Category: Global Financial Markets

In years to come the 2023-24 years will be recognized as very special ones for share owners. Something to toast over what may prove to be an equally special Grand Cru. One that, thanks to the exceptional draw up in market values, has become more affordable to the patient investor. A case of what the wine cognoscenti might describe as linearity- from much extra wealth created to the wine cellar.  Though why a straight uncomplicated line from lips to throat, should be regarded as an attribute of a fine wine escapes me. I thought one pays up for complexity in wines, never simply described.

This past year the S&P 500 delivered the best annual returns this century. Comparable to the recovery from the panic drawdowns of 2008 (GFC) or 2020 (Covid) The Index, up 30 % in the twelve months to September 2024 was very generously valued a year ago -at 21 times earnings. It is now even more expensive and valued at 25 times reported earnings. The average S&P P/E since 2000 has been 19.7 times. Unusually It has not taken a draw down to lead a strong recovery. This time has been different. Strength on Strength.

The S&P 500 Index Annual Returns – calculated monthly 2000-2024

Source; Bloomberg and Investec Wealth and Investment.

The upward direction of the S&P Index recently has been dominated by a few stocks- the so described magnificent seven- making the Index unusually concentrated, less diverse and therefore more risky than usual.  The top three by market value Microsoft Corp., Apple, Inc., and Nvidia Corp., constituted 20% of the S&P 500 this year, while the top seven stocks accounted for 32%. 

Yet while the S&P 500 is up 22% this year to September, the equal-weighted S&P 500, the average listed company, is up by less – a mere 14.9%.  During the first half of the year, the S&P 500 rose by 15.2%, and by 5.9% in Q3, while the equal-weighted S&P 500 increased by only 5% over the same period. This greater than 10% performance gap between the weighted and unweighted indices was the widest in nearly 30 years. Only about a quarter of S&P 500 stocks kept pace with the market’s overall return during the first half of this year, with over a quarter experiencing negative returns. If you did not own the very largest stocks and own them in size, you likely underperformed the indices. Risk (less diversification) and return were as usual well correlated.  

The “magnificent seven” and so the market are valued for the prospective growth in the demand for artificial intelligence that they supply the backbone for. But their investment case so strongly appreciated will only be fully revealed over time. This makes their valuations less dependent on near term earnings and so on the essentially short-term business cycle. They are valued much more idiosyncratically than your average value company on their own recognizances. They have also grown earnings and cash flows at well above the average rate to date. These super growers with impressive track records are allocating truly massive volumes of internally generated cash flows to supplying the essential facilities that the average firm will be drawing upon and hopefully paying up for.  They also have the financial strength to pay dividends and buy back shares. In contrast, the average S&P 500 company is valued more heavily on the short-term outlook for the U.S. economy.  About which there has been and perhaps will always be considerable uncertainty.

The S&P 500 Index, the equally weighted S&P Index and the JSE All Share Index. Total returns to October (2023=100) USD Values

Source; Bloomberg and Investec Wealth and Investment.

The JSE has also enjoyed a very good year. Up by as much as the S&P since October 2023. 40% in USD and still impressively 28% higher in the mighty ZAR. The JSE All Share Index measured has added as much to SA portfolios as would have holding the S&P Index. A wealth adding outcome for old-fashioned reasons. The prospect of faster growth has fired up the share market and the value of RSA bonds and the exchange rate. Less inflation, lower interest rates and faster growth in GDP and government revenues has been very heady stuff. Enough perhaps to add to the prices bid at the Wine Guild Auction and deserving of an early toast to the GNU.

The S&P 500 Index, the equally weighted S&P Index and the JSE All Share Index. Total returns to October (2023=100) Rand Values

Source; Bloomberg and Investec Wealth and Investment.

The financial markets have welcomed the Government of National Unity (GNU) The reactions in the bond market have been particularly favourable. The JSE All Bond Index on August 26^th was up by 11.4% since the election of May 2029. The share market was up by 7.1% while the ZAR has gained 4% vs the US dollar and vs other EM currencies. Given the importance of equities and bonds held by SA households in unit trusts and pension plans (some 15.2 trillion rands worth at year end 2023) representing 85% of all the assets held by SA households) such market moves have already had a very significant impact on the wealth of South Africans.

The promise of faster growth has added close to 10% or over 5 trillion rands mutual funds to the SA household balance sheet. Extra real money indeed and helpful for stimulating additional household spending, of which SA has had too little of for many years now. [i]It is not only the supply side constraints that have held back the economy. Demands from households and the firms that serve them have been insufficient to drive growth above an immiserating 1% a year.

The importance of the judgments of the global capital market of SA economic policy for the average South African, their hopes for employment and a comfortable retirement, for which they sacrifice heavily, cannot be underestimated.  

Post election movement in the Financial Markets. Daily Data – May 29^th – August 26^th 2024. May 29^th=100

Source; Bloomberg, Investec Wealth & Investment.

The strength of the ZAR is particularly welcome. It brings with it lower inflation and lower short-term interest rates essential for a recovery in the economy. The positive link between the outlook for growth and the behaviour of the ZAR has again been emphasised, (more growth stronger rand and vice versa) as has the link between a stronger rand and inflation.

There is no room for complacency. The status of RSA debt has improved, but interest rates and the cost of capital remain elevated. Our credit rating remains significantly weaker than it was between 2002 and 2008 when our economy did grow at close to 5% p.a. (see below)

The RSA Credit Rating. The CDS spread between the yield on RSA 5 year USD Denominated Bonds and a 5 year US Treasury Bond

Source; Bloomberg, Investec Wealth & Investment.

There is much room to further impress investors. By taking economic policy decisions now, that by promising faster growth over the longer term, could immediately further strengthen the bond and currency market.

The National Health Initiative, now being actively promoted, does the opposite. It promises more of the same fundamental weaknesses that have infected all the State directed enterprises to date. The direction of health care reforms should also be one of seeking partnerships with the private sector- with private hospitals and practitioners. It calls for experimenting with the private control and management of hospital services. Hospitals currently funded by the State that perform so poorly on all metrics, including the costs of supplying inferior service.

A helpful positive note was offered by the Transnet CEO. Michelle Phillips who said yesterday that  “…the entity’s move to maintain run and invest at Ngqura and the 670km container corridor would be reworked after potential bidders complained that the conditions attached to the tender were too stringent and costly for the private sector to fully participate..” (BD August 28 Thando Maeko)

The public sector in SA, in all its guises, needs to come to realistic terms with the potential providers of private capital and skills that are essential to our economic purpose. Their managers need to fully understand how to deal with potential private sector partners who operate globally.  Such knowledge applies to plans for ports and railways and refineries, for the supply of water and the transmission of electricity. And for bringing minerals, oil and gas to the surface. And to recognise the terms and conditions, no more or less than internationally competitive terms, that would bring potentially abundant and truly economic game changing offshore gas, onshore. Offering credible deals of this kind would be enough to move the markets.  And so immediately, with lower interest rates and a stronger rand and less inflation, would help realise the growth in incomes and employment necessary to re-elect a GNU in 2029.

[i] I am drawing on a recent comprehensive analysis of the SA balance sheets by J.Makoena and K Setshedi published in the SA Reserve Bank Quarterly Bulletin, June 2024. The study shows how very well developed are pension and retirement savings in SA (120% of GDP) are compared to other emerging economies. And so the importance of investor sentiment for SA wealth owners.

Dealing with Covid in 2020 was a frightening episode. The JSE All Share Index lost 20% of its value by March that year and the S&P 500, suffered a very similar drawdown, of 20% in USD. Yet something predictable then followed. Between January 2020 and July 2024 share markets have given very good returns and they have outperformed bonds and cash by large margins. R100 invested in the JSE immediately pre Covid with dividends reinvested, would now be worth R173. Had the R100 been invested in the S&P 500 it would now be worth significantly more R236. The same R100 if invested in the Bond Index or in a money market fund with interest reinvested would have grown to only R144 and R130 respectively.

