Author: Brian Kantor

Bernanke’s legacy: The great (and ongoing) monetary experiment

Ben Bernanke has now retired as Fed chairman, having rewritten the book on central banking.

He has done this not so much by what he and his fellow governors (including his successor Janet Yellen) did to address the Global Financial Crisis (GFC) that erupted in 2008, but by the enormous scale to which he supplied cash to the US and global financial system as well as in injecting new capital to shore up financial institutions whose failure would pose a risk to the financial system.

The scale of Fed interventions in the financial markets is indicated in the figure below which highlights the explosive growth in the asset side of its balance sheet. The initial actions taken after the collapse of Lehman Brothers in September 2008, what may be regarded as classical central bank assistance for a financial system in a crisis of liquidity, was superseded by further massive injections of cash into the US and global financial system as the figure makes clear. The cash made available by the central bank in exchange for securities supplied (discounted) by hard pressed banks, when only cash would satisfy depositors and other lenders to banks, alleviated the panic and allowed normally sound financial institutions to escape the run for cash. But Quantitiative Easing (QE) thereafter became much more than a temporary help to the financial system.


Chairman Bernanke recently took the opportunity to explain his actions and the reasoning behind them in a valedictory address to his own tribe (that of professional economists) gathered at the annual meeting of the American Economic Association (AEA) in early January 20141. On the role of a central bank in a financial crisis, he said:

“For the U.S. and global economies, the most important event of the past eight years was, of course, the global financial crisis and the deep recession that it triggered. As I have observed on other occasions, the crisis bore a strong family resemblance to a classic financial panic, except that it took place in the complex environment of the 21st century global financial system. Likewise, the tools used to fight the panic, though adapted to the modern context, were analogous to those that would have been used a century ago, including liquidity provision by the central bank, liability guarantees, recapitalization, and the provision of assurances and information to the public.”

Furthermore:

“The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions. However, the institutional context had changed substantially since Bagehot wrote. The panics of the 19th and early 20th centuries typically involved runs on commercial banks and other depository institutions. Prior to the recent crisis, in contrast, credit extension …….. Accordingly, to help calm the panic, the Federal Reserve provided liquidity not only to commercial banks, but also to other types of financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. .Because funding markets are global in scope and U.S. borrowers depend importantly on foreign lenders, the Federal Reserve also approved currency swap agreements with 14 foreign central banks.

“Providing liquidity represented only the first step in stabilizing the financial system. Subsequent efforts focused on rebuilding the public’s confidence, notably including public guarantees of bank debt by the Federal Deposit Insurance Corporation and of money market funds by the Treasury Department, as well as the injection of public capital into banking institutions. The bank stress test that the Federal Reserve led in the spring of 2009, which included detailed public disclosure of information regarding the solvency of our largest banks, further buttressed confidence in the banking system.”

In the accompanying notes to his speech, the following explanations of shadow banking as well as the special arrangements made to boost liquidity were specified as follows:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and nonbank mortgage companies.

“ Liquidity tools employed by the Federal Reserve that were closely tied to the central bank’s traditional role as lender of last resort involved the provision of short-term liquidity to depository and other financial institutions and included the traditional discount window, the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). A second set of tools involved the provision of liquidity directly to borrowers and investors in those credit markets key to households and businesses where the expanding crisis threatened to materially impede the availability of financing. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF) fall into this category.”

The initial injections of liquidity by the Fed to deal with the crisis was followed by actions that did write a further new page to the central bankers’ play book. That is, in the form of very large and regular additional injections of additional cash into the financial system, made on the Fed’s own initiative, in the form of a massive bond and security buying programme, which accelerated in late 2011 and early 2013 (QE2 and QE3) that was undertaken not so much to shore up the financial system that had stabilized, but undertaken as conventional monetary policy to influence the state of the economy by managing key interest rates and especially mortgage rates.

Usually, monetary policy focuses on changes in short term interest rates, leaving long term interest rates and the slope of the yield curve to the market place. But in the US, the mortgage rate, so important for the US housing market, is a long term fixed rate of interest linked to long term interest rates and US Treasury Bond Yields. These long term fixed mortgage rates (30 year loans) available to homeowners are made possible only with the aid of government, in the form of the government sponsored mortgage lending bodies Fannie Mae and Freddy Mac, whose lending practices did so much to precipitate the housing boom and bust and were particularly in need of rescuing by the US Treasury. Their roles in the crisis do not feature in the Bernanke speech made to the AEA.

The state of the US housing market is a crucial ingredient for improving the state of US household balance sheets that are so necessary if households are to spend more in order that  that the US economy can recover from recession. Households account for over 70% of all final demands in the US and only when households lead can firms be expected to follow with their own spending plans. These household balance sheets had been devastated by the collapse in house prices, by 30% on average from the peak in 2006 to the trough in average house prices in 2011. It was this boom in house prices followed by a collapse in them that was the proximate cause of the financial crisis itself.

This bubble and bust, after all, happened on Bernanke’s watch as a governor and then as chairman of the Fed, for which the Fed does not take responsibility. A fuller explanation of the deeper causes of the GFC was offered by Bernanke in his speech to the AEA:

“The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.”

The obvious question for critics of Bernanke is why the Fed itself did not do more to slow down the increases in the supply of credit from banks and the so called shadow banks? Perhaps the Fed could not do more, given its lack of adherence to money and credit supply targets and its heavy reliance on interest rates as its principal instrument of policy.

Given what happened in the housing price boom, it seems clear that policy determined interest rates should have been much higher to slow down the growth in credit. But it may also be argued that interest rates themselves are insufficient to moderate a credit cycle. This is an essentially monetarist point not addressed by Bernanke. In other words, to say there is more to monetary policy than interest rates. The supply of money and bank credit is deserving of control according to the monetarist critique. The Bernanke remedy for protecting the system against the prospect of a future financial crisis is predictably familiar: better regulation and more equity on the books of banks and other lenders. It may be argued that there will always be enough capital, regulated or not, in normal times, and too little in any financial crisis regardless of generally well funded financial institutions. Prevention of a financial crisis may prove impossible and the attempt to do so may be costly in terms of too little, rather than too much, lending and leverage in normal conditions (when lenders are appropriately default risk-conscious and do not make bad loans on a scale that makes for a credit and asset price bubble that ends in tears). The cure for a crisis should always be on hand and the Bernanke recipe will hopefully not be forgotten in the good times.

Any current concern about monetary aggregates would have to be on the liabilities side of the Fed balance sheet, conspicuous not so much for the volume of deposits held by the member commercial banks with the Fed, but with the historically unprecedented volume or ratio of deposits (cash) held by these banks with the Fed, in excess of their regulated cash reserve requirements. Also conspicuous is the lack of growth in bank lending to businesses – despite the abundance of cash on hand (see figures 2 and 3).

 

As Bernanke explained:

“To provide additional monetary policy accommodation despite the constraint imposed by the effective lower bound on interest rates, the Federal Reserve turned to two alternative tools: enhanced forward guidance regarding the likely path of the federal funds rate and large-scale purchases of longer-term securities for the Federal Reserve’s portfolio. Other major central banks have responded to developments since 2008 in roughly similar ways. For example, the Bank of England and the Bank of Japan have employed detailed forward guidance and conducted large-scale asset purchases, while the European Central Bank has moved to reduce the perceived risk of sovereign debt, provided banks with substantial liquidity, and offered qualitative guidance regarding the future path of interest rates.”

The use of forward guidance to help the market place forecast the path of interest rates more accurately, so reducing uncertainties in the market place leading hopefully to better financial decisions, predates the Bernanke chairmanship of the Fed. However, he should be credited with taking the Fed to new levels of transparency and much improved communication with both the marketplace and the politicians. In Bernanke’s words:

“The crisis and its aftermath, however, raised the need for communication and explanation by the Federal Reserve to a new level. We took extraordinary measures to meet extraordinary economic challenges, and we had to explain those measures to earn the public’s support and confidence. Talking only to the Congress and to market participants would not have been enough. The effort to inform the public engaged the whole institution, including both Board members and the staff. As Chairman, I did my part, by appearing on television programs, holding town halls, taking student questions at universities, and visiting a military base to talk to soldiers and their families. The Federal Reserve Banks also played key roles in providing public information in their Districts, through programs, publications, speeches, and other media.

The crisis has passed, but I think the Fed’s need to educate and explain will only grow.”

Historically US banks held minimum excess cash reserves, meeting any demand for cash by borrowing reserves in the Federal Funds market (the interbank market for cash), so making the Fed Funds rate the key money market rate and the instrument of Fed monetary policy. Holding idle cash is not usually profitable banking – but it has become so to an extraordinary degree. Furthermore, the large volume of excess reserves means that short term interest rates fall to zero from which they cannot fall any further. The reason they have remained above zero is that the Fed has been willing to reward the banks for their excess reserves by offering 0.25% p.a on their deposits with the Fed.

Every purchase of bonds or mortgage backed securities made by the Fed in its asset purchase programme must end up on the books of a bank as a deposit with the Fed. But before the extra phases of QE, the banks would make every effort to put their cash to work earning interest rather than holding them largely idle (as they are now doing). But it would appear that the Fed expects the demand for excess cash to remain a permanent feature of the financial landscape and can cope accordingly.

According to Bernanke:

“Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC’s ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate. It is possible, however, that some specific aspects of the Federal Reserve’s operating framework will change; the Committee will be considering this question in the future, taking into account what it learned from its experience with an expanded balance sheet and new tools for managing interest rates.”

It seems clear that the market is not frightened by the prospect that abundant supplies of cash will in turn lead to more inflation as the cash is lent and spent, as monetary history foretells. The market clearly believes in the capacity of the Fed to remove the proverbial punchbowl before the party gets going. Judged by the difference between yields on vanilla Treasury bonds and their inflation protected alternatives, inflation of no more than 2% a year is expected in the US over the next 20 years. According to Bernanke, who is much more concerned with the dangers of deflation, arguing that inflation of less than 2% should be regarded as deflation (given the hard to measure improvements in the quality of goods and services). Therefore if inflation is less than 2% this becomes an argument for more, rather than less, accommodative monetary policy by the Fed.

The market clearly finds the Bernanke arguments and guidance highly convincing. These expectations are a measure of Bernanke’s success as a central banker. He has surely helped save the financial system from a potential disaster and has done so without adding to fears of inflation.

The US economy has not however enjoyed the strong recovery that usually follows a recession. Bernanke has some explanation for this tepid growth:

“In retrospect, at least, many of the factors that held back the recovery can be identified. Some of these factors were difficult or impossible to anticipate, such as the resurgence in financial volatility associated with the European sovereign debt and banking crisis and the economic effects of natural disasters in Japan and elsewhere. Other factors were more predictable; in particular, we appreciated early on, though perhaps to a lesser extent than we might have, that the boom and bust left severe imbalances that would take time to work off. As Carmen Reinhart and Ken Rogoff noted in their prescient research, economic activity following financial crises tends to be anemic, especially when the preceding economic expansion was accompanied by rapid growth in credit and real estate prices.16 Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.”

