Brian Kantor – Page 26

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

Private sector credit: No joy or danger

Bank credit and money supply statistics for July 2012, released yesterday, indicate that growth in the demand for and supply of credit and money continues at a sedate pace. The pace of growth appears strong enough to keep the economy moving forward – but at a pace that will not fully engage the economy’s potential.

In line with house prices, that are at best moving sideways, mortgage lending by the banks continues to grow very slowly, at about a 2% per annum rate. Growth in mortgage lending over the past three months however did pick up some momentum – perhaps indicating some reversal of recent trends. Without a demand from their customers for secured credit, the interest the banks have in expanding access to unsecured credit will hopefully be sustained, supplying some impetus to the economy that is sorely needed.

These trends confirm that monetary policy will stay on an accommodative course – designed to encourage domestic spending when little help can be expected from the global economy and demand for exports. Credit and money supply trends help make the argument for lower rather than higher short term interest rates. Brian Kantor

You can’t always get what you want: Is platinum mining profitable?

The Rolling Stones captured the disillusion of the 1960s counter culture in their hit song “You Can’t Always Get What You Want”. It was released in 1969 after the initial wave of 1960s optimism had surged to anger and disenchantment. The song offers practical hope by suggesting that we should strive to get what we need since we’re bound to fall short in getting what we want.

The platinum industry has been one of great hope and now disillusionment. Has it been profitable and created value? Is it profitable today and what is implied in the share prices of platinum mining companies? By answering these questions, we can begin realistically to untangle economic wants and needs.

We’ve aggregated the historical financial statements of the four largest platinum miners (Anglo American Platinum, Impala, Lonmin and Northam) and calculated the inflation-adjusted cash flow return on operating assets, CFROI®. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slipped below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for this industry. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time. The rush was on to mine platinum and build company strategies around this effort. 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 as shown in our chart. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop below 2% – 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 and excavation costs, and lower platinum prices. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders. This has resulted in cost-cutting, lay-offs and chops 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 2012 and 2013 and estimated the real return on capital. It remains very poor at a wealth destructive level of 2%. There is no hint of a return to superior profitability in the share prices of platinum miners. At best, the market has them priced to return to a real return on capital of 6%, which is the average real cost of capital.

It looks highly unlikely that platinum miners will be able to satisfy the wants of their stakeholders. All parties should focus on what is realistically possible and economically feasible. 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. Though grave damage to employment prospects in what was once a promising industry has surely already been done, northern Europe’s response to the Great Recession remains a potential template for management and labour. The cold reality is that capital in the form of increasingly sophisticated and robotic equipment will continue to replace labour. Management will have had their minds ever more strongly focused on such possibilities by recent events.

Moreover, SA has a responsibility to the global economy to supply platinum in predictable volume: the motor industry depends on this. Higher platinum prices, while a helpful short term response to disrupted output, would encourage the search for alternatives to platinum for auto catalysts. This would mean a decline in platinum prices over the long term.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline. Perhaps they will even decline to the point where nationalising the industry with full compensation might seem a tragically realistic proposition.

Nationalisation 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, carry the can for the failures of management. To its financial detriment, government would have to invest scarce funds in a capital-intensive industry that is not generating a sufficient return. Workers might think management (subject to the discipline of taxpayers rather than shareholders) would be a softer touch, but this would lead to the spiral of greater destruction of economic value and ultimately fewer jobs. Government and taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. David Holland* and Brian Kantor

*David Holland is a senior advisor to Credit Suisse and was previously a Managing Director at Credit Suisse HOLT based in London in charge of the global HOLT Valuation & Analytics group.

Interest Rates: The Marcus Put

Headline CPI inflation declined to 4.9% for the 12 months to July. This welcome lower rate of inflation does not tell the full story of the direction of prices. A year can be a long time in economic life and what happens to prices in between can be much more revealing about inflation trends. Over the past three months prices have increased very slowly – more slowly than they did a year ago, as we show below. Prices rose by 0.08% in May, 0.24% in June and 0.32% in July.

These relatively small monthly increases compared to a year before have brought down the three month rate of inflation, seasonally adjusted and annualised, sharply lower to well below 4%. ( See below)

If current trends in the CPI persist, the outlook is for an inflation rate of no more than 3.5% this time next year, as we show in the chart below. It should be noticed that monthly increases in the CPI were particularly rapid early this year, thus offering the possibility of seeing year on year inflation come down further in early 2013 (that is, if monthly increases then turn out to be below the rather high monthly increases of early 2012).

