The rand has recovered strongly this month – by about 7% against the US dollar, and has performed similarly Vs the Aussie dollar and an index of EM currencies. The rand had weakened through much of 2023. It weakened by a further 3% when the SARB increased rates unexpectedly sharply by 50 b.p. on May 25th. Since June 1st the ZAR has recovered – as interest rates in SA have fallen away. arply.
The ZAR Vs The USD, the AUD and the EM Currency Index. (Daily Data January 2023=100)
Source; Bloomberg and Investec Wealth and Investment Long term RSA bond yields have declined significantly and helpfully by between 50 and 70 basis points this month. The Yankee Bond, a five year dollar denominated claim on the RSA, now yields a lower 6.4% p.a. compared to the 7% p.a. offered on June 1st. Moreover, the spread between the RSA dollar bond and a US Treasury of the same duration has narrowed significantly from 3.6% p.a to 2.8% p.a. This interest rate spread provides a very good indicator of the risks of default attached to SA bonds. More important perhaps for the direction of the rand and the economy has been the recent inflection in short-term interest rates. When the SARB raised rates on the 25th May, the money market, as represented by the forward rate agreements of the banks, immediately predicted a further one per cent hike in short rates over the next six months. The SARB is now expected to be much less aggressive. The market is now expecting short rates to rise by a quarter per cent.
RSA Dollar Denominated (5 year Yankee Yield) and the SA Sovereign Risk Premium (Daily Data 2023)
Source; Bloomberg and Investec Wealth and Investment
Why have surprisingly lower short term interest rates helped the rand as surprisingly higher rates clearly weakened the rand last month? There is much more than coincidence at work here. Higher short-term rates – higher overdraft and mortgage rates- combined with the higher prices that follow a weaker rand – are expected to further depress spending in SA and the growth outlook for the economy. The weaker the outlook for the economy, the weaker the growth in incomes before and after taxes, the more government debt is likely to be issued. And the graver becomes the eventual danger a of a debt default. For which still higher interest rate rewards have to be offered to investors to compensate them for the additional risks implied by a deteriorating fiscal condition. These higher interest rates then raise the cost of capital for SA business – making them still less likely to undertake growth encouraging capex. The Reserve Bank is ill advised to react to exchange rate shocks in ways that further threaten the growth outlook – and can prove counterproductive by weakening the rand that then lead to still higher prices. Interest rate increases make sense when excess spending – excess demand – is putting pressure on prices. Which is not the case for the SA economy today. The right response to exchange rate shocks is to ignore them as their temporary impact on the price level falls away. Absent any additional consistent pressure on prices from the demand side of the economy, over which the SARB will always have strong influence. The notion of self-perpetuating inflationary expectations, as promoted by the Reserve Bank when explaining its interest rate reactions to a weaker rand, is supported neither by evidence nor is it consistent with self-interested economic behaviour. It is poor theory and even poorer practice. But this leaves open the question- why then have interest rates come down in SA? The answer can be found offshore. The Fed has found good reason not to push its own rates higher. The pause on rate increases in the US became widely expected and was confirmed yesterday gives the SARB even less reason to raise its own interest rates. The Fed by dealing effectively with a surge in inflation (which has not been self-perpetuating) has improved the outlook for interest rates, the SA economy and the rand.
Update on US Inflation – to May 14th 2023.
Both CPI (4.0%) and PPI headline inflation fell more than expected in May. Monthly moves were low – 0.2% for CPI and negative for PPI. The only proviso was the elevated rate 0.4% m-m for core CPI- CPI excluding energy and food. But core has a very large rental weight- over 40% which was up 8% y/y – but rentals are clearly heading lower and core may not be the most useful leading indicator for CPI – PPI- now strongly lower may do much better in predicting CPI. The Fed paused but member dot plots indicated further increases to come. But the Chairman says the Fed will remain data dependent and my view is that the Fed panic about inflation is over. Because demand pressures on inflation are largely absent- thanks to higher interest rates and negative growth in money supply and bank credit. The global pressure on interest rates in SA is therefore abating. As discussed in my commentary above
US Headline Inflation Y/Y growth in Index
US Inflation over the past three months – % per 3 months annualized. CPI now running at a quarterly rate of 2%. PPI inflation – headline and quarterly- is now negative
Monthly % move in CPI Seasonally Adjusted. Latest April-May 2023=0.12%.
Chat GPT has been an overnight sensation in the world of internet dependents – that is most of us. Though as any overnight sensation would attest – it takes a lifetime of sacrifice and investment to become that overnight sensation. As has surely been the case with the application of Generative Artificial Intelligence. Huge investments have been made – are being made – in developing and applying AI. And the great IT firms are leading the way with their impressive operating margins and returns on capital and abundance of cash flow invested in clouds of computers . They profitably supply the indispensable picks and shovels at the frontiers of knowledge.
And much of their heavy R&D is in the form of employment benefits for their army of researchers – increasingly applying AI – to answer the questions their customers and colleagues ask of them- and answer them far more effectively and rapidly. Among the important applications of AI is in the writing of the code that animates software and its development. With AI the applications and adaptations – the answers to the coders – comes much more rapidly. And the R&D is mostly expensed through the income statement and may not appear on the balance sheet. But will attract great value from the investors who determine the share price of the IT giants who dominate the market value of the S&P 500. Understandably so given the promise of AI. Perhaps the most important question shareholders should now be asking their managers is how are you adapting to AI?
It is estimated that a fifth of the time of office workers is spent answering enquiries of one kind an another. Imagine AI as that true expert on the customer or the internal functions and operations of your company always sitting beside you and your laptop, and comfortably speaking and understanding your language. You will have clearer answers and immediate answers to the questions. Better still the expert may help you ask better more imaginative and important questions- the answers to which will follow. It is asking the right questions that lead advances in science. Humans will be needed for that.
McKinsey has attempted to measure the potential of AI from the bottom up so to speak. By examining in detail how AI is now and could be adopted in the workplace. They have come up with very imposing estimates of extra GDP and of faster rates of change of output and productivity. Which is output volumes divided by numbers of work hours producing them. To quote Bloomberg on the McKinsey study “ Whole swathes of business activity, from sales and marketing to customer operations, are set to become more embedded in software — with potential economic benefits of as much as $4.4-trillion, about 4.4% of the world economy’s output — according to the study by McKinsey’s research arm…….Depending on how the technology is adopted and implemented, productivity could increase 0.1%-0.6% over the next 20 years, it found….”
A follow up question is worth asking. How well will the growth in productivity show up in the numbers we use to measure output and productivity and its growth? One of the puzzles economists have been wrestling with for many years is the apparently persistently slow growth in productivity recorded over many years despite conspicuous automation and labour saving. Are we entering a new phase of productivity improvements – almost certainly – but to recognize them we will need superior techniques to measure them.
We measure the value rather than the volume of production. Revenues recorded are prices charged in money of the day, multiplied by the quantity of goods and service supplied- easier to measure in mines, farms and factories than in the increasingly predominant service sector of a modern economy that sells a service the volume of which may not be obvious. For example how does one judge the quality of a report produced by an analyst today- enhanced by abundant data and powerful software and increasingly by AI? Not surely by the number of words written. Furthermore an enhanced customer service, better advice more rapidly provided, as for example, provided by a call centre, now armed with AI, will not be usually be directly charged for. The improved benefits it provides will come with a single charge for the good or service supported by a call centre- a laptop or cell phone for example. Or the fee charged by a customer relationship manager- a financial advisor perhaps, based upon assets being managed. A higher price or fee perhaps charged for the good or service bundled with the call centre or advisor would not necessarily mean more inflation. But rather represent a higher payment for an improved good or service.
To calculate output (GDP) and incomes or the values added we compare firm revenues today with revenues one or ten years ago, when prices observed were generally lower- given inflation. To make comparisons of real output and income and their growth over time, the value of all the goods or services supplied, must be adjusted for inflation to estimate the volume of goods or services produced. To estimate the real volume of goods or services produced or incomes generated over time. Most important prices have also to be adjusted for the changes in the quality of the of the goods and services supplied. We will not just be comparing the price of an aspirins with an aspirin which may well have increased over time. But rather comparing the prices charged for ever more accurately targeted capsules, developed with the aid of AI, and worth more in a real sense. AI is very likely to improve the quality as well as the quantity of goods or services provided.
Improved and lower costs of production could bring a mixture of absolutely lower prices and improved quality. It might mean deflation rather than inflation. How much prices fall in response to increased supplies will depend upon the growth in demand generally. That is on monetary and fiscal policy that could cause prices to rise on average even as economic growth – that is the volume of goods and services provided is growing. But if you underestimate quality gains incorporated into the price of goods and services and overestimate inflation by a per cent or two a year, you will then be underestimating productivity gains and economic growth at the same rate. And then be telling a very different story about economic progress. Perhaps AI will help economists and statisticians adjust more accurately for the changing and improved nature of the goods and services we consume.
A depressing reflection of the State of South Africa was the complaint of Richard Friedland, CEO of private health provider, Netcare, about a coming nursing crisis. An aging cohort of nurses, many more of whom will be retiring, is not being replaced for want of government action – ‘…..about which it was warned well in advance and chose to ignore it …” Netcare, he reported “…had been accredited to train more than 3,000 a year; it now trains barely a 10th of that…”
Clearly there is a demand for more nurses and a very large potential supply of aspirant nurses, given the current employment benefits and prospects. Why the government stands in the way of Netcare helping to close the gap between supply and demand of nurses is perhaps not as obvious as it should be?
Let us attempt to round up the usual suspects. The first suspect must be the arguments against private medicine that are made in principle. The case for equal treatment for all, paid for by the taxpayer, is one that ideologues employed in the Department of Health, hold fervently. Helping the nursing and other services a private hospital provides may provide may threaten this vision.
Though even the ideologues appear to concede the case for top up medical benefits paid for by the more prosperous. Perhaps they realistically understand that the better off in their key economic roles are much more likely to take themselves and their contribution to the revenues of government away from SA, for want of a world class and affordable medical service. A benefit we assuredly receive from the private hospitals and independent physicians that they are willing to pay for through a pay as you go system.
For an economy so obviously lacking in human capital, and not only for the capital embodied in the cohort of nurses, who are especially attractive immigrants, the consequences of an uncompetitive medical offering for highly mobile skilled South Africans are truly disastrous for income growth and taxes collected in SA. Upon which any National Health Service must ultimately
depend. Equal and hopelessly inferior is not an attractive prospect even for those who ignore the current realities of our government provided medical services.
It may still be asked why can’t the government, via its own large suite of public hospitals and large budgets, are failing to train more nurses and doctors for that matter? The answer is in the existing budget constraints. Budgets that provide well for those already in government service, provide employment benefits that keep up with and often exceed inflation of living costs, but leave very little over to employ new entrants to government service, of whom there are potentially legions. The private sector does not compete at all well with the public sector in the competition for workers of all skills- taking into account the private medical and pension benefits that the public sector employees draw upon.
But more important in the resistance to private medicine may be the force already prominent in explaining the actions and allocations of budget, commonly taken by state operated agencies in SA. Public hospitals and their procurement practice –definitely not excepted. The taxpayer has been held to ransom by the opportunists who intermediate between the State as payer and the service and goods providers. They have been extracting wealth from the taxpayers on a mind-numbing scale as Zondo our media and the US government has revealed.
The envisaged National Health Service will be a single payer for all the health services provided by the state. The intended budget will be an enormous one and the opportunities to navigate the gaps between the government as payer and the service and goods providers will be many and valuable. That that you can’t do (big) business with the SA government without a bribe or kickback must be regarded as alas, unproven. The evidence, the reality of SA, vitiates the case for a universal health system. But the private interest in such arrangements is a powerful one. That providers of private medicine in SA will have to resist to survive. They must make their case to the voting public- as Netcare has done.
In a previous piece (What can help the Rand and the economy? – ZA Economist) we discussed how ever-changing probabilities make Financial Risk so hard to measure and that investment outcomes are dominated by the return received, with any notion of the past risk faced quickly fading from memory. Thus, if a successful share investment has yielded an excellent return, is the happy result either because the shareholder took on extra risk and got lucky , or because the savvy investor knew the share was undervalued and proved to be so, becomes irrelevant.