He also blames the slow recovery on the unintended consequence of unplanned government fiscal austerity:

“To this list of reasons for the slow recovery–the effects of the financial crisis, problems in the housing and mortgage markets, weaker-than-expected productivity growth, and events in Europe and elsewhere–I would add one more significant factor– – 18 – Since that time, however, federal fiscal policy has turned quite restrictive; according to the Congressional Budget Office, tax increases and spending cuts likely lowered output growth in 2013 by as much as 1-1/2 percentage points. In addition, throughout much of the recovery, state and local government budgets have been highly contractionary, reflecting their adjustment to sharply declining tax revenues. To illustrate the extent of fiscal tightness, at the current point in the recovery from the 2001 recession, employment at all levels of government had increased by nearly 600,000 workers; in contrast, in the current recovery, government employment has declined by more than 700,000 jobs, a net difference of more than 1.3 million jobs. There have been corresponding cuts in government investment, in infrastructure for example, as well as increases in taxes and reductions in transfers.

“Although long-term fiscal sustainability is a critical objective, excessively tight near-term fiscal policies have likely been counterproductive. Most importantly, with fiscal and monetary policy working in opposite directions, the recovery is weaker than it otherwise would be. But the current policy mix is particularly problematic when interest rates are very low, as is the case today. Monetary policy has less room to maneuver when interest rates are close to zero, while expansionary fiscal policy is likely both more effective and less costly in terms of increased debt burden when interest rates are pinned at low levels. A more balanced policy mix might also avoid some of the costs of very low interest rates, such as potential risks to financial stability, without sacrificing jobs and growth.”

Bernanke then went on to paint an optimistic picture of the US economy:

“I have discussed the factors that have held back the recovery, not only to better understand the recent past but also to think about the economy’s prospects. The encouraging news is that the headwinds I have mentioned may now be abating. Near-term fiscal policy at the federal level remains restrictive, but the degree of restraint on economic growth seems likely to lessen somewhat in 2014 and even more so in 2015; meanwhile, the budgetary situations of state and local governments have improved, reducing the need for further sharp cuts. The aftereffects of the housing bust also appear to have waned. For example, notwithstanding the effects of somewhat higher mortgage rates, house prices have rebounded, with one consequence being that the number of homeowners with “underwater” mortgages has dropped significantly, as have foreclosures and mortgage delinquencies. Household balance sheets have strengthened considerably, with wealth and income rising and the household debt-service burden at its lowest level in decades. Partly as a result of households’ improved finances, lending standards to households are showing signs of easing, though potential mortgage borrowers still face impediments. Businesses, especially larger ones, are also in good financial shape. The combination of financial healing, greater balance in the housing market, less fiscal restraint, and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters. But, of course, if the experience of the past few years teaches us anything, it is that we should be cautious in our forecasts.”

It can be argued by his critics that the Bernanke innovations have been part of the problem rather than the solution. It would be very hard to argue that injecting liquidity and capital into the financial system to avert an incipient financial crisis in 2008-09 was the wrong thing to do. But it may yet be asked, then, if QE2 and QE3 were also necessary? Would not a sooner return to monetary normality have been confidence boosting, rather than undermining, business confidence, which is essential to any sustained recovery? Further bouts of QE have led to large additions to the excess cash held by banks, rather than additional lending undertaken by them that would have helped the economy along. Would the banks and the US corporations have put more of their strong balance sheets to work to help the economy along had monetary policy been less innovative, or at least had QE not been advanced as strongly as it was? Growth in bank credit and money supply (M2) has slowed down rather than picked up in recent years, despite the creation of so much more base money (see the figure on bank lending). That the banks have been able to earn 0.25% on their vast cash balances has surely encouraged them to hold rather than lend out their cash.

Furthermore, while fiscal policy could have been less restrictive in the short run, would any political failure to implement a modest degree of austerity at Federal and State level, not have made households even more anxious about their economic futures and the tax burdens accompanying them, leading to still less private spending?

The performance of the US economy over the next few years will be the test of the Bernanke years. If the US economy regains momentum without inflation, the Bernanke innovations will have proved their worth. They would then provide the concrete evidence that it is possible to create money, à outrance, and then take away the juice when that becomes necessary. Tapering of QE, the initial thought of which that so disturbed the markets in May 2013, is but a first tentative step to the actual withdrawal of cash from the system and the shrinking of the Fed balance sheet. The monetary experiment, conducted with deep knowledge of monetary history and theory that fortunately characterised the Bernanke years, remains an experiment. We must hope for the sake of continued economic progress both in the US and elsewhere that it proves a highly successful experiment.

1The Federal Reserve: Looking Back, Looking Forward, Remarks by Ben S. Bernanke, Chairman Board of Governors of the Federal Reserve System at
Annual Meeting of the American Economic Association
Philadelphia, Pennsylvania
3 January 2014
Source: Federal Reserve System of the United States, Speeches of Governors. All quotations referred to are taken from the published version of this speech.

Easter effects and the economy: A moveable feast

That moveable feast, Easter, is always a complicating factor for economists relying on monthly updates, coming as it often does at different times in either March or April.

Easter is late this year, and this can cause problems for economists, forecasters and policymakers. The President of the European Central Bank, Mario Draghi, informed an interrogator accordingly at his most recent press conference last week of Easter effects – when discussing the of the timing of ECB quantitative easing, an all important issue for the market place.

Question: Can you describe a little bit more what kind of information you are looking for on whether or not these latest inflation figures are changing your medium-term outlook? If you’re not going to act when its 0.5%, what does it take to get you to act on some of these things? And my second question is: you clearly changed the rhetoric a little bit in terms of your willingness to act swiftly – being resolute – but do your rhetoric and your easing bias lose credibility each passing month that you do nothing in the face of these very low inflation rates?

Draghi: On the first point: there are a couple of factors that somehow clouded the analysis of whether this latest inflation data would actually be a material change in our medium-term outlook or not. One has to do with the volatility of services prices and the fact that Easter time this year comes remarkably later than last year. The explanation is that, around Easter time, services expenditure usually goes up – demand for services goes up – especially travel, and this affected last year’s prices and it’s going to affect this year’s prices. So you have a base effect which produced much lower inflation data in March and may well produce higher inflation data next month.

Easter holidays always have an impact on spending in South Africa and flows through shops and show rooms. With Easter coming later this year, economic statistics for March 2014, especially when compared to March last year need to be treated with particular caution. Perhaps the best approach to reading the state of the economy around Easter time would be to take an average of March and April activity.

Our Hard Number Index (HNI) of the state of the SA economy at March month end combines these two very up to date releases – vehicle sales and the notes issued by the Reserve Bank (adjusted for CPI). Both are hard numbers not compromised in any way by the vagaries of sample surveys.

The HNI, as the chart below shows, captures the turning points in the Reserve Bank Coinciding Business Cycle Indicator. This indicator has only been updated to December 2013, making it not very useful as a measure of the current state of the economy. Two months can be a long time in economics as well as politics. The HNI for March is barely changed from the February reading, indicating that the economy has neither picked up nor lost momentum. It remains as it was on course for slower growth.

The HNI turned lower in the third quarter of 2013 while the Reserve Bank Indicator for December was still pointing higher. Numbers above 100 for either Index indicate that the economy is growing, but the HNI suggests that the forward momentum of the economy has slowed down. If present trends continue, the growth rate of the economy will slow down further in the months ahead.

As we also show below, the HNI does a good job approximating the growth trends in real Household Consumption Spending and Gross Domestic Spending (GDE). These add spending by the government sector and spending on capital goods and inventories to the all important household spending category, which accounts for over 60% of all spending. Both growth rates appear to be tracking lower in line with the HNI.

The rand however, as the past weeks have demonstrated, will not have to wait for smaller trade and current account deficits on the balance of payments – it will respond to movements of capital in and out of emerging markets. The best hope for the SA economy over the next two years will be a revival in emerging bond and equity markets that leads to a stronger rand and less inflation. Less inflation, accompanied by (at worst) stable short term interest rates and accompanied by lower rates further along the yield curve, could revive household spending, an essential ingredient if the economy is to grow faster in a sustained way.

A reprise of a rand recovery, accompanied by lower interest rates and less inflation, which led to the boom of 2003-2008, may seem as unlikely now as it did then. Such a scenario may be improbable, but it is not impossible. We must hope for such a fertile egg from the Easter Bunny.

Economic reality and the MPC – coming together?

The first and second meetings of the Monetary Policy Committee (MPC) of the Reserve Bank in 2014 have come and gone and been accompanied by very different reactions in the money market.

The first meeting on 29 January produced a significant interest rate surprise on the upside when the MPC decided to raise its key repo rate by 50bps. The second meeting on 27 March produced a much smaller surprise in the other direction. Note in the chart below that the first upside interest rate surprise in January 2014 was associated with a significantly weaker rand while the surprising downside move in short term interest rates in March was accompanied by a stronger rand. Short term rates are represented in the figure by the Johannesburg interbank rate (Jibar) expected in three months – that is the forward rate of interest implicit in the relationship between the three month and six month JIBAR rate. Changes in this rate indicate interest rate surprises. Hence the inflation outlook deteriorated as interest rates moved higher and improved as interest rates were kept on hold.

This inconsistent and essentially unpredictable relationship between movements in SA interest rates and the rand is clearly coincidental – it is not a causal relationship because the value of the rand is determined by global or (more particularly) emerging market economic forces rather than domestic policy decisions. As we show below, where emerging market equities go, the rand follows. And emerging equity and bond markets are led by global risk appetite. The more inclined global investors are to take on more risk, the better emerging market equities and bonds perform, including those listed on the JSE. The behaviour of SA stocks and bonds and the exchange value of the rand is highly consistent with that of emerging markets genrally as we show in the chart below. The rand follows the Emerging Market Equity Index (MSCI EM) as does the JSE All Share Index (both in US dollars) while both the rand and the JSE respond to the spread between RSA and US Treasury 10 year bond yields that can be regarded as a measure of SA specific exchange rate risk. The wider the spread the more exchange rate weakness expected.

But what does this all mean for monetary policy in SA and for the direction of short term interest rates? As we are all well aware Reserve Bank interest rate settings are meant to hold inflation within its target band of three to six per cent per annum. But inflation takes its cue mostly from the direction of the rand, which is beyond any predictable influence of interest rates – as has been demonstrated once more.

And so the Reserve Bank remains essentially powerless to manage inflation in the face of exchange rate shocks (over which it has no obvious or predictable influence). Interest rates can influence spending in SA, causing the economy to grow faster or slower without necessarily influencing the direction of prices. In other words inflation can rise, as it has done recently, even though the economy has operated well below its potential and will continue to do so. Therefore higher interest rates can  slow the economy down further without causing inflation to fall. This is a painful dilemma of which the MPC seems only too well aware. To quote its statement of 27 March:

“The Monetary Policy Committee is acutely aware of the policy dilemma of rising inflation pressures in a subdued economic growth environment.

