Point of View: There’s not so much gold in them thar hills

The front page of the Wall Street Journal this week (25 August) carried a story about South Africa leading the world – in illegal gold digging. To quote the report “Dangerous Economy Thrives in South Africa’s Abandoned Gold Mines” by Devon Maylie:

“After years of watching its dominance over the gold industry shrink dramatically, South Africa has emerged as the world capital of illegal gold digging. In staggering numbers—easily into the tens of thousands—desperate former miners and gang members have created a subterranean subculture of abandoned mine-shaft wanderers. Armed with a few crude tools, they dig into blasted or cement-sealed mines, comb through tunnels, and spend days chiseling away at bedrock.
“Once the world’s biggest gold producer, South Africa accounted for 80% of the global supplies as recently as 1970. Today, that figure is less than 1%, in large part because China and other countries have sharply picked up their own production, forcing mine closures here that created an opening for freelancers. Today, some 4,400 abandoned mines dot the countryside, almost four times the number in operation, according to South Africa’s Council for Geoscience. And while there are still about 150,000 formally employed gold miners in South Africa, ‘we’re very close to the point where there will be more illegal miners than legal miners,’ says Anthony Turton, a South African mining consultant.”

The Journal continued:

“… taken together, the output of these swelling ranks are having a noticeable affect on the bottom-line of the country’s sagging mining industry and tax revenues. South Africa’s Chamber of Mines, a body that represents mining companies, estimates that the country loses about 5% of its potential annual mineral output to illegal mining activities, equivalent to around $2 billion. In 2010, the most recent year available, the government estimated losing $500 million in tax and export revenue from gold illegally mined and sold in the black market, compared with about $2 billion it raises annually in corporate taxes from all mining companies.”

A few caveats are perhaps in order here. In 2012 the the Chamber of Mines reported gold production of 167 metric tonnes, or 5.8% of world production that year, well down on output and share of global production in 2003, as illustrated below:

The member companies of the Chamber did much better in extracting gold bearing ore from their mines than in extracting gold as the second table shows. The tonnes of gold-bearing rock they milled actually increased in recent years. What has declined precipitously is the average amount of gold contained in each tonne of ore raised to the surface. Each tonne of rock extracted, expensively and dangerously, from the bowels of the earth now contain a miniscule average 2.9 grams per metric tonne. The loss of SA’s share in global mine production has much more to do with declining grades (from 4.56 grams per tonne in 2003) than it has to do with increased output elsewhere. Global gold output has increased by approximately 230 tones since 2003, while production from all SA mines fell by 208.6 tonnes over the same period. In other words, production outside SA has increased by a little more than SA production has declined.

An important further point worth making is that annual production of gold is a very small proportion of the gold ever produced. Almost all of this has survived and is held as a store of wealth. Therefore, as is surely apparent, the price of gold is little affected by current output – legal or illegal. The legitimate mines may lose potential output to thieves and the SA government is not able to collect income from illegal or informal miners, while the price is unaffected by illegal mining activity – equivalent to 5% to 10% of the legal production. Furthermore, if the gold has been extracted illegally from shafts that have been permanently abandoned, such output is incremental, not lost. The gold would have stayed in the ground and not helped produce any income at all. The costs of mining this otherwise abandoned gold is borne entirely by the workers themselves, including the risks of losing their lives to rock falls and their gold to gangsters preying on them.

Incidentally, the gold produced in SA in 2012 earned R73bn, well up from the R32.9bn realised in 2003 thanks to the higher rand gold price. 5% – 10% of this attributed to illegal gold miners is significantly more than the R2bn worth of illegal mining revenues reported by the WSJ and does not take account of other mining sales that altogether totaled R363.8bn in 2012. Such illegal mining activity, currently largely unrecorded, could add significantly to the SA GDP were it to be included in the national income accounts.

Yet while the recorded output of gold has declined and the numbers employed in gold mining has fallen from 198 465 employees in 2003 to 142 201 in 2012, average earnings of these workers have improved significantly over the same period. Total gold mining earnings amounted to R22.24bn in 2012 or R156 386 per employee, compared to approximately R63 900 earned by the average worker in 2003, or to R103 000 in 2012 (the equivalent when adjusted for CPI). In other words, the average employee in the gold mining industry, of whom there are now fewer, appears to be earning about 48% more in CPI adjusted terms in 2012 than they did in 2003.

These improved remuneration and employment trends are unlikely to be independent. The fewer surviving gold mine workers have become more productive, helped no doubt by more and better equipment per worker, judged by the volume of ore extracted rather than the gold produced. The industry would not have survived otherwise than by providing fewer jobs in exchange for what have become better paid and more productive workers. Operating margins for the Chamber member mines have improved rather than deteriorated over the years, as we show below, despite lower grades of gold mining ore.

The safety record of the industry, judged by fatality rates, has also improved as we show below. Thus the industry has provided better and safer jobs, but for regrettably fewer workers.

As the WSJ makes only too clear, the willingness of the illegal miners to undertake the hazardous and poorly remunerated work they engage in has much to do with the lack of alternative employment opportunities. To quote the article again:

”’If I could find a proper job, I would leave this,’” says Albert Khoza, 27, who says he started illegal prospecting eight years ago because he couldn’t find work and was desperate to send money to his family. On this day, outside an old mine about 60 miles from where Mr. Matjila mines, he has been handling mercury with his bare hands. His eyes are bloodshot and infected, as he stokes the fire with plastic containers”.

Or, as the other illegal miner interviewed, Mr. Matjila, is reported to have said: “’We’re not criminals, I don’t want to be doing this. But I need to make some money.’ Then he stood up to walk down the road to the hardware store to check on prices of new supplies. ‘We have to make a plan to find another hammer,’ he says.

The challenge to the SA economy is to resolve the inevitable trade-offs between better jobs for some workers and the very poor alternatives then open to those who are unable to gain access to what is described as ”decent jobs”. The formal SA labour market has not been allowed to match the supply of and demand for labour at anything like market-clearing employment benefits. And so we have the insiders, those with formal employment and willing to launch strike action to further improve their conditions of employment; and the outsiders who find it so difficult to gain entry to formal employment, of whom the illegal miners represent a numerically important group, as numerous, so we are told, as those formally employed in gold mining.

