Brian Kantor – Page 30

Interest rates: Sombre is good

A sombre outlook for the domestic and the global economy was presented yesterday by Reserve Bank governor Gill Marcus, helping the case for leaving rates unchanged, as had been confidently expected. The case for higher rates any time soon was weakened by the arguments presented in the MPC statement and in the Q&A session that followed. The opportunity to lower rates was not considered, as we were informed, though perhaps it should have been. Cost push pressures on inflation were again emphasized in the statement – and second round effects of higher inflation expected (on inflation itself) were regarded as not in evidence. Inflationary expectations, as measured for the Bank, were reported as stable to lower.

The Reserve Bank expects the small breach of the upper 6% band of the inflation targets by the first quarter of 2012 but is of the view that this breach will be very temporary and therefore no reason in itself to raise the repo rate. Base effects are pushing inflation higher in the second half of 2011 and will reverse in 2012. The key to the inflation target remains the foreign exchange value of the rand and this is proving very helpful and we think will continue to be so – to the point that the Reserve Bank is over- rather than underestimating inflation.

Prominent reference was made in the statement and in the Q&A to the “core” rate of inflation, that is inflation excluding food and energy prices, which is of the order of just over 3%. An inflation target set in terms of core inflation rather than headline inflation is preferred by many of the leading authorities on inflation targeting and the Reserve Bank may well be moving in that direction. This represents an important and welcome departure from previous Governor Mboweni’s practice and rhetoric, who was determined to allow no such distinctions or escape clauses for meeting the inflation targets. This different mindset reinforces our argument for and prediction of low interest rates for longer. Moreover it raises the likelihood of generally more stable short term interest rates in the future which would be very helpful for SA business and its customers.

Closing the gap

At the Q&A, so called output gaps received interesting attention, that is the gap between potential GDP and actual levels of output. This gap is judged still to be open but is said to be closing with current growth rates ahead of potential growth. Potential output growth this year was indicated as only 3.5% with second half growth slowing down rather than picking up. This represents a very pessimistic view of SA’s long term growth potential and is not one consistent with much growth in employment and the government objectives for employment growth.

This Reserve Bank sense of potential growth is presumably derived from a limited estimate of SA’s ability to attract foreign capital, equivalent by definition to the sustainable size of the current account deficit – both usually measured as a share of GDP. We have argued that such pessimism may be unjustified and that growth can lead capital inflows that finance and sustain growth. In other words, grow faster to improve the returns on capital invested, and the capital from global sources will be forthcoming. There is a potential virtuous circle for SA that was in evidence between 2003 and 2007 (grow faster- attract more capital – sustain the value of the rand – holds down inflation and interest rates). But expressing faith or confidence in such possibilities of faster growth with less inflation aided by foreign capital, is not behaviour expected of inflation vigilant central bankers.

GDP growth is expected by the Reserve Bank to be about 3.7% in 2011 and 3.9% in 2012, increasing to 4.4% in 2013. When the presumed output gap is finally closed (on these assumptions) late in 2012 the case for raising rates will then be more confidently made. Pressures on global food inflation are however thought by the MPC to have peaked. The MPC outlook is for inflation at the upper band 6% rate by year end and is expected to remain above this 6% upper band for the inflation target until the second quarter of 2012 and receding thereafter.

Something in reserve …

Had we been at the Q&A session we would have asked the Governor and her bench of advisors why the Reserve Bank thinks it still useful to add to its already abundant supply of foreign exchange reserves. These are large enough for any conceivable emergency that might shock the SA balance of payments. The governor indicated her own confusion about the forces that drive the rand. Clearly Reserve Bank interventions in the currency market have had no predictable influence on the rand. The realised strength of the rand has made such intervention very expensive for the SA taxpayer on whose behalf the Treasury borrows rands at 6% to 8%, to offset the impact of dollar purchases on the money supply, for the Reserve Bank to invest in US dollars and Euros that return around 2% at best. It has been an expensive and futile exercise in trying to resist market forces.

We might suggest that the behaviour of the rand is not that mysterious and will continue to take its cue from global risk appetite, well reflected in emerging equity and bond markets. The well understood rand does not make it easier to predict. This remains the essential problem for monetary policy in SA, which is to hold inflation down not for its own sake but to encourage long term economic growth (lest we forget the purpose of inflation targeting).

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 22 July

Employment: The annual strike (that is the loss of jobs) season is well under way

The annual strike season is well under way. The usual well above inflation increases are being demanded accompanied by the usual marches, highly rhythmical toi-toing and some violent intimidation of workers, less inclined to put their jobs at risk. And after losses of production and presumably also of wages, management and unions settle on still significant increases above recent inflation rates.

The season might well be called the season of further loss of permanent jobs in the formal sector of the economy. Wages and benefits improve for those who keep their jobs, while management are strongly encouraged to proceed with operating strategies that rely less and less on unskilled labour and more on capital equipment employed.

The outcomes are plain to see in the ever widening gap between output growth and formal employment growth. This has become ever more conspicuous after 1995, due to more onerous regulation of the SA labour market (for management).

The labour saving logic practised by management is sensible enough – including their willingness to concede well above inflation increases. The logic driving union action is less obvious to those outside the ranks of union leaders and presumably their generally supportive rank and file who seem to appreciate a good fight with their bosses. One might be inclined to think, given the long established employment trends, that the leaders would rather wish to encourage employment (perhaps of their sons and daughters) and so union membership and the dues they collect with less militancy and less aggressive demands for more. Clearly there is something else at work that makes union militancy, rather than co-operation, the action that keeps the union leadership in their jobs. And so the history repeats itself: higher real employment benefits, fewer formal sector jobs and productivity gains to compensate for more expensive labour.

Shareholders by contrast have no reason to be immediately concerned about these trends, unless they fear, as they may well, the instability threatened by the growing divide between those in good jobs and those increasingly excluded from gaining access to them. But this is an issue that the management of any one firm cannot address. The reality is that management teams have adopted labour saving or especially unskilled labour saving policies that have proved to be consistently profitable and can be expected to continue to be profitable.

Over recent years the share of operating surpluses in the gross value added by the SA corporate sector has if anything tended to rise while that of employees (including managers) in the form of wages in cash and kind has tended to fall. In other words operating profits have been improving despite higher wages for those who hold on to their jobs.

The share of the operating surplus in the value added by non-financial corporations in SA and their gross cash savings is shown below. As may be seen it is a much improved picture, especially in the form of cash flow generated by these firms that has no doubt added to balance sheet strength and added value for shareholders.

The issue confronting the firms, the unions and SA generally, is how these cash flows and profits should best be employed – in reducing debt, paying dividends, making acquisitions or (much more helpfully) for economic growth adding to capital equipment or workers employed.

The answer for SA is obvious enough to all – more jobs. The uncomfortable truth is that management has no good reason to alter its ways. They are reacting to the fact of economic life in SA that the real cost of capital, in the form of a lower risk premium paid by SA firms, has come down materially, given a most helpful political transformation. Over the same period their real cost of hiring labour has increased materially.

