Author: Brian Kantor

South Africans abroad: Return of the diaspora

 

The return of skilled South African from abroad has been a boon to the economy

SA may have made it difficult for firms to hire skilled foreigners. It has not done much, fortunately for the sake of the economy, to inhibit the flow of skilled South Africans back home. It should be doing all it can to encourage the diaspora to come back home.

The numbers of returning South Africans reversing the brain drain has been very impressive. I have been given an estimate of the number of returning professionals and managers by employment placement firm Adcorp, which is in a good position to know the details. The number Adcorp estimates is a very impressive 370 000 skilled migrants who have returned to SA since 2009. In recent years the SA economy has managed to do without attracting skilled foreigners in magnitude by absorbing large numbers of its own. Some sense of the importance of these returnees for the economy will be indicated below.

As may be seen in the figure below, the average real wage at which Adcorp was able to place young professionals or managers doubled through the SA economy boom years between 2003 and 2008, from R150 000 a year in 2003 to R350 000 in 2009. To convert these salaries to 2013 money, multiply by about 1.3 times. In recent years these real salaries at which Adcorp has been able to place clients has declined significantly. Clearly South African firms hiring skilled labour could have benefitted from access to immigrant skills before 2009 – just as they have benefitted from migrant skilled labour since.

 

Putting SA skilled migration trends in context

To give a better idea of the importance of 370 000 skilled entrants to the SA labour market we can refer to data supplied by SARS in its recently issued 2013 Tax Statistics, that can be found on the national Treasury web site. SARS reports 15 418 920 individuals as registered for PAYE. Not all potential income taxpayers earn enough to have to pay income tax (more than R60 000 a year in 2012). These numbers of registered taxpayers has increased dramatically in recent years as firms were forced to include all workers in their tax filings from 2011.

 

Of the 15.4m registered workers, some 5.1m actually paid income tax. 3.2m of these taxpayers earned a taxable income of more than R120 000 – perhaps qualifying them as skilled. These 370 000 returning migrants therefore represent more than 10% of the skilled labour force.

Who pays the tax – and some dissonance

It is of interest to note that 338 724 taxpayers reported taxable income of more than R500 000 in 2012. Of these, 73 250 taxpayers enjoyed taxable income of more than R1m in 2012, of whom 16 952 earned between R2m and R5m; while a mere 2 787 taxpayers reported taxable income of more than R5m.

What makes these statistics especially interesting is that the 15.4m taxpayers registered with SARS compare favourably with the employment numbers recorded by Stats SA in its Quarterly Labour Force Survey that records employment and unemployment from a survey of households. Stats SA reports a labour force of 18m of whom 10m only are estimated as formally employed.

 

Such grave dissonance between the numbers of employees recorded by SARS and by Stats SA needs to be urgently resolved if we are to say anything useful about the SA labour market and the impact of immigration and migration on it and design policies accordingly.

The greater the supply of skills the better the economy – and the poor stand to benefit most from skilled migrants.

For SA Jewish Board of Deputies,  The Big Immigration Debate- what type of immigration policy should South Africa adopt? With remarks from Naledi Pandor, Minister of Home Affairs, Mamphela Ramphele, Cris Whelan, Rapelanf Rabana and myself

Cape Town, 31st October 2013

Why immigrants are good for economic development

Increased supplies of any valuable resource, natural resources, fertile land, convenient waterways, minerals  etc as well as of labour or capital are helpful to an economy- they bring more output and incomes, including revenue for the Government. Immigrants not only add to the potential supply of labour they can add to the supply of capital as well as of enterprise. By capital one means not only their savings but of more importance the value of the skills they have acquired through education or training and through on the job learning in their home countries.

Immigrants are a self selected group – they have get up and go- a willingness to escape poverty or the lack of opportunity at home. They are therefore likely to have an above average degree of enterprise and risk tolerance.

The (present) value of their skills – realised in the production of goods and services – and represented by the employment benefits they earn – over and above those earned by unskilled workers with almost only their energy to offer – is described by economists as human capital. It can be calculated in a very similar way in which the present value of some flow of income from a machine or building can be estimated. Human capital is created through a process very much like that undertaken when more tangible capital, physical plant and equipment is added to the capital stock. It typically takes a willingness to save , to give up the current consumption of goods and services – while undergoing training or an education – for the sake of increased incomes and consumption in the future. In other words individuals save to invest in their skills the returns from which will be enjoyed over time in the form of extra income and additional consumption that comes with higher incomes. The returns from investing in human capital- the extra income associated with extra years of education- can  be very high indeed which is why such savings and investment activity is eagerly undertaken.

Often this training and education, the generation of human capital, will be highly subsidised by governments- that is by taxpayers hoping for a return on their contributions in addition to that realised by the better skilled individuals themselves. That is to say a better skilled or educated population generates positive externalities for the community at large.

The case for encouraging the immigration of skilled labour is for the host society to benefit from these externalities. That is to gain benefits beyond those realised by the migrants themselves, when given the opportunity to apply their skills or enterprise in the economy to which they have migrated .

Migration has income (output) effects but also influences income differences.

The extra supply of migrant skills or energy will have an influence on not only on total output (GDP) and incomes but also on real or relative employment benefits. That is on the relative or comparative incomes of the better off who benefit from human capital and the less well off who command very little of it. An increased supply of skilled workers will tend to reduce their scarcity value. By the same token an increased supply of skills will increase the relative scarcity of unskilled labour. The more capital, including the more human capital available to an  economy, the higher will tend to be the demand for and the so the real value of lower paid, less skilled labour

It seems clear that the value (real wages earned) earned by relatively unskilled labour local labour will benefit from an increased supply of human as well as physical capital. The more capital made available to an economy relative to its supplies of labour, the greater the scarcity of labour, the more demand for such labour, the more productive such labour and so the greater will be its rewards as employers compete for their services.  Workers with equal strength have long commanded a higher scarcity value in the US compared to China because of the relative abundance in the US of natural resources as well as of capital. Adding capital is very helpful to those with only their strength to offer employers – it is less obviously welcome by those advantaged with skills, human capital, who might resent the competition and the pressure on their employment benefits.

The political resistance to the migration of skilled workers would most obviously come from the economically advantaged, those with valuable education and skills – not those disadvantaged for want of education or training. The political resistance to the migration of unskilled labour will surely come from the relatively disadvantaged through lack of skills. Those in possession of scarce skills or capital more generally will have a strong economic interest in encouraging unskilled migrants. Less expensive labour intensive services for the homes of the better off, is an obvious benefit.

South Africa’s immigration practice has by design or practice been helpful to the advantage South Africans- and not helpful to the poor.

South Africa’s policies with respect to immigration- allowing by accident or design relatively free access for unskilled labour – from Zimbabawe or elsewhere in Africa- while by accident or design – raising barriers to the migration of skilled labour have surely been helpful to the those advantaged with skills or capital while being generally unhelpful to established unskilled labour.

Potential workers (unskilled and skilled) will migrate from regions with lower real employment benefits to those that offer more, if opportunity presents itself. By so doing all other things remaining the same they will add to the scarcity of labour in the home region and reduce it in the host region. Employers in the host region will welcome more labour and those in the home region will find their employment costs uncomfortable. The flow of people as the flow of capital is usually a response to growth and so the prospect of higher returns. Faster growing nations and regions attract workers and capital while slow growing regions repel labour and capital.

Push from conditions in the home country rather than the pull of an improved labour market in the host country can drive the flow of migrants

However there is the possibility of push rather than pull dominating outcomes in the labour and capital markets. Famine or failed nations can drive people and their savings away and help to depress returns in the host country that if growing slowly will find it more difficult to be hospitable. The case of people migrating away from Zimbabwe towards SA is a case more of push than pull. The case of skilled South Africans migrating away from the UK or the US after the Global Financial Crisis and its impact on employment opportunities is a further case of push more than pull.

South Africa may have made it difficult for firms to hire skilled foreigners. It has not done much, fortunately for the sake of the economy, to inhibit the flow of skilled South Africans back home. The numbers of returning South Africans reversing the brain drain has been very impressive. I have been given the number of returning professionals and managers by employment agency Adcorp- who are in a good position to know the details – as a very impressive 370,000 skilled migrants who have returned to SA since 2009. In recent years the SA economy has managed to do without attracting skilled foreigners in magnitude by absorbing large numbers of its own Diaspora. I will give some sense of the importance of these returnees for the economy at large below.

The impact on the remuneration of the professional classes in SA of this return is demonstrated by this figure shown below, also obtained from Adcorp. As may be seen the average real wage at which they were able to place young professionals or managers doubled through the SA economy boom years between 2003 and 2008 from R150,000 p.a in 2003 to R350,000 in 2009. To convert these salaries to 2013 money multiply by about 1.3 times. In recent years these salaries at which Adcorp have been able to place their clients has declined significantly. Furthermore the number of these placements by Adcorp has declined by as much as 60% No doubt in the face of the increased supply of skills provided by the returnees. Clearly South African firms hiring skilled labour could have benefitted from access to immigrant skills before 2009 – just as they have benefitted from migrant skilled labour since.

Source; Adcorp, Private Communication

 

Putting SA skilled migration trends in context

 

To give a better idea of the importance of 370 000 skilled entrants to the SA labour market we can refer to data supplied by SARS in their recently issued, 2013 Tax Statistics, that can be found on the national Treasury web site. SARS reports 15 418 920 individuals as registered for PAYE. Not all potential income taxpayers earn enough to have to pay income tax (more than R60,000 p.a. in 2012) These numbers of registered taxpayers have increased dramatically in recent years as firms were forced to include all workers in their tax filings from 2011. (See table below)

Of the 15.4m registered workers some 5.1m actually paid income tax. 3.2m of these taxpayers earned a taxable income of more than R120,000 – perhaps qualifying them as skilled. These 370 000 returning migrants therefore represent more than 10% of the skilled labour force. It will be of interest to note that 338,724 taxpayers reported taxable income of more than R500,000 in 2012, 73,250 taxpayers enjoyed taxable income of more than R1m in 2012 of whom 16,952 earned bwtween R2 and R5 million while a mere 2,787 taxpayers reported taxable income of more than R5m.

