Author: Brian Kantor

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

By Brian Kantor

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

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

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

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

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

By Brian Kantor

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

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

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

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

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

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

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

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

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

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

A day in the markets that can become the stuff of legends

By Brian Kantor 

Between the SA bond market opening at 08h00 yesterday, long term interest rates went up and the rand went weaker in almost perfect unison, by about 2% or more as foreign investors sold RSA bonds as they were selling all other emerging market bonds. And then just before noon the heavy traffic reversed course – again in perfect unison. When the bond market closed in SA, the rand had regained nearly 1% of its opening value and the long bond prices were nearly 3% stronger. Of the emerging market bonds, the RSAs had served best by the end of the SA trading day with most of the peer group in negative territory, for example Turkish lira denominated long bond yields were the worst performer, up 36bps.

The Bloomberg screens below copied at 17h00 tell the story – in normalised percentage terms and in actual prices and yields:

 

The precipitating force adding to yields and global bond market volatility has been the further sharply higher move in US long dated Treasury Bond yields. The financial markets are struggling to cope with the initial steps in what may well be a return to something like normal yields on US Treasuries. How long this will take and where higher interest rates will come to rest are important matters of conjecture. With higher yields promised by the safest bonds, the search for riskier yield elsewhere loses some of its urgency: hence the move away not only from higher yielding emerging market bonds but also from higher yielding utilities and property companies. Another dampener for the higher yield market has been significantly higher long bond yields in Japan – despite QE – and a stronger yen.

But of particular interest is that higher yields on vanilla bonds in the US have been accompanied by higher yields on the inflation linked variety. The yields on long dated US TIPS (inflation protected bonds) have moved higher, fully in line with the inflation-exposed bonds. The TIPS are now offering a positive real rate of return – the real yields until recently were negative. Thus the difference in these yields – the extra yield on the vanilla bonds being compensation for bearing the risks that unexpectedly high inflation will erode the value of interest income – has not altered much at all. It is therefore expectations of stronger sustainable future economic growth rates and therefore increases in the real demand for capital, that are driving real returns higher.

Higher real returns on capital is surely good news about the US and the global economy because it implies improved growth prospects. Faster growth should augment operating profits, cash flow, earnings and dividends of globally focused companies. The improved bottom lines may well be expected to compensate for the higher costs of capital (or required returns) as interest rates rise.

However this was not the case yesterday. Global equity markets were in strong retreat. The JSE, in rands, lost over 3% of its opening value (though less in US dollars). What was also of interest was that the sharp turnaround in the value of the rand after midday had no easily observable impact on the JSE or the sectors that make it up – it was a deep red colour where ever you looked.

The global companies listed on the JSE, the SABMillers, Richemonts and BATs of this world, did not act as rand hedges either before or after noon. The interest rate sensitive sectors on the JSE – property, banks and retailers – also bled through the day even as the rand strengthened.

A comparison of the price performance of the different sectors of the SA financial markets this year is made below. The increase in long dated interest rates in SA, as reflected by the All Bond Index (ALBI) and its inflation linked equivalent (ILBI) has dragged down the Property Loan Stock Index from a near 20% gain in mid May to a mere 4% up on Monday. Bonds have suffered more than property while equities had done about as well as property by Monday’s close. Using month end data and the JSE at the close on 10 June, we show how the S&P 500 in rands has provided excellent returns this year, over 40% if dividends are included. The global plays on the JSE (the Industrial Hedges) have performed nearly as well while the resource companies, the commodity plays, and the interest rates sensitive SA plays have all lagged. These two groups of companies – those sensitive to interest rates or commodity prices – have both lost about 5% of their rand value since 1 January 2013. The weak rand has, perhaps surprisingly, not helped the commodity plays while, as would have been expected, it has damaged the prospects for the SA economy-dependent plays.

Conclusion

The outlook for the rand, the JSE and emerging markets will be determined by the usual mixture of global forces and SA political specifics (in SA’s case). The recent volatility in financial markets can be attributed to global forces. But the rand is off a much weaker base for SA reasons. The global tug of war between higher interest rates and better growth prospects appears to be under way. Our sense is that the growth team will win this tug of war over moderately higher interest rates in the US, to the advantage of the S&P 500.

The rand and other emerging market currencies, including the weak rand, may well benefit from strength in global equity markets – though not as easily from bond markets. The SA specifics wil lalso continue to influence the value of the rand. Any sense that the mining sector wil not be as severley disrupted by strike action than expected, could bring a degree of rand strength. Even a modest recovery in the rand and bond market will make it easier for the the Reserve Bank to keep its repo rate on hold. It should do so regardless of the exchange value of the rand that is beyond the influence of SA monetary policy – as should be apparent to all.

The Hard Number Index: The demand side of the economy has held up – but the economy is under pressure from the failures on the supply side

By Brian Kantor


Hard Number Index updated – economy still growing but at a slower pace

We have updated our SA economic activity indicator, the Hard Number Index (HNI) for May 2013 with the release of vehicle sales and notes in circulation data. The HNI indicates that economic activity in May was still growing at an improved rate. The forward momentum however (the speed of the economy) is slowing down and is predicted to slow down further over the next 12 months. The change in the HNI may be regarded as the second derivative of the economy with the HNI or the business cycle as its rate of change – positive or sometimes negative when the economy shrinks.

The HNI and the Reserve Bank Indicator are both well above the 100 level

Our index is an equally weighted combination of new unit vehicle sales and the notes in circulation issued by the Reserve Bank – adjusted for the CPI – that we call the Real Money Base (RMB). These two hard numbers provide a very up to date view of the state of the economy, being released within a week of any month end. We show a comparison of the Coinciding Indicator of the Business Cycle as calculated by the Reserve Bank. This indicator is based upon seven or more time series mostly using sample surveys rather than hard numbers that are released with variable time lags. The latest estimate made by the Reserve Bank is only for February 2013.

As the chart shows, our HNI has identified rather accurately recent turning points in the Reserve Bank indicator. The Reserve Bank recently rebased this indicator to December 2010 and we have done the same. Numbers above 100 in these diffusion indexes indicate that the economy is growing and numbers below that the economy is shrinking. Both the HNI and the Coinciding Business Cycle Indicator are recording numbers well above the 100 of December 2010, implying still strong growth momentum. Our indicator predicts that this forward speed has slowed and will slow further in the months to come.

Vehicle Sales remain a strong feature of the economy – real money base growth slowing

The most encouraging feature of the SA economy is the strength of new vehicles sold domestically. Export volumes have also gathered momentum, accounting for about half of domestic sales volumes. While the growth in unit vehicle sales has slowed down it has remained close to an 8% annual rate and is predicted, via a time series forecast, to maintain this rate. The supply of central bank cash, adjusted for higher consumer prices, peaked recently at about an 8% real rate and is currently growing at about a 4% rate – held back by more inflation and a slowdown in the growth in cash held by the public and banks. It is forecast to slow further.

Money supply (M3) and Bank Credit Growth have picked up

The bank credit and broader measures of the money supply have been updated to April 2013. As we show, the growth in M3 and in credit supplied to the private sector has gathered momentum despite consistent weakness in demands for mortgage finance. Bank credit could not be regarded as a drag on growth.

The drag on the economy is coming from the rand

The drag on growth in domestic spending is now coming from offshore. The limits to this growth are set by the willingness of foreign suppliers of capital in one form or another to fund our spending. This willingness is revealed in the foreign exchange value of the rand. This has deteriorated significantly in recent months, putting upward pressure on the prices consumers and firms have to pay for their goods and services, especially those with high import content. These higher prices might also be accompanied by higher interest rates.

Our view is that, given the weaker predicted state of the economy, the Reserve Bank will wisely resist increasing short term interest rates. Relief for the economy will however not come from lower interest rates. The source of recovery will have to come from increased exports, especially of metals and minerals. The rand is weaker because it is expected that the mining sector, which accounts for 60% of exports, will be further disrupted by strike action. Were the mines able to operate at a better than expected rate, the rand would benefit and the chances of lower interest rates, well justified by slower growth in domestic demand, would greatly improve.

Inflation and the rand: Why doing nothing is the best SA monetary policy can do

By Brian Kantor

An unfortunate history of exchange volatility

The SA economy is once more challenged by an exchange rate shock. As we show below, such exchange rate weakness – of the order of a 15% or more move lower in the trade weighted exchange rate, compared to a year before is hardly unknown. In fact the latest shock is the fourth since 2000. As we also show below, the rand had lost as much as 26% of its foreign trading value by May 2002. By early 2007 the rand was down by about 15% on its value a year before and then 20 months later had lost 19% of its value.

The rand on 31 May 2013 was about 14% weaker than 12 months ago on a trade weighted basis. It will also be appreciated that while the long term trend in the value of the rand since 2000 has been one of rand weakness, the direction is by no means one way. Weakness can be followed by strength of similar magnitude. These unpredictable shocks, in the form of large sustained movements in the value of the rand in both directions, can be of similar magnitude and can complicate business decision making and monetary policy. They are a most undesirable feature of the SA economic landscape.

The sources of exchange rate volatility have very little to do with monetary policy

These large exchange rate movements are a response to interruptions or disruptions in the flow of capital to and from South Africa. Increased demands for rands push the rand higher and less demand moves the price of the rand higher or lower when valued in other currencies. It is very much a market-determined and flexible – very flexible in both directions – rate of exchange. The SA Reserve Bank does not typically use its own stock of foreign exchange to intervene in the market for rands.

This market, a deep one at that, regularly transacts over US$15bn worth of rands every trading day, according to the Reserve Bank on the basis of information provided by the trading banks. Three quarters of the trade is conducted between third parties without a direct connection to SA trade or finance. They presumably trade and hedge the rand so actively as a proxy for currencies that are less liquid. As we show below there is no obvious relationship between the trade weighted value of the rand and turnover in the currency market.

The one highly predictable impact of an exchange rate shock- more or less inflation

The one highly predictable influence of an exchange rate shock is that more or less inflation will follow in the opposite direction. More inflation when the rand weakens – less when it strengthens. It is most important to recognise that for SA the exchange rate leads and the inflation rate follows. In conventional monetary theory it is faster domestic inflation (caused by easy monetary policy) that leads to a weaker exchange rate. The weaker exchange rate then should help to maintain the international competitiveness of exporters and firms that compete with more expensive imports priced in the weaker domestic currency. In the figure below we identify the timing of the shocks that have sent the rand weaker and show how the trend in the inflation rate has followed these shocks consistently.

In the figure below we show the results of a very simple model. The trend in inflation is very simply explained in a single regression equation by the annual movement in the trade weighted exchange rate, lagged by six months. The model does well in predicting the direction of inflation in SA and also its level. The explanatory power of the model is rather good – explaining over 60% of the inflation trend. As the chart also shows, there is somewhat more to inflation than the exchange value of the rand. The model significantly underestimated inflation in 2008-09 and has less significantly underestimated it recently.

Among other forces moving SA prices and inflation are trends in global prices, particularly in the prices of grains and other soft commodities in US dollars that influence the domestic price of food when translated at import price parity into rands. The global price of oil is also very important in this regard. Clearly independent of the value of the rand, global inflation or deflation (including oil price increases or decreases) will influence prices in SA and their rate of change. The pace of administered prices increases in SA (taxes by another name) will also have an influence on the CPI. So will the strength or otherwise of domestic spending, supported more or less by the growth in money supply and credit and interest rates, that is by monetary policy.

