How well is the equity market reading the Fed?

 

The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.

While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.

Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?

We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.

The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.

The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.

The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.

It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders

Taking stock of GDP

The SA economy in Q2 2015 was not as it appeared – after taking an inventory

According to the first readings of gross domestic output (GDP), in real terms for Q2 2015, the SA economy performed very poorly. It is estimated by Stats SA to have shrunk by 1.3% on a seasonally adjusted annual rate in the quarter.

(All figures are taken from the Quarterly Bulletin of the SA Reserve Bank, September 2015.)

 

On a second reading for the second quarter of figures provided by the SA Reserve Bank, which include estimates of the demand side of the economy, the outcomes, on the face of it things. seem even worse. Gross Domestic Expenditure (GDE) is estimated to have declined by as much as a 7.2% rate in the quarter. The outcomes were not nearly as dire as might be inferred from either the GDP or GDE estimates. Final demand, the sum of spending by households, firms and the government sector, actually grew by about 1%. That final demands continued to grow at a very modest pace is consistent with our own measures of economic activity. What turned final demands into very weak GDE growth rates was a dramatic decline in inventories. Inventories in Q1 grew by R8.8bn on a seasonally adjusted annual rate. In Q2 they declined by the equivalent rate of over R38bn. This decline in inventories was enough to reduce real GDP in the quarter by as much as 6.2%.

Much of the action is attributable to the large seasonal adjustment factor interpolated to the estimates of inventories, the consistency of which may well be questioned. It is normally the case that the second and third quarters are periods when inventories are built up and the fourth and first quarters are normally associated with a general run down in inventories. But as the Reserve Bank comments, inventory events in Q2 were anything but normal in the mining and oil sectors. To quote the Economic Review of the Reserve Bank for Q2 2015:

Following a modest build-up in inventories in the first quarter of 2015, real inventory levels declined significantly at an annualised pace of R38,9 billion (at 2010 prices) in the second quarter. The rundown of real inventories in the second quarter of 2015 was mainly due to the destocking in the mining and manufacturing sectors, partly reflecting subdued business confidence levels and a decline in import volumes.

In the mining sector, inventory levels at platinum mines in particular contracted during the period on account of a significant increase in the exports of platinum in order to fulfil offshore export obligations. The rundown of inventories in the manufacturing sector partly reflected lower crude oil import volumes due to scheduled maintenance shutdowns at major oil refineries over the period. Consistent with a slower pace of increase in retail trade sales, the level of real inventories in the commerce sector rose in the second quarter. Industrial and commercial inventories as a percentage of the non-agricultural GDP remained unchanged at 13,8 per cent in the first and second quarters of 2015.

Inventories can run down because firms lacking confidence in future sales plan for a reduction in goods held on the shelves or in warehouses. They may also run down in an unplanned way because firms are surprised by the actual sales they were able to make. The planned reduction in inventories can represent bad news for the economy as orders decline. The unplanned reduction can mean better news should firms attempt to rebuild inventories. Similarly, a planned increase in inventories can reflect a more confident outlook for sales to come. An unplanned build-up of inventories may also reflect unexpectedly poor current sales volumes, and so fewer orders to come in the quarters ahead. Making the distinction between planned and unplanned inventory accumulation will be all important for any forecast of economic growth. In the case of the SA economy in Q2, it seems clear from the Reserve Bank statement that the run down in inventories in Q2 was for largely idiosyncratic reasons, making the application of seasonal adjustments particularly subject to error.

Judged by the estimated growth in final demand, the economy did not deteriorate in Q2 as the statistics on the pure face of it may suggest. In our judgment of the National Income Accounts released for Q2, the economy continues on its unsatisfactorily slow growth path as other indicators of the economic activity, included our own Hard Number Index, have revealed. The economy is growing slowly and not shrinking, nor is it about to do so. There is moreover at least one silver lining to be found in the latest statistics. As much as inventories subtracted from the growth rate, net exports added as much, due to the growth in export volumes and the stagnation of import volumes. The trade balance went into surplus and the current account deficit declined thanks to the weaker rand and the relative absence of strike action.

Another development this year, essential to lessening the tax burden on the productive part of South Africa, and so increasing potential growth, is the further decline in public sector employment in Q1 noted by the Reserve Bank. Lower tax rates and less spent on employment benefits for a bloated public sector, also lower interest rates, will help stimulate a recovery in the all-important household spending that is essential for faster, sustained growth over the longer run.

A combination of export growth and a stronger trade balance combined with a smaller budget deficit, accompanying fewer expensive public officials, of the kind revealed in Q2 2015, is some of the right stuff necessary to recalibrate the SA economy in the collective mind of the global capital market from a fragile to a resilient economy.

Time to change the narrative

The Reserve Bank needs to change the narrative on inflation and interest rates to take full account of the economic realities

The rand exchange rate since 1995 has proven to be anything but predictable. Despite this, with the help of hindsight it is possible to explain why the rand has behaved as it has over the years. It can be shown that, since 2014, it has been more a case of US dollar strength, against almost all currencies, than rand weakness that explains the rand/dollar exchange rate. In recent weeks the rand has also weakened against the euro, again also in line with almost all other emerging market currencies.

 

Explaining dollar strength is an art form all of its own. It has much to do with the superior performance of the US economy over the past few years, allowing US interest rates at the long end of the yield curve to rise relatively to rates prevailing in Europe and Japan. The strength of the US recovery has also led the money market to believe that short monetary policy determined rates in the US are soon about to rise – adding to the demand for US dollars.

A consistently important influence on the foreign exchange value of the rand is the state of global capital markets. When global allocators of capital feel more secure about the state of the global economy, they favour riskier assets and riskier currencies. And vice versa: when caution rules, funds flow in the opposite direction to safer havens. The rand as a well traded emerging market currency (as well as rand denominated bonds and equities) falls into the category of one of the more risky, that is volatile, currencies and markets, as do most other emerging markets (EM) currencies. Currency moves associated with the Global Financial Crisis (GFC) of 2008-09, shown in the figure above, illustrate the vulnerability of the rand to such events.

It is possible to measure such risks in the bond markets. Measures in the form of a wider or narrower interest rate spread between South African or other EM debt can help identify the degree of risk aversion or appetite prevailing in the global capital markets. RSA and other EM US dollar-denominated debt trades at higher yields than US Treasury Bonds. These higher yields compensate investors for the risk that the debt issued in US dollar may not be honoured.

Foreign investors may also hold local currency denominated debt, for example rand debt, and so receive interest income in rands and other local currencies rather than dollars. Since the local central banks print their own currency and as much as they choose, there is no danger of any formal default on such debt, only that they may lose some of their US dollar value should inflation accelerate. The risk to these offshore investors holding local currency denominated securities is that the guaranteed interest income paid in a local currency will lose dollar value should the higher interest currency depreciate over time. The higher interest rates on rand-denominated debt compensate investors for expected rand weakness. The equilibrium and relationship between the difference in the interest rate for securities of the same duration and risk class and the contemporaneous percentage difference between spot and forward exchange rates is known as interest parity. Arbitrage maintains this relationship.

It can be demonstrated that the spot rand will generally weaken as these interest rate spreads widen – and vice versa when the spreads narrow. In the figure below we show two measures of SA risk: exchange rate risk and sovereign or default risk. The yield spread between RSA 10 year bonds and US Treasury bonds of the same duration is shown on the left hand scale while the cost of insuring RSA dollar debt of five years duration against default, known as the Collateralised Debt Security (CDS) spread issued by global banks, is shown on the right hand scale. Higher spreads of either kind are generally associated with rand weakness and vice versa for rand strength. It may be noticed how these spreads widened dramatically in 2008. Both spreads have moved in a narrower band since 2010 while the CDS spread fell back towards about 200bps.

It is possible to identify risks of default associated more specifically with SA rather than with EM bonds generally by comparing the CDS spread for RSA bonds with the spreads attached to all other EM debt, as estimated by JPMorgan. As may be seen in the figures below, SA risk and EM risk measures are highly correlated over time, indicating very similar forces at work. A wider difference between the EM Index spread and the RSA CDS spread, indicates a more favourable relative status for SA and vice versa. It may be noticed that this difference narrowed after August 2012 indicating a deterioration in RSA credit rating. However it may also be seen that the credit standing of SA has improved relative to other EM debt over the past year. Russia, Brazil, Turkey, Malaysia and Indonesia have all been making heavy recent weather of their connections to global finance. It may also be noticed that SA’s relative standing in the debt markets deteriorated before the GFC, as the repo rate increased and then improved in a relative sense compared to the EM average during and after the global crisis.

The rand may however also weaken or strengthen in response to perceptions of SA specific risks, independently of developments in global markets. Political and economic developments in SA may cause the market to sell or buy rand-denominated securities, leading to wider or narrower spreads or for the debt rating agencies to change their credit ratings.

The unrest and violence at the Marikana platinum mine in August 2012 was one such unfortunate SA event that weakened the rand against all currencies, including other emerging market currencies. It can be shown that the rand has traded off the weaker post-Marikana base ever since; though much of the direction of the rand exchange rate since can be explained by global rather than further SA influences.

Economic theory suggests that a primary influence on the exchange value of a currency is the difference between the rate of inflation in the home currency and inflation experienced by its trading partners. The exchange rate is expected, in theory, to move to compensate for these differences in inflation in order to maintain global competitiveness for producers and distributors in both the domestic and foreign markets. What is lost or gained by relatively fast or slow inflation of prices and costs, is expected to be offset by compensating movements in the exchange rate, thus maintaining Purchasing Power Parity (PPP). Unfortunately for the theory and the SA economy, PPP can contribute very little to any explanation of the exchange value of the rand since 1995.

It is the capital account rather than the trade account of the SA balance of payments (BOP) that has dominated the rand exchange rate ever since the capital account was integrated with the trade account of the BOP in 1995. The figure below makes the point very clearly. The difference between the theoretical PPP equivalent rand and the market rand makes for the real rand exchange. It is the deviation from PPP that makes a real difference to exporters and importers. A weak real rand makes exports more profitable and imports more expensive. According to Reserve Bank estimates, the real trade weighted rand is now about 20% weaker than its PPP equivalent and 10% weaker against the US dollar according to our own calculations, using comparative CPIs in SA and the US to infer the theoretical PPP USD/ZAR exchange rate.

The reality is that the highly unpredictable exchange rate leads changes in the SA CPI. Currency depreciation does not accompany or follow changes in the CPI as PPP theory would presume, it tends rather to lead inflation. How much inflation will actually follow a weaker rand will also depend on the underlying trends in the global commodity markets. Also important for subsequent inflation will be the impact of changes in tax rates and administered prices, also hard to predict

As we show below, there is a highly variable relationship between changes in import prices and consumer prices in SA, even as changes in import prices tending to lead changes in headline inflation, the lags are also variable. Hence to forecast inflation in SA, with any degree of accuracy or conviction, would require not only an accurate prediction of the essentially unpredictable exchange rate, but also of the almost equally difficult to predict pass through effect of a weaker rand on the CPI. Import price inflation is now running well below headline inflation, so helping to contain the inflation impact of the weaker rand.

If inflation in SA in say two years cannot be predicted with any degree of accuracy or conviction, as would appear obvious given all the unknowns that could impact on consumer prices over any 24 month period, then one can have little confidence that monetary policy and changes in the repo rate will help realise some narrowly targeted rate of inflation. The fan charts of the Reserve Bank published in its 2015 Monetary Policy Review that indicate the possible inflation outcomes, confirm the difficulty in forecasting inflation with any confidence. The chart below shows that there is a 90% chance of inflation in SA in 2017 being somewhere between 3% and 10%.

In practice in these unpredictable circumstances, all the Reserve Bank can do is react to inflation, rather than anticipate inflation and act appropriately to help stabilise inflation and the economy. In reacting to realised inflation by raising its repo rate when inflation is accelerating, the Reserve Bank has a further problem. The impact of interest rate changes on the rand is itself unpredictable. The impact of higher interest rates on the exchange value of the rand is as likely to weaken as strengthen the rand. Higher interest rates, if they are regarded as likely to slow down the economy, may well imply lower returns to capital and discourage capital inflows. If this turns out to be the case, higher interest rates may well be associated with more inflation.

