Interest rates, inflation and exchange rates in SA. Dominated by expectations.

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

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

Source Bloomberg and Investec Wealth & Investment

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

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

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

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

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

Source; Bloomberg, Investec Wealth & Investment

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

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

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

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

Interest and Exchange Rate Trends. Annual Data

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

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

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

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

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

Interest rates, inflation and exchange rates- a complicated nexus

Brian Kantor, 7th March 2024.

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

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

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

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

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

Source; Bloomberg, Investec Wealth & Investment

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

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

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

Interest and Exchange Rate Trends. Annual Data

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

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

Wealth may matter more than income

The resilience of the US economy in the face of higher interest rates has surprised many. Members of the Fed Open Market Committee, having pencilled several cuts to interest rates to come this year, have seemingly reversed course. Their pivot was precipitate. The still highly satisfactory state of the US economy must take the credit- or the blame -depending on whether you a borrower or lender be including in SA. US GDP, that is total output, has grown by 3% year on year and by a below expected 1.6% annualised in Q1 2024.  Retail sales, an all-important measure of the state of demand in the US, had a lively February and March. Yet sales had declined steadily for many months before and retail sales deflated by the CPI are still two percent below that of January 2023. This revived willingness of US households to spend more has occurred despite minimal growth in real personal disposable incomes. In February incomes were only 2% higher than they were in early 2023, despite very full employment. Tell that to the White House.

US Retail Sales and Real Disposable Incomes (January 2023=100) Monthly Data to March 2024

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

The good news about spending propensities with its implications for high interest rates for longer had a mixed reception in the financial markets. Given the new uncertainty about Fed action to come, stocks and bonds have fallen back this month.

This minor pull back has come after investors had enjoyed a full recovery from the significant declines in the valuations of stocks and bonds in 2022 when interest rates rose dramatically to deal with the inflation that had taken central banks and the markets by surprise. Yet it has all worked out rather well in the financial and housing markets.  History tells us that it takes a financial crisis, to cause a recession, and the global financial system avoided one this time round.

The place to look for an explanation of US economic resilience is the behaviour of the US financial markets themselves.  US wealth, consisting mostly of financial assets, stocks bonds and equity in homes, net of household debt, has been increasing dramatically since the Global Financial Crisis of 2010. And received a huge injection from the Covid relief payments and the strength of the financial markets in 2023.  US household wealth, net of debts,  is now of the order of 156 trillion dollars. That is about seven times Personal Disposable Incomes. It was but 110 trillion dollars in early 2020, and now worth 156 trillion. Up by approximately 40 trillion dollars since the Covid lockdowns.  Personal Incomes after taxation have grown by a mere 45 billion dollars since then. (see charts below)

Changes in wealth are as much a source of additional spending and borrowing power as any other source of income. In aggregate  unrealised wealth gains dominate changes in other sources of income. Changes in wealth, even if capital gains can reverse, can significantly  influence current spending.  .Though predicting the wealth effect on aggregate spending requires predicting wealth itself. Which is even more difficult than predicting the disposable income effect on spending. Success in predicting financial markets would be modern alchemy. Yet essential if economic forecasting is to have any scientific validity.

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US Wealth, Personal Disposable Incomes and Wealth to Income Ratio

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

US Households. Annual Change in Net Wealth, Value of Financial Assets and Personal Disposable Incomes (USD Billions)

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

Household Wealth in South Africa is about 4.5 times larger than household incomes after taxation. This ratio increased markedly during the growth boom pf 2002-2008 and has largely stabilised since. (see charts below) The wealth of SA households is about to be challenged by a new dispensation. That is the right to easily draw down a third of their accumulated wealth held in pension funds and retirement annuities, the impending two pot system. The impact on spending, interest rates and on the financial and real estate markets in SA will be significant. The forecasters in and out of the Reserve Bank will be fully engaged in predicting the outcomes. Waiting to see what happens may be the only sensible option.

SA Households. Net Wealth and the Wealth to Disposable Income Ratio

Source; SA Reserve Bank Investec Wealth & Investment.

South African Households Annual Changes (R billion) in Net Wealth, Financial Assets and Debt.

Source; SA Reserve Bank Investec Wealth & Investment.

Private over public equity- a winning strategy?

March 31st 2024

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

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

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

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

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

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

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

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

Source; Bloomberg, Investec Wealth and Investment International

What will be the catalyst for South African growth?

Private sector involvement in South Africa’s key capital expenditure (capex) projects could be the catalyst to set off a virtuous cycle of investment and growth.

The Covid-19 lockdowns led to some unusual economic developments. Among them was that gross savings in South Africa came to exceed all declining expenditures on capital goods (new plant and equipment, new houses and apartments, etc). Thus, a “capital light” South Africa became an exporter of our scarce savings.

Last year normal service was resumed, capex increased by more than savings and South Africa became a net importer of foreign capital again. This “back to normal” state also meant that incomes fell short of all spending in 2023 and that the current account of the balance of payments went into deficit. All these deficits were equivalent to a modest 1.6% of GDP (see below).

SA national income and balance of payments – measured as a share of GDP

SA national income and balance of payments – measured as a share of GDP

Source: SA Reserve Bank (national income and balance of payments accounts) and Investec Wealth & Investment, 09/04/2024

Is this good or bad news? Clearly, the more capital South Africa can attract from foreign savers – particularly if it were used to fund productivity and income-advancing plant and equipment, and R&D – the better the economy would perform in the short and long run. Or to put in another way, the higher the levels of gross spending, relative to current incomes, the larger the capital inflows and the larger the current account deficits.

