ZA Economist – Page 12 – A blog on the South African economy and global financial markets

The Investment Holding Company. How to understand the value it adds or destroys for its shareholders and how to align the interests of its managers and shareholders.

This report has been written with the managers of Remgro, an important Investment Holding Company listed on the JSE, very much in mind. Their managers having received a less than enthusiastic response of their shareholders to their remuneration policies, the company engaged with shareholders on the issue. An action to engage with shareholders that is to be much welcomed.

I have given much thought and written many words explaining why investment holding companies usually worth less than the value of their assets less debt they owned, why in fact they sell at a discount to their Net Asset Value. It occurred to me, as a Remgro shareholder in response to the invitation from the Remgro managers, that my approach could be used to properly align the behaviour of the managers of Remgro with their shareholders. I then engaged with other shareholders in a Remgro webcast and offered to extend my analysis- an offer that was respectfully accepted. This is the result

Applying the logic of the capital market to the managers of companies that invest in other companies

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds –should be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro, a PSG, a Naspers in South Africa or a Berkshire-Hathaway, the most successful of all Investment Holding Companies listed in New York, unlike the managers of a Unit Trust or Mutual Fund, are endowed with permanent capital by shareholders. Capital that cannot be recalled should shareholders become disillusioned with the capabilities of the managers of the holding company. This allows the managers of the HC to invest capital in operating companies for the long run, without regard to the danger that their shareholders will withdraw the funds invested with them- as can be the case with a Unit Trust.

A Unit Trust always trades at values almost identical to the value of the assets it owns, whether funds are flowing in or out or its value per unit has declined or increased- of great relevance to unit holders. This is because these assets can and may have to be liquidated for what they can fetch in the market place.

This is not the case with an Investment Holding Company (HC) The HC cannot be forced to liquidate assets if its shareholders lose confidence in the ability of its managers to beat the market or meet the expectations of shareholders. Therefore the value of the HC shares will go down or up depending on how well or poorly the shares of the holding company are expected to perform relative to the other opportunities available to investors in the share market.

The price of a HC share will be set and reset continuously to satisfy the required risk adjusted returns of potential investors. A lower share price will, other things equal, compensate for any expected failure of the HC to achieve market beating returns through its holdings of assets and its ongoing investment programme. Vice versa a higher HC share price can turn what are expected to be excellent judgments made by the HC, into merely normal risk adjusted returns. In this way through changes in share prices that anticipate the future, the outstanding managers of any company, be it an operating company or a HC that invests in operating companies, that is capable of earning internal rates of return that exceed their costs of capital, will only provide their shareholders with market related returns. Successful companies expected to maintain their excellence charge a high entry price in the form of a demanding share price. Less successful companies charge in effect much less to enter their share registers. Expected returns adjusted for risks therefore tend to be very similar across the board of investment opportunities.

This makes the market place a very hard task master for the managers of a company to have to satisfy. Managing only as well as the market expects the firm to be managed will only provide market average returns for shareholders. And so the direction of the market will have a large influence on share price movements over which managers have little immediate influence. Better therefore to judge the capabilities of a management team by the internal returns realised on the capital they deploy – not market returns.

The managers of the holding company must expect that the operating companies they invest in, are capable of realising (internal) returns on the capital they invest that exceed the cost of capital provided them. That is capable of realising returns that exceed their required risk adjusted returns.

These potentially successful investments may be described as those with positive Net Present Value or NPV. If indeed this proves so, and the managers of subsidiary companies succeed in their tasks, the managers of the HC must hope that the share market comes to share this optimism in their ability to find cost of capital beating investment opportunities. This would add value to the HC whose shares will reflect the prospect of better returns to come from the capital allocated to subsidiary companies in their portfolio. Other things equal, the more valuable their subsidiary companies become over time , the greater will be the value of the HC.

Past performance may only be a partial guide to future performance

Past performance, even a good track record, a record of having found cost of capital beating investment opportunities, may only be a partial guide to future success. The capabilities of the holding companies’ managers to add further value by the additional investment decisions they are expected will be under continuous assessment by potential investors in its shares.

Therefore the market’s estimate of the Net Present Value of the investment programme of the holding company can have a very significant influence on its market value. This value will depend on the scale of the additional investments expected to be undertaken by the HC , as well as the expected ability these investments to realise returns – internal rates of return on capital invested, (irr)– in excess of their costs of capital or required risk adjusted returns.

These expectations will determine the market’s assessment of the NPV of the investment programme. If the irr from the investment programme is expected (by the market place) to fall short of the cost of capital, then the NPV will have a negative value- a negative value that will be in proportion to the value destroying scale of the investment programme. If so the investment programme will reduce rather than add to the market value of the holding company.

The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect, we argue, mostly this pessimism about the expected value of their future investment decisions. A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns.

How managers of the holding company can add to its market value

That an investment holding company may be worth less than the value of the assets it owns is a reproach that the managers of holding companies should always attempt to overcome. They can attempt to do this by making better investment decisions, positive NPV decisions, and convince potential shareholders that they are capable of doing so. They can also add to their value for shareholders by exercising supervision and control over the managers of the subsidiary companies, listed and unlisted, they hold significant stakes in and therefore carry influence over.

They may be able to add to their market value by converting unlisted assets, whose true market value can only be estimated, into potentially higher valued listed assets with an objectively determined market price. They may also succeed in adding value for their shareholders by unbundling listed assets to shareholders when these investments have matured. This would mean reducing the market value (MV) of the holding company but also its NAV and so possibly narrow the absolute gap between its MV and NAV.

Increases in the market value of the listed assets of the holding company adds strength to its balance sheet. Such strength may encourage the managers of the holding company to raise more debt to invest in an expanded investment programme. This extra debt raised to fund a more ambitious investment programme can only be expected to add market value if the returns internal to the holding company exceed its cost of capital. If it is not expected to do so, these investments and the debt raised to fund them will reduce rather than add to NPV. The influence of the NPV estimates on the value of the holding company will however depend on scale of new investment activity compared to the size of the established portfolio. The greater the risks additional acquisitions imply for the balance sheet, the greater will be the influence of the NPV calculation.

A further influence on the value of a holding company will be the costs of maintaining its head office and complement of managers employed at head office. Clearly the net expenses of head office- costs less fees earned from subsidiary companies will reduce the value of the HC.

Our view is that the difference between the value of the holding company and the assets it has invested shareholders capital in is the correct measure of the contribution of managers to shareholder welfare. Hence improvements in the difference between the market value of the holding company and the market value of the assets it has invested in (it may be a negative number) should form the basis with which their managers should be evaluated and remunerated.

A little mathematics to help make the points

In the analysis offered below we support these propositions by identifying, using the logic of algebra, the forces that influence the market value MV as well as the NAV of an investment holding company and the differences between them.

A conventional calculation is made of the Net Asset Value (NAV) of the holding company as the sum of its parts- the sum of the market value of its assets less its net debts.

The NAV of a holding company is defined as

NAV = ML+ MU- NDt …………………. (1)

Where ML is the market value of its listed assets, MU the assumed market value of its unlisted assets less its net debt – debts-cash (NDt) held at holding company level. MU will be an estimate provided by either the holding company itself or independently by an analysis making comparisons of the market value of the holding company with its sum of parts, its NAV. Any difference between the valuation of unlisted assets included in NAV and the market value accorded to such assets by investors in the holding company (a valuation that cannot be made explicit) will have consequences as will be identified below.

The market value (MV) of the listed holding company is established on the stock exchange and can be assumed to be the sum of the following forces acting on its share price and market value

MV=ML+MUm-NDt+HO+NPV………………………… (2)

Where ML is again, as in equation 1, the explicit market value of the listed assets, MUm is the market’s estimate of the value of the unlisted assets that may or may not have a value close to that of the MU included in NAV in equation 1. NDt is the sum of the holding company debt less cash, also as in equation 1, recorded on the balance sheet of the holding company. HO is the cost or benefit to holding company shareholders of head office expenses, including the remuneration of head office management and other employees, less any fees paid to head office by the subsidiary companies for services rendered. HO would usually be a net cost for shareholders in the holding company and if so would reduce the market value of the holding company.

The final force in determining the market value of any holding company is NPV as discussed previously. NPV is defined as the present value attached by the share market to the investment programme the holding company is expected to undertake in the future. The more active this expected investment programme and the larger the programme – relative to the current composition and size of the holding company balance sheet, the more important will be the value attached to NPV. Furthermore it should be recognised from equation 2 that the scale of the investment programme, relative to the size of the established portfolio of listed and unlisted assets will determine how much the dial, so to speak of market value, moves in response to NPV.

Were the holding company managers be expected to undertake investments, be they acquisitions or greenfield projects, that returned more than their cost of capital, this would reflect in a positive NPV. That is to say the greater the (expected) spread between realised and required risk adjusted returns, the greater will be the value attached to NPV for any given (estimated) monetary value attached to the investment programme. However, as discussed previously, the holding company may be expected to be unable to find cost of capital beating investment opportunities. If so NPV would have a negative value and the more the holding company were expected to invest in new projects, the larger would be the negative value that will be attached to NPV. A negative value accorded to NPV would clearly reduce the market value MV of the holding company as per equation 2.

The success or otherwise of the ability of the holding company to add value for its shareholders can be measured as the difference between NAV, net asset value, the sum of parts, and the market value (MV) of the listed holding company or

Value Add= NAV-MV …………………. (3)

It should be noted in the formulation of equation 3, that NAV is presumed to be larger than MV. This is a usual feature of holding companies that are usually worth less than their sum of parts. This negative value is often expressed as a percentage discount of NAV to its market value- as defined below in equation 5.

If we substitute equations 1 and 2 into equation 3 the forces common to the determination of market value (MV)and NAV in equations 2 and 3 that is MU, Net Debt, Debt less cash, cancel out and we can conveniently write the difference between NAV and MV as simply

(NAV-MV) = – (NPV+HO- (MU-MUm))…………………… (4)

It will be noticed that the higher the absolute value of NPV the smaller the difference between NAV and MV. Were however the NPV to attract a negative value the variables on the right hand side of equation 4 would (other things held constant) take on a positive value and increase the difference between NAV and MV. Other forces remaining unchanged, head office expenses and differences between the estimate of the value of the unlisted assets included in NAV and its “true” unobservable value will also narrow the difference between NAV and MV.

The net costs of head office (HO) as mentioned, is likely to have a negative value for shareholders, as would any overestimate of the value of the unlisted assets. If so, to have MV exceed NAV and so for the holding company to stand at a premium rather than a discount to its NAV, the NPV would have to attain enough of a positive value to overtake these other negative forces acting on MV.

A further value add indicated in equation 4 would be to narrow any difference between the value of the unlisted assets included in NAV and its true market value, which cannot be directly observed. Listing these subsidiary companies may well serve this purpose. It will provide them with an objectively determined value that may well exceed its lower implicit value as unlisted companies. If so this can add market value to the holding company.

It would seem clear from this formulation (equation 4) that for those holding companies with an active investment programme, the key to value destruction or creation, the difference between NAV and MV, will be the expected value of its investment programme (NPV) It would seem entirely appropriate for shareholders in the holding company to incentivise the managers of the holding company by their proven ability to narrow this difference and improve VA. Positive changes in VA- that is less of a difference between NAV and MV –that would take an absolute money value that can be calculated continuously – could form the basis by which the performance of the managers of the holding company are evaluated.

We have shown that much of any such improvement in the market value of the holding company and its ability to add value for shareholders should be attributed to improvements in NPV, a variable very much under the control of the managers of the holding company. The reduction of head office costs, or better debt management, or some reassessment of the value in the unlisted portfolio, is perhaps unlikely to significantly move the market value of the holding company.

Were the managers of the holding company able to make better investment decisions and more important perhaps, were expected to make better investment decisions, the market place would reward the shareholders in the holding company accordingly. Though further any contribution they might make to increase the market value of listed companies under their influence or control, could also help reduce the difference between NAV and MV, as we will demonstrate further.

Investment analysts give particular attention to the discount to NAV of the holding company. The notion is that there is will be some mean reversion of this discount and so an above average discount may indicate a buying opportunity and the converse for a below average discount. This discount is defined as

(NAV-MV)/NAV % …………………………………………… (5)

This notion of a (normal) positive discount is also consistent with the notion as indicated previously that the NAV usually exceeds MV. If we divide both sides of equation 4 by NAV and substitute the components of NAV in the denominator we derive the positive discount to NAV as

Disc%=- (H0+NPV-(MU-MUm))/(ML+MU-NDt) …… (6)

As may be seen in equation 6, if the combined value of the numerator is a positive number, then the discount attains a negative value- that is the market value of the holding company would stand at a premium to the sum of its parts – Berkshire Hathaway might be an example.

