Author: Brian Kantor

The paradox of competition

The paradox of competition. You can lose because you have won the game.

When portfolio managers and active investors value a company, they are bound to seek out companies’ advantages that can keep actual and potential competitors at bay. Moreover, they seek companies with long lasting, hopefully more or less permanent, advantages over the ever likely completion, advantages that will not “fade away”, in the face of inevitable competitors.

The talk may be of companies protected by moats, preferably moats that surround an impregnable castle filled with crocodiles that keep out the potential invaders, that is the competition. Reference may be made to protection provided by loyalty to brands that translate into good operating profit margins; or to intellectual property that is difficult for the competitors to replicate and reduce pricing power. It’s a search for companies that generate a flow of ideas that lead to constant innovation of production methods and of products and services valued by customers; and those with good ideas that will receive strong encouragement from large budgets devoted to research and development that can help sustain market leading capabilities through consistent innovation that keeps competitors at bay.

Such advantages for shareholders will be revealed in persistently good returns on the capital provided by shareholders and invested by the team of managers – managers who are well selected and properly incentivised, and also well-governed by a strong board of directors, including executive directors with well aligned financial interests in the firm. Furthermore, the best growth companies will have lots of “runway” – that is a long pipeline of projects in which to successfully invest additional capital that will be generated largely through cash retained by the profitable company. By good returns on capital is meant returns on capital invested by the firm (internal rates of return: cash out compared to cash in) that can be confidently predicted to consistently exceed the returns required of similarly risky shares available on the share market, that is market beating returns.

Such companies that are expected to perform outstandingly well for long, naturally command very high values. Their high rates of profitability – high expected (internal) rates of return on the shareholder capital invested – will command great appreciation in the share market. High share prices will convert high internal rates of return on capital invested into something like expected normal or market-related returns. The virtues will be well reflected in the higher price paid for a share of the company. Thus the best firms may not provide exceptional share market returns, unless their excellent capabilities are consistently under appreciated. This is an unlikely state of affairs given the strong incentives active investors and their advisers have to search for and find hidden jewels in the market place.

Such excellent companies – market beating companies for the long run – are therefore highly likely to enjoy a degree of market dominance. Their pricing power and profit margins will be testament to this. In other words, they are companies so competitive that they prove consistently dominant in their market places.

But such market dominance – that has to be continuously maintained in the market place serving their customers better than the competition – has its own downside. It is bound to attract the attention of the competition authorities. The highly successful company – successful because it has a high degree of market dominance – may have to prove that it has not abused such market dominance. The fact that the returns on capital are so consistently high may well be taken as prima facie evidence of abuse that will be hard to refute. It may well be instructed to change business practices that have served the company well because they do not satisfy some theoretical notion of better practice. Such companies have become an obvious target for government action.

Foreign-owned companies that achieve market dominance outside their home markets may be particularly vulnerable to regulation. These interventions are designed perhaps to protect more politically influential but in reality less competitive domestic firms. Hence the actions taken by the European competition authorities against the likes of Google, Facebook and Microsoft who have proved such great servants of European consumers.

And so one of the risk of competitive success is that such success will be penalised by government action. A proper appreciation that market dominance is the happy result of true competition that has proved to be disruptive of established markets, through the innovation of products and methods, would avoid such policy interventions that destroy rather than promote competition.

Market forces and market dominance can be much better left to look after themselves, because innovation is a constant disruptive threat for even the best-managed and dominant firms. These firms will know that dominance may well prove to be temporary and so they will behave accordingly, by serving their customers who always have choices and by so doing satisfying their shareholders. 14 September 2016

The golden question

Gold and gold mining companies – is there a case to be made for including them in portfolios?

Gold mining companies listed on the JSE have been enjoying a golden year. The JSE Gold Mining Index (rand value) has gained over 200% this year (see figure 1 below). This outperformance of gold mining shares has much to do with improved operating results, gold mining specifics, more than with the gold price, though in US dollar terms the gold price has enjoyed something of a recovery in 2016. In figure 3, we show the daily price of gold in US dollars and rands going back to 2006. As may be seen the rand price of gold has risen more or less consistently since 2006 while the gold price rose very strongly and consistently in USD until 2011 where-after it fell back sharply – until the modest recovery of 2016.

We show in figure 3 below how far the performance of the gold miners so lagged behind that of the JSE All Share Index until 2016. The weight of gold shares in the JSE ALSI is now about 3.1% up from 1.45% at the start of 2016. In figures 4 and 5 we compare the performance of the gold miners to other sectors of the JSE. As may be seen, the JSE Industrials have been the outstanding performers over the longer run- but not in 2016. The higher rand price of gold clearly did not translate into higher operating profits in rends or USD. As may be seen investors would have done far better holding gold itself rather than gold shares for much of this period – until very recently.

As may be seen in figure 6 above, the JSE Gold Mining Index has been a distinct underperformer since 2005 – though it outperformed briefly in 2006 and again during the Financial Crisis of 2008-09 and then again, making up for some of the lost ground again this year. R100 invested in the Industrial Index on 1 January 2005 would now be worth over R771; and in the Gold Index about R152; while the R100 invested in the All Share Index would now be worth about R423. The rand price of gold rose by 7.7 times over the same period, gaining as much as the Industrial Index as we have shown in figure 3.

