Category: SA Economy

Democracy has been very good for SA shareholders

The JSE crossed a milestone yesterday, with the All Share Index closing above 50 000 for the first time. It first closed above 5000 in April 1994, just before SA became a fully-fledged democracy. Over the same period, dividends per Index Share have grown from R117.89 in April 1994 to R1373.25 today, and that is at an average rate of 13.68% a year. Earnings per share have increased at a compound 13.18% a year rate, implying something of a modest and surely deserved rerating for the Index over the years.

The move from 5 000 to 50 000 is equivalent to an average annual compound return of 14.41%. Inflation averaged 6.32% a year over the period. Real JSE returns therefore have averaged over 8% over the period, a more than adequate reward for the risks shareholders have had to bear. The best month for the JSE since 1994, compared to a year before, was in April 2006, when the annual return was a positive 54%, while the worst decline in annual returns was realised in February 2009, when the ALSI Index had lost 43%.

That the Index has been able to increase about 10 times since then is no accident – it is the result of excellent performances by the managers of the companies that make up the JSE, not only in the form of higher levels of earnings and dividends delivered to shareholders, but also in much improved returns on the capital provided by share and debt holders.

The progress of South African companies in increasing their efficiency and value is depicted graphically in the chart below. Until 1994, the year that SA became a full democracy, the average South African company was earning a real return on the cash invested by companies- the return in the form of real cash out compared to real cash in (cash flow return on operating assets, or CFROI) at or below 6%, which is the global average for non-financial firms. Thus South African companies were generally destroying shareholder value before 1994, especially when considering how much higher the real cost of capital would have been in those highly uncertain times. But since 1994, the median CFROI has sloped upwards and remained well above 6%.

Today’s median listed South African company is reporting a very healthy CFROI of 10%. And as can also be seen in the figure, the performance of the top and bottom quintiles of SA companies has also sloped upwards, indicating more value creation for the best firms and less value destruction for the worst. At present, some 20% of South African companies are generating economic returns on capital above 15%, which is world-class profitability.

(It is worth noting that if a company generates a 10% inflation-adjusted return on capital, it generates enough cash to grow its assets at 10% in real terms.)

How does SA compare to other countries?

We show in the chart below the inflation-adjusted economic returns on capital of listed non-financial companies in a number of different countries during the past decade (Matthews, Bryant and David Holland, “Global Industry CFROI Performance Handbook, Credit Suisse HOLT”, February 2013). In what may come as a surprise to many, the figure reveals that South African companies have been generating the highest median economic returns in the world, better than Australia’s and those of the US and the UK. This is an accomplishment to take pride in, one that demonstrates that listed South African companies are well managed and competitive.

Most important to recognize and appreciate is that SA’s democracy gave SA companies the opportunity to engage globally in the years after 1994, in ways that politics made impossible before. JSE listed companies have been able to realise the economies of scale and specialisation that access to global markets in good services and capital makes possible. SA shareholders have every reason to be grateful for SA democracy, which helped produce such unexpectedly good returns on capital.

The SA economy is vulnerable to large swings in foreign portfolio flows into and out of our debt and equity markets. It should be appreciated that the funds are attracted in part because they can be withdrawn at short notice, in what have proven to be liquid and, to a degree, resilient markets.

Furthermore the SA economy, given a lack of domestic savings (the result of a bias towards consumption spending to which government policies of redistribution and transformation contribute) cannot hope to sustain even modest growth without significant inflows of foreign savings, at the rate of 5% of GDP.

The difference between low savings, at about 14% of GDP, and higher rates of capital expenditure, running at about 19% of GDP is equal to the deficit on the current account of the balance of payments. South Africans, to maintain their standard of living, must hope that, on balance, capital continues to flow towards South Africa – for which we have to give up an increasing net flow of interest and dividend payments abroad. As a result of capital attracted over the years these payments now account for over half of the current account deficit.

These shocks may have little to do with South African events and much more to do with global events, for example global financial crises or decisions of the US Fed that impact on markets and yields in a global capital market, of which SA and other emerging markets are an integrated component of. Another factor may be the exchange controls that still apply to domestic portfolios. That the share of these portfolios held offshore may not exceed specified limits – 25 or 30 per cent – may mean that relatively favourable offshore market moves (perhaps the result of rand weakness) may require the partial repatriation of SA portfolios held abroad.

It needs to be appreciated that for every foreign seller or buyer of a listed security (unlike a new issue), there will be an equal and opposite domestic investor, attracted (or repelled), by lower (higher) prices and higher (lower) yields led by these foreign flows. These variable prices and yields act as one of the absorbers of the shocks that result in more or less foreign capital flowing in or out of the rand.

The other important shock absorber is the variability of the exchange value of the rand. A weaker rand may well lead to thoughts of a rand recovery, encouraging capital inflows while a stronger rand may well lead to the opposite.

We show, in the figures below, the link between these foreign net bond and equity market portfolio flows over a rolling 30 day period and the 30 day percentage move in the rand/US dollar since 2005. Rand weakness is represented by a positive number. The correlation between these two series is a negative (-0.40) over the period 2013-2014. Since early 2013, the worst 30 day period saw net outflows R1.382bn and the most favourable, net inflows of R759m. The best 30 day period for the rand saw it gain 12.5% and the worst was a depreciation of 5.6%.

Clearly these capital flows play a statistically significant impact on the value of the rand, though as clearly there are other forces acting on the currency market over any 30 day period. Foreign capital flowed out heavily towards the end of 2013 and then again in January 2014, enough to cause significant rand weakness. These flows have sinced turned positive and helped the rand to recover.

Ideally, capital flows to and from SA would be more predictable and the rand less volatile, to the benefit of SA based business enterprises. It would also make inflation and the direction of short and long term interest rates much more predictable, further reducing the risk of running an SA-based business. But there seems little chance of this, given the continued dependence of the economy on foreign capital and the shocks, both positive and negative, domestic and foreign, that will continue to affect flows of capital and the terms on which capital is made available.