What makes these statistics especially interesting is that the 15.4 million taxpayers registered with SARS compare very favourably indeed with the employment numbers recorded by Stats SA in their Quarterly Labour Force Survey that records employment and unemployment from a survey of households . Stats SA reports a labour force of 18m of whom 10m only are estimated as formally employed. (See below)

Source; Stats SA QLFS

Such grave dissonance between the numbers of employees recorded by SARS and by Stats SA needs to be urgently resolved if we are to say anything useful about the SA labour market and the impact of immigration and migration on it.

Demanding valuations on the JSE: Sentiment or fundamentals?

Market watchers are well aware that share prices on the JSE have run faster than earnings. The price over earnings multiples have increased to their highest levels since January 2000. Is this rerating of the market irrational exuberance as many fear or has it a more fundamental explanation?

The rerating of the market owes much to the increased values attached to the leading industrial companies listed on the JSE. Their values have been rising significantly faster than their earnings and are now trading at close to 24 times reported headline earnings per share.

By contrast, the prices of resource companies have held up much better than their earnings, which have declined significantly, but are clearly expected to recover strongly. Reported JSE Resource Index earnings per share are more than 22% below their levels of a year ago. Financial companies on the JSE have not rerated. Their price to earnings multiples remained largely unchanged and remain undemanding of earnings growth.

While the share prices of the major companies included in the JSE Industrial Index have risen faster than earnings, it is perhaps less apparent just how well these companies have performed on the earnings front. We show below the progress of JSE Industrial Index earnings per share since 2003 when these earnings first took off after a long period of stagnation, especially when measured in real terms.

Earnings grew very rapidly until interrupted by the Global Financial crisis of 2008-09. The decline in these earnings was modest and temporary and then resumed an upward path about as steep as that realised between 2004 and 2008. This observation needs emphasis. Despite what will be regarded as well below par global and SA economic growth since 2009, JSE Industrial Index earnings per share have been growing as rapidly as they did during the boom years of 2003-2008.

In the figure below, we convert recent industrial earnings growth into real terms. Real industrial earnings growth has averaged about 9% per annum, or 15% in nominal terms, with little sign to date of a slow-down in the pace of growth. Indeed the pace of growth appears to be remarkably stable as well as strong.

Investors, it may be concluded, are paying up, not only for earnings but for strong and stable earnings growth. The question to be answered therefore is not so much as to why the market has rerated JSE industrial earnings – they surely deserve such a rerating based on past performance – but whether or not the impressive consistent pace of earnings growth can be sustained. Future performance will depend not only on the capabilities of managers, who have proved capable of growing earnings and realising consistently high returns on shareholder capital employed in what have been tough times, but also on a recovery in the pace of SA and global economic growth.

Good news for SA – US bond yields are at three month lows

With the US government back to its spending and borrowing ways until at least January 2014, long dated  US Treasury yields fell yesterday to their lowest levels  in four months three months. RSA yields followed suit also reaching their lowest levels since July. (See below)

 

RSA and USA 10 year bond yields (daily data)

Source; I-net Bridge and Investec Wealth and Investment

The difference between these yields may be regarded as the RSA risk premium or equivalently the average rate at which the ZAR/USD exchange rate is expected to depreciate over the next ten years. As may be seen this risk premium too has narrowed significantly since reaching its recent peak of over 5.5% p.a. in late August 2013. This was when US and RSA rates were at their recent highs on fears of QE tapering that have since been allayed. ( See below)

 The RSA risk premium (daily data)

 

Source; I-net Bridge and Investec Wealth and Investment

We have pointed to the key role played in global financial markets by US treasury yields. Emerging market equity, bond and currencies (of which SA is such a conspicuous component) are particularly exposed to higher US rates. As we suggested while rising yields might be good news about the improving state of the US economy rising yields in SA and other emerging market economies would not be at all helpful given that growth rates have been slowing down rather than picking up. For emerging markets, at least for now, the lower the US rates the better.

And so it has been proved. The decline in US rates has been very good news for the rand, the rand bond markets and also the JSE in rand  and USD.  In USD the JSE All Share Index has recovered strongly from its mid year lows and is now worth almost as much in USD as it was in January 2013. (See below)

 

US 10 year bond yields and the JSE (USD value)

Source; I-net Bridge and Investec Wealth and Investment

Again conventional wisdom about the rand has been proved wrong. It is a strong rather than a week rand that is good for the JSE. The factors that move the rand weaker or stronger- both for global and domestic reasons that encourage or discourage risk taking- are either harmful or helpful to the rand and simultaneously harmful or helpful to the USD as well as the rand value of SA listed assets.

Lower interest rates in the US have been good news for the rand and rand denominated stocks and bonds. The value of almost all financial assets measured in rands and dollars have moved move in the opposite direction to the rand cost of a dollar. Or if preferred, have moved in the same direction as the US dollar cost of a rand. Companies with predominantly dollar based revenues- are not in fact rand hedges- they do not gain value when the rand weakens – they simply lose less of their rand value than do the SA economy plays- when the rand weakens. They may also gain less rand and USD value when the rand strengthens. It would be better to regard companies listed on the JSE, whose operations are largely independent of the SA economy, as SA economy hedges rather than rand hedges.

 

 

 

Toll charges are not the problem, the way they have been determined is the problem

The SA National Roads Agency (SANRAL) very clearly misjudged its pricing power when setting the original tolls for the Gauteng commuter belt. Toll road charging is as much about politics as economics, as the Agency now knows only too well.

But what are the economic principles that inform SANRAL tolls? I trawled through the SANRAL website for answers and find very little by way of guidance. How “the right price” for a new road to be built and tolled is determined appears to receive very little attention or analysis in the documentation presented to the SA public by SANRAL.

There are some clues that indicate the tolling pricing philosophy. SANRAL pays close attention to the volume of traffic on its roads. To quote its Strategy: “Traffic data forms the basis of planning in SANRAL. Because it is important for SANRAL to have accurate traffic data for the entire national road network, it is covered by strategically positioned traffic counters.” Source: SANRAL Strategic Plan

SANRAL is also naturally well aware of its credit ratings and the strength of its balance sheets. Debt management would appear to play an important role in its tolling determinations , according to its Strategy Document:

“SANRAL has historically sought to reduce its dependence on transfers from the fiscus, using the strength of its balance sheet to finance the toll road programme…….. to allow it to continue its borrowing programme efficiently to fund the toll roads. The aim is to maintain the credit ratings at sovereign equivalent levels at all times. But the recent uncertainty around the implementation of electronic tolling on the GFIP has caused nervousness among investors. The rating agency has placed SANRAL‟s ratings on review for a possible downgrade.”

Not all of the extensive road network, for which the agency is responsible, is suitable for tolling, due to the lack of sufficient traffic to cover even the costs of collecting the tolls. But the costs of maintaining and extending the road network are formidable and for meeting this responsibility, the revenue from tolls (where they do cover their costs of collection) are for SANRAL a more helpful alternative source of finance than grants from the National Treasury.

The Toll Budget proposed in 2012-13 illustrates the financial objectives for SANRAL, presuming it got its way with tolls. Income from tolls were proposed to increase from R3.69bn in 2012-13 to R6.34bn in 2014-15. Expenditure on operations was to rise much more slowly, from R2.42bn to 2.84bn over the same period. That is to say, operating profits would rise from R1.27bn in 2012-13 to R3.5bn in 2014-15.

This improvement would go some way to meeting the growing finance charges associated with a massive increase in capital expenditure on roads to be tolled, that occurred between 2008-9 and 2011-12, as well as the extra debt associated with this capital expenditure programme. Capex of R25.37bn was incurred over these years and funded largely with debt. This burst of capex on toll roads according to the Toll Budget will slow down to R2.24bn in 2012-13, R1.45bn in 2013-14 and R1.58bn in 2015-16. This mixture of rising operating profits and declining capex and debt issues would clearly improve the SANRAL balance sheet.

The strong indication is that, with these balance sheet objectives very much in mind, the guiding principle in determining the tolls charged is based largely upon what the expected, closely monitored, traffic will bear. In other words, the tolls are set to maximise revenue. The more traffic, the more essential the route to be travelled, the stronger the demand and so the higher the tolls, would seem to be the modus operandi. In other words the tolls are set independently of the costs of building and maintaining the roads, with the most popular routes producing the largest operating surpluses.

The transport engineers might call this a pure congestion charge. It is not a user charge system but a system for cross subsidising users.

It is good economics to apply user charges as an alternative to general taxation, from which the taxpayer may receive very little benefit. The Gauteng commuter, not the Cape Town commuter, should pay for Gauteng roads. Nor should the Cape Town or Gauteng motorist be expected to pay for the costs of using the little used road from Calvinia to Upington.

But then how much should the Gauteng commuter be expected to pay? Not surely as much as the Gauteng traffic could bear. Given the lack of alternative routes and transport this could be a very high price indeed – as SANRAL originally intended.

The right price for a new toll road would be a toll that could be expected to generate enough revenue and operating surplus to cover all costs of building the road, including the opportunity cost of the capital employed. It would be inflation protected. If, in applying this principle, the right price can be expected to be generated over the estimated life of the asset (say 20 years), providing revenues sufficient to cover all costs, including a (low) risk adjusted return on capital, then the road should be built. If this condition cannot be met, either the road should not be constructed at all, or some explicit subsidy from the taxpayer would have to be in the budget for the road, using the same pricing principles. This economically sensible “right price” for a new road, for which there would be good demand, as for example an improved Gauteng road network, would surely be far lower than a “what the traffic can bear” charge.

It is essentially this pricing principle that the energy regulator has used to determine the price that Eskom, with its monopoly power, is allowed to charge its customers. Nor did NERSA allow debt management considerations to influence its price determination. As with a new power station, a new road, bridge or flyover is fully justified when the price charged is sufficient to generate enough revenue to cover all costs and to provide an appropriate return on capital. And using debt to fund infrastructure also makes sense, providing the returns justify the capital expenditure. Debt management should not be allowed to influence prices.

Roads are highly productive. Building new roads or access to them can make every economic sense when the right price is charged to their users. An active road building programme for the SA economy is urgently called for, especially where demand for roads is most intense, as it is around Gauteng or Cape Town. Yet the right price to be charged to justify this programme should not be seen as a congestion charge designed to force the use of alternative transport – or as a way of cross subsidising the building of roads that cannot cover their costs.