The Gold Index has also been twice as risky as the All Share Index. We show daily price moves in 2016 in 2016 in figure 7 below. When measured by the Standard Deviation of these daily percentage price moves, Gold Mining Shares listed on the JSE have been about twice as risky as the JSE All Share Index in 2016. The JSE All Share Index however has proved only slightly less risky than holding a claim on the rand gold price in 2016. The same pattern holds for much of the period 2005-2016, using daily price movements. On average the JSE Gold Index, on a daily basis, has been about twice as volatile as the All Share Index and the rand gold price. Thus the risk adjusted return expected from the gold mines would have to be significantly higher than that expected from gold itself, or from a well-diversified portfolio of JSE listed shares, to command a place in a risk averse portfolio.

Doing well out of gold shares surely would have demanded exquisite timing – both when to buy and when to sell. It is not a sector to buy and hold stocks for the long term. It is a highly cyclical sector of the market, with no long term growth prospects. And as we have illustrated, investing in gold mines, rather than in gold, is much more than an investment in the gold price. It is an investment in the capability of the mine managers to extract profits and dividends out of gold mines that are the quintessential declining industry.

Gold mines run out of gold as SA gold mines have been doing consistently for many years. Deeper mines are more costly and dangerous to operate and green field expansion is subject to more expensive regulation, to protect the environment as well as miners. All these considerations help make the case for gold over much riskier gold mines, though the stock of gold available to be traded will remain many times annual output over the long run. The market for gold is a stock market rather than a flow market. It is demand for the stock rather than extra supplies that drive the price.

It would appear easier to explain the price of gold than the value of a gold mine. Since gold does not pay interest, the cost of holding gold is an opportunity cost – income from other assets foregone when holding gold. Using US real interest rates – the real yield on a US Inflation Linked Bond of 10 year duration has done very well in explaining the US dollar value of an ounce of gold since 2006. The correlation between the daily level of the gold price and the real interest rates has been as high as a negative (-0.91) (see figures 9 and 10 below). In other words, as the cost of holding gold has gone up or down (as measured by the risk free real interest rate) the gold price in US dollar has moved consistently in the opposite direction. Real interest rates in the US fell consistently between 2005 and 2011 encouraging demand for gold – then increased to a higher level in 2013, where they stabilised until declining again in 2016, providing it would seem, a further boost to the price of gold. These real interest rates reflect the global demand for capital to invest in productive assets. They have been declining because of a global reluctance to undertake real capital expenditure and so to borrow for the purpose. Low real interest rates reflect slow global growth. And so gold has been a good hedge against slow growth, as well as insurance against financial disruption.

Inflation-linked US bonds have provided some protection against the S&P 500 – the daily correlation between the 10 year TIPS yield and the S&P 500 Index was a negative (-0.43) between 2006 and 2016 while the correlation between the S&P and the level of the gold price is a positive, though statistically insignificant (0.18). The correlation of daily moves in the S&P and the TIPS yield is a positive (0.23) and negative (-0.20) between daily changes in the gold price and the S&P. As important, the correlation between daily moves in the gold price and the S&P 500 are close to zero. Gold has been a useful diversifier for the S&P Index.

This past performance suggests that gold can be held in the portfolio as a potentially useful hedge against economic stagnation – stagnation that means low real interest rates – and also as insurance against global financial crises. The case for gold shares is much more difficult to make on the basis of recent performance. The problem with holding gold shares is the difficulty and predictability of turning a higher gold price into higher earnings for shareholders. Shares in gold mining companies comes with operational risks. If the gold miners could resolve these operational issues then gold shares could become a highly leveraged play on the gold price. The share price would then reflect the increased value of gold reserves: gold in the ground as well as gold above it.

Not all gold mines will be alike. The search should be on for gold mines with significant reserves of gold and highly predictable operating costs and taxes and regulations. The more highly automated a gold mine, the better the mine will be in this regard. Gold mines with these characteristics could give highly leveraged returns to changes in the gold price – in both directions – making them more attractive than gold itself for insurance and risk diversification.

 

Taking a bite of the Apple

The European competition authorities have ruled that Apple has wrongly benefitted from a tax deal with Ireland that allowed Apple to avoid almost all company taxes on its sales in Europe, the Middle East and Africa. The €13bn company income tax Apple is estimated to have saved on the taxes has been classified as state aid to industries. Hence illegally and to be refunded to the Irish government in the first instance- plus interest. No doubt other European governments and maybe even South Africa (assuming the Treasury is not otherwise engaged) will be looking to Ireland for their share of the taxes unfairly saved on the Apple income generated in their economies and transferred through their tax haven in Ireland.

The principle that taxes should be levied equally – at the same rate – on all companies generating income within a particular tax jurisdiction seems right. But it is a principle much more honoured in the breach than the observance. The effective rate of tax (taxes actually paid on economic income consistently applied) will vary widely within any jurisdiction, with the full encouragement of their respective governments. The company tax rate may vary from country to country – in Ireland it is a low 12.5% is levied on income that may be defined in very different ways from one tax authority to another from company to company.

A company may benefit from a variety of incentives designed to stimulate economic activity generally and capital expenditure in a particular location, perhaps in an export zone or a depressed region or blighted precincts of a city. They may utilise incentives to employ young workers or to train them. Investment allowances may far exceed the rate at which capital is actually depreciating to encourage capex. And governments may well collaborate in R&D that effectively subsidises the creation of intellectual property. A further important source of tax savings comes from the treatment of interest payments on debt. The more debt, the higher the tax rate, the less tax paid or deferred. And so every company everywhere (not just Apple) manages its own effective tax rate as much as the law allows it to do. It would be letting down its owners (mostly affecting the value of their shares in their retirement plans) if it failed to pay as little tax it can.

