Author: Brian Kantor

Natural gas: Economic development vs the status quo

More than a year ago we indicated the potential of natural gas extracted from shale rock and that the SA Karoo basin covered in shale rock might contain a great deal of this new source of energy. In a report in the Calgary Herald, of 18 April, Peter Terzakian referred to a very recent assessment of shale gas potential in 48 basins in 32 countries released by the US Energy Information Agency.

To quote the Calgary Herald: “ The numbers are staggering: over a six-fold increase in the 1,001 trillion cubic feet (Tcf) of natural gas that was previously known to be “proven” reserves. According to the EIA report, over 6,600 Tcf of shale gas resources are estimated to be technically recoverable”. As the Calgary Herald explains “……..To put this in perspective, 1,000 Tcf of natural gas contains the equivalent energy to 166 billion barrels of oil – a staggering amount considering that the discovery of 10 billion barrels of conventional oil these days is a rare occurrence….”

We might add by way of comparison that the annual global consumption of oil is of the order of 87m barrels per day of which SA consumes about approximately 555 000 barrels per day.

The Calgary Herald produced a table of the largest 15 such shale gas reserves to point to the vast recoverable resource in China. But as may be seen below the estimate of the technically recoverable resource in South Africa at 500 TCF (none yet proven) is no small potatoes either- it is the fifth largest such resource and equivalent to 83billion barrels.

Were this potential output of natural gas, estimated as recoverable by the US EIA, to be captured from the Karoo shale it would be very large potatoes indeed. It would be the equivalent to about 400 years of SA consumption of oil at current rates: 365*550 00 = 202.575m per annum; (83000mb/202.575mbpa) = 402 years

These numbers derived from estimates that are as objective and scientific as any should help concentrate minds at the SA Department of Mineral Resources that has placed a freeze on rights to explore for natural gas in SA until it has formulated a policy. The benefits of discoveries of natural gas in SA of anything like this order of magnitude would very obviously be transformational for the SA economy. It would offer the prospect of much faster growth in national output and in incomes, including the incomes to be received by the SA government and of the poor to whom it may be hoped a good portion of the extra income would be distributed.

There might well be damage to the environment to be traded off for these great potential benefits. Such tradeoffs can presumably be calculated and compensation offered if necessary to those negatively affected. There is too much at stake for any other approach to be adopted.

How much actual damage to be caused will continue to be disputed. However what should be borne in mind is that the damage to the environment caused by extracting other sources of energy in SA especially open cast or even deep level coal mining, would need to be brought into the calculation. Or in other words, less damage to the Waterberg traded off for damage to the Karoo

In many countries the prospects of shale gas have been greeted like the proverbial manna from heaven. Technically recoverable gas is being converted into proven reserves and actual output at a rapid rate. The economics of shale gas are rapidly transforming the energy equation in the US. But in SA the green movement seemed to have sounded an alarm that has deafened any account of the potential benefits. That the Karoo farmers have (recently) been denied any direct benefits from the gas under their land has no doubt added to the cacophony of protest.

Shell Oil, which appears to be well ahead in the race for Karoo gas, has argued (Business Report May 3 2011 p 17) to the contrary, that the process of extracting gas from shale “can be done without significant environmental damage”. That Shell has an interest in such arguments does not make the argument invalid. Furthermore the actual experience of damage to the environment in shale basins where gas is already being extracted in significant volumes will provide very important evidence.

The negative external effects of extraction or of any minerals in the ground do not remove the necessity to actually calculate the relevant tradeoffs as best as science will allow. Without such calculations and tradeoffs, economic development itself becomes much more difficult to realise. This is a fact of economic life well enough known to the greens who have no taste for the rising incomes and especially the rising consumption power of the masses.

Such an environmental assessment would then enable full compensation to be actually paid out to those damaged directly. The great potential extra income to be generated from natural gas potentially available deep under the Karoo shale rock is very likely to greatly exceed the damage caused to neighbours. If this is not the case then the project should not be allowed to go ahead.

The Department of Mineral Resources should however be well aware when establishing its policy that not only will natural gas discoveries on this potential scale be transformational for the SA economy, it will prove even more transforming of the energy sector of the economy. The Department should know that transformation of this order of magnitude will naturally not only be resisted by those directly in the path of discovery. Resistance would also come from those who think they may lose the race for supremacy for natural gas from SA sources because they have been slow out the blocks. The national interest in economic growth will count for little when opposed by vested interests.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Natural gas: Economic development vs the status quo

Financial markets in April: From Pennsylvania Ave to Pretoria

Many South Africans who took an extended break from work celebrating Easter, Freedom Day and the Bolshevik Revolution (more or less in that order), were no doubt comforted by the largely false notion that somebody else was paying for their time off and foregone output (other than those paid by the hour, who know much better). The rest of the world carried on producing and earning more or less as usual for most of the time (notwithstanding the Bin Laden news).

