Author: Brian Kantor

Hard Number Index: Slow and steady growth

Updating the state of the SA economy to February 2015 with our Hard Number Index (HNI). Economic activity continues to show slow and steady growth, with no obvious speed wobble.

The two very up to date hard numbers, unit vehicle sales in SA and the value of notes in circulation, have been released for February 2015. We deflate the money series with the CPI and seasonally adjust, smooth and extrapolate both series using a time series forecasting method. Both series continue to point higher, with unit vehicle sales continuing their recovery from the blip in early 2014.

It should be recognised that new unit vehicle deliveries to the SA buyer have maintained a robust pace, comparable with peak sales of 2006-07. Much improved exports of built up vehicles have also been helpful lately to the motor assemblers and their component suppliers, who account for the largest share of all manufacturing activity. The money base, adjusted for the CPI, had declined in 2008-09 but the demand for and supply of real cash has grown consistently since in line with economic growth generally.

When both series are converted into annual growth rates, it shows that the growth cycle remains in a recovery phase but that the current growth rates are predicted to slow down in 2015. Vehicle sales may be regarded as a very good proxy for capital expenditure undertaken by households and firms, while the demand for cash supplied by the Reserve Bank on demands for notes from the banks that are having to meet their customers’ demands for cash on hand rather than a deposit in the bank. These demands reveal spending intentions by households and may be regarded as a good coinciding indicator of spending decisions.

We combine these two hard numbers, vehicle sales and notes in circulation to establish our Hard Number Index of Economic Activity in SA (HNI). As we show below, the HNI for February 2015 has held its level and is forecast to continue to do so over the next 12 months. In other words, the growth in economic activity in SA is modestly positive but is not expected to gain or lose forward momentum. The HNI may be compared in this figure to the Coincident Business Cycle Indicator of the SA Reserve Bank that was still rising in November 2014, the latest month measured. We show in the further figure that the rate of change of the HNI, what may be regarded as the second derivative of the business cycle, that the rate of change of economic activity is predicted to remain barely in positive territory. That is to say, more of the same slow growth in economic activity in SA should be expected. The catalyst that would stimulate a stronger upswing in the business cycle remains very hard to identify.

The demand for and supply of cash in the economy has proved very helpful in predicting the state of economic activity in SA over many years. We include cash in our HNI for this reason and also because data on cash in circulation is so up to date and turns what may be coincident economic action, spending and cash determined simultaneously, into a leading indicator.

It may be of interest to recognise that despite all the innovations banks have made in the electronic transfers of deposits and encouraging the use of these convenient means of payment, the importance of the ratio of cash in the economy has not declined over the years. As we show below, the cash intensity of the economy (compared to estimated retail trade volumes) appears to have risen steadily between 1980 and 2000. It then stabilised at a higher level: it declined until 2010 and now appears to be rising again.

Part of the decline in demands for notes after 2003 was from the deposit taking banks themselves. The retail banks reduced their own demands for notes when the Reserve Bank stopped accepting notes in the bank tills and ATMs as part of required cash reserves. Only reserves held as deposits with the Reserve Bank qualified thereafter. But while this influence on the demand for cash seems to have worked its way through the system in the form of a decline in the cash to retail ratio, the ratio of cash to economic activity (represented here by officially measured retail volumes) seems inexplicably high. It does suggest that the statisticians may well be underestimating retail volumes and economic activity conducted informally. The informal economy has a much higher propensity to use cash rather than electronics to close deals. Hence the particular usefulness of cash as a leading indicator because it incorporates informal unrecorded economic activity that may well contribute significantly more to the economy than is officially recognised.

Monetary policy: The big bad wolf

Published in Business Day on 11 March 2015: http://www.bdlive.co.za/opinion/2015/03/11/monetary-policy-the-big-bad-wolf

PUBLIC enemy number one for central bankers in the developed world is deflation. When the consumer price index (CPI) declines we have deflation, when it rises we have the opposite, inflation. Prices in general fall when aggregate demand in the economy exercised by households, firms and governments fails to keep up with potential supply. Prices rise when demand exceeds supply.

The economic problem in the developed world, and in much of the less developed world including SA, is too little rather than too much demand and that has called for highly unconventional monetary policy.

Central bankers, with modern Japan very much in mind where prices have been falling and economic growth has been abysmally slow since the early 1990s, are convinced that deflation depresses spending and thus serves to prevent an economy from achieving its growth potential.

They are therefore doing all they can to stimulate more spending to arrest deflation or a possible decline in average prices. What they can do to encourage reluctant spenders is to create more money and reduce interest rates. Inflation, as they used to say, was too much money chasing too few goods. Deflation may be said to be caused by the opposite — too little money chasing too many goods. Inflation calls for less demand and so less money creation. Deflation calls urgently for the opposite — more money creation to increase aggregate demand and the supply of goods and services given widespread excess capacity, including the supply of labour.

While central bankers have the power to create as much extra cash as they judge appropriate, they have had to overcome a technical problem. The extra cash intended to encourage more spending may get stuck in the banking system and, when it does, there may be no additional demand for goods and services and the extra money created (at no cost) may not encourage spending or lending and provide no relief of the unwanted deflationary pressures. The banks may hold the extra cash as additional cash reserves or use the cash to pay off loans they may have incurred previously with the central bank.

The mechanics of money creation go simply as follows: The cash the central banks create (or more specifically the financial claims they create on themselves, called deposits with the central bank) when buying securities from willing sellers in the financial markets (typically pension funds or financial institutions of one kind or another) reflects immediately as extra privately owned deposits with private banks.

In the first instance, as the proceeds of a sale of securities by a private bank customer are banked, the private bank will have raised an additional deposit liability and will receive in return an asset in the form of an additional claim on the central bank. That is, the asset to match their additional deposit liabilities will take the form of an increase in their (cash) reserves at the central bank.

Normally the banks will make every effort to convert this extra cash into a loan that earns them more interest. Such loans would then lead to more spending. Normally banks keep minimal cash reserves in excess of the regulated requirement to hold cash reserves in fractional (say, 5%) proportion to their deposit liabilities.

But ever since the global financial crisis of 2008 this has not been the case at all. The central banks, led by the US Federal Reserve, have bought trillions of dollars worth of financial securities and the private banks have added trillions of dollars to their cash reserves.

The assets of the major central banks have expanded over the years. Their extra assets have consisted of securities issued by governments, for example, in the form of mortgage backed securities issued by the government backed mortgage lending agencies Fannie Mae and Freddie Mac in the US.

It should be noted that the European Central Bank’s (ECB’s) balance sheet has been shrinking in recent years, unlike those of the other central banks. This decline in ECB assets and liabilities (mostly cash reserves of the banks) has represented additional deflationary pressure on spending in Europe. The European banks have been repaying ECB loans previously made to them and the ECB has now responded by initiating a further programme of quantitative easing (QE), that is to say security purchases, intended to inject an extra €60bn a month into the banks of Europe over the next 21 months. That is to encourage bank lending and spending to counter deflation.

The important point to note is that creating money in the form of a deposit with the central bank by buying securities in the market costs society almost nothing. Creating money that is an asset of the banks, and so an addition to the wealth of the community, does not require any sacrifice of consumption or savings, as would any other form of wealth creation. It is literally money for jam. But in normal times too much money means too much spending and inflation. Hence the political resistance in normal times to creating more money — because it normally leads to unpopular inflation.

But the times have not been normal. The extra supply of money in the developed world has been accompanied by extra demands by the banks to hold money. So too little rather than too much spending has remained the economic problem. Hence the case for creating still more money, until deflation is finally conquered as the extra supply of cash is exchanged for goods and services.

The extra liabilities issued by the central bank matching the extra assets were mostly to private banks in the form of cash balances in excess of required cash reserves. In the US the banks have received 0.25% a year on these cash reserves.

It should be noted that the US banks have begun marginally to reduce their cash reserves with the Fed and that the assets of the Fed are rising more slowly with the end of quantitative easing in October 2014. Quantitative easing ended because the recovery of the US economy is well under way and presumably does not need further encouragement in the form of further increases in the supply of cash. The banks presumably have more than enough excess cash to meet the demands of borrowers. It could be argued that at least in the case of the US — the economy is recovering — the dangers of deflation have receded and the danger of inflation taking over is judged to be absent as a result of quantitative easing.

There is very little inflation priced into the yields offered on 30-year US Treasury bonds that offer yields below 3% and less than 2% more than inflation-protected US obligations with the same duration. Japan and Europe, it may be presumed, will be doing still more quantitative easing or as much as it takes to get the banks to lend out more of their cash.

The problem of deflation is complicated by very low or even negative interest rates. Cash has one advantage over other assets. The income return on cash can only fall to zero and no further. Other assets, for example, government securities or bank deposits, may come to offer less than zero income, that is only offer negative interest rates.

The German government, for example, can now borrow for up to five years, charging rather than paying interest to its creditors. In other words, it can borrow about €105 from you and promise to pay you €3 interest and only repay you €100 in a year’s time. In other words, the transaction will have cost you €2. But this, alas for widows and orphans and all those searching for a certain interest income, may be the best risk adjusted return on offer.

If prices decline by 2% over the year, your €100 will buy you as much as €102 did a year before, so adding to your real return. But you would have done still better holding cash as €100 in cash will still be worth no less than €100 after 12 months and will also buy you more if prices on average have declined.

Hence deflation forces down interest rates and encourages the demand for cash (and safe deposit boxes in which to store cash more safely than under the mattress, though they come with a fee).

Negative deposit rates therefore discourage the demand for bank deposits as an alternative to cash and more importantly for the goods and services that may be expected to become cheaper over time. Deflation also encourages banks and other lenders to hold cash reserves rather than lend them out. Loans may not be repaid in difficult times, especially when these enormous cash reserves earn the banks a positive rate of interest from the central bank.

Hence a further reason for central banks to fight deflation (and too little rather than too much spending) by flooding the system with additional cash to the point when the supply of cash can eventually, even with very low or negative interest rates, overwhelm the demand for cash. Just keep on pumping in the liquid stuff and the dam must overflow its banks. Once again the cost of doing so is zero.