Clearly any change that reduces the scale of the numerator (top line) or increases the denominator (bottom line) of this ratio will reduce the discount. Thus a less expensive head office (HO) or an increase (less negative) in the value of future business (NPV) will reduce the discount. (These forces represented in the numerator of equation 6 are preceded by a negative sign. As per the denominator, any increase in ML or MU or a reduction in net debt will reduce the discount.

However while reducing the discount is unambiguously helpful to shareholders and will be accompanied by an improvement in NPV, this will not always or necessarily be the result of action taken at holding company level. Any increase for example in the market value of the listed ML or unlisted investments MU will help increase the absolute value of the denominator of equation 6 and reduce the discount and add NPV. But such favourable developments may have everything to do with market wide developments that influence ML or MU and have little to do with the contributions made by the management team at holding company level.

Thus it is the performance of the established portfolio relative to some relevant peer group rather than the absolute performance of the established portfolio should be of greater relevance when the performance of the managers are evaluated. These influences on the value add might be positive or negative for the value add for which management should not be penalised or rewarded.

It would therefore be best to measure the contribution of management by a focus on the underlying drivers of NPV seen as independent of the other forces acting on the market value of the holding company. Furthermore the focus of the managers of the holding company and their remuneration committees should be on recent changes in the absolute difference between NAV and MV and not on the ratio between them.

Unbundling may prove a value added activity – the interdependence of the balance sheet and the investment programme- for which the algebra cannot illuminate.

Unbundling listed assets to shareholders might well be a value adding exercise. It would simultaneously reduce both NAV and MV, but possibly reduce the absolute gap between them. Because such action could illustrate a willingness of the management of the holding company to rely less on past success and to focus more on the merits of its on-going investment programme. Reducing the size and strength of the holding company balance sheet may make the holding company less able and so less likely to undertake value destroying investments. An improvement in (expected) NPV and so a narrowing of the difference between NAV and MV might well follow such an unbundling exercises to the advantage of shareholders. That is helpful to shareholders because even as the absolute size of the holding company’s NAV and MV decline, the difference between them may become less negative- even become positive should MV exceed NAV

Conclusion

We would reiterate that the purpose of the managers of the holding company should be to serve their shareholders by reducing the absolute difference between NAV and MV and be rewarded for doing so. A focus on this difference, hopefully turning a negative number into a (large positive one) would be highly appropriate to this purpose.

Appendix

Remgro: chart reflecting estimated difference between the market value of Remgro and our calculation of its net asset value

Source: Investec Wealth & Investment analyst model

Naspers: chart reflecting estimated difference between the market value of Naspers and our calculation of its net asset value

Source: Investec Wealth & Investment analyst model

Global savings and interest rates- will we see normalisation?

What the world needs now is more than love- there is also too little spending. [1]More of that would also be very welcome. Particularly welcome would be extra spending by business enterprises on capital equipment. This lack of demand, combined with a rising global savings rate, has created an abundance of saving that explains the exceptionally low interest rate rewards for saving in developed economies. This glut of savings followed the global financial crisis (GFC) of 2008-09 that made managers more fearful to spend or lend while additional regulations restricted their freedom to do so.

The story of the global glut of savings can be told in a few pictures provided by the World Bank shown below. When will then consider how the bond market in the US may be indicating some incipient revival of the animal spirits of US corporations. Encouraged, as they attest, by lower tax rates and much more sympathetic regulators.

Figure 1 charts gross global savings as a per cent of gross global incomes. (GNI) As may be seen share of savings of income has been rising steadily over the years. The GFC hit savings even harder than incomes (upon which savings depend) but since then savings have made an ever larger claim on incomes (26% in 2015). The global savings rate was only about 21% of incomes in the fast growing and higher interest rate world of the mid-nineties. It has been on a generally upward trend since, as may be seen.

Gross savings – (savings before amortisation of capital that turns gross into net savings) are dominated by the cash retained by corporations. Households may save – but other households over the same period may be large borrowers and reduce the net contribution households make to the capital market. And most governments are net borrowers- borrowing even more than they spend on infrastructure that is counted as saving.

Fig 1; Gross savings as per cent of Gross Global Income

As we show below in figure 2, the rate at which real capital – plant and infrastructure – has been accumulated has been trending in very much the opposite lower direction. There was a brief surge in the rate of capital formation in 2005 – a boom year for the global economy – but this was not sustained and was but 24% of global incomes in 2016- compared to a higher global savings rate of 26%.

Fig.2; Gross Capital Formation (% of GDP)

Source; World Bank

In the case of South Africa, with a lower gross savings rate of less than 18% of GDP, the cash retained by the corporate sector (including state owned enterprises) accounts for more than 100% of all gross savings. The household sector’s net contribution to gross savings flows is barely positive and the government sector is a net dis-saver. We show the trends in the SA savings rate below. The profits from the gold booms of the seventies and early eighties were responsible for the very high savings rates then.

Fig 3; South Africa – Gross Savings Rate

Source; World Bank

South Africa cannot realistically hope to raise its savings rate significantly. It can however hope to raise the rate at which capital expenditure is undertaken. That is by reducing the risks of investing in SA- and growing faster and attracting the savings to fund more rapid growth. That would be freely available from the large pool of global savings anxiously seeking better returns- given the right incentives and protections to do so. There is, as indicated, no global shortage of capital – only of attractive investment opportunities that SA could be offering.

The current rate of capital formation currently in SA is only slightly higher than the low savings rate – hence the small net inflows of foreign capital. The difference between any nation’s gross savings and capital formation is approximately equal to the net capital inflow and so the current account deficit on the balance of payments. The item that balances the current account deficit (exports-imports +debt service) – is the change in forex reserves- usually a comparatively small number.

South Africa could do with much faster growth that would encourage more capital formation and attract the foreign savings to fund this growth. And higher corporate incomes would mean more corporate savings. It is slow growth that is at the core of SA’s economic issues. Not the lack of savings. If we grew faster both the current account deficit and the capital inflows would be larger and the rate of capital formation higher. And a larger capital stock would bring more employment and higher incomes for a more productive labour force.

The US despite a relatively low and fairly stable savings rate (currently also around 18% of GNI as in South Africa) is, given the scale of its economy, still a large saver on the global stage. Though the US economy is the largest by far drawer on the global capital market to fund its spending as we show below in figure 8. While the US has been saving absolutely more recently, Chinese savings have now far overtaken US savings in absolute magnitude. Germany is another large saver, adding significantly to global savings in recent years, as we show below.

Fig. 4; Global Savings Rates

Source; World Bank

Fig.5; Gross savings (current US dollars) by economy

Source; World Bank

The Chinese are not only the largest contributor to global savings, saving an extraordinary 45% of their GNI – a rate that as may be seen has been declining from above 50%- they are also undertaking by far the largest share of global capital formation. They created plant and equipment – real capital – worth over USD 5 trillion in 2016 or at a rate equivalent to 45% of GNI, similar to the investment rate- meaning that most of the Chinese savings were utilised domestically.

Fig.6; China Gross Capital Formation (% GDP)

Source; World Bank

But this raises a very important issue for the Chinese. Given the rate at which they save and invest in real capital the realised growth in Chinese incomes must be regarded as disappointingly poor- even when about a 7 per cent p.a rate. It suggests that much of the capital formed is still unproductively utilised. The full discipline of western style capital markets is surely something still to be introduced to China to improve returns on savings. But for all the relative inefficiency of Chines capital, the sheer volume of Chinese capital formation has made it the dominant force in the market for minerals and metals that are used to create capital goods.

Fig.7; Gross capital formation by economy – current US dollars

Source; World Bank

In figure 8 below we show how The US dominates the demand side of the flows through global capital market- and the thrifty Europeans – the supply side. As may be seen these trends that made US economic actors the dominant utilisers of global capital are predominatly a post 2000 development.

It is these capital flows that drive the US dollar exchange rate – and by implication all other exchange rates. Trade flows react to exchange rates- rather than the other way round. This is also the case for SA. With one important difference- foreign trade for the US economy is equivalent to about 25% of GDP. In SA imports and exports – valued at unpredictable exchange rates are equal to about 50% of GDP.

Fig. 8, Net Financial Flows from Europe and to the US. Current US dollars

Source; World Bank

The flows of savings and flows into the US have not only moved the dollar they have moved interest rates. Perhaps the best measure of the global rewards for saving are found in the direction of the real rates of interest offered by an inflation linked bond issued by the US Treasury. Such a bond may be regarded as free of default as well as inflation risk. The risks of inflation are reflected in the yield on a vanilla bond. In the figure 9 below we compare the yield on a 10 Year US Treasury Bond and its inflation protected alternative with the same duration. As may be seen the nominal and real yields have both trended lower. The vanilla treasury bond was offering over 5% p.a in 2005- now the yield for a ten year loan provided the US is about 2.7% p.a. Real yields were over 2%. p.a. in 2005-06. They are now about a half of one per cent p.a. – after a period of negative returns in 2012-2013.

More important these yields have been rising in 2018 indicating some small degree of greater demands for capital. The real and nominal yields however remain very low by historic standards as will be appreciated. Normality – that is any sustained higher global growth rates, must mean much higher real yields. Higher nominal yields will also depend on how much inflation comes to be added to real yields.

Fig. 9; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2005- 2018)

Source; Bloomberg and Investec Wealth and Investment

Fig. 10; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2018)

Source; Bloomberg and Investec Wealth and Investment

In figure 11 below we show the difference between these nominal and real interest rates. These differences represent the extra compensation bond investors receive for taking on inflation risk. It may be regarded as a highly objective measure of inflationary expectations. The more inflation expected the wider must be the spread between nominal and real yields. As may be seen- excluding the impact of the GFC this spread or inflation expected has remained between two and three per cent per annum. It is important to recognise that these inflationary expectations remain very subdued despite a recent increase. Equity investors as well as bond investors must hope that inflation expectations remain subdued enough to hold down nominal interest rates even as real yields rise to reflect a stronger global economy and a revival of capital formation. Low inflation with faster growth is an especially favourable scenario for equity markets.

Fig.11; Inflation compensation in the US Treasury Bond Market – spread between nominal and real 10 year US Treasury Bond Yields

Source; Bloomberg and Investec Wealth and Investment

[1] With acknowledgement to Burt Bacharach

Lessons from US tax reforms

Taxes: Appearance and reality in the US and everywhere else

Reducing the US corporate tax rate and the taxes applied to offshore profits earned by US corporations and the repatriation of cash generated offshore, has had perhaps unintended consequences that are proving very helpful to the tax reformers. Some leading companies have immediately converted lower taxes to come into bonuses for their employees.

These reactions help raise the issue of who actually pays an income tax or a payroll tax. Those employees soon to notice a lower tax charge on their salary slips will have no doubts about who pays the income tax – and how they benefit from any reduction in tax rates. Shareholders receiving extra dividends, because the company has more after tax cash to distribute, will draw similar conclusions about the immediate benefits of lower tax rates.

But these immediate reactions to lower tax rates in the US will not be the last or the most important consequences of lower income tax rates. Lower tax rates will have improved the prospective returns on capital invested by US companies. More than pay dividends or buy back shares, the company may therefore wish to invest more in plant and equipment.

If so, and this seems very likely judged by the reactions of CEOs, the additional capacity will give these firms the capacity to produce more. To sell more they may well have to reduce prices or improve the other terms on which they supply their customers. The benefits of lower tax rates will thus also go to their customers in the form of lower prices or better quality or better service, depending on the competition to attract more custom. And workers may benefit as the firm hires more of them, perhaps on more favourable terms, again depending on the competition in the labour market for new hires.

In the long run the benefits of a higher return on shareholders capital, higher because less is paid away in taxes, will tend to be competed away. Actual returns after taxes may then fall away to a new equilibrium of lower required returns on a larger stock of equipment and a larger, better paid labour force in which more intellectual capital has been embedded. The effects of higher tax rates would similarly be reversed into higher prices as investment and hiring activity responds negatively to higher required returns before taxes.

These long run effects will be hard to identify, precisely because nothing much of what else will affect the economy will remain unchanged after a tax regime is changed and economic actors respond. Exchange rates may change, while tax rates in other countries may change to make imports more competitive. Trade across borders may be become more or less open. Yet it would be hard to argue that changes in taxes will not have wider consequences than is revealed on a payslip or dividend payment.