However what can be predicted with conviction is that higher interest rates will suppress spending and reduce the rate of economic growth. Hence it is possible that higher interest rates will lead to no less inflation and perhaps lead to more inflation, given what might subsequently happen to the rand, and could be accompanied by slower growth.

The policy implication of the unpredictable rand and inflation is that the Reserve Bank should only react to inflation when prices are rising because domestic demand is increasing faster than domestic supplies, perhaps because money and credit supplies are growing too rapidly. It should not react to higher prices irrespective of the cause of such higher prices. For example, higher prices that follow exchange rate or other supply side shocks, following droughts or higher taxes on domestic goods or services. These shocks depress demand and higher interest rates will depress demand even further to no useful anti-inflationary effect.

The Reserve Bank might argue that if it didn’t react to higher inflation, whatever its cause, inflation would trend higher because of so-called second round effects. If it failed to react, more inflation would come to be expected and in turn lead by some self-fulfilling prophecy and producer pricing power, to more inflation itself. There is no evidence to support the view that more inflation expected leads to more inflation.

Indeed inflation expected in SA has remained remarkably stable around the 6% level, the upper range of the inflation targets. Expected inflation is a constant rather than a variable in the SA inflation story.

The problem for policy makers is that the market has been conditioned to expect higher interest rates, irrespective of the cause of higher inflation and the implications this may have for the economy. The task for the Reserve Bank is to change the narrative to take full account of the economic realities. The value of the rand and its impact on inflation is unpredictable and monetary policy should not be expected to react to it or other supply side shocks to the CPI that are of a temporary nature. The flexible exchange rate should be regarded as a shock absorber for the economy – not a threat to it. The proper task for the Reserve Bank is to manage aggregate spending in SA in a counter cyclical way. Chasing inflation targets, regardless of their provenance, can lead to pro-cyclical monetary policy.

Extraordinary volatility in all markets – causes and effects

The past week or two of exceptional market volatility was not so much a case of China sneezing and the world catching cold – but the sense that China may have little idea of how to cope with a cold. Its feverish interventions in the Shanghai stock market and perhaps also the currency market did not make a good impression. Surely the advice – starve a fever but feed a cold – holds everywhere.

Clearly there is much room for further slips before China becomes more of a fully market and service-driven economy – policy errors that will continue to complicate the calculation of market values in and outside of the Middle Kingdom. Fortunately, the US economy, despite some doubts about possible China contagion, remains well set on its recovery path. A major upward revision of US Q2 GDP growth rates released yesterday would have served as a helpful vapor rub for unnecessarily troubled breasts.

It remains for the Fed to get its long heralded first interest rate hike out of the way – to help confirm that the US economy has normalised, even when accompanied by below normal inflation rates. Our sense is that the markets will be reassured rather than troubled buy a 25bp increase in the Federal Funds rate, while giving the Fed ample time to consider its next move on the path to normality.

It is emerging market (EM) equities that have lagged far behind the progress made in developed equity markets since 2011. They have most to gain from a US recovery that can be expected to promote faster growth everywhere. EM equities and currencies, South Africa naturally included, lost relatively most in the recent turmoil. It is encouraging to observe that EM equities (priced in US dollars) have recovered as much as (or more) than the US market in recent days.

 

Also coming back with the recovery in equity markets was the volatility indicator for the S&P 500 (the VIX) and the risk premium for SA and the rand – indicated by the spread between RSA and US bond yields. There is clearly scope for further declines in these risk indicators and if they do decline to anything like normal levels, we will see further strength in the S&P 500 – and also in the rand.

 

What also may have been noticed in all the turbulence and rand weakness was that there was only one place to hide in the equity markets from rand weakness – in gold shares. In other words, there were no rand hedges, other than the gold shares. The rand value of even the most globally exposed counters, the global consumer plays and their like, declined with the cost of a US dollar.

There is an important difference between equities that can be regarded as rand hedges (rand values that rise with rand weakness\) and SA economy hedges. When the rand weakens for global reasons the dollar and the rand value of most equities and bonds will decline, as recent trends confirm. Hence there are no rand hedges outside the gold mines when the global risk outlook deteriorates. When the rand declines for South African specific reasons – those companies on the JSE with a largely global footprint – will see the US dollar value of their activities largely unaffected; hence rand weakness for SA reasons can then translate into higher rand values.

Gold is different. Its price and the value of gold mines, in US dollars, tends to rise in troubled times. Hence the extreme behaviour of JSE-listed gold mines in August. Between 17 August and 24 August, the JSE mold miners gained 27.8%. This was while the USD/ZAR exchange rate moved from R12.90 to R13.21 – down some 2.3%. Over the same few days of rand weakness the All Share Index went from 50751 to 47631, a decline of 6.3%. Over the next three days the Gold Mine Index gave up 19.25% of its rand value at the close on the 24 August as the All Share Index added 3.1% and the rand stabilised.

Clearly, SA gold shares can protect portfolios meaningfully against global risk aversion, even though they have proved to be a very expensive form of portfolio insurance over the longer run. The SA gold mines have suffered from not only higher costs of production and declining grades of ore mined, they have also proved vulnerable to SA events (strikes and the like) that limit production. Investors in SA mines should wish for a weaker rand in response to additional global risk aversion, unaccompanied by greater SA risks to their production.

South African shareholders should therefore wish for rand strength – not for rand weakness – unless they have an unhealthy weight in gold shares. But they should wish even more for rand strength that might follow a reduction in SA specific risks. If perceptions of SA risk, currently reflected in a high discount rate used to value company profits realised from SA activities, were to decline in response to better economic governance, the US dollar value of the rand would rise and the rand and the US dollar value of SA securities would rise. And most important, SA would be able to attract more foreign capital of all kinds on improved terms to help realise faster growth.

An avoidable trade off

Less growth for no less inflation: a trade off that could have been avoided with lower, not higher, interest rates

Since the Monetary Policy Committee (MPC) of the Reserve Bank decided to raise its repo rate by 0.25 percentage points on Thursday, the outlook for SA growth has deteriorated, because of the likely impact of higher interest rates on spending; while the outlook for inflation has deteriorated, because the rand has weakened. Less growth for more inflation hardly seems like a useful tradeoff, but that is what the SA economy has to confront.

Can we however blame the Reserve Bank for the weaker rand? We can, if the prospect of slower growth is expected to reduce the case for investing in SA and therefore is associated with the weaker rand. But the rand may have weakened for other reasons unrelated to the Reserve Bank decision. Emerging market risks may have simultaneously increased, thus discouraging capital inflows, or something the MPC also worries about – interest rates in the US may increase, so driving capital away from emerging markets leading to a weaker rand.

Neither of these forces since Thursday last week can explain the fact that the rand lost a little ground to other emerging market currencies, while interest rates in the US fell rather than rose. Moreover, while long term rates in SA remained little changed, the spread between RSA and US rates widened since the interest rate increase, indicating an increase in the SA risk premium (a wider spread is usually associated with rand weakness).

Furthermore short term rates – up to one year duration – all rose in tandem after the MPC meeting, indicating that the outlook for interest rates to come has not changed in response to Reserve Bank action or explanation. The interest rate carry in favour of the rand, AKA the SA risk premium, remains as it was. The forward looking stance of monetary policy, in the collective view of the money market, has therefore not softened – a softening that might have served to explain the weaker rand, but does not.

All of this indicates another point we have made repeatedly. The impact of any move in policy-determined SA interest rates on the exchange value of the rand is essentially unpredictable. This makes the relationship between interest rate changes and inflation also highly unpredictable, so undermining the logic of inflation targets. Inflation targets, if they are to be met with interest rate settings, demand a predictable relationship between interest rate movements and inflation itself. This predictability does not exist.

The unpredictable reactions in the currency markets help vitiate the presumption that interest rates can be a useful instrument for realising inflation targets. Upredictable increases in administered prices, the price of electricity, water, municipal services etc. that may drive inflation temporarily higher (as might a weaker maize harvest) are supply side forces that do not respond to higher interest rates. The notion that interest rates should rise in response to an economically damaging drought is surely risible. Higher interest rates in SA do have one highly predictable effect and that is to reduce spending.

The latest surprise for the inflation forecasting model of the Reserve Bank from which interest rate settings take their cue, is that the so called pass through effect from a weaker rand to higher prices is about half as strong as predicted by the model. Both the rand prices of imports (helpfully) and exports (unhelpfully for the domestic economy) are lower than they were a year ago, reducing rather than adding to the pressure on the CPI. This time round it is not the weaker rand that can be blamed for higher inflation to date- but a still weaker rand clearly imposes the risk of more inflation to come.

The MPC, by increasing short term interest rates, willingly added to the risks of still lower growth rates. Our view is that this represents a distinct error of judgment.

To quote the MPC statement:

“The MPC has indicated for some time that it is in a hiking cycle in response to rising inflation risks, and a normalisation of the policy rate over time. The MPC is cognisant of the fact that domestic inflation is not driven by demand factors, and the outlook for household consumption expenditure remains subdued. Economic growth remains subdued, constrained by electricity supply disruptions and low business and consumer confidence and the risks to the outlook remain on the downside. However, as emphasised previously, we have to be mindful of the risk of second-round effects on inflation, and the committee is concerned that failure to act against these heightened pressures and risks will cause inflation expectations to become entrenched at higher levels.”

We would take issue with the relevance of the so defined second round effects that is so important to the Reserve Bank view of how inflation comes about. That is the notion that more inflation expected can lead to more inflation as a kind of self fulfilling process and that it takes, if necessary, painfully higher interest rates to control such expectations. The reality, in our view, is that these inflation expectations held in SA are particularly well entrenched and highly stable at around the 6% level, the upper end of the inflation target band. That is, if we infer inflation expected from the actions of investors in the bond market, being the difference in yields offered by vanilla bonds and their inflation protected alternatives of similar duration. These differences are shown below for 10 year bond yields.

Thus, the remarkable fact about the extra rewards for taking on inflation risk – the difference between a coupon exposed to unexpected inflation and one completely protected against actual inflation – I is how stable it has been, around about 6%, the period of the global financial crisis in 2008 excluded. The daily average spread since 2009 has been 5.95%, with a maximum yield spread of 6.92% and a minimum of 4.55%, with a Standard Deviation of 0.41%. It would seem to us that the inflation leads inflation expected – not the other way round- and that it would take an extended period of inflation well below 6% p.a to reduce inflation expected. These second round effects are a theory without empirical support that is preventing monetary policy from acting in a usefully counter cyclical way. A cycle that calls for lower not higher interest rates to encourage not discourage growth that attracts capital and might support not weaken the rand.

Furthermore, the MPC should recognise that price setters, that is most firms, set prices according to what the market will bear, that prices are not simply cost or wages plus sum pre-determined profit margin. Higher costs will lead to lower margins if demands from the market restrict pricing power, and higher wages can lead to fewer people employed in the presence of weak demand and the absence of pricing power.

In the distinct presence of weak demand, fully recognised by the MPC, neither expected inflation nor higher wages explain higher inflation in SA. Nor does money or credit growth help explain why inflation in SA is currently as high as it is. Households are borrowing very little more than they did a year ago and firms are borrowing more, but to invest abroad not locally. Money supply growth remains subdued.

Higher taxes, in the form of higher administered prices, explain much of inflation to date and help explain much of the inflation forecast by the Reserve Bank Model. Administered prices, petrol and electricity for example, are assumed to increase by 11.7% and 12.5% respectively in 2016. Yet these price increases add further to the pressure on household and business budgets and further inhibit spending. Yet the MPC seems convinced their monetary policy settings remain supportive of the economy rather than a threat to it. To quote the PMC statement further:

“The expected inflation trajectory implies that the real repurchase rate remains low and possibly still slightly negative at times, and below its longer term average. The monetary policy stance therefore remains supportive of the domestic economy. The continuing challenge is for monetary policy to achieve a fine balance between achieving our core mandate of price stability and not undermining short term growth unduly. Monetary policy actions will continue to be sensitive, to the extent possible, to the fragile state of the economy. As before, any future moves will therefore be highly data dependent.”

We must beg to differ about the measured stance of monetary policy. A prime rate of 9.25% is well ahead of the price increases most private businesses are able to charge their customers. They do not have the monopoly powers of an Eskom or a municipality to charge more regardless of the state of demand. Keeping prices rising in line with headline inflation (not of their making) is becoming much more difficult, so making monetary policy ever less supportive of the domestic economy.

