Author: Brian Kantor

A strange moment for the rand

The mystery of the strange behaviour of the rand yesterday (Wednesday) has been solved. Sudden rand weakness had nothing to do with South African events: it weakened suddenly around 11h30 in complete sympathy with a simultaneous decline in the exchange value of the Brazilian real.

As may be seen in the chart below, both currencies weakened significantly at about this time. Hence the rand weakness can be described as a response to emerging market rather than SA specific risk. To deepen the mystery further however, other emerging market currencies, such as the Turkish Lira and the Mexican peso, did not react in anything like the same way. The mystery therefore is to recognise those forces that simultaneously weakened the Brazilian and SA currencies. As for now, this remains something of an unsolved mystery.

The JSE moreover did not react to rand weakness, as might ordinarily have been expected. Retailers, who are particularly vulnerable to rand weakness and the higher import prices that come with it, held up very well and the rand hedges – both of the Industrial and Resource kind – did not outperform.

What Brazil and SA have in common are iron ore exports to China. There was a conference call yesterday organised by one of the institutional brokers on the proposed reduction in Chinese domestic iron ore tax, where it was stated that a more favourable tax treatment of domestic iron ore producers might well reduce the Chinese demand for iron ore imports.

This episode in the currency markets perhaps illustrates once more how important China is to the outlook for commodity prices. Yesterday was not at all a bad day for commodity prices. Iron ore fines were quoted at prices only marginally ahead of the day before and nearly 8% higher, year to date, while the CRB Commodity Price Index was unchanged on the day. Brian Kantor

Striking the rand

The troubles on the mines and now the farms of SA have hurt the rand. The rand is now significantly weaker than would have been predicted given the behaviour of emerging market equities and RSA sovereign risk spreads.

These two factors provide a very good explanation of the rand/USD exchange rate on a day to day basis. As we show below, the rand is about 12% weaker than predicted by this model of the rand.

As may be seen below, the MSCI emerging market index has held up over recent months, as has the cost of insuring against a default on RSA foreign currency denominated debt with a five year credit default swap.

However, as may also be seen, RSA debt has derated in recent months. Compared with Turkish, Russian. Brazilian or Mexican debt, the costs of insuring RSA debt has become relatively more expensive.

Yet compared to the past, the SA risk spread remains very low by its own standards, at 150bps above the returns on US five year debt.

The exchange value of the rand will continue to be driven by global economic forces, as revealed by: the value of emerging market equities, the risks associated with SA (shown in the debt markets) and now also by SA specifics in the form of strike action. The markets will assess not so much the incidence of strike action, but its expected impact on the economy, notably exports and domestic economic activity. The challenge for the SA government is to reform its system of labour relations to make strike action less likely and less violent; and employment growth more likely. Brian Kantor

Domestic spending: Encouraging October

The demand for cash supplied by the Reserve Bank continued to grow strongly in the three months to October 2012. As we have explained before, the Reserve Bank note issue has proved to be a very good indicator of the spending intentions of SA households.

As we show below, the demand for cash fell off in early 2012 but picked up very strongly from mid year. Over the past three months the note issue, seasonally adjusted and annualised, grew by a robust 21%. As we also show, the growth in the broader money supply – mostly in the form of deposits issued by the banks – grew similarly in the three months to September month end.

Unit vehicle sales have followed a very similar trajectory to the note issue (adjusted for inflation), losing momentum in the first half of 2012 and then recovering strongly to October.

Unit vehicle sales and the note issue (adjusted for the CPI) make up our Hard Number Index (HNI) of the state of the economy. The HNI has two advantages: it is very up to date (updated to October 2012 month end) and it is based on actual recorded volumes (hard numbers) rather than the estimates made from sample surveys.

Given the strength in both vehicle sales and cash volumes, the HNI indicates that the economy has continued to move forward at a good pace. Its rate of growth – what can be regarded as the second derivate of economic activity – however continues to slow down. The indications therefore are that the SA economy is continuing to move forward at a good pace but that its forward momentum is slowing.


Other data releases for October – to be released in due course – are likely to confirm that domestic spending intentions and actions remain robust, surprisingly perhaps to the market place.

The figures for the note issue and unit vehicle sales are the first data posted for the economy post Marikana. It would appear that the strike action on the mines and roads of SA have had little negative influence on spending intentions. This resilience of domestic demand is very welcome when foreign demand is growing as slowly as it is, given the weak state of the global economy. If the economy is to retain its growth momentum, which is essential for political stability and a satisfactory fiscal state of affairs, it will continue to depend on the domestic spender. Domestic spending is being encouraged by low interest rates, which can be expected to stay low until global economic conditions improve.

The Census reports good real progress in household incomes and household numbers

The general impression provided by the census is that significant economic progress has been made in SA over the past 10 years. There are now 14.45m identified households, 28% more than were counted in 2001. Average household incomes of R103 204 were reported compared to R48 305 in 2001. That is an increase of 113% in money of the day terms. Given that the CPI increased by 77% over this period, this implies a real increase of approximately 36% in average household incomes over the 10 years.

The poorest SA households are those led by black Africans. However they did significantly better than the average SA household. Households headed by black South Africans increased their average household incomes by 169% in current prices or by nearly double, when adjusted for inflation between the censuses of 2001 and 2011. The objective of advancing the previously disadvantaged has been met about as well as the government could have realistically hoped for.

The census is consistent with National Income estimates

These increases in self assessed incomes, in response to the question asking respondents to estimate “gross monthly or annual income before deductions and including all sources of income” compare very well with the growth in per capita incomes as estimated by the National Income Accounts. Gross National Income per capita in real terms grew by 35.5% between 2001 and 2011 or at a compound average growth rate of 3.04% p.a. Such growth rates in per capita or average household incomes represent much more than the much despised trickle down. If growth is maintained at this rate over the next 10 years this would represent a doubling of average incomes in 20 years and significant economic progress indeed.

One of the benefits of higher incomes is more and smaller households

It is not surprising, given an improved standard of living, that the number of identified households has increased much faster than the population itself. The population grew from 40.58m residents in 2001 to 51.77m in 2011, an increase of 14.2%, compared to the larger 28% increase in the number of households. Many more family members have had the means able to form households of their own.

The average SA household therefore consists of a surprisingly few 3.58 average members in 2011 compared to a similarly few 3.62 members in 2001. Perhaps this small average household is attributable to the large number of female led households with presumably no males of working age to add to household income or numbers. Households led by women earn significantly less than the average. (see below)

The composition of the housing stock

Of the 14.4m housing units identified by the census the great bulk are formal houses or apartments. 1.14 units are described as traditional, 1.249m as informal dwellings (stand alone shacks) with a further 713 thousand shacks in back yards. The ownership structure of these housing units makes interesting reading. Nearly 6m of the units are identified as owned and fully paid off (See below). It is these owners who surely make the most reliable and sought after recipients of unsecured loans.

Stuff at home

These homes – owner rented and mortgaged – seem very well provisioned with household appliances and consumer goods. 10m refrigerators and 11m stoves were identified, together with 4.5m washing machines and more computers, 3m, than vacuum cleaners. 10.7m TV sets entertain the stay-at-homes backed up by as many as 8.5m DVD players and unsurprisingly, 13m cell phones.

Large differences in provincial income –or is it an urban / rural divide?