It is also surely true that the benefits, medical or pension etc. that employers provide for their workers will influence the supply of workers, skilled and unskilled, to the firm. The better the benefits, the greater will be the potential supply of job applicants and the lower the quit rates. Increased supplies of actual and potential workers in response to improved other benefits of employment will mean the firm has to offer less take home pay to attract the workers it wishes to hire.

Employees may well be paying for the benefits in the form of a cash salary sacrifice, which is to the advantage of the hiring firm. And taxpayers will be contributing, should the benefits in kind rather than cash enjoy much lower tax rates, in other forms of tax. Such tax favours for employees may help make the firm more competitive, in the form of a lower wage bill. This in turn may enable it to offer lower prices or better terms to their customers – as in the case of lower income taxes.
In these and many other ways, hard to identify, taxes tend to find their way into the prices consumers pay for the goods and services they buy. And this applies to all taxes and not only the VAT or sales taxes imposed on final expenditures.

Higher taxes mean higher prices and vice versa. And as important for the supply side effects of taxes of all kinds is how well the tax revenues are utilised. A good ratio between taxes collected and benefits provided, for obvious example in the quality of education supplied by governments, will tend to increase the supply of skills and lower costs of production and prices to the benefit of consumers ultimately.

The conclusion to come to when recognising the full ramifications of a tax system on the supply of and demand for goods and services, is to keep the tax system as simple as possible. That is to avoid trying to redistribute income through taxes of one kind or another (that find their way into prices) and hence may not redistribute income at all. All taxes may become a tax on expenditure rather than on income. Appearances of redistribution of income through can be very deceptive and damaging to an economy.

It would be more helpful to recognise reality and simply tax expenditure of all kinds at the same rate, thus avoiding income taxes, including taxes on income of companies and taxing one form of income in cash or kind at very different rates. Redistribution is best done by targeting government expenditure – not taxes. As is raising the taxes to pay for benefits as least disruptively as possible. 9 February 2018

A volatility storm – has it passed?

The S&P on Monday lost 4% by its close. The Dow had its largest one day loss in history, over 1000 points. In percentage terms it was the worst day for the New York markets since September 2011.

It is easier to understand what didn’t move the New York markets on Monday than what did. It was not any economic news, which was notably absent on the day. Nor was it interest rates. Interest rates moved the markets on Friday when they rose sharply in response to the impressive employment report. Both real and nominal bond yields closed sharply lower by the close on Monday and have maintained lower levels compared to Friday’s close on early Tuesday morning, even as the equity markets remained under pressure before the markets opened.

The most conspicuously unusual behaviour on markets was registered by the CBOE Volatility Index, the VIX. It closed 20 points higher at 37, the largest point and percentage change in this Index ever. And most of this increase took place in the last two hours of trading: it moved from 10 to over 30 in two hours. It appears that much of the price move and the huge volumes of trading activity associated with it was the result of special funds attempting to close out strategies based upon low volatility. Their attempts to do so forced up the Index and forced share prices lower.

The issue for market commentators before the market opened was how soon, as it is described, the systematic bid for volatility would subside. Judged by the strong recovery of the equity markets (S&P up one per cent as I write on Tuesday evening) in the first hour of trading the danger posed by rebalancing volatility strategies may have passed. Yet volatility – the form of minute to minute movements in share prices and Index averages of them – remains highly elevated. The VIX on 6 February continued to trade at these elevated levels as the market indices gyrate between positive and negative values.

Some economic realities

Perhaps in times when economic fundamentals appear irrelevant to company valuations, it is good to be reminded of just what has been happening at the economic coal face. Though coal is surely the wrong metaphor, the companies we refer to here are moving the frontier of economic activity – of how we work and consume that has changed so dramatically.

Some of the leading new economy companies reported their results for Q4 2017. The scale of their operations and the growth in their revenues is nothing less than very impressive. Apple for example reported quarterly sales of $88.29bn, up 13% on the same quarter in 2016. Amazon reported Q4 sales of $60.5bn, up no less than 38% on the same quarter a year before and up 31% for the year. Facebook grew sales in Q4 2017 to $12.97bn and by 47% and Alphabet generated revenues in Q4 of $32.32bn, up 24%. And Microsoft (in business for much longer) grew its sales in Q4 2017 by 12%, to $25.83bn.

All these companies that are thriving impressively and are being generously valued accordingly – described as the FAAGMS – have a competitive and a regulatory threat. Their success to date is as vulnerable to disruption by competitors – known and unknown – as they have proved to be to what were then established ways of doing business.

However their success and the market dominance it seems to create – of which their approving customers are the arbiters – is bound to attract the attention of regulators and tax collectors. That is of economic agents, with interests and powers of their own, who are philosophically unwilling to concede the race for dominance in a market place is to be determined by consumers and regulate accordingly. They would do well to accept that what constitutes the relevant market place is fluid and incapable of being usefully defined and confined. Competition for the budgets of households and of all the firms that ultimately compete for their favour remains highly intense, as the fast growing sales of the Apples, Amazons, Facebooks, Googles and Microsofts prove. Society should best leave the unpredictable outcomes to this competition. 7 February

Equity markets and interest rates in the US

Equity markets and interest rates in the US – will we avoid inflation surprises?

The equity markets in the US have had an outstanding run. The S&P 500 is up 26% since January 2017 and has advanced with unusually low volatility. Day to day movements in the Index have been very limited by the standards of the past. The fundamentals of the market have been supportive of higher valuations. High operating margins and rising earnings, with upward revisions of earnings to come, combined with still low interest rates, have attracted these higher valuations. The future of earnings and margins has been further enhanced by the income tax cuts for corporates, small businesses and individuals. The animal spirits of corporate leaders are stirring, promising a boost to the economy from a strong pick up in capital expenditure.

The concern is that unexpectedly higher interest rates can offset these benefits, as earnings are discounted to estimate present values. As we show below, US Treasury bond market yields have been rising this year – but from abnormally low levels. Nominal yields for 10-year money have increased this year from 2.45% to current levels of 2.72%. So have real yields – they have risen from a very low half a per cent in early 2018 to over 0.6% now. Furthermore, the gap between nominal and real inflation protected interest rates has increased from 2.45% at the start of 2018 to the current level of over 2.7%. This spread reveals the inflation rate predicted by the bond market. The bond market is anticipating and being compensated for slightly more inflation expected over the next 10 years.

The Fed’s target for inflation is 2% – a target that it is still to meet and is by no means certain of meeting any time soon. The Federal Open Market Committee, reporting this week (31 January 2018) still expects inflation to stabilise around its 2% objective over the medium term in its latest statement. It also repeated its view “that near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely…”

The most supportive scenario for the equity market will be one of rising real interest rates – indicating stronger growth in demands for capital – coupled with still very subdued expected inflation that will sustain low nominal interest rates. It is not higher real interest rates that represent danger to equity valuations. It is more inflation expected that would drive nominal interest rates higher that represent the threat to equity markets. Not only the Fed, but the markets, will be watching inflation developments closely. They will also be watching each other closely to avoid inflation surprises. Equity investors must hope that inflation does not surprise on the high side. Low inflation and strong real growth are what equity markets will thrive on, as they have done lately. 2 February 2018

SA – back in the emerging market fold

The South African economy has recently re-joined the world of emerging markets. The JSE, measured in US dollars, has caught up dramatically after having lagged well behind the surging MSCI Emerging Market Index. The JSE, in US dollars, and the SA component of the emerging market (EM) Index have gained over 40% since January 2017 as we show below in figure 1.

These EM and JSE gains have come after an extended period of underperformance when compared to the S&P 500. The S&P 500 has been making new highs so consistently over the past year. The EM Index and the JSE, in US dollars, have still to be worth more dollars than in 2011.

This JSE catch-up has come with the burst of rand strength that accompanied the defeat of President Jacob Zuma and his faction at the ANC electoral congress in December 201, a defeat that promised a new direction for the SA economy. The rand had weakened by about 11% compared to our basket of equally weighted other EM currencies by November. It is now about 4% stronger than the basket of EM peers (see figure 2).

Rand and EM currency strength has come with a noticeably weaker US dollar. The US dollar index (DXY) lost about 12% of its exchange value against other developed market currencies since early 2017 while the index of EM currencies has gained about 10% on the dollar, with the rand up by over 15% over the year.

A weak US dollar is good news for EM economies and especially their consumers. It brings currency strength and lower inflation – particularly of imported goods – and lower interest rates. It is very hard to see how the SA Reserve Bank can fail to respond to these trends with lower interest rates in due course.

The renewed hopes for the SA economy have extended to the bond market and to the risk premiums attached to SA government debt. Both inflationary expectations – measured as the spread between a vanilla 10 year RSA bond and its inflation linked equivalent – have declined sharply, from over 7% in November to about 6% currently. The spread between the RSA 10 year yield and its US Treasury bond of similar duration, that represents the expected depreciation of the ZAR/USD (the interest carry), has also declined by a similar degree. Yet both spreads remain quite elevated by the standards of the past. The belief in permanently lower inflation or a stronger rand is still lacking (See figure 3).

The cost of insuring RSA US dollar-denominated debt has also responded well to the new dispensation in SA. After many years of trading as junk – ever since Zuma sacked finance minister Nene in December 2015 – RSA debt is now competing again on investment grade yields.

Further support for the rand and EM currencies has come from higher commodity and metal prices. As we show below, industrial metal prices have performed better than commodity prices indices (that includes a heavy 27% weighting in oil). The London Metal Exchange Index is up 30% in US dollars since early 2017 (see figure 5). A stronger global economy combined with a weaker US dollar is helpful to EM economies including SA with their dependence on exporting minerals and metals.

The politics as well as the economics of SA are now in a much healthier state as the market place confirms. And the global economy is offering much more encouragement for SA exporters. But as indicated in our figures, there is room for further improvement. Inflation and interest rates can recede and the exchange rate and sovereign risk spreads have room to narrow further. The opportunity presented to SA is to stop the rot (developments to date have been well appreciated in the market place) and then to follow through with wealth creating and poverty reduction initiatives. 29 January 2018

US earnings and tax rates – a temporary conundrum

You may think that cutting company tax rates in the US from 35% to 21% of their earnings would boost after-tax earnings. But not so fast – while the longer run impact of the lower taxes will clearly benefit shareholders and employees, the immediate impact of a lower tax rate can significantly reduce, rather than improve the bottom line. This is the case with a number of the very large US banks reporting or about to report their latest results.

Citibank, according to the Wall Street Journal, is about to report a large loss for the final quarter of 2017. It will be making enough of a tax charge to its earnings – as much as US$20bn – for the bank to become loss making in 2017. Some of the other major US banks, for example JPMorgan, will also be deducting large sums (in its case $2.4bn) from its earnings as a once-off adjustment for lower tax rates to come. Wells Fargo by contrast was able to add $3.35bn to its earnings, as was another large bank, PNC, which added about 9c to its reported earnings of $4.18 a share.

The banks and firms that are able to immediately boost earnings have net deferred liabilities, some $2.37bn worth in the case of PNC. In the past, these provisions against future tax liabilities had been deducted from earnings. Now with lower tax rates, this reserve can be reduced and added back to earnings. JPMorgan and Citibank, by contrast, have on balance accumulated tax assets rather than liabilities. They include tax benefits to be realised in the future as an asset on their balance sheets. The accumulation of such potential benefits has boosted earnings over the years. At a lower tax rate, these assets are worth less when they are written off against current earnings.

Incidentally, the Journal article while commenting on the generally very favourable operating performance of the bank as a whole also reports a further charge to JPMorgan earnings, as follows:

“JPMorgan’s corporate and investment banking unit was weighed down by weak trading, slumping 17% to $3.37 billion after stripping out the tax-overhaul impact. It also was hit with losses as high as $273 million related to client Steinhoff International Holdings NV, which is dealing with a wide-ranging accounting probe that is expected to also dig into other large banks’ results.” (WSJ, Peter Rudegeair)

These important recent developments on the earnings front raise the issue about the usefulness for investors or operating managers of these heavily and frequently adjusted bottom-line earnings. Quarterly reported earnings cannot be regarded as a reliable measure of the long run potential of the companies reporting. Nor, since the definition of earnings has changed so much over the years, can these reported earnings be helpfully compared to earnings in the past, nor to historic share prices, in the hope that price earnings ratios will revert to some long run average.

