelines can be separated from railways and compete with each other and the generation of electricity by a number of independent power producers could be separated from its distribution. Partial private ownership or private-public partnerships of various proportions might also attract private capital. But without private sector control of the performance of the managers, workers and their remuneration, the efficiency with which the infrastructure is operated and expanded is unlikely to improve.

The reason for the state-owned companies to remain state-owned has little to do with efficiency. It is the political influence of the managers and workers that have kept them so. The have been able to defend their superior employment benefits at the expense of taxpayers and customers. This largesse has brought the system into disrepute and strained the ability of taxpayers to keep the gravy train running. We must hope for reforms of the essential kind that change the goal of the managers of these companies from serving themselves to serving their owners. By doing so they would relieve taxpayers from the risks they now carry and help their customers for whom they would compete, and help the economy to grow faster. 1 March 2018

The Investment Holding Company. How to understand the value it adds or destroys for its shareholders and how to align the interests of its managers and shareholders.

This report has been written with the managers of Remgro, an important Investment Holding Company listed on the JSE, very much in mind. Their managers having received a less than enthusiastic response of their shareholders to their remuneration policies, the company engaged with shareholders on the issue. An action to engage with shareholders that is to be much welcomed.

I have given much thought and written many words explaining why investment holding companies usually worth less than the value of their assets less debt they owned, why in fact they sell at a discount to their Net Asset Value. It occurred to me, as a Remgro shareholder in response to the invitation from the Remgro managers, that my approach could be used to properly align the behaviour of the managers of Remgro with their shareholders. I then engaged with other shareholders in a Remgro webcast and offered to extend my analysis- an offer that was respectfully accepted. This is the result

 Applying the logic of the capital market to the managers of companies that invest in other companies

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds –should be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro, a PSG,  a Naspers in South Africa or a Berkshire-Hathaway, the most successful of all Investment Holding Companies listed in New York,  unlike the managers of a Unit Trust or Mutual Fund, are endowed with permanent capital by shareholders. Capital that cannot be recalled should shareholders become disillusioned with the capabilities of the managers of the holding company. This allows the managers  of the HC to invest capital in operating companies for the long run, without regard to the danger that their shareholders will withdraw the funds invested with them- as can be  the case with a Unit Trust.

A Unit Trust always trades at values almost identical to the value of the assets it owns, whether funds are flowing in or out or its value per unit has declined or increased- of great relevance to unit holders. This is because these assets can and may have to be liquidated for what they can fetch in the market place.

This is not the case with an Investment Holding Company (HC) The HC  cannot be forced to liquidate assets if its shareholders lose confidence in the ability of its managers to beat the market or meet the expectations of shareholders. Therefore the value of the HC shares will go down or up depending on how well or poorly the shares of the holding company are expected to perform relative to the other opportunities available to investors in the share market.

The price of a HC share will be set and reset continuously to satisfy the required risk adjusted returns of potential investors. A lower share price will, other things equal, compensate for any expected failure of the HC to achieve market beating returns through its holdings of assets and its ongoing investment programme. Vice versa a higher HC share price can turn what are expected to be excellent judgments made by the HC, into merely normal risk adjusted returns.  In this way through changes in share prices that anticipate the future, the outstanding managers of any company, be it an operating company or a HC that invests in operating companies, that is capable of earning internal rates of return that exceed their costs of capital, will only provide their shareholders with market related returns. Successful companies expected to maintain their excellence charge a high entry price in the form of a demanding share price. Less successful companies charge in effect much less to enter their share registers. Expected returns adjusted for risks therefore tend to be very similar across the board of investment opportunities.

This makes the market place a very hard task master for the managers of a company to have to satisfy. Managing only as well as the market expects the firm to be managed will only provide market average returns for shareholders. And so the direction of the market will have a large influence on share price movements over which managers have little immediate influence. Better therefore to judge the capabilities of a management team by the internal returns realised on the capital they deploy – not market returns.

The managers of the holding company must expect that the operating companies they invest in, are capable of realising (internal) returns on the capital they invest that exceed the cost of capital provided them. That is capable of realising returns that exceed their required risk adjusted returns.

These potentially successful investments may be described as those with positive Net Present Value or NPV. If indeed this proves so, and the managers of subsidiary companies succeed in their tasks, the managers of the HC must hope that the share market comes to share this optimism in their ability to find cost of capital beating investment opportunities. This would add value to the HC whose shares will reflect the prospect of better returns to come from the capital allocated to subsidiary companies in their portfolio. Other things equal, the more valuable their subsidiary companies become over time , the greater will be the value of the HC.

Past performance may only be a partial guide to future performance

Past performance, even a good track record, a record of having found cost of capital beating investment opportunities, may only be a partial guide to future success. The capabilities of the holding companies’ managers to add further value by the additional investment decisions they are expected will be under continuous assessment by potential investors in its shares.

Therefore the market’s estimate of the Net Present Value of the investment programme of the holding company can have a very significant influence on its market value. This value will depend on the scale of the additional investments expected to be undertaken by the HC , as well as the expected ability these investments to realise returns – internal rates of return on capital invested, (irr)– in excess of their costs of capital or required risk adjusted returns.

These expectations will determine the market’s assessment of the  NPV of the investment programme. If the irr from the investment programme is expected (by the market place) to fall short of the cost of capital, then the NPV will have a negative value- a negative value that will be in proportion to the value destroying scale of the investment programme. If so the investment programme will reduce rather than add to the market value of the holding company.

The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect, we argue, mostly this pessimism about the expected value of their future investment decisions. A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns.

How managers of the holding company can add to its market value

That an investment holding company may be worth less than the value of the assets it owns is a reproach that the managers of holding companies should always attempt to overcome. They can attempt to do this by making better investment decisions, positive NPV decisions, and convince potential shareholders that they are capable of doing so. They can also add to their value for shareholders by exercising supervision and control over the managers of the subsidiary companies, listed and unlisted, they hold significant stakes in and therefore carry influence over.

They may be able to add to their market value by converting unlisted assets, whose true market value can only be estimated, into potentially higher valued listed assets with an objectively determined market price. They may also succeed in adding value for their shareholders by unbundling listed assets to shareholders when these investments have matured. This would mean reducing the market value (MV) of the holding company but also its NAV and so possibly narrow the absolute gap between its MV and NAV.

Increases in the market value of the listed assets of the holding company adds strength to its balance sheet. Such strength may encourage the managers of the holding company to raise more debt to invest in an expanded investment programme. This extra debt raised to fund a more ambitious investment programme can only be expected to add market value if the returns internal to the holding company exceed its cost of capital. If it is not expected to do so, these investments and the debt raised to fund them will reduce rather than add to NPV. The influence of the NPV estimates on the value of the holding company will however depend on scale of new investment activity compared to the size of the established portfolio. The greater the risks additional acquisitions imply for the balance sheet, the greater will be the influence of the NPV calculation.

A further influence on the value of a holding company will be the costs of maintaining its head office and complement of managers employed at head office. Clearly the net expenses of head office- costs less fees earned from subsidiary companies will reduce the value of the HC.

Our view is that the difference between the value of the holding company and the assets it has invested shareholders capital in is the correct measure of the contribution of managers to shareholder welfare. Hence improvements in the difference between the market value of the holding company and the market value of the assets it has invested in (it may be a negative number) should form the basis with which their managers should be evaluated and remunerated.

A little mathematics to help make the points

In the analysis offered below we support these propositions by identifying, using the logic of algebra, the forces that influence the market value MV as well as the NAV of an investment holding company and the differences between them.

A conventional calculation is made of the Net Asset Value (NAV) of the holding company as the sum of its parts- the sum of the market value of its assets less its net debts.

The NAV of a holding company is defined as

NAV = ML+ MU- NDt  ………………….       (1)

Where ML is the market value of its listed assets, MU the assumed market value of its unlisted assets less its net debt – debts-cash (NDt) held at holding company level. MU will be an estimate provided by either the holding company itself or independently by an analysis making comparisons of the market value of the holding company with its sum of parts, its NAV. Any difference between the valuation of unlisted assets included in NAV and the market value accorded to such assets by investors in the holding company (a valuation that cannot be made explicit) will have consequences as will be identified below.

The market value (MV) of the listed holding company is established on the stock exchange and can be assumed to be the sum of the following forces acting on its share price and market value

MV=ML+MUm-NDt+HO+NPV…………………………   (2)

Where ML is again, as in equation 1, the explicit market value of the listed assets, MUm is the market’s estimate of the value of the unlisted assets that may or may not have a value close to that of the MU included in NAV in equation 1.  NDt is the sum of the holding company debt less cash, also as in equation 1, recorded on the balance sheet of the holding company. HO is the cost or benefit to holding company shareholders of head office expenses, including the remuneration of head office management and other employees, less any fees paid to head office by the subsidiary companies for services rendered. HO would usually be a net cost for shareholders in the holding company and if so would reduce the market value of the holding company.

