Author: Brian Kantor

Helicopters in a different form

It is not helicopters but old fashioned government spending – funded by debt or cash – that will be called into action to get developed market economies going again.

The notion (metaphor) of helicopter money was first invoked by the foremost monetarist Milton Friedman and revived by Ben Bernanke, later Governor of the US Fed, to indicate how central banks might overcome a theoretical possibility that has in reality become a very real problem for central bankers today. The problem for the central banks of the US, Europe and especially Japan is that the vast quantities of extra money they have created in recent years, quantities of money that would have been unimaginable before the Global Financial Crisis of 2008, have been bottled up in the banks who have held on to the extra cash received rather than used it to make loans that would have helped their economies along.

The cash was received by the banks or their customers from the central banks in exchange for the government and other securities bought from them in the credit markets and directly from the banks themselves. The cash shows up as extra deposits held by the private deposit taking banks with their central banks – the bankers to the banks. It has been a process of money creation described as quantitative easing (QE) that has led to trillions of dollars, euros or other currencies of extra assets held by central banks – matched by an equal growth in their liabilities, mostly to the banking system in the form of extra deposits held with the central bank (see below).

But why did these central banks create the extra cash in such extraordinary magnitude? In the first place in the US it was to rescue the banking and insurance systems from collapse in the face of their losses incurred in the debt markets that led to the failure of a leading bank Lehman that might have brought down the financial system with it. In Europe it was to prevent a meltdown in the market for most European government debt that could have brought down all lenders to government – not only banks but pension funds and insurance companies and their dependents. In Switzerland the cash came from purchases by the central bank of dollars and euros that flooded into the Swiss banking system and would otherwise have driven the Swiss Franc even stronger than it has become. In Japan the extra cash was always designed to offset the recessionary and deflationary forces long plaguing the economy.The original purpose of QE in the US and Europe was to prevent a financial collapse. The second related reason was to fight recession and deflation. Extra money and the lower interest rates accompanying it are meant to encourage extra spending and extra lending to the same purpose. Extra money and lower interest rates usually do this to an economy – stimulate demand. Usually with extra demand comes higher prices and inflation.

The banks receive the extra cash directly from the central bank in exchange for the securities previously held on their own balance sheets or who may receive the extra central bank cash firstly with the deposits made by their clients when banking the proceeds of their own asset sales. Their clients deposit the cheques or, more likely, EFTs issued by the central bank in their private banking accounts and the banks then receive an equivalent credit on their own deposit accounts with the central bank as the cheques on the central bank are cleared or the EFTs’ given electronic effect. And so in this way, through asset purchases by the central bank acting on its own initiative, extra central bank money enters the financial system, a permanent increase that can only be reversed when the central bank sells down the securities it has bought.

The banks have an option to hold the extra cash rather than lend it out to firms or households, who would ordinarily spend the cash so made available. And banks in the US, Japan, England and Europe and Switzerland have done just this in an extreme way. They are holding the extra cash supplied to them by their central banks as additional cash reserves way in excess of the requirement to hold reserves.

The US Money Base shown below is the sum of currency and bank deposits (adjusted for reserve requirements) held with the central bank (see below the US Money Base that has grown in line with excess reserves held by the Fed and the extraordinary growth in the deposits held by Swiss banks with the Swiss National Bank).

 

And so the call for the imaginary helicopters to bypass the banking system and jettison bundles of cash that people would pick up gratefully and spend on goods and services so reviving a stagnant economy (stagnant for want of enough demand, not for want of potential output and employment that is the usual economic problem).

The helicopters however will have to take a different form. They will have to be ordered by governments and budgeted for in Congresses or Parliaments. Central banks can buy assets in the financial markets and directly from banks. They cannot order up government spending that they can help fund. That is the job of governments who decide how much to spend and how to fund their spending. Governments can fund spending by taxing their citizenry, which means they will have less to spend. This is never very popular with voters. They can fund government spending by genuine borrowing in the market place – competing with other potential borrowers – crowding them out by offering market-related interest rates and other terms to lenders. Or they can fund their expenditure by calling on the central bank for loans that, as a government agency, they cannot easily refuse to do.

In taking up the securities offered to them by the government the central bank credits the deposit accounts of the governments to the same (nominal) value as the debt offered in exchange. Both the assets and deposit liabilities of the central bank then increase by the same sum as the extra debt is bought by the central banks and the government deposit credited. As the government agencies write cheques on their deposit account – or do the EFTs on them – the government deposit runs down and the deposits of the private banks with the central bank run up. In this way, the supply of cash held by the private sector increases, just as it does in the case of QE.

And the private banks and their customers will have the same choice about what to do with the extra cash held on their own balance sheets. Spend more, lend more or pay back debts or hold the extra cash, as they have largely been doing.

But there is an important difference when the money is created to fund extra government spending. Spending by government on goods services or labour or perhaps welfare grants will have increased, so directly adding to aggregate spending. By spending more, the revenues of business suppliers and the incomes of households will have risen with their extra money balances received for their services or benefits. This is why spending by government – funded with extra money is usually highly inflationary – can be highly inflationary as it was in the Weimar Republic of Germany after World War 1 or as it was in Zimbabwe not so long ago or as it is now driving prices higher in Venezuela.

But the current danger in the West is deflation, the result of too little rather than too much spending. Inflation seems very far away, as revealed by the very low or even negative interest rates offered by a number of governments to willing lenders for extended periods of time. For some government issuing debt – at negative interest rates that produces an income for the government – is cheaper than issuing cash that gives only a zero rate of interest.

The continued weakness of developed economies suffering from a lack of demand, despite low interest rates, calls for money and debt and or money creation by governments. The call for less austerity or more government spending relative to taxes collected is being heard in Japan. It is a voice being sounded loud and clear in post Brexit Britain. The Italians are very anxious to use government money to revive their own failed banking system. The Germans with their own particular inflation demons will however resist the idea of central banks directly funding governments, but for how long? Hillary Clinton promises spending on infrastructure. Donald Trump worries about government debt – for now as far as we can tell.

How long can weak economies and very low interest rates and abundant supplies of cash co-exist? It will not take helicopters but unhappy voters to stimulate more government spending, funded with cheap debt or cash. And the voters appear particularly restless on both sides of the Atlantic and, for that matter, the Mediterranean. 1 August 2016

A fuller account of the above discussion can be found here: Money supply and economic activity in South Africa – The relationship updated to 2011

Saying farewell to holding companies and hello to low voting shares

Written with the fond memory of the late great Dr. Jos Gerson – a colleague and warm friend who was the complete expert on Corporate Ownership and Control in South Africa. He is missed – especially at a time like this.

For a taste of the earlier work on these issues see on the blog under Research this publication

Shareholders as agents and principals: The case for South Africa’s corporate governance system Journal of Applied Corporate Finance, 1995 8(1)

 

Saying farewell to holding companies and hello to low voting shares – lessons from the Pick n Pay Holding Company unbundling.

One of the last of the once numerous pure holding companies listed on the JSE, Pick n Pay Holdings Limited (PWK), is no longer with us – to the palpable delight of its shareholders. PWK is a pure holding company because its only asset was a 52.69% shareholding in the operating company, supermarket chain Pick n Pay (PIK), from which it received dividends and paid out almost all of them (after limited expenses) to its own set of shareholders. PWK incurred no debt and acquired no other assets.

Its sole purpose was an important one – at least to its majority shareholder, the Ackerman family, who held over 50% of the shares in PIK and therefore continued to control its destiny with a minority stake in the operating company of 26% (51% of 52% = 26% roughly). These arrangements, sometimes unkindly described as pyramid schemes, enabled founding families of successful listed enterprises in SA (and elsewhere) to attract capital from sources outside the family, without giving up a proportionate degree of voting rights. Family control would be loosened should more than 50% of the listed operating company be publicly owned. But this constraint could be overcome by selling up to 50% to outsiders in a listed holding company with at least a 50% controlling stake in the operating company.

This process of divesting ownership rights without surrendering proportionate control was taken to an entirely legitimate extreme by the Rupert and Herzog families who controlled Remgro. Their concern to maintain control of the operating companies of the large Rembrandt Group led to the formation of four JSE listed holding companies. Top of the listed pyramid was Technical and Industrial Investments Limited with a 60.4% stake in also listed Technical Investment Corporation Limited that held 40.56% of listed Rembrandt Controlling Investments that owned 51. 07% of the listed operating company Rembrandt Group Limited that generated all the earnings and dividends.

Just in case you thought that this did not add up to 50% ownership, the top of the listed pyramid Technical and Industrial Investments Ltd held a further 9.6% of Rembrandt Controlling Investments Ltd. In this way, by inviting outsiders to share ownership in a tier of holding companies, the founding families continued to appoint and control the managers of businesses within the large Rembrandt Group with an ownership stake in it of about 5%. It was not democracy but it was a case of capitalist acts between consenting adults.

Clearly all of the other shareholders in Rembrandt and its holding companies, as those in PIK and PWK, understood fully that by buying shares in the operating or holding companies they would be sharing in the fortunes of the operating company without ever being able to force their collective will on the controlling shareholders. That they were willing to do so was to the great credit of the founding and controlling shareholders. They were trusted by those providing a large majority of the risk capital employed to act in the interest of all shareholders in wealth creation. That the family interests in the operating assets were proportionately small but represented a large proportion of the wealth of the controlling families would be a source of comfort to effectively minority shareholders, in votes if not in claims on dividends or assets.

There are of course simpler ways of separating ownership and control than layers of holding companies. Shares in the operating company with differential voting rights can serve the same function more simply and much less expensively. But these arrangements were until recently effectively prohibited by the listing requirements of the JSE, with the exception of a few grandfathered arrangements such as applied to Naspers with its great majority of non-voting shares. With a change in listing requirements and in SA company law, Rembrandt was able to collapse its pyramids while maintaining control with unlisted B shares and Pick and Pay has broadly, with the enthusiastic approval of its shareholders, followed this example. Family control of PIK is being controlled with family ownership B shares with effectively over 50% of the voting rights in PIK.

The shareholders in PWK who are to receive PIK shares in exchange had every reason to welcome the new arrangements. They, on the announcement of the intention to proceed with the collapsing of PWK and the unbundling of its 52.69% holding of shares in PIK to its shareholders, saw the value of a PWK share increase by over 12% on the day of the announcement.

Shares in PWK, the holding company, had until then always traded at a variable discount to the value of the shares of PWK held in PIK. Or, in other words, the market value of PWK was always less than the market value of the shares it held in PIK. In 1999 this discount was as much as 30%. On 13 June 2016, before the unbundling announcement, the discount was 18.8%. By the close of trade on 14 June it had fallen to 3% after the PWK share price had gained 12.6% on the day while PIK shares lost 2% (see below).

The reasons for this persistent discount, or more particularly why it varied so much over the years, is not immediately obvious. After all PWK was but a clone of PIK. A discount could be justified by the fact that the holding company incurred listing and other expenses as well as perhaps additional STC. Consequently we calculate that PWK shareholders received less by way of dividends than the 52.69% ownership stake in PIK would ordinarily imply. We calculate from the dividend flows paid by the two companies (share price*dividend yield) that PWK received dividends equivalent to roughly 48% of those paid by PIK (see below).
Consequently the dividend yield on a PWK share consistently exceeded that of a PIK share – a lower entry price making up for the lesser flow of dividends (see below).