It would seem obvious to all but those who find it convenient to deny the relationship between employment levels and employment benefits. That is to say. in the interest of more formal jobs, it is the unions that need to become less militant and more co-operative with management. The unions need to promote employment by encouraging the adoption of policies that would make for a more flexible labour market and a much more mobile labour force that could adapt appropriately to the state of the economy. Maybe only an economic policy Codesa will lead to this.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 21 July

Gold is for the risk averse, gold shares for the risk loving

The gold price in US dollars and in rands has moved ever higher while JSE listed gold shares have moved mostly sideways over recent years. The explanation seems obvious enough. The cost of mining gold in SA has risen every bit as rapidly as the price of gold while the volume of gold mined in SA has declined consistently with these higher costs and the lower grade of ore being crushed. In 1970, before the price of gold escaped the constraints of the gold standard that set the price at $35 or approximately R27 per troy ounce, SA mines produced over 600 metric tonnes of gold a year.

SA gold mines now produce fewer than 200 tonnes of gold a year and this output is falling. The only consolation in this sad tale of events is that presumably the US dollar and rand price of gold would be a lot lower had SA continued to produce as much as it did before.

But the hope that the gold mines will be able to take advantage of the higher gold price in the form of profits and dividends seems to rest eternal. Investors have consistently paid up more for the dividends actually paid by the gold mines. Currently the mines are selling at 122 times their trailing dividends or at a dividend yield of less than a third of one per cent. Gold mining accounting earnings follow no consistent pattern and have often been negative in recent years. For the record , the JSE Gold index reported earnings per share have been positive over the past 12 months and the share prices are on average 315 times their trailing earnings.

The hope clearly implicit in these extraordinary market ratings is that gold mining companies will some day, maybe soon, be able to get more valuable gold out of the ground at greatly improved margins. This makes gold shares the ones with the longest odds in the equity markets. This taste for risk may well continue to provide support for gold shares for some time to come. Presumably the risk lovers assign only a small proportion of their portfolios to this gamble.

Accordingly the relationship between the gold price (much higher) and gold shares (sideways) is therefore a very weak one and may remain so until the mines actually deliver much improved dividends. Since January 2008, for every one per cent daily move in the rand gold price, the JSE Gold Mining Index has moved on average by only 0.42% (the so called gold price beta). However the gold price explains only about 7% of the daily move in gold shares over this period. There is clearly much more than the influence of the gold price at work on gold shares. The gold price expressed in US dollars does only a marginally better job explaining the JSE Gold index (in rands) with a beta close to 0.75 but still with very low R squared or explanatory power of 0.16%.

Gold shares are clearly only for the risk lovers. Gold itself however would have served the risk averse very well over this period. This is because, on average, when the market was down the gold price was up and vice versa. The correlation between daily moves in the JSE All share and the rand gold price was a negative (-0.16). Negative correlations of this order of magnitude provide outstandingly good risk reducing diversification benefits for portfolio managers. The correlation between daily changes in the rand gold price and the S&P 500 in US dollars has been even more negative (-0.44). Thus for South Africans with exposure to developed equity markets, gold would have provided especially good insurance. For the offshore investor the correlation of daily changes in the dollar price of gold and the S&P 500 was close to zero (0.04) over the period indicating that gold would also have provided very good insurance for the US dollar investor.

Past performance may not be a guide to future performance. But if the past is anything to go by the case for investing in gold, especially for South Africans, has been greatly strengthened while the case for investing in gold shares remains at best unproven.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 20 July

The JSE, rand and emerging markets: Following the same path

The JSE and emerging equity markets (as measured by the MSCI EM Index) have moved sideways this year. However, in something that is consistent with the now very well established pattern, the two markets indices have moved closely together day to day and month to month. Furthermore the rand, confirming another well established relationship, has continued to move closely in line with the emerging market Index.

Our model of the rand/US dollar (which includes only the MSCI EM Index as its explanation) indicates that fair value for the rand/US dollar on 12 July (given the level of the EM Index) was R6.90 compared to a closing value that day of R6.85. The fit of this model run with daily data since 1 January 2009 is extraordinarily good.

The strength of the association between the value of the MSCI EM and the JSE is explained only in small part by the fact that JSE listed shares constitute 8% of the EM Index itself and therefore attract the interest of emerging market (EM) fund managers. The relationship is more fundamentally explained by the fact that the stream of JSE All Share Index earnings per share, in US dollars, approximates very closely those of the earnings per share generated by the EM universe itself. Thus the values attached to these expected streams of earnings, by global portfolio managers, are highly comparable.

Investec Securities has created its own large market cap EM Index of about 190 individual EM companies and aggregated their earnings per share to derive both an Index called the IBICEMI and its associated Index earnings per share. As may be seen below, the IBICEMI tracks the benchmark MSCI EM Index very closely and may be considered fully representative of benchmark earnings per share.

It may also be seen how closely JSE earnings per share and EM earnings per share have been related over the years. Both earnings series demonstrated extraordinarily rapid growth in earnings measured in US dollar through the boom years of 2002-2007 before the onset of the global financial crisis in 2008. Moreover EM and JSE earnings survived the crisis in much better shape than the S&P 500 and earnings per share now exceed their pre-crisis peak levels in US dollars. The JSE Index in US dollars is now above its pre crisis peak values while the MSCI EM has still to reach pre crisis levels. This re-rating of the JSE relative to the EM ( values rising ahead of earnings ) may be seen below with the JSE trading at a 14.85 times reported earnings and the IBICEMI EM Index trading at a lower 11.21 times trailing earnings.

This rerating of the JSE may be explained by the respective earnings cycles. JSE earnings per share, while following a similar path, have grown significantly faster over the past 12 months than EM earnings represented by their large caps. JSE earnings per share measured in US dollars grew by about 46% in the 12 months to June 2011 while EM earnings growth was a less robust 26% over the same period. Clearly the relatively greater dependence of the JSE on Resource companies and their earnings has served the JSE very well as metal and commodity prices moved ahead of their year ago levels.

It can be confidently predicted that the values attached to Emerging Markets and the JSE will continue to be strongly influenced by earnings reported and expected. It can also be predicted, though perhaps somewhat less confidently, that the foreign exchange value of the rand will continue to be determined in large measure by the state of emerging equity markets. The JSE, the EM equity Indexes and the rand can be confidently predicted to remain highly responsive to the outlook for the global economy, to which emerging market economies contribute most of the growth.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 15 July 2011: The JSE, rand and emerging markets: Following the same path

The Hard Number Index: Satisfactory but not improving

Economic activity in SA expanded in June, but according to our Hard Number Index of Economic Activity (HNI) the pace of growth may well have slowed marginally rather than picked up momentum.

Our HNI attaches equal weights to two very up to date hard numbers, namely new vehicle sales for June, as released by NAAMSA, and the size of the note issue as at the end of June. The HNI may be compared to the Coinciding Indicator of the SA Business Cycle calculated by the SA Reserve Bank. This indicator, with a very similar lower turning point for the current cycle, is however only updated to March 2011, leaving it well behind current economic events.

Vehicle sales began a very strong recovery in late 2009. Sales of all new vehicles were particularly strong in March 2011. Actual sales that month were 53 478 units, which, since March is usually a very good month for vehicle sales, translated into a seasonally adjusted 50 101 units. Since March 2011 vehicle sales have fallen back significantly from these levels, though sales in June were modestly up on those of May. On a seasonally adjusted basis sales had fallen from the over 50 000 units sold in March to 43 108 units sold in May and recovered to 44 359 units sold in June 2011. The vehicle sales growth cycle appears to have declined significantly with the current annual growth trend around the 10% annual rate, perhaps to recede further.