The economy is fragile and higher interest rates have made it still more so. Had the Reserve Bank been more sensitive to the state of the economy and more data dependent (and not embarked on a premature path to higher interest rates) the economy would have better prospects and a stronger not weaker rand might well have reflected this.

Unleashing the household sector

The state of the SA economy – reading the tea leaves and providing a recipe for a stronger reviving brew

The trend in retail sales volumes in 2015, now updated to May, help confirm that the SA economic engine is stuck in a slow growth gear of between 2% and 2.5% a year. Year on year retail inflation is also fairly stable between 4% and 5%.

Our Hard Number Index (HNI) of SA economic activity, based on new vehicle sales and cash issued by the Reserve Bank, adjusted for consumer prices, updated to the June month end, indicates a very similar pattern to that of retail, a pattern of slow growth. This is predicted to continue for the next 12 months at its current very pedestrian pace. We add the Reserve Bank Co-incident Business Cycle Indicator, based on 12 economic time series, for comparison, also smoothed and extrapolated beyond March 2015, the latest data point for this series. All of these indicators of reveal similar trends and cyclical turning points that provide very little sense of a cyclical upswing. The HNI shows up as a very reliable leading indicator of retail volumes and the more broadly measured business cycle.

It may be of some consolation that the indicators still predict some positive growth, though higher interest rates, if imposed by the Reserve Bank, may threaten even these predictions of slow growth. There is no suggestion that spending growth is about to pick up to add to inflationary pressures that are almost entirely the result of higher taxes on fuel and energy and municipal services generally.

The series for import and export prices to March 2015 suggest deflation rather than inflation emanating from the balance of payments and the exchange rate. The rand is weaker against the US dollar but stronger against the euro and only marginally weaker on a trade weighted basis compared to a year ago. Import or export prices (measured by the export or import deflator) were lower in Q1 2015 than they were a year before and so are not adding pressure to SA inflation rates: nor is domestic spending. The tax increases and the drought in the maize belt that have pushed the CPI temporarily higher, will not respond favourably to higher interest rates that the Reserve Bank seems intent on imposing on a highly fragile economy.

The case for raising short term interest rates in these circumstances is, in our judgment. a very poor one. It is certain only to further depress domestic spending without promising to have any predictably favourable influence on inflation or inflation expected over the next 12 – 18 months. As we will show SA needs lower rather than higher interest rates if it is to escape from slow growth forever.

The question the Reserve Bank should be considering – as should all those with responsibility for economic policy – is how can the economy hope to break out of this seemingly indefinite prospect of slow growth? Ideally it would be increased exports that lead the economy to faster growth. But exports from SA will be constrained by the weakness in metal and mineral prices associated with slow global growth and the fact that global supplies of metals have caught up with the extra demand that came from China in the boom years before 2008, though as we have seen recently, merely keeping the factories and mines working rather than shut down through strike action can help to add to exports and employment and incomes.

Stimulus from government spending has also run its course – it was ended by rising government debt and interest payments and threats to credit ratings accompanying these adverse trends. Increased duties on fuel and energy as well as higher income tax rates are not only adding to inflation- they are an extra burden on household budgets. And to look to the capital expenditure programmes of publicly owned corporations to lift the economy, as was the official case made a few years ago, would seem only to court further disaster. The clear reluctance of private business to invest more in their SA operations will continue until their capacity to produce more is challenged by increased demands form their customers. Private businesses in Q1 2015 reduced their capital expenditure and their payrolls.

The essential condition for any step up in SA growth rates is an increased willingness of households to spend and borrow more. Household spending accounts for about 60% of all spending and without encouragement for the rest of the economy from the household sector (encouragement now clearly lacking), the economy will not grow faster. How then could this come about? A look back at how the economy managed to grow much faster between 2003 and 2008 may be instructive.

In figure 3 below we show how spending in 2008 collapsed as retail prices rose sharply after the rand weakened in response to the Global Financial Crisis. Notice also the extraordinary growth in retail volumes between 2003 and 2007 as retail inflation subsided. Inflation subsided then as the rand strengthened and lower interest rates followed lower inflation so stimulating consumption spending further. Bank lending, as mentioned (particularly mortgage lending to households), grew even faster than consumption spending, so providing strong support for the spending intentions of households.

At the peak of the growth cycle in mid 2006, bank lending to the private sector was 26% up on a year before and mortgage lending had grown by about 30% on a year before. The value of residences owned by households increased by an average 21% a year between 2003 and 2007, adding significantly to the willingness of households to borrow and spend and banks to lend to them on the security of rising house prices. See figure 5 below that illustrates these housing and household wealth effects.

SA spending grew faster than output between 2003 and 2008 and the current account went into deficit, having remained in balance throughout the slow growth years that preceded the boom. Foreign capital more than made up the shortfall in domestic savings. The boom in spending and growth between 2003 and 2008 could not have continued without support from foreign capital that proved very forthcoming.

This helps make an essential point: growth improves returns on capital and attracts additional savings from all sources, domestic and foreign, to fund faster growth and benefit from higher returns on capital invested. Slow growth repels capital because expected returns fall away. The limits to spending and growth are set by the supply of savings from domestic and foreign sources. But to attract capital, conditions for it need to be attractive. Expected growth rather than stagnation or worse is the essential lure for capital.

If the economy were to grow faster in response to a pick-up in household spending, the lack of domestic savings might prove a constraint, should foreign capital not be fully forthcoming. If this were to happen, the rand would come under pressure and higher inflation would then call for higher interest rates – trends that would in turn inhibit any incipient recovery in household spending.

The point to be recognised is that unless the economy asks for more foreign capital the answer as to how much would be made available, only time and evidence would be able to tell. But there would be no point in inhibiting any recovery in household spending for fear that it might soon run into the sands. Entry into a virtuous circle of something like the 2003-2007 episode of faster growth will hopefully be attempted sometime in the not too distant future and would have to be led by faster growth in household spending. South Africans can only hope for the chance to test the market for capital to fund our growth.

One positive influence on spending will be the improved state of household balance sheets. The household ratios of debts to assets have declined – helped by a recent improvement in the value of houses, which are up by about 10%.

Lower, not higher short term and mortgage interest rates, would be helpful to this end. A recovery in the prospects for emerging equity and bond markets that have underperformed developed markets since 2011 would be very helpful indeed. The rand would attract a share of additional flows into emerging markets and so help add strength to its value, improve the outlook for lower inflation and lower interest rates. In other words, 2003-2007 reprised. We live in hope for more favourable tail winds from off shore.

But there is much South Africa could do to improve its economic prospects and its attractions to foreign capital, which are essential to any attempt to lift growth rates. They come under the broad rubric of reducing the risks of investing in SA business. Planning for more competitive labour and energy markets (less power to the unions and privatisation of generating capacity very much included) would go a long way to raising the bar for the SA economy and attracting capital to the all-important purpose of faster growth in incomes.

SA economy: Household help

Faster growth will have to be led by SA consumers. Adding to household indebtedness is the solution, not the problem.

The SA economy added neither jobs nor capital equipment in Q1 2015. The business sector is unlikely to come to the rescue of the economy unless households lead the way forward and prove able and willing to spend more. Growth in household spending growth, that contributes about 60% to GDP, has been trending lower ever since the post-recession recovery of 2010. Though in the latest quarter to be reported, Q1 2015, growth in household consumption spending estimated at an annual rate of 2.8% actually helped, raise rather than depressed GDP, which grew at a very pedestrian 1.3% rate in Q1, 2015. The national income statistics reveal the great reluctance of the corporate sector to spend more on equipment or workers. In Q1 2015 fixed capital expenditure by private businesses declined as did their payrolls.

The statistics on bank lending to the private sector are very consistent with the revealed reluctance of households to spend more and to borrow to the purpose. Yet the banks are lending far more freely to the SA corporate sector at a well over 10% rate of growth. However this corporate borrowing is not showing up as additional spending on fixed or working capital, that is, to employ more workers.

It would therefore appear that SA businesses are using their strong balance sheets to fund offshore rather than on shore operations. The significant increase in mortgage borrowing by SA corporations, presumably to this end, is noteworthy. By contrast household borrowing from the banks, including mortgage borrowing, has long grown more slowly, in fact declining in recent years when loans are adjusted for inflation. The price of the average house in SA has also been falling in real terms, so discouraging households to borrow or banks to lend to them in a secured way.

Much attention is usually given to the rising debt levels and ratios of households. The rising ratio of SA household indebtedness to disposable incomes is often referred to as a signal of the over indebted state of the average SA household. As may be seen below, this debt ratio increased markedly between 2003 and 2007 when the economy enjoyed something of a boom. This boom was led inevitably by a surge in household consumption spending , funded increasingly with credit, especially mortgage credit, linked to rising house prices of the period.

Also often referred to is the debt service to disposable incomes ratio, which has declined in recent years as interest rates have fallen- presumably a positive influence on spending. But this ratio ignores interest received by households that has fallen with lower interest rates- presumably to the detriment of household spending.

Much less attention unfortunately is paid to the other side of their balance sheet. As we show below the asset side of the SA balance sheet strengthened consistently before and after the meltdown in equity markets in 2008-09. A mixture of good returns in the equity and bond markets and a diminished appetite for debt has seen the household debt to asset ratio fall significantly.

The reluctance of SA households to borrow more and or the banks to provide more credit for them is being maintained despite a marked improvement in the balance sheets of SA households. Hopefully at some point soon, this balance sheet strength will translate into more household spending and borrowing. These improved balance sheets may well have helped sustain household spending in the face of deteriorating employment and profit prospects in Q1 2015.

As may be seen in the figure above the ratio of household wealth to disposable incomes fell between 1980 and 1996. These were very difficult years of political transition for the SA economy, made all the more difficult by declining metal prices. This wealth ratio has since risen significantly to the peak levels associated with the gold and gold share boom of the 1979-1981. Access by SA companies and individuals to global markets and global capital that came with the transition to democracy has clearly been wealth adding and so helpful to SA wealth owners. The value of their shares, homes and retirement plans has more than kept up with after tax incomes in recent years.

In the figures below, we show the composition of the asset side of the household balance sheet in 2014 and also how the mix of assets has been changing. The largest share of household wealth is held in the form of claims on pension funds and life insurance with ownership of residential buildings following closely in importance. The fastest growing component of household wealth is holdings of other financial assets, investments in shares and bonds mostly via unit trusts, while bank deposits lag well behind in importance.

In the figure below we compare the real, after inflation growth in household assets, in household debts, household consumption expenditure and real household per capita incomes. These growth rates move in much the same direction. More household borrowing is associated with greater wealth, more spending and most importantly, a faster rate of growth in real per capita incomes. This virtuous circle that is initiated by more household spending and more borrowing to the purpose is particularly well illustrated through the boom years of 2003-2007, the only recent period when the SA economy could be described as performing well. Over this five year period, household assets in real terms increased at an average rate of 11.9% a year, household debts by an astonishing real rate of 15.6% a year, while household consumption spending grew by 5.9% a year on average and household per capita real incomes were up at a welcome average real rate of 3.9% a year. Without the extra credit, all this good stuff could not have happened. So what is not to like about a credit accommodating boon to spending and economic growth?

One possible regret would be that such rapid growth rates cannot be sustained in the absence of an increase in domestic savings as well as of wealth. The ratio of gross savings to GDP in SA has been in more or less continuous decline since the peak rates realised in 1980 as is shown below.

This declining savings rate has meant a greater dependence on foreign capital inflows to maintain growth rates. Even the slow growth of recent years has had to be accompanied by deficits on the current account of the balance of foreign payments and equilibrating capital inflows that have funded these deficits and more – also adding to foreign exchange reserves.

Given the low rate of domestic savings, South Africans have had to sell more debt to foreign investors and shares to foreign investors. More interest and dividend payments have gone offshore in consequence. But what is not well recognised by those who concern themselves (unnecessarily) with the sustainability of faster growth is that faster economic growth attracts capital and slower growth frightens capital away (Unnecessary because the sustainability of the growth will either be supported by the capital market or will not be, in which case the potential growth will not materialise, leaving nothing to worry about, except slow growth).