Until Europe succeeds in overcoming deflation and stagnation we can expect interest rates in there to stay low and for the euro to stay weak. The US dollar, offering higher interest rates because its economic recovery is well under way thanks to three rounds of quantitative easing, can be expected to stay strong. We may also expect deflation and low interest rates in Europe to help hold down long-term rates in the US and elsewhere as European lenders seek higher yields abroad.

The weak euro and stronger dollar (and perhaps also stronger emerging-market currencies, including the rand) may also help restrain any increase in short- and long-term interest rates globally. It may take some time before the major central banks can say with any confidence: goodbye to deflation and welcome back the old enemy, inflation.

What can stop US dollar strength?

Only a narrower interest rate spread in favour of the dollar – which widened this morning.

The ECB initiated its bond buying (QE) programme yesterday. By this morning the German 10 year Bund yields had fallen back by about 7bp to 0.3101% p.a. The 10 year US Treasury Bond yields had also declined by about 4bp to 2.19% p.a. Hence the yield spread between these government bonds widened further and (not co-incidentally) the dollar strengthened against the euro and most other currencies, including the rand, weakened.

The extra yield from the Treasuries would appear irresistible and has clearly contributed to dollar strength, as it has been doing consistently since June 2014. The scatter plot relating daily levels of the euro and the 10 year spread tells the story since January 2014. The negative correlation between these two series on a daily basis is a negative (-0.81) over the period. Spread wider means dollar stronger (and vice versa) would seem a very good bet for now.

What then could cause the spread to narrow and take some of the gloss off the rampant dollar? A recovery in the euro economy would lead to higher yields there. More likely sooner are higher yields in the US, especially at the short end of the yield curve, as the Fed responds to the clear signs of a good economic recovery under way. But the strong dollar itself will add to deflationary pressures in the US as the dollar prices of metals and minerals and commodities recede further, adding to deflationary pressures in the US. Exporters to the US, receiving more local currency for their sales, may well be inclined to offer their goods at lower dollar prices. These deflationary trends may well give pause to the Fed. After all, if inflation and inflationary expectations remain highly subdued why should the FED wish to slow down the economy?

In this way, higher interest rates in Europe and a slower route to what might eventually become more normalised rates in the US, may well reduce the attractions of the US dollar. Until then, the attractions of a wide spread in favour of US dollar determined interest rates is very likely to support the dollar against the euro and perhaps also to add further dollar strength and other currency weakness. Living with a strong dollar rather than trying to compete with it with higher local interest rates, which will slow down other economies, would seem to be the way for monetary policy to go, including in SA.

All about risk and return

Risk and expected returns: The inevitable trade off and how to improve it to the advantage of the SA economy.

Equities are more risky than fixed interest (bonds) and bonds are more risky than cash. Hence equities must be expected to return more than bonds and cash, as compensation for investors willing to bear the extra risk associated with shares. The risk we bear when owning different assets is that we cannot be sure what they will be worth in the future when we might be forced to cash in – the next day, month, year or even, in the case of active traders, in twenty minutes’ time. Hence the more risk, the lower will be the prices attached to assets so that expected returns improve.

Past performance of SA assets provides very strong support for the theory that more risk is accompanied by higher returns. Shares in general have returned significantly more than bonds or cash (in the form of capital gains and dividends or interest received over successive 12 month periods) for SA wealth owners since 2000. But these higher returns have come with significantly more risk, as measured by the movements around the average 12 month returns, calculated monthly. The JSE All Share Index returned an average 16.12% over this period, with a Standard Deviation (SD) about this average of 17.8% p.a. In the worst month for shareholders over this period, February 2009, the 12 month returns on the JSE were a negative 43% while in April 2006 shareholders were up 54% on a year before. The bond market returned an average 11.3% over the same period, with a much lower SD of 6.7% and a worst month, April 2014, when the All Bond Index (ALBI) returned a negative 3.1% over the previous 12 months. The best month for the ALBI was the 27% annual return realized in June 2001. Cash on average returned approximately 8.2% p.a between January 2000 and 2015 with a SD of 2% p.a.

Since inflation averaged 5.9% p.a over the period, all asset classes have provided very good real returns, higher on average than could have realistically been expected back then and more than could be expected over the next 10 years. Such excellent returns, if they are to be repeated, would have to be accompanied by excellent management of the capital invested by SA listed companies and a lower SA risk premium demanded by foreign investors. It was this potent mixture of good management and less risk priced into the JSE share and bond markets that delivered such excellent past performance.

The more the cash in value of any asset varies from day to day, the more uncertainty about their cash in value and so the more risky this asset. In the figure below we show the daily percentage move in the JSE All Share Index and the S&P 500 Index. The price of any individual share included in this index is likely to be more variable in both directions than that of the average share represented by the Index.

This day to day volatility can be measured as a rolling 30 day average SD of these price moves. It will also be reflected in the cost of an option on the Index. The more volatile the market is expected to become, the more expensive it will be for investors to insure against such volatility by buying or selling an option to buy or sell the Index at an agreed, predetermined value. The cost of such an option on the S&P 500 is indicated by the Volatility Index (the VIX) traded in Chicago sometimes described as the fear index. The higher the value of the VIX, higher the cost of an option on the market and the more the fear. The VIX may be regarded as a forward looking measure of expected volatility and the rolling SD as a record of past volatility. Yet past volatility appears to strongly influence expected volatility as we show in the figures below. We also include in the figure the rolling SD of the euro/US dollar exchange rate. It should be noted that volatility appears to revert back to some long term average of about 12. It spiked up dramatically during the global financial crisis in 2008. It also spiked during the various phases of the European debt crisis of 2010 and 2011. Volatility in the share markets now appears as close to average. The VIX had a value of about 14 yesterday. See the figure below.

We provide a close up of recent daily volatility in a further figure below. Volatility moved higher in late 2014 and early 2015. In the share market, volatility has moved back to the long run average very recently while volatility in the key foreign exchange market, the euro/US dollar rate, volatility has moved in the opposite, higher direction.

The relationship between volatility or risk of holding a share and its price, that is the return realised for the owner, is almost perfectly negatively correlated. So if volatility rises, share prices will move in the opposite direction in a highly predictable way. The figures below for the S&P 500 illustrate this. The correlation between daily percentage changes in the VIX and the S&P 500 is a negative 0.84 for daily closing prices since January 2014. The negative relationship between the recent decline in volatility on the value of the S&P 500 Index (volatility up, share prices down), is also illustrated.

Correlation does not however mean causation. The cause of share price or exchange rate volatility is in the degrees of uncertainty felt by investors about what the future may hold for the economy and for the companies and currency traders that are influenced by by these economic developments. If the world could be predicted with certainty, there would be no reason for prices to change; no reason for investors to change their mind about future prospects and so to force prices lower or higher to reflect their less or more optimism about future prospects. For every buyer who must think prices will rise in the future to provide attractive returns, a profit seeker willing to bid up an asset price, there will be a seller (a profit taker) who thinks the prices or the market in general will move in the opposite direction. The more uncertain the future appears, the more they will tend to disagree and the more prices will move widely in both directions from day to day to reflect their differences of opinion until something like greater calm in the markets resumes. This degree of movement in both directions, up then down, down then up, is what makes for volatility. The random price walk that always characterises asset price movements over time s can become abecome a wider or narrower path as prices fluctuate one with wider or lesser changes in both directions over time, as has been illustrated above.

ByG greater calm in the market place is characterized by smaller swings in prices from day to day or even within a trading day resulting in smaller moves, implies one associates with a higher degree of consensus about the state of the world and so the less reason incentive for market participants to push prices more sharply in one and the other direction, when markets are highly liquid and attract many buyers and sellersMore volatile markets, that is wider price swings in both directions, imply a higher degree of dissonance about future prospects.. Changes in market prices Volatility reflects essential disagreement between market participants about the state of the world and the prospects for companies. And prices fall as volatility rises in order to provide investors in general with higher expected returns to compensate for these greater perceived risks.

Thus it might help market participants trying to time correctly their entry into or exit from the market to ask a different question – not where the market is going, but rather where will volatility be going, that is will the world become more or less risky? That is because if it does become more or less risky as prices fluctuate over a wider range, the value of relatively risky assets (perhaps all assets other than the true safe havens – perhaps only US Treasury Bills and Bonds) will move in the opposite direction. Or in other words, the question to ask is not what is the likely outlook for the economy etc. but rather, what is the outlook for the economy and for listed companies, currencies and almost all bonds?

Another way of putting it is to ask whether market views will have reason to become more or less diverse. Will events evolve that become more or less easy for market participants to interpret? Will it become easier to solve the known unknowns that investors recognise as consistently driving valuations? A global financial crisis is a very unusual event, the outcomes from which were extremely difficult to agree about – hence the volatility in 2008 and 2009. A Eurozone debt crisis raises uncertainty about how it will all work out for share prices interest rand exchange rates – as would any breakup of the Eurozone system, another first time possibility for which history supplies little guidance..

Hence the obligation for policy makers to act as predictably as possible. Certainty in economic policy reduces risks for investors and helps raise values. Less risk means higher asset prices and lower expected returns. If SA wishes to attract foreign and domestic capital on superior terms, the aim should be to reduce the high risk premium attached to incomes dependent on the SA economy. High returns of the kind earned by investors in SA assets since 2000 might well be realized, should the SA risk premium come down rather than go up over the next few years. The SA government could do a much better job than it has been doing to introduce certainty in its economic policies and, as important, certainty that the right income enhancing policies are being adopted.

Point of View: Less obvious than they seem

Lower average inflation in SA is surely welcome – but will it make doing business or consumption less risky? The benefits of lower inflation in SA may well be less obvious than they seem.

The average price that SA consumers paid for goods and services actually fell by 0.2% in January. The Consumer Price Index (CPI) measured 110.8 in January compared to a level of 111 reached in December 2014 (based on December 2012 = 100). The CPI first reached the level of 111 in August 2014 and is now lower than it was five months ago. Thus headline inflation, calculated as the year on year change in the CPI, has fallen away sharply and, if present trends in the CPI were to continue (which is unlikely) , inflation in a year would be below 2%.

The CPI is but an indicator of the average prices paid by the average SA household for a fixed representative basket of goods, as pre-determined by Stats SA based on its surveys of household spending patterns. As we are all well aware, any average can hide a large dispersion about the mean. The old saw about feet in the fridge and head in the oven yielding a moderate average bodily temperature makes the point. Some of the goods and services included in the CPI may be rising at a much faster rate than others – some important items may even be falling, helping to reduce the CPI and the average inflation rate. This has been the case over the past 12 months.

