Author: Brian Kantor

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.

The Hard Number Index: Little holiday cheer

A combination of vehicle sales and the money base (adjusted for inflation) provides a good and up to date leading indicator for the SA Business Cycle. New unit vehicle sales in November on a seasonally adjusted basis were 2 081 units down on October 2013 and were weak enough to turn the vehicle cycle in a Southerly direction. If current sales volumes are extrapolated, the industry is heading for an 8% decline in sales in 2014.

The demand for and supply of cash (adjusted for inflation) were also lower on a seasonally adjusted basis in November 2013 than in October 2013 and the outlook is for persistently slower growth in the money base in the year ahead.

 

Strike action in the motor sector and the consequent supply side constraints (rather than a lack of demand) may have been responsible for some of the lost sales in the show rooms that could be made up in December. The demand for cash in November is typically robust, given spending intentions for the holiday month of December that lead households and firms to hold more cash. The recent slowdown in demands for cash, adjusted for inflation, therefore does not suggest a buoyant season is in prospect for SA retailers.

It also indicates – when combined with vehicle sales that forms our Hard Number Index of the state of the economy – that the pace of growth in economic activity has stalled at a regrettably very modest pace.

The SA economy is running below its rather modest potential growth rate of about 3%. It is moreover very difficult to see where the impetus for growth can come from. The weaker foreign exchange value of the rand has added pressure on the prices of goods and services and is reducing the purchasing power of households. This ability to spend is also being undermined by higher administered prices; that is by what should be called higher taxes, in the form of tolls for roads and higher charges for electricity and other municipal services.

But the weaker rand not only inhibits the adoption of lower interest rates from which household budgets would benefit – especially in the form of lower mortgage payments. It has raised the possibility of higher interest rates – and so even more subdued household spending on which the economy is so dependent. So any stimulus from household spending for retailers or the local manufacturers seems a distant prospect.

This leaves higher export prices and volumes as the only possible source of faster growth over the next year or two. The weaker rand could be helpful to this purpose. It does make exporting more profitable and importing less profitable, at least until higher inflation erodes the benefits of a weaker rand. But raising exports does require fully productive mines and factories and the co-operation of trade unions, cooperation that was conspicuously absent in the third quarter, hence the weaker trade balance and slow GDP growth, both of which contributed to a weaker rand. Slow growth means low returns for investors and so discourages capital inflows that might support the rand.

The most conspicuous beneficiaries of the weaker rand would appear to be the service providers to foreign and perhaps also domestic tourists persuaded to holiday at home by expensive travel plans. Tourism after all contributes significantly more to the economy than mining and employs far more people. Farmers, provided the weather proves co-operative are also well placed to benefit from and respond to higher rand prices now available on foreign markets and also in the domestic market, where higher import parity prices might prevail.

The other hope is that a stronger global economy, while it has lead to higher interest rates in the US and elsewhere, and so (for now) pressure on the rand, will in due course help raise demand for as well as the prices of goods produced in SA. A combination of stronger exports and faster growth that encourages capital inflows and so a stronger rand, followed by lower interest rates, is the way out of the slow growth path upon which the SA economy is now set. The best monetary policy can do for the economy in these circumstances is nothing at all to interest rates. Higher interest rates can only further damage domestic spending and discourage the case for investing in South African assets. It could also very easily lead to a weaker rather than firmer rand. Slower growth with still more inflation should not be a policy option.

Ode to Shiller (or is it a lament?) and his contribution to financial economics

We examine the models of 2013 Nobel laureate Robert Shiller and see what predictive role they have in the performance of the S&P 500.

The joys of receiving the 2013 Nobel Prize for economics – shared between Eugene Fama, Robert Shiller and Lars Peter Hansen – may well have been tempered. The ideas of Shiller and Fama on how financial markets behave are about as far apart as they get. Fama made his reputation exposing the economic logic, the efficiency of the market. Shiller made his attempting to prove the opposite.

We consider below just how useful price/earnings (PE) ratios are for market timing decisions. We ask whether the Shiller approach has merit – it continues to receive attention from market timers – or whether Shiller in his call that the S&P 500 market was greatly overvalued in 2000 (as it subsequently proved to be), was just lucky enough to be in the right place and time to draw favourable attention to his work.

Bubbles are good for some

Shiller’s analysis of an overbought stock market in 2000 was based on apparently unsustainably high price-earnings ratios for the S&P 500. He used a 120 month (10 year) moving average of real (CPI deflated) earnings as the denominator and real share prices, represented by the S&P 500 for which he derived data going back to 1871, as the initial starting point for the analysis. The Shiller PE is also described as the Cyclically Adjusted Price Earnings ratio (CAPE).

