Author: Brian Kantor

A revolutionary proposal to transform the prospects of the SA economy – eliminate company tax

There seems little hope of permanently raising GDP growth rates. Persistently slow growth in SA threatens fiscal sustainability. It also threatens social stability. It prolongs the agony of widespread poverty. Something radical is called for to stimulate growth – and by radical I do not mean potentially disastrous expropriation of wealth or the introduction of a National Minimum Wage that, even if it relieves the poverty of those who manage to keep their jobs, will leave many more out of work and even more dependent on informal (illegal) employment and welfare provided by taxpayers.

The radical proposal to transform the prospects of the SA economy is to completely eliminate corporate income tax and replace it with a mixture of additional payroll and wealth taxes. Zero rating company earnings would provide a large boost for saving, capital expenditure, employment and the GDP growth rate. The sums involved are not trivial: corporate income tax yields about R200bn per annum or close to 20% of all government revenues.

The significant amount of tax saved adds to the case for eliminating the tax. Companies would save and invest in plant machinery and people much of the extra R200bn they would save in taxes. It would be a boost to the competitiveness of SA companies and could lead to lower prices. It would attract foreign capital because required returns – after taxes – directly investing in SA based enterprises, would be much reduced. It would make SA a haven for the establishment of head offices. Taxable income from global companies newly established in SA would be transferred in rather than out – as was a major concern of Davis Tax Committee.

Zero taxes for companies would eliminate all the distortions created when companies are taxed additionally and separately from their owners. Taxes on all income distributed by companies would be taxed at the income tax rates that apply to their owners, as is the case with any partnership. All the shareholders in SA companies would become what is known in the US as Master Limited Partners, enjoying the advantages of limited liability for debts but taxed as individuals or institutions at the same tax rates.

Dividends would be taxed as would rental or interest income when received, at the same rate applied to all income. There would be no double taxation of company income and dividends as there would be no relief for interest or any other expense incurred by the company. There would be no deduction for depreciation or amortisation. How much to allow as a deduction from earnings would be company business alone, as would be the decision to retain or pay out cash, with due regard for economic depreciation and the economic income of the company.

The company could be required to collect a withholding tax on all dividends and interest or rent paid out by a company to its capital providers at say a 25% rate, to secure a consistent predictable flow of revenue to the SA Revenue Service (SARS). Owners would credit such payments in their tax returns. Pension and retirement funds as agents of owners and capital providers should be made subject to the same withholding tax. Individuals and their retirement plans, including all their collective investment schemes, would be dealt with in exactly the same way when taxed on income received, including taxes on realised capital gains that should be treated as income.

This would eliminate the major distortion caused by taxing individual savings plans at a much higher rate than that of the collective investment schemes. Personal income tax incentives to contribute to savings plans would not be prejudiced by zero company tax nor would direct subsidies to companies. Yet subsidies are much more transparent to the taxpayer than income tax concessions – a further advantage of zero company tax.

There is in fact no good economic reason to tax the income of companies separately from the income of their owners. Taxing companies probably happened originally because it was administratively very easy to do so. That a tax is convenient to collect, rather than is easy to impose the collection duties on a company collecting tax on behalf of SARS, does not make for a good tax – one that treats all taxpayers equally – and does as little harm to the workings of the economy as is possible.

Dividends and the tax collected on dividends is very likely to increase significantly as company earnings rose – especially if dividends and interest and rent paid to pension and retirement funds were to be included in the tax net as they should be – taxed at say a 25% rate.

A social security tax at a low starting rate could help make up for the losses of company income tax. As indicated in the Budget Review, total payrolls in SA are of the order of R2 300 billion. 5% of this is over R120bn. In the first instance this is paid by employers, but in the long run the payroll tax likely to be paid, in effect, by employees as a wage or salary sacrifice. South African assets in the form of homes, pension funds shares etc. are of the order of R10 000 bllion. Assets in the form of homes are already taxed at market value by municipalities. Wealth in the form of shares in businesses and pension funds etc. could be taxed at the same rate. A 2% wealth tax could bring in as much as the corporate income tax, about R200bn.

With the elimination of company income tax, wealth in the form of shares in businesses, incorporated and not incorporated, would get an immediate boost, an extra inflation-protected R200bn a year in extra earnings – capitalised at a more friendly rate of say 4% – because of the business friendly tax reforms. The R200bn permanently saved by business owners in taxes might be worth 25 times R200bn or more than R5 000 billion to its owners. In other words, more than enough to compensate pension funds and their like for higher taxes on their income.

A wealth tax would also have a popular redistribution flavour to it. But a combination of a wealth tax and an elimination of company taxes would do more than redistribute wealth. It would help create wealth and income and transform the prospects of the SA economy.

 

 

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

Point of View: The optimum competition policy

Is there a true public interest in employment retention, either at Optimum Coal Mine or anywhere else in the economy?

The controversy surrounding the purchase by Tegeta Exploration and Resources, a Gupta controlled company, of Optimum Coal Mine for R2.5bn from Glencore has been grabbing the headlines in the local media. Optimum Coal Mine supplies Eskom and enjoys a near 10% share of the Richards Bay coal export terminal.

Part of the controversy was about the alleged role of Mineral Resources Minister Mosebenzi Zwane. According to a report in Business Day by Natasha Marrion on 23 February: “Mr Zwane said his only interest in the deal was to ensure that no jobs were lost under the new owner.”

Business Day further reported “that the Competition Tribunal has cleared the way for the Gupta-controlled Tegeta Exploration and Resources to acquire Optimum Coal, on condition there are no merger-specific job losses. The approval comes as the Treasury is reviewing all of power utility Eskom’s coal and diesel contracts.”

There is heightened public interest in the terms of this deal, for many reasons. What is of interest in this instance though is that the Competition Commission and Tribunal however chose to interest themselves only in the employment implications of the deal, following their mandate to consider the public interest as well as the competition implications of any deal of this magnitude. As the Appeal Court indicated in its precedent making judgment in 2011 on the Massmart-Walmart merger, the task of Competition Policy is to determine:

1. Whether or not the merger is likely to substantially prevent or lessen
competition;
2. If the result of this inquiry is in the affirmative, whether technological,
efficiency or other pro-competitive gains will trump the initial
conclusion so reached in stage 1 together, with the further
consideration based on substantial public interest grounds, which in
turn, could justify permitting or refusing the merger; and
3. Notwithstanding the outcome of the enquiries in 1 or 2, the
determination of whether the merger can or cannot be justified on
substantial public interest grounds.
The legislature sets out specific public interest grounds in s 12 A (3):
“(3) When determining whether a merger can or cannot be justified on
public interest grounds, the Competition Commission or the
Competition Tribunal must consider the effect that the merger will
have on –
(a) a particular industrial sector or region;
(b) employment;
(c) the ability of small businesses, or firms controlled or owned by
historically disadvantaged persons, to become competitive;
and
(d) the ability of national industries to compete in international
markets.”
Clause 3d, “the ability of national industries to compete in international markets”, as well as clause 3b “employment” might well have also have been used to examine the contract. Clearly the competitive terms on which Eskom sources its coal will affect its costs and the prices it will ask the regulator to approve. The ability of all SA industry to compete effectively depends on the price and availability of electricity.

That the Treasury is apparently also investigating this Eskom contract, among other Eskom contracts, might be a reason for the competition authorities to have ignored this public interest in the terms of the contract. Be that as it may be, the Competition Commission’s determination of the mandated public interest as in 12a clause 3 of the Act, in employment retention, following that of the Competition Appeal Court judgment in the case of the Walmart Merger, and further pursued in the Tegeta case, needs to be seriously examined.

The case of the entry of WalMart to the SA economy. The welcome mat was not laid out.

An important case for competition law in SA, resolved in 2011 on Appeal to the Competition Appeal Court headed by Judge Dennis Davis, involved the purchase of a majority stake in a local JSE-listed retailer and wholesaler, Massmart, by the largest retailer in the world, Walmart. Approval of the deal was given by the Competition Tribunal because it was “common cause” – to quote the Judgment of the Competition Appeal Court, on the Tribunal – “that there was no threat to competition”. Indeed it was so conceded by the counsel for the parties contesting the approval of the merger in Court, to quote a report on the proceedings: “Paul McNally, who submitted closing arguments on behalf of the union… said his clients accepted that there would be lower prices as a result of the acquisition, but that these would come at the expense of local jobs.” 1

Surely this common cause should have been sufficient to approve the merger and to extend a warm welcome to Wal-Mart, especially from SA consumers, who were bound to benefit from more competition for their spending power. Given the importance of foreign capital for the economy and its growth prospects, a warm welcome too might have been extended in recognition of the confidence that the world’s largest retailer was expressing in the SA economy. This friendly response to an important investor in the SA economy might well have encouraged more direct foreign investment that is very obviously in the broad public interest.

The Competition Tribunal however surrounded its approval of the deal with a number of onerous and complicated conditions. Such conditions were highly sympathetic to the arguments made by the trade unions interested in the merger, but costly to Walmart and therefore its ability to compete in the market place with other retailers and wholesalers.

The conditions required of the merged entity by the Tribunal included restrictions on retrenchments, preferences for previously retrenched workers when employment opportunities presented themselves and R100m to be invested in a programme to support local business, combined with a requirement to train local South African suppliers on how to do business with the merged entity and with Wal-Mart with the programme and its administration to be “advised by a committee established by it and on which representatives of trade unions, business including SMMEs, and the government will be invited to serve”.

However the merger was taken on appeal to the Competition Appeal Court by the concerned unions and Ministers of State who sought to have the merger disallowed on public interest grounds. The Appeal Court agreed to allow the merger but decided to largely support the Tribunal by surrounding the deal with the conditions as had been recommended by the Tribunal (somewhat modified) but clearly not to the advantage of Wal-Mart as a competitor.

This seems a very unhelpful and unlikely course to take for a body designed to promote competition. Mergers and acquisitions, friendly and especially hostile ones, are among the more important ways in which businesses realise economies of scale that allow them to become more efficient more profitable and by definition more competitive in the interest of its customers of whom they wish to win more over. Any synergies to be realised in a larger, combined entity almost inevitably involve retrenchments of staff. Indeed, the ability to avoid duplication of personnel and systems and to reduce operating costs and improve margins is often the prime motivation for any merger or acquisition.

A vibrant economy is one where, over time, workers and managers are continuously being allocated and reallocated to more efficient purposes. This requires that some firms will be reducing their complements of workers while others are increasing theirs and net employment gains are registered for a growing potential labour force. Without job losses, there would be far fewer job gains made possible. A system that made it very difficult to retrench workers is one that discourages hiring in the first place. It makes for a stagnant economy, with a feudal style labour market that treats jobs as an entitlement, not at all easily discarded and highly discouraging to job creation.

