Author: Brian Kantor

Brian Kantor

28^th September 2022

The Covid lockdowns has quite dramatically altered the relationships between the South African economy and its global trading and financial partners. What followed Covid was a dramatic improvement in the balance of exports and imports. After 2020 exports, helped by higher prices, grew significantly faster than imports to take the balance of trade to a mammoth, nearly 10% of GDP by Q2 2021. As export prices have fallen off more recently the trade surplus has declined to a still impressive 4.8% of GDP in Q2 2022.

The difference between exports and imports is also the difference between GDP- output or equivalently incomes – earned producing that output – and Gross Domestic Expenditure –mostly on consumption by households and  partially on capital goods by firms – that can be funded with loans to supplement current incomes. The trade balance – when positive -represents an excess of local supply over local demands- a contributor to global supply chains- rather than a drawer or absorber of them.  The SA economy has thus helped dampen global inflation.

The closely watched current account of the balance of payments adds foreign mostly investment income to the trade balance. South African borrowers and capital raisers pay out interest and dividends at  higher rates and yields than they typically receive from their foreign investments. Even though South African’s foreign assets roughly match their foreign liabilities (thanks to Naspers and its Ten Cent investment) This force usually turns trade surpluses into current account deficits – being the sum of the trade balance and the net foreign income accounts.   

By definition of the balance of payments accounting system the current account deficits (or surpluses) are equal to foreign capital inflows or outflows. Instead of drawing on global capital markets to fund its capital expenditure budgets South African savers- almost all realized by its corporations to offset very marginal surpluses of the household sector and public sector deficits, became a significant source of savings for world capital markets. Instead of drawing on global capital markets to fund capital expenditure budgets we became a significant source of savings for world capital markets- some 300 billion rands worth since Covid. The current account is now in rough balance.

The trade balance, the current account and net foreign income. South African Balance of Payments Statistics. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

Rather a lender than a borrower is conventionally good news for balance sheets and credit ratings- – provided all else remains the same.  Ideally raising capital even debt – to spend on capital goods with long productive lives that earn above the cost of debt- is good for any company or government and all its dependents. It means faster growth- and faster growth is the key to attract capital – especially equity capital – on favourable risk adjusted terms. Though the influence of removing one of the SA deficits, the capital account deficit – and improving the fiscal deficit, also with the help of the exporters, has not been conspicuous in the market for rands. The exchange rate of the ZAR with the USD, as for all other currencies, is being dominated  by the dollar and the actions of the US Fed.

There is a dark side to South Africa’s lesser dependence on foreign capital. The reason the SA trade balance has improved as much as it has is because the rate at which South African’s have saved since Covid disrupted incomes and output has held up much better than the rate at which the economy has added to its capital stock. The ratio of Capital Expenditure to GDP has very worryingly continued to decline – from the 20% of GDP range before 2016 to the current 14% of GDP rate. The savings rate appears to have stabilized at the 14% rate.

These capital expenditure trends portend very poorly for the economy. They imply persistently slow growth that will continue to threaten the ability of the SA government to raise revenues to fund its ambitious welfare programmes. Slow growth adds to the risk of investing in SA and the cost of raising capital from all sources domestic and foreign. It means less capital expenditure and slower growth. Ideally South Africa should be raising its capital expenditure rate and funding more of it by attracting foreign capital on favourable terms, growing faster by reducing the risk premium with appropriate actions. Current account deficits and capital inflows to fund growth would then be very welcome.

The trade balance and the difference between savings and capital expenditure. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

Savings and Capital Expenditure. Ratio to GDP. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

Ask not what you can do for the boss. Ask what your boss can do for you

An earlier study of the returns from investing in the best companies (BCs) to work for, as revealed by their employees, has been replicated with very similar results – as reported in the recent Financial Analysts Journal. An index of US companies that best satisfy their employees, would have provided market beating returns over an extended period to 2020, on average a meaningful extra 2-3% p.a. over the long run. Incidentally a similar methodology applied to selected groups of companies with very good ESG qualifications revealed slightly inferior returns. It is understandable why investors might have paid up for companies to feel better about themselves. Less obvious is why investors have so conspicuously spurned the advantages of investing in companies that are so well appreciated by their employees.

A different relationship between the causes and effects of companies that best satisfy their employees may explain the observed outcomes. It is the economic and financial performance of the best companies surveyed that perhaps explains their superior status with employees more than the other way round. The better the economic performance of a company, the better the company will be able and willing to look after their managers and workers and win their trust.