We have mentioned before that the Combined Motor Holdings (CMH) share price has consistently provided a very good, even leading, indicator of the state of the new vehicle market. This relationship appears to be holding up with the CMH share price having peaked late last year, consistent with the peak in the new vehicle cycle.

While the news about vehicle sales may be regarded as somewhat less encouraging about the current state of the SA economy, the demand for and supply of notes in June is somewhat more encouraging. The Reserve Bank, when it issues notes, satisfies the extra demands of the public for notes, presumably to spend, and from the banks for cash reserves, presumably so that they are able to lend more. Banks in SA do not hold excess cash reserves of any magnitude and so the supply of notes, adjusted for cash reserve requirements, is equivalent to the money base of the system, adjusted for cash reserve requirements, or what is also described as high powered money. This makes the note issue a reliable coinciding indicator of economic activity, with the great advantage of being a highly up to date indicator.

The growth in supply of notes to the economy slowed down consistently between early 2009 and early 2011. This growth cycle appears to have picked up momentum recently. The slower growth in the supply of notes, until recently, was however offset by lower inflation, providing scope for acceleration in the growth in the real supply of notes. This growth was necessary to sustain the economic recovery under way. Now a mixture of slightly higher inflation and slightly faster growth in the note issue has helped stabilise the real money base cycle at about a four per cent rate.

If the economy is to sustain a growth rate that is still below its potential or sustainable rate, a further increase in the rate of growth in the demands for cash, well ahead of inflation is called for. No help in this regard can be expected from lower interest rates. SA does not (alas) engage in money supply targeting or quantitative easing. However it may be hoped that any increase in short term interest rates will be postponed until the demands for and supply of bank credit and the demands for the banks and the public for more cash indicate a clear case for tightening. The case for tightening based on the most recent money supply and credit numbers remains, a very week one. Faster growth in the supply of narrow money, broad money and bank credit deserves encouragement.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:Daily View 13 July

Eskom: Surprise, Surprise – Eskom is awash with cash

A Business Day leader (29 June) referring to the more than doubling of Eskom’s reported profits in 2010-11 to R8.5bn raised the question of whether the electricity utility should have been granted the large increases it was.

Reference in this regard might have been better made to the cash flow generated by Eskom’s operations. These amounted to the very substantial flow of R28.3bn, representing an increase of R12.3bn or 77% from the year before.

However the net cash flow generated for the company was reduced to R22.3bn, after accounting for the cash lost through so called embedded derivatives (that is the cash cost of meeting Eskom’s contractual obligations to the aluminium smelters) and cash lost and gained from Eskom’s considerable trading activity in financial assets and liabilities, that is in its own debt. The equivalent net cash flow number the year before was a mere R9.1bn, making for an even larger percentage increase of 245% in internally generated cash flow in 2010-2011.

Most impressive of all in pure financial terms is that this R22bn went a long way, more than half the way, to funding the very large R44.3bn of capital expenditure incurred in 2010-2011. In other words, current consumers are now financing more than half of the very large capital expenditure being incurred by Eskom to meet future demands for electricity (for which future consumers will be expected to pay an appropriate price). Next year, after a further 25% increase in its regulated tariff, the revenues and cash flows and the contribution of internal funding can be expected to increase by similar large proportions and amounts.

These financial outcomes should not have come as a surprise to anyone familiar with Eskom’s established generating and distribution capacity.

Once Eskom ran out of its excess supplies of generating capacity and new capacity had to be installed, it became essential to adjust tariffs from those based on historical costs to charges based on the returns required to justify the essential investment in additional generating and distribution capacity. This would inevitably mean large increases in revenue produced by the established power stations for as long as they remain economically viable (that is can cover their direct operational costs) and so in the accounting profits and cash flows delivered by Eskom.

Power plants, once constructed, can be expected to have very long economic lives as Eskom’s history confirms. We have argued that the right price to charge current consumers for electricity today is the tariff that would provide the owners of Eskom (the RSA government) with an appropriate risk adjusted return on capital. We have judged this to be about 2% p.a. above the government’s own cost of raising long term capital, as represented by the yield on long term RSA bonds. That is to say, an extra return of about 2% pa over the cost of borrowing, given the low risk nature of an electric utility Eskom with monopoly powers, would seem the right price.

We also argued that the issue of the right tariff and the appropriateness of the real investment decisions to be made in additional electricity capacity should not be confused with how the additional capacity should best be funded (that is, with debt or equity capital). We argued that the SA government should either provide the capital in the form of an infusion of equity capital or by guaranteeing the debts of its wholly owned subsidiary – so reducing the funding costs to its potential minimum. We also indicated that a low risk business like an electricity utility could be expected to fund most of its expansion with debt rather than equity capital. We argued that it would be poor economics and unhelpful economic policy to overcharge, that is to tax current consumers for electricity, to finance the expansion of Eskom. Current and future consumers could be expected to pay the right price for electricity. That is, enough to provide an appropriate return on capital: no more or no less.

When we simulated the operational costs of a new power station of the scale planned by Eskom with a required return of 10% pa, we came up with a tariff to be charged today of the order of the 40c per Kilowatt Hour currently being charged. Our own sense is that inflation adjusting this tariff over the foreseeable future would be sufficient to the purpose of recovering the full cost of generating and distributing electricity in SA. We would be inclined to agree that a further 25% increase in the tariff would be a step too far. Economic growth would benefit greatly from competitively priced electricity in SA.

We would also recommend that Eskom maintains an appropriately high debt to equity ratio of the order of 90% debt and 10% equity. Further, to maintain this recommended debt to equity ratio, current tax payers could benefit from their profitable stake in Eskom through a substantial flow of dividends and tax payments. This year, despite its much improved finances, Eskom is not paying a dividend nor is it paying much by way of actual taxes. The income tax reported in its accounts is an impressive R3.3bn. The actual cash tax paid reported in its cash flow statement is a mere R151m and even less than the cash tax of R210m paid the year before.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 30 June: Eskom: Surprise, Surprise – Eskom is awash with cash

The economy: Steady as it goes

The Reserve Bank Quarterly Bulletin published yesterday has provided further detail on the highly satisfactory performance of the SA economy in the first quarter. Household spending growth has led the economic recovery and was sustained in the quarter at an above 5% rate. Government consumption spending also grew strongly.

The weakest spot in the economy remained the reluctance of the private sector to add to its plant and equipment. However the consistent run down in inventories had come to a natural end in the fourth quarter of 2010 and a sharp buildup in inventories, from highly depressed levels relative to output saw Gross Domestic Expenditure (GDE) rise by over 8% at an annual rate, much faster than Gross Domestic Output (GDP) that as was previously announced grew by 4.8% in the quarter.

If one is to draw a bottom line on the update provided by the Reserve Bank, it is that the economy is growing satisfactorily enough led by household and government spending. However if these growth rates are to be sustained and improved, as must be the objective of policy, the economy needs a stronger commitment by business to additional capital expenditure and to the provision of more employment. More formal employment would help the housing market and highly depressed construction of housing activity that is labour intensive. A business friendly approach by government and its agencies seems to be an essential and urgent requirement for economic and employment growth.