In the figure below, we compare the Shiller price/smoothed earnings multiple to the conventional measure using reported or what are often called trailing earnings. The two series differ most dramatically during the Global Financial Crisis (GFC) of 2008 when prices held up, even though reported earnings had collapsed. Shiller earnings, being a 120 month moving average, moderated this fall in earnings, so leading to a much lower multiple in 2008-09 and a much higher one therafter, given the recovery in trailing earnings. As may be seen in the chart below, the current Shiller PE multiple is now significantly more demanding than a multiple based on reported earnings.

The problem with a moving average when earnings collapse

The application of a 120 month moving average to estimate earnings means that the low level of reported bottom line S&P earnings in 2009-10 will continue to drag down Shiller earnings, relative to the much higher subsequent reported earnings, for 10 years thereafter. The current Shiller PE ratio is 24.42, while the conventional trailing PE is 19.43 (see Figure 2). The long term average (1871- 2013) monthly Shiller PE ratio is 16.5 and the conventional PE has a long run average of 15.83.

Incidentally, in contradiction to the Shiller notion that share prices are more variable than reported earnings – indicating some degree of irrationality in valuations – the opposite has been true since the late 19th century using the data suppled by Shiller. The average move in the real S&P has been 3.56% a year, calculated over 1578 months (over 131 years), while the average annual growth in real reported S&P earnings has been 6.86% over the same period.

Since 1960, the average real price move has remained at 3.6% a year while the average growth in earnings has been higher, at 11.6% a year. The standard deviation (SD) of real price moves, the conventional measure of volatility, has been 16.09% a year since 1960, while that of real earnings growth has been much greater, a staggering SD of 78.5% (influenced by the post GFC collapse in earnings and changes in accounting conventions that now discourage any protection of the bottom line that might have helped smooth earnings in the past).

The Shiller theory of value and the evidence – problems with a price earnings model that does not revert to some consistent long term average

The Shiller theory is that the Shiller price to smoothed earnings multiple will provide a superior method for recognising an over- or undervalued share market than the conventional measure of a price to earnings ratio. Or, in other words, comparing the Shiller PE to its long run average can assist market timing decisions. The problem for those using either measure is that neither of them can be regarded as reverting over time to their long term averages. The ability to revert (called mean reversion by econometricians) can be calculated – and it can be very clearly shown that these ratios do not converge to long term averages. These PE multiples can remain well above or well below their long term averages for long periods of time. There can thus be little confidence, based on the statistical evidence, that the PE multiple will consistently gravitate to some long term average within some operationally useful period of time for investors to time entry to or exit from the share market

Using either measure of the PE multiple, conventional or Shiller, the market appeared to be as significantly over valued long after Fed chairman at the time, Alan Greenspan, spoke memorably in 1996 of irrational exuberance. The S&P and the price to earnings multiples moved significantly higher for another four years.

It is expected earnings that drive value

It should be appreciated that investors use past performance, as represented by realised earnings, as a proxy or starting point for expected earnings when undertaking any valuation exercise. Future earnings will determine future valuations and the path of future earnings may well be expected to diverge from past earnings for any number of reasons – for example underlying economic growth can realistically be expected to gain or lose momentum for an extended period of time, adding to or subtracting from expected profits.

Unforeseen economic policy events, taxes, regulation or even natural events can alter the present value calculations that investors make. They may view the economic outlook with more or less confidence. The less their confidence, the more risk they will attempt to allow for when they buy or sell assets and so the higher or lower the discount rate or equity risk premium they would use to calculate a present value for a stream of benefits. The real cost of capital may well change as global and domestic propensities to save increase or decline, given degrees of capital mobility.

The future may well be different and investors can rationally hope to benefit from the difference. Most assets, including the real plant and equipment that corporations invest in, have a natural limited economic life. Earnings that might add value to an asset if it survives beyond a twenty year horizon cannot add much present value.

It can be demonstrated that small adjustments to two key influences on the price earnings multiple can drive the PE ratio dramatically lower or higher. These are in the required rate of return (or the cost of capital used to discount expected earnings) or in the expected growth rates in earnings themselves. Even small changes in the discount rate or the expected growth in earnings or dividends can have an explosive impact on the PE ratio.

Time will tell whether investors were too optimistic or too pessimistic about these forces that drive valuations. Market prices set in advance may be proved wrong by subsequent market moves – but this would not prove the valuation process as irrational. The unexpected might well prove the norm to which valuations adjust. This is a point Eugene Fama would no doubt make in response to accusations of market inefficiency – because markets may appear to change their collective minds and forecast poorly. It does suggest however that forecasting share prices is difficult to do successfully and also that using a simple metric like the price earnings multiple – compared to its long run average – is not the holy grail of share market valuations.

The growth in earnings and share prices

As an alternative to the PE ratio, we examine below the relationship between the annual growth in earnings and the annual growth in share prices. It seems reasonable to expect the relationship between the growth in earnings and prices, or between price moves and earnings moves, to cancel out over a period of time. Either prices catch up with faster earnings growth or, vice versa, earnings growth can catch up with higher share prices, so closing the gap between growth in prices and growth in earnings. If earnings fail to grow as expected, prices will then tend to retreat, thus closing the gap between price and earnings movements.