The final force in determining the market value of any holding company is NPV as discussed previously. NPV is defined as the present value attached by the share market to the investment programme the holding company is expected to undertake in the future. The more active this expected investment programme and the larger the programme – relative to the current composition and size of the holding company balance sheet, the more important will be the value attached to NPV. Furthermore it should be recognised from equation 2 that the scale of the investment programme, relative to the size of the established portfolio of listed and unlisted assets will determine how much the dial, so to speak of market value, moves in response to NPV.

Were the holding company managers be expected to undertake investments, be they acquisitions or greenfield projects, that returned more than their cost of capital, this would reflect in a positive NPV. That is to say the greater the (expected) spread between realised and required risk adjusted returns, the greater will be the value attached to NPV for any given (estimated) monetary value attached to the investment programme. However, as discussed previously, the holding company may be expected to be unable to find cost of capital beating investment opportunities. If so NPV would have a negative value and the more the holding company were expected to invest in new projects, the larger would be the negative value that will be attached to NPV. A negative value accorded to NPV would clearly reduce the market value MV of the holding company as per equation 2.

The success or otherwise of the ability of the holding company to add value for its shareholders can be measured as the difference between NAV, net asset value, the  sum of parts, and the market value (MV) of the listed holding company or

Value Add= NAV-MV      …………………. (3)

It should be noted in the formulation of equation 3, that NAV is presumed to be larger than MV. This is a usual feature of holding companies that are usually worth less than their sum of parts. This negative value is often expressed as a percentage discount of NAV to its market value- as defined below in equation 5.

If we substitute equations 1 and 2 into equation 3 the forces common to the determination of market value (MV)and NAV in equations 2 and 3 that is MU, Net Debt, Debt less cash, cancel out and we can conveniently write the difference between NAV and MV as  simply

(NAV-MV) = – (NPV+HO- (MU-MUm))…………………… (4)

It will be noticed that the higher the absolute value of NPV the smaller the difference between NAV and MV. Were however the NPV to attract a negative value the variables on the right hand side of equation 4 would (other things held constant) take on a positive value and increase the difference between NAV and MV.  Other forces remaining unchanged, head office expenses and differences between the estimate of the value of the unlisted assets included in NAV and its “true” unobservable value will also narrow the difference between NAV and MV.

The net costs of head office (HO)  as mentioned, is likely to have a negative value for shareholders, as would any overestimate of the value of the unlisted assets. If so, to have MV exceed NAV and so for the holding company to stand at a premium rather than a discount to its NAV, the NPV would have to attain enough of a positive value to overtake these other negative forces acting on MV.

A further value add indicated in equation 4 would be to narrow any difference between the value of the unlisted assets included in NAV and its true market value, which cannot be directly observed. Listing these subsidiary companies may well serve this purpose. It will provide them with an objectively determined value that may well exceed its lower implicit value as unlisted companies. If so this can add market value to the holding company.

It would seem clear from this formulation (equation 4) that for those holding companies with an active investment programme, the key to value destruction or creation, the difference between NAV and MV, will be the expected value of its investment programme (NPV) It would seem entirely appropriate for shareholders in the holding company to incentivise the managers of the holding company by their proven ability to narrow this difference and improve VA. Positive changes in VA- that is less of a difference between NAV and MV –that would take an absolute money value that can be calculated continuously – could form the basis by which the performance of the managers of the holding company are evaluated.

We have shown that much of any such improvement in the market value of the holding company and its ability to add value for shareholders should be attributed to improvements in NPV, a variable very much under the control of the managers of the holding company. The reduction of head office costs, or better debt management, or some reassessment of the value in the unlisted portfolio, is perhaps unlikely to significantly move the market value of the holding company.

Were the managers of the holding company able to make better investment decisions and more important perhaps, were expected to make better investment decisions, the market place would reward the shareholders in the holding company accordingly. Though further any contribution they might make to increase  the market value of listed companies under their influence or control, could also help reduce the difference between NAV and MV, as we will demonstrate further.

Investment analysts give particular attention to the discount to NAV of the holding company. The notion is that there is will be some mean reversion of this discount and so an above average discount may indicate a buying opportunity and the converse for a below average discount. This discount is defined as

(NAV-MV)/NAV % ……………………………………………  (5)

This notion of a (normal) positive discount is also consistent with the notion as indicated previously that the NAV usually exceeds MV.  If we divide both sides of equation 4 by NAV and substitute the components of NAV in the denominator we derive the positive discount to NAV as

Disc%=- (H0+NPV-(MU-MUm))/(ML+MU-NDt)        ……                  (6)

As may be seen in equation 6, if the combined value of the numerator is a positive number, then the discount attains a negative value- that is the market value of the holding company would stand at a premium to the sum of its parts – Berkshire Hathaway might be an example.

Clearly any change that reduces the scale of the numerator (top line) or increases the denominator (bottom line) of this ratio will reduce the discount. Thus a less expensive head office (HO) or an increase (less negative) in the value of future business (NPV) will reduce the discount. (These forces represented in the numerator of equation 6 are preceded by a negative sign. As per the denominator, any increase in ML or MU or a reduction in net debt will reduce the discount.

However while reducing the discount is unambiguously helpful to shareholders and will be accompanied by an improvement in NPV, this will not always or necessarily be the result of action taken at holding company level. Any increase for example in the market value of the listed ML or unlisted investments MU will help increase the absolute value of the denominator of equation 6 and reduce the discount and add NPV. But such favourable developments may have everything to do with market wide developments that influence ML or MU and have little to do with the contributions made by the management team at holding company level.

Thus it is the performance of the established portfolio relative to some relevant peer group rather than the absolute performance of the established portfolio should be of greater relevance when the performance of the managers are evaluated. These influences on the value add might be positive or negative for the value add for which management should not be penalised or rewarded.

It would therefore be best to measure the contribution of management by a focus on the underlying drivers of NPV seen as independent of the other forces acting on the market value of the holding company. Furthermore the focus of the managers of the holding company and their remuneration committees should be on recent changes in the absolute difference between NAV and MV and not on the ratio between them.

Unbundling may prove a value added activity – the interdependence of the balance sheet and the investment programme- for which the algebra cannot illuminate.

Unbundling listed assets to shareholders might well be a value adding exercise. It would simultaneously reduce both NAV and MV, but possibly reduce the absolute gap between them. Because such action could illustrate a willingness of the management of the holding company to rely less on past success and to focus more on the merits of its on-going investment programme. Reducing the size and strength of the holding company balance sheet may make the holding company less able and so less likely to undertake value destroying investments. An improvement in (expected) NPV and so a narrowing of the difference between NAV and MV might well follow such an unbundling exercises to the advantage of shareholders. That is helpful to shareholders because even as the absolute size of the holding company’s NAV and MV decline, the difference between them may become less negative- even become positive should MV exceed NAV

Conclusion

We would reiterate that the purpose of the managers of the holding company should be to serve their shareholders by reducing the absolute difference between NAV and MV and be rewarded for doing so. A focus on this difference, hopefully turning a negative number into a (large positive one) would be highly appropriate to this purpose.

Appendix

Remgro: chart reflecting estimated difference between the market value of Remgro and our calculation of its net asset value

1

Source: Investec Wealth & Investment analyst model

Naspers: chart reflecting estimated difference between the market value of Naspers and our calculation of its net asset value

2

Source: Investec Wealth & Investment analyst model

 

 

Global savings and interest rates- will we see normalisation?

 

What the world needs now is more than love- there is also too little spending. [1]More of that would also be very welcome. Particularly welcome would be extra spending by business enterprises on capital equipment. This lack of demand, combined with a rising global savings rate, has created an abundance of saving that explains the exceptionally low interest rate rewards for saving in developed economies. This glut of savings followed the global financial crisis (GFC) of 2008-09 that made managers more fearful to spend or lend while additional regulations restricted their freedom to do so.

The story of the global glut of savings can be told in a few pictures provided by the World Bank shown below. When will then consider how the bond market in the US may be indicating some incipient revival of the animal spirits of US corporations. Encouraged, as they attest, by lower tax rates and much more sympathetic regulators.