The different components of the household budget have realised very different inflation rates. The average price increased by 4.4% since January 2014. Food and non-alcoholic beverages, with a large weight in the average budget of 15.41%, rose by an above average 6.5% over the past 12 months. Inside the food trolley, dairy products, milk, eggs and cheese rose by as much as 12.1% year on year. The goods helping to hold down average inflation in 2014 were petrol, with a 5.6% weight, was down 17.6% over the 12 months, while the prices of so called private transport, with a weight of 7.25%, fell by 13%. Telecommunication equipment, presumably high quality or computer power adjusted, was estimated to have fallen by 12.1% in 12 months.

While the quality adjusted prices charged for cell phones and the like may well fall further, the chances of fuel prices declining further seems remote – since even if the rand price of a barrel of oil were to decline further, National Treasury is bound to levy a higher excise tax on petrol and diesel.

Clearly the all important relative prices – the price of food relative to the price of transport – changed quite dramatically and can be expected to continue to do so. Businesses have to be constantly aware of the changing relationship between the prices of the goods and services they buy, including labour services, and the prices they are able to charge in their market places and adjust accordingly.

Presumably households consume more of the relatively cheaper goods and less of the more expensive stuff. They may well trade down – that is sacrifice quality for price as goods or services become relatively more expensive. Stats SA only periodically (every five years or so) adjusts its CPI trolley of goods and services for such shifts – that may be influenced by price as well as by innovations on the supply side of the economy.

Another way of measuring prices is through the use of deflators, as used in the National Income Accounts to convert the value added in money of the day prices to their real equivalent. A deflator takes current consumption or expenditure patterns and converts them into their constant price equivalents. In other words, it calculates what the goods and services bought today would have cost in some base year. Changes in this deflator then offer an alternative view of inflation.

A comparison between the Household Consumption Goods Deflator and the CPI, based on 2010 prices as well as the respective inflation rates, is shown below. The trends are similar but not identical.

Using the deflators can demonstrate just how much relative prices have changed in SA over the years. Deflators are available for a large number of items included in total household consumption. The deflators for the main categories – household spending; non-durable goods, mainly food and beverages; semi durables, mainly clothes and footwear; durables, namely vehicles, furniture and appliances; and household services, utilities, restaurants, entertainment and domestic service – are shown below and are based on 1990 prices for purposes of comparison. As may be seen, the prices of food and services have increased at a much faster rate than the prices of semi-durable and durable consumer goods. Food prices have increased by over seven times since 1990 and clothes and footwear by only two times, with services increasing at almost the same rate as non-durables. We also demonstrate how much more relatively expensive food and services have become.

A large part of the theoretical case made for low rates of inflation is that low inflation helps stabilise relative prices. Such greater certainty about relative prices – or the relationship between the prices of the goods and services we sell and those we buy – would be helpful to producers and consumers. It would help to reduce uncertainty about relative prices and so reduce the risks of undertaking consumption and production over time, which would thus be to the advantage of economic growth.

Unfortunately there is no evidence that lower consumer goods inflation in SA has in any way reduced the dispersion of the prices of goods and services consumed by households about their average. According to the deflators, the rates of inflation of the many goods and services consumed by households differ now by as much as they ever have, as we show below.

The benefits of lower inflation in SA may well be less obvious than they seem. Lower inflation does not appear to have reduced the risks in consumption and production. Relative prices remain as variable as ever. Nor does it appear to have stabilised interest rates after inflation or the rand exchange rate (once adjusted for differences in inflation between SA and our trading partners).

Interest rates: A play on the rates

The JSE as a play on interest rates. The scope for still lower long term interest rates in SA

The importance of movements in interest rates for share prices over the past 12 months has never been more obvious on the JSE. Interest rates turned out to be significantly lower than expected early in 2014 and a group of large cap interest rate sensitive stocks, banks, retailers and property companies, have accordingly performed outstandingly well.

Since 1 February 2014 to 30 January 2015 our market cap weighted Index of large cap interest rate sensitive stocks generated a total return (including dividends) of 48.7%. The Global Consumer Play Index, also market weighted and one that includes Naspers and Aspen, while also performing well returned a lesser 42.9% while the JSE All Share returned 16.8%. The S&P 500, the best performer of the developed equity markets provided a 12 month return in rands of 19.6%, a highly satisfactory outcome, but less than half the return provided by the SA interest rate plays, as may be seen below.

(The index of Interest Rate Plays is made up of the following 30 companies: BGA, FSR, GRT, INL, INP, IPL, MSM, NED, RMH, SBK, TRU, CCO, CLS, CPI, FPT, HYP, NEP, PIK, RDF, RES, TFG, WBO, MPC, WHL, CPF, ATT, PSG, RPL, AEG and FFA. The Global Consumer Plays are: APN, BTI, CFR, MDC, MTN, NPN, SAB, SHF, NTC and ITU)

These interest rate sensitive stocks on the JSE should be regarded as demandingly valued by the standards of the recent past. They were priced at January month end at a well above average 16.9 times trailing earnings. They surely have benefitted from unexpectedly lower interest rates.

Presumably these interest rate sensitive stocks will remain so, making the further direction of interest rates in SA of great importance in stock selection and asset allocation. Long term interest rates in SA will moreover continue to take direction from interest rates in the US and Europe. Furthermore the value of the rand is bound to be strongly influenced by the self same interest rate trends.

When interest rates in the developed financial markets decline, all things remaining the same, especially country specific risk factors, funds will tend to flow towards less developed markets where yields are higher. The search for yield in a low interest rate world will tend to compress yields and yield spreads everywhere, so adding to the demand for emerging market currencies that supports exchange rates, including the rand. And where the rand goes will influence the outlook for inflation in SA and so the direction of short term rates. Over the past year lower euro yields have been very strongly associated with a stronger rand vs the euro, as well as a weaker euro and rand vs the US dollar. A weaker euro, both against the US dollar and the rand, has come with additional demands  for and lower yields on RSA long dated government bonds.

The wider spread between US and German yields shown in figure 1 has clearly helped to add to US dollar strength and can be expected to continue to do so.

Given the freedom to move capital from one market to another, it is clear that interest rates in Europe must influence rates in the US and vice versa – rates in the US must influence rates in Europe as well as SA and elsewhere. It seems as clear that, were it not for the weakness of the Eurozone economies and the threat of deflation there, as well as the promise of European Central Bank (ECB) quantitative easing on a large scale (and so very low Eurozone interest rates), long term interest rates in the US would have been a lot higher than they now are. The leading force in the longer end of the global bond market may well be European deflation rather than US economic growth and the reactions of the US Fed. The US economy seems firmly set on a good growth path. The impressive growth in the numbers of workers employed in the US is ample testimony to the strength of the US economy. The latest employment numbers have been revised sharply higher for 2014, when an extra 3.04 million employees were added to private payrolls. The response of long term US interest rates to these bullish developments has been quite muted.

These employment numbers may well encourage the US Fed in June to raise its own key short term Fed Funds rate from its current zero level, as is now widely anticipated in the money market. But longer term rates may still take their cue from rates in Europe and stay where they are, with 10 year Treasury yields staying closer to the current 2% level than the 3% level, which might be regarded as more normal. In such a case, long term interest rates in SA will also not move sharply higher any time soon. If however rates in Europe trend still lower under pressure from aggressive QE interest rates in Europe, the US and SA can still surprise on the downside. A stronger dollar would press on both US inflation and growth rates and weaken the case for higher short term rates.

While the level of RSA rates will respond to the directions of global markets it may be asked what should be regarded as the normal level of interest rates in SA? The Reserve Bank has spoken of the normalisation of SA interest rates, implying higher rates should be expected, though in its latest Monetary Policy Statement it referred to a likely pause in rates given the much improved inflation outlook. Normal must refer to rates after inflation or, when longer rates are interpreted, it would be by reference to market rates after expected inflation, that is to say real rates.

In figure 7 below we compare RSA 10 year nominal bond yields with their inflation protected alternative yield since 2005. Nominal RSA Yields have a daily average of 8.13% p.a since 2005 with a high of 10.9 % p.a. in August 2008 – and a low of 6.13 in May 2013. Inflation protected real yields averaged 2.4% p.a with a high of 3.65% p.a and a temporary low of 0.38% p.a. in May 2013. The daily volatility of both these yield series, measured by the Standard Deviation (SD) of the daily yields about the average, was about the same, 0.69% p.a.

The difference in these yields, nominal and real, may be regarded as compensation for bearing the inflation risk in vanilla bonds in the form of higher yields, has averaged 5.8% p.a with a SD of 0.61% p.a. Inflation expectations revealed by the RSA bond market appear as highly stable about the 6% p.a level, which is the upper end of the Reserve Bank’s target range for inflation. Headline inflation in SA calculated monthly has not co-incidentally averaged 6.1% since January 2005. Thus normal long bond yields might be regarded as 6% for inflation plus 2.5% p.a as a real return, summing up to approximately 8.5% p.a yield on a long dated RSA bond.

The evidence is that inflation compensation in the bond market follows the inflation trends with a long lag. It will take a sustained period of well below average 6% inflation to reduce the expected inflation priced into nominal bond yields of about 6% p.a. It will take faster growth in SA and globally to raise inflation linked 10 year real interest rates in SA meaningfully above their current 1.72% p.a. This seems an unlikely development in the short term. The equivalent 10 year real inflation protected (TIPS) yield in the US is only 0.28%, offering investors in inflation linked RSAs a real yield spread of 1.5% p.a. This real spread appears rather attractive in current global circumstances and may well decline. This real spread can be compared to a nominal yield spread of 5.44% p.a. in favour of 10 year RSAs on 9 February 2015 (that is the RSA at 7.38% – US Treasury at 1.94% = 5.44%, which is very much in line with the trends in this spread since 2008).

The case for JSE listed interest rate sensitive stocks at current demanding valuations could be based on the prospect of a further decline in SA interest rates. In the first instance this is on US rates rising less than the currently modest 20bps expected by the US Treasury bond market in a year’s time. The market is expecting the 10 year US Treasury Yield to rise from the current 2% p.a to approximately 2.2% p.a in a year. This expected increase should not be regarded as a grave threat to the SA bond market. It could take lower rates in Europe to deny such expectations or any softer actions or words from the US Fed regarding its Fed Funds rate.