Monetary policy is largely impotent in the face of exchange rate shocks of this order of magnitude

It should be very obvious from the recent history of inflation in SA that there is little the Reserve Bank or monetary policy can do about inflation because it cannot influence the variable exchange value of the rand in any predictable way. The same monetary history tells us that raising or lowering interest rates have simply no predictable impact on the exchange rate. Monetary policy is largely impotent in the circumstances of exchange rate shocks of the order of magnitude suffered by SA. Inflation targeting, to which SA subscribed in the early 2000s with all the sincerity of the newly converted, had as its justification the conventional wisdom of monetary policy of that period. The presumption of inflation targeting was that a politically independent central bank would target inflation with its interest rate settings in a sound way and inflation and the exchange rate would behave itself in a predictable way.

The unpredictable nature of exchange rate shocks – global or domestic in origin

That presumption has proved to be a false one. The exchange rate has not behaved itself and so measured inflation has remained largely outside the influence of monetary policy. Monetary policy and interest rate settings can clearly influence domestic spending. But maintaining the balance of domestic demand and potential supply does not at all necessarily secure exchange rate stability as we observe.

The exchange rate can have an unhealthy life all of its own, responding as it does to global forces, as it did during the Global Financial Crisis of 2008-09. This crisis increased the global demands for safe havens and reduced the demand for riskier emerging market assets and their currencies, including the weaker rand, and led to more inflation in SA.

The other shocks to the rand we have identified are much more SA specific in their origins. We can identify such SA specific risks driving the rand by comparing the behaviour of the rand to other emerging market or commodity currencies over a period of rand weakness or strength. The forces driving the rand in 2001-02 and in 2006-7 were largely SA specific in their origins. The rand has weakened by significantly more than its peers over these periods of weakness.

The only time the Reserve Bank may be held responsible for rand weakness was in 2006-7. Then the bank adopted interest rate settings that were too severe, that threatened the growth prospects for the SA economy and frightened capital away. The 2001-2002 weakness was an unintended consequence of partial exchange control reform – that led to panic demands for foreign currency by local wealth owners and fund managers. The latest burst of rand weakness that began in August 2012 is associated clearly with labour relations on the mines and elsewhere that threaten mining output and exports that are so important to the trade balance of the rand. Foreign and local investors have been discouraged by the political responses to this crisis.

Nothing for the Reserve Bank to do but watch the economy ride out the storm

As clear as are the political origins of the latest exchange rate shock is that the Reserve Bank and its interest rate settings can do nothing now to meaningfully assist the rand. It is out of their hands. Raising interest rates would further weaken domestic spending, that cannot be regarded as excessive. Still slower growth in domestic spending following any imposition of higher interest rates would if anything further undermine the case for investing in SA and could lead to a still weaker rand. Indeed, were it not for rand weakness, interest rates would have been reduced to encourage domestic demand. But such action might well be regarded as less than responsible in the circumstances.

The best the Reserve Bank can do in these difficult circumstances is to do very little. The economy must be left to rise out the exchange rate shock and the temporary increase in inflation that is likely to follow. The weaker rand will encourage production for export and for the domestic market as prices and profit margins for exporters and those competing with imports have improved. Hopefully the mining sector will be allowed to benefit from these price and profit trends. Hopefully too, the politicians can help the industry. Higher prices, especially for goods or services with high import content, will discourage consumption. There is nothing the Reserve Bank can usefully do to slow these inflation and relative price effects down. Raising interest rates would damage the economy further. The best monetary policy can do in response to an exchange rate shock (that is not of its making) is to do nothing at all – but also to explain why doing nothing is the best policy.

How important is mining to the SA Economy. It depends on how you measure it.

A crisis of poor returns on capital invested and declining employment opportunities

SA mining is in crisis. And the travails of SA mining, more particularly those of gold and platinum mining are having a very negative impact on GDP and expected GDP growth and on the value of the rand. To survive as viable businesses able to cover their costs of capital the mines have to plan for lower costs of operations and that means to plan for lower levels of production and employment, that is plan the closing rather than the opening of mining shafts. Investors in the industry and in the South African economy are not at all sanguine about the prospects for the industry and this lack of confidence is well reflected in the market value of the mining companies and in the exchange value of the ZAR.

The market fears further disruption of mining output by uncooperative trade unions. Union leaders do not appear to share the same sense as have shareholders and potential investors have of an industry in crisis. The Unions are expected to further resist retrenchment of their members and to continue to demand what shareholders and also the government regard as hopelessly unrealistic demands for improved employment benefits.

The future of deep level mining in South Africa may well lie in much higher levels of automation. This is a course of action not suited to an economy with so many unemployed or employed on far inferior terms outside the mining sector.

The mining sector contributes much to exports and to the outlook for the rand and interest rates

Lower levels of mining production, particularly if they are the result of strike action, threaten the trade account of the balance of payments and justify a weaker rand. The weaker rand then implies more inflation that makes it harder for the Reserve Bank to offer relief to the economy in the form of lower interest rates, relief, absent a widening trade deficit, that would make every economic sense.

Growth in Domestic Expenditure (GDE) has held up significantly better than growth in domestic output (GDP) meaning stronger growth in imports than in exports. The failures of the mining sector to produce more and to take advantage of what has been until recently, highly favourable price trends ( as we will show below) are a large part of the explanation of current rand weakness and slow economic growth generally.

The share market doesn’t expect growth in output or even growth in earnings and dividends from the mining houses and their subsidiaries. It is rather demanding that the mining houses pay much closer attention to cost control and operational excellence. These low market expectations should act as a warning to managers, workers and the government responsible for mining policy. The lower profits and reduced growth expected is not in synch with demands for higher wages, electricity prices and government interference with mining rights and the taxation of mining profits.  The potential upside for shareholders is that if these low expectations can be countered by sober management and better relations with labour and government then these mining companies stand a stronger chance of recovering their status with investors. Merely sustaining the output of gold, platinum even at lower planned levels, would be surprisingly good news and likely to be well received in the share and currency markets.

How dependent then is the SA economy on the mining sector? It all depends on how the share is measured

The SA economy remains highly dependent on the export of minerals and metals. Directly exported minerals and metals account for as much as 60% of all export revenue. Hence the sensitivity of the foreign exchange value of the rand to mineral and metal prices and their production.

Mining’s share of the Gross Value Added (GVA) by all sectors of the SA economy in 2012 was no more than 5.5% when measured in constant 2005 prices. When both mining output and GVA, including mining output, is measured in current prices, mining’s share rises to 9.3% of GVA. As we show below, when measured in constant 2005 prices, the contribution of mining to GVA and GDP has been steadily declining over many years from a large 23% share in 1960 to the current less than 6% share , regardless of the direction of global metal and mineral prices and so mining revenues.

As we also show that when the share of mining is measured in current money of the day prices the share of mining in the economy takes on a very different complexion. The share of mining in the SA economy, so measured as a ratio in current money of the day prices, was less than 12% in 1960, compared to over 23% in constant price terms that year. In 1970 the share of mining in GVA was 8.8% if measured in current prices, or a much higher share, 20% of the economy,  if measured in constant 2005 prices. Thereafter the mining share measured in current prices rises significantly rises in response to the very significant increases in the gold price in the seventies. When the gold price peaked in 1980 the share of mining in GVA in current price terms was as much as 21%- but then only about 12% if recorded in constant 2005 prices. Thereafter, as the gold price fell away and the prices of mining output were subject to a long period of deflation and a further decline in the output of gold, the share of mining in current price terms fell further to a much less important 7% by the year 2000. Thereafter when measured in current prices Mining gained a marginally larger share of the economy to the 9% share measured in 2012. The increased output of and higher prices coal and iron ore were significant contributors to thei increase in economy share. The share of mining in the economy in constant price terms by strong contrast declines continuously after 1960 and appears completely unaffected by relative prices or industry trends as we show below.

The share of Mining in Gross Value Added using constant 2005 prices or current prices

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

Real prices matter a great deal to producers

A key to the role of any sector of the economy, with an improving or deteriorating share of the economy, is surely relative price trends. When a sector enjoys what may be called pricing power, that is to say the sector can price increases ahead of the average rate of inflation , then one would expect improved profit margins to follow and extra output to be encouraged. In the figure below we show how the SA Mining Sector Price Index, that is the mining sector deflator, has compared over the years with all prices, including the prices of metals and minerals, as reflected by the Gross Value Added Deflator.

As may be seen between 1960 and 1970 Mining Sector selling prices lagged well behind the selling prices of all SA production or value Added.   In the seventies, helped especially by a rising gold price, prices realised by the SA mines, rose significantly faster than prices in general. A long period of metal and mineral price deflation then followed until approximately 1999 when commodity prices picked up strongly in absolute and relative terms. These favourable trends or terms of mining trade were then disrupted by the Global Financial Crisis of 2008-09

The Mining Sector Deflator compared to the Gross value Added Deflator (2005=100) Logarithmic Scale

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

 If we divide the Mining Sector deflator by the GVA deflator we get the relative price of mining output. For producers in any sector the higher the relative price the better and the more encouragement offered to increase otput.[1] In the figure below we compare these relative prices with the share of Mining in GVA, measured in current prices. As may be seen the share of mining grows and declines very consistently with improvements in or a deterioration of the relative prices of mining output. Such responses make every economic sense. That the share of mining, when measured in constant price terms, declines consistently and independently of these relative prices makes very little intuitive sense. Relative prices appear to make no positive impact on the mining sector at all when the mining share is measured in constant prices. The share of mining in the economy, when measured in constant prices, simply declines continuously as may be seen.

The reason for this highly counterintuitive result is simply in the arithmetic of National Income Accounting conventions. If sector prices – for example mining sector prices – rise faster than prices in general then the share of that sector in the economy, when measured in constant prices, automatically declines and vice versa when sector prices rise more slowly than prices in general the share of that sector will rise automatically. [i]

The presumption of such a result is that it is the supply side of the economy, rather than demand forces that drive relative prices and so relative shares in national income methods of calculation. That is it is an increase in supply that results in a lower relative price and so a larger share of the economy. Rather, that as in the case of mining output, where prices are set globally and the mines are price takers, to presume that it is an increase in global demand that leads to higher prices and in turn to more profitable production and so increases in output and in the share of the economy realized by a sector.

Applying the standard convention to the share of Mining and also Exports in SA subject to similar price trends becomes seriously misleading. Measuring sectoral shares using current prices makes much more economic sense.

It should be noticed in the figure below that SA miners benefitted from an extraordinary increases in the prices for their output compared to prices in general in the seventies and after 2000. Relative prices have moved further to the advantage of the mining sector over the past twelve years as may also be seen. That Mining’s share of the economy did not rise anything like as significantly in the past decade and more reflects the wasted opportunity to benefit from the commodity super cycle. The mining boom in terms of volume of output produced regrettably largely passed South African production by. The costs of mining gold and platinum rise as rapidly as did prices. Uncertainties about government policies towards mining and the failure to invest in additional transport infrastructure to export more coal and iron ore also contributed significantly to the modest supply side responses to much more favourable relative price trends.

Mining share of GVA and Relative Mining Prices


Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

Another very good reason to question the use of constant prices to calculate sectoral shares of the economy  is that these shares can change meaningfully with changes in the base year used to measure constant prices. Using exactly the same price series, the same deflators, measured in constant 2005 prices or constant 2000 or constant 1970 prices can make a large difference to the share of a sector measured in constant prices as we show below. Using a deflator with 1970 prices =100 for both Mining and GVA, to one using much lower 2000 prices or 2005 prices as the base equal to 100 shifts the share of mining in constant prices in 2012 from 2.4% using 1970 prices to 4.8% using 2000 prices to 5.5% using 2005 prices. [ii]

Share of Mining In the SA economy using different base years


Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

 

That changing the base year can have such a meaningful effect on the sector share makes the use of constant prices as the basis for calculating the share of different sectors in the economy highly unsatisfactory. While the trends in the sector share, measured in constant prices using different base years, remains exactly the same the numerical values can turn out to be very different. Every change in the base year results in once and all constant shift in the trend giving a different impression of the importance of the sector to the economy. This is why in our judgment the most consistent measure of mining’s contribution is the ratio of mining output to Gross Value Added ( GVA)when both mining output and that of all sectors including mining GVA, is measured in money of the day prices. By this calculation the share of mining in the SA economy peaked in 1980 at over 20% and currently contributes about 9% of all value added as we show above.