 

The value of a PWK share in which control of PIK rested may have been boosted (it was not) by the chance that a takeover bid for control of PIK via PWK might have been offered and accepted. Control of PIK would change with a smaller 50% stake in PWK – a possibility that might have attracted a control premium to a PWK share. I recall Raymond Ackerman announcing that any such change in control premium paid for the controlling stake would be shared by all shareholders, presumably in PIK as well as PWK. If so, there would have been no value to be added holding the effectively high voting rights in PWK rather than in PIK. The premium or possible discount that might be paid for the high voting 26% of PIK held by the family controlling interests in the form of B shares, would presumably not now be subject to formal approval by the full body of shareholders.

For all the variable price discount and the higher dividend yield the total returns holding a PIK share rather than a PWK share were very similar over the years. Though until the unbundling shareholders in PIK reinvesting their dividends in additional PIK shares would have enjoyed marginally higher returns than those in PWK. Though as we show below this total return gap narrowed sharply on the unbundling. A R100 invested in PIK shares in 1990 with dividends reinvested would now be worth R3,463 while the same investment in PWK would have grown to R3,397. Excellent results for long term shareholders have been provided by the managers and controllers of PIK, especially when compared to the returns received from holding the much more diversified shares that make up the JSE All Share Index.

 

The outcomes for PIK and PWK shareholders have not been as favourable since 2010, as we show below. With recent share price gains, PIK and PWK returns have matched those of the JSE All Share Index but fallen below those provided by Shoprite (SHP) a strong competitor and by the General Retail Index which does not include PIK and SHP. This helps make an important point. For any business to succeed over the long run, it demands that the constant threat and challenges from competition that emerges in ever changing forms be successfully withstood. This makes the owners of any business, however well established, at significant risk of underperforming or even failure. Owners sacrificing potential returns for less risk may have appeal at any stage of the development of a business.

Judged by these outstanding returns with hindsight, it could be concluded that the Ackerman family interests might have been better served by keeping the company private and not inviting outsiders to share in the company’s significant successes over the years.

Hindsight however is not an appropriate vantage point to make investment decisions. Start-ups, as Pick n Pay once was, are always highly risky affairs. Most start-ups will not succeed in the sense that the returns realised for their owner-managers exceed those they could have realised, taking much less risk working for somebody else.

But when a start-up is a proven success, the incentive for the successful owner-manager to reduce the risks to their wealth so concentrated, by effectively investing less in the original enterprise and diversifying their wealth, becomes an ever stronger one. Risks can be reduced by withdrawing cash from the original business through selling a stake in the business or equivalently by withdrawing cash more gradually from the business in dividends, cash that is then invested presumably in a more cautious, more diversified way. The Ackerman family appears to have followed this route.

An alternative approach is that taken by the Rupert and Herzog families and that is to use the successful business that is the original foundation of their wealth to fund a programme that diversifies their business risks – by investing in a variety of listed and unlisted enterprises that remain under firm family control. And to invite outside shareholders to share in the risks and rewards the family is taking with its own wealth.

Both approaches to building and diversifying wealth can clearly succeed despite (or is it because?) of the concentration of control and the differential shareholding voting rights, this may call for. It is a wise financial system that does not stand in the way of such potentially highly value adding arrangements shareholders might make with each other – that shareholders be allowed to trade off any possibility of a hostile takeover for the benefits of sharing in the rewards of great family controlled enterprises, as the Pick n Pay shareholders have just agreed to.

The end of higher interest rates is in sight – a different monetary policy narrative is still called for

The end of the current cycle of rising short term interest rates in SA that began in January 2014 is thankfully in sight.

Given the continued weakness of demand for goods and services, it will take the assumption of a more or less stable rand about current rates of exchange rates to bring inflation and forecasts of inflation in 2017 well below the upper 6% band of the inflation targets. The Reserve Bank model of inflation has reduced its estimate of headline inflation in December 2016 to 7.1%, from its May forecast of 7.3%.

The Bank, which was predicting a gradual decline in headline inflation in 2017, has maintained its central estimate of inflation in December 2017 at 5.5%. It has revised lower its already weak GDP growth forecasts. It is forecasting no growth in 2016 (previously 0.6% p.a) and an anemic 1.1% p.a. GDP growth in 2017 compared to 1.3% p.a estimated previously. Our own exercise in simulating the Reserve Bank forecasting model, using current exchange rates, has generated the following forecasts for headline inflation (see below). The Governor indicated that the Bank’s own forecasts were made with unchanged assumptions about the exchange rate, hence the slightly higher estimates of inflation.

 

combination of very slow growth with less inflation vitiates any possible argument for higher interest rates for now and hopefully for an extended period of time to come.

Should inflation sustain a downward trend and growth in SA remain well below potential growth, the case for cutting rates to stimulate growth will become irresistible in due course. Food prices off their high levels brought by the drought have already stopped rising (according to the June CPI) and so will help materially to reduce the rate at which prices in general rise next year. The chances have improved for a very helpful inflation and interest rate surprise in the downward direction.

These developments in the currency and capital markets beg a question difficult to answer, given the impossibility of re-winding the economic clock. Did the interest rate increases imposed on a fragile economy do anything at all to hold back inflation?

Given the global forces that have driven the exchange value of the rand and all emerging market currencies weaker, it is not at all obvious that higher interest rates have made the rand more attractive to hold or acquire. Nor will interest increases have done anything at all to have offset the impact of the Zuma intervention in fiscal affairs that made the rand such an underperforming emerging currency and bond market until recently. Indeed, by further slowing down growth, higher interest rates may have discouraged investment in SA and weakened rather than strengthened the rand, while clearly discouraging the credit rating agencies and investors in the RSA bond market, leading to higher long term interest rates.

Recent trends in the rand and other emerging market (EM) currencies are shown below. We show how the rand has made some gains against other EM currencies recently. We also show that after significant weakness in 2015, the rand in 2016 has now gained against the Aussie dollar and gained even further against sterling. The impact of the Zuma intervention in December 2015 and Brexit on the rand is indicated.

 

What must be conceded is the role of Reserve Bank rhetoric about interest rates – explained as being bound to rise given more inflation and inflation expected. So any reluctance to act on interest rates would have had the Bank accused of being soft on inflation – so undermining its independent inflation-fighting credentials. An essential distinction that needs to be made by the Bank is about the different forces that can drive prices higher. The difference between prices that rise because less is being supplied to the economy, and prices that increase in response to higher levels of demand that run ahead of potential supplies, call for very different monetary policy reactions. It is a vital distinction about inflation that the Reserve Bank very self-consciously has refused to acknowledge.

Inflation in SA has accelerated in recent years mostly because of the supply side shocks to supplies of goods and services and the higher prices that have followed. Exchange rate shocks have caused prices to rise independently of the state of domestic demand, as has the drought that reduced the local supply of essential foodstuffs. These inevitably higher prices have further discouraged demand. Adding higher interest rates to the mixture then depresses demand even further, without seemingly doing much at all to restrain the upward march of the CPI.

What the SA economy deserved and didn’t get from the Reserve Bank was a very different narrative, one that can explain why interest rates do not have to rise irrespective of the forces driving prices higher. That excess demand justifies higher interest rates; reduced supplies do not. And therefore why sacrificing growth, for no less inflation realised, is not good monetary policy. 22 July 2016

The markets after Brexit

Brexit is now seemingly a non-event for the global economy and its financial markets. A move to less quality in financial markets may be under way.

Brexit came as a large shock to the markets – but within two days of extra anxiety and an equity sell off – the Brexit effect came to be almost immediately reversed. Stock markets are now well ahead of where they ended on 24 June and are ahead of levels reached on 30 May. The benchmark MSCI Emerging Market Index on 14 July was 7.5% up on its 30 May level, fully accompanied by the JSE All Share that had lost over 12% per cent of its 30 May value (in US dollars) in the immediate aftermath of Brexit. The key S&P 500 Index has also recovered strongly. A feature of the equity markets in 2016 has been how unusually closely the developed and emerging stock market indexes have been correlated with each other when measured in US dollars (see figure 1 below).

 

The VIX Index that measures share price volatility on the S&P 500, simultaneously and consistently moved strongly in the opposite direction, while volatility on the JSE measured by the SAVI has remained elevated, consistent with the sideways move in the JSE when measured in rands rather than in US dollars. The volatility of the stronger USD/ZAR exchange rate has remained elevated as has, to a smaller degree, the realised volatility of the USD/EUR (see figures 2 and 3 below).
With renewed strength in emerging market equity and (especially) bond markets, emerging market currencies have shown strength against the US dollar, as we show below. We also show that the rand has performed better than the average emerging market currency, represented as an unweighted average of nine other emerging market currencies, excluding the rand and the Chinese yuan, as well as the Korean won and the Singapore dollar that enjoy a somewhat different status to the representative emerging market. The rand has gained about 10% against the US dollar and about 6% against the emerging market average since 30 May, as may be seen in figure 4.

 

A more risk-tolerant market place in the aftermath of Brexit has not only been helpful to emerging markets generally, but it has proved particularly helpful to the rand and the market in RSA bonds. As shown below, default risk spreads have receded for emerging market bonds, including RSA US dollar-denominated bonds. Judged by the spread between RSA yields and those of the high risk EM Bond Index, SA’s relative credit rating has improved recently as shown in figure 6.

 

A further important spread, that between RSA 10 year rand yields and US Treasury 10 year bond yields, has also narrowed as long term interest rates in developed markets and in emerging markets receded in the wake of Brexit. This spread represents the rate at which the rand is expected to weaken against the US dollar over the next 10 years (see figure 7 below).

The fact that most government long term bond yields declined further and immediately in the wake of Brexit – including gilt yields in the UK – indicated that Brexit was not regarded as a financial crisis, but rather as an indicator of slower global growth and less inflation to come. This conclusion was also evident in the decline in inflation-linked bond yields to very low levels.

This decline in the cost of funding government expenditure (especially in the form of negative costs of borrowing for up to 10 years for some governments) can be expected to encourage governments (not only the UK government) to borrow more to spend more and to attempt to reverse the austerity forced on them by the Global Financial Crisis of 2008 and the subsequent Euro bond crises, that were such a particularly expensive burden for European taxpayers. That burden of having to meet ever larger interest rate commitments has become something of a bonanza for European governments, faced as they are with a fractious electorate.

The sense that less austerity is now more firmly in prospect may have led investors to price in less risk when valuing equities. We have argued that a high equity risk premium is reflected in the value of the S&P 500 Index when valuation models that discount S&P earnings and especially dividends with prevailing very low interest rates. Still lower discount rates after Brexit may help explain the higher equity values. A search for yield in emerging bond markets, driving emerging market discount rates lower, may explain why more risky emerging market equities have also added value.

The very recent economic news moreover has been surprisingly good, rather than disappointing. The trends in the US economy have been particularly encouraging. The Citibank Economic Surprise Index for the US has moved significantly higher with the stronger S&P (revealing more data releases ahead of rather than behind consensus forecasts) (See figure 8 below).