It calls for a user charge sufficient to cover costs of building and maintaining roads, wherever possible and no more; or for an explicit subsidy that the tax payer will be called upon to supplement user charges when revenues from practically feasible user charges would fall short of the requirement to cover all costs.

These – economic return on capital – pricing principles have not guided SANRAL. That the originally intended Gauteng toll charges proved politically impossible has unfortunately made sensible toll charging of the right kind indicated less likely. It is likely to have a negative impact on productive road building in SA.

SA equities: Foreigners buy when the locals sell – this can be good news for the rand

For every foreign buyer on the JSE there is an equal and opposite domestic seller. The question therefore is what should make local institutions wish to sell when foreigners are keen to buy? Or, put another way, what would make foreign investors think prices on the JSE were too low (hence the buy decision) and domestic portfolio managers simultaneously think them too high (hence their sale)?

The answer may have something to do with the constraints faced by fund managers. For South African funds these come in the form of regulations limiting their exposure to equities in general. No more than 75% of a retirement fund can be held in equities and not more than 25% of the portfolio can be held abroad. Hence, when share prices run (especially when the rand weakens) they may well exceed these limits and be forced to rebalance their portfolios. Foreign investors, by contrast, are typically underweight exposure to SA and can easily add to SA weights, should they wish to do so.

Chris Holdsworth in his latest October Quantitative Strategy Report for Investec Securities published on 10 October shows how SA institutions, given strong performance by equities both here and abroad, are currently heavily weighted in equities:

He also shows that the SA institutions react to strongly to equities outperforming bonds, as they have done recently by reducing exposure to equities, that is selling equities to buy bonds, as shown below:

Hence they are now likely to be selling equities to them, likely to be buying bonds, at least to some extent, from them and also likely to be gradually repatriating funds from abroad to satisfy the 25% limit.

Holdsworth calculates that should equities outperform bonds by 12% over the next 12 months, SA institutions could sell up to R100bn of equities in rebalancing portfolio switches. If so the large current account deficit and the rand will receive considerable support from inflows into the equity market. A strong rand however improves the case for the bond market by inhibiting any thought of higher short term interest rates. The SA interest plays, property, banks and retailers – that benefit from low interest rates – become particularly attractive when interest rates become more likely to go down rather than up.

Expectations of rand strength (and lower interest rates) is not a consensus view in the market place and so there is clearly room for a rand and interest rate surprise. Any strength in emerging equity markets generally will support both the JSE and the rand and further encourage SA fund managers to reduce exposure to JSE listed securities encouraging foreigners to buy. That the rand is an emerging market equity play is no accident. It is partly also a result of regulation of portfolios.

The Hard Number Index: The current state of the SA economy

Information for September 2013 on new vehicle sales and the supply and demand for notes issued by the Reserve Bank has been released. These two very up-to-date hard numbers make up our Hard Number Index (HNI) of the immediate state of the SA business cycle.

These indicate that the pace of the economy is little changed from that of the previous month. The SA economy, according to the HNI, is still growing but the pace of its forward momentum, modest enough as it is, has stalled.

Vehicle sales of 54 281 new units in September were nearly 2000 units fewer than those of August 2013; but when measured on a seasonally adjusted basis sales declined by a lesser 700 units. A time series forecast indicates that by this time next year, the industry will be supplying units to the SA market at an annual rate of 632 390 units, slightly down on the current annualised rate of 649 400 units. The strike action in the motor industry in September appears to have affected export volumes – these were down sharply from the previous month, more than sales made at retail level. No doubt inventories, supplemented by imports, kept sales going with the influence of any supply disruptions postponed.

Given the recent stability of the rand, though at lower levels, it may be presumed that sales aimed at pre-empting expected price increases would have been less of an influence. Low financial charges by banks eager to lend, secured by the vehicles themselves, no doubt remained a positive influence on sales volumes.

The most important influence on sales over the next 12 months will be the direction of interest rates. Clearly the showrooms, as much as all retailers, would appreciate lower, not higher, interest rates that the weak state of the economy surely justifies. As somebody told me many years ago when asked about the determination of the price of a new car: “How long is a piece of string?” What you pay for a new vehicle is a mixture of financing charges, estimated residual values as well as the prices on the lists in car magazines. The pricing of a cell phone call and the telephones used to make them – subject to regulation of some of the charges cell phone companies levy on each other – are as difficult to understand and predict. The presumption that a reduction in some regulated charge made by cell phone companies will lead to an equivalent reduction in company revenue, is much too simplified a view of price-setting behaviour.

The supply and demand for Reserve Bank cash (the other half of the HNI) continues to grow at a strong but also declining growth rate, as we show below. This demand for cash reflects in part informal economic activity. The forecast of real growth of slightly below year on year 4% this time next year is again consistent with stable, but unsatisfactorily slow growth in household spending. On this evidence there is no case at all for an interest rate increase in SA. An increase would slow down growth further and would have no discernable influence on the inflation rate that will take its cue from the exchange rate that, as we have often argued, is beyond the control of the Reserve Bank. Rather, an interest rate cut is called for to sustain growth in spending and such growth is likely to attract foreign capital to support the rand and improve the outlook for inflation.

 

The SA economy needs help – and not just from foreign investors

In 2003 the SA economy took off and the current account deficit of the balance of payments (exports minus imports of goods and services plus the difference between interest and dividends earned from offshore investments and paid out for them) increased very significantly.

From an unsatisfactory period of slow growth and a minimal current account between 1995 and 2002, after 2003 faster growth in SA was understandably financed in greater measure with the foreign savings the economy was able to attract to help fund economic growth. Given the low rate of domestic savings, the limits to SA growth are set in part by the willingness of foreigners to invest in SA debt and SA business. Without these foreign savings, the growth potential of the economy would be seriously constrained. Foreign capital makes the difference between a rate of capital formation of an unsatisfactory 14% to 15% of GDP to a more helpful possible 20% rate of additional investment in plant and equipment.

Growth, or rather expected growth (of a business, or an economy that is the aggregation of business and government activity) attracts extra capital and the failure to grow repels capital and investment. Economic growth, supported by capital inflows, is much to be welcomed. The current account deficit indicates the supply of foreign capital, to which a highly positive connotation can be given. It also measures the demand for foreign capital by domestic economic agents – a demand that indicates vulnerability to the possibility that such demands may not be met.

As we show below, the pace of economic growth in SA was disrupted by the Global Financial Crisis of 2008 and the deficits fell away. However since 2011, the growth rates have been very subdued and yet the deficit has remained very large. Clearly economic growth rates have remained unsatisfactorily low, as has the domestic savings rate, itself in part a casualty of slower growth in incomes and higher taxes on them, while the dependence on foreign capital (represented by the current account deficits) has remained very large.

The ability of SA to continue to attract foreign capital is welcome. Without it the economy could not grow even as slowly as it has done. Without it, the exchange rate would be weaker still, the outlook for inflation worse and the danger of higher interest rates greater – all of which would further diminish growth rates and the prospects for growth.

But attracting foreign capital is no free lunch for the economy. It is equivalent to having to sell the family silver to keep food on the table. The family silver sold is measured by the difference between income paid to foreigners in the form of dividends, interest and income received from them. The deficit on the debt and asset service account of the balance of payments has been widening as more of SA business is owned by foreigners and more debt issued to them. Income from capital invested abroad by South Africans made abroad has also increased but not nearly as rapidly as income paid out. This foreign income deficit is responsible for a large proportion of the current account deficit: about a third of it, or 2% of GDP in 2013, which is down marginally on recent years because of less profitable SA business paying out less in the form of dividends to offshore owners.

The objective for SA economic policy in these unsatisfactory circumstances of slow growth and higher inflation should be to make every effort to increase output, employment and savings. Two obvious initiatives would make a very large difference. The urgent call is for reforms that would encourage the demand for and supply of potentially abundant less skilled labour by repealing closed shop and minimum wage laws. Imposing secret ballots on strike proposals by union leaders would surely help sustain production in the factories and mines, which has been so disrupted recently.

The other clear route to higher savings and investment output and employment is to reduce income taxes on all business in exchange for more capital invested and more jobs created. A bias towards taxes on consumption rather than income is as urgently called for as labour market reforms.

Inflation targets are proving to be a very unhelpful guide to monetary policy settings

With the SA inflation rate above the upper band of the target it was inevitable that the Reserve Bank’s Monetary Policy Committee (MPC)  at its latest meeting and Press Conference, would focus on inflation and the risks to it rather than the unpromising growth outlook and the prospect of even slower growth to come. The question that should have been asked of the Governor and the members of the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest- that higher interest rates lead to less inflation and vice-versa.

The answer, following conventional theory, might have been that higher rates would slow down spending and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans. The evidence is however very strong that interest rate changes in SA do not have any predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile, highly independently of SA short term interest rates, for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea when domestic demand is growing too slowly rather too rapidly for economic comfort. Higher interest rates in these circumstances are a bad idea because higher interest rates leads to still slower growth in the economy and because growth determines capital flows and so the exchange value of the rand, higher short rates imposed by the Reserve Bank may in fact lead to more rather than less inflation.

In the figure below this point is made. It is a scatter plot of daily percentage moves in the ZAR/USD exchange rate and short term interest rates, represented by the 3 month Johannesburg Inter bank rate (JIBAR). As may be seen there has been about the same chance of an interest rate move leading to a more or a less valuable rand since January 2008. The correlation statistic for this relationship is very close to zero, in fact 0.000006 to be exact.

A scatter plot- daily percentage moves in short rates and the ZAR ( daily data January 2009- September 2013)

Source I-net Bridge Investec Wealth and Investment

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy that depends, for want of domestic savings, on a highly variable flow of foreign capital. This leads in turn to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends – while using interest rates as far as they can be used – to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do until the global capital markets calm down. It is just as well that in the past week the rand has strengthened, improving the inflation outlook and so helping to keep the Reserve Bank on the interest rate fence, where it should stay.