Much larger differences in household incomes are however recorded by the different provinces. Average household incomes are highest in Gauteng (R156 243) and the Western Cape R143 460 – almost three times as high as average household income in the poorest provinces (See below).

These income differences may be regarded as more of an urban-rural divide than a provincial one. The gap between household incomes in the Durban metropolitan region and that or rural KwaZulu-Natal is probably every bit as wide as it is between Gauteng and Limpopo.

Higher incomes mean greater opportunity and so migration – a force to be recognised in advance and encouraged

It is these differences in incomes and income earning opportunities that understandably have led to large numbers (presumably mostly younger men and women) migrating to Gauteng and the Western Cape. Over a million people have migrated to Gauteng over the past 10 years and over 300 000 to the Western Cape. The Eastern Cape has seen net outward migration of 278 000 persons, mostly to the Western Cape, and in Limpopo Province: a net 152 000 residents have migrated to other provinces, mostly to Gauteng.

Migration plus population growth has seen the population of Gauteng increase from 9.38m in 2001 to 12. 27m in 2011, an increase of 30%. This makes Gauteng by far the most populous SA province. The population of the Western Cape has increased by 28% over the 10 years to 5.8m people, more than the population of the much poorer Eastern Cape.

Since transfers from the central government to the provinces are based on the size of their populations, these developments have significant budgetary implications. The argument that the governments of the Western Cape and Gauteng will make is that with migration of this order of magnitude, 10 years is too long to wait to adjust budgets in recognition of population growth and the additional demands growth n population makes on provincial budgets.

However the logic behind the allocation of funds to the provinces based on existing populations, rather than their economic potential, should be questioned. If economic and employment growth were the objective of economic policy then it would surely be better to back the winning provinces – those that offer significant employment and income opportunity – rather than redistribute taxpayers’ contributions to those provinces where economic prospects and achievement are so lacking. The economic potential of SA, as everywhere in the world, lies in the urban not the rural areas. Brian Kantor

Retailers: Making sense of retail sales volumes and the value of JSE Retail counters

Retail sales volumes in August 2012 were up nearly 2% in August when measured on a seasonally adjusted basis, or 6.5% ahead of their December 2011 volumes. (See below)


Apparently the buoyancy of sales took economists somewhat by surprise. However observers of the note issue and unit vehicle sales (updated to September 2012 month end) that make up our Hard Number Indicator of the state of the SA economy, should have been less surprised. The retail volumes follow the pattern established by both vehicle sales and the real note issue. That is, growth in volumes, seasonally adjusted, when calculated on a three month rolling basis, picked up strongly towards year end 2011, then fell back sharply in early 2012, whereafter growth accelerated again. (See below)

As we have suggested, and has been confirmed by the strength in retail sales volumes, the SA economy has had more life in it than has generally been appreciated.

The stock market was perhaps less surprised by the strength in retail sales, given the recent strength of the General Retail and Food and Drug Indexes on the JSE. The value of the JSE General Retail Index, in real CPI adjusted terms, has increased by 35% between January 2011 and 17 October 2012 with much of this strength coming in 2012. Real sales volumes grew by 10% between January 2011 and August 2012.

The valuations of retail companies have clearly improved significantly faster than those of real sales. They have also outpaced real retail earnings per share, leading to elevated ratios of share prices to earnings of the retail counters, as has been well documented. However what has not been as well recognised is the extraordinary growth in real dividends distributed by the retail companies. Dividends per retail index share have grown much more rapidly than earnings per share. Dividends in fact have not only grown faster than earnings – 2.64 times as rapidly since 2002 – they have also outpaced the increase in the retail Index as we show below.

Thus, while the price to earnings multiple attached to the general retailers in SA has increased significantly since 2002 (from 9.32 in early 2002 to the current 19.6 times) the price to dividend ratio has in fact fallen since 2002, from R40 paid for a rand of dividends in January 2002 to a mere 31.3 times today.


Retail companies listed on the JSE have benefitted from strong growth in sales and stronger growth in bottom line earnings as operating margins have improved. But they have also been able to generate strong growth in free cash flow – that is cash generated after increases in investments in working and fixed capital. The strength of their balance sheets, or perhaps an inability to find sufficient opportunities to deploy cash inside their businesses, has encouraged the retailers to pay out cash to their shareholders in the form of share buybacks and a reduction in earnings cover. The ratio of earnings to dividends per share has declined dramatically over the years, a decline that appears to be accelerating.


These dividends per retail share (in US dollars) have grown at an average compound rate of about 27.1% p.a since 2003 and have clearly had great appeal for foreign investors who have come to hold an increasing proportion of the shares in issue while SA fund managers have (regrettably) reduced their stakes. The Index in US dollars (excluding dividends) has increased at an average compound rate of 24.9% p.a over the same period.


Dividend yield and growth in dividends that SA retailers have been able to generate have had particular appeal in a world of very low interest rates. The exceptional returns provided by SA retailers in recent years are therefore not at all surprising in the circumstances. Their valuations – seen as a dividend rather than an earnings plays – make every sense. Brian Kantor

Outrageous pricing is bad for economy’s competitiveness

SOUTH African Airways (SAA) is a wholly owned subsidiary of the Republic of South Africa, as is Airports Company South Africa (Acsa).

SAA has run out of cash and has been given authority to raise R6bn in debt guaranteed by taxpayers to keep flying.

Acsa, by contrast, is awash with cash. For the financial year to the end of March, it generated R2.9bn in cash flows on customer revenues of R5.8bn — compared with R1.7bn on revenues of R4.6bn the year before. Last year, SAA generated just R278m of cash flow on income of R22.8bn.

This very different state of affairs is not coincidental. Acsa’s gains have been the losses or sacrifice of revenues that SAA and other airlines have had to make in favour of Acsa’s tariffs. SAA is almost certainly Acsa’s largest customer — the collector of the bulk of the fees paid by airlines and their passengers for the use of Acsa’s airports. These fees have risen significantly in recent years and account for a large proportion of what we pay to fly. The revenues the airlines can collect from their passengers is constrained by competition between them. There is no such constraint on the charges Acsa can levy given its near monopoly over all the airports in South Africa.

Acsa has not been shy to exploit its pricing power and neither the regulator nor the Competition Commission has acted as much of a constraint on the exercise of this monopoly power. An increasing proportion of the gross price per passenger flight that the market for air travel will bear, is being collected by Acsa at the expense of the airlines.

This is an issue recognised in economics as the pipeline problem. If you own an oil well or a coal or iron-ore mine and somebody else owns the only pipeline to the port, you are at their mercy. The owner of the transport monopoly can extract all the surplus you might otherwise earn from your mining operations — which is why the mine owners would do well to either own the lines to the market or sign very long-term leases for their use on terms that make economic sense.

Failing that, they may have to rely on the mercy of the regulators, who may control tariffs. The regulators, however, may be inclined to exaggerate the returns required by the owners of very low-risk rail, pipelines and ports, and so allow them to charge more heavily than would be the case were the ports and the lines to compete actively with each other for business. There is every reason to suspect the regulators in South Africa of this bias.

The government has invested on the ground and in the air. The airline business is notorious for the poor returns provided for shareholders while passenger numbers have soared over the years. The major airlines would have done much better to have invested in airports as well as fleets of airliners — as indeed the government, which owns SAA and Acsa, has done. It therefore makes economic sense for the government to keep SAA going — if only to collect the fees Acsa is able to charge. It would also make sense for SAA to be competently managed so that it, as well as Acsa, could contribute dividends and taxes to government revenues and help relieve the burden on ordinary taxpayers.