A flexible labour market, by contrast, gives firms a high degree of freedom to hire and fire and allows workers to freely choose their employers and move easily from one job to another. The favourable outcomes of such freedoms enjoyed over time can be observed in the US or UK, with a highly productive and well paid labour force and a significant rate of turnover of jobs.

The South African labour market, or at least the labour employed in the formal sector of the economy that provides the much prized, so-called “decent jobs”, is highly inflexible. Job retention, rather than job growth, has become the primary objective of labour market regulations and it would appear also competition policy. The prospect of an extended period of unemployment is an unhappily realistic one for many of those threatened with retrenchment.

This is a weakness of the labour market that policies for competition should be addressing, not reinforcing. The competition authorities, by their rulings on job retention, have made the economy less efficient and competitive than it could be. By setting these precedents, it also makes efficiency enhancing investments and acquisitions less likely and so the efficient use of capital and labour less likely.

There is a public interest in a more competitive and efficient market for goods and services and for labour. There is only a private interest in avoiding particular retrenchments. Competition policy misuses the public interest in employment. The public interest is in employment growth and a more productive labour force to which mergers and acquisitions can make a very important contribution.

1 http://mg.co.za/article/2011-05-31-walmartmassmart-deal-approved-with-conditions

The Hard Number Index: Hope rests with the rand

The SA Business Cycle, a call on interest rates – which is a call on the rand. Here’s hoping for lower interest rates

The release of new vehicle sales and the note issue for February 2016 allows us to update our Hard Number Index (HNI) of the current state of the SA economy. The HNI has proved to be an accurate leading indicator of the Reserve Bank Business Cycle Indicator that is now only updated to November 2015.

The HNI for February is little changed from the January reading and indicates that the currently slow pace of economic activity is being maintained. See the figures below, where the HNI is compared to the Reserve Bank Business Cycle and extrapolated to February 2017. As may be seen below, the forecast is for but marginally higher levels of activity this time next year. The good news is perhaps that no obvious further deceleration in the pace of economic activity was recorded in February 2016.

New unit vehicle sales continued to decline slowly last month. The time series forecast is for sales to decline from the current annual rate of 607 000 units to an annual rate 582 540 new units sold into the SA market in February 2017, a decline of 6.8%. This would represent a modest cyclical decline when compared with past downturns in the vehicle cycle. This atypical, low amplitude new vehicle sales cycle will have had much to do with the current, comparatively low amplitude uptick in the interest rate cycle.

The other component of the HNI, the cash cycle, adjusted for inflation, has also turned lower, mainly the result of higher inflation. As may be seen in the chart below, current growth rates are of the order of 2% per annum and are forecast to remain at this rate, consistent with the GDP growth outlook.

The cash cycle possibly captures the influence of the informal economy. The vehicle cycle reflects the spending on capital goods, the cycle of firms and the household’s demands for consumer durables. This includes motor vehicles as well as washing machines, furniture, appliances etc that are financed with credit. Very few new vehicles are now exchanged for cash. Therefore market interest rates are possibly the largest influence on the cost of leasing (renting) a new motor vehicle.

The other important influences on the cost of ownership will be the value of any used vehicle traded in, or the residual value agreed to. The higher the residual value or the longer the repayment schedule, the lower will be the monthly rental payment. And the monthly payment may well be offset by the separately itemised charge for the motor plan. It is the highly negotiable gross monthly payment that will be the key influence on demands for new vehicles, rather than the theoretical list price, as is also the case with many other large ticket items bought by households.

Unfortunately it is this mostly theoretical vehicle list price that will rise with rand weakness and be reflected in the CPI and to which the Reserve Bank may react with still higher interest rates.

It would be a much more accurate measure, of the possibly less inflated monthly cost of owning a vehicle, were it reflected in the CPI by this leasing charge, rather than by new vehicle prices, as is the case with the CPI treatment of the cost of owning a home. This is correctly reflected in the CPI as an implicit rental charge to the owner occupier, rather than by house prices themselves. And so, the key influence on vehicle sales and house prices will be short term interest rates – though monthly payments may well be held back by more intense competition to make sales and issue motor plans.

For the sake of the motor manufacturers and dealers, and for the sake of the economy generally, the hope must be for lower, not higher interest rates. Such hopes rest with the behaviour of the rand, over which, it may be added, short term interest rates will have very little influence, judged by past performance.

The hope for lower interest rates in SA and a cyclical upswing rest with the exchange value of the rand. The rand will take its cue from the attraction of interest rates at the long end of the yield curve. Any improved flow into emerging markets will also attract funds into the RSA bond and equity market and strengthen the rand, as will any diminution of SA specific risks.

The risks of presidential intervention in fiscal policy have not dissipated, though they have declined compared from levels first reached with the dismissal of Finance Minister Nhlanhla Nene in December 2015. The risk premiums attached to RSA debt remain elevated accordingly. Furthermore, emerging market risks more generally have declined both absolutely and relatively to the SA CDS spread, as we show below. The gap between more risky emerging market debt and RSA debt has narrowed, even as both spreads have declined. The wider this spread gap, the better the SA rating. So it may be concluded that much of the recent improvement in RSA credit ratings is attributable to global, rather than SA, specific events.

The upside is that these SA risks are overstated and that President Jacob Zuma will prove them so by allowing Finance Minister Pravin Gordhan the essential freedom and authority to manage fiscal policy in the conventional way. If this happens, then the rand can strengthen further. This would help to put downward pressure on the inflation rate as well as on long term RSA interest rates. Less inflation and less inflation expected may well bring lower interest rates. The next cyclical recovery, including a recovery in the vehicle market, depends upon a stronger rand and the lower interest rates that will accompany rand strength.

Budget 2016: Austerity is not enough

Austerity will not be enough to improve the RSA credit rating. Privatisation will be essential to achieve this.

The 2016-17 SA Budget to be presented on 24 February is set to be an austere one. A mixture of higher tax rates and faster growth in tax revenues seems bound to accompany slower growth in government expenditure. The objective will be to reduce the debt to GDP ratio and to impress the rating agencies accordingly.

But fiscal austerity, accompanying higher interest rates imposed by the Reserve Bank, coupled with more inflation, will not help the SA economy to escape its growth malaise. In the short term, taken on its own, such austerity is likely to inhibit any cyclical recovery.

Fiscal austerity may be necessary for securing a better credit rating for SA and lower costs of funding government debt. But it will not be sufficient – and the rating agencies may well come to remind the Treasury that the greatest risk to the SA economy is persistently slow growth. Something more than fiscal austerity is required to improve the national balance sheet and impress the global capital markets, as well as to improve confidence in the prospects for the SA economy.

A commitment to privatisation of state owned and funded enterprises is urgently called for. Asset sales to private owners and operators would reduce national debt and interest payments while relieving the tax payer from further calls on their cash that has far more useful alternative applications.

Private ownership and responsibility for operating failures would absolve the regulators from conceding abnormally high increases in electricity or water tariffs as an alternative to the hard pressed Treasury raising additional debt or equity to keep the public enterprises going. But such higher tariffs – tariffs that are by now more than high enough to secure private capital to supply the essential services – are taxes by another name. They reduce disposable incomes by as much as any indirect tax increase would and, by lifting the rate of inflation, they unfortunately and unnecessarily encourage the Reserve Bank to add to the misery by raising interest rates even further. Exchange rate shocks, tax shocks and drought are very poor reasons for raising interest rates – but are a likely outcome given the Reserve Bank’s modus operandi.

The national balance sheet would benefit greatly from a willingness to sell off (at any price) rather than continue to support failing public enterprises with bail outs in the form of taxpayer cash or guarantees of the debt issued by public enterprises. The scope for the better management of what are now publicly owned and funded enterprises is very large. The political will to do so would be very well received in global capital markets. There would be no lack of foreign capital to access the opportunities a well-designed process of privatisation would offer.

The sale (fully or partially) of SAA comes to mind – as does a listed private share in the Airports Company of SA. The other sea ports of SA are also very valuable assets that would benefit from private owners, while their customers would benefit from competition between them. The generating capacity of Eskom could be unbundled and sold off to a variety of owners and managers, who would then be subject to the full discipline of a competitive market for energy – and a cost conscious regulator.

Such reforms would add value to the rand and reduce inflation and interest rates. A recovery in the rand and lower interest rates would be a great stimulus to the economy. An upswing in the business cycle would follow and the structural reforms of failing public enterprises would raise the long run growth potential of the economy.

The state of the markets

The State of the Nation speech delivered by President Jacob Zuma to Parliament on Thursday 11 February revealed a more open and pragmatic approach to the prospect of privatisation. The capital markets so far have not registered any marked approval of such intentions. The sovereign risk spreads and the outlook for inflation have not yet improved in any immediately obvious way.

The spread between RSA long term interest rates and their US equivalents remain elevated, albeit below the levels recorded when President Zuma intervened in fiscal policy and sacked the then Minister of Finance, Nhlanhla Nene, on 9 December. This risk spread, currently over 7% p.a. is, the rate at which the rand is expected to depreciate over the next 10 years. What is to be gained by a US dollar investor in the form of higher yields is expected to be perfectly off set by exchange rate weakness in the market for forward exchange. If this were not the case, then arbitrage opportunities to make certain profits in the bond and currency markets would open up.

The market is clearly expecting a high rate of further rand weakness. Consistently, given the expected weakness in the rand, the expectation of more inflation to come over the next 10 years, remains equally elevated. A weaker rand must be expected to bring more inflation with it. The compensation for inflation provided in the RSA bond market thus remains at about the same level of over 7% p.a. Vanilla bonds, which are vulnerable to unexpectedly high inflation, still offer over 7% p.a more than the inflation protected variety yields of under 3%. This yield spread can be regarded as an objective measure of inflation expected.

In the figures below we show how the gap between RSA yields and US Treasury Bond yields widened significantly on 9 December. They have since receded but spreads remain elevated, as has inflation compensation. They do not appear to have reacted favourably to the State of the Nation speech.

A somewhat similar picture emerges when we compare the risk spreads on RSA dollar-denominated debt. The cost of insuring an RSA Yankee dollar-denominated five year bond moved sharply higher on 9 December and has widened further since then. But the risk spreads on even higher risk emerging market debt have also widened. This indicates that the higher risks associated with RSA debt have not been a purely SA event. Global risk aversion has also been an influence on credit ratings. However the current RSA credit default swap (CDS) spread of over 350bps, already effectively gives SA debt junk status.