But then this raises the issue that Apple has already raised in tis defence as has the US government. How does one value the intellectual property (IP) in an Apple device? And who owns the IP and where are the owners of the IP located? In Europe – at the head office post box in Cork or in California where much of the design and research is undertaken? Operating margins are very large – maybe up to 90% of the sales price in an Apple store. What if Apple California charged all its subsidiaries everywhere heavily for the IP that accounts for the difference between revenues and costs? Profits and income in Europe and Africa could disappear and profits in the US explode given very high US company tax rates. The reason Apple does not or has not run its business this way is obvious enough; it has been able to plan its taxes and cash holdings to save US taxes.

The insoluble problem with taxing companies and determining company income is that company income is not treated as the income of its owners – or as it would be in a business partnership. In a partnership (which can be a limited liability one) all the wages and salaries, interest, rents, dividends or capital gains are treated as income and taxed at the individual income tax rates. Total taxes collected (withheld) by the partnership could easily grow rather than decline given that there would be no company tax to shield. And the value of companies absent taxes would increase greatly, calling for a wealth as well as a capital gains tax on their owners. The problem with company tax is company tax. The world would be better without it.1 September 2016

 

Point of View: PPC and the debt vs equity debate

Is debt cheaper than equity? PPC shareholders will argue otherwise.

That debt is cheaper than equity is one of the conventional wisdoms of financial theory and perhaps practice. It appears to reduce the weighted average cost of capital (WACC). The more interest-bearing debt as an alternative to equity capital used to fund an enterprise, and the higher the company tax rate, the lower the WACC.

Yet while debt may save taxes it is also a much more risky form of capital. Even satisfactory operating profits may prove insufficient to pay a heavy interest bill or, perhaps more important, allow for the rescheduling of debts should they become due at an inconvenient moment. And so what is gained in taxes saved may be off-set (and more) by the risks of default incorporated in the cost of capital (the risk adjusted returns demanded and expected by shareholders) the firm may be required to satisfy.

Hence debt may raise rather than reduce the cost of capital for a firm when the cost of capital is defined correctly, not as the weighted by debt costs of finance, but as the returns required of any company to justify allocating equity and debt capital to it – capital that has many alternative applications. It is a required return understood as an opportunity rather than an interest cost of capital employed – equity capital included – the cost of which does not have a line on any profit and loss statement.

With hindsight the shareholders in PPC would surely have much preferred to have supplied the company with the extra R4bn of equity capital, before the company embarked on its expansion drive outside of SA in 2010, as they have now being called upon to do to pay back debts that unexpectedly came due. And had they, or rather their underwriters (for a 3% fee) not proved willing to add equity capital – the company would have in all likelihood gone under – and much of the R9 per share stake in the company they still owned on 23 August when the plans for a rights issue were concluded, might have been lost. Their losses as shareholders facing the prospect of defaulting on their debts to date have been very large ones, as we show in the figure below, but the R4bn rights issue promises to stop the rot of share value destruction.

The debt crisis for PPC was caused by a sharp credit ratings downgrade by S&P. This allowed the owners of R1.6bn of short term notes issued by PPC to demand immediate repayment of this capital and interest, which they did. Banks were called upon to rescue the company and the rights issue became an expensive condition of their assistance. That the company could make its self so vulnerable to a ratings downgrade, something not under its own control, speaks of very poor debt management, as well as what appears again with hindsight, as too much debt.

Having said that, on the face of it, the company has maintained a large enough gap between its earnings before interest and its interest expenses to sustain itself. In FY2016 these so-called “jaws” are expected to close sharply, on lower sales revenue, though they are expected to widen sharply again in 2017. According to Bloomberg, in FY2015, PPC earnings before interest were R1.660bn and its interest expense R490m, leaving R1.052bn of income after interest. In FY2016, earnings before interest are expected to decline sharply to R751m, the result of lower sales volumes, while interest expenses are expected to fall to R318m, leaving earnings after interest of R507m. Adding depreciation of R393m leaves the company with earnings before interest tax depreciation and amortisation (EBITDA) of R1.144bn in 2016 – just enough to fund about R1.068bn of additional capex. A marked improvement in sales, earnings and cash flows in the years to come has been predicted.

The rights at R4 per additional share were offered on Tuesday 23 August at a large discount of 55.5% to the then share price of R8.99. This discount is of little consequence to the existing shareholders. The cheaper the price of the shares they are issuing to themselves, the more shares they will have the presumed valuable rights to subscribe for or dispose of. Their share of the company is thus not being reduced even though many more PPC shares may be issued. They can choose to maintain their proportionate share of the company, or to be fully compensated for giving up a share by selling their rights to subscribe to others at their market value.

What is of significance to actual or potential shareholders is the amount of the capital being raised. The R4bn capital raised through the issue of 1 billion additional shares (previously 602m) should be compared with the share market value of the company that was but R5.477bn on 24 August 2016. The capital raising exercise is a large one and the success with which this extra capital is utilised will determine the future of the company.

The discount itself makes it very likely that shareholders, established or newly introduced, rather than the underwriters, will sell or take up their rights that will have some attractive positive value. The larger the discount for any given share price, the more valuable will be these rights (all other influences on the share price remaining unchanged – which they are unlikely to do.). These rights will sell for approximately the difference between the R4 subscription price and the value of the shares to which the rights are attached, between 2 September and until the rights vest on 16 September. The higher or lower the PPC share price between now and then, the more or less will be the value of the right to subscribe at R4, though such rights can only be traded after 2 September, when the share price will fall to reflect the larger number of shares to be issued.

