Brian Kantor – Page 23

The Hard Number Index: Little holiday cheer

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

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

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

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

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

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

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

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

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

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

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

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

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

Bubbles are good for some

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

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

The problem with a moving average when earnings collapse

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

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

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

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

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

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

It is expected earnings that drive value

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

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

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

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

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

The growth in earnings and share prices

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

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

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

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

Connecting the level of the market to the level of earnings

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

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

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

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

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

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

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

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

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

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

Statistical issues with these regression equations

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

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

How to apply these models, with their statistical weaknesses recognised

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

Conclusion: The market proposes – economic reality disposes

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

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

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

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

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

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

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

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

Remuneration of senior executives: Where angels should fear to tread

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

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

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

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

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

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

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

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

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

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

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

Electricity pricing: Power plays

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

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

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

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

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

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

Interest rates: Giving pause to the hawks

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

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

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

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

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

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

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

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

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

JSE industrial earnings: 1960s nostalgia

Some SA financial history

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

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

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

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

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

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

Industrial earnings dissected – global and SA economy plays

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

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

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

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

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

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

(For more details, view the PDF here)

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

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

Some detail

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

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

Some uncomfortable recent ABL history

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

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

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

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

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

Doing the numbers for the ABL rights issue

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

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

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

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

The dilution factor – best to be ignored

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

US yields: Good news and bad for emerging markets

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

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

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

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

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

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

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

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, 31^st 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

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.

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