The contribution of manufacturing to the SA economy is exaggerated using constant price calculations

 

The same approach to measuring the share of Manufacturing in  SA production can  be taken. In the figure below we show Manufacturing’s share in GVA as well as the relative price of manufacturing Output. As may be seen the share of Manufacturing measured in current prices was approximately 24% in the eighties. It has since declined markedly to a 12.4% share in 2012. This declining share has been accompanied consistently by an almost continuous decline in relative prices. This downward price pressure has clearly accelerated in recent years. Manufacturing in SA has become increasingly exposed to competition, especially from abroad. Consumers and retailers and their employees have benefited from the competition.

Manufacturing Sector; Share of Output and Relative Prices

Source;  SA Reserve Bank Data Bank, Investec Wealth and Investment.

Conclusion

Economic statistics should accurately reflect economic realities and hopefully lead to appropriate economic policy and policy changes. Measuring sector shares in SA in constant price terms as is the National Income Accounting Convention is very misleading about the role of mining in South Africa and therefore also about the role of other sectors, including Manufacturing as we have argued. A irony is that if shares in the economy were measured in current rather than constant price terms this past quarter the disappointing and currency moving Q1 GDP numbers would have looked rather different. Manufacturing, with a lower share of the economy when measured in current prices, 12.3% share in current prices in 2012 compared to 17.2% in constant prices, with a close to 8% decline in output on a seasonally adjusted and annualized basis, would have been less of a drag on economic growth. And mining output that increased in Q1 given a larger share of GVA (5.6% in constant prices, 9.3% in current prices) would have added more to the growth rate.

 

[1] The case of Gold Mining in South Africa is somewhat different to the norm. In the seventies and eighties the higher gold price offered a choice to the mines. They could choose to mine shafts with lower grade, that is ore with lower gold content and in this way extend the life of the mines by extracting more gold bearing ore so leaving less gold behind. They typically elected, where possible, to extract more gold bearing ore from underground with lower average gold content. As a result the output of gold fell from 1000 metric tons in 1970 to 670 tons in 1985 while the tones of ore extracted and milled by the mines grew by about 30% from 75m tons in 1970 to 105m tons over this period 1970 – 1985. Capital expenditure by the gold mines was R106m in 1970 and R1911m in 1985. Working profit per ton of ore milled was a marginal R3.9 in 1970 and a hugely profitable R70.46 in 1985.  416,846 workers were employed by the gold mines in 1970 and 513,832 in 1985. If productivity was measured as output of gold per worker employed then it declined sharply over this period, from 2.3 kg of gold per worker in 1970 to 1.3kg in 1985. If productivity was however more realistically measured as tones of ore extracted per worker, then it would have improved from 178 tonnes of ore milled d per worker in 1970 to 203.5 tonnes in 1985. These tradeoffs of lower grade for a longer mining life seem no longer available to the gold mining industry. The better grades of ore appear as largely exhausted and the industry is forced to mine lower grade ore at ever deeper more costly levels. The volume of ore extracted has declined consistently over the past ten years while the annual output of gold from SA mines is now below 200 tonnes. (See Table Below)  Source; Annual Reports of Chamber of Mines of South Africa.


[i] The mathematical proof of this and other propositions made here are to be found in a paper written in 1987 with Iraj Abedian, Relative Price Changes and their Effects on Sectoral Contributions to National Income , that can be found in my blog www.zaeconomist.com

[ii] Reducing or increasing the absolute value attached to the price series reduces or increases the sectoral share by a constant value. The 1970 deflator rises from a very low absolute base of 100 in 1970 to a level of close to 50000 in 2012- a 500 times increase in average prices over the 42 years. The deflator for 1970 using 2005 prices as the basis would have an absolute value of 0.869 compared to the value of 100 if 1970 was chosen as the base year. Clearly such absolute numbers with excatly the same underlying trend should not have a real effect.

 

Equity markets and retirement: Back to the future

By Brian Kantor

It is retirement plans for the future that should concern us, not those of the past that have done so well in South Africa.

The weekend newspapers were full of exhortations for South Africans to save more than they appear inclined to do for a comfortable retirement. Personal Finance, in a caption (Weekend Argus 18 May 2013) reports: “You need to save more than you planned to do if you want to have a financially secure retirement, because of interest rates and investment market expectations.”

Given the decline in long term interest rates (and so expected market returns), it will take a larger capital sum to purchase a highly predictable flow of monthly annuity income from a life insurance company. Or, in other words, for any given life expectancy, a million rand of accumulated savings will now buy you significantly less monthly income from an annuity supplier than it would have 10 years ago, when long term interest rates and so expected returns were much higher than they now are.

The article in Personal Finance is accompanied by a figure describing the monthly “inflation-related” pension that could be purchased “by a 65 year old man with provision for spouses annuity and a 10 year guarantee” with R1m. The figure shows the contracted monthly pension as having declined from over R3 700 per month in December 2007 to about R3 000 per month today. A vanilla annuity without any inflation protection would provide about a fixed R60 000- R70 000 per annum for the same retiree.

Interest rates on an RSA bond with 10 years to maturity have declined markedly since 2002 from over 12% for a generic 10 year bond, to their current levels of about 6.3% while inflation linked real yields offered by the RSA government have declined even further, from 4.93% in early January 2002 to their current levels of about 0.6% (see below).

The expected return on a bond is its yield. The expected return on an (on average) risky equity is the bond yield plus an equity risk premium of an extra four or five per cent per annum. If realised returns approximate expected returns – a very large presumption – the lower the market interest rate and the lower the expected returns from bonds or equities, the more you will have to save to secure a given monthly income.

It is these largely certain income streams, a certain nominal 6.3% per annum or so from a 10 year RSA, or a real 0.6% (that is 0.6% plus actual inflation from an inflation-linked 10 year RSA), that form the basis on which a guaranteed annuity of either the inflation exposed or inflation protected variety will be offered by a life insurance company (the R36 000 or R70 000 annuity per annum referred to).

Realised and expected returns may however turn out to be very different. In the US for example, on 31 January 2002 very long dated US Treasury Bonds offered a yield of about 5.43%. Total annual returns from these long dated bonds, calculated each month end between January 2002 and April 2013, averaged approximately 8.75%. Total returns are the sum of interest yield, interest/capital values plus the annual change in the market value of the bond.

As long term interest rates in the US trended significantly lower over the period, long bond prices went proportionately higher, so providing unexpectedly good returns from US bond portfolios – on average 3.3% per annum above the expected returns of 5.43% offered by a 30 year US Treasury Bond on 31 January 2002. By contrast the average US equity investor realised well below expected returns. Equity returns would have been expected to realise about 9% a year in January 2002. Actual returns on the S&P 500, including dividends and capital gains and losses, averaged a mere 2.8% per annum. over the 11 year period. US inflation averaged 2.44% over the period, well ahead of short term interest rates that were an average 2%. Unexpectedly low inflation a brought down long term interest rates and pushed up bond prices to the advantage of bond holders. They did very little for equity investors who would have expected to have earned a premium return over bonds given their greater volatility.

Contributors to a reasonably well managed defined contribution SA pension fund since 2002, that would sensibly have included a good weighting in equities, have realised excellent real returns on their pension funds, than might have been reasonably expected early in 2002. The returns realised in the RSA bond and equity markets over the past 10 years have been well ahead of inflation.

And the actual inflation expected by bond and equity investors and implicit in long dated bond yields in 2002 proved to be greatly overestimated. The fact that interest rates fell over the period, so increasing the market value of any bonds held by a pension fund, added meaningfully to these bond market returns. Very long term interest rates in SA in January 2002 were 14.16%. They have more than halved since then. Actual returns on these bonds since then have averaged over 12% per annum. The return on the All Bond Index (with an average term to maturity of six years) was an average 10.13% per annum. The JSE, represented by the All Share Index, returned an average 15.5% a year while short term interest rates averaged about 8.6%. These returns were especially impressive when compared to inflation that averaged an unexpectedly low 5.9%. A balanced SA pension plan over these 11 years and four months was thus adding real purchasing power to savings at a most impressive rate – a most helpful outcome to those contributors to pension funds intending to retire today.

High real returns from the RSA bond market, combined presumably with excellent real returns from the share market, in which even a conservatively managed pension fund would have benefitted, plus good real returns from the money market, meant that the capital value of any SA pension fund should have grown rapidly enough since 2002 (after management fees) to overcome the reality of lower expected returns in 2013.

Some simulation exercises can help make the point about just how well the current cohort of those facing retirement today have been served by the exceptionally good returns provided by the SA capital markets since 2002.

For example, consider an intended retiree of 65 years today, who had a defined contribution balance of R5m in 2002 and earned a salary then of R500 000. Let us say that his salary grew at 8% a year over the period and he continued to contribute 10% of his growing salary to his pension plan. If the pension plan had a modest 50% weight in equities, 40% in bonds and 10% in cash based on realised returns since 2002, his nest egg would have grown to over R22m by April 2013. Had he not added to his savings, his wealth would have mounted to about R20m. His salary by 2013 would have grown to over R1.1m and his R22m would have bought him an inflation protected retirement income of about R792 000 a year. If he were prepared to take on inflation risk he might be able to secure an annual constant nominal income of about R1.5m for as long as he lived. His post retirement income would thus seem to bear a highly satisfactory relationship to his pre retirement income. It would not make a great deal of difference to these outcomes if part of his 2002 nest egg of R5m was in the form of equity in his own home. The return on homes in the form of implicit rental yield plus capital gains (especially until 2008) would have compared well with alternative investments.

What about the future?

It is therefore not so much the savers of the past that we should be worrying about, but the savers of the future who now have to face lower expected real returns in the market place. Their ability to build up an adequate store of purchasing power for old age is being compromised by low expected real returns. These low expected returns may well turn out to be low realised real returns, in which case a higher rate of real savings is urgently called for by all those intending to retire in 10 or more years.

The danger to investors in long dated fixed interest securities is unexpectedly higher, not unexpectedly lower interest rates. It is not lower nominal interest rates but higher rates that make it more difficult to build savings for the future, as we have shown. Lower inflation can compensate fully for lower nominal interest rates when a fixed annuity is purchased.

Lower expected real returns, all other things equal, demand a higher rate of real savings to sustain a desired rate of post retirement real purchasing power. A higher rate of real saving can be expressed as a larger percentage of nominal income contracted to a pension or retirement savings scheme. But the danger to current savers is that these real and nominal interest rates will rise over time, reducing the value of any bond portfolio. This is the opposite of the benign winds of lower interest rates that have blown over capital markets over the past 20 years.

It should therefore be appreciated that the current level of real interest rates expressed explicitly as the real return on long dated inflation linkers issued by governments is exceptionally low. Real interest rates close to zero are well below long term averages that have been of the order of two or three per cent. In normal times real interest rates can surely be expected to regress back to long term averages. If they do, does it make sense for those retiring today to commit their capital permanently to such low returns? Furthermore, those planning to retire in the next 10 or 20 years might well judge it appropriate to accept more risk in their retirement portfolios – that is the risk that real interest rates will rise as the economy grows and so the demand to invest more capital in real assets raises the competition for savings. Proportionately more equity (that promises higher returns in exchange for more risk) seems to us to be a sensible response to what may be a short lived world of very low interest rates.