The circular accompanying the Final Terms of the Rights Issue refers to a theoretical value of the shares once they begin trading after 16 September as R5.92 per share, that is given the share price on the day of the announcement, of R8.99. A better description of this theoretical value would be to describe it as the break-even price of the shares. This is the price that would enable shareholders or underwriters to recover the additional R4bn they will have invested in the company when the shares trade ex-rights. In other words it is the future price for the 1.6 billion shares in issue that would raise the market value of the company by an extra R4bn. equivalent to the extra capital raised – or from the R5.66bn it was worth on 23 August to R9.66bn.

Since the additional R4bn raised by the company is assured by the underwriters, the question the shareholders will have to ask themselves is whether or not the extra capital they subscribe to at R4 per share will come to be worth more than R4 per share plus an extra – say 15% p.a. – in the years to come. 15% is the sum of the risk free rate, the return on a RSA 10 year bond of about 9% plus an assumed equity risk premium of 6% p.a., being the returns they could expect from an alternatively risky investment. If the answer is a positive one, they should take up their rights, and if not they should sell their rights to others who think differently. Though any reluctance to take up the rights will reduce their value.

Until the rights offer closes on Friday 16 September and until shareholders have made up their minds to follow their rights or sell them, the target they will be aiming at (for their proportionate share of an extra R4bn of value) will be a moving one, as the PPC share price changes and as both the shares and the rights trade between 2 September and 19 September 2016. The higher (lower) the share price between now and then the higher (lower) will be this break even share price1. The PPC share price closed on Friday 26 August at R8.75, reducing the breakeven price from R6 marginally to R5.91 per share.

The value of a PPC share hereafter, initially with and later without rights, will depend on how well its managers are expected deploy the extra capital they will have at their disposal both now and in the future. Reducing the debt of the company by R3bn, as intended, appears necessary to secure the survival of the company. This reduction in debt will reduce its risks of failure and perhaps add value for shareholders by reducing for now the risk-adjusted returns required by shareholders. That is to reduce the discount rate applied to future expected cash flows.

What however will be the most decisive influence on the PPC share price over the next 10 years or more will not be its capital structure (more or less debt to equity) but the return on the capital it realises and is expected to realise. How the capital is raised, be it from lenders, new shareholders or from established shareholders in the form of cash retained, will be of very secondary importance. Unless, that is, the company again fails to manage its debt and equity competently – a surely much less complicated task than managing complex projects. 29 August 2016

 

1The breakeven price (P2) can be found by solving the following equation P2=(S1*P1)+k))/S2, where S1 is the number of shares in issue before the rights issue (602m) in the case of PPC and S2 the augmented number (1602m) while the additional capital to be raised, k, is R4bn. P1 is the share price before the rights can be exercised (R5.92 on 23 August) change or the share price plus the market value of the right – in the PPC case the right to subscribe to an extra 1.6 shares at R4 a share.

Competition policy in SA – in whose interest is it?

Mergers and acquisitions (M&A) are vital ingredients for a well performing economic system. Through M&A, the better-managed firms take care of the weaker performers leading to better use of the economy’s scarce resources. The success of M&A will be measured in the returns on the capital (debt and equity capital) so risked. The shareholders and the managers acting for the acquiring companies must hope for returns above the required risk-adjusted returns set for them in the market place. If they succeed, they will be improving the economy (improving the relationship between inputs and outputs) and adding wealth for their shareholders. There is a clear public interest in successful M&A activity.

But any such agreement reached between the buyer and seller of a whole company (or part of it) has a further hurdle to clear. The government may decide that the planned merger should be disallowed in a different public interest or, if permitted, that it should be made subject to conditions that can make the takeover more expensive and the larger business less successful. Increasingly, this has become the practice of competition policy in SA, especially when the intended acquirer is a large foreign-owned company.

What has been demanded of the foreign acquirer, even when the intended merger is judged to increase, rather than reduce potential competition in the market place, can only be described as a shakedown exercised by the competition authorities. For example, the demands made of Walmart in its takeover of Massmart and, more recently, in similar demands made of AB Inbev in its takeover of SABMiller. These are unpredictably expensive interventions in business relationships that add to the cost and risks of M&A. They will discourage such attempted activity and the ordinarily welcome flows of financial and intellectual capital accompanying M&A initiated offshore. It is perhaps good politics, but very poor business practice that is unhelpful to economic growth.

Perhaps more damaging to the economy and to the owners of businesses are the now usual conditions for approval, which stipulate that employment be guaranteed at pre-merger levels. Such demands must make it harder to realise the cost savings that a merger might otherwise make possible. A competitive economy, actively competing for labour and capital, so as to improve returns on capital and the productivity of labour through M&A, is inconsistent with guaranteed employment. There is a public interest in employing labour most productively and in labour mobility – not in guaranteed employment that benefits a few private interests.

In recent rulings, the Competition Commission has extended its reach further to the boardroom, in effect instructing merger intending managers and owners how to run their operations. To approve the merger of Southern Sun Hotels with listed hotel-owning company Hospitality, it demanded that the latter be managed independently by its own executive team “.. that would not include anyone who is involved in management in any capacity at Southern Sun”. Thus the rights and responsibilities that come with ownership were truncated. It came to a similar recent ruling, for similar reasons, the presumed sharing of presumed confidential information, on African Rainbow Capital’s deal to buy 30% of the shares in ooba — a mortgage originator controlled by SA’s biggest estate agencies.