The almost stagnant money and credit numbers indicate very clearly the lack of demand for plant and equipment and for new homes. They also confirm that the economy is not yet operating at what might be regarded as its growth potential. The balance of trade, including the weakness in demand for imports, also confirms that the economy could be growing faster (given easy access to foreign capital on favourable terms). There is moreover little indication that the economy is picking up momentum.

The concern rather, given recent trends, must be that the economy could easily lose momentum (depending in part on the uncertain state of the global economy and demands for exports). The fragility of business confidence could be another negative influence. The best monetary policy could do in the circumstances, would be leave interest rates well alone and unchanged.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:Daily View: The economy: Steady as it goes

The rand: Remarkably unaffected by global risk aversion

The benchmark Emerging Equity Index lost a further 2.2% last week in response to the uncertainties associated with the ongoing Greek debt saga. The New York indexes held their ground as the news about the state of the US economy improved marginally.

The SA component of this index, the MSCI SA, as may be noticed, did better than the average emerging market thanks to a rand that held up very well in the circumstances of the increased risks being priced into global markets. Both the volatility priced into options on the S&P 500, the VIX index and the emerging market bond spread reflected the lesser appetite for risk late last week.

The trade weighted value of the rand last week was only fractionally weaker by the weekend which in the circumstances of elevated global risk must be regarded as a surprisingly good outcome. The rand/US dollar exchange rate can be very well explained by the emerging market equity index and on this basis the rand can be regarded as very marginally overvalued, to the order of about 3.5%. In the figure below we show the results of this model that predicts the value of the rand/US dollar using the MSCI Index as its only explanation. The fit of this model using daily data since early 2009 has been exceptionally good, as may be seen.

It seems to us that the equity markets are well supported by undemanding valuations relative to earnings and dividends. The fixed interest markets continue to offer very little competition for savings and seem unlikely to do so within the next 12 months. It seems to us also that despite the crisis in Europe, the outlook for the global economy, US weakness taken into account, remains satisfactory enough to make further good growth in earnings from globally focused companies a very likely reality. Currently lower oil prices will help materially to this end.

The future of the euro, or rather, the continued participation of Greece in the Eurozone remains uncertain. How far the German and French leaders are prepared to go to avoid what appears unthinkable to them, and that is a breakup of the euro, and how much help they will be getting from the Greeks to this ideological end, remains unresolved. The likelihood of Europe (that is, Northern European taxpayers) footing ever more of the bill for European unity seems to us somewhat more, rather than less, likely post this weekend’s deliberations. The equity markets would surely like confirmation of their willingness to pay the price for the failure to date of Europe to co-ordinate fiscal and monetary policy. It is a failure that will have to be addressed with or without the active commitment of Greece

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 20 June: The rand: Remarkably unaffected by global risk aversion

Bonds and property: The case for the defence

The past two weeks have been difficult ones for equity investors on the JSE. RSA Bonds, represented by the All Bond Index (ALBI) have however proved highly defensive. Recently listed property on the JSE has proved even more defensive against underperforming equities. As we show below the value of property this turbulent quarter has performed in line with bonds and significantly outperformed bonds in May and June to date.

The JSE Property Loan Stock (PLS) index has long proved to be significantly more sensitive to long term interest rates than to the equity market. Over the past three years every one percent move in the bond market has seen the PLS Index increase or decrease by about 1.6%. Every one per cent move in the JSE Top 40 Index has seen the PLS move on average by less than one half a per cent (0.5%) over the same period.

The recent strength in the bond market has been very helpful for the PLS index, as could have been expected on the basis of recent past performance. But forces fundamental to the property loan stock companies listed on the JSE have perhaps also been as helpful to property valuations. The dividends per share distributed by the PLS companies since the global financial crisis of 2008 compare more than well with the dividends per share paid by JSE listed companies generally. As we also show these dividends continue to keep pace with inflation.

And so holders of the PLS Index since 2008 have realised an initial dividend yield in line with that of long term interest rates, with inflation linked growth in dividends paid. An inflation protected yield of between seven and eight per cent is highly attractive and has been highly protective of the value of PLS stocks. Were investors confident that such inflation linked or beating distributions could continue, the initial yield on PLS stocks could be expected to fall significantly and the value of PLS stocks be expected to rise.

The week that was: US equity and corporate debt markets continue to diverge

It was another poor week for equities with the S&P 500 off by over 2% while emerging markets and the JSE were not spared the more bearish sentiment.

Metal and commodity prices however ended the week largely unaffected by the sense that the global economy was slowing down. Metal prices are still well ahead of year ago levels. The IMF updated its outlook for the global economy last week and left its forecasts very much as they were. Faster growth in Europe is making up for softness in the US. This should be consoling to those inclined to believe that the soft patch in US data releases are more than a temporary pause. The oil price as always will play an important role in the months to come in determining the spending power and state of mind of the US consumer. A modest pullback in US gasoline prices, while other commodity prices retain current levels, would be very helpful for the US consumer and the market mood.

Unless US earnings and dividends actually disappoint – index earnings are currently about US$81 per share and are expected to breach the US$100 level by year end 2011 – the US share market now offers even more value than it did a month ago with a prospective PE multiple of less than 13 times. Any threat to valuations from higher interest rates seems to have been put off for longer and the spreads over US Treasuries offered by investment grade and high yield corporate borrowers in the US barely budged last week. Despite very heavy issuance of new corporate debt and despite the thought that the US economy may be slowing down, high levels of confidence in the strength of US corporate balance sheets has been maintained. The performance of the US economy and the equity markets will depend on confidence: US business leaders have to deploy their strong balance sheets. Washington DC could help by dealing effectively with its fiscal deficits.

Industrial and employment policy: A new dawn or a false dawn?

The long awaited subsidy for Job Creation has become a reality. The Jobs Fund will make available R9bn over the next three
years as a subsidy for jobs to be created and encouraged with R2bn available this financial year. The fund will be administered by
the Development Bank (DBSA). It will be “…targeted at established companies with a good track record and plans to expand
existing programmes or pilot innovative approaches to employment creation, with a special focus on opportunities for young
people..” (Q&A, Media Briefing, Houses of Parliament, 7 June 2011).

The four areas of focus are Enterprise Development, Infrastructure Investment, Support for Work Seekers and Institutional
Capacity Building, including internship and mentorship programmes. The focus seems broad enough to cover almost any aspect
of business activity.

The approved programmes will be “..cost and risk shared by participants..to ensure real ownership..” In other words, private sector
participants will have to provide matching funds on a 1 to 1 ratio. A reduced own contribution is intended for “non-private sector
applicants” These would include municipalities and public enterprises. It may presumably include NGOs and their like. Applications
must be made by 31 July for funding this year.

The scheme will clearly be employment creating among the ranks of the consultants. It should prove particularly welcome to firms
with well established training programmes. “Support for Work Seekers; assistance with job search, mobilisation and enhancement
of training activities, support for career guidance and placement services” (Media briefing) will surely prove a boon to the well
established and much maligned labour brokers. The statement above reads like an accurate description of their business model.
The SA government is trading off a significant proportion of its corporate tax base for new industrial projects and subsidies for
employment. In addition to the R9bn Jobs Fund the newly defined s12i Tax incentives are backed by a 2011-12 Budget allocation
of R20bn. These are by no means trivial amounts in absolute terms, or relative to all the tax collected from SA companies. It would
be of interest to know the proportion of company taxes paid by manufacturers. Would it be as much as R20bn allocated in the
2011-2012 Budget?