The Reserve Bank has published its latest Financial Stability Report (FSR) (March 2014). Among its understandable concerns is this dependence of the SA economy on flows of portfolio capital into and out of the equity and bond markets.

The FSR shows how these flows in and out of the rand and shows how these flows were closely linked to much larger flows out of emerging markets generally:

The report states that “non-resident investors in South Africa were net sellers of R69 billion worth of domestic bonds and equities between October 2013 and March 2014. Over this period, a large part of of equity sales was concentrated in the mining and media sectors. Since the beginning of 2014, equity outflows from the banking sector have accounted for the largest proportion of equity outflows…………

The report goes on to state rather “…It would appear, however, that not all sale proceeds from the sell-off were transferred abroad”

This statement that indicates that not all the flow into and out of the rand from abroad can be accounted for by the statisticians and the banks that supply the record of foreign trade and financial transactions. The balance of payments accounts, that should sum to zero theoretically, are in reality balanced by what is often a very large item, known as Unrecorded Transactions. This line item was particularly large in Q4 2013, of R30.6bn, compared to recorded capital flows of R5.3bn. We show some of the the key balance of payments statistics below and the importance of unrecorded transactions in the scheme of things.

The reality is that the the SA balance of payments is somewhat mysterious; and so conclusions about the role of capital flows in the economy must be treated with some caution. The capital flows themselves may be under- or overestimated, as may exports or imports or even interest and dividend payments.

What however is fully known and recorded is what happens to the rand and security prices. Presumably the exchange rate and security prices act to equalise the supply and demand for the rand and securities denominated in rands on a continuous basis.

The important conclusion to draw is to let the markets act as the shock absorber, and for the monetary policy authorities to set their interest rates with the state of the domestic economy in mind. Monetary policy should aim at minimising the gap between actual and potential output. Interest rate stability and predictability is within the remit of monetary policy and should be an aim of policy. The influence of unpredictable exchange rates, led by unpredictable capital flows, on the rand and on inflation, are best ignored.

According to the UCT Unilever Institute, the black middle class went from 1.7 million in 2004 to 4.2 million in 2012 to 5.4 million in 2014. The white middle class has been roughly stagnant: 2.8 million in 2004 to 3.0 million in 2014 (Source: UCT Unilever Institute). The number of high-earning blacks (i.e. those earning more than the average white) went from 120,000 in 2001 to 1.9 million in 2014 – 77% of these were in the private sector (Source: Adcorp).

The income differences within the different racial groups have probably widened with the rapid growth in the black middle class and the transformation of the public service that now provides much less protection for low-skilled whites. Most important, the unemployment rates indicate that a regrettably low percentage of the potential black labour force is not working in the formal sector and therefore not earning or reporting any income.

The income statistics and the GINI coefficient that measures income inequalities in SA do not indicate the important role the SA government plays in ameliorating poverty and therefore supporting consumption expenditure. The distribution of expenditure, including the benefits of expenditure by government agencies, especially if divided by racial categories, will look very different to the distribution of income or wealth. Of all government expenditure, equivalent to 33% of GDP, some 60% is classified as social services, that is spending by government on health, education and protection services. Much of these budgets are allocated to the improved employment benefits of the black middle class who work for government, supplying so-called social services. But measuring the quality of delivery is much more difficult than measuring how much is spent on them.

Yet of this expenditure on welfare, spending that constitutes 60% of all government expenditure, some 15% or nearly 5% of GDP, consists of cash supplied on a means tested basis to the identified poor. That is cash paid monthly as old age pensions, child support grants or disability grants. These payments have been growing strongly over the years, keeping up fully with inflation, and have provided an important form of poverty relief.

The taxpayers who have paid for this relief (and other government expenditure) are to an important degree income tax payers. Of all government revenues, which amount to about 30% of GDP, some 55% come from taxes on income and profits of businesses. Registered companies are budgeted to contribute nearly 35% of these income and profit taxes, or nearly 20% of all government revenue, in this financial year 2014-15. Of the personal income taxpayers, the highest income earners, those expected to earn over R750,000, will pay over 40% of all the income tax collected, while earning about 24% of all personal incomes – which include all reported income, interest, dividends and rents generated from assets.

These relatively high income earners constitute only 4.6% of all the 15.254 million potential income tax payers on the books of the SA Revenue Service (SARS). Of these registered for income tax purposes, some 8.835 million will fall below the income tax threshold of R70,000 income per annum and so will not contribute income tax. These low income earners will generate only 11.5% of all expected reported incomes in fiscal year 2014/15. (Source: Budget Review 2014, National Treasury, Republic of South Africa, Table 4.2).

These statistics from SARS confirm how unevenly distributed income is in South Africa and also how much redistribution of income is taking place via income taxes as well as via the distribution of government expenditure, which is biased in favour of the poor.

Higher income South Africans, it should be recognised, will be consuming and paying for almost exclusively private education, health care and will also employ privately supplied security services. The relationship between taxes paid and benefits received is not at all as balanced as it may be in the developed world where the biases in spending are often in favour of the middle class, who make up a large proportion of the electorate. To stay competitive in the global market for skills, this relatively unfavourable balance of taxes paid for benefits received by the high income earners and income tax payers has to be made up in the form of higher pre-tax salaries – purchasing power adjusted – compared to employment benefits and government services available for scarce skills in the developed world.

The scope for raising income or wealth tax rates would seem very limited – given the mobility of skilled South Africans and their capital. Higher tax rates, at some point, would inevitably mean lower tax revenues. The government appears well aware of this trade off, given that the Budget plan for the next three years is to maintain hitherto very stable ratios to GDP of government expenditure (33%) and government revenues (30%). Clearly the limits to government expenditure and redistribution of incomes will be set by the rate of economic growth. Redistribution with growth, to which efficient use of capital will play an important part, would seem the only realistic option.