The other hope for interest rate sensitive stocks on the JSE would be a decline in the RSA real rate, which appears quite high, compared to real rates elsewhere. A modest decline in the real rate would help depress nominal rates. A more likely, but more and more potentially significant decline in RSA bond yields could follow any decline in inflation expected. This could occur if SA headline inflation stays well below the 6% mark for an extended period of time. Clearly, with interest rates and the valuations of interest rate sensitive stocks where they are, there are upside as well as downside risks to interest rates in SA and to SA interest rate sensitive JSE listed companies.

Hard Number Index: Picking Up Momentum

A dispatch from the economic front: vehicle sales and supplies of cash are picking up momentum

Sales of new vehicles by SA dealers in January 2015 some 52306 units of all sizes were good enough to keep the new vehicle sales cycle on a recovery path that began in mid year. If recent trends are sustained, the network is on track to sell over 700 000 new units in 2015, close to the record levels achieved in 2006.

We combine this statistic with another very up to date hard number, notes issued by the Reserve Bank in January 2015, to establish our Hard Number Index (HNI) of the state of the economy. The HNI for January 2015 indicates that economic activity in SA continues to grow at a modest pace.

Furthermore the pace of activity that appeared to be slowing down in mid-year has gained some momentum and is forecast to sustain this rate of growth in 2015. The HNI may be compared to the coinciding business cycle indicator of the SA Reserve Bank. This economic activity indicator, based on a much larger set of mostly sample surveys (not actual hard numbers) is also pointing higher, suggesting a pickup in growth rates, but is only updated to October 2014. It should be noted that the turning points of the HNI and the Reserve Bank indicator were very well synchronised when the economy first began to recover from the post Global Financial Crisis recession, in 2009.

In the figure below we track the two separate growth cycles, unit vehicle sales and demands and supplies of real cash – the note issue – deflated by the CPI. Both series are pointing higher. This upward momentum will be sustained by less inflation to come and the relief lower rates of inflation provide for interest rates. The lower inflation might, in due course, possibly only in 2016, mean lower (not higher) costs of financing vehicles and will help the vehicle market and the economy generally.

Monetary policy: The big bad wolf

Deflation is the big bad wolf threatening monetary policy. The logic of QE

Public enemy number one for central bankers in the developed world is deflation. When the CPI declines we have deflation, when it rises we have the opposite, inflation. Prices in general fall, when aggregate demand in the economy exercised by households, firms and governments, fails to keep up with potential supply. Prices rise when demand exceeds supply in general. The economic problem in the developed world and in much of the less developed world (including SA) is too little rather than too much demand that has called for highly unconventional monetary policy.

These central bankers, with modern Japan very much in mind where prices have been falling and economic growth abysmally slow since the early nineties, are convinced that deflation depresses spending and by so doing serves to prevent an economy from achieving its growth potential.

They are therefore doing all they can to stimulate more spending to arrest deflation or a possible decline in average prices. What they can do to encourage reluctant spenders is to create more money and reduce interest rates. Inflation, as they used to say, was too much money chasing too few goods. Deflation may be said to be caused by the opposite – too little money chasing too many goods. Inflation calls for less demand and so less money creation. Deflation calls urgently for the opposite – more money creation.

But while these central bankers have the power to create as much extra cash as they judge appropriate they have had to overcome a technical problem. The extra cash intended to encourage more spending may get stuck in the banking system. And when it does there may be no additional demand for goods and services and the extra money created (at no cost) may not encourage spending or lending and provide no relief of the unwanted deflationary pressures. The banks may hold the extra cash as additional cash reserves or use the cash to pay off loans they may have incurred previously with the central bank.

The mechanics of money creation go simply as follows. The cash the central banks create (or more specifically the financial claims they create on themselves called deposits with the central bank) when buying securities from willing sellers in the financial markets (typically pension funds or financial institutions of one kind or another) reflects immediately as extra privately owned deposits with private banks. In the first instance, as the proceeds of a sale of securities by a private bank customer are banked, the private bank will have raised an additional deposit liability and will receive in return an asset in the form of additional claim on the central bank. That is, the asset to match their additional deposit liabilities will take the form of an increase in their (cash) reserves at the central bank. Normally the banks will make every effort to convert this extra cash into a loan that earns them more interest. Such loans would then lead to more spending. Normally banks keep minimal cash reserves in excess of the regulated requirement to hold cash reserves in fractional (say 5%) proportion to their deposit liabilities.

But ever since the Global Financial Crisis of 2008 this has not been the case at all. The central banks, led by the US Federal Reserve Bank, have bought trillions of dollars worth of financial securities and the private banks have added trillions of dollars to their cash reserves. In the figure below we show how the assets of the major central banks have expanded over the years. Their extra assets have consisted of securities issued by governments of government agencies- for example in the form of mortgage backed securities issued by government backed mortage lending agencies Fannie Mae and Freddie Mac in the US.

It should be noted that the ECB balance sheet has been shrinking in recent years, unlike those of the other central banks. This decline in ECB assets and liabilities (mostly cash reserves of the banks) has represented additional deflationary pressure on spending in Europe. The European banks have been repaying ECB loans previously made to them and the ECB has now responded by initiating a further programme of QE, that is to say security purchases, intended to inject an extra EUR60bn a month into the banks of Europe over the next 21 months. That is to encourage bank lending and spending to counter deflation.

The important point to note is that creating money in the form of a deposit with the central bank by buying securities in the market costs society almost nothing. Creating money that is an asset of the banks and an addition to the wealth of the community does not require any sacrifice of consumption or savings, as would any other form of wealth creation. It is literally money for nothing. But in normal times too much money means too much spending and inflation. Hence the resistance in normal times to creating money – because it normally leads to inflation.

But the times have not been normal. The extra supplies of money have been accompanied by extra demands by the banks to hold money and too little rather than too much spending has remained the economic problem. Hence the case for creating still more money until deflation is conquered and central banks can get back to worrying about too much money and inflation.

The extra liabilities issued by the central bank matching the extra assets were mostly to private banks in the form of cash balances in excess of required cash reserves. In the US the banks have received 0.25% p.a on these cash reserves.

It should be notie that the US banks have begun marginally to reduce their cash reserves with the Fed and that the assets of the Fed are rising more slowly with the end of QE in October 2014. QE ended because the recovery of the US economy is well under way and presumably does not need further encouragement in the form of further increases in the supply of cash. The banks presumably have more than enough excess cash to meet the demands of borrowers from banks. It could be argued that QE at least in the case of the US – the economy is recovering – the dangers of deflation have receded and the danger of inflation taking over is judged to be absent.

There is very little inflation priced into the yields offered on 30 year US Treasury Bonds that offer yields below 3% and less than 2% more than inflation protected US obligations with the same duration. Japan and Europe, it may be presumed, will be doing still more QE or as much as it takes to get the banks to lend out more of their cash.

The problem of deflation is complicated by very low or even negative interest rates. Cash has one advantage over other assets. The income return on cash can only fall to zero. Other assets, for example government securities or bank deposits, may only offer negative interest rates. The German government, for example, can now borrow for up to 10 years, charging rather than paying interest. In other words, it can take about 105 euros from you and promise to pay you 3 euros interest and repay you 100 euros in a year’s time. In other words the transaction will have cost you 2 euros and this, alas, is the best risk adjusted return you can get, though, if prices in general decline by 2% over the year, your 100 euros will be worth as much as 102 a year before adding to your real return. But you would have done better holding cash. 100 euros in cash will still be worth 100 after 12 months and will also buy you more.

Hence deflation forces down interest rates and encourages the demand for cash (and safe deposit boxes) and discourages the demand for bank deposits and for goods and services that may be expected to become cheaper. Deflation also encourages banks and other lenders to hold cash rather than to lend it out. Hence further reason to fight deflation (and too little rather than too much spending) by flooding the system with additional cash so that the supply of cash can eventually, even with very low or negative interest rates, overwhelm the demand for cash.

Until Europe succeeds in overcoming deflation and stagnation we can expect interest rates in Europe to stay low and for the euro to stay weak; and the US dollar (offering higher interest rates) to stay strong. We may also expect deflation and low interest rates in Europe to help hold down long term rates in the US and elsewhere as European lenders seek higher yields abroad. The weak euro and stronger dollar (and perhaps also stronger emerging market currencies, including the rand) may also help restrain any increase in short and long interest rates globally. It may take some time before we can say with any confidence: goodbye to deflation and welcome back inflation.

The MPC says welcome to 2015. Will it say out with the old, in with the new?

The Monetary Policy Committee (MPC) of the Reserve Bank will be reporting back today on its first meeting of 2015.

The MPC did not have a good 2014. By the year end it had become clear that it had overestimated both SA inflation and growth in 2014 and beyond.

The estimates of inflation were overtaken by events outside SA, over which the Reserve Bank has no influence. These were events that moved global prices and interest rates markedly lower and the rand no weaker on a trade weighted basis, despite the strong US dollar. However the increases in the MPC short term repo rate in 2014, to 5.75%, by an initial 50 bp in January followed by a further 25bp in July, would have discouraged domestic spending to a degree. This was spending that in mid year gave every indication of slowing down even more rapidly than initially forecast. But the higher cost of credit had no discernible influence on inflation, dominated as it was by global price trends, especially that of oil and grains, and the exchange rate.

Hindsight would suggest that short term interest rates in SA should at worst have been kept on hold in 2014 and, better still, should have moved lower. Longer term rates certainly did, determined as they are by market forces, though they were market forces with an eye always on central bank action.

The Reserve Bank might be inclined to contest such an observation. It stressed in its statements released after its MPC meetings that fighting inflation was its primary task and moreover that it regarded its monetary policy as always accommodating, a reference to the unusually small gap between interest rates and inflation.

According to its statement in July 2014, when it raised short rates by a further 25bp:

“The MPC is also increasingly concerned about the inflation outlook, and the further upside risks to the forecast. Although the exchange rate remains a key factor in this regard, the possibility of a wage-price spiral should wage settlements well in excess of inflation and productivity growth become an economy-wide norm has increased. Although the inflation trajectory has not deteriorated markedly since the previous meeting, upside risks have increased, and it is expected to remain uncomfortably close to the upper end of the target range when it does eventually return to within the target. The upside risk factors make this trajectory highly vulnerable to any significant changes in inflation pressures.