A predictable outcome–given the large outperformance by a representative share portfolio on the JSE since 2000, or for that matter also since 1980 or 1960. The R100 invested in the JSE Index in 2000 would have grown to R2152 that is by 21 times at an annual average rate of return of 13.12% p.a. The R100 in money market would have grown by 6.3 times and the Bond Index by 10.6 times over the same period. Incidentally the JSE has kept up with the S&P also measured in rands over these 24 years. The JSE outperformed significantly until 2010 and has underperformed since.

The JSE has therefore recovered very well from significant periodic drawdowns since 2000, 40% down in 2002, 51% in 2008, 24% after Covid and 15% with Fed tightening in 2022.

Equities are expected to give superior returns because they are more risky to hold than cash or bonds. The higher returns expected of equities compensate for the different risk of losses investors believe they are exposed to holding shares. Higher expected returns mean lower entry prices for investors,  all else remaining the same. And these expected extra returns have been delivered to date by most Stock Exchanges.

Share prices move each day about an average of close to zero. They demonstrate a random walk with hopefully upward drift to give the expected positive returns over the long run. The more difficulty investors have in interpreting the news about a company or an economy, the wider are the daily swings in prices in both directions. This volatility gives rise to an objective measure of risk. It will be reflected in the cost of an option to insure against volatility. Investors can buy or sell a volatility index, the VIX, based on the underlying volatility of the S&P 500. When S&P volatility (risk) rises share prices fall. And vice versa They do so to improve or reduce prospective returns, in a statistically significant way.  As has again been the case this year.

Yet were share market returns measured over longer periods, the risk of an in period loss falls significantly. The average returns when investing on the JSE or S&P market are very similar when returns are measured over one, five or ten year holding periods. Since 2020 returns for holding the S&P Index have averaged about 14% over one year and 11.1% p.a. and 11.2% p.a. when calculated over consecutive five year and ten-year periods respectiverly. However, the Standard Deviation (SD) of returns about the average has been much higher for one-year returns (13.87) than for five or ten year returns with SD’s of 2.93 and 1.96. The same relationship holds when the analysis is taken back to 2000. Risks (the SD or volatility of returns) have fallen sharply when the investment period is extended beyond one year. Absolute losses when returns are measured over five- or ten-year periods occur rarely. It took a Financial Crisis to do so.

The extra expected returns for extra equity risk applies to the averagely risk-averse investor with limited wealth. When you are investing for you children and grandchildren and their children, and are wealthy enough not to have to worry about being forced to cash in your shares, you can invest without much risk -and you can expect to pick up the money left on the table by the more risk averse.  Further support for time in the market – not timing the market.

You might have expected more volatile markets, in this election year. The evidence however suggests otherwise. Investors on the JSE and the New York Stock Exchanges have coped comfortably well with the potential dangers.  Daily volatility on both share markets, the scale of daily ups and downs in average share prices, has been unusually subdued, and well below long term averages in the US. Electing a scoundrel or a cognitively challenged US President has not made much of a difference to stability in the US markets The coalition outcome in SA proved welcome but not much of a surprise, again as judged by volatility trends. The Volatility Index for the S&P 500 – the VIX-  also known as the Fear Index- has averaged 13 this year well below a daily long-term average 2000-2024 of 19. The equivalent construct for the JSE, the SA Volatility Index (SAVI) – with a similar long-term average of 21, has also trended lower this year.

As may be easily observed the chances of an Index or any well traded share moving higher or lower on any day are about the same. The pattern is thus of a random walk, of ups being matched by downs of roughly the same average magnitude. Yet happily for shareholders these movements have come with a slight upward bias, above a daily average of zero, to provide shareholders with positive returns over the longer run. If they stayed invested in the share market the end result has been strongly positive annual returns over five or ten year periods rolled back each month.

(See below the daily moves of the S&P 500 and the JSE All Share Index in 2024. We also show the Daily SAVI in 2023-24 as well as actual volatility of the JSE – calculated as the rolling 30 day Standard Deviation about the Daily Average Share Pirce Move)

Daily % Share Index Movements on the JSE and the S&P 500 in 2024

Source; Bloomberg and Investec Wealth & Investment

Daily Moves in the SA Volatility Index (SAVI) and Volatility Measured as the Standard Deviation of the JSE (Annualised as a rolling 30-day average)

Source; Bloomberg and Investec Wealth & Investment

When daily volatility is more elevated, share prices will change consistently in the opposite direction. When the VIX or SAVI goes up share prices go down most days. They do so to improve the chances of higher risk adjusted returns- off a lower entry price- to compensate for more risk incurred.  And vice versa. In 2024 it has been vice versa in the US and in SA- risks have fallen and values have improved.  Extra risk comes with more returns and vice versa as nature intends. (see below)

The average move for the JSE in 2024 in the six months to June 2024 was an encouraging 0.27% per day. The S&P did only half as well- providing an average gain of 0.11% per day.   

Daily % Changes in the VIX and the S&P 500 in 2024. Scatter Plot

Source; Bloomberg and Investec Wealth & Investment

Daily % Changes in the SAVI and the JSE in 2024. Scatter Plot

Source; Bloomberg and Investec Wealth & Investment

It is the quality of economic policy, more than the presumed certainty of such policies, good bad or somewhere in between, that will matter much more for financial markets in the long run. Any willingness of investors to accord a SA facing business an  extended economic life will also add to present values. Provided the Return on Equity (ROE) exceeds the opportunity cost of capital, faster expected growth for a longer term, can explode the current present value of a share and market multiples. Price over Current Earnings or Cash flows and Market to Book ratios.

An accompaniment of lower ROE’s and a lower discount rate attached to future surpluses would also add much additional market value to SA companies.  And to their willingness and ability to undertake and fund growth enhancing capex and employment. Faster growth if realised will add to an extra flow of cash to the government, bringing less risk to the fiscal outlook. And be reflected in lower interest and discount rates across the board and in higher share prices.

Extra wealth created in the bond and equity markets, is a game played by all with formal employment and retirement plans, and not only the richer few. The capital markets will provide an objective measure of the performance of the government of national unity (GNU) The score will be continuously kept and updated. While investors have not been frightened by the GNU, they have still to give approval. Over to the GNU.

Dealing with Covid in 2020 was a frightening episode. The JSE All Share Index lost 20% of its value by March that year and the S&P 500, suffered a very similar drawdown, of 20% in USD. Yet something predictable then followed. Between January 2020 and July 2024 share markets have given very good returns and they have outperformed bonds and cash by large margins. R100 invested in the JSE immediately pre Covid with dividends reinvested, would now be worth R173. Had the R100 been invested in the S&P 500 it would now be worth significantly more R236. The same R100 if invested in the Bond Index or in a money market fund with interest reinvested would have grown to only R144 and R130 respectively.

Cumulative Returns by Asset Classes (2020=100)

Source; Bloomberg and Investec Wealth & Investment

A predictable outcome–given the large outperformance by a representative share portfolio on the JSE since 2000, or for that matter also since 1980 or 1960. The R100 invested in the JSE Index in 2000 would have grown to R2152 that is by 21 times at an annual average rate of return of 13.12% p.a. The R100 in money market would have grown by 6.3 times and the Bond Index by 10.6 times over the same period. Incidentally the JSE has kept up with the S&P also measured in rands over these 24 years. The JSE outperformed significantly until 2010 and has underperformed since.

The JSE has therefore recovered very well from significant periodic drawdowns since 2000, 40% down in 2002, 51% in 2008, 24% after Covid and 15% with Fed tightening in 2022.

The JSE All Share Index Cumulative Returns (2000=100) Per Cent Draw Downs Indicated on X axis

Source; Bloomberg and Investec Wealth & Investment

Equities are expected to give superior returns because they are more risky to hold than cash or bonds. The higher returns expected of equities compensate for the different risk of losses investors believe they are exposed to holding shares. Higher expected returns mean lower entry prices for investors,  all else remaining the same. And these expected extra returns have been delivered to date by most Stock Exchanges.