We therefore compare the emerging market spread with the SA spread. The wider this difference the better the relative credit rating of SA debt. As may be seen on the right hand scale of the figure below, this difference narrowed sharply on 9 December, indicating an immediately inferior SA credit rating. But the SA credit rating then improved in a relative sense, given the larger difference between average emerging market yields and RSA equivalent debt. Encouragingly, this spread has increased further in recent days, indicating an improving SA credit rating – when compared to a peer group.

We await with great interest the detailed Budget proposals. Not only will the plans for government spending, tax and debt issues be influential. The plans for asset sales, that is for privatisation, may prove even more important. A combination of fiscal austerity with credible privatisation plans could have a profound influence on SA’s credit rating, the rand and the longer term growth prospects for the SA economy.

The rand and the SA economy: All about the dollar

Markets are all about the mighty US dollar at the moment – weakness rather than strength is the hope for the SA economy. But rand strength could follow the right SA responses to our impaired credit rating

The markets this year have been most concerned about the danger of the Fed raising interest rates as US growth prospects were deteriorating. A strong US dollar, in such circumstances, posed a particular threat to emerging market currency, bond and equity markets. The presumed greater risk of a global recession was increasingly reflected by significantly lower commodity prices and the shares of the companies that produce them. Emerging market equities, bonds and currencies markets all revealed these increasingly risk averse sentiments.

The highly correlated and not co-incidental weakness in commodity and emerging markets continued until the last week in January as we show below. The Commodity Research Bureau Index (CRB) shown below includes about a 27% weighting in oil. A further figure compares the prices of particular metals to the emerging market (EM) equity index (MSCI EM). Price weakness until late January 2016 and a recovery since is revealed in the figures below.

The previously strong US dollar however weakened this week, as the danger of higher interest rates in the US faded away. Dovish interest rate comments by the Chairman of the New York Fed led the dollar lower. It was a spark that lit up the shares of the mining companies. The shares of leading mining companies listed on the JSE responded dramatically to a weaker US dollar. As at Friday afternoon 5 January, Anglo leads the pack and is up about 36% since the Monday close on 1 February.

The rand and the JSE as a whole responded as it usually does to the global forces that move EM markets. SA had earlier revealed particular dangers to its policy settings that led to a significantly weaker rand and higher risk spreads, compared to its EM peers. But these SA-specific risks were a December event, though the EM influence is apparent throughout the extended December to February period with a degree of extra SA risk revealed in December.

The striking impact of the stronger rand on the long end of the RSA bond market is shown below. The rand – as influenced by global forces, as it usually does – overwhelmed the impact of higher short term rates on the bond and equity markets, as imposed by the MPC of the Reserve Bank on Thursday 28 January.

In the figure below we compare alternative measures of SA risk that reveal a very similar pattern of SA risk aversion. The difference between RSA and USA bond yields compensates investors for the expected weakness of the USD/ZAR exchange rate. This risk premium jumped up sharply on 10 December 2015 when Finance Minister Nene lost his job. The risk premium has since declined, helped by the stronger rand and lower interest rates since. Yet the SA risks priced into the markets remain highly elevated as is shown by the wider five year CDS spread, both absolutely and relative to the spread on equivalent Turkish dollar-denominated debt. This spread, equivalent to the difference between the running yield on RSA US dollar denominated debt and its US equivalent, represents the cost of insuring against RSA debt default.

The SA economy is growing very slowly. The decision by the Reserve Bank to further increase its repo rate will add to the contractionary pressures acting on the economy. Fiscal austerity seems very likely to be introduced in the 2016-17 Budget to be presented later this month. The hope must be that the painful demonstration of fiscal conservatism will lower the risk premium attached to SA debt and equities, so attracting more capital to SA and so add to the value of the rand.

Only a stronger rand, bringing lower than expected inflation and lower interest rates, can reverse the cyclical direction of the economy. A weaker dollar and stronger flows into EMs will be a great help to the rand. But it will take more than a credible commitment to fiscal conservatism to reduce the SA-specific risks holding back the rand and the economy. A recognition by the government that the partial privatisation of underperforming state-owned enterprises would improve the performance of the economy and the quality of the RSA balance sheet, is essential to reducing the risk premium added to the returns of investments in SA.

Point of View: Credit anxiety

There is much anxiety about how much poor South Africans are paying in interest for the credit they receive. Newly shocking to observers is the fact that if a good is purchased on credit the monthly payments may amount to much more than the purchase price. For example, if a fridge had a face value of R10 000 to a buyer on credit, paying 25% p.a interest and repaying the capital sum over 10 years, the buyer would be making monthly payments of R227. And so over the life of the loan would have paid in interest and capital repayments an amount of R27 299 of which R17 299 would have been interest. Had the loan been a five year loan at the same 25% rate of interest, the monthly payments would have been higher, R294 per month, meaning lower total payments of R17 611 of which much less, R7 611 would have been the interest expense.

Why then would anyone borrow for a longer rather than a shorter period if it costs so much more? One could however ask an even more obvious question. Why would anyone buy on credit rather than pay cash, especially when the cash price is very likely to be a lower discounted one? The answer should be obvious. They buy on credit because they do not have the wherewithal to pay cash.

Without access to credit they would be denied the essential services of the fridge. Further saving the R294 minus R227 (R67) per month might mean a fridge fuller with essential food. The value of the fridge to the household borrower is in fact what they are willing to pay for it, the R227 or R294 per month. They are consuming the services of the fridge for which they are clearly willing to pay. For the lender, shorter repayment periods, higher monthly payments and less interest accrued becomes a less risky transaction, one they otherwise might wish to encourage. Borrowers however have to be judged as credit worthy enough to enjoy extended credit terms. The choice of extending the repayment period, paying more interest, may in fact be a limited one- unfortunately.

The cash buyer will not be paying interest, but nevertheless will be foregoing the opportunity to earn interest or dividends on the cash they have allocated to a particular asset. It might well be a good decision for them to rent or lease an asset rather than pay cash and put the cash to better use elsewhere. For example, to rent rather than buy a home and do something much more valuable with the cash invested, perhaps even to pay the deposit on a house bought to rent with a mortgage loan.

As with the fridge, somebody buying a home on credit pays out a lot more in interest and capital repayments than the purchase price of their home. A R1m home bought on mortgage credit at a low 10% per annum paid off over 20 years, will mean a monthly payment of R9 650 and will accumulate total payments of R2 316 052 – more than twice the purchase price paid. But the proud home owner would have saved rental payments over the period and the home will have a market value after 20 years, unlike some household appliance.

The house bought on credit will have provided a flow of services, accommodation services, similar in nature to the services provided by a fridge or TV – benefits that are received in exchange for interest and principal paid. Also, such leverage may prove to be a very good financial deal if the house more than maintains its after inflation value. Access to such credit provides a rare opportunity for salaried homeowners to add to their wealth through leverage. Such lending and borrowing on terms agreed to by borrowers and lenders surely deserves every encouragement, even if, as is bound to be the case, interest paid apparently means a more expensive house over time.

Household appliances do not provide the lender with anything like the same protection against losses should the borrower default – hence the higher charges required by lenders competing for the business. These charges reward the dealer who incurs the costs associated with the bundle of goods and services associated with any transaction concluded on credit. Charges that will be intended to cover the interest costs of supplying credit, the costs of goods supplied with the credit, and the services associated with the goods, for example the rent paid for trading space and the working capital invested in an inventory of goods from which customers can choose. This bundle of benefits – goods and services including credit services supplied to a customer – may come with a single charge, for example for a dress bought on credit at a given price to be paid off over time. Yet the price of the dress is very likely to incorporate a very high, but unknown to outsiders, profit margin intended to cover all the associated costs including the risks of non-payment. There is fortunately very little comment about regulating gross profit margins on goods supplied on credit.

There is much comment however about the apparent inequity when the terms of the transaction are in a mix of separately itemised charges – some combination of listed price, interest charges, delivery and insurance charges etc. may be specified. And complained about if one or other of the charges, considered alone, appears exorbitant. But what will matter to all buyers paying a single charge or multiple charges is how much they will be required to pay each month and whether or not it is worth making the monthly payment. And what will matter to the seller of the mix of credit and goods supplied, is whether the revenues they collect – perhaps is a variety of itemised charges – will cover their costs, including a return on capital invested appropriate to the risks incurred. If the returns exceed the required returns, more competition to supply goods and credit can be confidently expected. But if some of the charges made are controlled on an apparent cost-plus basis, such as insurance charges, any loss of revenue will have to be made up in one or other of the other charges (if the goods and credit are to be supplied in the same volume and variety). If the loss of revenue cannot be made up, less credit will be supplied.

The SA government has however decided not to leave the outcomes in credit markets to be determined by market forces. They have regulated the terms of the contracts by more than what willing lenders and equally willing borrowers might otherwise agree to. Loans, including mortgage loans, may be forced to be limited to some proportion of wage incomes and the terms of the loan, including the interest rate agreed to or charges for insurance arrangements, may be subject to regulation.

Treating borrowers in this way, as less than capable of looking after themselves, as adults managing their credit affairs, has consequences. So too has not trusting potential lenders to compete with each other with loan facilities that will compete away excess risk adjusted returns in providing credit. Such interventions in the credit market mean less credit supplied. It means fewer fridges, TVs, computers and furniture in homes, less clothing in the wardrobe, all understandably very important to the household. It also means fewer houses owned by the occupier.

Regulations of this kind may protect some less than responsible borrowers and lenders from borrowing and lending more than they should have. Yet by imposing regulations on the potentially credit worthy, as judged by willing lenders, they frustrate the plans of potentially worthy borrowers to gain access to credit that is valuable to them, credit that might be supplied to them on terms they would be willing to agree to. In the absence of credit from established businesses with reputations to protect and repeat business to encourage, desperate borrowers may well be forced into the clutches of the informal payday lenders and their ilk. Lenders who will charge much higher rates of interest for loans of typically very short duration, with repayment secured violently if necessary.

The regulators appear only aware of the costs of poor credit decisions, rather than the benefits of many more good ones made, under the discipline of market forces. Access to credit has played a very important role in improving the standard of living of many South Africans with improving income prospects but little wealth to draw upon. It is in reality a South African success story.

The self- regulatory capabilities of a market place, including those of a credit market, receive too little respect in South Africa. The costs – intended and unintended – of the flood of additional rules and regulations that prevent agreements between willing sellers and buyers, willing borrowers and lenders, are too easily ignored by an ambitious bureaucracy. These ever growing regulatory burdens on market participants are an important part of the reason why the SA economy is stagnating.