The very recent news from China is that stimulus there has been working to stabilise GDP growth rates. Such more positive indicators of global growth will also have helped to modify what was already a high degree of global risk aversion before the UK referendum. Commodity prices, of particular importance for emerging economies and emerging equity markets, have recovered from depressed levels in January and have stabilised recently after Brexit (see figure 9 below).
This strength in emerging markets may be regarded as something of a reversal of the move to quality in equity markets that has so dominated equity market trends in recent years. A marked preference has been exercised for shares with bond-like qualities, revealed in the form of predictably defensive earnings flows, accompanied by relatively low share price volatility. These are qualities more easily found in developed markets but capable of adding to well above average price earnings multiples to favoured companies in emerging markets, including on the JSE. The JSE, by market value, has come to be dominated by relatively few companies with a global rather than a SA economy footprint. And the price-to-earnings ratios of these companies has risen markedly, dragging up the multiples for the JSE as a whole. We have described this class of shares that are well hedged against the rand and SA economy risks, as Global Consumer Plays.Chris Holdsworth in his Q3 Strategy Review for Investec Securities, published on 13 July has identified these trends – a preference for quality in response to lower interest rates that have left the average share price to earnings ratios well behind the elevated few (see figures from Investec Securities below).

Any further move away from quality will be very welcome to emerging market currencies, bonds and equities. It would be very helpful to the exchange value of the rand and the outlook for inflation and interest rates. It would be especially helpful to the SA economy plays that have so lagged the high quality Global Consumer Plays in recent years. Rand strength for global as well as SA-specific reasons could reverse such relative performance. Less quality may come to offer better value should global risk tolerance, even though justifiably elevated, continue to improve as it has done since Brexit.

Making sense of S&P 500 valuations – a dividend perspective

Is the best measure of past performance on the S&P 500 Index earnings or dividends per share? It can make a big difference

Our recent report on S&P 500 earnings per share indicated that, adjusted for very low interest rates, the S&P 500 Index at June month end could not be regarded as optimistically valued, even though earnings had been falling and the ratio of the Index level to trailing earnings was well above average. Since then, the Index has marched on to record levels (helped by still lower long-term interest rates) to support this proposition of a market that was not very optimistic about forward earnings.

The case for regarding the key US equity market as risk averse rather than risk tolerant would be enhanced, should S&P 500 dividends rather than S&P 500 earnings be regarded as a superior measure of how companies have performed for their shareholders in recent years. As we show below, S&P 500 dividends per share have continued to increase even as earnings per share have declined, while the growth in dividends declared has remained strongly positive even as the growth rate has declined (figures 1 and 2 below).

Clearly the average listed US large cap company has been paying out relatively more of the cash it has generated (and borrowed) in dividends – rather than adding to its plant and equipment. The pay-out ratio (that of earnings to dividends) has declined from the over three level in 2011 to less than two times earnings recently (see figure 3). This, presumably, is more of a problem for the economy than for shareholders, especially when interest income has come under such pressure.

When we run a regression model to explain the level of the S&P 500 Index using dividends discounted by long term interest rates, the Index appears as distinctly undervalued for reported dividends on 30 June 2016. This is more undervalued (some 30% undervalued) than in a model using Index earnings as the measure of corporate performance – as demonstrated in our report of Monday 11 July (see figure 4 below).

On the basis of the dividend model, the market has been pricing in a high degree of risk aversion. Or, equivalently, it has been demanding a large equity risk premium to compensate for the perceived risks to earnings and dividend flows (the larger the equity risk premium, the lower must be share prices – other things held the same, that is trailing earnings or dividends and interest rates – to compensate investors for the perceived risks to the market).

The equity risk premium can be defined directly as the difference between the earnings or dividend yield on the Index and long-term interest rates. The larger these differences in yields, the larger the equity risk premium and the lower share prices will be. An undervalued market, as indicated by the negative residual of the dividend model as shown above, where the predicted (fitted) by the model value of the Index is far above the prevailing level of the market, indicates a large equity risk premium. In figure 5 below, we compare the residual of the earnings and dividend models with this equity risk premium. As may be seen, they describe the same facts: a large equity risk premium accompanied by an undervalued market and vice versa.

These equity risk premiums or under-/overvalued markets – relative to past performance, adjusted with prevailing interest rates – may prove justified or unjustified by subsequent performance, reflected by future earnings and dividends declared. Disappointing or surprisingly good earnings and dividends may flow from listed companies. It would appear that despite the record level of the S&P 500 and record levels of dividends, shareholders are currently very cautious rather than optimistic about earnings and dividend prospects.

Their expectations of dividends and earnings to come have become somewhat easier to meet. There is perhaps more safety in the market at current levels than is generally recognised.

Brexit so far – not so bad for the global economy

Having spent the first post Brexit week in London it is hard to exaggerate the disappointment, even foreboding, felt by our colleagues in the London office of Investec. A leap into a world where the known unknowns have multiplied exceedingly is naturally unwelcome to those whose vocation it is to manage risks to wealth in an as well-considered way as possible. Clearly risks to the outcomes in the real economy and the financial markets – particularly in the UK – have become greater than they were and volatility in markets is likely to be exaggerated until a clearer view of what the future may hold for Britain, Europe and the Global economy, of which the share of Britain and Europe is above 20%.

The most obvious unknown is the impact on the UK economy – though the description United Kingdom may well be an exaggeration – with the sharp regional and generational divides of the referendum revealed. The political unknowns seem unlikely to be resolved any time soon as the UK is understandably in no hurry to formally invoke the exit option. An accompanying unknown is who will lead the UK through these negotiations, the outcomes of which, to be decided in Westminster by the legislators not the voters, will surely lead to further appeals to voters by way of a general election or even a further referendum. However, under new rules the next general election will only be called in 2020 – unless a large majority of the MP’s determine otherwise. The Conservative government and no doubt the parliamentary Labour Party, in turmoil over its leader, are clearly not of any mind to go to the country any time soon.

The obvious issue for any updated economic forecast of the UK economy is the degree to which the prevailing uncertainties and the risks associated with them will undermine the confidence business and household decision makers have in their economic prospects. Less confidence will mean less spending, as investment and consumption plans are put on hold and as plan Bs are evolved. It will not take much of a deviation from trend to turn positive GDP growth into stagnation, or worse, recession. But neither the Bank of England under Governor Mark Carney nor the Treasury under George Osborne have waited for the dust to settle. They have reacted with promises of counter measures: lower interest rates and less onerous applications of the requirements of banks to reserve capital, at the expense of lending. But as Carney cautioned correctly – “there are limits to what the Bank of England can do” – if people are determined to tighten their belts in a more uncertain environment. Confidence in the future outlook for revenues and employment benefits is the all-important and fragile foundation of all forward looking economic actions. Decisions made today that are taken not only by firms, but more importantly by households, that account for 70% of all spending in the UK.

Though to be sure it is the revenue to be gained or lost from supplying financial services to Europe and the world (a particular strength of the UK economy) – despite, or is it because of, sterling rather than the euro – that is uppermost in the considerations of the City of London. A square mile that is currently in the throes of a most impressive building boom. It is very hard to count the cranes from my bedroom window overlooking much of the City.

George Osborne, the Chancellor of the Exchequer, was doing his best over the weekend to bolster confidence and enhance spending. The intention to balance the government’s budget by 2020 has been abandoned. Less rather than more austerity is in prospect – understandably so – given the encouragement provided by extraordinarily low borrowing costs. In the midst of a financial crisis the yield on 10 year Gilts dropped well below 1%. Gilts, like almost all other government bonds – including those issued by RSA – were regarded as safer, except by the rating agencies. It becomes much less of a crisis when government debt becomes still cheaper to issue rather, than as is more usually the case in a crisis, when government loans become ever more expensive to raise and austerity in a recession becomes impossible to resist.

Osborne moreover promised more than more government spending. He made the case for a sharply lower corporate tax rate of 15% – close to the 12.5% rate in Ireland – a matter of already deep anguish to Brussels who would much prefer less rather than more fiscal competition in Europe. The UK, with all its other advantages in the form of good commercial law and as a tax haven, could become an even more powerful competitor for corporate head offices.

Escaping the clutches of the Brussels bureaucrats may offer Britain many such opportunities to trade more freely with each other and with the rest of the world, while hopefully negotiating full access to trade with the European community, not only with mutually beneficial low tariffs but – more important – to reduce non-tariff barriers to trade. This is particularly the case in services that have made the European community much less of a free trading zone than it appears to be on the surface.

Clearly the biggest threat to growth to incomes and profits of companies in the UK and everywhere, including in the US, is the rising populist threat to freer trade and globalisation generally that is considered to have left important constituencies behind. The leave vote was surely a protest vote as much as a vote for independence (independence to control the flow of immigrants to the UK, who in fact have proved generally to be a source of faster growth) as well as a response to the income earning opportunities that a fast growing UK economy has provided.

For a South African analyst in London with long experience analysing volatile exchange rates, the one most obvious conclusion to draw is how helpful weaker sterling has been to absorb some of the shocks caused by UK-specific uncertainties. Sterling devalued by about 10% on the Brexit news. The sterling value of the FTSE Index has largely held its own. Shares, particularly those of the global companies very well represented on the FTSE Index, have seen a weaker sterling translate into higher sterling values, particularly when their US dollar values improved with the strong recovery registered in New York last week.

Equities can perform as currency hedges when the currency weakness represents additional country specific rather than global risks. The sterling or rather the UK economy hedges on the FTSE came, as they do on the JSE, from global rather than local economy plays.

On this exchange rate note it is encouraging to note how well the rand, in company with most other emerging currencies and bonds, held up through the Brexit crisis (see below). Some stability in commodity and energy prices were consistent with these developments. The news about the global economy since Brexit has not reflected a state of crisis for the global economy, to which emerging markets are especially vulnerable. So far not so bad.

 

Why companies are saving more and investing less

The global economy is suffering from an unusual problem of too little demand rather than the usual problem of scarcity, ie too little produced and so too little earned. Hence the relative abundance of the global supply of savings over the demand to utilise them, so causing some interest rates in the developed world to become negative and prices to fall (deflation rather than inflation) and growth to slow.

Since much of the savings realised are made by companies in the form of retained earnings and cash (that is earnings augmented by depreciation and amortisation) the question then arises – why are companies saving as much as they are rather than using their cash and borrowing power to demand more plant and equipment that would add helpfully to both current spending and future production?

In the US, where an economic recovery from the recession of 2008-09 has been well under way for a number of years, fixed investment spending (excluding spending on new home and apartments), having recovered strongly, is now in decline and threatens slower GDP growth to come.

It is not coincidental that demand for additional capacity credit by US corporations remains subdued while balance sheets have strengthened. The debts of US non-financial corporations, compared to their market values are proportionately as low as they have been since the 1950s.

 

With the cash retained by non-financial corporations, the financial assets on their balance sheets have come to command a much higher share of their net worth. The share of financial assets of total assets has grown significantly, from the 30% ratios common before 1970 to the well over 55% today, a ratio reached in the early 2000s and sustained since then and now seemingly increasing further.

 

 

The ability of US corporations to save more and build balance sheet strength has been greatly assisted by improved profit margins – now well above rates of profit realised in the fifties. As may be seen these profit margins peaked in 2011 at about a 12 % rate and are now running a little lower, with profit margins running at a still impressive 10% of valued added by non-financial corporations.

The lack of competition from additional capacity has surely helped maintain these profit margins, as well as cash flows and corporate savings. But it does not explain why the typical US corporation has not invested more in real assets nor why they have preferred to return relatively more cash to shareholders in dividends and share buy backs. Even so called growth companies, with ambitious plans to roll out more stores or distribution capacity, seem able and willing to fund their growth and yet also pay back more. They paying back to institutional shareholders (in the form of dividends and buy backs) who themselves are holding record proportions of highly liquid assets in their portfolios.