But there is one measure of the performance of a company or of a stock market that has the same meaning and significance today that it has today as it did 50 or 100 years ago. That is the cash paid out to shareholders as dividends. Companies do not easily pay away real cash unless they are confident they can maintain such payments. As such their dividend payments constitute a very real measure of normalised earnings.

A comparison between S&P 500 Index earnings and dividends makes the point. As we show in figure 1 below, dividend flows are far smoother than earnings; smooth enough to be regarded statistically as well as for economic reasons as a normalised measure of earnings.

Of particular significance is that dividends survived the financial crisis of 2008 far better than earnings, as may be seen. Earnings in that period collapsed dramatically as all the failed loans and less valuable assets of the banks and financial institutions were written off earnings. Dividends held up relatively to earnings to reflect the future of US business rather than its immediate past.

And share prices since the crisis are much better explained by the flow of dividends than the flow of earnings. As may also be seen in figures 2 and 3, dividends payments by S&P 500 companies grew steadily between 2014 and 2016, even as earnings fell away sharply in 2014. This helped to support further improving share prices.

S&P Index dividends moreover have continued their steady advance even as earnings have rebounded very strongly, as the figure shows. Dividends since 2012, a period when the S&P Index gained an average 13% p.a., have grown on average by 10.5% p.a, while earnings grew by 3.5% p.a on average, with twice as much volatility. It would appear investors bidding up share prices were taking more notice of normalised than actual earnings, that is of the consistent growth in dividends.

As we show below the quite stable dividend yield on the S&P 500 is very much in line with its post-2000 average. This does not appear to indicate an overvalued market, especially when this dividend yield is compared to interest income which is the alternative to dividends. And lower tax rates will surely encourage US businesses to raise their dividend payments. 16 January 2018

Reading the share market – beyond market timing

27^th December 2017.

Every well traded market offers opportunity and danger. The opportunity is to buy low and sell high. The grave danger is that the investor/speculator does the opposite- sells at the bottom and buys at the top. The history of returns from equity markets reveals just how tempting it is to try and get the timing of entry into and exit from the market right; or, to put it more modestly, why it is important not to get the timing badly wrong.

The irregular pattern of past returns from equities

In figure 1 we show that since January 2000, the ups and downs of the S&P 500 Index of the largest companies listed on the New York Stock Exchange and the JSE All Share Index. With the benefit of hindsight, we can see that getting out of the New York market in early 2000 and re-entering in 2002, would have been very good for wealth creation. For investors on the JSE, timing would have called for even greater agility. It would have been best to have sold off somewhat later, in 2002, and then to have re-entered in 2003, so benefiting from the excellent returns available until the Global Financial Crisis (GFC) of 2008 caused so much damage to all equity markets.

Despite all the understandable gloom and doom of that unhappy episode in the history of capitalism, the GFC was followed by a period of strong and sustained value gains that continue to the present day (late 2017). It has been a rising equity tide that only briefly faltered in 2014. Those with strong beliefs in the essential strength of the global economic system and, more important, with faith in the capabilities of central bankers to come to the rescue, did well not to sell out in 2008 at what proved to be a deep bottom to share prices.

Figure 1: Annual returns on the S&P 500 Index (USD) and the JSE All Share Index (ZAR)

Source: Iress and Investec Wealth & Investment

These total share market returns (price changes and dividends received) have been calculated as gains or losses realised over the previous 12 months and calculated each month. The average annual return on the S&P 500 between January 2000 and November 2017, in US dollars, was 5.3% compared to 14.4% in rands generated on the JSE. The worst month for both markets was in late 2008, when both markets were down over 50% on the year before. The best year-on-year return on the S&P 500 over this period was 43%, realised in the 12 months to February 2010, while the best months for investors on the JSE were in late 2005 when annual returns peaked at over 50%. Adjusted for inflation in the US and SA, the S&P Index has provided about a real average 3% p.a return and the JSE an impressive 8% p.a. in real rands.

When measured in US dollars, the JSE also outperformed, having delivered close to 7.5 % p.a on average compared to the 5.3% p.a earned on the S&P 500. It may be seen in figure 2 below that the JSE provided superior US dollar returns between 2003 and 2007, but offered markedly inferior returns (in US dollars) compared to the S&P 500 since 2012. These high average returns over an extended period of time surely indicate the advantage of maintaining consistently high exposure to equities over the long run.

Figure 2: annual US dollar returns – S&P 500 Index and the JSE All Share Index

Source: Iress and Investec Wealth & Investment

While timing which market to favour over another – the JSE before 2008 and the S&P 500 after 2014 – can make an important difference to investment outcomes, it should also be noted that the returns on the S&P 500 and the JSE are quite highly correlated on average (close to 70%) in all the ways to measure performance.

The forces common to all equity markets around the world will often be directed from the US economy and its asset markets to the rest of the world – rather than the other way round – making an analysis of the state of the S&P 500 a very good starting point for analysing any equity market.

The essential question then arises. Is it possible to undertake value-adding or loss-avoiding equity market timing decisions with any degree of analytical conviction? Such market timing decisions are unavoidable for any fund manager or investment strategist with responsibilities for funds that are not all-equity funds. Any fund required by its investors to hold a balance in their portfolios of cash, fixed interest investments of various kinds as well as the many alternative asset classes that might feature in portfolios, would have to exercise judgements about the risk inherent in equity markets at any point in time.

The risk that the equity markets might, as they have in the past, melt down or even melt up – only then perhaps to melt down again – must therefore be uppermost in the minds of all fund managers having to decide on an appropriate allocation of assets. Even those running all equity funds have to decide how to time turning newly entrusted cash into equities and, more important still, which particular equities to buy and sell.

The broad direction of the equity or any other market can only be known after the event. From day to day, month to month or quarter to quarter, market prices and values are about as likely to go up as they are to go down. These short-term price moves therefore appear to observers as largely random, as the figure of monthly changes and daily moves in the S&P 500 Index shown below demonstrate. Note the still random (down/up, up/ down in no predictable order or magnitude) but very wide daily moves in the S&P 500 during 2008-2009 and during the euro bond crisis of 2011.

Figure 3: S&P 500 monthly returns (percent)

Source: Iress and Investec Wealth & Investment

Figure 4: S&P 500 daily returns (2005-2017)

Source: Iress and Investec Wealth & Investment

But these daily or monthly movements may reveal a broad drift in either direction, more up than down, or the other way round, measured over longer period of time. So when daily and monthly moves are converted into annual changes, observers will get the drift (after the event) and a persistent statistically smoothed trend in returns, that peaks and troughs in some more regular way, will be registered, as shown in figures one and two above. These phases, from top to bottom in annual returns, are defined as either a bull or bear market or something in between, depending on the depth or height of the following trough or peak, but can only be identified with hindsight.

Understanding how assets are valued

This does not mean that nothing meaningful can ever be said about the state of a market after it has moved higher or lower. With observation of the past we can understand the forces that have driven the value of any company higher or lower and so the average of them represented by a stock market index and therefore recognise the forces that might drive them higher or lower in the future, if past performance can be relied upon.

Successful, more profitable companies – those that earn a high return on the capital shareholders provide their managers – after all command higher values than less successful ones. And part of their success or failure will also have to do with the environment in which they operate. The laws and regulations, including the taxes their shareholders are subject to, will influence their ability to generate revenues and reduce costs, as will fiscal and monetary policies. The more certainty about these forces in the future, the less (more) risk to be discounted in the prices paid and the more (less) valuable will be the future flows of revenues and costs in which owners will share.

These market wide forces that determine the value of a share market index are in principle not difficult to identify. In practice they raise many unresolved issues about how best to give effect to the underlying theory. The economic caravan always moves on making it impossible to prove the superiority of one valuation approach over another. Holding other things equal is only possible in the laboratory, not in the economy.

The market can be thought of as conducting a continuous net present value (NPV) calculation, estimating a flow of benefits from share ownership over time, the numerator of the equation. That can be calculated as earnings (profits) or dividends or net (free after-capital expenditure) cash flow expected. The calculations of these are highly correlated when measured for an aggregate of all the firms that make up the Index. This expected performance of the market is then assumed to be discounted by a rate that reflects the required risk-adjusted rate of return set by the market.

The cost of owning shares rather than other assets, is given effect in the applied discount rate. It represents the opportunity foregone to own other assets, for example government or private bonds or cash, that offer pre-determined interest rate rewards with less default risk. In addition shareholders will, it is assumed, expect some additional reward, described as an equity risk premium (ERP) for the extra risks incurred in share ownership that offer no predetermined income. Hence a higher discount rate when the ERP is added to benchmark, default risk free fixed interest rates as provided by securities issued by a government. Such risks can be measured by the variability of the value of the share index from day to day, as shown above, a process of price determination that makes share prices more variable and less predictable than those of almost all other relevant asset classes.

These share prices will go up or down as the discount rate rises or falls with changes in interest rates. And with circumstances that cause investors to attach more uncertainty to the flow of benefits they expect from share ownership. The price of the shares goes lower or higher to compensate for these extra or reduced risks to the outlook for the economy and the companies who contribute to it.

The numerator of the NPV equation that summarises the expected flow of benefits to owners may be regarded (for reasons of simplicity) as (relatively) stable. A lower (higher) share price reconciles this given outlook with the required risk adjusted return that makes owning a share seem worthwhile. So when discount rates go up (down) – valuations (share prices) move in the opposite direction to improve (reduce) the expected returns from share ownership. Lower prices, other things being equal including expectations of profits to come, mean higher expected returns and vice versa.

Understanding and taking issue with the market consensus

One of the essential questions with which to interrogate the market, is to judge whether current market-determined interest rates are likely to move higher or lower or the environment that companies will operate in is going to become more or less helpful to their profitability. By definition, what surprises the market moves in interest rates or tax rates or risk premiums, will move valuations in the opposite direction. You may believe that the marketplace has misread the true state of affairs, such as the outlook for interest rates and risk premiums, and so has mispriced the share market, overvaluing or undervaluing it enough to encourage additional selling or buying.

The market consensus (revealed by the current level of the Index) will also have incorporated its expectations of performance to come by the companies represented in the Index. This consensus may also prove fallible. Earnings may be about to accelerate or decelerate in surprising ways. Operating profit margins may stay higher or lower for longer than expected. The economy itself may be about to enter an extended period of well-above past growth rates. If so, and you will have your own reasons for believing so, this would provide good reason to reduce or increase exposure.

Such contrarian opinions, if acted upon will add to or reduce exposure to equities. The market consensus is determined by its participants, all with the same incentive to understand it better, as you have, and is studied by many with great analytical skills and vast experience. Consensus has every reason to be the consensus. And when the consensus changes – as we have shown it so often changes – it will do so for good and well-informed reasons. Beating the market – that is getting market timing right – is a formidable task, so humility is advised.

While perfectly timing market entry or exit is not a task given to ordinary mortals, we can draw some helpful inferences about the condition of the market place, given this sense of what has driven past performance. We are in a position to judge how appropriately valued a market is at a point in time and therefore what would be required of the wider economic forces at work to take the market higher- or prevent it from going lower. We will attempt to recognise what is being assumed of the equity market – what assumptions are reflected in the prices paid for shares – and whether or not you can agree or differ from what is at all times the market consensus.

Our valuation exercises

We judge whether the equity market is demandingly or un-demandingly valued in the following way. We determine how current valuations are more or less demanding of additional dividends. Why dividends? Because they have the same meaning today as always: cash paid out to shareholders rather than retained by the enterprise. They are not subject to changing accounting conventions, such as the nature of capital expenditure and research and development expenditure that may or may not be fully expensed to reduce earnings. What may appear as an overvalued market would need a strong flow of dividends to justify current values and expectations. An undervalued market would be pricing in a slow-down in dividend payments. Good or poor dividend flows can take the market higher or lower.

Furthermore, we judge whether the market is more or less complacent about the discount rates that will be attached to these dividends to come. In this we are also aware that the interest rates we observe and that the market expects, as revealed by the level of long term interest rates and the slope of the yield curve, may be abnormally low or high – but might normalise to some degree in the near future.

We utilise regression equations that compare the current level of the leading equity index the S&P 500 to the level predicted by trailing dividends and long-term interest rates. The results of such an exercise are shown below. The model equation predicts a significantly higher S&P 500 than is the case today, some 40% higher. By this standard the S&P is currently undervalued.

The model provides a very good fit and both explanatory variables easily pass the test for statistical significance and accord well with economic theory. It explains past market behaviour well.