Share prices move each day about an average of close to zero. They demonstrate a random walk with hopefully upward drift to give the expected positive returns over the long run. The more difficulty investors have in interpreting the news about a company or an economy, the wider are the daily swings in prices in both directions. This volatility gives rise to an objective measure of risk. It will be reflected in the cost of an option to insure against volatility. Investors can buy or sell a volatility index, the VIX, based on the underlying volatility of the S&P 500. When S&P volatility (risk) rises share prices fall. And vice versa They do so to improve or reduce prospective returns, in a statistically significant way.  As has again been the case this year.

Risk and Return on the S&P 500 in 2024 (Daily % Moves in the S&P Index and the VIX) R = (-0.68)

Source; Bloomberg and Investec Wealth & Investment

Yet were share market returns measured over longer periods, the risk of an in period loss falls significantly. The average returns when investing on the JSE or S&P market are very similar when returns are measured over one, five or ten year holding periods. Since 2020 returns for holding the S&P Index have averaged about 14% over one year and 11.1% p.a. and 11.2% p.a. when calculated over consecutive five year and ten-year periods respectiverly. However, the Standard Deviation (SD) of returns about the average has been much higher for one-year returns (13.87) than for five or ten year returns with SD’s of 2.93 and 1.96. The same relationship holds when the analysis is taken back to 2000. Risks (the SD or volatility of returns) have fallen sharply when the investment period is extended beyond one year. Absolute losses when returns are measured over five- or ten-year periods occur rarely. It took a Financial Crisis to do so.

The extra expected returns for extra equity risk applies to the averagely risk-averse investor with limited wealth. When you are investing for you children and grandchildren and their children, and are wealthy enough not to have to worry about being forced to cash in your shares, you can invest without much risk -and you can expect to pick up the money left on the table by the more risk averse.  Further support for time in the market – not timing the market.

Returns on the S&P 500 Index. Over One, five and ten year periods.  Monthly Data 2020- 2024.

Source; Bloomberg and Investec Wealth & Investment

There is a confident calm in the SA financial markets despite the upcoming election the outcomes of which are surely uncertain. Since about two weeks ago the premium for accepting the risk of a SA debt default, measured as the spread between the yields on RSA dollar denominated debt and USA Treasury yields, narrowed marginally to 2.5% p.a by May 7th. It was 2.71% on April 25^th. The spread between RSA and USA 5 year bond yields, has remained stable though it is still a discouragingly wide 5.8% p.a. as US and RSA interest rates moved lower off recent highs.  Very recently the US dollar has become a little less expensive and value of the ZAR has improved when exchanged for other EM currencies, both by about 2% between since April 25^th – which appears as the recent turning point in sentiment – and May 7th

Interest rate spreads and exchange rate ratios. April – May 2024- Daily Data

Source Bloomberg and Investec Wealth & Investment

Interest rates, by themselves, tell us little about the rewards for saving or the cost of borrowing. It is after inflation interest rates, that reflect the real rewards for saving and the real cost of issuing debt. Real rates have declined with inflation in the developed world since the mid-eighties. Post covid the long decline in real and nominal bond yields appears to have reversed accompanied by higher inflation. Inflation and nominal and real interest rates in SA have remained comparatively elevated, even as inflation has receded. Since 2000 the real after realised inflation rate for an RSA 10 year Bond has averaged 3.7% p.a. while a US Treasury has offered on average a real less than 1% p.a. The current RSA-USA real yield gap is a large 6% p.a. for ten-year money. Making for undesirably expensive capital for the SA public and private sectors.

Real (after inflation) Long term Interest Rates in SA and the USA

Source; Bloomberg, Federal Reserve Bank of St.Louis, SA Reserve Bank, Investec Wealth & Investment

Yet with the advent of inflation protected government bonds rather than be exposed to potentially harmful, inflation events, that reduce the purchasing power of their interest income lenders can own fully inflation protected bonds. Bonds that are guaranteed to maintain their purchasing power regardless of the inflation outcomes. Since 2010 the RSA ten-year inflation linker has offered an average real 2.84% p.a. compared to an average 0.32% p.a. for the US equivalent. This real yield gap has widened significantly in recent years as RSA real yields have risen. The RSA inflation linked ten-year bond currently offer an impressive 5.3% compared to 2.1% for the US TIPS- a real spread of over 3% p.a.

Real Inflation Protected Yields in South Africa and the US. 10-year Government Bond Yields

Source; Bloomberg, Investec Wealth & Investment

Why has this high real 5.3% p.a. inflation protected yield not attracted more investor interest and a higher value? It is a rand denominated bond with no default risk- and no inflation risk. To which the equivalent vanilla bond is subject to – and to default through inflation – should control of the money supply be abandoned, as is always possible, should governments become irresponsible spenders. The current yield on an inflation exposed RSA vanilla bond with ten years to maturity is now about 12% p.a.  And after inflation, if maintained around the current 5%, would become a very realised high real yield- and very comparable with the yield on the inflation linker.

These RSA nominal and real yields are closely connected and elevated, by expectations of rand weakness. A market-based weaker expected exchange rate is revealed by the positive difference between RSA and USA borrowing costs and interest rates over all durations, from 3 months to ten years. This carry, or equivalently, the actual or potential cost of hedging rand exposure by buying dollars for forward delivery, reduces the actual or expected dollar returns on SA debt held by foreign investors. That is when they convert rand income, be it inflation protected or exposed,  and capital gains in rands into dollars when exiting a trade in a rand denominated security, they will be well aware of the dangers of rand weakness. If they expose themselves to rand risks and do not hedge their exposure with forward cover, they will make a dollar profit when the rand weakens by less than the carry, that is by less than the difference in SA and US interest rates over the investment period. If the rand weakens by more than the carry they will have been better of holding the lesser interest paying, dollar denominated security.

The SA carry, the expected move in the USD/ZAR exchange rate, is however consistently much wider than the difference in actual and expected SA and US inflation. One might surmise that movements in exchange rates equilibrate differences in inflation and differences in expected inflation between trading partners. To level the foreign trading field. But this has not at all been the case. Since 2010 the highly volatile USD/ZAR has weakened on an annual average rate of a 6.3% p.a. The comparatively stable ten-year carry, the average extra cost of buying dollars for forward delivery,  has averaged 6.53% p.a. while the difference between expected inflation in SA and the US, has averaged a fairly consistent 4% p.a. While the difference in realised inflation has averaged a mere 2.9% p.a. These long-term trends have made the USD/ZAR a consistently undervalued, therefore highly competitive exchange rate.

Reducing inflation will reduce interest rate levels and unhelpful interest rate volatility and real rates, as the Reserve Bank has asserted it is likely to do. But it will not necessarily make the rand more competitive as the Bank also asserts. With lower inflation the exchange rate might weaken by less than the difference in realised inflation rates between SA and in our trading partners. In which case lower interest rates and a stronger rand could well be accompanied by a less competitive exchange rate.

Interest and Exchange Rate Trends. Annual Data

Source; Bloomberg, Federal Reserve Bank of St.Louis, SA Reserve Bank, Investec Wealth & Investment

Persistently lower SA inflation and lower interest rates will therefore require not only less inflation, but less expected exchange rate weakness. That is a reduced difference between SA and US interest rates as SA interest rates fall.

How could this be achieved? A stronger rand and a stronger rand expected, and with it less inflation realised and expected, can only come with faster real growth, that would bring more favourable flows of taxes, proportionately smaller fiscal deficits and issues of RSA debt- given also restrained government spending linked closely to the same real growth trajectory. The Reserve Bank has limited influence on essential supply side reforms that would be essential to raise the actual and expected growth rates. The Reserve Bank lacks any predictable influence on the most important leading inflation indicator, the exchange rate, influenced as it is so strongly by global risk appetites as well as economic policy successes or failures. Interest rate increases at the short end of the money markets should never be used to fight rand or domestic currency weakness generally. Exchange rates should be left to market forces, and the wider spreads that accompany exchange rate weakness and the higher prices that temporarily accompany currency weakness are very hard to overcome without additional damage to the spending side of the economy. The Bank of Japan has been learning as much.