There is incidentally, no lack of competition between US businesses. Competition is as intense and disruptive as it has ever been. The competition to know your customer better and so be more relevant than the competition in the offerings you can make to them is the essential task facing business managers. And so part of the answer to the reluctance to add to capacity is the fact that capital equipment (hardware supported by software) is so much more productive than before. A dollar of capital equipment utilised today does so much more than it used to – meaning less of it is needed to meet current demands of customers.

It must take higher levels of demand from households and perhaps also governments to stimulate more capital expenditure and less cash retention by the modern business corporation. Capital expenditure typically follows growth in demands by households. Households in the US account for over 70% of all spending. In SA, households’ share of the economy is also all important, at over 60% of spending. It is the growth in household spending that puts pressure on the capacity of firms to satisfy demands and to improve revenues and profit margins doing so. It is the weakness of household spending in the US and even more so in SA that explains much of the reluctance to build physical capacity.

Why are households in the US and SA not spending and borrowing more in ways that would encourage more capex by firms? In SA’s case the answer is perhaps more obvious. Household spending has been strongly discouraged by rising interest rates. Until interest rates reverse direction in SA, it is hard to anticipate a cyclical recovery reinforced by capex.

In the US and SA, what will be essential to faster growth will be the confidence of households in their future income prospects. It is this confidence, much more than changes in interest rates, that is essential to the purpose of economic growth. The role of politics in building or undermining confidence in the future prospects of an economy is all important. Perhaps it is the failure of the politicians (and perhaps also central banks) to build confidence in both households and the firms in their prospects, is the essential reason why spending remains as subdued as it is.

How (not) to value a CEO

Alec Hogg in his Daily Insider column of 6 June had the following harsh words for Sasol’s David Constable:

“In the 2015 annual report, Sasol chairman Dr Mandla Gantsho admitted trying to extend CEO David Constable’s five year contract which expires this month. Shareholders should be grateful he wasn’t more persuasive. Together with another Canadian, Anglo’s Cynthia Carroll, Constable ranks as the worst ever CEO appointed by a major South African company.
“Soon after arriving in July 2011, the Canadian aborted Sasol’s long and costly flirtation with China, switching attention into his native North America. In Monday’s trading statement, the company said it will write down billions more on its Montney Shale Gas field, taking the loss on the Canadian investment to a staggering R11.5bn. Worse, the cost of its 40% complete Louisiana chemicals cracker has escalated to $11bn from the $8.9bn shareholders had been told.
“If more salt were needed for those wounds, it is sure to come in the remuneration section of Sasol’s 2016 annual report. Given the way these things are structured, Constable’s R50m a year package is likely to have ratcheted up still further in his final 12 months.”

But is this the right way to measure the value added or lost by shareholders over the tenure of a CEO, by reference to the losses written off or the overruns added in the books of the companies they own a share of?  What matters to shareholders is what happens in their own books; that is in the value of the shares they own. And share prices attempt as best they can to discount the future performance of a company – rather than its past – as written up by the accountants. Shareholders in Sasol will rather be inclined to compare the performance of their shares under Constable’s surveillance with that of others they may have owned. In this regard they may be grateful that Sasol, since 2012, did significantly better than other Resource stocks, but regret that Sasol did significantly worse than the JSE All Share Index.

Shareholders would have been much better off staying away from Resource companies and investing in Industrial and Financial shares, especially after mid-2014. Even the best managed resource and oil companies would not have been able to avoid the damage caused by lower commodity and oil prices – forces over which CEOs cannot be easily held accountable for. In the figure below we show the relationship between the Sasol share price and the price of oil in US dollars. This relationship become much stronger when the US dollar value of a Sasol share is compared to the US dollar price of oil. Quite clearly, the US dollar value of a Sasol share is almost completely always explained by the oil price. This is a force over which the CEO has no influence whatsoever. Incidentally, the relationship between the oil price in rands and the Sasol share price, also measured in rands, is a statistically very weak relationship. It is the dollar price of oil that matters for the Sasol share price – not the rand price – even if much of Sasol’s revenues are derived from selling oil in rands at a dollar equivalent price.

 

In the figure below we show the results of a statistical exercise where we compare the Sasol share price in US dollars with the share price that would have been predicted using the US dollar price of a barrel of oil as the only explanation, over the period when David Constable was CEO. As may be seen, it was only in 2013-2014, ahead of the subsequent collapse in the oil price, when something other than the spot oil price is seen to significantly influence the US dollar value of a Sasol share. Perhaps the Sasol share price then was reflecting unrequited optimism in still higher oil prices. And when this did not materialise, the usual relationship between the price of oil and the price of Sasol was resumed.

 

On these considerations it is hard to establish what difference a well paid or indeed even an underpaid CEO can be expected to make to the value of a Sasol given the predominant influence of the price of oil on the share price. Perhaps the major task of a CEO so captured by forces beyond its control is to avoid poorly executed projects designed to increase or even simply maintain the production of Sasol’s oil, gas and chemical output. The selection of good projects and good project management is the essential task of a company like Sasol. Perhaps Sasol, under Constable, can be fairly criticised on such grounds, as Alec Hogg has done.

Time, as always, will tell how well intentioned, designed and executed the Sasol Louisiana cracker project has been. But in the meanwhile, shareholders in Sasol can perhaps exercise a legitimate grievance about the recent performance of the company. Its share price in US dollars has performed significantly worse than that of the two oil majors, Exxon-Mobil and Chevron, that are as highly dependent on the price of oil as is Sasol. Perhaps such measures of relative stock market performance should feature in any discussion of the appropriate remuneration of a CEO.

 

*The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment

Now to turn a reprieve into a recovery

The markets have reacted favourably to the S&P rating decision – is there more favour to be shown?

The markets have reacted favourably to the Standard & Poor’s (S&P) decision to leave SA’s credit rating broadly unchanged that was announced after the SA markets had closed on Friday, 3 June. Clearly the danger of a formal derating of RSA debt was reflected in market yields before the S&P announcement. As we show in figure 1, RSA bond yields and risk spreads have narrowed. The current spread of about 285bp provided by a RSA five year bond over a US Treasury of the same duration now indicates a near investment grade status in the market place. The spread is shown below where it is compared to Credit Default Swaps (CDS) on high yield emerging market (EM) bonds and also on Mexican bonds of the same duration. These spreads represent the cost of insuring the debt against default.

In figure 2, we show how RSA debt has enjoyed something of a re-rating in recent days when compared, as it should be, to other EM debt yields. The yield gap between EM and RSA debt has widened, indicating an improved status for SA, while the extra yield provided by RSA debt compared to Mexican debt has also declined from about 140bp. A longer view of these relationships is also shown in figure 3, which shows that RSA debt has suffered a de-rating in the market place since early 2015, a de-rating magnified by the Zuma intervention in the Ministry of Finance in December 2015. While RSA yields have declined in a relative sense over recent days, SA’s credit rating in the market has not regained the status it enjoyed prior to the Zuma intervention.

A similar pattern of improved sentiment has been revealed in the foreign exchange markets. The rand has gained value vs the US dollar recently, not only in an absolute sense, but also relative to other EM currencies that might be expected to be influenced by moves in the US dollar vs all currencies. In figure 4, we compare the USD/ZAR rate of exchange to that of an equally weighted basket of nine other EM currencies (Turkey, Russia, Hungary, Brazil, Mexico, Chile, Philippines, India and Malaysia). As Figure 4 shows, the rand and the average EM currencies have gained against the US dollar recently. However the ratio of the rand to the EM currencies (April 2012=1) has improved from 1.32 in late May to about 1.28 on 6 June, an improvement of about 3%. A longer term view of these relationships is shown in figure 5, where it may be seen that the rand, compared to other EM currencies, is still slightly weaker than it was before the Zuma actions in December.

In figure 6, we show the RSA 10 year bond yields since early 2015. We also show the difference between RSA yields in rands with US Treasury bond yields in US dollars. This risk spread may be regarded as the average rate at which the rand is expected to depreciate against the US dollar over the next 10 years. The higher yields compensate investors for the expected exchange rate losses. This risk spread has declined in recent days but remains well above the spreads offered prior to the Zuma shock to the bond and other markets.

The SA Treasury has been able to convince the rating agencies of its commitment to fiscal conservatism. The Treasury will need to be allowed to get on with the task without interference from the Presidency. The bond and currency markets, given but only a partial recovery, would still appear to regard such interference as a possibility. What the Treasury also needs, as much as it needs the authority to manage SA’s fiscal affairs, is a cyclical recovery and faster growth. Such a recovery would be greatly assisted by further strength in the rand and lower bond yields. US dollar weakness would further help promote such trends, as they have done recently. If such favourable trends were to materialise, the Reserve Bank would surely have to reverse its own damaging interest rate course. A loosening rather than a tightening interest rate cycle is urgently called for. Lower interest rates and lower interest rates expected will make a cyclical recovery all the more likely. SA has enjoyed something of an unexpected reprieve from the rating agencies. A strong follow up in the form of lower interest rates across the yield curve can turn a reprieve into a recovery.

Musings on May

May was a poor month for the rand. It lost about 10% of its US dollar value by month end. But perhaps of more importance, it also lost about 6% of its value against an average of nine other emerging market currencies (Turkey, Russia, Hungary, Brazil, Mexico, Chile, Philippines, Malaysia, India).

 

Clearly there were specifically South African as well as global forces driving the rand weaker. Uncertainty about the direction of fiscal policy in SA and the role of President Jacob Zuma in introducing such uncertainty has not dissipated and, moreover, seems to have re-entered the markets in an attenuated form during May. Global forces, well represented by other emerging market currencies, are a consistent influence on the exchange value of the rand. But SA specific risks can also influence the rand – that can be identified when the rand behaves to a degree independently as it did again in May. The Zuma effect on the rand is easily identified by its behaviour of after 9 December 2015 when the President replaced the Minister of Finance, Nhlanhla Nene. As may be seen, the rand not only weakened but weakened relatively to other emerging market (EM) currencies, as identified by the ratio of the USD/ZAR to the average US dollar value of the other EM currencies. As may be seen in figure 2 below, this ratio, with higher numbers indicating rand weakness, increased in December 2015 and has remained elevated at these higher ratios since then. The rand did enjoy some absolute strength from late January 2016 and some relative strength in April 2016, which was reversed in May. Figure 3, which shows the developments in the currency market in 2016, makes this very clear.

When we run a regression model explaining the value of the rand using the EM average exchange rate and the EM default risk premium as explanations, we get the results shown below – using daily data from January 2013. As may be seen in figure 4, the Zuma intervention added about two rands to the cost of a US dollar. It may be seen that while the rand has strengthened since, this extra rand weakness has remained of the order of between one and two rands per dollar. The predicted value for the USD/ZAR on 31 May was R14.20 compared to its market value of about R15.70.

 

Après the debt crisis, le deluge?

Greek debt was back in the news last week. The news that Eurozone finance ministers had overcome an impasse with the IMF and will disburse €10.3bn to enable Greece to meet its immediate commitments to the IMF and the European Central Bank (ECB) of about €4bn. This still leaves Greece with close to €300bn of debt to be repaid over the next 30 years. A surely impossible task of fiscal adjustment – despite debt relief to date that has amounted to close to €200bn. One can only wonder all over again how Greece managed to run up such debt and why it has so little in the form of productive infrastructure and additional human capital to show for it.