Figure 1 charts gross global savings as a per cent of gross global incomes. (GNI) As may be seen share of savings of income has been rising steadily over the years. The GFC hit savings even harder than incomes (upon which savings depend) but since then savings have made an ever larger claim on incomes (26% in 2015). The global savings rate was only about 21% of incomes in the fast growing and higher interest rate world of the mid-nineties. It has been on a generally upward trend since, as may be seen.

Gross savings – (savings before amortisation of capital that turns gross into net savings) are dominated by the cash retained by corporations. Households may save – but other households over the same period may be large borrowers and reduce the net contribution households make to the capital market. And most governments are net borrowers- borrowing even more than they spend on infrastructure that is counted as saving.

Fig 1; Gross savings as per cent of Gross Global Income  

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As we show below in figure 2, the rate at which real capital – plant and infrastructure – has been accumulated has been trending in very much the opposite lower direction. There was a brief surge in the rate of capital formation in 2005 – a boom year for the global economy – but this was not sustained and was but 24% of global incomes in 2016- compared to a higher global savings rate of 26%.

Fig.2; Gross Capital Formation (% of GDP)

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Source; World Bank

In the case of South Africa, with a lower gross savings rate of less than 18% of GDP, the cash retained by the corporate sector (including state owned enterprises) accounts for more than 100% of all gross savings. The household sector’s net contribution to gross savings flows is barely positive and the government sector is a net dis-saver. We show the trends in the SA savings rate below. The profits from the gold booms of the seventies and early eighties were responsible for the very high savings rates then.

Fig 3; South Africa – Gross Savings Rate

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Source; World Bank

South Africa cannot realistically hope to raise its savings rate significantly. It can however hope to raise the rate at which capital expenditure is undertaken. That is by reducing the risks of investing in SA- and growing faster and attracting the savings to fund more rapid growth. That would be freely available from the large pool of global savings anxiously seeking better returns- given the right incentives and protections to do so. There is, as indicated, no global shortage of capital – only of attractive investment opportunities that SA could be offering.

The current rate of capital formation currently in SA is only slightly higher than the low savings rate – hence the small net inflows of foreign capital. The difference between any nation’s gross savings and capital formation is approximately equal to the net capital inflow and so the current account deficit on the balance of payments. The item that balances the current account deficit (exports-imports +debt service) – is the change in forex reserves- usually a comparatively small number.

South Africa could do with much faster growth that would encourage more capital formation and attract the foreign savings to fund this growth. And higher corporate incomes would mean more corporate savings. It is slow growth that is at the core of SA’s economic issues. Not the lack of savings. If we grew faster both the current account deficit and the capital inflows would be larger and the rate of capital formation higher. And a larger capital stock would bring more employment and higher incomes for a more productive labour force.

The US despite a relatively low and fairly stable savings rate (currently also around 18% of GNI as in South Africa) is, given the scale of its economy, still a large saver on the global stage. Though the US economy is the largest by far drawer on the global capital market to fund its spending as we show below in figure 8. While the US has been saving absolutely more recently, Chinese savings have now far overtaken US savings in absolute magnitude. Germany is another large saver, adding significantly to global savings in recent years, as we show below.

 Fig. 4; Global Savings Rates

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Source; World Bank

 

Fig.5; Gross savings (current US dollars) by economy

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Source; World Bank

The Chinese are not only the largest contributor to global savings, saving an extraordinary 45% of their GNI – a rate that as may be seen has been declining from above 50%- they are also undertaking by far the largest share of global capital formation. They created plant and equipment – real capital – worth over USD 5 trillion in 2016 or at a rate equivalent to 45% of GNI, similar to the investment rate- meaning that most of the Chinese savings were utilised domestically.

Fig.6; China Gross Capital Formation (% GDP)

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Source; World Bank

But this raises a very important issue for the Chinese. Given the rate at which they save and invest in real capital the realised growth in Chinese incomes must be regarded as disappointingly poor- even when about a 7 per cent p.a rate. It suggests that much of the capital formed is still unproductively utilised. The full discipline of western style capital markets is surely something still to be introduced to China to improve returns on savings. But for all the relative inefficiency of Chines capital, the sheer volume of Chinese capital formation has made it the dominant force in the market for minerals and metals that are used to create  capital goods.

 

Fig.7; Gross capital formation by economy – current US dollars

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Source; World Bank

In figure 8 below we show how The US dominates the demand side of the flows through global capital market- and the thrifty Europeans –  the supply side. As may be seen these trends that made US economic actors the dominant utilisers of global capital are predominatly a post 2000 development.

It is these capital flows that drive the US dollar exchange rate – and by implication all other exchange rates. Trade flows react to exchange rates- rather than the other way round. This is also the case for SA. With one important difference- foreign trade for the US economy is equivalent to about 25% of GDP. In SA imports and exports – valued at unpredictable exchange rates are equal to about 50% of GDP.

Fig. 8, Net Financial Flows from Europe and to the US. Current US dollars

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Source; World Bank

The flows of savings and flows into the US have not only moved the dollar they have moved interest rates. Perhaps the best measure of the global rewards for saving are found in the direction of the real rates of interest offered by an inflation linked bond issued by the US Treasury. Such a bond may be regarded as free of default as well as inflation risk. The risks of inflation are reflected in the yield on a vanilla bond. In the figure 9 below we compare the yield on a 10 Year US Treasury Bond and its inflation protected alternative with the same duration. As may be seen the nominal and real yields have both trended lower. The vanilla treasury bond was offering over 5% p.a in 2005- now the yield for a ten year loan provided the US is about 2.7% p.a. Real yields were over 2%. p.a. in 2005-06. They are now about a half of one per cent p.a. – after a period of negative returns in 2012-2013.

More important these yields have been rising in 2018 indicating some small degree of greater demands for capital. The real and nominal yields however remain very low by historic standards as will be appreciated. Normality – that is any sustained higher global growth rates, must mean much  higher real yields. Higher nominal yields will also depend on how much inflation comes to be added to real yields.

Fig. 9; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2005- 2018)

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Source; Bloomberg and Investec Wealth and Investment

Fig. 10; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2018)

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Source; Bloomberg and Investec Wealth and Investment

In figure 11 below we show the difference between these nominal and real interest rates. These differences represent the extra compensation bond investors receive for taking on inflation risk. It may be regarded as a highly objective measure of inflationary expectations. The more inflation expected the wider must be the spread between nominal and real yields. As may be seen- excluding the impact of the GFC this spread or inflation expected has remained between two and three per cent per annum. It is important to recognise that these inflationary expectations remain very subdued despite a recent increase. Equity investors as well as bond investors must hope that inflation expectations remain subdued enough to hold down nominal interest rates even as real yields rise to reflect a stronger global economy and a revival of capital formation. Low inflation with faster growth is an especially favourable scenario for equity markets.

Fig.11; Inflation compensation in the US Treasury Bond Market – spread between nominal and real 10 year US Treasury Bond Yields

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Source; Bloomberg and Investec Wealth and Investment

[1] With acknowledgement to Burt Bacharach

Lessons from US tax reforms

Taxes: Appearance and reality in the US and everywhere else

Reducing the US corporate tax rate and the taxes applied to offshore profits earned by US corporations and the repatriation of cash generated offshore, has had perhaps unintended consequences that are proving very helpful to the tax reformers. Some leading companies have immediately converted lower taxes to come into bonuses for their employees.

These reactions help raise the issue of who actually pays an income tax or a payroll tax. Those employees soon to notice a lower tax charge on their salary slips will have no doubts about who pays the income tax – and how they benefit from any reduction in tax rates. Shareholders receiving extra dividends, because the company has more after tax cash to distribute, will draw similar conclusions about the immediate benefits of lower tax rates.

But these immediate reactions to lower tax rates in the US will not be the last or the most important consequences of lower income tax rates. Lower tax rates will have improved the prospective returns on capital invested by US companies. More than pay dividends or buy back shares, the company may therefore wish to invest more in plant and equipment.

If so, and this seems very likely judged by the reactions of CEOs, the additional capacity will give these firms the capacity to produce more. To sell more they may well have to reduce prices or improve the other terms on which they supply their customers. The benefits of lower tax rates will thus also go to their customers in the form of lower prices or better quality or better service, depending on the competition to attract more custom. And workers may benefit as the firm hires more of them, perhaps on more favourable terms, again depending on the competition in the labour market for new hires.

In the long run the benefits of a higher return on shareholders capital, higher because less is paid away in taxes, will tend to be competed away. Actual returns after taxes may then fall away to a new equilibrium of lower required returns on a larger stock of equipment and a larger, better paid labour force in which more intellectual capital has been embedded. The effects of higher tax rates would similarly be reversed into higher prices as investment and hiring activity responds negatively to higher required returns before taxes.