A wider or ideally a narrower carry, that is the interest rate spread between economies and currencies is part of a new equilibrium in financial markets.  It reflects the adjustment to more or less perceived exchange rate risk and less or more capital supplied to a domestic financial market. It calls for the right supply side reforms that lead to faster growth and improved expected risk adjusted returns from additional private capital supplied willingly to domestic borrowers. Including to the government, the borrower that sets the level of interest rates.

The Reserve Bank as should other central banks effectively manage the demand side of the economy, so that demand, under the influence of real short term interest rates, does not exceed potential local supplies, nor fall short of them. So to avoid upward or lower pressure on prices and incomes, wage and interest incomes included. This is far from the actual state of the SA economy today. It suffers from too little rather than too much spending. The Bank could now help growth and the foreign exchange value of the ZAR by reducing what are very high nominal and real short term interest rates that have throttled domestic spending. 

Brian Kantor, 7^th March 2024.

Lenders demand compensation for expected inflation with higher interest rates and borrowers are willing to pay more when higher prices are expected to erode their real borrowing costs. Interest rates, after inflation, therefore reveal the real rewards for saving and the real cost of issuing debt. Real interest rates in SA have remained elevated, even as inflation has receded. Since 2000 the real income owning a RSA 10 year Bond has averaged 3.7% p.a. while a US Treasury has offered on average less than 1% p.a. The current RSA-USA 10 year real yield gap is a large 6% p.a.

Real (after inflation) Long term Interest Rates in SA and the USA

Source; Bloomberg, Federal Reserve Bank of St.Louis, SA Reserve Bank, Investec Wealth & Investment

With the advent of inflation protected government bonds, lenders can now avoid exposure to uncertain inflation. They can buy a bond with a guaranteed real return. That is receive an initial yield to be augmented by actual inflation. Since 2010 the RSA ten-year inflation linker has offered an average real 2.84% p.a. compared to an average 0.32% p.a. for the US equivalent. This real yield gap has widened significantly as RSA real yields have risen. The RSA inflation linked ten-year bond currently offers an imposing 5.3% compared to 2.1% for the US TIPS- a real spread of over 3% p.a. Capital is really very expensive in SA and discourages capex.

Real Inflation Protected Yields in South Africa and the US. 10-year Government Bond Yields

Source; Bloomberg, Investec Wealth & Investment

Why has this high 5.3% p.a. real yield not attracted more investor interest and a higher value? It is a rand denominated bond with no default risk- and no inflation risk. To which the equivalent vanilla bond is subject to – and at worst should inflation accelerate – to the effective expropriation of wealth tied up in a bond. The current yield on an equivalent vanilla bond is now about 12% p.a.  Time will tell whether it delivers a real return in excess of the certain 5.2% on offer from the inflation linker.

All the RSA bond yields are connected and elevated by expectations of rand weakness.  That reduces the expected dollar returns for any foreign investor. The weaker expected course of the rand is revealed by the positive difference between RSA and USA interest rates over all durations. This carry, or equivalently, the actual or potential cost of hedging or compensating for exposure to the rand, reduces the actual or expected dollar returns on SA debt held by foreign investors who are an important source of capital for the RSA. It is expected returns in dollars not rands, even inflation adjusted rand income, that guides their investment decisions.

This carry, is moreover consistently wider than the difference in actual and expected SA and US inflation. One might surmise that movements in exchange rates equilibrate differences in inflation between trading partners, to help level the foreign trading field. But this has not at all been the case. Since 2010 the highly volatile USD/ZAR has weakened on an annual average rate of a 6.3% p.a. The comparatively stable ten-year carry has averaged 6.53% p.a. while the difference between expected inflation in SA and the US, has averaged a consistently lower 4% p.a. While the difference in realised inflation in SA and the US has averaged a mere 2.9% p.a. Persistently lower SA inflation will therefore require not only less inflation but also less expected exchange rate weakness, that is a narrower carry.

Interest and Exchange Rate Trends. Annual Data

Source; Bloomberg, Federal Reserve Bank of St.Louis, SA Reserve Bank, Investec Wealth & Investment

A stronger rand and a stronger rand expected, can only come with faster real growth. The Reserve Bank has limited influence on growth enhancing supply side reforms including any predictable influence on the exchange rate with its interest rate settings. It should manage the demand side of the economy, so that demand, under the influence of real short term interest rates, does not exceed potential local supplies, nor fall short of them, to put avoidable domestic pressure on prices and incomes. The Bank could now help growth and the foreign exchange value of the ZAR by reducing what are very high nominal and real short term interest rates that have throttled domestic spending. 

March 31^st 2024

Over the past 20 years institutional fund allocators have fallen in love with high-fee paying, internally valued, and illiquid private investment strategies known as Private Equity (PE). The PE industry has evolved from a small cottage industry to a very important asset class. The PE partnerships that manage the process have gone the other way. Converting from small private partnerships to highly valued public companies.  With their revenue and earnings and market value propelled by the ever-increasing inflow of assets they have captured from institutions. Supporting strategies that promise to ignore the “hated” and unavoidable volatility associated with owning listed stocks. Their founders are the new Titans of Wall Street.

These PE managers typically invest alongside their pension fund and endowment partners in the series of multiple separate funds (partnerships) they initiate and raise capital for.   The largest the Blackstone Group Inc. has over $1 tr of assets under its management (AUM) and a stock-market value of $155b. Other prominent names in the category include KKR, the Carlyle Group, Apollo, Ares, Blackrock and Brookfield.

For privately owned operating companies sourcing capital from these private equity funds has clearly become an increasingly viable alternative to an initial public offering of their shares. The number of publicly listed companies traded on US exchanges has fallen dramatically from a peak in 1996 of 8,000 plus. Now only 3700 companies are listed in the US. Astonishingly there are now about five times as many private equity-backed firms in the US as there are publicly held companies according to the Wells-Fargo Bank.

Staying or going private works because the private co-owners and managers of their business operations are very likely to focus narrowly on realising a cost of capital beating return on the capital at risk, including their own capital. The controllers of the private equity funds are aware of the advantages of appropriately incentivised owner-managers. They design their contracts with the private companies they oversee accordingly. And the private companies that the funds invest in will also be encouraged to raise debt to improve returns on less equity capital.

Regular fund valuations and annual returns on the funds however are conveniently based on internal calculations of net asset value. Reporting smoother annual returns, so calculated, than provided by listed equity plays well in the annual performance reports provided to trustees of pension funds and endowments. Moreover, if returns on equity generally exceed the costs of finance over the long run, as expected, the case for leveraging returns on equity capital with more debt is a powerful one. And lenders also like smoother, predictable returns, especially when secured by the pre-commitments to subscribe funds when called. The longer the call for capital by the funds can be delayed, the higher will be the returns on the lesser equity capital invested.

A further advantage is that their private companies supplied with capital will be given time –five to up to ten years – to prove their business case – before the funds have to be liquidated. Perhaps via an initial public offering of shares (IPO) public market conditions permitting. Or a sale of assets to another PE fund. Perhaps even rolled over to a new fund raised by the same fund manager. The performance fees paid to the private equity firms themselves (perhaps 20% of the capital gain) will be realised on the final liquidation of a fund. Management fees of typically 1-1.5% p.a. on AUM will also be collected. These performance fees account for a large proportion of the fund manager’s revenue.

Yet paradoxically it would have been an even better idea to have become a General rather than a Limited partner in these burgeoning private equity funds. That is owning the shares of the listed private equity managers as an alternative to subscribing to one of their funds. The shares of six of the largest listed PE managers – yes volatile and market-related – have SIGNIFICANTLY outpaced the excellent performance of the S&P 500 Index itself. And PARADOXICALLY outperformed most of the funds they have managed. Taking more risk in PE investments has had its reward. (see below)

Listed Private Equity Companies; Market Cap weighted value of six large listed PE managers. (2014=100) Month End Data.