Figure 5: Regression model* of the S&P 500 (1970-2017)

Source: Iress and Investec Wealth & Investment

*Representation:

LOG(SP) = -1.80463655704 + 1.18059721064*LOG(SPDIV) – 0.0727779346562*USGB10

We can back test the model. If the model was run with data only up to November 2014 when the S&P began its new upward momentum we would have received a very helpful signal that the S&P was in fact very undervalued at that time. This signal would have encouraged investors at that point in time to have maintained high equity weight in portfolios- or what is described as a risk-on position.

Similarly had we applied the model in early 2000, just before the so called Dot.com bubble burst, the model would have registered that the S&P 500 Index was then greatly overvalued for prevailing dividend flows and interest rates Reducing exposure to equities at that point in time would have been very much the right approach to have taken – as we soon came to find out. We should add however that the model would also have registered a high degree of overvaluation as many as three years before the market fell away from its high peak. Even irrational exuberance, as Alan Greenspan memorably described it in 1997, perhaps relying on a similar approach to value determination, or its reverse undue pessimism, can persist for an extended period of time, making our model or any such valuation exercise based on historical performance unhelpful as a short-term trading model, but still valuable as a basis with which to interrogate market consensus.

In our models we regard the value of the S&P 500 as representing the present value of a flow of dividends (the performance measure) discounted by its opportunity cost, represented by the interest rate (the expected return) on offer from a 10-year US bond yield. An alternative approach would be to compare the value of the Index to the expected economic performance of the companies included in the Index, and then to infer the discount rate that could equalise price and expected performance in the NPV equation.

The Holt system[1] undertakes this calculation. It estimates the free cash flow return on capital realised by and expected from all listed companies (CFROI) real cash flow return on real cash invested using the same algorithms applied to all the companies covered by the system and its data base. This analysis can be used to derive a market discount rate for any Index that equalises the value of an Index, for example the S&P 500, to the cash flows expected from it.

In the figure below we compare this nominal Holt discount rate for the S&P 500 to US long term interest rates. These discount rates have receded with long-term interest rates, as theory would predict. Note also that both interest and the Holt discount rate are at very low levels, implying higher share prices for any given flow of dividends.

Of greater importance perhaps for share prices than discount and interest rates is the spread between them. This spread, the extra risk premium for holding equities rather than bonds, has widened in recent years. While the discount rate may have declined, it has maintained and even increased the distance between it and interest rates, so encouraging demand for equities.

When we replace interest rates with this risk premium in our dividend discount model we get a very similar signal of a currently undervalued S&P 500 (see below).[2]

Figure 6: US Holt discount rates (nominal) US long bond yields (10 year) and risk spread

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 7: Real Holt discount rates and real interest rates and real risk spread

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Figure 8: A model of the S&P 500 (explanatory variables, dividends and spread between discount rate and long term interest rates)*

*Representation of the equation:

LOG(SP) = -4.59846533561 + 1.51940769795*LOG(SPDIV) – 0.0501430590849*(CFROINOM-USGB10)

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

Therefore we conclude that the S&P 500, despite its recent strong upward momentum, is undervalued for current dividends and interest rates or the risk spread. However some caution about the level of the S&P Index is called for by a sense that long-term interest rates are now very low and may well normalise. A further reason to be cautious about the current level of the S&P 500 is that the day-to-day volatility of the Index has been very low by comparison with the past. This indicates an unusual degree of comfort with the current state of the US share market. Were volatility to normalise, share prices would probably under pressure.

Hence our asset allocation advice has been to retain a neutral exposure to equities for now, with the next 18 months in mind. On a shorter term view (less than six months) however, we are of the view that upside strength is at least as likely as any move lower.

When we review the JSE applying a similar method of analysis, the rand values of the All Share Index appears as fairly valued for trailing dividends and US Interest rates. It also appears fairly valued when all the variables of the model are converted into US dollars. However when the (high) level of the S&P is included as an explanation of the USD value of the JSE in place of US interest rates the JSE appears as now attractively undervalued.

The S&P 500 is normally a rising tide that lifts all boats. But in the case of the JSE this has not been the recent case. Not only the JSE but emerging market equity indexes generally also lagged behind the S&P 500 after 2014 and until mid-2016. It will take less SA risk, which comes with an improved political dispensation, to focus global attention on the potential value in SA equities, particularly the companies heavily exposed to the SA economy. The SA political news has improved and the case for SA equities exposed to a potentially stronger SA economy, has also improved, making the case for a somewhat overweight exposure to this sector of the JSE.

Figure 9: A model of the US dollar value of the JSE with dividends and US interest rates*

*Representation:

LOG(JSE USD ) = 1.3925529347 + 0.776827626347*LOG(DIVIDENDS USD ) – 0.127168505553*US 10 Y Bond Yields

Source: Credit Suisse Holt, Iress and Investec Wealth & Investment

[1] Credit-suisse.com/holtmethodolgy

“HOLT derives a market-implied discount rate by equating firm enterprise value to the net present value of free cash flow (FCFF). HOLTs FCFF is generated by a systematic process based on consensus earnings estimates, a growth forecast, and Fade. This process is similar to calculating a yield-to-maturity on a bond” See Holt Notes November 2012

[2] In order to undertake the analysis over an extended period of time we added US inflation to the real Holt discount rate for the US sample to establish a nominal discount rate to be compared with nominal interest rate. An equivalent series of US real interest rates (Tips) is only available from 1997

The great taskmaster

The success of any business enterprise is measured by the return realised on the capital entrusted to it. The managers of an enterprise will rationally direct the capital provided them to particular business purposes in the expectation of a return on the capital invested that exceeds its opportunity cost, that is greater than the expected return from the next best alternative project with similar risks of success or failure. The more risk of failure, the greater must be the required (breakeven) return.

Measuring the internal rates of return delivered by an operating enterprise in a consistent way over any short period of time, for example a year or six months, has its own accounting for performance complications. The fullness of time, or until the venture is sold or liquidated, may be necessary for calculating how well the owners have done with their capital. However calculating the risks of failure of any potential project is much more a matter of judgement and sound process, than any precise measurement.

The only returns that can be measured with accuracy are those realised for investors in listed and well-traded companies. Returns come explicitly in the form of capital gains or losses and dividends or capital repayments received. And risks to potential returns are measured by the variability of these (monthly) returns over time that hopefully have a consistent enough pattern. A consistency furthermore that identifies the returns from a company as more or less risky compared to the pattern of average returns realized on the stock market. These measures can then form the basis of a required risk-adjusted return for a company or an investor to aim at.

These so-called betas that compare returns on individual shares to market returns as above or below averagely risky may in fact be quite unstable variables when measured over different time periods. Furthermore, these equations that relate company returns to market returns may or may not explain a great deal of past realised returns. The alpha of the total return equation that reveals company specific influences on total returns may account for much of realised returns.

This may be as well when judging the competence of the managers deciding and executing on projects. If the share market returns are mostly alpha (under the control of manager) and not the result of market wide developments over which managers have no influence, then determining the contribution of managers to realised returns becomes a consistent process.

Those buying a share from a willing seller are mostly gaining a share in the established assets and liabilities of an operating company – a share that the seller is willingly giving up – at a price that satisfies both. They are not providing extra capital for the firm to employ.

By establishing a price for a share they are however providing information about the market value of the company’s operations and so by implication the terms on which the company could raise further share or debt capital, should they wish to do so to supplement the company’s own savings to be invested in ongoing projects. The additional capital invested by operating companies will mostly be funded through cash retained by the firm, that is from additional savings provided by established shareholders.

The secondary share market transactions, through their influence on share prices, converts the internal rates of return realised by and expected of an operating company, into expected market returns. The superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company. The higher (lower) the share price the lower (higher) must be the expected returns for any given operating outcomes.

In this way through share price action, higher costs of entry into the investment opportunity, companies and their managers that are expected to generate way above average returns on the capital they invest in on-going operations and projects, may in reality only provide market-related average returns to share owners over any reporting period, say the next year or two. The further implication of these market expectations, incorporated into share prices, is that only a surprisingly good or disappointing operating results will move the market. The expected will already be reflected be in the price of a share or loan.

The implications of these expectations and their influence on share market prices and share market returns for managers and their rewards, provided by shareholders, seems obvious. Managers should be rewarded for their ability to realise or exceed the required internally generated returns on capital invested: charged to exceed targets for internal rates of return that are set presumably and consistently by a board of directors, acting in the interest of their shareholders.

Better still, targets set for managers that are made public and well understood and can be defended when exceeded and managers who are then rewarded accordingly. By contrast, share market returns that anticipate good or poor performance, cannot reveal how well or poorly operating managers have done with capital entrusted to them. Rewarding operating managers on the basis of how their shares performed is not a good method. Excellent companies that are expected to maintain their excellence and perform as expected to very high standards may only generate average returns. And poor management can wrongly benefit from above normal returns if expectations and share prices are set low enough. The correct basis for recording the value of managers to their shareholders is to recognise as accurately as possible, the realised internal rates of return on the shareholders capital they have employed.

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds – can however be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro or PSG or a Naspers, are endowed with permanent capital by original shareholders that cannot be recalled. This allows them to invest capital in operating companies for the long run. They, the managers of the holding company, when allocating capital to one or other purpose, must expect that the managers of these operating companies they invest in are capable of realising above average (internal) returns on the capital they invest. If indeed this proves so, they must hope that the share market comes to share this optimism and prices the holding company shares accordingly, to reflect the increased value of the assets it owns. Other things being equal, the greater the market value of their investments the greater will be the market value of the holding company.

But other things may nor remain the same. The market place is always a hard task master. Past performance, even good investment management performance, may only be a partial guide to expected performance. The capabilities of the holding companies’ managers to add value by the additional investment decisions they are expected to make today and tomorrow – not only the investments they made in the past – will also be reflected in the value attached to their shares.

These can stand at a discount or at a premium to the market value of the assets they own. The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect this pessimism about the expected value of their future investment decisions.

A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns. It is a market reproach that the managers of holding companies should always attempt to overcome, by making better investment decisions. And by exercising better management of their portfolios, including converting unlisted assets into potentially more valuable listed assets and also by indicating a willingness to unbundle successful listed assets to shareholders when these investments have matured. And be rewarded appropriately when they succeed in doing so.

21 December 2017

The SA economy – some Christmas cheer

The incipient cyclical recovery identified in our last report on the state of the SA economy has been confirmed by the most recent data releases. New vehicle sales and the supply of cash to the economy at November month end both support the view that the economy is demonstrating resilience.

We combine these up to date, hard numbers (not based on sample surveys) to calculate our Hard Number Indicator (HNI) of the business cycle. As we show in figure 1 the HNI is now pointing higher after showing little momentum after 2014 and having moved lower in 2016. The annual change in this indicator (the second derivative of the business cycle) has moved into positive territory and is forecast to maintain this momentum.

The components of the HNI are shown below. The real money base, the note issue, adjusted for the CPI (to November 2017) has become less negative while the new vehicle sales have maintained an encouraging revival.

If recent vehicle sales trends are maintained, new vehicle sales would be running at a 600 000 unit rate at year end 2018. This would represent a welcome recovery from the cyclical trough of mid-2016 but would still leave sales well below the previous peak rates of 2006 and 2012-2014.

Sales volumes at retail level, excluding motor vehicles, have been reported for October 2017. They show that the retail sales cycle continues its upward momentum and is pointing to growth rates of about 3% through 2018. This growth will be assisted by the growth in demands for cash. Extra cash is still a very good coinciding indicator of retail spending intentions despite all the digital alternatives to cash in SA (see figure 4).

Perhaps a more important encouragement for households to spend more is that prices at retail level have hardly increased over the past few months. The retail price deflator has moved sideways even as the CPI continues its upward trend, though also at a more modest rate. Hence the trend in inflation at retail level is sharply lower and, if sustained, will prove a stimulus to spending (see figures 5 and 6). The key to the door of lower prices at retail level is the exchange value of the rand. The outcome of the ANC succession struggle at Nasrec this weekend will be well reflected in the rand and in turn in retail spending and inflation. 14 December 2017

ANC elective conference – what are the odds?

The markets have been recording their judgements about the outcome of the battle to succeed President Jacob Zuma as leader of the ANC to be decided over the next few days. The prospects of Cyril Ramaphosa succeeding has been recorded in the degree of rand strength versus its emerging market peers. As we show in figure 1 below, the rand weakened in response to the appointment of Minister of Finance Malusi Gigaba in March and weakened further after he presented his mini-Budget statement in October. Since then, and despite a very critical report from the credit rating agencies and a downgrade, the rand has recovered strongly – in an important relative sense – and not only versus the US dollar.