Economic reality means tradeoffs, not least for economic policy

That growth in SA historically has occurred unfairly, with unusual degrees of income and wealth differences, is a fact of economic life that even SA governments, whose best intention is to reduce income and wealth inequalities, would have to take account of. Policies designed to achieve greater equality of economic outcomes may restrict growth rates and thus growth in government revenues that support redistribution of income and wealth. These are developments that would make achieving a greater degree of equality of economic outcomes and (what is not the same thing at all) realising less absolute poverty, that much harder to achieve.

South Africans have only to look north to Zimbabwe to recognise how the aggressive redistribution of wealth (without compensation) can destroy wealth creation and economic growth. While perhaps achieving greater equality it has also resulted in significantly greater poverty.

The consequences of income redistribution and transformation in SA: more consumption spending and lower savings.

The transformation of the income levels and prospects of the black middle class in SA as well as the income and welfare support provided for poor South Africans has had the effect of raising consumption spending as a share of GDP and reducing the gross savings rate. Gross savings, of which more than 100% are now made by the corporate sector from cash retained and invested by them, have fallen from around 25% of GDP in the early 1980s to current levels of about 14%. Fortunately the rate of capital formation, encouraged by high returns on capital has held up much better to the advantage of economic growth and tax revenues.

But the difference between domestic capital formation and savings has to be made up by infusions of foreign capital. By definition the difference between national gross savings and capital formation is the current account deficit on the balance of payments (see below).

South Africans have had to rely on foreign capital to an important degree, in order to maintain their consumption expenditure, much influenced as it has been by the transformation of the economy, in the form of the rise of the new middle class and the redistribution of income and government expenditure towards the poor. Foreign investors, essentially attracted by high returns, have become very important shareholders in JSE-listed corporations and rand-denominated government debt. Some 40% of SA government debt denominated in rands is now held by foreign investors. South Africans have been significant net sellers of SA equity and debt and foreigners net buyers over recent years.

Raising consumption expenditure rates has been no free lunch for South African wealth owners. They have had to gradually give up a share of their wealth and income from capital invested in JSE -listed companies, mostly held in the form of pension and retirement funds managed for them, to foreign share and debt holders. Of the current account deficit, which is running at about 6% of GDP, an increasing proportion, now equivalent to about half or 3% of GDP, is accounted for by net payments of interest and dividends abroad.

High returns on capital have made higher levels of real expenditure by lower income South Africans and previously disadvantaged black South Africans not only possible, but relatively painless for the wealthy share and debt holders who have gained directly from a rising share and debt market. The tax outcomes, and strongly rising government revenues, have not destroyed this growth process.

The implications for South Africa seem clear enough: to encourage economic growth so as to be able to redistribute more income and wealth to the poor. Any bias in favour of redistribution without growth would be destructive of wealth and incomes. Local and foreign investors, upon whom we depend to maintain our current levels of income and expenditure, don’t like uncertainty and much prefer transparency in government and corporate policy.

If global risk appetite is diminished, then shareholders in all countries will suffer. But those with the least uncertainty when it comes to corporate governance, government policy, inflation, and tax policy will be perceived as safe and suffer less. There are immense benefits to aligning policy with uncertainty reduction. A lower real cost of capital will increase market values, and make marginal investments more attractive. This fuels growth and reinvestment, which create more jobs and tax revenue. Typically, a 1% change in the cost of capital or required returns for investors means a 20% change in equity valuation! This is the old fashioned goal: less risk, more growth should be the aim of economic policy, rather than the chimera of enough income equality.

Pat on the back but much work needs to be done

South African companies should continue to focus on generating world beating returns on capital while government focuses on minimising uncertainty for them. In particular the government should remove the constraints on employment growth in South Africa and encourage labour intensive entrepreneurs to compete with the labour-shy formal business. More competitive labour markets (and the lower labour costs that would come with it) might allow smaller businesses, with less easy access to capital markets, to compete more effectively with formal business, if only they were allowed to do so.

Most important is that South Africans should recognise what should be obvious to all but the ideologically blind. When it comes to delivery, SA business has proved successful and our society should be building on this success. Business to business relationships in SA – subject to competitive forces – work well. By contrast, positive government to business relationships have been profoundly compromised and government delivery of services, despite an abundance of resources provided mostly by taxpayers, has been gravely inadequate.

If we can beat the world in managing businesses for return on capital, we can complete the job in building a South Africa where all prosper. South Africa is its own worst enemy by not according successful business enterprise the respect it deserves from policy makers.

The successes of business can be widely shared beyond current shareholders in the form of higher incomes and in revenues for the state, as well as increased employment. Growth with distribution is a worthy goal for policy and high returns on capital can contribute to this.

David Holland is Senior Adviser, HOLT and adviser to Credit Suisse. The views expressed are his own and not necessarily those of HOLT or Credit Suisse

Our Hard Number Index (HNI) of the state of the SA economy at March month end combines these two very up to date releases – vehicle sales and the notes issued by the Reserve Bank (adjusted for CPI). Both are hard numbers not compromised in any way by the vagaries of sample surveys.

The HNI, as the chart below shows, captures the turning points in the Reserve Bank Coinciding Business Cycle Indicator. This indicator has only been updated to December 2013, making it not very useful as a measure of the current state of the economy. Two months can be a long time in economics as well as politics. The HNI for March is barely changed from the February reading, indicating that the economy has neither picked up nor lost momentum. It remains as it was on course for slower growth.

The HNI turned lower in the third quarter of 2013 while the Reserve Bank Indicator for December was still pointing higher. Numbers above 100 for either Index indicate that the economy is growing, but the HNI suggests that the forward momentum of the economy has slowed down. If present trends continue, the growth rate of the economy will slow down further in the months ahead.

As we also show below, the HNI does a good job approximating the growth trends in real Household Consumption Spending and Gross Domestic Spending (GDE). These add spending by the government sector and spending on capital goods and inventories to the all important household spending category, which accounts for over 60% of all spending. Both growth rates appear to be tracking lower in line with the HNI.

The rand however, as the past weeks have demonstrated, will not have to wait for smaller trade and current account deficits on the balance of payments – it will respond to movements of capital in and out of emerging markets. The best hope for the SA economy over the next two years will be a revival in emerging bond and equity markets that leads to a stronger rand and less inflation. Less inflation, accompanied by (at worst) stable short term interest rates and accompanied by lower rates further along the yield curve, could revive household spending, an essential ingredient if the economy is to grow faster in a sustained way.