These trends could be damaged by a combination of a weaker rand and supply side disruption (drought and war) which might drive global grain and oil prices higher. If global growth gathered enough momentum to drive up metal and commodity prices generally, for demand side reasons, the rand might well strengthen to moderate such influences on the prices of imported and exported goods. Faster growth in export markets would be very helpful to the SA economy. It could bring faster growth without more inflation, because the rand will strengthen.

Slower global growth would be very likely to weaken the rand and cause the inflation numbers and outlook to deteriorate. The domestic economy will also be harmed by such trends. It would mean slower growth and higher inflation. The case for raising interest rates under such adverse circumstances is a poor one. It would mean still slower growth without any predictable impact on the inflation rate.

The Reserve Bank, under present leadership, seems unlikely to raise rates should this adverse scenario materialise. If the economy stays its present course (less inflation and growth that remains below potential growth), the case for lowering rates improves. The more hopeful scenario – the SA economy to benefit from a reviving global economy and higher commodity prices and a more valuable rand meaning no more inflation – the case for lower interest rates also improves.

And so in the light of currently lower inflation, the case for lower interest rates has improved. Furthermore it is hard to contemplate more favourable or less favourable economic circumstances that would drive short rates higher. We might describe the outlook for (lower) interest rates in SA as the Marcus Put. Brian Kantor

SA economy: Growing, but at a decelerating pace

Retail sales help confirm a welcome recovery of spending in June

Retail sales volumes reported by Stats SA last week confirm that the SA economy had a rather good month in June. Sales volumes picked up strongly, having grown very little on a seasonally adjusted basis between December 2011 and May 2012. As we show below retail sales volumes(at constant 2008 prices) recovered strongly in late 2009 from their post recession lows, picked up momentum in late 2011, but then fell away rather badly on a seasonally adjusted basis in the first five months of 2012.

We had learned earlier that June 2012 was also a good month for the banks. This is not a coincidence: economic activity tends to lead rather than follow bank lending. The banks respond to demands for credit to fund intended spending decisions by households and firms. Bank credit extended to the private sector grew strongly in June 2012, as did the deposit liabilities of the banking system (known as M3, the broadly defined supply of money). M3 almost flat-lined between December and May while bank credit grew steadily over the period and also picked up momentum in June.

The data for June 2012 may be regarded as encouraging enough to suggest no further cuts in interest rates are necessary to keep the economy going forward at a satisfactory pace. However June is a long time ago. We are more than half way through August and a month can be a long time in economic life.

Updating the state of the economy to July 2012

We do however have some useful additional information about developments in July 2012, in the form of vehicle sales and the notes issued by the SA Reserve Bank. These two hard numbers help make up our hard Number Index (HNI) of the immediate state of the SA economy (or, to put it more precisely, combining the vehicle sales with the note issue adjusted for the CPI, equally weighted, gives us the Hard Number Index). As may be seen below, both series show a very similar pattern to that of retail volumes and the money and credit numbers. They show a good recovery in activity in the second half of 2011 that accelerated towards year end. Thereafter activity flat-lined between January and May 2012 as may be seen below. It may also be seen that in July the faster pace was maintained at the higher June levels.

The Hard Number Index (HNI) – an estimate of the state of the SA economy in July

An HNI above 100 indicate growth in economic activity. As may be seen below, economic activity in SA according to the HNI continues to expand but at a slower pace. When these trends are extrapolated further the outlook is for further increases in economic activity and for the rate of increase to slow down further.

Why the HNI is a good leading indicator for the SA economy

In the figure below we compare our HNI to the Reserve Bank Business Cycle Indicator that is based on a wider number of activity indicators based on sample surveys. Both series indicate very little growth in economic activity before 2003, with numbers that stayed around 100. The measures of economic activity have been consistently well above 100 ever since 2002, indicating that the economy has grown consistently since then, though at a forward pace that accelerated until 2006; slowed down between 2006 or 2007; and then picked up forward momentum in 2010.

The two series have tracked each other very well over the years. They indicate the same time in 2010 when the pace of growth began to accelerate again rather than decelerate. The rate of change of the HNI turned down well before the Coinciding Indicator in 2006 as may also be seen. The advantage of the HNI is that it very up to date – available measured for July 2012 while the Reserve Bank Indicator has only been updated to only.April 2012.