The solution to the general lack of formal employment opportunities appears as far away as ever. Strike action not only leads to higher real wages and reduced employment opportunities, but still greater incentives to substitute reliable machinery for more expensive and unreliable labour that makes continuous production very difficult to achieve. The unpredictable impact of strikes on production is perhaps as much an incentive to reduce complements of relatively unskilled workers as are higher real costs of their employment.

To encourage employment in the gold mining industry and everywhere else, it would be very helpful if workers were willing to share in the risks of production, as the illegal miners appear willing to do: that is to accept less by way of guaranteed pay and more by way of rewards linked to performance and profits. In other words, for workers to become, to a greater degree, owners of the enterprises they engage with. If pay went up and down with the gold price, the gold mining industry would surely be willing to bear the risks of hiring more workers.

Global interest rates: The lowdown on Europe

Long term interest rates have kept surprisingly low – and the source of this surprise is the threat of deflation in Europe. The ECB will have to do what it takes to avert this threat.

We have long been of the view that the key to the short term behaviour of global equity markets is the direction of long dated US Treasury yields. Until fairly recently it may have been said that the actions of the US Fed were decisive for the direction of these interest rates. The Fed, via its Quantitative Easing (QE) programme had become a very large holder of US Treasuries and mortgage backed securities.

 

These exchanges of Fed cash (in the form of Fed deposits) for bond and mortgage backed securities were undertaken with the specific intention of not only protecting the financial system, but of holding down mortgage rates to assist the recovery of the US housing market and so of household wealth. At the peak of these operations US$80bn of these securities were being added to the asset side of the Fed balance sheet each month and simultaneously to the cash balances kept by US banks.

The slow but more or less steady recovery of the US economy allowed the Fed to suggest in May 2013 that it would be tapering such injections of cash into the system and that by late 2014 it would hope to end QE. It has since followed through on this prospect. Monthly net purchases of these securities in the market have been tapered and the security purchase programme will be over soon. This announcement of a likely end to the Fed support of the fixed interest market led however to the “taper tantrum” of May 2013. Long bond yields rose significantly and equity values declined. Volatility, in the form of daily moves in equity markets, increased and emerging equity and bond markets – regarded as more risky than developed markets – were particularly affected.

Then, despite the Fed taper in 2014, the trend in long term interest rates reversed direction, markets calmed down and share markets recovered. Indeed, market volatilities as measured by the Volatility Index, the VIX (the so-called “fear index”), had fallen back to pre financial crisis levels by mid 2014 and the US equity markets has moved back to record high levels.

The danger of the VIX at such low levels was that volatility could spike higher and share markets accordingly retreat (given that they were regarded by many observers as, at worst, fairly valued by the standards of the past, as represented by conventional Price/earnings multiples).

It could be demonstrated by reference to past episodes of low volatility and demanding valuations that such a combination of low volatility and generously valued equities would need more than good earnings growth to provide good returns. In the past it appeared that only lower long term interest could overcome well valued equities and low volatility. Moreover, it was widely assumed that long term interest rates in the US, very low by the standards of the past, could only be expected to increase. The upwardly sloping US treasury yield curve indicated very clearly such expectations of higher interest rates to come and incidentally still does so.

To the surprise of the bond market and despite the Fed taper, long term interest rates in the US fell rather than rose in July and August 2014. It was lower interest rates in Europe, especially in Germany, that led global rates lower in July. Not only did German Bund yields fall, with US and other rates falling in sympathy, but the spread between lower European and US rates actually widened, surely adding to the appeal of US Treasuries. The Spanish government now pays less for 10 year money than Uncle Sam.

The Fed therefore is no longer the lead steer of the bond market herd. The danger of deflation in Europe is that it leads interest rates lower. And this deflation is all the more likely given quantitative tightening in Europe to date, rather than easing. Unlike the Fed or the Bank of Japan, the assets and liabilities of the ECB have been falling significantly rather than increasing. That the supply of European bank credit and broader measures of money has been falling is consistent with a lack of demand for ECB deposits.

These broad trends will have to be reversed if European deflation is to be avoided. The ECB will have to do what it takes to increase the supply of money and bank credit. QE action is called for and can be expected to continue to hold down global bond yields. Euro deflation trumps the risk of higher interest rates.

The figures below fully illustrate this story of falling interest rates, declining volatilities and higher share prices. We also show how the US dollar has strengthened in response to this improved spread in favour of the US and how developed and emerging equity markets (including the JSE) when are running together, when measured in US dollar terms.

Banks and shadow banking: Out of the shadows

Should we be frightened of our banks and their shadows or should we rather learn how to deal with banking failure?

Shadow banks rather than non-bank financial intermediaries

A new description – shadow banks – has entered the financial lexicon. The term is, as we may infer, is not used in a positive context. Rather it is to alert the public to the potential dangers in shadow banks, as opposed to the presumably better regulated banks proper.

This is a use of language consistent with one of the dictionary definitions of the word:

A dominant or pervasive threat, influence, or atmosphere, especially one causing gloom, fear, doubt, or the like: They lived under the shadow of war.

Or perhaps alluding to shadowy, defined as:

1. full of shadows; dark; shady
2. resembling a shadow in faintness; vague
3. illusory or imaginary
4. mysterious or secretive: a shadowy underworld figure

 Source:  www.Dictionary.com

An older, less pejorative description of this class of financial institution or lender would have been non-bank financial intermediary or perhaps near-bank financial intermediary to describe those firms that closely resembled banks in their lending activities. Examples are mortgage lenders (once called building societies), insurance companies, pension funds, money market funds and unit trusts, all of which would have fall under the modern description, shadow banks.

 

As we show below, drawing on the March 2014 Financial Stability Report of the SA Reserve Bank, the share of SA banks in the total business of Financial Intermediation in SA has declined over the past few years while the share of other financial intermediaries (including money market funds and unit trusts) has risen consistently, also in part at the expense of pension and retirement funds

 

Source; SA Reserve Bank Financial Stability Report, March 2014

The role of financial intermediaries is to facilitate the capital providing and raising activities of economic actors, domestic and foreign. They stand between (intermediate) the providers of capital in the economic system, be they households or firms, and those raising funds, to cover (temporary) financial deficits, that is, other households and firms and government agencies needing finance. They also compete for financial custom with those providers and users of finance who might bypass the financial intermediaries completely and deal directly with each other.

Such activities may be described as disintermediation when, for example, a firm previously dependent on bank finance bypasses the banks and issues its own debt or equity in the financial markets. The subscribers to such issues may however well be other financial intermediaries, for example pension funds, in which case  it is the banks that will have been disintermediated.