Expectations of Platinum Mining in South Africa – Anchored in the False Bay

As printed in Business Day 14 May 2013 

by David Holland and Brian Kantor[1]

Behavioral studies have shown that humans exhibit a strong anchoring tendency.   When the world changes, they remain anchored to the one they know instead of adapting to the new order. Evidence for this behavior is ubiquitous when parsing through government and labour comments about the ability of mining companies to pay more or hire increased numbers of workers. This is undoubtedly a reason for delay and lack of resolution in discussions between government, organized labour and Anglo American Platinum about the company’s need to reduce costs and investment.

We would like to take a step back and assess how profitable platinum miners are, and calculate the expectations embedded in their market prices. Once we understand those expectations, we can focus on the best way forward for the business and its stakeholders.

The platinum industry has been one of great hope and now disillusionment. We aggregated the historical financial statements of the 5 largest South African platinum miners (Anglo American Platinum, Impala, Lonmin, Northam and Royal Bafokeng) and calculated the inflation-adjusted cash flow return on operating assets, CFROI, which is the real return on capital for the industry. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slumbered below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for platinum miners. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time (the average CFROI for global industrial and service companies is 6%). The rush to mine platinum and build company strategies around this effort was on, e.g., Lonmin bet its future on platinum.

The 2nd wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop to 1% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.

Unfortunately, operating returns have not improved much and have remained below the cost of capital throughout the global slowdown due to increasing labour, electricity and excavation costs, and lower platinum prices.  By cost of capital, we mean the minimum return required of an investment in an industry with proper regard to the risks involved in its operations and financial constraints. The greater the risks, the greater the return required to sustain or expand the industry. Firms or sectors of the economy that prove unable to satisfy their cost of capital decline while firms that beat their cost of capital are strongly encouraged by shareholders and other capital providers to expand and to raise the finances necessary to do so.

The 2012 CFROI in the platinum sector of the SA economy was a miserable minus 0.6%, which is the lowest return on capital since 1992 when our calculations on realized returns in the sector begin. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders or the market place to support their operations. This has resulted in unavoidable cost-cutting, lay-offs and deep cuts to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.

And what does the future hold?  We’ve taken analyst expectations for 2013 and 2014 and estimated the real return on capital.  It remains very poor at a value destructive level of 0% for 2013 and a depressed 3.4% until 2017.  There is no hint of a return to superior profitability in the share prices of platinum miners. The market has them valued to continue to realize a real return on capital of less than 6%, which is the average real return on capital for industrial and service firms throughout the world. As an aside, despite high gold prices, profitability for SA gold miners is no better. Their aggregate CFROI is expected to remain around a value destructive 3% for the next 5 years.

In a nutshell, South African platinum and gold miners are destroying value and are expected to continue to do so. They are in a dire economic state. To survive they have to reduce costs. Demands for wage increases that far exceed inflation are now totally unrealistic and cannot be fulfilled. These demands are anchored to a past that no longer exists. The tragedy is that for the workers who are bound to lose their jobs mining platinum, there are no forms of alternative employment that will provide them with anything like the same rewards.

All parties should focus on what is realistically possible and economically feasible. A wage freeze, reduced hours or some form of deferred pay are called for to minimize the pain. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits for those still fortunate enough to retain their jobs. Any improved employment benefits that may be extracted will go to even fewer surviving workers. There is however another way that makes much more economic sense for all stakeholders not least the government and SARS that shares fully in profits and also wages earned. Cooperation – yes, call it co-option if you like – is urgently called for.

In normal economic circumstances it is sensible for employees of a failing firm not to sacrifice current benefits to keep their employers going. Ordinarily, they can expect to find equally well-paid work with another firm in an industry willing and able to employ them. After all, skilled or even less skilled but experienced workers are a valuable scarce resource in a well functioning economy that sustains close to full employment conditions. Unfortunately, this does not describe the SA labour market with its relatively few insiders employed formally and the many others, particularly young potential workers so anxious to join them but unable to do so.

Moreover most workers prefer fixed predictable rewards to variable income. The risks of variable incomes are borne by shareholders and to a degree, managers with bonuses linked to the company’s operating performance. If a failing firm is unable to offer market related benefits to its employees or indeed its owners, then it deserves to fail and the scarce resources it was employing and in effect wasting could be transferred to other firms capable of employing resources more productively.

In the case of platinum and gold miners in South Africa, the prospect of alternative employment with anything like the same benefits is very bleak. Workers would be well advised to settle for less especially now and hope to make it up at a later stage should the prospects of the industry and its productivity improve. Deferred pay offers an inventive compromise where current pay sacrificed is exchanged for shares or even options on shares to be realized at some point in the future. It would then be in all parties’ best interest for productivity and return on capital to improve. If these cost savings were made or even expected to be realized, the shares the workers owned in the industry, exchanged for lower take home pay, would appreciate significantly. Sacrifices made now to hold on to jobs could be more than made up in the share market. And more valuable platinum and mining companies would be able to much more easily fund growth in output and employment rather than manage as best they can declining output and employment.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline further and its prospects deteriorate. Perhaps even to the point where nationalizing the industry with full compensation might seem a realistic proposition. It may cost relatively little to take over a failed industry. Nationalization however will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders who will have lost so much, carry the can for the failures of management and unions that must share the blame. The government and its agencies have many alternative and much better uses for tax revenues than to subsidise the already well-paid workers in a difficult, capital-intensive industry that is likely to realize poor returns.

The unions might think correctly that management subject to the discipline of taxpayers rather than shareholders would be a softer touch. Government and its taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. By taking stock of the poor economic performance of the platinum mining industry and its depressed expectations, all parties can negotiate from a shared set of financial and economic facts. These are difficult times and creative approaches are needed. All parties need to be anchored in the right bay signaled by today’s reality and expectations.


[1] David Holland is an independent consultant and senior advisor to Credit Suisse. Brian Kantor is Chief Strategist and Economist with Investec Wealth and Investment.

 

Listed JSE property continues to surprise. Can it continue do so?

Exceptional returns all over again.

Property stocks listed on the JSE have again confounded the market place. From the beginning of the year to 8 May 2013, the Property Loan Stock (PLS) Index returned nearly 20% compared to 5% from the All Bond Index and 4% from the JSE All Share Index.

Since 30 April 2012 the returns provided by the PLS Index in capital appreciation and dividends have been even more spectacular. The PLS Index returned over 47%, over a period when the All Share and All Bond Indexes also provided still very good total returns of 21% and 18% respectively. Between January 2000 and May 2013 The PLS Index provided average annual returns, calculated monthly, of 23.4%, compared to an average 15.5% for the All Share Index, 11.9% average from the All Bond Index and about 8.8% average returns from the money market. Annual inflation averaged about 5.8% over the period.

What has the market missed when valuing JSE listed property? Interest rates and / or property fundamentals?

The extra value attached to listed property could have come from unexpectedly good rental income and / or unexpected declines in the rates at which those rental flows are discounted. Listed property valuations have very clearly had the benefit of unexpected declines in interest rates. Less obvious may have been unexpectedly good or perhaps also unexpectedly consistent growth in rental incomes after costs. Expected dividends are not made explcit like interest rates and interest rate expectations. At best they can only be inferred from market movements themselves.

In the figure below we show how the dividends distributed by the companies represented in the PLS Index, weighted by company size, have grown over the years. Over the extended period the dividends paid have fully kept up with the Consumer Price Index (CPI). Having lagged behind the CPI between 2002 and 2004, the PLS Index’s dividends per share had caught up with inflation by 2006. Since then they have matched inflation almost perfectly. Such consistent growth in distributions, despite the global financial crisis of 2008 that had a particularly severe impact on listed property elsewhere, might well have taken investors by surprise and justified something of a rerating for the sector. However no such re-rating has occurred.

The benefits of lower interest rates for property valuations

The value of JSE listed property companies has been very clearly assisted by unexpected declines in SA interest rates. As interest rates come down, property companies benefit in two ways. Firstly, their bottom lines benefit from less interest expensed. Secondly, the discount or capitalisation rate attached to expected rental income goes down and values go up with lower interest rates.

As we show in the figure below, long term interest rates and the PLS dividend yield have declined in more or less lock step. We also show the difference between long RSA bond yields and the initial PLS dividend yield. This yield spread represents the rating of the PLS. A widening spread indicates less market approval (a de-rating) and a narrowing spread indicates a more favourable rating (a re-rating). This spread widened to the disadvantage of the property sector in 2002-03. It then narrowed significantly from a +5% spread to a -2% by 2007. Thereafter the spread widened as interest rates rose in 2008 and narrowed again in 2009. This risk spread has remained highly stable since then.

It may be concluded therefore that the sector has not improved its rating relative to long term bonds since 2009. The improved property returns since then can be attributed to interest rate movements rather than to any sense of improved property market fundamentals.

Given that PLS dividends have kept pace with inflation (and may be expected to maintain this pace), the PLS dividend yield could then be regarded as a real inflation protected yield. Thus a comparison can be made with the real, fully inflation protected yield offered by RSA inflation linkers. The yield on the R197, an inflation-linked 10 year bond, has fallen dramatically over the past 12 months. Yet the spread between the PLS dividend yield and the inflation-linked R197 has remained largely unchanged as may be seen in the figure below. This “real” spread, the extra rewards for holding listed property, has not declined in recent years. This provides further proof that higher PLS values have been driven by interest rates rather than improved sentiment. No re-rating of the PLS sector has taken place according to these metrics.

Making the case for the PLS sector at current levels and yields.

The listed property sector is highly sensitive to interest rate movements. We calculate that for every 1% move in the All Bond Index, the PLS Index can be expected to move in the order of 1.5%. We have shown that the major force acting on the PLS Index in recent years have been lower interest rates. As we have indicated, there is little sign in the market place that expectations of the property sector have become more demanding. It is lower interest rates rather than faster growth in expected rental income (and the dividends associated with better underlying economic performance) that have driven the PLS Index higher.

What then are the required returns that will drive property valuations and development activity in SA over the long run? Our sense is that that the normal risk premium for a well diversified, listed and well traded SA property portfolio should be of the order of extra 2-3% per annum over long term interest rates on RSA bonds.

If that is the case, the expected risk-adjusted return on listed property would now be of the order of 9-10% per annum, that is about 3% above the current 10 year RSA bond yield of 6.13%. The current PLS Index dividend yield is 5.2%. Expected inflation implicit in the RSA bond market is 5.56% – being the difference in the nominal yield on a generic RSA 10 year bond of 6.13% and the equivalently dated inflation-linked RSA197 that currently yields 0.57%.

Adding inflation equaling growth in PLS dividends of 5.57% to the initial PLS dividend yield of 5.2% gives us an expected return of 10.77% per annum, or a PLS risk premium of 4.64% per annum. This is a risk premium significantly higher than our estimate of a required risk premium of 2-3%. It suggests that if we are right about a normal risk premium there is still some upside for the PLS Index at current interest rates.

Subtracting the RSA inflation linked yield of 0.6% from the 5% PLS dividend yield gives us real risk premium of the same magnitude, of about 4% plus. Again this seems too generous a reward for the risks in well diversified real estate.

The fundamental case for investing in JSE listed property today is that the current risk premiums available in the market place are larger than necessary for attracting funds to the sector. Yet it should be appreciated that regardless of the long term case for investing in JSE listed real estate (that may or may not prove compelling), the short term movements in the PLS Index will be dominated by movements in interest rates. In the short, if not the long run, the property sector remains a play on the direction of interest rates, regardless of the investment fundamentals. Brian Kantor

Why a great variety of new cars on the road is good economic policy

A lead article in BD by Alexander Parker, (Friday 5 April) was introduced with the headline State-Aided car exports ‘almost 40% of trade gap’.