On returning to work today however, South Africans (those who follow such things) will discover that April was a very good month for offshore investors in SA stocks. Had they invested in the SA component of the emerging market index their return in US dollars in April would have been as much as 5.3%, well ahead of the monthly return for the EM Index, the S&P 500 and the US small caps. In the still mighty rand the returns would have been less impressive with JSE industrials leading the way.

In the US it is proving an exceptionally good quarterly earnings reporting season, still to be concluded. The S&P 500 has ended higher four out of the last five months, has been well supported by better earnings and has not (yet) benefitted from a re-rating.

It was not so much rand strength that accounted for these differences in returns, but the weak dollar. The US Fed at its April Open Market Committee meeting in April and at its very first press conference held thereafter, made it clear that it still regarded unemployment and slow growth, rather than inflation, as its major challenge. With the European Central Bank indicating the reverse sense of priorities, the US dollar weakened in line with an expected widening of the Euro-US dollar yield gap.

The rand accordingly gained against the US dollar in April and, after some mid month weakness, held its own by month end against the basket of other currencies with which SA trades, weighted by their share of exports from and imports into SA. Against a basket of other Emerging Market (EM) currencies the rand made a modest gain in April 2011, even as it weakened marginally againsts the Aussie dollar.

The fundamentals of the rand as a commodity currency that takes its cue from the Aussie dollar, was reaffirmed in April – though with the Aussie dollar trading at close to 109 US cents, a small degree of rand weakness vs the Aussie dollar was perhaps understandable.

Commodity prices were lifted by the weaker US dollar with gold leading the way and the US dollar oil price ending the month a little below its peak levels of earlier in the month. Any weakness in the oil price would be very welcome to central bankers everywhere, especially Mr Bernanke, who is on record as suggesting the spike in commodity and food prices will reverse this year.

The benefits of rand strength that mostly accompanies higher commodity prices will surely be appreciated in Church Street, Pretoria, as helping to contain SA inflation. We can hope that in Church Street, as on Pennsylvania Ave Washington, the fragility of the domestic economic revival, remains of greater concern than an inflation rate, over which the SA Reserve Bank can have no influence, other than not to stand in the way of currency strength.

The rand oil price, after its spike to R840 per barrel early in the month (caused by higher oil prices in US dollars and a temporarily weaker rand is now close to R820), has come off since then, a trend we can hope will lead to lower prices at the pump.

The stable rand, it would appear, has had a modest influence on interest rate expectations. Longer term interest rates that had moved higher in March 2011, moved lower last month, as we show below. The SA money market is still factoring in an increase in short rates within six months. Our view is that this would not be called for and will be resisted by the Reserve Bank, leaving short term rates on hold in 2011.

Perhaps the most notable move in financial markets in April 2011 was the decline in real interest rates in the US. While vanilla bond yields declined modestly, the real yield on the 10 year Inflation protected bonds (TIPS) declined by about 20bps. Inflation protected 10 year yields fell from a minimal 0.96% at the start of month to barely over 0.70% by month end.

Clearly the real cost of capital remains exceptionally low in the US and globally, the lack of demand for capital and abundant supplies of global savings being the primary explanation for this. Nevertheless, investors are seemingly willing to pay up for insurance against higher inflation that remains decisively a long term rather than an immediate threat. The case for the US maintaining its highly accommodative stance seems unanswerable for now. If this means a weaker US dollar so be it; the Fed will not be deflected from its task of assisting economic recovery rather than resisting inflation. Brian Kantor

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:Financial markets in April: From Pennsylvania Ave to Pretoria

The price of luck: Why betting on the long shots or the high PE companies is expensive

We are all well aware that gamblers are losers on average. If they were not it would not pay the casinos, race courses, bookmakers and lotteries to supply them with gambling opportunities. Nor would governments be able to tax gambling winnings as heavily as they do were not gamblers as eager as they are to gamble on the unfavourable terms they do, made all the more unfavourable by heavy taxes on their winnings.

What is not as clear is why gamblers on average prove so willing to apparently throw away their income. The answer is they enjoy the process, the frisson of perhaps winning big and sometimes doing so. The vast majority of gamblers, perhaps more than 98% of them in SA, are well able to limit their losses to a small proportion of their incomes. On average about 1% of disposable incomes are spent on gambling activity of all kinds in SA.

Technically gamblers who trade off expected losses for the pleasures they receive are not risk averse as is conventionally assumed; they are risk loving, playing a game for which the outcomes are not normally distributed around zero. The outcomes are very much skewed to the right hand side of the distribution: many small losses with a small probability of a few big wins.

And so gamblers accept much less than the mathematical odds implied by a normal distribution of outcomes for the opportunity to win big. Or in other words they pay up for the chances they take. It has been established conclusively for US race tracks that the actual odds of a 100-1 outsider winning a race is about 160-1. Researchers with lots of data and computer power at their disposal have calculated the expected betting return from all US horse races run between 1992 and 2001.

These results were shown by Chris Holdsworth in a recent report written for Investec Securities (Long shot bias and the equity market, Investec Securities, 18 April 2011)) that extends the analysis to the equity market in SA.