A reprise of a rand recovery, accompanied by lower interest rates and less inflation, which led to the boom of 2003-2008, may seem as unlikely now as it did then. Such a scenario may be improbable, but it is not impossible. We must hope for such a fertile egg from the Easter Bunny.

Dragging down expenditure and GDP growth in Q4 2013 was an extraordinary run down in inventories that were estimated to have declined by as much as R22.3bn in constant prices. The improved trade balance added 7.8% to Q4 growth, while the decline in inventories reduced Q4 growth by 5.2%.

The decreased level of inventories, with high import content, would have helped improve the balance of foreign trade. But the reduced demand for goods held on the shelves and in the warehouses may well reflect less confidence by the business sector in the growth outlook. Such a lack of confidence would also reveal itself in an increase in the dividends paid out to shareholders of SA companies, including to the increased proportion of foreign owners on the share registers of SA companies. Dividends paid to foreign shareholders went up sharply in 2013 while dividends received by SA shareholders in offshore companies declined as sharply, adding to the current account deficit.

The current account deficit, seasonally adjusted, nevertheless declined sharply from an annual rate of R215.8bn in Q3 2013 to R178.9bn in Q4, while the trade deficit declined from an annual rate of R114bn in Q3 to R62.6bn in Q4. The estimated actual current account deficit in Q4 was R36bn, down from R61bn in Q3, 2013.

Slow growth may well mean a surplus on trade and a smaller current account deficit and thus less dependence on foreign capital. Such trends should not be regarded as good economic news, although perhaps it is welcome to foreign investors concerned about the dependence of the economy on foreign capital, given that foreign capital has become more risk averse in recent months.

Between 1995 and 2003, when the economy grew slowly, the current account was balanced and the economy accordingly attracted very little foreign capital. The same pattern held more recently after the economy slowed down in 2009. The economy grew much faster between 2003 and 2008 because it could attract foreign capital and the current account deficit could widen. Surely faster growth made possible by foreign capital is to be preferred to slow growth arising out of fear that foreign capital may be withdrawn or become more expensive.

There is a virtuous economic circle for the SA economy. Demonstrate faster growth, promise higher returns to investors, and capital from both domestic and foreign sources will be made readily available to any business enterprise. The faster the rate of growth, the better the case businesses have to add to the productive stock of real capital, plant and equipment, to hire more workers and managers and with company investments in training, to help the work force to become more skilled and efficient and so capable of earning more. Growth leads and capital follows.

The major challenge faced by the SA economy is that the growth rates have slowed down recently, mostly for reasons of our own making. SA has a structural growth problem, not a structural balance of payments problem. Grow faster and the balance of payments will sort itself out.

But the growth issues facing the economy have been exacerbated because foreign capital has become more expensive since May 2013 for reasons largely beyond SA’s influence. This has led to a weaker exchange rate and upward pressure on prices further depressing already slow growth in real consumption spending. These price trends in turn raise the danger that interest rates will be set higher, again further depressing domestic spending and reducing prospective growth rates and the business case for adding to capacity. These expectations of weaker growth discourage capital inflows and may lead to a still weaker rand, which is anything but a virtuous economic circle.

The scope for an economic revival in SA, led by households, is limited, given the recessionary state of the formal labour market and so the income constrained limits to the growth in household credit. It would seem realistic to predict that faster growth in SA over the next few years could only be led by a surge in exports. A stronger global economy and higher prices for the metals and minerals we produce and export is a necessary condition for an export led recovery. Continuous production by the mines and factories is also necessary for greater export revenues and volumes. These were not possible in 2012 and 2013, given the pervasive strikes that reduced output from the mines and factories.

Hopefully the business sector could “come to the party” as the Minister of Finance invited business to do in his recent Budget speech. In this regard the good news suggested by the updated National Income Accounts is that the business sector (represented by the National Income Accounts for non-financial corporations, including the publically owned corporations, Eskom and Transnet) have indeed dressed up their performance. SA corporations increased their capital expenditures in 2013 and proved willing to fund their larger capital budgets by raising additional debt finance on a significant scale, despite deteriorating cash flows, represented in the figure below by Gross Corporate Savings.

But the same statistics indicate one of the structural weaknesses of the SA economy – a low domestic savings rate compared to a higher rate of capital formation. Hence a funding gap that can only be overcome by use of foreign savings. (See the figure below that indicates gross savings and capital formation rates in SA).

The figure also indicates that almost all the savings made in SA are made by the corporate sector in the form of retained cash. The government and household sector contribute little to the savings pool.

That the rate of capital formation is greater than the savings rate is surely a positive indicator for the economy. With economic growth the primary objective of economic policy, a slower pace of capital formation in SA would surely not be recommended. Such advice would be equivalent to advocating a structurally smaller current account deficit, since the difference between capital formation and gross savings is by definition the current account deficit and also the net foreign capital flows. Such advice is often loosely given without proper regard for its implications for economic growth.

Attempts to encourage a higher rate of domestic savings might make good economic sense. Significantly increased savings are however unlikely to be forthcoming from SA households. Achieving a higher gross savings rate would for all practical purposes require a willingness to tax corporate earnings at a lower effective rate so that they could save and invest more.

Lower taxes on corporate income would have to be accompanied by higher taxes on personal incomes and household spending. This is a change in the tax structure that does not appear politically possible, given also a presumed unchanged government propensity to spend. In the absence of any higher propensity to save, the path forward for the SA economy remains as it has been. Grow faster to attract savings from global capital markets and do what it takes to encourage business to grow faster so that they can attract more capital from abroad.

The HNI is derived from two equally weighted and very up to date releases for SA unit vehicle sales and the notes issued by the Reserve Bank for February 2014. Both statistics reflect actual sales in February or real notes in circulation at February month end, making them hard numbers rather than estimates based on small sample surveys.