If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. The weakness of domestic spending calls for lower not higher interest rates. Lower rates would will help stimulate faster growth. And so doing would add expected value to SA companies, especially to those heavily exposed to the SA economy and the domestic spender. This would add to the incentives for foreign investors to buy JSE listed shares. It would also encourage foreign controlled businesses in South Africa to add to their plant and equipment and retain cash rather than pay out dividends to foreign shareholders. Such a more favourable outlook for the SA economy and the capital that flows in response may well strengthen the rand and improve the inflation outlook.

A focus on inflation targets, beyond Reserve Bank control via interest rate determination, prevents the Bank from doing the right thing for what interest rates do influence in a consistent way and that is domestic spending. Lower interest rates and the demands for credit that accompany them can stimulate demand and higher interest rates can be used to discourage demand when it becomes excessive. When domestic spending growth is adding significantly to domestically driven pressures on prices higher interest rates are called for. This is clearly, and by the Reserve Bank’s admission, not the case now. The opposite is true, domestic demand is more than weak enough to deny local price setters much pricing power. And in these circumstances higher wages conceded to Union pressure lead to fewer jobs and on balance less rather than more spending. Prices are set by what the market will bear rather than operating costs. Operating margins rise and fall with operating costs- – in the absence of support form customers- and prices do not necessarily follow.

A target for what is judged to be sustainable growth in domestic spending might be a useful adjunct to monetary policy that regards low inflation as helpful to economic growth. A target for inflation, without a predictable exchange rate, just gets in the way of interest rate settings that should be helpful for growth.

Inflation targets are proving to be a very unhelpful guide to monetary policy settings

With the SA inflation rate above the upper band of the target it was inevitable that the MPC at its latest meeting and Press Conference would focus on inflation and the risks to it rather than the unpromising growth outlook and the risks of even slower growth to come. The question that should have been asked of the Governor and the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest.

The answer following conventional theory might have been that it would slow down spending – even more than it has slowed down to date – and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and so harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans, as it might well do. The evidence is very strong that interest rate changes in SA have had no predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea in these circumstances. A bad idea because it may well lead to higher interest rates, slower growth and because growth determines capital flows, may mean more rather than less inflation.

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy like the SA economy that is dependent for its growth on a highly variable flow of foreign capital that leads to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends while using interest rates as far as they can be used to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do. It is just as well that in the past day the rand has strengthened improving the inflation outlook and so helping to keep the Reserve Bank on the fence where it should stay. If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. These will help growth and by improving the incentives for foreign investors to buy South Africa may well strengthen the rand and improve the inflation outlook.

Talking about the strong Rand today it was highly instructive that the stronger rand was accompanied by higher Rand values attached to almost all financial assets. Almost all equities appreciated – global plays for example NPN or BTI or SAB became more valuable in rands – despite the stronger rand – as did the SA plays – banks and retailers – as did almost all Resource companies, especially the gold miners that might ordinarily be expected to suffer from rand strength and benefit from rand weakness. In other words there were no rand hedges on the JSE on the 18th September (.i.e. companies that benefit in rand terms from rand weakness or are harmed in rand terms by rand strength).

There is in fact very little recent evidence of rand hedge qualities in JSE listed companies. This is because rand strength reflects good news about the global and the SA economy – for example lower interest rates in the US – absent tapering – that is good economic news. The good news effect on the dollar value of JSE stocks outweighs the effect of translating higher dollar values into stronger rands. Hence no rand hedge characteristics are consistently to be observed. The opposite is mostly true when the rand weakens on bad news. A weaker rand does not usually compensate for the lower dollar prices of globally traded shares when the outlook for the global and or SA economy deteriorates. Therefore investors should hope for a strong rather than a weak rand. But is remains true that the SA economy plays- businesses that benefit from lower interest rates that may well follow a stronger rand and the lower inflation that follows-  stand to benefit even more than the global companies listed on the JSE that generate a much smaller proportion of their revenues and profits from the SA economy.

Takeaways from the SA Reserve Bank Quarterly Bulletin, September 2013

The Reserve Bank has filled in the picture of the SA economy in Q2 2013 adding expenditure, balance of payments accounts as well as money, credit and financial statistics to numbers released earlier by Stats SA for domestic output (GDP). Growth in GDP at a seasonally adjusted rate of 3% in Q2, picked up momentum from the 0.9% rate recorded in Q1 2013. GDP grew by a pedestrian 2.5% in 2012. The modest acceleration in output (GDP) growth in Q2 was attributable almost entirely to a strong recovery in manufacturing output, that grew at an annual equivalent rate 11.5%, having declined the quarter before at a 7.9% p.a. rate. Mining output, by contrast, having grown by a robust 14.8% in Q1, declined at a 5.6% rate in Q2. Agricultural output declined further in Q2 at a 3.7% rate. Growth rates of the tertiary sector measuring activity in services, retail government and financial services, for example, are far more stable than those of manufacturing, mining and agriculture. But growth in service activity has been disappointingly slow of late growing by a mere 2.4% p.a. in Q1 and 2.3% p.a. in Q2 2013, having grown by an only slightly higher rate of 3% in 2012. (see below)

It should be appreciated that the SA economy is dominated by the supply of and demand for services that now accounts for 69% of all value added (the primary sector, mining and agriculture delivers but 11.85% of the economy while and manufacturing has a 12.5% share when measured in current prices. Outcomes in both the trade sector (wholesale and retail and catering activity) with a 16% share of the economy and financial services with a 21.5% share are far more significant for GDP and its growth than trends in manufacturing and mining

 

It could be said that the currently depressed growth rates are the result of a lack of demand for goods and especially services rather than a lack of potential supply of them. Final demands for goods and services from households firms and the government grew by only 2.5% in Q2 2013, well down from the 4% pace of 2012. Gross Domestic Expenditure that adds changes in inventories to final demands grew at a marginally faster rate of 2.7% in Q2 also well down on the 4.1% increase recorded in 2012. (See below)

Real gross domestic expenditure

Clearly the growth in aggregate spending is slowing down markedly though not all categories of spending were so negatively affected. Household spending on durable goods (cars, appliances etc) grew at a remarkable 11.8% annual rate in Q2 while growth in demand for semi-durables (shoes and clothes) also grew very strongly in Q2 at an 8.2% rate, sustaining the extraordinary growth rates of the past few years. By contrast a decline in the demand for the all important service sectors was recorded in Q2 – again continuing the very weak growth trends of the past few years. (see below)

The explanation for such dramatically divergent trends is in the very different prices being charged. The prices of services(largely influenced by administrative action and regulation) have risen much faster than the prices of clothing and durable goods the services of which are consumed by households. The table below makes this very clear. In the year to date the prices of consumer goods on average rose by 6.3% – the prices of clothing by 3.3% and that described as (durable household content and equipment at an even lower 2.9% while the prices of ‘communication” – telephones and calls rose by a well below average by 1.8%. Clearly prices, relative prices matter for these demand trends.

The weaker rand threatens the relative price trends that have been so favorable for the consumers and retailers of durables and semi -durables. A strong rand is good for consumption generally because it helps makes consumption goods cheaper and lowers the costs of finance, though some forms of consumption benefit more than others. Vice versa a weak rand drives consumption growth lower prices and interest rates higher. Indeed lower levels of consumption and higher levels of production for export and as competition with imports is a necessary part of the adjustment process to a weaker real rand.

The rand weakened because supplies of foreign capital so essential to fund even sub-par 3% growth in SA were made available on less favorable terms. Partly for SA specific reasons- especially the strike action on the mines and partly in recent weeks for global reasons- higher interest rates in the US.

In recent days the SA specifics in the form of a threatened disruption of mining output- so important in the export basket- have seemed less threatening. The threat and reality of higher interest rates in the US has also become less damaging to EM currencies including the ZAR. The recovery in the ZAR especially Vs emerging and commodity currencies reflects some of this. The hope must be that a stronger rand – the result of more favorable global investor sentiment towards SA- will allow lower interest rates that are so badly needed to stimulate domestic demand. Without stronger demands for services, supported as it would have to be by more favorable terms on which foreign capital is made available to SA borrowers, that in turn leads to lower interest rates and more freely available credit, the economy cannot hope to escape any time soon from its current slow growth phase.

All tables and figures included are taken from the SA Reserve Bank Quarterly Bulletin, September 2013

The SA economy needs lower not higher short term interest rates. Will it get them?

The SA economy, according to our Hard Number Indicator (HNI) continued to move ahead in August 2013. Growth in economic activity remained positive in August. However the forward motion of the economy appears to be losing rather than gaining speed. Our very up to date business cycle indicator is based on two equally weighted hard numbers that are released very soon after the end of the previous month, unit vehicle sales and the note issue.

This Indicator, the HNI, has proved to be very relaible in recognising the turning points in the offcial business cycle, the coinciding business cycle indicator published by the S.A Reserve Bank, that is based on a larger number of economic indicators derived mostly based on sample surveys, not hard numbers, and therefore is only published at best two or three months later than the HNI.

As we show the HNI appears to have reached a plateau suggesting that the forward momentum of the economy that has picked up speed strongly since the recession of 2008-09 has now stabilised. The forecast also suggests that the economy may not grow any faster over the next twelve months. (See below)

The Hard Number Indicator of the Current State of the SA economy.

The components of the HNI are shown below. As may be seen the supply of and demand for cash continued to grow at a rapid rate in August 2013 in both nominal and inflation adjusted terms. The trend in the extra cash supplied by the Reserve Bank to the economy remains above a 10% p.a. rate though the trend appears to be declining. Adjusted for rising inflation the real growth rates remain above 4% p.a as may be seen. This growth must be attributed in good measure to underestimated informal economic activity that is cash intensive.

The cash cycle- rowth in the supply of Reserve Bank Notes

New unit vehicle sales, that have been such a source of strength for the economy over the past two years, appears to be losing momentum, as we show below. On a seasonally adjusted basis August unit vehicle sales on the domestic market were well down on July sales and suggest that new vehicle sales are unlikely to increase over the next twelve months. Yet if sales volumes can be maintained at current seasonally adjusted levels, such outcomes, in the light of the history of the sector would be regarded as satisfactory. Significant increases in exports of new vehicles, labour relations permitting, could add to motor manufacturing activity.

Growth in new unit vehicle sales to the SA market.

SA Unit Vehicle Sales. Annualised and Forecast.