In the boom years after 2003 the inflation rate in fact came down as the rand strengthened with inflows of capital. SA enjoyed faster growth and lower inflation until the boom ended with much higher interest rates, imposed by the Reserve Bank, before not after, the Global Financial Crisis frightened capital away.

If SA is to re-enter the virtuous circle of faster growth and supportive capital inflows of the kind enjoyed after 2003, it will have to be accompanied by a renewed appetite for household borrowing and lending. Strong balance sheets may help initiate a recovery in the household credit cycle. Higher short term interest rates will do the opposite. A test of the hypothesis that faster growth in SA can be self sustaining when supported by capital inflows is overdue. Hopefully conditions in global capital markets will become more risk tolerant and more inclined to fund growth in SA. A growth encouraging agenda, initiated by the SA government, would be a much needed further stimulus to raising SA growth rates and attracting foreign investment.

An interesting side show

The rise of Naspers and its implications for the JSE; and why the main show for emerging markets remains the US economy, not Shanghai or Greece.

One of the important features of the JSE over the past few years has been the extraordinary rise of Naspers (NPN). As a result of this, NPN has become a very large share of the JSE indexes (some 11% of the JSE ALSI and Top 40 Indexes) and an even larger share of the SA component of the MSCI Emerging Market Index (MSCI SA) where it carries a weight of over 19%.

MSCI SA excludes all the companies on the JSE with primary listings elsewhere, including therefore the heavyweights, Anglo American, BHP Billiton, Glencore, SABMiller, British American Tobacco and Richemont that have primary listings elsewhere, so adding to the NPN weight. MSCI SA accounts for nearly 8% of the emerging market benchmark, giving NPN a 1.5% share in MSCI EM. Tencent, the Chinese internet firm in which NPN has a 34% shareholding, that accounts aso accounting for almost all of NPN’s market value, is the third largest company included in MSCI EM with a weight of 2.57%. The share of NPN in Tencent will not have been counted twice in the free floats that determine index weights, making the combined weight of NPN and Tencent equivalent to over 4% of the MSCI EM larger than the weight accorded to Samsung. The diagram and table below show these weightings.

 

Clearly the share prices of NPN and Tencent are significant influences on the direction taken by the EM Index, while EM trends (and index trackers) will in turn influence the market value of Tencent and NPN. And so in turn, via the weight of NPN in the JSE, these forces directly influence the direction of the JSE Indexes and through flows of capital will also affect the exchange value of the rand. As we show below, not only has the rising NPN share price increased its weight in the Indexes the trade in NPN shares now accounts (clearly not co-incidentally ) for a large percentage of the value of all shares traded on the JSE. On some days the trade in NPN has accounted for well over twenty per cent of all the shares traded on the JSE (See below).

 

The JSE therefore has become to an important extent a play on NPN. And NPN is in turn (almost) a proxy for Ten Cent that is a play on Chinese mobile applications, including games and payment systems. Ten Cent describes itself as an Internet Service Portal. This NPN-Ten cent connection to the JSE accounts in part for the close links between the JSE and the EM Indexes, when both are measured in a common currency. It will be noticed that the EM Index and the JSE in USD dollars are now below their levels of January 2014 making them distinct underperformers compared to the S&P 500.

A recent force acting on global markets, especially EM markets, has been the extraordinary behaviour of the Shanghai equity market. The volatility in Shanghai listed shares as well as the direction of the Shanghai Composite Index, up then down since late 2014 is indicated below.

We show below that the EM Index and NPN largely ignored the extreme behaviour of the Shanghai Index until this past week when the markets and the rand seemed to have become somewhat “Shanghaied”, following that market sharply up and down. This turbulence on the Shanghai share market has clearly influenced the value of EMs, NPN and Tencent, as well as the rand, in recent days. On Wednesday (8 July), NPN in US dollars and Shanghai both lost about 6% of their value, while recovering as much on the Thursday.

It will take a greater sense of calm in Shanghai to reduce risks and attract funds into EMs and provide support for their currencies, including the rand. But more important still for EM economies and their listed companies over the longer term, will be a recovery in the global economic outlook. Any sustained recovery in the US economy should be welcomed by investors in EM. Any increase in short term interest rates in the US, from abnormally low levels, should therefore also be welcomed and regarded as confirmation of a US economic recovery under way; an economic recovery that is likely to extend to the global economy in due course. Events in Greece and Shanghai will remain distracting side shows to the main event, the state of the US economy.

‘Season of outrageous demands for wage increases upon us’

As published in Business Day 10 July 2015: http://www.bdlive.co.za/opinion/2015/07/10/season-of-outrageous-demands-for-wage-increases-upon-us

THE season of outrageous demands for wage increases is upon us. And, more important, it is the season of wage agreements that appear to take little account of the hundreds of thousands of workers outside the mine and factory gates who would willingly accept employment for existing benefits.

Even more unsettling will be the loss of jobs, as managers replace unskilled workers with machines and more skilled and experienced workers productive enough to justify their higher costs of hire. The losers will be the newly unemployed with little opportunity for alternative employment on anything like the same conditions.

How, then, can one make sense of this seemingly irrational behaviour by the unions? How can they not be aware, it will be asked, as their members will continue to be retrenched in large numbers? Why do the unions do what they do? They are surely as well aware as any that higher real wages can lead to job losses in the sectors of the economy where they exercise the power to strike.

The answer must be that they are well aware of the economic circumstances and the trade-off between wage gains and job losses, which they make for their own good reasons. I would suggest that, in fact, unions are not in the business of maximising employment or employment opportunities. Rather, unions are in the business of maximising the total wages paid to their members. The objective they quite rationally and self-interestedly attempt to achieve is the highest possible wage bill, not the number of wage earners or members of the union. It is the total wage bill agreed to by employers that forms the basis for collecting dues from members. Therefore, (percentage) increases in employment benefits can more than compensate for fewer workers employed. And better paid members may be more willing and able to pay their dues.

It is theoretically and practically possible for the wage bill paid by firms to rise in both nominal and real terms even as employment drops. This is precisely what has happened in the mining and other sectors of SA’s economy. While employment has declined in recent years, total compensation paid to employees of all kinds has continued to increase, and so presumably have the dues paid to their unions (collected conveniently by the employers themselves).

To put these outcomes in terms familiar to the financial sector, the asset base of the unions and staff associations from which they collect their fee income — the wage bill — has continued to rise as the unemployment rate continues to remain damagingly high to the economy, but not necessarily to the unions. There is nothing ignorant or irrational in all this, just predictable self-interest at work. Such an explanation fits the facts of the economy and its labour market well.

The statistics help make the point. SA’s economy may well have become less labour intensive — fewer worker hours employed per unit of gross domestic product (GDP) — but the share of total remuneration in GDP or total value added has changed very little. The wage bill (not numbers employed) has risen more or less in line with output. The share of owners and funders and rentiers in SA output peaked at about 47% of GDP in 2008 (before the global financial crisis) and has been in decline since (now 44%) as the share of employees has been rising. Employment benefits now constitute 46% of GDP. That is despite or maybe because of slow growth that reduces the rewards for savings and the demands for labour — but not necessarily the rewards of the majority who hold on to their jobs.

A similar picture emerges for the mining sector. The share of mining output accrued by employees has been rising in recent years, from 35% of total output (in current prices) to about 42% in 2013. In other words, the unions appear to be successful if their objective is (as I infer) to increase the wage bill paid by the industry rather than the numbers employed at the expense of the other claimants — shareholders and creditors — on the value added by the mining sector

Thus, while mining employment was at 2008 levels in 2013, average employment benefits per worker employed have risen consistently, at an average annual rate of more than 11% in money-of-the-day terms, and equivalent to an average increase of 4.5% in real terms, using the GDP deflator to convert nominal into real growth of employment benefits or rather costs to owners. The average employee in the mining sector came with an average cost to employers of more than R220,000 per employee in 2013. Not bad work if you can keep it.

The data on compensation of employees supplied by Statistics SA goes back only to 2005. It is, however, possible to view mining output and employment over a much longer period. The mining work force declined dramatically in the 1990s, from nearly 800,000 employees to about 400,000 by 2002, whereafter the number rose to more than 500,000 in 2008. Volumes of mining output, having declined in the 1990s as metal prices came under pressure, increased significantly in the mid-naughties, only to fall away again after 2008. The producers of iron ore and coal produced significantly more during the commodity price super-cycle that accompanied the Chinese thirst for raw materials. The big losses of output were suffered by the gold mines, as they ran out of profitable grade to extract.

But a focus on mining volumes rather than mining revenues (volumes times price) misses the driving forces in the industry. SA’s mining industry had the advantage of rising prices, especially after 2000, and became significantly more profitable — enough to hire more labour as well as offer significantly higher rewards to its employees between 2000 and 2008, after the savage job losses incurred in the 1990s.

A better sense of the environment for SA’s mines, for their owners, managers and workers, can be gained if we reduce mining revenues to their real equivalents by deflating current revenues by prices in general, represented by the GDP deflator, rather than by the index of the prices of the metals and minerals themselves, which rose much faster than prices in general to the advantage of the mines. Real mining revenues measured this way show a strong growth pattern until 2008 and explain the employment and wage trends much better than mining volumes that have remained almost constant over many years.

Notwithstanding a better appreciation of SA’s mining environment, it can still be asked about employment of workers in SA that is so desperately needed. A better understanding of the self-interested behaviour of the unions (in the quantum of dues collected) and the shareholders in mines attempting to improve returns on their capital, which have led to fewer better paid and skilled workers, should lead us to expect more of the same in the years to come. This would be a trade-off of better jobs in the industry for fewer employment opportunities and more capital (robots) per unit of output.

What then can be usefully done to encourage employment in SA, especially of unskilled workers, of whom there is an abundance? The first step would be not to look to the established unions or firms as sources of employment gains. The right way to look for employment gains is to find ways to inject competition in the labour market. Competition for customers and workers and competition for work will help convert the pursuit of self-interest to better serve the broad interests of society; that is in more employment.

More competition for the established interests in mining and every other sector of SA (unions and firms) from labour-intensive firms needs to be encouraged in every way possible. This means, in practice, rules and regulations that allow willing hirers and suppliers of labour to more easily agree to terms (they may well be low-wage terms) without artificial barriers. These barriers to more competition in the labour market come particularly in the form of closed shop agreements that apply to all firms and workers, wherever located or regulated. Less regulation and more competition is the solution to the employment problem. Higher employment benefits for the fortunate few with artificially enhanced bargaining powers will not reduce the unemployment rate any more than it has to date.

 

Some good news from the motor manufacturers

The balance of SA foreign trade turned into a very welcome surplus of about R5bn in May 2015. It apparently took the market by surprise, though it should not have, since the National Association of Automobile Manufacturers (Naamsa) had previously reported over 33 000 vehicles exported that month, more than enough to turn the trade flows.

Further good news came from Naamsa yesterday that reported 31 422 vehicles exported in June, another very good month for the motor manufacturing sector, the largest component of manufacturing generally, and the balance of payments. Export volumes of over 30 000 units now compare very well, with a satisfactory 50 251 units sold in the local market. Domestic sales numbered 47 868 units in May and June sales were about 1000 units higher, on a seasonally adjusted basis. However, as we show below, the vehicle cycle is clearly pointing to lower sales to come, with annual sales precited to fall from the current rate of 612 000 units to an annual rate of 523 000 units in June 2016.

This makes sustaining exports even more important for the industry and its dependents. The limits to exports are set by the willingness of the workers and their unions to stay on the job. The ability of the local industry to sustain its role in the global vehicle supply chain will depend on offering security of supply over the long run. The role of the unions in offering predictability of supplies from SA plants is clearly crucial. It is surely possible for the owners and the unions to come to terms on exchanging better paid jobs for reliability of attendance at work. Inevitably though, fewer person hours will be employed per vehicle produced as robots are substituted for more expensive labour, as is the case in manufacturing plants everywhere.

Yet if export volumes can be enhanced it may be possible to hire more rather than fewer workers – at better wages – even if the on average more expensively hired worker is made more productive with the aid of computer-driven equipment. The motor industry and the SA economy – in the form perhaps of a stronger rand – has much to gain from an infusion of self interested economic reality into collective bargaining. The reality is that it may be possible to provide well paid employment for a larger work force in some industries, if the opportunity to increase output for foreign markets can be taken. The highly competitive current rand exchange rate should encourage these negotiations. A better trade balance may well in turn help sustain the exchange value of the rand, which in turn would be very encouraging to domestic consumers. Additional demands from the households are even more essential to lifting SA GDP growth than are exports.