How fares the SA economy? An update to December

With new vehicle sales and the Reserve Bank note issue for December to hand, we can update our Hard Number Indicator (HNI) of the state of the economy at year end. The economy maintained its sedate pace in December. The forecast is for more of the same in the year ahead, that is for slow but not negative growth in 2016. Our HNI serves as a useful leading indicator of the Reserve Bank Business Cycle Indicator updated only to September 2015.

The HNI and the Reserve Bank coinciding business cycle indicator measure the level of economic activity. When these are converted into rates of change, we show below that the growth rate in the HNI has been declining since 2010 and is currently barely positive and is forecast to remain barely so. It is of some consolation to notice that the weak growth outlook has not deteriorated and is forecast no to do so. The consistent way in which growth in the HNI leads the Reserve Bank cycle helps to confirm its usefulness. It has the advantage of being very up to date and based on hard numbers not sample surveys.

Sales of new vehicles of all sizes in the SA market (that make up half of the HNI) are shown below. While sales are 4% down on a year before, sales volumes, which have averaged over 50 000 units a month, must be regarded as very satisfactory, given the state of the overall economy, especially for the SA manufacturers who also delivered 337 748 units to foreign markets in 2015, 20.5% up on a year before.

The other half of the HNI is made up of the growth in the real supply of and demand for cash. These demands for cash have been growing at a real 4% p.a as we show below. However the cash cycle appears to have peaked earlier in 2015, helped by lower inflation. The demands for cash, to spend on holidays and presents, rise strongly in November and December, though growth slowed this December off a very high base established in December 2014. The growth in demands for cash in SA, despite the heavy and growing use of electronic alternatives to cash, speak eloquently of the important role the informal economy plays in SA – a role however that is not reflected in official estimates of the size of the informal sector, as about 5% only of GDP.

The outlook for domestic spending has deteriorated, with the collapse in the exchange value of the rand. Higher rand prices for goods with high import or import replacement content or export potential will further discourage spending by households. That the oil price in dollars has declined by even more than the dollar value of a rand has been a welcome source of relief for households and firms. The inflation outlook has therefore not deteriorated as much as it would ordinarily have done with a rand this heavily damaged.

Hopefully this lesser inflation outlook will help restrain the Reserve Bank from raising interest rates as much as they would otherwise have done. Higher interest rates will do little to help the rand; they have not helped the rand to date that has been driven by global and SA forces well beyond the influence of monetary policy and interest rates. However higher interest rates will be sure to add to the contractionary forces slowing the economy- and undermine further the case for investing in SA. Is it too much to hope for a sanguine Reserve Bank- one that will allow the exchange rate to absorb the economic shocks- and not to add to them? And to happily surprise the market accordingly.

From Shanghai to Johannesburg – More than the weak rand at work

The JSE has, over the years, become less a play on the SA economy and much more a play on the global economy. This degree of independence for investors from the ups and downs of the SA economy and the value of the rand is provided by an important group of companies listed on the JSE that we describe as global consumer plays (GCPs). They comprise principally Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI), Naspers (NPN), which has become largely a Chinese internet company through its 35% holding in Tencent, listed in Hong Kong, and MTN, which generates much of its revenues and incurs costs outside of South Africa. To these we added Steinhoff (SNR), Aspen (APN), Mediclinic( MDC), Netcare (NTC) and Intu (ITU), a London based property company.

We combine these companies into an Index, using their Swix weights (the proportion of their shares on the SA register) as the basis of their inclusion in our GCP Index. This gives NPN by far the largest weight in our Index. Foreign owners of NPN hold their shares in NPN on the JSE register because NPN shares are not listed on other exchanges. This is not the case when the shares are also primarily listed on other exchanges, as is the case with BTI, CFR and SAB, where only a small proportion of SA owners would be registered as such by the JSE.

Such independence is helpful to shareholders when the rand weakens. It is even more helpful when the rand weakens for particularly South African reasons, as it did in December 2015. In these circumstances the dollar value of these shares is likely to be little affected by events in SA and so their dollar values translate into rands at a higher USD/ZAR rate. When the rand weakens in line with all emerging market currencies, because of increased global risk aversion, the dollar value of these shares may well come under pressure, giving them less of a rand hedge quality. In such circumstances the rand can weaken by less than the decline in the dollar value of such shares, meaning that their rand value can go down even as the rand weakens. Nonetheless their rand values are likely to hold up better than the purer SA economy plays. Thus it is better to describe these shares as South African economy hedges than as rand hedges.

In the figure below, we compare the performance of the GCP Index with that of the S&P 500, also measured in rands. The comparison was highly favourable to the GCPs until this year. It has become very unfavourable in January 2016 as the chart shows. The S&P 500, in devalued rands, continues to move ahead while the GCP Index has gone backwards.

The main reason for this recent underperformance has been the NPN share price. As we show below, NPN outperformed the S&P 500 over a long period, but this has not been the case since mid-2015. The Shanghai market weakness would appear to have extended to Tencent and so to NPN. The links between Shanghai and other global equity markets has become much stronger recently and NPN is clearly affected by this.

Some of the other important components of our GCP Index have done significantly worse than NPN, as we show below where we compare total returns over the past 12 months to 15 January 2016. The distinct underperformers are APN and MTN and the distinct outperformer SAB. Clearly as with any company, firm specific risks as well as market risks including risks to the rand can greatly affect performance – as they have done with APN and MTN in 2015.

In the figure below we compare the performance of other sectors of the JSE with that of the GCP Index. Both the group of Top 40 SA Industrials and the SA interest rate plays have also had a very poor January. The commodity price plays (excluding the gold mines) continue to underperform both absolutely and relatively. The weak rand and the higher interest rates that are expected to follow a weaker rand are unhelpful market forces for SA economy plays.

The one consolation in all this JSE weakness across the board is that the oil price has fallen by more than the rand (see below). Thus the inflationary pressures that usually follow a weaker rand and usually higher fuel and transport costs, are not present. This means less inflation to come. Interest rates in SA may not rise as much as they are expected to rise. If this turns out to be the case, the depressed SA plays may well offer value over the next 12 months.

Monetary policy and the MPC: Recognising the facts

The members of the Monetary Policy Committee (MPC) of the Reserve Bank will be even more perturbed about the behaviour of the rand than the rest of us. However they have had (and will have) as little influence over its direction as you or me. The link between short term interest rates that they control and the USD/ZAR exchange rate is shown in the chart below. As may be seen, they began a rate hiking cycle in January 2014 and since then, the higher the rates, the weaker the rand has been. It is very hard to argue that the rand would have been any weaker than it now is had interest rates remained on hold over this period.

There is no good reason to believe that this relationship between interest rates and the rand will be any more predictable in the year ahead than it has been. What is predictable is the impact of interest rates on spending and so GDP growth. Higher interest rates have served to slow the economy down over the past 24 months. Still higher rates will mean even slower growth – without necessarily supporting the rand – and perhaps might even encourage further rand weakness. The slower the growth, the less reason foreign and domestic owners or managers of capital have to invest in South Africa. Growth expected leads the capital flows that determine the value of the rand.

The sooner the members of the MPC fully recognise these facts of SA economic life, the less likely they are to damage the growth prospects of the economy. The exchange value of the rand and so the inflation rate and the expectation of inflation (that take their cue from the exchange rate, for good reasons also incorporated into the Reserve Bank forecasts of inflation) is beyond their influence. Raising interest rates at a time like this because it may support the rand makes no sense at all. The rand may or may not strengthen – for altogether other reasons – especially sentiment about the investment case for emerging markets generally.

More global risk tolerance will mean a stronger rand and vice versa as usual. But the rand has not behaved as usual since President Jacob Zuma intervened so dramatically in SA’s fiscal affairs last month. Without such intervention, the rand, given global risk appetites, would have been much closer to 14 to the US dollar than 17. Zuma’s actions caused financial markets to raise significantly the doubts it has about SA’s ability and willingness to fund its government expenditure without printing money – and so causing inflation.

Hence not only did the rand weaken dramatically, but the expected value of the rand weakened even further. The spread between RSA and US Treasury bond yields, that indicate the compensation for expected rand weakness in the bond market, widened with rand weakness. A weaker rand has resulted in an even weaker rand to come- expected to lose value vs the US dollar at an over 7% p.a rate on average over the next 10 years.

Furthermore the risks of default on SA’s dollar denominated debt widened significantly – enough to take SA dollar bond yields into junk territory. SA dollar-denominated interest rates have risen ahead of equivalent junk-rated Russian debt but are still below those on even more vulnerable Brazilian foreign currency denominated debt.

The newly appointed Minister of Finance, Pravin Gordhan, has committed himself and the country to fiscal sustainability. The market place should believe him, in my judgment. But the market as yet is not giving him the benefit of their doubts. They are going to take a great deal of convincing that SA can live within its means by sticking to the strict limits on government spending that it has set for itself. The role the Reserve Bank can play in this is a limited one. Monetary policy settings will not make much of a difference to perceptions of fiscal policy. They can make a difference to the state of the economy with their interest rate settings. Slower growth makes the task of funding the fiscal deficits even more difficult. They will not be doing Gordhan or you and me any favours hiking interest rates.

SA markets: The Zuma shock wave has not passed through

The Zuma shock wave of Wednesday 9 December 2015, when Nhlanhla Nene was replaced by the little-known David van Rooyen, only to be replaced that weekend by Pravin Gordhan, has had time to be absorbed by the markets.

As we show below, some recovery from the events of that day have been registered on the share, bond and currency markets. As may be seen below, the JSE All Share Index has recovered best: at one point in late December it was almost back to its month end November levels. The RSA bond market, represented by the All Bond Index, with a duration of about six years, was the most deeply affected at the time, but then recovered and is now trading at about 94% of its 1 December value. The trade weighted rand is worth about 8% less than it was on 1 December.

That the Zuma intervention in our fiscal affairs is not regarded by the market as a temporary aberration but more as a permanent danger, is fully reflected in the extra costs of insuring against a RSA default of its obligations on its foreign currency denominated debt. The five year Credit Default Swap (CDS) spreads on RSA debt widened sharply on 9 December and have remained at a highly elevated level of over 350bps. This spread has also increased sharply when compared to the spread on the Emerging Market Bond Index (EMBI – indicated by a narrower difference between the EMBI and RSA spreads) and also when compared to Russian spreads. SA is now regarded as more likely to default than Russia and Brazil. Our credit rating in the market place is thus of junk status. It appears to be only a matter of time before the credit rating agencies catch up with the market place.

