Category: SA Economy

GDP grew in the second quarter, despite very weak spending. Without a recovery in spending the SA economy will continue to struggle. Will the Reserve Bank help or hinder a recovery?

The SA economy, measured by GDP (the real output of goods and services) grew in the second quarter (Q2), at a satisfactory (annual equivalent) rate of 3.3%. In the first quarter (Q1) output had declined at a -1.3% annual rate. Hence the economy avoided a recession – defined conventionally as two successive quarters of negative growth. However an examination of the expenditure side of the economy reveals a much less satisfactory state of economic affairs. Total spending, Gross Domestic Expenditure (GDE) in real terms declined in Q2 by as much as GDP increased, at a -3.3% rate. The difference between GDP and GDE is by definition net exports: the difference between exports that add to domestic output and imports that substitute for domestic output. On a seasonally adjusted basis, export volumes grew very strongly in Q2, while import volumes declined enough to add a net 6.7% to the GDP growth rate.

Final demand makes up a large component of GDE. It aggregates the compensation spending by households and government and the expenditure by government agencies and the private sector on additional capital goods. This aggregate declined (by 0.1%) in Q2 – an improvement on the 2.8% decline estimated in Q1. The further component of GDE is inventories accumulated or run down. In Q2 inventories are estimated to have declined by a real R22.7bn, contributing a large negative (-3.2% p.a) to the GDP growth rate in Q2.

When the spending of households is aggregated with that of privately owned businesses on capital equipment, that is when government spending and investment in inventories are excluded from final demand, we find a similar reluctance of private households and firms to spend more. Private demand for goods and services has been growing at consistently slower rates in recent years appears and now appears to be in retreat, having declined marginally in Q2 2016, not quite keeping up with inflation, defined as the year on year increase in the GDP deflator. The supply of money and bank credit has been growing as slowly as private spending. This is clearly not co-incidental. The growth in spending and credit to fund spending tend to run together.

The performance of the economy in recent years indicates clearly that the increases in interest rates imposed on the economy since January 2014, while they have worked to reduce spending and so the growth in GDE and GDP, have not helped in any significant or predictable way to reduce inflation or inflation expected. Inflation in SA – that leads rather follows inflation expected – has been dominated by shocks in the form of a weaker exchange rate that has driven up the prices of imported goods and a drought that has reduced domestic supplies of food staples and increased dependence on imports. Higher regulated prices and taxes on expenditure have added to the supply side shocks that can drive prices higher – despite weak demand that only to a limited extent has helped to hold back prices. The exchange rate itself has taken its cue, not from interest rates set in Pretoria, but in Washington DC. It is not only the rand but all emerging market currencies that have depreciated as capital flowed to developed, rather than less developed markets, in recent years. Moreover wage rates and prices are determined simultaneously and interdependently in SA. Higher wages have come at the expense of employment opportunities as well as recent profit margins, when final demand is lacking and the firms lack a degree of pricing power.

The reality that the Reserve Bank finds so hard to recognize is that scope for an independent monetary policy to control inflation is very limited if the domestic authorities do not have any consistent influence over the exchange rate. This has been the case for South Africa as it is for most emerging market central banks with flexible exchange rates that respond to highly unpredictable capital flows. The figures below demonstrate that the common global rather than SA forces that have been responsible for almost all of the weak rand and the higher prices that have come with it. The EM Currency basket represents nine equally weighted emerging market currencies (The Russian ruble, Indian rupee, Hungarian forint, Mexican, Chilean and Philippine pesos, Turkish lira, Brazilian real and Malaysian ringgit). Though it must be added, the rand has been a distinct underperformer since 2012 – losing about 20% more than the EM basket Vs the US dollar. The current value of the rand is now (20 September) a little ahead of where it would be predicted to be – given the exchange value of the EM basket as its predictor – and so also taking into account the weaker bias against the rand.

The Reserve Bank, through its unhelpful interest rate and money supply actions, has significantly influenced the growth in spending. Higher interest rates may have reduced measured GDP growth by as much as 2% p.a. The limited feedback loop from interest rates to spending and so on to inflation has been dominated by the independence of SA interest rates and other highly unpredictable forces acting on the exchange rate and administered prices. The hope for a cyclical recovery of the SA economy and the lower interest rates that will be necessary to the purpose, rests on a degree of rand stability that will accompany a revival of capital flows into EM markets and currencies. A normal harvest will also help to hold down inflation in 2017.