We examined the difference between annual price movements in the S&P Index and the simultaneous growth in earnings, both conventional and Shiller. The results of the exercise are pictured in Figure 4 below.

These differences in the annual growth in share prices and the growth in earnings do appear to revert to zero over time, though not necessarily in any regular way, either within the same year or even over the next few years. This suggests that it may well take a long time for the adjustment process of share prices to corporate performance or the other way round, to work out. The annual differences between the growth in share prices and earnings have an almost random, rather than persistent, character and so these differences in growth rates provide little notice of whether the current gap between the recent growth in prices and earnings will subsequently widen or narrow.

When we compare the growth in the S&P over 29 consecutive five year periods, with the growth in earnings over the same five years, we do get a somewhat better statistical fit. However the results are not convincing: even if we could successfully forecast earnings and earnings growth over the next five years we could not be confident that we would derive accurate predictions of the stock market . In the figure below, we show the results of such an exercise for the five year changes in the real S&P and real S&P reported earnings since 1871.

Connecting the level of the market to the level of earnings

While the PE ratio compared to its long run average provides little help in predicting the direction of the market , we may be able to gain some insight by comparing the level of the market with the level of earnings using regression analysis, especially if we add the influence of interest rates to the description of the level of the market relative to reported earnings. The difference between this approach and those of Shiller or conventional PE ratios to indicate an over- or undervalued market, is that it allows for a discount rate to be added to earnings or dividends as an additional explanation of value. The opportunity cost of holding equities in the form of interest income foregone surely influences the prices investors are willing to pay for a share in a listed company.

Adding long term US interest rates to both of these equations improves the fit of these models. The interest rate variable included in these models is the yield on a 10 year US Treasury Bond, for which data is also available back to 1871. The interest rate betas have the predicted negative association with share prices and are statistically significant.

The equation drawn, sometimes described as the Fed Model, with the natural log of the real S&P explained by the log of real S&P dividends and long term interest rates since 1880 and compared to actual values, is shown below. Judged by this model, the S&P 500 is currently about 9% undervalued.

By any conceivable measure of past performance, the S&P 500 was greatly overvalued in 2000

Utilising any of the variations of the Fed model, the US equity market was very demandingly valued in 2000. Using the Shiller definition of earnings as the explanatory variable without interest rates, a regression equation run over the period 1880-2000 indicates that the real value of the S&P was 2.7 times its value predicted by the Fed model with Shiller earnings in early 2000. Substituting reported earnings for Shiller earnings in this PE model indicates a market 2.2 times above that predicted by real earnings.

The problem for the investor utilising the Fed model is that in mid 1996 the S&P was already 1.9 times its value with Shiller earnings and 1.6 times its value, as predicted by reported earnings. Utilising either the Shiller earnings approach or reported earnings would have told essentially the same story. Yet the demanding valuations persisted for many years.

The case for dividends rather than earnings as the measure of past performance

It can be argued, especially taking into account the recent earnings turbulence, that real S&P dividends per share are a superior measure of past performance to reported S&P earnings. Definitions of bottom line earnings may change over the years as accountants revise their conventions. Dividends are much less complicated: they are simply cash in money of the day paid to shareholders. Buying back shares, subject to changes in financial fashion, serves the same purpose but does not show up immediately as dividends per share.

Reported dividends per share held up much better than trailing earnings per share through the GFC. They therefore provide a much more realistic estimate of realised corporate performance and perhaps also the performance expected by management, than bottom line earnings that were so much affected by the write offs of financial institutions (see Figure 8 below).

Regression models of the real S&P 500 over the period 1960-2013, using either real trailing earnings, real Shiller earnings or real dividends as the explanatory variable, together with the 10 year Treasury yield, indicates that the S&P 500 is currently under rather than overvalued: by 13% using real Shiller earnings and long term interest rates; fairly valued using trailing real earnings and interest rates; and as much as 32% undervalued using real dividends per share, when combined with interest rates.

Statistical issues with these regression equations

The statistical issues with these linear regression models, using levels of earnings or dividends with interest rates to explain the market, is that, as with the Shiller or conventional PE, the under- or overvaluation identified by the models are persistent. One of the essential conditions for unbiased regression estimates is that the error term, that part of the dependent variable not explained by the model, should have an expected value of zero and be normally distributed about zero (that is the regression estimate should have the same probability of being above or below the estimated value).

This is not the case with these models, which reveal what statisticians would describe as serial correlation and therefore do not provide unbiased estimates of the relationships identified. When this persistence of errors occurs, the results of any linear regression analysis and the validity of the estimated coefficients are compromised. As we indicated earlier, this persistence of Shiller’s PE away from its long run average is subject to the same bias. Lars-Peter Hansen was awarded his share of the Nobel Prize for providing methods to overcome the serial correlation and many other problems caused when the data is compromised.