The same many hours devoted with the same energy and skills to a struggling business, are very likely to provide very inferior rewards over a lifetime of work. Promotion and training opportunities will be more limited. Initiatives to encourage self-improvement of the workforce will be unaffordable and the job itself will be much less secure. Bonuses and share option schemes that come with success and that make climbing the slippery corporate ladders so attractive will be largely absent.

It turns out that the best companies to work for are also unusually successful when measured by the other criteria for performance. To quote the study, “Overall, the main takeaway from these statistics is that BCs are rarely tiny-cap stocks, they are typically large, and a few are extremely large companies…… , we also see that, on average, BCs have relatively high market-to-book ratios of 12.44 and gross-profit-to-total-assets ratios of 38%, and that BCs spend relatively little on capital expenditures (4% of revenue) and have relatively large amounts of intangibles in their balance sheet (22% of total assets)….. BCs are large companies, with an average (median) market capitalization of $55bn. This shows that BCs tend to be large companies and the size distribution is skewed to the right….”

Most large companies were small to begin with and size is a measure of their success- able to sustain better still to improve their returns on additional capital employed. Such achievements characterize the true growth companies well worth being an early investor or employee in. The ideal business to invest in or work for would be a start-up that grows rapidly and becomes large and consistently successful on all dimensions. Perhaps what the list of BC’s – that change significantly from year to year- about 20% enter and leave the lists annually – include a biased sample of surprisingly successful companies- revealed in part by their superior employment practice. The best run companies are priced for success and therefore returns realized may not beat the share market. The surprisingly improved companies will do so. Identifying surprising strength before other investors do is the holy grail of investors and indeed also of workers with choices to make.

The key success factor in any business are the capabilities of its senior managers and directors. The employed insiders are in a very good position to evaluate them. The transfer market can serve those with competitive and marketable skills as well as it does in football should they have reason to doubt their leaders. Moreover, as they do in football, they should not resent the high rewards received by the best executors, the true and rare superstars that create and preserve so much value for workers and shareholders and as important for their valued customers.

When will inflation in the US (9.1% in June) peak? My answer is about now. And the surveys of inflation and the state of the financial markets support this proposition. If month to month increases in the US CPI revert to something like the 20 year average, inflation in the US will be trending well below 7% by year end and fall back to 2% p.a. by late 2023. Bloomberg surveys conducted in July indicate in inflation in Europe- now over 8% p.a. to recede to 2% by year end. Inflation in SA, still to peak at over 7%, is expected decline to 5% by late 2023.

The supply side disruptions that ramped up oil, grains, shipping costs and metal prices (unfortunately for the South African economy) have abated. They are all well off their recent peaks. Industrial Commodity and Metal prices are 50% lower than their peak values of January 2022. These prices may remain at high levels, but they are no longer rising to force inflation higher.

Industrial Commodity Price Index. January 2022=100. Daily Data

Source; Bloomberg and Investec Wealth and Investment

Prices have their supply and demand causes as they have had in our post Covid, post Russian invasion world. They also have their intended effects. They have helped repress demand for goods, more than for services, in the developed world and South Africa. Inflation is properly defined as a continuous increase in the CPI. It takes more than essentially temporary supply side shocks for inflation to proceed at persistently higher levels. Inflation can only be sustained with continued stimulation of demand. Without additional demand, the higher prices perhaps planned in advance by suppliers with price setting powers, cannot be sustained. Without support from the demand side of the economy, from further injections of demand, stimulated by central banks and governments, the market-place will not t absorb higher prices.  In the absence of supportive demand, prices will, perhaps only gradually, adjust lower in response to help sustain sales revenues and bottom lines.

Prices are not what firms would like them to be, higher usually, but are conditioned by what their customers will bear. Expecting more inflation and setting higher prices accordingly regardless of the stae of demand cannot be a self-fulfilling prophecy.  It is not consistent with economic rationality. The clear evidence from the recent surveys and the bond markets is that economic actors are not naively extrapolating recent inflation into the distant future. They are wisely seeing beyond current inflation to the longer-term demand and supply forces that will act on prices- including the role expected to be played by fiscal and monetary policy. As with the surveys, inflation expected, as priced in the market for US Treasury Bonds, so called break-even rates, have receded in the past week-despite higher realized inflation.