Knowing the downside, estimating how much of a loss any portfolio or balance sheet can take and survive a potential loss is an essential task for the risk taking investor. Deciding what is a good bet – improving the odds of success by improving expected returns for any presumed risk -or reducing risks of failure for any expected return -makes every good sense.
Holding gold or perhaps more realistically holding a claim on a stock of gold held in some very safe place, has long proved itself as a sensible way to protect wealth against disasters in the form of war or revolution or more prosaically against inflation and their impact on many other ways to conserve wealth. As the dangers of an economic calamity rise, so typically, as will be expected, the price of gold will move higher.
If so, as will a claim on gold bearing rocks in the ground, that will be gradually turned into gold on the surface by a gold mining company. A share in the expected profits of a gold mining company will then also provide very useful insurance against danger. The gold price and the share price will move in the same direction – but given all the potential gold in the ground, and the risks associate with bringing it to the surface – the share price will be far more variable, hence far riskier than the gold on the surface. The recent sharp upward movement in the gold price provides an appropriate example. The gold price has moved up 10% or so in dollars over the last year. If we take the example of the GoldFields (GFI) share price, this has moved up around 160% (a factor of 1.60times the Gold Price movement) over the same period.
But an investor seeking safety owning gold has still a further alternative. That is to buy an option to buy a share in a well traded gold mining company, at a pre-determined future date, at a price agreed to today. The options can be bought or sold at market determined prices until the expiry date of the option, after which that right or option becomes worthless.
Option prices therefore exhibit a still much greater level of variability (or risk) than the underlying metal or share prices . Because of this character they give investors an excellent opportunity to raise the expected return from an exposure to movements in the gold prices , with a much smaller risk of a loss should the gold price move lower. Give the option price volatility – the factor here
. The availability of gold shares and more so options on gold shares give investors, who want to speculate or to hedge a portfolio of gold bullion against a large contrary or unexpected movement in the gold price make for a very efficient vehicle to hedge the exposure while laying out significantly less capital or incurring expenses to improve the expected return- risk trade-off.
Graham- one needs protection against a fall in the gold price and/or the multiplied fall in the value of a share or an option. One hedges the gold bullion price position by selling (shorting) the shares or selling the option- the puts -to hedge the exposure to the share price. It is cheaper to sell the shares and cheaper still to put the shares. I have tried to spell this out but with difficulty as you will see. A portfolio of gold bullion. Gold price down 10% portfolio down 10%. Bullion price down 10% GFI down 100% – 10 times more. A short of how many GFI shares (1% of the portfolio) would give the bullion portfolio protection against a 10% fall in the gold price. A put option on GFI equivalent to 0.2% of the portfolio in gold would presumably protect against a 10% fall in the gold price.
In recent months a short duration Call Option on GFI, has moved up about 500% (a factor of 50 times greater than the move in the gold price) By agreeing to sell the share and more so an option on the share, one will have exposed (expensed) significantly less actual capital for the same hedging effect. Thatis protection against losses should the gold price move lower rather than higher – as was the expectation. If the gold price had fallen 10%, then one would have lost 10% of the portfolio capital if one had held gold coins (a ten percent fall for ten per cent of the portfolio), 1% of the portfolio for a short on the GFI shares but lost only 0.2% of the portfolio capital, if the outlay was in the form of a put on the GFI shares rather than a short. Therefore, one would have been be unambiguously better off to hold the gold share options (puts) (a 50th of the gold bullion loss). Thus for the portfolio manager who is a gold bull and is already committed to holding a large amount of bullion, he can turbo-boost his investment in gold, with little added risk, by making a relatively small purchase, risking relatively little capital on a highly geared Gold share options. The potential gain (retrun on capital invested in the option) will be very large should the gold price move higher- but the potential loss – compared to the losses incurred by investing the same amount of capital in gold or gold shares – should it all turn out badly – will be much smaller. The return- risk trade-off, calculated looking ahead rather than behind, will have been greatly improved.The fact that at any moment in time judged by observing the random daily nature of the gold price, the gold price has as much chance of rising or falling from its current market determined value, means that the gold bulls are always matched by the gold bears – at the market determined price, or share price, or option price on the shares. The profit seekers in a higher gold price– as in any other actively traded asset – will always be matched by the profit seekers – those who are cashing in on their positions, believing the price will go down. And they will be able to do so at a market clearing price that matches the amounts of bullion or share or options bought and sold. The market makers, including the option providers, will match buyers and sellers. They ideally from their perspective will be rewarded with a fee and not be exposed to the highly unpredictable move in the underlying metal or share prices.
Structuring such risk reducing strategies is complicated for the average private investor. But it may be straightforward for banks or others who provide structured products bought by retail investors. Constructs that trade off less upside gain for less downside risk of losses It should be possible to put together a blended product of say 90% gold bullion and 10% Gold share options of appropriate duration. Such a listed financial security registered for trade on the JSE would exhibit high gearing to the gold price upside but for lower risk of losing capital should the gold price move in the wrong direction, which it may well do. Over to the market place.
In early 1980 the Rand reached a peak of 1.32 US$ to the Rand; yes, the Rand then bought more than one dollar! This was the time of a very high gold price of $820 per oz. when Russia invaded Afghanistan and WW3 looked like a real possibility. It was but 35 dollars an ounce in 1970. Things have not been as rosy on the exchange rate front since. The exchange rate is currently around 19.2 Rand to the $. This means that in purely nominal terms the Rand is currently 1/25th (against the dollar) of what it was in those heady days of 1980! If the ZAR merely adjusted for differences in SA and US inflation since 2000 the dollar would now cost less than R13. In a relative sense- the ratio of the market to the Purchasing Power Parity was only wider in 2002 when the ZAR was nearly 80% undervalued. At current exchange rates it is about 50% undervalued. Or in other words the rand buys roughly 50% less in NYC than it does in SA as SA visitors will testify. The great deals will now be realised by tourists to SA –until the rand sticker prices in the stores and on the menus are marked higher. See figure 1
Figure1. The USD/ZAR and its PPP equivalent.1 Monthly data to April 2023.
Source; Federal Reserve Bank of St.Louis, Stats SA and Investec Wealth and Investment
In the seventies as the gold price took off- more in USD than ZAR, SA was the largest gold producer in the world and gold mining was hugely lucrative for shareholders in the gold mines and for the SA government who collected much extra revenue from taxes, and royalties paid by the gold mines. Platinum mining was only then getting going and subsequently got a huge boost from the widespread use of catalytic converters in the exhausts of motor vehicles. Coal exports got going after the construction of the huge export terminal at Richard’s Bay, and the rich Sishen iron ore deposit was still to be exploited.
South Africa is now merely the eighth largest producer of gold in the world, producing but a sixth of the gold delivered in 1970. And gold production is now a relatively small part of the South African economy that in the seventies accounted for 60% of all exports from SA and about 16% of GDP. The link between the gold price and the exchange rate
is now correspondingly weak and has done little to save us from facing the second weakest Rand on record and ever higher long-term interest rates.
The strength of the Rand is still much influenced by the state of the commodity-price cycle, as South Africa remains a commodity-based and exporting economy. It is also determined in large part by perceptions of South Africa’s economic future and the associated safety of investing in SA. Foreign and local investors require a return that compensates for the perceived risk of investing in SA- including the risk of rand weakness. These perceived risks influence flows of capital to and from SA and can strongly influence the foreign exchange value of the ZAR, as they have this year. As an emerging market, South African risk generally follows the average emerging market risk, but SA specific risk has recently risen dramatically in the face of income destroying load shedding and more recently for reputation destroying toenadering with the reviled Russians. This year the rand has weakened by about 13% vs the Aussie dollar and 11% Vs the EM basket. Much of the relative weakness occurred in January and February in response to load shedding. With additional exchange and bond market weakness (higher yield spreads) on the 10th May in response to the Russian revelations. (see figures 2,3 and 4)
The ratio of the USD/ZAR exchange rate to the USD/Emerging Market (EM) average provides a useful indicator of SA risk. This ratio indicates that SA is again in economic crisis territory. The hope is that this time is not different- and the USD/EM ratio recovers to something like normal, as it has done after all the other crises that have damaged the ZAR and the SA economy. Relative to an average EM currency the ZAR has never been weaker than it is now. The outlook for the SA economy, judged by this ratio, has never been as bleak as it is now.
Fig.2: Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1
Higher ratios indicate relative rand weakness
Source; Bloomberg and Investec Wealth and Investment.
Fig.3; Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 15th May 2023. Higher numbers indicate relative rand weakness.
Fig.4; Rand Weakness, Inflation expected and the RSA Sovereign Risk Premium. 5 year yield spreads. Daily Data 2023 to May 16th 2023.
Source; Bloomberg Investec Wealth and Investment
In response to this exchange rate shock – for reasons specific to SA – the SA rate of inflation is very likely to trend higher, independently of by how much the Reserve Bank raises short-term interest rates to further reduce spending pressures on prices. Yet raising short-term rates is almost certainly negative for growth in incomes and employment of which the SA economy is already so sorely lacking, given load shedding and a general loss of confidence in the competence of the SA government. The forces that have given us this latest exchange rate shock are completely out of the Reserve Bank’s control. The
Governor needs to recognise this and do little additional harm to the economy and its growth prospects- by not reacting to the exchange rate shock.
It seems evident that the surging rand prices for our mineral exports may not help the Rand this time. A working Transnet to ship the metals and goods out the country would help – as even more important would be a consistent supply of electricity. But it is hard to be optimistic about such immediate responses and investors shared this pessimism earlier in the year and well before our damaging Russian connection came to light to add further to relative rand weakness.
Unfortunately, we do seem saddled for now with a weak Rand and a near-term uptick in inflation. Yet the weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices for their production. Their extra rand costs of production will lag higher rand revenues until local inflation catches up with the inflation of the rand prices, they will be able to charge on foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers) listed on the JSE. Sectors of the JSE that face abroad can provide a very good hedge against rand weakness that occurs for SA specific reasons, as they are predictably doing.
The rand cost of petrol and diesel will play an important role in influencing the inflation rate in the months to come. A saving grace for the inflation outlook is that the dollar price of oil and gas has fallen away- by more than the ZAR has weakened against the USD. (see figure 5)
Fig.5; Brent Oil price – per barrel in USD and ZAR
Source; Bloomberg and Investec Wealth and Investment
The biggest danger to the local economy is that the Reserve Bank will raise interest rates further (the money market already expects increases of over 100b.p. in the next few months) The most recent attempt to support the ZAR raising interest rates by 50 b.p. at the last Monetary Policy has been a conspicuous failure. It has not helped, could not support the rand in the circumstances, but has further depressed spending and the growth outlook. And helped push long term interest rates and the cost of capital higher.
The best approach to rand shocks – that have nothing to do with monetary policy settings- is surely to ignore them – and let the inflation work itself out without higher interest rates. One has long hoped that SA had learned the lesson to not interfere with the currency market. Interest rates can have little impact on the ZAR in current circumstances. The best support for the rand will come from faster economic growth that raises incomes and tax revenues for the state.
Long term interest rates in SA are now punishingly higher than they were last week and the rand is now expected to weaken at an even more accelerated rate than was the case a week ago. This is because SA remains at greater risk – given the even more depressed outlook for growth – of not easily balancing its fiscal books. The expectation of even slower growth to follow still higher borrowing costs, as is widely expected, has added to these risks.
The only way out of the mess SA has got itself into is to surprise investors by delivering surprisingly faster growth- even an extra one percent higher GDP would be helpful. The Reserve Bank has a crucial role to play in this by ignoring the exchange rate shock. Eliminating load shedding and delivering more exports are even more important to improve the growth outlook and reduce SA risks.