Source; Bloomberg, Investec Wealth and Investment International

The odds on a US recession in the next twelve months have receded in the light of the continued willingness of US households to spend more- despite much higher interest rates and reductions in the supply of money and bank credit.  Spending on goods and food services rose by 0.7% in September on top of a robust increase of 0.8% in August. The annual increase in retail sales is 3.7% and the increase over the past three months is running at an annual equivalent of 8% p.a. Prices at retail level are falling. They stimulate demand but they also devalue the inventories held to satisfy demand. Prices have their supply and demand causes. They also have their effects on demand- and supply. Lower prices stimulate demand and incomes are now growing faster than prices.

All that is holding up the US CPI – now 3.7% up on a year ago – are house prices – and what are imputed as owners’ equivalent rent. That is at what the owners could earn if they rented their homes  They are up 7% on a year before. They have a huge weight in the CPI – over 25% – and if excluded from the CPI – would have headline inflation running in the US below the 2% target. Cash rentals account for a further 7% of the US CPI. By contrast food eaten at home carries a weight of only 8.6% in the CPI and food eaten out is 4.8% of the US CPI Index. SA also includes owners’ equivalent rent in its CPI with a weight of 12.99% and actual rentals account for only 3.5% of the index. Both rental series in SA are up by a below average 2.6% on a year before. The headline inflation rate in SA was 5.4% in September.

Owners equivalent rent is a very different animal to other prices. Higher implicit rentals based on the improved value of an owner’s home are not the usual drag on spending. The extra wealth in homes, as would all increases in household wealth, more valuable  pension plans, more valuable share portfolios, etc. will encourage more, not less spending. The boom in US house prices post Covid has had much to do with the ability and willingness of US households to spend more and help push up prices generally. Average house prices in the US are now falling under pressure form much higher mortgage rates and house price inflation to date will be falling away rapidly as will owner’s equivalent rentals. Thus helping to reduce headline inflation.

The question investors are asking about both inflation (falling) and the state of the economy ( holding up) is what will it all mean for interest rates. The stronger the economy the lesser the pressure on the Fed to lower short rates. And the greater will be the pressure on long term rates in the US. The key ten-year Treasury Bond is now offering 4.9% p.a. reaching a 16 year high.  In the share market what is expected to be gained on the swings of earnings may be lost on the roundabouts of higher interest rates, used to discount future earnings. But if inflation is subdued, any visible weakness in the economy, can be followed immediately by lower interest rates. This thought will be consoling to investors.

The attention paid to GDP by investors is fully justified. Where GDP goes so will the earnings reported by companies. Their correlation since 1970 is (R=0.97) Though helpfully to shareholders in recent years earnings have been running well ahead of earnings indicating widening profit margins from the IT giants. GDP , on a quarter-to-quarter basis, is a highly volatile series. Though growth in earnings is much more volatile.

US GDP and S&P 500 Earnings. Current values. (1970=100)

Source; Bloomberg, Federal Reserve Bank of St. Louis  and Investec Wealth and Investment.

The underlying trend in GDP and earnings will never be obvious. To make sense of their momentum, to recognize some persistent cycle, the data has to be smoothed and compared to a year before. Thus we will know only in a year or more whether the US economy has escaped a recession. It is not recessions that move markets, only expected recessions do so. And the jury will always remain out.

GDP and S&P 500 Earnings Growth Quarter to Quarter % Annualised.

Source; Bloomberg, Federal Reserve Bank of St. Louis and Investec Wealth and Investment.

Politicians propose spending and revenue plans – but the bond market disposes and not always kindly. In the UK plans to combine tax reforms that only work gradually with an immediate massive increase in subsidizing the consumption of energy with borrowed money was apparently a step too far for lenders to HMG and the governing party.  

Yet long term interest rates in the US and Europe were also rising rapidly. In Germany Ten-year money yielding negative rates in January had increased to 2% p.a. by October. US   US Treasury Bonds that offered 1% p.a. in early January 2022 now yield over 4% p.a. and indeed offer more interest in US dollars than the much battered 10 year gilts.

Long Term (10 Year) Interest Rates in the US, UK and Germany. Daily Data to October 25th

Source; Bloomberg and Investec Wealth and Investment

Blaming all this wealth destruction on a potentially profligate UK government is further complicated by the fact that not only were nominal interest rates on the rise – more so were real rates. Real ten-year yields in the US now deliver a yield of close to 2% p.a. – they offered a negative 1% in January 2022. They now exceed the returns on a UK ten year inflation linker that has increased from a negative -3% in early 2022 to the current much higher 0% p.a. Equivalent Inflation protected German Bunds also now offer about 0% p.a. – compared to -2% early in 2022.

Real Inflation Protected 10 year Bond Yields

Source; Bloomberg and Investec Wealth and Investment

It is the real cost of funding developed government debt that have been driven much higher this year -not more inflation expected. Expectations of more inflation to come would have found expression in higher interest rates for inflation exposed lenders and not necessarily in higher real yields. Expected inflation measured as the difference in nominal and real yields for equivalent bonds has not increased this year in the US,UK or Europe. Inflation expected in the in the UK over the next ten years has remained about 4% p.a. this year, higher than inflation expected in Germany and the US that have varied about the 2.5% p.a. rate.

Source; Bloomberg and Investec Wealth and Investment

It is not easy to explain why real interest rates in the developed world have risen so significantly this year. Additional competing demands for capital to fund capital expenditure that might ordinarily help explain higher costs of capital and rewards for savers have been notably absent. An alternative explanation is that greater risks to lenders has forced yields higher and bond prices lower to compensate lenders for assuming extra risks – that more risk demands higher returns and forces bond values lower. The risks posed by central banks struggling to cope with inflation have made bond markets far more volatile. The negative correlation between the increases in US bond market volatility Index and the Global Bond Index is strikingly large this year. The link between increased volatility and lower bond and equity valuations seems highly relevant. If it is the risk of central bank policy errors that have driven up required returns it may be hoped that a more predictable Fed will be accompanied by lower government bond yields.

US Bond market volatility and the Global Bond Market Index

Source; Bloomberg and Investec Wealth and Investment

Thanks to the inflation panicking Fed, government bonds have proved anything but a safe haven for pension and retirement funds in the developed world. But in high bond yield, high risk South Africa, RSA  bonds have performed much better than equities for pension and retirement funds. The increase in long bond yields have been offset by much higher initial yields, leaving the bond market total return indexes in rands unchanged year to date while the JSE Swix Index has cost investors about 4% this year. RSA 10 year nominal yields started 2022 at 9.73% and have risen to 11.5% while the real yield on the inflation protected bonds are up from 3.63% to an elevated 4.6% p.a.

JSE Bond and Equity, Total Return Indexes January 2022=100. Daily Data

Source; Bloomberg and Investec Wealth and Investment

These high yields mean very expensive debt for SA taxpayers and offer high risk premiums to compensate for what has been a seriously deteriorating fiscal stance since 2010. The MTBS just presented represents a serious attempt to regain fiscal sustainability. If the plans are realized the debt to GDP ratios will decline to levels well below that of the US or UK. A primary budget surplus – revenues exceeding all but interest expenses – has come surprisingly in sight. Achieved this would surely represent fiscal sustainability and help bring down RSA yields closer to those of the developed market borrowers.

The financial market reactions to the US CPI news on 13^th September provides an extreme example of how surprising news plays out in the day-to-day movements of share prices, interest and exchange rates. The key global equity benchmark, the S&P 500 lost nearly 5% of its opening value after the announcement that inflation in August had been slightly higher than expected. Implying that the Fed that sets short term interest rates in the US would be more aggressive in its anti-inflationary resolve, making a recession inevitable and more severe.