The US bond market expects inflation to average 2.1% p.a.  over the next five years and 2.3% p.a. over the next ten years- very close to the 2% p.a. Fed target for inflation. The SA bond market is now offering still higher rewards for bearing inflation risk- despite the inflation-fighting zeal of our Reserve Bank. The money and bond markets in the US are priced for a reversal of the direction of interest rates next year, with the peak in short rates having been brought sharply forward to January 2023 at 3.25%. The SA money market predicts much higher interest rates for a much more extended period. One hopes wrongly given the absence of demand side pressures on prices and the state of the economy.

Inflation expectations revealed in the Treasury and RSA bond markets. Daily data.

Source; Bloomberg and Investec Wealth and Investment

The best reason to expect inflation to subside in the US, Europe and South Africa is that the demands for goods and many services are already well depressed, thanks to higher prices. Spending is no longer being supported by additional income subsidies or by rapid growth in the money supply and bank credit. The money supply in the US (M2) has ground to a halt. The essential question is still to be answered. Is the US and Europe heading for recession aided and abetted by central banks intent on raising interest rates too aggressively and indeed unnecessarily fighting the last war? Central banks should know better than to lead their economies into recession while inflation is moving in the right direction and their economies head in the wrong direction.

A growing number of employers have insisted that their employees must come back to their work- places. Elon Musk, has demanded that Tesla or Space Ex staff spend at least 40 hours in their offices and that those who do not want to do so “…. Should pretend to work somewhere else…” He also wrote “Tesla has and will create and actually manufacture the most exciting and meaningful products of any company on Earth, this will not happen by phoning it in.”  Many other firms, feel the same disillusionment.

WFH is an option – not a compulsion. But an option modern technology has now made possible in ways that were not possible before. Homework was hardly unknown before.  Writers, composers and artists as well as weavers and sewers, home bakers, worked from home long before the gig-workers who congregate at the internet café. You may you noticed how the coffee mavens all look up from their laptops to appraise the new arrivals? Seeking company no doubt that they could find at the water cooler.

Being able to measure accurately the relationship between how they reward their employees and how much they contribute to the output and profits of the firm is an essential responsibility of any business. It could not hope to survive without accurate calculations of the costs and benefits of alternative working arrangements. And the firms faced with WFH preferences have been learning by doing as they always do.

It can be assumed with great confidence that the great majority of employees will be paid no more or less than the value they will be expected to add for their employer – be it from the office or home. Furthermore, as clearly, nobody will be rewarded for the time they spend commuting. It is paid for in  income or leisure sacrificed by the commuter. Recent evidence that the revealed willingness to go back to the office in the US is inversely related to the time spent commuting is no surprise. The lucky winners from the enforced lockdowns have been those who to live far from the office – that they chose to do for – their own good reasons – pre the lockdowns.

Employers are not the only party with the right to choose where best to work. Workers will make their own choices. The ratio of job openings to work seekers in the US has never been higher and the opportunity to work from home has not been greater this century.  

The Tesla office worker who has remained in California, even though the Tesla office is now in Texas, may well tell Elon what to do with his job. They may even accept a lower salary to WFH – the cost of the commute is their bargaining chip. As is the saved rental and all other not at all insignificant costs of supplying an office desk that may improve their case to WFH. They may even be able to do two jobs from home- as many do- given the time freed up and the absence of supervision or whistle blowers. Elon and other collaboration mindful employers may have to offer a premium to get the preferred workers to the office- if they are more productive there.

The individual households who choose where and how they live will help determine how the world of work will look in ten years or more. The developers of offices and homes and retail space will respond rationally to the choices and ongoing experiments of all those who hire and supply labour of all kinds- billions of decisions will prove decisive. The world of work and production evolves continuously, usually in an imperceptible way, to the signals provided from the market for labour. There is no design – just efficient outcomes. Employers no longer requiring office workers to attend on Saturdays, or offering extended annual holidays, are not providing charity but are making a considered response to market forces- necessary to attract workers of the right kind and at the right price.  They will continue to respond accordingly.

The responses to the opportunity to work from home that technology has made possible- and made the lockdowns possible – will evolve sensibly and rationally. Provided freedom to choose is respected as the essential ingredient for a successful, highly adaptive economy.

Global stock markets have done well for investors over the years. We look at what will be required for them to continue to do so.

The compounding growth of the West is powered by business enterprises and savers share in the wealth created.