The latest shock to the SA currency and bond markets is of a large scale, similar to those of 2001, and of 2008-9, that was linked to the Global Financial Crisis, also to the Zuma-Nenegate shock of 2015-16, and the Covid shock of 2020. This shock is entirely of our own making. It is the punishing result of a failure to keep the lights on and choose our friends more carefully. We can assert this not only by reference to the abruptly higher rand costs of a USD or Euro, but by the poor performance of the ZAR against other emerging market (EM) and commodity currencies. A weakness that was pronounced earlier in the year as load shedding increasingly hurt the growth prospects of the economy and that was accentuated on the news of our arms business with Russia. The ZAR this year to the 24th of May, after a further burst of weakness on the 10th May, is about 10% weaker Vs the Aussie dollar and 12% weaker Vs the JPMorgan Index of EM exchange rates.
Fig.1 Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 24th May 2023. (2023=100) Higher numbers indicate relative rand weakness.
The ZAR compared to a basket of seven EM currencies – the ZAR/EM ratio – has never been weaker than it is now. The ratio very easily identifies the periodic shocks to flows of capital to and from SA since 1995. One can only hope that this time will not be different and that the ZAR bounces back- at least relative to our peers.
Fig.2. Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1 to 15th May 2023
Higher ratios indicate relative rand weakness
Source; Bloomberg and Investec Wealth and Investment.
The RSA bond market could not escape similar punishment. Yields on long dated RSA Rand and USD denominated debt rose by about 60 b.p. between the 9th and 15th of May having all tracked higher through much of 2023. The case for investing more in SA plant and equipment has become that much harder to make. And the rand -judged by the wider carry- the difference between interest rates in SA and the USA- is now expected to weaken at an even faster rate- despite recent rand weakness. All bad news for our economy
Fig.3 Interest rate movements in 2023. Daily Data to 24th May
Source; Bloomberg and Investec Wealth and Investment.
The weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices. Their extra rand costs of production will lag higher rand revenues and until local inflation catches up with the higher rand prices they will be able to charge on
foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers or the International Mining Houses) listed on the JSE and who account for more than half its market value. The JSE is not in shock- it is well hedged against SA specific shocks.
How quickly inflation rises in the months to come will depend on the rand price of imported oil. A saving grace for the inflation outlook is that the dollar price of oil has fallen by more than the rand- hence a lower rand price of a barrel of oil.
Fig.4; Brent Oil price – per barrel in USD and ZAR
Source; Bloomberg and Investec Wealth and Investment
The interest rates set by the Reserve Bank will make no difference to the rand or the inflation rate. Hopefully they will react to an exchange rate shock by not reacting to one. And do what little they can not to slow down growth any further.
The Treasury could help –by keeping the peak loading generators on for longer. And pay for the extra diesel or LPG. Every hour of load shedding not only means less income and output generally – it means lower tax collections. Every rand spent on diesel by the public or on replacing Eskom means less tax revenue in proportion to the company and personal income tax rates and the conversion to solar
allowances. Spending taxpayers rands on diesel will pay for itself. And possibly produce the growth surprise that could turn, only can turn around the rand.
Banks are different to other financial intermediaries. They do more than borrow and lend. They manage the payments system without which any modern economy could not function. The payments system cannot be allowed to fail and banks deserve support should their stability come into question. Which, as was apparent in the US recently, cannot be taken for granted.
Banks maintain the payments system by supplying deposits to their clients and transmitting many of them on demand. They bear the operating costs of doing so – which are considerable. They have to remain viable businesses, so they have to cover their operating costs with transactions fees and more importantly by lending long and borrowing short- realizing net interest income, essential to their profits and survival. Banks, competing with each other, are forced to operate with very limited cash reserves. They hold very limited reserves of equity- that is owner’s capital – and are highly leveraged for the same profit seeking purpose. The dangers come with the territory.
A margin of safety for them is to be found in their holdings of other liquid assets, mostly debt issued by the government, with varying maturities and interest rates, that the central bank will almost always repurchase for cash when asked to do so. In SA the cash to demand deposit ratio is less than three percent and the liquid assets to deposits ratio is now equivalent to about 40%.
SA Bank Deposits withdrawable on demand and Cash and Liquid Asset Reserves. January 2023
Source; SA Reserve Bank and Investec Wealth and Investment
Bankers everywhere must surely be considering attaching a longer notice period to their deposits and to reduce their dependence on transactions accounts – with interest rate incentives to do so. Giving them more time to call for a rescue from the authorities or other banks should their deposits drain away suddenly.
The relationship between the US Fed and its member banks changed in an important way after 2008. To rescue the banking system the Fed injected cash into the financial system on a very large scale through purchases of Government Securities from the banks and their customers in exchange for bank deposits with the Fed. A process of money creation described euphemistically as quantitative easing. (QE) Ever since then US banks have continued to hold large cash reserves despite short phases of quantitative tightening (QT) to reduce the supply of cash as is the case now- or at least before the banks ran into cash withdrawal problems
US Banks Deposits with the Fed
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment
The policy determined interest rate is now the rate the Fed offers the banks on deposit rather than the rate charged them for cash borrowed. The SARB decided it too would no longer attempt to keep banks short of cash. SA banks since 2022 can now hold excess cash reserves and earn interest on them. Reserve Bank lending to the banks has fallen away sharply recently.
SA Banks; Actual, Required and Borrowed Cash Reserves.
Source; SA Reserve Bank and Investec Wealth and Investment
But will central banks be able to exercise good control over the supply of money (mostly bank deposits) and bank credit? The supply of bank deposits and supply of bank credit depends in part on the cash reserves supplied to them by the central bank. More cash supplied by the central bank leads to more bank lending and higher levels of deposits (M3) and vice versa. But this money multiplier (Deposits/Cash Reserves) can now rise or fall depending on how much cash the banks choose to hold, rather than on the extra cash supplied them by a central bank. One bank’s extra lending becomes another bank’s extra deposits. If the banks prefer to hold more cash and lend less, the supply of deposits and the money supply will shrink and vice versa. Therefore, the money supply will tend to grow faster during the booms when demand for bank credit is buoyant, and then grow slower when demands for bank credit is weak- as is now the case in the US – making a recession more likely. Ideally central banks can contain inflation and help smooth the business cycle by controlling the supply of money and credit. The current dispensation for banks with excess cash makes this less likely.
Mpact a South African paper and packaging company has recently reported highly satisfactory results. It has a rare attribute for a SA based industrial company. It appears to have very good growth prospects linked to good export prospects for SA agriculture as highlighted in BD on May 2nd.
And Mpact seems very willing to invest in the growth opportunity and to raise capital from internal and external sources to fund the growth opportunities. It speaks of a 20% internal rate of return on these projects which would be well above the 15% p.a. that could be regarded as the opportunity cost of the capital it raises.
But the Mpact story is complicated by its shareholding. Caxton an apparently less than friendly shareholder unwilling to raise its 34.9% stake to the point where it has to make an offer to all other shareholders. It prefers to merge its operations with Mpact, a prospect the Mpact board is actively discouraging.
Caxton however argues that Mpact has raised too much debt for its comfort. It may have in mind using its own cash pile to fund the capex after a merger. It may nevertheless have a generally valid point. Mpact might be better advised to fund its growth raising more additional equity capital and less extra debt. This might not suit Caxton but would be a less risky strategy. And there is not good reason that SA pension funds with their typical 60% equity – 40% debt would not welcome the opportunity to contribute additional equity capital that promises good returns.
It is a strategy to be recommended to any growing company. Any equity capital raised that beats its cost of capital will very likely add value for its shareholders old and new. The value of the firm will increase by more than extra capital raised- adding wealth for shareholders with a smaller (diluted) share of what will have become a larger cake. Dilution can take place for good growth reasons- and not only to save off the bankruptcy – that always comes with too much debt.
The temptation always offered by interest rates below what prospective internal rates of return on capex is to raise debt to improve the return on shareholder’s equity. When the internal rates of return have in fact exceeded the costs of finance, hindsight tells us more debt, would and should have been the obviously preferred source of capital. But in an uncertain world such favourable outcomes cannot be known in advance.
The savings in taxes paid, because interest payments are deducted from taxable income, that is equal in value to the tax rate multiplied by the interest paid, may be presumed to reduce the “weighted average cost of capital’ – and so perhaps reduce the target internal rate of return required to justify an investment decision. I would counsel against such an approach. Expected return on all the capital put to work, however funded, should be the initial critical consideration independent of tax to be paid. If the expected returns are attractive, the appropriate financial structure can then be considered. Debt is not necessarily cheaper than equity – because it is more risky – and the firm may well have to pay up for the financial risk it has taken on, usually when it is least convenient to do so.
When the source of any reported growth in earnings appears to be financial engineering, and is largely debt financed, it should be treated with suspicion by actual or potential investors in the shares of such a company. Returns on all capital invested needs to be greater than the interest rate on debt raised and in addition need to at least meet the returns required by shareholders who have alternative investment opportunities. How best to fund the growth should be a secondary consideration after the favourable return on all capital invested can be assumed with confidence.
MPact should be strongly encouraged by its shareholders and South Africans more generally to realise all the projects that can confidently earn 20% p.a. And raising extra equity rather than only debt capital will help ease their way down their apparently long runway -should the 20% materialise.
There was no good reason for the Reserve Bank to have surprised with a 50 basis point increase in its repo rate. There is in fact no good reason at all to subject the beleaguered SA economy to any further increases in interest rates. Given the bank’s own assessment of the state of the economy. To quote the statement of the Monetary Policy Committee of the 30th March. “Turning to inflation prospects, our current growth forecasts leaves the output gap around zero, implying little positive or negative pressures on inflation from expected growth”. The output gap is the estimated difference between potential growth in the economy (the supply side) and the growth in demand expected. The expectations for both growth in demand and supply are depressingly slow- no more than 1% p.a. over the next two years.. But clearly there are no demand side pressures on the price level.
The Bank’s forecasting model indicates that every 1 per cent shock to the repo rate will reduce GDP growth by 0.17% on an annual basis with the peak impact two or three quarters after the interest rate shock. While inflation is predicted to decline by 0.12% two years after the shock. While these are the estimated impact of higher or lower interest rates, other things equal, other things are very likely to change in highly unpredictable ways. For example exchange rates, or food prices or electricity tariffs or export prices- supply side shocks – over which the Reserve Bank has no control, nor any superior ability to predict. And which are as likely to move higher or lower over the forecast period and therefore should be ignored when setting interest rates. The strong focus of policy attention should be on the demand side of the economy- on the potential output gap over which the Bank does exercise influence. And without excess demand price increases cannot continue in an ever-higher direction- irrespective of recent inflation. Why the Bank would risk even slower growth by imposing still higher short term interest rates is hard to appreciate.
Since its January meeting the Bank, by no means alone, has been surprised by global inflation, by food prices, by rand weakness etc, enough to have taken recent headline inflation rates above what was predicted at earlier meetings. Though the longer term expected trend in headline inflation remains as it was – pointing distinctly lower below the targeted band. Incidentally the core inflation rate that excludes energy and food prices – large supply side shocks – has behaved almost exactly as expected. All further reason to have stood pat.
SA Headline Inflation. Actual and forecast by the Reserve Bank
Source; SA Reserve Bank and Investec Wealth and Investment
SA Core Inflation. Actual and forecast by the Reserve Bank
Source; SA Reserve Bank and Investec Wealth and Investment
There is perhaps more to the decision to raise interest rates than the usual focus on prices. The MPC statement and the Q&A session after the meeting cast unusual concern about the foreign financing needs of the SA economy. To quote the MPC statement again – “South Africa’s external financing needs are expected to rise. With a sharply lower export commodity price index, stable oil prices and somewhat weaker growth in export volumes, the current account balance is forecast to deteriorate to a deficit of 2.7% of GDP for the next three years. Weaker commodity prices and higher sate-owned enterprise financing needs will put pressure on financing conditions for rand-denominated bonds. Ten-year bond yields currently trade at about 11.2%, despite the expected moderation of inflation over the forecast period”
It therefore appears to me that higher interest rates to attract foreign capital interest rates may have played a decisive role in the MPC decision. The rand and the long end of the bond market did benefit from a wider interest rate spread in a modest way. But such experiments in exchange rate management are surely not to be recommended, given all else that can happen to exchange rates. I thought we have learned (expensively) to leave exchange rates and long-term interest rates to sort out balance of payments flows – and yet still to learn to set interest rates with the domestic economy front of mind.