How to apply these models, with their statistical weaknesses recognised

It is best to regard these models not so much as helping time entry or exit from the market (trading models), but rather as a way to interrogate and perhaps understand the level of the market and the earnings and interest rate expectations implied by current market valuations. If the model suggests the market is significantly overvalued by its own standards, a degree of caution may be called for. And vice versa, if the market is deeply undervalued a degree of confidence in its future recovery may be encouraged by undemanding earnings expectations. Again, there should be no confidence that these identified valuation gaps will be closed rapidly. Earnings can catch up with prices or prices can catch up with earnings as the truth about underlying economic performance is revealed and this may take time.

Conclusion: The market proposes – economic reality disposes

The lesson to be drawn from this analysis is that in the long run, valuations will catch up with economic performance or performance will catch up with valuations. However predicting the direction of the market over the next month, year or five years (even knowing where earnings and dividends are going) is not easy to do.

Trading theories that rely on price/earnings ratios or the relationship between the level of earnings and prices may indicate degrees of investor exuberance or despondency by the standards of the past. But there can be no certainty that temporary exuberance or despondency will prove excessive or short lived.

There will always be more than earnings or dividends (or even expected earnings or dividends) at work in driving the market in one direction or another. The growth in expected earnings as well as the discount rate attached to them may be in a constant flux, making accurate predictions of market returns extremely difficult to make. Not only would it be necessary to predict earnings with accuracy, but also the direction of interest rates and the degree of risk aversion or tolerance that may emerge.

The direction of causation may well be from prices to earnings rather than from earnings or expected earnings to share prices. For example, the higher the share price, the more willing and able the company will be to expand its operations and increase its bottom line earnings. Market volatility furthermore provides no proof of market irrationality. It indicates only the difficulty in forecasting the behaviour of complex systems with feedback loops – in the case of the share market from performance to prices and also from share prices to the economic performance of a company.

The forces driving the rand and the Brazilian real are global, not domestic

The recent weakness in the rand has once more much more to do with global forces than the disappointing news about the the current account of the balance of payments. The pressure on the rand has been matched by the pressure on the Brazilian real, making the rand cost of a holiday on Ipanema beach slightly cheaper than it was in late October.

It is instructive to recognise that this weakness in the real and the relative stability in the rand/real exchange rate have come despite very aggressive increases in Brazilian interest rates, imposed in response to the weaker real.

These increases have not helped the real while they have probably weakened the growth outlook for the Brazilian economy. The SA Reserve Bank is hopefully taking note: higher interest rates do not necessarily protect the currency while they almost certainly restrain domestic spending. It is the growth outlook more than the short term interest carry that drives capital flows, which in turn support a currency and improve the inflation outlook. Sustain growth rates and the currency will be supported. Weaken growth rates and foreign investors are more likely to take their capital elsewhere – even back to the developed world.

Remuneration of senior executives: Where angels should fear to tread

Those shareholders in Sun International (SUI) who voted against its pay policy on 22 November (49.89% of shareholders, while 5.05% abstained) probably did not do themselves any favours, at least in the short term. Since then the share price has fallen from R101 to R95.6 by midday yesterday (2 December).

The market value of the company has fallen accordingly, from R11.53bn on 22 November to the current R10.91bn, a loss of R617m – a whole lot more than the extra they might have paid senior executives.

 

Clearly the vote on pay could not easily be said to have helped shareholders. However it is impossible to say how much it cost them with certainty. There may well have been other forces at work driving the share price lower, forces common to all the JSE listed companies – or hotel and casino companies in particular.

Ideally we would isolate these market effects from the impact of events specific to Sun International itself. Unfortunately the relationship between the share price and that of the market itself is a very weak one. The relationship between the share price and that of its rival Tsogo Sun (TSH) is also too weak to enable us to isolate market-wide effects on the share price with any degree of confidence.

Perhaps coincidentally, the Tsogo Sun share price and market value have also been subject to downward pressure recently, though less so than Sun International.

Nothing can be more important for shareholders than the quality of top management and the incentives that encourage their efforts on behalf of shareholders. The essence of good corporate governance is for the directors to appoint the best possible chief executive, at a market related package, and to design the right package for him or her that is related to the internal return on capital realised by the company. The board should to be able to manage the market place for top management well.

This market, like the market for capital and the goods and services companies deliver, is itself a competitive global market. Another responsibility of any board of directors is to make sure that the remuneration policies, including the mix of contractual and performance based rewards, for all employees, is well designed for shareholders. Impressing the soundness of such policies on shareholders is part of the role to be played by the CEO and the board.

Second guessing these essentially complex policies at annual meetings of the company is unlikely to add shareholder value. Nor are interventions in remuneration packages by governments and their regulators likely to be helpful to shareholders. Such interference is very likely to be driven by envy about income differences, rather than objective measures of performance that play well in the political arena and usually receive encouragement in the media.