The economic history of Western economies is an admirable one. Their standard of living has been transformed over the past 200 years by consistently positive year-by-year growth in output and in incomes per head, despite the rapid growth in population over the same period. And all of this was achieved despite the destruction of life and capital, buildings and valuable infrastructure by periodic wars. The Russian war in Ukraine is an awful reminder of how destructive war is. It will take many years of sacrificing consumption – of saving and productive investment in capital equipment and infrastructure – to make up for these losses.

Privately owned businesses are responsible for much of the growth in incomes earned, and in the extra goods and services supplied to the western economies over time. Their most decisive stakeholder is the consumer of this growing cornucopia of goods and services that they produce. Their owners earn a surplus after all contracted-for costs of production have been met and revenues have been collected. There is the risk of a loss, though a growing economy makes losses less likely. More efficient businesses will also compete on the prices for and quality of goods and services they provide their customers, at the possible expense of the revenue line. Improvements in the productivity of capital will be widely shared.

A stock exchange enables the ownership rights in larger businesses to be widely and conveniently shared and traded. It provides the average saver the opportunity to plug into these surpluses and the wealth-creating machine of immense force that is business enterprise, mostly via their pension and mutual funds. These widely dispersed owners have realised much more wealth creation than they would have done by investing their savings in the money market, bank deposits or in the bonds and bills issued by governments. And they would have done even better had they further postponed consumption and reinvested the dividend income they received, as well as conserving their capital gains by staying in the stock market.

The JSE, very much part of a global capital market, has provided comparably excellent returns over the many years of its existence and has repeated the performance this century.  As illustrated below, the average annual total returns with dividends reinvested from the JSE since 2000 have been nearly twice as high as the interest earned on cash and paid out: 13.5% annually vs 7.6% annually. The compounding effect has been so powerful because the returns on extra capital invested by privately owned businesses have been so positive. Economists therefore go further, given past performance. They regard these high expected returns over the long run, as part of the cost of capital employed. They add these higher expected returns to the returns that should be required of any company contemplating an investment decision. It is called the (expected) equity risk premium. If the proposed project cannot promise to leap over this higher hurdle of required returns on capital, the advice is not to go ahead.

JSE All Share Index, with or without reinvesting dividends, and money market returns (three-month Johannesburg Inter Bank Rate) (2000 = 100)

Source: Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022

JSE All Share Index total returns vs cash (three-month Johannesburg Inter Bank Rate) 2000 to 2021

Source; Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022

It is not only returns that matter – so does risk. Human nature says (expected) return and estimates of risk are positively related.

So, the obvious conclusion would seem to be to invest in the stock market, since, based on past experience it can be expected to perform well in the long-term, even if there are some short-term blips. It is these short-term blips however that discourage investment in the share market. Between 2000 and 2021 the annual total return on the JSE was 13.5% a year and that provided by the money market was a much less 7.6% a year return on average. However judged by the movement about this average return, the JSE was nearly seven times as risky, as measured by the standard deviation about these returns (see figure above) – the risk that your shares may be worth much less in a few days or months, when you might be forced by circumstances to liquidate your wealth. This can be a major deterrent to share ownership.

The greater the risk aversion, the less comfort wealth owners and potential share owners have in the outlook for assets, the less time they wish to spend in the stock market, the less valuable businesses become. And the greater will be the risk premium earned by those willing and able to stay in the stock market. Bearing extra risk will likely bring extra returns because the entry price to the share market is reduced by the risk aversion of other potential investors. It has been true of the share market over the long run and market volatility, or risk, is likely to continue to negatively influence the long-term value of shares, so improving realised rates of return for those with an extended time in the market.

Albert Einstein famously described the power of compounding interest or returns as the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn’t, pays for it.” This powerful force of low-digit exponential growth, of growth compounding on growth, year on year, is well demonstrated by the long-term ability of the major stock exchanges to grow wealth for shareholders in a consistent way over the same long run.

It is the return on owners’ capital that is the source of all interest income

But where do these good compounding share market returns come from? From businesses who are entrusted with much of the accumulated savings or wealth, described as capital employed in any market-led economy. The owners and managers of businesses are incentivised to husband scarce capital, as best they know how. The rate of return they realise on the capital employed, the productivity of that capital, is the foundation upon which all rewards from saving and owning capital or wealth is built. Firms experiment continuously in improving the return on the capital they utilise. They aim to improve the relationship between the cash value of the resources they invest in, called operating costs and what comes out as revenues, and they apply their fixed and working capital to the purpose. The results of such efforts are measured, hopefully in a consistent and comparative way, as return on capital employed inside the firm. The rewards for savers who supply the firms with capital to invest, come not only in the form of dividends paid, but in offers of interest payments that firms are able and willing to make to attract capital, in competition with other firms for the same potentially productive capital.