Another wholly owned subsidiary of the government (and also awash with cash) is Eskom. With much higher prices for the electricity it generates and delivers, cash is pouring into the utility. Some ball-park numbers taken from Eskom’s financial statements will help to make the point. In 2009, Eskom’s cash flow from operations was R5.16bn on revenues from electricity sales of R53.09bn. In the year to March, cash flow from operations was R38.7bn on sales of R114.7bn. Since 2009, cash flows from operations have increased 7.5 times on sales revenues that have grown 2.16 times. This shows how freely the cash flows from all the established capacity when prices are allowed to increase as they have done.

Eskom continues to invest in new capacity. In 2009, it spent R44.7bn on new plants and securing fuel supplies. This year it has spent nearly R59bn for the same purpose. But given the abundant supplies of cash delivered from operations (R38.7bn this year), Eskom needed to raise only R16.5bn of additional debt in the past financial year compared with R30.5bn of debt raised in 2009. Eskom’s debt-to-equity ratio is falling significantly. No doubt this is to the satisfaction of Eskom’s management and the Treasury. But whether such extreme trends are good for the economy is moot.

What is the required return on capital invested in monopoly airports or electricity generators? The justification for higher prices is that they are needed to provide an economic return on the additional capital Eskom is investing in more plant and equipment. The principle of charging enough to cover the full costs of additional capital investment in additional capacity desperately needed by a growing economy is entirely valid. Prices have to be only high enough to cover operating costs as well as to provide an appropriate return on the additional capital invested.

A critical consideration is what return on capital is appropriate for this. The National Energy Regulator of South Africa regards a real return of 8% a year as appropriate for Eskom. Such a return is far too high given the nature of a monopoly utility business that is essentially a very low-risk activity. To aim at a return of about half of this would be about right for the owners of airports or power plants with monopoly rights. A real return of 4% is equivalent to a nominal return of about 10% or about 2% a year above the return on an South Africa long-dated bond. A risk premium of 2%, or about half the average equity risk premium, is consistent with a very low-risk enterprise. The global average real return for utilities of all kinds is about 4% a year.

My own spreadsheet on Eskom indicates that if it gets its preferred way for 90c/kWh, compared with the current 60c, the internal rate of return it would realise on its investment in new power stations, Medupi and Kusile, would be an extraordinary and outrageous 20% a year or more. The potential providers of alternative energy or of contributions to the grid will be cheering Eskom all the way to the bank.

Providing for a real return of 8% or more represents very expensive electricity or airports, even assuming best practice in the management of projects and supplies that may not be justified given such a comfortable financial environment. Inappropriately higher charges by state-owned enterprises, designed to realise much higher real returns on capital, while convenient for the boards and managers of Acsa and Eskom, are very bad news for the economy and its competitiveness. The much better alternative would be an agreed and much lower charge for capital — leading to lower prices for essential services and an insistence on best-practice cost management. It would mean less abundant cash flows for the utilities supplying the service and more debt on their balance sheets (guaranteed by the taxpayer), and so a more competitive economy.

It would also represent a pricing policy that is much fairer to current generations. Under the present practice of forcing savings from consumers through excessive charges for utilities, charges that should better be described as taxes, future generations will inherit the capital stock without the debt that they might appropriately be expected to be still be paying off over time.

Perhaps it might also lead to a fairer labour market in which strike action by relatively well-paid workers is apparently being encouraged by inroads being made on their real wages by ever-higher utility charges.

The SA economy: Hard numbers confirm the reliance on spending

We regard the note issue as a very reliable indicator of spending intentions in SA. It has a particular advantage in that it is updated every month with the release of the Reserve Bank balance sheet, usually within the first week of the next month. The Reserve Bank has now published its balance sheet for September and as we show below, the note issue, on a seasonally adjusted basis, grew strongly towards year end 2011, then moved largely sideways until May 2012 and since then has grown quite strongly. The note issue, seasonally adjusted in September 2012, maintained this strong upward momentum in September and is now well ahead of its level in December 2011.


The strong recovery in the note issue is well demonstrated by the growth measured on a three month rolling basis. This three month growth in the seasonally adjusted note issue, when annualised, turned negative in May 2012, picked up to 17% in June, grew by 24% in August and 18% in September 2012.


When adjusted for consumer prices, the recovery in the real note issue is equally impressive, with the three month growth rate recording about 20% in 2012. These trends in the real cash supply are matched very closely by trends in unit vehicle sales. They too were up strongly in late 2012, moved sideways until May and then also recovered strongly (see below).


These two series (both up to date hard numbers), rather than based on sample surveys make up our own economic activity indicator that we call our Hard Number Index (HNI). As we show below, supported by the uptick in vehicle volumes and the real note issue, the HNI has continued to move ahead – indicating continued growth in SA economic activity at a more or less stable rate. Numbers above 100 for the HNI indicate the economy is growing and its rate of change, also shown, indicates whether the economy is picking up or losing forward momentum. It would appear that the speed of the economy has slowed down from its peak but has in September almost maintained the speed reached in August 2012. Given the fears of a marked slowdown in activity this outcome should be regarded as highly satisfactory.


It would appear that the SA economy, on the demand side, has shown more strength than is perhaps widely appreciated. Spending appears to have picked up, rather than slowed down, between May and September 2012. These trends have also been confirmed by retail sales and broader money supply trends that we have reported upon. Given the disruptions on the supply side of the economy, this strength in demand is likely to also show up in a wider trade deficit. This might enhance the case for rand weakness – but the underlying strength of demand should also encourage investment and inward capital flows. Brian Kantor

US monetary policy: What Ben may have seen

The scale of QE3, that is of further money creation in the US, the promise of an extra injection of US$85b into the US monetary system each month for as long as it takes until the unemployment rate normalises, is impressive indeed. It comes after QE1 and QE2 that has seen the US money base increase enormously from about US$800bn before the financial crisis to nearly US$2.6 trillion today.

The money base, adjusted for reserve requirements, is dollars in the form of greenbacks issued by the Federal Reserve System held by the public and the banks, not only in the US, but all over the world and in the form of deposits held by US banks, which are members of the Federal Reserve System, at their Federal Reserve Banks. Almost all of the extra deposits held by these banks are in excess of the requirement to hold a certain ratio of cash as required reserves. US banks that held no excess cash reserves before the crisis are now hoarding well over $1 trillion of excess reserves.

Fed chairman Ben Bernanke would much rather have these banks reduce their excess cash by making more loans or buying more assets in the market place. This would be good for the US economy, which suffers from too little demand to engage all its available resources, especially potential workers, many of whom have withdrawn from the labour market and no longer seek jobs. Pumping money into the system is meant to encourage more lending and spending. As may be seen in the figure below, the money base, despite all the prompting it has had, stopped growing in mid year. Hence the case for still more cash – cash that costs the Fed almost nothing to create and might yet do much good.


The injections of cash into the banking system have not been without impact on the broader definition of money, M2, which incorporates almost all of the liabilities of the banking system (mostly deposits with retail banks), and which has been growing strongly. This has been helpful for spending growth. However M2 growth also appears to have peaked and is tapering off. This too would concern Bernanke.