 

Why banks are different from all other financial intermediaries

What then makes banks different in principle from other financial intermediaries? It may be in the detailed manner in which they are regulated, as we indicate above. But pension and retirement funds are also subject to particular regulations and regulators designed to protect providers of capital to them as are the managers of money market funds or unit trusts.

Banks are different not because they borrow and lend (or, more generally, raise and provide capital); they are different fundamentally because an important part of their function is to provide, via some of the deposit liabilities they raise, an alternative to the cash provided by the central bank that can be used for transactions, in the older terminology, as a much more convenient medium of exchange . In so doing, they provide an essential service to the economy, providing a payment system without which the modern economy would founder.

 

The danger with banks, narrowly confined to those few institutions that provide the payments mechanism, is that a large bank failure would bring down the payments mechanism with it. This is a danger to the broader economy almost too ghastly to contemplate. It is a danger that makes a large transaction clearing bank, on which all other financial institutions depend, not only to hold their cash, but more importantly, to help make payments, too big to fail. If such a bank were in danger of failing and unable to recapitalise itself in the market place, it would be obliged to call on the taxpayer for additional capital and the central bank for cash as a lender of last resort. A call that the central bank and the government could not, in good sense, resist. Shareholders given such a rescue should then lose all they have invested in the bank while depositors might be saved while bank creditors generally may or may not be obliged to accept a haircut. A possible haircut would help bank creditors exercise essential disciplines over banks as borrowers. The moral hazard of too big to fail and therefore too big to have to worry about default could be overcome without jeopardising the payments system with a predictable well recognised set of bankruptcy procedures for banks.

 

Clearly, facilitating payments by transferring deposits on demand of their depositors, is not all that banks do. Not all their funding is by way of deposits that may be transferred or withdrawn on demand. Term deposits as well as ordinary debt may be more important on their balance sheets than current accounts or transaction balances.

 

Banks, narrowly defined as the providers of a payments system, largely originated by offering an alternative medium of exchange to that of transferring gold or silver and the notes issued by a central banks to settle obligations. The owners of banks came to realise that they did not have to maintain anything like a 100% backing in gold or notes or deposits with the central banks for the deposits that could be withdrawn without notice, to survive profitably.

 

Fractional reserve banking was seen to be possible and profitable. In other words, the interest spread between the cost of raising deposits, with demand deposits paying the lowest interest or no interest at all, helped the banks make profits on the spread between their borrowing costs and interest income and so helped pay for the costs of maintaining the payments mechanism – a form of cross subsidy. It may be surmised that had the banks had to levy fees to cover all the costs, including a return on capital, of providing the payments mechanism, bank deposits might have proved less attractive and the growth of retail banks accordingly more inhibited than it was.

 

Banks in SA have become more dependent on net interest income in recent years, rising from about 5% to 10% of net income, while operating expenses have grown by about the same percentage. Return on equity has declined but remains a respectable 15% p.a.

Source; SA Reserve Bank Financial Stability Report, March 2014

 

The inevitable risks in fractional reserve banking and leveraged banks

Such fractional reserves however do pose a risk to the shareholders of banks as well as to their depositors. There might be a run on the bank that could cause the bank to fail, making the shares they owned in the bank valueless. Clearly, the interest earning assets it typically held could not be cashed in as easily as its deposit liabilities. Banking failures led to responses by regulators – firstly in the form of a compulsory cash to deposit ratio demanded of banks and in the form of deposit insurance designed to protect the smaller depositor. This was introduced in the US in the 1930s in response to the Great Depression and the banking failures associated with it.

Compared to most other financial institutions, including the so-called shadow banks, banks proper have always been among the most highly leveraged of business enterprises.. Their debts include all deposits, current and time deposits, equivalent to 90% or more of their assets, leaving little room for errors in the loans made.

The protection provided to depositors in the form of required cash or liquid asset reserves could not insure any bank or financial institution against the bad loans that could wipe out shareholders equity and cause a bank to go out of business.  Hence the regulatory focus in recent years, not so much on cash adequacy, but on equity capital adequacy. The Basel rules promoted by the central bankers’ central bank, the Bank for International Settlements located in Basel, Switzerland, have imposed higher equity capital ratios of banks.

Understandably, the SA Reserve Bank as the regulator of the SA banks has given attention in its Financial Stability Report to the capital adequacy as well as the operating character of the banks under their supervision. The results of this analysis indicate that by international standards, the four large SA banks are well capitalised and well managed. As the table below shows, a capital to asset ratio of nearly 15% provides a return on banking shareholders’ equity of close to 15%, even though the return on total assets held by the banks is only 1.1%. Without high degrees of leverage SA banks might not be profitable enough to be willing to cross-subsidise the payments mechanism. If so other providers of a payments mechanism would then have to be found.

Funding such alternative providers with fees charged might not seem an attractive alternative to the current banking system that facilitates payments, partly through the interest spread, but with the danger than banks can fail. Dealing with the possibility of failure may well prove a better approach than imposing capital and cash requirements of banks that make them unable to easily stay in business.

There are no guarantees against banking failure

 

There is no guarantee that regulated bank capital, adequate for normal times and not so demanding as to threaten the profitability of banks and their survival as business enterprises, would be sufficient to support the banks in abnormal times. The global financial crisis of 2008 took place in most unusual circumstances, that is when the an average house price in the US declined by as much as 30% from peak to trough. Such declines meant that much of the mortgage lending of US banks had to be written off. Even a capital adequacy ratio of 15% might not protect a banking system, with a typically large dependence on mortgage lending, against failure, should the security in house prices collapse as they did in the US. SA banks have held up to 50% of all their assets in the form of nominally secure mortgage loans. They too would not have survived a collapse in house prices of similar magnitude.

 

Is it possible to insulate the payments mechanism from other banking activity? And what would it cost the holders of transaction balances?

 

It may be possible, given modern technology, to separate the payments system from  bank lending and borrowing. The payments system could be conceivably managed by the specialised equivalents of a credit card company that would compete for non interest bearing transactions balances on a fee only basis. The transfer mechanism could well be a smart phone or some equivalent device.