The less risky interest income offered by all other borrowers, the banks and the government, is therefore strongly influenced by the same return on capital realised by the business enterprise that employs a large proportion of the capital available. The banks, the money market funds, or the government as a borrower, would not offer the interest they do, unless the firms were able to earn a positive rate of return on all the capital they utilise and have to compete for. This includes competing for the overdrafts and mortgage loans provided by banks and other financial intermediaries.  The higher the expected real returns from all the capital employed in businesses, the more competition from firms for additional capital to invest, the larger will be the real rewards for all saving. Be it named interest or dividends or lease payments or capital gains depending on the financial arrangements agreed to between suppliers and raisers of capital.

The internal return on capital is what is converted into market value and market returns

It is the positive internal rates of return on capital realised by the business enterprise, not share market returns, that reveals the productivity of the capital it employs. The share market in turn translates expected internal returns on capital into current share market values. The market value of the firm should be understood as the present value of future operating or cash surpluses over operating costs, expected from the firm, discounted by the required returns expected from likely alternative investments.  The most valuable firms in the market-place – measured as the ratio of its current market valuation to current earnings or better current cash flows – are those firms that are expected to consistently improve their internal returns on capital and to add more capital by doing so. In other words, they are expected to consistently improve the productivity of capital they utilise and are able and willing to attract more capital, both loan and equity capital, to realise the growth opportunity, and to successfully hold the competition at bay that always threatens prices and operating margins.

The two measures of performance (the internal and market returns) are likely to be highly correlated over the long run. But such present value calculations made by the buyers and sellers of shares in companies are subject to considerable uncertainty from day to day and week to week or quarter to quarter. There is uncertainty about flows of revenue, operating costs and returns from alternative investments that determine the discount rate. There are more than enough unknowns to make estimating the future value of a firm or a market of them, a risky business. Risky returns help to direct savings to the lower return, less risky alternatives, for example to cash or cash like assets.

Knowledge (technology) improves the productivity of capital. Will it continue to do so, and will shareholders receive as valuable a share of the surplus generated?

The force that has driven the extraordinary and consistently unpredicted improvements in income and wealth and in the supply of goods and services delivered, is the success of technology and its application by the business organisation in sustaining and improving the (internal) return on capital, year by year and decade by decade. From railroads to electricity to the motor car, computers and the internet, technology has provided the opportunity to improve returns on capital and increase incomes and wealth, of which a large part is held in the form of shares of companies. A further explanation for consistently good returns to capital over time is perhaps that technology has consistently delivered more than most investors thought technology would deliver over the last two centuries. Stock markets have done so well because the productivity improvements from innovative technology have been at least what the market hoped they might deliver, and consistently delivered at least the productivity enhancements that it is expected to deliver, and typically considerably more. We have had few technology disappointments and technology has overwhelmingly surprised on the upside.

Will technology continue to consistently surprise on the upside in future and benefit the owners of the representative business enterprise and its customers and employees (and government treasuries) in the same way it has done over the last 200 years? There are some caveats.

Productivity has been dramatically driven by improving and ever cheaper computer power. Moore’s law, which predicts that computer power per dollar invested in a chip will increase at an exponential rate, has been shown to be approximately true for around 50 years. But such increases in the power of computer chips must necessarily face physical limitations because of the finite nature of matter.

Similarly, can one assume that the efficiency of food production will continue to improve at the rates it has in the past? The finite resources of planet earth may put a brake on the pace of technological improvement (unless we extend ourselves by settling the planets and beyond, and investing in knowledge itself may defeat the law of diminishing returns). Moreover, will humanity attach as much importance to increasing further our command over goods and services through productive capital expenditure as much as we have in the past and tolerate the share of output going to owners of capital as we have in the past? Capital and its application may be given a lower priority and if so, growth rates will subside.

That the SA economy has performed quite as poorly as it has in recent years is not easily explained. The rate of growth of less than 2% a year represents a very poor outcome, with alas little prospect of any lift off, according to the economic forecasters in and outside government. Yet there are more corrupt economies with much less of an endowment of capital and skills that grow faster.