These long run effects will be hard to identify, precisely because nothing much of what else will affect the economy will remain unchanged after a tax regime is changed and economic actors respond. Exchange rates may change, while tax rates in other countries may change to make imports more competitive. Trade across borders may be become more or less open. Yet it would be hard to argue that changes in taxes will not have wider consequences than is revealed on a payslip or dividend payment.

It is also surely true that the benefits, medical or pension etc. that employers provide for their workers will influence the supply of workers, skilled and unskilled, to the firm. The better the benefits, the greater will be the potential supply of job applicants and the lower the quit rates. Increased supplies of actual and potential workers in response to improved other benefits of employment will mean the firm has to offer less take home pay to attract the workers it wishes to hire.

Employees may well be paying for the benefits in the form of a cash salary sacrifice, which is to the advantage of the hiring firm. And taxpayers will be contributing, should the benefits in kind rather than cash enjoy much lower tax rates, in other forms of tax. Such tax favours for employees may help make the firm more competitive, in the form of a lower wage bill. This in turn may enable it to offer lower prices or better terms to their customers – as in the case of lower income taxes.
In these and many other ways, hard to identify, taxes tend to find their way into the prices consumers pay for the goods and services they buy. And this applies to all taxes and not only the VAT or sales taxes imposed on final expenditures.

Higher taxes mean higher prices and vice versa. And as important for the supply side effects of taxes of all kinds is how well the tax revenues are utilised. A good ratio between taxes collected and benefits provided, for obvious example in the quality of education supplied by governments, will tend to increase the supply of skills and lower costs of production and prices to the benefit of consumers ultimately.

The conclusion to come to when recognising the full ramifications of a tax system on the supply of and demand for goods and services, is to keep the tax system as simple as possible. That is to avoid trying to redistribute income through taxes of one kind or another (that find their way into prices) and hence may not redistribute income at all. All taxes may become a tax on expenditure rather than on income. Appearances of redistribution of income through can be very deceptive and damaging to an economy.

It would be more helpful to recognise reality and simply tax expenditure of all kinds at the same rate, thus avoiding income taxes, including taxes on income of companies and taxing one form of income in cash or kind at very different rates. Redistribution is best done by targeting government expenditure – not taxes. As is raising the taxes to pay for benefits as least disruptively as possible. 9 February 2018

A volatility storm – has it passed?

The S&P on Monday lost 4% by its close. The Dow had its largest one day loss in history, over 1000 points. In percentage terms it was the worst day for the New York markets since September 2011.

It is easier to understand what didn’t move the New York markets on Monday than what did. It was not any economic news, which was notably absent on the day. Nor was it interest rates. Interest rates moved the markets on Friday when they rose sharply in response to the impressive employment report. Both real and nominal bond yields closed sharply lower by the close on Monday and have maintained lower levels compared to Friday’s close on early Tuesday morning, even as the equity markets remained under pressure before the markets opened.

The most conspicuously unusual behaviour on markets was registered by the CBOE Volatility Index, the VIX. It closed 20 points higher at 37, the largest point and percentage change in this Index ever. And most of this increase took place in the last two hours of trading: it moved from 10 to over 30 in two hours. It appears that much of the price move and the huge volumes of trading activity associated with it was the result of special funds attempting to close out strategies based upon low volatility. Their attempts to do so forced up the Index and forced share prices lower.

The issue for market commentators before the market opened was how soon, as it is described, the systematic bid for volatility would subside. Judged by the strong recovery of the equity markets (S&P up one per cent as I write on Tuesday evening) in the first hour of trading the danger posed by rebalancing volatility strategies may have passed. Yet volatility – the form of minute to minute movements in share prices and Index averages of them – remains highly elevated. The VIX on 6 February continued to trade at these elevated levels as the market indices gyrate between positive and negative values.

Some economic realities

Perhaps in times when economic fundamentals appear irrelevant to company valuations, it is good to be reminded of just what has been happening at the economic coal face. Though coal is surely the wrong metaphor, the companies we refer to here are moving the frontier of economic activity – of how we work and consume that has changed so dramatically.

Some of the leading new economy companies reported their results for Q4 2017. The scale of their operations and the growth in their revenues is nothing less than very impressive. Apple for example reported quarterly sales of $88.29bn, up 13% on the same quarter in 2016. Amazon reported Q4 sales of $60.5bn, up no less than 38% on the same quarter a year before and up 31% for the year. Facebook grew sales in Q4 2017 to $12.97bn and by 47% and Alphabet generated revenues in Q4 of $32.32bn, up 24%. And Microsoft (in business for much longer) grew its sales in Q4 2017 by 12%, to $25.83bn.

All these companies that are thriving impressively and are being generously valued accordingly – described as the FAAGMS – have a competitive and a regulatory threat. Their success to date is as vulnerable to disruption by competitors – known and unknown – as they have proved to be to what were then established ways of doing business.

However their success and the market dominance it seems to create – of which their approving customers are the arbiters – is bound to attract the attention of regulators and tax collectors. That is of economic agents, with interests and powers of their own, who are philosophically unwilling to concede the race for dominance in a market place is to be determined by consumers and regulate accordingly. They would do well to accept that what constitutes the relevant market place is fluid and incapable of being usefully defined and confined. Competition for the budgets of households and of all the firms that ultimately compete for their favour remains highly intense, as the fast growing sales of the Apples, Amazons, Facebooks, Googles and Microsofts prove. Society should best leave the unpredictable outcomes to this competition. 7 February

Equity markets and interest rates in the US

Equity markets and interest rates in the US – will we avoid inflation surprises?

The equity markets in the US have had an outstanding run. The S&P 500 is up 26% since January 2017 and has advanced with unusually low volatility. Day to day movements in the Index have been very limited by the standards of the past. The fundamentals of the market have been supportive of higher valuations. High operating margins and rising earnings, with upward revisions of earnings to come, combined with still low interest rates, have attracted these higher valuations. The future of earnings and margins has been further enhanced by the income tax cuts for corporates, small businesses and individuals. The animal spirits of corporate leaders are stirring, promising a boost to the economy from a strong pick up in capital expenditure.

The concern is that unexpectedly higher interest rates can offset these benefits, as earnings are discounted to estimate present values. As we show below, US Treasury bond market yields have been rising this year – but from abnormally low levels. Nominal yields for 10-year money have increased this year from 2.45% to current levels of 2.72%. So have real yields – they have risen from a very low half a per cent in early 2018 to over 0.6% now. Furthermore, the gap between nominal and real inflation protected interest rates has increased from 2.45% at the start of 2018 to the current level of over 2.7%. This spread reveals the inflation rate predicted by the bond market. The bond market is anticipating and being compensated for slightly more inflation expected over the next 10 years.

The Fed’s target for inflation is 2% – a target that it is still to meet and is by no means certain of meeting any time soon. The Federal Open Market Committee, reporting this week (31 January 2018) still expects inflation to stabilise around its 2% objective over the medium term in its latest statement. It also repeated its view “that near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely…”

The most supportive scenario for the equity market will be one of rising real interest rates – indicating stronger growth in demands for capital – coupled with still very subdued expected inflation that will sustain low nominal interest rates. It is not higher real interest rates that represent danger to equity valuations. It is more inflation expected that would drive nominal interest rates higher that represent the threat to equity markets. Not only the Fed, but the markets, will be watching inflation developments closely. They will also be watching each other closely to avoid inflation surprises. Equity investors must hope that inflation does not surprise on the high side. Low inflation and strong real growth are what equity markets will thrive on, as they have done lately. 2 February 2018

SA – back in the emerging market fold

The South African economy has recently re-joined the world of emerging markets. The JSE, measured in US dollars, has caught up dramatically after having lagged well behind the surging MSCI Emerging Market Index. The JSE, in US dollars, and the SA component of the emerging market (EM) Index have gained over 40% since January 2017 as we show below in figure 1.

These EM and JSE gains have come after an extended period of underperformance when compared to the S&P 500. The S&P 500 has been making new highs so consistently over the past year. The EM Index and the JSE, in US dollars, have still to be worth more dollars than in 2011.

This JSE catch-up has come with the burst of rand strength that accompanied the defeat of President Jacob Zuma and his faction at the ANC electoral congress in December 201, a defeat that promised a new direction for the SA economy. The rand had weakened by about 11% compared to our basket of equally weighted other EM currencies by November. It is now about 4% stronger than the basket of EM peers (see figure 2).

Rand and EM currency strength has come with a noticeably weaker US dollar. The US dollar index (DXY) lost about 12% of its exchange value against other developed market currencies since early 2017 while the index of EM currencies has gained about 10% on the dollar, with the rand up by over 15% over the year.