“The main upside risk to the forecast continues to come from the exchange rate, which, despite the recent relative stability, remains vulnerable to global rebalancing. The expected normalisation of monetary policy in advanced economies is unlikely to be linear or smooth, and the timing and pace is uncertain.

“The rand is also vulnerable to domestic idiosyncratic factors, including protracted work stoppages, electricity supply constraints, and the slow adjustment of the current account deficit. Pass-through from the exchange rate to prices has been relatively muted to date but there is some evidence that it is accelerating. However, the forecast already incorporates a higher pass-through than has been experienced up to now.

“At the same time, the domestic economic outlook remains fragile, with the risks assessed to be on the downside. Demand pressures remain benign as consumption expenditure continues to slow amid weakening credit extension to households and high levels of household indebtedness. The upward trend in the core inflation forecast is assessed to reflect exchange rate pressures rather than underlying demand pressures.”

So then how should the MPC respond to exchange rate-driven price increases? The obvious answer would appear to be to accept the limitations of inflation targeting in the absence of any predictable reaction of exchange rates to interest rate settings. That is to ignore completely the exchange rate shock effect on inflation and focus on domestic forces that influence the inflation rate: lowering rates when the economy is operating below potential and raising them when spending (led by money and credit growth) is growing so rapidly as to add to inflationary pressures. And to explain very clearly why it would be acting this way.

But this unfortunately is not the way the MPC is still inclined to think. It worries about the inflationary effect of inflationary expectations. To quote its recent statement again:

“Given the lags with which monetary policy operates, the MPC will continue to focus on the medium term inflation trajectory. The committee is aware that too slow a pace of tightening could undermine inflation expectations and may require more aggressive tightening in the future. Consistent with our mandate, a fine balance is required to ensure that inflation is contained while minimising the cost to output”.

The MPC would be well advised to accept another bit of SA economic reality, which is that not only does the exchange rate lead inflation, but inflation itself leads inflation expectations – not the other other way round. There is no evidence that inflationary expectations lead inflation higher or lower. More SA inflation leads to more inflation expected though, as the MPC is well aware, inflation expected has remained remarkably constant over the years: around six per cent per annum that is the upper end of the inflation target band.

The MPC did the right thing this time round not to raise its repo rate. It made a mistake to raise its repo rate at the January meeting. The money market made the mistake of immediately anticipating a further 200bp increase in interest rates by January 2015. The Governor has done very good work guiding the market away from such interest rate expectations that, if realised, would be even more costly to the economy. The money market now expects only a 100bp increase in short term rates by early next year. The market may again be very wrong about this, dependent as the direction of inflation and interest rates are on the behaviour of the rand over the next 12 months. But even good news for the exchange rate will still leave monetary policy in SA on a fundamentally wrong tack. The interest rate cycle in SA, as in any normal economic state of affairs, should be led by the state of the domestic economy, not by the direction of unpredictable global capital.

National income accounts: Challenges – and some helpful responses

The SA national income accounts – updated to 2013 – indicate the challenges facing the economy and helpful responses being made by some of the important economic actors.

The better, if not exactly comforting, news from the SA Reserve Bank’s March 2014 Quarterly Bulletin, about the economy in 2013, is that export revenues (in current rands) picked up and are now growing a little faster than imports, having lagged well behind imports in recent years.

This smaller difference between imports and exports in Q4 2013 added significantly to GDP, which was 3.8% larger in Q4 than a year ago.

Dragging down expenditure and GDP growth in Q4 2013 was an extraordinary run down in inventories that were estimated to have declined by as much as R22.3bn in constant prices. The improved trade balance added 7.8% to Q4 growth, while the decline in inventories reduced Q4 growth by 5.2%.

The decreased level of inventories, with high import content, would have helped improve the balance of foreign trade. But the reduced demand for goods held on the shelves and in the warehouses may well reflect less confidence by the business sector in the growth outlook. Such a lack of confidence would also reveal itself in an increase in the dividends paid out to shareholders of SA companies, including to the increased proportion of foreign owners on the share registers of SA companies. Dividends paid to foreign shareholders went up sharply in 2013 while dividends received by SA shareholders in offshore companies declined as sharply, adding to the current account deficit.

The current account deficit, seasonally adjusted, nevertheless declined sharply from an annual rate of R215.8bn in Q3 2013 to R178.9bn in Q4, while the trade deficit declined from an annual rate of R114bn in Q3 to R62.6bn in Q4. The estimated actual current account deficit in Q4 was R36bn, down from R61bn in Q3, 2013.

Slow growth may well mean a surplus on trade and a smaller current account deficit and thus less dependence on foreign capital. Such trends should not be regarded as good economic news, although perhaps it is welcome to foreign investors concerned about the dependence of the economy on foreign capital, given that foreign capital has become more risk averse in recent months.

Between 1995 and 2003, when the economy grew slowly, the current account was balanced and the economy accordingly attracted very little foreign capital. The same pattern held more recently after the economy slowed down in 2009. The economy grew much faster between 2003 and 2008 because it could attract foreign capital and the current account deficit could widen. Surely faster growth made possible by foreign capital is to be preferred to slow growth arising out of fear that foreign capital may be withdrawn or become more expensive.

There is a virtuous economic circle for the SA economy. Demonstrate faster growth, promise higher returns to investors, and capital from both domestic and foreign sources will be made readily available to any business enterprise. The faster the rate of growth, the better the case businesses have to add to the productive stock of real capital, plant and equipment, to hire more workers and managers and with company investments in training, to help the work force to become more skilled and efficient and so capable of earning more. Growth leads and capital follows.

The major challenge faced by the SA economy is that the growth rates have slowed down recently, mostly for reasons of our own making. SA has a structural growth problem, not a structural balance of payments problem. Grow faster and the balance of payments will sort itself out.

But the growth issues facing the economy have been exacerbated because foreign capital has become more expensive since May 2013 for reasons largely beyond SA’s influence. This has led to a weaker exchange rate and upward pressure on prices further depressing already slow growth in real consumption spending. These price trends in turn raise the danger that interest rates will be set higher, again further depressing domestic spending and reducing prospective growth rates and the business case for adding to capacity. These expectations of weaker growth discourage capital inflows and may lead to a still weaker rand, which is anything but a virtuous economic circle.

The scope for an economic revival in SA, led by households, is limited, given the recessionary state of the formal labour market and so the income constrained limits to the growth in household credit. It would seem realistic to predict that faster growth in SA over the next few years could only be led by a surge in exports. A stronger global economy and higher prices for the metals and minerals we produce and export is a necessary condition for an export led recovery. Continuous production by the mines and factories is also necessary for greater export revenues and volumes. These were not possible in 2012 and 2013, given the pervasive strikes that reduced output from the mines and factories.

Hopefully the business sector could “come to the party” as the Minister of Finance invited business to do in his recent Budget speech. In this regard the good news suggested by the updated National Income Accounts is that the business sector (represented by the National Income Accounts for non-financial corporations, including the publically owned corporations, Eskom and Transnet) have indeed dressed up their performance. SA corporations increased their capital expenditures in 2013 and proved willing to fund their larger capital budgets by raising additional debt finance on a significant scale, despite deteriorating cash flows, represented in the figure below by Gross Corporate Savings.

But the same statistics indicate one of the structural weaknesses of the SA economy – a low domestic savings rate compared to a higher rate of capital formation. Hence a funding gap that can only be overcome by use of foreign savings. (See the figure below that indicates gross savings and capital formation rates in SA).

The figure also indicates that almost all the savings made in SA are made by the corporate sector in the form of retained cash. The government and household sector contribute little to the savings pool.

That the rate of capital formation is greater than the savings rate is surely a positive indicator for the economy. With economic growth the primary objective of economic policy, a slower pace of capital formation in SA would surely not be recommended. Such advice would be equivalent to advocating a structurally smaller current account deficit, since the difference between capital formation and gross savings is by definition the current account deficit and also the net foreign capital flows. Such advice is often loosely given without proper regard for its implications for economic growth.

Attempts to encourage a higher rate of domestic savings might make good economic sense. Significantly increased savings are however unlikely to be forthcoming from SA households. Achieving a higher gross savings rate would for all practical purposes require a willingness to tax corporate earnings at a lower effective rate so that they could save and invest more.

Lower taxes on corporate income would have to be accompanied by higher taxes on personal incomes and household spending. This is a change in the tax structure that does not appear politically possible, given also a presumed unchanged government propensity to spend. In the absence of any higher propensity to save, the path forward for the SA economy remains as it has been. Grow faster to attract savings from global capital markets and do what it takes to encourage business to grow faster so that they can attract more capital from abroad.

The markets in 2014: Identifying the key performance drivers and drawing some scenarios

Developed and emerging equity markets, including the JSE, came under pressure in January 2014 but recovered strongly in February and early March. The JSE in February did especially well for both rand and US dollar investors.

We show in the figures below how these developments on the JSE – a poor January followed by a recovery since – are strongly associated with movements in the bond markets. In January, long dated US Treasury yields were falling while SA yields in rands (unusually) were rising. In February, US yields moved sideways while SA yields fell. Hence the yield spread between SA bonds and US Treasuries widened sharply in January and narrowed in February, to the advantage of the JSE (in rands and US dollars) and the rand. These relationships between interest rates, the rand and the JSE developments are not coincidental. They are causal.

 

The yield spread is the risk premium attached to SA assets. The wider the risk premium, the higher the discount rate attached to rand income, and the lower the value of the rand and the US dollar value of SA assets. In the figures below we show how the rand/US dollar exchange rate and emerging market (EM) equities responded to the yield spread in 2014. The rand responds to capital flows into and out of the SA bond market and the JSE.

If we could accurately predict the direction of US interest rates and the risk premium, we would be able to accurately predict the direction of the rand and the JSE.

In the figures below we demonstrate these relationships since January 2013, using daily data. The S&P 500 has been an outperformer over this period and the JSE in US dollars consistently tracks the EM average very closely. This relationship is not coincidental either. JSE earnings and dividends in US dollars track the EM average closely because JSE earnings are more dependent on the state of the world than on the SA economy – as is the case for most EM listed companies. The JSE and EMs generally have performed better relative to the S&P 500 recently after lagging behind badly in 2013.

 

The patterns may be more or less regular, but predicting the direction of US rates and the yield spread is anything less than obvious. We can however suggest alternative scenarios and their implications, and assign our sense of the probabilities.

Four possible scenarios for the US economy:
+ = above expected growth or inflation
– = unexpectedly low growth and inflation.