The worst bets on the US race courses, in the sense of what you can expect to get back on the basis of historical outcomes, have been on the longest shots. US punters on the races should expect to lose over $60 for every 100 to 1 bet they make. The “fair odds” would have been about 160 to 1, that is 100-1 long shots win only once in 160 attempts not 100.

The explanation for this willingness of gamblers to pay above the theoretical odds for the chance of a big win is surely their taste for risk. They value the small chance of a big win much more than they fear a small (even near certain) loss.

Gamblers who play a lottery, that typically pays out only about 50% of what is taken in, do so for the same reason – for the chance of a really big life changing win. They are in fact risk loving rather than risk averse and pay up accordingly. Government controls over the supply of lottery type games and bookmakers as well as, more recently, online gambling in the US of course prevents the potential gambling competition from improving these especially poor lottery odds or indeed the odds on the race track or the spread at football games.

Holdsworth found that analogous to the results of the gambling research, investors “over pay” for the opportunity to invest in companies listed on the JSE with well above market average PE ratios. The attraction of the high flying companies for risk lovers is that when the companies with high PEs actually grow their earnings even faster than the market expected, as implicit in high trailing multiples, the return can be spectacularly good. And so the risk lovers looking at the far right distribution of potential outcomes drive up valuations and generally overvalue and pay above the theoretical normal distribution odds for the average high PE stock. The ordinary risk averse investor is deterred as much or more so by expected losses as much as they are encouraged by expected returns. This is not necessarily so for the risk lovers.

Holdsworth pursued the analogy of the taste for high PE stocks with the taste for long shots on the race course in the following way

To quote his explanation of the method he used

“……..At the beginning of each year from 1994 to 2010 we ranked the constituents of the ALSI by 12m trailing P/E. We then measured the return of each of these stocks over the subsequent 12 months including dividends. We grouped the stocks into deciles based on their P/E within each year. For each year we then had ten equally weighted portfolios based on starting P/E. If our classification is correct then the dispersion of one year returns for the stocks in the high P/E decile should have a much larger tail on the right hand side than that of the low P/E stocks. The top 1% of returns for the high P/E stocks (represented as 0.99 percentile in the chart below) were above 750%. Top 1% of returns for the low P/E portfolio were just under 400%. …….high P/E stocks have a higher propensity for very large returns over one year than low P/E stocks. If this characteristic attracts risk seeking investors, as we think it does, that would imply a lower expected return.

For each year in our sample we measured the return of each decile relative to the average of all the deciles. We then summed up the averages for each decile across the 17 years in the sample. The chart for average returns for each decile is remarkably similar to the horse race chart above .The cost of gambling in the market is high. On average the high P/E portfolio underperformed the average of the deciles by 10% p.a. over the 17 year window. This portfolio would have contained some spectacular winners but their outperformance would have been drowned out by the remaining large number of constituents with sub par performance. The low P/E portfolio, while containing fewer stellar performances, would have outperformed the average of the deciles by just under 4% per annum. Like long shot horses, investors have consistently paid over the odds for high P/E stocks……”

Holdsworth explained that as with gambling it would be sensible for risk lovers in the share market to strictly limit the number of long shots taken and the scale of the investment made in them. Accordingly there also would be no point in holding a number of such stocks. The more diversified the portfolio of very high PE stocks the larger the chance of realising the predicted well below normal returns, if the history of past performance on the JSE is relevant. It would be the equivalent of taking all the tickets in a lottery or raffle where the prize is worth less than the tickets sold.

We would suggest with Holdsworth that investing in high PE stocks it is similar to making a bet where expected losses can be sustained in the hope of a big win. Such action is clearly not for the faint hearted with limited wealth at their disposal.

These results, as with betting odds, should not be regarded as representing market inefficiency or market failure. Rather they represent competitively determined outcomes, given the important presence in the market place of risk loving behaviour.

The risk averse can benefit from these risk loving propensities by betting mostly on the shorter odds favourites that come in the form of the well established blue chips. They have proven track records and whose earnings are not likely to deviate greatly from expectations. These companies will not be expected to shoot the lights out as will be reflected in their average PE rating.

And in the share market, unlike the gambling markets, investors would be playing a positive (after much lower expenses including taxes on winnings) game where the sum of the gains can be realistically expected to exceed the sum of the losses over time. Past performance indicates very clearly as much, as Holdsworth has painstakingly confirmed.

Such advice would not come as a surprise to the typically cautious fund manager or advisor. They might be pleased to know that their experience and intuition is indeed very well supported by past performance on the JSE.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View – The price of luck: Why betting on the long shots or the high PE companies is expensive

Equity and currency markets: Oil price calls the tune?

Last week was not a good week for the JSE or the rand. The SA component of the MSCI emerging market index lost over 5% of its US dollar value at the beginning of last week compared to a loss of just over 2% recorded for the benchmark EM Index itself. The rand lost 2.4% of its US dollar value by the weekend and about the same against the weighted average currencies of its trading partners. Rand weakness versus the Aussie dollar, another commodity currency, was of the same order of magnitude.