Yet both savings and capex have fallen to low proportions of total incomes. The savings and capex rates, now around 15% of GDP,  have been in decline. Compare this with the strong growth years between 2002 and 2008, when capex again surged, the savings rate remained subdued,  and foreign capital flowed in to realise faster growth (see below).

Gross capex and gross savings as a percentage of GDP  

Gross capex and gross savings as a percentage of GDP

Source: SA Reserve Bank (national income and balance of payments accounts) and Investec Wealth & Investment, 09/04/2024

To achieve faster growth in incomes and expenditure, you need higher levels of capex. You also need South African households to spend more on the goods and services supplied by the local producers. Without support from interest-rate dependent household spending (now decidedly lacking), private businesses will not invest enough. Thus, any immediate increase in the savings rate (less spent) would neither be welcome nor realistic.

SA distribution of gross savings (R millions)

SA distribution of gross savings (R millions)

Source: SA Reserve Bank (production, distribution and accumulation accounts) and Investec Wealth & Investment, 09/04/2024

The extra debt raised by households to fund their homes, cars, furniture and appliances, largely cancels out their significant contributions to pension and retirement funds.  This is why business savings (cash retained out of earnings) account for all of gross savings in South Africa.  In the interest of faster growth for SA we would prefer businesses to spend more, to rely less on their own free cash flow, and augment their capex by raising debt or equity capital, including from abroad, as they did between 2002 and 2008.  Negative free cash flow would be good for business and economic growth. As it was between 2002 and 2008 (see below)

But what would it take to set off for a virtuous cycle of more household spending and more profitable businesses, willing to raise their capex and labour forces, to then generate higher incomes for their workers?

SA corporation savings (cash retained) over disposable incomes (earnings after taxes)

SA corporation savings (cash retained) over disposable incomes (earnings after taxes)

Source: SA Reserve Bank (production, distribution and accumulation accounts) and Investec Wealth & Investment, 09/04/2024

Much of the capex (over 70%) in South Africa is undertaken by private business enterprises. The share of the public corporations and the government in all capex has fallen away in recent years, (now 28%) after rising to well over 30% ten years ago. The Medupi and Kusile power plants and the Chinese locomotives were expensive projects that did not add to electricity generated or tonnes carried. It’s not enough to spend more on essential infrastructure, it must be capital well spent, to ensure the private sector can thrive.

SA gross capital expenditures (R millions) and share of private business in total capex (RHS)

SA gross capital expenditures (R millions) and share of private business in total capex (RHS)

Source: SA Reserve Bank and Investec Wealth & Investment, 09/04/2024

Eskom and Transnet have clearly failed the key economic survival test of earning a positive return on capital, as the government now recognises. The privately managed alternative is very much in prospect and the economic case for investing in South African infrastructure remains strong.

The private capital to fund such capex would be readily available from local and foreign sources. Private equity managers with access to institutional capital would be eager participants and the right terms to attract capital would not be onerous. These terms would have to guarantee inflation-linked utility charges, based on a realistic risk-adjusted return on the capital invested. Private business or private-public partnership so engaged would also need to be left largely free to sign their own procurement contracts. In this way, the virtuous circle would be set in motion.

The Shoprite Story. How impressive is it really?

Shoprite is an outstandingly successful South African business as its interim results to December 2023 confirm.   It has grown rand revenues and volumes by taking an increased share of the retail market. The return on the capital invested in the business remains impressively high. Post Covid returns on capital invested has encouragingly picked up again.

R100 invested in SHP shares in 2015, with dividends reinvested in SHP, would have grown to R231 by March 2024. Earnings per share have grown by 55% since January 2015. (see below) The same R100 invested in the JSE All Share Index would have grown to a similar R198 over the same period. (see below) Though SHP bottom earnings per share seemed to have something of a recent plateau – load shedding and the associated costs of keeping the lights on have raised costs.

SHP Total Returns and Earnings (2015=100)

Source; Bloomberg and Investec Wealth and Investment

But earnings and returns for shareholders in rands of the day that consistently lose purchasing power need an adjustment for inflation. The performance of SHP in real deflated rands or in USD dollars has not been nearly as imposing. Recent earnings when deflated by the CPI or when converted into USD are still marginally below levels of January 2015 and well below real or dollar earnings that peaked in 2017. (see below) The average annual returns for a USD investor in SHP since 2015 would have been about 6% p.a. compared to 10.6% p.a. on average for the Rand investor. SHP earnings in US dollars are now 6% below their levels of 2015.

Shoprite Earnings in Rands, Real Rands and US dollars (2015=100)

Source; Bloomberg and Investec Wealth and Investment

Shoprite- performance in USD (2015=100)

Source; Bloomberg and Investec Wealth and Investment

The SHP returns realised for shareholders compare closely with those of the JSE All Share Index but have lagged well behind the rand returns realised on the S&P 500 Index. (see below) Even a great SA business has not rewarded investors very well when compared to returns realised in New York. It would have taken a great business encouraged by a growing economy to have done so.  

The depressingly slow growth rates realised and expected are implicit in very undemanding valuations of SA economy facing enterprises. The investment case for SHP and every SA economy facing business, at current valuations would have to be made on the possibility of SA GDP growth rates surprising on the upside.