By the recent trends in GDP the US economy was already in recession despite a fully employed labour force. Recession without rising un-employment would have been unimaginable before the Covid lockdowns. The Fed failed to imagine the inflation that would follow the stimulus it, and the US Treasury, had provided to the post covid economy and this has become the problem for investors and speculators required to anticipate what the Fed will be doing to protect the value of the assets entrusted to them.

Yet it should be recognized that the US CPI Index in fact is no longer rising – average prices fell marginally in August as it had done the month before. But perhaps not as much as had been expected. The headline inflation rate- the rate most noticed by the households and the politicians had reached a peak of 9.1% in June and has since fallen to 8.3% as the CPI moved sideways. The increase in prices over the past three months was lower – 5.3% p.a.

Inflation in the US. Headline % p.a.  Monthly % and three monthly % p.a.

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

Yet even if the average prices faced by consumers stabilized at current levels until June 2023 the headline rate of inflation would remain elevated- at 6% p.a. by year end and could return to zero only by June 2023. One wonders just how realistic are the Fed’s plans to reduce inflation rates in shorter order. Patience is called for

The outlook for Inflation if the US CPI stabilized at current levels.

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

The true surprise in the inflation print was the trend in prices that exclude volatile food and energy prices. It was these supply side shocks to prices that had helped to drive the index higher and they are reversing sharply. However, the inflation of prices, excluding food and energy remains elevated. They are now 6% ahead of price a year ago. The Fed is known to focus on core rather than headline inflation.

Headline and “Core” inflation in the US

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

The largest weight in the US CPI Index is given to the costs of Shelter. They account for over 32% of the Index of which 28% is attributed to the implied rentals owner occupiers pay to themselves. The equivalent weight in the SA CPI is much lower – 13%. Where house prices go – so do rents – and the implicit costs – rather the rewards – of home ownership – and inflation. But surely the reactions of those who own more valuable homes are very different to those who rent?  Higher explicit rentals drain household budgets – and lead to less spent on other goods and services- and are resented accordingly as are all price increases. Higher implicit owner-occupied rentals do the opposite. They are welcomed and lead to more spending and borrowing. House price inflation in the US has been very rapid until recently- and rents may be catching up- meaning higher than otherwise inflation rates.

Prices always reflect a mix of demand and supply side forces. But ever higher prices- inflation – cannot perpetuate itself unless accompanied by continuous increases in demand. It is the impact of higher prices on the willingness and ability of households to spend more that is already weighing on the US economy. Incomes are barely keeping up with inflation. And the supply of money (bank deposits) and bank lending in the US has stopped growing further constrains spending.  If inflation is caused by too much money chasing too few goods the US is already well on the way to permanently lower inflation. The danger is that the Fed does not recognize this in good time  – and as the market place fears.

US Money Growth (M2 seasonally adjusted)

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

The daily average for the VIX in the two years before the pandemic was 19 – it was over 80 at the height of both crises. It has recently moved back to 19.

The S&P 500 index is now in record territory in nominal and real terms. In inflation-adjusted terms, the S&P 500 is up about 7.4% a year since the low point of the financial crisis. Real earnings over the same period have grown at an annual average rate of 5.9% since 2009, an above average performance.

Looking for cover
Another regular feature of a crisis is the behaviour of the cover ratio – the normally very close relationship between earnings and dividends. The more cash retained (the less paid out) the more value that is added for shareholders.

We make the presumption that the extra cash retained is invested well and earns above its opportunity cost. S&P earnings are again rising much more rapidly than dividends (which held up better during the crises). Indeed, analysts, absent the usual guidance from the managers of the companies they report on, are still struggling to catch up with the buoyant earnings recovery now under way. Earnings surprises are the order of the day.

The cover ratio for the JSE follows a similar pattern in times of crisis and has a similarly negative impact on share valuations. The more companies pay out dividends relative to earnings, the less these companies are generally worth. The recent recovery in cover ratios to something like their longer-term averages is another sign of normality, as well as a support for share prices. Ideally, the JSE cover ratio declines in line with the increase in opportunities to invest in ways that would add value.

SA shows its metal
A further regular feature of the economic crises of recent times and the recovery from them has been the behaviour of commodity and metal prices that make up the bulk of SA’s exports. They fall during a crisis and they recover strongly as the crisis passes by as they are doing now. Metal and mineral prices lead the South African business cycle in a very regular way. Commodity prices lead, the rand follows, inflation is then contained and interest rates, at worst, do not rise. And the money and credit cycles accommodate the rising incomes that emanate initially from the mining sector.

We are far from the super cycle we benefitted from in the lead up to the GFC of 2008. But we can hope that above normal demand for metals will continue to impress itself on below normal supply responses, translating into higher prices.

While long-term interest rates in SA have recovered from their crisis-driven extremes, they remain discouragingly elevated. Discouraging because they imply high hurdles for capital expenditure budgets to leap over and hence low cover ratios and less cash retained for capex. The gap between short and long-term interest rates, the slope of the yield curve, has moreover remained at crisis levels.

The yield curve implies that short-term interest rates will double within three years. This is a prospect that seems completely out of line with the outlook for the SA economy. We can only hope that the market has got this badly wrong.

The crisis-driven SA economy should not be forced to adjust to higher interest rates. It would be inconsistent with the economic and financial stability that the Reserve Bank is constitutionally charged to secure. It takes much more than low inflation to overcome an economic crisis, as South Africa may still come to recognise.

If we are to take seriously the signals from global bond markets- as we should- savers should expect a decade or more of very low returns. The decline in bond yields due to mature in 10 years or more accelerated dramatically during and after the Global Financial Crisis (GFC) (see below)

Less inflation expected is part of the explanation for these lower yields. But it is more than lower expected inflation at work. Yields on inflation protected securities – those that add realized inflation to a semi-annual payment – have declined to rates below zero. Before the GFC the US offered savers up to a risk free 3% p.a. return for 10 years, after inflation. The equivalent real yield today is a negative one of (-0.11% p.a). (see below)

Real Yields in the US 10 year Inflation Linked Bonds ( TIPS)

Source; Bloomberg and Investec Wealth and Investment

These low risk-free rates also mean that firms investing the capital of their shareholders have very low investment hurdles to clear to justify their investment decisions. A 6% internal rate of return would be enough to satisfy the average shareholder given the competition from fixed interest. Equity returns might also be expected to gravitate to these lower levels.

Another way to describe these capital market realities is that the rate at which the value of pension and retirement plans can be expected to compound is expected to be at a much slower one than they have  been in the recent past. Savers will need to save significantly more of their incomes to realise the same post-retirement benefits.

The past decade has in fact been particularly good for global pension funds.  In the ten years after 2010 the global equity index  returned 10.5% p.a. on average while a 60-40 blend of global equities and global bonds returned an average 6.4% p.a. with less risk. US equities would have served investors even better, realizing average returns of 13.4% p.a,  well ahead of US inflation of 1.8% p.a. over the period.

Total portfolio returns 2010-2019 (January 2010 =100)

Source; Bloomberg and Investec Wealth and Investment

Why then has global capital become so abundant and cheap over recent years? Many would think that Quantitative Easing  (QE) the creation of money on a vast scale by the global central bankers, has driven up asset prices and depressed expected returns. An additional three and more trillion US dollars-worth has been added to the stock of cash since the GFC.

Global Money Creation

Source; Bloomberg and Investec Wealth and Investment

But almost all of this cash has been added to the cash reserves of banks- and not exchanged for financial securities or used to supply credit to businesses that could have stimulated extra spending. Bank credit growth has remained muted in the US and even more muted in Europe and Japan.

The supply of global savings has in fact held up rather better than the demand for them, helped by an extraordinary increase in the gross savings to GDP ratio in Germany. These savings have increased from about 22% of GDP in 2000 to 30% of GDP in 2018- while the investment ratio has remained at around 22% of GDP. Government budget surpluses have contributed to this surplus of savings in Germany. For advanced economies the share of government expenditure in GDP has fallen from 42% in 2010 to 38% in 2018 while the share of revenue has remained stable at about a lower 35% of GDP. This could be described as global fiscal austerity  -post the confidence sapping GFC.