Creating cash is intended to increase the supply of money and bank credit (which it has done) but a faster rate of growth would be better under current circumstances. A further reason for QE3 would be to encourage M2 and bank credit growth to accelerate rather than decelerate (see below).

Bernanke will be doing all he can and he has considerable power to issue cash without limit: he can thus keep interest rates down all along the yield curve. This is until and maybe beyond the time that the Fed is confident the economic recovery is gathering strong momentum and unemployment normalises. What he will also be considering is to no longer offer the banks interest on their deposits with the Fed. This might encourage the banks to use rather than hoard their cash. The markets will to judge when rapid growth in central bank cash starts to succeed too well in preventing deflation and in stimulating economic activity and becomes inflationary (as history teaches it always does).

Economic data: Still motoring along

Recently released data on the broadly defined money supply (M3) to August 2012 and new unit vehicle sales updated to September 2012 are consistent with a pattern observed for other indicators of the state of the economy. These include retail sales volumes and the note issue (cash held by the banks and public). The message is that a strong pick-up in activity was recorded in the final quarter of 2011 and was followed by, at best, a sideways trend until May. In June 2012 activity picked up and the higher levels of activity have been sustained since then.

We show this pattern of monthly activity, seasonally adjusted, below. Vehicle sales volumes now exceed the strong sales realised in December 2011 when seasonally adjusted. This recovery in sales volumes should be regarded as highly satisfactory by the industry. The money supply trends, also seasonally adjusted, show a similar pattern, while bank credit extended to the private sector has advanced more steadily as may also be seen in the chart.

Year on year growth rates do not tell the story of what can happen within a 12 month period. That vehicle sales have slowed down (off a higher base) to 1.34% p.a. appears to be something of a disappointment to the Industry but should not be. The growth in vehicle sales on a three month rolling basis – when seasonally adjusted and annualised – tells a much happier story about the state of the vehicle market. It also tells a happier story about the state of the domestic economy more generally when the note issue and the broadly defined money supply, calculated on a three month rolling basis, are taken into account.

The SA economy clearly picked up momentum in mid year while activity appears to be well sustained at higher levels. This strength has perhaps not been widely recognised, given a focus on year on year growth rates. These will come under further pressure from the higher base realised in late 2011. The strength of demand has however shown up in higher imports and (given pressure on export revenues volumes) in a wider trade deficit.

Lower interest rates have been helpful for sustaining domestic demand. Interest rates will need to stay low, and perhaps decline further, to encourage demand in the absence of any likely stimulus for the economy from exports – particularly exports from the disrupted mining sector.

SA bond markets: That steepening curve

There were two important developments last week for the market in rand denominated fixed interest bonds. Firstly, RSA bonds are now included in the Citibank World Government Bond Index – a widely applied bench mark Index for government bonds. This would have encouraged demand for RSA bonds and the rand, even though the intention to include SA in the Index (the result of growing demands for RSA bonds) was announced well before the actual event.

Secondly, and simultaneously negative for SA long term interest rates and the rand, was the announcement by Moody’s that it was joining S&P and Fitch (the other debt rating agencies) in downgrading SA’s credit rating.

The impact of these events on the bond market was to be seen last week in a steepening of the yield curve beyond three years’ duration. The one year rate of interest expected by the market place in the future can be interpolated from the level and slope of the yield curve. As we show below, the market now expects short rates (one year yields, currently about 5% p.a.) to decline slightly over the next year and a half. They are then expected to increase to 6.5% in three and a half years and thereafter to continue to increase gradually, reaching a level of 10% in 15 years.

By South African standards this forecast or market consensus view would represent low and well behaved short term interest rates. The proactive decision by the Reserve Bank of Australia today to unexpectedly cut its key lending rate by 25bp may well encourage the SA Reserve Bank to follow its example. The market may now well price in a higher probability of an interest rate cut in SA.

The key to interest rates over the long run will be inflation; and the key to inflation will be global inflation coupled to the performance of the rand. In this regard, the markets are registering less expected weakness in the rand over the next 10 years. The gap between 10 year US Treasury yields and RSA 10 year yields has narrowed from about 6.38% a year ago to 4.9% on Friday.

This difference in yields represents break even depreciation of the rand against the US dollar. If the rand depreciates by more than this it would pay to borrow dollars rather than rands (and vice versa if the rand depreciates by less). In other words, the cost of insuring against rand weakness over the next 10 years in the forward exchange market would approximate this difference in interest rates. This difference may also be described as the SA risk premium – nominal returns on SA securities measured in rands would be expected to exceed US dollar returns by this margin. Last week the SA risk premium widened from 4.83% at the beginning of the week to 4.9% by the weekend (see below). This difference is also described as the interest rate carry.

An alternative measure of SA risk is the sovereign risk premium. This is the difference between the yield on RSA US dollar denominated debt and that of US treasuries of similar duration. The reward for carrying RSA default risk has declined over the past year, very much in line with emerging market US dollar-denominated debt generally. Last week, this risk premium ended the week as it started (see below).

Movements in these bond market spreads on US dollar denominated emerging market debt can go a long way in explaining movements in the rand. However as we show below, the rand is currently significantly weaker than might have been predicted, given the levels of emerging market equities and bonds (about 10% weaker).
Perhaps this extra degree of rand weakness (attributable to SA specific events) is being recognised in less rand weakness going forward – as reflected in the lower interest rate carry. More rand weakness today is associated with less, rather than more, weakness expected tomorrow or next year.

On a trade weighted basis it should be noted that the rand is little changed on a year ago and also was highly stable last week. This implies that little additional pressure on local prices is now being exerted from offshore. Brian Kantor

Why is capital so much more productive than labour in South Africa?

JSE listed companies have an impressive record of generating wealth for their shareholders. We show how they have done so through their excellent management of the capital they have invested. We show also that such impressive performance has been associated with tepid growth in Real Value Added by the SA economy and declines in formal employment.

Click to read the full piece.

Mediclinic (MDC) and Capitec (CPI): The rights and wrongs of a rights issue – revisited

A number of JSE listed companies, most recently Mediclinic (MDC) and Capitec Bank Holdings (CPI) have announced significant capital raising exercises by way of rights issues to its shareholders to subscribe additional equity capital. Mediclinic has planned to raise an additional R5bn from its shareholders, adding 26% to the number of its shares in issue, while Capitec will raise R2.25bn thus increasing its shares in issue by 14%. Both issues are underwritten.

If the rights to subscribe new equity capital are taken up by established shareholders in the same proportion they currently hold shares, their share of the company will be unaltered. They will be entitled to the same share of dividends as before.

There is no change in ownership when a sole owner or all shareholders inject additional capital in the same proportion as their established shareholding.

In the case of a rights issue, established shareholders may however elect to sell their rights to subscribe to additional shares should they prove valuable, in which case they are giving up a share of the company and rewarded for doing so.

The key question for shareholders and the market place is the following: how well will the extra capital raised be employed? Will the capital raised from old or new shareholders earn a return in excess of its opportunity costs? (That is, will it earn a return in excess of the returns shareholders or potential shareholders might expect from the same amount of capital they could invest in businesses with a similar risk character.)

If the answer is yes, the market value of the company could be expected to increase by more than the value of the additional capital injected into the company. If the answer is a no, then distributing cash on the books of the company to shareholders, rather than raising additional cash, would be appropriate.