1. Growth + Inflation – The triumph of Bernanke

2. Growth – Inflation + The scourge of Stagflation stalks the land

3. Growth – Inflation – More of the recent same?

4. Growth + Inflation + Punchbowl not removed in time

 

Scenario 1: Unexpectedly strong growth with no more inflation. This implies higher US nominal and real interest rates and will call for an early reversal of quantitative easing (QE)

Implications: Good for US equities and cash but bad for long dated bonds, yield plays, inflation linkers and EM. Good for the US dollar. EM currencies will come under pressure. Risk spreads may decline, helping higher yield credit, including EM credit, given less default risk. The preference then would be for developed market equities over EM equities since they are more able to win the tug of war against the higher cost of capital (though in due course EM equities will also benefit from a stronger global economy).

Assigned probability: 30%

Scenario 2: Stagflation – slow growth with more inflation

This implies low real interest rates with a steep yield curve as higher expected inflation gets priced into the long end of the bond market. This is ideal for inflation linkers: risk spreads widen and more inflation will be better for equities than bonds, though not good for either. Stagflation will be better for EM equities that offer more growth at lower real discount rates. Cash will have appeal if short rates stay above inflation. Fears will enter the markets of not only inflation but also of inflation fighting responses that will further reduce the US and global growth outlook. Bad for the US dollar, good for precious metals.

Probability: 10%

Scenario 3: More of the recent same. Below par growth – below par inflation

More QE will mean low real and nominal rates (the failure of QE will raise policy issues and encourage more direct intervention in markets, adding risk and volatility). Bonds to be preferred over equities – EM equities and currencies will be preferred to developed markets and currencies and defensive stocks may be worth paying up for. Gold will have appeal given low real rates and danger of intervention.

Probability: 25%

Scenario 4: Punchbowl not removed in time; QE overshoots, meaning above par growth with above par inflation

Real and nominal interest rates will kick up. Equities will be preferred over all bonds – credit may offer equity like returns. Developed market equities will be preferred over emerging markets. Cash will be better than bonds – high real interest rates will counter inflation expected in the gold price. Real estate with rental growth prospects will have strong appeal as an inflation hedge.

Probability: 35%

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.

Hard Number Index: The economy is growing – but the pace of growth has slowed

Our Hard Number Index of economic activity (HNI) was little changed in February 2014. As the chart below shows, the SA economy as indicated by the HNI is growing (numbers above 100 based on January 2010, indicate growth) but the pace of growth is slowing down slowed and that its forward momentum has stabilized at the slower pace first registered in January 2014 .

The HNI is compared to the Reserve Bank Coinciding Business Cycle Indicator that is based upon a larger set of data derived from sample surveys. As the chart shows, the Reserve Bank Indicator is only updated to November 2013. It also indicates a growing economy with the pace of growth picking up in November 2013.

The HNI is derived from two equally weighted and very up to date releases for SA unit vehicle sales and the notes issued by the Reserve Bank for February 2014. Both statistics reflect actual sales in February or real notes in circulation at February month end, making them hard numbers rather than estimates based on small sample surveys.

In February the unit vehicle sales on a seasonally adjusted basis declined from January levels while the note issue, adjusted for CPI, picked up some momentum, largely cancelling each other out,in the calculation of the HNI. While declining on a seasonally adjusted basis, unit vehicle sales, having peaked in early 2013, are still maintaining a satisfactory pace.

If the current trend in sales is maintained, the industry should be selling new vehicles at an annualised rate of 620 000 units in February 2015, that is about 6% down on the sales in February 2013, about 3% off current sales volumes and way ahead of the post recession sales volumes of early 2009. No doubt the industry would be well pleased should domestic vehicle sales decline by only 3% over the next year.

Interest rates and the availability of credit from the banks will influence these vehicle sales outcomes. The latest news on interest rates and the exchange value of the rand is rather encouraging in this regard. A recovery in the rand has helped reduce interest rates across the yield curve. A week ago, short term rates were expected to rise by over 2 percentage points over the next 12 months. Now they are expected to rise by only 1.66 percentage points over the same period.

Our view is that interest rates will not increase by more than 50bps over the next 12 months and even this increase is not at all certain. Rates may well remain on hold. The interest rate outcomes and the inflation outlook will depend mostly on what happens to the rand over the next few months. If the rand holds at current rates of exchange, the inflation outlook will improve and the case for raising rates at all will fall away. The expected state of the economy is for slower growth, as revealed by the business cycle and, in an up to date way, by the HNI, while it is also confirmed by credit growth and by growth in household spending: these are trending down rather than up. This strongly suggests that the interest rate cycle itself should be trending down rather than up. It would have done so but for the weak rand.

Joseph Stiglitz, a celebrated American economist, in his speech to the Discovery Investment Conference on Wednesday, 5 March, agreed with our long expressed view on the inadvisability of blindly targeting inflation irrespective of the state of the economy. We would add a further reason for not raising rates, namely the absence of any predictable influence of interest rates over the direction of the rand and therefore of inflation. As we have argued, using the evidence from the market, higher interest rates cannot be relied upon at all to add strength to the rand.

The value of the rand is determined by global forces well beyond the influence of SA short term interest rates. Yet by further reducing domestic demand and so the growth outlook and the case for investing in SA businesses, higher interest rates may well frighten away foreign capital and on balance weaken the rand.

Raising interest rates in SA is justified if domestic spending, fueled by domestic credit, is growing rapidly, thus helping to drive up the prices of goods and services. It is not at all justified if prices are rising because of reduced supplies of goods and services.

An exchange rate shock of the kind that has driven the rand weaker over the past six months, is as much a supply side shock as a drought would have reduced food supplies, so causing prices to rise. It makes no more sense to raise interest rates when a drought forces up food and other prices than when conditions in global capital markets drive down the value of the rand and similarly tends to push up prices.

Resource companies: The earnings tide has turned

The JSE All Share (ALSI) Index earnings per share are growing again. As the chart below shows, nominal earnings are now back at the record levels of 2012, while real earnings and earnings valued in US dollars (at current exchange rates), while increasing,still have some way to go to get back to their peak levels of 2007-08.

The level of JSE ALSI earnings has been assisted by a very strong recovery in the earnings reported by JSE listed Resource companies for the period ending 31 December 2013, off a low base. We show the cycle of JSE Resource Index earnings per share below. The annual growth in these resource earnings is highly variable.

Trailing earnings had declined by as much as 40% on a year before by mid 2013, before their recent recovery. They had previously recorded over 80% growth in their recovery from the global financial crisis. Reported JSE Resource earnings are now increasing and in positive growth territory compared to a year before. These growth rates are gathering momentum of their very low base, helped by the still weaker rand and (hopefully) less disruption of mining output by strike action.

It seems clear that the share market typically anticipates the earnings cycle to some degree. Share prices hold up better than earnings when earnings are falling and when earnings pick up again share prices lag behind. In other words, the earnings are expected to follow a consistent cycle of periods of above and below normal growth rates. They are expected to recover to something like normal when earnings are most depressed and the earnings cycle is at its trough and to fall away back to normal when growth rates have peaked.

A consistent pattern of prices anticipating earnings shows up in the price to earnings multiple attached to resource earnings. The multiple tends to rise in the downswings of the earnings cycle and in to decline in the upswings. We show below the PE ratio for the Resource Index. The PE multiple was at a low point in early 2009 after the post crisis peak in the earnings cycle. Thereafter the PE multiple rose rapidly, even as earnings continued to decline to a negative growth rate of minus 40% p.a. in mid 2010. Then, after the reported earnings had again assumed a strong upward trajectory (reaching a peak of 80% p.a. growth by mid 2011), the PE multiple fell away sharply to a trough in mid 2012. Then the PE multiple recovered strongly as Resource earnings again fell away, having fallen by over 40% by mid 2013. This PE multiple, after rising in 2013 as earnings fell away, has now fallen in early 2014, with the recent uptick in reported earnings.

The crisp question then for investors looking for good returns from Resource stocks is whether or not the growth in resource earnings will be fast enough to overcome a declining PE multiple attached to these reported earnings? As we show below, the severe decline in the PE multiple from its peak in early 2010 was accompanied by positive returns from the Resource sector for a further 12 months – the growth in earnings over this period compensated for the lower value attached by the share market to these reported earnings. Something like this may well happen again: as the PE multiple recedes back to something like normal, the improved earnings may help improve absolute share prices.

The key issue then is the outlook for resource earnings themselves over the next 12 months. Based on history Resource earnings do have a tendency to normalise as the share market appears to expect it to do. We provide below a measure of normalised or cyclically adjusted Resource Index earnings.

This is calculated using time series forecasts based on the previous ten years of monthly data that is rolled forward every month. Our cyclically adjusted earnings are a time series best fit. We suggest that this measure provides as good an approximation of trend or normalised earnings expected by investors as can be derived by statistics. Reported and normalised Resource Index earnings are represented in the figure below over the long run going back to 1980, using 10 years of data going back to 1970 to generate the first estimate for January 1980 and then rolling the forecast forward for each month thereafter by dropping a month and adding one. We also show the results of this exercise close up for the period 2008 and 2014.

Reported Resource Index earnings are currently well below the normalised measure. If earnings do in fact trend back to these normalised levels they still have a great deal of catch up to do. That is, from R2000 of reported earnings per Index share to R2800, a potential increase of 40%.

Such an increase would, as we have shown, not be out of line with past performance and would provide scope for good returns even if the PE multiple falls away. This growth in earnings however is by no means predetermined. It will be dependent on some known unknowns, such as the value of the rand over the next 12 months as well the ability of the mine managers to sustain or even increase output and to control costs.

 

The rand / US dollar exchange rate, were it to strengthen, would not necessarily be a threat to Resource valuations. If the rand strengthens it may reflect a growing appetite by global investors to take on emerging market and commodity market risk. They would do so if the outlook for global economic growth improves and therefore becomes more promising for emerging market exporters and the prices they are expected to realise for their metals and minerals.

A stronger rand may well be offset on the revenue line of mining companies by stronger commodity markets and higher US dollar prices.

The rand may also benefit from improved SA specifics, in particular a resolution of the strike threats and action on the mines that so damage exports from SA, without the mines having to accede to costly wage increases. It is not the rand hedge qualities of the SA mines that will determine their long term value to shareholders. It will be their ability to generate a flow of earnings, or better still a flow of US dollar earnings, that will be decisive in the long run. In other words, the mine managers through good fortune (strong growth in China) and excellent cost management may prove that they are able to send the underlying long term trend in normalised earnings in a strongly upward direction.

The gambling industry: No ordinary industry

The casino industry, and the established gambling industry in general, face threats from new sources.

Gambling is no ordinary industry. Nowhere can anyone with simply the will and the capital to do so offer an open opportunity to the public to play games of chance for money.

To enter the gambling business, investors typically have to cross very high barriers to entry set by regulation. They will need to acquire a special licence and, much harder perhaps, a prescribed suitable venue to play the games. They will also have to satisfy strict instructions as to what particular games of chance and prizes they can offer.