Thus rand weakness was mostly behind the relative underperformance of the JSE. The issue then is what was behind rand weakness itself. Not surprisingly in these circumstances foreigners were net sellers of SA equities through the week and modest net buyers of SA rand denominated bonds.

Or, to put it the other way round, locals were net buyers of JSE listed stocks – though not enthusiastically enough to prevent a modest 1.76% decline in the rand value of the JSE. For every foreign net seller there has to be an equal and opposite net SA buyer and vice versa. When share prices generally fall it may be inferred that the sellers were more determined to sell than the buyers were keen to take stock off their hands.

Over the past 12 months it is foreign investors who have been the keen buyers and locals the less keen sellers, enough for the JSE and MSCI SA to have proved outperformers in a generally improved market.

This year the S&P has proven to be a modest outperformer, with the JSE in US dollars and rands lagging behind and barely maintaining its values of 1 January 2011. We continue to argue that the most obviously least demandingly valued market is the S&P 500 with the JSE marginally less attractive than the MSCI EM. However we do not expect the performance of these three equity indexes to diverge greatly, dependent as they all are on global growth.

The strength of the global economy is reflected in commodity and metal prices. These as we show below have mostly moved sideways rather than higher over the past four months. However the great exception has been the price of oil as we show below.

Oil price shocks of this kind are more the result of the threat to supplies of oil from the Middle East than the impact of additional demands for oil emanating from an expanding global economy. As such they represent a threat to global growth and to other commodity and metal prices. Higher fuel prices absorb spending power and threaten higher inflation and higher interest rates. And so they also represent a danger to equity markets and to commodity currencies that do not have much oil or energy in their export baskets. In this regard the Aussie dollar may be somewhat better insulated than the rand.

Ideally from the perspective of investors in equities and resources (other than in oil and oil producers) the oil price will decline as fears about disrupted supplies decline. This will improve the outlook for growth, inflation and interest rates. A mixture of lower oil prices and stable, not necessarily higher, other commodity prices would be the right stuff for equity markets and the rand. Still higher oil prices would not be at all welcome.


To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Equity and currency markets: Oil price calls the tune?

Study on Inflation and Inflation Expectations in South Africa

Our study strongly supports the view that supply side shocks on inflation in SA are best ignored by monetary policy. The analysis infers that raising interest rates in the face of a supply side shock that pushes prices temporarily higher will reduce demand in the economy without affecting inflation in the short term or inflation expected in the short or longer term. We show very clearly that realised inflation has affected inflation expected to a modest degree in South Africa. But the reverse does not hold at all – inflation expected does not affect inflation. Thus in response to supply side shocks, especially those that emanate from net foreign capital flows and the exchange rate, a much better way should be sought to anchor longer term inflationary expectations in SA than raising short term interest rates. It would seem that raising interest rates to fight inflationary expectations or so called second round effects on inflation can impose large costs on the economy in the form of lost output to no useful purpose.

A preliminary draft of our study is available here: Study on Inflation and Inflation Expectations in South Africa

Other recent research on monetary policy:
Lessons from the Global Financial Crisis

The global forces that drive SA’s Financial markets from day to day – an analysis with the implications drawn for monetary policy

A full directory of my research on monetary policy is can be found here: Research Papers – Monetary and Financial Economics

Good news about home loans and employment

In a previous note on the state of the SA economy we pointed to the weakness in bank lending and the slowing growth in the money supply, particularly in the supply of Reserve Bank cash to the banks and the public. This indicated to us that while the SA business cycle was firmly in an upswing phase, the pace of recovery was not accelerating.

We showed that the housing market leads the credit market – higher house prices both encourage home owners to spend and borrow more and encourage entrants to the housing market. Higher house prices also mean larger mortgage bonds issued by the banks.

We suggested that what was needed to add momentum to the housing and credit markets market was growth in employment. Get a good job and the credit to buy a house and a car will likely follow.

In this regard the news from both the job and home loan markets in March, released this week by the leading employment agency Adcorp and the bond originator Ooba, was very encouraging. Ooba reported via I-Net Bridge that the number of bond applications in March had reached a three year high, that the average number of bond application in March was the highest level recorded since May 2008 and 36% higher than the average monthly application intake recorded in 2010. Not only applications but approved home loans were also strongly up and represented the highest value of approved home loans since October 2008. Yet these much improved volumes of potential bond business were still only 36% of the application volumes recorded at the peak of the market in May 2007.

Adcorp monitors the labour market very comprehensively and reported in its March Employment Report that in February employment in the formal sector was up 7.3% on a year before while informal employment grew by 2.0% “, the first time since January 2006 that the formal sector drew workers out of informal employment..” Its Index of Employment, having moved sideways, is now pointing higher.

The business of Adcorp is to find jobs for workers, something it has proved very successful at but whose success has inspired a Cosatu led thrust to close its business down.