It will take lower interest rates to encourage the demand for and supply of bank credit. It will take lower inflation and inflation expected to encourage the Reserve Bank to lower short term rates. It would seem self-evident, given the want of demand for goods and services and for the labour to help produce them, that the direction of SA interest rates should be downward rather than upward.

The highly competitive weak rand – now some 30% below its purchasing power equivalent value (see below) will continue to encourage exports (labour relations permitting) and discourage imports and may help sustain GDP, as it did in Q2 2016. However, given the importance of household spending for the economy, accounting as it does for over 60% of all spending and given also the further dependence of capital expenditure by private companies on the demands households make on their established capacity, any consistent recovery in the SA and the weak economy – will require the stimulus of lower interest rates. We can hope that a stable or better, a stronger rand and less inflation, makes this possible. We can also hope for a more realistic and helpful narrative from the Reserve Bank that recognises that interest rates influence growth much more than inflation and that maintaining growth rates is a highly appropriate objective for monetary policy – especially when controlling inflation is not within its control. 20 September 2016

Having spent the first post Brexit week in London it is hard to exaggerate the disappointment, even foreboding, felt by our colleagues in the London office of Investec. A leap into a world where the known unknowns have multiplied exceedingly is naturally unwelcome to those whose vocation it is to manage risks to wealth in an as well-considered way as possible. Clearly risks to the outcomes in the real economy and the financial markets – particularly in the UK – have become greater than they were and volatility in markets is likely to be exaggerated until a clearer view of what the future may hold for Britain, Europe and the Global economy, of which the share of Britain and Europe is above 20%.

The most obvious unknown is the impact on the UK economy – though the description United Kingdom may well be an exaggeration – with the sharp regional and generational divides of the referendum revealed. The political unknowns seem unlikely to be resolved any time soon as the UK is understandably in no hurry to formally invoke the exit option. An accompanying unknown is who will lead the UK through these negotiations, the outcomes of which, to be decided in Westminster by the legislators not the voters, will surely lead to further appeals to voters by way of a general election or even a further referendum. However, under new rules the next general election will only be called in 2020 – unless a large majority of the MP’s determine otherwise. The Conservative government and no doubt the parliamentary Labour Party, in turmoil over its leader, are clearly not of any mind to go to the country any time soon.

The obvious issue for any updated economic forecast of the UK economy is the degree to which the prevailing uncertainties and the risks associated with them will undermine the confidence business and household decision makers have in their economic prospects. Less confidence will mean less spending, as investment and consumption plans are put on hold and as plan Bs are evolved. It will not take much of a deviation from trend to turn positive GDP growth into stagnation, or worse, recession. But neither the Bank of England under Governor Mark Carney nor the Treasury under George Osborne have waited for the dust to settle. They have reacted with promises of counter measures: lower interest rates and less onerous applications of the requirements of banks to reserve capital, at the expense of lending. But as Carney cautioned correctly – “there are limits to what the Bank of England can do” – if people are determined to tighten their belts in a more uncertain environment. Confidence in the future outlook for revenues and employment benefits is the all-important and fragile foundation of all forward looking economic actions. Decisions made today that are taken not only by firms, but more importantly by households, that account for 70% of all spending in the UK.

Though to be sure it is the revenue to be gained or lost from supplying financial services to Europe and the world (a particular strength of the UK economy) – despite, or is it because of, sterling rather than the euro – that is uppermost in the considerations of the City of London. A square mile that is currently in the throes of a most impressive building boom. It is very hard to count the cranes from my bedroom window overlooking much of the City.

George Osborne, the Chancellor of the Exchequer, was doing his best over the weekend to bolster confidence and enhance spending. The intention to balance the government’s budget by 2020 has been abandoned. Less rather than more austerity is in prospect – understandably so – given the encouragement provided by extraordinarily low borrowing costs. In the midst of a financial crisis the yield on 10 year Gilts dropped well below 1%. Gilts, like almost all other government bonds – including those issued by RSA – were regarded as safer, except by the rating agencies. It becomes much less of a crisis when government debt becomes still cheaper to issue rather, than as is more usually the case in a crisis, when government loans become ever more expensive to raise and austerity in a recession becomes impossible to resist.