In February the unit vehicle sales on a seasonally adjusted basis declined from January levels while the note issue, adjusted for CPI, picked up some momentum, largely cancelling each other out,in the calculation of the HNI. While declining on a seasonally adjusted basis, unit vehicle sales, having peaked in early 2013, are still maintaining a satisfactory pace.

If the current trend in sales is maintained, the industry should be selling new vehicles at an annualised rate of 620 000 units in February 2015, that is about 6% down on the sales in February 2013, about 3% off current sales volumes and way ahead of the post recession sales volumes of early 2009. No doubt the industry would be well pleased should domestic vehicle sales decline by only 3% over the next year.

Interest rates and the availability of credit from the banks will influence these vehicle sales outcomes. The latest news on interest rates and the exchange value of the rand is rather encouraging in this regard. A recovery in the rand has helped reduce interest rates across the yield curve. A week ago, short term rates were expected to rise by over 2 percentage points over the next 12 months. Now they are expected to rise by only 1.66 percentage points over the same period.

Our view is that interest rates will not increase by more than 50bps over the next 12 months and even this increase is not at all certain. Rates may well remain on hold. The interest rate outcomes and the inflation outlook will depend mostly on what happens to the rand over the next few months. If the rand holds at current rates of exchange, the inflation outlook will improve and the case for raising rates at all will fall away. The expected state of the economy is for slower growth, as revealed by the business cycle and, in an up to date way, by the HNI, while it is also confirmed by credit growth and by growth in household spending: these are trending down rather than up. This strongly suggests that the interest rate cycle itself should be trending down rather than up. It would have done so but for the weak rand.

Joseph Stiglitz, a celebrated American economist, in his speech to the Discovery Investment Conference on Wednesday, 5 March, agreed with our long expressed view on the inadvisability of blindly targeting inflation irrespective of the state of the economy. We would add a further reason for not raising rates, namely the absence of any predictable influence of interest rates over the direction of the rand and therefore of inflation. As we have argued, using the evidence from the market, higher interest rates cannot be relied upon at all to add strength to the rand.

The value of the rand is determined by global forces well beyond the influence of SA short term interest rates. Yet by further reducing domestic demand and so the growth outlook and the case for investing in SA businesses, higher interest rates may well frighten away foreign capital and on balance weaken the rand.

Raising interest rates in SA is justified if domestic spending, fueled by domestic credit, is growing rapidly, thus helping to drive up the prices of goods and services. It is not at all justified if prices are rising because of reduced supplies of goods and services.

An exchange rate shock of the kind that has driven the rand weaker over the past six months, is as much a supply side shock as a drought would have reduced food supplies, so causing prices to rise. It makes no more sense to raise interest rates when a drought forces up food and other prices than when conditions in global capital markets drive down the value of the rand and similarly tends to push up prices.

The level of JSE ALSI earnings has been assisted by a very strong recovery in the earnings reported by JSE listed Resource companies for the period ending 31 December 2013, off a low base. We show the cycle of JSE Resource Index earnings per share below. The annual growth in these resource earnings is highly variable.

Trailing earnings had declined by as much as 40% on a year before by mid 2013, before their recent recovery. They had previously recorded over 80% growth in their recovery from the global financial crisis. Reported JSE Resource earnings are now increasing and in positive growth territory compared to a year before. These growth rates are gathering momentum of their very low base, helped by the still weaker rand and (hopefully) less disruption of mining output by strike action.

It seems clear that the share market typically anticipates the earnings cycle to some degree. Share prices hold up better than earnings when earnings are falling and when earnings pick up again share prices lag behind. In other words, the earnings are expected to follow a consistent cycle of periods of above and below normal growth rates. They are expected to recover to something like normal when earnings are most depressed and the earnings cycle is at its trough and to fall away back to normal when growth rates have peaked.

A consistent pattern of prices anticipating earnings shows up in the price to earnings multiple attached to resource earnings. The multiple tends to rise in the downswings of the earnings cycle and in to decline in the upswings. We show below the PE ratio for the Resource Index. The PE multiple was at a low point in early 2009 after the post crisis peak in the earnings cycle. Thereafter the PE multiple rose rapidly, even as earnings continued to decline to a negative growth rate of minus 40% p.a. in mid 2010. Then, after the reported earnings had again assumed a strong upward trajectory (reaching a peak of 80% p.a. growth by mid 2011), the PE multiple fell away sharply to a trough in mid 2012. Then the PE multiple recovered strongly as Resource earnings again fell away, having fallen by over 40% by mid 2013. This PE multiple, after rising in 2013 as earnings fell away, has now fallen in early 2014, with the recent uptick in reported earnings.

The crisp question then for investors looking for good returns from Resource stocks is whether or not the growth in resource earnings will be fast enough to overcome a declining PE multiple attached to these reported earnings? As we show below, the severe decline in the PE multiple from its peak in early 2010 was accompanied by positive returns from the Resource sector for a further 12 months – the growth in earnings over this period compensated for the lower value attached by the share market to these reported earnings. Something like this may well happen again: as the PE multiple recedes back to something like normal, the improved earnings may help improve absolute share prices.

The key issue then is the outlook for resource earnings themselves over the next 12 months. Based on history Resource earnings do have a tendency to normalise as the share market appears to expect it to do. We provide below a measure of normalised or cyclically adjusted Resource Index earnings.

This is calculated using time series forecasts based on the previous ten years of monthly data that is rolled forward every month. Our cyclically adjusted earnings are a time series best fit. We suggest that this measure provides as good an approximation of trend or normalised earnings expected by investors as can be derived by statistics. Reported and normalised Resource Index earnings are represented in the figure below over the long run going back to 1980, using 10 years of data going back to 1970 to generate the first estimate for January 1980 and then rolling the forecast forward for each month thereafter by dropping a month and adding one. We also show the results of this exercise close up for the period 2008 and 2014.

Reported Resource Index earnings are currently well below the normalised measure. If earnings do in fact trend back to these normalised levels they still have a great deal of catch up to do. That is, from R2000 of reported earnings per Index share to R2800, a potential increase of 40%.