 

The proviso would have to be 100% reserve backing for these balances held for clients to transfer. These reserves that would fully cover the liability would have to take the form of a cash deposit with the central bank or notes held in the ATMs.  A deposit with a private bank would not be sufficient to the purpose- the other private bank, unlike a central bank can also fail and so bring down the payments system. If such a separation of banking from payments was enforced by regulation, large banks might not then be too big to fail any more than any other financial intermediary or indeed any other business enterprise might be regarded as too big to fail. But the unsubsidised transaction fees that would have to be levied to cover the costs of such an independent  payments system, fully protected against failure, that would include an appropriate return on shareholders capital invested in such payment companies, might prove more onerous than the costs of maintaining transaction balances with the banks today that provide a bundle of services, including facilitating transactions.

 

It is striking how expensive it is to transfer cash through the specialised agencies that provide a pure money transfer service. A fee of 5% or more of the value of such a transaction is not unusual. The case for bundling banking services, even should banks need to be recapitalised should they fail in unusual circumstances, may well be a price worth paying. In other words what is required for financial stability and a low cost payments service is a predictable rescue service for the few large banks that manage the payments system.

 

 

 

 

 

Volatility: The calm before the storm or is the balmy weather to continue?

Share markets have calmed down, as have most other financial markets. The S&P 500 Index is as relaxed as it was before the Global Financial Crisis broke in September 2008. Daily moves in share prices are confined to an unusually narrow range and the cost of an option on the market (insurance against volatility) has fallen accordingly, as we show below.

A similar benign pattern of modest daily moves can be observed of the JSE Top 40 Index as is also shown.
The volatility priced into an option on the S&P 500 is the Volatility Index (VIX), which is actively traded on the Chicago Board of Exchange. This index is sometimes described as the Fear Index. The more fear or uncertainty about the state of the world, the more investors struggle to make sense of it all, the more prices move in both directions. The theoretical equivalent of the VIX calculated for the JSE is the SAVI. In a global capital market where uncertainty about the future is a common denominator, the VIX and the SAVI move closely together. Force one winds in New York City translate into force one winds on the JSE.

Both the VIX and the SAVI may be understood as forward looking measures of volatility used to price options, but they appear to track actual volatility – measured as the standard deviation (SD) about average daily price moves – very closely. We compare the VIX this year to the 30 day rolling moving average of the SD of the S&P 500 below. Both measures of volatility have declined this year, indicating that investors generally have a much more sanguine view of the future prospects of the companies they invest in.

The stability of the global financial system appears well secured by QE in the US, while the Draghi pronouncement “to do what it takes” to shore up European sovereign credit has soothed the sometimes savage breast of Mr and Ms Market.

So far so very good. Lower volatility (less fear of the future and so less of a risk premium demanded of financial assets hence higher present values attached to expected earnings) has been accompanied, as it almost always is, by higher share values.

 

The relationship between share prices generally and volatility is consistently strong: when volatility is up, share prices move down and vice versa. The correlation of both the daily level of the VIX and the S&P 500 and percentage changes in both series since 2005 remains very high, of the order of (-0.60) or higher when levels are correlated and even higher (-0.74) when daily changes are correlated.

The good news about financial markets today is that volatilities are low and fear of some economic crisis apparently largely absent. The down side is literally that – if volatility is already so low can it go lower? and if not, can we expect share prices to go much higher? The answer is still perhaps so if the fear stays away. The markets may well continue to grind mostly higher as they have been doing recently. But the chances of a global event that would again frighten shareholders and their agents cannot ever be ignored.

It appears that markets are much more inclined to crash lower on bad news that may mean a change in the world as we know it, than to crash higher on good news. Good news seems to dribble in slowly, bad news can come crashing down on your head overnight. Let us hope that the flow of economic news continues to be mostly encouraging and volatility stays low and share prices grind higher.

Point of View: A growth, not a savings problem

SA has a growth in income problem – not a lack of savings problem. The lack of growth and its consequences are plain to see. The apparent shortage of savings (the difference between domestic savings and capital formation) shows up in the current account deficit of the balance of payments and in the equivalent inflows of foreign savings.

The bigger the current account deficit, the larger the inflows of foreign savings. Without the access to foreign savings, the current account deficit would be much smaller, spending on all goods and services including plant and equipment would have to be cut back even further and the economy would be growing even slower. Faster growth would mean higher returns for savings and help attract more foreign savings and keep more of domestic savings productively applied back home. Slower growth undermines the case for investing in SA. It will mean a weaker rand and more inflation and perhaps higher interest rates to undermine growth prospects further.

Faster growth and the extra profits that come with it would also be retained by SA businesses, so adding to domestic savings. Of the gross savings rate of SA, equivalent to only about 14% of GDP, more than 100% is undertaken by corporations that retain earnings and cash flow. We would like them to plough back their earnings and cash flow (after paying taxes) into additional plant and equipment and larger work forces, rather than paying dividends, buying back shares or repaying debts. They would do more of this good stuff if they were more confident about the growth prospects.

The problem for any economy is not a lack of capital (savings by another name), but a want of good returns on it. Raise the returns and the capital will be freely available. The focus of attention of South Africans should not be on a lack of capital, or its reflection in the current account deficit, but on how to promote faster growth that will help raise the return on capital to attract more of it from all sources, domestic and foreign.

Deidre N. McCloskey in her book Bourgeois Dignity – Why economics cannot explain the modern world (Chicago University Press 2012) makes the crucial points in the following highly individual and entertaining way:

“There are many tales told about the prehistory of thrift. The central tales are Marxist or Weberian or now growth-theory-ish. They are mistaken. Accumulation has not been the heart of modern economic growth, or of the change from medieval to the early-modern economy, or from the early modern to the fully modern economy. It has been a necessary medium, but rather easily supplied…The substance has been innovation. If you personally wish to grow a little rich, by all means be thrifty, and thereby accumulate for retirement. But a much better bet is to have a good idea and be the first to invest in it. And if you wish your society to be rich you should urge an acceptance of creative destruction and an honouring of wealth if obtained honestly by innovation. You should not urge thrift, not much……………You should work for your society to be free, and thereby open to new ideas, and thereby educable and ingenious. You should try and persuade people to admire properly balanced bourgeois virtues without worshiping them. Your society will thereby become very, very rich. American society nowadays is notably unthrifty. The fact is much lamented by modern puritans, left and right. Yet because the United States accepts innovation and because it honors Warren Buffett it will continue to be rich, in frozen pizzas and in artistic creativity and in scope for the average person.” (pp 166-167)

South Africans are also notably unthrifty, understandably so, given the transformation of the middle class who achieve this status with little by way of household capital. Get a good job and the financial system will arrange for a house and a car on credit, as it should. The problem now is not too much credit, but rather too few jobs and the income that comes with employment and so the capacity to borrow.