It will take structural supply side reforms to surprise on the upside. Of the kind indeed offered by the Treasury in its 2024 Budget and Review. The Treasury makes the case for less government spending and a lesser tax burden to raise SA’s growth potential. It makes the right noises and calls for public – private partnerships and  “crowding in private capital”. The help for the economy would come all the sooner in the form of lower interest rates, less rand weakness expected and less inflation, were these proposals regarded as credible. With more growth expected fiscal sustainability would become much more likely. Long term interest rates would decline as the appetite for RSA debt improved. And lower discount rates attached to SA earnings would command more market value.

Lower long term interest rates (after inflation) would reduce the high real cost of capital that SA businesses have now to hurdle over. Whichever fewer businesses are understandably attempting to do. Without expected growth in the demand for their goods and services, businesses will not invest much in additional plant or people. SHF perhaps excepted. The current lack of business capex severely undermines the growth potential of the SA economy over the long term.

Yet SA suffers not only from a supply side problem. The economy also suffers from a lack of demand for goods and services. Demand leads supply as much as supply constrains incomes and demands for goods and services. The case for significantly lower short term interest rates to immediately stimulate more spending by households – seems incontestable- outside perhaps of the Reserve Bank.

The Budget Promise- will it be fulfilled?

Introduction

In my pre-Budget comments I had argued that SA could only hope to for SA to escape its debt and slow growth trap by ensuring that government spending and revenues grow no faster than the real economy. I asked whether the SA government would be able to grasp this nettle? Given its long term trend of rising real levels of government spending and taxing – with taxes playing a growth suffocating catch up with spending – and government debt ever increasing as a ratio to GDP and spending of interest rising to over 20% of all spending the danger is that SA will resort to its central bank for funding and the inflation, to inevitably follow, will push up interest rates that will reduce the value of long-term RSA bonds outstanding and weaken the rand. Default through inflation becomes more likely and so lenders demand compensation in the form of higher initial yields and risk spreads. That make borrowing more expensive and a debt trap ever more likely. The earlier pre budget comment is available here.

An emphatic response Spending growing at a slower rate than GDP

The short post-Budget answer is that the government has delivered a Budget that would take fiscal policy on a very different and very necessary path. For all the good reasons made very clear in the Budget Review. Almost to the point that the Treasury presents itself as an alternative and highly critical government agency. It is a top-down plan that deserves full support and for which the governments to come should be held fully accountable.

Between 2024/5 and 27/28, GDP in current prices is predicted to grow by 25% – or at an average rate of 5.9% p.a. All government spending is planned to increase by 21%, by 27/28 or an average 5% p.a. while taxes will grow faster by 24% or an average 5.2% a year over the same period. Government spending, excluding interest payments is more heavily constrained to grow at well below the growth in GDP, at a very demanding mere 4.2% a year. The payroll for the 216000 government officials employed by the central government, at an average R470000 a year, is expected to increase at 4.2% a year until 1927/28 with minimal increases in the numbers employed, and well below inflation expected.

Growth in GDP and Government Expenditure (Consolidated)
Government Expenditure and Revenue 2023/4 =100

All this genuine austerity would mean reducing the real burden of government spending (exp/GDP) and to a lesser degree the real burden on taxpayers (Rev/GDP) and allow the debt to GDP ratios to stabilise and decline. Especially should these very different long-term trends impress investors in SA enough to have them supply extra capital to reduce the risk premium and the interest they demand of the RSA and to factor in less persistent weakness of the rand Vs the major currencies. As is very much the Treasury intention.

The thoughts that have moved the Treasury are well illustrated by the following extract from the Budget Review. They are enough to warm the cockles of a heart sympathetic to a market led economy. Even more warming were the intention and practice to pass the incentives to add and maintain the infrastructure to the private sector.

Are the plans credible? The market remains unconvinced

One could perhaps argue and judge that these austere budget plans are too ambitious and hence not credible.   The Budget proposals have however not received any positive reactions in the currency or bond markets. Long term interest rates have not declined nor has the risk spreads between RSA and US Treasury Bond Yields declined. They remain at highly elevated levels. So far not so good for the SA economy.

Interest rate spreads before and after the Budget. February- March 2024 (Daily Data)
Interest rate spreads- a long run view 2005-2024 with SA specific risks identified. (Daily Data)
Interest rate Spreads over the longer run – 2010-2024.Daily Data

The rand has weakened marginally against the EM currency basket since the Budget. A minor degree of extra SA specific risk rather than the strong dollar is to be held responsible. (see below)

The ZAR Vs the US and Aussie Dollar and the EM Basket February-March 2024 (Daily Data)
The ZAR Vs the US and Aussie Dollar and the EM Basket over the longer run ; 2010-2024 (Daily Data)

Taking of reducing the inflation targets has not been well received- for good reasons.

Perhaps the post budget suggestion by the Treasury that they would welcome a reduction in the inflation target has muddied the waters. How would lower inflation be realised without a stronger rand? A rand that could, with a more favourable view of fiscal policy, be expected to depreciate at less than the current 5.5% p.a. rate – which clearly adds to prices charged and inflation expected. Absent a stronger rand, a lower target for inflation would imply even more restrictive and growth and tax revenue defeating than current monetary policy settings. It is not something to be welcomed by investors.

The Treasury would be well advised to wait for the approval of their policy intentions as and when registered in the bond and money markets, in the form of lower interest rates and a stronger rand – before they explicitly aim at lower inflation. The Treasury may well be getting ahead of itself.