Fixed capital formation and employment offered by private businesses is at best in a holding pattern – capital formation being maintained at levels first reached in 2008. Capital formation by the public sector is in sharp decline- necessarily so – given past performance. The unwillingness of SA business to invest in future output and income generation and in their workforces – describes slow growth – but does not explain its causes. Such reluctance needs to be understood and addressed if the outlook for the economy is to improve.

Fixed Capital Formation Constant 2015 Prices

Source; SA Reserve Bank and Investec Wealth and Investment

Total Real Fixed Capital Formation (2000=100)

Source; SA Reserve Bank and Investec Wealth and Investment

We need look no further for a large part of the explanation of unusually slow growth than to the disastrous failures of the SA public sector.   South Africa relies heavily on the State as a producer of essential services, including electricity, water, transport, ports and education. More heavily than is wise or necessary. The inability of Eskom to meet depressed demands for electricity clearly sets limits to growth as do the failures of Transnet to run the railways and ports anything like competently.

These operational failures have meant very large amounts of wasted, taxpayer and consumer provided capital and opportunity. The relationship between what has been spent on the large new electricity generating stations Medupi and Kusile and what has come out as additional electricity is especially egregious and damaging. As much as 1.1 trillion rands was invested in electricity, water and gas between 2000 and 2021. Much of it in electricity generation. Shockingly, almost unbelievably, the real output of electricity etc. has declined by 20% since 2000.

Electricity, gas and water. Capital Formation;  Constant (2015) and Current Prices

Source; SA Reserve Bank and Investec Wealth and Investment

Electricity, gas and water. Capital Formation and Valued Added 2000- 2020. Constant 2015 Prices

Source; SA Reserve Bank and Investec Wealth and Investment

The abject failures of other government agencies – of the provinces and in particular municipalities – to maintain the quality of the essential services they are tasked to provide, water, roads, sewage, building plans, education training and health care etc. has become ever more destructive of the opportunities open to business and households. Such failures are also reflected in the declining real value of the homes South Africans own –a large percentage of the wealth of the average household – which has made them less able and willing to demand additional goods and services from SA business.

Hopefully the economy will not stay on these destructive paths. Restructuring the ownership and incentive structures facing the public sector is an obvious and urgent requirement for faster growth- for more capital formation of the human and physical kind. As is reducing the reliance on the public sector to deliver the essentials.

But we need a meta explanation and understanding of why the public sector has failed South Africans so particularly badly to move forward.   The key political objective on which the public sector leaders were evaluated was clearly not the efficient use of resources, with quality of delivery related rewards, within sensibly constrained budgets. The Scandinavian model, if you like, did not apply. The primary objective set the new leaders of the public sector – and for which they were presumably judged and rewarded – was the transformation of the racial character of the public sector workforce. 

It is an economic truism that you get from people (managers and workers) what you pay them for. This key performance indicator, transformation, has been achieved with huge waste, financial and in foregone opportunities. Losses that were exaggerated by the opportunities the lack of attention to the costs of operations, and their value to consumers, offered for theft, fraud and the patronage of the incompetent.

The continued enthusiasm for demanding that the private sector to transform further and faster seems uninhibited by any comparison of the cost and benefits of forcing transformation. There is perhaps one consolation in all this- the private sector cannot ignore the bottom line in the way the public sector was able to do for so long.

Much notice is being given to the disruption of supply chains by lockdowns and by war in Ukraine. With hindsight, producing more of the essential components in-house or holding larger inventories to avoid relying on just-in -time delivery would have been a superior, that is less costly choice to have made. But very few firms are fully integrated. The steel mills are likely to outsource their sources of coking coal and the gold mines their sources of power -for obvious reasons- outsourcing is expected to be cheaper. A continuous comparison will be made of the expected costs of in or outsourcing all the different operations that lead to the final delivery of any product or service supplied. Such decisions help to determine the optimum size and scope of any enterprise. Less can well be more for shareholders.

All firms are defined by some mixture of in-house activity and goods and services contracted for. Even the accounting and human resource function may be outsourced to specialist service providers as easily as the company canteen. Decisions to outsource may hopefully mean a better focus on what are properly understood to be the essential ingredients for any thriving business. The objective should be to be realistic and prescient about how best to release the key competencies that make the firm competitive and are its essential reason for being and surviving. Strategic decisions to insource that make the firm larger and less specialised – or outsourcing to other firms- that makes it smaller and more specialised – cannot be outsourced.