The HNI may therefore be regarded as a very useful and up to date indicator of the SA Business Cycle. There is every indication from it that the SA economy will continue to grow in 2012-2013 but at a decelerating pace that is not likely to threaten any change in current interest rate settings. These have been helpful to date in keeping the economy moving forward, despite a weaker global economy, by encouraging household spending and the extra credit needed to sustain it. Brian Kantor

Keynesian economics and Quantitative Easing: Can they restore economic health?

The economic problem is usually one of unlimited wants and highly limited means to satisfy them. It is a supply side problem that only improved productivity and improved access to capital or natural resources can ameliorate.

Economic growth sustained over the past 200 years or so has helped many to overcome the economic problem, at least to a degree. When obesity rather than starvation becomes the major danger to individual well being in the developed economies considerable economic progress has been made.

But sometimes the economic problem becomes one of too little spending rather than of dismal constraints on spending. Too little demand is now the major problem in many of the developed economies and also for us in SA. Given the current availability of labour, plant and equipment in the US, Europe and SA, more goods and services would be produced and more income would be earned in the process of expanded production, if only economic agents would spend more. More spending is thus possible without the usual trade-offs and choices having to be made between one kind of spending or another. There is no opportunity cost to employing more resources when they are standing idle.

It was a severe lack of demand that severely afflicted the US economy and other economies in the 1930s. The US economy nearly halved its size between 1929 and 1933 and economic activity had not recovered 1929 levels by 1939. These catastrophic economic events gave rise to what has come to be known as Keynesian economics, named after the famous English economist John Maynard Keynes. Keynes in the late 1930s had persuaded much of the economics profession to agree that in the absence of sufficient demand from the private sector (firms and households) governments should fill the gap between potential and actual supply of goods and services by spending and borrowing more. In other words, he argued for expanded fiscal deficits to stimulate demand when aggregate demand was painfully lacking.

Keynesianism today

Such arguments are being made today, most prominently by Nobel Prize winning economists Paul Krugman and Joseph Stiglitz. They argue against the austerity apparently being practised by the US and European governments or recommended for them. In fact the fiscal deficits of the US and UK have widened enormously, and more or less automatically, as government revenues declined with the recession and as government spending, including spending on bailing out banks and other financial institutions, increased. But whether the larger deficits or higher levels of government spending helped to stabilise their economies, as the Keynesians predict, is not at all obvious. Arthur Laffer, in a recent Wall Street Journal article, argued that the opposite has in fact happened: that the stronger the growth in government spending, the slower the growth in GDP. He presented the following table linking changes in government spending to declines in GDP growth as evidence for this:

The UK, US, Germany and Japan, despite increased spending and larger deficits and borrowing requirements, have enjoyed one great advantage not available to Greece, Portugal, Ireland, Spain and Italy. The cost of borrowing, even of issuing very long term loans in the US, UK and Germany, has come down dramatically while the interest rates charged to Spain and Italy have risen enough to threaten their fiscal viability.

In contradiction to the Laffer evidence, it may be argued that growth would have been even slower without these increases in government spending. In the case of the Krugman-Stiglitz arguments for less, rather than more UK austerity, there is no way of knowing with any confidence what might have happened to interest rates in the UK in the absence of intended austerity. Higher interest rates would have severely further limited spending by the private and public sectors in the UK, had borrowing costs been forced higher by nervous investors in UK gilts.

The limits to government spending

The essential criticism of the Keynesian approach to recessions is that governments can only ever account for a portion of total spending. Increased spending by the public sector may well be offset by lower levels of spending by households and firms fearful of the impact of extra government spending and borrowing on their own financial welfare.

Higher interest rates associated with more government borrowing may crowd out private spending Higher taxes that will be expected to levied in the future to cover interest to be paid on a much enlarged volume of government debt may induce more private savings. Households and firms may seek to protect their own balance sheets and wealth that they believe may be subject to higher levels of taxation.

The potential limits to the ability of governments to increase total spending and the danger that firms and households and other government agencies may spend less, can be illustrated by reference to the US GDP statistics and Budget.

Of the US GDP of nearly US$14 trillion in 2011, spending by all government agencies, Federal, state and municipal governments on consumption and investment amounted to $3 trillion or 21% of GDP. Of this spending the Federal government accounted for but $1.14 trillion or about 38%.