RSA 10 year bond yields and the USDZAR – before and after the decision to raise the repo rate by 50 b.p.
The demise of Silicone Valley Bank (SVB) the 15th largest US bank, with an important systemic role in the roll out of US Tech happened quickly. In less than 24 hours it was all over for shareholders as the regulators took over to prevent banking contagion. By offering insurance not only on the deposits of all denominations of SVB, but effectively on all deposits with US banks, should it be needed.
It was not a run on the banking system – depositors were not lining up to cash in their deposits- as they might have done in primitive times before. They were acting online, transferring their deposits as quickly as they could to their accounts with the banking behemoths JP Morgan, and their like. As the venture capitalists and their many subsidiary companies did with their deposits with SVB,
It was clear what caused the panic withdrawal of deposits from SVB. It was a sudden loss in the share market value of SVB to which the depositors acted as they did. They may not have known what was going on but they took fright. It is the market value of a company and its capital raising potential that protects creditors and this protection had fallen away. For reasons that had everything to do with decisions taken by SVB itself on surely very poor advice, that investors in SVB had recognized as destroying the market value of SVB.
The problem for SVB and other banks was that the fixed interest rate yield on their essentially sound assets had been rising steadily, causing their values to decline, even as the interest rates paid on deposits were edging higher in response to Fed tightening. Accordingly, the net interest income earned by the banks and their earnings per share were in decline. A trend clearly uncomfortable to earnings conscious and presumably earnings growth incentivized managers of SVB.
The advice was to mark the portfolio to market values, and recognize the capital losses on the balance sheet. To raise additional share capital in the market to restore required capital to asset ratios and to invest the capital in higher yielding government and other securities. By so doing improving net interest income and the earnings outlook and the share price.
There was no regulatory compulsion to recognize the losses on their portfolio. The alternative was to have let the assets run off as they became due and to accept the consequent decline in earnings for the next three years or so and the possibly negative reactions of the capital market to a well understood and unavoidable economic reality. There would then have been no need to raise additional capital.
The capital market would surely have been capable of seeing beyond the decline in earnings and focused on the inherent quality of the SVB balance sheet and its potentially durable business model. The problem for SVB was that the capital market clearly did not think that the proposed plans for the balance sheet made good sense and that two billion dollars of extra capital required could be raised on reasonable terms. Doubts that put pressure on the share price that undermined the possibility of raising the additional capital.
The protection in the form of market value for depositors and shareholders in SVB and beyond fell away dramatically and the bank went down. All because of a false belief in managing earnings per share and the failure to recognize how companies are properly appreciated and valued on the share market. Concerns that extend well beyond the short-term prospects for accounting earnings. Adjusting wisely to Covid 19 and its aftermaths has proved difficult enough for the great growth companies with the strong balance sheets. It is even more difficult for banks, with high degrees of leverage, to wisely adjust their balance sheets in such unpredictable circumstances. SVB clearly failed to do so.
Makawber’s principles apply to National as well as household budgets. Expenditure less than revenue equals happiness. Expenditure that consistently exceeds income brings misery. Iin the form of ever rising and more expensive levels of debt, the service of which takes an ever-larger share of the revenue collected and of all expenditure. Paying interest and repaying capital maintains your credit rating -more or less- it does not buy votes.
South Africa has been on this spendthrift path, without pause, ever since the Global Financial Crisis. Since fiscal year 2008-09 to date real government expenditure has grown by an average 3.2% p.a. Government revenues have lagged, growing by an average 2% p.a. after inflation. This extra 1.2% of spending makes a large difference to debt levels over time. Real GDP has grown by an immiserating 1.2% p.a. average since 2009.
Government debt net of cash was a manageable R483.2b in 2007/8 and equivalent to 20% of GDP. The net debt this past financial year is nearly ten times higher at R4483b and equivalent to over 67% of GDP. Servicing this debt took 8.8% of all government revenue in 2008-09. This share of revenue grew consistently to 18.8% in Covid year 2021 as revenues collapsed with the lockdowns. This depressing ratio fell back to 17.1% in 2021/22 as the inflationary comeback from Covid brought hundreds of billions of extra unexpected taxes from SA mining companies. A mixed blessing as these companies remained reluctant to invest more in SA and so paid more tax.
Not only did the volume of debt incurred rise, but interest rates both paid by the government and by private borrowers also rose well ahead of inflation to compensate investors in SA government and private debt for the dangerous trajectory of our debt. Such trends could easily be extrapolated into a debt crisis and be expected to do so. That if not corrected could lead to a desperate eventual resort to the central bank as a lender of last resort and its money printing press. That is to a default by inflating away the real value of the debts incurred. A not uncommon event in monetary history of the world.
The 2023-04 Budget has made an essential, praiseworthy attempt to reverse the direction of spending and revenue. Over the next three years all government spending is planned to grow by 8.5%, and more slowly than government revenue which is expected to increase by 10.4%. The extra borrowing, the fiscal deficit would then decline from the current 4.2% of GDP to 3.2% by 2025/06 despite very modest expected growth in GDP. If the plans materialize, the debt to GDP ratio will stabilize in the low 70% range and the debt service ratio will be contained below 20% of all revenues. A path to fiscal sustainability has been opened.
The issue of how well or badly the government spends the money collected or borrowed and then allocated across the spending departments and state sponsored enterprises, and how onerous is the tax regime, clearly influence economic growth. Fiscal responsibility of the kind, hopefully to be demonstrated, almost balancing the books, is vitally necessary for economic stability but is not sufficient to the purpose of faster economic growth. It is the larger task for government to get value for taxpayers income it extracts.
The economic dust seldom settles in South Africa. The Budget was soon overtaken by De Ruyter’s last stand. Yet judged by the muted reactions in the financial markets the Budget did little to change what we pay to raise capital, public and private. RSA 5 year bonds still yield well over 9% p.a. or a very expensive real 5% p.a. after expected inflation of 5.5% p.a. Judged by the difference between RSA and USA Bonds, the rand is still expected to weaken – by a punishing 5% p.a. over the next five years and about 7% a year on average over the next 10 years. SA dollar denominated, 5 year debt, now yields 6.56% p.a. representing a default risk premium of 2.3% p.a. and more than double investors in Mexican debt pay for the same insurance. Clearly the market and the economy need much more convincing that we have permanently changed our ways.
Measures of SA Risk; Daily Data 2022- 2023.
Source; Bloomberg and Investec Wealth and Investment
Nostalgia has its comforts. But looking ahead rather than behind may be the better New Year resolution. Especially for those with the responsibility for directing a business enterprise. It is best for them to move on from the inevitable mistakes they have made in business or in life. To not throw good money after bad to avoid embarrassment. Not to not sell off the best divisions to sustain the underperformers with capital they should better be starved of. Do as Woolworths did with David Jones – but do it much faster. And change the seriously erring CEO and the Board members who supported them sooner rather than later. Furthermore, do not encumber the strong operating managers with the capital that was once wasted overpaying for acquisitions. The poor deals and the waste of shareholders capital were not their mistakes. Yet they may be doing very well operating the plant and equipment handed to them and need recognition and encouragement accordingly. Therefore, the firm should accurately estimate the current market value of the plant and equipment they are held responsible for. And reward them when they achieve returns on this capital that exceeds required returns, the opportunity cost of the capital employed. The investors who value the business will, as managers should, look forward and estimate expected returns based on current market values – and will add or subtract based on expected not past performance. The future is for every business and every individual to prepare for. The technology for dramatically improving the productivity of
capital is available for you and your competitors. If only you or they knew better how to serve your key stakeholder, the customer, they will attempt to do so expecting to add market value for their owners. The future will be theirs that succeed. Frustrated South African customers of the state-owned enterprises know that they operate to serve other stakeholders, not their customers. Other KPI’s are much more important. Most obviously to serve the interest of their employees or suppliers without regard for the bottom line. What will the future bring for this operating model that so clearly fails to deliver to customers? The obvious solution is to introduce incentives for them based on the same return on capital criteria that makes private business so customer friendly. Is this politically possible? The pace of technology may well be accelerating and its outcomes ever more uncertain. And a source of ever greater anxiety to the bosses and their teams. Ours seems a less happy era. Maybe technology is to blame. Yet there is also a business imperative to apply technology, 1 to improve the resilience and reduce the dissonance of the workforce, so enhancing productivity and competitiveness. The evidence from working from home, made possible by improved technology, is very suggestive about what the future of work may hold. It suggests that the future will be one of fewer hours worked, including fewer (highly unproductive) hours getting to and from the workplace. Fewer hours worked because improved technology enables more output produced and therefore more income per (fewer) hours worked required to satisfy the necessities of life and more time to play or bring up the children. If collaboration at the work-place is valuable – because it
makes the firm more innovative and competitive – the representative firm may therefore have to pay more, as well as give more time off, to get key workers to come to the office. And for those who much prefer to work from home and are therefore less productive, may well accept lower hourly rewards to do so. The challenge for all will be to find meaning in life. A strong sense of vocation, of finding purpose and satisfaction in work for its own sake, as well as for what it may buy, including time-off will remain as helpful as ever.
SA Breweries with 90% or more of the beer sold in South Africa has intervened before the Competition Tribunal on the terms of the Heineken acquisition of Distell. SAB has argued that the Tribunal should force Heineken to dispose of its powerful Hunters and Savanah brands rather than, as Heineken has proposed, to dispose of its own weaker by sales, Strongbow cider brand, to a local consortium. That is in order to meet the likely Competition Policy objections to the deal of what would become a cider monopoly. Heineken’s intended local buyer is a consortium of the craft brewer Devil’s Peak and a BEE partner. SAB has argued that it would lack the “relevant expertise, financial muscle or distribution network”, to effectively compete with the other two ciders: Hunters and Savanna”
What is at work here is but another example of rivals or potential rivals hoping to influence competition policy to improve their own ability to compete in the market. In other words, to manipulate policies, intended presumably to enhance competition, to limit competition, in the interest of their owners, their shareholders. And why, it may be asked, should they not attempt to do so? They are simply playing by the rules made by their governments for them.
To expect corporations and their managers to do otherwise – other than to attempt to maximise the value of the assets including their brands – competing in all the ways they are permitted to do – including in the courts of law- is not only naïve but also unwise. Self-interest is the powerful driving force of the market led system that delivers the beer and the cider and everything else that consumers choose – subject to regulation.
It is competition that keeps the prices companies charge in close relationship to the costs they incur. Cost that they have every incentive in containing in the interest of holding down prices, improving service and realizing the profit maximizing, optimum scale of operations. Which may, when economies of scale present themselves, as it does in beer and cider production, lead to a degree of dominance in the markets served. When the competition policy or any policy outcomes are perverse, we should look to reforming the policy, not the business modus operandi that naturally competes in all the ways legitimately open to them.
That Advocate Jerome Wilson acting for Heinekens to quote BD “… accused SAB of being “opportunistic” and using the guise of competition concerns for its own business interests…” is a non-sequitur of the kind more easily made by lawyers than economists. It reinforces my concern that competition policy in SA has become such a fertile field for lawyers with precedent, not necessarily good economics, as the guide.
But there is a certain irony in SAB, now a wholly owned subsidiary of ABN-INBEV, choosing to compete in this way. The pioneers who built SAB to the great global company it became, as well as the dominant brewer in SA, effectively expanded the demand for and supply of beer in SA at what were surely attractive prices and terms for their customers. They could not have succeeded otherwise. Then in a final glorious act, agreed to sell their business at what has proved to be highly favourable terms for their highly appreciative shareholders. Pensioners living off the SAB shares they owned can well say cheers. They might not have thought it in their interest, or even perhaps, appropriate to invoke competition policy. The goose can easily become the gander.