The news from the labour and housing market must be regarded as encouraging, but not yet encouraging enough to lead the Reserve Bank to become less cautious about the state of the economy. As the IMF suggested, and as we have done, any early move to higher interest rates would be highly premature. Hopefully also the SA government will leave what is working well in the labour market (the demand for and supply of temporary employment) well alone.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 13 April: Good news about home loans and employment

The state of the SA economy: Moving forward but not picking up speed

We have updated our Hard Number Index (HNI) of the state of the SA economy to March 2011. The HNI combines two very up-to-date hard numbers, unit vehicle sales and the note issue of the Reserve Bank adjusted for Consumer Prices to form a business cycle indicator.

The HNI continued to move higher in March, though the speed at which the economy is moving forward (the rate of change of the HNI itself) has probably stabilised and may well slow down. We also compare the HNI with the Co-Inciding Business Cycle Indicator of the Reserve Bank that is only updated to January 2011. The turning points of the two Indexes are well aligned making the HNI a good and up to date leading indicator of the current state of the economy.

Read the rest of the story in Daily Ideas in today’s Daily View: The state of the SA economy: Moving forward but not picking up speed

Vehicle sales: Shifting into overdrive

March 2011 turned out to be another strong month for new vehicle sales both domestically and for exports. Sales in SA rose to 53 478 units while exports were a record 29 254. On a seasonally adjusted basis, domestic sales kept up with sales in February 2011 and the industry remains on track to sustain sales of new vehicles at a monthly rate of around 50 000. Seasonal adjustments are always complicated by Easter holiday influences in March and April and so a still clearer picture will have to wait until April sales volumes are released.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 5 April: Vehicle sales: Shifting into overdrive

The underlying growth in new vehicle sales appears to have reached something of a peak at about the 23% year on year rate of growth. Growth rates in vehicles can be expected to slow down as the year on year comparisons become more demanding. Growth rates in new vehicles sales are now approximating the pace realised at the end of the previous boom in 2006-07.

It is of interest to note that sales of heavy trucks and buses in March 2011 were up by 298 units or 21.4% on a year before. Thus it is not only households that are adding to their stock of new vehicles, but firms are doing so too. This indicates a recovering appetite for fixed investment spending in SA that to date has been the weakest component of domestic spending. The banks, short of mortgage business, have clearly welcomed the opportunity to provide credit for vehicle purchases; though no doubt the balance sheets of the motor manufacturers have also been put to work facilitating sales. Brian Kantor

Equity market earnings: A volatile month ends well (especially for offshore investors)

March 2011, by month end, proved a very satisfactory month for foreign investors in the JSE. The SA component of the benchmark MSCI Emerging Market Index ( that excludes the dual listed companies on the JSE), performed very well and in line with the emerging markets benchmark, as we show below.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:Daily View 4 April: Equity market earnings: A volatile month ends well (especially for offshore investors)

The total return performance of the JSE and of the MSCI SA in March 2011 was assisted by the strength in the rand against the US dollar and also by the relative strength in JSE reported earnings, especially when converted into US dollars. JSE reported earnings in US dollars are now growing significantly faster than those reported by the EM stocks included in our Investec Big Cap emerging market index.

Such faster growth is implicit in the currently superior rating enjoyed by the JSE. As we show below the JSE is trading at 15.3 times trailing earnings and our EM Index at a less demanding 12.3 times.

The S&P 500 by contrast is now trading at 17 times reported earnings. The annual growth in these S&P earnings is now 50% but this is growth off a highly depressed level of 2009 and 2010 – when S&P earnings collapsed from a peak level of over US$80 in late 2007 to less than US$10 per share by mid 2009, as a result of the global financial crisis.

Thus it will take until the end of the year to make proper sense of the underlying growth in reported S&P earnings; these are currently US$77 per share and are expected to approach US$100 within 12 months. The issue of how best to normalise S&P earnings will remain a very difficult one for many years, given the collapse of 2009.

Investec Securities calculates normalised earnings for the JSE. Its calculation (as shown below) suggests that the price to normalised JSE earnings ratio is below the trailing multiple. This indicates that if earnings continue to normalise, the price earnings multiple for the JSE may recede further. The bottom up forecasts of JSE earnings one year ahead indicate expected growth in JSE earnings in rands of close to 30% to be reported over the next 12 months.

The earnings outlook for the JSE appears to us as strongly supportive of current valuations. Our view remains however that the most obvious value in equity markets is suggested by the S&P rather than emerging markets, of which the JSE is an integral part. Should S&P earnings proceed as expected and approximate US$100 in 12 months, the multiple adjusted for expected rather than trailing earnings falls to about 13 times. This is well below long term averages for the S&P.

However any strength in the S&P that becomes realised as investors grow more confident about the earnings outlook is unlikely to mean weakness in emerging markets, but only perhaps a relative underperformance. Should the growth in S&P earnings materialise as expected, this will indicate that the US economy is in good enough health to withstand higher interest rates.

The usual tug of war between better earnings and higher interest rates can be expected to resume within the next 12 months. However it is only expected to restrain in part any rerating of the S&P and the advance of the S&P itself. We regard good 12 month S&P returns of the order of 10-12% as a distinct possibility. Brian Kantor

Interest rates: A change of heart at the MPC?