Osborne moreover promised more than more government spending. He made the case for a sharply lower corporate tax rate of 15% – close to the 12.5% rate in Ireland – a matter of already deep anguish to Brussels who would much prefer less rather than more fiscal competition in Europe. The UK, with all its other advantages in the form of good commercial law and as a tax haven, could become an even more powerful competitor for corporate head offices.

Escaping the clutches of the Brussels bureaucrats may offer Britain many such opportunities to trade more freely with each other and with the rest of the world, while hopefully negotiating full access to trade with the European community, not only with mutually beneficial low tariffs but – more important – to reduce non-tariff barriers to trade. This is particularly the case in services that have made the European community much less of a free trading zone than it appears to be on the surface.

Clearly the biggest threat to growth to incomes and profits of companies in the UK and everywhere, including in the US, is the rising populist threat to freer trade and globalisation generally that is considered to have left important constituencies behind. The leave vote was surely a protest vote as much as a vote for independence (independence to control the flow of immigrants to the UK, who in fact have proved generally to be a source of faster growth) as well as a response to the income earning opportunities that a fast growing UK economy has provided.

For a South African analyst in London with long experience analysing volatile exchange rates, the one most obvious conclusion to draw is how helpful weaker sterling has been to absorb some of the shocks caused by UK-specific uncertainties. Sterling devalued by about 10% on the Brexit news. The sterling value of the FTSE Index has largely held its own. Shares, particularly those of the global companies very well represented on the FTSE Index, have seen a weaker sterling translate into higher sterling values, particularly when their US dollar values improved with the strong recovery registered in New York last week.

Equities can perform as currency hedges when the currency weakness represents additional country specific rather than global risks. The sterling or rather the UK economy hedges on the FTSE came, as they do on the JSE, from global rather than local economy plays.

On this exchange rate note it is encouraging to note how well the rand, in company with most other emerging currencies and bonds, held up through the Brexit crisis (see below). Some stability in commodity and energy prices were consistent with these developments. The news about the global economy since Brexit has not reflected a state of crisis for the global economy, to which emerging markets are especially vulnerable. So far not so bad.

The markets have reacted favourably to the S&P rating decision – is there more favour to be shown?

The markets have reacted favourably to the Standard & Poor’s (S&P) decision to leave SA’s credit rating broadly unchanged that was announced after the SA markets had closed on Friday, 3 June. Clearly the danger of a formal derating of RSA debt was reflected in market yields before the S&P announcement. As we show in figure 1, RSA bond yields and risk spreads have narrowed. The current spread of about 285bp provided by a RSA five year bond over a US Treasury of the same duration now indicates a near investment grade status in the market place. The spread is shown below where it is compared to Credit Default Swaps (CDS) on high yield emerging market (EM) bonds and also on Mexican bonds of the same duration. These spreads represent the cost of insuring the debt against default.

In figure 2, we show how RSA debt has enjoyed something of a re-rating in recent days when compared, as it should be, to other EM debt yields. The yield gap between EM and RSA debt has widened, indicating an improved status for SA, while the extra yield provided by RSA debt compared to Mexican debt has also declined from about 140bp. A longer view of these relationships is also shown in figure 3, which shows that RSA debt has suffered a de-rating in the market place since early 2015, a de-rating magnified by the Zuma intervention in the Ministry of Finance in December 2015. While RSA yields have declined in a relative sense over recent days, SA’s credit rating in the market has not regained the status it enjoyed prior to the Zuma intervention.