Unless the SA government can convince the market place very soon that SA’s fiscal intentions have not changed permanently for the worse, the Zuma shock will prove very expensive for SA’s taxpayers who have to service significantly more expensive debts to come as current debts are matured. Nkandla is very small change compared to this potential bill. The market place will need assurance that SA’s tax base can withstand the higher interest expenses incurred. Evidence that the growth in government expenditure, especially the growth in spending on government sector employment benefits, is slowing down sharply, would be helpful to this end. More important still is any indication and that the growth outlook for SA is improving to help generate more tax revenue to ease the pain of higher taxes rates. The chances of more fiscal discipline seem better than a meaningful pick up in GDP growth. Though the dramatically more competitive rand could and should be helpful to this end, strikes and unhelpful policy interventions permitting. The Barmy Cricket Army are an advance tourist guard doing their best to improve export earnings.

The spread between the RSA 10 year bond yield and the yield on a 10 year US Treasury also widened sharply, to over 8% on the fateful day and has since narrowed to about 7.2% as may be seen in figure 5. This spread indicates that the rand is expected to depreciate by about 7.2% a year, on average, over the next 10 years.

The reactions in the market place to date indicate that the rand continues to respond to the usual daily forces, but off a significantly weaker base. The weaker emerging equity and bond markets are, the weaker the USD/ZAR exchange rate will be and vice versa. Commodity price trends will also be an influence on exchange rates. But these forces are acting off a weaker base, as we show below. The rand is now much weaker than would have been predicted before December 2015 using the Aussie / US dollar exchange rate and the EMBI spread as predictors. A value closer to R13 than R16 might have seemed more reasonable before 9 December. The question then arises: can we confidently expect the base value of the USD/ZAR to improve any time soon?

The answer appears to be an unfortunately negative one, absent an equally dramatic development on the political and economic policy fronts. It does not take much to imagine what that would have to be. The government however will be under few illusions that SA’s dependence on foreign capital remains as heavy as ever. Given the currently low base and highly depressed expectations of SA, the benefits of surprising the markets with good news could have an unusual upside. Good, credible news about fiscal sustainability and more market respecting (business friendly) dispositions- maybe even some privatisation of publicly owned assets to reduce public debt and improve economic efficiency, could much improve the mood. Call them public private partnerships if you have to. But actions and better intentions towards market forces, both inside and outside the country, are urgently called for.

The SA economy at month end November 2015. Do we thank the informal (unrecorded) sector?

We have received some useful information about the state of the SA economy at the end of November 2015. New motor vehicle sales and cash in circulation at month end November present something of a mixed picture. We examine both below and combine them to update our Hard Number Index (HNI) of the current state of the SA economy.

Vehicle volumes in November came in marginally ahead of sales a year before and on a seasonally adjusted basis were also slightly ahead of sales in October 2015. But the sales cycle, when seasonally adjusted and smoothed, continues to point lower, albeit only very gradually so.

The local industry is delivering new vehicles at an annual rate of about 600,000 units and the time series forecast indicates that this rate of sales may well be maintained to the end of 2016. Such an outcome would be regarded as highly satisfactory when compared to peak sales of about 700,000 units back in 2006. (See below) For the manufacturing arm of the SA motor industry, exports that are running at an impressive, about half the rate of domestic sales, are a further assist to activity levels. This series may be regarded as broadly representative of demand for durable goods and equipment.

New Unit Vehicle Sales in South Africa

Source; Naamsa, I-net Bridge and Investec Wealth and Investment.

The demand for and supply of cash in November by contrast has been growing very strongly. By a 10.6% p.a or 5.7% p.a rate when adjusted for headline inflation of 4.6%. This represents very strong growth in the demand for cash- to spend presumably. Though as may also be seen the cash cycle may have peaked.

The extra demands for cash presumably come mostly from economic actors outside the formal sector. The formal sector has very convenient electronic transfer facilities as alternatives to transferring cash. Electronic fund transfers have increased from a value of R4,919b in 2009, that is nearly 5 trillion, to R8.4t in 2014 or at a compound average rate of 8.9% p.a over the six years. Over the same period credit card transaction increased from R142,198b in 2009 to R258.6 by 2014 or by a compound average rate of 9.9% p.a while the use of cheques declined from a value of over R1.1t in 2009 to a mere R243b by 2014.

The supply of notes issued by the Reserve bank have grown from R75.2b in November 2009 to R134.7b in November 2015, that is at a compound average rate of 9.7% p.a. That is the demand for and supply of old fashioned cash has grown in line with the growth in electronic alternatives. Clearly there is a great deal of economic activity in South Africa that escapes electronic action or surveillance. We show the respective nominal and real note cycles below. Both show a strong acceleration in 2015.

The Cash Cycles- annual growth in the note issue.

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The note issue cycle and the retail sales cycle in money of the day are closely related as we show below. The advantage of observing the note issue is that it is a much more up to date statistic than is the estimate of retail sales, the most recent being for September 2009. The strength in the note issue in November 2015 bodes rather well for retail sales in December and perhaps especially so for sales made outside the electronic payments system.

The cash and retail cycles. Current prices

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

When we combine the vehicle cycle with the cash cycle we derive our Hard Number Index (HNI) of economic activity in SA. As may be seen the HNI indicates that the SA economy continues to maintain its current pedestrian pace, helped by strength in the note issue and not harmed too severely by the downturn in unit vehicle sales.

As indicated 2016 seems to offer a similar outcome. The HNI is compared to the Reserve Bank Business Cycle Indicator that has been updated only to August 2015. The HNI can be regarded as a helpful leading indicator for the SA economy-more helpful than the Reserve Bank’s own Leading Economic Indicator that consistently has been pointing to a slow down since 2009 – a leading indicator belied by the upward slope of the Business Cycle itself- and the HNI. ( See below)

S.A. Business Cycle Indicators (2010=100)

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The slow pace of economic growth in SA is partly attributable to the dictates of the global business cycle. The weak state of global commodity and emerging markets remains a drag on the SA economy. Any business cycle recovery in SA will have to come from a revival in emerging market economies linked to a pick-up in metal and mineral prices that will be accompanied by a stronger rand and less inflation and perhaps lower interest rates. This prospect now appears remote. Though a mixture of stronger growth in the US and Europe with less fear about the Chinese economy would be very helpful to this end. South Africa could help itself with growth improving, market friendly, structural reforms. This prospect unfortunately appears as remote as the recovery in global metal markets.

Another own goal for SA

The SA government seems determined to press ahead with a national minimum wage (NMW). This is apparently with the agreement of organised business and labour, though the minimum levels themselves are still in dispute. It however appears likely that the NMW will be set close to the incomes that define “the working poor”, those who earned less than about R4000 per month in 2015 for a 35 hour working week.

Not much poverty relief at R4000 per month, you may think. 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 SA1 , even after adding 40% to wage incomes to compensate for “underreporting” in the Labour Force Surveys undertaken by Stas SA, 48% of all wage incomes representing 5m workers fall below R4000 per month and 40% earn 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%). At the other end of the spectrum is mining, where 22% of the work force earn less than R4000 per month. Even in the comparatively well paid and well skilled manufacturing sector, about 48% of the work force are estimated to earn less than R4000 per month.

Unless the laws of supply and demand for labour can be repealed, it seems obvious that were the NMW to be made effective, the consequences for currently low paid workers would be very serious. Many will lose their jobs, while many more young workers hoping to enter the labour market will find it even more difficult to gain entry to formal employment. Some excluded from formal employment may find work in the unregulated informal sector and many others will be required to work fewer hours, as employers seek to make their work force more efficient, to compensate for an artificially higher hourly rate. This trend is already well under way, according to the study. Other employment benefits provided by employers, such as pensions, health, housing and food, may be reduced to compensate for higher take home pay.

Why then would the government wish to push ahead with such a predictably disastrous initiative, imposed without regard to labour market fundamentals? Can the government and its advisors truly believe that wages have little to do with employment or that some miracle of economic growth or currently unrealised productivity gains will come to raise the demand for labour? Surely not, though the support of trade unions and large businesses for an NMW, expecting less competition for jobs from low paid workers or firms able to hire them, is entirely rational self-interest at work. Unions attempt to maximise the wage bill they can draw member dues from and business seeks to maximise profit, not employment. Robots can replace workers very easily especially at higher wages or rather improved employment benefits.

The case for an NMW must be a political one. It cannot be an economic one. If an NMW, proclaimed at levels well above market determined wages could cure poverty, the economic problem of poverty in SA and everywhere else would have been solved by decree a long time ago. The government must believe that fewer but better paid, so called decent jobs, will mean more support for it at the ballot box. Nobody would thank a government for employment at wages that do not provide an escape from poverty, even if the alternative more poverty for now and more dependence on government hand-outs of cash and housing.

Our labour market regulations and interventions have long been pushing employment and employment benefits strongly in this direction. Fewer well paid private sector formal jobs have been provided – relative to GDP – and many people have joined the ranks of the unemployed or the informally employed, the latter not fully captured in GDP estimates.

NMW may be a recipe for political survival but is not a cure for poverty in SA. It will retard the rate of economic growth in SA that is the only long term cure for poverty. Economic growth, sustained at a rate well above population growth, would gradually lift all incomes in SA, including those of the worst paid, as well as skilled workers. Achieving higher growth rates demands a more flexible labour market. Unfortunately SA continues to move in the other direction.

Monetary policy in SA – the dangers of bad theory put into practice

The Reserve Bank is well aware that there are no demand side upward pressures on the inflation rate. In fact the opposite is very much the case. Weak demand is clearly constraining the power that sellers have to increase prices, not only in South Africa but globally. Hence for inflation forecasters, including those at the Bank, lower rather than higher than expected inflation.

Moreover, the price increases to come from Eskom and municipalities and perhaps also the Government (higher tax rates) can be expected to not only add to the CPI but deflate household spending even further in the months to come. But regardless of even slower growth to come, the Monetary Policy Committee (MPC) decided on a 4-2 count that a further sacrifice of expected growth was called for.

To quote the concluding remarks of its statement of 19 November:

“In the absence of demand pressures, the MPC had to decide whether to act now or later. On the one hand, given the relative stability in the underlying core inflation, delaying the adjustment could give the MPC room to re-assess these unfolding developments at the next meeting, and avoid possible additional headwinds to the weak growth outlook. On the other hand, delaying the adjustment further could lead to second-round effects and require an even stronger monetary policy response in the future, with more severe consequences for short-term growth.