The article quoted Roger Pitot of the National Association of Automotive Components and Allied Manufacturers, that the motor industry’s trade deficit was R49bn “or more than 40% of the national trade deficit … by far the highest we’ve ever had”. Presumably this trade deficit is the difference between the imports of motor vehicles (fully built) and also of components of motor vehicles (to be assembled in SA) and the exports of motor vehicles and components from SA.

Fair enough – but then the article goes on to quote Gavin Maile from KPMG “… local production of vehicles for export also contributed to the trade deficit …” an observation given prominence in the headline.

(This last statement is a non sequitur. Any exports of motor vehicles from SA would reduce the trade deficit provided, which seems reasonable enough to assume, that the prices received for the the exported vehicles covered at least some of the labour, transport and rental cost etc incurred in SA assembling and/or shipping out the vehicles. This would be true even if all the components of the vehicles exported were imported. Indeed, if the fully built up vehicles were shipped to SA and then re-shipped to neighbouring countries, outside the customs union, provided there were extra rands to be earned in these operations, the SA trade deficit would decline.) Imports might go up in rand terms importing the vehicles and or their components, but if some of the imports were then re-exported exports measured in rands would go up by more than the rand cost of the imported vehicles or the components previously imported.

But these logical quibbles aside, the more important point is that there is no logical reason to expect or plan for a balance of imports and and exports in any one sector of the economy as perhaps the component producers are suggesting and would prefer. There will always be sectors of the economy that profitably export far more than they import: for example mining or farming and other sectors, such as the motor industry where the opposite applies.

We and the firms we own and work for strive to profitably produce a surplus of the services or goods that we specialise in to supply the world of consumers and users, both domestic and foreign. We then turn these sales into money for salaries and wages and rents and taxes and profits for owners who then exchange this income for all the other goods and services that are cheaper to buy in than produce ourselves. As Adam Smith explained many years ago, division of labour and the productivity gained through specilaisation is limited by the extent of the market. These benefits of trade are widened by opportunities to sell to and buy from foreign firms and households.

An economy protected against foreign competition will not only import less but also export less because it denies itself the advantages of specialisation in goods and services in which it has comparative advantages (in both the domestic and foreign markets). The notion that trading partners will willingly buy from SA firms without an equal opportunity for their firms to also sell to SA customers is clearly false. Trade is a two-way street where the traffic is best kept flowing freely in both directions.

It is possibly a moot point whether SA would have much of a domestic motor assembly, let alone a domestic motor manufacturing industry, were it not for a long history of protection offered to the domestic manufacturer and component producer. The effective protection against imports may have declined to a degree – hence the greater volume of imported vehicles. The one great advantage of the current system of incentivising exports by giving license to import, is an SA market with a great variety of vehicles (though how well prices paid on the local showroom floors compare with prices abroad is a subject of much debate).

This variety of new vehicles on offer in the domestic market – from luxury to utility – not only encourages demand for vehicles but also employment in the distribution and maintenance of these vehicles. One wonders how the numbers employed in distributing and servicing the vehicle stock compare with those employed in manufacturing vehicles and components. Less variety on offer would mean reduced demand for new vehicles and a smaller slower growing vehicle park to service and trade.

But aside from employment gains made in distributing and servicing an enhanced vehicle park, there is another very valuable benefit from having a great variety of new motor vehicles for customers to choose from. The quality of motoring experiences for many highly paid and highly skilled participants in our economy – the indispensable rain makers so to speak – ranks for them (in lifestyle) not far behind, in importance and relevance, to the quality of their homes, children’s education and medical services. Force them all to drive the equivalent of the East German Trabant or a limited selection of cars that might be produced cheaply in relatively large numbers in SA, would mean a less attractive life style for them and so effectively a still higher tax rate imposed on their incomes.

With all taxes or exactions on their standard of living, these key personnel with artificially diminished choices in vehicles or in any other goods and services they wished to spend their own incomes on, would have to be compensated with higher pre- tax incomes to help keep them in SA. Being able to exercise consumer sovereignty not only makes you free: it also makes your economy more competitive in the market for skills and so in all markets for goods and services that domestic suppliers enter.

Freedom to enjoy the full variety of goods and services on offer in the global village, especially educational, medical and motoring services (at competitive prices that only openness to imports can bring), helps hold down the cost of attracting essential skills without which no industry or economy can hope to be competitive. Adopting free trade helps supply a better quality of life, including importantly a better quality of motoring. This is sensible economic policy that pays off for all sectors of the economy, especially for those that have a comparative advantage in exporting their surplus production. Protecting the market against imported goods or services inevitably will bring lower levels of exports and a lower standard of living for all- rich and poor.

Brian Kantor

Platinum mining in SA: Anchored in the False Bay

By David Holland and Brian Kantor

Behavioural studies have shown that humans exhibit a strong anchoring tendency. When the world changes, they remain anchored to the one they know instead of adapting to the new order. Evidence for this behaviour is ubiquitous when parsing through government and labour comments about the ability of mining companies to pay more or hire increased numbers of workers. This is undoubtedly a reason for delay and lack of resolution in discussions between government, organised labour and Anglo American Platinum about the company’s need to reduce costs and investment.

We would like to take a step back and assess how profitable platinum miners are, and calculate the expectations embedded in their market prices. Once we understand those expectations, we can focus on the best way forward for the businesses and their stakeholders.

The platinum industry has been one of great hope and now disillusionment. We aggregated the historical financial statements of the five largest South African platinum miners (Anglo American Platinum, Impala, Lonmin, Northam and Royal Bafokeng) and calculated the inflation-adjusted cash flow return on operating assets, CFROI, which is the real return on capital for the industry. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slumbered below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for platinum miners. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time (the average CFROI for global industrial and service companies is 6%). The rush to mine platinum and build company strategies around this effort was on, e.g., Lonmin bet its future on platinum.

The second wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop to 1% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.

Unfortunately, operating returns have not improved much and have remained below the cost of capital throughout the global slowdown due to increasing labour, electricity and excavation costs, and lower platinum prices. By cost of capital, we mean the minimum return required of an investment in an industry with proper regard to the risks involved in its operations and financial constraints. The greater the risks, the greater the return required to sustain or expand the industry. Firms or sectors of the economy that prove unable to satisfy their cost of capital decline while firms that beat their cost of capital are strongly encouraged by shareholders and other capital providers to expand and to raise the finances necessary to do so.

The 2012 CFROI in the platinum sector of the SA economy was a miserable minus 0.6%, which is the lowest return on capital since 1992 when our calculations on realised returns in the sector begin. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders or the market place to support their operations. This has resulted in unavoidable cost-cutting, lay-offs and deep cuts to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.

And what does the future hold? We’ve taken analyst expectations for 2013 and 2014 and estimated the real return on capital. It remains very poor at a value destructive level of 0% for 2013 and a depressed 3.4% until 2017. There is no hint of a return to superior profitability in the share prices of platinum miners. The market has them valued to continue to realise a real return on capital of less than 6%, which is the average real return on capital for industrial and service firms throughout the world.

In a nutshell, South African platinum miners are destroying value and are expected to continue to do so. They are in a very dire economic state. To survive they have to reduce costs. Demands for wage increases that far exceed inflation are now totally unrealistic and cannot be fulfilled. These demands are anchored to a past that no longer exists. The tragedy is that for the workers who are bound to lose their jobs mining platinum, there are no forms of alternative employment that will provide them with anything like the same rewards.

All parties should focus on what is realistically possible and economically feasible. A wage freeze, reduced hours or some form of deferred pay are called for to minimise the pain. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits. Deferred pay offers the potential for an inventive compromise where pay is exchanged for share options. It would be in all parties’ best interest for productivity to improve and for the shares to appreciate.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline further and its prospects deteriorate, perhaps even to the point where nationalising the industry with full compensation might seem a realistic proposition. It may cost relatively little to take over a failed industry. Nationalisation however will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders who will have lost so much, carry the can for the failures of management and unions that must share the blame. The government and its agencies have many alternative and much better uses for tax revenues than to subsidise the already well-paid workers in a difficult, capital-intensive industry that is likely to realise poor returns.

The unions might think (correctly) that management subject to the discipline of taxpayers rather than shareholders would be a softer touch. Government and its taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. By taking stock of the poor economic performance of the platinum mining industry and its depressed expectations, all parties can negotiate from a shared set of financial and economic facts. These are difficult times and creative approaches are needed. All parties need to be anchored in the right bay, signaled by today’s reality and expectations.

David Holland is an independent consultant and senior advisor to Credit Suisse. Brian Kantor is Chief Strategist and Economist with Investec Wealth and Investment.

Vehicle sales: Combined impact

April proved to be a good month for SA motor plants and showrooms. 50 920 units were sold with all sales categories – from new cars sold to households to very expensive heavy vehicles sold to business (and exports too) – well up on March and on sales recorded a year before. The early Easter holidays had reduced trading days in March compared to a year before, increasing trading opportunities in April.

On a seasonally adjusted basis, unit sales were up by a solid 7 644 units in April compared to March and were nearly 20% up on April sales a year before. If we combine March and April sales, sales this year of 105 866 units were 6.7% higher than the equivalent two months in 2012. This growth in domestic sales will surely be very encouraging to the industry, especially to its manufacturing and assembly arm, accompanied as it was by very good export volumes of 22 907 units – equal to a solid 45% of domestic sales volumes.

When sales are smoothed and extrapolated using a time series forecast, sales appear to be on track for close to 700 000 units on an annual basis by this time next year. This would leave unit sales close to their record pace of late 2007.

As we show below, the industry marked time between 1990 and 2003. Sales then took off very strongly only to be much depressed in the aftermath of the global financial crisis.

This financial crisis was accompanied by a much weaker rand and significantly higher interest rates. Money market rates were over 12% in mid 2008, with overdraft and mortgage rates of the order of 15% p.a. They have come down steadily and significantly since then. As we show below, vehicle sales in SA appear highly sensitive to the level of interest rates and the associated finance costs. The money market is expecting interest rates at worst to remain at current levels for an extended period of time. Our own view is that the next move in SA interest rates will be down, not up, due to sub-par growth rates. These vehicle sales do however confirm that the economy is performing somewhat better on the demand side than the supply side.

The recent strength in the rand and the lower inflation rate this implies improves the chance of an interest rate cut. The sensitivity of vehicle sales to interest rates makes the argument for lower interest rates a still stronger one. The motor manufacturers are the the largest contributors to manufacturing activity generally. They and the economy deserve all the predictable help they can get form lower interest rates. Brian Kantor

The cash conundrum

There is far more cash out there than can be explained by National Income Estimates of Expenditure and Output. This is as true of the US as it is of SA.

A modern economy laden with old fashioned cash

A peculiar feature of the modern economy is just how much cash lies around. The demand for cash appears largely unaffected by the growing use of highly convenient alternatives to cash to pay a bill, or check out of a hotel restaurant or shop. The value of transactions processed by the banks has grown very significantly with the use of credit and debit cards. A still more important development is the use of an online transaction that transfers ownership of a bank deposit from one party to another with a few clicks on a computer.

The extraordinary demand for dollars circulating outside the US banking system has attracted renewed interest following a revised estimate of the greenbacks held outside the US. (See James Surowieki, “The Underground Recovery” in the New Yorker, 25 April and referred to by John Mauldin in his free weekly investment and economic newsletter, “Thoughts from the Frontline”, 27 April, John Mauldin. The revised estimates of off shore holdings came from Edgar Feige of the University of Wisconsin, a pioneer in the analysis of the demand for cash.)