A similar pattern of improved sentiment has been revealed in the foreign exchange markets. The rand has gained value vs the US dollar recently, not only in an absolute sense, but also relative to other EM currencies that might be expected to be influenced by moves in the US dollar vs all currencies. In figure 4, we compare the USD/ZAR rate of exchange to that of an equally weighted basket of nine other EM currencies (Turkey, Russia, Hungary, Brazil, Mexico, Chile, Philippines, India and Malaysia). As Figure 4 shows, the rand and the average EM currencies have gained against the US dollar recently. However the ratio of the rand to the EM currencies (April 2012=1) has improved from 1.32 in late May to about 1.28 on 6 June, an improvement of about 3%. A longer term view of these relationships is shown in figure 5, where it may be seen that the rand, compared to other EM currencies, is still slightly weaker than it was before the Zuma actions in December.

In figure 6, we show the RSA 10 year bond yields since early 2015. We also show the difference between RSA yields in rands with US Treasury bond yields in US dollars. This risk spread may be regarded as the average rate at which the rand is expected to depreciate against the US dollar over the next 10 years. The higher yields compensate investors for the expected exchange rate losses. This risk spread has declined in recent days but remains well above the spreads offered prior to the Zuma shock to the bond and other markets.

The SA Treasury has been able to convince the rating agencies of its commitment to fiscal conservatism. The Treasury will need to be allowed to get on with the task without interference from the Presidency. The bond and currency markets, given but only a partial recovery, would still appear to regard such interference as a possibility. What the Treasury also needs, as much as it needs the authority to manage SA’s fiscal affairs, is a cyclical recovery and faster growth. Such a recovery would be greatly assisted by further strength in the rand and lower bond yields. US dollar weakness would further help promote such trends, as they have done recently. If such favourable trends were to materialise, the Reserve Bank would surely have to reverse its own damaging interest rate course. A loosening rather than a tightening interest rate cycle is urgently called for. Lower interest rates and lower interest rates expected will make a cyclical recovery all the more likely. SA has enjoyed something of an unexpected reprieve from the rating agencies. A strong follow up in the form of lower interest rates across the yield curve can turn a reprieve into a recovery.

Moody’s Investors Service showed its softer side when confirming SA’s investment grade credit rating. The rating agency made it clear that to maintain this grade, SA would need to increase its GDP – that is, simply not fall into recession. A mere 0.5% increase in 2016 would meet Moody’s modest expectation, followed by 1.5% in 2017.

Growth, as Moody points out, not only makes government debt easier to manage. It helps the banks and the households meet their obligations and will also encourage firms to invest more in additional capacity.

To quote the preamble to the report:

“The confirmation of South Africa’s ratings reflects Moody’s view that the country is likely approaching a turning point after several years of falling growth; that the 2016/17 budget and medium term fiscal plan will likely stabilize and eventually reduce the general government debt metrics; and that recent political developments, while disruptive, testify to the underlying strength of South Africa’s institutions.

“The negative outlook speaks to the implementation risks associated with the structural and legislative reforms that the government, business and labor recently agreed in order to restore confidence and encourage private sector investment, upon which Moody’s expectations for growth and fiscal consolidation in coming years — and hence the Baa2 rating — rely.”

Moody’s identifies three drivers that inform its decision. The first, most critical, we would suggest, is that the economy will recover from a business cycle trough:

“..The first driver for the confirmation is Moody’s expectation that South Africa’s economic growth will gradually strengthen after reaching a trough this year, as the various supply-side shocks that have suppressed economic activity since 2014 recede. Specifically, the electricity supply is now more reliable, the drought is ending and the number of work days lost to strikes has shrunk significantly (a trend that planned rule changes are likely to embed further). In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.

“Alongside the more competitive exchange rate, these improving trends are likely to strengthen growth in South Africa from the second half of this year and thereafter. While we expect the economy to expand by only 0.5% in 2016, we expect growth to rise to 1.5% in 2017. Moreover, ongoing structural reforms and diminished infrastructure bottlenecks offer upside potential for growth over the medium term. The recent rapprochement between the government, business and labor holds promise from the standpoint of identifying areas of mutual concern. A number of benchmark actions related to matters such as the rationalization of state-owned enterprises (SOEs) and the enactment of labor market reforms have been identified in the process. To the extent that implementation of such measures helps boost business confidence, investment and job creation, they would improve prospects for gradually reducing wide economic disparities and high levels of poverty, deprivation and unemployment.”