The dilution factor

The common notion that issuing additional shares will “dilute” the stake of established shareholders, because more shares in issue reduces earnings per share, assumes implicitly that the additional capital raised will not be used productively enough to cover the costs of the capital raised or earn more than the required risk adjusted return.

But this is not necessarily so. Additional capital can be productively employed and can add, rather than reduce, value for shareholders. It will be up to the market place to decide the issue.

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

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

Estimating the value add in the case of a rights issue is more complicated. This is because the rights are typically priced at a large discount to the prevailing share price before the announcement. The reason for pricing the rights at a discount to the prevailing share price is to attract attention to the offer and by so doing to make sure that the rights to subscribe additional capital will have market value and so will be followed and the additional capital secured.

It should be appreciated that the established shareholders would be largely indifferent to the price selected for the rights issue. The lower the price, the more shares would have to be issued to shareholders to raise the same amount of additional capital. In effect, the shareholders are issuing shares to themselves – as would a sole owner injecting more capital into his or her business. For a sole owner the nominal price attached to the shares would be irrelevant. The lower the nominal price attached to the shares the larger the number of additional shares to be issued for the same amount of capital invested. The same is true of a rights issue. What matters is the amount of capital the shareholders are called upon to subscribe to. This can be divided into a larger or smaller number of shares by adjusting the price at which the rights are offered.

In the case of the Mediclinic rights issue, the company has priced the rights at 28.63 cents per share, raising R5bn by issuing 1.76m additional shares. Management might have decided to halve the offer of shares to 14.315 cents per share and issued twice as many shares, without disadvantaging the shareholders on its books. The advantage in offering large discounts is that the rights to subscribe to the new shares are very likely to offer positive value and if so, may more easily be disposed of by those shareholders who are financially constrained.

Simply put, the Mediclinic rights issue will be value adding for established shareholders if, after the capital raising exercise is concluded and the money raised, the company is worth more than an extra R5bn and the Capitec rights issue will be successful if the company is worth R2.3bn after its capital raising processes has been concluded.

Putting it algebraically

Some simple algebra can help make the point (readers without a mathematical bent may choose to skip this part and proceed to the conclusion). The break even condition is that the market value of the company after the conclusion of the capital raising exercise (defined as MC2) will be greater or at least equal to the market value of the company pre the rights issue, defined as MC1 plus the additional capital raised defined as k. That is MC2>MC1+k if the capital raising exercise is to be judged a success.

This equation may also be used to establish a share price that would represent a break even for shareholders after the conclusion of the rights issue. That is, the share price after the event that would satisfy the value add (or rather the no value loss) condition. MC2, the value of the company after the rights issue is concluded, may be derived conventionally by multiplying the share price (post rights issue) by the number of shares in issue (S2), that is the market value of the company after the capital raising exercise MC2 = P2 * S2 and MC1, the value of the company before the announcement, calculated in the same way as P1*S1 where S1 was the number of shares in issue before the rights issue. P2 is the breakeven price after the announcement. Substituting P1*S1 for MC1 and P2*S2 for MC2 and solving this equation for P2, the break even post rights issue price, gives the following formula for the break even share price after a rights issue as: P2 = (S1*P1+k)/S2.

In the case of Mediclinic, P1 was R40.05, the price ruling on the day before the announcement on 1 August. There were 652.3m shares then in issue (S1= 653.1m). After the rights issue, the number of shares in issue will rise to 827m (S2). K, the additional amount to be raised, is R5bn. Thus the break even share price P2 = R37.6.

Mediclinic closed at R40 on 27 September while the value of the rights closed at R11.30. Since shareholders received the right to 26.77 shares per hundred shares owned, these rights were then worth R3.02 per share to each shareholder (11.3*0.2677). Thus the post rights value of a share in Mediclinic was approximately R40.00 plus R3.02, that is R43.02, on the day before the trade in the rights was to close and comfortably in excess of the R37.6 break even share price.

If the price of a Mediclinic share today (1 October) maintains its 27 September value of approximately R43, the company will be worth R35.5bn. This may be compared to its pre-rights value of R26.12bn. In other words shareholders have put in an extra R5bn and have added value of R4.38bn. This rights issue may be regarded therefore as successful.

The break even share price for Capitec, by the same calculation, is R200.6. The share price on 27 September was R215.5. This price incorporates the rights to new shares at R160 that can be traded after 22 October until 2 November. If this value were to be maintained after 2 November, the company (with 114.4m shares then in issue) would have a market value of R2.45bn. This may be compared to its market value of R2.07bn before the announcement of the rights issue. Thus shareholders would be getting an extra R3.956bn for the additional R2.248bn they are investing in the company – a gain of R1.71bn.

Conclusion

Thus the capital raising exercises of both Mediclinic and Capitec may be regarded as very successful, at least so far. They are clearly expected to add value to the companies, that is, the extra capital raised is expected to more than cover its costs, above the risk adjusted required rate of return for investments of a similar character. Brian Kantor

SA economy: Retail strength

There would appear to be some disappointment with the retail sales numbers for July 2012, details of which were released on Wednesday. We would argue by contrast that sales volumes in July confirmed a strongly upward trend in sales that began in May 2012, gathered strong momentum in June and was well sustained in July 2012. Retailers and their shareholders have every reason to be satisfied with this sustained revival in sales volumes.

The highly satisfactory longer term and shorter term trends in recent sales volumes are shown below. It will be seen that retail volumes have recovered significantly from their recent recession which hit a trough in 2009. In constant 2008 retail prices sales volumes in July 2012 (at record levels as may be seen) were some 17.3% above their lows of October 2009.

The real (CPI) adjusted earnings per share of the General Retailers Index of the JSE has clearly benefitted from the strength in sales. Real Retail index earnings per share have responded even more strongly than sales volumes, having risen nearly 40% from their April 2010 lows – though they have still to exceed pre-recession real levels of earnings.


These differences in interpretation of the state of the retail trade sector owe everything to the period of time over which growth is measured. The year on year growth rates, comparing levels this month to the same month 12 months before, are highly smoothed estimates. They can easily miss much of what has transpired through the year. A year can be a very long time in economics as well as politics. The value in looking at retail sales trends over a shorter period than a year is particularly apposite this year.

Retail sales volumes grew strongly in the final quarter of 2011; they were especially buoyant in December 2012 when seasonally adjusted – as they have to be given the strong seasonal influence on sales. This is especially important in the Southern Hemisphere when Christmas spending is combined with summer holiday spending. The seasonal adjustment factor is 1.36 for December and 0.96 for August. That is to say: December sales can be expected to be about 36% stronger than the average month and July sales about 3.3% weaker than the average month.

The growth in retail sales volumes of 4.2% year on year was reported by I-Net Bridge as being well below market consensus that expected a 7.2% rise in sales volumes. The sales volumes reported were based on a new sample survey of the retail sector, making consensus forecasts perhaps less relevant than they usually are.

Based on these new sample sales volumes, seasonally adjusted as they have to be to make good sense of them, the level of real sales volumes in July were only up a marginal 0.1% on June 2012. However June 2012 was a very good month for retail sales volumes. Moreover estimates of sales in June 2012, applying the new sample estimates, were also revised upwards providing a higher base from which growth in July was estimated.