A new fiscal order beckons.

The National Budget to be presented next Wednesday may well be the last under the full control of the ANC led government. The ANC may need support the from other parties to govern after the elections to set Budgets. And these other parties should have different and perhaps even better ideas about taxes and government expenditure. They might even mirabile dictu insist that continuing to award comparatively well paid and well cossetted public sector officials well above inflation increases in their compensation is not the best way to utilize tax revenues. That employing more doctors, nurses, teachers and prosecutors, unable for want of a large enough budget to break into public sector employment, might be a much better idea than paying the establishment more. They may understand that ever rising tax revenues are a major drag on economic growth and that the country therefore cannot afford to increase government expenditure at the rate it has been increasing over many years now. It has meant an ever-growing interest bill that crowds out other spending and threatens fiscal sustainability and brings very high borrowing costs in its wake.

Though the major threat to the Budget outcomes this year has been the lack of revenue. The weak economy and its negative impact on company earnings and taxes has taken a heavy toll on revenues. They are expected to fall some R80b below year ago estimates- about a 4 % miss. Weaker prices for our metal and mineral exports have dragged on mining revenues and earnings. It will all mean more borrowing, perhaps also some drawing down on Treasury cash and foreign exchange reserves to reduce debt issuance. But this will but paper over the cracks. Something very different is called for.

Higher tax rates will seem counter productive and expenditure growth will have to be constrained even in an election year. Though it is surely hard to argue that the SA economy has suffered for want of government spending. The opposite must be argued – that the economy has suffered from too much and too much unproductive government spending and hence too heavy a burden of taxes.

Ever since the recession of 2009 government spending and tax collected at national level have grown at a rapid clip – ahead of inflation and nominal GDP. With the growth in expenditure slightly faster than the growth in revenues and the consistent shortfalls made up with much extra borrowing.  You can describe it, up to a point, as conservative budgeting. Necessarily so in the circumstances, but surely economic policy must hope to do better than slowly strangle an economy.  Being re-elected demands no less.

If we base our fiscal history on 2010 levels, National Government Expenditure is up 2.9 times, Revenue up 2.8 times, compensation of public officials up 2.7 times while interest paid is 3.39 times higher than it was in 2010 and runs at about R28 billion a month- a heavy price to pay for the mere right to borrow more. The CPI is up a mere 2 times since 2010. And the ratio of revenue to GDP is up from about 22% to 26%. These are the unimpressive statistics that damage growth and make losing elections inevitable.

A Fiscal Summary

Key Fiscal Statistics (2010=100)

South African fiscal policy settings have been seen by investors in RSA bonds and bills as a slow-moving train wreck. They have demanded high interest rate premiums to overcome the risks to fiscal sustainability undermined fundamentally by slow growth and insufficiently restrined spending and taxing. And to satisfy their expectation that the rand will weaken consistently and inflation stay at high levels and eat into their rand incomes in real or USD dollar equivalents. It will take a much different fiscal path to reverse such expectations and lift growth rates. That is in short for government spending and revenues to grow no faster than the real economy. Will the next SA government be able to grasp this nettle?

The rose garden of good government seems far away

They never promised us – nor did we realistically expect – a public sector in SA that performs as well as they seemingly do in say Scandinavia. What we have in SA is however widely recognised as an almost complete failure. The government offers little defence of its current practice  – only long agendas for reform. Which raises the question – why does the SA public sector perform quite so badly?

One feature of the SA public sector deserves notice. The financial rewards it offers its officials – salaries, medical and pension benefits and secure tenure, are clearly very attractive when compared to the private sector. Such that there is very little movement from public to private employment. The regret of the government is that the limited flow of taxes has provided minimal scope for raising the numbers of teachers, nurses or humble pothole fillers. For those that have jobs are given more– in the form of regular above inflation increases in their salaries. While the hospital wards and classrooms become increasingly crowded and the roads impassable and the lights are off rather than on.

Given the superiority of public employment and given the abject failure of the economy and the labour market to absorb many more men and women of working age into formal employment, the issue of just how the favoured jobs in the public sector are allocated becomes especially important to understand.  Recruiting strictly on the merits of potential recruits is clearly not the overriding modus operandi in SA.  Observing racially prescribed quotas are one of the binding constraints. And a key performance indicator by which institutions and their leaders are measured.

ANC Cadre employment is another important objective of government employment policy. That notwithstanding the implications drawn by the Zondo Commission of Enquiry, is a practice that has not been disavowed by the President.  And yet should cadre deployment not be the overriding mission and practice of the HR specialists in government, nor merit their North Star, the tempting gap between the supply and demand for highly prized employment opportunities with governments, of all kinds and agencies in SA, is very likely to be filled by unorthodox procedures in exchange for a finder’s fee or some equivalent. The opportunity to capture some of the ongoing rents will not have escaped those with bargaining power or influence. Historically in other regimes, shop-stewards, backed by Unions with the power to strike down essential services, have exercised such powers when allocating limited and well-paid jobs as on the Docks or the construction sites or among the waste removers. Nepotism may be another description for it.  As they say nature, including homo economicus, abhors a vacuum. 

If employment in the public sector is not explained by objective measures of ability to perform important functions – by qualifications carefully vetted and by psychometric measures of potential etc objectively administered. And when advancement is based upon years of service, and not key performance indicators (KPI’s) of the kind common in the private sector, how are the officials so appointed, likely to behave, all the way up the hierarchy? As may be presumed of all in the workplace, they will behave mostly in a self-interested way.  You do get what you pay for.