Global interest rates: The prospect of a normal world

The prospects of higher interest rates in the US and Europe, indicating more normal economies, should be welcomed, not feared

It should be recognised that while the rand has been on a weakening path against the US dollar since 2010, so has the euro since the second quarter of last year. This dollar strength, coupled with euro weakness, has left the rand, weighted by the share of its foreign trade conducted in different currencies, largely unchanged since early 2014. The euro has the largest weight (29.26%) in this trade weighted rand, while the generally strong Chinese yuan has a 20.54% weight and the US dollar a much lower weight of 13.77%.

Thus there has been minimal pressure on the SA inflation rate (CPI) from higher prices for imported goods. If anything, especially when the rand price of oil and other imported commodities is taken into account, the impact has been one of imported deflation rather than inflation. And the CPI would be behaving much like the PPI is (PPI inflation is now about 3%) were it not for higher taxes levied on the fuel price and higher prices for Eskom – which is also a tax on energy consumers being asked to cough up for Eskom’s operational failures.

The rand weakened significantly against all currencies in the aftermath of the Marikana mining disaster of August 2012. The rand, on its exchange rate crosses, has not recovered these losses. However, since early 2013, the rand US dollar exchange rate has very largely reflected global rather than specifically SA influences, that is US dollar strength rather than rand weakness. The rand / US dollar on a daily basis (since 2013) can be fully explained by two variables only – by the Aussie / US dollar exchange rate, which has also consistently weakened over the period, and lower mineral and metal prices. The further statistically significant influence has been the spread between long term US interest rates and their higher RSA equivalents – this reflects SA risk, or expected rand weakness. The interest rate spread also consistently adds rand / US dollar weakness (or strength when the interest spread narrows). The ability of this model to predict the daily value of the rand / US dollar since January 2013 is shown below. The fit is a very good one. Moreover, the model displays a high degree of reversion to the mean. That is to say, an under or overvalued rand according to the model has quickly reverted to its predicted value. For now, or until SA specific risks enter the equation, for better or worse, the model presents itself as a good trading model. At present the rand, after a recent recovery, appears about one per cent ahead of its predicted value.
 

The future strength of the US dollar against all currencies or, equivalently, the weakness of the euro, will depend on the pace of economic recovery in the US and in Europe. The pace of recovery will be revealed by the direction of short and long term interest rates. If rates in the US increase ahead of euro rates, because the US recovery becomes more robust, the dollar is likely to strengthen, and vice versa should US growth disappoint. The question then is what might these higher rates in the US and in Europe mean for emerging equity and bond markets? Clearly higher rates in the US will ordinarily mean higher long bond yields in SA and in other emerging markets. This cannot in itself be regarded as helpful for bond and also equity values in the emerging world. However faster growth in the US and Europe would translate into faster global growth, upon which emerging market economies are so dependent. This could attract capital towards emerging markets, strengthen their currencies and narrow the interest rate spread between, for example, rand-denominated bonds and US bonds of similar duration.

It is striking how emerging market equities and currencies have underperformed the US equity markets since 2011. Measured in US dollars, the benchmark MSCI Emerging Market Index and the JSE have, at best, moved sideways while the S&P 500 has stormed ahead.

The weaknesses of the global economy over the past five years have proved to be a large drag on emerging market equities. Faster global growth, accompanied by higher interest rates, can only improve the outlook for emerging market equities and perhaps their currencies. The prospect of higher interest rates in the US to accompany faster growth should be welcomed by equity owners, especially emerging market shareholders, who have had such a rough time of it in recent years. Faster global growth, led by the US, is very likely to be good news for equity investors everywhere, and especially those in emerging markets.

Greek debt – whose problem is it?

There is the old saw about when you borrow money from a bank, paying interest and repaying the loans are your problem. But when you are unable to meet the terms of the loan it becomes the banks problem. If the bank had been more risk averse or done its sums better it would not have loaned as much and you might not have gone broke.

Greek debt, it now appears, is becoming less of a problem for the Greeks and much more of a problem for the IMF and the European governments (rather the European tax payers) via the ECB, the European Investment Bank and the European Financial Stability Mechanism, who have backed the Greek governments (that is Greek taxpayers) with over €300bn of credit repayable over the next 30 and more years, with about €25bn due this year. Both the Greeks and the lenders involved must be well aware of the problem that the banks have. Almost all of the outstanding Greek debt is now owed to governments and their agencies (that is their taxpayers) after successive bail outs that avoided default and converted private into publicly owned debt.

The problem for the lenders is how much of the debt that they can realistically hope to collect, were the Greeks to declare default. In other words, how many cents on the euro could they still hope to collect in the bankruptcy proceedings that must follow? Unless the Greek government is willing to isolate Greece not only from the European Monetary System but from international trade and finance, they will still have to come to formal terms with their creditors. In such negotiations that will follow, the creditors would still have to be realistic about the demands they could make on the Greek people and their representatives in current and future governments.

The costs of having to leave the euro and the European Union (EU) are bargaining chips to encourage the Greek government to spend less on their many supplicants and grow faster through growth encouraging reforms. This would mean more competition in Greece and could enable the creditors to collect more of the funds they supplied to Greek governments so negligently in the past. Throwing more good money after what is now obviously bad, has less appeal for the creditor governments than it did – given the unwillingness of the Greek government to do or even to be seen to do what is asked of them. But the opportunity to make as much of your debt problems the problem of your bankers, as the Greeks have attempted to do, may still prove to have been a useful strategy – if Greece comes to better terms and retains its status in Europe.

Opportunity for the Greek economy with a Greek exit (Grexit) may come in the form of a weak drachma. But any gain in competitiveness through a weaker exchange rate is surely likely to be quickly eroded by higher inflation. Not facing up to economic realities (without access to foreign or domestic credit) will surely mean money creation and inflation to come. Not reforming a pension system that so encourages early retirement will remain a drag on economic growth, as will retaining so many of the policies that have bankrupted Greece. Greece, given the apparent appeal of its leftist leaders, could well become the Venezuela of Europe should it exit the EU. If this happens, it may take a long period of time and persistent economic failures for economic realities to reestablish themselves in the Greek imagination: you cannot spend as a nation much more than you produce, unless you can persuade others to lend to you. The likelihood of such persuasion succeeding any time soon, in the absence of some kind of deal with the EU, seems remote.

European bond markets can clearly withstand a Grexit from the euro. ECB support for the bonds issued by Spain, Portugal and Italy has eliminated contagion from a Greek default. The state of the markets in other euro government bonds tells us as much. Yet there is still much to lose for Europe – the banks will still be left with the problem of what to do with Greek debt even should Greece have been punished with expulsion from the EU. Formally writing off much of the Greek debt, as will have to be done should Greece default, will not be a comfortable exercise. So, given the alternatives for both creditors and debtors, a deal might yet be struck. This would be a deal that allows the creditors to postpone for now any formal recognition of how much they have lost, while allowing the Greek government to claim a much better deal than offered earlier, including access to further financial support, with a frank recognition that the debt cannot ever be fully repaid, even under the most conceivably favourable assumptions about the Greek economy.

Point of View: The rationale behind wage demands

Explaining the actions of trade unions in SA. Why it is not irrational to go on strike for higher wages even when employment declines. What are the policy implications?

The season of outrageous demands for wage increases is upon us. And, more important, it is the season of wage agreements that appear to take little account of the hundreds of thousands of workers outside the mine and factory gates who would willingly accept employment for current benefits.

Even more unsettling will be the loss of jobs, as managers replace unskilled workers with machines and more skilled and experienced workers productive enough to justify their higher costs of hire. The losers will be the newly unemployed with little opportunity for alternative employment on anything like the same conditions.

How then can one make sense of this seemingly irrational behaviour by the unions making the demands? How they can not be aware, it will be asked, since their members will continue to be retrenched in large numbers. Why then do the unions do what they do? They are surely as well aware as any that higher real wages can lead to job losses in the sectors of the economy where they exercise the power to strike?

The answer must be that they are well aware of the economic circumstances and the trade off between wage gains and job losses, which they make for their own good reasons. We would suggest that, in fact, unions are not in the business of maximising employment or employment opportunities. Rather, unions are in the business of maximising the total wages paid to their members. The objective they quite rationally and self-interestedly attempt to achieve is the highest possible wage bill, not the number of wage earners or members of the union. It is the total wage bill agreed to by employers that forms the basis for collecting dues from members. Therefore (percentage) increases in employment benefits can more than compensate for fewer workers employed. And better paid members may be more willing and able to pay their dues.

It is theoretically and practically possible for the wage bill paid by firms to rise in both nominal and real terms even as employment drops away. This is precisely what has happened in the mining and other sectors of the SA economy. While employment has declined in recent years, total compensation paid to employees of all kinds has continued to increase, and so presumably have the dues paid to their unions (collected conveniently by the employers themselves).

To put these outcomes in terms familiar to the financial sector, the asset base of the unions and staff associations from which they collect their fee income, the wage bill, has continued to rise as the unemployment rate continues to remain damagingly high to the economy, but not necessarily to the unions. There is nothing ignorant or irrational in all this, just predictable self-interest at work. Such an explanation fits the facts of the economy and its labour market well.

The statistics help make the point. The SA economy may well have become less labour intensive – fewer worker hours employed per unit of GDP – but the share of total remuneration in GDP or total value added has changed very little. The wage bill (not numbers employed) has risen more or less in line with output as we show below. The share of owners and funders and rentiers in SA output peaked in 2008 (before the global financial crisis) and has been in decline since, as the share of employees, has been rising. That is despite or maybe because of slow growth that reduces the rewards for savings and the demands for labour – but not necessarily the rewards of those, the majority who hold on to their jobs.

A similar picture emerges for the mining sector. In the figures below we compare mining output in money of the day (R millions) with total compensation paid by the industry to its employees. The share of mining output accrued by employees has been rising in recent years. In other words, the unions appear to be successful if their objective is (as we infer) to increase the wage bill paid by the industry rather than the numbers employed.

While mining employment was at 2008 levels in 2013, average employment benefits per worker employed have risen consistently, at an over 11% average annual rate in money of the day terms , and equivalent to an average increase of 4.5% in real terms, using the GDP deflator to convert nominal into real growth of employment benefits or rather costs to owners. The average employee in the mining sector came with an average cost to employers of over R220 000 per employee in 2013. Not bad work if (big if) you can get it.

The data on compensation of employees supplied by Stats SA only goes back to 2005. It is however possible to view mining output and employment over a much longer period. In the figure below we graph mining output in volumes (tonnes of coal and iron ore, kilograms of gold and platinum produced) and numbers employed in mining going back to 1990. The mining work force declined dramatically in the 1990s from nearly 800 000 employees to about 400 000 by 2002, where after the number rose to over 500 000 in 2008. Volumes of mining output, having declined in the 1990s as metal prices came under pressure, increased significantly in the mid-naughties, only to fall away again after 2008. The producers of iron ore and coal produced significantly more during the commodity price super cycle that accompanied the Chinese thirst for raw materials. The big losses of output were suffered by the gold mines, as they ran out of profitable grade to extract.

But a focus on mining volumes rather than mining revenues (volumes times price) misses the driving forces in the industry. The SA mining industry had the advantage of rising prices, especially after 2000 and became significantly more profitable, profitable enough to hire more labour as well as offer significantly higher rewards to their employees between 2000 and 2008, after the savage job losses incurred in the 1990s.

A better sense of the environment for SA mines, for their owners, managers and workers can be gained from the figure below. Here we reduce mining revenues to their real equivalents by deflating current revenues by prices in general, represented by the GDP deflator, rather than by the index of the prices of the metals and minerals themselves, which rose much faster than prices in general to the advantage of the mines. Real mining revenues measured this way show a strong growth pattern until 2008 and explain the employment and wage trends much better than mining volumes that have remained almost constant over many years.