These trends are well captured by annual growth measured on a three month rolling basis. After rising sharply in late 2011, the rolling three month growth in the seasonally adjusted sales volumes fell off sharply in the first quarter of this year and then recovered strongly. The current year on year growth rate in the seasonally adjusted volumes is a robust 5.9% (not 4.2% as per the unadjusted numbers) while the rolling three month growth rates, having risen to over 10% in May and June, have receded to a 7.3% annual pace.


This momentum in retail sales volumes in July is highly consistent with other economic indicators we have reported upon. Retail sales volumes, like unit vehicle sales and the value of notes in circulation, when seasonally adjusted, were no higher in May 2012 than they had been in December 2011. Retail sales volumes, vehicle sales and cash in circulation had similarly demonstrated very strong growth in late 2011,

The economy therefore would seem to have a little more life in it than is usually recognised. Household consumption spending grew very slowly in the second quarter, at a less than 3% rate. It would appear that spending growth has picked up since then and perhaps a lot more so for the merchandise supplied by retailers and motor dealers. This is in contrast with the demand for services by households. Low rates of inflation have helped encourage demand for goods; while much faster inflation of the prices of services (as much as 10% per annum faster) has discouraged the demand for services.

The difference between year on year changes in the CPI (headline inflation) and more recent trends in consumer prices has also become vey significant recently. While year on year the CPI was up very marginally from 4.9% to 5%, recent trends in the CPI have been much more favourable. On a three month rolling basis CPI inflation slowed down to below 3% p.a in August, the result of a succession of very small monthly increases. The CPI increased by 0.24% in August 2012 from 0.325% in July, 0.24% in June and 0.08% in May 2012. Retail goods inflation, as represented by changes in the retail goods deflator, slowed down almost completely in the three months to July 2012, as we also show below.

A sense of inflation trending down (as per the rolling three months growth rates in the CPI) or trending up (as per the year on year growth rates) leads to implications for the inflation outlook and so perhaps to interest rate settings. That monthly increases in the CPI were very high in the early months of 2012 means that there is every chance of a sharp decline in the year on year inflation rates in early 2013. Monthly increases in the CPI in late 2011 were by contrast very subdued, meaning that the year on year headline rate of inflation is likely to rise in the months immediately ahead.

These month by month blips in the headline inflation rate should surely be ignored. It is the underlying trend that will be either friendly or unfriendly for the longer term trends in the CPI. And this trend will be dominated by the rate of exchange for the rand – over which interest rates and monetary policy have no predictable influence if again past performance is the guide.

The notion that year on year headline inflation should lead the direction of interest rates in SA – rather than the state of the domestic economy – is an idea that has fortunately lost credibility at the Reserve Bank if not yet in the media. Brian Kantor

Equity markets: Is it time to rotate into the cyclical stocks?

A defining recent feature of the JSE and other stock markets this year has been the very good performance of the defensive stocks, especially those with attractive dividend yields and balance sheets to support growth in dividends. By contrast, the performance of the cyclical stocks – especially mining companies – has been very poor both absolutely and relatively, when their performance has been compared to the defensives.

We show below the relative performance of the Resource, Financial and Industrial Indexes between 1 January and 18 September. As may be seen, in 2012 the Financials and Industrials on average have gained about 30% on the average Resource counter listed on the JSE.

Such outcomes are very understandable in a world of exceptionally low interest rates, coupled as they are with grave doubts about the strength of any global cyclical economic recovery (from which metal and mineral prices and the profits of mining companies would stand to benefit).

This outperformance was reversed on 13 September when Fed chairman Ben Bernanke and the Federal Open Market Committee announced QE3. The Fed plans to inject an additional US$85bn of cash into the US monetary system each month through additional purchases of mortgage backed securities and US government bonds. The intention is to keep interest rates as low as possible for as long as it might take to revive the US economy and employment or at least until 2015.

The question therefore is not whether or not the Fed will achieve its objective of low interest rates. This it will surely do thanks to its freedom to effectively create as much cash as it deems appropriate and also to twist the yield curve accordingly, that is borrow short and lend long if necessary, to hold down long rates relative to short rates (which are close to zero and will surely remain so for some extended time). The question is whether continued low interest rates can stimulate a more robust economic recovery. If they can then the underappreciated cyclical stocks would especially stand to benefit.

The stock markets on Thursday and Friday last week reacted as if it was truly time for the cyclical stocks. They gained materially against the Financials and Industrials. There also appeared to be some rotation on the JSE away from the Industrials and Financials. On the Monday these trends were partially reversed as we show below.

Our own view, expressed on the day after Bernanke fired his bazooka, was that the promise of a further extended period of low interest rates would continue to make secure dividend yields well above money market rates still appear attractive, given the absence of any assured cyclical recovery. Playing defence, we thought, might remain the best policy in these new circumstances. It seemed clear to us that pumping money into the system would be helpful to asset prices generally – but perhaps not especially helpful to the cyclicals. Still more highly accommodative monetary policy might not, we surmised, provide the quick fix for the global economy. It has not done so to date. The jury will remain out on this for some time we think – or until a global cyclical recovery appears much more likely.

Global monetary policy: Ben signals his intentions and the markets like what they are told

Ben Bernanke fired his Bazooka yesterday. He pledged the Fed to further purchases of securities in the market without effective limit and for as long as it takes. The Federal Open Market Committee (FOMC) indicated net injections of cash of the order of US$85bn a month for as long as it takes. The indication from the FOMC is that

“…exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”.

The asset markets were pleasantly surprised by the scale of the intended interventions in the asset market as well as their unlimited nature.

The key paragraph of the OMC statement read as follows:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Will these additional actions (QE3) work to revive the US economy and reduce the unemployment rate to a natural 5% or so within the next few years? The answer must be not necessarily so, given that highly accommodative monetary policies to date have not worked very obviously to reduce the unemployment rate below a stubborn 8%, with many more potential workers discouraged from looking for jobs (though how poorly the US economy would have looked without the accommodative actions to date can only be speculated about).

Persistently low interest rates and continuous injections of cash into the securities markets cannot do any harm to employment prospects. Nor can very low interest rates (as far as the eye can see) do anything but support the property market generally and related construction activity (unless these exceptional monetary measures were considered dangerous to the long term health of the economy and so undermine business and household confidence. This does not seem to be the present danger at all).

QE3 is likely to be very positively received by US business. However the boost to confidence necessary to strongly revive the spending plans of US business will have to be taken by the politicians after the elections. Better economic news from Europe and Asia would also be confidence boosting, but clarity on the outlook for Europe and China may not be imminent.

Monetary stimulus is helpful to asset markets. Higher asset prices support pension plans and encourage households to spend more. Low interest rates )that are expected to stay low) add to the argument for equities – especially those that come with dividend yield.

What sectors benefit?

The further question then is what sectors of the equity markets stand to benefit most in a still more friendly monetary policy environment? The case for the defensive stocks, that is those that pay dividends and have the balance sheets to maintain dividends, is most obviously improved.

The cyclical stocks, while not prejudiced at all by easy monetary policy and low interest rates would benefit most from a cyclical recovery itself. This, as we have suggested, is not a certainty in the short term: until a cyclical recovery clearly manifests itself, the outlook for commodity prices appears uncertain.