Absent any link between merit, performance and reward, accepting the grave responsibility for carefully spending hard earned taxes, or of being a conscientious public servant for its own reward, is much less likely to be the outcome. Denying the capture of highly valuable contracts with government, opening the tender honestly, whistle blowing when procurement rules are flaunted, becomes essentially quixotic, even dangerous. Going the extra mile when nursing or teaching or policing all becomes much less likely.  After all, where else is the citizen to go for a permit or essential documentation, or the poor to go for schooling or medical care or protection?  They are easily treated as supplicants rather than valuable customers. Producers rather than consumer’s interest will prevail.

The case for meritorious public service is essential to the purpose of good government. Introducing much more of it in SA will however have to overcome powerful interests in the established favour and crony driven system. It will take the recognition, resentments and ultimately the votes of the victims of poor service to do so.

Are movements in the ZAR/USD exchange rate a mystery?

Brian Kantor and David Holland

A great deal of commercial, domestic, and speculative energy is spent pondering the future of the rand (ZAR). The foreign exchange value of the rand will remain highly variable and unpredictable. The best prediction for tomorrow’s exchange rate is today’s rate but with a high level of variance that increases with time. As in the past, the rand is unlikely to be a one-way bet. It will experience periods of negative and positive turbulence. On average, persistent rand weakness is expected in the currency markets due to the higher inflation and sovereign risk of South Africa relative to the US dollar (USD) and other hard currencies. The rand cost of a US dollar is priced to rise at an average rate of 5.5% p.a. over the next five years and by about 4.5% this year. Yet, for all its volatility, changes in the foreign exchange value of the rand can be almost fully explained by but two persistent influences on its value. These are the exchange rates of other emerging market currencies with the dollar and the dollar prices of industrial metals that SA exports. 1

Since 2010, daily movements in the EM currency basket explain 54% of daily movements in the ZAR/USD exchange rate. This is a highly significant association. If you had a crystal ball that foretold future EM basket to USD rates, you could make confident and profitable bets on the trajectory of the rand’s exchange rate. Unfortunately, exchange rates are random walk processes that are impossible to precisely predict. And commodity prices also follow a random walk process. Your best guess for tomorrow’s ZAR/USD exchange rate is today’s rate plus or minus 1% (and ±2.2% if you’re looking a week ahead).

Knowing why the rand behaves as it has may however not help much to predict where it is heading. Forecasting the USD/ZAR demands an accurate forecast of the dollar value of other EM currencies and metal prices. A clearly formidable task. A strong dollar, as measured vs its developed economy peers, will clearly force EM and ZAR weakness and probably also weigh on metal prices, when expressed in USD – and vice versa. Though the major force acting on metal prices will be the state of the Chinese economy- the major destination for industrial metals – and so another known unknown with relevance for the ZAR.

The other forces acting on the rand are South African specific events. Political shocks and own goals that move the rand irregularly and unpredictably one way that then may be reversed. These shocks account for up to 46% of the movement in the rand relative to other emerging markets.

This is where wise economic policy and effective implementation of those policies can positively influence the exchange rate. The persistently weaker bias of the rand when compared to not only the US dollar, but also when compared to other emerging market currencies, is due to the failure of the South

African economy to deliver meaningful growth and attractive returns. The rand is riskier than the emerging market basket to a significant degree. A drop of 1% in the EM basket typically translates into a 1.5% drop in the rand. Government’s job is not only to shoot fewer own goals, but to convince through positive coordinated action that South Africa is not significantly riskier than other emerging markets. The potential gains are a less risky rand, a lower cost of capital, greater investment, job creation, and more wealth for the country to share.

Exchange Rates and Metal Prices (USD) Daily Data (July 2010=100)

The ZAR and the EM basket. Higher number indicate rand weakness.

Looking closely at the Foreign Exchange and Cash Reserves of SA. There are no free lunches.

The RSA can hope to raise tax revenues at a faster rate and reduce the pace at which government spending is growing to escape the debt trap. Reversing the direction of government spending and revenues is made very difficult by a stagnant economy. But there is also another way. That is to sell assets owned by the government. Not only could asset sales or leases be a source of extra income for government to replace extra borrowing and interest paid, but it could also be a most valuable exercise in the broad public interest. Regardless of how much the asset sales would fetch which after much neglect might need much maintenance and repair.

The assets would be made to work much better in private hands and with private business interests managing the outcomes for a bottom line- as private owners are empowered to do. The assets would come to be worth more and their owners and service providers, including employees, would increase their output. Incomes and taxes. Sadly the status quo, the well rewarded private interests of the managers, workers and especially those of the suppliers of services and goods to the state owned enterprises on highly favourable corrupted terms stand in the way of the pursuit of a broad public interest.

But there is another way. That is to sell assets owned by the government. Asset sales or leases could be a source of extra income for the government to replace extra borrowing and interest paid. Regardless of how much the asset sales would fetch, they would be made to work much better in private hands. The assets would come to be worth more and their owners and service providers, including employees would increase their output. Incomes and taxes paid.

Do the foreign exchange reserves managed by the Reserve Bank on behalf of the government fall into this category of assets that could usefully be sold down?  It is possible to hold too much as well as too little gold and foreign currencies on the national balance sheet. They are held as a useful reserve against unforeseeable contingencies. That is a possible collapse of exports or capital inflows, or a flight of capital  that would make essential imports unobtainable or foreign debts and interest unpayable.