Even when government spending is a large proportion of GDP, a high percentage of this is in the form of transfers to households and firms. So spending decisions are in the hands of these households and firms, who might feel constrained for the reasons outlined above.

Normal times would have meant no need for QE 1, 2 or 3 or for the very low interest rates that have accompanied QE (quantitative easing). The collapse of Lehman Brothers in September 2008 threatened to bring down the US banking and financial system. Flooding the system with liquidity (cash created by the Fed) is the time honoured method of preventing a financial implosion. The great free marketer and anti-Keynesian, Milton Friedman, with Anna Schwartz in their monumental work Monetary History of the US, had accused the Fed failing to respond in this way in 1930 and by so failing in its mission, allowed a preventable financial crisis to become an economic crisis of disastrous proportions. This was not a mistake Ben Bernanke (well versed as he was in monetary history), was going to make as head of the Fed.

What about the liquidity trap?

But the Bernanke-led Fed, having avoided a financial implosion, is faced with a problem that both Keynes and Friedman were very conscious of. Keynesians wrote of the dangers of a liquidity trap: that cash could be made freely available to the banking system at very low interest rates by the central banks; but if the banks were reluctant to lend and its customers reluctant to borrow or spend, the cash would get stuck with the banks or the public. The system could fall into the liquidity trap and so lower interest rates or increases in the supply of cash would do little to stimulate economic activity.

Keynesians then call for government spending. Friedman and Bernanke in their writing called upon a hypothetical helicopter to by-pass reluctant banks to spread cash around, which would be spent to help the economy recover. Bernanke came to be known disparagingly as helicopter Ben for this idea. The trouble with helicopter-induced money creation is that it would have to be sanctioned by Congress – it would have to be included in the Budget as fiscal policy. This makes it a highly impractical response.

Given an inability to force co-operation from banks to inject cash and spending into the system, the Fed and the European Central Bank have to rely on monetary policy. They would thus continue to make cash available to the banking system and to engage in QE, so keeping the financial system afloat, and to hold interest rates as close to zero for as long as it takes, until confidence and entrepreneurial spirits revive. Moreover, Bernanke has been lecturing politicians on the need to exercise fiscal propriety to help restore business and household confidence. Brian Kantor

Global markets: Becoming more cold-blooded

The Volatility Index (VIX), which is traded on the Chicago Board Options Exchange and that reflects the implied volatility of an option on the S&P 500, has been trading at very low levels recently. It has been in the mid teens, or at levels that were common before the Global Financial Crisis triggered by the collapse of Lehman Brothers.

As we show below the VIX rose to as much as 80 in late 2008. We also show how the Euro Crises drove the VIX markedly higher, though never to Lehman type levels of anxiety.

What is noticeable is just how little affected the share markets and the options traders were by the latest flurries in the share dovecote caused by weakness in Spanish and Italian debt. Judged by the behaviour of the VIX this year, the markets have not been nearly as noisy as the commentators.

We also show that where the VIX goes, so goes the S&P 500 in the opposite direction. When risks go up (as reflected by actual or implied volatility of share prices) returns (that is share prices) go down and vice versa. The correlation between daily percentage moves in the VIX and the S&P is (-0.80), which is very close to a one to opposite one relationship.

This may (hopefully) mean that we have entered a much more sanguine market place and if sustained, this degree of detachment will remain helpful to shares and what are regarded as riskier bonds. The safe haven bonds, by the same token, will not then attract the same anxious attention to the point where favoured governments have been paid by investors to take their money for up to two years rather than the other way round.

The attention of the market place may turn much more closely to the outlook for earnings and interest rates rather than the the very hard to estimate (small) probability of catastrophic financial events. These probabilities can alter meaningfully from day to day, so adding to share and bond price volatility of the kind observed post Lehman and post the Euro crises

The JSE in July: Interest rates matter

July 2012 proved to be another good month for the Interest rate plays and the Industrial Hedges listed on the JSE Top 40 Index. It was yet another poor month for the Commodity price plays as we show below.

The Industrial hedges are those large cap companies listed on the JSE that are largely exposed to the global economy and whose values are insensitive to both SA interest rates and commodity prices. British American Tobacco, SAB, Naspers and Richemont have proved highly defensive against the risks to the global economy posed by the Eurozone crisis. The cyclical commodity price plays by contrast have been much damaged by these anxieties and share market trends in July proved no exception.