For undemandingly valued JSE listed cyclicals that would ordinarily benefit from of higher operating margins from SA specific rand weakness, this takes some of the wind out of their sails. The stronger rand in a world of persistently low interest rates (likely to extend to SA) is helpful for the interest rate sensitive stocks on the JSE.

The conclusion one comes to is that Bernanke, while helping equity markets, has in our opinion not yet improved the case for cyclical over defensives. The time for the cyclicals will come when the outllook for a global cyclical recovery appears more certain. Brian Kantor

The SA economy: In a holding pattern

The SA economy was in a holding pattern in the second quarter, helped by infrastructure spend, capital inflows and a sympathetic Reserve Bank

The SA economy did better on the demand side than it did on the supply side in the second quarter of 2012. Statistics on domestic expenditure, only now released by the SA Reserve Bank, complete the national Income accounts for the quarter. They show that Gross Domestic Expenditure (GDE) grew by 4.7 % in the second quarter at a seasonally adjusted annual rate – compared to GDP that grew at a 3.2% rate.

The fastest growing component of demand was Gross Fixed Capital Formation (GFCF) that grew by 5.7%. Households increased their spending on consumption goods by a pedestrian 2.9%, but household spending on durable goods (vehicles and appliances etc) and semi- durables (clothes etc) grew much faster than this while spending on non-durables (food) and especially services grew much slower: spending on services actually declined.


No doubt relative prices and, to a lesser degree, extra credit played a large part in these outcomes. Food and service prices rose faster than the prices of cars, appliances, clothes and perhaps especially services provided by municipalities. Consumers adjusted their spending accordingly, as they have been doing for some time. The Reserve Bank shows that the household debt to disposable income rose slightly after this ratio had fallen for an extended period. Thanks to lower interest rates, the debt servicing to disposable income ratio has stabilised at a very low 6%.

Where is the infrastructure spend?

This is a question often asked. The growth in spending on infrastructure is very apparent in the numbers. Capital expenditure by the government and the public sectors grew very rapidly in the quarter: by 9.1% pa and 15.75 pa respectively. Perhaps the impact is not easily seen or felt because of its high import content.


When spending rises faster than output, imports grow faster than exports and the balance of trade deteriorates. The major contributor to the very large current account deficit (which ran at a annual rate of over 6% of GDP in the second quarter) was a weaker trade balance. Export volumes nevertheless grew at a good rate of 5.9%, while imports grew even faster at a 9.7% real rate. Yet while export volumes grew strongly, prices for minerals and metals realised on global markets were less favourable, leading to a decline in rand revenues from the mining sector. Mining sector output in fact recovered very strongly from a low base in the quarter, so making an unusually important contribution to GDP growth in the quarter.

The outflows on the current account were fully matched by net inflows of foreign capital of R48bn. This is not a coincidence – it is much more like two sides of an equation. Without the capital the rand would have been much weaker, prices of imported and exported goods would have been much higher and demand for imports lower.

The economy would also have grown at a still slower rate without support from foreign investors. This makes the current account deficit and the accompanying capital inflows much more of an opportunity than the problem that it is so often and simplistically portrayed as. It is economic growth in SA that drives the returns on capital and the interest rates that attract foreign capital. Less growth means inevitably less capital attracted. Faster growth attracts more capital. Had growth in SA been even slower in the second quarter the current account deficit would have been smaller and capital inflows smaller. The rand might then have been even weaker (it lost 4.8% of its traded value in the second quarter, having gained 4.4% in the first) and inflation higher. These clearly would not have been desirable outcomes.

That much of the growth in imports was attributable to capital formation – which adds to the economy’s growth potential – is therefore helpful in attracting capital. Also helpful is that foreign currency debt issued by the SA government and the banks remains at manageable levels and has shown very little growth. A further helpful factor is that foreigners have shown a strong appetite for rand denominated debt, upon which default is technically impossible. Since there is no limit to the number of rands the SA government (via the Reserve Bank) could create to pay off rand debts, this demand for rand denominated debt represents a vote of confidence in SA’s fiscal conservatism and in the strength of its banking system.

The banks raised nearly US$9bn of rand denominated debts from foreign lenders between the first and second quarters. The private sector outside of the banks reduced their foreign debts over the same 12 months.

There are clearly upper limits to the liabilities SA and South African households and businesses can incur. What these limits are, are not known. Until they are known and a lack of foreign capital becomes an actual problem for the economy, it makes no sense to sacrifice growth for fear of reaching these limits. In fact slower growth would in all likelihood exacerbate, rather than help resolve any lack of capital inflow.

If the economy picks up momentum over the next 12 months (hopefully stimulated by faster global growth and higher export volumes and prices) returns on capital invested in SA business will improve and interest rates may well rise. These trends will attract foreign capital and the rand would very likely strengthen in what will be a more risk-on environment.

If the economy fails to pick up momentum in the absence of a recovery in the global economy, domestic demand will need and get encouragement from perhaps lower interest rates. A weaker rand would seem likely in such less hopeful circumstances. Should growth rates remain unsatisfactory over the next 12 months, the Reserve Bank is no more likely to feel restrained in its interest rate settings by the current account deficit than it has been to date. The best monetary policy reaction to the current account deficit or capital inflows is one of benign neglect. The Reserve Bank seems capable of ignoring the balance of payments. Brian Kantor

Global markets: A harbinger of a new Spring – or a one day wonder?

On Thursday Mario Draghi spoke and the markets liked what they heard about the outlook for Europe. The judgment was that taking on more risk in the markets might well be rewarded. On Friday we saw a most unlikely set of outcomes in response to a healthier appetite for risk taking. That risky currency, the rand, gathered strength. Resources on the JSE benefitted particularly, despite (or rather because of) the rand strength associated with strength in underlying metal and mineral prices that are linked to an improved outlook for the global economy.

As we have noted often before, resources only benefit from a weaker rand or are harmed by a stronger rand when this occurs for SA specific reasons. Only then do they behave as rand hedges. Ordinarily they are rand plays – doing best when the rand strengthens – for global growth reasons.

SA financials are also mostly rand plays – doing better when the rand strengthens and the outlook for lower inflation and interest rates improves with rand strength. But surprisingly on Friday SA Financials lost ground. While JSE Mining was up 3.75% on the day, the JSE Fini15 lost 0.8% of its value. Financials and banks offshore had a very good Friday by contrast, as we show below:

Given the improved appetite for taking on risk, the large losers on Friday were the globally traded, highly defensive counters. These are the shares that have been coveted for their dividend yields and prospects of special dividends in a world of very low interest rates. For example British American Tobacco lost R14 or approximately 3% of its opening value on Friday. On the FTSE the stock was down 1.5%.

These developments on Friday helped reverse a long running saga on the JSE of underperforming resource counters and strongly outperforming producers and distributors of consumers goods with strong balance sheets paying dividends that are likely to be sustained.

Investors globally on Friday clearly rotated away from demandingly valued defensives to cyclically dependent stocks and financials that appear undervalued by their own standards. Why SA financials should have failed to benefit from this switch and rand strength may be regarded as something of an anomaly. Is this the start of something potentially very big – the reversal of the defensive trends that have dominated market performance over the past 12 months, or merely a minor correction of such trends? Our position has been to maintain a moderately risk on exposure to equities generally with a bias in favour of defensive dividend payers. A few more days like Friday would help concentrate our minds, perhaps leading us to a somewhat different, more risk-on conclusion. Brian Kantor

The Eurozone: A declaration of monetary independence

Mario Draghi asserted the independence of the European Central Bank (ECB) to act as the independent central bank of Europe and to be the responsible guardian of the “irreversible” euro. This declaration of independence was supported by all but one of the governors of the ECB.