South Africa’s foreign assets have grown strongly over recent years, in current rand value.  Since 2010 these reserves have grown from R299 billion to the current levels of approximately R1200b. But when these reserves when measured in foreign purchasing power, in US dollars, while they have doubled since 2010, they still only amount to 62b dollars. There are not many battleships or jet fighters you can buy with that loose change.

Much of the growth in the stock of reserves is the result of a weaker rand. Which is accounted for in the SARB books by mark to market value adjustments of their higher rand values. Which currently have an accumulated value of over R400b. They are described as the Gold and Foreign Asset Contingency Reserve and is recorded as a liability to the Government on the SARB balance sheet. On any consolidated Treasury and SARB balance sheets these assets and liabilities cancel out leaving only the market value of the forex reserves as a net government asset. As SARB Governor has pointed out, these reserves would have to be sold to realize any value.

The other R800 of foreign assets on the SARB balance sheet originally come from the positive flows on the balance of payments when the Reserve Bank buys dollars in exchange for deposits in rands at the Reserve Bank. The extra foreign asset held by the SARB is then held in the form of a dollar or other foreign exchange deposit in a foreign bank. The extra liability is a (cash) deposit at the SARB.

In recent years the source of extra dollars supplied to the SARB is very likely to have come from the Government Treasury rather than the private banks and their customers. A flexible exchange rate will have balanced the supply of and demand for foreign currency transactions that originate in the private economy. The extra dollars acquired by the Treasury will have been borrowed by the government offshore or have been the result of flows of foreign aid or concessionary finance provided SA. And then sold by the Treasury to the Reserve Bank for an additional credit on the Government Deposit Accounts with the SARB.

The Gold and Foreign Assets of the South African Reserve Bank. R million

Source; SA Reserve Bank and Investec Wealth and Investment

It is striking how rapidly the Government Deposits with the Reserve Bank, deposits denominated in foreign currencies and rands grew since 2010. Though these cash reserves peaked in 2020 at close to R250b and have been drawn down sharply in recent years. It may be asked why these cash reserves need to be as large as they are? Why expensive debt must be raised by the government to hold cash.

Yet running down the Treasury deposits to spend in SA increases the cash reserves of the banking system. The SA banks now hold large amounts of excess cash reserves- upon which they earn now high market related interest rates. Should however the banks turn the extra cash into extra bank lending the supply of bank deposits, the money supply, will grow rapidly and encourage inflation. It is a possibility that will bare close attention.

SA Government Deposits with the South African Reserve Bank

Source; SA Reserve Bank and Investec Wealth and Investment

SA Private Banks;  Required and Actual Deposits with the Reserve Bank and Cash Reserves Borrowed (to August 2023)

Source; SA Reserve Bank and Investec Wealth and Investment

Who do we thank- the Federal Reserve Bank?

South Africans this week benefitted from a powerful demonstration of our integration into global capital markets. On Tuesday November 14th, the interest yield on the key ten-year US Treasury Bond fell by about 20 b.p. from 4.63% to 4.44% p.a. By the end of the day, the 10 year RSA bond yield had declined by the same 20 b.p. from 11.66% to 11.45% p.a. The yield on a RSA dollar denominated five year bond fell from 7.52 to 7.19 per cent p.a. leaving the yield spread with the US TB, an objective measure of SA sovereign risk, slightly compressed at 2.76% p.a. The dollar weakened across the board. And with higher bond values the share markets almost everywhere responded very agreeably for investors and pension plans. The JSE gained nearly two per cent on the Tuesday (5% in USD) and again by a further near 2% on the Wednesday.

All this on the news that inflation in the US had fallen to by a little more than had been expected after the CPI remained unchanged in the month. The chances of further increases in short term interest rates therefore fell away as they have in SA. And long rates moved in sympathy. Should the US economy slow down sharply as slowing retail spending as strongly suggested in a print released on Thursday, declines in US short rates will follow in short order adding to dollar weakness and rand strength. Or at least as investors, if not yet the Fed, thinks.

US Inflation; Annual, Quarterly and Monthly

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

All it might be thought as much ado about relatively little- a mere blip on the CPI. If you could predict nominal US GDP and interest rates over the next ten years you would be able to predict share and bond values with a high degree of accuracy- if the past is anything to go by. Predictions that will not be much affected by the failure of the Fed to manage inflation during the Covid lockdowns. Or by what has been its near panic and confusing rhetoric in dialing back inflation. That so roiled the equity and bond markets in 2021- and 2022, a strong bull market in most of 2023 has yet to fully recover from.

Perhaps the most intriguing feature of recent trends in the US GDP has been the growing share of Corporate Profits after taxes in GDP. The ratio of these profits to GDP- have nearly doubled since the early nineties. A profit ratio that investors must hope managers, with the aid of R&D, in which they invest so heavily, can defend to add to share values.

Another question about the long run value of US corporations and their rivals elsewhere will be about the cost of capital by which their expected profits will be discounted. A puzzle is why have long term interest rates in the US have increased as much as they have this year? It is not more inflation expected that have driven up yields. They have remained well contained below 3% p.a. despite higher rates of inflation. Quantitative tightening – the sale by the Fed and other central banks of vast amounts of government bonds bought after the GFC and during Covid, is surely part of the explanation.