The second driver for the unchanged rating was “The Stabilization of government debt ratios likely to occur in 2016/17” and the third was “Recent political developments testify to the strength of South Africa’s institutions”.

The rating was placed on a negative watch because such hopeful predictions have still to materialise. Or, to put it bluntly, will the economy grow by 0.5% in 2016 and 1.5% in 2017? These are not demanding outcomes even by SA’s well below average growth performance in recent years. What then could cause SA to fall into recession?

The simple short answer would be a further slowdown in household spending. Since households account for over 60% of all spending, any further reluctance in their willingness or ability to spend more will drag the economy into recession. It will neither encourage firms to invest more in people or capacity nor encourage foreign savers to fund our savings deficit.

It is striking that Moody’s could look to lower rather than higher interest rates to improve the growth outlook and the ratings prospects. To repeat the observation made above from Moody’s:

“In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.”

We have long questioned the Reserve Bank’s decisions to raise interest rates into higher inflation and a weaker economy. It seems to us that the higher rates can make no predictable impact on inflation or, it may be added, on inflation expected – that has also risen lately despite the weakness of the economy and despite interest rates that have been rising since early 2014. This proves only that inflation and expected inflation is dominated by forces well beyond the influence of higher short term interest rates. That is in particular by the behaviour of the rand, the behaviour of the weather, the behaviour of the President, the behaviour of global commodity and oil prices and Eskom and its regulators, to mention some of the supply side shocks that have driven inflation in SA higher.

Interest rate increases do nothing useful to contain inflation in a world where the supply side shocks are pushing prices higher and household spending lower. What they do is to reduce household spending further than would have been the case with stable or lower interest rates. For every one percent increase in the repo rate, the Reserve Bank forecasts a 0.4% reduction in GDP growth over two years.

This should be emphasised, in the light of the Moody’s report, since rate increases prejudice rather than enhance our credit rating. An independent central bank is one of SA’s institutional strengths. But such independence could have been much better managed than it has been. Lower, not higher interest rates, would have served the economy better (and still can) and helped preserve its growth rates. Moody’s would seem to agree.

Are there other forces at work that could help the economy grow a little faster? The weaker real and more competitive rand finally seems to be helping the manufacturers as well as the tourist business. The latest survey of manufacturing activity, the Barclays PMI, shows a very healthy recovery and positive growth. If the past strong statistical relationship between the PMI and GDP growth is to be relied upon (showed below), this improvement does suggest significantly faster growth to come. The PMI is well up and the GDP growth rates in Q2 can be expected to follow. We thank Chris Holdsworth of Investec Securities for drawing this relationship to our attention:

 

The other helpful influence at work is a much smaller foreign trade deficit recorded over the past two months. Less imported and more exported add to GDP growth rates. A decline in inventories held, especially inventories with import content, may offset these favourable forces on recorded GDP growth. But a combination of a more competitive rand and a more cautious Reserve Bank, more sensitive to the growth outlook, as well as the business cycle trough from which conditions improve rather than deteriorate, should deliver growth of 0.5% this year and 1.5% next; enough to satisfy Moody’s. Raising the growth rates to permanently higher rates of over 3% requires the structural reforms of the labour and other markets that Moody’s appears surprisingly optimistic about. One can only hope that their optimism is justified.

A notable milestone in SA’s financial history was passed in the second half of 2015. For the very first time, the value of South Africans’ foreign assets has come to exceed the value of the South African assets and debt held by foreign investors. At year end, our holdings of foreign assets, worth over R6 trillion, exceeded our foreign liabilities by as much as R714bn.

 

The buildup in offshore assets legally owned and managed by South African businesses, pension and retirement funds as well as directly by wealthy individuals, began from very modest levels in 1994, when South Africans became acceptable participants in global financial markets.

The growth in foreign assets and liabilities has served South Africans particularly well in recent years as the SA economy has been severely buffeted by a damaging combination of weak growth and higher inflation. Stagflation has accompanied a collapse in the currency, higher charges for utilities a severe drought and, to top all these economic body blows, we have seen (avoidably) higher borrowing costs imposed by the Reserve Bank.