The same improvement in sentiment is revealed in the market for US dollar-denominated RSA bonds. As we show in figure 2, the spread between the interest rate yield on five-year RSA bonds and five-year US Treasury bonds that offers compensation for extra SA risks of default, has also narrowed from 2.2% in early November to about 1.8% on 14 December.

A still more direct measure of the probabilities of one or other candidate being first past the post is provided by online sportsbook operator Sportingbet (https://www.sportingbet.co.za).

When their books first opened the odds on the various potential candidates – or those not yet identified were as shown below. The favourite was Nkosazana Dlamini-Zuma with a 42% chance of winning (1/2.4) while Cyril Ramaphosa was given only a 27% probability of winning, less than the chances of Zweli Mkhize.

The decimal odds are now as shown below. Ramaphosa is the firm favourite, given a 57% chance of winning compared to a 33% chance for his closest rival Dlamini-Zuma. The odds on any other outcome have blown out.

The volume or value of bets cast is not disclosed, but we are informed by Sportingbet that 65% of the bets and 61% of the stakes have been cast for Ramaphosa, while 21% of the bets have been placed on Dlamini-Zuma and a larger proportion (36%) of the stakes cast for her. These books will close on Saturday 16 December and we are informed by the firm, who describe themselves as operator of South Africa’s largest online sportsbook:

“Unfortunately, as part of our trading risk management policy, and as a company policy, we never disclose amounts wagered, numbers of bets, or users on any single event. I can share however that considering it’s a “novelty” (or non-sporting event) market, the bet activity and interest on this is impressive. “

There is a great deal at stake for the economy in the ANC race for the top. Clearly, judged by the markets and the odds and the politically savvy involved, there are no certain outcomes. Were therefore the favourite to win and the more decisive the victory, the stronger the rand and the lower the risk spreads – and so the chances of a strong SA economic recovery. Perhaps something those casting their votes might bear in mind. 15 December 2017

Hail to the SA consumer

The South African economy cannot be said to be performing to its potential. But in one important sense it is performing well – for consumers. Those with income or borrowing capacity will not find the economy wanting when they come to exercise their spending choices over the holiday season.

The shops will be well stocked and able to meet their every demands and desires, be it for essentials or luxuries supplied from all parts of the world. They will not lack for bread or toilet paper or for wine, beer or spirits. Or lack for wonderful world class entertainment at the theatres and movie houses. The book shops will be well stocked for those who still regard reading as entertaining and valuable. Excellent restaurants of all ethnic persuasions will be open to them, but may require an advance booking, given the competition from foreign tourists, who are showing their increased appetite for what we enjoy at the prices we pay.

This is as it should be. Successful economies gained their cornucopias by putting the demands of consumers in first place. That is preventing producers, farmers or factory owners or avaricious rulers or ecclesiastical orders or soldiers to decide what is to be produced. And when consumers largely rule the economy and producers are required to respond to them, economies flourish. Doing it the other way round – for the state to put the interest of producers, including those employed by them – whose own well-being is always threatened by competition – is a recipe for economic failure and for stagnation and corruption and the waste of the opportunity to consume more.

A consumer-led economy need ask very little of the state. The State and its officials will not be called upon to design industrial policy or determine development plans, policies that require foresight that is simply not available to even the best informed and least self-interested official. What the effective State has to provide is the protection of contracts freely entered into and the capital of those who have saved and puts their capital and skills to work, hoping to satisfy their customers and be rewarded for doing so.

The state should also ensure that the success or failure of businesses, large and small, is determined by their sales to customers and the costs of doing so. Not where financial success is dependent on an ability to negotiate a morass of regulation and relations with powerful officials. This system inevitably advantages bigger business over their smaller rivals.

A consumer-led economy is a continuous process or trial and error, of firms learning and adapting to unpredictable circumstances. The winners and losers for the consumers’ spending power emerge – they are not chosen by planners. South Africa incidentally, since 1994, has spent hundreds of billions of rands – perhaps over 400 billion rands of them – in subsidising industries of one kind or another with taxpayers’ money or tax concessions, money that could have been put to much better effect by consumers, especially poor ones.

The South African government alas appears only too willing to continue to put producers and officials first. For example competition policy is directed to serve industrial and labour policy rather than protect consumers.

More important for economic development, given that education and training precedes the ability to produce, earn and consume more, it is tragically the educators, the producers, who are first in line when the huge government budgets for such purposes are allocated. Were the taxpayer to pay the fees to enable all those desperately seeking education and training to attend private schools, universities and training establishments, of their own choosing, the valuable customer would come first. And the outcomes in the form of additional employment and incomes would be far superior.

The market for jobs in South Africa – why it performs so poorly and what can be done to improve it

Piece written for the Free Market Foundation: http://www.freemarketfoundation.com/publications-view/the-market-for-jobs-in-south-africa-%e2%80%93-why-it-performs-so-poorly-and-what-can-be-done-to-improve-it-

A pdf version is also available here.

Exchange rate risks for international businesses and investors: why South Africa is not unique

The global economy remains hostage to a volatile US dollar

The US dollar continues to serve as the primary international unit of account and as the pre-eminent reserve currency held by central and other banks, yet the rate at which the US dollar is exchanged for other currencies remains vulnerable to large moves in both directions, so adding risks to all financial transactions that make reference to it. In figure 1 below, we show the performance of the US dollar against its developed market peers (The US dollar index or DXY). We also show the real dollar exchange rate against the same major trading partners. The real exchange rate adjusts the nominal trade-weighted exchange rate for differences in inflation rates. We discuss the economic importance of real exchange rates further below. However, it should be noted that the real and nominal US exchange rates have followed a similar pattern.

Figure 1: The trade-weighted real and nominal exchange value of the US dollar (1975=100)

Sources: Bloomberg, The Federal Reserve Bank of St. Louis (Fred Data Base) and Investec Wealth & Investment

In figure 2, we show the performance of the US dollar against its developed market peers, an index of emerging market exchange rates since 2010 that excludes the rand, and the rand/US dollar rate.

Figure 2: The US dollar vs. major currencies, an emerging market currency basket and the rand (higher numbers indicate exchange rate strength), monthly data (2010=100)

Sources: Bloomberg, The Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

The extraordinary strength of the US dollar in 2014 was associated with a high degree of emerging market (and rand) exchange rate weakness. Also note that a degree of US dollar weakness that begins in mid-2016 has been associated with a recovery in the emerging market basket (and the rand). US dollar volatility poses particular challenges for monetary policy in emerging economies. We return to this important issue below.

The real exchange rate is what matters for real business activity

Inflation can make a producer or distributor of goods or services less competitive in home and foreign markets. However, a weaker exchange rate can protect operating margins against those rivals subject to less inflation. What may be gained or lost in the ability to compete on price – when expressed in any common currency – can be offset by changes in the rate of exchange.

When the offset is complete, the exchange rate will have weakened or strengthened by the percentage differences in inflation in the home country and that of its trading partners. If such circumstances, the exchange rate would be said to conform to purchasing power parity (PPP). Thus, PPP is regarded as a theoretical equilibrium to which exchange rates will converge in time.

The deviations from PPP-equivalent exchange rates are used to calculate a real exchange rate. It is this real exchange rate that defines the competitiveness of prevailing market-determined exchange rates. A real exchange rate with a value of more than 100 indicates an overvalued exchange rate and a value less than 100 indicates a competitive or undervalued exchange rate. The direction of the real exchange rate towards or away from 100 shows whether domestic producers have become more or less internationally competitive.

The calculation of a real exchange rate can include multiple exchange rates and an equivalent number of inflation rates – weighted by the share of imports and export held by different trading partners. The prices of relevance for the calculation of inflation and the real exchange rate are usually derived from prices charged for the manufactured goods that are presumed to dominate international trade.

The history of flexible exchange rates in SA shows that, the USD/ZAR exchange rate as well as the trade-weighted rand exchange rate, have consistently deviated from PPP-equivalent exchange rates and in varying degrees (see figures 3 to 5). This indicates that when SA firms engage in foreign trade and have to compete on the domestic market with imports this is a risky activity, given the variability of the real exchange rate and operating margins.

Measuring real exchange rates – a focus on South Africa

These divergences from PPP-equivalent exchange rates, i.e. fluctuations in the real rand exchange rate, are large and variable. This real rand exchange rate volatility for the rand is linked to the removal of exchange controls on foreign investors that were effectively withdrawn in 1995. There was a brief period of real exchange rate volatility, between 1983 and 1985, when foreign investors were also free to move funds into and out of South Africa. A further source of capital flows has been the progressive relief on the exchange controls applied to South African residents.

Freer capital flows rather than trade flows have dominated the demand for and supply of rands exchanged for US dollars and other currencies, and has introduced significantly more rand exchange rate volatility . It is the flow of global capital that has similarly dominated exchange rate trends in all economies that are open to this free flow of capital.

As we show below, using January 1970 as the starting point, the USD/ZAR exchange rate diverged significantly from PPP in 1985, then conformed to PPP between 1988 and 1995, whereafter the divergence has been continuous, though still highly variable. Heavy shocks to the USD/ZAR exchange rate are to be observed in 2001-02, 2008 and 2014. These sharp deviations from PPP have been followed by movement back towards PPP.

Sensitivity to the base year

Notice too that the PPP calculation is sensitive to the base year used to calculate the price indices. When 2010 is taken as the starting point for the calculation, the absolute deviations from PPP exchange rates are of a different magnitude. However, the movement away from or back towards PPP-equivalent exchange rates takes the same direction in both versions of PPP-equivalent exchange rates.

The starting point for any such calculation should be when the actual exchange rate approximates PPP, as it did in 1970. By 2010, the base year for calculating the current real exchange rate, the USD/ZAR exchange rate had moved far away from PPP, using a 1970 base year. When the base year is taken to be 2010, the rand appears as less undervalued generally and even as overvalued in 2010 – when the USD/ZAR traded at less than its PPP equivalent (2010 prices).

Figure 3: Market and Purchasing Power Parity exchange rates (USD/ZAR) (1970=100)

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED Data Base), Investec Wealth & Investment

Figure 4: Market and Purchasing Power Parity exchange rates (USD/ZAR) (2010=100)

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

In figure 5 below we show the ratio of the PPP-equivalent USD/ZAR exchange rates to the market-determined USD/ZAR, using 1970 or 2010 as the base year. This ratio may be regarded as representing the real USD/ZAR exchange rates. Values above 100 indicate an overvalued (less competitive) nominal exchange rate and values below 100 indicate the opposite – the nominal exchange rate has changed by more than the difference in inflation in SA and the US.

Using 2010 prices and exchange rates, the rand was overvalued for much of the period from 1970 to 1995 and for some years afterwards. The strong real rand was supported in the 1970s by rising gold and metal prices in US dollars. The picture using 1970 prices as the basis of the calculation is different, revealing a consistently undervalued rand after 1985.

Figure 5: USD/ZAR – the ratio of PPP to market exchange rates; a measure of the real exchange rate using different base years

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Real exchange rates considered more widely – the international evidence

In the figures below, we show a variety of trade-weighted real exchange rates for the period 1995-2017, as calculated by the Bank for International Settlements and the SA Reserve Bank. All these real exchange rates are highly variable, including those of the US. The real US dollar demonstrated continuous strength between 1995 and 2002, then weakness to 2008, whereafter the safe haven status of the US dollar in a time of crisis added some real strength to the trade-weighted exchange rate. A further period of pronounced real dollar strength ensued after 2014. Not coincidentally, the real trade weighted rand moved in very much the opposite direction, as seen in figure 6.

It should be recognised that the real rand, for all its volatility and the risks to which it has exposed SA business, has not in fact been more variable than the real dollar. As a relatively small economy that is very open to foreign trade, real exchange rates are, of course, more important for the South African economy. The value of exports and imports for South Africa is equivalent to about 50% of GDP. The exposure to imports and exports in the US is equivalent to about 30% of GDP.

As may be seen in the figures below, the real euro and real sterling have also been highly variable since 1995, while the Brazilian real has been more variable than most. The summary statistics for these real exchange rates are provided in Table 1.

The conclusion, therefore, is that the volatility of the real rand that so complicates the business of exporting from and importing to SA is not exceptional. The same complications and risks of doing business across frontiers, or rather exchange rate regimes, apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere. As such, these risks are presumed to have increased the required returns on capital invested in servicing global markets.