What the Commission seems unable to recognise is that competition of the kind that most effectively challenges established firms will come from innovation and the application of technology, not from current participants and current practice. A good example of this is the large current and future threat to the pricing and other power of hotel owners and operators in Cape Town that comes from Airbnb, which has a large and growing presence in the Cape Town market.

The competition authorities in SA are in danger of overreach, if not hubris. It would benefit from a better understanding of and more respect for dynamic market forces and be much less inclined to interfere with them. And so would the economy and its growth prospects.

Tough Love

National Minimum Wage Panel – do your duty and offer tough love and resist the arguments for economic miracles.

The government has (thankfully) decided to kick the National Minimum Wage (NMW) into touch. The hope must be that the panel come to advise that any NMW high enough to make a meaningful difference to the circumstances of the working poor, is a very bad idea. It’s a bad idea because it cannot offer much poverty relief (to those who keep their jobs) without destroying the opportunity for many more in SA, particularly the young and inexperienced and those outside the cities, to find work.

The problem is that even many of those who find work (mostly in the cities), at the lower end of the wage scales, remain poor. The working poor in SA have been defined as those who earn less than R4000 per month. Yet the problem is that most of those with jobs in SA earn much less than this, while a large number of potential workers are unemployed and earn no wage income at all.

According to a comprehensive recent study of the labour market in SA by Arden Finn for the University of the Witwatersrand, 48% of all wage incomes, representing 5m workers, fell below R4000 per month in 2015 and 40% earned  less than R3000 per month, about 2.7m workers out of a total employed of about 13m. The proportion of those employed who fall below R4000 are much higher in the rural areas, higher in agriculture (nearly 90%) and domestic services (95%). In mining, 22% of the work force earned less than R4000 per month in 2015, while in the comparatively well paid and skilled manufacturing sector, about 48% of the work force were estimated to earn less than R4000 per month.

How many would lose their jobs? And how many would hold on to them to receive the promised benefits of higher minimum wages? These are the numbers that would have to be estimated by the panel. They would have to allow for all the other independent forces at work, other than wages, that could favourably or unfavourably influence numbers employed. For those on the panel who believe that SA can repeal the laws of supply and demand for labour and that wages have little to do with what workers are expected to add to business revenues, and so higher minimums can happen without very unhelpful employment effects – there is a question they will have to answer.

If a higher NMW can make such a helpful difference to poverty without serious consequences for the unemployed and their poverty, why not set the NMW ever higher?  If an NMW of R4000 a month is not enough to escape poverty, why not double or treble these minimums? They must surely agree that the number of job losses would increase as the distance between current wages and the intended minimums widened. Agree, that is, that the only way to avoid extra unemployment would be to set the minimums very close to actual minimum wages in the very different locales where they are earned, a symbolic rather than a practical gesture.

The panel could turn to the well-known relationship between employment, employment benefits and output (measured as value added or contribution to GDP) in the formal sector of the SA for evidence that improved employment benefits, for those who keep their jobs, leads to less employment for the rest. GDP has grown consistently while employment has stagnated and the numbers unemployed have risen as the potential work force has grown. Yet the real wage bills have grown more or less in line with real GDP. In other words, the percentage decline in the numbers employed has been less than the percentage increase in employment benefits paid out. Nice work if you can get it and too many South African have not got it. And wages and profits have maintained their share of value added. Firms have adapted well to more expensive labour; the unemployed have not been able to do so. Their interests should be paramount in policy action.

An NMW set well above market related rewards will reinforce such trends. It will not be fair to the non-working poor nor promote economic growth, the only known way to truly relieve poverty and raise wages over time. It is the duty of economists to practice tough love – to recognise the inevitable trade-offs should a NMW be introduced. We can but hope the panel will do its duty and resist politically tempting actions that have predictably disastrous effects. After all, if we knew how to eliminate poverty with a wave of a wand (the NMW is such a wand) we would have done so a long while ago.

 

Explaining the strength in emerging equity markets

This year is proving a very good one for emerging markets (EM) after years of lagging behind the S&P 500 (see figure 1 below).

 

Capital flows being good for EM equities (and bonds) have also been helpful for EM currencies, including the rand, and so the JSE, while it usually performs in line with the EM when measured in US dollars, has offered well above average EM returns to the offshore investor on the JSE this year (see Figure 2 below). As we have explained in earlier reports, strength in EM equities and bonds has a consistently favourable influence on the exchange value of the rand and most other EM currencies.

The question then arises of why are EM capital markets attracting revived interest from global investors? Is it simply the search for yield in a low yield, low expected return world? Or is there more substance to the switches to EM investors are making in the form of improved economic outcomes and better growth in EM economies and earnings from EM-listed companies to come. We provide some answers below that indicate the substance behind the strength in EM equities, including those listed on the JSE.

The underperformance of EM equities since 2011 has been accompanied- by weak earnings – earnings per share that have lagged well behind those generated by the S&P 500 Index. As may be seen in figure 3, S&P 500 earnings measured in US dollars compared to EM or JSE earnings in early 2010 , are more than 80% ahead, when measured in US dollars. The underperformance of EM equities has been highly consistent with this underperformance, as has the strength of the S&P been consistent with the impressive recovery in S&P earnings.

 

It should however be noted below in Figure 4 that EM and JSE earnings, having suffered a severe decline in 2015 led by lower commodity prices, appear to have reached a cyclical trough and are now increasing from their low base, while S&P earnings are also now pointing higher, after declining since early 2015. This revival in average earnings must be regarded as helpful for equity valuations generally, especially in a world of very low interest rates. That EM and S&P share prices moves have been highly correlated in 2016 is consistent with a similarly higher trajectory for earnings, especially should recent trends be sustained, as has been indicated.