A weak US dollar is good news for EM economies and especially their consumers. It brings currency strength and lower inflation – particularly of imported goods – and lower interest rates. It is very hard to see how the SA Reserve Bank can fail to respond to these trends with lower interest rates in due course.

The renewed hopes for the SA economy have extended to the bond market and to the risk premiums attached to SA government debt. Both inflationary expectations – measured as the spread between a vanilla 10 year RSA bond and its inflation linked equivalent – have declined sharply, from over 7% in November to about 6% currently. The spread between the RSA 10 year yield and its US Treasury bond of similar duration, that represents the expected depreciation of the ZAR/USD (the interest carry), has also declined by a similar degree. Yet both spreads remain quite elevated by the standards of the past. The belief in permanently lower inflation or a stronger rand is still lacking (See figure 3).

The cost of insuring RSA US dollar-denominated debt has also responded well to the new dispensation in SA. After many years of trading as junk – ever since Zuma sacked finance minister Nene in December 2015 – RSA debt is now competing again on investment grade yields.

Further support for the rand and EM currencies has come from higher commodity and metal prices. As we show below, industrial metal prices have performed better than commodity prices indices (that includes a heavy 27% weighting in oil). The London Metal Exchange Index is up 30% in US dollars since early 2017 (see figure 5). A stronger global economy combined with a weaker US dollar is helpful to EM economies including SA with their dependence on exporting minerals and metals.

The politics as well as the economics of SA are now in a much healthier state as the market place confirms. And the global economy is offering much more encouragement for SA exporters. But as indicated in our figures, there is room for further improvement. Inflation and interest rates can recede and the exchange rate and sovereign risk spreads have room to narrow further. The opportunity presented to SA is to stop the rot (developments to date have been well appreciated in the market place) and then to follow through with wealth creating and poverty reduction initiatives. 29 January 2018

US earnings and tax rates – a temporary conundrum

You may think that cutting company tax rates in the US from 35% to 21% of their earnings would boost after-tax earnings. But not so fast – while the longer run impact of the lower taxes will clearly benefit shareholders and employees, the immediate impact of a lower tax rate can significantly reduce, rather than improve the bottom line. This is the case with a number of the very large US banks reporting or about to report their latest results.

Citibank, according to the Wall Street Journal, is about to report a large loss for the final quarter of 2017. It will be making enough of a tax charge to its earnings – as much as US$20bn – for the bank to become loss making in 2017. Some of the other major US banks, for example JPMorgan, will also be deducting large sums (in its case $2.4bn) from its earnings as a once-off adjustment for lower tax rates to come. Wells Fargo by contrast was able to add $3.35bn to its earnings, as was another large bank, PNC, which added about 9c to its reported earnings of $4.18 a share.

The banks and firms that are able to immediately boost earnings have net deferred liabilities, some $2.37bn worth in the case of PNC. In the past, these provisions against future tax liabilities had been deducted from earnings. Now with lower tax rates, this reserve can be reduced and added back to earnings. JPMorgan and Citibank, by contrast, have on balance accumulated tax assets rather than liabilities. They include tax benefits to be realised in the future as an asset on their balance sheets. The accumulation of such potential benefits has boosted earnings over the years. At a lower tax rate, these assets are worth less when they are written off against current earnings.

Incidentally, the Journal article while commenting on the generally very favourable operating performance of the bank as a whole also reports a further charge to JPMorgan earnings, as follows:

“JPMorgan’s corporate and investment banking unit was weighed down by weak trading, slumping 17% to $3.37 billion after stripping out the tax-overhaul impact. It also was hit with losses as high as $273 million related to client Steinhoff International Holdings NV, which is dealing with a wide-ranging accounting probe that is expected to also dig into other large banks’ results.” (WSJ, Peter Rudegeair)

These important recent developments on the earnings front raise the issue about the usefulness for investors or operating managers of these heavily and frequently adjusted bottom-line earnings. Quarterly reported earnings cannot be regarded as a reliable measure of the long run potential of the companies reporting. Nor, since the definition of earnings has changed so much over the years, can these reported earnings be helpfully compared to earnings in the past, nor to historic share prices, in the hope that price earnings ratios will revert to some long run average.

But there is one measure of the performance of a company or of a stock market that has the same meaning and significance today that it has today as it did 50 or 100 years ago. That is the cash paid out to shareholders as dividends. Companies do not easily pay away real cash unless they are confident they can maintain such payments. As such their dividend payments constitute a very real measure of normalised earnings.

A comparison between S&P 500 Index earnings and dividends makes the point. As we show in figure 1 below, dividend flows are far smoother than earnings; smooth enough to be regarded statistically as well as for economic reasons as a normalised measure of earnings.

Of particular significance is that dividends survived the financial crisis of 2008 far better than earnings, as may be seen. Earnings in that period collapsed dramatically as all the failed loans and less valuable assets of the banks and financial institutions were written off earnings. Dividends held up relatively to earnings to reflect the future of US business rather than its immediate past.

And share prices since the crisis are much better explained by the flow of dividends than the flow of earnings. As may also be seen in figures 2 and 3, dividends payments by S&P 500 companies grew steadily between 2014 and 2016, even as earnings fell away sharply in 2014. This helped to support further improving share prices.

S&P Index dividends moreover have continued their steady advance even as earnings have rebounded very strongly, as the figure shows. Dividends since 2012, a period when the S&P Index gained an average 13% p.a., have grown on average by 10.5% p.a, while earnings grew by 3.5% p.a on average, with twice as much volatility. It would appear investors bidding up share prices were taking more notice of normalised than actual earnings, that is of the consistent growth in dividends.

As we show below the quite stable dividend yield on the S&P 500 is very much in line with its post-2000 average. This does not appear to indicate an overvalued market, especially when this dividend yield is compared to interest income which is the alternative to dividends. And lower tax rates will surely encourage US businesses to raise their dividend payments. 16 January 2018

Reading the share market – beyond market timing

27th December 2017.

Every well traded market offers opportunity and danger. The opportunity is to buy low and sell high. The grave danger is that the investor/speculator does the opposite- sells at the bottom and buys at the top. The history of returns from equity markets reveals just how tempting it is to try and get the timing of entry into and exit from the market right; or, to put it more modestly, why it is important not to get the timing badly wrong.

The irregular pattern of past returns from equities

In figure 1 we show that since January 2000, the ups and downs of the S&P 500 Index of the largest companies listed on the New York Stock Exchange and the JSE All Share Index. With the benefit of hindsight, we can see that getting out of the New York market in early 2000 and re-entering in 2002, would have been very good for wealth creation. For investors on the JSE, timing would have called for even greater agility. It would have been best to have sold off somewhat later, in 2002, and then to have re-entered in 2003, so benefiting from the excellent returns available until the Global Financial Crisis (GFC) of 2008 caused so much damage to all equity markets.

Despite all the understandable gloom and doom of that unhappy episode in the history of capitalism, the GFC was followed by a period of strong and sustained value gains that continue to the present day (late 2017). It has been a rising equity tide that only briefly faltered in 2014. Those with strong beliefs in the essential strength of the global economic system and, more important, with faith in the capabilities of central bankers to come to the rescue, did well not to sell out in  2008 at what proved to be a deep bottom to share prices.

Figure 1: Annual returns on the S&P 500 Index (USD) and the JSE All Share Index (ZAR)

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Source: Iress and Investec Wealth & Investment

 

These total share market returns (price changes and dividends received) have been calculated as gains or losses realised over the previous 12 months and calculated each month. The average annual return on the S&P 500  between January 2000 and November 2017, in US dollars, was 5.3% compared to 14.4% in rands generated on the JSE. The worst month for both markets was in late 2008, when both markets were down over 50% on the year before. The best year-on-year return on the S&P 500 over this period was 43%, realised in the 12 months to February 2010, while the best months for investors on the JSE were in late 2005 when annual returns peaked at over 50%. Adjusted for inflation in the US and SA, the S&P Index has provided about a real average 3% p.a return and the JSE an impressive 8% p.a. in real rands.

When measured in US dollars, the JSE also outperformed, having delivered close to 7.5 % p.a on average compared to the 5.3% p.a earned on the S&P 500. It may be seen in figure 2 below that the JSE provided superior US dollar returns between 2003 and 2007, but offered markedly inferior returns (in US dollars) compared to the S&P 500 since 2012. These high average returns over an extended period of time surely indicate the advantage of maintaining consistently high exposure to equities over the long run.