The National Income Accounts released on August 27th estimated that GDP grew at an improved seasonally adjusted 3% rate in Q2 2013. However GDP in Q2 2013 was only 2% higher than year before. These growth rates must be regarded as highly unsatisfactory given the potential for faster growth. Such GDP outcomes would ordinarily call for lower interest rates. Unfortunately the times cannot be regarded as ordinary with the foreign exchange value of the rand, in company with other foreign capital dependent economies, under so much pressure form higher long term interest rates in the US.

The inflationary implications of a weaker rand therefore make lower short term interest rates less likely. Lower rates would be very helpful for not only vehicle sales but housing prices and employment creating residential construction activity. Were mortgage rates closer to five per cent than ten per cent a lively housing market and many more new houses would surrely follow.

Higher short term interest rates, incluinding the rates charged for mortgage or car loans would further slow down the SA economy and hopefully will be avoided. The weaker rand and the higher prices to be charged domestuic consumers will anayway be taking their toll of domestic spending. Already subdued domestic spending will be under enough additional downward from higher prices, particularly from higher petrol and diesel prices. Spending does not need further discouragement from still higher interest rates.

Higher rand prices for exported goods should however encourage the mining and agricultural sectors to produce more. Manufacturing activity should also benefit from incentives to export more and also as domestic producers compete with now more expensive imported goods for space on the shelves of retailers. But extra output and incomes can only be realised if the mines and factories stay open for business.

The rand is not only a play on US interest rates. It is a play on SA labour relations that deteriorated so badly a year and more ago at the Marikana platinum mine that saw the ZAR perform so poorly not only against the USD but also against other Emerging Market currencies.

An unexpected recent degree of realism about wage demands appears now to be influencing the SA labour market. The outlook for mining and manufacturing output has improved accordingly and the rand has benefitted to a degree from this. In recent weeks and days the ZAR has been a relatively strong EM currency and the Indian Rupee particularly weak, as we show below.

The foreign currency cost of a rand

This small degree of rand strength has been accompanied by some relief for long term interest rates in South Africa. These rates as they did throughout the EM world followed higher yields in the US higher after warnings of the tapering of Quantitative Easing entered the global financial markets in late May 2013. In recent days the gap between RSA and USA yields has also narrowed indicating a lower cost of forward cover and somewhat less rand depreciation expected over the next ten years. (See below)

Long term interest rates; RSA and USA

The interest rate yield premium. (RSA-USA ten year bond yields)

More of the same – that is SA specific reasons for a stronger rand linked to more production on the mines and in the factories –especially if accompanied by lower rather than higher US bond yields – would be especially welcome news for the SA economy. It would improve the outlook for inflation and perhaps allow for lower rather than higher short term interest.

But in the absence of such favourable forces the right monetary policy response to higher US rates and a stronger dollar would be to continue to leave the adjustment process to a fully market determined ZAR and to keep short term interest rates where they are .

The Hard Number Index: Looking to export prices and volumes to revive the SA economy – held up by domestic spending

By Brian Kantor

There are at least two strong features of the SA economy, notably domestic unit vehicle sales and the supply of notes. Domestic vehicle sales in the 12 months to July are being sustained at 66 2000 units, close to the record sales of over 700 000 units in 2006-7 terms. The growth rate in vehicle sales has declined but remains positive at about 5%, helped by low financing costs and low rates of inflation of the prices of new vehicles.

The Reserve Bank note issue has grown by more than 12% over the past 12 months. Growth has held up strongly over the past three months to July, though the trend would appear to be in decline to about a 9% rate over 12 months.

 

The demand for new vehicle sales of all sizes comes largely from the formal sector of the economy – those with access to bank credit – while the growth in the note issue reflects less formal economic activity of those who prefer cash to credit or debit cards. Both sources of demand have been very welcome to an economy under pressure.

We combine both of these very up to date series to form our Hard Number Index (HNI) of the current state of the SA economy with the note issue, deflated by consumer prices. The results are shown below. The Hard Number Index has moved higher but appears to be peaking. Growth in economic activity, while still positive, is slowing down.

This latest indicator of the state of the SA economy, of sub-par growth subsiding, will not come as much of a surprise to economy watchers. Growth in domestic spending has probably held up better than many would have predicted and meant the economy could maintain some forward momentum, despite the weakness of exports and export prices. But the economy could do with all the further help it can get from stronger demands from world markets to boost local production and incomes.

Sustained output of minerals and metals, less disrupted by strikes and walkouts, would be a big plus for growth. Higher prices for commodities coupled with better export volumes and revenues would also help the rand. A stronger rand would mean less inflation to come and lead to lower interest rates that could help sustain domestic spending. The problems in mining have not only damaged output and employment in mining and manufacturing; they have kept up interest rates. The domestic economy has deserved the lower interest rates that an improved foreign trade account and better than expected labour relations could help deliver.

Economic policy: The solution for poor project management in SA is private ownership

When a private company grossly mismanages a project designed to add revenues and profits or mismanages the project such that its capital costs grossly exceed budget, the management takes the blame. They may lose their jobs as well as their reputations, and the shareholders who appointed them have to bear the burden of a lower return on the extra plant and equipment created. In extreme cases the overruns and the waste of capital incurred may bring the company down, causing shareholders to lose all and debt holders to salvage what they can out of the loss making wreck.

In the case of a government-owned and regulated monopoly the outcomes for the management and the company may not be so severe. Unlike the private company, the regulator may be persuaded to allow the company to charge more to maintain a regulated return on the extra capital employed. Unlike the private company facing competition and market determined prices, largely beyond its control, the public monopoly may be able to cover its cost overruns with higher prices. With little alternative, the consumer will have to pay up and hope to economise on the more expensive essential service. The consumers, not the company, then have to bear the consequences of what might well be very poor project management. And the international competitiveness of all those who use the now more expensive service suffers accordingly. Factories and mines will then become less profitable, especially in export markets, because they will not be able to pass on higher costs, so discouraging further investment in their enterprises. And households will see their real disposable incomes taxed further, discouraging consumption of other goods and services.

Making customers rather than owners carry the proverbial can for poor project management is not only unfair – it covers up for poor management so encouraging managers to become less responsible and efficient.

Price and return on capital-regulated state owned enterprises play a critical role in supplying the SA economy with essential infrastructure, such as new power stations (Medupi) and new pipelines (Transnet’s new pipeline from Durban to Gauteng). The problem is that the managers of these state owned enterprises are not making a very good fist of project management. These important projects are well behind time and well over original budget.

Fortunately for the consumers of electricity or pipelines, the regulator is adopting a more critical approach to the costs, both capital and operating, claimed by Eskom and Transnet to justify higher prices. A report (Businessday/BDlive, Razina Munshi, 2 August 2013) commented:

“The National Energy Regulator of South Africa (Nersa) is investigating the near doubling of the costs of Transnet’s new multiproduct fuel pipeline from Durban to Gauteng, in a move that could herald closer scrutiny of big cost overruns on state infrastructure projects. The outcome of the probe could also have implications for petroleum pipeline tariff hike requests in the future……. Transnet originally budgeted R12.7bn for the project, but this soon rose to R15.4bn, and it quickly became clear that even that was conservative. The final price tag of R23.4bn includes the cost of pump stations in Durban and Heidelberg, still under construction….”

Commenting on Eskom’s claim for higher prices, Business Report (12 July 2013 ) said: “The failure to push through big-enough price increases has created a 225 billion-rand cash-flow shortfall as the company struggles to meet the continent’s biggest economy’s electricity demands.”

This cash flow shortfall – the difference for Eskom revenues between a 16% per annum price increase over five years and the 8% per annum increase granted by Nersa – helps reinforce the important point. If the consumers cannot be forced to pay up for management failure, then the owners have to.

The owner of Eskom and Transnet is of course the Republic of South Africa, ie the citizens whom the government represents. To overcome the huge cost overruns they, the people, have to come up with the extra cash, that is the extra capital required to keep Eskom and Transnet going. They have to borrow the money and pay the extra interest on the additional debt, and/or impose additional taxes on themselves to cover up for poor project management. Even if some of the people believe that others, not themselves, will be stumping up it is clear that the funds so raised and the taxes paid could be put to better alternative uses, for example building homes, schools or hospitals.

It is not at all clear why the people of SA would wish to take on these risks of poor project management that they need not have to do. The assets and activities of Eskom and Transnet could be privatised, as they are in many economies, with the current plant and equipment sold off at market determined prices. The pipeline would fetch a pretty penny at current regulated prices. In this way not only would the debt levels and interest expense of the Republic be reduced significantly, the exposure of the SA citizen to huge cost overruns would be eliminated. Shareholders in privately owned utilities with highly predictable revenue streams would willingly bear those risks, especially if the regulator offers them a fair risk-adjusted return on capital. And the Republic would also collect its normal share (28%) of the profits earned by a privately owned utility and the dividends paid out.

Little sympathy should be accorded to Eskom having to raise the extra debt to cover their cost overruns. A recent positive response by a private company, Exxaro/GDF Suez Energy to a Department of Energy call for participation in electricity generation (13 June 2013);if accepted, will allow this private company to build a new coal fired power station producing a respectable 680MW of electricity, to be delivered to the grid at presumably current wholesale prices set by the regulator for Eskom – plus inflation.

This indicates that the price of electricity in SA is now more than high enough to encourage private owners to risk their capital to supply additional electricity. No doubt the company has built in high enough returns on the capital it intends to employ to make the project viable. Should it succeed SARS will be looking to its normal share of profits. And should it fail to produce a profit, or even go out of business, the shareholders will have to stand up and bear the loss. Some other group of owners would then take over the plant at what will be a distressed price and hope to manage it better.

SA citizens would surely find this a better prospect than having to bear the risks of owning assets over which they have very little control and their managers do not appear to do a very good job of managing.

Turning Income into Wealth – something not necessarily under the control of the saver

Earning an above average income does not make you well off or wealthy. The best one can do is to save and hope for the miracle of compound returns to give you the retirement you aspire to.

It is savings not income that makes you wealthy

Earning an above average income does not make you well off or wealthy. You might spend it all on the good things in life and have nothing left over when the income from work dries up – as it must at some point in time when age, infirmity or injury undermines your income earning capacity. It is not only the body but the creative mind that may give in prematurely. The profligate actor, artist, musician, writer or sports star may have a brief life in the fast lane and have nothing left to show for it other than some great stories, unless they put away some of their extraordinary earnings. Mick Jagger and his ever rolling stones would be a notable exception.