“Complicating the decision was the deteriorating economic growth outlook. Although the change to the growth forecast was marginal, the risks to the outlook, which were more or less balanced at the previous meeting, are now assessed to be on the downside. Against this difficult backdrop, the MPC decided to increase the repurchase rate by 25 basis points to 6,25 per cent per annum effective from 20 November 2015. Four members preferred an increase, while two members favoured an unchanged stance. “
The Reserve Bank has again been guided by a theory of dubious logic and unbacked by evidence that inflation expected in SA can drive inflation ever higher – regardless of the state of demand in an economy. Or in other words firms and trade unions with price and wage setting power, in their budgets and plans for the future, having set their new demands on consumers and employers with expected inflation in mind – will stick to them. Stick to them, that is, and then ask for still more at the next round regardless of the ability or willingness of customers or employers to meet these demands. Without support from the demand side of the economy and highly accommodative monetary policy responses to higher expected and actual inflation, ever higher prices cannot stick, and will not stick because such behaviour is simply not consistent with income maximising behaviour. It has not done so to date and will not do so as the theory of prices, properly understood, would predict.

In simple theories of inflation used by most central banks, including the US Fed, and as explained very clearly in an important speech given by Fed Chair Yellen recently, the influence of inflationary expectations on prices – that find the way into prices asked for – are combined with and excess demand or supply variable, known as the output gap. The theory is that the wider the output gap, the less inflation – for any given inflation expected. The Reserve Bank has seen fit to deny the role of the output gap and its own already higher interest rate settings in restraining inflation. It is a peculiar monetary policy and, more important, theory of economic behaviour that is being applied by the Reserve Bank.

Furthermore, the evidence is very strong that inflation expected in SA is highly stable about the 6% level and is likely to remain so – if and when inflation in SA trends lower. It can and should do so if the rand strengthens – a force largely beyond Reserve Bank powers or powers to predict. Inflation leads inflation expected in SA, as it did between 2003 and 2006 when, thanks to a strong recovery in the rand, inflation receded and inflation expected followed.

We can only hope for a further episode of rand recovery, lower rates of inflation in SA to follow and less inflation expected as measured by the gap between conventional and inflation linked bond yields. If this should happen then the theory of inflation being driven by the mere thought of more inflation will be thoroughly and most helpfully disabused – as it should be.

As it happened on Thursday 19 November, the chances of this test of the theory improved for reasons, surely completely independently of the Reserve Bank decision that was taken at about 15h30 our time. As Bloomberg shows (see figures below) almost exactly at that time the MPC announced higher short term rates for SA, long term interest rates in the US fell quite sharply and long term rates in SA followed lower. A surprising combination of higher short term rates in SA and lower long term rates was to be observed. Also to be observed was a stronger rand. Again, this was caused by forces quite beyond Reserve Bank influence. Emerging equity markets enjoyed a nice bounce higher – consistently combined with the lower interest rates in the US – and even more consistently combined with a firmer rand. Clearly the fear of a Fed rate hike has been well priced into markets: the Fed decision to raise rates in December has become much more certain fact and its impact much less disturbing.

This confirms once more that the most important influence on inflation, the behaviour of the rand, is largely beyond the influence of short term interest rates in SA. Therefore the Reserve Bank can in practice only hope to influence the level of demand in SA, which it does consistently by raising or lowering interest rates. Given weak demand and the absence of demand side pressures on prices in SA, it should be lowering, not raising its repo rate. The Reserve Bank is relying on a theory that inflation in SA could become self-fulfilling and therefore demands higher interest rates, doing our economy a grave disservice in the process.

 

Global rates: The dropping of the shoe

The reactions of the Fed. The other shoe has dropped – thankfully for those living downstairs.

The first Fed shoe dropped in May 2013 when it announced it would soon be halting, or in its own words “tapering” QE, that is the purchase by the Fed of US government bonds and mortgage backed paper in the market place in exchange for its own deposits. In other words, the Fed signaled its intention to stop creating money, as it had been doing to the tune of an extra US$85bn a month. True to its word, by year end 2014, QE was suspended.

The reactions in the financial markets to this announcement in 2013 were quite dramatic, and especially so in emerging market (EM) equity, currency and bond markets, including South Africa. The rand lost over 12% of its US dollar value within a few weeks, from about R9 to the dollar at the beginning of May 2013 to about R10 at month end while the yield on the RSA 10 year increased from 6.3% p.a to 7.08% p.a by month end. The benchmark EM equity index, the MSCI EM, lost 10% of its value between May and June 2013 while the US dollar value of the JSE All Share Index lost 6.8% in US dollars over the two months.

The second Fed shoe has now dropped, which is perhaps just as well for those who have been waiting for it to hit the floor. The second shoe comes in the form of the upward move in the Fed’s short term rates, the first such increase since the financial crisis of 2008. An increase of 25bps in US short term rates in December now seems certain, or at least the market place has reacted as if it is almost certain.

Market reaction to this news have been far more muted than the responses described as the taper tantrums of 2013. The rand has lost about three percent of its dollar exchange value since the September month end. 10 year bond yields are about 30bps higher in response to the now firm prospect of higher short rates in the US.

The shoe having dropped, is there more damage in prospect for the rand and the borrowing costs of the SA government? The answer will depend largely on ongoing investor sentiment towards emerging markets. Higher interest rates in the US and elsewhere are not welcome in hard-pressed EM economies. But confirmation that the US economy is firmly on a recovery track, is surely encouraging to all those EM businesses that trade with the US. A combination of strength in the US and less anxiety about the Chinese economy would surely be better news for EM economies and their longer term prospects that now appear so poor (as reflected in EM share markets that in US dollars are well down on their levels of September 2009, while the New York benchmark S&P 500 has been racking higher ever since).

The rand remains an EM equity currency. It continues to move in response to the US dollar value of the EM equity benchmark as we show below. South African events do not appear to affect the rand in any consistent or significant way.

The rand is little changed versus other EM currencies over recent days, though both the Turkish lira and Brazilian real have recovered some of their weakness against the rand. On a trade weighted basis, the rand, in line with other EM currency and equity markets, has weakened significantly since mid-year, though much of the damage occurred in August rather than very recently.

The rand’s daily moves can be well explained by global market developments independently of SA political or economic developments (which cannot anyway be regarded as favourable). For example, as we show below, the rand rate against the US dollar can be predicted to closely follow trends in the US dollar / Australian dollar exchange rate, coupled with a measure of SA sovereign risk. Sovereign risk is measured as the premium investors would pay to ensure against SA government default on its debt. The results of such a model are shown below. It suggests that the rand, now trading at over R14 to the US dollar, has overshot its predicted value of R13.50 or so.

We get a similar result and a similarly satisfactory model of the rand when we replace the influence of the Australian dollar with the MSCI EM and combine this with the credit default spread on US dollar-denominated SA debt. The rand appears somewhat oversold using these models.

It is also clear that as the prospect of higher US rates has become more certain, the risks associated with EM debt, as measured by the spreads over US government debt, have also increased. The spreads attached to SA debt have widened largely in line with EM spreads generally. SA specific risks do not appear to have had a significant influence on these spreads recently. Higher spreads and higher interest rates in SA appear mostly as an EM rather than SA event. The Credit Default Swap (CDS) spread between SA dollar-denominated debt and the average EM (Brady Bond) spread has not altered recently. In a relative sense, SA debt lost some rating ground versus other EM borrowers by mid-year, however. The spread in favour of SA can be seen to have narrowed.

Long term interest rates in SA have followed modestly higher rates in the US as the near certain increase in short rates was priced into the debt markets. As we have mentioned, these increases can be regarded as modest to date.

The wider EM risk spreads have not led to any exaggerated movements in the yields on rand-denominated RSA debt. We must hope that the very little inflation expected in the US helps to continue to restrain the Fed from ratcheting up short rates and that long term rates in the US remain at historically low levels for an extended period of time. We expect very dovish Fed reactions, especially given the stronger dollar that will keep down the pressure on metal and mineral prices and make deflation rather than inflation the focus of Fed concerns.

Less upward pressure from US interest rates on SA rates (short and long) will be helpful for the rand and the inflation outlook in SA. Hopefully, less pressure will restrain the Reserve Bank from even thinking about higher interest rates. Higher rates in SA would not necessarily protect the rand should the dollar get stronger with higher rates in the US.

The other shoe – in the form of market reactions to higher interest rates in the US – may well have dropped. And the reactions in the market place to date reflect a much more relaxed response to the prospect of higher rates in the US than was the case in 2013. We must hope and encourage the Reserve Bank to also keep its composure.

Secular Stagnation or normalisation of the global economy? Giving the patient time to return to health

A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market. Our own view is somewhat different – the world is moving gradually along the road to normalisation.

The balanced portfolio – how should it be weighted for the next 18 months. More or less in equities – Risk on or risk off.

The global portfolio manager has become noticeably uncertain about the global growth outlook and the outlook for US interest rates. The day-to-day volatility of share, bond and currency markets reveals this. More risk means higher required returns and thus lower valuations, and vice versa.

The twin concerns (global growth and US rates) are not independent of each other. Faster growth would normally lead to higher interest rates and higher rates might then be regarded as a welcome indicator of faster growth under way. Slower growth would ordinarily lead to lower rates. In a normal environment, good economic news could mean higher interest rates, but also increased revenues and profits for listed companies, so would therefore be well received in financial markets.

But the times are not normal. The developed economies (apart possibly from the US) appear to be suffering from growth that is too low for comfort and inflation rates that are too low for the comfort of central banks. The emerging economies, particularly the commodity producers, are suffering from slow growth as well as weak demand and lower prices for their exports – leading to pressure on their exchange rates. Devaluation of emerging market currencies brings higher rather than lower prices in its wake and possibly (and ill advisedly), higher interest rates that in turn would reduce growth rates further. The emerging market policy makers would prefer faster growth in the developed economies they supply and lower interest rates to take pressure off their currencies and inflation rates.

Ideally, lower interest rates designed to stimulate faster growth in the high income world, would be broadly welcome in the financial markets. There is however the problem that interest rates, more particularly real, after-inflation interest rates, are already at historically low levels. How much further can they be made to fall? There are, for practical and theoretical reasons, lower bounds to interest rates.

Quantitative easing (QE) may become the only tool available to central banks when fighting deflation, has become their primary objective and when interest rates are very low, perhaps even below zero. But even supplying more cash to the banking system may not work if the banks prefer to hold the extra cash, in the form of extra deposits with the central bank, rather than put them to work funding additional loans and overdrafts. QE may have saved the financial system, but the rate of growth in bank credit has remained very weak in Europe while somewhat more robust in the US.