Notwithstanding a better appreciation of the SA mining environment it can still be asked about employment of workers in SA that is so desperately needed. A better understanding of the self-interested behaviour of the unions (in the quantum of dues collected) and the shareholders in mines attempting to improve returns on their capital, which have led to fewer better paid and skilled workers, should lead us to expect more of the same in the years to come. This would be a trade off of better jobs in the industry for fewer employment opportunities and more capital (robots) per unit of output.

What then can be usefully done to encourage employment in SA, especially of unskilled workers, of whom there is an abundance? The first step would be not to look to the established unions or firms as sources of employment gains. The right way to look for employment gains is to find ways to inject competition in the labour market. Competition for customers and workers and competition for work will help convert the pursuit of self-interest to better serve the broad interests of society; that is in more employment.

More competition for the established interests in the mining and every other sector of the SA (unions and firms) from labour intensive firms needs to be encouraged in every way possible. This means in practice rules and regulations that allow willing hirers and suppliers of labour to more easily agree to terms (they may well be low wage terms) without artificial barriers. These barriers to more competition in the labour market come particularly in the form of closed shop agreements that apply to all firms and workers wherever located or regulated. Less regulation and more competition is the solution to the employment problem. Higher employment benefits for the fortunate few with artificially enhanced bargaining powers will not reduce the unemployment rate any more than it has to date.

Presumably these risks of default decline as growth prospects improve. And improved growth prospects (lower risk) are well associated with higher share prices. In the figure below we show the relationship between the value of the MSCI Emerging Market Index benchmark and the JSE ALSI and the CDS risk spread over recent years. We show how the CDS spread for RSA five year US dollar-denominated debt and the JSE in US dollars have moved in consistently opposite directions.

These relationships would suggest that the threat to the JSE and the rand will not be higher rates in the US and Europe, provided they are accompanied by improved global growth prospects. The threat however to the rand, the RSA bond market and the SA economy plays might still come from SA specific factors. These include strikes, load shedding and higher short rates imposed by the Reserve Bank that prevent the SA economy from participating in a faster growing global economy. The objective of the SA economic policy makers is to avoid such pitfalls.

The SA economy in May 2015: Slow but steady forward momentum, for now

The course of the SA economy at the end of May 2015 appears largely unchanged since February. This is judged by the pace of new vehicle sales and demands for cash (adjusted for inflation) in May.

These two hard numbers, which are not dependent on surveys based on selected samples – released very soon after the economic events themselves – serve to make up our Hard Number Indicator (HNI) of the immediate state of the SA economy.

The HNI may be compared to the Reserve Bank’s Coinciding business cycle indicator, updated only to February 2015. Current readings well above 100 (2010=100) indicate that the economy has moved ahead at a more or less constant modest forward speed, and is forecast to continue to maintain this pace over the next 12 months. This impression is supported by comparison with the very similar readings taken a month before. The recent inflexion of the HNI is also supported by the Reserve Bank Indicator that has continued to point higher, at least until February 2015 the latest observation.

Unit vehicle sales, after a strong start to the year, however fell back in May 2015, especially when viewed on a seasonally adjusted basis. The trend in new vehicle sales on the local market is now pointing lower towards a pace of 45 000 units per month or an annual market of about 540 000 units in 12 months’ time.

The consolation for the automobile manufacturers and their suppliers in South Africa, the largest component of domestic manufacturing activity, facing a likely decline in sales volumes, is that exports in May rose very strongly to 33 411 units, enough to maintain very high volumes of overall activity in this important sector of the economy. Hopefully the unions will also recognise the long term benefits to them of sustained production and the export contracts that will flow from the SA plants being regarded as reliable partners in global manufacture.

A lower underlying trend in the headline inflation rate has helped support the growth in the demand for and supply of cash. But this favourable trend appears likely to be reversed in the months ahead, according to our time series based forecast. The prediction of higher inflation to come in the months ahead would be well supported by other forecasts, including those made with the Reserve Bank forecasting model. This model predicts that headline inflation, off its low base of early 2015, will breach the 6% upper band of its inflation targets in early 2016 but fall back within it later in the year.

There might be some relief that the SA economy has not slowed down faster in 2015 and has been able to sustain a modest rate of growth, equivalent to GDP growth of about 2% a year. The biggest threat to sustaining a mere 2% a year growth in output would be higher inflation itself- particularly the sort of inflation that has been inflicting the SA economy in the form of higher taxes and higher electricity prices (taxes by another name), as well as poorer harvests that push maize and food prices in SA higher. Higher prices forced by the supply side of the economy, extract from the purchasing power of households and depress the real incomes of households and the volume of spending they wish to undertake, which constitutes such a large component of total spending (over 60% of the total of spending). Without a recovery in household spending growth the economy will not grow faster than it is now doing. Businesses will only wish to add significantly more to their capacity in response to stronger demands from their ultimate customers, the household spender.

A weaker rand imposes the same risk of higher prices to come and would act as a further drain on household spending power and propensities. In the 12 months to date the rand has held its trade weighted value rather well (despite the stronger dollar) and could not be regarded as contributing to higher inflation to come. Without higher excise tax rates, on what is now a lower rand price for oil compared to a year ago, the inflation rate would have been significantly lower and so would have eliminated, at least for now, any argument for higher interest rates, given the state of demand.

The further and imminent danger to the growth prospects of the economy is the pronounced intention of the Reserve Bank to raise interest rates, apparently regardless of the state of the economy or the unpredictability of the impact of higher short rates on the exchange value of the rand and inflation. The hope for the SA economy and for a firmer rand must be an improved outlook for the global economy and especially emerging market economies that encourage flows of funds to emerging market equities and bonds that will support emerging market currencies. A stronger, not weaker, rand might then accompany a gradual normalization of global growth and global interest rates.

Until then emerging market central banks, including the SA Reserve Bank, would be wise to do nothing to harm their own growth prospects with tighter monetary policies in response to a gradual normalisation of interest rates in the developed world. The tool to help their economies adjust to possible volatility in global capital markets should be exchange rate flexibility, not higher interest rates.

Will the Reserve Bank prove data or path dependent?

The members of the Federal Open Markets Committee (FOMC), while contemplating an increase in their key Fed Funds rate from an abnormal zero per cent to a slightly less abnormal 0.25%, are at pains to emphasise that such decisions remain “data dependent”.

Most recently chair Janet Yellen indicated that if the data on the US economy confirm their forecasts of an economic recovery well under way, then interest rates in the US will rise this year – this after spending all the while since 2009 at about zero. One would hope that their counterparts on the Monetary Policy Committee (MPC) of the SA Reserve Bank remain equally data dependent.

The danger is that the MPC has become path dependent – it has signaled its firm intention to raise rates this year regardless of the state of the SA economy, the state of which (if anything) has deteriorated in recent months as household spending on goods and services has slowed down. The MPC might believe that not raising rates (independent of data) would be interpreted as being soft on inflation – a most unfortunate state of path dependence if that becomes the case. Travelling down this path to still higher short term rates would be a grave error of judgment, even if the market place regards such interest rate developments as inevitable. The MPC needs to step off this path it has mapped out for itself.

It has to be pointed out that any further increases in its repo rate have been postponed ever since June 2014, presumably because of the weak economic data. The SA inflation to date has had nothing to do with excess demand that would usually call for restraint in the form of higher borrowing costs. Spending by firms, households and recently by the government itself (practising a degree of austerity) have grown even more slowly than even energy-repressed supply. Higher observed prices have almost everything to do with higher taxes on expenditure – on petrol and diesel and on electricity charged by Eskom and municipalities – with the prospect of further increases to come. Absent of these tax events the inflation rate would have been about the three per cent rate it reached in February 2015 – between August 2014 and February 2015 the CPI itself hardly rose at all – indicating a very subdued underlying trend in inflation before higher taxes kicked in. The firm rand in a world of deflation was a very helpful contributor to these trends. Despite the strong US dollar and because of the weak euro, with the largest weight in our foreign trade, the trade weighted rand is little changed from its exchange value 12 months ago. See below, where strength is indicated by higher numbers:

These more favourable exchange rate and demand side influences on prices in general have been well reflected Producer Price Inflation, prices charged at the factory and mine gates, that was 3% in April 2015. The mines and factories are not exercising much pricing power- the markets they serve are not proving very accommodating to higher prices they are being charged for their inputs- for tax and trade union reasons. The notion that real interest rates in SA- measured conventionally and unhelpfully as the difference between overdraft rates and CPI inflation is not a burden on producers – is belied by the fact that producers are not achieving anything like average consumer price increases in the prices they are able to charge their customers. Costs may rise, including the costs of hiring labour, but profit margins may well have to give way to economic realities, as will employment opportunities- even as may be observed – in the public sector.

The Reserve Bank would have to argue that inflation in SA would have been higher and would be higher if it did not raise its rates. Their argument is that expected inflation drives prices and inflation. The evidence for such a feedback loop from inflation expected to inflation is very unconvincing. Indeed the rate of inflation expected by the bond market has remained remarkably stable around the 6% p.a rate, the upper end of the inflation target range, indicating very little change in observed inflation could have come from that constant quarter. If anything actual inflation leads inflation expected. Inflation comes down and less is expected – inflation goes up and more inflation is priced into long term interest rates- not the other way round. See below where we show inflation compensation- the difference yields on 10 year RSA’s and their inflation linked equivalentsyields over the past 12 months. Inflation compensation moved lower with less inflation and has since moved higher as it became apparent that he receiver of revenue would tax much of the gains from lower oil prices.

The Reserve Bank must argue that without its actions and narrative, inflation expected would now be higher and inflation even higher. It is impossible to refute such a counterfactual. To know what would have happened had interest rates not been raised last year and had the Reserve Bank not suggested that further rate increases were to be expected, remains an unknown. But we would argue that there is something very wrong with a narrative that suggests interest rates must rise regardless of the state of the economy, especially if it cannot be known with any degree of confidence, that higher interest rates can reliably influence the rate of inflation itself.

The link between higher interest rates and the exchange value of the rand and therefore on inflation to come, is particularly difficult to establish, given all the other influences on the rand. Especially the impact on emerging market currencies generally of a highly variable and unpredictable global taste for risk and so the flows into emerging market equities and bonds and their currencies. However it can be predicted, with a much higher degree of confidence, that higher rates will depress domestic demand and GDP growth rates. As the rating agencies constantly remind us, the biggest risk to SA and its credit rating is slow growth. Sacrificing growth for whatever reason is a risky strategy, especially if its impact on inflation is unpredictable. In fact stronger growth can lead to less inflation if growth attracts foreign capital and supports the rand. And vice versa when the prospect of slower growth drives capital away from SA and weakens the rand

The major uncertainty facing the markets in the near future will be the reaction to the Fed rate increase. The impact of this widely expected move on emerging market currencies will be very hard to predict with accuracy. In the past, rising US rates that accompanied faster US growth rates have usually had a favourable impact on emerging markets. This is because US growth implies faster global growth, from which emerging market economies and their financial markets and currencies stand to benefit. It makes little sense for the Reserve Bank to talk up local interest rates for fear that higher rates in the US will weaken the rand and cause inflation in SA to increase. Higher interest rates will do nothing to counter such a shock, should it occur.

The right policy response to any currency shock is to ignore it and allow exchange rate flexibility to help the economy recover from such a shock. Higher inflation that follows a supply side shock of the exchange rate or tax kind itself depresses domestic spending. Interest rate increases in such circumstances are not called for – despite higher inflation. This should be the Reserve Bank narrative, not its vain pursuit of inflation targets, regardless of the causes or consequences of inflation. Policy actions above all should be data dependent and not predetermined.

Point of View: A question of (investment) trusts

Understanding investment trusts and how they can add value for shareholders regardless of any apparent discount to NAV.

Remgro, through its various iterations, has proved to be one of the JSE’s great success stories. It has consistently provided its shareholders with market beating returns. Still family controlled, it has evolved from a tobacco company into a diversified conglomerate, an investment trust, controlling subsidiary companies in finance, industry and at times mining, some stock exchange listed, others unlisted. Restructuring and unbundling, including that of its interests in Richemont, have accompanied this path of impressive value creation for patient shareholders.