The Monetary Policy Committee of the Reserve Bank (MPC) as expected left the Reserve Bank repo rate unchanged yesterday. While the rate was unchanged the tone of the MPC statement and of the answers to the questions posed by journalists at the media conference was very different, in our estimation, from the previous meeting. Interest rate increases were clearly very far from the minds of the MPC. The pause button on short term rates remains very much in place. The focus of the statement and the subsequent discussion was clearly on the risks to the growth and employment outlook for the SA economy rather than the risks to the inflation outlook. This was despite the inflation forecasts being revised upwards in response to higher oil and fuel prices on global markets: these are expected to approach the upper band of its 3-6 percent inflation target band.

The money market and bond market will have to revise its view of the timing of the next increase in short term rates and was in the process of doing so yesterday. Higher policy determined interest rates will be postponed until the outlook for the economy can be predicted with greater confidence and the economy is operating much closer to its potential. We regard this evidence of Reserve Bank restraint as entirely appropriate and very encouraging for the outlook for the real SA economy. Most importantly from our perspective is the explicit recognition that these price pressures are of the cost push variety rather than of demand pull variety. To quote the MPC statement: “Since the previous meeting of the Monetary Policy Committee, the risks to the outlook for domestic inflation have increased on the upside, mainly as a result of cost push pressures. The domestic growth prognosis has improved, and the recovery is expected to be sustained, although not at rates sufficient to make appreciable inroads into the unemployment situation in South Africa.

“…….At this stage there are no discernible inflationary pressures coming from the demand side of the economy….”

And in concluding remarks:

“…The MPC is of the view that the risks to the inflation outlook are on the upside. However, these risks and underlying pressures are mainly of a cost push nature…”.

To further quote the MPC:

“The trajectory of the CPI forecast of the Bank has changed somewhat since the previous meeting of the Monetary Policy Committee. Nevertheless, inflation is still expected to remain within the target range over the entire forecast period. Inflation is now expected to average 4,7 per cent in 2011 and 5,7 per cent in 2012. This represents an upward adjustment of approximately half a percentage point in both 2011 and 2012. Inflation is expected to peak at 5,8 per cent in the first quarter of 2012 before declining to 5,6 per cent in the fourth quarter. The upward adjustment is mainly due to revised assumptions regarding the international oil price over the forecast period.”

What monetary policy can’t do
Presumably the Bank has referred to cost push rather than demand pull forces on the inflation rate because monetary policy and interest rates can do little to influence cost push pressures on prices in the short run or over the relevant forecast period. This important distinction was not one easily made by the MPC before when it would refer to the danger to inflation itself of inflationary expectations themselves. Such references were happily absent this time. It has always seemed to us an argument not at all well supported by the evidence. That is inflationary expectations, as surveyed, or inflation compensation made available at the longer end of the bond market, have been largely impervious (almost always about 6% pa) to the direction of inflation itself: this has moved sharply in both directions over recent years.

The only time when inflation compensation in the bond market (being the difference between yields on conventional government bonds and inflation protected yields) moved sharply lower and then higher was at the height of the global financial crisis when risk aversion and deflation, rather than inflation itself, became the primary concern of investors.

The MPC has become anxious about the global economy and therefore the dangers of what it regards as an increasingly uncertain global economy for the SA economy where a modest recovery is now under way. The troubled sense of the MPC view of the world and of the dangers this represents for the SA economy is well captured by the following observations made in its statement: “The global economic recovery, although uneven, is expected to continue, led by a strong performance in global manufacturing. However significant downside risks remain, due to the confluence of shocks that have the potential to stall the nascent recovery. Growth in emerging markets remains robust, but Asian economies in particular may be negatively impacted by the recent developments in Japan. The global growth outlook may also be dependent on the extent to which the authorities in China manage to slow their economy down.

“….Domestic growth prospects appear to have improved moderately. Real gross domestic product grew by 2,8 per cent in 2010, and at an annualised rate of 4,4 per cent in the fourth quarter. The forecast of the Bank has increased somewhat since the previous meeting of the MPC, with GDP now expected to average 3,7 per cent and 3,9 per cent in 2011 and 2012 respectively. These growth rates, while an improvement, are still too low to have a significant impact on the unemployment rate which measured 24,0 per cent in the fourth quarter of 2010….. There are indications that although consumption expenditure growth will remain relatively robust, it is unlikely to accelerate to excessive levels in the short term…..The various house price indices all indicate that house prices are either falling or increasing at very low nominal rates. This, combined with the recent decline in equity prices, may contribute to a moderation of the impact of wealth effects on consumption.”

We welcome the emphasis the MPC is placing on the state of the economy and on the absence of demand side pressures on the economy. There is much more than inflation at risk for the SA economy and the Reserve Bank has made this very clear. This represents good news for the SA economy and we are confident that what we would regard as a change of heart of the Reserve Bank will be well received in the market place, including the currency market. Initial reactions in the bond and currency markets were positive and they are likely to remain constructive. Brian Kantor

Inflation and interest rates: The glass is half full

While headline annual consumer inflation was unchanged at 3.7% in February, the underlying trend indicates a somewhat faster rate of inflation of about 4.2%. These trends may be calculated as the monthly move in the seasonally adjusted and smoothed CPI, which is then annualised, or as the quarter to quarter annualised increases in the CPI. Both are running at a similar rate of above 4%. If the current trends are sustained the inflation rate will approach 5% over the next 12 months.