Such an increase would, as we have shown, not be out of line with past performance and would provide scope for good returns even if the PE multiple falls away. This growth in earnings however is by no means predetermined. It will be dependent on some known unknowns, such as the value of the rand over the next 12 months as well the ability of the mine managers to sustain or even increase output and to control costs.

The rand / US dollar exchange rate, were it to strengthen, would not necessarily be a threat to Resource valuations. If the rand strengthens it may reflect a growing appetite by global investors to take on emerging market and commodity market risk. They would do so if the outlook for global economic growth improves and therefore becomes more promising for emerging market exporters and the prices they are expected to realise for their metals and minerals.

A stronger rand may well be offset on the revenue line of mining companies by stronger commodity markets and higher US dollar prices.

The rand may also benefit from improved SA specifics, in particular a resolution of the strike threats and action on the mines that so damage exports from SA, without the mines having to accede to costly wage increases. It is not the rand hedge qualities of the SA mines that will determine their long term value to shareholders. It will be their ability to generate a flow of earnings, or better still a flow of US dollar earnings, that will be decisive in the long run. In other words, the mine managers through good fortune (strong growth in China) and excellent cost management may prove that they are able to send the underlying long term trend in normalised earnings in a strongly upward direction.

The casino industry, and the established gambling industry in general, face threats from new sources.

Gambling is no ordinary industry. Nowhere can anyone with simply the will and the capital to do so offer an open opportunity to the public to play games of chance for money.

To enter the gambling business, investors typically have to cross very high barriers to entry set by regulation. They will need to acquire a special licence and, much harder perhaps, a prescribed suitable venue to play the games. They will also have to satisfy strict instructions as to what particular games of chance and prizes they can offer.

The reason why societies intervene in the gambling market has much to do with a religious, essentially paternalistic, objection to gambling, or rather perhaps a visceral objection to the sometimes large gambling losses that may be suffered by particular gamblers they know or have heard about. The best practical argument for tolerating and legalising gambling services is that what inevitably follows prohibition or the imposition of onerous taxes: illegal gambling, which is even worse for the community.

This argument applies also to how society can best manage all of what are broadly regarded as the popular “vices”. Driving consumption underground is not good public policy.

Furthermore, if enthusiastic gamblers are prevented from gambling near where they live they will travel to jurisdictions near and far to do so. The opportunity to tax the activity for useful local purposes – perhaps to reduce the burden of other taxes or to provide employment at home rather than elsewhere – may well win the political arguments for and against licensing gambling.

The opportunity to tax gambling activity as an alternative to imposing other taxes, may well win the political arguments for and against licensing gambling. The prospect of employment at nearby casinos or race tracks, rather than far away, will be an additional argument for local or provincial authorities to license gambling venues.

The history of casinos in SA

The history of the large entertainment casinos in SA with their banks of slot machines and a variety of table games that attract many players, provides a good case study of the practical and political forces at work when dispensations for gambling are imposed or relieved. Casinos were illegal in SA before the so called “homelands” were allowed to license them. The customers would travel from SA to gamble and for other pleasures or vices not legally available closer to home. The homeland authorities would tax these activities and relieve the SA taxpayer of some of their burdens. In SA, consequently, there had also grown up a large, illegal, unregulated and untaxed, local casino industry.

With the re-unification of a democratic SA and the demise of the homeland authorities, it was sensibly decided to legitimise the casino industry in SA, to place it under the authority of the respective provinces and most important, to strictly limit the number of casino licenses nationally and by the province. Only up to forty casino licences in all could be issued and provinces were able to license their operation within the urban areas close to their potential customers. The distant, previously homeland casinos, while they retained their licenses, lost their competitiveness. Why travel further than to a convenient casino close to home?

The success of these newly established SA urban casinos in attracting custom soon became apparent. Their success in attracting a larger share of the household budgets for gambling became immediately and painfully obvious to the horse racing clubs and their dependents on the tracks and farms. Horse racing had benefitted from something close to a legal gambling monopoly in SA. The revenues from gambling on horses, shared with the private bookmakers and with the provinces as taxes, had helped support a thriving, labour intensive, industry. Horses are not easily groomed by robots. Casinos too provide employment and income earning opportunities for local business to supply their needs.

But the gains of the owners, workers, suppliers and the players at the new SA casinos, at the expense, in part, of the racing clubs and their extended network, help illustrate an important point.

The different gambling offers compete with each other for a fairly predictable share of domestic household disposable incomes, in SA equivalent to between one and one and a half per cent of disposable income on average, though the share does vary by province and by city. The demand for gambling services can also be shown to depend in part on the disposable incomes of households and also on the traveling time taken to access gambling venues. Both the poor and the rich tend to spend a lower than average proportion of their incomes on gambling than the middle income earners.

The role played by the archetypal foreign travelling high roller in the typical casino, outside of the special cases of Las Vegas and more lately Macau (casinos are still illegal in mainland China), has been shown to be minimally important to the large urban casino in South Africa and elsewhere. The SA casino business caters to a local customer base. Online gambling opportunities may be about to change all this – if allowed to do so.

But while the casinos compete with each other and with the tote, the lottery and the private bookmakers, the limits to entry have proved valuable to the licensed casino operators.

For these reasons, a partial casino monopoly in one urban area can prove so valuable – and something the operators are prepared to pay for (in cash or kind).

A turn around the Cape

On this basis the Western Cape Government in the late 1990s was persuaded to grant an exclusive 10 year right to operate only one casino within the Cape Town metropolitan region (as well as on the basis of a more decentralised economic development that would come with allocating a limited number of new licenses outside of the city).

The exclusive license was then determined by way of a competition, a beauty contest between different potential operators who were asked to compete for the licence by offering a variety of additional benefits to the province as well as the new casino itself in exchange for this exclusivity. Sun International and its partners won a closely contested bidding process with an offer of a themed casino in Goodwood plus other benefits to the province of a major financial and organisational contribution to help found the Cape Town International Convention Centre.