The bank’s government bond buying campaign is to be concentrated on maturities of less than three years to maturity. These purchases, now called the Outright Monetary Transactions (OMTs) will be conducted without any limit other than constrained by the judgment of Draghi and his colleagues. These purchases of all government bonds linked to the euro will not be inhibited by inferior credit ratings, nor would the ECB claim any seniority of its claims against borrowing governments ahead of private lenders. This is an important principle designed to draw private sector support for the bond market. ECB support for the market in distressed government bonds is conditional, that is on the condition that those governments seeking aid from Europe, the ECB and the IMF abide by the conditions set for such support. The “conditionality’ of ECB was strongly emphasised, no doubt to address likely criticism that the programme represented a soft option for hard pressed European states unable (so far) to convince the market place that they can continue to meet their obligations to creditors.

Predictably, the plan did draw criticism from the Bundesbank as representing fiscal assistance to governments and therefore was not within the mandate of the ECB. No doubt it was this German viewpoint that has so delayed the assertion of ECB independence and its ability to do, in practice, what it takes to protect a financial system in times of crisis. What it takes to solve a financial and banking crisis, as the Fed has proved recently, is quite simply the exercise of a central bank’s power to print money without limits, other than those set by its own judgment as to how much extra cash it will takes to solve a crisis. Once the crisis is resolved (hopefully, with excellent timing), it will then take back the cash from the banking system that could otherwise become inflationary (as excess supplies of money over the demand to hold money, inevitably become).

Sterilisation

Draghi did say that the automatic money supply effects of its bond purchases – crediting the banks with extra deposits at the central bank – would be “sterilised”. In other words, they would be countered by simultaneous ECB bond sales. Presumably, if the banks choose to hold excess cash reserves(as they have been doing to a very large extent in the US and Europe) sterilisation would not be called for.

Draghi was firm and forthright that his plan fully confirmed to the mandate of the ECB that charges the Bank with achieving monetary stability for Europe. Monetary stability, according to Draghi, demands the survival of the euro and the integration of the currently “fragmented” European monetary system. These are essential components of monetary stability and his ability to enter the bond markets without restraint is essential to this purpose, according to Draghi.

An integrated Eurpean monetary system would mean similar interest rates and costs and availability of credit in all the European centres of finance. It would also have to mean well co-ordinated fiscal policies and banking regulations and a unified European banking system. Europe will work towards this – monetary stability and the irreversibility of the euro to which the ECB is committed allows time for the European project – the European Union – to be completed.

It will take time, maybe lots of time, to be realised, but Draghi has acted to reduce what he described as “tail risk”, that is to reduce the perhaps small but catastrophic possibility of a banking and financial collapse in Europe.

It has taken a long time for the ECB to assert itself as a fully independent central bank. The almost immediate reactions to the Draghi plan were highly favourable. Risks came off, to the advantage of the bond, equity and currency markets, including the rand. If the market is convinced that the ECB could do what it would have to do in a time of crisis then maybe the markets in euro debt and interbank loans will calm down enough to avoid the ECB from actually exercising its powers. The bazooka is loaded: it may not have to be fired.

Fired or not, the markets can return to the still difficult task of forecasting the state of the global economy (Europe included) without the same fear about the tail risk of a European financial break down that the ECB has addressed. Brian Kantor

SA listed property: Running on technically enhanced blades?

The Property Loan Stock (PLS) Index has again performed outstandingly well this year to date, realising returns of over 40%. It has also enjoyed an exceptionally good quarter to date with returns of over 16%. The Index has moreover significantly outperformed the bond market as may be seen below.

The gap between RSA bond yields and the trailing dividend yield on the PLS Index may be regarded as a way to rate the listed property market. One can presume that the lower this difference in yields (currently negative), the superior the rating enjoyed by the property stocks. Presumably also, the lower the trailing dividend yield on the PLS Index, then the faster the dividends paid are expected to grow.

As we show below the yield gap between RSA bond yields and the initial trailing property dividend yield has narrowed markedly over the years. This yield gap stabilised at about a negative one per cent per annum after 2008, indicating very little of a rerating until very recently, when over the past month, the yield gap narrowed sharply (that is became distinctly more negative) to the advantage of PLS valuations.

In the figures below we show the performance of the PLS in the form of index dividends per share as well as the growth in these distributions. These dividends have grown consistently and continued to increase through the recession of 2008-2009. Their growth was particularly rapid in 2008. Growth in dividends fell off in 2009 and has since managed to keep pace with inflation. Real CPI adjusted PLS dividends have stabilised since 2008 and are expected to continue to do so. Nominal dividends are currently growing at about 6% per annum – compared to inflation (currently about 5%) and is expected by the bond market to average about 6% over the next 10 years.

The current PLS trailing dividend yield of 5.66% represents a record low. Should PLS dividends continue to match inflation (as they are confidently expected to do at least for the next two years) this would correspond to a real yield of the same 5.66%. We have long argued that a real yield of 5% should be regarded as appropriate for the sector, given its risk character.This real 5% would represent an expected risk premium for investors in the PLS Index of about 2% over inflation linked government bonds that normally could be expected to offer about a real 3%.

Current RSA inflation-linked yields have however fallen far below the 3% real yield that might be regarded as a normal real return on a default free, inflation risk free government bond. The yield on the 10 year RSA197 has however fallen to a record low 1.53% real yield.

Compared to a certain real 1.53%, a prospective 5.7% real yield from the PLS Index may still appear attractive. If dividends distributed keep pace with inflation, this initial 5.7% converts into a real 5.7%. This prospective extra real return over and above the return on the government inflation linked bond (currently about 4%), may still seem be more than enough to cover the risk that PLS dividends will not be able to keep up with inflation. This extra 4% real risk premium is still well ahead of the 2% risk premium (5% less the normal 3%) that we have argued should be sufficient to the purpose of attracting funds to the PLS sector.

The conclusion we come to is that until real interest rates on the long dated inflation linkers in SA normalise towards the 3% p.a rate, the PLS counters (that promise a real return of over 5% per annum) may still appear attractive. Brian Kantor

New vehicle sales: Maintaining a brisk pace

New vehicle sales were at a highly satisfactory level in August 2012. Unit sales have maintained their recovery from somewhat depressed 2012 Q2 levels. Actual sales were up from 54087 units in July to 56253 units in August 2012. On a seasonally adjusted basis unit sales were up by 1831 units.

It should be noticed that on a seasonally adjusted basis sales are well up on a year before but are little changed from sales levels (when seasonally adjusted) realised in December 2011. Given the surge in sales that materialised late in 2011, this higher base of sales will make year on year growth comparisons (currently 9% p.a) more onerous in the months to come.

Yet if currently favourable trends persist, the retail sector of the motor industry could look to a monthly sales rate of 56 000 units this time next year, compared to the current rate of 52 600 new units now being sold. This would represent a growth trend of about 7% that, if realized, would be regarded as highly favourable for this sector of the economy. Clearly, lower and stable rates of interest are helping to sustain this important sector of the SA economy. Brian Kantor