One can also determine whether there is a general tendency of exchange rates to revert to PPP and foreign trade-neutral real exchange rates. In other words, can one conduct a statistical test of whether real exchange rates are mean reverting?

The answer is that they don’t pass this statistical test with any degree of statistical confidence. The Chinese and Japanese real exchange rate trends since 1995 are most conspicuously not mean reverting to the theoretical 100 as may be observed in figure 9. The real yuan has a distinct and persistently stronger trend while the real yen moves persistently weaker.

Figure 6: Real exchange rates 1995-2017, South Africa and the US (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 7: Real exchange rates 1995-2017, South Africa and Brazil (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 8: Real exchange rates 1995-2017, UK and Eurozone (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 9: Real exchange rates 1995-2017, China and Japan (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database)and Investec Wealth & Investment

Table 1: Real exchange rates summary statistics

The importance of capital rather than trade flows in determining nominal and real exchange rates

The notion that exchange rates will trend, over time, back towards some kind of competitive equilibrium, as imports and export volumes adjust to the real exchange rate effects on operating margins, therefore does not hold. The volatile behaviour of both nominal and real exchange rates is driven by unpredictable capital flows rather than by flows of currencies generated by the international trade in goods and services.

These capital flows that are based upon changing expectations of future returns, move the rate of exchange stronger or weaker. Inflation rates then react, but not rapidly or sufficiently enough to sustain PPP.

The exchange rate therefore leads inflation and the nominal exchange rate leads the real exchange rate – because inflation rates are much more stable than exchange rates. This stability is partly the result of the convention that measures inflation as the year-on-year change in consumer or other price indices, rather than as price moves over shorter periods of time. For example, a one or three month trend in consumer prices would indicate much more variability. The variability of real exchange rates has, in practice, almost everything to do with shocks to nominal exchange rates rather than price.

The shocks to the real exchange rate observed in the charts above therefore have very little to do with shocks to inflation rates. The openness of an economy to imports of staple commodities reduces the impact of harvests that are subject to unfavourable climatic conditions. Droughts and famines might otherwise have pushed prices temporarily much higher, providing a price shock to the economy.

As we show in figure 10 below, annual moves in the nominal ZAR/USD exchange rate dominate the moves in the real rand exchange rate that are so important for operating businesses and their operating profit margins. Similar results could be found for many other economies and their currencies as was found to be true of the US demonstrated in Figure 1

Figure 10: Annual changes in the USD/ZAR nominal and real exchange rates

The impact of exchange rates on prices and inflation

Exchange rate shocks will have implications for the domestic price level. Other things being equal, the price of imported goods and the prices realised for exports in the local currency will rise or fall with the price of a US dollar. Other things may not remain unchanged and may also effect the prices charged domestically. For example, the US dollar price of imported oil may be rising or falling as might other imported commodities.

Dollar strength might well mean downward pressure on prices set in US dollar and dollar weakness might have the opposite effect. The state of the domestic economy will also have an influence on prices. The more or less buoyant domestic spending is, the greater or lesser the pressure on domestic prices will be. However a weaker exchange rate and the higher prices that are likely to accompany it will, in themselves, act to reduce spending power. They may also undermine the confidence of households and firms in their economic prospects, and their willingness to spend more or less of their incomes.

How should monetary policy react to exchange rate shocks?

How then should monetary policy and interest rates react to exchange rate shocks that are so difficult to anticipate? We would argue the best approach to exchange rate shocks is not to react to them at all. This is because such shocks are temporary rather than persistent. If such exchange rate shocks really are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should nevertheless be recognised that dollar strength and other currency weakness can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness observed between 2014 and 2016.

The difference between rand weakness against the dollar and the weakness of other emerging market currencies vs. the US dollar represents additional SA specific risks to the returns expected from SA domiciled assets. We show these global and SA influences on the rand in the figure below. The USD/ZAR and the equally weighted Index of nine other emerging market currencies generally move in the same direction. The ratio of the USD/ZAR exchange rate to the USD/EM basket indicates South Africa-specific risks at work. These South Africa-specific risks spiked significantly in 2001, 2008 and 2015, when they added to rand weakness for global reasons. In other words, a weakness against the US dollar was shared by the other emerging market currencies.

Figure 11: The US dollar vs the rand and the EM Basket (LHS); and the Ratio rand/EM (RHS)

Source: Bloomberg and Investment Wealth & Investment

Thus, much of the persistently high rates of inflation over the period between January 2014 and June 2016 (an average of 5.5% per annum) can be explained by dollar strength and its impact on the rand prices of imports, exports and alternatives for both in the production and price choices firms make. Inflation remained at these levels despite increases in interest rates and near recessionary conditions.

South African inflation over this period cannot be explained by the extra demands exercised by local households or businesses. Aggregate spending remained highly depressed over this period, which was also due to the inflation of prices charged to them. A drought proved to add another supply side shock to the rand prices of staple foods.

Only persistent and permanent increases in the demands for good and services, fueled by persistent increases in the supply of money and credit, will lead to continuous increases in prices and, sooner or later, increases in the price of foreign exchange. Interest rate expectations and capital flows will, in such circumstances of highly accommodating monetary policy settings, come to anticipate more inflation and help weaken the exchange rate.

A central bank charged with securing permanently low inflation would have to react to demand side pressures of this kind on prices. But they are strongly advised not to react to exchange rate shocks, especially when they occur in the absence of excess domestic demand over domestic potential supplies.

To react this way is to make monetary policy hostage to the variable and difficult to predict, nominal and real US dollar exchange rate. It is a risky exposure that businesses engaging in international trade cannot easily avoid. But monetary policy would do well to do what it can to moderate the shocks that emanate from the foreign exchange market. Unfortunately, the SA Reserve Bank added higher interest rates to exchange rate misery over the 2014-2016 period. We regard these as errors of monetary policy that reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

The volatile dollar can easily lead to such monetary policy errors of judgment – as in the case of South Africa. Emerging market economies, particularly those with significant exposure to foreign trade, are especially vulnerable to fighting exchange rate shocks, that is US dollar-driven shocks, with higher interest rates, which further damage the prospects for local businesses.

These are errors the US is much less likely to make, given that the dollar is likely to be the source of the exchange rate shocks. Monetary policy in the US understandably does not react to the exchange value of the dollar. Therefore, when investing abroad, a bias in favour of dollar based investing seems appropriate.

It may be concluded that the volatility of the real rand (that so complicates the business of exporting from and importing to SA) is not exceptional. The same complications and risks of doing business across frontiers and exchange rate regimes apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere.

The alternatives to fiduciary currencies and flexible exchange rates

The alternative to flexible exchange rates is fixing the rate at which a domestic currency may be converted into another currency. For example, the Hong Kong dollar has been fixed at 7.8 to the US dollar for many years. This fixed exchange rate link demands that inflation and interest rates in the two currencies will be very similar, to protect the sustainability of the fix. However, this also means that the real USD/HK exchange rate has been as variable as the real USD exchange rate.

An alternative form of fixing an exchange rate that was practiced widely before 1970 elsewhere including in the US, would be to fix the rate of exchange to the price of gold or silver at some predetermined local currency price of gold. For example, between 1933 and 1970 the dollar could be converted into gold at 35 US dollars per troy ounce.

This gold convertibility requirement restrained central banks from increasing the supply of cash issued to banks – held mostly in the form of deposits with the central bank – that could be converted into gold in the days of the gold standard. Constraints on the growth in the supply of central bank cash in turn helped to sustain low rates of inflation in normal times.

In abnormal times of large balance of payments outflows, this convertibility of local currency deposits into gold (that could be exercised by foreign central banks after 1945) might break down, as it did for the US in the early 1970s. This breakdown, or not enough central bank stocks of gold to meet the demands for gold by other central banks, might lead to either a new fix of the rate of exchange of gold for the local currency, or lead to inconvertible currencies. This would be a move to flexible exchange rates and the abandonment of the gold standard.

This is what the US chose to do in 1971 under pressure to convert dollar liabilities into gold that came from the French government particularly. The French strongly objected to the reserve currency role played by the US dollar that increased demands for dollars that they argued added to the economic power of the US.

It might be recalled that the IMF, established immediately after the end of the Second World War to assist a global economic recovery, effectively restored the gold standard and reaffirmed the convertibility of US dollar into gold. The IMF, however, also allowed for and supported orderly adjustments to fixed exchange rates under conditions of “fundamental disequilibrium”.

The intention was to avoid a series of competitive devaluations and ‘beggar your neighbour’ policies that were such a damaging feature of international economic relations in the depressed 1930s.

The problem that fixed exchange rates after 1945 could not resolve, was when a global shortage of dollars became a surplus of dollars. In effect, the US as the dominant economic power that supplied the reserve currency was unwilling to play the gold standard game and limit the supply of dollars to sustain convertibility at a fixed rate. And so the global economy has had to cope with flexible exchange rates that do not necessarily trend to PPP-equivalent exchange rates. The price paid for allowing flexible and market-determined exchange rates to absorb the shocks caused by highly variable capital flows, has been to add to the risks of cross border trade flows

US Tax reform- how to respond effectively

The leaked “Paradise Papers” reveal how global companies minimize their tax payments by (legally) routing revenue and taxable earnings through low tax or no tax jurisdictions. Such revelations should not be a surprise given the significant differences in company tax rates and tax systems across tax regimes that influence corporate actions.

The obvious solution to this reality is not to tax companies at all. Rather to tax all the income generated by business operations for their many dependents, where they reside at the personal income rate. Though the very highly income taxed may still decide to live in Monaco, the Bahamas or Mauritius – a freedom they should not be denied and where they may well be subject to high expenditure and property taxes.

The owners of businesses can be taxed on the dividends received and the wealth (capital) gains, realized and unrealized gains generated for them. Their lenders can all be taxed on the interest received from business borrowers. All landlords including institutional owners can be taxed on their rental income.

And those employees receiving benefits in cash or kind, including contributions the firms make on their behalf to pension plans and social security funds, can as usual have taxes withheld from them by their employers and passed on to the government. Indeed fuller use of businesses as tax collectors. Forcing them to withhold income of all kinds, for which the individual income tax payer is only later credited. Collection rates are likely to be as good as they are with PAYE and could fully make up for any loss of taxes from companies.

The costs incurred by companies collecting taxes for the government are (understandably) allowed as a deduction from their taxable income. Usually also allowed as a deduction from taxable company income are the interest, rental and employment costs incurred by the firm – though not all interest incurred may be treated the same way. Also allowed as a deductible expense will be a rate of depreciation of the purchase price of plant and equipment, though with different rates applied to similar asset classes in different jurisdictions. These allowances may or may not approximate the actual loss of market value incurred by the company. And if not will add to or deduct from the economic income being generated.

All companies and individuals have every incentive to manage their tax liabilities as best they can and not only where they best report revenue and income. They may well structure their balance sheets with more risky debt to take advantage of the taxes saved. Debts that may (wrongly) appear cheaper than equity, the opportunity cost of which, is not allowed as a tax expense.

With the elimination of taxes on the income of businesses, all this tax structuring and gaming will disappear. Companies and their auditors would have to determine the measure of income as well as assets and liabilities to report. And so owners and managers would more rationally incur expenses, including interest and depreciation and location costs, regardless of their tax implications.

The US Congress is currently proposing a dramatic reduction in its federal corporate tax rate to 20% to make its companies more competitive. A reduction intended to keep more of them and their taxable income and investment and employment activity at home. There are also tax reforms on the agenda. Among them is to allow firms to fully deduct all capital expenditure (whatever its life) from taxable income- a very important way to increase economic income after taxes. A further proposal is to disallow all interest incurred as a business expense.

This would take the US company tax system close to a very low company tax rate – much lower than 20% in economic effect, given how income is to be defined. It is a new competitive challenge that all other economies will have to confront. The ideal way to compete with the US and all the tax havens is to eliminate the company tax system.

The market and the bookmakers inform us about the ANC succession battle (Update)

Below follows an update on this piece from Monday.