In the 2010-11 Budget estimated revenue from companies was R150bn or 24% of all estimated tax revenues of R643bn. The SA
government’s dependence on income from companies is unusually large. In many other tax regimes the corporate tax rate may be
comparable to the rates levied on company profits in South Africa. But when taxes actually paid are reduced by investment and
many other allowances provided by government to stimulate investment and job creation, the effective (economic) tax rate
becomes much lower than the nominal company tax rate.

SA is following this route. More subsidy and allowances provided for companies, in one way and another, tax concessions and job
subsidies included, that lead to less tax paid and a lower effective tax on business profits. No doubt these lower taxes paid will be
very welcome to businesses that are able to engage skilfully with the system.

If however the path of government spending is to remain unaffected, as would appear likely, the taxes saved or the subsidies
provided to the companies that benefit, would have to be made up by taxes collected from other taxpayers. This must mean
increased taxes on consumption expenditure or on individual incomes; or companies outside the sectors favoured by industrial
policy will be forced to pay up for the benefits provided to industry.

The SA government clearly thinks, as do governments almost everywhere, that it can do better than simply providing an
encouraging tax and regulation environment for business in general. It clearly believes it can pick the winners in the industrial
space rather than leaving the investment and employment decisions to participants in the market place on a field levelled by
equally generous tax treatment, irrespective of the designated activity and location in which it takes place.

It would promote economic growth in SA if more generous investment or depreciation allowances were offered to business in
general rather than those judged particularly worthy by the bureaucrats involved. This would encourage companies to save and
invest more of their after tax earnings or cash flow. Investment allowances reduce the taxable income of companies, leading to
less tax paid and more cash retained and invested. This would lead in turn to more output and employment. But this is an
argument for lower business taxes in general rather than for particular benefits or subsidies.

One has to question the ability of the government through the Department of Trade and Industry (DTI) or any other of its agencies,
the Development Bank or the IDC, to pick the winners, without fear or favour, among the many proposals that are bound to be
made to it. As indicated there will be a great deal of taxpayer’s money at stake.

The government has proved itself much more capable of raising tax revenues than spending them effectively. The subsidies or tax
concessions will surely add to industrial output and employment. But we will never know how much better the economy might have
done and the employment created had much less discretion been exercised over tax concessions or subsidies. As the saying goes if you want more of something subsidise it, if you want less tax it. SA is doing both – extracting more tax from some
employers, employees and consumers, while subsidising other businesses and their employment decisions more generously.

The government through the DTI (and organs like the competition authorities) seems to show a marked and regrettable lack of
respect for the creative powers of private businesses. The simple recipe for economic growth is one that relies on businesses
directed by their owners and senior managers, to pursue their self interest, constrained essentially by the competition provided by
other businesses for their customers, workers and providers of capital. Economic history has surely proved that the recipe works.
But governing best by governing least does not serve the interest of ambitious policy makers. There is a constant flow of new
regulations and intrusions that SA business has to manage which adds to their costs and reduces their competitiveness with
imported goods. There moreover appears no popular ground swell of support for activist economic policies. The impetus seems to
come directly from officials and their consultants.

The poor protest about the lack of delivery of basic services by government not about the lack of delivery of basic goods and
services by businesses. SA Business, unlike the SA government, delivers very effectively. It would deliver more jobs if the labour
market were less heavily regulated to encourage them to do so.

Industrial policy and the Job Fund have become an expensive and counterproductive alternative to sensible, employment growth
encouraging, de-regulation of the labour market. The intervention by the competition authorities in the employment and
procurement decisions to be made by Massmart and Wal-Mart provide an obvious case in point and a further example of
government officials thinking they know better how business should be run in the interest of more employment. The goods and
services market has been made less competitive to make up for the lack of competition in the labour market. The employment
problem is one of the government’s own making, acting as it has done to entrench the rights of established workers, at the
expense of potential entrants to the ranks of the formally employed.

The government and its officials will no doubt point to the jobs gained through subsidy and perhaps also compulsion to employ
more labour demanded of the government departments themselves and publicly owned enterprises. The jobs lost because of
higher taxes and job destroying regulation will be much less obvious and ignored to the great disadvantage of the poor in SA who
need jobs – not handouts to lift them out of poverty.

The solution to the failures of the SA economy, or rather its formal businesses to provide jobs would seem obvious to all but those
with an interest in the status quo – the trade unions and the officials who write and implement interventions in the labour and other
markets of the economy. This is to rely less on government and its regulatory, taxing and subsidy powers and more on private
business to deliver more of the essential goods and services demanded in a modern economy.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 8 June: Industrial and employment policy: A new dawn or a false dawn?

Global markets and the rand: Not all bad news

The flow of disappointing US economic data continued with the Payroll report of Friday that reported a gain of 54 000 in May, well below the monthly average gain in 2011 of 182 000, and an increase in the unemployment rate from 9% to 9.1%. The unemployment rate was not all bad news as, according to the US Survey of households, an extra 272 000 workers joined the labour force only partly offset by a 105 000 increase in household employment.

More people entered the labour force, presumably because they thought they could realistically find work, but not all did so. Hourly earnings in the US are rising very slowly, by 0.1% in April and 0.3% in May. With little growth in wages, any perceived inflationary threat from the labour market has dissipated, providing further reason for postponing higher interest rates and hence the weaker US dollar.

Not all the recent news about the US economy was bad, The ISM non-manufacturing index that covers 90% of the US economy rose from 52.8 to 54.6, marginally ahead of consensus. Numbers above 50 indicate growth. More encouraging was that the employment component of this Index rose from 51.9 to 54, consistent with payroll growth of 175 000, and faster than that indicated by the official payroll report.

The weaker numbers and their implications for low interest rates for longer weakened the dollar and strengthened the euro and emerging market currencies, including the rand. This made the week a better one for US dollar investors on the JSE and emerging markets generally than it was for investors in the S&P 500, that after an extended period of outperformance lost ground to emerging markets last week.

The rand during the week had turned out to be a particularly strong emerging market currency. The rand made gains not only against the US dollar, the euro and the Aussie dollar but also gained about 3% against our basket of other emerging market currencies.

It would appear that the rand had gained from the approval of the Competition Tribunal of the Wal-Mart / Massmart deal after having weakened relative to the Aussie dollar and other emerging markets in the weeks leading up to the decision. SA specific risks, that is policies more or less friendly to foreign investment, would appear to have a modest influence on the exchange value of the rand in recent weeks. The more important influence on the rand will remain those emanating from global markets in the form of commodity prices and flows into emerging market bonds and equities.

The news from the commodity markets was not unsatisfactory as prices held up, helped by the weaker US dollar. The oil price in US dollars was largely unchanged.

The stronger rand and the more uncertain outlook for the US and global economy weakens further the case for higher interest rates in SA. This has been partly recognised in the bond market with a downward shift of the term structure of interest rates. The probability of an increase in the repo rate this year receded the week before last but remained largely unaffected by the news last week.