Technological change alters the optimum size of any firm. That the decision to outsource the IT function to the computer cloud is seen as the right decision now, would not have been feasible twenty years ago. Then firms with heavy demands on data collection and processing would have had no choice but to invest in mainframes and tinker with legacy systems with large in-house IT departments. That may be very difficult to abandon. The operators in the cloud can reduce the danger of excess or deficient computing capacity by attracting a well-diversified customer base.  The market share gains of one customer can offset the losses of another competing with it, so adding to the predictability of the demand for an outsourced service or component. Such a pooling of business risks can be a great driver of economies of scale and allow the concentrator to offer competitive terms to a more specialised operation.

A similar explanation fits the component manufacturers who supply a variety of competing assemblers of appliances or automobiles whose core capabilities may be in the design and marketing of their badges – not in in-house manufacture at which they may not excel. Every entrant into the burgeoning electric vehicle industry is having to answer the important question – how much of our production could or should we outsource? The answer Tesla provided- producing its own batteries in its own very large factories with very substantial and fixed overhead costs – may no longer best serve the purpose. The enhanced scale of the specialist provider may also facilitate R&D on a scale that any inhouse department could not justify and could leave the integrated firm behind in the development of intellectual property – that can be hired on reasonable terms from the inventors. Firms no longer have to run their own warehousing and distribution systems. The delivery of goods produced is increasingly outsourced to specialist logistic providers who can deliver more cheaply or more conveniently to a variety of customers than can a firm hope to do running its own trucks and warehouses.  They can fill the return legs. Sales online to a global market have been made possible not only by the internet but by outsourcing delivery to the specialised courier.

These opportunities to outsource essential inputs in production or service provision are a huge boon to the entrepreneurs whose barrier to entry was traditionally limited access to capital- understandably – given their unknown potential. By outsourcing – by staying lean and capital light and highly focused – the start-up’s plans to compete become more viable. Good for them their customers and very good for the economy that hosts them.

Brian Kantor March 30^th 2022

The Quarterly Labour Force Survey released this week provides estimates of employment and unemployment that are way beyond the norm for developed economies for which employment surveys are designed. They come as no surprise. In Q4 2021, 262,000 more jobs were provided in SA  compared to the quarter before, while an additional 278000 more workers were declared unemployed, taking the unemployment rate marginally  higher to an extraordinary 35.03%. The SA labour force is estimated as 22.4 persons, of whom 14.5 million are working and 7.9 million are actively seeking work. The labour force represents but 57% of the working age population (ages 15-65)  which leaves 17 million adult South Africans not economically active

There is more to the depressed employment statistics in SA than slow growth. In 2000 there was 40% more persons employed per unit of GDP than there were in 2000. These latest estimates continue to show employment in SA lagging well behind GDP. Employment has flatlined at about 94% of their pre-lockdown levels.  GDP by contrast fell sharply to 84% of its pre-Covid levels by Q2 2020, but has since recovered to 98.3% of its pre-Covid level.

Employment and GDP (2019=100)

Source; SA Reserve Bank and Investec Wealth and Investment

The ratio of employment to GDP (2019=1)

Source; SA Reserve Bank and Investec Wealth and Investment

How are these employment statistics, particularly the unemployment estimatesto be interpreted and reconciled with estimates of income and expenditure in SA? Part of the problem with estimating unemployment, especially where the unemployed are not simply and conveniently measured when collecting unemployment benefits, is that the unemployed are largely self-defined in SA. One may be not working, yet very willing and able to work at short notice and indicate as such to a telephone enquiry from Stats SA and so be classified as unemployed. But such a respondent (perhaps in a rural area) may only be willing to work for rewards that are unavailable and unrealistic to expect.  Hence such a potential worker is not part of the labour force and more accurately should be regarded as not economically active, not as unemployed. South Africa may have an employment problem – not an unemployment problem on anything like the same scale.

The more the consumption power provided to households in kind and cash, other than via income from work, the higher will tend to be the wage that would makes it sensible for potential workers to supply and accept employment- what economists describe as the reservation wage below which it makes little sense to supply labour. Welfare benefits provided by the taxpayer, housing, medical care and cash grants, education, or help provided by an extended family, all help to raise the wage rates that employers have to offer when seeking a supply of workers. The tragedy is that so few South Africans qualify for the well-paid decent work offered by employers that would, if available, encourage many more of them to actively join the labour market. The excluded workers should blame the failures of the education system to qualify them for the decent work and accompanying benefits that formal employers mostly prefer to provide.