The immediate outlook for the economy depends on who governs SA after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economic outlook and the value of the financial claims on it. The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market suddenly came to reverse recently very unfavourable trends to register less SA risk. The rand strengthened, not only against the USD, but more meaningfully, also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. Still less SA risk has been registered this week in the foreign exchange markets. The ratio of the USD/ZAR to the USD EM basket (Jan 1^st 2017=1) had moved out to 1.104 on the 13^th November is 1.065 a relative SA gain of 3.6%

The behaviour of these foreign exchange indicators in 2017 is shown in figure 1 below. As may be seen, despite this recent improvement in sentiment, 2017 has not been a good year for the ZAR. The USD/ZAR weakened relative to its EM peers when Finance Minister Gordhan, in public dispute with the President over spending plans, was sacked in March 2017. It also suffered in response to the Budget statement presented by his successor, Milusi Gigaba in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall – this was well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohort would soon announce more government spending, on nuclear power or students, rather than less, regardless of the fiscal constraints.

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1^st=100 to November , 23^rd OR ratio (LHS) =1

Source; Bloomberg and Investec Wealth and Investment

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability. Just how vulnerable is President Zuma remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

Source; Bloomberg and Investec Wealth and Investment

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate, widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. The difference however between RSA rand bond yields however has widened gain to 7.2% p.a. and is back to levels recorded on the 14^th November. The default risk premium attached to five year RSA dollar denominated bonds though has declined further from 208 b.p on the 14^th November to 187 b.p on the 23^rd November

In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee) Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17^th. These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

In figure 5 we show the interest carry- the rate at which the USD/ZAR is expected to weaken over the next ten years and inflation expectations. These are measured as the spread between a vanilla bond that carries inflation risk and an inflation linker of the same duration that avoids inflation risk. As may be seen more inflation expected is strongly connected to the rate at which the ZAR is expected to weaken. It should be recognized that the weaker the rand the more it is expected to weaken further. It will take a stronger rand to reduce inflation expected- a welcome development that is beyond the influence of interest rates themselves.

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015 to November 23, 2017

Source; Bloomberg and Investec Wealth and Investment

Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

Source; Bloomberg and Investec Wealth and Investment

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( now very probably) being determined in December 2017. The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) They have not changed since- indicating perhaps a lack of betting activity. These odds imply a 40% chance of Dlamini-Zuma winning the nomination and a 45% chance for CR. As they say in racing circles- the favourite does not always win- but don’t bet against it.

Lower South African risks and the stronger rand and lower interest and inflation rates associated with rand strength are good for the economy and all the businesses and their stakeholders dependent on the economy. One prediction can be made with some degree of conviction. That is without less SA risk any cyclical recovery in the SA economy is unlikely.

Additional Figures

Equity performance in 2017 to November 17^th Daily Data

Credit Default Swap Spreads over US Treasuries 5 year; Daily Data 2015-2017

Credit Default Swaps over US Treasuries, 5 year Daily Data to November 17^th 2017.

[1] Our construct for Emerging Market exchange rates that exclude the ZAR is an equally weighted nine currency basket of the Turkish Lire, Russian Ruble, Hungarian Forint, Brazilian Real, Mexican, Chilian and Philippine Pesos, Indian Rupee and Malaysian Ringit

The market tells us about the ANC succession battle

The outlook for the SA economy depends on who governs after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economy and the value of the financial claims on it. The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market registered less SA risk as the rand strengthened, not only against the USD, but more meaningfully the rand also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. The political developments that actually moved the market are however not that obvious.

The behaviour of these indicators in 2017 is shown in figure 1 below. As may be seen 2017, despite this recent improvement in sentiment, has not been a good year for the ZAR. It weakened relative to its EM peers when highly respected Finance Minister Gordhan was also sacked in March. It also suffered in response to the Budget statement of his successor in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall – that were well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohorts would soon announce more rather than less government spending regardless of the fiscal constraints.

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1^st=100 or ratio (LHS) =1

Source; Bloomberg and Investec Wealth and Investment

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly and ignominiously sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability. Just how vulnerable remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

Source; Bloomberg and Investec Wealth and Investment

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee) Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17^th. These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015-2017

Source; Bloomberg and Investec Wealth and Investment
Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

Source; Bloomberg and Investec Wealth and Investment

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( probably) being determined in December 2017. The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) As they say in racing circles- the favourite does not always win- but don’t bet against it.

A world of exchange rate volatility – tough on trade and central banks

SA is very open to international trade. The aggregate value of imports and exports in any year is equal to 50% of GDP. Yet all this great volume of trade across borders is subject to highly volatile exchange rates. This volatility adds considerable risks to exporters, importers and those who compete with imports and exports in the local market.

What matters for the operating margins of businesses is exchange rates adjusted for differences in inflation between trading partners. These are known as real exchange rates. An undervalued exchange rate will add to profit margins, while an overvalued one – should the exchange rate change by less than the differences in inflation – will depress margins.

When the offset is complete, or when what is gained or lost on the exchange rate is equal to the difference in inflation rates, purchasing power parity (PPP) exchange rates are said to hold. In such a case, the prices of common goods or services delivered in any market place will be about the same when expressed in any common currency. Real exchange rates above 100 indicate overvalued exchange rates while real exchange rates below 100 indicate the opposite: an undervalued or generally competitive exchange rate.

It is however changes in nominal exchange rates that are the predominant force behind changes in the real exchange rate. In SA and elsewhere, frequent shocks to the exchange rates lead the process and inflation rates follow.

However the SA experience with real exchange rate volatility is by no means unique. The trade-weighted real US dollar exchange rate has been even more variable than the real rand exchange rate. And those of Europe and the UK are similarly variable.

In figure 1 below we show the performance of the US dollar rate of exchange against its developed market peers (DXY). We also show the real dollar exchange rate against its major trading partners. The pattern has been a highly unstable and destabilising one for the global economy, which relies on the US dollar as a reserve currency and unit of account.

We compare below in figure 2 a variety of trade weighted real exchange rates for the period 1995- 2017. As may be seen, all these real exchange rates are highly variable. Not co-incidentally, the real trade-weighted rand moved in very much the opposite direction to the real US dollar. The real euro and real sterling have also been highly variable since 1995. A consistently overvalued, less competitive real sterling between 1996 and 2007 can be identified. More recently, with Brexit in sight, sterling has become much more competitive.

Moreover none of the real exchange rates considered above can pass a statistical test for mean reversion. The Chinese and Japanese real exchange rates trends shown below conspicuously do not revert to the theoretical PPP 100. The real yuan has had a distinct and persistently stronger trend (off what was a very undervalued base in the mid-90s) while the real yen moves persistently weaker off what was presumably a very overvalued base in 1995.

How should monetary policy react to exchange rate shocks?

This global nominal and real exchange rate volatility – as well as the lack of mean reversion to trade neutral purchasing power parity exchange rates – has greatly inconvenienced global trade. It has also greatly complicated the reactions of central banks.

We would argue the best approach central banks should adopt to exchange rate shocks is to ignore them. This is because such shocks are unpredictable and largely beyond their control. They have little to do with competitiveness in international trade and almost all to do with capital flows responding to changes in expected returns across different economies. If such exchange rate shocks are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should be recognised that dollar strength and other currency weakness in response to persistent capital flows can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness and also emerging market currency weakness observed between 2014 and mid-2016. Ditto the higher inflation rates that followed.

But to react to exchange rate shocks as if they threatened permanently higher inflation is to make monetary policy hostage to the unpredictable US dollar exchange rate. Monetary policy in the emerging market world would do better to moderate rather than exaggerate the shocks to spending intentions and confidence that may emanate from the market in foreign exchange.

Unfortunately the SA Reserve Bank, from early 2014, added higher interest rates to the contractionary forces emanating from a weaker exchange rate. We regard this as an error of monetary policy that unhelpfully further reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

Monetary policy in the US understandably does not react to the exchange value of the dollar. Thus when investing abroad (investments that always carry extra risks given exchange rate volatility) a bias in favour of US-based investing seems appropriate. Or, in other words, the risks posed by a volatile real and nominal US dollar to monetary policy and real economic activity everywhere else are best hedged by investing in the US rather than in more macro policy error prone economies. 9 November 2017

The Bond market anticipates Reserve Bank reactions to a higher oil price- more bad news for the SA economy.

The bond market anticipates Reserve Bank reactions to a higher oil price – meaning more bad news for the SA economy.

The RSA bond market and the rand weakened on Friday: the yields on RSA bonds rose markedly across the yield curve. The RSA five-year yield added 22bps (0.22 percentage points) and the 10-year yield 24bps.

The spread between RSA yields and their equivalent US Treasury Bond yields (the carry) also widened by about the same number of basis points – indicating that not only did the rand weaken on the day but still more rand weakness was expected on the day.

The gap between RSA five-year and 10-year vanilla bonds and their inflation-linked alternatives also widened, indicating more SA inflation expected over the next five and 10 years, about two tenths of one per cent per annum more inflation expected over the next five and 10 years, with inflation now expected to average almost 7% over the next five and 10 years (see figure 3 below). The real yield on the inflation-linked five-year bond, at 2.43%, was unchanged on Friday, indicating that the higher nominal bond yields reflected a changed view of the outlook for inflation.

Further confirmation that it was inflation expected rather than real forces at work was that the sovereign risk spread was largely unchanged on the day. The extra yield offered on an RSA US dollar-denominated bond edged up only marginally, while the cost of a CDS swap that insures RSA debt against default, actually declined on the day (see below).

A large part of the rand weakness on Friday can be attributed to global rather than SA-specific forces at work, in the form of a degree of US dollar strength against both its peers (the euro et al) and against an Index of emerging market currencies that accords an 8.33% weight to the rand (see below).

Having identified more inflation expected behind the higher RSA bond yields and spreads, it remains the task to explain why inflation should have been expected to increase. Perhaps it has something to do with higher oil and metal prices. A combination of a higher oil price in US dollars and a weaker rand would be expected to add to inflationary pressures and depress domestic spending. The rand and US dollar price of a barrel of oil did spike higher on Friday. We can only hope that this supply side shock for inflation will be ignored by the Reserve Bank. Past performance alas makes it likely that the Reserve Bank would raise rather than leave interest rates alone in such circumstances. Perhaps this was also behind the spike in RSA interest rates across the yield curve. Short rates also rose on Friday, indicating an expectation that the Reserve Bank is more likely to increase the repo rate.

Our argument is not with the market but with the Reserve Bank that continues to treat supply side shocks to inflation as if they are permanent rather than temporary. Given all else that plagues the economy, such possible monetary policy reactions can make even the strongest still standing feel very weak. 7 November 2017

An expensive Budget failure – for extra-budget reasons

The Budget statement and speech on Wednesday badly disappointed the market in the rand and in RSA bonds. Since the Budget statement, the rand has lost about 3.3% of its US dollar value and was nearly 4% weaker against other emerging market exchange rates. This indicates that rand weakness and additional SA specific risks are at work.

The government’s cost of raising funds for 10 years has risen by about 22 basis points (0.22 percentage points), while five year money has since become a quarter of a percent more expensive for the SA tax payer. The spread investors receive as compensation for the risk that SA may default on its US dollar-denominated debt has increased by approximately 13 basis points.

Given that SA, to the 2020/21 fiscal year, will have to raise about R1 trillion to fund the growing deficit and to roll over maturing debt, the Budget statement has been a very expensive failure for the SA taxpayer. Furthermore, by weakening the rand, widening the risks to our credit ratings and to the rand and by adding to the inflation rate, the prospects for faster economic growth have deteriorated.

Yet one has difficulty in understanding why the statement was so poorly received. The statement continues to commit the government to fiscal conservatism. That taxes collected were a very large R50bn less than estimated in the February Budget, was widely signaled, as was the breach of the spending ceilings incurred to keep SAA alive. Furthermore, the decision to increase the Budget deficit and the borrowing requirement, rather than raise tax rates, makes good sense in such dire circumstances.

The Treasury may be implicitly conceding that raising the income tax rates in February proved counterproductive. Higher tax rates have not increased revenues and have in all probability discouraged growth. Raising income tax rates in the near future may well have become less likely.

Strictly controlling government spending while selling government assets is the only way out of the debt and interest trap. But privatisation on any scale appears as unlikely after the Budget statement as it was before.

What then are the steps the SA government could immediately take that might raise confidence in the prospects for the economy, enough to encourage households to spend more of their incomes and for firms to add jobs and capacity to meet their extra demands? Confidence enough to lift growth rates closer to a highly feasible 3% rather than 1% a year?

What is essential is no less than a confidence boosting conviction that the SA government is capable of ridding the economy of those individuals who have gained destructive control of the commanding heights of the SA economy. It therefore takes more than a statement to improve the outlook for the SA economy and to escape the stagnation that makes sound budgeting so difficult. 27 October 2017