Germany – Gross Savings and Investment to GDP ratios

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

IMF – All Advanced Economies – Ratio of Government Expenditure and Revenue to GDP

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

Perhaps depressing the demand for capital may be the changing nature of business investment. Production of goods and more so of the services that command a growing share of GDP, may well have become capital light.  Investment in R&D may not be counted as capital at all. Nor is intangible capital as easily leveraged.

Lower interest rates have their causes -they also have their effects. They are very likely to encourage more spending – by governments and firms and households. Mr.Trump does not practice fiscal austerity. Boris Johnson also appears eager to spend and borrow more. It would be surprising if firms and many more governments did not respond to the incentive to borrow and spend more and compete more actively for capital. Permanently low interest rates and returns and low inflation may be expected – but they are not inevitable. The cure for low interest rates (high asset prices) might well be low interest rates.

Shorter version published in Business Day, Friday 15^th November

The market value of any business will surely  be determined by its economic performance. The most commonly applied and highly accessible proxy for performance are the earnings reported by its accountants and auditors. Cash dividends paid might be a superior indicator given how the definition of bottom line earnings has changed over time. Cash flows may be better still but are less readily available.

Robert Shiller provides 148 years and 1776 months of US stock market data. US S&P Index values, index earnings and dividends per share have followed a very similar path. The correlation between monthly prices, earnings and dividends, all up nearly 20,000 times since 1871, is close to one. [1]

Share Prices, Earnings and Dividends per Share (1871=100) Log Scale

Source; Shiller Data, Investec Wealth and Investment

The P/E ratio for the S&P has averaged 15.76 over the long period with a low of 5 in 1917 and a high of 124 after earnings had collapsed in May 2009 while the Index held up to a degree. And dividends held up much better than earnings.

Source; Shiller Data, Investec Wealth and Investment

If we run a regression equation relating the Index to earnings or dividends per share the residual of these equations (that what is not explained by the model) has a strong tendency to trend to zero- given enough time. Or in other words the price-earnings ratios have tended to revert to their long-term average of 15.8  over time but with variable lags.

The higher the P/E multiple the faster earnings must be expected to grow when they to make up for the low initial yield E/P and vice versa. Expected earnings drive current market prices. Surprisingly higher or lower revealed earnings will tend to move prices in the opposite direction. Earnings may catch up with prices or prices follow earnings. The move to any long-term equilibrium can come from either  direction, with advantage or disadvantage to shareholders.

Therefore be warned. Knowing that a PE ratio is above or below a long term average is not going to make you rich or poor speculating in the share market. The correlation of starting PE and returns realized over the next twelve months is close to zero.

The starting PE appears to become more helpful as a guide to investors when returns realized over an extended period are compared to it.  High starting PE’s are associated with generally lower returns and vice versa over three or five year subsequent windows. When we relate starting PE’s 36 or 60 periods before with returns realized three or five years afterwards over the entire period we do get a statistically supportive result. Choosing the right entry point to the market and waiting patiently for the outcomes would have been generally helpful to investors.

Examining the relationship between prices and earnings in the US does reveal some extreme cases. In the late forties and late seventies the market would have appeared as very cheap. But these were not good times for the US. The US was fighting and possibly losing a war in Korea. In the mid and late seventies the US was subject to stagflation- rapidly rising prices and slow growth. Also very un-promising times for shareholders.

However normality returned to the great advantage of those who did not share the prevailing pessimism and stayed in the market.  Between 1950 and 1953 the S&P PE crept up from seven to eleven times helping the total returns on the Index to average 22% p.a. In early 1978 the P/E was 8 times. Over the next three years the S&P delivered over 11% p.a on average as the US got its inflation under control.

By contrast in early 2000 at the height of IT optimism the S&P was trading at an extreme 33 times. Over the subsequent three years the S&P delivered negative twelve returns of -8.7% p.a. The IT bubble was only apparent after the event when expected earnings proved highly elusive.

S&P earnings collapsed during the GFC of 2008-09. From about $80 per index share in 2006 to less than $7 in early 2009. This sent the P/E multiple to 124 even as the Index fell sharply to a value of 757 by March 2009.  According to earnings the S&P was greatly overvalued. According to dividends that held up much better through the crisis, the market appeared as deeply undervalued. The dividend buy signal proved the right one as the economy recovered (unexpectedly) with lots of (unexpected) help from the Fed and the Treasury. The S&P Index since those dark days has that provided returns that have compounded on average at of over 13% p.a.

What is very different about the share market today in the US are the extraordinarily low interest rates- both long and short rates – that have surely helped drive the market higher as competition for shares from the money and bond markets fell away. What may appear as a demanding PE of about 22 times becomes much more understandable given abnormally low interest rates. Is this the permanently new normal for interest rates. Or will interest rates mean revert? And what is normal? Only time will tell.

[1] http://www.econ.yale.edu/~shiller/data.htm

Brian Kantor 3^rd April 2019

The state of the US economy gets very close attention from investors in the stock market. The market moved sharply lower in late December on fears of a US slowdown. More recently it has bounced back strongly as the outlook became less threatening as the Fed came to share some of the market anxieties and indicated it would not now be raising short term interest rates.

This raises a question. Could you make a fortune buying or selling shares accurately forecasting US GDP growth rates over the next few years? The answer is a highly qualified yes.  It would take very surprising – to others – very fast growth to deliver well above average returns in the stock market or, as surprising to all but yourself, very slow growth to deliver unusually poor returns.

Such phases of very fast or very slow growth, that presumably could confound the forecasters and investors, have in fact been very rare events. Since 1967 there have only been seven recessions in the US.  There have been about the same number of so-called technical recessions – defined as two or more consecutive quarters when the real GDP declined.

I count 20 quarters since 1967 when growth in the US was less than 1% per annum. Average annual returns on the S&P over these low growth quarters was a negative 11.8%. The worst quarter for shareholders was Q1 2009 when the market was down 47% on the same quarter a year before. However slow growth was not always bad news for investors. In Q2 1981, when growth fell at a 2.9% rate, the S&P 500 Index was up by 19.4% on a year before. Yet the statistical relationship between growth and returns over these low growth quarters was a generally very weak one with a simple positive correlation of only 0.07- not nearly enough  regularity to rely upon as an investment policy.

Slow growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

I have also identified 98 quarters when growth in the US was a strong over 3% p.a. On average over these quarters the annual returns averaged an impressive 14.7% p.a. But this high average came with a great deal of variability around this average. The best annual return of 46.7% came in Q3 1982 and the worst -17.7% in Q4 1973. The statistical relationship between strong quarterly growth and annual returns is also very weak with a correlation close to zero.

Fast growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

The statistical relationship between quarterly growth and returns over the entire period 1967-2018 is altogether a very weak one. Linear regression equations that explain annual index returns with quarterly growth rates have very little explanatory power. Using smoother annual GDP growth rates in the equation do little better. R squares of no more than 0.16 indicate that there is much more than growth determining annual or even more variable quarterly returns. Generally accurate forecasts of GDP growth are simply not going to cut the returns mustard.

The problem for any reliance on patterns of past performance is that the markets are always forward looking. The well-considered, forecasts of the economy and of the companies dependent on it, will already have helped determine the current value of any company and of any Index average of them. Hence only economic surprises- indeed only large surprises in the GDP numbers can move the market.  But anticipating these surprises is largely beyond the capabilities of the collective of forecasters – who will employ similar methods evaluating the widely available data that anticipates and makes up the GDP itself. Any surprises are going to surprise the forecasters as much as the market

However as recent developments on the share market indicate- down and up with not so much the GDP itself – but with expectations of it- what matters over any short period of time in the markets is not so much the forecasts themselves, but the confidence held in such forecasts. These will never be in a constant state. Any additional uncertainty about the state of the economy (less confidence in the forecasts) adds volatility to the market. That is wider daily moves in the market up and down. And when the market moves through a wider daily range share prices will move in the opposite direction in a statistically very consistent way.