Figure 2: annual US dollar returns – S&P 500 Index and the JSE All Share Index

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Source: Iress and Investec Wealth & Investment

While timing which market to favour over another – the JSE before 2008 and the S&P 500 after 2014 – can make an important difference to investment outcomes, it should also be noted that the returns on the S&P 500 and the JSE are quite highly correlated on average  (close to 70%) in all the ways to measure performance.

The forces common to all equity markets around the world will often be directed from the US economy and its asset markets to the rest of the world – rather than the other way round – making an analysis of the state of the S&P 500 a very good starting point for analysing any equity market.

The essential question then arises. Is it possible to undertake value-adding or loss-avoiding equity market timing decisions with any degree of analytical conviction?  Such market timing decisions are unavoidable for any fund manager or investment strategist with responsibilities for funds that are not all-equity funds. Any fund required by its investors to hold a balance in their portfolios of cash, fixed interest investments of various kinds as well as the many alternative asset classes that might feature in portfolios, would have to exercise judgements about the risk inherent in equity markets at any point in time.

The risk that the equity markets might, as they have in the past, melt down or even melt up – only then perhaps to melt down again – must therefore be uppermost in the minds of all fund managers having to decide on an appropriate allocation of assets. Even those running all equity funds have to decide how to time turning newly entrusted cash into equities and, more important still, which particular equities to buy and sell.

The broad direction of the equity or any other market can only be known after the event. From day to day, month to month or quarter to quarter, market prices and values are about as likely to go up as they are to go down. These short-term price moves therefore appear to observers as largely random, as the figure of monthly changes and daily moves in the S&P 500 Index shown below demonstrate. Note the still random (down/up, up/ down in no predictable order or magnitude) but very wide daily moves in the S&P 500 during 2008-2009 and during the euro bond crisis of 2011.

Figure 3: S&P 500 monthly returns (percent)

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Source: Iress and Investec Wealth & Investment

Figure 4: S&P 500 daily returns (2005-2017)

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Source: Iress and Investec Wealth & Investment

But these daily or monthly movements may reveal a broad drift in either direction, more up than down, or the other way round, measured over longer period of time. So when daily and monthly moves are converted into annual changes, observers will get the drift (after the event) and a persistent statistically smoothed trend in returns, that peaks and troughs in some more regular way, will be registered, as shown in figures one and two above. These phases, from top to bottom in annual returns, are defined as either a bull or bear market or something in between, depending on the depth or height of the following trough or peak, but can only be identified with hindsight.

Understanding how assets are valued

This does not mean that nothing meaningful can ever be said about the state of a market after it has moved higher or lower. With observation of the past we can understand the forces that have driven the value of any company higher or lower and so the average of them represented by a stock market index and therefore recognise the forces that might drive them higher or lower in the future, if past performance can be relied upon.

Successful, more profitable companies – those that earn a high return on the capital shareholders provide their managers – after all command higher values than less successful ones. And part of their success or failure will also have to do with the environment in which they operate. The laws and regulations, including the taxes their shareholders are subject to, will influence their ability to generate revenues and reduce costs, as will fiscal and monetary policies. The more certainty about these forces in the future, the less (more) risk to be discounted in the prices paid and the more (less) valuable will be the future flows of revenues and costs in which owners will share.

These market wide forces that determine the value of a share market index are in principle not difficult to identify. In practice they raise many unresolved issues about how best to give effect to the underlying theory. The economic caravan always moves on making it impossible to prove the superiority of one valuation approach over another. Holding other things equal is only possible in the laboratory, not in the economy.

The market can be thought of as conducting a continuous net present value (NPV) calculation, estimating a flow of benefits from share ownership over time, the numerator of the equation. That can be calculated as earnings (profits) or dividends or net (free after-capital expenditure) cash flow expected. The calculations of these are highly correlated when measured for an aggregate of all the firms that make up the Index. This expected performance of the market is then assumed to be discounted by a rate that reflects the required risk-adjusted rate of return set by the market.

The cost of owning shares rather than other assets, is given effect in the applied discount rate. It represents the opportunity foregone to own other assets, for example government or private bonds or cash, that offer pre-determined interest rate rewards with less default risk. In addition shareholders will, it is assumed, expect some additional reward, described as an equity risk premium (ERP) for the extra risks incurred in share ownership that offer no predetermined income. Hence a higher discount rate when the ERP is added to benchmark, default risk free fixed interest rates as provided by securities issued by a government. Such risks can be measured by the variability of the value of the share index from day to day, as shown above, a process of price determination that makes share prices more variable and less predictable than those of almost all other relevant asset classes.

These share prices will go up or down as the discount rate rises or falls with changes in interest rates. And with circumstances that cause investors to attach more uncertainty to the flow of benefits they expect from share ownership. The price of the shares goes lower or higher to compensate for these extra or reduced risks to the outlook for the economy and the companies who contribute to it.

The numerator of the NPV equation that summarises the expected flow of benefits to owners may be regarded (for reasons of simplicity) as (relatively) stable. A lower (higher) share price reconciles this given outlook with the required risk adjusted return that makes owning a share seem worthwhile. So when discount rates go up (down)  – valuations (share prices) move in the opposite direction to improve (reduce) the expected returns from share ownership.  Lower prices, other things being equal including expectations of profits to come, mean higher expected returns and vice versa.

Understanding and taking issue with the market consensus

One of the essential questions with which to interrogate the market, is to judge whether current market-determined interest rates are likely to move higher or lower or the environment that companies will operate in is going to become more or less helpful to their profitability. By definition, what surprises the market moves in interest rates or tax rates or risk premiums, will move valuations in the opposite direction. You may believe that the marketplace has misread the true state of affairs, such as the outlook for interest rates and risk premiums, and so has mispriced the share market, overvaluing or undervaluing it enough to encourage additional selling or buying.

The market consensus (revealed by the current level of the Index) will also have incorporated its expectations of performance to come by the companies represented in the Index. This consensus may also prove fallible. Earnings may be about to accelerate or decelerate in surprising ways. Operating profit margins may stay higher or lower for longer than expected. The economy itself may be about to enter an extended period of well-above past growth rates. If so, and you will have your own reasons for believing so, this would provide good reason to reduce or increase exposure.

Such contrarian opinions, if acted upon will add to or reduce exposure to equities. The market consensus is determined by its participants, all with the same incentive to understand it better, as you have, and is studied by many with great analytical skills and vast experience. Consensus has every reason to be the consensus. And when the consensus changes – as we have shown it so often changes – it will do so for good and well-informed reasons. Beating the market – that is getting market timing right – is a formidable task, so humility is advised.

While perfectly timing market entry or exit is not a task given to ordinary mortals, we can draw some helpful inferences about the condition of the market place, given this sense of what has driven past performance. We are in a position to judge how appropriately valued a market is at a point in time and therefore what would be required of the wider economic forces at work to take the market higher- or prevent it from going lower.  We will attempt to recognise what is being assumed of the equity market – what assumptions are reflected in the prices paid for shares – and whether or not you can agree or differ from what is at all times the market consensus.

Our valuation exercises

We judge whether the equity market is demandingly or un-demandingly valued in the following way. We determine how current valuations are more or less demanding of additional dividends. Why dividends? Because they have the same meaning today as always: cash paid out to shareholders rather than retained by the enterprise. They are not subject to changing accounting conventions, such as the nature of capital expenditure and research and development expenditure that may or may not be fully expensed to reduce earnings. What may appear as an overvalued market would need a strong flow of dividends to justify current values and expectations. An undervalued market would be pricing in a slow-down in dividend payments. Good or poor dividend flows can take the market higher or lower.

Furthermore, we judge whether the market is more or less complacent about the discount rates that will be attached to these dividends to come. In this we are also aware that the interest rates we observe and that the market expects, as revealed by the level of long term interest rates and the slope of the yield curve, may be abnormally low or high – but might normalise to some degree in the near future.

We utilise regression equations that compare the current level of the leading equity index the S&P 500 to the level predicted by trailing dividends and long-term interest rates. The results of such an exercise are shown below. The model equation predicts a significantly higher S&P 500 than is the case today, some 40% higher. By this standard the S&P is currently undervalued.

The model provides a very good fit and both explanatory variables easily pass the test for statistical significance and accord well with economic theory. It explains past market behaviour well.

 

Figure 5: Regression model* of the S&P 500 (1970-2017)

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Source: Iress and Investec Wealth & Investment

*Representation:

LOG(SP) = -1.80463655704 + 1.18059721064*LOG(SPDIV) – 0.0727779346562*USGB10

We can back test the model. If the model was run with data only up to November 2014 when the S&P began its new upward momentum we would have received a very helpful signal that the S&P was in fact very undervalued at that time. This signal would have encouraged investors at that point in time to have maintained high equity weight in portfolios- or what is described as a risk-on position.