After allowing for the 27% held offshore, this leaves about US$750bn of cash in US wallets, purses, under mattresses and in safety vaults. This is equivalent to over $2000 cash stored by every person in the US. The average American family that is hard pressed for cash at the end of every month will be surprised to know how cash flush they are presumed to be. But as with many other metrics, such averages tell us very little about the financial condition of the average family. The distribution of these extraordinary cash holdings is no doubt highly skewed to the right, with relatively few holders holding the bulk of the cash for their own good reasons.

The demand for cash and other transactions in SA

In SA a similarly extraordinary growth in the demand for cash outside the banking system has been recorded. The rapid growth in demands for cash has taken place despite the impressive advances made in the availability and use of alternatives to cash in SA, as in the US and elsewhere, with the adoption by banks of new technologies. The notes in circulation outside the banking system grew from nearly R23bn at the end of 1999 to over R81b by the end of 2012. That is at an average compound growth rate of 11.3% p.a. Adjusted for inflation the average compound rate of growth was 4.4% p.a. (See below)

 

According to the 2011 census there are some 15 milion households in SA. Dividing R8.1bn of cash in circulation by these 15 million households would mean that the average household in SA held on average as much as R5 400 in cash at the end of 2012. A small, fairly constant proportion of this cash will be held in neighbouring countries, especially Zimbabwe, but these demands are unlikely to account for more than 4% of the rand notes and coin currently in circulation.

In the figures below we show the strong growth in the value of electronic transactions effected by the SA Banks. Not surprisingly, given their convenience, the use of electronic fund transfers (EFTs) has grown significantly while the use of cheques has fallen away. The use of credit cards, while still relatively small, has more or less kept pace with the other forms of exchange since 2002, as we show below.

The value of purely electronic transactions facilitated by the banks grew from R155.2bn in January 2003 to R603.5bn in December 2012, that is at an average compound growth rate of approximately 13.6% p.a. This growth, while impressive, is only about 2% p.a faster than the growth in cash, despite the switch from cheques to EFTs. The average EFT processed by the banks is now about R8 583 per transaction and the average credit card transaction is of the order of R545. These average sized transactions are lower than they were in 2003 when adjusted for inflation.

The average low income SA household is too poor to hold this much cash at the expense of the inadequate food, clothes, energy or educational services they consume. And so we should conclude that the heavy lifting of cash in SA is probably not being done by the road side hawker or marginal retailer, but by more significant business enterprises and their owners.

How can we explain the demand for cash? Using cash escapes surveillance.

The question then is what is all this cash on hand being used for? Cash very obviously serves the interests of those who wish to hide their income from the tax authorities or the officials responsible for means testing welfare benefits. Using cash helps escape surveillance by government and the financial system generally. Honestly declaring extra income earned that takes welfare recipients beyond the income thresholds or tax payers into higher tax brackets can make for what are effectively very high rates of taxation of income at the margin. An extra $100 or rands of extra income earned and declared may well mean more than a hundred of sacrificed benefits or as much in taxes levied.

The currency approach to measuring informal activity

Clearly there is a lot more cash out there in use in SA and the US and in many other economies than can be explained by officially estimated incomes or expenditure, especially given the growth in the use of the alternatives to cash. The question then is just how much income and economic activity goes unrecorded when cash is exchanged for labour and goods and services? Just how much income or expenditure is going unrecorded because the transactions and the value they add are made in cash and are not reported in any reliable consistent way?

An estimate of how much activity is not recorded can be found by observation of the demand for cash itself. The essence of the approach is to attempt to explain and predict the demand for cash using incomes, prices and improvements in payments technology, measured as the value of electronic transactions processed by the banks, as explanations of the demand for cash. The observed higher demands for cash, the demands for cash that cannot be explained in this economically sensible way, then becomes a proxy for estimating the unrecorded levels of economic activity.

How much economic activity is not recorded?

The New Yorker article suggested that as much as $2 trillion worth of economic activity in the US may be going unrecorded. Given that the US GDP is officially estimated at just over $16 trillion, this would make unrecorded activity or the informal economy in the US equivalent to about 12% of the official US economy. Such an estimate is on the low side of estimates made for a number of developed economies, using a variety of methods to supplement national income estimates, including the currency demand models.

Many years ago I attempted to replicate the studies of Feige and others using SA data. In those days the SA economy and its labour market was severely infected by apartheid. In particular, the pass laws and other racially inspired laws and regulations prevented employers providing work and employees from offering their labour. These controls would have encouraged “illegal” activity and employment and the use of cash to avoid detection. My ball park estimates of unrecorded activity were equivalent to over 15% of the official economy. Or, in other words, the SA economy was then perhaps 15% larger than indicated by estimated GDP.

This approach did not find favour. The official estimates of unrecorded activity in SA to this day, officially assumed to be very largely informal retail activity, are estimated to be only about five per cent of recorded activity. This estimate is extraordinarily, perhaps unbelievably low, by international comparisons.

The incentives to use cash in the US and South Africa

For the US the major incentive to use cash may well be, as the New Yorker suggests, to avoid losing welfare benefits. In South Africa a further more important reason for using cash may be to escape not only tax or avoid the loss of welfare benefits but also and more importantly to escape the burdens of a highly regulated labour market. The incentive to use cash, rather than banks, to side step the regulations of the labour market and also by so doing to escape the supervision of the Receiver of Revenue, is surely a powerful motive for using cash.

More unrecorded activity means more unrecorded employment. If so this does not weaken the argument for a less regulated economy

If we are underestimating income and expenditure we are also underestimating actual employment. The only employment numbers we can be reasonably be sure of are the jobs offered by the formal sector. Unrecorded economic activity and unrecorded employment are therefore also matters of conjecture.

If SA has less of an employment problem than the official estimates indicate, given the unrecorded economic activity and associated employment, it still has as much of a poverty problem. The solution to SA poverty is faster growth, especially in faster growth of formal employment. But such growth in employment will not be realized or recorded unless the incentives for all businesses, especially small businesses, to operate formally are much improved.

Conclusion: Greater economic freedom for South Africa will add to incomes and employment and reduce the demands for cash and increase rather than reduce tax collected.

Encouraging formal employment and less evasion of taxation requires freer labour markets, less complicated income taxation, lower business income tax rates and much more sympathetic regulation of small businesses and their owners. Such steps might well raise more rather than reduce tax revenues as small businesses elect to operate above rather than below the radar screen. If they did so one of their attendant benefits would be access to a much more convenient payments system.

Progress in this regard may well be recognised by slower growth in the demand for and supply of cash. Unfortunately SA, with new licensing demands on all businesses that would seem to be in the interest only of the officials attempting to enforce new licensing laws, seems to be moving in the other direction. Brian Kantor

Bond markets: Fair winds from Tokyo for the bond market

Last week was a poor week for equities. JSE listed equities underperformed their emerging market peers and the rand also weakened in sympathy (see below). The trade weighted rand lost about three per cent by the end of the week.

Somewhat surprisingly – given rand weakness that ordinarily implies more inflation to come – the market in rand denominated fixed interest securities, across the yield curve, had a very strong week. The forward rate agreements offered by the banks moved sharply lower (and bond prices higher) implying, in the market’s view, that there was no chance of an increase in the repo rate over the next 18 months.

 

The yield curve represented by the zero coupon bonds also moved sharply lower beyond six years’ duration – by over 40 basis points. The implication of this move is that the RSA one year interest rate, while still expected to move higher over the years, is now only expected to breach the 7% level in 2020.

Consistently with these moves lower (in actual and expected interest rates), inflation expectations have declined. These expectations are implicit in the difference between vanilla RSA bonds that are exposed to the risks of higher inflation and the inflation linkers that are fully protected against inflation. This measure ofinflation expected, or more literally compensation for bearing inflation risk, is given much attention by the Reserve Bank. The argument is that inflation expected causes inflation itself, for which incidentally there is little evidence. The feedback loop is from higher inflation to more inflation expected, not the other way around. This measure of inflation expected has remained stubbornly and very consistently above 6% for much of the past few years. That it declined last week will be welcome news to the Reserve Bank and provides further strength to the argument being reflected in the money market that the next move in the repo rate is down rather than up.

The one consolation in the weaker rand is that it is being accompanied by consistent weakness in commodity prices. Generally a trend from which precious and other metals as well as oil have not escaped, so implying less inflationary pressure.

It is the weakness in commodity and metal prices and in emerging equity markets that have weighed on the rand and other emerging and commodity currencies. As we show below, the rand has made some small gains against the Aussie dollar and the Brazilian real since early March, though it did weaken marginally last week.

For global bonds, including the RSA bonds, the commitment to extraordinary money supply growth in Japan and the intention to weaken the yen, brings about the so-called yen carry trade. The difference between interest rates in Japan and almost everywhere else is thus a primary reason for downward pressure on global interest rates. Borrowing in yen and buying rand denominated securities was a poor trade in the first week of April, but a much better one over the past two weeks, notwithstanding the weaker rand against most currencies last week, the yen excepted. Brian Kantor

Monetary policy: A movable feast

Easter is the bane of those who attempt to measure the temperature of an economy. Without a good fix on current activity it is very difficult to forecast the future. The trouble with the Easter festivals is that unlike Christmas celebrations, they come at different times of the year. An early Easter for the average retailer will add to sales in March and reduce them in April and vice versa when Easter falls in April.

For motor dealers the opposite is true. For some reason, obscure to us, probably due to the regulation of their hours of trading, they stay closed on public holidays and Sundays. In other words, unlike your ordinary retailers who stay open on holidays for the convenience of customers and to the advantage of their part time employees, the motor dealers lose trading days over Easter.

This makes the essential seasonal adjustment more difficult to estimate. For retail sales in South Africa, the Christmas influence on spending at retail level, combined as it with the summer holiday effect on spending is very large. For the average South African retailer December month sales on average account for 35% more than the average month. To get a good idea of how good or bad retailers have done in December compared to past Decembers or to November, sales revenues of the average retailer have to be reduced (divided by) a factor of 1.35. For the motor dealer new vehicle unit sales have to be scaled up by 0.85 (ie divided by a factor of 0.85).

Over the longer run March and April on average have proved to be a slightly below sales months for the average retailer: the scaling factor is 0.98 or 0.97. But life is more complicated for the motor dealer. March is usually an above average month, with a scaling factor of 1.08, and presumably March becomes an even stronger month when Easter does not reduce showroom hours as they did this year. Meanwhile April, presumably because Easter usually but not always falls in April, is a below average month with a scaling up factor of 0.87.

This year, with Easter in March, will be a more difficult year to interpret sales trends for the motor dealers and perhaps also for retailers generally. To get at the underlying trend in sales and sales volumes we would have to scale up for the motor dealers and scale down for the orinary retailers by more than usual, but just how much would be a matter of some guess work. We will have to wait for sales in April to be confident in our measures.

Estimates of retail sales provided by Stats SA are only up to date to February. As we show below, the estimate of sales volumes in February were encouraging, suggesting that , on a seasonally adjusted basis, it was a better month for retailers than January 2013. On a seasonally adjusted basis retail volumes declined by 1.75% in January compared to December 2012 and grew by 2.7% in February compared to January. February volumes, compared to February 2012, were up 7.4%.

However despite this pick up in February sales volumes, extrapolating recent trends, appropriately seasonally adjusted and smoothed, suggests that the growth in retail volumes will continue to slow down marginally over the next 12 months. However this forecast growth in retail sales volumes can still be regarded as satisfactory. Real growth is predicted to be 4% in February 2014. With retail inflation currently running at a 4.6% year on year rate and predicted to rise to 5.2% in February 2014, this suggests that retail sales in current prices may be running at a close to 10% rate this time next year.