But it is not only vanilla bond yields that have risen this year. Real yields- the inflation protected bond yields – have risen dramatically this year. From near zero earlier in 2023 to their current over 2% p.a. Clearly capital has become not only more productive of profits in the US – it has also become more expensive in a real sense, to counter productivity and profit gains when valuing companies. Will it remain so? That is the trillion-dollar question.

US Share of after tax corporate profits in GDP.

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

The gap between real interest rates in SA where a very low risk ten-year inflation linker offers over 4% p.a. – making for very expensive capital for SA corporations, and the US – has narrowed sharply. Surprisingly perhaps, real interest rates in SA have not followed global trends. Making for at lease relatively lower costs of capital for SA based corporations, good news,  which we can hope will lead to more investment.  

Inflation Protected Real Bond Yields RSA and USA – 10 year bonds

Source; Bloomberg and Investec Wealth and Investment

Risk Spreads – RSA-USA 10 year Bond Yields

Source; Bloomberg and Investec Wealth and Investment

Sticking to the fiscal guns.

The short fall in government revenues of R56.8 billion reported in the Budget Review of 2023 came as no surprise to observers of the monthly tax returns. It represented a moderate miss in volatile circumstances – equivalent to 3.1% of the revenues expected in the February 2023 Budget of R1787.5 billion. A very large number and equivalent to 25% of GDP. This real tax burden (Taxes/GDP) is not expected to change over the next few years. Underestimated company tax, lower by R35.8b and net revenues from VAT down by R25.6b, accounted for much of the revenue shortfall. Weaker metal prices and massive investments in alternatives to Eskom power were largely responsible for both declines. Personal Income Tax grew as expected by 7% in line with some growth in real wages and salaries for those employed in the formal sector.  The shortfall will be fully covered by raising additional loans of about R54b.

The higher ratio of national government expenditure to GDP, currently 29.1%, is estimated to decline to about 28% of GDP over the next three years. Still leaving scope for a positive Primary Balance of 0.3% of GDP this year and 1% next year. Raising revenues to exceed expenditures, net of borrowing expenses, is the first and necessary step to reducing the burden of National Debt to GDP-now about 74%, though predicted to decline to about 71% of GDP in three years. National government expenditure, is estimated to increase by an average 4.6% p.a. over the next three years, including servicing our debts, currently over 20% of all revenue that will cost the taxpayers about R400 billion this year. That would represent a decline after inflation.

The SA government is still practicing fiscal conservatism despite persistently slow growth that weighs so heavily on revenue.  And inhibits expenditure. And raises persistent doubts about fiscal sustainability. That is the willingness of the government to avoid money creation, that is a heavy reliance on its central and private banks to fund its expenditure over the long run. Which raises the risks of more inflation and is already well reflected in high borrowing costs.  Risks incidentally that have not trended higher in the run up to the Budget Review. Encouragingly the debt and currency markets reacted positively to the statement itself. The rand strengthened to improve the outlook for inflation and long bond yields declined by about 15 b.p.to help reduce debt service costs.

Source; Bloomberg

South Africa; Risk Spreads- Differences in borrowing costs. RSA-USA

Source; Bloomberg, Investec Wealth and Investment

In reading the Budget Review and listening to the Minister one is struck by how deeply dissatisfied the government  is with its own performance. The statement is a catalogue of government failure.

To quote the statement

The case for reconfiguring government, as it is put, is vigorously argued by the government itself. It will however need its own genuine champions informed by events rather than a stale ideology. It will have quite simply to put the private sector and private sector incentives in control of much of the activities so badly performed by the SOE’s and government departments generally, that could be outsourced. It can be called private public partnerships rather than privatization, but the essential reforms required will be to incentivize operating managers on the bottom line and return on capital- as the private sector does – to thrive and survive.  The upside is incalculable.

And as far as funding a reformed public sector, the place to start would be to dispose of key underperforming assets on the best possible terms. Selling assets or leasing them over the long term would be equivalent methods for raising capital and reducing government debt. The leases can be sold to funders (foreign and local) who would be very keen to provide finance on favourable terms, given credible operators. The Transnet iron-ore line from Sishen to Saldanha would be an obvious candidate for sale or lease. There will be many other such projects made much more valuable under different operating control. For the mines to lease and operate their essential gateways to the market would add many billions to their values and taxable incomes.

Recessions are viewed through the back window.

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

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

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

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

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

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

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

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

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

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

Some Basics of Supply and Demand

We all know that market determined prices reconcile supply and demand. Higher prices discourage demand and encourage supply. What is true of an individual price is true of all prices on average, as represented by a Consumer Price Index(CPI) That prices generally tend to rise with increased demands or reduced supplies and vice versa seems obvious enough.

Higher prices discourage demand and encourage supply. That prices generally tend to rise with increased demands or reduced supplies and vice versa seems obvious enough. But the supply and demand for all goods and services are not determined independently of each other. The supply of all goods and services produced in an economy over a year is equivalent to all the incomes earned producing the goods and services that year. The value added by all producers (GDP) is equal to all the incomes earned supplying the inputs that produce output. Incomes are received as wages, rents, interest, dividends, taxes on production and what is left over, the profits or losses for the owners after all input costs have been incurred.

Produce more, earn more and you are very likely to spend more. The economic problem, not enough of everything, too little income, is surely not the result of any reluctance to spend on the necessities or luxuries of life. The problem is we do not produce enough, earn enough income to spend really more.