But South African business has been notably innovative – hence the excellent returns on capital invested and rising share prices. The current account deficit, that is the consumption propensities of South Africans, has been financed to an important degree by reducing our stake in our excellent businesses (many of which have become plays on the global economy) thanks to SA’s improved status in the world and relative freedom from capital controls. Most important, while South Africans have reduced their stake in JSE-listed businesses, partly in exchange for shares in companies listed elsewhere, the remaining stake is worth a lot more than it was. The share of the cake may have declined, but the cake is a much bigger one, thanks to innovative management who are appreciated by fund managers abroad.

For SA to grow faster, the innovative power of business must be released and encouraged rather than discouraged by government interventions. Business should be treated with respect rather than the hostility that seems to be the inclination of a bureaucracy that lacks appreciation of the essential bourgeois virtues that McCloskey celebrates.

Go to the supermarket thou sluggard- consider their ways and be wise

In mysterious (super) markets we should trust to serve our economic interest – not regulators of prices

A typical supermarket carries many thousands of separate items on its shelves. It may also offer a variety of other services at its tills or counters, including payment or transaction services. The operating profit margins on these different items or services will vary greatly and may even vary from day to day as buyers take advantage of opportunities to buy low and sell high. Their suppliers may also offer discounts for prompt payment or bulk orders or their payment terms may be extended to help add profit margins.

The shopper couldn’t possibly hope to know such details nor should they care to know. All they might be aware of is the price of some KVI (known value item), for example a jar of coffee or a box of tea. And the supermarket will try and make sure that the KVIs are priced competitively. If the tomatoes are a profitable line at the vegetable counter they may well help cross subsidise the cooking oil, but nobody other than the shop managers needs to be well aware of this.

What will matter to the shopper, a matter of which the shopkeeper will be well aware, is not the price of any one item on the menu, but of the cost of a trolley load of groceries and the cost in time and transport of collecting it. Shareholders and managers care whether the selling price of the average shopping trolley or basket will more than cover the average costs of delivering the trolley load – rents and employment costs included. Most important is that these prices on average are high enough to provide a satisfactory return on the capital invested in the chain of shops and distribution centres and trucks needed to keep the shelves well stocked and so the customers coming through the doors. Margins may go down and true profits go up, to the ultimate advantage to both customers and shareholders.

If the realised return on capital is above risk adjusted returns, shoppers and non-shoppers can be assured that the essential service of supplying and delivering goods and services to households will continue to be provided at prices they prove willing to pay for. Indeed, the more profitable the enterprise, the more likely the retail offering will be extended to more locations, with fuller stocked shelves in ever greater variety.

Consumers generally can be assured that the cure for high or “exploitative” prices and margins is high prices themselves. High prices that lead to above normal or required returns on capital encourage more supply, that in due course will reduce prices. In other words, consumers can rely on market forces to supply goods and services and to restrain pricing power.

The owners of profitable firms are well incentivised to expand their offerings. Unprofitable firms who are unable to charge enough (sometimes inconveniently for their loyal customers) will go out of business. Perhaps as consumers we should worry more about unsustainably low prices than unsustainably high prices. High prices bring more goods with greater variety; low prices will mean reduced supplies and less variety and quality.

In the presumed absence of competition, we rely on regulators to determine prices on a cost plus basis; hopefully not too high a return that might mean very high prices not vulnerable to competitive forces. There is a danger that regulation of some prices in an essentially bundled offering may fail to recognize the overarching role played in the economy by return on capital and the important tendency for excess returns to be competed away.

The threats to SA consumers of additional regulation that come to mind are the potential assaults on the menu of charges made by furniture retailers who supply furniture bundled with credit, delivery costs and perhaps personal insurance. Or on the suppliers of chickens bundled with brine, the proportion of which is regulated. Or the services of cell phone companies, who among the services they provide, include connections to other cell phone companies, that are now subject to a lower regulated charge.

The itemised insurance or delivery charges levied by a furniture retailer may look exorbitantly high, seemingly well above observable costs. A regulator may then demand lower charges for them. But such lower charges may well mean a higher price for the separately itemised furniture item. The insurance charges may well have cross subsidised the price of the furniture item. Then lower charges for insurance will mean higher explicit prices for the furniture itself, if the cost of capital is to be recovered. Similarly, by reducing the cell phone interconnection charge – the cost of a bundled pre paid contract – perhaps the subsidized cell phone itself may well will go up. And if it costs less to bulk up a chicken with brine than with mealie meal, the price of chicken will surely reflect this as the chicken producers compete with each other to make extra sales.

Provided furniture retailers, cell phone companies or chicken producers compete with each other, we need not concern ourselves with the charges of the individual items, than we need to concern ourselves with the gross profit margins of all the separate items provided by a supermarket. We can rely on competition rather than regulation to constrain prices and to secure essential supplies.

An easy to recognise feature of regulated markets is insufficient supply and non-price rationing – that is long queues for service or forced sacrifices of quality and variety. Think of the waiting lists for “free housing” or medical services at public hospitals in SA or of power load shedding due to the lack of regulated generating capacity.

The essential problem is that it is hard to understand and appreciate the hidden hand of market forces. It seems easier to think that prices are some simple mark up on costs. The problem is compounded in that students of economics are more easily and taught how markets fail than how they work in what appears to be mysterious ways. History tells us that governments (that is government officials) are much more easily prone to failure to supply essential goods and services than market forces driven by profit seeking companies.

The price regulator is bound to be some university-trained economist. The successful entrepreneur does not need to understand theoretical economics at all – only how to buy low and sell high and the more they succeed the better off we will all be. More important than price competition will be innovation, new products / services or improved methods of production that are introduced to the economy by enterprising companies and risk loving individuals. These companies and individuals will have high prospective margins very much in mind but in turn will be subject to emulation and margin pressure. Regulation can only serve to stifle, not promote, innovation.

Property yields: Expected total returns from property or shares matters much more than initial yield

Growth can more than make up for lower initial yields – something apparently not well understood in property circles

Reference will often be made to some acquisition or other being earnings “accretive”. Clearly an acquisition would hardly be made if it did not promise at least to add to earnings per share (EPS) and thus to the value of each share in issue. It may be thought, naively, that the simplest way for a listed company to accrete EPS would be to issue shares trading at a particular superior price/earnings (PE) multiple in exchange for another company trading at a lower PE ratio.