In a world where prices are falling, it might take interest rates well below zero, that is well below the rate of deflation, to stimulate more borrowing and spending; that is to effectively reduce the real costs of borrowing and repaying loans that rise as prices fall. Deflation is helpful to lenders and harmful to borrowers. Inflation does the opposite, which is why expected inflation and / or deflation would always be reflected in the terms lenders and borrowers could agree upon.

Expected inflation brings higher interest rates and expected deflation would result in lower rates, even negative market-determined interest rates. In other words, you could be paid by lenders to issue debt (at negative rates of interest) as governments in Europe are being paid to do. The German government now to offers a positive rate of interest for Bunds that mature only after 2021. Recently the US Treasury has issued three month bills at a zero rate of interest, a record low.

The problem with negative interest rates imposed upon central banks is that negative rates of interest on bank deposits or other rewards for lending provided by financial institutions generally, would have to compete with cash in portfolios. Cash, or rather the notes issued by central banks as well as their deposits, will maintain their money value despite deflation, providing a highly competitive zero rate of interest, when other safe haven rates fall below zero. For wealth owners, holding cash rather than lending or spending it will not help an economy grow faster. Such problems for central banks are exacerbated when deflation is accompanied by a recession.

It is the problem with deflation, rather than inflation, that is occupying the central banks’ minds in the US and Europe. The target for the US Federal Reserve (Fed) is 2% inflation. Anything less than 2% would therefore call for lower interest rates for fear of what deflation could do to spending and economic growth.

The problem for the Fed and Fed watchers is that the Fed has strongly signaled that it will be increasing its key short term interest rates this year. But while such an increase might make sense for the US, given the economic recovery to date, it will not be helpful outside the US. It also makes less sense for the US if it leads to deflation, accompanied as it is likely to be by a stronger dollar and so more deflationary pressures inside and outside the US. There is moreover a more general concern that US growth may disappoint anyway and that any interest rate increase will not be called for.

These considerations, especially the explicit Fed concerns expressed about the state of the global economy, convinced the Fed to postpone any increase in short rates at the Federal Open Markets Committee meeting of 23 September. This decision at first was poorly received in the market place. Fed vacillation appeared to add something to the risk premium attached to equities and currencies. More recently, a weaker employment number for the US, that strengthened the case for a postponement of an interest rate increase, saw the risk premiums decline with a much better tone on the equity and currency markets, especially for emerging market currencies.

It seems clear that the developed equity markets would welcome a mixture of stable (or even lower than previously expected) interest rates in the US. The outlook for global economic growth has also been revised lower by the International Monetary Fund and other forecasters, including other central banks, making the case for lower, not higher, interest rates in the US.

Most important for portfolio selections, developed equity markets appear rather pessimistic about economic and earnings prospects. They appear to be already valued for very slow growth. Goldman Sachs, in a recent report on European equities, given an equity risk premium of 5% (that is expected returns from equities 5% above the risk free rate that is close to zero) infers that the Stoxx 600 index for European equities is priced for zero growth in earnings per share, compared to the long term average of 5.1% p.a.

If we apply the same 5% p.a equity risk premium to the S&P 500 Index, using the implied growth in earnings per share as the risk free rate, represented by the 10 year bond yield (currently about 2.10% p.a) plus 5%, less the S&P current earnings yield of 4.93%, we derive an implied permanent growth in earnings per share of about 2% p.a. This is well below the average annual growth rate realised since 1990. With 10 year US inflation-protected bonds currently offering a very low 0.55% p.a, and nominal 10 year US Treasury trading at 2.09% p.a, the compensation for bearing the risks of inflation, or inflation expected by the bond market, over the next 10 years is currently about 1.54% p.a. Thus the implied real growth in S&P earnings per share is less than 0.5% p.a. This confirms that US equities, like European equities, are currently priced for very slow growth.

It would appear that the market is expecting secular stagnation of the developed economies rather than any normalisation of growth rates. A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market.

Conclusion – our view is different

Our own view is somewhat different. While aware of what is a somewhat confused market place, we are still expecting a further gradual move to economic normalisation. This is a process that followed the global financial crisis of 2008. This will be reflected in a gradual increase in the willingness of households in developed economies to borrow to spend and of banks to lend to them. Household debt to income ratios are in continuous decline, as are household debt to debt service ratios. A decline in these debt ratios points to normalisation of household spending propensities. This process is essential, if aggregate demand is to grow at something like normal rates, given the importance of household spending for GDP in the developed world.

It seems to us that the global economic problem is one of too little demand rather than too little being produced or capable of being produced. The supply potential of developed economies is being continuously enhanced by innovation and improved technology. Addressing the problem of under spending, after the global financial crisis, we appreciate, has taken longer than normal and required very unconventional monetary policy. This may well have had something of a negative impact on business confidence and so slower growth in capital expenditure by firms that has held back economic growth. But if households came to spend more of their incomes and firms exercise more of their capital equipment, they would normally be inclined to add to their plant and machinery and perhaps also their labour forces. Capex, rather than buying back shares or engaging in acquisitions, would then make more economic sense.

Equity markets in the developed world appear undemandingly valued for current interest rates. Interest rate increases, we think, are unlikely to threaten these valuations. Any sense that the developed markets will not slip into recession or secular stagnation will be helpful for equity values. The emerging market economies, where GDP growth and particularly earnings growth, remain under pressure from lower commodity prices, may take longer to normalise. Their progress will depend on the same improved sentiment about global growth that would mean normalisation of developed economies rather than secular stagnation. Our recommendation therefore for the composition of balanced portfolios, those that mix equities, bonds, property and cash, is for a continued modest bias in favour of risk-on, rather than insurance assets.

Prices and Budget Reviews – all promising austerity rather than progress

Amid the pandemonium in and around Parliament yesterday, something may have been missed. What probably escaped notice was that for a third month the CPI was unchanged. It reached a value of 116.1 in July, remained 116.1 in August and prices maintained that level of 116.1 in September. In other words, average prices in SA since July 2015 have remained unchanged and so the inflation rate in Q3 2015 remained a round zero. Headline inflation, the percentage increase in the CPI over 12 months was 4.6%, also unchanged from August 2015.

The upward pressure on the CPI from rising utility bills and house rentals, including the rentals owner occupiers are assumed to pay themselves, that added 0.9% to the CPI in September, was offset by lower petrol and transport costs that took 1.6% off the index. The prices of food and non-alcoholic beverages rose by a mere 0.1% in the month.

These outcomes in Q3 must have come as a surprise to the Reserve Bank, which believes inflation is driven largely by inflationary expectations. Hence its tendency to impose higher interest rates on the economy, regardless of where the pressure on prices may be coming from, less supplied or more demanded, for fear that inflationary expectations are self-fulfilling.

These inflationary expectations, with a much weaker rand in the quarter, might have been expected to have been elevated in Q3. Judged by the gap between the yield on conventional and inflation-protected RSA bonds, reflecting compensation for bearing inflation risk, as good a measure of inflation expectations as any, have changed little, and remained very stable about the 6% level, in line with the upper band to the inflation targets, as it has done for many years.

It is clearly not expected inflation that stabilised the CPI at 116.1 (2012=100). It was the weakness of final demands for goods and services that has so limited the pricing power of firms supplying households and firms not only in SA but almost everywhere else too. This lack of demand has put pressure on the dollar prices of goods imported into SA, including that of oil and grains. The so-called pass through effect on prices of a weaker rand is running at about a fifth of the impact predicted by the Reserve Bank’s inflation forecasting model.

The Reserve Bank needs a better theory of how prices are formed in SA than are determined (mostly) by inflationary expectations. This will help it avoid imposing unwelcome extra burdens on the economy in the form of higher interest rates when too little, rather than too much, spending is part of the problem, as it has been doing ever since early 2014 when short term rates were first increased.

Yes, higher taxes on energy or higher charges for electricity or water or roads or imports may put upward pressure on prices charged (as may the budgets of firms with pricing power) that presume prices can be increased in line with inflation expected. But as is now highly apparent, prices charged and recognised in the CPI are not crudely equivalent to costs, including employment costs, plus some profit margin. They are much better explained as profit-maximising or perhaps loss-minimising prices – what the market will bear prices, which reveal highly variable operating profit margins.

The update from Shoprite, SA’s leading food retailer released on the morning of the CPI update, told the same story of pressure on food prices and operating margins. And the declining employment numbers tell of the pressure of higher wage demands on numbers employed rather than on prices charged.

It is the weak state of final demands from both SA households and firms that is holding down the CPI as well as the GDP that is barely growing. Higher taxes imposed by the national government and the higher charges for electricity etc. levied by municipalities and yes also the fees charged by educational and medical service providers that have monopoly type pricing power and also, most avoidably, higher interest rates set by the Reserve Bank, have all taken their toll on household budgets and spending power and so the pricing power of the firms supplying them.

This lack of demand for goods and services and labour is being exacerbated by the inability of the SA government to sensibly limit and manage its own spending on employment benefits for government workers, the largest item by far in its Budget. This outcome, understandable in the circumstances, and given conservative objectives for government debt ratios, means discouraging still higher taxes on the productive economic agents of the economy and less spending by government on other items, including on useful infrastructure.

The Budget statement to Parliament was eloquent in its admission that unexpectedly large employment benefit concessions to public sector employees greatly disturbed the Treasury’s Medium term expenditure and revenue plans. This disruption to sound fiscal policy was explained in the Budget Statement as somehow beyond the control of the government itself. The bargaining arrangements with public sector unions that led to such exorbitant outcomes post the main Budget in February 2015, may well have been out of the control of the Treasury and its fiscal constraints. As such it represents just another government failure.

It is the failure of the government to recognise that the path to faster growth in SA is not only through more effective government spending, but less of it, combined with less interference in the economy that so engages the well paid but now shrinking government workforce. It is less government and so lower taxes and much more reliance on business for solutions to poverty and growth that should be the way forward for SA. Resisting this direction, as it is being resisted in Budget after Budget, leads to higher taxes and charges and less rather than more spending and slower rather than faster growth. In other words more public and private austerity of the kind we are experiencing.

The price of good advice

Calculating the costs and benefits of financial advice – a dangerous exercise in the US and a necessary one in South Africa

 

It may be argued that one of the important functions managers of private wealth provide is that we can help save our clients from themselves. When we (the wealth managers) act on clients’ behalf, in a conservative way, conscious of risks as well as returns, with wealth entrusted to us, we may well help prevent them from making disastrous investment decisions all on their own. Such poor financial decisions may cost them far more than the fees we charge for our advice and record keeping. Earning extra returns for clients, ahead of the fees incurred, is not the only purpose of our fiduciary duties. Saving wealth owners from themselves is perhaps even more important.