The US equity markets are undemandingly valued relative to earnings and interest rates and have become less so this past week. The weaker data disturbs the outlook for future earnings as the performance of the S&P 500 this past week made perfectly clear. The key to the outlook for the US economy and the equity markets will be the willingness of US business to put their strong balance sheets to work hiring workers and buying equipment.

The confidence of US business would be greatly assisted by the belief that Washington will deal effectively with the US Budget and US government debt. Any sense that China is loosening rather than tightening its monetary stance will be very helpful too.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View – June 6: Global markets and the rand: Not all bad news

Vehicle sales: Not much vroom

Naamsa released its new units sold statistics for May 2011 yesterday. The numbers are not encouraging. April 2011 was a poor month for sales, especially when compared to sales in March 2011, and the fall off in monthly sales, when seasonally adjusted, continued in May as we show below.

The sales quarter to quarter and seasonally adjusted have fallen sharply from a very strong March 2011 as we also show. The growth in sales is now barely positive, compared to a year ago, which is a long time in the motor dealing business, and in fact negative on a three month moving quarterly basis as may also be seen.

Making the seasonal adjustment for two months with an unusual number of public holidays, including the Easter holidays that fell in April, has no doubt complicated the analysis of the underlying cyclical trend. Holidays are good for shopping malls but not vehicle show rooms. Also adding complexity are disruptions in the supply chains that start North of Tokyo. Is it a relative lack of demand or an inability to supply that is holding back sales? The Naamsa explanation quoted below appears to attach some (though not major) importance to negative supply side forces.

“..During May, 2011 – constraints on the availability of components from Japan impacted on the production of certain product lines in South Africa and, together with shortages of various models sourced from Japan, this would have contributed to the slow down in the rate of growth in the new car and light commercial vehicle sales cycle for the month. These factors would also have contributed to lower aggregate industry exports. It was anticipated that the supply position would normalize over the medium term..”

Our own interpretation is that the peak of the vehicle cycle has been reached and the growth trend is now a significantly lower one. The market for new vehicles seems to be stabilising at a monthly pace of approximately 47 000 new units sold, well below the heady pace of 60 000 units sold at the peak of the previous motor vehicle cycle of early 2007. That is to say, year on year growth in December 2011 on December 2010 will be about 5%.

The current and projected level of vehicle sales help confirm our impression of an SA economy that is growing satisfactorily, but that the growth is not accelerating. There would appear to be no danger of excess demand materialising any time soon.

The economy, on the basis of these May vehicle sales and the April credit, money supply and house price data, appears to be taking longer to reach its growth potential than previously thought. Moreover the risks have increased recently that the global economy will not support export volumes and prices strongly enough to help take up the slack in domestic demand over potential supply. The danger of a global slowdown has risen in response to signs of slowing rather than accelerating growth in the US. The case for higher interest rates in SA, in the light of domestic vehicle sales and exports of vehicles, has weakened further.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 3 June: Vehicle sales: Not much vroom

Credit and housing markets: Still no case for higher rates

The credit and money supply numbers for April 2011 indicate that the pace of money supply and credit growth, especially growth in mortgages, pedestrian before, is slowing down gradually, rather than accelerating. The growth trends in M3, the broadest definition of the money supply including almost all deposits issued by the banks, is most clearly pointing lower.

It is demands for bank credit that lead the money supply process in SA. As the banks lend more, the Reserve Bank accommodates the banks with additional cash- that is cash reserves – at the prevailing repo rate. More credit demanded leading to more money supplied is the modus operandi of the SA Reserve Bank. The demands for credit lead the supply of cash and more broadly defined money. A large proportion of SA bank lending is on mortgage and mortgage demands remain especially tepid as we also show below.

Growth in mortgage lending follows house price inflation, as we show below, where it may be seen that the price of the average home is now unchanged compared with a year ago. A housing boom leads to a credit boom and rapid growth in the money supply as it did between 2003 and 2008 – and when the housing boom slows down, so does money supply growth as it has recently. Interest rate settings have proved incapable of effectively moderating the credit and money supply cycles in SA.

Until the housing market picks up the growth in bank lending will remain subdued. The recovery in the housing market has lagged behind the recovery in the economy. It will take further growth in formal sector employment to revive the housing market.

Lower interest rates on mortgage loans, applied much earlier in the slow down, might have helped moderate the contraction in the credit and money cycles, but these now appear most unlikely given the recent uptick in inflation. The credit and money supply numbers should however help dissuade the Reserve Bank from raising interest rates.

There is clearly no money or credit supply growth reason for raising interest rates, nor any excess demands for houses or anything else that would need to be restrained by higher interest rates. Indeed the opposite, lower rates, would still appear appropriate, given the state of the economy and in particular the state of the housing market and the construction industry that is an important employer of labour.

We show below the recent collapse in the cycle of buildings completed. We show how building plans passed have led the building industry lower. The indication is that he planning cycle has at best bottomed out, offering only the hope that construction activity will soon also bottom out and recover.

It is of interest to note that house prices lead not only mortgage demands but also building plans passed. It takes higher house prices to encourage construction activity.

The weak state of the credit and housing markets, that are inextricably bound together, makes the case for lower rather than higher interest rates. The Reserve Bank appears understandably reluctant to raise interest rates in the circumstances. The currently higher inflation rate is of the supply side, cost push administered price variety over which monetary policy has no influence and if it persists will weaken demand further.

Furthermore, as we have mentioned before, we have found no evidence of second round effects of inflation, that is, more inflation that leads to more inflation expected that leads in turn to more actual inflation. Fighting these feared second round effects have become an argument for higher interest rates, regardless of their negative effect on economic activity. Such arguments should be ignored and the SA public and market place made to understand why.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 1 June: Credit and housing markets: Still no case for higher rates

With reporting season behind us, some room for comfort in current valuations

The quarterly earnings reporting season is now almost behind us. As we show below the deep trough in earnings in 2009, coinciding with the global recession, is now more than a year behind us. JSE All Share earnings per share since May 2009 (smoothed) have grown by nearly 40% with the growth in Resource Sector earnings leading the other sectors by a very large margin. Financial Sector earnings reported to date are barely ahead of where they were a year ago while JSE Resource Sector earnings have grown by nearly 80% with Industrial Sector earnings up by about 20% on a year before.

The Resource counters have clearly benefited from the recovery in commodity prices that has contributed also to the strength of the rand. The industrial companies have gained from the recovery in the global economy and the recovery in the SA economy where growth is pacing that of global growth. Industrial companies, especially the domestic retailers and distributors of goods and services with high import content, benefit form rand strength. The banks might ordinarily have been expected to benefit from rand strength and the lower interest rates that follow lower inflation led by rand strength. However the demands for bank credit have stalled at only marginally positive growth rates. Until house prices and demands for mortgage loans pick up momentum the growth in bank revenues will remain subdued.

We compare reported JSE earnings, so called trailing earnings, with what we describe as normalised earnings. Normalised earnings are estimated using a 10 year rolling time trend. Trailing earnings are catching up with normalised earnings. If the past is a guide to the future then there would appear to be considerable scope for further earnings upside. The underlying trend in earnings growth also suggests as much. If the underlying trend in All Share earnings is extrapolated, the prediction is growth in All Share earnings of 30%, to be reported in 12 months’ time, led by growth in JSE Resource earnings of over 60%. Clearly such a time series forecast would be vitiated by any sharp reversal in commodity prices.