 

Save and hope for the miracle of compound returns to give you the retirement you aspire to

Wealth is gained by saving – consuming less than your income and by investing the savings in (hopefully) income earning assets and, most important , reinvesting rather than consuming this extra income your wealth is bringing (at least until you need it to sustain your life style in the hoped for accustomed manner). By accustomed we would mean being able to consume as much or almost as much  as you did when you could rely on a more or less regular income from your work. A rule of thumb is that your wealth or capital should be sufficient to allow you to continue to spend at the rate equivalent to 75% of the real goods and services consumed before retirement. (The pattern of spending may well alter with age but the real volume of spending will ideally be well sustained). Sustaining this pre-retirement standard of living might require gradually drawing down capital to support these consumption demands.

 

Yet 75% of a low number may well remain a low number. Many would aspire to at least 75% of a large number rather than a small number. This means earning well, saving a good proportion of these earnings and perhaps, even more important, achieving very good returns on the savings made. High incomes, a consistently high savings rate and excellent returns on savings is the path to true wealth – it is a much steeper path than one that could lead to a comfortable retirement for the middle income earner.

 

How to get more than comfortable: that is, how to get rich

True riches, achieved by the relatively few, are when the wealth or capital that has been accumulated over a life time can provide for a very comfortable life style without the wealth owner having to consume any of that wealth. That is to say, a stock of capital that generates enough income to provide for both generous consumption demands and enable further savings to not only preserve, but indeed to add to the real value of the capital owned.

 

There are perhaps two obvious routes to conspicuous wealth (if not conspicuous consumption) for the self-made man or woman. The first is to establish and manage-own a very successful business. Success in this way will very likely mean not only the successful execution of a business model. It may require mortgaging the home to raise the initial funds to start the venture and then to sustain growth by reinvesting a high proportion of the cash flow generated by the enterprise. This process of saving income and reinvesting it in the successful business can realise a very high rate of return, making the owner manager very wealthy.

 

These returns on the capital invested will be measured by the increase in the market value (assets less debts) of the business plus the extra income earned that again may be mostly reinvested in the business. Such a high savings and investment plan by a owner-manager is inevitably highly risky – all the family eggs are in one basket and risk adjusted returns have to be high to justify the risks taken. When the value of the enterprise is well proven, the owner manager may wish to cash in by selling up or by selling a share in the company and by paying dividends that are then used to fund a more diversified portfolio of other assets.

Another path to riches may be climbing the slippery ladder of a well established stock exchange listed corporation. This would be one that enjoys growing appreciation from fund managers and is awarded a rising market value. Significant wealth for the top management will come with the increased value of their share options or the shares regularly awarded as part of remuneration and held by them. On retirement or resignation, these shares can be held or again exchanged for a more diversified, less risky portfolio of assets.

 

Options for the risk-averse family man or woman or professional.

The usually risk averse average salary man or woman and the highly successful partner or principal in a professional practice will typically take a different path to comfortable retirement or, possibly, great wealth if the income is high enough. They will have to save a proportion of their incomes and contribute to a pension or retirement fund. The tax advantages of such contractual savings schemes are considerable while there may also be opportunities for the higher income earners, the highly successful professional, to save and invest independently in the stock, bond or property markets.

 

It is investment returns more than the contribution rate that matters for the saver.

The more the salary man and professional save and the sooner they contribute to a savings plan, the more wealth they will accumulate. But as (or more) important will be the returns they earn on their investments. We will demonstrate and illustrate the differences it makes to the wealth outcomes between a low or higher real rate of return on a portfolio, especially when these returns are compounded over an extended period of time.

 

Doing the numbers – demonstrating the miracle of compound returns

In an earlier exercise of this kind published in our Daily View we considered a salaried individual aged 55 in SA in December 2001 expecting to retire 11 years later. By 2001 this individual was assumed to have accumulated assets of R5m and was earning a gross salary of R500 000 per annum and also assumed to contribute 15% of this gross salary  to a no fee no tax pension fund. We also assumed that the salary would grow at 8% per annum. The Pension was invested fairly conservatively in a constant mix: 60% in the JSE All Share Index, 30% in the All Bond Index and 10% in the money market. We calculated the performance of this fund using realised returns over the period to April 2013 some 137 months later.

The results of this savings plan would have been very good indeed. The salary would have grown at an 8% p.a. compound rate from R500 000 to R1 165 813 while the value of the portfolio, worth R5m at the beginning of the period, would have been worth R23.952m in April 2013. The ratio of wealth to salary that was 10 times in 2002 would have increased to 20 times the final salary earned in 2013. This individual would have been able to support a life style much better than the equivalent of 75% of final salary. Consuming at a mere 5% rate of this capital – a rate likely to preserve real capital – would yield R1.19m in year one – slightly more than the final salary. At current interest rates in SA R1m of capital, to be consumed, can buy you about R80 000 of more or less certain nominal annuity income per annum or about R35 000 of inflation linked income at 65, for as long as you or your spouse survive.

 

Excellent past performance is not guranteed

The reason for these highly favourable outcomes for the saver retiring about now, was the excellent real returns realised by the equity, bond and money markets over the period. The JSE delivered an average 15.58% p.a. return over the period, the All Bond Index 10.55% p.a. and the money market 8.22% p.a. on average. Combining these asset classes in the proportion 60, 30, 10 would have given an average annual return of 13.3% p.a. over the period, well ahead of inflation that averaged 5.9% p.a. This average real return of 7.4% p.a. was well ahead of the growth in salary of 8% p.a. equivalent to a real inflation adjusted 2.1% p.a. Hence the increase in the ratio of wealth to salary from 10 to 20 times. Incidentally, had this salary earner in 2002 decided not to save any more of his or her salary after 2001,  the outcomes would still have been highly satisfactory. The portfolio would have grown to R21.291m through the effect of compounding high returns and reinvesting income.

It would be unrealistic to expect real returns of this kind over the next 10 years.

 

A simulation exercise to guide future savings plans

We will show in a simulation exercise what might apply to future contributors to SA savings plans. We will demonstrate that the rate of compounding real after inflation returns – higher or lower – especially when sustained over a long period – will overwhelm the impact of higher or lower savings rates. The Excel spread sheet attached to this report can be used to demonstrate this point. It allows for a great variety of savings options and real return and inflation assumptions that readers, with Excel at their command can try out for themselves.

 

The model and the scenarios

The model assumes a starting monthly salary of R10000 and a working life of 40 years. This working life is broken into three stages: a 10 year phase followed by a further 20 year phase with a final phase of 10 years to allow for different assumptions about real salary growth, percentage of salary invested and real returns through the phases. The simulation exercise also allows for different constant rates of inflation over the 40 year period. Given the emphasis on real growth, the assumed inflation rate has very little influence on the real outcomes though it will affect the nominal rand values as will be shown.

 

Let us then demonstrate a few outcomes to help make the essential points.

Scenario 1 may be regarded as highly, unrealistically favourable to the long term saver, assuming equity like returns of the kind realised by the JSE over the past 10 years, that is average real returns of 10%. It assumes a contribution rate of 15% over the full 40 year period and real, above inflation salary growth of 2% p.a. for the first 10 years of working life, 4% pa. for the next 20 years and 2% p.a. real growth over the final 10 years of employment. The assumed inflation rate is 6% p.a.

 

The results are shown below in two figures. The first tracks the salary and portfolio in money of the day (assuming 6% p.a inflation) and the second tracks the important ratio of wealth to final salary. A ratio of above 10 can be regarded as highly satisfactory with retirement in prospect. As may be seen, Scenario 1 leads to some very large numbers after 40 years: a final salary of R3.7m and a portfolio worth R92.7m – a highly satisfactory wealth to income ratio of 24.65 times.

 

Scenario 1: High returns

 

Ratio of Wealth to Income

 

Source: Investec Wealth & Investment

 

Scenario 2 is much less favourable for the saver. With the same inflation and real salary growth assumption and despite a higher constant 20% contribution rate,  the assumption of an average 3% real return on the portfolio means that the portfolio would be worth a mere R29.3m after 40 years of contributions, or only 7.8 times the same final salary. Retirement in these circumstances would call for a much reduced standard of living.

 

Scenario 2: Low returns – high contribution rate

 

Source: Investec Wealth & Investment

 

Scenario 3 is hopefully more realistic. It assumes an average 6% p.a. real return and a 15% constant contribution rate. The results as shown below may be regarded as satisfactory. The final wealth to income ratio would be 10.4 times.

 

Scenario 3: Satisfactory returns – 15% contribution rate

 

Source: Investec Wealth & Investment

Were the saver in Scenario 3 to only contribute a modest 7% of salary for the first 10 years to the pension plan yielding a satisfactory 6% real return, the final portfolio would have grown to R32.055m in 40 years or 8.5 times compared to the 10.4 times or R39.299m that would have been available had the initial contributions been at the 15% rate.

The implication of this analysis is that achieving a satisfactory wealth to final income ratio of 10 times is no gimme – even with the most favourable savings outcomes. Consistently saving 20% of gross salary for 40 years might not get you there unless real returns were well north of a real 3% p.a. These essential higher real returns are by no means guaranteed even if equity risk were taken on in large measure.

The advice to new entrants to the labour force would be to start saving early in a working life and hope for high real returns. Unfortunately what is in your control, raising your savings rate, will not compensate for low real returns. This conclusion suggests very strongly that the long term saver should have a strong bias in favour of risky equities from which higher returns can be legitimately expected. But such higher returns that might compensate for more equity risk cannot be guaranteed any more than can the returns on bonds or cash be estimated with any certainty.

Saving in addition to the pension plan

It would therefore be highly advisable to supplement a pension plan with home ownership. Paying off a mortgage bond over 30 years is a savings scheme that will give you an effective real rental return of the order of 5% p.a. It will give you the choice of consuming accommodation service in the style to which you are accustomed, that is by staying on in the house you own. Or by offering the choice of scaling down your consumption of house, moving to the smaller apartment or less expensive home in the country town, and converting some of the remaining home equity into other income producing assets. What should be strongly resisted is converting home equity into consumption before retirement. Forced contractual saving in the form of paying off the bond is a constraint worth accepting for the long run.