SAB were fond of arguing evocatively that they were competing for a “share of throat” That is with every other beverage, alcoholic or non-alcoholic that competed with their beer for a share of household’s budgets. And that this gave them every motivation to expand, not restrict the supply of beer, with truly competitive pricing and related services. And they were right. And their successful practice proved it so. Market dominance was the outcome of serving the customer. They earned it and did not abuse the power it gave them. If we widen the definition of any market, as we should to be realistic, we reduce the share of any participant in it.
The competition will always be intense for the choices that households make, regulations permitting. The pursuit of self-interest will ensure a constant striving to beat the market and become very wealthy doing so. How consumers will come to choose from the unpredictable and changing menu placed before them is impossible to predict. Their larger interest is in changing the menu, in innovation and technology that can significantly alter how they spend over time. Best therefore to leave the mysterious forces of competition to evolve. To trust the pursuit of self-interest and competition – not its regulators- with possibly very different interests to those of consumers.
Competition policy would best ask the simple question, will some acquisition or arrangement be in the consumers’ interest? Will it mean lower prices, better service – enhanced supply and or quality – more R&D -more innovation or not? Chat-GPT might provide the answer.
The problem with competition policy in SA is that it pursues a broad public interest. And the public interests, very diverse public interests, may conflict with that of consumers. Maintaining employment (in the interest of workers) after an acquisition is likely to mean higher costs and higher prices and or less capable service delivery. And will in advance, given the likely constraints on efficiency, reduce the case for a potentially cost-saving merger that will not be in the interest of consumers. Cost saving is very much in the customer’s or potential customer’s interest.
Forcing the owners of any business, local or foreign owned to meet empowerment or any other criteria demanded of their potential investors, is likely to reduce the ability of an acquirer to raise capital on favourable terms. Capital with which to compete with established interests in the SA throat – as SAB is surely well-aware
In the early days of the economy wide lockdowns of 2020, I remarked that “Today is a time of epidemiologists, central bankers and yes, of schemers too…..” I added that we will discover in due course whose reputations will have survived the economic crisis better intact. I was alluding to Edmund Burke’s unenthusiastic Reflections on the Revolution in France (1790)
The pandemic, as we well know, has had many losers and more than a few beneficiaries. Perhaps economists who have long observed monetary events are among the less disadvantaged by Covid19. Inflation reared up dramatically and new evidence about its causes and consequences was on offer and demanded interpretation. The experience and analysis of the high inflation nineteen seventies when I learnt my monetary economics became relevant again. The problem for the US economy and those with much diminished wealth is that the Fed does not have a monetarist model of inflation [1] As inflation came down after 1980 and money supply growth rates became less variable, and the supply of and demand for money were mostly well matched, such neglect of the role of money in determining inflation was perhaps understandable. The neglect turned out to be anything but benign under the extreme behaviour of the money supply after 2020. History may well come to judge central bankers much less kindly than the commentators appear to be doing today.
The updated evidence on inflation to December 2022
The headline inflation rate in the US peaked at 9.1% in June 2022. It fell rapidly and was 6.5% in December 2022. The monthly increases in the price level, slowed down very significantly after June. The CPI, not seasonally adjusted, was no higher in December 2022 than they were in June. The seasonally adjusted version was only slightly higher over the six months and both versions of the CPI fell in December 2022. On a six-month view there was no inflation in the US. (see figures 1 and 2 below)
Fig. 1; US Headline Inflation 1970-2012
Fig.2; The US CPI Unadjusted and Seasonally Adjusted and Monthly percentage change in US Prices January 2021 to December 2022
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The convention of measuring inflation as the year-on-year growth in the CPI has not helped to understand inflation dynamics under current highly unusual and volatile circumstances. Six months can be a very long time for an economy. Waiting a year to see what happens may be too long for a business or a central bank making a judgment and adjusting accordingly. If these monthly increases in the CPI remain at these levels for a further six months, the headline inflation will recede (but gradually) to close to zero by June 2023. There would be no good reason to expect a reversal of these trends, absent any new supply side shocks to the economy. Shocks over which the Fed has no influence, should be ignored because they are temporary and reverse as the recent post -Covid supply side shocks have reversed.
The demand side of the US price equation will not pose an inflationary danger if recent subdued trends in spending and in the money supply and bank credit are maintained. Without any sharp reversal of short-term interest rates this seems highly likely. The Fed has done what it needed to do to contain inflation and that was to contain increases in aggregate spending.
Unfortunately, the Fed greatly underestimated inflation and its persistence on the way up and has almost as egregiously overestimated it on the way down. Monetarists will argue – with new evidence on their side- that these failures to forecast the direction of inflation – that the Fed paid too little attention to the sharp swings in the growth in the money supply post 2020. These money swings were of unprecedented magnitude, which was every reason to attempt to moderate them and to have anticipated their impact on demand and prices.
There would seem no reason to risk nor threaten a recession to maintain low rates of inflation in 2023. Nor to frighten investors and businesses about such possibilities, given the outlook for inflation. The fright has been severe enough to remove trillions of dollars off the value of US equities and government and other bonds. There is good reason for the Fed and the market to forecast satisfactorily low rates of inflation in 2023. On the evidence of inflation and its causes, the Fed guidance should be on the likely and reassuring prospect of a soft landing.
A unique experiment in fiscal and monetary policy – Government spending and money creation – a predictably inflationary combination
The US reactions to the lockdowns in the form of vast injections of income transfers and increases in the money supply provided a unique experiment in economic policy. In Q2 2020 current federal government expenditure grew by 4.1 trillion dollars, from 4.8tr to 8.9tr. The spending was funded mostly with debt a part was funded by running down the treasury balance with the Fed. Federal government debt increased by about 3 trillion dollars in Q2 2020. It grew further from 23 trillion pre-Covid to 32 trillion by Q3 2022.
The income sacrificed by the lock-down was immediately replaced and even exceeded by the generosity of government grants. As was reflected in an equally rapid increase in the deposits held by households at banks. Households initially saved much of the extra money transferred to them from the Treasury as Covid relief. The opportunity to spend more on services, face-to-face was restricted, as was the supply of goods by the anti-Covid repressions.
The broad money supply (M2) that includes most bank deposits and money market funds, increased from 15.5 trillion dollars in early 2020 to a peak of 21.7 trillion by February 2022, from which levels it declined in 2022. The growth in the money supply was as much as 27% p.a. in February 2021. This extra spending by the Federal Government, rapidly executed, was unprecedented even when compared to war times. The extraordinary growth in the money supply engineered by the Fed was also on a scale not previously known, even when compared to the actions taken during the Global Financial Crisis (GFC) of 2008-09 to share up the financial system with money.
Fig.3 US Federal Government Expenditures and Federal Debt. Quarterly Data
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Fig. 4: The US Money Supply (M2) and Annual growth rates (Monthly data)
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Quantitative easing (QE) that is the large-scale purchases by central banks of US government bonds was reversed and became quantitative tightening in late 2022, as may be seen in figure 5 below. To be noted also is the decline in the cash reserves of the US banking system- held with the Federal Reserve Banks in 2022. Nevertheless, the US banks continue to hold vast excess reserves, over the now redundant required reserves. They receive interest on these deposits with the Fed and judged by the absence of money supply and credit growth the banks have not been switching from cash to overdrafts and their like, as they might have done, had demands for credit been more buoyant.
Fig. 5; The Federal Reserve Banks. Federal Debt and Reserves of the Banking System
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Inflation surprises and their deflationary after-shocks.
Yet the rapid and persistent increase in spending and in prices that followed the lockdowns in 2021 came as a surprise to many, including the Fed. But less so to those few economists who regard changes in the money supply as a reliable leading indicator of economic activity and of the price level. Attention to the forces that influence the supply of and the demand for money now leads one to conclude that the inflationary danger to the US economy, the prospect of a process of continuously rising prices, sustained over an extended period-of-time, has passed. The problem for investors and the market in stocks and bonds, is that the Fed has not yet shared this view. It should be noticed in figure 6 that the Money Supply adjusted for consumer prices has declined since January 2022 having peaked in September 2021. The year-on-year growth in Real M2 was a negative ( -6%) in October 2022
Fig.6; Real Money Supply (M2/CPI) 2020=100
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The increase in the inflation rate revealed in 2021, surprising the Fed and most market participants and their economic forecasters and advisors, caused the Fed and other central banks to react vigorously with much higher short term interest rates, intended to fight the new inflation. And to restore the reputation of the Fed as an effective inflation fighter.
These higher borrowing costs, combined with higher prices, perhaps a more powerful influence on intentions to spend, has absorbed the spending power of households. Higher prices have also increased the demand for money and helped reduce the post-Covid excess supplies of money (deposits at banks) held by households. Higher price levels, higher incomes and greater wealth all serve to increase the demand to hold money in portfolios, or as transactions balances. Higher prices have their supply and demand causes. They also have their effects – they restrain the willingness and ability to continue to spend more- all other influences, including especially ongoing money supply growth, remaining unchanged. Which to repeat has largely been the case even if not intentioned by the Fed.
The flat path of private consumption expenditure in 2022
The absence of further growth in the money supply and bank credit in 2022 has helped to restrain the growth in real private consumption expenditure (PCE) as we show below. PCE accounts for about 70 per cent of all US spending and the capital expenditure, spending on plant and equipment, undertaken by US facing businesses is also dependent on the expected pace of real PCE.
Fig. 7; US Real Private Consumption Expenditure and Growth. Monthly Data to December 2022.
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Fig.8; Growth in PCE. Annual and Monthly
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Other measures of economic activity, for example the monthly surveys of activity in the manufacturing sector and now also for the service sector, indicate that the US economy is shrinking. Both the ISM and S&P Global services PMI readings are now below 50 for the US indicting a contraction in the supply of services that and have followed the contraction in US manufacturing PMI, a figure also below 50. The quarterly estimates of real GDP that draw upon higher frequency data are very likely to confirm that income and output growth is at best growing very slowly or is also in decline. If the future is to be like the past, these leading indicators of economic activity, contracting, portend a decline in real GDP, that is a recession.
The decline in the money supply and in the supply of and demand for bank credit (the asset side of bank balance sheets) was not an explicit intention of Fed policy – it has been an unintended consequence of higher prices and interest rates that have depressed the growth in spending by households and firms. The Fed does not target the growth in the money supply. Nor to my observation has the Fed ever referred to this slow growth in money as a cause or indicator of inflation to come.
Only persistent and continuous increases in aggregate demand- accompanied necessarily by increases in the supply of money – can perpetuate high rates of inflation
The Fed therefore may be said to have done its job containing permanently higher inflation. Inflation, defined as a continuous increase in prices, caused by an increase in the supply of money, in excess of the demand to willingly hold that money. That is a decision to hold money willingly in portfolios rather than convert the additional money supplied to the economy into additional demands for goods, services and assets, financial and real. An exchange of excess money for goods, services and assets of all kinds that are substitutes for cash in portfolios, causes their prices to rise. This transmission of extra money to extra aggregate demand surely explains a significant part of the higher prices realised for goods services and assets, financial and real of all kinds in the recovery from the lockdowns of early 2020. That is excess supplies of money led and inflation followed, as traditional monetary theory, would have predicted.
By mid-2022 enough of the extra excess money supplied earlier in response to the stimulus of 2020-21 had been added to US portfolios. With the aid of higher prices, the demand to hold money has caught up with the extra supplies of money The absence of excess real demands for goods and services, as revealed by the stagnation of real private consumption expenditures, indicates that the adjustment to higher inflation in the form of extra demands to hold money, has been made in the US.
It is only a further increase in the money supply that can keep aggregate demand growing fast enough to counter higher prices and to result in continuously rising prices. This danger has passed. Aggregate demand for goods and services in the US is now weak enough and will remain weak enough to call for a reversal of Fed actions taken to date- without causing permanently higher inflation. This inflation too will pass- absent accommodation of higher prices with faster money supply growth – which it is not receiving.
The Fed panicked and should have guided to a soft landing of less inflation to come without having to induce a recession.