To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:
Daily View 24 March – Inflation and Interest Rates

The forces pushing up prices are in part global in the form of rising dollar prices for food and energy. These, as the Reserve Bank pointed out in its Quarterly Bulletin, have been rising sharply as a result of increased demands and some supply side disruptions or expected disruptions in the supply of oil from the Middle East.

Breaking down the February data
The counter to such pressures has been the strength of the rand over the past 12 months. This counter pressure has been more effective in the case of food and less so for the petrol price. The food price component of the CPI is up by 3.6% compared to a year ago. Food prices actually fell by 0.1% in February 2011. The petrol price rose by 3.1% in February and higher oil prices, as well as higher excise taxes on petrol, took the year on year increase in petrol prices to 12.1%.

Food and non-alcoholic beverages account for 15.68% of the CPI basket while transport costs have a large weight of 18.8%. However Purchase of Vehicles carries by far the largest component of transport costs with a weight in the basket of 11.8% out of the 18.8% allocated to transport generally. Petrol has a weight of 3.93% and Public transport also influenced by the petrol and diesel prices has a 2.73% share of the CPI.

Owing to the downward pressure the strong rand placed on new vehicle prices, the overall transport component only increased by 2.6% over the past 12 months despite the higher petrol price. Including the prices of new vehicles rather than their implicit or explicit leasing or rental rates is surely an anomaly in the calculation of the CPI. It is the opportunity implicit or explicit leasing costs of owning a vehicle rather than the price of a vehicle that matters to households. The price of a new or used car furthermore is hardly something clearly indicated on any price list. It will be affected by financial arrangements and by warranties as well as residual and trade in values, all designed to help make a sale.

This anomaly (rentals or prices) is avoided in the case of another important category that makes up the CPI. That is the item Owners’ Equivalent Rent that makes up 12.21% of the basket with Actual rentals for housing making up a further 3.49% of the basket. Electricity prices, which rose by 18.6% over the past 12 months, have a weight of but 1.87%. Actual rents are estimated to have increased by 5.4% and owners’ equivalent rents by 3.9% over the past 12 months. Rentals were unchanged in February, presumably because they were not surveyed last month.

The future of rentals and the rate of inflation will be determined by the state of the housing market. Short term interest rates and the availability of mortgage bonds will clearly influence house prices, rents and rental returns and these will take their cue from the rand. However if house prices rise rapidly landlords may well accept a lower rental rate of return and vice versa. When house prices fall rental may prove much stickier leaving the direction of rentals somewhat independent of house price inflation.

Nevertheless home owners are likely to spend more rather than less as their balance sheets improve with higher house prices, which is unlike the case when most other prices rise. Higher (relative) prices generally restrain rather than encourage extra demands.

The right medicine
This brings attention to the most important contributor to the monthly increase of 0.7% in the CPI. Increased costs of insurance, especially medical insurance, rose by 5.2% in the month and contributed 0.4 percentage points of the increase in prices. These insurance costs are also only surveyed annually rather than monthly and revealed a year on year increase of 4.2%. Are not such increases reflective of the increasing real shortages of skilled medical personnel rather than demand side pressures on prices?

Such shortages of skills are exacerbated by the difficulties imposed by our immigration policies. They show up also in the rate of inflation of educational services provided to households. Primary and secondary education became 10.2% more expensive over the past twelve months and tertiary education was up by 7.9% over the same period.

The forces that restrain domestic inflation and the pricing power of local suppliers are the prices paid for imported goods and services and also the employment benefits received by the internationally mobile owners of scarce skills. Thus the value of the rand is the key to the underlying rate of inflation in SA.

Efforts taken to weaken the rand mean more rather than less inflation. They would also mean slower rather than faster growth, particularly in household spending, which responds favourably to lower prices and lower interest rates that follow lower prices. Growth and inflation in SA over the next twelve months will depend mostly on the global forces that determine resource and commodity prices and capital flows to emerging markets, including SA.

The most favourable outcomes for the SA economy – faster growth with low rates of inflation – will be those associated with rising commodity prices and so a strong rand. High prices for metals and minerals and inevitably also the price of oil (and also coal that we export so much of) represents good news for the SA economy. These forces proved most helpful in reviving the economy in 2010. We must hope for further fair winds to blow in from the global economy in 2011 and restraint from the SA Reserve Bank.

Equity markets: Back to square one

The nuclear cloud hanging over Japan lifted on Friday. Japan can get back to work and begin the rebuilding of its economy sooner rather than later. Relief that the radiation damage to Japan would be limited improved the outlook for the global economy to which equity markets responded very positively over the past two trading days. Equity markets are now back to the levels of 10 March, the day before the Tsunami struck.