The similar path of JSE earnings and that of the EM average – of which the JSE contributes only a small part, about 8% – should be recognised. It goes a long way to explain the similar direction of the EM Index and that of the JSE, when measured in US dollars. The JSE behaves as an average EM equity market because JSE earnings compare very well with the EM average. This is because JSE-listed companies, including industrial companies, are highly exposed to the global economy, even more than the SA economy.

 

In figure 5 below, we compare the average prices investors have been paying for average earnings. As may be seen, investors in the S&P Index have enjoyed a significant increase in the average P/E multiples and seen the Index re-rate when compared to the multiples attached to EM earnings. Such reactions are entirely consistent with impressive past performance, especially when accompanied by low interest rates that surely add to the present value of future earnings or cash flows expected. But the fact that S&P earnings have become expensive by the standards of the past and EM earnings can be acquired significantly cheaper than S&P earnings, will have attracted interest in EM compnaies, especially when the global economic and earnings prospects appear to be improving.

 

One sign of an improved economic state can be found in the Citibank surprise Index calculated for the 10 largest economies. As we show below in figure 6, the high frequency economic data has become much more encouraging. Expectations are being surprised on the upside. These more positive surprises are clearly helping to lift the equity markets. The economic news has been improving, surprisingly so, and global equity markets are responding accordingly. The strength in equities is well explained by economic fundamentals, especially so when the threat of higher interest rates seems so distant. 15 August 2016

 

The rand is mostly well explained by global forces. Yet SA specific risks have also declined to add further value to the ZAR. Long may these trends persist.

 

The rand has enjoyed a strong recovery in recent weeks. We say enjoyed advisedly. A strong rand is very helpful to households and their spending. It means less inflation (even deflation of the prices of goods or services with high import content or of those that compete with imports) and so less inflation expected in the prices firms set for their customers. If rand strength or even rand stability can be maintained, lower interest rates will follow to further encourage spending. Households directly account for over 60% of all spending, while spending by firms that supply households on capital equipment and their wage bills will take their cue from household demands. Any hope of a cyclical recovery of the SA economy depends crucially on the now more helpful direction of the rand.

Exporters may see their profit margins contract with a stronger rand. However, crucial for them will be the reasons for rand strength or weakness as the case may be. If the rand appreciates because the global economy is gathering momentum, or is expected to do so, then rand strength may well be accompanied by higher US dollar prices for the metals and minerals they sell on world markets, and vice versa, rand weakness might well be accompanied by or even caused by lower commodity prices. In which case revenues gained via a depreciated rand may well be offset by weaker US dollar prices. As has been the case for much of the past few years. Falling dollar prices for metals and minerals for much of the past few years – other than gold- have accompanied the weaker rand. And to some extent can be held responsible for the weaker rand.

Fig 1; Commodity Price Index (CRB) in USD and in ZAR

fig1

It is therefore important to identify the sources of rand weakness or strength. It is important to recognise the difference between global forces and SA-specific events that have driven or can drive the rand weaker or stronger, even though the implications for the state of the SA economy of rand strength or weakness, from whatever cause, global or SA specific, will be similar. The more risky (uncertain) the outlook for the global and SA economies, the weaker the rand and vice versa whatever the sources of more or less risk- be they Global or South African.

However if the cause of rand weakness is SA in origin – attributable to economic policies or expectations of them – those responsible for currency weakness and a consequently weaker economy can be held accountable by the democratic process. Policy makers may lose support, enough to change the direction of policy direction that could add rand strength. The rand strength that has accompanied the local government elections and a politically damaged Presidency are pointing in this direction and have made disruptive interference in SA’s fiscal policy settings less likely. Hence an extra degree of ZAR strength for SA specific reasons.

We offer an analysis that clearly can identify the causes of rand weakness or strength as either global or SA specific. The simple method is to compare the behaviour of the USD/ZAR exchange rate with that of nine other emerging market (EM) currencies that can be expected to be similarly influenced as is the ZAR by global forces. We compare an Index of these USD/EM exchange rates with that of the USD/ZAR exchange rate below (The exchange rates included in the Index are all given the same weight. The Index is made up of the Turkish Lira, Russian Ruble, Hungarian Forint, Brazilian Real, the Mexican, Chilean, Philippine Pesos, Indian Rupee and the Malaysian Ringgit). It may be seen that the weakness of the rand since 2013 has been accompanied by EM currency weakness generally. Much of the rand depreciation of recent years may therefore be attributed to global not SA specific influences on capital flows and exchange rates. It has been an extended period of dollar strength as much as EM weakness. The US dollar has also gathered strength vs the euro and the yen over this period.

 

Fig.2; The USD/ZAR and the USD/EM Average, 2013-2016 (Daily Data)

fig2

Source; Bloomberg and Investec Wealth and Investment

 

However it has not been only a matter of USD strength. As may be seen below when we compare the performance of the ZAR to the EM basket there have been periods of rand weakness – from January 2013 to September 2014- followed by a period of relative rand strength that turned into significant weakness in late 2015 when president Zuma frightened the market for the rand and RSA’s with his surprise sacking of the then Minister of Finance Nene. As may also be seen the recovery of the rand dates from late May 2016 and has gained significant momentum recently with the outcomes, expected and realized in the Local Government elections of August 3rd 2016. Since the close of trade on Friday 5th August the ZAR has gained 2.6% vs the USD while the nine currency EM average exchange rate is about 0.90% stronger vs the USD.