The Fed has badly overreacted to its failure to contain inflation in the aftermath of Covid, as have other central bankers, including the Bank of England and the ECB. They have focused on inflation that has passed rather than the path of inflation to come. The Fed has failed to provide comfort that inflation is on the way down, as it is doing – given the absence of any strength in aggregate spending – that would be necessary to sustain continuous increases in prices.
Central bankers should not have been surprised as much as they were by post Covid stimulus and its impact on spending and on prices. Strains to complicated supply side chains and upward pressure on prices, given lockdowns were surely inevitable. Thereafter, the additional supply side shocks associated with the lockdowns and later with the Russian war on Ukraine became a further complicating factor driving prices still higher in 2022.
Yet the supply side shocks, most important, the impact of higher energy, also food and commodity prices, had clearly come to reverse by mid-2022. Accordingly headline inflation, the change in the CPI over twelve months, was bound to reverse sharply, as it has done, after the much higher prices of mid 2021 come to fall out of the Price Indexes.
Responding to supply side shocks to the price level.
Dealing appropriately with supply side shocks on the price level is a large part of the art of central banking. Central banks can only hope to influence the demand side of the price equation that equilibrates,with market clearing prices and quantities of all the many individual prices goods and services that make up the Consumer Price Index. The task set central banks is to help keep aggregate demand within the strict limits of the capacity of an economy to supply goods and services. This helps realise general price stability and full employment or potential output of the economy. It takes accurate forecasts of aggregate demand and supply to help fine-tune the economy with appropriately higher or lower interest rates, determined by the central bank. These interest rates act on the economy with a lag making forecasting the path of the economy essential to the purpose. It was a task admittedly made much more complicated in 2020 by the lockdowns of normal economic activity that were then overtaken by a major conflict in Europe.
Supply side shocks that will temporarily move the price level higher or indeed lower are therefore best ignored by policy setters and should be allowed to work their way gradually through the economy. Higher prices, as indicated earlier, are part of the normal adjustment process to less supplied or more demanded. Fewer than expected goods and services supplied to an economy could be the result of droughts or floods or famine or war. Or more usually, for less developed economies, a supply side price shock will be the result of a collapse in the foreign exchange value of a currency.
The case for ignoring supply- side shocks should be part of the forward-looking guidance central bankers offer the marketplace. It should therefore be carefully explained why the demand side of the economy may best be left as it was, not subject to higher or lower interest rates, given the absence of any demand side pressures on prices, should this be the case, as it has been the case in the US in 2022. And the central bankers should advise accordingly.
Steady as it goes is called for. A recognition of the limited powers of central bankers to always control prices within a narrow range- given the possibility of a severe supply side shocks -should be well understood and well communicated to the economy. The uncertain dynamics of inflation in 2021-2022 needed more sympathetic understanding and treatment than they appeared to receive from either the Fed or indeed most market commentators.
Post-Covid, central bankers including the Fed have continued to raise interest rates rapidly in response to higher prices, regardless of their supply side or demand side or mixture of both. They have not accommodated higher prices but allowed them to restrain demand and contain inflation – perhaps more than they needed to do. But they have not presented a confident front that inflation would and could be controlled without unnecessary damage to the economy.
It was surely possible to bring inflation back in line without a very costly recession as may still be the case. But with the right messaging it might also have been possible to do so without disrupting financial and asset markets that understandably became so fearful that the Fed would induce a recession.
Fanciful fears of self-perpetuating inflation explain the reactions of the Fed
Central bankers, rather than ignore the supply side shocks that partially explained the dramatic increase in the price level, fretted openly that economic actors would simply extrapolate their recent inflation experiences and can add continuously to prices. That higher inflation could lead to more inflation and so inflation becomes entrenched in the economy with highly damaging effects on economic growth over the long run. Much market commentary as well as Fed commentary has been about inflation becoming entrenched because of the danger of a higher wage- higher price spiral- that needed to be vigorously countered.
But such fears were highly exaggerated and have little evidence to support the notion of inflation simply feeding on itself. Absent a decision to react to a slow-down in an economy subject to the negative influence of higher prices, with still more of the money that initially caused prices to rise in the first place. It takes still more money to overcome the negative effect of higher prices themselves on demand and on the pace of economic growth. Prices will continue to rise only if the supply of money is allowed to continue to increase to offset the impact on spending of higher prices. This has not been the case in the US. The supply of money stopped increasing in 2022 and spending fell away to take the pressure off prices.
The determinants of inflation expected
It is surely not rational to set prices or wages regardless of what the market can be expected to bear. Economic actors with pricing power, including the power to demand higher wages, can easily be disappointed in their plans to charge more should demand for their goods and services at higher prices proves lacking. Slack being the difference between actual and potential GDP. [2] Economic slack can overcome more inflation expected as previously conventional central bank theories asserted. The highly reduced inflation equation in the Fed and other central bank models (Inflation = inflation expected – slack) indicates as such. The more slack, the less inflation, for any given expected inflation, is the theory.
Price setters would always like to raise prices or wages, to charge more, but they are restrained by the market for their offerings. They are forced to adjust their prices to what the market will bear, rather than what they might have expected their customers to have borne. The decline in inflation in the US recently helps make this important point. The US market in general is no longer able or willing to bear still higher prices for want of slack or potential slack.
The momentum of past inflation may well influence expected inflation. But it would not be rational to do so in some simple-minded way, given the possibility of slack in the economy. Any rational model of expected inflation would moderate inflation expected by slack expected. And the slack expected would depend upon the expected reactions of the central bank and might allow a role for the growth in money supply and bank credit.
We should expect more of a central bank than having to induce a recession to control inflation. The realistic promise should be one of a soft-landing and a central bank should acquire a reputation to deliver that. Inflation is to be avoided and can be avoided – but it should not have to take a highly destructive recession to do so.
Adding further increases in interest rates in the US and elsewhere to depress demand further in 2023 is a step too far- given the clear absence of buoyant demands from households. The opportunity exists for a soft-landing for the US economy, with inflation heading permanently lower to the 2% p.a. target of the Fed while avoiding a recession. But it will take an early pivot by the Fed to lower not higher interest rates by late 2023.
Employment, wages and prices- what is the relationship?
One other regular source of market moving news has been about the buoyant state of the labour market. The prospect of a recession, given very full employment, is a most unusual combination of circumstances. An un-employment rate below 4% and the growth in the numbers employed above 200,000 per month, as has been the case, are not normally consistent with a recession any time soon. (see figure 9 below)
As the financial markets were well-aware, a fully engaged labour force might well encourage the Fed to continue to worry more about the upside risks to inflation than the downside risks to growth. Especially if it held some conventional assumption about the higher wages that come with full employment will lead to further upward pressure on price- a wage-price spiral.
However interpreting the true state of the labour market- in particular the willingness of potential workers to supply labour – post Covid – is proving especially difficult. A taste for leisure rather than work has been facilitated by Covid relief and led to fewer potential employees seeking work. Given the lower participation rates in the labour force, employers particularly in the service sector, became unusually willing to pay-up to secure workers expected to remain in short supply.
The numbers employed outside agriculture appear to have caught up with pre-Covid levels. But are still below where pre-Covid trends in employment might have taken the labour market. The growth in the numbers employed month to month, which averaged a very steady 1.64% p.a. between 2011 and 2019. The post lockdown recovery saw the growth in US employment to peak at 10% in early 2021. The growth in the numbers employed now appears to be slowing down, consistently with a normal slow-down in spending.
Fig. 9; US employment and annual growth in employment. Monthly data
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The Fed view on the relationship between wages and prices – a recent pivot – and back
Yet the Fed in August 2020 revealed a willingness to experiment with the relationship between inflation and the state of the US economy, and more particularly, to experiment with the relationship between the state of the US labour market and wages and prices. Chairman Jerome Powell opined [3] that there was no predictable relationship between them and so the Fed would tolerate, even encourage, lower rates of unemployment and higher levels of employment, without exposing the economy to more inflation. In short, Powell pronounced that the Phillips curve that posits a costly trade-off of extra employment for lower inflation does not exist or, in his words, the curve has flattened.
Economic theory has long explained the demise of the Phillips curve observed first in the high inflation slow growth, stagflation 1970s. Economic agents, be they firms or trade unions, or indeed highly paid executives, learn to build inflation into their price and wage settings. A view on inflation – inflationary expectations – are rationally baked into their budgets and plans, and current price and wage decisions. Thus it is not realised inflation that will have a real impact on hiring and production decisions. Since expected inflation will be reflected in the prices and wages agreed to in advance, it will be inflation surprises, higher or lower, that will invalidate, to a degree, the best-laid plans of businesses and their employees and force an adjustment to price and wage plans.
The financial markets and the outlook for inflation – fighting the Fed and losing
The marketplace, correctly in my opinion, has maintained a different more benign view of the outlook for inflation than has the Fed and its officers. Expectations of inflation over the long run are revealed by the differences between the yield on vanilla and inflation linked bonds. They have remained well contained and close to the 2% p.a. inflation target of the Fed.
By year end 2022 the difference between the nominal yield offered by a 10 year US Treasury and the real, fully inflation protected, yield on a 10 year US bond, a TIPS, (Treasury Inflation Protected Security) was of the order of 2.25% p.a. Investors exposed to the risk that inflation would erode the purchasing power of their fixed interest income, of 3.7% p.a. for ten years were offered an extra 2.25% p.a. to accept this inflation risk. Investors in either the vanilla or inflation protected bonds would breakeven if inflation turned out to average 2.25% p.a over the next ten years as expected in the bond market. This inflation compensation -the breakeven yield spread provides a highly objective view of inflation from investors with much to gain or lose should inflation turn out higher or lower than expected.
The surprising feature of the behaviour of the long bond yields through a period of much higher inflation is that real as well as nominal bond yields have risen sharply- helping to close the gap between them. Higher nominal yields to accompany more inflation and to provide compensation for more inflation expected is not a surprise. The surprise is the increase in real yields that have accompanied more inflation and amidst widespread expectations of slower growth – even recession to come. Forces that might ordinarily be expected to reduce the case for businesses to raise more capital and lead to lower rather than higher real interest rates.
My explanation for this anomaly was that volatility as measured in the bond markets had also risen with uncertainty about the actions the Fed might take to control inflation. Therefore, all yields, nominal and real, rose to compensate investors for the extra risks they believed they were taking. More perceived risk means lower bond and equity values in 2022 that are necessary to provide higher expected returns in both the equity and bond markets in 2022. Subject to these increased risks to interest rates the bond markets in 2022 proved anything but safe havens for investors.
Fig.10; US Bond Market; 10 year Conventional and Inflation Protected Treasury Bonds. Yields and inflation compensation (break- evens)
Source; Bloomberg and Investec Wealth and Investment.
Fig. 11; US Bond market volatility index (Move) and the Bond Index. Daily Data
Source; Bloomberg and Investec Wealth and Investment.
Fig. 12. The S&P 500 index and the Volatility Index (Vix) Log Values Daily Data 2020- 2022
Source; Bloomberg and Investec Wealth and Investment.
Conclusion – The Fed is now following rather than leading the data
Expected inflation or expected GDP influences current valuations and business operations. The future is all in the price as may be said, but the future may turn out very differently. It is only surprises that move financial markets and the real economy as in the expectations adjusted Philips curve discussed earlier. These ideas were incorporated into economic theory in the nineteen seventies and eighties and the developers of the theory were rewarded with a number of Nobel Prizes for economics. [4]The task of central banks following the expectations sensitive and now conventional central bank wisdom, is to help anchor inflationary expectations to avoid such surprises. The Fed hopes to do so by providing forward guidance on central bank policy intentions with which the market hopefully concurs and behaves accordingly providing a higher degree of market stability. Thus, by reducing uncertainty about the future path of inflation and the real economy helpful guidance helps make business plans more accurate and less subject to alterations in output and employment plans. Closing the potential gap between expectations and economic and financial market outcomes is thought to reduce risk and required returns and therefore helps promote economic growth.
However, the Fed in its recent latest post- rapid inflation incantation, has been very disinclined to offer any comfort to investors about its intentions. Fears of unknown, and what are presented as highly unpredictable inflation, rather than slow growth, remain uppermost in its thinking.