The reason why societies intervene in the gambling market has much to do with a religious, essentially paternalistic, objection to gambling, or rather perhaps a visceral objection to the sometimes large gambling losses that may be suffered by particular gamblers they know or have heard about. The best practical argument for tolerating and legalising gambling services is that what inevitably follows prohibition or the imposition of onerous taxes: illegal gambling, which is even worse for the community.

This argument applies also to how society can best manage all of what are broadly regarded as the popular “vices”. Driving consumption underground is not good public policy.

Furthermore, if enthusiastic gamblers are prevented from gambling near where they live they will travel to jurisdictions near and far to do so. The opportunity to tax the activity for useful local purposes – perhaps to reduce the burden of other taxes or to provide employment at home rather than elsewhere – may well win the political arguments for and against licensing gambling.

The opportunity to tax gambling activity as an alternative to imposing other taxes, may well win the political arguments for and against licensing gambling. The prospect of employment at nearby casinos or race tracks, rather than far away, will be an additional argument for local or provincial authorities to license gambling venues.

The history of casinos in SA

The history of the large entertainment casinos in SA with their banks of slot machines and a variety of table games that attract many players, provides a good case study of the practical and political forces at work when dispensations for gambling are imposed or relieved. Casinos were illegal in SA before the so called “homelands” were allowed to license them. The customers would travel from SA to gamble and for other pleasures or vices not legally available closer to home. The homeland authorities would tax these activities and relieve the SA taxpayer of some of their burdens. In SA, consequently, there had also grown up a large, illegal, unregulated and untaxed, local casino industry.

With the re-unification of a democratic SA and the demise of the homeland authorities, it was sensibly decided to legitimise the casino industry in SA, to place it under the authority of the respective provinces and most important, to strictly limit the number of casino licenses nationally and by the province. Only up to forty casino licences in all could be issued and provinces were able to license their operation within the urban areas close to their potential customers. The distant, previously homeland casinos, while they retained their licenses, lost their competitiveness. Why travel further than to a convenient casino close to home?

The success of these newly established SA urban casinos in attracting custom soon became apparent. Their success in attracting a larger share of the household budgets for gambling became immediately and painfully obvious to the horse racing clubs and their dependents on the tracks and farms. Horse racing had benefitted from something close to a legal gambling monopoly in SA. The revenues from gambling on horses, shared with the private bookmakers and with the provinces as taxes, had helped support a thriving, labour intensive, industry. Horses are not easily groomed by robots. Casinos too provide employment and income earning opportunities for local business to supply their needs.

But the gains of the owners, workers, suppliers and the players at the new SA casinos, at the expense, in part, of the racing clubs and their extended network, help illustrate an important point.

The different gambling offers compete with each other for a fairly predictable share of domestic household disposable incomes, in SA equivalent to between one and one and a half per cent of disposable income on average, though the share does vary by province and by city. The demand for gambling services can also be shown to depend in part on the disposable incomes of households and also on the traveling time taken to access gambling venues. Both the poor and the rich tend to spend a lower than average proportion of their incomes on gambling than the middle income earners.

The role played by the archetypal foreign travelling high roller in the typical casino, outside of the special cases of Las Vegas and more lately Macau (casinos are still illegal in mainland China), has been shown to be minimally important to the large urban casino in South Africa and elsewhere. The SA casino business caters to a local customer base. Online gambling opportunities may be about to change all this – if allowed to do so.

But while the casinos compete with each other and with the tote, the lottery and the private bookmakers, the limits to entry have proved valuable to the licensed casino operators.

For these reasons, a partial casino monopoly in one urban area can prove so valuable – and something the operators are prepared to pay for (in cash or kind).

A turn around the Cape

On this basis the Western Cape Government in the late 1990s was persuaded to grant an exclusive 10 year right to operate only one casino within the Cape Town metropolitan region (as well as on the basis of a more decentralised economic development that would come with allocating a limited number of new licenses outside of the city).

The exclusive license was then determined by way of a competition, a beauty contest between different potential operators who were asked to compete for the licence by offering a variety of additional benefits to the province as well as the new casino itself in exchange for this exclusivity. Sun International and its partners won a closely contested bidding process with an offer of a themed casino in Goodwood plus other benefits to the province of a major financial and organisational contribution to help found the Cape Town International Convention Centre.

This exclusivity agreement has run its course and the province could exercise a further opportunity to extend the exclusivity agreement for upfront benefits in cash and kind in the broad public interest. Sun International, with a well established and well preserved casino complex in operation, would be in an especially strong position to compete financially for a new exclusive license and to offer significant benefits to the province and its citizens for a renewed exclusivity agreement.

Unlike its potential competitors it would largely save the cost of building a new casino. Yet judging by recent public commentary or rather the absence of it, the province seems inclined to forgo these potential benefits and seems inclined to allow the transfer of one of the rural casino licenses to the city.

The people of the province, as far as I am aware, have not been widely consulted on or informed about such a choice – of two casinos or one (with all the upfront payments in cash and kind that might be offered for continued exclusivity). It is a choice deserving of very serious consideration by the citizens of the Province and its elected representatives.

The upshot of any decision to permit two casinos would be likely to divide the market roughly between the two operators as well as to reduce the market for casino-like services in one of the rural areas, with the indirect knock-on effects on local employees and suppliers the loss of casino business would bring. Unless the total casino market in the Western Cape would grow significantly in response to an additional casino offering in Cape Town (an unlikely outcome) there would not be meaningfully more tax revenues for the province to collect nor any additional employment or ongoing economic activity. The rural area losing its casino would suffer obvious economic losses. The established Cape Town operator might well offer, in its bid for renewed exclusivity, additional benefits to the city or province in exchange for an extension of exclusivity.

Any additional hotel or entertainment facilities that might accompany any additional casino cannot be regarded as among the additional benefits provided by a new urban casino in Cape Town. There is no shortage of hotels, restaurants or entertainment amenities in Cape Town. Such additional entertainment facilities would very likely displace activity in restaurants and entertainment venues generally.

New threats

There is however a more serious threat to legitimate gambling interests in SA. It comes in the form of still more competition for the gambling rand from the proliferation of limited payout slot machines and electronic bingo terminals (EBTs) that are slot machines in practice. The latter offer an additional competitive advantage to the gambler in that they can promise effectively unlimited pay outs, unlike the limited payout slot machines previously licensed. Limiting pay outs restricts the competition of conventional casino-based slot machines for gambling revenue with casinos, the tote and the National Lottery. Unlimited, or less limited payouts, have an attraction to many casino or horse racing gamblers whose objective is the big win, even when the odds of doing so are very long shots.

The slot machines, masquerading as bingo machines, overcome this disadvantage of limited pay outs and may well become increasingly ubiquitous and competitive against the established providers.

A still bigger threat to established gambling enterprises is surely the online gambling opportunities that modern technology makes available. The cost of providing a gambling opportunity on the internet or participating in one, from home anywhere in the world, is close to zero. The offering therefore is infinitely scalable. By comparison running a casino or a racing club is a very costly enterprise because they employ people and require a physical structure and presence.

Lower costs of production of any good or service usually means lower prices as firms compete for a larger market share with better terms – and in the case of gambling this might well mean better terms or bigger potential prizes for the serious gambler.

This provides online gambling with a great competitive advantage over conventional gambling providers. The online sites that can attract many customers from all over the world, at very low cost, are likely to offer the better odds or the most commanding big payouts – especially if internet gambling pays very little tax!

The value of any casino or racing club is therefore under threat of the potential proliferation of EBTs and legal access to internet gambling. The threat from new technology and the great uncertainty about what the gambling landscape in SA will look like over the foreseeable future is currently influencing the value attached to Casinos and their licenses in SA. Therefore the case for establishing an additional casino in Cape Town, or the price the established casino might pay to keep it out, must now be subject to unusual uncertainty.

It is in the interests of the wider community that as much certainty as possible about the gambling landscape be created. The objective should be to maximise as far as possible the domestic SA public interest in the gambling industry for taxpayers, employers or employees and investors in addition to those of gamblers themselves. The possible migration to a highly competitive SA gambling industry dominated by offshore providers, with the interest of the serious gambler in effect treated as paramount, should surely not be allowed to happen by default, but only rather after careful consideration of its full economic and social consequences .

Monetary policy: The limits to inflation targeting

Is SA monetary policy accommodative? It all depends on whose inflation and whose interest rates you have in mind

We are told by the Reserve Bank that monetary policy in SA is “accommodative” because interest rates are below the rate of inflation. That is because real interest rates are negative. But whose interest rates and whose inflation rates can the Reserve Bank be referring to? From the perspective of lenders the interest paid on savings accounts in the banks are not keeping up with inflation – and more so if tax has to be paid on interest income. Low real interest rates are tough on savers, but, for a good reason, borrowers may be unable to pay any more for the use of their savings.

But from the perspective of business borrowers, especially small businesses still able to borrow from their banks at prime plus something over 9%, finance may in reality be very expensive. The presumption of negative real interest rates is that businesses will be able to increase the prices they charge their customers at more than the 9% per annum they pay in interest. If this were the case, simply financing a warehouse of non-perishable goods that increase in value by more than the costs of finance (after taxes) becomes a no-brainer of a profitable business decision. This would presumably make monetary policy accommodative and encourage business.

But is this currently the case for many businesses serving the domestic market? Do they currently have the power to price their goods or services ahead of the rate of inflation that was 5.4% in December 2013?

The weakened state of demand for goods and services may prevent this as the more detailed inflation statistics bear out. The headline inflation rate is the weighted average of the prices of goods and services consumed by the mythical average SA household, some of which have risen by much more than the average and others by much less. It is administered prices, those charged by municipalities for water and electricity etc and those subject to additional excise duties, for example alcoholic beverages (up 7.2% on average with beer up 9.2% on December a year before), that have been making the inflation running . Administered prices were up nearly 8% on a year before in December 2013.

By contrast, the price of clothing and footwear is estimated to have increased by a mere 3.6% and 3% respectively. The food basket itself was also only 3% up, believe it or not. The farmers, food retailers and manufacturers will know all about their pricing power and the pressure on their sales volumes and profit margins.

It is clear that rising prices in SA have very little to do with any strong demands being registered by consumers. As is well recognized, SA households are under increasing budget pressures from higher prices and taxes imposed upon them. And, most relevant, they are suffering from a lack of pricing power in the most important market for their services, in the market for their labour services.

By recent accounts from Adcorp the rate of dismissal from private sector jobs is accelerating and workers are much less mobile than usual. They are therefore presumably somewhat fearfully holding onto the jobs they have, rather than moving to better paid ones. This is not an environment likely to encourage growth in spending, despite interest rates in the money market being below the headline inflation rate.

In fact monetary policy is doing very little to encourage domestic spending and, indeed, with the recent increase in benchmark short rates, has become less so. Even less demand side pressure on spending can be expected as prices continue to rise, driven especially by a weaker rand over which domestic interest rates have little or no influence.