The interest rate sensitive stocks, especially banks, retailers and listed SA property (all of which are highly dependent on the SA economy) have benefitted from the surprising decline in SA interest rates and especially the July cut in the Reserve Bank repo rate. We show below, with the aid of Chris Holdsworth of Investec Securities, just how significantly lower SA interest rates have moved across the yield curve in recent weeks.

The term structure of interest rates at any point in time makes it possible to infer the short rates expected by the market over the next 15 years. As we show below the rate of interest on RSA bonds with one year to maturity is now expected to remain unchanged over the next year. Then it is expected to increase much more gradually over the next few years and to remain below 7% p.a for another four years. This outlook for interest rates is very encouraging to those companies for whom interest rates are an important influence on their revenues and profits.

The market in fixed interest securities can change its mind and can be expected to do so again. Holdsworth has developed and successfully tested a theory about the forces that drive the gap between long and short rates in SA. The theory is that money supply growth rates lead interest rate moves by about 12 months. The explanation for this is highly plausible. Given monetary policy practice in SA, the supply of money (defined broadly as M3) and bank credit accommodate the demand for money and credit. Economic activity therefore leads money supply and credit growth and so subsequent moves in interest rates. In other words, economic activity leads and money supply and interest rates follow in due course.

The test of this theory of short term rates is shown below. The money supply has done a good job at predicting short rates and has done better, statistically, than the yield curve itself in forecasting short rates. The Holdsworth prediction, given recent money supply trends, is for still lower short rates to come, of the order of 4.6% p.a in 12 months’ time. The forecast of the three month rate in June 2013, implicit in the Forward Rate Agreements offered by the banks, is currently 4.9% p.a.

Whether these forecasts will prove accurate or not will depend upon the state of the SA economy over the next 12 months. The stronger the economy the higher will be interest rates and vice versa. All will be revealed by the growth in the balance sheets of the banking system, that is in the money supply broadly defined (M3). These constitute most of the liabilities of the banks and the supply of bank credit. These money and credit aggregates as well as the state of the economy will be closely watched by the Reserve Bank.

However when these aggregates are converted into growth over three months (calculated monthly), the picture looks rather different. Growth in credit supply has slowed sharply while growth in M3 remains anemic with both now at about a 4% p.a. rate of growth. Such growth rates, if maintained, would mean lower rather than higher interest rates to come. These aggregates will bear especially close watching over the months to come. Brian Kantor

The Hard Number Index: A good June

We play close attention to two important indicators of the state of the SA economy. These are new vehicle sales and the notes issued by the SA Reserve Bank. The great advantage of these data points is that they are very up to date and that they are based on hard numbers rather than sample surveys that inevitably have measurement issues.

We combine these two hard numbers to form our Hard Number Index (HNI) of the current state of the SA economy. We deflate the note issue by the Consumer Price Index (extrapolated one month ahead) to establish the real note issue that makes up half of the HNI. As we show below, the HNI has provided a very good leading indicator of the SA Business Cycle as calculated by the Reserve Bank. The recent turning points in the two cycles have coincided very closely.

The advantage of the HNI is that it provides an early indication of the state of the economy in June2012. The Reserve Bank Indicator only gives us an estimate of the state of the economy as of March 2012, for which period we anyway have the much broader GDP figures and other national income estimates.

It may be seen from the HNI that economic activity in SA continued to expand in June. The pace of growth in June, as reflected by the rate of change of the HNI (what may be regarded as the second derivative of the business cycle) has however continued to slow. Nevertheless June 2012 was a very solid month for new vehicle sales and the note issue in June showed a marked pick up compared to the note issue three months before.

As we show below, the note issue, having grown very strongly towards year end 2011, fell back between January and May 2012 only to recover in June 2012. Clearly the demand for notes is affected by the spending seasons, especially in December, and can only be interpreted with the aid of an adjustment for seasonal influences. That the value of the notes issued in June 2012 grew so strongly in response to the extra demands for cash from by the public and the banks, is an encouraging sign of improving spending propensities.

It is of interest that the note issue has grown significantly faster than the supply of bank credit or of broader measures of the money supply. This implies that these may take a similar path to that of bank credit extension to the private sector. This would suggest that the additional demand for cash is coming from the public to fulfill spending intentions rather than from the banks. It is the informal rather than the formal sector of the economy that uses cash rather than access to bank deposits as its principal medium of exchange. Therefore this may suggest that the informal sector is growing faster than the formal sector and by so doing is helping to sustain the pace of economic activity.