 

A study made by US economist Robert Litan seems to agree. As reported in the Wall Street Journal (online edition, 4 October), Litan in July testified before the US Congress against a US Labor Department plan to regulate financial advisers. His cost-benefit analysis estimated that, during a market downturn, the proposed regulation of financial advisers, with associated higher fees for advice, could cost investors—especially those who aren’t wealthy—tens of billions of dollars. The cost to clients would be incurred by depriving them of good financial advice, such as advice against panic selling, that they may well have chosen were fees for advice lower.

 

The regulation of financial advice can raise the cost of advice, perhaps through an extra fee, that many clients may prefer not to pay. Hence the greater likelihood of poor investment decisions made without useful advice: not only the mistake of buying at the top of the market and selling at the bottom, but also advice that should and would discourage any naïve or greedy propensity to ignore the relationship between a promised return and the associated risk of receiving much less, or indeed no return at all. The Litan evidence would have been in the form of an examination of the comparative track records of investors achieved with or without advice – in the light of the observed sensitivity of clients to the fees charged for that advice.

 

Political costs, too

 

The story in the WSJ is only partly about the benefits and costs of financial advice. It is also about how his testimony cost Litan his job. A veteran of 40 years with the Brookings Institution, Litan offended left-leaning Massachusetts Senator Elizabeth Warren, who is sponsoring the intended legislation. He was accused, in a letter Warren wrote to the head of Brookings, of concealing a conflict of interest by not disclosing that his study was supported by the Capital Group, a very large mutual fund manager in the US. This conflict of interest accusation, according to the WSJ, was made “notwithstanding” that the first page of Litan’s testimony says: “The study was supported by the Capital Group, one of the largest mutual fund asset managers in the U.S.”  Senator Warren called that disclosure “vague”—while the WSJ named this accusation “an obvious falsehood”.

 

A private company with an interest in opposing regulation may often sponsor research in think tanks or universities. Even more often, a government agency may sponsor research inside or outside of government itself with an equally obvious and opposing political and bureaucratic interest in implementing additional regulation. Ideally the research, regardless of its sponsor or conclusions, should be allowed to inform public opinion and the legislative outcomes that may follow. Disclosure of sponsorship is both ethical and wise so that any possibly convenient conflict of interest argument will not prove decisive in any adjudication process.

 

The quality of any research can surely be tested and cross examined regardless of its provenance, as is the evidence of the so-described “expert witnesses” in our courts, paid for by one or other of the litigating parties. An expert witness, talking to the book of a pay-master, in disregard of the evidence, will soon be found out as biased in any thorough cross- examination and such advice will be correctly ignored.

 

In South Africa, the Treasury and the Financial Services Board have been much involved in regulating the quality of investment advice provided to savers and by financial advisers. Clearly quality advice is desirable. But, as in the US, it also comes with a price, in the form of higher fees or costs, which potential clients may judge as not worth paying for.

 

One hopes (but doubts) that a similar analysis of the perhaps unintended costs and consequences, as well as the benefits of additional financial regulation in SA, has been undertaken for our market place. A study of the kind provided by Litan – that explores the danger that many more savers will go inexpertly or inadequately advised and so make poor and very costly financial decisions, because such advice is deemed too expensive – would be welcome.

 

There are always benefits to be had from every regulation of market forces. There are also always associated costs, some more obvious than others. Both the additional benefits and the full extra costs, associated with an intended regulation, should be calculated, as fully as they can, regardless of where the chips may fall.

Payrolls post mortem

Reading the changing market mind has become a more difficult exercise.

The report on US payrolls report on Friday, which was up 142 000 and well below the consensus estimate of 201 000, was not good news about the US economy.

The initial reaction of the equity and bond markets after the data release was to drive share prices sharply lower and bond values higher. But an hour later the share market reversed itself and ended the day 1.5% higher. Bad news about the economy had become good news for markets. These reactions, in the form of higher equity values to a weaker than expected employment number, might be a consistent response to a view that short term interest rates in the US would not now be rising any time soon.

The US dollar also weakened significantly through the day against the very hard pressed emerging market currencies, including the rand. Bad news was not only good news in New York; it was well received everywhere.

These market reactions on Friday – bad news for the economy translated into good news for markets, because interest rates would be lower than previously expected – were however in sharp contrast to the negative market reactions to the Fed decision on 23 September to delay any increase in interest rates for global rather than US economic weakness. Then, after initially welcoming the Fed decision, the equity markets turned sharply lower and emerging market currencies and equities were then particularly hard hit.

Other things being equal, lower interest or discount rates can justify higher equity (present) values. But the economic activity, or lack of it, that move interest rates are other things, especially the revenue and operating profit lines of companies. This means that other forces driving equity values cannot be assumed to remain unaffected by the state of the economy. Helpfully for shareholders, the market seems convinced for now that the lower US discount rate attached to expected operating earnings, as interest rates stay lower for longer, will more than offset any pressure on revenues and operating profits. Lower US interest rates relative to interest rates elsewhere, may well mean a weaker US dollar and also stronger emerging market currencies. Such prospects are helpful to emerging and commodity-producing economies.

Such very different reactions and market patterns revealed within a short period of time to market making news, makes for confusion about the state of the market mind. Will bad news about the US remain good news about the equity and bond markets and vice versa? Will the economic data releases confirm the strength of the US economy and send equities, currencies and bonds in the direction they mostly took in August and September 2015, for fear of higher interest rates? Ideally for shareholders around the world, the Fed will continue to worry more about slow growth and deflation than the reverse, and that such caution, reflected in consistently low short rates, will prove to be too pessimistic about both threats to the global economy, for an extended period of time.

Reflationary policies are usually helpful to share markets. The bullish argument for markets is that the Fed and the ECB (and indeed EM central banks) remain in a reflationary mood while growth prospects remain largely unchanged.

How well is the equity market reading the Fed?

 

The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.

While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.

Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?

We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.

The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.

The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.

The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.

It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders

Taking stock of GDP

The SA economy in Q2 2015 was not as it appeared – after taking an inventory

According to the first readings of gross domestic output (GDP), in real terms for Q2 2015, the SA economy performed very poorly. It is estimated by Stats SA to have shrunk by 1.3% on a seasonally adjusted annual rate in the quarter.

(All figures are taken from the Quarterly Bulletin of the SA Reserve Bank, September 2015.)

 

On a second reading for the second quarter of figures provided by the SA Reserve Bank, which include estimates of the demand side of the economy, the outcomes, on the face of it things. seem even worse. Gross Domestic Expenditure (GDE) is estimated to have declined by as much as a 7.2% rate in the quarter. The outcomes were not nearly as dire as might be inferred from either the GDP or GDE estimates. Final demand, the sum of spending by households, firms and the government sector, actually grew by about 1%. That final demands continued to grow at a very modest pace is consistent with our own measures of economic activity. What turned final demands into very weak GDE growth rates was a dramatic decline in inventories. Inventories in Q1 grew by R8.8bn on a seasonally adjusted annual rate. In Q2 they declined by the equivalent rate of over R38bn. This decline in inventories was enough to reduce real GDP in the quarter by as much as 6.2%.

Much of the action is attributable to the large seasonal adjustment factor interpolated to the estimates of inventories, the consistency of which may well be questioned. It is normally the case that the second and third quarters are periods when inventories are built up and the fourth and first quarters are normally associated with a general run down in inventories. But as the Reserve Bank comments, inventory events in Q2 were anything but normal in the mining and oil sectors. To quote the Economic Review of the Reserve Bank for Q2 2015:

Following a modest build-up in inventories in the first quarter of 2015, real inventory levels declined significantly at an annualised pace of R38,9 billion (at 2010 prices) in the second quarter. The rundown of real inventories in the second quarter of 2015 was mainly due to the destocking in the mining and manufacturing sectors, partly reflecting subdued business confidence levels and a decline in import volumes.

In the mining sector, inventory levels at platinum mines in particular contracted during the period on account of a significant increase in the exports of platinum in order to fulfil offshore export obligations. The rundown of inventories in the manufacturing sector partly reflected lower crude oil import volumes due to scheduled maintenance shutdowns at major oil refineries over the period. Consistent with a slower pace of increase in retail trade sales, the level of real inventories in the commerce sector rose in the second quarter. Industrial and commercial inventories as a percentage of the non-agricultural GDP remained unchanged at 13,8 per cent in the first and second quarters of 2015.

Inventories can run down because firms lacking confidence in future sales plan for a reduction in goods held on the shelves or in warehouses. They may also run down in an unplanned way because firms are surprised by the actual sales they were able to make. The planned reduction in inventories can represent bad news for the economy as orders decline. The unplanned reduction can mean better news should firms attempt to rebuild inventories. Similarly, a planned increase in inventories can reflect a more confident outlook for sales to come. An unplanned build-up of inventories may also reflect unexpectedly poor current sales volumes, and so fewer orders to come in the quarters ahead. Making the distinction between planned and unplanned inventory accumulation will be all important for any forecast of economic growth. In the case of the SA economy in Q2, it seems clear from the Reserve Bank statement that the run down in inventories in Q2 was for largely idiosyncratic reasons, making the application of seasonal adjustments particularly subject to error.

Judged by the estimated growth in final demand, the economy did not deteriorate in Q2 as the statistics on the pure face of it may suggest. In our judgment of the National Income Accounts released for Q2, the economy continues on its unsatisfactorily slow growth path as other indicators of the economic activity, included our own Hard Number Index, have revealed. The economy is growing slowly and not shrinking, nor is it about to do so. There is moreover at least one silver lining to be found in the latest statistics. As much as inventories subtracted from the growth rate, net exports added as much, due to the growth in export volumes and the stagnation of import volumes. The trade balance went into surplus and the current account deficit declined thanks to the weaker rand and the relative absence of strike action.

Another development this year, essential to lessening the tax burden on the productive part of South Africa, and so increasing potential growth, is the further decline in public sector employment in Q1 noted by the Reserve Bank. Lower tax rates and less spent on employment benefits for a bloated public sector, also lower interest rates, will help stimulate a recovery in the all-important household spending that is essential for faster, sustained growth over the longer run.

A combination of export growth and a stronger trade balance combined with a smaller budget deficit, accompanying fewer expensive public officials, of the kind revealed in Q2 2015, is some of the right stuff necessary to recalibrate the SA economy in the collective mind of the global capital market from a fragile to a resilient economy.