The fact that the SA economy is as weak as it is, indicates quite clearly that interest rates should have been significantly lower than they have been, and that they should be falling, rather than rising, given the deteriorating state of the economy. Furthermore, targeting inflation when prices are rising for supply side (exchange rate shocks, drought and taxes) rather than demand side reasons makes little economic sense. Inflation targeting in SA can only makes good sense when the exchange rate itself responds predictably to interests rate settings. The rand over much of the past 12 years or so has not behaved anything like this.

Aiming for low inflation is good monetary policy. Trying to meet inflation targets is proving again to mean very poor monetary policy in S.A.

The Hard Number Index: Foot off the accelerator

Hard numbers for January 2014 in the form of vehicle sales and notes in circulation are now available. We combine them to form our Hard Number Index (HNI) – a useful indicator of the state of the SA economy because it is so up to date.

The indication from the HNI is that while the economy is maintaining its forward momentum (numbers above 100 indicate growth) the pace of growth is slowing down and is forecast to slow further in the months ahead. This lower absolute number for the HNI in January 2014 is the first decline in the HNI registered since the economy escaped from the recession of 2008-09, when the HNI as may be seen turned briefly below the 100 level.

The turning points in the HNI anticipate those of the Reserve Bank Coinciding Business Cycle Indicator consistently well, as we also show. However this business cycle indicator has only been updated to October 2013 which is a long time ago in the business of economic analysis and forecasting. It will not come as much of a surprise to observers that the pace of domestic spending in SA slowed down in January. Higher short term interest rates imposed by the Reserve Bank in late January 2014 will do nothing to encourage spending growth that at best was stalling in the final quarter of 2013.

 

It was the slowdown in the growth in the supply and demand for cash (adjusted for inflation) in January 2014 that dragged the HNI lower. The real money base growth cycle peaked in 2011 and has been on a more or less consistently lower trajectory since then. The forecast is for a further decline in this growth rate.

 

By contrast, unit vehicle sales in January 2014 held up well. On a seasonally adjusted basis unit sales in January 2014 were about 1000 units higher than in December 2013, that in turn, on a seasonally adjusted basis, were well up on November 2013 sales.

For the motor dealers, December and January are both usually below average months for selling new vehicles. The current level of sales would translate into an annual rate of sales of about 650 000 units this time next year, which would be little changed from the pace of sales in 2013. However some preemptive buying ahead of exchange rate forced increases in list prices may well have provided a temporary boost to new unit sales in December and January. A combination of a weaker rand and higher financing costs does not bode well for the new vehicle market in SA.

For motor and component manufacturers, the profit opportunity must be in export markets where prices are set presumably in foreign currencies – trade unions permitting. The opportunity for SA to lift growth rates from the currently unsatisfactory pace, must lie with increases in export volumes. The weak real rand/US dollar rate, currently about 17% below its purchasing power equivalent value compared to its 1995 value, offers the opportunity for SA producers to take full advantage of higher operating profit margins to increase export volumes and rand revenues significantly. It is up to SA management and workers to seize the opportunity to share in the operating surpluses that a weak real rand makes possible.

Rand and bond markets: Some very welcome relief from the global bond market

Emerging market (EM) stocks and bonds had suffered and developed market equities had flourished, since long term interest rates in the US began their ascent in May 2013, when the US Fed first signaled its intention to taper its support of the US bond market and reduce its injections of cash into the system.

 

The rand, in company with many other EM currencies took its cue – as it usually does – from the capital flows into and out of EM equities and bonds. The New Year brought no relief for EM markets and currencies, regardless of the direction of US long rates, that turned generally lower in 2014.

That is until last week, when EM markets and currencies ended the week on a stronger note. The key to this improvement was a narrowing spread between US and EM local currency bond yields, as exemplified by the performance of SA government bonds last week. The spread narrowed and the rand and the JSE, in US dollar terms, benefitted – as did other EM equities.

We may hope that this relief for EM markets is more than a straw in the wind and that the now significantly lower EM bond and equity prices have renewed appeal for global fund managers. Any sustained strength in EM currencies will help restrain EM central banks (including the SARB) from raising short term interest rates. The SA-US yield spread will deserve particularly close watching in the days and months ahead.

Monetary policy: The Aussies win the exchange rate toss – again

The Monetary Policy Committee (MPC) of the SARB met on Tuesday 28 January with the rand down about 30% against the US dollar on a year before. Predictably, given the openness of the SA economy to exports and imports, the SA inflation rate had picked up and was forecast to exceed its inflation target range of 3- 6% later in 2014.

The next day the MPC decided to raise its key repo rate by 50bp from 5% to 5.5%. The rand in response weakened further, by about 3% by the close of trading on the Wednesday 29 January.

The Reserve Bank of Australia (RBA) decided on 3 February to leave its cash rate unchanged at 2.5%. The Aussie dollar (which had also lost a significant amount over the last year, approximately 17% against the US dollar) responded favourably to the decision, gaining about 1.6% against the US dollar on the day.

 

These market reactions help prove a point we have made repeatedly: higher interest rates may not necessarily support a currency; thus leaving interest rates alone, or even reducing them, may support a currency, especially in times of exchange rate volatility.

 

Higher short term interest rates may imply a deteriorating growth outlook, meaning lower rather than higher expected returns on flows of risk capital to and from an economy. As a result, the net outflows of foreign exchange may exceed the inflows, leading to a weaker domestic currency and more rather than less subsequent pressure on consumer and producer prices. Lower or unchanged interest rates, by contrast, may improve the economic outlook and prospective returns and attract more rather than less net foreign capital. It is growth prospects rather than nominal interest rates that drive capital flows to businesses and economies.

 

Australian cricket prowess may wax and wane. But Australian monetary policy has proved consistently adept at ignoring large movements in the Aussie dollar exchange rate, even welcoming the opportunity provided for more balanced growth. In the words of RBA governor, Glenn Stevens, from its media release of 4 February:

 

“The exchange rate has declined further, which, if sustained, will assist in achieving balanced growth in the economy.”

 

The picture presented of the Australian economy is not however without its challenges for policy. As shown by further extracts from the media release, there are threats to Australian growth, employment and prices – enough to keep interest rates at their currently low accommodative level in expectation of an improving outlook over the long term:

 

“In Australia, information becoming available over the summer suggests slightly firmer consumer demand and foreshadows a solid expansion in housing construction. Some indicators of business conditions and confidence have shown improvement. At the same time, with resources sector investment spending set to decline significantly, considerable structural change occurring and lingering uncertainty in some areas of the business community, near-term prospects for business investment remain subdued. The demand for labour has remained weak and, as a result, the rate of unemployment has continued to edge higher. Growth in wages has declined noticeably.

 

“Inflation in the December quarter was higher than expected. This may be explained in part by faster than anticipated pass-through of the lower exchange rate, though domestic prices also continued to rise at a solid pace, despite slower growth in labour costs. If domestic costs remain contained, some moderation in the growth of prices for non-traded goods could be expected over time.

 

“Monetary policy remains accommodative. Interest rates are very low and savers continue to look for higher returns in response to low rates on safe instruments. Credit growth remains low overall but is picking up gradually for households. Dwelling prices have increased further over the past several months. The exchange rate has declined further, which, if sustained, will assist in achieving balanced growth in the economy.

 

“Looking ahead, the Bank expects growth to remain below trend for a time yet and unemployment to rise further before it peaks. Beyond the short term, growth is expected to strengthen, helped by continued low interest rates and the lower exchange rate. Inflation is expected to be somewhat higher than forecast three months ago, but still consistent with the 2–3 per cent target over the next two years.”

 

By sad contrast the outlook for the SA economy has deteriorated, with no sign that domestic spending (linked inevitably to deteriorating conditions in the labour market) can lead the economy out of its doldrums. Still higher prices for goods with high import and export content will depress spending further and higher interest rates will further discourage very slow growing demands for and supplies of credit.  The remarks made by governor Stevens about the poor outlook for investment in the Australian resource sector are also not encouraging for the SA resource sector. The hope must be that the weak rand and the much improved operating margins in the export sector and for firms competing with imports can lead the economy onto a faster growth path –labour unions permitting.

 

The problem for the SA economy and its interest rate sensitive sectors is that not only did short term interest rates rise last week, but they were immediately expected to rise significantly further by as much as an extra 2% over the next few months by the money market.

Such increases would be most unwelcome to a hard pressed economy – even unthinkable had they been imposed last week. These higher interest rates would be unlikely to help the rand in the near future and the inflation outlook any more than they have helped to date, for the reasons we have indicated.

In our response to the MPC decision we cautioned against the danger of such an interest rate spiral heralded by the 50bp increase in the repo rate. We noted that a spirited defence of the case for not raising rates will be as imperative the next time the MPC meets, should the rand not have gained strength by then and the inflation outlook remains as unsatisfactory as it is now.

We noted further that without such an argument, the economy may well set off on a 1998 like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.

Monetary policy needs to be not only data dependent, but also accompanied by good and appropriate guidance for the market about monetary policy that makes good economic sense.

We are therefore much encouraged by the guidance offered by governor Gill Marcus this week when, in an interview with Reuters, she remarked: “Money market expectations of a 200 basis point rate increase this year were exaggerated.”

In response to these remarks, interest rates along the RSA yield curve moved lower and the rand has held up well against most currencies, excluding the Aussie dollar. This provides further evidence of how to manage exchange rate volatility the Australian wa

Interest rates: Falling into the trap

The Reserve Bank raises rates modestly and falls into the trap set by other central banks. Too little by half to impress the markets – more than enough to damage the economy.

The Reserve Bank fell into the trap set for it by its central bank peers in Turkey and India (and Brazil and Indonesia which are already in a tightening mode) who raised short rates to defend their weaker exchange rates.

That this strong armed defence (including direct intervention in the foreign exchange markets) has failed to support the likes of the Turkish lira or the Brazilian real, might have given  pause to the Monetary Policy Committee (MPC). A minority of members voted against the increase, presumably because they know that higher interest rates have an unpredictable influence on exchange rates – particularly when global capital markets are under strain – while having a predictably negative influence on already weak domestic spending and therefore economic growth.

The Governor or the members of the MPC cannot explain how higher interest rates will reduce inflation rates, unless the exchange rate strengthens in response to higher rates, which it may or may not do. The immediate response to the 50bps increase has been a weaker rather than stronger rand. It may however be argued that the market expected a more hawkish response of at least a 100bp increase and sold the rand accordingly. In other words, so the argument goes, the MPC surprised the market not because it raised rates but because it did not raise them much further.

What the SA economy needed and did not get from the Reserve Bank was a vigorous analysis of the uselessness in current circumstances of capital market volatility of raising short term interest rates. A full explanation should have been provided, and would have explained why a 50bp increase would be irrelevant for the exchange rate and harmful to the economy and why any larger hike in interest rates, perhaps expected in the market place, was unthinkable given the weak domestic economy. Nor, it might have been pointed out, would an even larger increase in short rates have helped the rand anymore than it has helped the Turkish lira.