The notion that higher inflation could be self-fulfilling and harmfully so for the economy over the long run appears to dominate their approach. The Fed appears willing to accept a recession if necessary to the purpose of reducing inflation expected and so inflation. A view that the market is understandably fearful of. And to some extent the market has not accepted the Fed view as has been revealed in forward interest rates, lower forward rates, than appear in Fed Open Market Committee guidance (the so-called dot plots of OMC members)
My own view is that the market is very likely to be closer to the truth on inflation and therefore on the path of interest rates than the Fed. That the Fed, more than the market, is likely to be surprised by the inflation and interest rate outcomes.
Central bankers are unlikely to emerge from Covid with their reputations for sound judgment about inflation fully intact. No more than the epidemiologists whose predictions of disaster proved highly fallible. The case for economic lockdowns given their cost and collateral damage has become increasingly suspect with the knowledge since gained.
Perhaps the next time society is threatened by an epidemic the cost-benefit analysis of economists may carry more weight with the politicians and their officials who appear so independently powerful to exercise executive authority. And maybe next time, without the lockdowns, the temptation to add as much stimulus as was added post-Covid – with all its consequences – inflation followed perhaps by recession – will be resisted to a greater extent.
The Jury will stay out on these issues through much of 2023. My contention that inflation is heading lower because the money supply is decreasing is well supported by the latest trends as of December 2022. The monthly increases in the US CPI are all pointing to much lower headline inflation. A trend that will become ever more obvious to all observers including those at the Fed. The case for higher short term interest rates will then surely have been lost. The case for assisting the US economy with lower interest and a pick-up in money supply growth rates will then become irresistible.
[1] I offered a monetarist interpretation of these developments in early 2022
Brian Kantor, Recent Monetary History; A Monetarist Perspective, Journal of Applied Corporate Finance • Volume 34 Number 2 Spring 2022
[2] I wrote about the beliefs of central bankers in 2016
Brian Kantor, The Beliefs of Central Bankers About Inflation and the Business Cycle—and Some Reasons to Question the Faith. Journal of Applied Corporate Finance • Volume 28 Number 1 Winter 2016.
[3] All references to Chairman Powell and his thoughts are taken from his speech to the symposium on economic policy organized by the Federal Reserve Bank of Kansas City 8/27/2020;
New Economic Challenges and the Fed’s Monetary Policy Review
Chair Jerome H. Powell. At “Navigating the Decade Ahead: Implications for Monetary Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (via webcast)
[4] My own attempt to follow the chain and train of such new thoughts can be found in Rational Expectations and Economic Thought, Brian Kantor, Journal of Economic Literature, Vol. XVII, December 1979,pp 1422-1441
South Africa needs a plan to reduce the national debt and interest bill
The national debt and the interest bill for SA taxpayers have grown sharply since 2010 – the national debt grew by over R200bn before the Covid-19 lockdowns and by over R400bn in 2021. This year, taxpayers’ interest bill will be of the order of R300bn, compared with R57bn in 2008, while the national debt will approach R4 trillion, equivalent to about 60% of GDP – from a mere 18% in 2008. This is a dangerous trend that needs to be reversed.
In 2008, the interest bill accounted for 8% of all government spending but has since doubled to 16%. At an average 8% yield on the debt, every 1% increase in the average cost of funding the debt adds about R32bn to the interest bill. As the real national debt increases, taxpayers and voters may become unwilling to keep paying this overwhelming interest bill. Destruction of wealth through inflation of the value of the outstanding local currency-denominated debt will then follow. These types of developments do not come as a surprise to investors. History has made them aware of the dangers of default and they demand compensation for the risks of funding national debts, in the form of higher interest rates paid for upfront.
SA government growth in expenditure, revenue and national debt
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
In this context, South Africa has been penalised for its presumed inability to reverse course on its fiscal trajectory. High interest rates paid by the government and then passed on to businesses have compensated lenders for expected inflation and the expected accompanying weakness of its currency. The expected weaker rand detracts significantly from the expected returns of foreign investors earning rand incomes when converted to US dollars at some future point in time.
Government interest paid (R billions – LHS) and the ratio of interest paid to total debt (RHS)
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Looking closer at the cause of the rise in the national debt and interest bill, the chief culprit was government spending, which was sustained at a generous rate relative to real GDP after the recession of 2009 and 2010, while the revenue growth lagged. This problem was exacerbated by the lockdowns of 2021. Between 2008 and 2021, government spending after inflation grew by an average of 4% a year, while growth in real revenues increased by an average of 1.2% a year. Real revenues declined by 10% in 2010 and by 16% in 2021. The recession was bad news for the Treasury and higher tax rates were bad news for the economy.
Real growth in national government expenditure and revenue
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Much of the extra borrowing undertaken by the government since 2008 has been used to fund consumption spending rather than capital expenditure, a situation that is not helpful for growth. Real spending on compensation for government employees grew by about 30% between 2010 and 2018. Real capex by the government fell away sharply after 2015 and is now 25% below 2015 levels. The numbers employed in government have not increased meaningfully – it is average real employment benefits that have. An expensive patronage system seems to be at work.
Real general government spending on employee compensation and capital expenditure (2010=100, LHS) and the ratio of compensation to capex (RHS)
Source: SA Reserve Bank (Production and income accounts) and Investec Wealth & Investment, 10/11/2022
The call for fiscal sustainability made by Minister of Finance Enoch Godongwana in his recent mid-term Budget update is founded on the principle of restraining government spending on employee benefits. This is a restraint that is essential for promoting the long-term interests of all South Africans in economic development, including those who now work for or hope to work for the government.
Fiscal reform will be needed to achieve this sustainability. For example, it could extend beyond the objective of reducing the gap between government expenditure and revenue. The government could publish a capital budget and commit to raising national debt only to fund capex. This would help to permanently close the gap between government borrowing and government capex that was allowed to open up after 2008. Honest procurement of well-selected cost-of-capital beating projects should not be regarded as an impossible task.
Growth in national debt and capital expenditure by government
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Abundant summer rain in SA has taken the weather forecasters and climatologists by surprise. They did not expect La Nina to persist for a third successive year- which was thought highly unlikely. La Nina describes an upswelling of cooler water in the Pacific Ocean that brings more precipitation with it – in Southern Africa – and less in other parts of South America. Its opposite is the little boy- La Nino – associated with warmer seas – and a drier South Africa. The quality of the weather forecasts has apparently been improving but the predictions of the climate models more than 10 days ahead are surely not to be described as confidently made with little margin for error.
Therefore, what confidence should we attach to forecasts of climate over the next fifty or more years? Yet society is being called upon very vociferously to believe in the climate models and their predictions of very harmful global warming. We are therefore being called upon – perhaps better described as being forcefully instructed so by our betters – to eliminate emissions of carbon dioxide – at enormous expense – to limit global warming. Costs of the astronomical order of 200 trillion dollars are bandied about. Which incidentally makes it extremely unlikely that resources of that order of magnitude will be willingly supplied by still highly constrained economies – and their dependents. Many billions of whom still lack clean and affordable energy to heat their shelters and cook their food.
The climate models will not only have to accurately estimate the volume of Co2 and other gas emissions to come and estimate within narrow limits their impact on average temperatures, and also predict how different parts of the planet will respond differently. They will also have to estimate the influence of the other powerful natural forces that will simultaneously and powerfully act on climate. Forces prominent in any climate model will have to include estimates of the variable influence of our lucky old Sun on climate. I am told by an expert that there is significant disagreement on whether we are about to enter a relatively quiet sunspot cycle, which normally leads to a period of cooling.
Another persistently powerful forces on climate will be ocean flux of which the Ninas and Ninos are an example. To quote the same authority “- the Atlantic Multi-decadal Oscillation (AMO) is a cyclic phenomenon of sea surface temperature anomalies in the North Atlantic Ocean. They switch between positive and negative temperature phases over ~80-year periods. The consensus view is that the AMO is about to shift to a cool phase”.
Climate models are necessarily highly complex and hence prone to error. The climatologists carry grave responsibility for the accuracy of their models. And the politicians will be held responsible for the expected trade-offs of present costs (higher taxes and energy prices) for future- always less than certain – benefits. I am no climate expert. However, I am well-aware of the fallibility of long-term forecasts of the state of any economy. And of the weakness of scenario building that inevitably attaches too much weight to recently observed phenomena. I am conscious that the planning horizon of any firm that commits to capital expenditure is seldom beyond 20 years for very good reasons. Relying on benefits beyond twenty years are too uncertain to influence current outcomes- it is also true of governments and its plans.
It makes good sense to wait and see what dangers and the opportunities that climate change may bring over the long run. A stronger better endowed economy will have the capacity to better manage adversity. The potential danger of global warming adds to the case for faster not slower growth- for more, rather than less resilience. Humans are well practiced in adapting to natural challenges. We can rely on them to cope with continuous climate change.
Relying on ambitious plans imposed top down has not yet proved a useful strategy for humanity. The plan to control climate through intervening severely in the global market for energy is highly ambitious and top down in a manner not ever embraced before. Yet the search for cheaper, less noxious, less dangerous, and more reliable energy is one of the positive steps for mankind that are still worth taking. What South Africa could be doing with great urgency would be to bring the oil and gas recently discovered off our shores onshore
The market reaction to the release of US CPI data shows the extent to which the inflation dynamics have changed. Central banks should take note.
New York on 10 November was one of those days that will be fondly remembered by those with skin in the game, in the form of investments in the equity and fixed-income markets. This was the day that the key S&P 500 index added 5.54% to its value by the close of trading and the more IT-exposed Nasdaq added even more, 7.35%. These moves were the largest on any one day since the world came to realistic terms with the damage caused to their economies by the lockdowns of 2020.
Government bonds, which typically make up 40% of any conservatively managed portfolio, also became significantly more valuable as longer-term interest rates receded sharply. The yield on the benchmark 10-year Treasury fell from 4.14% to 3.82, on the same day, the largest such daily move since 2009 (the dollar value of bonds moves higher as yields decline). On the following day, as an illustration, the JSE All Share Index had gained 3.2% by 11h15, while the rand was up 2. 7% against the US dollar by mid-morning.
The source of all the good news was unusually obvious. US inflation for October reported that day was surprisingly low. Simply put, the (new) expectation of less inflation implied less aggressive Federal Reserve policies and lower-than-previously-expected short-term interest rates. Furthermore, the higher probability of the US avoiding recession added present value to stocks and bonds. The trend to lower inflation was further confirmed later, with similarly favourable market reactions: producer prices also surprised on the downside with prices rising by a month-on-month 0.2% in October, half the rate expected by the market.
The Fed, having been so completely surprised by the surge in inflation in 2021, seems determined to march the US economy into recession to eliminate an inflation that they seemed unable to forecast with any degree of confidence. Monetary policy has become data-driven, guided by the view through the rear window. This has been accompanied by the fear that persistently high inflation could become a self-fulfilling tragedy for the US economy. The approach of the Fed seemed to be that, if a recession was the price to pay for avoiding permanently higher inflation, then recession it would have to be, much to the discomfort of the US share and bond markets. For the year to 15 November, the S&P 500 is down by 17% and the benchmark bond index is about 12% lower.
US stocks and bonds in 2022. (1 January 2022 = 100)
Source: Bloomberg and Investec Wealth & Investment, 16/11/2022
But should the Fed and the market have been so surprised? Surely not – if it had been closely following recent trends in inflation and spending by households and firms, then it would have appreciated why inflation had come to a screeching halt since its peak of 9.1% in June 2022. A year can be a very long time for an economy. The consumer price index (CPI), which was 9% higher in June 2022 than a year before, has flat-lined since June 2022. Consumer prices had stopped increasing in June and the increase over a rolling three-month period has slowed to a 2.3% annualised rate. If this trend in the CPI continues, then the inflation rate will still be a high 6.9% at year-end, but will then fall away sharply to less than 1% by June next year. US headline inflation is apparently on a path to zero.