Similarly had we applied the model in early 2000, just before the so called Dot.com bubble burst, the model would have registered that the S&P 500 Index was then greatly overvalued for prevailing dividend flows and interest rates  Reducing exposure to equities at that point in time would have been very much the right approach to have taken – as we soon came to find out.  We should add however that the model would also have registered a high degree of overvaluation as many as three years before the market fell away from its high peak. Even irrational exuberance, as Alan Greenspan memorably described it in 1997, perhaps relying on a similar approach to value determination,  or its reverse undue pessimism, can persist for an extended period of time, making our model or any such valuation exercise based on historical performance unhelpful as a short-term trading model, but still valuable as a basis with which to interrogate market consensus.

In our models we regard the value of the S&P 500 as representing the present value of a flow of dividends (the performance measure) discounted by its opportunity cost, represented by the interest rate (the expected return) on offer from a 10-year US bond yield. An alternative approach would be to compare the value of the Index to the expected economic performance of the companies included in the Index, and then to infer the discount rate that could equalise price and expected performance in the NPV equation.

The Holt system[1] undertakes this calculation. It estimates the free cash flow return on capital realised by and expected from all listed companies (CFROI) real cash flow return on real cash invested using the same algorithms applied to all the companies covered by the system and its data base.  This analysis can be used to derive a market discount rate for any Index that equalises the value of an Index, for example the S&P 500, to the cash flows expected from it.

In the figure below we compare this nominal Holt discount rate for the S&P 500 to US long term interest rates. These discount rates have receded with long-term interest rates, as theory would predict.  Note also that both interest and the Holt discount rate are at very low levels, implying higher share prices for any given flow of dividends.

Of greater importance perhaps for share prices than discount and interest rates is the spread between them. This spread, the extra risk premium for holding equities rather than bonds, has widened in recent years. While the discount rate may have declined, it has maintained and even increased the distance between it and interest rates, so encouraging demand for equities.

When we replace interest rates with this risk premium in our dividend discount model we get a very similar signal of a currently undervalued S&P 500 (see below).[2]

Figure 6: US Holt discount rates (nominal) US long bond yields (10 year) and risk spread

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Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 7: Real Holt discount rates and real interest rates and real risk spread

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Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 8: A model of the S&P 500 (explanatory variables, dividends and spread between discount rate and long term interest rates)*

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*Representation of the equation:

LOG(SP) = -4.59846533561 + 1.51940769795*LOG(SPDIV) – 0.0501430590849*(CFROINOM-USGB10)

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Therefore we conclude that the S&P 500, despite its recent strong upward momentum, is undervalued for current dividends and interest rates or the risk spread. However some caution about the level of the S&P Index is called for by a sense that long-term interest rates are now very low and may well normalise. A further reason to be cautious about the current level of the S&P 500 is that the day-to-day volatility of the Index has been very low by comparison with the past. This indicates an unusual degree of comfort with the current state of the US share market. Were volatility to normalise, share prices would probably under pressure.

Hence our asset allocation advice has been to retain a neutral exposure to equities for now, with the next 18 months in mind. On a shorter term view (less than six months) however, we are of the view that upside strength is at least as likely as any move lower.

When we review the JSE applying a similar method of analysis, the rand values of the All Share Index appears as fairly valued for trailing dividends and US Interest rates. It also appears fairly valued when all the variables of the model are converted into US dollars. However when the (high) level of the S&P is included as an explanation of the USD value of the JSE in place of US interest rates the JSE appears as now attractively undervalued.

The S&P 500 is normally a rising tide that lifts all boats. But in the case of the JSE this has not been the recent case. Not only the JSE but emerging market equity indexes generally also lagged behind the S&P 500 after 2014 and until mid-2016.  It will take less SA risk, which comes with an improved political dispensation, to focus global attention on the potential value in SA equities, particularly the companies heavily exposed to the SA economy. The SA political news has improved and the case for SA equities exposed to a potentially stronger SA economy, has also improved, making the case for a somewhat overweight exposure to this sector of the JSE.

Figure 9: A model of the US dollar value of the JSE with dividends and US interest rates*

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*Representation:

LOG(JSE USD ) = 1.3925529347 + 0.776827626347*LOG(DIVIDENDS USD ) – 0.127168505553*US 10 Y Bond Yields

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

[1] Credit-suisse.com/holtmethodolgy

“HOLT derives a market-implied discount rate by equating firm enterprise value to the net present value of free cash flow (FCFF). HOLTs FCFF is generated by a systematic process based on consensus earnings estimates, a growth forecast, and Fade. This process is similar to calculating a yield-to-maturity on a bond” See Holt Notes November 2012

[2] In order to undertake the analysis over an extended period of time we added US inflation to the real Holt discount rate for the US sample to establish a nominal discount rate to be compared with nominal interest rate. An equivalent series of US real interest rates (Tips) is only available from 1997

The great taskmaster

The success of any business enterprise is measured by the return realised on the capital entrusted to it. The managers of an enterprise will rationally direct the capital provided them to particular business purposes in the expectation of a return on the capital invested that exceeds its opportunity cost, that is greater than the expected return from the next best alternative project with similar risks of success or failure. The more risk of failure, the greater must be the required (breakeven) return.

Measuring the internal rates of return delivered by an operating enterprise in a consistent way over any short period of time, for example a year or six months, has its own accounting for performance complications. The fullness of time, or until the venture is sold or liquidated, may be necessary for calculating how well the owners have done with their capital. However calculating the risks of failure of any potential project is much more a matter of judgement and sound process, than any precise measurement.

The only returns that can be measured with accuracy are those realised for investors in listed and well-traded companies. Returns come explicitly in the form of capital gains or losses and dividends or capital repayments received. And risks to potential returns are measured by the variability of these (monthly) returns over time that hopefully have a consistent enough pattern. A consistency furthermore that identifies the returns from a company as more or less risky compared to the pattern of average returns realized on the stock market. These measures can then form the basis of a required risk-adjusted return for a company or an investor to aim at.

These so-called betas that compare returns on individual shares to market returns as above or below averagely risky may in fact be quite unstable variables when measured over different time periods. Furthermore, these equations that relate company returns to market returns may or may not explain a great deal of past realised returns. The alpha of the total return equation that reveals company specific influences on total returns may account for much of realised returns.

This may be as well when judging the competence of the managers deciding and executing on projects. If the share market returns are mostly alpha (under the control of manager) and not the result of market wide developments over which managers have no influence, then determining the contribution of managers to realised returns becomes a consistent process.

Those buying a share from a willing seller are mostly gaining a share in the established assets and liabilities of an operating company – a share that the seller is willingly giving up – at a price that satisfies both. They are not providing extra capital for the firm to employ.

By establishing a price for a share they are however providing information about the market value of the company’s operations and so by implication the terms on which the company could raise further share or debt capital, should they wish to do so to supplement the company’s own savings to be invested in ongoing projects. The additional capital invested by operating companies will mostly be funded through cash retained by the firm, that is from additional savings provided by established shareholders.

The secondary share market transactions, through their influence on share prices, converts the internal rates of return realised by and expected of an operating company, into expected market returns. The superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company. The higher (lower) the share price the lower (higher) must be the expected returns for any given operating outcomes.

In this way through share price action, higher costs of entry into the investment opportunity, companies and their managers that are expected to generate way above average returns on the capital they invest in on-going operations and projects, may in reality only provide market-related average returns to share owners over any reporting period, say the next year or two. The further implication of these market expectations, incorporated into share prices, is that only a surprisingly good or disappointing operating results will move the market. The expected will already be reflected be in the price of a share or loan.

The implications of these expectations and their influence on share market prices and share market returns for managers and their rewards, provided by shareholders, seems obvious. Managers should be rewarded for their ability to realise or exceed the required internally generated returns on capital invested: charged to exceed targets for internal rates of return that are set presumably and consistently by a board of directors, acting in the interest of their shareholders.

Better still, targets set for managers that are made public and well understood and can be defended when exceeded and managers who are then rewarded accordingly. By contrast, share market returns that anticipate good or poor performance, cannot reveal how well or poorly operating managers have done with capital entrusted to them. Rewarding operating managers on the basis of how their shares performed is not a good method. Excellent companies that are expected to maintain their excellence and perform as expected to very high standards may only generate average returns. And poor management can wrongly benefit from above normal returns if expectations and share prices are set low enough. The correct basis for recording the value of managers to their shareholders is to recognise as accurately as possible, the realised internal rates of return on the shareholders capital they have employed.