The Reserve Bank is likely to take much more notice of the slower growth in bank credit than the faster growth in its note issue when deciding on the right level of interest rates. It is the weak credit numbers, combined with threats to the global economy and so to export volumes and prices, which could lead the Reserve Bank to lower its repo rate next week when its Monetary Policy Committee (MPC) reconvenes.

The SA economy is still operating below its potential growth of about 4% p.a. Lower interest rates would encourage more domestic spending and borrowing and help prevent some further economic slippage (in the form of a still wide gap between potential and actual output that exports cannot realistically be expected to close anytime soon). With an improved inflation outlook it would make sense for the Reserve Bank to do what it can to help sustain domestic spending – the one potentially brighter light in an otherwise difficult economic environment. Hopefully the Reserve Bank will make a similar judgment. Brian Kantor

JSE listed retailers: Identifying impressive outperformance

JSE listed retailers listed in the General Retailer or Food and Drug Retailer sub-indexes continue to enjoy great approval from investors. They have outperformed the All Share Index since 2003 by very large margins with the Food and Drug Retailers performing especially well with this Index rising by an extraordinary 1200% over the period 1 January 2003 to 22 June 2012 compared to a still very satisfactory 400% improvement for the All Share Index.

The General Retail Index did twice as well as the All Share. Over the period January 2003- June 2012 the JSE ALSI provided an average return, including dividends, calculated monthly of 15.2% p.a., compared to 25.3% from the General Retailers and 28.7% realised by the Food and Drug Retail Index.

The sector has re-rated: prices have risen further than earnings

The outperformance by retailers was almost as impressive on the earnings front. Retail Index earnings per share have grown twice as fast as All Share Earnings, growing six times compared to the three fold increase recorded by the market as a whole (including the contribution made by retailers. The General Retailers, having seen earnings decline in the recession of 2009, have now caught up with Food and Drug Index earnings per share. Impressively the Food and Drug Retailers were able to sustain impressive growth in their earnings despite the recession.

Over the past twelve months to 22 June the General and Food Retailers, co-incidentally, both provided their shareholders with as much as a 34% return. Clearly investors continue to be surprised by the sustained excellent economic performance of the retailers. Returns of this order of magnitude are far in excess of the risk adjusted returns required to satisfy investors and therefore must represent further unexpectedly good performance over the past twelve months. But having been surprised, investors have come to expect more from their retailers, as revealed by more demanding valuations.

The Food retailers are trading at over 25 times trailing earnings and the General Retailers 18 times compared with the market as a whole that is priced at a much less demanding 12.5 times reported earnings.

Identifying the performance drivers

As we indicated in our previous report on retailers on the JSE, these companies, in growing their earnings, have realised extraordinarily good (internal) returns on shareholders capital they have invested in recent years. The accounting returns on equity capital for the latest reporting period have ranged from 20% to 49% as indicated in the table below.

Given these exceptionally good returns on capital and given what have become demanding market valuations, we thought it helpful to compare the listed retailers using three metrics. In our previous report we compared Shoprite to Pick n Pay and Woolworths. In this report we extend the comparison to Truworths (TRU), The Foschini Group (TFG) and Mr Price (MPC).

Firstly we compare the ability of the different retailers to realise cash from sales revenue. In the figure below we compare cash to sales ratios of three retailers. All three have proven ability to turn sales into cash on the balance sheet but TRU is a clear leader in this regard as may be seen.

But realising cash is not all that will determine the value of the company. It is what is done with the cash that will matter to shareholders. Investing the cash will add more value than paying it out in dividends or share buy backs, provided the returns on capital exceed their opportunity costs. Clearly the retailers meet this proviso by large margins.

We show the ratio of capex to cash flows below. By this criterion TRU ranks behind MPC and more so TFG. TFG appears as the most willing to turn cash into fixed and perhaps also working assets. But all three retailers typically invest only at best to half the cash they generate.

This reluctance, or rather perhaps the inability, to find value adding investment opportunities is demonstrated by rather tepid and variable growth in capital expenditure itself as we show below. As may be seen the rate of capital expenditure appears to have slowed down in recent years.

Conclusion

It seems fair to conclude that these listed retailers have done done much better at the operating level than they have at identifying and implementing growth enhancing investment activity. If they are to surprise the market in the future as they have done in the past, they would need to do both. Brian Kantor