The man or woman in the street usually finds it a lot easier to understand the extraordinary rewards of the superstars of sport and entertainment that fill the arenas. The role played by the superstars of business in generating revenue and profit is clearly not so well appreciated.

The true quality of remuneration policies of a company (as of its management generally) will be measured by the share market – not so much by absolute share market performance (which is often beyond the control of the company), but by the relative performance of one company compared to its close competitors.

Such comparisons will be determined by sustained differences in the internal rates of return on investing shareholders capital. It is to these differences that management should be held accountable for at annual general meetings and to which remuneration policies should be directed. Votes about how much the CEO has earned, or will earn, may serve only as a distraction.

Electricity pricing: Power plays

One notices that aspirant independent and alternative power generators are not only willing to add generating capacity to the SA grid, but are willing to do so at prices per kilowatt hour (KWH) that are little above the regulated prices offered to Eskom. As encouraging, is that there would appear to be no lack of foreign and domestic capital to fund these projects designed to add to capacity or to replace Eskom as the economic supplier.

This makes an important point. It is not a lack of capital that constrains SA economic growth. Global capital has never been more abundant or indeed cheaper. The constraint is the lack of growth itself that reduces the expected return on capital and so the incentive to invest more capital in SA projects. Clearly the energy sector at current wholesale prices for electricity is an attractive investment destination.

Hence the energy regulator Nersa must have set prices high enough, despite all of Eskom’s protestations to the contrary. Clearly also, at current prices, there is no reason to have to depend on Eskom to add further generating capacity and for the government to have to borrow on its behalf or what comes to the same thing – to guarantee more of Eskom debt at the cost of its credit rating. The private sector has demonstrated it is willing to build and fund all the electricity South Africans would be willing to buy at current prices, adjusted for inflation. Eskom is to receive an extra 8% a year per KWH for the next four years.

The latest entry to the ranks of alternative suppliers of electricity is ArcelorMittal, which sees an opportunity to reduce its considerable energy costs at its Saldanha Steel Plant by generating its own, using imported gas as its feedstock. Its economics depends on selling 600 of the 800 planned Megawatt capacity to the grid – ie to Eskom, which may not be enthusiastic about the idea.

A more obvious customer would be the City of Cape Town which might well be able to negotiate a below Eskom price for a guaranteed takeoff. The City officials tell me (with perhaps a typical lack of enthusiasm for innovation) that the law makes such a deal impossible or that somehow Nersa would not allow it. This would mean perhaps that the law is an ass that needs to be turned in a different direction. Nersa surely would have no objection to wholesale electricity prices below regulated levels?

Or, perhaps, such reactions reveal that the electricity sector has yet to come to terms with the reality that Eskom’s regulated prices are not too low to discourage additional capacity building, but are in fact more than high enough to encourage expensive alternatives to coal or gas fired alternatives. And perhaps even so high as to discourage demands for electricity upon which a competitive economy depends. Surely the lower the price of electricity, the better for the SA economy? Or am I missing something?

Interest rates: Giving pause to the hawks

The Governor of the Reserve Bank, Gill Marcus, saw fit in her Q&A session after the Monetary Policy Committee (MPC) meeting to adopt a more hawkish tone about the direction of interest rates. This came after the MPC decided to leave short rates on hold.

Perhaps the MPC needs to be reminded that raising short term rates will not do anything useful for the inflation rate unless the rand responded favourably to such a move.

Judged by the relationship between daily changes in short rates and daily moves in the rand since 2007, there is in fact as much chance of the rand weakening as strengthening when short rates rise. This relationship since 2008 is shown below in a scatter plot and has a correlation of zero.

Higher rates however can be expected to slow down domestic spending that, as the Reserve Bank is well aware, is growing very slowly and is putting deflationary, rather than inflationary, pressure on prices. The risk is that higher rates will damage the economy without having any favourable impact on inflation or inflation expectations.

It is a risk not worth taking. The Reserve Bank should have lowered interest rates long ago but in current circumstances of “tapering” risk on US rates and the rand, the best approach the Reserve Bank could take is to do nothing at all. It almost appears, from the body language of the Governor, as if doing nothing about interest rates or the exchange rate is a hard act for the MPC. Doing nothing for now and until domestic demand has picked up momentum, which it shows no signs of doing, is highly recommended.

Just in case the Bank thought its tough talk had any favourable impact on the rand it should know that any strength in the rand on late Thursday and Friday was due to a favourable upward move in emerging equity markets that helped the rand as much as it did other emerging market currencies. Absent SA political risks (over which the Bank has no influence) the rand remains exposed to global economic forces for which emerging market (EM) equity and bond markets are a very good proxy. We show the links between the rand and the MSCI EM Equity Index and also those between EM credit spreads over US Treasuries and the rand below. Clearly global forces are driving the rand and will continue to do so – independently of short rates set by the Reserve Bank.