The most important recent unbundling exercise undertaken by Remgro was in 2008 when its shares in British American Tobacco (BTI), acquired earlier in exchange for its SA tobacco operations, were partly unbundled to its shareholders, accompanied by a secondary listing for BTI on the JSE. A further part of the Remgro shareholding in BTI was exchanged for shares in another JSE-listed counter and investment trust, Reinet, also under the same family control, with the intention to utilise its holding of BTI shares as currency for another diversified portfolio, with a focus on offshore opportunities. Since the BTI unbundling of 2008, Remgro has provided its shareholders with an average annual return (dividends plus capital appreciation, calculated each month) of 23%. This is well ahead of the returns provided by the JSE All Share Index, which averaged 17% p.a over the same period. Yet all the while these excellent and market beating returns were being generated, the Remgro shares are calculated to have traded at less than the value of its sum of parts, that is to say, it consistently traded at a discount to its net asset value (NAV).

The implication of this discount to NAV is that at any point in time the Remgro management could have added immediate value for its shareholders by realising its higher NAV through disposal or unbundling of its holdings. In other words, the company at any point in time would have been worth more to its shareholders broken up than maintained as a continuing operation.

 

 

 

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How then is it possible to reconcile the fact that a share that consistently outperforms the market should be so consistently undervalued by the market? It should be appreciated that any business, including a listed holding company such as Remgro, is much more than the estimated value of its parts at any moment in time. That is to say a company is more than the value of what may be called its existing business, unless it is in the process of being unwound or liquidated. It is an ongoing enterprise with a presumably long life to come. Future business activity and decisions taken will be expected to add to the value of its current activities. For a business that invests in other businesses, value can be expected to be added or lost by decisions to invest more or less in other businesses, as well as more or less in the subsidiary companies in which the trust has an established controlling interest. The more value added to be expected from upcoming investment decisions, the higher will be the value of the holding company for any given base of listed and unlisted assets (marked to market) and the net debt that make up the calculated NAV.

Supporting this assertion is the observation that not all investment trusts sell at a discount to NAV. Some, for example the shares in Berkshire Hathaway run by the famed Warren Buffet, consistently trade at a value that exceeds its sum of parts. Brait and Rockcastle, listed on the JSE, which invest in other listed and unlisted businesses, are currently valued at a significant premium to their sum of parts. Brait currently is worth at least 45% more than its own estimate of NAV while Rockcastle, a property owning holding company offers a premium over NAV of about 70%. PSG, another investment holding company, has mostly traded at a consistently small discount to NAV but is now valued almost exactly in line with its estimated NAV.

It would appear that the market expects relatively more value add to come from the investment decisions to be made by a Brait or Rockcastle or PSG, than it does from Remgro. The current value of the shares of these holding companies has risen absolutely and relatively to NAV to reflect the market’s expectation of the high internal rate of returns expected to be realised in the future as their investment programmes are unveiled. Higher (lower) expected internal rates of return are converted through share price moves into normal risk adjusted returns. The expected outperforming businesses become relatively more expensive in the share market – perhaps thereby commanding a premium over NAV – while the expected underperformers trade at a lower share price to provide the expected normal returns, so revealing a discount to NAV.

The NAV of a holding company however is merely an estimate, subject perhaps to significant measurement errors, especially when a significant proportion of the NAV is made up of unlisted assets. Any persistent discount to NAV of the Remgro kind may reflect in part an overestimate of the value of its unlisted subsidiaries included in NAV. The NAV of a holding company is defined as the sum of the market value of its listed assets, which are known with certainty, plus the estimated market value of its unlisted assets, the values of which can only be inferred with much less certainty. The more unlisted relative to listed assets held by the holding company, the less confidence can be attached to any estimates of NAV.

The share market value of the holding company will surely be influenced by the same variables, the market value of listed assets and the estimates of the value of unlisted assets minus net debt. But there will be other additional forces influencing the market value of the holding company that will not typically be included in the calculation of NAV. As mentioned, the highly uncertain value of its future business activities will influence its current share price. These growth plans may well involve raising additional debt or equity, so adding to or reducing the value of the holding company shares, both absolutely and relative to the current explicit NAV that includes only current net debt. Other forces that could add to or reduce the value of the holding company and so influence the discount or premium, not included in NAV, are any fees paid by subsidiary companies to the head office, in excess of the costs of delivering such services to them. They would detract from the value of the holding company when the subsidiary companies are being subsidised by head office. When fees are paid by the holding company to an independent and controlling management company, this would detract from its value from shareholders, as would any guarantees provided by the holding company to the creditors of a subsidiary company. The market value of the subsidiaries would rise, given such arrangements and that of the holding company fall, so adding to any revealed discount to NAV.

It should be appreciated that in the calculation of NAV, the value of the listed assets will move continuously with their market values, as will the share price of the holding company likely to rise or fall in the same direction as that of the listed subsidiaries when they count for a large share of all assets. But not all the components of NAV will vary continuously. The net debt will be fixed for a period of time, as might the directors’ valuations of the unlisted subsidiaries. Thus the calculated NAV will tend to lag behind the market as it moves generally higher or lower and the discount or premium to NAV will then decline or fall automatically in line with market related moves that have little to do with company specifics or the actions of management. In other words, the market moves and the discount or premium automatically follows.

If this updated discount or premium can be shown to revert over time to some predictable average (which may not be the case) then it may be useful to time entry into or out of the shares of the holding company. But the direction of causation is surely from the value attached to the holding company to the discount or premium – rather than the other way round. The task for management is to influence the value of the holding company not the discount or premium.

Yet any improved prospect of a partial liquidation of holding company assets, say through an unbundling, will add to the market value of the holding company and reduce the discount. After an unbundling the market value of the holding company will decline simultaneously and then, depending on the future prospects and expectations of holding company actions, including future unbundling decisions, a discount or premium to NAV may emerge. The performance of Remgro prior to and after the BTI unbundling conformed very well to this pattern. An improvement in the value of the holding company shares and a reduction in the discount to NAV on announcement of an unbundling – a sharp reduction in the value of the holding company after the unbundling and the resumption of a large discount when the reduced Remgro emerged. See figure 1 above.

The purpose of any closed end investment trust should be the same as that of any business and that is to add value for its shareholders by generating returns in excess of its risk adjusted cost of capital. That is to say, by providing returns that exceed required returns, for similarly risky assets. Risks are reduced for shareholders through diversification as the investment trust may do. But shareholders can hold a well diversified portfolio of listed assets without assistance from the managers of an investment trust. The special benefits an investment trust can therefore hope to offer its shareholders is through identifying and nurturing smaller companies, listed and unlisted, that through the involvement of the holding company become much more valuable companies. When the nurturing process is judged to be over and the listed subsidiary is fully capable of standing on its own feet, a revealed willingness to unbundle or dispose of such interest would add value to any successful holding company.

This means the holding company or trust will actively manage a somewhat concentrated portfolio, much more concentrated than that of the average unit trust. Such opportunities to concentrate the portfolio and stay active and involved with the management of subsidiary companies may only become available with the permanent capital provided to a closed end investment trust. The successful holding company may best be regarded and behave as a listed private equity fund. True value adding active investment programmes require patience and the ability to stay invested in and involved in a subsidiary company for the long run. Unit trusts or exchange traded funds do not lend themselves to active investment or a long run buy and hold and actively managed strategy of the kind recommended by Warren Buffett. A focus on discounts to estimates of NAV, to make the case for the liquidation of the company for a short term gain, rather than a focus on the hopefully rising value of the shares in the holding company over the long term, may well confuse the investment and business case for the holding company, as it would for any private equity fund. The success of Remgro over the long run helps make the case for investment trusts as an investment vehicle. So too for Brait and PSG, which are perhaps best understood as listed private equity and highly suited to be part of a portfolio for the long run.

 

Appendix

 

A little light algebra and calculus can help clarify the issues and identify the forces driving a discount or premium to NAV

 

Let us therefore define the discount as follows, treating the discount as a positive number and percentage. Any premium should MV>NAV would show up as a negative number.

 

Disc % = (NAV-MV)/NAV ………………………………………..           1

Where NAV is Net Asset Value (sum of parts), MV is market value of listed holding company

NAV = ML+MU-NDt …………………………………………….       (2)

 

Where NAV is defined as the sum of the maket value of the listed assets held by the holding company. MU is the assumed market value of the unlisted assets(shares in subsidiary companies) held by the holding company and NDt is the net debt held on the books of the holding company – that is debt less cash.

Note to valuation of unlisted subsidiaries MU;

MU may be based on an estimate of the directors or as inferred by an analyst using some valuation method- perhaps by multiplying forecast earnings by a multiple taken from some like listed company with a similar risk profile to the unlisted subsidiary. Clearly this estimate is subject to much more uncertainty than the ML that will be known with complete certainty at any point in time. Thus the greater the proportion of MU on the balance sheet the less confidence can be placed on any estimate of NAV.

The market value of the holding company may be regarded as

 

MV=ML+MU-NDt+HO+NPV………………………………………………..(3)

That is to say all the forces acting on NAV, plus the assumed value of head office fees and subsidies (HO)activity and of likely much greater importance the assessment markets of the net present value of additional investment and capital raising activity NPV. NPV or HO may be adding to or subtracting from the market value of the holding company MV.

A further force influencing the market value of the holding company would be any liability for capital gains taxes on any realisation of assets. Unbundling would no presumably attract any capital gains for the holding company. These tax considerations are not taken up here

IF we substitute equations 2 and 3 into equation one the forces common to 2 and 3 ML,MU,NDt cancel out and we can conveniently write the Discount as the ratio

 

Disc= – (H0+NPV)/(ML+MU-NDt ) ………………………………………..(4)

 

Clearly any change that reduces the numerator (top line) or increases the denominator (bottom line) of this ratio will reduce the discount. Thus an increase in the value attached to the Head Office or the value of future business will reduce the discount. ( These forces are preceded by a negative sign in the ratio) A large increase in the value attached to investment activity will also reduce the discount and might even turn the ratio into a negative value, that is a premium. Clearly should the market value of listed or unlisted assets rise or Net Debt decline (become less negative) the denominator would attain a larger absolute number, so reducing the discount. The implication of this ratio seems very obvious. If the management of a holding company wishes to add value for shareholders in ways that will reduce any discount to NAV or realise a premium then they would need to convince the market of their ability to find and execute more value adding positive NPV projects. Turning unlisted assets into more valuable listed assets would clearly serve this purpose

 

Some calculus might also help to illuminate the forces at work. Differentiating the expression would indicate clearly that the discount declines for increases in H0 or NPV

 

That is dDisc/dNPV or dDisc/dHO= -1/(ML+MU-NDt)

This result indicates that the larger the absolute size of the holding company the more difficult it will become to move the discount through changes in the business model

 

Differentiating for small changes in the variables in the denominator is a more complicated procedure but would yield the following result for dML or dMU or dDNt

 

 

For example dDisc/DML= -(H0+NPV)/(ML+MU-NDt)^2

 

Again it may be shown that the impact of any change in ML,MU or NDt will be influenced by the existing scale of the listed assets held ML. The larger the absolute size of ML the less sensitive the discount will be to any increase in ML. The same sensitivities would apply to changes in MU or NDT. This reaction function is illustrated below

 

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The future will be determined by interest rates and risk spreads

The long term interest rate front has seen some real action this month. The attack on the prevailing very low yields was led by the German Bunds. It would appear that the modestly positive GDP growth recorded in Europe in the first quarter of 2015 – hence an expected increase in demands for capital to invest – was the trigger for this move.

Europe’s GDP expanded by 0.4% from the previous quarter, or 1.6% at an annualised rate. Further encouragement was to be found in the extension of better growth rates from Germany (where the quarterly growth rate receded slightly) to Italy and France.

US Treasury Bond and RSA bond yields predictably followed the Bunds higher. We illustrate this in the chart below, where the log scale better tells the story of rising yields in proportionate terms. The 10 year Bund yield increased from very close to zero (0.14%) at the April month end to a level of 0.72% on 13 May. Over the same two week period, the yield on the 10 year US Treasury Bond rose from 2.06% at April month end to 2.27% by the close on the 13 May. The 10 year RSA yield increased from 7.85% to 7.994%, slightly lower than the 8.051% registered at the close of trade the day before.