“Although inflation expectations have remained relatively anchored, should inflation persist outside the target band, these expectations risk becoming dislodged.

“The MPC has decided to continue on its gradual normalisation path and raise the repurchase rate by 25 basis points to 5,75 per cent per annum, effective from Friday 18 July. Given the expected inflation trajectory, the real repurchase rate remains slightly negative and well below its longer term neutral level. The monetary policy stance remains supportive of the domestic economy, and, as before, any future moves will be gradual and highly data dependent.

“We would like to reiterate that monetary policy should not be seen as the growth engine of the economy. The sources of the below par growth performance are largely outside the realms of monetary policy.”

The lesson the Reserve Bank might however take from events in 2014 is that while it is true that the “the sources of the below par growth performance are largely outside the realms of monetary policy”, so is the inflation rate.

Inflation in 2015 will continue to be dominated by events beyond the influence of SA monetary policy and short term interest rate settings. For some obvious examples of only the known unknowns, the timing of the first US FED rate increase, June 2015 or later, will matter for global growth and inflation forecasts. So will the success or otherwise of European quantitative easing and how deflation in Europe presses down euro yields and hence the flow of funds both to the US and emerging markets (including SA) in search of higher yields. A possibly still stronger dollar might press further on the oil and other metal prices, meaning less inflation and possibly slower growth in the US. The economic recovery in the US, depending on its pace, may encourage tepid growth in emerging economies, adding to the attractions of their equities and currencies, including the rand. Such outcomes will in turn bring rate increases in the US either forward or back.

The MPC, as is clear from the statements it issued, worried a great deal in 2014 about the turbulence in global markets and economies and how it should react to the interest rate decisions of other central banks. As it turned out, the higher rates imposed by a number of emerging market central banks, including the SA Reserve Bank, were ill advised and are being reversed in the light of lower inflation.

The MPC will almost certainly keep its repo rate on hold today. Hopefully its future decisions will remain data dependent and not presume a so described normalisation of interest rates any time soon. Normalisation of (higher) interest rates presumes a normalisation of global economic circumstances that remain distinctly abnormal as deflation and QE in Europe confirm.

It would be wise for the Reserve Bank to realise that its influence over growth, inflation and inflation expectations is limited given the exposure of the SA economy to global forces.

There is however one feedback loop over which it has some influence. This is the loop from short term interest rates to domestic spending. Higher rates discourage such spending and lower rates can encourage it. This is the only channel of influence the Reserve Bank can rely upon to some degree.

It should therefore concentrate on ensuring that domestic demand neither adds to nor detracts from inflationary or deflationary pressures. Or, in other words, to attempt with its interest rate settings to match domestic spending (influenced as it will be by bank lending) to potential domestic production as closely as possible. If it succeeds in this, it will have done what little it can realistically hope to achieve in consistently low inflation in SA. Hoping to do more than this, especially in hoping to predict the course of global economic events, and then to react “correctly”, is beyond its limited powers. This was amply shown to be the case in 2014.

Domestic spending in SA has been running at what can be presumed to be well below normal levels and rates of growth. It can do with all the help it will be getting from lower inflation and lower fuel prices. Additional help from lower short term interest rates may well be called for in due course, if spending growth remains subdued.

A helping hand from Europe

How European Central Bank (ECB) Quantitative Easing (QE) moved the markets, including the rand and the RSA Yields. Is this good news for emerging market economies?

The unexpected scale of the intended QE in Europe announced on Thursday moved the markets. Most conspicuously it weakened the euro vs the US dollar. Such weakness must be good for European exporters and thus for growth prospects in Europe regardless of how much more lending European banks will do with their pumped up cash reserves. Some stimulus from a weaker euro will add something to the demand for bank credit, which has been as weak as the supply of bank credit from European banks – hence the case for QE.

US dollar strength and euro weakness was an entirely predictable response to what became a wider interest rate spread in favour of US Treasuries over Bunds.

The rand not only gained against the euro but also strengthened against the US dollar on the QE facts.

This strength was however not confined to the rand. It was also extended to many of the other emerging market currencies. The rand lost a little bit of ground against the Brazilian real and gained against the Turkish lira. It also held its own against the Mexican peso and Indian rupee as we also show below. Thus euro weakness vs the US dollar extended to emerging market currencies, including the rand.

The strength of the rand vs the euro was linked with further strength in the RSA bond market. We have alluded in previous notes to the recently strong relationship between the rand/euro and RSA long bond yields. This trend of declining RSA yields associated with rand/euro strength held up strongly over the past few days. It indicates that the lower euro interest rates and a wider spread in favour of RSA (and presumably other emerging market) bond yields also attracted flows of funds out of or away from Europe – enough to move emerging market bond yields lower.

It was not only emerging market bond markets that seemed to benefit from changes in flows of funds in response to ECB QE. Emerging market equity markets, including the JSE when measured in US dollars, also outperformed the S&P 500.

Lower interest rates and determined reflation in Europe have improved global growth prospects. It does appear that EM bond and currency markets have benefitted and that EM economies may grow faster in response to the sustained improvement in the US economy and now hopefully better growth prospects in Europe on which EM economies depend. So much can be read into market moves. As we have mentioned before it is hard to predict other than dollar strength Vs the Euro in the light of the sustained spread in the yields offered by US Treasuries over German Bunds. It seems that the wide spread between Euro yields and EM yields can help to protect EM currencies including the ZAR from dollar strength. This means less inflation as well as low long term rates. It can also mean lower short term rates that might help stimulate growth even as inflation comes down.

The lack of pricing power in SA and its favourable implications for the economy

The CPI in December 2014 was no higher than it was in August 2014. 

The Consumer Price Index (CPI – based to 100 in December 2012) reached the level of 111 in August. In December the CPI fell by 0.2 points and was back at the 111 level. In other words, on average, prices in SA have not changed in five months.

Headline inflation is measured as the year on year change in the CPI. Prices since December 2013 have risen 5.3%. However, if we measure the change in prices over a shorter three month period, this inflation rate is zero, way below headline inflation. If current trends continue and are extrapolated using a time series forecast, SA is heading for significantly lower inflation, perhaps below 4% by the end of 2015. Lower petrol and diesel prices in January may send the CPI still lower and reduce the forecast rates of inflation further, though it is highly likely that if the rand oil price stays where it is, the government will impose an additional excise tax on petrol, diesel and paraffin in its February Budget proposals.

The bond market, where interest rate contracts between the government and pension funds can be written for 20 or more years, the risks of more or less inflation are fully reflected in long term interest rates. Inflation-protected bonds offered by the government enable lenders to avoid the risks of inflation turning out higher than expected and provide a riskless certain real return (provided governments measure inflation objectively and stand by the contract). The difference between the nominal and real yield on RSA bonds of similar duration (say 10 years) therefore represents compensation for bearing inflation risk and is an objective market-determined measure of expected inflation.

Less inflation in SA, linked to the accompanying stability of the rand on a trade weighted basis and lower oil and commodity prices (when expressed in the strong US dollar) has helped lead interest rates in SA lower. The gap between the yields on nominal inflation-exposed benchmark 10 year RSAs and their inflation-linked equivalents (RSA 212) has also narrowed recently and has followed headline inflation lower.

Less inflation leads to less inflation expected – the Reserve Bank is wrong to think it can go the other way round – there is no good evidence for the so-called second round effects (more inflation expected that are assumed to lead inflation higher). But it should also be appreciated that inflation compensation in SA is very sticky about the 6% level. It has stayed close to that level even as inflation came down sharply from high levels after the Global Financial Crisis and crept higher in the second quarter of last year. The Reserve Bank will have little influence on these inflation expectations – provided inflation behaves “normally” – and it should recognise that its policy targets can only be about inflation and also growth, not inflation expected.

It may take inflation well below 6% and sustained at that level over an extended period of time to reduce inflation compensation in the bond market well below the 6% level. RSA bond yields (lower or higher) will continue to take their cue from global interest rate trends – to be led by euro rates, as they have been led in 2014. It is the interest rates in Europe (reflecting fears of deflation and central bank reactions to deflation) followed by lower rates in the US, that have attracted flows from off shore into to the rand bond market causing SA interest rates to fall while helping the rand to strengthen. The stable to stronger rand has helped reduce inflation while having a much more subdued influence on inflation expected.

The importance of these trends, all well beyond Reserve Bank influence, will mean that the Reserve Bank is very unlikely to raise its repo rate this year and may even reduce it next year should the economy not pick up momentum. A mixture of less inflation with faster growth in SA, encouraged by stable interest rates, is the new welcome opportunity provided by global deflation for the SA economy to lift its growth rates. Such optimism is already being reflected in the buoyant recent performance of the interest rate sensitive stocks listed on the JSE: the retailers, banks and property companies.

More growth expected and the improved profitability associated with faster growth will attract more capital to SA, as it has been doing over the past few days. These flows support the rand and make faster growth with less inflation more likely. These are good reasons why the Reserve banks should focus its attentions on what it can do to assist growth in SA and leave inflation – over which it has little influence – to the global market forces that drive the rand and long term interest rates.

Point of View: The Uber test

My colleagues who get out a bit and would never ever drive and drink are wild about Uber, their preferred taxi service. The Uber taxi service is made possible by ever advancing information technology. The service could not be offered without the GPS enabled smart phone with its extraordinary advances in computing capabilities that Uber relies upon.

The service offers a number of advantages over its competition, however well connected or instructed by a call centre. The most decisive advantage is the flexibility and certainty of the service provided – you can call an Uber car and driver up precisely when you need it (something you may not wish to decide in advance) and know with a high degree of certainty that the call will be answered and punctually: a clear advantage that the alternative services, including those provided by a taxi allowed to roam, cannot offer with anything like the same predictability. Finding a cab on a busy street corner to take you quickly out of the rain cannot be predicted with any confidence.