The recent Brazilian experience with hiking short rates – to which reference was made at the MPC meeting – should be salutary for the SA Reserve Bank. In response to dollar strength and weakness in the Brazilian real, the Brazilian central bank hiked short term rates aggressively in mid year. As we show below, such aggression) no doubt harmful to the domestic economy) has not has any favourable impact on the Brazilian real/rand exchange rate. The weak rand has more than held its own with the real without support from higher interest rates as we show below.

The reason that currencies weaken in the face of higher short rates is because higher interest rates can damage longer term growth prospects and frighten capital away.

The path to a stronger rand and lower inflation is faster SA growth – this will encourage portfolio inflows and foreign direct investment to SA. Slowing down growth can be highly counterproductive: by discouraging foreign capital, it can weaken the rand and lead to more, not less inflation. Such possibilities should give strong pause to thoughts of higher short term interest rates.

JSE industrial earnings: 1960s nostalgia

Some SA financial history

You would have to go back to 1969 to find the JSE Industrial Index as demandingly valued as it is today. The Industrial sector of the JSE is now valued at nearly 24 times reported earnings. The market is clearly demanding or expecting the earnings of JSE listed industrial companies to continue to grow strongly and consistently – as they have succeeded in doing in recent years.

 

For those with long memories or knowledge of SA financial history, that episode of very demanding valuation in the mid 1960s did not turn out well for shareholders who entered the market in 1965. As we show below, it took until 1995 for the JSE Industrial Index, adjusted for inflation, to regain its 1965 levels. Thereafter, as we also show below, real share prices on average fell back again and only decisively exceeded the average 1965 real valuations in 2005. Since then we have seen spectacular real increases. Between 2005 and 2013 the JSE Industrial the Index has increased by nearly six times in real value to reach its current record levels.

 

 

 

 

 

This time has been different – The explosion of share prices and earnings after 2005

These improvements in share market valuations since 2005 have been supported by almost equally strong advances in reported earnings, adjusted for inflation. While share prices have increased by six times in real terms since 2005, real index earnings have increased by nearly five times over the same period, with only one temporary set back associated with the global financial crisis. This very impressive growth, if sustained, would be well worth paying up for in higher share prices. In other words, it is economic fundamentals, not irrational exuberance, that can explain the market in JSE listed Industrials.

It should be noted that after a period of strong growth in real earnings between 1960 and 1980, real industrial earnings in 2004 were no higher than they had been in the mid 1970s. The surge in earnings and earnings growth, as with share prices, began in 2005 and has been sustained since then. It represented a sea change in the circumstances of SA industrial companies. What is to be observed is a remarkable transformation of the real profitability of JSE-listed industrial companies.

 

Since January 2011 the growth in real industrial earnings has averaged 12.9% a year, while real dividends have grown significantly faster – by nearly 30% a year on average. These, it will be appreciated, are very impressive recent real growth rates. As may also be seen below, while both growth rates have slowed down, a time series forecast predicts that the growth in real dividends will pick up momentum while the growth in real earnings will remain positive in real terms in 2014. But all of this will have to be proved and investors will be watching the earnings and dividend news particularly closely.

 

 

Industrial earnings dissected – global and SA economy plays

Among the large industrial companies listed on the JSE it is the group of the Industrial Hedges that have made the running on the JSE. These are companies that depend on the global economy rather than the SA economy. We have created an Index of these companies weighted by their SA share holdings. The Index is made up of British American Tobacco, Aspen, SABMiller, Naspers, Steinhoff, Richemont, MTN, Netcare and Medicilinic. This group of companies generated a total return of close to 50% over the 12 months to the end of October 2013, compared to 23% for the All Share Index and a 42% return for the Industrial Index (the latter includes the Industrial Hedges as well as the SA economy-dependent large industrial companies).

Unsurprisingly, the Industrial Hedges have also outperformed on the earnings growth front. Yet it should be noticed that in recent months the SA Industrials have increased their reported earnings, in money of the day rands, at about the same rate as the global group.

 

The state of the global economy will prove decisive for corporate performance

It will take good support from the global and SA economies to realise the growth in earnings required to justify current market valuations. The global economy plays will benefit directly from US growth. With faster US growth will come higher long term interest rates though. For now this makes US rates a bigger threat to emerging market economies, their currencies and their stock markets than to the US economy and US equities – as we observe from market reactions to higher and lower US long term rates. Rand weakness adds to the case for the global plays relative to the SA Industrials. Rand strength improves the case for industrials dependent on the SA economy.

 

In due course faster US growth should feed through to emerging market economies and the companies dependent on them – including the SA Industrials. In the long run good news about the US economy means good news for the global economy; but not necessarily immediately. For now the ideal scenario for emerging markets would be modest increases in long term US rates – as the US economy consistently gains momentum and drags global growth along with it. The more delayed and slower the tapering of the extra cash injected into the US economy, the better for emerging market equities, including the JSE.