The graphic below, from the Wall Street Journal, reveals Greece’s obligations over the next 40 years:

But this particular odyssey has moved on beyond the Aegean Seas.The Euro debt crisis seems to have faded into the background. Eurobond yields for the most vulnerable of the Euro borrowers are now well below pre-crisis levels, as we show below.

The relief for the bond markets came partly in the form of some modest fiscal austerity but largely, and more importantly, came from the ECB doing “whatever it took” to rescue the bond market with its quantitative easing programme – buying bonds in the market place in exchange for deposits placed by banks with their central banks. It was following the example of the US Fed, the Bank of Japan and the Bank of England in providing extraordinary supplies of central bank money to their banking systems via purchases of government and other debt instruments in the debt markets.As a result, central banks have become major sources of demand for government bonds and as such, have not only relieved the banks of any lack of liquidity but have also, through their actions in the bond markets, have directly led interest rates lower. We rely on the Bank of International Settlements (BIS) for the operational details and balance sheet outcomes shown below.

These central banks are all government agencies and so their assets and liabilities should be consolidated with those of their respective government treasuries. In effect, the net debt of the government (net of central bank holdings) has been to an ever greater degree funded with deposits (cash reserves) issued by their central banks. In the case of the ECB and the BOJ, but not the US Fed, these deposits are penalised with a negative rate of interest. In other words, with cash that is an interest bearing liability of the government. So far, most of the extra cash issued by central banks has been held by the banks rather than used to supply bank credit. Hence aggregate spending by households and firms has remained highly subdued.Deflation rather than inflation has become the feature of the developed world, despite the unprecedented increase in the supply of central bank money. Deflation and, more important, the expectation that inflation will remain highly subdued for the next 30 years at least, has meant persistently low interest rates. In parts of the developed world like Japan and Switzerland, nominal interest rates offered by governments for 10 year loans have turned negative. In other words, lenders are now paying governments to take their savings for an extended period, rather than receiving interest income from them. Another way of explaining such circumstances is that issuing long-dated debt at negative interest rates is even more helpful to governments and their taxpayers than issuing zero interest bearing notes or deposits at the central bank, unless bank deposits held at the central bank also attract a negative interest rate (as they may well do).

Accordingly while government debt has grown – though much less so for debt held outside central banks – interest rates have receded and government’s debt service costs have declined rather than increased. The debt burden for taxpayers has become less rather than more oppressive. Moreover, the global economy continues to operate well below what may be regarded as its growth potential. These conditions make for an obvious political response. They make the case for more government spending, funded by issuing very cheap debt rather than higher tax rates or tax revenues. A call, that is, for government stimulus rather than austerity now that the debt crisis has been dealt with.

The major central banks, other than the Fed, are still doing as much as they can to add to the money stock and to reduce interest rates across the yield curve. But the lack of demand for, as well as reluctance to supply, bank credit has meant persistently weak demand. The temptation for governments to popularly spend more and raise more debt would seem to be irresistible.

The Japanese government, with a gross debt to GDP ratio of as much as 400% (though with much of the debt held by the Bank of Japan and the Post Office Bank) is not resisting. It is postponing an intended increase in sales tax that had been mooted before to close the large fiscal deficit. Where Japan, with its negative costs of borrowing leads, other governments will be encouraged to follow. Will inflation be expected to remain as low as it now does?

Monetary policy: Thanks for the small relief

The Reserve Bank, thankfully and understandably, given the near recession state of the economy, decided not to raise its repo rate at its meeting last week. The Monetary Policy Committee (MPC) statement concluded that:

“The increase in the repo rate at the previous MPC meeting contributed to the improvement in the longer-term inflation forecast, and that move should be seen in conjunction with previous actions in the cycle and the lagged effects of monetary policy. The MPC felt that there is some room to pause in this tightening cycle and accordingly decided to keep the repurchase rate unchanged for now at 7,0 per cent per annum. Five members preferred no change, while one member preferred a 25 basis point increase.

“The MPC remains focused on its inflation mandate, but sensitive to the extent possible to the state of the economy. The MPC will not hesitate to act appropriately should the inflation dynamics require a response, within a flexible inflation targeting framework. Future moves, as before, will continue to be highly data dependent.”

The MPC, as indicated, continues to regard itself as in a tightening cycle. Why further likely interest rate increases will be helpful in reducing the inflation rate any more, than past increases have done, is much less obvious. As we show below, short-term interest rates in SA have risen by 2% since the first 50bp increase in the repo rate was imposed in January 2014. Inflation, having fallen in early 2015, has recently risen sharply above 6%. A very good proxy for expected inflation – inflation compensation in the bond market, being the difference between the yield on a vanilla RSA 10-year bond and its inflation-protected equivalent – also rose sharply in late 2015, as did the difference between RSA 10-year bond yields and US Treasuries of the same duration. This difference may be regarded as the average annual rate at which the rand is expected to depreciate against the US dollar over the next 10 years.

These unfortunate trends have occurred despite higher interest rates and despite a weaker economy, to which higher interest rates have undoubtedly contributed. According to the Reserve Bank forecasting model, every one percentage point increase in the repo rate reduces the GDP growth rates by 0.4% p.a. and the inflation rate by 0.3% over the subsequent 12 months. To put such predicted reactions in some perspective, this means that to reduce the inflation rate by one and a half percent from 6.5% (above the target range of 3% to 6%) to 5%, it would take a five percentage point increase in short term interest rates. Interest rate increases that would be predicted to reduce GDP growth rates by two percentage points, say from plus one to minus one. This is a high price to pay in foregone output and incomes it must be agreed for still high inflation.

The increases in short rates to date will have reduced already anemic GDP growth rates by close to one percentage point. But such outcomes presume that all other influences on the inflation rate and on GDP growth included in the forecasting model will have remained as predicted by the assumptions and feedback loops of the model – a very unlikely outcome indeed, as recent experience will have demonstrated.

The recent increase in the inflation rate owes a great deal to rising food prices- the delayed impact of the drought that so reduced the maize, wheat and other harvests. The much weaker rand and higher administered prices, especially electricity charges, would have added to the pressures on costs and prices. But the pass through effect of a weaker rand on imported inflation and so the CPI, was unusually muted in 2015 given lower oil and commodity prices. Weakness in emerging markets and emerging market (EM) currencies in response to weaker EM growth and less risk tolerance in global capital markets however meant a weaker rand that depreciated against a stronger USD, broadly in line with the other EM currencies. But the events that moved the rand and inflationary expectations higher and added materially to SA risk, and to a still weaker rand expected over the next 10 years, were very South African in origin. President Jacob Zuma’s intervention in SA’s financial affairs was unprecedented and unpredictable. It did much damage to the annual inflation and exchange rate outlook – adding about 2% p.a more to both – such that increases in interest rates, even very significant increases, would not have countered and cannot be expected to counter. Yet they would have damaged the real economy in the predicted way.

The outlook for inflation will continue to be dominated by forces well beyond the influence of Reserve Bank interest rates, making inflation forecasts an unreliable exercise. Politics, the weather and global forces, including degrees of risk aversion accompanying commodity price trends, will be as decisive as they have been to date. Raising interest rates in such circumstances can have only one fairly predictable outcome: to slow down the economy further so making a credit ratings downgrade more likely.

The only justification for ever raising interest rates aggressively in SA would be when aggregate demand is rising strongly enough to put upward pressure on prices. Such pressure on prices will however then be accompanied by strong growth, not the weak growth now experienced. If the economy were growing well, say at a 5% rate and inflation was rising at above target rates, say at 6.5% p.a, then raising interest rates by say 300bp over a 24 month period could make every sense. Inflation could then be expected to come down to below six per cent and growth could slow down to a still satisfactory 4% or so rate.

The distinction between demand side forces acting on inflation that would justify higher interest rates and supply side shocks that drive the inflation rate temporarily higher and simultaneously but reduce demand and growth rates, is an essential one to make. Supply side shocks on prices should be ignored by monetary policy: this is the conventional wisdom. It is a distinction between supply side and demand side-driven higher prices that the Reserve Bank refuses to make. It has cost the economy dearly, while inflation and inflation expected have accelerated for reasons that have had little to do with the Reserve Bank. As I have said before, monetary policy in SA needs a better narrative, one that will preserve the credibility of the Reserve Bank without it having to play King Canute.

Incidentally, if the most recent forecasts of the Reserve Bank for inflation (below target in 2018) and GDP growth (no more than 1.7% in 2018) turn out to be accurate, the case for raising interest rates and any extension of a tightening cycle will remain as weak as it is now. Here’s hoping for better weather, conservative fiscal policy settings and a credible Minister of Finance, and a stable or stronger rand, enough to reverse inflation trends and lead interest rates lower- an essential condition for a cyclical recovery.

Point of View: Artificial intelligence and the productivity conundrum

The world’s first artificially intelligent lawyer has arrived. Called Ross, and built on IBM’s famous cognitive computer called Watson, it has been “employed” by US firm Baker & Hostetler to work in its bankruptcy practice.

According to Futurism.com, Ross can “read and understand language, postulate hypotheses when asked questions, research, and then generate responses (along with references and citations) to back up its conclusions. Ross also learns from experience, gaining speed and knowledge the more you interact with it”. (http://futurism.com/artificially-intelligent-lawyer-ross-hired-first-official-law-firm/)

It’s not just lawyers who should be looking over their shoulders. All sorts of knowledge workers could see their employment prospects and livelihoods threatened by artificial intelligence, including journalists, accountants, portfolio managers, even surgeons and physicians.

With the aid of the internet and easy access to case law and its interpretation, fewer lawyers may be required to resolve a bankruptcy procedure. Fewer analysts may be required to value a company with the aid of Bloomberg data and its accompanying suite of programmes. Lasers directed by unerringly accurate robots may well help reduce the time in the operating theatre and the dangers of doing so.

What is the impact of these newly adapted technologies on productivity in the industry and the economy as a whole? Let’s use the example of the artificially intelligent bankruptcy lawyer above. The productivity of the lawyers in bankruptcy practice can be defined as the number of cases concluded divided by the number of lawyer hours billed to do so*. Presumably the number of lawyers (and legal hours billed) will decline with the aid of Ross. Thus the surviving lawyers working on bankruptcy law in a legal practice will have become more productive in the sense of an increase in the ratio (cases concluded/hours billed). Measuring productivity in this case seems a simple task.

It becomes much more difficult to measure the productivity of a service provider when real output is much trickier, and sometimes impossible, to measure. One would not wish to measure the productivity of an analyst, journalist, artist or inventor of a new video game by the number of words written and published or number of pictures painted or pixels injected. The quality of the work produced is surely more important than the quantity of output and “quality” is recognised in revenues generated. As is admitted by the calculators of productivity, it is impossible to measure the productivity of government officials, because it is not possible to measure how much they produce. All that can be measured is their employment benefits – an input. In the case of an author, composer, copywriter or game developer, only the value of the royalties they have earned can be measured – their revenue line, not the time spent writing the masterpiece. Measuring productivity requires that inputs and outputs can be independently measured, which is not always the case, especially for service providers.