This exclusivity agreement has run its course and the province could exercise a further opportunity to extend the exclusivity agreement for upfront benefits in cash and kind in the broad public interest. Sun International, with a well established and well preserved casino complex in operation, would be in an especially strong position to compete financially for a new exclusive license and to offer significant benefits to the province and its citizens for a renewed exclusivity agreement.

Unlike its potential competitors it would largely save the cost of building a new casino. Yet judging by recent public commentary or rather the absence of it, the province seems inclined to forgo these potential benefits and seems inclined to allow the transfer of one of the rural casino licenses to the city.

The people of the province, as far as I am aware, have not been widely consulted on or informed about such a choice – of two casinos or one (with all the upfront payments in cash and kind that might be offered for continued exclusivity). It is a choice deserving of very serious consideration by the citizens of the Province and its elected representatives.

The upshot of any decision to permit two casinos would be likely to divide the market roughly between the two operators as well as to reduce the market for casino-like services in one of the rural areas, with the indirect knock-on effects on local employees and suppliers the loss of casino business would bring. Unless the total casino market in the Western Cape would grow significantly in response to an additional casino offering in Cape Town (an unlikely outcome) there would not be meaningfully more tax revenues for the province to collect nor any additional employment or ongoing economic activity. The rural area losing its casino would suffer obvious economic losses. The established Cape Town operator might well offer, in its bid for renewed exclusivity, additional benefits to the city or province in exchange for an extension of exclusivity.

Any additional hotel or entertainment facilities that might accompany any additional casino cannot be regarded as among the additional benefits provided by a new urban casino in Cape Town. There is no shortage of hotels, restaurants or entertainment amenities in Cape Town. Such additional entertainment facilities would very likely displace activity in restaurants and entertainment venues generally.

New threats

There is however a more serious threat to legitimate gambling interests in SA. It comes in the form of still more competition for the gambling rand from the proliferation of limited payout slot machines and electronic bingo terminals (EBTs) that are slot machines in practice. The latter offer an additional competitive advantage to the gambler in that they can promise effectively unlimited pay outs, unlike the limited payout slot machines previously licensed. Limiting pay outs restricts the competition of conventional casino-based slot machines for gambling revenue with casinos, the tote and the National Lottery. Unlimited, or less limited payouts, have an attraction to many casino or horse racing gamblers whose objective is the big win, even when the odds of doing so are very long shots.

The slot machines, masquerading as bingo machines, overcome this disadvantage of limited pay outs and may well become increasingly ubiquitous and competitive against the established providers.

A still bigger threat to established gambling enterprises is surely the online gambling opportunities that modern technology makes available. The cost of providing a gambling opportunity on the internet or participating in one, from home anywhere in the world, is close to zero. The offering therefore is infinitely scalable. By comparison running a casino or a racing club is a very costly enterprise because they employ people and require a physical structure and presence.

Lower costs of production of any good or service usually means lower prices as firms compete for a larger market share with better terms – and in the case of gambling this might well mean better terms or bigger potential prizes for the serious gambler.

This provides online gambling with a great competitive advantage over conventional gambling providers. The online sites that can attract many customers from all over the world, at very low cost, are likely to offer the better odds or the most commanding big payouts – especially if internet gambling pays very little tax!

The value of any casino or racing club is therefore under threat of the potential proliferation of EBTs and legal access to internet gambling. The threat from new technology and the great uncertainty about what the gambling landscape in SA will look like over the foreseeable future is currently influencing the value attached to Casinos and their licenses in SA. Therefore the case for establishing an additional casino in Cape Town, or the price the established casino might pay to keep it out, must now be subject to unusual uncertainty.

It is in the interests of the wider community that as much certainty as possible about the gambling landscape be created. The objective should be to maximise as far as possible the domestic SA public interest in the gambling industry for taxpayers, employers or employees and investors in addition to those of gamblers themselves. The possible migration to a highly competitive SA gambling industry dominated by offshore providers, with the interest of the serious gambler in effect treated as paramount, should surely not be allowed to happen by default, but only rather after careful consideration of its full economic and social consequences .

The money supply numbers at end December showed a somewhat similar improvement compared to November when seasonal influences are factored in. In the figure below we adjust the nominal note issue for the CPI and show that, on a seasonally adjusted basis, the real money base (supply of cash) picked up momentum in December 2013. When the latest statistics are used for a time series forecast, the real money base is predicted to have increased by 2.7% by year end 2014 – equivalent to nominal growth in the note issue of some 8% and consistent with an estimated inflation rate of about 6% in 2014. This is consistent with a predicted modest aggregate spending growth of about the same magnitude, of less than 3%.

What can be concluded from the latest economic news is that the SA economy has not, as may have been feared by some, fallen on its face. Rather, it seems able to sustain a modest forward momentum that, in the circumstances of disrupted production and a depreciated exchange rate that helps sustain high rates of inflation, may perhaps be consoling.

We combine the two hard numbers, unit vehicle sales and the real supply of cash in equal weights to form our Hard Number Index (HNI) of economic activity. We have previously shown that the turning points in the HNI – pointing to a pick up or slow down in the mostly forward pace of economic activity – track the Reserve Bank’s Coinciding Business Cycle Indicator Index very well. The distinct advantage of the HNI is that it is available within a week of the end of the previous month, rather than only three or more months later (as the Reserve Bank indicator is). The updated HNI is shown below. It shows that the SA economy is still growing and can be expected to continue to move forward at the current slow speed. The December data has helped to keep the HNI on this modestly faster track.

The opportunity for the economy to pick up momentum in 2014 will have to be led by exports and replacement of imported goods and services by domestic suppliers. The weaker rand can help promote exports and discourage imports, provided that the mines and factories stay open as do the restaurants, shops, hotels and B&Bs catering to foreign tourists.

A stronger pick up in the global economy, led by the US, will be helpful for exporters and the US dollar prices they receive. The scope for a domestic demand led stimulus for the economy is limited, given the state of global capital markets that are revealing a greater preference for developed rather than emerging market assets. The danger to the economy is not that domestic spending will pick up – but that it can slow down further under the pressures of higher prices and higher interest rates.