Such an argument will be as imperative the next time the MPC meets, should the rand not have gained strength by then and should the inflation outlook remain as unsatisfactory as it is now and the economy become even less well placed to tolerate a further increase in rates. Without such an argument the economy may well set off on a 1998 Chris Stals-like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.

We have been here before and we should remember how much better the Australians coped at that time with Aussie dollar weakness – by sitting on their interest rate hands and not reacting to the essentially temporary inflation danger presented by a (temporarily?) weaker exchange rate. The comparison between the success the Aussies had by doing nothing and the pain suffered for example by the SA, New Zealand and Chilean economies in the late nineties, where interest rates were increased aggressively in response to emerging and commodity market crisis-driven exchange rate weakness, makes  a most instructive case study.

The right response to a weaker exchange rate driven by forces beyond the control of the Reserve Bank is not to react at all. It should ride out the exchange rate weakness as best it can and focus on the requirements of the domestic economy. The MPC did not have the wisdom to do this and unfortunately made a modest concession, a mere 50bp concession, to poorly considered market expectations and poorly executed monetary policy reactions in other emerging markets.

We can only hope it does a much better job before and during the next MPC meeting of defending the SA economy against ill considered and unhelpful interest rate increases. Monetary policy needs to be not only data dependent, as the Governor has indicated following the Fed mantra, but accompanied by appropriate guidance for the market that makes good economic sense. That is why we will not be embarking on an interest rate spiral unless the domestic economy can justify it – which it is very unlikely to do anytime soon.

 

Emerging markets: Biter gets bitten

Emerging markets are now hurting developed economies – rather than the other way round.

The flavour of financial markets for much of the past 12 months has been a strong preference for equities over bonds and for developed equity markets over emerging markets (EMs). The developed equity markets, led by the S&P 500, performed well, even as US long term interest rates rose significantly and consistently between May and September 2013.

Higher interest rates in the US were a response to the first intimations that the US Fed would be reducing the scale of its Quantitative Easing (QE): that is, the rate at which it would be adding to its portfolio of government bonds and mortgage backed Paper and adding to the money base. In December the Fed announced its intention to “taper” its injections of cash from US$85bn a month to US$75bn. This action was well received by developed equity markets. It was interpreted as confirming the good news about the state of the US economy, thus helping the earnings outlook for US corporations and their market value.

By contrast EM equities did not react at all well to the news about tapering and higher US interest rates. At best EM equities tended to move sideways or lower in 2013 as long term interest rates on EM bonds followed US rates higher. Hence developed market equities significantly outperformed EM equities.

The outlook for EM economies was widely regarded as deteriorating in 2013, even as that of the US was improving, making higher interest rates for EM borrowers distinctly unwelcome. Not only did EM equity and bond markets weaken, but EM currencies came under pressure as funds rotated away from emerging to developed markets. The performance of the JSE and the rand proved no exception to the other EM markets and currencies.

Indeed the rand has been among the weaker of the EM currencies. Commodity based currencies, including the Australian and Canadian dollars, also weakened significantly in response to uncertainty and unease about the prospects for the Chinese economy, the leading EM economy that has such an important influence on demand for commodities like iron ore, copper and coal.

The comfort zone in developed market equities however became significantly smaller on Friday 24 January. The risks in emerging economies on the day infected developed markets. EM contagion became the order of the day. Long term interest rates fell sharply as investors sought safety in US bonds and US equities fell away as risk appetite waned. EM currencies came under particular pressure and while long term interest rates in the US fell those in EM currencies, including the rand rose. Risk spreads across the board, including US corporate spreads, rose rather than fell with lower US rates.

In this way EMs were subject to a risk off threat just as they had previously been subject to a risk on threat. All news has appeared as bad news for EMs. Both higher as well as lower US long term rates have proved unhelpful to EM equities, bonds and currencies.

It may be some consolation to know that a risk off threat to emerging markets, or indeed a risk on threat to emerging markets, should only be of limited duration. Should long term interest rates in the US continue to move lower, the search for higher yields will extend to EMs and reverse the flight of capital from EMs. If US economic growth is well sustained and interest rates rise to reflect the increased demands for real capital that accompany economic growth, the good news will eventually spread to the global economy, including emerging economies. Good news about the US economy will sooner or later translate into good news for EM economies and their markets.

Investors in EM markets, including those equity investors whose wealth is measured in rands, should wish for higher rather than lower US long term interest rates, that is for US economic strength rather than weakness. In the longer run what is good for US business will be good for EMs and SA business.

In the shorter run the challenge for EM economies, especially the SA economy, is to turn a much more competitive currency into export and import replacement led growth. Constructive labour relations and constructive government relations with SA business, in the form of encouraging tax policies and infrastructure roll out, are essential to this purpose. It will also be helpful if the Reserve Bank continues to leave interest rates on hold while leaving the exchange rate to help the economy adjust to higher costs of capital. The mantra for monetary policy should be to float with the tides rather than attempt, Canute like, to reverse them.

 

Developing economies including SA are up against it – what can we do to help ourselves?

The Wall Street Journal Online edition led on 23 January with the following report:

“Investors Flee Developing Countries Currencies in Many Emerging Markets Take a Pounding, Hit by Growth Fears

Investors dumped currencies in emerging markets, underscoring growing anxiety about the ability of developing nations to prop up their economies as they face uneven growth.

The Argentinian peso tumbled more than 15% against the dollar in early trading as the South American nation’s central bank stepped back from its efforts to protect the currency, forcing the bank to reverse course to stem the slide. The Turkish lira sank to a record low against the dollar for a ninth straight day. The Russian ruble and South African rand hit multiyear lows.

U.S. stocks tumbled as well, reflecting the world-wide pullback from riskier assets and continuing a weekslong struggle to regain the upward momentum seen at the end of 2013. The Dow Jones Industrial Average slid 175.99 points, or 1.1%, to 16197.35, the lowest close since Dec. 19.”

The Wall Street Journal (WSJ) indicated that the Turkish lira was the worst affected by the move out of emerging markets since 1 January, followed by the rand, down 3.54%, and the Russian ruble, also down 3.54%. Clearly emerging market economies (with a few exceptions, perhaps Mexico) are very much out of favour and may well stay out of favour if the current investor mood is sustained.

It was in fact not only a bad day for emerging markets and currencies it was a risk off day in the US with, accordingly, equities prices down and bond prices up. The risk on threat to emerging markets and their currencies including the rand can be easily identified. That is  more confidence in the US growth outlook (less risk attached to the prospects for the economy and the companies dependent upon it) leads to higher interest rates. These higher interest or discount rates have been mostly tolerated by the valuations attached to US equities, but unwelcome to emerging market equities as rising interest rates in emerging economies, led inevitably by the US rates, threaten the already unpromising growth outlook for emerging economies.

Clearly, as demonstrated yesterday, there is also a risk-off threat to emerging markets even as US rates move lower. The question then, to refer to the WSJ report, what can emerging market governments and central banks do to prop up their economies. Raising interest rates have done little to help support exchange rates. Intervening in the foreign exchange markets by selling US dollars has also not helped to stem the currency weakness. The global tide is flowing too strongly to be diverted and higher interest rates simply weaken domestic demand further. Higher interest rates put additional downward pressure on expected growth rates and undermine further the case for investing in the beleaguered emerging economies.

One sincerely hopes that the SA authorities have taken full notice of the unhappy experience of those emerging market central banks that, unwisely and unlike the SARB, have reacted in a highly activist way to the pressures in the currency and bond markets emanating from global investors and capital flows out of emerging economies and back to developed ones. Surely the best approach for an economy under stress is to allow a floating exchange rate to help absorb the pressures imposed by less sympathetic global investors; and to do what they can with monetary policy to help relieve some of the unwelcome pressure on domestic spending. While lowering short term interest rates in the circumstances of a sharp currency depreciation might be regarded as too sanguine an approach, leaving them on hold – that is doing nothing – would seem to be the best that can be done by a central bank in circumstances beyond the control of the monetary authorities.

For South Africa this means the mines, factories, hotels, restaurants and tour operators should stay open for business – or, better still, work overtime and double shifts where extra demands present themselves as they are doing most obviously for the SA hospitality industry where extra demand- encouraged by the weaker rand is leading to extra supply and the extra incomes and employment that comes with it.. The task for economic policy in SA is to make sure the export and import replacement-led growth happens and is encouraged. Sensibly reformed labour relations and policies for labour employed in mining and manufacturing, currently highly conspicuous by their absence, would be very helpful as would a highly supportive and well managed roll out of infrastructure; More success in these endeavours would be the best response to an increasingly sceptical global investor. Only faster growth or the prospect of faster growth will  attract more  capital to the businesses that drive the SA economy and would support the rand and by so doing also improve the outlook for inflation.

There is an important economic opportunity for the SA economy provided by the weaker real rand exchange rate (defined as an exchange rate that has moved significantly more than can be justified by relatively fast domestic inflation). The opportunity is for domestic producers, enjoying wider operating profit margins, to take a larger share of both the domestic market from importers and to increase their share of export markets through keener pricing on the local and foreign markets and  increased output and employment Such responses raise growth rates and by so doing are the only know method likely to impress foreign investors.

An Overview on Asset Allocation for Balanced SA Pension Funds in 2014

Taking on equity risk was well rewarded in 2013. It was especially so for shareholders in companies listed on the developed market exchanges led by the New York benchmark, the S&P 500, that returned an extraordinary near 30% annual return. Shareholders in the average Emerging Market (EM) company did not do nearly as well, having seen the USD value of their shares decline. However when measured in depreciated local currencies, strongly positive returns may have been earned on equities, as were provided for the rand investor on the JSE. Furthermore for local EM currency investors equities are likely to have performed much better than local currency bonds or cash as was decidedly the case for rand investors. Even long dated US Treasury Bonds did not provide positive returns in rands given rising long term rates in the US.

Read the full piece here: An overview on Asset Allocation for 2014

US interest rates: What they mean for SA and emerging markets

The unexpectedly poor new jobs number for the US released on Friday 10 January, some 70 000 jobs added in December compared to about 200 000 expected, sent long term interest rates in the US sharply lower. The yields on the vanilla as well as the inflation linked varieties all fell on a revised view of the underlying strength of the US economy. Yesterday these yields remained at the lower levels.

SA interest rates predictably also fell, though the yield spread widened, namely the difference between long dated RSAs and US Treasuries marginally:

 

The news about the possibly diminished strength of the US economy suggested by the labour market surveys, implies that the extra cash injected into the US financial system through asset purchases by the US Fed (QE) will proceed at a slower rather than faster rate – hence more demand for US Bonds and lower long term interest rates.