If it were so easy to add wealth by issuing relatively highly rated shares to buy lower rated shares, no recorded differences in PE multiples could survive such an obvious arbitrage. All earnings would then command the same price which obviously has not turned out to be the case.

The reason for the observed differences in PE multiples or earnings yields (the inverse of the PE ratio), or for matter dividend yields, is that an asset, particularly the bundle of assets and liabilities that make up a company, has a life of more than one year. A company may have an indeterminately long life given that company assets may be replaced or added to. Assets with economic lives of more than one year will be valued on their earnings and dividend growth prospects as well as their initial or first year yields.

The more growth in earnings expected over the life of an asset, the more investors will be prepared to pay for the asset. The faster the expected growth in benefits for shareholders, the higher the price paid per share and the lower the first year yield.

High initial yielding assets will be expected to have short lives and / or limited earnings, when compared to lower yielding assets or companies. If the market has correctly priced two assets in a similar sector of the economy and facing similar risks to their earnings potential, their expected returns will be the same, even though the initial earnings or dividend yields may be very different. Buying the company with a low PE ratio that is expected to grow its profits slowly, while selling a part of what is expected to be a fast growing company with a higher PE will not necessarily add value to the shareholders diluting their share of profits. What is gained in the form of the relatively low price paid for the asset will likely be lost in the form of the slower growth in earnings from the cheap asset – cheap for that reason.

Unless the assets bought can be transformed by better management or the value of the combined asset pool enhanced by economies of larger scale – the fabled synergies that may or may not justify an acquisition – two plus two cannot be worth more than four. Adding low PE assets to high PE assets must reduce the combined PE in line with a weighted average of the established assets and the newly acquired assets with different growth prospects.

There is a well known equation in the financial literature used to make this point, the so calledGordon growth model (see explanation at the end of this piece). This equation simplifies the standard Present Value (discounted cash flow) valuation model applied to any stream of expected operating profits that is discounted back to its present value by applying an appropriate risk adjusted discount rate to the flow of expected profits.

Parsing property returns

The model provides yet another example of the no free lunch principle in life. High yields imply short economic lives and vice versa – though one might think otherwise when listening to the managers of SA listed property companies and their shareholders who appear concerned, above all, to avoid yield dilution when acquiring assets. They appear fearful of buying assets that currently yield less than the current yield on their listed portfolio regardless of what may be differently better growth prospects.

Such observations are however made against a backdrop of extraordinarily good returns from listed SA property. Since May 2004 listed property has returned an average 20.7% a year, while the JSE All Share Index provided an annual average return, calculated monthly, of 18.14%. The All Government Bond Index, the ALBI, has generated an average total return, capital gains/losses plus dividend or interest income, of 8.86% a year over the same period.

 

Property returns were on average less risky than shares, with a standard deviation (SD) of returns of 15.85% a year compared to a SD of share returns of 18.14%. Lower bond market returns were significantly less variable over this extended period than shares or property, with a SD of 5.16. The money market would have yielded about 7.34% a year over the same period, with still less variablity.

The chart below shows how the initial dividend yields have come down since 2008 in company with lower long term interest rates and declining growth in dividends paid. It may also be noticed that recently, while bond yields have moved higher, the initial dividend yield has moved in the other direction, meaning a recent rerating of the Property Index and improved recent returns from property compared to bonds.

The initial JSE Property Index dividend yield averaged 7.54% since 2004 compared to an average 2.75% for the JSE. The growth in JSE dividends has averaged 16.22% a year (despite the global financial crisis) compared to the steady average growth of 7.67% a year in dividends paid by the listed property companies.

 

Faster growth in dividends from all JSE equities has clearly compensated investors for initially lower dividend yields, when compared to property investors who started with much higher initial yields but were subject to slower growth in dividends received. The result has been similarly excellent total returns.

When we add the initial dividend yield to the growth in dividends realized, we get what may be regarded as an internal rate of return (IRR). The IRR for the JSE over the period 2004-2014 was an average 18.98% a year, while the IRR for SA Listed Property was 15.22%. However these realised returns from holding property rather than shares were significantly less variable in the light of the collapse in JSE ALSI dividends in 2009. The SD for the IRR of the property sector was 5.34 compared to 19.29 for listed shares. Clearly the income streams from property, if not as much their valuations (and total returns) have proved more consistent than JSE equities in general and such predictability of dividend streams must have helped to enhance their appeal.

Within the property sector itself, we tested the proposition that the highest yielding property companies can be expected to generate the highest returns. The method used was to rank all the components of the Index by their initial yield every month and to calculate and compare returns over the next 12 months. No such consistently positive relationship between initial yield and subsequent returns from the individual property companies was found. In fact, initial company yields have had no statistical power to explain differences in the returns realised by the different listed companies.

This result was consistent with the theory that what should matter for investors in property, is the combination of initial yield plus growth in dividends. Initial yield alone or apparent concerns about yield dilution should not be a focus of attention. What matters is the combination of initial yield and subsequent growth.

 

The Gordon growth model

The Gordon growth model makes the simplifying assumption that the expected growth in operating profits, earnings and dividends is a constant, permanent one. Thus the price(present value) to dividend ratio can be expressed as P/D= 1/(r-g) where r is the required risk adjusted return or cost of capital equivalent to the discount rate and g the permanent growth rate. The equation can be converted to an equivalent PE by assuming a constant ratio of earnings to dividends.

This equation can then be reformulated to infer the permanent dividend or earnings growth rate implicit in current share prices and dividend yields. That is the cost of capital r, is the sum of the interest rate available from a low risk long dated government bond , say of 8% p.a plus an appropriate risk premium. That is, an equity risk premium of an average 4 or 5 per cent per annum, to be added to the bond yield to give the required return. That is r is equal to say 8 (government bond yield) +5 (risk Premium) =13% p.a. Depending on the above or below average risks, the company faces this average risk premium can be added to or subtracted from.

The initial certain first year dividend yield (for example 3% a year) can then be subtracted from the 13% required long run return in our example to give the implied (permanent) growth in dividends necessary if the required return is to be realised over time. In this example g, the annual growth in dividends would have to be at a 10% annual rate to justify an initial yield of 3%. Clearly, the higher the initial yield the lower the expected growth rate in g required to satisfy r, the risk adjusted required returns. Vice- versa – low initial yields will be associated with higher expected growth rates in dividends or earnings.