These underlying trends may be regarded as encouraging of higher valuations on the JSE. As we also show the JSE All Share price to trailing earnings is just under 16 times while the price to normalised earnings ratio is of the order of a below average 14 times. Clearly for the market to move ahead normalised earnings will have to materialise and most important world markets will have to be supportive.

Earnings and dividends from companies listed on the developed equity markets have also recovered strongly from crisis depressed levels of 2009. S&P reported earnings per share in the first quarter of 2011 have recovered to over US$81 compared to the barely US$7 of mid 2009. S&P earnings and dividends per share are now nearly back to their record pre financial crisis record levels.

It makes no sense to attempt to normalise S&P earnings given their extraordinary recent collapse. Consensus forecasts expect US dollar 100 of S&P earnings per share by year end, to be reported in Q1 2012. When we normalise S&P dividends that were much less severely damaged we find that reported dividends are still trailing well behind normalised dividends.

The S&P at 1331 has recovered strongly and outpaced Emerging markets over the past six months as we had suggested it would. When we calculate a dividend discount model for the S&P, discounting trailing dividends by long term interest rates going back to 1980, we find the S&P to be 24% undervalued for trailing dividends and 32% undervalued for normalised dividends. We therefore continue to be of the view that the least demandingly valued of the equity markets is the S&P 500.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 31 May: With reporting season behind us, some room for comfort in current valuations

The rand: Foundations still to be laid

This past month has not been a particularly good one for the rand. The rand lost about 7% against the Aussie dollar in May 2011 to date, while losing less about three per cent Vs the Brazilian real and the US dollar.

We have long watched the relationship between the rand and the Aussie dollar for signs of South African specific risks influencing the value of the rand rather than commodity prices that are common to both currencies. A combination of commodity price strength and rand weakness is a heady one for investors in Resource companies, quoted in rands, on the JSE.

However the current modest rand weakness would appear to have more to do with favourable Australian, rather than less favourable South African specifics. This view is supported by the better performance of the rand against the US dollar and the Brazilian currency.

The rand is more than a commodity currency. It is also very much an emerging market currency and actively traded as a proxy for other less liquid emerging market currencies. The beat to which the rand is moving this month has been day to day volatility on emerging equity markets. The rand has been getting weaker or stronger as emerging equity markets have been going down or up in a highly synchronised way. And the JSE remains a highly representative emerging equity market.

It would appear that it is very much emerging market business as usual in the market for rands. If we run a model that uses the EM equity market Index to explain the rand/US dollar exchange rate using daily data since January 2008, the rand is trading almost exactly as the model predicts.

In the large market for the rand, with daily turnover of about US$20bn making it about the tenth largest foreign exchange market, three quarters of the transactions reported to the SA Reserve Bank are conducted between third parties with no direct link to SA foreign trade or capital movements. They trade the rand because they can trade the rand to hedge emerging market exposures.

The notion that the SA Reserve Bank could intervene effectively in such a market to move the exchange value of the rand in some preferred direction would seem a false premise. The Reserve Bank can buy foreign currency in this market to add to its reserves, as it has been doing, but such interventions could not easily be seen as market moving. The value of the rand continues to be dominated by global forces, particularly those that influence the outlook for the global economy and so emerging equity and bond markets. South African specifics seem to have had little influence on the exchange value of the rand in recent years and we expect global forces to continue to dominate the rand exchange rates.

The rand began the year at R6.61 per US dollar. It lost about 10% of this value by early February 2011 and then reclaimed its beginning of the year value in late April 2011. It has by now lost about 4% of its January 2011 value against the US dollar this year, while the Aussie and the real are about three percent stronger than they were at the beginning of the year.

While the volatility in the market for rands this year may be regarded as moderate by its own standards, the still unusual volatility in the rand must remain of concern to the authorities in SA. Without rand stability, predicting inflation and interest rates more than six months ahead with any degree of accuracy or confidence, remains a near impossible task. The foundations for genuinely stabilising monetary policy and interest rate settings in the form of a stable and predictable rand have still to be laid.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:
Daily View 27 May: The rand: Foundations still to be laid

SA markets: Did anyone offshore notice the SA elections?

To the extent that anyone offshore actually noticed SA political developments last week the reaction must be regarded as benign. The extra yield provided by SA government US dollar denominated (Yankee) bonds over the yield on similarly dated US Treasuries declined last week, leaving the SA Sovereign risk premium close to its historic lows and its lows of the past 12 months.

The rand had a good week, gaining about 2% on a trade weighted basis, which has left rand still well ahead of its year ago value. These credit ratings and exchange rate trends will be very helpful in restraining SA inflation and welcome to the Reserve Bank struggling to avoid having to raise interest rates.

The news on the exchange rate was well received in the bond market. The difference between the yield in rands on long dated RSA bonds and the long dated US Treasury Bonds (which may be regarded as the SA risk premium) also narrowed last week by about 20bps to about 5.20%. This yield gap has remained within the five to six per cent range over the past 12 months. It may be regarded as representing the rate at which the rand is expected to depreciate against the US dollar over the long run.

If the rand loses an average 5.2% a year over the next 10 years, investors in RSA and US Treasury Bonds will have broken even. If the purchasing power of the US dollar and the rand is thought to determine exchange rates in the long run, then this yield gap will also represent the difference between expected inflation in the two currency areas. The bond market offers explicit compensation for bearing inflation risk. Long dated RSA bond holders are receiving an extra 6.3% for holding vanilla bonds rather than their inflation linked alternative. This yield gap has remained persistently at this high level over the years though it declined by 15bp last week.

In the US the inflation compensation is currently 2.35%, indicating that inflation in SA is expected to average about 4% higher in SA than the US over the longer term.

The significant electoral swing recorded at the nationwide municipal elections to the DA was enough to encourage the opposition but was not enough to cause anything like panic in the ranks of the ANC. The true democratic credentials of the ANC will perhaps only be fully tested when it is in danger of losing power. This still seems a long way off and maybe for the market place and its state of mind this is just as well.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 23 May: SA markets: Did anyone offshore notice the SA elections?

After the MPC: Interest rate expectations and the rand

The money market has raised the probability of an early increase in short term interest rates (in three months’ time) following the meeting of the Reserve Bank’s Monetary Policy Committee (MPC) on Thursday that maintained the repo rate at 5.5%. The short term three month Forward Rate Agreement curve (FRA) of the banks moved higher by between 10 and 30bps across the range of forward rates beyond the next three months late last week.

Interest rates expected over the longer term, beyond four years, have remained unaffected. The zero coupon yield curve implies that the one year government bond rate, currently around 6% per annum, will rise consistently to a level of about 9% in four years’ time and then stabilise at this level.

These expectations remain consistent with inflation compensation priced into the bond market in the form of the yield gap between conventional RSA bond yields and their inflation linked alternatives. This gap remains consistently above 6% regardless of the rate of inflation.

Our own interpretation of the MPC statement and the press conference is that the Governor and the MPC would be extremely reluctant to take any interest rate action before the economy has regained its potential growth, which it is still some way from attaining. However further increases in fuel and food prices and the headline inflation rate might force them in this direction for fear of second round effects on inflation itself. In other words, more inflation expected would lead in turn to still more inflation.