What the hard numbers say

We do however have actual vehicle sales volumes for March from the National Association of Automobile Manufacturers (Naamsa). These must be interpreted with caution. We also know from the Reserve Bank the value of its notes in circulation at March month end. We use these hard numbers to compile our up to date Hard Number Index (HNI) of economic activity which is an equally weighted combination of the real note issue and new unit vehicle sales. As we show below, this Index compares very well in its turning points with the delayed Business Cycle Indicator provided by the Reserve Bank. The Index, updated to March, indicates that the economy continued to grow faster in March but that the rate of forward momentum was more or less constant and maybe slowing down.

Values above 100 indicate economic growth. The Index was helped by strong growth in the note issue. This growth too was influenced by the early Easter and the spending intentions associated with it. The demand for cash is itself a coinciding rather than a leading indicator of economic activity. Households hold more cash when they intend to spend more on goods and services. However the advantage of measuring the note issue is that it provides a much more up to date indicator of spending intentions than spending itself. Spending, for example at retail level, is an estimate made from a sample survey, not a hard number, and moreover is only available with a lag. It will only be well into May before we can update our estimate of retail spending.

The close statistical relationship between growth in the note issue and growth in retail sales at current prices is shown below. Both series are on a slower growth trend and are predicted to remain so.

Should such negative trends in domestic spending materialise, more aggressive monetary policy would surely be justified. High rates of inflation that threaten the inflation targets have inhibited such monetary policy responses to date and may continue to do so. However, high rates of inflation cannot be ascribed to excessive domestic demand for goods and services. The trends moreover suggest that the growth in demand will be slowing down, rather than speeding up. The recent inflation in SA have had little to do with excess demand and much more to do with weakness in the rate of exchange and so the costs of imports that reflect also global commodity price trends. These trends, for example in the US dollar price of petroleum, suggest less rather than more inflation to come from this source (independent of exchange rates).

The problem for an inflation concerned Reserve Bank is that there is little predictable connection between interest rates and the exchange value of the rand and therefore very little direct influence the Bank can exert on inflation rates. Higher interest rates, if they implied slower economic growth, might well discourage capital inflows and encourage capital outflows, so weakening the rand and thus add to inflation, even as higher interest rates and a weaker rand discourage domestic spending.

Lower interest rates, where they boost economic growth, might in turn attract portfolio flows to the JSE and lead to a stronger not weaker rand. Faster growth with less inflation then becomes a highly desirable possibility.

Inflation targeting, without being able to predict the direction of the rate of exchange when policy action is undertaken, makes little sense. It may come to pass that the Reserve Bank accepts that the most it can hope to do with its monetary policy is to stabilise domestic spending, without regard to the outcomes for inflation. Recent policy actions by the Reserve Bank strongly indicate that in practice the Bank is following a dual mandate – targeting growth as well as inflation.

If only the rand would behave itself in the months ahead (implying no upward pressure on inflation rates) this dual mandate could lead it to lower interest rates. Recent movements in short and long term interest rates indicate that the money and bond markets are according a higher probability to a reduction in the repo rate over the next 12 months. Brian Kantor

Anglo’s parting chief: How not to say goodbye

Published by Business Day, Friday April 19th 2013. Opinion and Analysis Section, p11

Taking leave of her long suffering shareholders, Cynthia Carroll chose to admonish rather than commiserate with them.  As the Financial Times reported:

In a parting shot at shareholder demands for greater cash returns, Cynthia Carroll told the FT that there was a “disconnect” between mining companies and investors, adding that the latter need to understand better “what it really takes to deliver projects”.

“Some [shareholders are] under severe pressure and want a return tomorrow.  They’re going to be hard-pressed to get them because it’s not going to happen that way.  We have to be ruthless in terms of what [costs] we’ve got to cut but we have to be mindful we’re in a long-term industry.”[1]

 The truth about the recent behaviour of investors in Anglo is that far from any alleged short term disconnect between price and performance, as alleged, Anglo shareholders  are demonstrating remarkable patience in the face of a simply disastrous performance of the company in recent years that has seen Anglo’s earnings collapse. Blaming the global slowdown and super cycle bust ring hollow when judged by Anglo’s poor performance relative to that of its large diversified mining house peers. BHP Billiton, Rio Tinto and Anglo American are all listed on the FTSE in London. Since 2007 when Ms Carroll became CEO, BHP Billiton has beaten the FTSE by a factor of 1.95; Rio Tinto has beaten it by 1.31 and Anglo has returned only 0.61 relative to every £1 invested in the FTSE. This is a sad case of sterling underperformance.

The price to earnings multiple for Anglo has shot up lately in response to a collapse in reported earnings after taxes and write offs. Thus indicating very clearly that shareholders are hopeful that earnings will recover in due course. Let us hope that their confidence in the newly appointed Anglo management to affect a recovery in the mining house operations will be justified. Far from being short cited in the face of very poor recent results investors are proving remarkably loyal to Anglo.

The sad news about Anglo’s (AGL) performance under Ms Carroll’s watch is easily captured in a few more diagrams.  We show that while AGL was once worth more than BHP Billiton (BIL), its market value is now considerably lower. From a peak market value of over R700b in 2007 before the Global Financial Crisis struck, the company was worth less than half R336.4b by March 2013. As we show BIL held up much better over the period and is now worth significantly more than AGL (approximately R230b more at the March 2013 month end). Compared to early 2003 before the commodity super cycle shareholders would have done about three times better holding BIL than AGL shares.

Such relative performance is well explained by earnings and dividends per share. Anglo’s after tax earnings per share having collapsed in the past financial year to December 2012 is now below its level of early 2003. BIL earnings per share, while also under strong downward pressure, grew much faster over the ten year period and are well above 2003 levels as we show.  The upshot of all this history is that AGL was selling at the March 2013  month end for a highly generous and forgiving multiple of over 30 times its reported earnings while BHP Billiton commands a much more sober multiple of 12.8 times. The average price to reported earnings multiples for both companies over the past ten years has been about 13.5 times. Based on this measure, Anglo is priced for a recovery and normalisation of its earnings.

Anglo American and BHP Billiton Market Value (R’ 000m)

 

Ratio Market value of Anglo/ BHP Billiton 2003=1

 

Anglo American Earnings and Dividends per share  (2003- 2013; South African cents )

 

 

BHP BILLITON Earnings and Dividends per share (2003- 3013 sa cents)

 

 

Anglo American and BHP Billiton Price/Earnings Multiple

 

While price earnings multiples give an impression of the long term expectations that inform market values, we can take a closer look at the South African mining industry to judge more accurately what the market expects of the mining houses in terms of operating profitability and value creation.

Contrary to Ms Carroll’s statements and those of many other pundits unsympathetic to market forces  investors have long-term expectations about growth, return on capital and risk when they value the anticipated future cash flow from companies.  They take a long term view because it is the value adding viewpoint to adopt. Smart investors and corporate executives back into and analyse market expectations to understand current valuations before they buy or sell shares. If expectations appear too optimistic then the investment shouldn’t be made.  Two much pessimism about the long term provides a buying opportunity.

Using CFROI[2], which is a measure of the real cash flow return on operating assets,  we investigate the return on capital implications implicit in the current values attached to the mining companies listed on the JSE.

The average real return on capital (CFROI) for global industrial and service companies is 6%.  Firms that can generate operating returns that beat this level can generally be said to be creating shareholder value.  Firms that generate real operating returns less than 6% are destroying shareholder value.  South Africa (defined as firms listed on the JSE) has one of the highest median CFROI values in the world at 10%.  This is something to be very proud of.  In general, South African companies are very well managed and create shareholder value. If they can continue to generate returns that beat their cost of capital, they should re-invest their earnings and grow.  It is not a lack of cash that stops companies from investing more in SA mining operations , but rather uncertainty about the risk and economics of future earnings from those investments.  The government should do all it can to welcome investment and decrease uncertainty if it truly wishes to unleash growth.

Unfortunately, the South African mining sector has not generated a particularly attractive return on capital.  The median CFROI for the aggregate South African mining industry is 6.2% over the past 20 years. It has exceeded 9% in only two years, 2001 and 2006.  Many miners did very well during the commodities super cycle from 2006 to 2008 but have generated value destructive operating returns since. Platinum mining has provided a  particularly disappointing return on capital since the super cycle collapsed as has much of the acquisition activity undertaken by the diversified miners.

 SA Miners All Regions All Sectors – Weighted

And so what are the current expectations implied by current market values?  The aggregate CFROI for the South African mining industry implicit in current valuations is expected to remain well below 6%, which is below the real cost of capital or the returns normally demanded of risky mining operations.  Spiralling costs and low commodity prices are squeezing profitability, and this squeeze (undemanding expected returns) is baked into today’s lower share prices.  If we compare forward expectations over the next five years for BIL, Rio Tinto and AGL, BIL is priced for its CFROI to go from 10% to 7%; Rio Tinto from 7% to 5%; and AGL from 5% to a value destructive 2%. Such low expectations indicate that AGL is either cheap or the market has decided it is a value trap. The onus is on management to prove the market wrong by improving operational control, not to blame the market for losing faith in the industry.

The share market doesn’t expect growth from the mining houses. It is rather demanding that the mining houses pay much closer attention to cost control and operational excellence. These low market expectations should act as a warning to managers, workers and the government responsible for mining policy. The lower profits and reduced growth expected is not in synch with demands for higher wages, electricity prices and government interference with mining rights and the taxation of mining profits.  If these low expectations can be countered by sober management and relations, then these companies and their returns stand a stronger chance of recovering their status with investors. In the long run it will be the real return on the cash invested by the mining companies that will be decisive in determining their value to shareholders. In the long run economic fundamentals will trump what may be volatile expectations. The mining companies can manage for the long run with complete confidence in the willingness of the share market to give them time but must bear in mind that actions speak louder than words.

 Brian Kantor and David Holland


[2] Follow this link for more information about CFROI: https://www.credit-suisse.com/investment_banking/holt/en/education/popup_tutorial1.jsp 

Equity markets: The stock market always has a message for us – reading the market signs

Published in Investec Wealth and Investment Private View Quarter 2 2013

There is perhaps only one observation one might make with great confidence about the value of a firm: that over the long run its market value will be aligned to its economic performance. The better the realised performance, the more valuable the firm or a share in it will be.

In the long run economic fundamentals account for share values

There is perhaps only one observation one might make with great confidence about the value of a firm: that over the long run its market value will be aligned to its economic performance. The better the realised performance, the more valuable the firm or a share in it will be.

The problem for the analyst or investor is that the market is always attempting to value the expected rather than the realised performance of a company. These expectations can change from day to day, while it is only over the very long run that performance and its valuation will converge in an understandable way. The market does however provide consistent clues about the expectations implicit in market valuations. These clues then allow the investor to make judgments about the realism of these expectations of performance. They may be judged too optimistic (therefore providing reasons to lighten exposure to the market) or too pessimistic (making a case for increasing exposure to equities, that is for taking on more risk).

A firm’s economic performance might be calculated using a variety of metrics: accounting earnings per share (after interest and taxes paid) would be the most obvious measure of performance; dividends per share or operating profits might serve better as a measure of business success or the lack of it; so might cash flow – so called EBITDA (earnings before interest, taxes, depreciation and amortisation) – be preferred as a measure of the economic performance of a company; free cash flow (that is cash flow after investment activity) might indicate how well the company is doing.

These performance measures might best be normalised to exclude extraordinary temporary additions to or subtractions from bottom line accounting earnings. This would give rise to the so called headline earnings reported by JSE listed companies or even normalised headline earnings reported by some companies. The deepest insights into how well a company is performing are most likely to be found in measuring the cash flow return on capital (the return on the cash invested by the firm, suitably adjusted for inflation).