African Bank (ABL): Getting to grips with the rights issue

(For more details, view the PDF here)

African Bank Limited (ABL) announced its intention to proceed with a rights issue of up to R4bn on 5 August. The terms of this rights issue were decided in early November: the company now plans to raise R5.48bn from its shareholders by issuing 685.28m shares at R8.00 in the ratio of 21 shares for every 25 shares held.

We will offer a method to measure the success of this rights issue for current ABL shareholders who may follow their rights or alternatively dispose of the shares that will carry these rights to their new owners.

Some detail

Shareholders or potential shareholders have until close of business on the JSE on Friday 8 November to qualify for these rights as registered shareholders. The rights will trade between 11 November and 29 November 2013. The last day to follow these rights, that is to pay R8 for the additional shares to be allotted, is 6 December.

The rights issue is fully underwritten and so it is certain the capital will be raised and the extra number of shares issued as intended. That is whatever happens to the share price of ABL between now and 6 December when all the shares can trade.

Some uncomfortable recent ABL history

The recent history of the ABL share price and its market value (share price multiplied by the number of shares in issue) is shown in the following chart. The bad news on 2 May took the form of a trading statement that indicated that earnings per share were expected to decline by between 25% and 29%.

The share price then immediately declined by 19.3% on the news. By the end of May the share price had declined still further to R16, reducing the market value of ABL by more than half of its pre-trading statement value, that is by nearly R13bn, over the month. Thereafter the share price varied from the R16 of 31 May to a high of R19 on 10 October. Clearly the company had grossly underestimated its bad debts, making a call on its shareholders to recapitalise the bank inevitable.

 

If the rights to subscribe new equity capital are taken up by established shareholders in the same proportion they currently hold shares, their share of the company is unaltered. They will be entitled to exactly the same share of dividends or the company (if liquidated) as before. In the case of a rights issue, established shareholders may however elect to sell all or part of their rights to subscribe to additional shares should these rights prove valuable, in which case they are giving up a share of the company but are fully compensated for doing so.

The key questions for shareholders and the market place are the following:

How well will the extra capital raised be employed by the managers of the company raising additional capital? Will the capital raised from old or new shareholders earn a return in excess of its opportunity costs? Will it earn a return in excess of the returns shareholders or potential shareholders might expect from the same amount of capital they could invest in businesses with a similar risk character?

Doing the numbers for the ABL rights issue

In the case of the ABL rights issue, the essential judgment to be made by the market place is whether or ABL will be worth more than the extra R5.482bn shareholders will have subscribed for in additional share capital, after 6 December. ABL had a market value of R12.33bn on 5 August when the rights issue was first announced. It would need to enjoy a market value of more than R17.88bn on 6 December (R12.34bn + R5.482bn = R17.88bn).

Given that 15.01m shares will have been issued by then, (the sum of the 685.28m new shares plus the 815.811m shares previously issued) the break even share price for the established shareholders would have to be approximately R11.88. A share price of more than this would confirm the success of the rights issue when the process has been finally concluded.

It is possible to infer the value of the rights implicit in the current R17.29 share price. R17.29 multipled by the 815m shares in issue gives a value of R14.09bn. If we add the additional capital of R5.5bn to this, we get an implicit post rights issue value for the company of R19.59bn. Dividing the R19.59bn by the 1501m shares gives an implicit post rights issue share price of R13.05. This is R1.17 ahead of the break even of R11.88. Hence the ABL capital raising exercise value has been value adding for shareholders.

Another way of measuring the value add is to compare the post rights value of ABL at R13.05 per share (R19.58bn) with the pre-rights issue value of R12.33bn to which the R5.5bn capital injection must be added. This amounts to R17.83bn and so the value add is R19.59bn – R17.83bn = R1.76bn.

The dilution factor – best to be ignored

The common notion is that issuing additional shares will “dilute” the stake of established shareholders, because more shares in issue reduces earnings per share. This assumes implicitly that the additional capital raised will not be used productively enough to cover the costs of the capital raised or earn more than the required risk adjusted return. But this is not necessarily so. Additional capital can be productively employed and can add, rather than reduce, value for shareholders.

 

In the case where balance sheets have been impaired, the ability to raise additional capital from shareholders in a rights issue adds value to the company by reducing its default risk. This would appear to be the main factor adding value to ABL. It is up to established shareholders in the first instance to approve any rights issue, on the presumption that it will add value to the stake they have in the company. If they approve and are willing to invest more it will be over to the market place to decide whether the gain in market value exceeds or falls short of the value of the additional capital subscribed.

 

In the case of a secondary issue of additional shares (rather than a rights issue) the answer is easily found by observing the share price after the capital raising. A gain in the share price would be evidence of a value adding capital raising exercise for both established shareholders who did not subscribe additional capital as well as for all those who did.