A further form of saving is early membership of a medical aid scheme. Initial early contributions to medical insurance cover more than the risks – later contributions by the older member typically do not provide cover. The excess premiums paid by the younger worker are a form of saving to be cashed in when old. Carrying full medical insurance is a very good way to save up for the medical bills that form such a large proportion of post retirement spending.

Please note that the attached spread sheet is based on an Investec Wealth & Investment model, according to the assumptions explained in the article: Click here to access spreadsheet

 

 

Global markets: The essential patterns

By Brian Kantor

We have suggested that the most important indicator of the state of global financial markets, of which SA is very much a part, is the direction of US long bond yields. Thursday and Friday last week provided a further demonstration of their importance for the markets and why they do what they do – and that is to respond the expected state of the US economy.

The better the economic news, the sooner the tapering of Fed injections of cash through additional purchases of US bonds and mortgage backed paper, currently running at USD85b per month, and so the higher the US long bond yields and yields everywhere else, including on SA government bonds.

The backdrop to these interest rate movements were reports on the US labour market. On Thursday afternoon (morning on the US East Coast, or 08h30), it was announced that initial claims for unemployment benefits had declined unexpectedly. This was good news about the US economy and so interest rates went up. On Friday at the same time the employment gains were announced: these were well below expectations – not good news at all.

The reactions in the markets are shown below. US Treasury bond yields went up on Thursday and down on Friday and the RSAs follow very closely (Figure 1). In Figure 2 it is shown how US Treasury bond yields go up and down in similar order and the rand/US dollar exchange rate follows in very close order as capital flows to and from emerging market bond markets responded to the higher then lower US Treasuries.

In Figure 3 we show the links between US bond yields and the S&P 500 Index. The good news that drove up interest rates was good news for the equity market on the Thursday. The initial reaction to the less good news on the Friday morning was to weaken the equity markets. But then through the Friday, the S&P 500 recovered its losses to end the day where it had started. This demonstrated a rather robust state of mind of equity investors. Perhaps the underlying fundamentals in the form of earnings reports and the outlook for them is proving supportive.

Of further interest, in Figure 4, is that the JSE followed the S&P 500 very closely throughout this period. We show this relationship through the index futures that offer more overlap than the spot indices.

QE: An exchange of bonds held by the public for cash issued by the Fed

QE easing may be regarded as an exchange of bonds for cash. The Fed holds more bonds and the banks hold more cash in the form of a Fed deposit. If the balance sheets of the US Fed and the Treasury were consolidated (as they should be since both are agencies of Uncle Sam) the consolidated US government balance sheet after QE is of the order of $2.4 trillion. It now shows lower liabilities to the public in the form of bonds that pay relatively high rates of interest, about 2.6% p.a for 10 year loans, and much larger liabilities in the form of bank deposits with the Fed (some $3.2 trillion) that pay much lower rates of interest, 0.25% p.a.

That these Fed deposits earn anything at all is something of an anomaly – something paid out of the goodness of the heart of Ben Bernanke to the shareholders of banks. It improves their income line and probably (controversially) makes the banks less reluctant to hold on to cash rather than lend it out.

But cash for bonds is likely to cause interest rates to fall and reversing the process – bonds exchanged for cash, as must eventually happen – should cause interest rates to rise. The market understands this very well. What it struggles with is the timing of this reversal, which will be dependent on the state of the US economy. And that is especially hard to predict.

Global Equity Markets: Well Developed?

A notable aspect of equity markets over the past two years has been the absolute and relative strength of developed equity markets. This newfound strength has come to reverse years of distinct underperformance compared to emerging markets, including the JSE.

In the figure below, we compare the performance of the S&P 500 to the MSCI Emerging Market (EM) Index, the benchmark emerging market index and the JSE All Share Index, converted to US dollars since 2000. As the chart shows, the very good relative performance of the S&P 500 is a very recent development. We consider whether these recent trends in relative performance can be sustained.

It should be noted that the JSE in US dollars has outperformed not only developed equity markets since 2000 but has also performed better than even the strongly performing MSCI EM Index that accords about an 8% weight to its SA component (the MSCI EM does not include JSE-listed companies with a primary listing elsewhere).

Relative performance: The S&P 500 vs the MSCI EM vs the JSE (in US dollars, 1 January 2013 = 1)

Source: I-Net Bridge and Investec Wealth & Investment

For the year to the end of June, the S&P 500 was up about 12.6% while the MSCI EM Index had lost 10.9% of its 1 January value and the JSE in US dollars was down about 14.2% (see below). The JSE in US dollars usually behaves very much like your average EM market, for good fundamental economic reasons as we will demonstrate. It has suffered an extra degree of rand weakness against the US dollar, compared to other EM currencies, and so the JSE in US dollars has lagged behind its EM peers.

The S&P 500 vs MSCI EM vs JSE (January 2013 = 100), daily data, US dollars

Source: I-Net Bridge and Investec Wealth & Investment

We can provide a good economic rather than sentiment-driven explanation for this recent outperformance by the S&P 500. We show below how S&P 500 earnings and dividends per share have moved higher since 2011 – while EM and JSE earnings have declined from their recent peaks.

We also show that the growth in EM earnings and JSE earnings in US dollars have been significantly negative – but appear to be coming less negative, while S&P dividends per share have remained positive, though may be trending lower. We provide a time series forecast of both series to mid 2014. Bottom up estimates of S&P 500 company earnings as well as an extrapolation of recent aggregate trends indicate that S&P earnings and dividends will rise further over the next 12 months from their current record levels. The time series forecasts of EM and JSE earnings also point higher, but only well into 2014.

Index earnings and dividends per share in US dollars (2000 = 100)

Source: I-Net Bridge and Investec Wealth & Investment

The earnings and dividend cycles (2010-2014)

Source: I-Net Bridge and Investec Wealth & Investment

Not only have the S&P 500-listed companies performed better than their EM rivals, but we would also suggest that the S&P 500-listed companies have delivered better than expected bottom lines while EM equities and the JSE have delivered disappointing earnings. We will use our valuation models to make this point.

 

We use S&P 500 dividends rather than earnings as our measure of the economic performance of the S&P 500 because of the complete collapse of earnings in 2008-09. This extraordinary decline in earnings largely reflected the impact of the Global Financial Crisis on the earnings of financial institutions that had to write off so much of their failed lending books. The decline in S&P 500 dividends was less severe and can be regarded as more reflective of the underlying economic conditions.

 

Our valuation models can be described as earnings or dividend discount models. We run a linear regression equation to explain the level of the respective indexes. We use the level of reported earnings or dividends and long term interest rates as explanations. The models reveal a highly significant positive and consistent relationship over time between the index and earnings or dividends and a negative relationship with interest rates, just as basic valuation theory would predict. These models can be regarded as price to earnings (PE) or dividend ratio predictors of the market levels, with these multiples adjusted for by the prevailing level of long term interest rates. These interest rates represent the rate at which earnings are presumed to be discounted to establish the present value of reported earnings. The long term interest rate acts in the model as a proxy for the required returns of equity investors, or the opportunity cost of capital.

 

The dividend or earnings discount models do a very good statistical job predicting the value of the different indexes, as we show below. When however market values, as predicted by the model, exceed current market values (i.e. the model suggests an overvalued index), we can describe the level of the market as being demandingly valued and vice versa as undemandingly valued, when the current level of a market is well below its predicted value. These predictions are based on past performance.  

 

When a market is demandingly valued, that is when current market values are well above predicted or “fair value” according to the model, it is so because earnings are expected to grow strongly and vice versa. Subsequent events will either confirm or refute these optimistic predictions. If earnings do grow as strongly as expected, the index will be supported. If earnings disappoint, the index is very likely to fall away to fall in line with lower earnings. Similarly, when the index seems undemandingly valued – that is, it stands well below its value as predicted by the model – then this may well be confirmed by subsequently poor reported earnings. Then, if earnings subsequently turn out stronger than expectations, share prices and the index will gather strength. The degree to which the predicted values fall above or below predicted values – indicating optimism or pessimism about the economic and earnings outlook – may also be regarded as a measure of risk aversion or risk tolerance.

 

The observer may then wish to take issue with the collective consensus views that are revealed by market prices. The market might be thought to be too optimistic about the outlook for earnings – too risk tolerant in other words. This would encourage the sceptical active investor to reduce exposure to equities. Or, if the market is judged too pessimistic, or too risk averse by an active portfolio manager, this would encourage a greater exposure to risky equities in the view that economic events and growth in earnings, will turn out stronger than the market expects.

 

The predictive power of this approach can be back tested by using the models. This will show whether the signals provided by the model to buy or sell more equities would have been justified by subsequent market moves.

 

Such a model of the S&P 500 run in October 2010 – using data going back to 1980 – would have suggested a deeply undervalued, risk averse market at that time (understandably so with the memory of the global crisis still very fresh in the memory). The degree of undervaluation was of the order of 50%. In other words, the S&P 500 was 50% weaker than would have been predicted, on the basis of the relationship till then between earnings, interest rates and the market. The same approach would have revealed an especially very overvalued or risk tolerant market in early 2000 – just before the Dot.com bubble burst.

 

Using the same valuation method for the JSE, with all variables measured in US dollars, and using the difference between RSA and US long term rates as the interest rate influence on valuations, the JSE in October 2010 appeared as significantly, or some 28%, overvalued. Subsequent strength in the S&P 500 and weakness in the JSE, when measured in US dollars, provide good support for the validity of the dividend discount model.

 

The JSE vs the S&P 500, US dollar values (2011- 2013)

 

Source: I-Net Bridge and Investec Wealth & Investment

We do not have index levels and index earnings data for emerging markets that go back to 1980. However a model of the MSCI EM, using monthly data estimated for the period 1997 to 2010, provides very good statistical fits and estimates. This indicates that emerging markets were fairly valued (not over or undervalued) in late 2010 as per the predictions of the earnings discount model.

For discount rates in this model we have used the spread on EM bonds. It would seem that investors in EM equities in late 2010 were anticipating further increases in earnings from the average EM company. That this performance did not materialize was surely disappointing to investors, leading to a decline in the EM equity markets. By contrast, the subsequent strength of S&P 500 earnings, given its undemanding valuations of that time, early in 2011, was surprisingly good and able to lift the S&P 500 higher.