 

Equities: Crossing the 50 000 barrier for the JSE

Democracy has been very good for SA shareholders

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

 

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

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

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

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

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

How does SA compare to other countries?

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

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

Avoiding the mind games

The MPC voted to keep interest rates on hold. Without a recovery in growth rates, interest rates will stay on hold – absent the dangerous mind games of January 2014 that led to an ill-timed rise in the repo rate.

The Monetary Policy Committee (MPC) of the Reserve Bank yesterday indicated that its outlook for SA inflation over the next few years has improved marginally. To quote the statement:

“The Bank’s forecast of headline inflation changed marginally since the previous meeting. Inflation is expected to average 6,2 per cent in 2014, compared with 6,3 per cent previously, with the peak of 6,5 per cent (previously 6,6 per cent) expected in the fourth quarter. The forecast average inflation for 2015 remained unchanged at 5,8 per cent. The forecast horizon has been extended and inflation is expected to average 5,5 per cent in 2016, and 5,4 per cent in the final quarter of that year. Inflation is still expected to remain outside the target band from the second quarter of 2014 until the second quarter of 2015.”

It also reported that inflation expectations are unchanged:

“The Reuters survey of inflation expectations of economic analysts conducted in May is more or less unchanged since the previous survey. Inflation is expected to average 6,3 per cent in the second quarter, and 6,2 per cent in the final two quarters of this year, before returning to within the target at an average of 5,8 per cent in the first quarter of 2015. Annual inflation is expected to average 6,2 per cent in 2014, and 5,6 per cent and 5,4 per cent in the subsequent two years respectively, somewhat lower than the Bank’s forecast.”

The growth outlook for the economy, according to the MPC by strong contrast has “deteriorated markedly” :

“The domestic economic growth outlook has deteriorated markedly, with the reversal of a number of the tentative positive signs observed at the beginning of the year. The Bank’s forecast for economic growth for 2014 has been revised down from 2,6 per cent at the previous meeting to 2,1 per cent, implying a further widening of the negative output gap. The forecast for 2015 remains unchanged at 3,1 per cent, and growth in 2016 is expected to average 3,4 per cent. However, the risks to these forecasts are increasingly to the downside against the renewed possibility of electricity load-shedding, among other factors.”

With this backdrop one might have thought that the decision not to raise short term interest rates would have been a formality. But not so for two members of the MPC – compared to the three at the meeting before – who actually voted for a further increase in rates. What can be on their minds?

It can’t be a belief that higher interest rates can do much to slow down inflation. The Investec Securities simulation for the Reserve Bank model of inflation and growth indicates that an increase of 25bps in the repo rate will only reduce its expected inflation by roughly 8bps and this would take seven quarters to take full effect. In other words, not much help on the inflation front at considerable further risk to the state of the economy – and moreover in the knowledge that an unpredictable exchange rate (that the model treats as an independent influence, about which assumptions rather than predictions are made when running the model).

The hard pressed SA economy had some good luck in the form of a stronger rand and a bumper maize harvest, which will help to hold down inflation in the months ahead. One gains an impression that had the rains not come when they did, the case for raising rates might have had more support.

That monetary policy is hostage to such obvious supply side shocks as drought and global risk aversion is not a comfortable thought. The reality is that inflation n SA has very little to do with the demand side of the economy (as the Reserve Bank acknowledges fully) and everything to do with factors over which interest rates have little influence: exchange rates and the harvest as well as the pace of administered price increases, which is the province of the regulators and the tax collectors.

At least this time round, at the media briefing and Q&A, the Governor was asked some leading questions about supply side effects and the influence of interest rates. She was even asked if the hike in rates in January (with hindsight surely a mistake) did any harm to the economy. There was little mea culpa in the response and a resort in the response to the non-testable theory that had the Bank not raised rates then second round effects – higher inflationary expectations – would have taken inflation higher. In fact there is no evidence that inflation expectations lead inflation rather than the other way round. And, as the MPC indicated, inflation expectations remain unchanged and the great constant in the economic environment.

This Q&A unfortunately indicates the danger in monetary policy: that members of the MPC come to believe that in order to preserve their inflation fighting credentials, and because the markets may expect them to raise interest rates, then that is what they have to do. This is regardless of the predicted outcomes for inflation and, more importantly, for growth.

The trouble with such monetary policy reactions is that they can never be tested or refuted. The economic caravan always moves on even as the dogs bark. Who can say with certainy what might have happened if the Bank had acted differently? Such mind games do not serve the SA economy well. Interest rates in SA should have been lower, not higher, given the state of the economy over the past 12 months The time for a cyclical upswing in interest rates is when the economy can justify it – not before. And there is clearly no justification for higher interest rates given the growth outlook.

Hard Number Index: Modest momentum

The economy in April maintained a very modest forward momentum – but the outlook is deteriorating, not improving.

Early data releases for vehicle sales and notes in circulation indicate that the economy in April 2014 maintained the modest forward momentum of the previous month. Our updated Hard Number Index (HNI), as we show below, is largely unchanged from the month before and reveals a similar outlook for still slower, but positive, growth rates in the months ahead.

The Index is based upon 2010 values. Index values above 100 indicate forward momentum. As we show, according to the HNI, the economy began a period of positive growth in 2004 that has continued since, but for a brief move backwards after the Global Financial Crisis broke in 2008 when the rand weakened and interest rates rose.

In the figure below we compare the HNI to the Reserve Bank’s coinciding business cycle indicator, also with a 2010 base, that has only been updated to January 2014 (with a value of 118). The Reserve Bank’s Indicator was still pointing higher in January 2014 while the HNI had turned lower in Q3 2013. The HNI has generally been a good timely leading indicator for the broader business cycle.

The performance of unit vehicle sales and the note issue is shown below. The outcomes are better than the raw numbers on a seasonally adjusted basis. But for Easter coming later this year than in 2013, such seasonal adjustments, as well as the raw numbers, need to be treated with caution.

If current trends persist, vehicle sales are heading lower, from a smoothed rate of 52 000 units per month, to about 50 000 units, equivalent to an annual rate of 600 000 units by April 2015. The local industry sold 647 217 units in 2013. Trends in the note issue suggest that the cash cycle may bottom out in Q4 2014. If this turns out to be the case, this modest recovery would be very welcome.