However, looking at the example of the number of bankruptcy cases (which we would regard as an independent measure of output), what if the quality of advice has improved even as the numbers of hours billed declines? The advice may be superior with the aid of Ross’s deep memory bank. How would we adjust for this quality dimension in our measure of legal productivity? The question is apposite for the service sector generally, where computers and data management (and improved knowledge) have presumably enhanced the quality of service provided by lawyers, analysts and other knowledge professions, including the improved offering of physicians supported by bigger data and better statistics. If the quality of advice has objectively improved, then any hour of consulting service will be delivering more in real terms than a case handled in the same time say 10 years before. The output of the consultant will in effect have increased, even if the input of time is the same. But by how much is the leading question. The physicians may be seeing the same number of patients a day, charging them higher fees, but they (their patients) are likely to be living longer and better lives.

In cases like this we will not be comparing like with like, apples with apples or aspirins with aspirins, making any measure of real output and so productivity over time a very difficult exercise and one subject to significant errors in what is measured. For example, your medical insurance may well have become more expensive – or your cover reduced – but are you not getting a better quality of medical service in return? And exactly how much better? In the case of medical insurance, only what you are paying – not your additional benefits – will find their way into the official price indices.

A further aspect is the impact of improved quality on the broader economy. If the bankruptcy cases are resolved with less billable time spent in court and hence with a larger percentage of debt being recovered with reduced legal expenses, this would be a clear gain to the creditors. Creditors would be better off in real terms, with less spent on legal fees and earlier resolution of their claims, meaning that the creditors could spend more on other goods or services or save more. And lawyers competing with each other for work that has become less costly for them to supply, may well charge you less for their time. It is competition for extra revenue that turns lower costs into lower prices – even in the legal profession – provided they do not collude on fees.

Could the GDP deflator, the price index that converts estimates of GDP in money of the day into a real equivalent, hope to pick this up with a high degree of accuracy? Enough to provide accurate measures of GDP or productivity growth over extended periods of time? The deflator used to convert nominal GDP into real GDP, attempts to adjust for quality improvements in the output of goods and, especially, services produced. Yet in South Africa, 68% of all value added is comprised of services of one kind or another the quality of which may well be changing over time, in ways that are very difficult to measure.

Ours is more of a service economy, than one that produces goods, the output of which is much more easily measured in units of more or less constant quality – for example number of bricks or tons of cement or steel. Thus, if we are underestimating quality improvements in the large service sector, we will be overestimating inflation and so underestimating the growth in real incomes, output and productivity.

Your real incomes and your productivity may well have increased even if you are taking home no more pay or other employment benefits. You may be benefitting from an enhanced quality of service as well as a very different mix of services than was available 10 years before, for example easy internet access that has so changed the way we work and play. This has become a particular problem in the developed world where prices as measured are generally falling. Deflation, rather than inflation, is the greater concern and nominal wages are not rising, even if productivity and the standard of living, differently measured and quality enhanced, is improving (though perhaps poorly recognised, as voters in their frustration at their constant money incomes turn to populists who promise a better standard of living). A mere one or two per cent extra a year factored into GDP or productivity growth measures, well within a range of possible measurement errors, would provide a very different impression of how the developed world is doing. A rising real standard of living, if only we could measure it, might well be accompanying stagnant employment benefits, when calculated in money of the day.

*One of the criteria the World Bank uses for measuring the ease of doing business in any country is outcomes in the bankruptcy courts. The tables below measure ease of doing business across a number of categories, and we show the SA and Australia findings where SA compares quite poorly. The ranking is, for example, 120/189 for ease of starting a business compared to 11 for Australia; and 41 for bankruptcy proceedings compared with 14 for Australia. Both countries rank poorly for trade across borders (130 and 89). Note we do much better than Australia when it comes to protecting minority investors: ranked 14 vs 66; and worse for getting credit, 59 Vs 5.

 

Why accurately measuring and anticipating inflation is much more than a statistical exercise

Tim Harford of the Financial Times in an article carried in Business Day 18th May (Big data power up inflation figures) writes of the attempts under way to predict inflation ahead of the official data releases using ‘big data” – in this case observing continuously thousands even billions of prices reported online “by hundreds of retailers in more than 60 countries”

There is however more to this very welcome exercise made possible by modern technology than improving our measures of inflation –or being better able to adjust prices for changes in the quality of the goods and service being priced in the market place- a truly formidable task as Harford suggests. Or for that matter in the practice of in using high frequency data to predict the next GDP announcement, which also comes with something of a time lag. Helping to anticipate the next GDP announcement in the US is an exercise undertaken by one of the branches of the Fed. The Federal Reserve Bank of Atlanta publishes its GDPNow forecasts of GDP that are attracting understandable attention in financial markets.

The primary purpose in being able to more accurately predicting inflation or growth announcements to come is that it helps the forecaster to anticipate central bank policy changes – in the form of interest rate adjustments or doses of money creation- now called Quantitative Easing- that may follow the news about inflation or growth. Past performance tells us that central banks will react in predictable ways to the unexpected, to the surprisingly good or bad economic news to which inflation and GDP announcements make a large contribution. The economic news is important because the central bank regards the news as important. They are mandated to meet targets for price stability and to help the economy realise its growth potential. Knowing what the central bank will do can be very valuable information. Valuable because what central banks can do is move markets. And beating the market- being ahead of the market moves – can be extraordinarily valuable. Just as being behind the new direction of a market can be as damaging to participants in markets who miss-read the signals.

Central banks however can only move the markets in what they may regard as the right directions if they can take the market place by surprise. As is well recognized in the market place- only surprising news matters- the expected is captured in current prices and valuations. And so there is every reason for participants in the financial markets not to be surprised so that they can take evasive action in good time and position themselves for what central banks and the market may do to them. Better forecasting models of inflation or growth – or even of the next inflation or GDP announcements, using new technology- big data- helps market participants to realize profits or avoid losses.

Yet by anticipating central bank action the market place helps void the intended influence of central bank actions on the economy. This makes central banks much less influential over the economy than the still generally accepted conventions allow central bankers about the role they can and should play in managing the business cycle. Robert Lucas of Chicago in 1995 was awarded a Nobel Prize in economics (as were other rational expectation theorists, for this “policy invariance” critique of central banks, including Finn Kydland and Edward Prescott (2004) And one could add to this list of path breaking Nobel Prize winning economists, Edmund Phelps (2006) and even Milton Friedman (1976) honoured for demonstrating that economic growth could not be stimulated by inflation. They showed that any favourable trade-offs of inflation (bad) for more growth (good) were between unexpected inflation (not inflation) and GDP growth- something very difficult to achieve in any consistent way because of inflation avoiding behaviour market participants would be bound to take. The case for more inflation had been made by the famous Phillips curve- a theory that at one stage enjoyed wide support in the economics profession as a justification for engineering more inflation. Inflation (higher prices) it was thought could help overcome price and wage rigidities that were presumed to prevent an economy finding its own path to full employment. It became the essence of Keynesian economics.

Modern central bankers now take inflationary expectations very seriously. So labelled Expected inflation augmented Phillips curves are at the heart of their inflation modelling. (Inappropriately given the history of a failed theory) They attempt through their policy interventions to “anchor” inflationary expectations- as the phrase goes. By anchoring inflationary expectations they hope to avoid inflationary surprises that are well understood to be damaging to the real economy.

Unexpectedly high or low inflation makes it harder for firms and trade unions, with price and wage setting power to make the right output and employment optimizing decisions about wages and prices. Unexpectedly high or low inflation can temporarily confuse them about the true state of the economy and so exaggerate the direction of the business cycle that will in time be reversed as inflation expected adjusts to actual inflation.

But this sensible understanding of the need to avoid inflation surprises does not seem to inhibit the larger ambitions of central banks to manage the business cycle. They still seem to believe that they able to helpfully “fine tune” the economy- manage the business cycle – through appropriate changes in interest rates and QE so that the economy can realizes its full growth potential. But logically or rather illogically this must mean being able to surprise the market place with their policy reactions – a market that is very determined not to be surprised.

In pursuing such grand ambitions to manage more than inflationary expectations, central bankers are perhaps promising more than they can hope to deliver- and so attaching too much attention to themselves. The market place has become increasingly skeptical about central bank delivering on its promises to manage aggregate global spending, demand that remains deficient despite the best efforts of central bankers world-wide. More central bank modesty – as well as more realism in the market place – about what central bankers can and cannot do – is called for.

Can technology rescue the banks from the regulators?

Mervyn King (not the famous South African one) – now Baron Mervyn King of Lothbury – was once a highly influential Professor at the London School of Economics and then the Governor of the Bank of England until 2013, during which time he helped guide the UK successfully through the financial crisis.

(More recently, he resigned from the Board of the Aston Villa Football Club, the team that finished last in the English Premier League this season. Since past performance is no guide to future performance (in football and in financial markets) this surely will be forgiven.)

King has written a book “The End of Alchemy” to express his disquiet with the post financial crisis banking system and how it is being regulated1. To quote King: “The strange thing is that after arguably the biggest financial crisis in history nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.”

The fundamental problem, King argues, is in the nature of the incentives banks have in taking risks with other people’s money. When the risk taking works out, the bank shareholders and managers get the rewards, while society has to bear the fall out when the risks turn out to have been very poorly managed. But is this heads I win – tails you lose asymmetrical risk-reward nexus that different for banks when compared to all other large listed companies?

The rewards for managers and shareholders in any company who take on sometimes highly leveraged risks of failure and then succeed (against the odds) can be enormous. The losses caused by the failure of a large public company can also be very serious for the economy at large – other suppliers or customers. They may well be sucked into bankruptcy should the firm suddenly have to close its doors and workers and managers will have to seek alternative employment. The larger the company or bank, the larger these potentially damaging knock-on effects. But if a company or bank is growing for good economic reasons, it would be poor policy to prevent this growth in efficiency for fear of subsequent failure.

The direct financial losses of business or bank failure will be typically borne by shareholders, whose stake in the winning or losing enterprise will be a small part of a low risk, well-diversified portfolio. These lower risks means less expensive capital for the risk taking firm and so more incentive to take on risk. Yet without limited liability for losses, very little risk taking would ever be undertaken. Society has every good reason to encourage risk taking by banks and others – it is the source of all economic progress – and to provide limited liability for capital providers.

Yet the long and mostly successful history of banks and other limited liability companies is that the price of success – the willingness to accept and deal with business and banking failure – has been well worth taking. The focus of policy should perhaps be on how to improve the defence against actual failure, rather than interfering with the freedom of banks to usefully put capital at risk, in the hope that this will prevent a crisis, by introducing better bankruptcy laws that can act much faster to get a business back on its feet and convert debt into equity to the purpose. This will provide debt holders – especially less well diversified lenders – with every incentive to monitor risk management by a bank or business and to introduce debt covenants to such purpose. Ordinary shareholders, even well diversified ones, will greatly appreciate such surveillance, making a mix of debt and equity finance a desirable one.

A business may well be worth rescuing if the reason for failure is too much debt rather than a poor operating performance. Furthermore, a reliance on central banks to restore macroeconomic stability when threatened by a financial crisis, that can be impossible to predict or avoid, is an essential and appropriate part of these defence mechanisms. The history of central banking is the history of how central banks, beginning with the once privately owned Bank of England (nationalised only in 1947) coped with financial crises.

Banks are however responsible for the management of the economy’s payments system. The payments system, hence the banks, cannot be allowed to fail; not even temporarily. The consequences would be too ghastly too contemplate, as they are being forced to contemplate in Zimbabwe as we write.