Updating the model and drawing conclusions about relative performance of developed and emerging markets

We can apply the same approach to the equity markets today. According to the dividend discount model, the S&P 500 today, supported by strong dividend flows, is still significantly undervalued for reported dividends adjusted for long term interest rates, judged by past performance. The model suggests fair value for the S&P 500 as almost 2500 compared to the 1630 levels prevailing recently.

The market and predicted value of the S&P 500, using the dividend discount model

Source: I-Net Bridge and Investec Wealth & Investment

The JSE measured in US dollars in June 2013 remains overvalued by about 22%, according to the model. Applying the model of the JSE measured in rands and using long term interest rates as the discount factor however, suggests that the JSE is not much more than fairly valued. The earnings discount model applied to the EM Index also suggests that this market is in fair value territory.

Thus one can conclude, with the aid of the earnings or dividend discount models, that the markets today are in a similar state to that of early 2011. The S&P 500 valuations appear still undemanding, while the emerging markets are in something like an equilibrium “fair value” state. On this basis, the S&P 500 and developed markets in general would seem much more defensive than the emerging markets and the JSE: the emerging markets remain more dependent on a good recovery in earnings than the S&P 500. Yet the outlook for earnings growth seems more promising in the developed than the emerging world – with the latter’s greater dependence on resource producing companies.

The state of the global economy will depend to an important degree on the future state of the US and Chinese economies. The developed markets will take their cue mostly from the US and the emerging markets mostly from China. One could say the same about commodity prices and the economies more dependent on them. Yet strength in the US, still a very large part of the global economy, will provide impetus to growth everywhere else including in Europe. The most direct beneficiaries of faster US growth will be the companies listed on the S&P 500. In a way it might also be said that China depends more on the US than the other way round.

Lower commodity prices reflect more subdued growth in China and expectations of growth there. However lower commodity prices, while harmful to the commodity producing economies, Australia, Brazil and SA among others, are very helpful to consumers everywhere and especially in the developed economies that account for much of consumer demand. This divergence would apply even more were the oil price also to give way, more than it has to date, to slower growth in China.

The conclusion one is inclined to come to is that, in the absence of a resurgence of growth in China and the other BRICs, and given the positioning of the different markets, the best value in equity markets over the next 12 months may well still be found in the developed rather than the emerging market space.

The realisation of these higher values will be threatened by abruptly higher movements in long term interest rates, of the kind that roiled all markets after the last meeting of the Fed. Faster economic growth in the US will lead to higher interest rates in due course. But faster growth means faster growth in earnings. This may be more than sufficient to overcome higher interest and discount rates in the market valuations attached to the companies delivering these higher earnings and dividends.

Interest rates: Higher interest rates in the US – good news for some

 What is good news for the US economy may or may not be good news for US equity markets. Good news means higher interest rates (or discount rates) with which to value the top and bottom lines of US companies – both of which can be expected to come with faster growth.

Higher discount rates (or required returns) may sometimes win the tug of war with improved earnings and send share prices lower rather than higher. But for emerging market economies and companies, the good news about the US means higher discount rates without the benefit of an improved earnings outlook, at least in the short term, until stronger growth in the US feeds through to the global economy.

The US economy may well be picking up momentum, as Bernanke indicated on 19 June, when he first spoke of tapering off quantitative easing (QE). The emerging market economies by contrast appear to be losing momentum as does the SA economy – this was fully apparent in the statement put out by the Monetary Policy Committee of the SA Reserve Bank last Thursday. Higher discount rates (that have their origin in an improving US economic outlook), when applied to a less optimistic outlook for emerging market (EM) growth and earnings, are unambiguously negative for EM equity and bond prices, EM currencies and all of the interest rate sensitive sectors everywhere.

So much is obvious from recent market moves that saw long term interest rates in the US initially move sharply higher in response to tapering talk, pushing sharply all higher yielding asset prices lower, including real estate and utilities as well as EM bonds and equities.

Last week this pressure eased, as long dated US Treasury Bond yields, both the standard fixed interest variety and (perhaps of greater significance) the inflation linked variety declined significantly, as we show below.

The relief for EM equities, bonds, real estate and currencies was palpable and very welcome. The best news for emerging markets will be a modestly improving economic outlook in the US – modest enough to keep long term interest rates on hold and, better still, to move them lower. Higher US equity valuations, in the absence of higher interest rates, will do no harm to EM equities. They may even help support them as they did last week. Brian Kantor

An encouraging week for investors in SA equities, bonds and the rand

By Brian Kantor

It was a good week for emerging markets (the MSCI EM up 4.4%) and the rand (which gained nearly 4% on a trade weighted basis) last week. It was an even better week for off shore investors in the SA component of the EM benchmark (MSCI SA) that had returned as much as 8% in US dollars by the weekend. On a trade weighted basis the rand is now about 18% down on its value of a year ago.

The response of the RSA bond market to the stronger rand was also consistently favourable. The yield gap between conventional RSA bonds and their inflation-linked alternatives narrowed to 6.1%, indicating less inflation expected, while the yield gap between RSA 10 year bond yields and the US 10 year Treasury bond also narrowed to below 4.9%, indicating a slower rate at which the rand is priced to weaken over the next 10 years. This breakeven exchange rate weakness may be regarded as a measure of the SA risk premium. It would take an extra 4.9% in rand income to justify an investment in rand denominated assets of equivalent risk, rather than US assets.

The rand and the rand bond market benefited last week from strength in emerging market equity and bond markets as US bond yields retreated from their fear of the end of QE spike last week. It should be appreciated that the bond market moves the week before in the US and elsewhere were of an extraordinary dimension –an apparent overreaction to a promised return to something like normal in the fixed interest space.

The partial recovery of the rand portends less inflation and the developments in the RSA fixed interest markets were consistent with this. Any further strength of this kind would convert premature fears of higher short term rates in SA into expectations of lower short term interest rates. The SA economy deserves lower borrowing costs and a stronger rand would make this possible. Better still for the rand would be less disruption of output on the mines than is currently expected (and priced into the rand).

Global interest rates: Ben Bernanke did not get what he wanted from the bond markets

By Brian Kantor

Fed chairman Ben Bernanke spoke of a surprisingly promising outlook for the US economy, of 3% to 3.5% growth in 2014 that, if it all materialises as predicted, would allow the Fed to taper off its securities purchase programme from September this year and to close down the purchases by late 2014 (currently of the order of $85bn a month).

The market listened and reacted in ways that were consistent with the prospect of faster growth in the US but they would not have pleased Bernanke. He was at pains to emphasise in his statements how conditional would be the direction of quantitative easing (QE), ie conditional on the actual improvement in the US economy (and the labour market in particular) to keep the market at ease. The severe bond market reactions were not welcome because higher interest rates (especially higher mortgage rates) may threaten the recovery itself.

Longer term interest rates moved sharply higher in reaction to Bernanke and the Fed. By the weekend the 10 year Treasury Bond yielded over 2.5%, compared to about 2% a week before. More economically significant was the move in inflation linked bonds (TIPS). These real yields moved even than did the yields on the vanilla Treasury bonds, from close to zero on 16 June to over half a per cent by the weekend. Higher real rates are consistent with an improving growth outlook, leading to increased demands for capital to invest in real assets. And so the gap between the vanilla yields and the inflation protected variety narrowed to less than 2%.

Bernanke indicated in his press conference that his target for inflation is 2% per annum – anything less in his view represents a deflationary danger for the economy. The market now expects inflation to be dangerously low – implying more, rather than less, monetary easing to come.
The negative reactions of the equity markets to the more promising outlook for the US economy were not as easily explained. The S&P 500 was down by just over 2% in the past week, having been very firm before the Fed statement. Stronger, more normal US growth of the kind the Fed is expecting drives earnings as well as interest rates higher – possibly enough to add rather than detract from the value of equities that remain (in our judgment) still undemandingly valued by the standards of history and the prospects for earnings.

These interest rate developments in the US had severe repercussions for emerging bond markets and emerging currencies, that until recently have been beneficiaries of a search for yield in a world of generally very low yields. Not-so-low yields in the US reversed these flows, leading to pressure on emerging market currencies and yields of all kinds. SA was not spared these withdrawals of cash from high yielding assets, though the rand and the rand bond market did less poorly than many other emerging market currencies and bond markets, subject as they have been, for example in Brazil and Turkey, to violent demonstrations on their streets.

The rand actually gained by a per cent or two against the basket of EM currencies and the Australian dollar in the week ending 21 June. The yields on both long dated conventional RSA bonds and the inflation-linked equivalents rose, though this yield gap widened slightly, offering more compensation for bearing SA inflation risk by the weekend.

The yield gap between RSA rand bond yields and US Treasury bond yields can be regarded as compensation for bearing the risk of the rand depreciating. This yield gap can also be described as break even rand depreciation. If the rand depreciates over time at a faster rate than implied by the difference in interest rates, it would be better to buy US bonds (and vice versa if the rand does better, that is depreciates on average by less than the difference in yields). This yield remained largely unchanged through the past week. While the rand has weakened against the US dollar it is not priced to weaken at a faster rate.

Expectations about the direction of short term interest rates in SA have been revised sharply higher to the disadvantage of all the interest rate sensitive stocks listed on the JSE, the retailers, property companies and banks etc. With a more sharply inclined yield curve the one year RSA rate expected in a year’s time was 5.13% on 30 April. It is now 7.6% (see below):

The state of the SA economy does not justify higher short term rates. The Reserve Bank is predicted to raise them notwithstanding. Our view is that the Reserve Bank will correctly resist raising rates until the SA economy has picked up momentum, rather than slowing down, as it appears to be doing.

The immediate future of the longer term interest rates in SA will take their cue largely from the direction of long term rates in the US. Better economic news emanating from emerging market economies (and China in particular), would also help the rand and the RSA bond market. There would appear to be some chance that the US bond market has over reacted to good news about the US economy – expectations that have still to be fully vindicated. Higher rates will also encourage the Fed to maintain, rather than slow down, the pace of its bond purchases. If so, the past week may well prove a temporary high water market for interest rates in the US and elsewhere.