There are other conveniences on offer to both the passenger and, as important, the driver who supplies the Uber service. No cash or credit card swipe is required. The reputation, not only of Uber but of the driver and passenger, is always on the line. It is in Uber’s interest to vet not only the competence of its drivers and the soundness of their vehicles but also the behaviour of their passengers. It is also in the interest of Uber to ensure that its drivers are not only competent but fully insured against accidents that may damage its passengers and therefore its reputation. Cars for hire understandably command higher insurance premiums than vehicles used only privately – they are more on than off the road and therefore are likely to suffer more accidents.

This care for its customers will be taken because the value of Uber as a business, as is the value of almost every business enterprise, is completely dependent on attracting repeat business. Its reputation is its most valuable business asset of which its owners and managers will be fully aware because of their own economic dependence on its reputation and value.

Perhaps the most valuable innovation of the Uber system that could be scaled up very easily is its treatment of the peak pricing and loading problem. When demand peaks, fares rise to restrain demand. But the same higher level of demand instantaneously revealed by the system, with or without the inducements of higher Uber charges, encourages additional supply. Capacity responds immediately to revealed demands because it is in the interest of drivers and owners of vehicles to do so. The costs to their owners of cars standing idle becomes patently obvious when the state of demand and the income earning opportunity becomes so conspicuous.

Most cars however stand idle most of the day and are employed almost entirely at peak hours in the working week. Uber offers a very effective way to bring enough of them out of idle storage to meet peak demands. What if the Uber service offered for income and profit could be extended to car sharing to and from work from homes that is currently only encouraged as acts of charity by the car owners and users? Uber might well be able to get you to economically share a ride to or from work at a time to suit perfectly.

But while Uber is a potential boon to consumers of taxi like services it is a clear and obvious danger to the established taxi services and the economic interests associated with them. The right to run a taxi service in many cities is a valuable one because supplies of the service are artificially restricted by regulation of entry into the business. It can also become a tradable right as the valuable trade in New York City taxi medallions demonstrates. The licensing system is also valuable to the officials with licensing power who have their own jobs and benefits to thank the regulations for.
Competition through innovation from Uber is as much a threat to the jobs and benefits of the regulator as it could be to established suppliers. It will not be a threat to the drivers for whom remuneration will be determined by the supply and demand for drivers. The supply of drivers and the employment benefits they command will be influenced by the difficulty to qualify as a licensed driver. Drivers will surely be a lot keener on the opportunities presented by Uber than licensed taxi owners. Uber should be seen as high tech system helping job creation.

The revealed demand for the Uber service at the prices being charged for them is proof of its welfare adding capability for the society at large. The patterns of demand for and the supply of the Uber service is an outcome of competition at work. Competition of the most important kind- that is not merely price competition for an established good or service – but the transforming competition that comes with invention, innovation and capital put at risk as well as capital used more intensively and productively than it was before. It is this ‘creative destruction’ that has made the economic world the much more powerful productive system it has become over the past 300 years or so. Had the Luddites had their way this economic progress would not have been allowed to happen1.

The reaction to Uber illustrates the destructive power of established interests and especially those of regulators to limit competition. Growth happens when individuals are left largely free to pursue their own interests by competing with the established suppliers working hard, taking risks and constantly innovating to improve their own rewards. The hidden hand that converts private benefits into public gains is a work in constant progress.

Growth is frustrated when established interests are protected against competition, be they those of the King and his court or by formal religions to protect their own interest in the established order. Or when competition is frustrated and growth potential denied in order to protect the interests of regulators and politicians in the established ways of doing things.

The different reactions to the entry of Uber into the market place, relatively encouraging or discouraging and highly suspicious reveal that the forces of competition may be treated by the broad society as instinctively helpful or otherwise. That is as innocent and welcome until proven otherwise. Or, alternatively they may be presumed guilty of unwelcome interference, until the entrant can prove themselves (with great difficulty) innocent of the charge of not causing economic damage. It is those economies that welcome competition, that believe market forces in principle should be allowed their freedom, that will pass the Uber test to the great benefit of society, not only in the convenience of its taxi service, but in every sphere of economic activity, the future shape of which is unimaginable, given the power of innovation.

1The Luddites were 19th-century English textile artisans who protested against newly developed labour-replacing machinery from 1811 to 1817. The stocking frames, spinning frames and power looms introduced during the Industrial Revolution threatened to replace the artisans with less-skilled, low-wage labourers, leaving them without work. I would suggest labour saving- productivity enhancing inventions rather than labour replacing. The supply and demand for labour and real wages have risen consistently since then even as the machinery has become ever more labour saving and micro-processor assisted. (Source: Wikipedia)

Global rates: What they mean for SA assets

Whither interest rates: up, down or sideways?

The most important feature of global financial markets in 2014 was the significant decline in long term government bond yields. On 1 January 2014 the 10 year US Treasury was trading at a 3.03% yield and the German Bund offered 1.94%. On Friday 16 January 2015 these yields had fallen to 1.83% and 0.46% respectively. These developments, led by German yields, were a great surprise to a market that was expecting both rates to increase, judged by the upward slope of the yield curve a year ago.

The US 30 year Treasury bond offered 3.96% a year ago. It now yields 2.45%, still above the 10 year rate, thus revealing that the market still expects interest rates to rise, but by much less and more gradually. The 10 year US Treasury is priced, in the futures markets, to rise from the current 1.84% to 2.08% in a year and to only 2.86% in 10 years’ time.

Long term interest rates in SA moved in the same direction and this trend lower accelerated in January 2015. Not only did long rates fall but the gap between long and short rates has narrowed sharply. Short term rates in SA have held up and only very recently has the money market revised its view that short term rates would be rising in 2015. The market would now appear to have put off any expected increase in short rates to 2016 and now appears to expect short rates to rise by about 1%t (100bp) over the next three years.

These unexpected movements in SA interest rates, long and short, have had a significant influence on the share prices of those companies listed on the JSE whose performance is known to be very sensitive to interest rates, for example property companies, banks and credit retailers. Changes in interest rates influence not only their cost of doing business but also stimulate or restrain demands for their services and top line growth. Our index of large market cap interest rate-sensitive stocks on the JSE performed as well in 2014 as the JSE-listed Global Consumer Plays and the S&P 500 (in common currencies) – well ahead of almost all the major stock markets in 20141.

Clearly interest rate trends matter a great deal for equity valuation in SA and had a powerful influence on the JSE in 2014. What the does the future hold for interest rates in SA? In 2014 and to date in 2015, RSA yields moved very closely in line with the rand/euro exchange rate. As we show below, interest rates in SA fell as the rand gained value against the euro. This relationship has held up very well this year.

This relationship (which has not always been as strong as this), between the euro/rand and the RSA yields makes every sense. It is weak growth and the threat of deflation in Europe that has sent all interest rates lower, including those in SA. It is these lower rates that have widened the spread between euro and US dollar and RSA rates even as rates have declined, adding to the case for holding dollars and rands. The dollar is strong and the rand is stable, so improving the outlook for inflation in SA in a deflationary (at least in dollars or euros) world.

The direction of economic activity and inflation, and so the exchange value of the euro, will continue to hold the key to the direction of interest rates in SA. This week the European Central Bank (ECB) hopes to add quantitative easing (QE) to its repertoire of instruments designed to avoid deflation and stimulate growth in Europe. We wait to see how much QE will be undertaken and how it will affect interest rates in Europe. In and of itself, QE would lower interest rates. However if QE is thought capable of reviving the Eurozone economy, then this would counter expectations of slow growth and deflation and might limit the downside to euro interest and exchange rates. Our sense is that provided the spread between US and euro rates holds up (currently about 1.4%) a strong or at worst stable US dollar/euro rate should be expected. Interest rates in SA would then move sideways at worst and possibly lower, with long rates continuing to lead short rates. If the rand holds up on a trade weighted basis (weaker against the US dollar and stronger against the euro), then the chances of inflation in SA surprising on the downside improves. Less inflation and less inflation expected portend lower (not higher) interest rates in SA.

1The Interest plays are a market (JSE SWIX) weighted average of:

BGA FSR GRT INL INP IPL MSM NED RMH SBK TRU CCO CLS CPI FPT HYP NEP PIK RDF RES TFG WBO MPC WHL CPF ATT PSG RPL AEG FFA

The SA Industrials Index combines:

BVT IPL SHP TBS VOD BAW AVI LHC SPP NPK

While the Global Consumer Plays consist of a market weighted combination of:

APN BTI CFR MDC MTN NPN SAB SHF NTC ITU

Hard Number Index: December boost

The SA economy is looking up again, judged by December data releases.

The SA economy in December continued on a modest recovery path that we had identified in November 2014. Growth in economic activity would appear to be gaining rather than losing momentum, as appeared to be the somber case in mid-year.

Vehicle sales and notes in circulation in December, two hard numbers about the state of the SA economy with a very early release, reveal some more encouraging trends. Vehicle sales were particularly robust and the note issue, when adjusted for lower inflation, also maintained its helpful upward trajectory.

We combine these two series with equal weights to calculate our Hard Number Index (HNI) of the immediate state of the SA economy. It may be seen that the HNI, having dipped lower earlier in 2014, has risen to higher levels again and is extrapolated to sustain this forward momentum in 2015. Numbers above 100 for the HNI indicate that the economy is moving forward, that is growing at a positive rate. Such forward momentum is also confirmed by the Reserve Bank Coinciding Business Cycle Indicator with very similar turning points but which has only been updated to the September month end.

This forward momentum may be established by looking at the second derivative of the business cycle, that is the rate of change of the HNI itself. As may be seen below, the rate of change of the rate of change in economic activity, the forward speed of the economy, reached a top in 2010 as the economy recovered from the recession of 2009. But this speed slowed down consistently until late in 2014 when it appears to have turned up again. It must be hoped that these more favourable activity growth trends will be sustained in 2015.

It was a very good month for sales of new vehicles in December 2014. 51 461 units were delivered to the local market and 21 833 units were exported. Local sales were marginally up on November but December, with its holidays, is typically a well below average month for the motor dealers. On a seasonally adjusted (SA) basis therefore, unit sales were strongly ahead of November as we show below.

Sales on a seasonally adjusted basis have recovered strongly from what appears as something of a slow down after September 2014 that was also a very a strong month. September sales may well have been boosted by improved availability of vehicles after the strike in the manufacturing sector and perhaps was also influenced by some pre-emptive buying in the light of rand weakness. We show below that the new vehicle sales cycle has turned distinctly higher, following the slowdown in mid year. If current trends were to be maintained, the industry would realise a 10% growth rate in 2015 or sales of over 700 000 units, an outcome that would be regarded as highly satisfactory for the industry, especially if it were accompanied by good export volumes. Exports can run at about 50% of local volumes.