Extra demands can be funded with debt. Yet for every borrower spending more than their incomes, there must be a lender saving as much. Matching financial deficits with financial surpluses, is the essential task of financial markets and financial institutions, and may not happen automatically or seamlessly. There may be times when the demand for credit and the spending associated with it may run faster or slower than the supply of savings. If so incomes and output may increase temporarily above or below long-term trends. We call that the business cycle. Interest rates (yet another price) may be temporarily too low or too high to perfectly much the supply of and demand for savings. But such imbalances must sooner or later will run up against the supply side realities, the lack of income.

There is a further complication. The supply of goods and service is augmented by imports. And demand includes demand for exports. In South Africa both imports and exports are each equivalent to about 30% of the economy, making a large difference to supply and demand. But the prices of these imports and exports are not set in South Africa. They are set in US dollars and translated into rands at highly unpredictable and generally weaker exchange rates. The prices paid for imports and exports affect average prices. And they mostly push the averages higher. It has been the case in SA of a weaker exchange rate leading, equivalent to a supply side shock, and prices following.

And the rand is still expected to depreciate against the dollar by more than the difference between SA and US inflation. The bond market expects the rand to weaken against the USD by an average 7.3% p.a. over the next ten years, being the spread between RSA bond yields (12%) and the US yield(4.7%) While the difference in inflation expected in SA (7.2% p.a.) and in the US (3.2% p.a) over the next ten years is much less, only 4.8% p.a. according to the break-even gap between vanilla bond and inflation protected bond yields.

Lenders to the SA government remain suspicious of SA’s ability to grow fast enough to raise the taxes  that could sustain fiscally responsible policies. That is the government will not avoid resorting to funding expenditure with money supplied by the central and private banks. A sure source of extra demands without extra supply that leads to ever higher prices as it does persistently in most African countries.

There is little monetary policy and short-term interest rates can do to strengthen the rand and bring inflation down further against this backdrop. That is without resulting in too little demanded and even less supplied than would be feasible. That in turn bringing  still slower growth more fiscal strain, higher borrowing costs and a still weaker rand- and higher prices.  The call is not to inhibit already depressed demand but for economic policy reforms that would stimulate the growth in SA output and incomes enough to change the outlook for fiscal policy, the exchange rate and inflation.

Building Brics – opportunity beckons

The group of countries that will make up the enlarged BRICS, Argentina, Egypt, Ethiopia, Iran, Suadi Arabia and the UAE have little in common other than a deep suspicion of the motives of the US and its close allies. A state of mind also shared by left wing opinion everywhere including in the US itself. If the unlikely combination of kingdoms, autocracies and genuine democracies is to become more than a another talking shop with an anti-West bias, then it should take an important lesson from the economic development of the US and Europe.

What has been of great benefit to the US and to Europe, since it established a common European market and Euro are their highly significant common currency areas.  The same money is used everywhere in the US and Europe as a medium of exchange and a unit of account. Thus unpredictable rates of exchange when buying or selling goods and services across frontiers are avoided, as are the direct costs of converting one currency into another- usually converting US dollars -into the domestic money.

Trade and financial flows between the states of the US and now of Europe is greatly encouraged by what is a fixed exchange rate regime within a common market, also free of protective of domestic industry tariffs or discrimination against foreign suppliers, by regulation. As it does incidentally when transactions of one kind or another take place within any country. The important trade between Gauteng and the Western Cape for example is facilitated by prices set in the rand common to both.

In the nineteenth century when which international trade and finance first flourished and economies came to benefit from wider markets for their goods and labour, and the ability to realise productivity and income enhancing economies of scale, currencies were mostly linked by fixed rates of exchange.  The link was the ability to convert the different monies, if necessary, into gold at a fixed rate. And the issuers of different monies made sure to maintain convertibility by protecting their balance of payments through adjusting domestic interest rates. If gold generally flowed out interest rates could be raised to conserve and attract gold reserves and vice versa. Provided the commitment to currency convertibility was fully credible, the extra interest received would balance the payments by attracting or retaining capital.

A modified fixed exchange rate system was re-established after the second world war with the US dollar as the reserve currency- but dollars that could be converted into gold at the request of other central banks. This commitment was abandoned unilaterally by the US in 1971 and market determined exchange rates, with the still dominant US dollar, became the norm. Highly variable rather than predictably fixed exchange rates have become the unsatisfactory order of the day. The rates of exchange of other currencies with the dollar, both in money of the day terms and when adjusted for differences in inflation of different currencies have varied very significantly – and unpredictably- damaging volumes of international trade and real investments.

US Dollar Exchange Rate Index. Market Determined and Inflation Adjusted

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

It has not been a case of exchange rate moves levelling the playing field for traders in goods and services- so maintaining purchasing power parity in the face of differences in inflation rates across trading partners. Rather the exchange rates have adjusted to equilibrate independent flows of capital – large and reversible flows – in search of better risk adjusted rates of return- to which inflation then responds. Weaker exchange rates lead to more inflation and vice versa. Without stable exchange rates, controlling inflation in the face of capital withdrawals and a suddenly weaker exchange rate with the US dollar can become a severe interest rate burden on the domestic economy – as South Africa demonstrates.

The enlarged BRICS could establish fixed exchange rates between each other to promote trade and investment. They might usefully adopt a Chinese standard- that is offer convertibility of their own currencies into Renminbi at fixed rates. And rely on the Bank of China to manage the float of the crucial rate of exchange of Renminbi into US dollars, as it now does.