 

However to be a truly value adding exercise, these share price gains made after a secondary issue would have to be compared to market or sector wide gains or losses. If the share price gains were above market average, the success of the capital raising exercise would be unambiguous. 

 

Estimating the impact of a rights issue is complicated; a lower share price may be compensated for by more shares owned.

 

Estimating the value add in the case of a rights issue is more complicated. This is because the rights are typically priced at a large discount to the prevailing share price before the announcement. The share price after a rights issue is likely to go down, but this will be compensated for by the fact that the shareholders, subject to a lower share price, will have received more shares at a discounted price, in exchange for additional capital subscribed.

The reason for pricing the rights at a discount to the prevailing share price is to attract attention to the offer and by so doing, to make sure that the rights to subscribe additional capital will have market value and so will be followed and the additional capital secured.

 

Making the comparison with a sole owner of a business investing more capital in it.

 

For any sole owner of a business enterprise injecting more capital into his or her business, the nominal price attached to the shares in issue would be irrelevant. He or she still owns all the shares.

 

When a sole owner decides to add capital to the private unlisted business, the test over time will be whether or not the business comes to be worth more than the extra capital invested – to which an opportunity cost should be added. That is what the same capital might have realised in an equivalently risky alternative investment.

 

The same is true of a rights issue in a listed company except, that if the shares are actively traded, the judgment of the market place on the wisdom in raising additional capital is immediate and continuous. Shares in a rights issue are being issued to shareholders in the same proportion to which they own them. As with a 100% owner, they would be issuing shares to themselves and their share of the company, after the rights issue, will remain the same should they follow their rights.

 

The rights issue price therefore is largely irrelevant to the established shareholders. What matters is the amount of capital the shareholders are called upon to subscribe to and what this capital they have subscribed for will come to be worth, when the rights issue and the capital raising exercise is concluded.

 

Why a large discount to the prevailing share price can be helpful to the success of the rights issue

 

This capital intended to be raised can be divided into a larger or smaller number of shares by adjusting the price at which the rights are offered without any important consequence for current shareholders – other than those who are financially constrained and therefore unwilling to come up with additional capital. They therefore would prefer not to take up their rights and to sell part or all of their rights to subscribe additional capital, presuming these rights had a positive value.

 

The same would be true for any underwriter that presumably would prefer not to have to take up their rights. For the underwriter the larger the discount the better; the larger the discount the less likely they will be called upon. One wonders if the underwriting commission properly reflects this trade off (as it should). For the underwriter, as for any shareholders less willing to follow rights, the larger the discount (and so the more additional shares issued) the better. A large discount to the prevailing share price will ensure an active market for the rights they wish to give up.

 

Conclusion

 

So far so good for shareholders in ABL following their rights issue. By agreeing to support the rights issue they have added value to the shares they owned. The market, as well as the shareholders, have so far voted in favour of the rights issue. Had the shareholders decided not to support the rights issue and proved unwilling to risk additional capital, the future of the bank might well have been regarded as much less certain and the share price damaged even more than it was. The market would have regarded any failure to support a rights issue as negative for the future of the Bank. The decision by shareholders to re-capitalise the bank was their vote of confidence in the management to realise good returns on capital in the future, even though they may have blotted their copy book. Forgiveness can be divine – but also value adding.

US yields: Good news and bad for emerging markets

 

The importance of the US economy for the SA economy and its financial markets was again demonstrated last week. Some good news about the state of the US economy came in the form of the Institute of Supply Managers’ (ISM) latest report on manufacturing activity. This indicated good underlying growth, sending US long term interest rates higher on Friday.

SA yields moved in the same upward direction. More importantly, the gap between SA and US yields widened on Friday 1 November (as we show in the chart below), indicating that more rand weakness is expected over the next 10 years than was expected the day before.

 

US 10 year bond yields rose from 2.48% to 2.62% on Friday. These long term rates had earlier approached 3% after news of possible Fed tapering entered the markets in late May 2013. By tapering we mean reducing the monthly Fed injections of cash into the banking system, now running at US$85bn a month.

The manufacturing sector indicator was better news for the US economy than for emerging market (EM) economies. The US economy may be in a position to withstand higher interest rates when the Fed eventually begins tapering its injection of additional cash into the system. But higher interest rates are not called for in most emerging market economies, including the SA economy (at least not for now).

In the figure below we show how the S&P 500 Index outperforms the JSE (and the MSCI EM Index, the emerging market benchmark) when the gap between US and SA (and other EMs) interest rates widens and vice versa when the yield differences narrow.

 

 

In due course any sustained strength in the US economy will percolate through to the rest of the world and its stock and currency markets. But until such dispersed economic strength is apparent, investors in emerging markets must hope for a slow, steady recovery in the US and for not significantly higher US long term rates. The chart below shows that the recent weakness in the rand was shared by other emerging market currencies.

Thus it seems clear that for now, the more the Fed delays tapering, the better for EM economies and their stock and currency markets.