We must hope that the Reserve Bank does not attempt to fight higher inflation, since it has no influence whatsoever over inflation given the sources of higher prices: the exchange rate, a possible drought in the maize producing areas, as well as relentlessly higher taxes in the form of higher municipal charges for electricity and toll roads.

Higher interest rates can only reduce domestic demand without influencing prices very much, so slowing down growth and, by doing so, probably frightening away rather than attracting foreign capital. Slower growth may well mean even more rand weakness and more inflation.

Strike action in the motor sector and the consequent supply side constraints (rather than a lack of demand) may have been responsible for some of the lost sales in the show rooms that could be made up in December. The demand for cash in November is typically robust, given spending intentions for the holiday month of December that lead households and firms to hold more cash. The recent slowdown in demands for cash, adjusted for inflation, therefore does not suggest a buoyant season is in prospect for SA retailers.

It also indicates – when combined with vehicle sales that forms our Hard Number Index of the state of the economy – that the pace of growth in economic activity has stalled at a regrettably very modest pace.

The SA economy is running below its rather modest potential growth rate of about 3%. It is moreover very difficult to see where the impetus for growth can come from. The weaker foreign exchange value of the rand has added pressure on the prices of goods and services and is reducing the purchasing power of households. This ability to spend is also being undermined by higher administered prices; that is by what should be called higher taxes, in the form of tolls for roads and higher charges for electricity and other municipal services.

But the weaker rand not only inhibits the adoption of lower interest rates from which household budgets would benefit – especially in the form of lower mortgage payments. It has raised the possibility of higher interest rates – and so even more subdued household spending on which the economy is so dependent. So any stimulus from household spending for retailers or the local manufacturers seems a distant prospect.

This leaves higher export prices and volumes as the only possible source of faster growth over the next year or two. The weaker rand could be helpful to this purpose. It does make exporting more profitable and importing less profitable, at least until higher inflation erodes the benefits of a weaker rand. But raising exports does require fully productive mines and factories and the co-operation of trade unions, cooperation that was conspicuously absent in the third quarter, hence the weaker trade balance and slow GDP growth, both of which contributed to a weaker rand. Slow growth means low returns for investors and so discourages capital inflows that might support the rand.

The most conspicuous beneficiaries of the weaker rand would appear to be the service providers to foreign and perhaps also domestic tourists persuaded to holiday at home by expensive travel plans. Tourism after all contributes significantly more to the economy than mining and employs far more people. Farmers, provided the weather proves co-operative are also well placed to benefit from and respond to higher rand prices now available on foreign markets and also in the domestic market, where higher import parity prices might prevail.

The other hope is that a stronger global economy, while it has lead to higher interest rates in the US and elsewhere, and so (for now) pressure on the rand, will in due course help raise demand for as well as the prices of goods produced in SA. A combination of stronger exports and faster growth that encourages capital inflows and so a stronger rand, followed by lower interest rates, is the way out of the slow growth path upon which the SA economy is now set. The best monetary policy can do for the economy in these circumstances is nothing at all to interest rates. Higher interest rates can only further damage domestic spending and discourage the case for investing in South African assets. It could also very easily lead to a weaker rather than firmer rand. Slower growth with still more inflation should not be a policy option.

The return of skilled South African from abroad has been a boon to the economy

SA may have made it difficult for firms to hire skilled foreigners. It has not done much, fortunately for the sake of the economy, to inhibit the flow of skilled South Africans back home. It should be doing all it can to encourage the diaspora to come back home.

The numbers of returning South Africans reversing the brain drain has been very impressive. I have been given an estimate of the number of returning professionals and managers by employment placement firm Adcorp, which is in a good position to know the details. The number Adcorp estimates is a very impressive 370 000 skilled migrants who have returned to SA since 2009. In recent years the SA economy has managed to do without attracting skilled foreigners in magnitude by absorbing large numbers of its own. Some sense of the importance of these returnees for the economy will be indicated below.

As may be seen in the figure below, the average real wage at which Adcorp was able to place young professionals or managers doubled through the SA economy boom years between 2003 and 2008, from R150 000 a year in 2003 to R350 000 in 2009. To convert these salaries to 2013 money, multiply by about 1.3 times. In recent years these real salaries at which Adcorp has been able to place clients has declined significantly. Clearly South African firms hiring skilled labour could have benefitted from access to immigrant skills before 2009 – just as they have benefitted from migrant skilled labour since.

Putting SA skilled migration trends in context

To give a better idea of the importance of 370 000 skilled entrants to the SA labour market we can refer to data supplied by SARS in its recently issued 2013 Tax Statistics, that can be found on the national Treasury web site. SARS reports 15 418 920 individuals as registered for PAYE. Not all potential income taxpayers earn enough to have to pay income tax (more than R60 000 a year in 2012). These numbers of registered taxpayers has increased dramatically in recent years as firms were forced to include all workers in their tax filings from 2011.

Of the 15.4m registered workers, some 5.1m actually paid income tax. 3.2m of these taxpayers earned a taxable income of more than R120 000 – perhaps qualifying them as skilled. These 370 000 returning migrants therefore represent more than 10% of the skilled labour force.

Who pays the tax – and some dissonance

It is of interest to note that 338 724 taxpayers reported taxable income of more than R500 000 in 2012. Of these, 73 250 taxpayers enjoyed taxable income of more than R1m in 2012, of whom 16 952 earned between R2m and R5m; while a mere 2 787 taxpayers reported taxable income of more than R5m.

What makes these statistics especially interesting is that the 15.4m taxpayers registered with SARS compare favourably with the employment numbers recorded by Stats SA in its Quarterly Labour Force Survey that records employment and unemployment from a survey of households. Stats SA reports a labour force of 18m of whom 10m only are estimated as formally employed.

Such grave dissonance between the numbers of employees recorded by SARS and by Stats SA needs to be urgently resolved if we are to say anything useful about the SA labour market and the impact of immigration and migration on it and design policies accordingly.