The impact of risk (changes in the VIX) on S&P returns 2016-2019; Daily Data. Correlation (-0.74)

Source;  Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment

Such changes in sentiment are not easily forecast. If they could be reliably anticipated this would undoubtedly be wealth enhancing to the forecaster or rather the sage. They are however best ignored by long term investors in favour of as good a forecast of the economy over the long run, as you can hope to make or receive.

 New York, November 21^st 2018

It is Thanksgiving this Thursday in the US – a truly inter-denominational holiday when Americans of all beliefs, secular and religious, give thanks for being American – as well they should.

This is a particularly important week for American retailers. They do not need not to be reminded of the competitive forces that threaten their established ways of doing business. Nor do investors who puzzle over the business models that can bring retail success or failure.

The day after thanksgiving is known as Black Friday, when sales and the profit margins on them will hopefully turn their cumulative bottom lines from red to black. It has been black Friday all week and month and advertised to extend well into December. Presumably, to bring sales forward, that is to make retailers less dependent on the last few trading days of the year.

The competition as we all know has become increasingly internet based  from distributors of product near and far, and yet only a day or two away. E commerce sales have grown by over three times since 2010 while total retail sales including E commerce transaction are 50%up since 2010.  Total US retail sales, excluding food service are currently over $440b and E commerce sales are over $120b (see figures 1 below)

Fig 1; US Retail and E Commerce sales (2010=100) Current prices

Source; Federal Reserve Bank of St.Louis (FRED) and Investec Wealth and Investment

The growth in E Commerce sales appears to have stabilised at about 10% per annum. (see figure 1)

Fig 2; Annual growth in total retail and E commerce sales in the US (current prices)

Source; Federal Reserve Bank of St.Louis (FRED) and Investec Wealth and Investment

Retail sales of all kinds have been growing strongly – though the growth cycle may have peaked- as may have GDP growth- leading perhaps to a more cautious Fed. How slowly growth rates will fall off the peak is the essential question for the Fed as well as Fed watchers and answers to which are moving the stock and bond markets. (see figure 3)

Fig.3: The US retail growth cycle

Source; Federal Reserve Bank of St.Louis (FRED) and Investec Wealth and Investment

The inportance of on-line trade is conspicuous in the flow of cardboard boxes of all sizes that overflow the parcel room of our apartment building. Including boxes of fresh food from neighbouring supermarkets. The neighbourhood stores of all kinds are under huge threat from the distant competition that competes on highly transparent prices on easily searched for goods on offer as well as convenient delivery.  As much is obvious from the many retail premises on ground level now standing vacant on the affluent upper East side of New York. The conveniently located service establishments survive, even flourish, while the local clothing store goes out of business because they lack the scale (and traffic both real and on the web) to offer a credible offering.

But spare a thought for SA retailers for whom sales volumes in December are much more important than they are for US retailers. November sales for US retailers – helped by Thanksgiving promotions – are significantly more buoyant than December volumes. According to my calculations of seasonal effects since 2010, US retail sales in December are now running at only 90 per cent of the average month while November sales are well above average, at 116% of the average month.  Retail sales in the US however include motor vehicle and gasoline sales that are excluded from the SA statistics. December sales in SA are as much as 137% above the average month helped as they are by summer holiday business as well as Christmas gifts. (See figure 4 below that shows the different seasonal pattern of sales in the US and SA)

Fig.4; The seasonal pattern of retail sales in SA and the US (2015=100)

Source; Federal Reserve Bank of St.Louis (FRED) and Investec Wealth and Investment

In the black Friday for SA retailers thus comes later than it does in the US.  And perhaps makes the case for adding promotions in November to smooth the sales cycle and reduce the stress of running a retail business. They may also hope that the Reserve Bank is not the grinch that spoils Christmas- though the answer to this will come on Thanksgiving.

Things became more active on the global interest rate front last week, led by an advance of US yields. The key 10-year US Treasury yield was below 3% earlier in the week, but was at 3.12% onThursday before pulling back to 3.05% on Friday (it was ar 3.07% this morning). Not only have yields moved higher, but the spread between US Treasury and German Bund yields have widened further, to 2.5%.

This may be thought to be enough of a carry (enough US dollar weakness priced in, that is) to attract funds to the US and restrain the upward march in US rates and the US dollar. The US dollar has gained not only against the euro and other developed market currencies, it has gained against emerging market (EM) currencies, like the rand, as is usual when the dollar rises against the euro, yen and sterling. A strong dollar is a particular threat to EM currencies. The JP Morgan EM exchange rate index is now at 66.1 while the the US vs developed market currencies index (DXY) is trading at 93.87.

The rand has been among the better EM performers in the face of the advancing dollar as we show in figures 4 and 5 below (all rates in these charts up to 18 May – though the rand did come under motre pressure than other EM currencies on Friday). The ratio of the USD/ZAR to our own construct of eight other EM currencies and their exchange rates with the US dollar, improved significantly between November 2017 and March 2018 and the USD/ZAR has maintained its rating since then. The story of the rand has once more become a story of the US dollar rather than of South African politics. And seems very likely to remain so.

This ratio was 0.917 on the Monday 14 May – it weakened to 0.934 by the Friday. The story of the rand has once more become a story of the US dollar rather than of South African politics, and seems very likely to remain so.

Interest rates in the US have risen (and the dollar has strengthened) because the acceleration in US growth has been confirmed by recent labour market trends and by the strength in retail sales volumes reported last week. The state of economies outside the US, in Europe and even in emerging markets however, appears less certain. Global growth appears, at least for now, less synchronised – making for fewer correlated movements in short- and long-term interest rates.

It is of interest to note that US shorter term interest rates have been rising faster than long rates. The spread between the 10 and two-year Treasury bond yields have narrowed further. This flatter yield curve indicates that the US may be getting closer to the end of the cycle of rising short rates. Or in other words the GDP growth rates that justify higher short rates may well have peaked and are slowing down- which if so will cause short rates to decline from higher levels in the not too distant future. (See figure 6 below)

It is of particular importance to note that the recent increase in US yields have not been a response to more inflation expected. Inflation-protected real yields offered by the Treasury (TIPS) have increased in line with vanilla bond yields. The spread between nominal and real 10-year treasury yields has remained largely unchanged around 2.2%. That is to say, the bond market continues to expect inflation to remain at the 2% level for the next 10 years. So what is driving nominal yields higher is more growth, rather than the expectation of more inflation, thus representing interest rate developments that are less dangerous to equity valuations than if it were only inflationary expectations that were driving yields higher. The more GDP (and so earnings growth) expected, the more it improves the numerator of any present value calculation, perhaps enough to compensate for higher discount rates.

South African bond yields, as well as the USD/ZAR, have moved higher in response to US yields. However the spread between RSA and Treasury yields has remained largely unchanged. The spread, which indicates by how much the rand is expected to weaken against the US dollar over the years, narrowed sharply after November 2017. In other words, as the political news out of South Africa improved. Figure 8 below shows the SA exchange rate risks and the more favourable trends in RSA and US long bond yields, and in exchange rate expectations since January 2017.

Conclusion: how best to react to dollar strength

A stronger US dollar is seldom good news for the growth prospects of emerging market economies, including South Africa. It puts upward pressure on prices and downward pressure on spending. It furthermore raises the danger of monetary policy errors of the kind Argentina has been making: raising interest rates to fight exchange rate weakness and the (temporarily) higher prices that follow. This then slows down economic growth further, without helping and maybe even harming the exchange rate. Slower growth drives capital away and interest rates, become less attractive when a still weaker exchange rate is expected.

The wise policy approach is to ignore of exchange rate weakness that is caused by dollar strength and not by excessive domestic spending. South Africa made such monetary policy errors during the last period of US dollar strength between 2011 and 2016. We may hope that such errors are not repeated. We may hope even that this period of dollar and US strength is a temporary one – and that growth outside the US resumes an upward trajectory. 21 May 2018