Particularly encouraging from the perspective of the wider economy and its longer term growth prospects, was the willingness of businesses to invest in new vehicles. Light commercial vehicle sales were 14.7% up on a year before while sales of the expensive, extra heavy commercial vehicles were up buy an especially robust 29.9% on December 2013.

The demand for and supply of notes also continued to grow faster at year end. Such demands indicate spending intentions and holiday sales reports from the major retailers – due in late January are likely to reveal a similar trend to those of the real note issue cycle. Significantly lower rates inflation realised over the past three months would also have helped the real money supply cycle.

As is well observed, faster or slower growth in economic activity tends to reinforce itself as economic actors react to the more or less favourable spending trends. Interest rate developments in 2015 will play a crucial role in adding reinforcement to growth prospects or detracting from them. In this regard global deflation and generally lower than expected interest rates have made any immediate rise in local interest rates much less likely than they were. The money and bond markets have revised their expectations of interest rate increases sharply lower in recent days and weeks. The money market appears now to expect a 50 basis point increase in short term interest rates over the next 12 months, in place of the earlier expectations that rates would rise by more than 1% by year end 2015. We would argue that even this revised expectation of higher interest rates will not be realised, and that interest rates in SA will stay on hold until domestic spending has gathered more strength than our modest growth forecasts suggest may be the case over the next 12 months. The case for lower interest rates, should inflation maintain its much slower recent pace, while spending growth rates remain positive but subdued, may well present itself for serious Reserve Bank attention by year end.

Equity markets: Keeping up with the S&P 500

The excellent performance of the S&P 500 in 2014 has been well matched by the Global Consumer Plays listed on the JSE

One of the features of the stock markets in 2014 was the outperformance of the New York-based S&P 500 against almost all other markets. This included the JSE and other emerging markets, with which the JSE kept close company as always.

As the chart below shows, the superior returns provided by the S&P 500 over the year were almost all earned after September. In October the S&P marched higher while the JSE (and the average emerging equity market), having kept up to a degree with the S&P 500 until then, fell back absolutely and relatively. By year end the S&P 500 had gained about 16% against the JSE. The JSE in 2014 delivered a negative total return (including dividends) in US dollar terms of approximately -2.5% while the S&P returned approximately 13.7%. Converted to rands, the JSE returned 10.7% and the S&P about 25.7% in 2014.

Not all sectors of the JSE lagged behind the S&P 500. The group of 10 JSE listed companies we describe as Global Consumer Plays (because their earnings and valuations are largely independent of the SA economy, including the direction of SA interest rates), have again fully matched the performance of the S&P 500 in 2014, as we show below.

Clearly this group of JSE listed companies provides South African investors with easy exposure to the global economy and diversification against the SA economy. We have shown before that the reason for the high correlation of returns from the Global Consumer Plays and the S&P is not coincidental but can be attributed to a highly comparable level of earnings when measured in a common currency. The earnings performance of the JSE-listed Global Consumer Plays is particularly impressive through the Global Financial Crisis, as may be seen in the chart below. It seems reasonable to predict that the earnings of Global Consumer Plays will continue to perform well in line with those of the S&P 500. It must be said though that with only 10 companies making up the index and also given the large weight accorded to Naspers (NPN) in the index the much less diversified and therefore more risky character of the Global Consumer Plays ,when compared to the S&P 500 needs to be recognised. The largest stock included in the S&P 500, Apple, accounts for less than 4% of this Index.

We have calculated a market cap weighted Index of these companies, the Global Consumer Play Index using their weights as in the SWIX Index calculated by the JSE, which accords index weights according to the proportion of shares issued by these companies held on the JSE register. This makes Naspers, with a weight of over 10% in the SWIX, the largest contributor to our Global Consumer Play Index with a weight of about 30%. The companies we include in the Index account for about 40% of the value of the JSE All Share Index. Other shares in this index are: Aspen, British American Tobacco, Richemont, Mediclinic, MTN, SABMiller, Steinhoff, Netcare and Intu.

We aggregate other components of the largest companies listed on the JSE as indices. These include the Commodity Price Plays, which have been distinct underperformers while the SA economy dependent industrial companies, which we combine in a further index, have performed somewhat better. Clearly the distinct outperformers on the JSE have been the Global Consumer Plays.

It seems reasonable to suggest that optimism or pessimism about the prospects for the S&P 500 should translate into similar prospects for the Global Consumer Plays on the JSE – whether valued in US dollars or in rands.

Financial markets: Risk off day

A risk off day in the markets – drawing some of the implications for inflation and growth

The markets yesterday must be regarded as having had a risk off day. Global government bond yields fell further (ie bond prices rose) while most equities, including those in the US, moved lower.

The US dollar, the safe haven currency, gained further strength against the euro, trading this morning at USD1.186. This dollar strength was also highly consistent with a further widening of the interest rate spread in favour of US Treasuries over equivalent German bunds. This morning the US 10 year Treasury has yielded 1.9487% compared to the 10 year German bund that offered a mere 0.446%. The gold price also rose, providing further proof of more risk aversion in the markets.

 

What exact form the additional risks took was perhaps not so obvious. The further decline in the oil price may well be the most likely suspect. A lower oil price clearly helps consumers and household spending and must be regarded as helpful to the growth outlook, given the important share of household spending in GDP, over 70% in the US and over 60% in SA. Yet while oil consumers stand to benefit, the rapid magnitude of the oil price decline must threaten those banks with exposure to the producers and service providers to the oil sector way beyond the US oil patch.

The full impact of such large shocks to the global economy, of the kind represented by these dramatic moves in the oil price, is hard to measure accurately with any degree of confidence. The extra risks priced into the bond and equity markets generally, understandably reflect some of this. More stable oil prices at these lower levels would help calm the markets and provide time for the full impact of a permanently lower oil price (if this is to be the case) to be better calculated and priced into bond and equity values.

A permanently lower oil price is on balance likely to be helpful for the global economy that has wanted for growth in household spending. It is likely to mean faster growth with less inflation, possibly accompanied by falling prices, that is deflation. If this happens, it will mean lower interest rates and so discount rates attached to income streams expected from oil and energy consuming businesses. They may well enjoy improved operating margins as production and distribution costs rise more slowly or, better still, decline when measured in money of the day. These trends, as they materialise, should show up in higher rather than lower values attached to most listed companies.

Yet while interest rates can be expected to decline with less inflation or even deflation expected, inflation linked interest rates offered by governments may well rise as growth picks up and demands for capital to invest by more profitable businesses also gains momentum. These real rates, highly indicative of the real cost of capital for all capital raisers, have been stable over the past year at low levels. Inflation expectations in the US, indicated by the difference between the yields on a vanilla bond exposed to inflation risk and the inflation protected equivalent (known as TIPS for Treasury Inflation Protected Securities), have declined also quite sharply in recent weeks (see below where we show the premium offered for bearing inflation risk in the US over the next ten years and the 10 year real TIPS yield).

However it is of interest to observe that yesterday, while nominal rates in the US fell away, the equivalent real yield actually rose. Perhaps this indicates that while less inflation is expected in the markets, growth expectations for the US may well have improved marginally on oil price trends.

We also graph the equivalent SA trends below. While the RSA 10 year yield, having risen sharply in January, has trended lower while the real 10 year yield has been stable, about the historically low 1.7% level. Of interest to note is that nominal RSA yields have declined sharply over the past two days, by about 30 basis points, from 7.82% on Monday to 7.51% this morning, the real rates have edged marginally higher. The markets in SA are now also pricing in less inflation expected and perhaps also stronger growth expected – in line with global trends.

 

Global interest rates and currencies: Making sense of surprises

A surprisingly strong US economy – a surprisingly weak euro. How will we be surprised in 2015?

Among the biggest surprises in 2014 was the decline in long term interest rates in Europe and the US. Another surprise for the market consensus in mid year was the strength of the US dollar and the weakness of the euro.

These two surprises were not unrelated. The decline in long term rates was led by European fears of deflation. US rates essentially followed the European lead lower, even as the US recovery gathered strength and expectations that the Fed would raise its target rate in 2015 firmed. But the decline in US rates lagged behind those in Europe and so the spread between these rates widened. We illustrate this in the charts below where we compare 10 year US Treasury and German Bund yields and show the generally widening spread between them.

Thus, despite persistent US dollar strength vs the euro and almost all other currencies from mid year, when the euro traded at close to US$1.40, the case for borrowing euros to lend dollars became ever stronger. Presumably the extra rewards for holding dollars rater than Euros added to the demand for, and the strength of, the US dollar.

The spread itself indicates that the market expects the US dollar to weaken against the euro, according to the theory of interest rate parity. Arbitrage makes the cost of forward cover equal to the difference in interest rates. If this were not the case riskless profits could be realised by simultaneously borrowing or lending in the one currency and buying or selling the currency in the market for forward exchange. The higher rates in the US are meant to compensate the lender of dollars and the borrower of euros for the expected weakness in the US dollar, thus making it a matter of indifference to a currency hedged borrower or lender in which currency a financial contract is written.

The recent strength of the US dollar, despite expected weakness, therefore represents an unambiguous surprise for the market. Yet it is difficult to predict a reversal of these exchange rate trends when the yield spread in favour of the US dollar remains as wide as it is or especially should it widen further. Unexpected strength in the US economy will help keep up US rates relatively to euro rates and the spread will encourage dollar strength, as has been the case in 2014. An unexpectedly weaker European economy will do the same: keep rates lower for longer in Europe as deflation takes hold and so add to US dollar strength and euro weakness.

The direction of the spread will tell us whether the market place has been too bullish or bearish about the US economy and too bearish or bullish about the outlook for the European economy. This key indicator will deserve the closest attention in the months ahead. If you believe the US economy will surprise on the upside, then buy dollars. If you believe Europe will surprise with better than expected growth, then sell the US dollar.

Productivity mystifies economists and central bankers- not business- for good reasons.

We are all well aware of how the micro-processor and its applications in information technology have changed the way we work or play. Robots have changed fundamentally the process of extracting or converting raw materials and distributing the goods and services we consume in ways that astonish and amaze us. We worry about how they appear to replace people like ourselves in the work place.