Accordingly, the spread between US and German yields, which had widened significantly earlier in the year, has narrowed sharply, to the advantage of the euro. The greater confidence in European recovery prospects helped send euro yields higher. The somewhat mixed picture about the robustness of the US economy, accompanied as it has been by weaker than expected spending at retail level, thus implying reluctance by the Fed to raise its short rates soon, helped restrain the increase in US yields. This narrowed the spread or interest rate carry and reduced the demand for US dollars.

The evidence suggests that the wider the spread in favour of US bonds, the stronger will be the dollar. The opposite has tended to be true of the rand and other emerging market currencies. The wider the spread in favour of the RSAs, the weaker has been the rand. This interest rate spread can be regarded as the risk premium carried by SA borrowers to compensate for the expected depreciation of the rand, as well as (presumably) sovereign risks. The RSA-USA 10 year yield spread, now 5.72%, is marginally lower than it was on 30 April 2015. It has moved within a rather narrow range since 2013, recording an average daily spread of 5.34%, with a maximum of 6.17% and a minimum of 4.31%.

It can be confidently expected that RSA rates will continue to follow equivalent US rates higher or lower; and that US rates will take their lead from euro rates. However, such co-movement of long term interest rates can be modified by changes in these interest rate spreads. The spread between RSA and US rates, that is SA risk, will be influenced by simultaneous changes in the outlook for the SA economy. The better/worse are SA growth rates (for example), the more capital will flow towards or away from SA, so narrowing or widening the spread and strengthening or weakening the rand.

But the spread will depend more consistently on a day to day basis on the outlook for emerging markets generally. Capital flows into and out of these economies and capital markets will respond to the expectations of emerging market growth and its implications for earnings of companies listed on their stock markets. The JSE All Share Index, when measured in US dollars, follows the emerging market benchmark indices very closely. This is because when capital flows into or out of these markets generally, the JSE consistently attracts or gives up a small, but predictable, share of such capital flows in the same direction. For any given level of global interest rates, the more confidence there is in emerging market growth, the narrower the risk or interest rate spread against the rand is likely to be, hence the stronger the rand is likely to be and the higher will be the US dollar value of emerging markets and JSE equities and bonds.

In the chart below we show how the MSCI Emerging Market Index and the JSE All Share Index (in US dollars) behave very similarly. It also shows how the two indices have underperformed the S&P 500 over recent years as the spread between SA and US interest rates have widened. We show these same trends in 2015.

These developments raise the issue of whether rising interest rates themselves (adjusted for changes in risk spreads) represent a threat to or an opportunity for investors in emerging equity and bond markets. Past performance suggests that rising rates in the US are much more likely to be associated with relative and absolute strength in emerging markets rather than weakness. The explanation for this seems clear enough. Rising rates in the US and Europe will accompany stronger growth and an improved growth outlook. Such growth in the developed world is helpful to the growth prospects in emerging economies, for which the developed economies are important sources of demand for their exports. A rising tide in the developed world will lift all boats – including those moored in the emerging economies.

The following figure strongly suggests as much. It shows how rapidly rising interest rates in the US between 2003 and 2007 were been associated with declining risk spreads for the emerging bond markets. The lower interest rates after the financial crisis in 2008 were in turn associated with greater emerging market bond risks. These risk spreads are represented by the average of the five year credit default swap spreads over US Treasury yields for Turkey, SA, Mexico and Brazil.

Presumably these risks of default decline as growth prospects improve. And improved growth prospects (lower risk) are well associated with higher share prices. In the figure below we show the relationship between the value of the MSCI Emerging Market Index benchmark and the JSE ALSI and the CDS risk spread over recent years. We show how the CDS spread for RSA five year US dollar-denominated debt and the JSE in US dollars have moved in consistently opposite directions.

These relationships would suggest that the threat to the JSE and the rand will not be higher rates in the US and Europe, provided they are accompanied by improved global growth prospects. The threat however to the rand, the RSA bond market and the SA economy plays might still come from SA specific factors. These include strikes, load shedding and higher short rates imposed by the Reserve Bank that prevent the SA economy from participating in a faster growing global economy. The objective of the SA economic policy makers is to avoid such pitfalls.

UIF and unintended consequences

A large post Budget surprise (though no relief for the workers in the form of UIF contributions) and other unintended consequences of it.

National Treasury was faced with a problem ahead of this year’s Budget: the Road Accident Fund was running a huge deficit while the Unemployment Insurance Fund (UIF) was running as large a surplus. And so the 2015 Budget proposed to take more than R10bn from the economy through higher taxes on petrol, diesel and paraffin while giving back to employees and employers in the form of significantly lower contributions to the UIF.

But now, most unusually, the Budget was anything but the final word on the matter as it almost always is on tax matters of this large order of magnitude. The government, in its wisdom, now intends to dispose of its taxing power otherwise. Contributions to the UIF will continue as before adding an extra R15b to government revenues.

To quote the Minister of Finance Nene, as reported in the daily media, the step was taken for fear of “unintended consequences” and to allow for further consultations. What these unintended consequences may be is not indicated and clearly escaped the Treasury when it drafted its Budget, a process that presumably takes much official effort and time and many a consultation. Another of the unintended consequences of the decision to reverse course will be to undermine the value of the Budget proposals themselves – until now regarded by businesses and households affected as a done deal rather than the opening of negotiations.

Incidentally the most important item on the expenditure side of the 2015 Budget was also left unresolved by the time the Budget was presented in February – the sum of tax payers’ contributions to the employment benefits of public sector employees (of which wages and salaries, after taxes and social security and pension contributions are only the largest but seemingly most visible part to those receiving and paying for the benefits). We can only hope that the decision to take more in the UIF contributions from the lower income average SA household with members in formal employment in the private sector is unrelated to unintended further generosity to public sector employees. These public sector employment benefits already compare more than favourably to those employed in the private sector. This is especially so when the very low risks of unemployment and defined benefit pensions related to final salaries, almost only provided by the public sector, but also guaranteed by the hard pressed taxpayers, are factored into the calculation of comparative employment benefits. Little wonder then that working for the government is much the desired objective of the majority of entrants to the labour market out of the schools and universities.

But a proper think on the role of social security contributions or the so called payroll taxes in SA is called for. They play a very small role in the overall tax structure compared to tax structures in the developed world. By comparison, SA relies much more heavily on income taxes collected from companies (or rather their shareholders), than employees in the developed world. Social Security, or what may be called National Insurance Contributions, can easily amount to 15% or more of the salary bill. This helps pay for the significant benefits received from their governments by the average household in medical benefits and pensions etc.

The scope in SA for raising additional income tax from companies or individuals is clearly limited. Higher income or expenditure tax rates may well lead to lower revenues collected, which is counterproductive both from the perspective of SARS as well as highly damaging to growth in employment, output and pre tax incomes. It is also not good tax policy to tax some expenditures, for example on energy (including electricity), at much higher rates than expenditure in general. It distorts expenditure and production patterns in unhelpful ways. Taxes are ideally general and proportional, rather than specific and unequal, if economic growth is to be encouraged.

It would only be fair to the large ranks of the unemployed or the underemployed unable (because of regulation of the labour market) to gain access to formal employment, that the comparatively well paid insiders with decent jobs should pay more for what has become the privilege of formal employment. The important point about payroll taxes, such as the UIF contributions made by workers and their employers in SA, is that they largely represent a sacrifice of their wages or salaries or other employment benefits, for example contributions to medical insurance, even when the employer pays in the cash. The workers subject to a payroll tax would have very likely taken home more not only because their contributions would have been lower, but because their employers, in time, would have seen their savings as a reason for paying higher wages or providing other benefits that help retain actual and potential employees whose sought after skills may be in short supply. Payroll taxes are largely a tax on workers (not their employers – something they would be well advised to appreciate) and so they should demand that their sacrifices of take home pay are always put to good use.

The curse of scale in financial markets- and how GE is getting rid of it – to shareholder applause

There is a latter day curse victimizing financial institutions. That is to be recognized by the regulator as a “Systematically Important Financial Institution” (SIFI) In other words one regarded by the regulators as being “too-big-to-fail”. Hence the requirement by regulators of any SIFI of very strong balance sheets that ensure against failure. This translates into ample highly liquid assets on the asset side of the balance sheet that yield minimum income for the bank. Such safe assets will have to be accompanied by secure funding in the form very long dated liabilities that may be expensive to raise. It may be required that such debt be converted at very short notice- to be given by the regulator- into equity – should solvency come under serious threat. Such unfavourable terms for debt holders would add further to the cost of such funding . Furthermore short term liabilities that can be withdrawn at the whim of lenders, for example deposit liabilities,do not qualify as desirable secure forms of funding. Regulators then require of banks good cover in the form of capital and holdings of cash or near cash to be acceptable sources of bank funding. These requirements make short term deposits a much more expensive source of funding for banks.

The problem with such safe guards and fail-safes is that they must all come with reduced returns on the capital subscribed by shareholders in any SIFI. Less risk forced upon borrowers and lenders (higher costs of raising funds and lower rewards for allocating them) translates inevitably into less profitable financial businesses with diminished prospects for growth. These lesser prospects for shareholders immediately subtract from the long term value of any bank or financial business to its shareholders. Such is the curse on shareholders. It is also a curse on potential borrowers from a financial institution. It means less appetite by banks to lend even at higher charges and to much slower or negative growth in their loan portfolios.

South African banks are also having to face up to additional constraints on both sides of their balance sheets imposed by the international bank regulation convention known as Basle 3. This means significantly increased costs for banks raising funds and reduced returns on shareholder capital they risk. It must also mean both more expensive bank loans and fewer borrowers qualifying for them. It is not a formula designed to facilitate economic growth for which bank credit is an essential ingredient.

One way to break the spell over the SIFI is to reduce the scale of your financial activities – that is for a financial institution to become as systemically unimportant as possible- something shareholders will welcome and the regulators cannot easily stop, as General Electric (GE) is now in the process of doing. GE announced the disposal of USD26b of its real estate assets and property lending to the Blackstone Group and Wells Fargo last week, the first steps in winding down its Financial Division. GE’s intention is to dispose of USD200b of property and financial assets and associated liabilities under its control. GE Capital accounted for 57% of GE earnings in 2007- pre the Financial Crisis – and this contribution is planned to decline to 10% of earnings in 2018. GE has also announced that ; USD50b of the asset sale proceeds will be used to buy back shares equivalent to about 17% of its current market value while it intends to maintain its dividend –another means to return excess cash to shareholders.

The share market reacted very favourably to the news, adding nearly 14% GE’s share price and as much as USD37b dollars to its market value almost overnight. (See below) Perhaps also worth noting is that despite the recent jump, a GE share is worth but half of what it was in 2002.

Clearly exiting its SIFI status can be a market value adding move something the shareholders in SIFIs everywhere will not fail to notice. Reducing the size of GE and prospective earnings from the financial division, while releasing capital for prospectively superior returns, inside and outside GE has already added value for GE shareholders. Making the additional point, if it needs to be made, that it is not earnings per share or the growth in earnings per share that matters for shareholders, but return on capital, especially improved returns on reduced capital employed, that can add to the value of a share.

An unknown to the market is to what extent such downsizing to avoid an unwelcome, “too-big-to-fail” status, will give pause to the regulators. Or will the growth of alternatives to banks (in the form of more profitable shadow banks and other lightly regulated lenders) encourage them to further extend their regulatory reach at the further cost of shareholders and borrowers? An alternative, less regulation intensive and profit destroying approach would be to recognize the possibility of financial or business failure, of even the largest financial institutions. Such failure would have to be accompanied with severe penalties for shareholders and also debt holders of failing institutions. A credible threat of failure with its highly wealth destroying consequences for equity and debt holders will restrain risk taking in the first instance. But in the event of failure it will need well designed bankruptcy procedures, known in advance by bankers and central bankers, to limit the potential collateral damage to soundly managed competitors. The Global Financial Crisis was not only a response to excessive risk taking – encouraged it should be recognised by US government interventions in the market for mortgages. It was aggravated by the lack of clear procedures for winding down or supporting financial failures. Fixing this failure is a better approach than regulations that attempt to eliminates both the risks of failure but also and the returns and the benefits to customers that come with taking such risks. The rewards of success, because of the risk of failure is the essential raison d’etre for any business enterprise including financial businesses. Denying the trade off between risk and returns will eliminate both as well as all potential SIFIs that have so much to contribute to any successful economy .