Fig.3; Performance of the USD/ZAR Vs the USD EM average. (Daily Data; January 2013=1)

fig3

Source; Bloomberg and Investec Wealth and Investment

A similar picture emerges when we trace the Credit Default Swaps for RSA dollar denominated debt and high yield EM debt in Fig 4. The CDS spread is equivalent to the difference in the USD yield on an RSA or EM 5 year bond and that of a five year US Treasury Bond. The credit rating of RSA debt in a relative sense can be expressed as the difference between the cost of insuring RSA debt against default Vs the cost of insuring high yield EM debt. The larger the negative spread in favour of RSA’s, the more favourable SA’s credit rating compared to other EM borrowers. As may be seen the RSA rating deteriorated in 2015 and is now enjoying something of an improved rating. Though the credit spreads indicate that there is some way to go before RSA credit attained the relative and absolute standing it had in 2012.

Fig.4; SA and Emerging Market Credit Spreads.

 fig4

Source; Bloomberg and Investec Wealth and Investment

 

To take the analysis further we have run a regression equation that explains the USD/ZAR exchange using the USD/EM exchange rate as the single explanatory variable. The fit is a statistically good one as may be seen in figures 5 and 6.  The EM currency basket explains over 90% of the USD/ZAR daily rate on average over the three and a half years. But as may be seen in figure 4, the ZAR was significantly undervalued in late 2015. The predicted value of the USD/ZAR at 2015 year end, given the exchange value of the other EM currencies might have been R14.86 compared to actual exchange rate at that fraught time of R16.62. Or in other words SA specific risks had made the USD almost R2 more expensive than it might have been at the end of 2015.

Fig.5; Value of ZAR compared to EM Basket on 1/1/2016.

fig5

Source; Bloomberg and Investec Wealth and Investment

As we show in figure 5 this valuation gap had disappeared by August 5th 2016.  The USD/ZAR exchange rate is now almost exactly where it could have been predicted to be by global forces alone. That is to say the current exchange value of the ZAR is precisely in line with other EM exchange rates.

 

Fig.6; Value of ZAR compared to EM Basket on 8/8/2016 Daily Data (2013-2016 August)

fig6

Source; Bloomberg and Investec Wealth and Investment

The future of the ZAR will, as always, be determined by the mix of global and SA specific forces. At current exchange rates it may be concluded that there is no margin of safety in the exchange value accorded the ZAR. It will gain or lose value from this level with changes in SA risk or with the direction of global capital flows that determine the value of EM currencies, bonds and equities.

The global capital flows acting on the ZAR are well represented by the direction of the EM equity markets. The ZAR and other EM exchange rates will continue to take their cue from flows into and out of EM equity and bond markets. In figures 7 and 8 below we show how sensitive has been the relationship between daily moves in the ZAR and by implication other EM exchange rates, to daily moves in the value of EM equities – represented by the benchmark MSCI EM Index. We show a scatter plot of these daily percentage changes below. This relationship has been particularly close recently as may be seen in the figures below.

Fig 7. Daily % Moves in the MSCI EM Equity Index and the USD/ZAR,  June 1st 2016- August 8th 2016

fig7

R=0.75;   R squared =0.56[1]

Source; Bloomberg and Investec Wealth and Investment

Fig 8: Daily % Moves in the EM Currency Index and the USD/ZAR; January 1st 2013 – August 8th,2016

fig8

R= 0.72; R squared = 0.52

Source; Bloomberg and Investec Wealth and Investment

A further feature of global equity markets this year has been the highly correlated movements in the S&P Index and EM Indexes including the JSE- when valued in USD. (See figure 9 below) Also notable is the extent to which the JSE, when valued in USD has outperformed other EM equities as well as the S&P tis. This has come after years of EM and JSE underperformance of a similar scale- especially when measured in strong USD.

Fig.9;  Equity Market Trends; USD. Daily Data 2016 (January 2016=100)

fig9

Source; Bloomberg and Investec Wealth and Investment

Fig.10; Equity Market Trends. USD.  Daily Data 2013-2016 (January 2016=100)

fig10

Source; Bloomberg and Investec Wealth and Investment

These recent trends are a reflection of less rather than more global risk aversion- and so a search for value in equities rather than in the defensive qualities of global consumer facing companies paying predictable and growing dividends. For the sake of the SA economy we can only hope that such trends persist. If they do the opportunity may soon present itself to the Reserve Bank to lower interest rates. It should do so and immediately stop predicting higher interest rates to come. The Treasury moreover should resist the opportunity a rand aided lower petrol and diesel price will give it to raise fuel taxes. A much needed cyclical recovery will take less inflation and lower interest rates. The opportunity a stronger rand may give to lower interest rates and to avoid higher tax rates should not be wasted.

[1] R is the correlation co-efficient. The R squared is for a least squares equation  dLog(ZAR) = c+ dLog(EM) + e

Features of the SA monetary system

We continue from our discussion of “helicopter money” (see Point of View: Helicopters in a different form, 1 August 2016) with a description and analysis of the SA monetary system. The Reserve Bank of SA has not practiced quantitative easing. By contrast, SA banks rather than being inundated with cash and excess reserves, have been kept consistently short of cash in support of the interest rate settings of the Reserve Bank. SA banks borrow cash from their central banks rather than hold excess cash reserves with it.

The SA Reserve Bank has not practised quantitative easing (QE). SA banks have not been inundated with cash derived from asset purchases in the securities market as had been the case in the developed world. Rather, SA monetary policy in recent years has practised a pro-cyclical policy with interest rates rising and subdued base money supply growth.