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds – can however be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro or PSG or a Naspers, are endowed with permanent capital by original shareholders that cannot be recalled. This allows them to invest capital in operating companies for the long run. They, the managers of the holding company, when allocating capital to one or other purpose, must expect that the managers of these operating companies they invest in are capable of realising above average (internal) returns on the capital they invest. If indeed this proves so, they must hope that the share market comes to share this optimism and prices the holding company shares accordingly, to reflect the increased value of the assets it owns. Other things being equal, the greater the market value of their investments the greater will be the market value of the holding company.

But other things may nor remain the same. The market place is always a hard task master. Past performance, even good investment management performance, may only be a partial guide to expected performance. The capabilities of the holding companies’ managers to add value by the additional investment decisions they are expected to make today and tomorrow – not only the investments they made in the past – will also be reflected in the value attached to their shares.

These can stand at a discount or at a premium to the market value of the assets they own. The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect this pessimism about the expected value of their future investment decisions.

A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns. It is a market reproach that the managers of holding companies should always attempt to overcome, by making better investment decisions. And by exercising better management of their portfolios, including converting unlisted assets into potentially more valuable listed assets and also by indicating a willingness to unbundle successful listed assets to shareholders when these investments have matured. And be rewarded appropriately when they succeed in doing so.

21 December 2017

The SA economy – some Christmas cheer

The incipient cyclical recovery identified in our last report on the state of the SA economy has been confirmed by the most recent data releases. New vehicle sales and the supply of cash to the economy at November month end both support the view that the economy is demonstrating resilience.

We combine these up to date, hard numbers (not based on sample surveys) to calculate our Hard Number Indicator (HNI) of the business cycle. As we show in figure 1 the HNI is now pointing higher after showing little momentum after 2014 and having moved lower in 2016. The annual change in this indicator (the second derivative of the business cycle) has moved into positive territory and is forecast to maintain this momentum.

The components of the HNI are shown below. The real money base, the note issue, adjusted for the CPI (to November 2017) has become less negative while the new vehicle sales have maintained an encouraging revival.

If recent vehicle sales trends are maintained, new vehicle sales would be running at a 600 000 unit rate at year end 2018. This would represent a welcome recovery from the cyclical trough of mid-2016 but would still leave sales well below the previous peak rates of 2006 and 2012-2014.

Sales volumes at retail level, excluding motor vehicles, have been reported for October 2017. They show that the retail sales cycle continues its upward momentum and is pointing to growth rates of about 3% through 2018. This growth will be assisted by the growth in demands for cash. Extra cash is still a very good coinciding indicator of retail spending intentions despite all the digital alternatives to cash in SA (see figure 4).

Perhaps a more important encouragement for households to spend more is that prices at retail level have hardly increased over the past few months. The retail price deflator has moved sideways even as the CPI continues its upward trend, though also at a more modest rate. Hence the trend in inflation at retail level is sharply lower and, if sustained, will prove a stimulus to spending (see figures 5 and 6). The key to the door of lower prices at retail level is the exchange value of the rand. The outcome of the ANC succession struggle at Nasrec this weekend will be well reflected in the rand and in turn in retail spending and inflation. 14 December 2017

ANC elective conference – what are the odds?

The markets have been recording their judgements about the outcome of the battle to succeed President Jacob Zuma as leader of the ANC to be decided over the next few days. The prospects of Cyril Ramaphosa succeeding has been recorded in the degree of rand strength versus its emerging market peers. As we show in figure 1 below, the rand weakened in response to the appointment of Minister of Finance Malusi Gigaba in March and weakened further after he presented his mini-Budget statement in October. Since then, and despite a very critical report from the credit rating agencies and a downgrade, the rand has recovered strongly – in an important relative sense – and not only versus the US dollar.

The same improvement in sentiment is revealed in the market for US dollar-denominated RSA bonds. As we show in figure 2, the spread between the interest rate yield on five-year RSA bonds and five-year US Treasury bonds that offers compensation for extra SA risks of default, has also narrowed from 2.2% in early November to about 1.8% on 14 December.

A still more direct measure of the probabilities of one or other candidate being first past the post is provided by online sportsbook operator Sportingbet (https://www.sportingbet.co.za).

When their books first opened the odds on the various potential candidates – or those not yet identified were as shown below. The favourite was Nkosazana Dlamini-Zuma with a 42% chance of winning (1/2.4) while Cyril Ramaphosa was given only a 27% probability of winning, less than the chances of Zweli Mkhize.

The decimal odds are now as shown below. Ramaphosa is the firm favourite, given a 57% chance of winning compared to a 33% chance for his closest rival Dlamini-Zuma. The odds on any other outcome have blown out.

The volume or value of bets cast is not disclosed, but we are informed by Sportingbet that 65% of the bets and 61% of the stakes have been cast for Ramaphosa, while 21% of the bets have been placed on Dlamini-Zuma and a larger proportion (36%) of the stakes cast for her. These books will close on Saturday 16 December and we are informed by the firm, who describe themselves as operator of South Africa’s largest online sportsbook:

“Unfortunately, as part of our trading risk management policy, and as a company policy, we never disclose amounts wagered, numbers of bets, or users on any single event. I can share however that considering it’s a “novelty” (or non-sporting event) market, the bet activity and interest on this is impressive. “

There is a great deal at stake for the economy in the ANC race for the top. Clearly, judged by the markets and the odds and the politically savvy involved, there are no certain outcomes. Were therefore the favourite to win and the more decisive the victory, the stronger the rand and the lower the risk spreads – and so the chances of a strong SA economic recovery. Perhaps something those casting their votes might bear in mind. 15 December 2017

Hail to the SA consumer

The South African economy cannot be said to be performing to its potential. But in one important sense it is performing well – for consumers. Those with income or borrowing capacity will not find the economy wanting when they come to exercise their spending choices over the holiday season.

The shops will be well stocked and able to meet their every demands and desires, be it for essentials or luxuries supplied from all parts of the world. They will not lack for bread or toilet paper or for wine, beer or spirits. Or lack for wonderful world class entertainment at the theatres and movie houses. The book shops will be well stocked for those who still regard reading as entertaining and valuable. Excellent restaurants of all ethnic persuasions will be open to them, but may require an advance booking, given the competition from foreign tourists, who are showing their increased appetite for what we enjoy at the prices we pay.

This is as it should be. Successful economies gained their cornucopias by putting the demands of consumers in first place. That is preventing producers, farmers or factory owners or avaricious rulers or ecclesiastical orders or soldiers to decide what is to be produced. And when consumers largely rule the economy and producers are required to respond to them, economies flourish. Doing it the other way round – for the state to put the interest of producers, including those employed by them – whose own well-being is always threatened by competition – is a recipe for economic failure and for stagnation and corruption and the waste of the opportunity to consume more.

A consumer-led economy need ask very little of the state. The State and its officials will not be called upon to design industrial policy or determine development plans, policies that require foresight that is simply not available to even the best informed and least self-interested official. What the effective State has to provide is the protection of contracts freely entered into and the capital of those who have saved and puts their capital and skills to work, hoping to satisfy their customers and be rewarded for doing so.

The state should also ensure that the success or failure of businesses, large and small, is determined by their sales to customers and the costs of doing so. Not where financial success is dependent on an ability to negotiate a morass of regulation and relations with powerful officials. This system inevitably advantages bigger business over their smaller rivals.

A consumer-led economy is a continuous process or trial and error, of firms learning and adapting to unpredictable circumstances. The winners and losers for the consumers’ spending power emerge – they are not chosen by planners. South Africa incidentally, since 1994, has spent hundreds of billions of rands – perhaps over 400 billion rands of them – in subsidising industries of one kind or another with taxpayers’ money or tax concessions, money that could have been put to much better effect by consumers, especially poor ones.

The South African government alas appears only too willing to continue to put producers and officials first. For example competition policy is directed to serve industrial and labour policy rather than protect consumers.

More important for economic development, given that education and training precedes the ability to produce, earn and consume more, it is tragically the educators, the producers, who are first in line when the huge government budgets for such purposes are allocated. Were the taxpayer to pay the fees to enable all those desperately seeking education and training to attend private schools, universities and training establishments, of their own choosing, the valuable customer would come first. And the outcomes in the form of additional employment and incomes would be far superior.

The market for jobs in South Africa – why it performs so poorly and what can be done to improve it

Piece written for the Free Market Foundation: http://www.freemarketfoundation.com/publications-view/the-market-for-jobs-in-south-africa-%e2%80%93-why-it-performs-so-poorly-and-what-can-be-done-to-improve-it-

A pdf version is also available here.