US Treasury Bonds, and especially their inflation protected variety (TIPS), benefitted from their safe have status. This left compensation for bond holders bearing inflation risk largely unchanged. This compensation (or what may be regarded as inflation expectations) is shown in the difference between vanilla bond yields and their inflation protected equivalents.

While US Treasuries predictably acted as safe havens, so somewhat surprisingly, did US corporate bonds. The high yield, so called Junk Bonds have held up particularly well through the recent turbulence.

The strength of the US corporate bond market reflects well of the balance sheets of the average US non-financial corporation. It also speaks well of the recovery prospects of the US economy. The case for equities, especially those well exposed to the global economy, remains a strong one, given what we have argued are undemanding valuations. And given the dramatic events of the past few weeks the markets are back to where they were and therefore continue to offer value in our judgment. That the markets could absorb all that nature and engineering fallibilities threw at them, might indicate less rather than more risk to the economic and earnings outlook.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Equity markets: Back to square one

The world economy: Whither the Yen, the global economy and so the rand

The online edition of the Wall Street Journal reported this morning has the following comment:

For the first time since they joined to rescue a sinking euro in 2000, the U.S., Japan, U.K., Canada and the European Central Bank Thursday night agreed to “concerted intervention in exchange markets.” The ECB manages the currency shared by G-7 members France, Germany and Italy.
Continue reading The world economy: Whither the Yen, the global economy and so the rand

Hard Number Index: Maintaining speed

The February 2011 reports on new unit vehicle sales and the Reserve Bank note issue have been released and we are able to update our Hard Number Index (HNI) of the current state of the SA economy. As may be seen below, the economy continued to pick up momentum in February 2011.
 
The very up to date HNI is proving a reliable leading indicator of both the Coinciding Business Cycle Indicator of the Reserve Bank (updated to November 2010) and the Reserve Bank Leading Indicator of the SA Business cycle (updated to December 2010).  
  Continue reading Hard Number Index: Maintaining speed

Vehicle sales: Why a strong rand is good

It was another big month for unit vehicle sales in February. On a seasonally adjusted basis sales were ahead of the January numbers, which in turn were well up on December.
 
Year on year growth in unit sales has remained in the plus 20% range. However the quarter to quarter growth rates, which are not dependent on base effects, have surged ahead and are now running well above a 40% per annum rate.
  Continue reading Vehicle sales: Why a strong rand is good

Currency markets: Explaining the weak US dollar and the strong rand

Recent trends in the currency markets following the spike in the oil price raise two questions: why has the US dollar weakened and why has the rand strengthened? It should be recognised that the rand has gained not only against the weaker US dollar but also against the crosses, including the Aussie dollar. In the figure below we show the trade weighted value of the rand and the oil price in US dollars based to 1 February 1 2011. The oil price is up about 13% while the trade weighted rand had gained nearly 3% since the oil price spiked in mid month.

The full version of this article can be found in the Daily View here: Currency markets: Explaining the weak US dollar and the strong rand

Money and credit: Sill growing too slowly for GDP and employment growth

The money and credit statistics released by the Reserve Bank yesterday indicate that while the money supply (broadly measured as M3) is maintaining a satisfactory rate of growth of around 7% per annum on a quarter to quarter basis, credit extended by the banks to the private sector has remained largely unchanged over the past quarter. Not coincidentally, the price of the average home in SA is also largely unchanged over the past year.

It will take an increase in mortgage credit to lift house prices, while it will take an improved housing market to encourage the banks to lend more and for property developers to wish to borrow more. The trends in money and credit supply indicate that short term interest rates are still too high rather than too low to assist the economy to realise its potential output growth. And so policy set interest rates are unlikely to increase any time soon.

The lower level of mortgage interest rates and a significantly lower debt service ratio for the average SA household  (See below) still have work to do to revive the housing market and construction activity linked to higher house prices. Perhaps the authorities, now so concerned with employment growth in SA and intending to subsidise employment with tax concessions, should be reminded that house building and renovations are highly labour intensive.

For graphs and tables, read the full Daily View here: Money and credit: Sill growing too slowly for GDP and employment growth

2011-2012 Budget: Getting value for government money

The first impression one has of the Budget proposals is just how strongly government revenues have grown over the past fiscal year, something around 13%. Also, how strongly tax revenues (not tax rates) are expected to increase over the next few years. At around a 10% per annum rate, or in real terms by about 5%, government expenditure is planned to grow at around an 8% rate or around equivalent to a 3% rate in expected inflation adjusted terms.

Read the full story in the Daily View here: 2011-2012 Budget: Getting value for government money

Earnings: Growth is accelerating – perhaps faster than expected

The much anticipated recovery in JSE earnings off a global financial crisis depressed base is now well under way. The results reported by Anglo and BHP Billiton (with a combined ALSI weight of about 24.7%) have contributed meaningfully to the reported growth rates. As we show below, ALSI earnings per share are now 36%  higher than a year ago while in real CPI deflated terms the growth is 32% and in US dollars an even more impressive 46% higher than February 2010.

Continue reading Earnings: Growth is accelerating – perhaps faster than expected