SA banks do not therefore hold reserves in the form of deposits at the central bank in excess of the reserves they were required to hold. As may be seen in the figures below, by contrast with their developed world counterparts, the SA banks are kept short of cash through liquidity absorbing operations by the Reserve Bank and, more importantly, by the SA Treasury.

Also to be noted is the liquidity provided consistently to the banking system by the Reserve Bank in the form of repurchases of assets from them as well as loans against reserve deposits. Rather than holding excess reserves over required cash reserves, the SA banks consistently borrow cash from the Reserve Bank to satisfy their regulated liquidity requirements.

It is these loans to the banking system that give the Reserve Bank full authority over short-term interest rates. The repo rate at which it makes cash available to the banks is the lowest rate in the money market from which all other short term interest rates take their cue. Keeping the banks short of cash ensures that changes in the policy-determined repo rate is made effective in the money market – that is, all other rates will automatically follow the repo rate because the banks are kept short of cash and borrow reserves rather than hold excess cash reserves.

In the US, the Fed pays interest on the deposit reserves banks hold with the Fed. The ECB, by contrast, applies a negative rate to the reserves banks hold with it. In other words, European banks have to pay rather than receive interest on the balances they keep with the ECB.

The cash reserves the banks acquire originate mostly through the balance of payments flows. Notice that the assets of the Reserve Bank are almost entirely foreign assets. Direct holdings of government securities are minimal, as reflected on the Reserve Bank balance sheet. When the balance of payments (BOP) flows are positive, the Reserve Bank adds to its foreign assets and when negative runs them down. The Reserve Bank buys foreign exchange in the currency market from the banks (and credits their deposit accounts with the Reserve Bank accordingly) or sells foreign exchange to them and then draws on their deposit accounts with the Reserve Bank as payment.

And so when the BOP flows are favourable, the Reserve Bank will be adding to its foreign assets and so to the foreign exchange reserves of SA via generally anonymous operations in the foreign exchange market. In so doing it is acting as a residual buyer or seller of foreign exchange and as such will be preventing exchange rate changes from balancing the supply and demand for foreign exchange. In a fully flexible exchange rate no changes in foreign exchange reserves would be observed, only equilibrating movements in exchange rates. The exchange rate will strengthen or weaken to equalise supply and demand for US dollars or other currencies on any one trading day. The Foreign Assets on the Reserve Bank balance sheet have increased consistently over the years. Hence the balance of payments influence on the money base- on the cash reserves of the banks- has been a strongly positive one.

Without intervention in the money market, these purchases of foreign exchange by the Reserve Bank would automatically lead to an equal increase in the cash reserves of the banking system. Their deposits at the Reserve Bank would automatically reflect larger deposit balances as foreign exchange is acquired from them and their clients. This source of cash however has been offset by SA Treasury operations in the money and securities markets.

To sterilise the potential increase in the money base of the system (defined as notes plus Bank Deposits at the central banks less required reserves) the Treasury issues more debt to the capital market. The debt is sold to the banks and their customers – they draw on their deposits to pay for the extra issues of debt – and the Treasury keeps the extra proceeds on its own government deposit account with the Reserve Bank. Provided these extra government deposits are held and not spent by the Treasury – as is the policy intention – the BOP effects on the money base (on bank deposits or reserves) will have been neutralised by increases in government deposits. (The money base only includes bank deposits with the Reserve Bank. Government deposits are not part of the money base.)
It is to be noted in the figure representing Reserve Bank Liabilities, how the Government Deposits with the Reserve Bank have grown as the Foreign Assets of the Reserve Bank have increased – extra liabilities for the Reserve Bank offsetting extra foreign assets held by the Reserve Bank. It is of interest to note that about half of the Treasury deposits at the Reserve Bank are denominated in foreign currencies.

 

The net effects of recent activity in the money market has meant much slower growth in the money base and the money and bank credit supplies over recent years. This slow growth has been entirely consistent with weak growth in aggregate spending and GDP. Note below how rapidly money and credit grew in the boom years of 2004-2008.

 

One test of monetary policy is its ability to moderate the amplitude of the business cycle. The strength of the boom between 2005 and 2008 and the subsequent collapse – and the persistently slow growth in money credit and spending after 2011 – indicates that monetary policy in SA has not been notably counter-cyclical. Nor can it claim much success in limiting inflation.

The problem for monetary policy in SA is the independent (of monetary policy settings) role played by the exchange rate in determining prices. Inflation has followed the exchange rate rather than money supply and interest rates. And the exchange rate movements have been dominated by global events- flows into and out of emerging market currencies (of which the rand is one) in response to global risk.

Economic activity picked up when inflation subsided between 2003- 2005, because the exchange value of the rand recovered strongly and because interest rates declined with less inflation. Inflation accelerated in 2008-9 as the exchange rate weakened and remained high with persistent exchange rate weakness. Interest rates were moved higher after 2014 as inflation picked up and the economy slowed down, further weakening demand without appearing to do anything to slow down inflation. These dilemmas for monetary policy will persist if exchange changes remain largely driven by global forces rather than SA interest rates.

An influence on this money multiplier in SA has been changes in the banks’ demands to hold notes in their tills and ATMs. The ratio of notes held by the banks to all notes in circulation fell away sharply after 2000, thus adding to the money multiplier. This ratio has increased more recently, so reducing the money multiplier. The Reserve Bank influenced this demand for notes by the banks by deciding in the early 2000s not to include notes held by the banks qualifying as required cash reserves.

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?