 

This move in US rates provided relief for emerging market currencies and their equity markets. The rand behaved entirely consistently on Friday 10 January – moving in the opposite direction to the Emerging Market Index, as it had been doing for most of 2013. However late on Monday in New York the rand came under renewed pressure (also felt to a smaller degree by the Turkish lira) while some emerging market currencies, including the Indonesian ruppiah strengthened markedly. The rand perhaps attracted selling pressure on Monday evening after Amcu gave notice that it was proceeding with strike action at Impala Platinum. Emerging equity markets were holding up well as the S&P 500 fell away by more than 1%.

These developments confirm once more that the most important indicator for emerging market equities and currencies will be the direction of long term US interest rates. For now, good news about the US economy (that translates into higher long term interest rates and is treated as good news for US equities and the US dollar), is simultaneously bad news for emerging market equities and currencies, as interest rate increases spread. Also, as we saw on Friday, when interest rates fall in the US, emerging market currencies and equities gather strength.

 

The rand is mostly a play on emerging market equities – the rand benefits from foreign capital that flows in when the JSE appears offers to offer value. This it does when US interest rates fall. If the recent past is to be our guide to the future, higher US interest rates are a threat to the rand and lower US rates a benefit. This will be so until good news about the US economy spreads to emerging market economies and higher interest rates can be more easily tolerated.

 

For now, those concerned about the poor health of the SA economy must hope that the US economy does less well than previously expected, that long term US rates decline rather than increase and that emerging market equities rise rather than fall to support the rand. This would reduce the danger of more SA inflation and damagingly higher interest rates.

 

The rand: Where to holiday in 2014

The rand: Where to holiday in 2014

By Brian Kantor

A recommendation to take your holidays at home, or failing that, try Indonesia, Turkey, India or Thailand in more or less that order.

 

South Africans, especially those with the taste for foreign holidays and the wealth to indulge this taste, will not have to be reminded that a number of the destinations they may have in mind will cost them significantly more rands than it would have done six months to a year ago.

 

There may be some consolation in the knowledge that while the US dollar now costs South African residents about 28% more and the euro 31% more than it did on 1 January 2013, an Australian dollar can be had for only approximately 9% and the yen a mere 5% more compared to a year ago and are now worth roughly the same number of rands they would have in June 2013. Sydney and Tokyo may still appear expensive cities for the SA visitor but not much more expensive than they were a year or six months ago.

Further consolation for the well-travelled South African with a taste for the more exotic is that some destinations have become significantly cheaper for them since June 2013, provided, and it is an important proviso,  prices are set in the local currency rather than in US dollars. Bali in Indonesia will appear a mere snip, with the Indonesian Rupiah having depreciated by about 12% against the rand since 1 June 2013. That never to be forgotten experience in the Istanbul Hamam could be about 8% cheaper and booking that Rio hotel for the World Cup should not be more expensive than it was six months ago – nor should the game changing visit to the Indian Ashram take more rands than it did six months ago. Bangkok or Pukhet might also appear something of a bargain buy. Mauritius, a favourite nearby destination for SA tourists, has proved remarkably exceptional in this regard. Its rupee has maintained its value against the US dollar and the euro.

These developments on the currency markets in 2013 illustrate the important forces that have influenced the foreign exchange value of the rand over the past 12 months.

The weakness in the rand across almost all currencies, including other emerging market currencies until June 2013, was SA specific in origin. It was caused by the failure of labour relations and the resort by the unions to strike action that disrupted production and especially exports from the mines and manufacturers. It became very apparent that export revenues and profits can only benefit from a weaker rand if output can be maintained or increased in response. This was not the case in SA in 2013. For want of exports, the trade and current account deficits remained large despite slow growth. This put sustained pressure on the rand from August 2012 until June 2013.

The weakness in the rand after June was much more a case of increased emerging market risks, rather than specific SA risks. The intention of the Fed to taper its injections of cash into the US financial system, first revealed in late May 2013, meant higher interest rates in the US and everywhere else. Capital tended to flow out of emerging market equity and bond markets into developed equity markets with very negative effects on most emerging market currencies. The “fragile five” emerging economies – Brazil, India, Indonesia, South Africa and Turkey – that ran current account deficits and therefore depended more heavily on foreign capital inflows proved particularly vulnerable.

Any recovery in emerging market currencies will depend upon renewed appetite for emerging market equities that have so underperformed in US dollar terms over the past two years.

Hard Number Index: A mildly encouraging December

The first indicators on the state of the SA economy at the end of December 2013 are now available in the form of unit vehicle sales and the currency issued. These two hard numbers provide a very accurate and up to date estimate of spending by households and firms.

The news on spending in December is mildly encouraging when account is taken of seasonal influences on the sales of vehicles and the demand for notes. December, for obvious holiday reasons, is a very strong month for the notes held in wallets, purses and ATMs. It is also a weak month for vehicle sales, as holiday makers do not typically visit motor show rooms.

Yet while actual new vehicle sales fell from 50 806 units in November 2013 to 46 501 units in December, on a seasonally adjusted basis unit vehicle sales in December were well up on November sales, by some 3 605 units, or a monthly gain of some 6.9%. If the latest trends in new vehicle sales are extrapolated forward, using a time series forecast, the sector could be looking for sales in 2014 of 626 000 units. This would represent a minimal annual decline in sales volumes of some 2.36%, an outcome the industry would gladly settle for.

The manufacturing arm of the sector can hope to benefit further from much higher levels of exported units in 2014, after the disruptions caused by strike action in 2013. The National Association of Automobile Manufacturers in SA (Naamsa) indicated that exports of 275 822 units, though a record number, were some 61 000 units fewer than expected.

The money supply numbers at end December showed a somewhat similar improvement compared to November when seasonal influences are factored in. In the figure below we adjust the nominal note issue for the CPI and show that, on a seasonally adjusted basis, the real money base (supply of cash) picked up momentum in December 2013. When the latest statistics are used for a time series forecast, the real money base is predicted to have increased by 2.7% by year end 2014 – equivalent to nominal growth in the note issue of some 8% and consistent with an estimated inflation rate of about 6% in 2014. This is consistent with a predicted modest aggregate spending growth of about the same magnitude, of less than 3%.

What can be concluded from the latest economic news is that the SA economy has not, as may have been feared by some, fallen on its face. Rather, it seems able to sustain a modest forward momentum that, in the circumstances of disrupted production and a depreciated exchange rate that helps sustain high rates of inflation, may perhaps be consoling.

We combine the two hard numbers, unit vehicle sales and the real supply of cash in equal weights to form our Hard Number Index (HNI) of economic activity. We have previously shown that the turning points in the HNI – pointing to a pick up or slow down in the mostly forward pace of economic activity – track the Reserve Bank’s Coinciding Business Cycle Indicator Index very well. The distinct advantage of the HNI is that it is available within a week of the end of the previous month, rather than only three or more months later (as the Reserve Bank indicator is). The updated HNI is shown below. It shows that the SA economy is still growing and can be expected to continue to move forward at the current slow speed. The December data has helped to keep the HNI on this modestly faster track.

The opportunity for the economy to pick up momentum in 2014 will have to be led by exports and replacement of imported goods and services by domestic suppliers. The weaker rand can help promote exports and discourage imports, provided that the mines and factories stay open as do the restaurants, shops, hotels and B&Bs catering to foreign tourists.

A stronger pick up in the global economy, led by the US, will be helpful for exporters and the US dollar prices they receive. The scope for a domestic demand led stimulus for the economy is limited, given the state of global capital markets that are revealing a greater preference for developed rather than emerging market assets. The danger to the economy is not that domestic spending will pick up – but that it can slow down further under the pressures of higher prices and higher interest rates.

We must hope that the Reserve Bank does not attempt to fight higher inflation, since it has no influence whatsoever over inflation given the sources of higher prices: the exchange rate, a possible drought in the maize producing areas, as well as relentlessly higher taxes in the form of higher municipal charges for electricity and toll roads.

Higher interest rates can only reduce domestic demand without influencing prices very much, so slowing down growth and, by doing so, probably frightening away rather than attracting foreign capital. Slower growth may well mean even more rand weakness and more inflation.

An emerging question

In the global village developed market equities and currencies continue to make the running. But for how much longer?

Good news about the US economy has led to the tapering that was first hinted at in May 2013 and became a reality late in the year. The Federal Open Market Committee announced on 18 December 2013 that it would begin reducing (tapering) the extra cash it injects into the US financial system through its bond and mortgage backed paper buying programme, for now from US$85bn per month to US$75bn.

The Fed also made it very clear that it did not expect to have to raise short term interest rates anytime soon and that all it might do by way of further tapering would remain US economic data dependent.

Long term interest rates in the US, and everywhere else, responded dramatically in May 2013 to the prospect of less support for bond prices and yields have remained on a generally upward path since then. The US equity markets were largely unruffled by the reality of higher interest rates. Good news about the US economy, as revealed by tapering intentions and action, was taken to mean better prospects for US corporations, despite higher interest rates. And so share prices rose further, especially in late December, as we show below.

Emerging equity markets and their currencies did not take at all well to the prospect and reality of higher interest rates in the US – notwithstanding the good news about the US economy that remains such an important part of the global economy. Clearly the state of most emerging market economies was not at all robust enough to tolerate higher interest rates. Their currencies, including the rand, weakened as funds flowed out of emerging equity and bond markets. While the local currency values of emerging market equities generally rose, as they did on the JSE, these price gains were not enough to compensate offshore investors for currency weakness.

In US dollar terms, the average emerging market equity went south rather than north in 2013, thus lagging well behind the trends registered on the developed equity markets (see below). Good news about the US economy did not translate into good news for emerging market economies.

Higher long interest rates in the US, that led to higher rates in emerging economies, including SA, put downward pressure on currencies and equities, when valued in US dollars. The one saving grace for interest rate sensitive economies and companies is that interest rate spreads between riskier bonds (including RSAs) and those issued by the US Treasury have tended to narrow recently, so moderating the impact of higher interest rates in the US (see below).

For now investors in emerging equity markets should hope that the expected recovery of the US economy is fully reflected in current long term bond yields. Indeed, economic disappointments (leading to lower bond yields) rather than surprisingly strong growth in the US (higher bond yields) would be greatly appreciated by emerging market equity and currency markets. Yet in any longer run view, a stronger US economy (given its large size) is good news for the global economy and especially for those emerging economies reliant on export flows to the developed world.

The better economic times seem more propitious for developed than for emerging markets and their valuations reflect this. In due course, the good economic news will spread to the emerging markets, their currencies and their equity and bond markets. For now developed equity markets, we think, continue to make the stronger case for equity investors than emerging equity markets, while equities generally make a much better case than bonds, given the risks of higher interest rates.

But a mixture of still more demanding valuations on developed equity markets and less demanding valuations on emerging markets, especially when measured in US dollars, could revive the case for emerging market equities and their currencies. At some point in time, the strong outperformance of developing equity markets and currencies will become the case for emerging markets that, after all, have the global economy in common. As they say, timing is everything.