South Africa chose to address poverty with welfare rather than by encouraging employment. It was a humane response and SA was economically able to redistribute consumption power on a meaningful scale. But it has had consequences. The more generous the welfare system, the better the employment benefits that have to provided by firms seeking labour, the higher will be the level of wages and so the fewer workers employed. South Africa’s recent economic history of improved welfare and a smaller proportion of the population employed confirms this prediction. There is a negative relationship between the price of labour and the demand for it, even if denied by the economists (nogal) who advocate and regulate higher minimum wages.

Yet higher wages have also much encouraged the supply of and demand for immigrant labour who arrive in SA with lower reservation wages determined to support their families earning and transferring income to them. And who are more easily hired because that can be more easily fired. The unregulated, employment intensive sectors of the economy are heavily populated by migrants – perhaps unknown and un-estimated millions of them – many working illegally. And whose employment status will not be answered with a phone call. The employment problem is concentrated on South Africans with access to welfare benefits. How many are employed in South Africa is an unknown  

Cadre deployment is to be expected everywhere. Incoming US administrations do it as a matter of course. But why have so many of the most influential of the SA cadres proved so very fallible, as revealed in full gory detail by Zondo.? It is the leaders after all who set the standard. That crime may be expected to pay, given kickbacks to the right places, is part of an explanation. Short-term horizons “ if I don’t take advantage then my insider competitors will do so” may help explain some of the observed behaviour. There has been no lack of competition for the material opportunities offered in the South Africa that have gone well beyond what could be regarded as decent salaries and other employment benefits. Including the generous rewards provided for serving on the boards or management teams of the semi-autonomous government boards responsible for regulating private conduct. Of which many became notorious for providing opportunity for shopping/conference trips abroad and for contrived multiple Board meetings, for which valuable hourly attendance fees are unnecessarily charged.

The key posts in SA government departments and agencies turnover very rapidly with changes in the direction of the political winds – so paranoia of those in office is not irrational. The large financial gains observed coming from BEE – without any obvious relationship between input and benefits realized – may be a further influence. That you become be fabulously rich when lucky in your partnerships –obtained through your political connections rather than your observable efforts or skills – and through doing business with government on highly favourable terms because of these connections – is morally debilitating. And indicates for wide notice that competence or dedication is not necessarily rewarded nor essential to the purpose of getting on in life.

Repeat business is the most valuable source of sales and profits for any business. It helps to keep their owners and workers honest and competitive striving to enhance valuable reputations for fair dealing. Governments departments or agencies however have monopoly power. A trust in their good practice is to be heavily relied upon. It is a trust demanded of those teaching a class, serving in a public hospital or in a police or border post enforcing the law. Yet we need them at more than they seem to need us. We wait in line or on-line patiently and smile obediently. We are not customers but supplicants of the government agencies with great influence over us. Imagine life without a passport, visa, vaccination certificate or a driving license, a good education, or a well-organized casualty ward? We would like to believe that the public servants are trying as hard as they know how, to please us. Because that is the right respectful way.

Unconstrained self-interest cannot fully explain what has gone on in SA. It calls for explanations made better by psychologists. philosophers or historians than economists. Do we understand the derivation of the values that determine the culture of the workplace? Can we explain how a sense of honour, honesty, patriotism or duty is developed to help set the reasonable and realistic expectations of the supplier and user of services of all kinds? Helpful attitudes and good performance are encouraged by a strong sense of vocation- a sense of a job worth doing well. For what are widely recognized as appropriate material rewards that can be well understood and accepted by all parties involved. How are they cultivated? They are part of the implicit employment, or what can be understood more broadly, as a social contract. The best standards do not emerge overnight and should be actively cultivated. Ethics has to be well taught.

When regimes change and the power structures change radically with it, a strong sense of life changing opportunities can become overwhelming and corrupting. The large gains achieved in SA via misgovernment have been highly very damaging to the incomes and prospects of most South Africans. It will take acknowledgement and understanding of it as the path to an agreed much improved moral order and stronger economy. It calls for a new social contract, the hope for a Zondo inspired devotion to doing your duty for fair reward and for obeying and enforcing laws justly made and deservedly respected. A community of those wanting to give service rather than take unfair advantage of their favoured status could become the new morality.