The power of mobile devices to connect us to our customers, colleagues, friends and information and entertainment of all kinds grows continuously, as does our dependence on them. Young people live happily (we hope) almost exclusively in their cyber worlds.

But all this information technology is not showing up in productivity measures – that is output per hour of work – as one surely thinks it should or would. All those factories, warehouses, cargo liners or railroads and ports with fewer workers and ever more sophisticated machines and devices that support those with jobs, must surely raise the ratio of what is produced to the number of person-hours employers provide compensation in wages and benefits for. The numbers indicate otherwise.

Alan S Blinder, a distinguished academic economist, Professor of Economics and Public Affairs at Princeton University and recent former vice-chairman of the Federal Reserve, writes in the on-line Wall Street Journal of 24 November of The Unsettling Mystery of Productivity, with the sub-title: Since 2010 US productivity has grown at a miserable rate. And no one, not even the Fed seems to understand why.

Blinder refers to the available history of productivity. Over 143 years of records show that the US has increased measured output per person hour employed outside of the farms by an average 2.3% p.a. That is, output per worker has increased nearly 26 times since 1870. Clearly the more valuable output workers are expected to produce, the greater real benefits (wages) they may be able to earn from employers competing for their more valuable services. Between 1948 and 1973, described as the golden age of productivity growth productivity grew by an average 2.8% p.a – yet between 1973 and 1995 it grew by only 1.4% p.a on average. It then picked up again growing by 2.6% p.a between 1996 and 2010 only to slow down to a miserable 0.7% p.a on average since; for reasons nobody, according to Blinder, seems to know why.

In South Africa productivity as calculated by the Reserve Bank has grown, on average, by a mere 1.02%p.a since 1970 and by 1.92% p.a on average between 2010- 2013. But in the seventies the price of gold doubled and doubled again allowing the mines to profitably reduce the average grade of ore they mined and extend the lives of the mines More rock was extracted expensively from the bowels of the earth but less gold was produced with more workers – meaning lower productivity and much improved profitabilty. Since 1995 productivity in SA has grown by 2.8% p.a on average despite the recent slowdown.

The unpredictability of productivity matters to the Fed and the Reserve Bank because their task is to align aggregate demand for goods services and labour to their potential supplies, using the tools of interest rate settings and money creation at their command. Not too much and not too little demand is called for. Too much means inflation – too little means deflation, which is regarded as equally or even more dangerous to well being. But knowing just how much means being able to predict potential supply upon which productivity growth would have had an all important bearing. Such productivity forecasting powers seems unavailable, so greatly complicating the task of monetary policy.

The problem to my mind is a measurement problem. The issues involved in converting business revenues, measured in dollars of the day, into equivalent volumes that can be compared over time. Productivity is the ratio of real output, real volumes of goods and services produced and charged for, to the number of person hours needed to produce them. But how is one to compare the value of a good or service produced 20 years ago with its equivalent today? An aspirin produced then is the same quality as an aspirin taken 30 years ago. But the same could not be said of a life saving drug available today that was not on the pharmacy shelves 30 years ago. The quality of medical care, given these technological gains has increased almost immeasurably. What then does the so called inflation of medical costs included in the CPI mean when what is being paid and charged for are much improved medical benefits? You are not comparing like with like, apples with apples, aspirins with aspirins.

Nor can an off the shelf or off the internet personal computer or laptop today be compared with those of 30 years ago when access to the internet was first initiated. They have the computing power that would have filled a large office with mainframes 20 years ago. And the same could be said of television monitors or motor vehicles or so many devices that are incomparable in quality with the options available then, perhaps infinitely better given that the ordinary of today would have been unimaginable not so long ago. A similar observation can be made of a modern automated machine tool when compared to the machines utilised before.

Therefore, if we are to compare real output over time we have to allow for changes in quality in order to generate an appropriate series of prices and what indeed the benefits received cost the consumer. Prices have to be quality adjusted if any sense is to be made of the volume of output produced and measured over time. Volume of output calculated for the purposes of measuring real output for GDP or productivity estimates is revenue in money of the day earned by businesses divided by what is hoped is a realistic measure of prices. If quality has improved dramatically or indeed infinitely in the case of goods or services previously unknown, this price denominator, known by economists as a deflator (deflating nominal values into real equivalents) has surely to take on a very large number with a proportionately large impact on real volumes. The Fed is conscious of the danger of underestimating quality gains regards the inflation it targets of less than 2% per annum as effectively deflation.

Can we have any confidence at all in the numbers attached to deflators that reduce the revenues of businesses to equivalent volumes or convert nominal GDP with its real equivalent? I would suggest that we can very easily underestimate quality gains and hence over estimate the numbers called deflators. Quality adjusted prices may be vastly lower than they are estimated to be. If so volumes produced would be much higher and productivity gains much greater than estimated. The mystery to be solved is an appropriate deflator especially for goods or services with infinitely higher computing power and value to their users. There may in fact be much more deflation about than is recognized. Hence monetary policy may be even tighter than it appears.

The closest relevant deflator I could find was for the prices charged by US retailers of appliances and electronic goods. This deflator, designed to measure the volume of these goods sold by the retailers with a base of 100 in 2009, had declined to 68.9 or some 37% over four years. In the US, the prices of all retail goods rose by 8% since 2009.

The closest equivalent deflator provided by Stats SA was for Furniture, Appliances and Electronic goods Retailers that showed a decline of 8.5% since 2009 while all retail prices rose by 23% over the same period.

Are these deflators and all the others that convert value to volume accurate enough to form the basis for productivity comparisons? One must doubt this. There is clearly enough room for error to add an average one or two per cent per annum to measured productivity growth.

But while such uncertainty about the relationship between price and quality changes may bother the economists and the Fed, they will be of little interest to the firms that produce goods and services. They will be hoping to add to profitability by managing, as best they can, the relationship between revenues and costs measured in money of the day, including the link between the money of the day costs of employing labour and what each employee may be adding to the top line. In fact employing more, relatively unproductive labour, may well be the more profitable option, depending on their cost of hire even if such employment maximizing decisions reduce productivity. The South African economy would do better if firms were hiring more low skilled less productive workers rather than making the efforts they do to raise the productivity of much better paid, but relatively few skilled workers with advanced equipment and superior data management.

It is be noted that while productivity is seemingly in decline, in the US profits as a share of output are at close to record levels. The impact of innovation on productivity and GDP may be mysterious given the difficulty of devising a suitable deflator. The influence on profitability would appear to be unambiguously helpful for shareholders.

And consumers of goods and services (known and unknown in abundant quantity) can be comforted that excess profits tend to be competed away and they will pay no more than it costs to supply them, costs that will include a required return on the capital employed by competing firms. The objective of business and their owners is to maximise profitability, not productivity. Real output and so real productivity are artifacts of economists and statisticians, not businesses, for which profits and return on capital are the key measures.

The Grinch who stole the low fuel price bonanza

Were it not for Eskom’s problems, the economy would now be cheering the impact of lower fuel prices.

The abrupt decline in the oil price shown in the chart below is potentially very good news for the SA economy.

These welcome trends have relieved the budgets of the average household and will encourage more spending. It has been the unwillingness and inability of households, who account for over 60% of all spending in SA, to spend more that has been such a drag on economic growth. In the quarter to September 2014, household spending grew at a below par real 1.3% annual rate, though this was an improvement on the 0.5% and 1.1% rates recorded in the two previous quarters of 2014. A lower petrol and diesel price will also reduce the cost of delivering these extra goods and services to households.

All of this should help add further downward pressure on the rate of inflation that over the past three months has fallen so sharply. We show the three month change in the CPI and Producer Price Index (PPI) below. Inflation over the past few months has declined sharply, making the prospect of higher short term interest rates much more unlikely and less threatening to spending by households.

It is also worth noting that the prices of many of the goods we export have held up better than the oil we import: about 20% of all imports. The ratio of the price of platinum and gold to the price of oil is shown below. In a relative sense the platinum we export now earns about 50% more than the oil we mostly import than it did only a few months ago. This is very helpful to the economy and its balance of trade. Over the longer term, as we also show back to 2010, these so called terms of foreign trade effects have not been generally favourable – oil was both absolutely and relative expensive until now.

The latest news about the state of the economy at November month end was mildly encouraging. Judged by vehicle sales and demands for cash – the two series we combine to make up our up to date Hard Number Index (HNI) – it seems that the economy has been gaining a little forward momentum. Numbers above 100 for this index indicate growth and higher numbers indicate that the speed is accelerating rather than decelerating. We compare our HNI to the Reserve Bank’s Coinciding Indicator of the Business Cycle that is also well above 100 and seemingly rising, though this series is only updated to August 2014 given its reliance on about 12 economic time series some of which are derived from sample surveys that are inevitably delayed.

The two series that make up the HNI are shown below. Unit vehicle sales appear to be holding up well and if current trends are sustained, will continue at current levels in 2015. To these should be added over 28 000 units exported in November that will be adding meaningfully to overall manufacturing activity.

The demands for notes, when adjusted for lower inflation, also seems to be confirming a cyclical recovery that we noticed last month. The recovery indicated in demands for cash to spend however, while welcome, can best be described as a slow one and hopefully will be a steady one.

If it were not for Eskom turning off the lights – apparently for a want of now much cheaper diesel to fuel peak generating capacity – we would all be feeling much more cheerful, as befits the season. How the impacts of cheaper fuel and less freely available electricity pan out will all be revealed in forthcoming economic activity and the measures of them. We watch and wait with the hope that Eskom can get more of its act together. Better still would be a growing realisation that reliance on one monopoly producer is a very bad idea. The risks of outages would be much lower if electricity generation from coal (and or other sources of fuel) would be better diversified.

The solution is to encourage the private sector to provide the additional capacity and for established capacity in the form of power plants to be sold off for what they can fetch in the market place. Such a willingness to sell off the faltering generating plants to well qualified operators of them would solve, at a stroke, the burden of additional debt that Eskom is imposing on the SA taxpayer debt ratings, revealed higher long term interest rates and a weaker rand. Such privatisation would also ensure much better management of electricity supply over the long run. They say evidence changes belief. The belief in public corporations must surely be highly challenging to the true believers in public ownership.