The interest spread between what a bank offers for deposits and receives for loans has helped to subsidise the cost to the banks of running the payments system. The customers of banks do not typically pay transaction fees to cover the full costs of the payments system they utilise. Hence the attractions of cheap funding for the banks in the form of very low interest transaction accounts and attractions for their customers in the form of low cost transactions that make up for low interest rates received. A comparison of bank charges with charges made by vendors using credit card systems or with the percent of the value of a transaction charged by the money changers and transmitters, makes the point. I am told that for every R100 transferred for example to Malawi through the banking system, the receiver will receive R90 at best. How much of the 9% charge goes to the banks, to the money change agents and the government, I do not know.

The business case for bundling bank borrowing, lending, trading and making payments may however be breaking down. Blockchain computing is being used to safely and cheaply move valuable Bitcoins around the world. The technology could extend to transactions effected by specialist electronic money-changers, charging low fees that still cover low costs. Pure transaction accounts could be made fully and always backed by reserves of central bank deposits or notes in the till or ATMs, rather than covered by deposits or reserves held with other more vulnerable banks. If transactional banking can be legally and economically separated from risk taking banking, the all-important payments system can be insulated from the danger of banking failure. Banks, as with other firms, can then be left to manage their own risks. This may well be the way to rescue banks – or rather their risk-absorbing shareholders and debt holders – from the profit-destroying and cost-raising burdens imposed by risk-avoiding regulators.

1These observations were stimulated by an article by Michael Lewis: On The End of Alchemy – A Central Bankers Memoir (Mervyn King Of The BOE), Actually Worth Reading, Bloomberg Business, 6 May 2016

 

Not so Moody after all

Moody’s Investors Service showed its softer side when confirming SA’s investment grade credit rating. The rating agency made it clear that to maintain this grade, SA would need to increase its GDP – that is, simply not fall into recession. A mere 0.5% increase in 2016 would meet Moody’s modest expectation, followed by 1.5% in 2017.

Growth, as Moody points out, not only makes government debt easier to manage. It helps the banks and the households meet their obligations and will also encourage firms to invest more in additional capacity.

To quote the preamble to the report:

“The confirmation of South Africa’s ratings reflects Moody’s view that the country is likely approaching a turning point after several years of falling growth; that the 2016/17 budget and medium term fiscal plan will likely stabilize and eventually reduce the general government debt metrics; and that recent political developments, while disruptive, testify to the underlying strength of South Africa’s institutions.

“The negative outlook speaks to the implementation risks associated with the structural and legislative reforms that the government, business and labor recently agreed in order to restore confidence and encourage private sector investment, upon which Moody’s expectations for growth and fiscal consolidation in coming years — and hence the Baa2 rating — rely.”

Moody’s identifies three drivers that inform its decision. The first, most critical, we would suggest, is that the economy will recover from a business cycle trough:

“..The first driver for the confirmation is Moody’s expectation that South Africa’s economic growth will gradually strengthen after reaching a trough this year, as the various supply-side shocks that have suppressed economic activity since 2014 recede. Specifically, the electricity supply is now more reliable, the drought is ending and the number of work days lost to strikes has shrunk significantly (a trend that planned rule changes are likely to embed further). In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.

“Alongside the more competitive exchange rate, these improving trends are likely to strengthen growth in South Africa from the second half of this year and thereafter. While we expect the economy to expand by only 0.5% in 2016, we expect growth to rise to 1.5% in 2017. Moreover, ongoing structural reforms and diminished infrastructure bottlenecks offer upside potential for growth over the medium term. The recent rapprochement between the government, business and labor holds promise from the standpoint of identifying areas of mutual concern. A number of benchmark actions related to matters such as the rationalization of state-owned enterprises (SOEs) and the enactment of labor market reforms have been identified in the process. To the extent that implementation of such measures helps boost business confidence, investment and job creation, they would improve prospects for gradually reducing wide economic disparities and high levels of poverty, deprivation and unemployment.”

The second driver for the unchanged rating was “The Stabilization of government debt ratios likely to occur in 2016/17” and the third was “Recent political developments testify to the strength of South Africa’s institutions”.

The rating was placed on a negative watch because such hopeful predictions have still to materialise. Or, to put it bluntly, will the economy grow by 0.5% in 2016 and 1.5% in 2017? These are not demanding outcomes even by SA’s well below average growth performance in recent years. What then could cause SA to fall into recession?

The simple short answer would be a further slowdown in household spending. Since households account for over 60% of all spending, any further reluctance in their willingness or ability to spend more will drag the economy into recession. It will neither encourage firms to invest more in people or capacity nor encourage foreign savers to fund our savings deficit.

It is striking that Moody’s could look to lower rather than higher interest rates to improve the growth outlook and the ratings prospects. To repeat the observation made above from Moody’s:

“In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.”

We have long questioned the Reserve Bank’s decisions to raise interest rates into higher inflation and a weaker economy. It seems to us that the higher rates can make no predictable impact on inflation or, it may be added, on inflation expected – that has also risen lately despite the weakness of the economy and despite interest rates that have been rising since early 2014. This proves only that inflation and expected inflation is dominated by forces well beyond the influence of higher short term interest rates. That is in particular by the behaviour of the rand, the behaviour of the weather, the behaviour of the President, the behaviour of global commodity and oil prices and Eskom and its regulators, to mention some of the supply side shocks that have driven inflation in SA higher.

Interest rate increases do nothing useful to contain inflation in a world where the supply side shocks are pushing prices higher and household spending lower. What they do is to reduce household spending further than would have been the case with stable or lower interest rates. For every one percent increase in the repo rate, the Reserve Bank forecasts a 0.4% reduction in GDP growth over two years.

This should be emphasised, in the light of the Moody’s report, since rate increases prejudice rather than enhance our credit rating. An independent central bank is one of SA’s institutional strengths. But such independence could have been much better managed than it has been. Lower, not higher interest rates, would have served the economy better (and still can) and helped preserve its growth rates. Moody’s would seem to agree.

Are there other forces at work that could help the economy grow a little faster? The weaker real and more competitive rand finally seems to be helping the manufacturers as well as the tourist business. The latest survey of manufacturing activity, the Barclays PMI, shows a very healthy recovery and positive growth. If the past strong statistical relationship between the PMI and GDP growth is to be relied upon (showed below), this improvement does suggest significantly faster growth to come. The PMI is well up and the GDP growth rates in Q2 can be expected to follow. We thank Chris Holdsworth of Investec Securities for drawing this relationship to our attention:

 

The other helpful influence at work is a much smaller foreign trade deficit recorded over the past two months. Less imported and more exported add to GDP growth rates. A decline in inventories held, especially inventories with import content, may offset these favourable forces on recorded GDP growth. But a combination of a more competitive rand and a more cautious Reserve Bank, more sensitive to the growth outlook, as well as the business cycle trough from which conditions improve rather than deteriorate, should deliver growth of 0.5% this year and 1.5% next; enough to satisfy Moody’s. Raising the growth rates to permanently higher rates of over 3% requires the structural reforms of the labour and other markets that Moody’s appears surprisingly optimistic about. One can only hope that their optimism is justified.

 

The wisdom in foreign exchange control reforms

A notable milestone in SA’s financial history was passed in the second half of 2015. For the very first time, the value of South Africans’ foreign assets has come to exceed the value of the South African assets and debt held by foreign investors. At year end, our holdings of foreign assets, worth over R6 trillion, exceeded our foreign liabilities by as much as R714bn.

 

The buildup in offshore assets legally owned and managed by South African businesses, pension and retirement funds as well as directly by wealthy individuals, began from very modest levels in 1994, when South Africans became acceptable participants in global financial markets.

The growth in foreign assets and liabilities has served South Africans particularly well in recent years as the SA economy has been severely buffeted by a damaging combination of weak growth and higher inflation. Stagflation has accompanied a collapse in the currency, higher charges for utilities a severe drought and, to top all these economic body blows, we have seen (avoidably) higher borrowing costs imposed by the Reserve Bank.

The increasingly large foreign component in SA portfolios of assets therefore has helped significantly to mitigate the shocks to their incomes and balance sheets caused by specifically negative South African events, both political and economic. The protection against their exposure to SA risks has come in large measure from the shares they own in JSE-listed industrial companies whose major sources of revenues and earnings (as well as the costs they incur) are generated outside SA.

The successful industrial companies that began life in SA and have prospered abroad include Naspers (NPN), SAB, British American Tobacco (BTI), Mediclinic (MEI), Richemont (CFR), MTN, Steinhoff (SNH), Brait (BAT) and Aspen (APN) . They have come to dominate the JSE when measured by market value. Up to 50% of the value of the JSE is accounted for by these large firms, that we can describe as Global Consumer Plays (GCPs). Before the rise of these now global companies, investors on the JSE would have been much more exposed to the highly variable fortunes of Resource companies that used to dominate the JSE. Without these opportunities to invest in these world class companies on the JSE, as well as the investments made abroad by these companies and other SA based companies outside of SA, the value of SA pensions and retirement plans might have looked very sad indeed.

An equally weighted Index of 14 of these GCPs on the JSE (including recent underperformers MTN, ASP and CFR) has performed as well as the leading global index, the S&P 500, over the past two years or so, adding about 30% to its rand value of January 2015.

Well-developed liquid capital markets not only provide companies and governments with access to capital. They provide wealth owners, and their fund and business managers, with the opportunity to diversify away firm or country specific risks. A well-diversified portfolio with a full variety of investment opportunities, none of which will dominate the balance sheet and whose individual returns are somewhat independent of each other, makes for a much less risky portfolio, that is a portfolio whose value, while expected to rise over time, will do so more predictably than most of its separate components (especially individual shares) included in the portfolio. The well diversified portfolio provides positive returns with significantly less risk – that is smaller value movements in both directions.

Less risk moreover translates into lower required returns of the investor or wealth owner. Lower required returns also mean lower costs of capital for the firms hoping to raise capital to expand their businesses. Lower required returns in turn will mean more capital invested, a larger capital stock and a stronger economy. This is one of the benefits of a well-developed capital market that can attract capital from savers everywhere and not only domestic ones- as has the SA capital market – where capital inflows have more or less matched capital outflows over the years – as we have shown in figure 1 above.

Human capital effect

But the less risky returns that the opportunity to invest globally provided to South Africans benefits not only the owners of tangible capital but also the owners of intangible human capital committed to the SA economy.

There is always a global shortage of skilled professionals, including managers of businesses, for which competition is intense. By enabling skilled South Africans to invest abroad and diversify away SA risk, their required returns from SA sources have also declined. That is, they are more willing to apply their skills in SA – and therefore are more willing to sacrifice returns, that is employment benefits – because their wealth is better insured against SA risks to their wealth. This now more favourable exchange of less risk for lower returns by owners of a crucial resource- the human capital of skilled professionals- helps to make the SA economy more globally competitive

It has been wise of the SA government to relax exchange control over the years – it has helped the economy retain its skills and so better ride out economic misfortunes.

Were the economy to grow faster over the next few years, the outward flow of capital would be more than matched by inward flows of fixed direct investment (FDI) and portfolio capital. Also, foreign controlled companies would be more inclined to reinvest profits than pay them out as dividends. Growth leads investment by companies in additional capacity and stimulates the flow of funds to support growth. Without faster growth, the flows through the net flows through the SA balance of payments will continue to be more out than in.