When we aggregate the performance of all the firms that make up a stock market, we find that all of these different measures of performance prove to be highly correlated. They will all tell a very similar story about how well the firms that make up the stock market have done over time.

Expected rather than past performance accounts for the short run behaviour of the market place

The problem for the investor is that while realised performance will be decisive in determining the value of a company over the long run, the market place does not sit by patiently waiting for economic performance to unfold. The day to day value of a company or the share market is determined by expected rather than past performance. And as investment advisors are constantly obliged to remind their clients, past performance is not necessarily a guide to future performance – even though it may be the only useful guide available.

Future economic performance implicit in current market values can as easily be overestimated as underestimated. If such estimates are proven (by subsequent events) to have been too optimistic, market values will tend to fall into line with disappointing economic outcomes. If the estimates of performance are too pessimistic then share prices will tend to rise and thus fall into line with the unexpectedly good economic outcomes.

Prices fall in line with performance – or performance catches up with prices

In any longer run view of the relationship between values and performance, either prices will fall into line with disappointing performance or unexpectedly good performance will drive prices higher. In the long run prices and performance will track each other.

The environment also matters – as reflected in the discount rate applied to future performance

There is a related issue when the value of a firm or a market has to be determined. This is the rate of discount which should be applied to expected performance, measured as a flow of earnings, dividends or free cash flow over time. Clearly future expected benefits from the ownership of an asset or firm are less valuable than current benefits gained from owning any asset or a share. Any market value can be logically regarded as being the result of a present value calculation. A similar calculation will be made by any firm contemplating capital expenditure. Future expected benefits have to be discounted to derive their present value.

This discount rate wlll be very much influenced by interest rates prevailing in the market place. Investing in a share is an alternative to investing in cash or short or long dated government bonds paying a fixed rate of interest with a certain money value. When investing in the shares or the debt of companies, a risk premium will be added to these interest rates to compensate for risk of default or failure.

But it is not only the risk to the firm that will be taken into account when values are estimated. It is the risks posed by government to the economic outcomes for firms and share owners that will be reflected in interest rates offered by government borrowers. For example the risks of higher or lower inflation will be revealed in these minimal interest rates, as will risks that government will tax interest income more heavily or will come to rely more heavily on debt than tax revenues to fund additional expenditure.

Furthermore interest rates will also rise or fall in response to a real shortage of savings. If the demand for savings or capital strengthens, from firms and the government itself, then real, after (expected) inflation interest rates will rise and vice versa. The greater the competition for capital, the higher will be real interest rates, and so the less valuable will be the present value of an asset as benefits are discounted at a higher rate.

Good news and bad news reasons for higher discount rates

This lower present value would occur with higher interest rates (all other things remaining equal). In this case the expected performance of the companies would have to be expected to remain unchanged in the face of higher interest rates. Often however the competition for capital will be most intense when companies are doing well and expect to do well.

These conditions would provide good news reasons for higher interest rates and could lead to higher values, despite higher costs of capital. The bad news reason for higher interest rates is when governments are thought more likely to misbehave by adopting less encouraging economic policies for the firms that make up the economy. Bad news about government policy or about the performance of a firm inevitably translates into higher interest rates and hence less valuable companies. Good news about improving government policies and or better managed firms usually means the opposite.

We may not be able to predict share prices in the short run, but we can know when the market place is optimistic or pessimistic about the economic future.

However accurately predicting the day to day moves in share prices is very difficult because expectations can change significantly as information, the news and its interpretation, percolate through the market place moving market values in a largely random way. Yet it is possible to observe when the market is more or less optimistic about the future. The best that the informed investor can hope to do is to use market values to infer how optimistic or pessimistic the market currently is about the prospects and to agree with or take issue with the prevailing sentiment. We undertake such an exercise for the value of the key share market index, the S&P 500 (representing the largest 500 companies shares listed on the New York and Nasdaq stock exchanges).

In the figure below we show the results of a simple regression equation which explains the value of the S&P 500 with reported dividends and long term US Treasury Bond Yields. This is equivalent to a present value calculation, with long term US government interest rates used as the discount rate.

As may be seen from the figure below, the explanatory power of this model is very good with actual and predicted values closely aligned in general. The goodness of fit of the model, measured by its R squared, is of the order of 95%. Thus the model may be regarded as providing a very good long term explanation of the value of the S&P 500. The S&P 500 over the long run is well explained by reported dividends and long term interest rates.

It should also be noticed that the fit was generally even closer before 2000 than since then, given the influence of the dotcom/tech bubble in the early 2000s and the Global Financial Crisis late in the decade.

The most striking conclusion to be drawn from this exercise is that the S&P 500 at the March 2013 month end, despite its recent strong gains, is still deeply undervalued by its own standards: in percentage terms about 40% below its predicted value. If the past were the guide to current performance, then the S&P 500 (given current dividends and interest rates) would have a predicted value of 2440 rather than the current (still record) level of 1560. In other words, it may be concluded that the market currently remains about as pessimistic about earnings and dividend prospects as it was at the height of the financial crisis in 2009. The same model estimated in May 2009 indicates that the market was then undervalued by 47%. As the chart shows, the S&P 500 recovered very strongly from these depressed 2009 levels over the next 24 months as prices caught up with the improved fundamentals of rising dividends and low interest rates. The same model, when estimated at the height of the stock market boom in May 2000, indicated that the market was then as much as 55% overvalued. Those times were times of extreme optimism about the prospects for listed US companies, an optimism that was not at all borne out by subsequent performance of earnings or dividends per share.

The S&P 500 Index: Actual and predicted values

Source: I-Net Bridge, Investec Wealth & Investment

We use easily calculated dividends per share rather than earnings per share as the measure of shareholder benefits. This is because S&P 500 earnings per share collapsed so precipitously during the Global Financial Crisis of 2009 as financial corporations had to write off their many bad loans. Dividends and operating profits held up much better over this period, as we show below, and therefore provide a much better reflection of the economic performance of the companies valued between 2008 and 2013. Both series have recovered very strongly and are close to or above their pre crisis levels.

S&P 500 Earnings and dividends per share in US cents (log scale)

Source: I-Net Bridge, Investec Wealth & Investment

It may therefore be concluded that if the past is anything to go by, the S&P 500 continues to offer value. By the standards of the past the market is very undervalued for current dividends and interest rates. Pessimism, rather than optimism about economic prospects for the S&P 500, appears to dominate sentiment. The potential investor in the market can make his or her own judgments about whether such essential pessimism is still justified.

It should be appreciated that, by these measures, the market can remain undervalued for an extended period of time. It is also possible that earnings and dividends may collapse to justify such pessimism. Interest rates in the US may also rise for bad news reasons, such as less faith in the US government. They may also rise for good news reasons because US firms become more willing to undertake capital expenditure and compete, pushing up interest rates accordingly. If so, the US economy and the global economy, as well as earnings and dividends that flow from the economy, are unlikely to disappoint. Stock market valuations would then play further catch up through realised performance.

It may be of some comfort to those with a bias in favour of buying and holding shares for the long term to know that by its own standards, that is relative to past performance and current interest rates, the US equity market remains deeply undervalued despite the recent gains made.

 Brian Kantor

From Tokyo to Johannesburg – a move in interest rates and the rand

There were some interesting developments on the SA interest rate front late last week. Long term rates in SA declined by more than they did in the US. Thus the spread between the rand yields on long dated RSAs over US Treasury Bonds narrowed.

This spread is equivalent to the rate at which the rand is expected to depreciate against the US dollar over the next 10 years or so. It is notable that as the rand weakened over the past 12 months the spread actually narrowed, indicating less (rather than more) rand weakness to come in the years ahead. This spread, which we describe as the SA risk premium, was over 6% this time last year; last week it had fallen to 4.58% (see below).

The gap between long dated vanilla RSA bonds and their inflation linked equivalents remains stubbornly around the 6% plus range, though this compensation for bearing inflation risk (implicit in long dated fixed interest) also narrowed marginally.


Inflation expected in the US, calculated similarly as the difference in yields on vanilla bonds and inflation linkers of similar duration, is of the order of 2.5%. This spread has widened marginally over the past 12 months (see below).


The spread between RSA US dollar-denominated (Yankee) bonds and US Treasuries also narrowed last week to about 150bps. The spread was below 120bps in December 2012.


RSA US dollar bonds have not performed as well as most of their emerging market peers over the past 12 months. Turkey now enjoys a superior credit rating to SA. Mexican and Brazilian bonds have been in particular favour with global investors as we show below.

A fair wind from Japan


The force dominating developments on the global interest rate front last week was the carry trade in the yen. Despite the markedly weaker yen – in response to aggressive money creation in Japan – interest rates in Japan remain below yields everywhere else. Thus borrowing yen to buy higher yielding securities everywhere else, including in SA, must have seemed like a good idea late last week. It has certainly proved to have been a good trade this week and may well be judged to offer further advantages in the weeks ahead. The rand and bond yields in SA will benefit from any such further yen carry trade – as should the interest rate plays on the JSE. Brian Kantor

New vehicle sales: A good but slower pace of sales in February

New unit vehicle sales fell off the torrid pace set in January 2013. On a seasonally adjusted basis, unit sales fell back from the 57 834 units sold in January to 52 760 units sold in February. We had suggested that January sales may have been boosted by pre-emptive buying in response to rand weakness.

As we show in the chart below, unit sales (seasonally adjusted and smoothed) remain on an upward tack. If current trends are maintained, the distributors of new cars in SA could be looking to monthly sales (seasonally adjusted) of 59 000 units by this time next year. This would take the industry almost back to the record levels of sales achieved in 2006. It is instructive to notice how little growth in vehicle sales volumes occurred between 1990 and 2002, but also how sales took off in the boom years (2003- 2007) before the recession knocked them back again. That sales are again approaching boom time volumes should be regarded as very good news about the resilience of the SA consumer.

While sales in the local market are satisfactory, even as their growth may have slowed, the motor manufacturers and component suppliers will be well pleased with fast growing export volumes. New vehicle exports numbered 27 011 units, or 5 057 more units than exported a year ago, a gain of 22.4%. It will be appreciated that vehicle exports are now running at a fraction more than 50% of domestic sales. This boost to exports will be particularly appreciated by the authorities and the currency traders worried about the slow pace of exports and the large trade deficit recorded in January 2013. Clearly vehicle sales have been encouraged by low interest rates and available bank credit. The low interest rates and banks eager to lend are very likely to continue to add impetus to the vehicle market. The weaker rand however, will make it harder for the dealers to compete on the price front – not only with other dealers but with all other goods and services that compete for a share of the household budget. Brian Kantor

Money and credit: No signs of a pickup in growth rates

Money supply and credit numbers for January 2013 show that while the supply of money (broadly defined as M3) continues to increase, the pace of growth remains subdued at about the 6.5% to 7 % year on year rate. The asset side of the bank’s balance sheet, represented by credit granted to the private sector, has been growing at a slightly faster rate, closer to a 9%.

There would however appear little evidence of any pickup in growth in bank lending or in the broadly defined money supply. Mortgage lending, which is usually a large component of credit supplied by the banks, about 50% of all bank credit provided to the private sector, continues to grow very slowly. Clearly house price gains and thus growth in mortgage lending are increasing very slowly, with the rate of growth slowing down.

These money supply and credit trends, as well as the very subdued trend in house prices, make the case for lower interest rates. Until such time as these trends move strongly in a higher direction, short term interest rates in SA will remain on hold – though given these money and credit trends the economy could well have done with lower interest rates. Brian Kantor