The increasingly large foreign component in SA portfolios of assets therefore has helped significantly to mitigate the shocks to their incomes and balance sheets caused by specifically negative South African events, both political and economic. The protection against their exposure to SA risks has come in large measure from the shares they own in JSE-listed industrial companies whose major sources of revenues and earnings (as well as the costs they incur) are generated outside SA.

The successful industrial companies that began life in SA and have prospered abroad include Naspers (NPN), SAB, British American Tobacco (BTI), Mediclinic (MEI), Richemont (CFR), MTN, Steinhoff (SNH), Brait (BAT) and Aspen (APN) . They have come to dominate the JSE when measured by market value. Up to 50% of the value of the JSE is accounted for by these large firms, that we can describe as Global Consumer Plays (GCPs). Before the rise of these now global companies, investors on the JSE would have been much more exposed to the highly variable fortunes of Resource companies that used to dominate the JSE. Without these opportunities to invest in these world class companies on the JSE, as well as the investments made abroad by these companies and other SA based companies outside of SA, the value of SA pensions and retirement plans might have looked very sad indeed.

An equally weighted Index of 14 of these GCPs on the JSE (including recent underperformers MTN, ASP and CFR) has performed as well as the leading global index, the S&P 500, over the past two years or so, adding about 30% to its rand value of January 2015.

Well-developed liquid capital markets not only provide companies and governments with access to capital. They provide wealth owners, and their fund and business managers, with the opportunity to diversify away firm or country specific risks. A well-diversified portfolio with a full variety of investment opportunities, none of which will dominate the balance sheet and whose individual returns are somewhat independent of each other, makes for a much less risky portfolio, that is a portfolio whose value, while expected to rise over time, will do so more predictably than most of its separate components (especially individual shares) included in the portfolio. The well diversified portfolio provides positive returns with significantly less risk – that is smaller value movements in both directions.

Less risk moreover translates into lower required returns of the investor or wealth owner. Lower required returns also mean lower costs of capital for the firms hoping to raise capital to expand their businesses. Lower required returns in turn will mean more capital invested, a larger capital stock and a stronger economy. This is one of the benefits of a well-developed capital market that can attract capital from savers everywhere and not only domestic ones- as has the SA capital market – where capital inflows have more or less matched capital outflows over the years – as we have shown in figure 1 above.

Human capital effect

But the less risky returns that the opportunity to invest globally provided to South Africans benefits not only the owners of tangible capital but also the owners of intangible human capital committed to the SA economy.

There is always a global shortage of skilled professionals, including managers of businesses, for which competition is intense. By enabling skilled South Africans to invest abroad and diversify away SA risk, their required returns from SA sources have also declined. That is, they are more willing to apply their skills in SA – and therefore are more willing to sacrifice returns, that is employment benefits – because their wealth is better insured against SA risks to their wealth. This now more favourable exchange of less risk for lower returns by owners of a crucial resource- the human capital of skilled professionals- helps to make the SA economy more globally competitive

It has been wise of the SA government to relax exchange control over the years – it has helped the economy retain its skills and so better ride out economic misfortunes.

Were the economy to grow faster over the next few years, the outward flow of capital would be more than matched by inward flows of fixed direct investment (FDI) and portfolio capital. Also, foreign controlled companies would be more inclined to reinvest profits than pay them out as dividends. Growth leads investment by companies in additional capacity and stimulates the flow of funds to support growth. Without faster growth, the flows through the net flows through the SA balance of payments will continue to be more out than in.

The economy would grow faster were global market forces to become more favourable to our emerging, metal price-dependent economy. The rand would then strengthen (as it has lately) and the inflation and interest rates would come down rather than rise to help the economy along. Faster growth over the longer term would respond to more business, employment and wealth friendly policy reforms, of which exchange control reform is a very good and helpful example.

Some details about capital flows

FDI is defined as an investment by a foreign company with a more than 10% shareholding. Portfolio investment is defined as a less than 10% share. As may be seen below, outward FDI has recently come to exceed inward FDI, while inward portfolio investments continue to exceed outward flows – that have become significantly larger.

As important for the SA balance of payments is the flow of dividend receipts and payments. The flows of dividends from portfolios has become a net positive for the SA economy while the flow of dividends from FDI remains strongly in the other direction.