We have found comprehensive evidence that inflation in SA does to a small degree influence inflation expected, as measured for the Reserve Bank by surveys conducted by the Stellenbosch Bureau of Economic Research for business, trade unions and financial institutions. However, the reverse has not been true, although the Reserve Bank seems to believe otherwise.

Moreover it is clearly concerned to preserve its inflation fighting credentials even if this should mean having to raise rates. This is so even when it is clear that the inflation it is attacking is not under its control and when higher interest rates might lead to slower growth and a wider gap between actual and potential output and employment. The striking feature of inflation expectations in SA is just how stable they have been and how they remain above the inflation target band of 3% to 6%.

As we indicated in our first reactions to the MPC statement, the outlook for interest rates in SA will depend primarily (and unfortunately) on the rand price of oil and the continued upward direction of administered prices and not on the state of the economy that might be intolerant of higher interest rates. There should be a better way of running monetary policy in SA with more sensitivity to the state of the domestic economy and with the media and the financial markets well able to understand that a shock to the inflation rate does not imply permanently higher inflation. Keeping interest rates on hold in such circumstances when demand pressures are subdued does not mean being soft on inflation. This better way is indicated by the inflation targeting mandate itself, which does not demand adherence to inflation targets regardless of the causes of inflation and the consequences of higher interest rates for the economy, as is indicated explicitly and clearly in Paragraph 4 of the Mandate.

The rand has however weakened in recent days despite an earlier expected increase in interest rates. This again confirms that the influence of movements in interest rates on the value of the rand is not easily predicted. As we show below the rand lost about 4% of its trade weighted value last week.

Perhaps the market is being influenced to a degree by the unknown outcomes of the municipal elections in SA on Wednesday, which have become a test of the national government and its competence to govern. A small additional protest vote would probably be welcome as an incentive for the government to improve its delivery. An unexpectedly large vote for the opposition might be regarded as a serious longer term threat to the powers that be, and would perhaps have unpredictable outcomes for the ruling party, its leadership and its policies. As we know markets do not appreciate uncertainty.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 16 May: After the MPC: Interest rate expectations and the rand

Think beyond just inflation

The Reserve Bank, as expected, kept its repo rate steady despite raising its estimate of inflation to come, now seeing inflation as marginally above 6% by year end. However it also predicted to return to within the band in 2012. The explanation of this increase was “cost push” rather than demand forces, therefore not justifying higher interest rates (in the absence of “second round effects”).

Second round effects are defined as higher inflation caused by more inflation expected. This, according to the theory of monetary policy, might demand higher interest rates to fight inflation expected, even if this depressed the economy. This dilemma – the unhappy trade off between inflation and economic activity – is something the MPC would naturally prefer to avoid. The big question is will it continue to do so?

Our own work has unambiguously identified the absence of second round effects. Inflation in SA has influenced inflation expected, not the other way round. Thus we do not expect second round effects to show up. But the inflation outlook remains particularly uncertain given the uncertainty about the direction of the US dollar and the oil price in particular. And if the inflation rate rises and is expected to stay above the upper band of 6% this policy dilemma will become more acute, with or without measurable second round effects.

We notice again and welcome the willingness of the Reserve Bank to think beyond actual inflation to the causes of inflation and the recognition that monetary policy must also bear the outlook for economic and employment growth in mind. The revised mandate for the Reserve Bank makes this very clear.

It should be pointed out though that, in answer to a question, this point about a broader focus than a focus on inflation only was not made by the governor. The governor, like all governors of central banks, would hate to be interpreted as being soft on inflation, particularly when inflation is expected to rise above the target band and even when there is very good reason to ignore “cost push” pressures. And so anti-inflationary vigilance must always be stressed by central bankers, for fear that their lack of monetary action being misinterpreted as evidence of a lack of anti-inflationary conviction by the market place.

However, as was made clear by the MPC, the state of the economy does not support higher interest rates. As we have previously indicated the Reserve Bank is also of the view that economic activity may have decelerated rather than accelerated recently. And so, until the economy does pick up significant momentum, accompanied by significantly faster growth in bank credit the Reserve Bank will prefer to keep interest rates on hold. Yet it might feel obliged to raise rates despite the weakness of aggregate demand (wrongly in our view) should the actual inflation outlook deteriorate even if such higher inflation is beyond the control of the Bank itself.

The oil price remains the big unknown for inflation to come. It was remarked at the Q&A session that food price inflation may have peaked according to the Bank. The consolation is that higher commodity prices will very likely be accompanied by a stronger rand. If the rand price of oil remains unchanged or falls, the danger of higher interest rates will be averted for perhaps up to a further 12 months, that is until the economy gains real traction, which it will if the rand remains stable and the oil price does not detract further from household spending.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 13 May: Think Beyond Just Inflation

Bank credit and vehicle sales: No room for complacency

The bank credit statistics updated by the Reserve Bank to March 2011 indicate that weak growth in the supply of bank credit to the SA economy may be slowing down rather than gaining momentum. As we show below, our calculation of the underlying trend in the supply of extra bank credit to the private sector, suggests as much. Year on year growth appears to have stabilised at just over 5% (about a very modest 1% after adjusting for inflation) while the underlying trend growth has declined to a just over a 4% rate.

Behind this weakness in the supply of and demand for bank credit is the housing market and so the demand for mortgage loans. Mortgage loans have become an ever more important asset of the SA banks and now account for about 50% of all bank lending to the private sector.

House price inflation understandably leads mortgage lending as we also show below. The more valuable the house the larger the mortgage loan provided to secure it. Moreover house price inflation encourages home ownership. House prices are however not providing much encouragement to home owners, potential home owners or the banks. Clearly bank lending and money supply growth are not contributing any impetus to the SA economy. By implication therefore interest rates in SA are too high rather than too low: a point that will be taken account of when the Monetary Policy Committee (MPC) of the Reserve Bank meets next week.

The market for new and by implication used vehicles in South Africa has been the most conspicuous benefactor of lower interest rates and a stronger rand. However sales statistics for new units sold in April indicate that the growth momentum has slowed down. April with its many public holidays is typically a very slow month for vehicle sales, as slow as December for similar holiday reasons. April 2011 saw more than the usual numbers of days off and so April vehicle sales will need to be treated with more than usual caution. For the record, unit sales adjusted for seasonal factors (as far as we can measure them accurately) declined from 49 003 units in March 2011 to 42 830 units in April.

Furthermore the ripples from the Japanese Tsunami are still to be felt in the supply chains (including SA plants). In the months ahead new vehicle sales may well be inhibited by a want of supply rather than a lack of demand, making this leading indicator temporarily less helpful than usual.

The recent credit and vehicle sales statistics justify the caution expressed at the last MPC meeting about the state of the SA economy and the risks to the growth outlook. The credit and money numbers state very clearly that there is no pressure from the demand side of the economy on output, employment or prices.

The food and energy prices that have risen have their sources well beyond the influence of monetary policy in SA. They nevertheless help slow down rather than speed up the local economy.

These facts of economic life in SA should continue to give the MPC pause. There is no case for higher interest rates in SA. Indeed there is a much better case for lower rather than higher interest rates to add momentum to money supply and credit growth, which are too slow rather than too rapid for the good of the economy.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:Bank credit and vehicle sales: No room for complacency