Inflation in the US
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment, 16/11/2022
The Fed should be acting accordingly, by recognising that aggregate spending in the US by households and firms has already slowed down markedly and does not threaten higher prices to come. The weakness of aggregate demand is restraining price increases. Higher prices to date have largely absorbed the spending power that was so boosted by vastly extra money supply and Treasury handouts provided in response to the lockdowns. Higher prices have their demand and supply side causes, but higher prices have their negative effects on spending power. Higher prices absorb disposable incomes and spending power. Higher wages – even given full employment in the US – have not fully kept up with higher prices, further restraining spending.
Inflation cannot perpetuate itself unless it’s accompanied by continuous increases in the demand for goods, which has not been the case in the US or Europe. The notion, endorsed by the Fed and many other central bankers (including the SA Reserve Bank), that higher prices and wages can simply perpetuate themselves, is a false notion. Inflation expectations soon run aground on the rock of deficient demand and unintended excess inventories. This theory of self-perpetuating inflation will not pass the test of evidence. The Fed and the market should be following the weak trends in spending closely. Ever higher interest rates could in these circumstances turn minimal growth in spending into spending declines – truly the stuff of recessions.
The Fed and the market would also be well advised to pay close attention to the trends in money supply growth. Inflation may be defined as a continuous increase in prices caused by an increase in the supply of money over the willingness to hold that extra money. All inflation is associated with excess supplies of money and the recent inflation in the US is no exception to this well-established rule.
A money supply explanation of the weakness of aggregate spending in the US also helps to explain why the demand for goods and services is growing so slowly. The important monetary facts are that money supply, broadly defined as M2 in the US, is now no larger than it was at the beginning of 2022. M2 amounted to US$21.62 trillion in January. By September, M2 had declined to US$21.46 trillion. The year-on-year growth in M2 that had peaked at an extraordinary 27% in early 2021 has slowed to a barely positive 3%, with the three-month growth rates now negative. Growth in commercial bank credit has also slowed down markedly. Year-on-year growth in bank credit was 7.6% in October 2022 while growth in bank credit provided has slowed to an annualised 1.6% over the past there months. The monetary, credit and price trends are pointing strongly to deflation rather than inflation by the end of next year. The market hopes that the Fed will recognise this in good enough time and avoid recession.
Money supply in the US (M2)
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment, 16/11/2022
Politicians propose spending and revenue plans – but the bond market disposes and not always kindly. In the UK plans to combine tax reforms that only work gradually with an immediate massive increase in subsidizing the consumption of energy with borrowed money was apparently a step too far for lenders to HMG and the governing party.
Yet long term interest rates in the US and Europe were also rising rapidly. In Germany Ten-year money yielding negative rates in January had increased to 2% p.a. by October. US US Treasury Bonds that offered 1% p.a. in early January 2022 now yield over 4% p.a. and indeed offer more interest in US dollars than the much battered 10 year gilts.
Long Term (10 Year) Interest Rates in the US, UK and Germany. Daily Data to October 25th
Source; Bloomberg and Investec Wealth and Investment
Blaming all this wealth destruction on a potentially profligate UK government is further complicated by the fact that not only were nominal interest rates on the rise – more so were real rates. Real ten-year yields in the US now deliver a yield of close to 2% p.a. – they offered a negative 1% in January 2022. They now exceed the returns on a UK ten year inflation linker that has increased from a negative -3% in early 2022 to the current much higher 0% p.a. Equivalent Inflation protected German Bunds also now offer about 0% p.a. – compared to -2% early in 2022.
Real Inflation Protected 10 year Bond Yields
Source; Bloomberg and Investec Wealth and Investment
It is the real cost of funding developed government debt that have been driven much higher this year -not more inflation expected. Expectations of more inflation to come would have found expression in higher interest rates for inflation exposed lenders and not necessarily in higher real yields. Expected inflation measured as the difference in nominal and real yields for equivalent bonds has not increased this year in the US,UK or Europe. Inflation expected in the in the UK over the next ten years has remained about 4% p.a. this year, higher than inflation expected in Germany and the US that have varied about the 2.5% p.a. rate.
Source; Bloomberg and Investec Wealth and Investment
It is not easy to explain why real interest rates in the developed world have risen so significantly this year. Additional competing demands for capital to fund capital expenditure that might ordinarily help explain higher costs of capital and rewards for savers have been notably absent. An alternative explanation is that greater risks to lenders has forced yields higher and bond prices lower to compensate lenders for assuming extra risks – that more risk demands higher returns and forces bond values lower. The risks posed by central banks struggling to cope with inflation have made bond markets far more volatile. The negative correlation between the increases in US bond market volatility Index and the Global Bond Index is strikingly large this year. The link between increased volatility and lower bond and equity valuations seems highly relevant. If it is the risk of central bank policy errors that have driven up required returns it may be hoped that a more predictable Fed will be accompanied by lower government bond yields.
US Bond market volatility and the Global Bond Market Index
Source; Bloomberg and Investec Wealth and Investment
Thanks to the inflation panicking Fed, government bonds have proved anything but a safe haven for pension and retirement funds in the developed world. But in high bond yield, high risk South Africa, RSA bonds have performed much better than equities for pension and retirement funds. The increase in long bond yields have been offset by much higher initial yields, leaving the bond market total return indexes in rands unchanged year to date while the JSE Swix Index has cost investors about 4% this year. RSA 10 year nominal yields started 2022 at 9.73% and have risen to 11.5% while the real yield on the inflation protected bonds are up from 3.63% to an elevated 4.6% p.a.
JSE Bond and Equity, Total Return Indexes January 2022=100. Daily Data
Source; Bloomberg and Investec Wealth and Investment
These high yields mean very expensive debt for SA taxpayers and offer high risk premiums to compensate for what has been a seriously deteriorating fiscal stance since 2010. The MTBS just presented represents a serious attempt to regain fiscal sustainability. If the plans are realized the debt to GDP ratios will decline to levels well below that of the US or UK. A primary budget surplus – revenues exceeding all but interest expenses – has come surprisingly in sight. Achieved this would surely represent fiscal sustainability and help bring down RSA yields closer to those of the developed market borrowers.
Risk is an elusive concept to pin down and for investors to grapple with in practical, measurable terms.
Investors who take a position on the stock market understand clearly what it means when they’re told their investment has produced a particular return over a particular period.
Most will also tell you they understand the notion of investment risk as an uncertainty of outcome; in particular, the higher the risk one is exposed to, the higher the chance that one loses one’s money. However, it is also accepted that in order to obtain good returns, one needs to take on extra risk. Then, in hindsight, risk is often used to explain why the realised return on an investment is high, on the one hand, or sometimes disastrously low on the other.
Underlying these perceptions of risk is the fundamental market tenet that one must expect to get rewarded for taking a position on an uncertain future. Therefore, markets must “price” risk into a share price, so that the higher the perceived risk of that investment, the higher the required future return on the investment. The problem is that neither this market-determined required return nor the associated risk is objectively measurable.
Still, plenty of people have tried. Quantitative financial analysts and the pioneering work of Nobel prize-winning economist Harry Markowitz use a statistical measure known as standard deviation (of return) as a proxy for risk. Typically, researchers in financial analysis will calculate an estimate of this standard deviation by using past values of share price returns.
In other words, to calculate the risk of a quoted company they would first compute the daily (or weekly) return of the share price over a certain period, and then compute the standard deviation of those returns. This measure, often termed volatility, is then taken as a measure of company risk. We will discuss below the flaws in this approach to measuring risk, but first consider some examples of situations where risk is much more precisely measurable.
In the game of roulette, played in casinos and assuming, of course, an unbiased wheel, we have constant probabilities of the ball landing on any of 36 numbers and zero at each spin of the wheel. It will be easily accepted that the risk involved in a bet on, say, red is much less than the risk of betting on the number 8-black, and one is rewarded accordingly.
If a red number comes up and you’ve bet R1 on red, you get R2 back. If you bet R1 on black and it comes up, you get R36 back.
Because the probabilities are fixed at each spin of the wheel, you could precisely calculate the expected return of your bet and the associated standard deviation of that return, which proxies for risk.
When one plays a game with fixed probabilities, one always knows precisely what one’s expected return is. But in financial markets, event probabilities are not known precisely and change over time.
The key point is that when one plays a game with fixed and known probabilities, and places a particular bet in that game, one always knows precisely what one’s expected return is, and also the risk one is exposed to.
But in financial markets, event probabilities are not known precisely and, in fact, change continuously over time. What’s more, there is no possible repetition within an economic system as there is in roulette; the clock cannot be put back, and no process can ever be repeated in exactly the same way.
However, in the case of measuring risk and return in financial markets, we can make some headway in certain circumstances.
For example, assuming the SA government does not default on its contractual payment obligation, one can calculate the exact realised return on an RSA government bond held to maturity.
This required return must reflect the chance of a country default (if there is a default, the return is zero). Apart from its local rand borrowing, the SA government also borrows money on foreign markets denominated in dollars. These SA “Yankee bonds” are traded in New York, along with similar dollar-denominated bonds from other countries.
The required premium of the return (the spread) over and above the return an investor obtains on US government bonds of similar tenure is termed the sovereign risk. It is a measure of the probability of the bonds being paid out, according to contract, in dollars.
One can then calculate the spreads for the different countries which have issued dollar bonds. So, in this case, one can quite precisely compare the market’s perceived risk of default for different countries in paying these dollar-denominated bonds, and compare sovereign risk across different countries.
In the share market, there is no similarly definitive way to obtain the expected return or the risk of any company share on the basis of share market prices. Market analysts often use proxies for comparative value (and hence comparative risk) such as p:es and various measures of yield, such as dividend yield or earnings yield. The underlying principle is that a high-risk company should be reflected in a comparatively low market price, given the current earnings or the dividend payout.
Quantitative portfolio analysts are, however, given the even more challenging task of combining different shares and instruments into a portfolio of assets expected to yield some overall return for some, often pre-mandated, risk.
They are thus faced with the problem of estimating portfolio (or share) risk in order to construct portfolios that fall within their given risk mandate. Given this problem, analysts almost always opt for using the estimated standard deviation of historical share price returns as a measure of volatility, which are then used as a proxy for risk.
There are plenty of problems associated with using past market data to measure risk or return But there are plenty of problems associated with using past market data to measure risk or return; the underlying issue is that markets are assumed to be efficient. This means the share price at any time can be assumed to reflect known information about the underlying company, but that price will continuously change as new information flows into the market.
Given that this new information is, by definition, unexpected and hence not predictable in any way, the resulting movement in share prices is, in turn, unpredictable. Therefore, past returns can give no indication of what future returns might be.
Risk, in contrast, may have some momentum in that a dramatic event, such as 9/11, will generally give rise to an extended period of return volatility, as markets grapple to understand and price in the impact of the event on share values.
However, though we may be able to anticipate volatility in the short term, the ability to do so over time is confounded by the statistical requirement of parameter stationarity.
In other words, if one wants to estimate a parameter using observations of that parameter over time, the parameter one is measuring cannot itself change over that period.
It’s a bit like locating a target when it’s moving, but your locating method must assume that the target is stationary. In the case of share price (or portfolio) volatility, this is an untenable assumption.
The conclusion is that any attempt to measure risk is problematic, especially in the context of listed companies.
However, there is little acknowledgment of this fact by analysts. Analysts require estimates of risk as a key input into almost any comparative share valuation or portfolio recommendation, but carefully avoid any interrogation of the validity of their estimates of risk. Individual investors may believe they understand risk, but their perceptions are often governed by whatever return they receive.
So: risk is an elusive concept to pin down and for investors to grapple with in practical, measurable terms. Fortunately, investors can usually take comfort in the one clear truth offered up by financial analysis. This is that the only sensible investment strategy is to carefully diversify one’s portfolio across as many asset classes as possible.
Then, assuming the world continues to advance technologically in the same innovative and productive ways it has in the past, irrespective of what unexpected challenges may arise, one’s investment will yield attractive returns over a long period.
Barr is emeritus professor of statistical sciences at the University of Cape Town (UCT);
Kantor chairs the Investec Wealth & Investment Research Institute and is emeritus professor of economics at UCT