The economy would grow faster were global market forces to become more favourable to our emerging, metal price-dependent economy. The rand would then strengthen (as it has lately) and the inflation and interest rates would come down rather than rise to help the economy along. Faster growth over the longer term would respond to more business, employment and wealth friendly policy reforms, of which exchange control reform is a very good and helpful example.

Some details about capital flows

FDI is defined as an investment by a foreign company with a more than 10% shareholding. Portfolio investment is defined as a less than 10% share. As may be seen below, outward FDI has recently come to exceed inward FDI, while inward portfolio investments continue to exceed outward flows – that have become significantly larger.

As important for the SA balance of payments is the flow of dividend receipts and payments. The flows of dividends from portfolios has become a net positive for the SA economy while the flow of dividends from FDI remains strongly in the other direction.

The rand: A global opportunity

Global rather than SA forces have taken the rand and the JSE higher. There is still much scope for improved SA fundamentals to add further strength to the rand and the economy

The rand has regained all the ground lost since December 2015 when President Zuma shocked the markets. How much of this recovery can be attributed to South African specifics (better news about the political state of SA) and how much can be attributed to global forces (less risk priced into emerging market currencies bonds and equities of which SA is so much a part of)? The answer is that to date almost all of the improved outcomes registered on the JSE and in the exchange value of the rand is the result of less global, rather than SA, risk.

The positive conclusion to draw from this is that were SA itself to be better appreciated in the capital markets on its own improved merits, there would be further upside for the rand – and for the SA economy that can only escape its current malaise with a stronger rand and the lower inflation and interest rates that will follow.

We show below that the rand has recovered in line with emerging market equities, represented by the benchmark MSCI EM. This index and the JSE indices are now also more valuable than they were in early December 2015. The JSE All Share Index (ALSI) in rands is also now ahead of its December value. MSCI EM is up about 20% from its recent lows of mid-January 2016 while the rand has gained about 15% since then. The JSE, when valued in US dollars, has performed even better than the average emerging market equity market, having gained about 25% since its lows of 18 January.

 

The higher SA-specific risks attached to the value of the rand in December are shown by the performance of the rand against other emerging market currencies since. As may be seen below, the rand has yet to recover its value of early December when measured against the Brazilian and Turkish currencies that have also strengthened against the US dollar over the period. On a trade weighted basis, the rand has lost about 4% since December.

A model of the daily value of the USD/ZAR that uses the USD/AUD and the emerging market bond risk spreads as predictors, with a very good statistical fit since 2012, indicates that without the Zuma intervention, the USD/ZAR might now have cost closer to R13 than the R14.7 it traded at yesterday (18 April), given the recovery in commodity currencies and the narrowing emerging market spreads.

That the recovery of the rand and the JSE has more to do with emerging markets rather than SA forces is shown below. Risk spreads attached to emerging market bonds and RSA dollar-denominated bonds have declined in recent months. However the difference between higher emerging market spreads over US Treasury yields and RSA spreads has narrowed. The wider this difference, the better the relative rating of SA bonds: the SA rating was at its relative high in late 2014 and has deteriorated since, though it is little changed from its rating of early December 2015.

A comparison of risk spreads attached to Brazilian and SA debt made below, shows how Brazilian credit has benefitted both absolutely and relatively to SA from the prospect that its President will be forced out of office. It should also be recognised that both Brazilian and SA debt are currently trading as high yield bonds. Investment grade bonds offer up to about 2.7% p.a more than five year US Treasuries.

When we turn to the bond market itself, we see that the yield on RSA 10 year rand-denominated bonds has fallen below 9% p.a but is still above the yields offered in early December. The spread between 10 year RSA rand rates and US 10 year Treasury Bond yields however remain above 7% p.a. This is a further indication that SA-specific risks priced into the bond markets remain highly elevated. They reveal that the rand is still expected to weaken by about 7% p.a against the US dollar – implying consistently high rates of inflation in SA over the next 10 years.

There remains every opportunity for SA to prove that the markets are wrong about the inflation and exchange rate outlook, with policies that convince the world that we will not be printing money to fund government spending and that our policies will be investor friendly. Of more importance, a stronger rand and lower interest rates would help lift GDP growth rates, to the further surprise of the markets and the credit rating agencies.

 

A Marie Antoinette moment – let them eat more expensive bread

The Treasury has just increased the duty on imported wheat by 34%, from R911 to R1 224 per tonne. Some 60% of SA’s demands for wheat are met from abroad. Accordingly the price of bread is predicted to increase by some 10%.

This is another bitter blow for the poor of SA, some 34% of the population, according to the World Bank. One might have thought that such a step that will benefit a few farmers at the expense of a huge number of impoverished consumers of bread, makes no sense at all. But apparently the Treasury had no choice in the matter at all, being bound by an agreed automatic wheat price formula, and was forced to act when threatened by High Court action taken by Grain SA. But the responsibility for the formula is that of the government and the formula may well be adjusted in the months to come, altogether too late to relieve poverty.

And were the farmers wise to exercise their rights at a time like this? They may well end up with lower duties or better still for the economy – no duties at all on a staple most of which is imported.

In the figures below we compare in rands the global (US dollar Chicago-based price of wheat) and local prices of wheat, having converted bushels to tonnes* and dollars to rands at current exchange rates. The local price is the price quoted on SAFEX for wheat, delivered in three months. The difference in the price of wheat, global and local, is the extra that South Africans pay for their wheat, a mixture of duties and shipping costs.

SA is not self-sufficient in wheat, hence the local price of wheat takes its cue from the cost of imports. Not that self-sufficiency in food or grains is a useful goal for policy because it must mean higher prices for wheat and other staples for which the SA climate and soils are not helpful. And higher prices for staples then lead to higher wages to compensate for higher costs of living that make all producers in SA less competitive with imported alternatives. Higher prices for wheat (or rice or sugar or barley or rye) mean less land planted to maize and so higher prices for maize, in which SA is normally more than self-sufficient for all the right reasons and where local prices usually take their cue from prices on global markets, less rather than plus transport costs to world markets. The current drought in SA and its expected impact on domestic supplies, has lifted maize prices towards import price parity – another, but unavoidable, blow to consumers. Also less land now under wheat, barley or rye is given to pasture and grazing that might otherwise have held down the price of meat.

A competitive economy is one that exploits its comparative advantages to export more and import more. It does not protect some producers at the expense of all consumers, nor those producers who could hold their own in both global and domestic markets without protection. A competitive economy also will not lack the means to import food, both the basic stuff and the more exotic varieties at globally determined prices. South Africa needs more, not less, competition to help reduce poverty and stimulate faster growth. Raising barriers to trade not only harms the poor today but it also undermines their prospects of escaping poverty over the longer run.

*For more on how to convert bushels to tonnes: https://www.agric.gov.ab.ca/app19/calc/crop/bushel2tonne.jsp

The rand: A welcome question of specifics

Is the recovery of the rand for global or SA reasons? Whatever the explanation, it is surely very welcome.

A recovery of the SA economy needs a stronger rand. A stronger rand will mean less inflation to come and lower interest rates. Unfortunately a weaker rand leads interest rates in the opposite direction making it just about impossible for the business cycle to turn higher. A combination of higher prices on the shelves and the petrol station forecourts following rand weakness, depresses household spending. And the higher interest rates that follow add to the inability of households to spend more – and to borrow more. Household spending, which accounts for over 60% of all spending, leads the economy in both directions. Without a recovery in the propensity of households to spend more, the best the SA economy can hope to do over the next 24 months would be to avoid recession.

The foreign exchange value of the rand responds to both global forces – that is global risk appetites that drive emerging markets and currencies lower or higher (including the rand) – and SA-specific risks that encourage capital flows to and from SA.

An obvious example of SA-specific risks driving the rand weaker and interest rates higher was provided by President Jacob Zuma in December. The week of Zuma interventions in the Treasury saw the rand sharply weaken and sent long term interest sharply higher. These interventions added about R2 to the cost of a US dollar – according to our model of the rand – and about 100bps or more to the cost of raising long-dated government debt.

Our model of “fair value” for the USD/ZAR relies on two forces, the USD/AUD and the emerging market risk spread. Had Zuma not acted as he did, the US dollar might well have cost no more than R14 in early December 2015. With the recent recovery in the USD/AUD and emerging market bonds, the current fair value for the rand would be closer to R13 than R14. This suggests that the Zuma danger to the rand has not left the currency or bond markets. And that the welcome recovery of the rand is mostly attributable to global rather than SA forces. We attempt below to isolate the impact of global from SA-specific risks on the exchange value of the rand and show that the recovery of the rand is mostly global rather than SA specific.

If indeed the recovery of the rand is mostly attributable to global rather than SA forces, there is the possibility that a revived respect for SA’s fiscal conservatism – demonstrated in the Pravin Gordhan Budget for 2016-17 – can still prove more helpful to the SA bond market and the rand, global forces permitting.

In the figure below we compare the performance of the rand to other currencies including a basket of emerging market currencies. The rand weakened against all currencies in 2015 – including other emerging market currencies. Furthermore the significant recovery of the rand in 2016 is in line with that of other commodity and emerging market currencies. This suggests again that global rather than SA forces explain the recent rand recovery.

A similar impression of predominant global forces is provided by the bond market. The spread between RSA 10 year bond yields and US Treasury Bond Yields of similar duration have stabilised at more than 7% p.a. having widened dramatically in December 2015. These spreads are significantly wider than they were in early 2015. This spread may be regarded as a measure of SA specific risk, or more particularly as a measure of expected rand weakness. The rand has weakened – and is expected to weaken further. An alternative measure of SA specific risk is provided by the CDS spread paid to insure SA US dollar denominated debt against default. This spread has moved very much in in line with the interest rate spread.

The recent narrowing of this insurance premium has however also been accompanied by a narrowing of the more general emerging market CDS spread, reflecting global forces at work. The gap between the higher emerging market CDS spread and the lower RSA spread narrowed sharply in December 2015, indicating a deterioration in SA’s relative credit standing. This relative standing has not improved much in 2016, as may be seen by a difference in spreads of only about 120bps. Note that the wider this spread, the better SA’s relative standing in the global credit markets.

The spread between RSA rand yields and their US Treasury yields of similar duration are by definition also the average rate at which the rand is expected to depreciate over the next 10 years. The fact is that the rand has weakened and is expected to weaken further – despite the wider interest carry in favour of the rand.

Given these expectations of rand weakness it is not surprising and entirely consistent that inflation compensation provided by the RSA bond market being the difference between an inflation linked yield and a nominal yield. This is a very good measure of inflation expected and has also risen and remains above 7% p.a.

The Reserve Bank pays particular attention to inflationary expectations, believing that these expectations can drive inflation higher. But without an improvement in the outlook for the rand, it is hard to imagine any decline in inflation expected. It is also very hard to imagine how higher short term interest rates can have any predictable influence on the spot or expected value of the rand and therefore on inflation to come. As we have emphasised the risks that drive the rand are global events or SA political developments, for which short term interest rates in SA are largely irrelevant.

The only predictable influence of higher short term interest rates in SA is still slower growth in household spending. Less growth without any predictably less inflation is not a trade off the Reserve Bank should be imposing on the SA economy, even though but may well continue to do so. The only hope for a cyclical recovery is a stronger rand – whatever its cause, global or South African.