Hopefully for the state of the economy, the recent strength in the rand and a significantly lower maize price will have reduced the Reserve Bank’s forecast inflation rate as well as reduced the danger to the economy of higher short term interest rates that would undermine the prospects of any cyclical recovery.

The Reserve Bank fortunately (in a close call) did not raise interest rates in March when the rand was much weaker and long term interest rates significantly higher. It is therefore difficult to see how the Monetary Policy Committee could argue this week for anything but maintaining interest rates at their current levels for a while longer.

Value on the JSE – A contrarian case for SA economy plays

22 April 2014

Based on valuation metrics and given that the impact of higher interest rates is already factored into the valuations of the SA Industrials and Interest rate sensitive counters, the downside for these SA economy-dependent stocks appears more limited than other key JSE sectors.

These are not the best of times for the SA economy, but not the worst of times for the JSE

The outlook for the SA economy is unsatisfactory. The rate of growth is slowing down and the Reserve Bank seems intent on raising interest rates that will slow growth further. This outlook does not portend well for those businesses that serve the SA economy. Investors on the JSE however can take comfort from the fact that the SA share market has become more dependent on the performance of the global economy. If we break down the earnings of the JSE All Share Index, over 60% is generated from revenues outside SA, while 70% of the daily movements on the JSE can be attributed to these global influences.

Should investors prefer global to local plays?

The issue for investors on the JSE therefore is how to allocate their exposure between the listed global and SA plays. Clearly, the worse the SA economy is expected to perform, the stronger the case for preferring the global over the SA plays.

The SA bond and money markets can be confidently presumed to have factored in at least a further 100bp increase in the key SA Reserve Bank repo rate over the next 12 months, with the expectation of more to come over the following 12 months. The stock market will also have taken this into account.

These forecasts currently weigh upon the valuations accorded the SA economy plays, especially those companies for whom the direction of interest rates has proved influential in the past, which can be identified as interest rate sensitive, such as banks, credit retailers and property companies. Yet we can also be confident that the forecasts and assumptions that have influenced the market place will be altered over time with the news flow and that the market will move accordingly.

What if interest rates turn out to be lower than currently forecast?

Should interest rates in SA increase by significantly less than currently expected, it would likely mean unexpectedly high and superior risk adjusted returns from investing in the SA economy plays on the JSE. The opposite impact would be registered should SA interest rates turn out to be even higher than currently expected. We regard the danger of upside interest rate surprises as significantly less than downside surprises for reasons to be explained.

The exchange value of the rand will determine the outcomes for inflation and interest rates

The path to lower than expected interest rates in SA would have to be opened up by a stronger rand. The path to higher than expected rates would have to follow a still weaker rand. A consistently stronger rand improves the outlook for inflation and would avoid any need to raise interest rates and vice versa. Chris Holdsworth1 has successfully replicated the inflation model of the Reserve Bank for Investec Securities and suggests that a rand weaker than R10.70 to the US dollar would lead to higher interest rates, designed to bring inflation back within the headline inflation target range of 3% to 6%. This target band for inflation is currently under threat following the rand weakness of the past 12 months – hence the expectation of higher short term rates. A rand consistently stronger than this R10.70 would keep short rates on hold.

The Holdsworth replication of the Reserve Bank econometric model gives a good sense of some of the dilemmas faced by the Monetary Policy Committee (MPC) of the Bank. The most important of these is that inflation has risen, and may rise further, even though the economy is operating at well below its potential, for want of domestic spending.

Raising interest rates would depress demand further, with little impact on the inflation rate itself. Holdsworth calculates, using the Reserve Bank econometric model, that a 50bp increase in the key short term interest rates typically leads to only a 16bp reduction in the inflation rate, seven quarters out. Therefore, should the rand breach R11.30 against the US dollar, the Reserve Bank would have to raise rates by 100bp or more to hope to get inflation below 6% by the end of 2015.

The possible influence of the SA output gap on the market outcomes

Such an increase in rates would have a highly predictable impact on spending and the so called output gap as estimated by the model. The output gap is the difference between the potential growth of the economy, estimated at 3-3.5% per annum by the Reserve Bank, and actual growth, which is currently well below this. This gap, as shown in the chart below, is currently very wide and will increase further with higher interest rates. Note too that the current GDP output gap is now at historically high levels, indicating that the economy is operating below its growth potential, for want of sufficient spending by households in particular.

1Chris Holdsworth, Quantitative Strategy, Investec Securities Proprietary Limited, Second Quarter 2014, April 2014.

 

 

A still weaker level of demand and the still fewer jobs associated with higher interest rates would be an unacceptable price for the economy to pay and the Reserve Bank might be persuaded that higher interest rates are not appropriate given the trade offs in the form of slower growth. Furthermore, as we show in our next chart, there is evidence that higher short term interest rates may be associated with a weaker rand, so the outlook for inflation, despite the lower levels of domestic spending, could deteriorate rather than improve with higher rates. Yet the market still expects the Reserve Bank to think and act otherwise. Our view is that should the output gap threaten to widen further, the Reserve Bank might think again about raising interest rates even if its inflation forecasts have not declined.

Questioning the structure of the Reserve Bank econometric model

One of our issues with the structure of the Reserve Bank econometric model is the assumption, incorporated in the multi equation model, that higher inflation leads to increases in wage inflation and in disposable incomes, adding impetus to household spending and helping to close the output gap.

This presumed relationship – more inflation and so temporarily faster and perhaps unsustainable growth – however relies on a demand side explanation of inflation. In other words, high rates of inflation reveal a state of excess demand in the economy that needs to be restrained. This, as we have indicated, is very far from an explanation of current inflation in SA.

The model also assumes that inflation expectations can be self-fulfilling and lead to higher prices even though demand pressures may be weak. There is no evidence of this. Inflation in SA leads inflation expectations, which remain very stable at about 6%. There is no statistically significant feedback loop from inflation expected to inflation.

Higher consumer prices can alternatively be attributed to reduced, or more expensive, supplies of goods and services, the result of the weaker rand as well as for electricity and other administratively set prices. Such supply side driven increases reduce rather than add to real disposable incomes and spending power, especially when formal employment is in decline or growing very slowly. A weak rand is bad news for the purchasing power of SA households. It becomes even worse news for them when accompanied by higher interest rates. Furthermore, households account for over 60% of all spending and the incentive private firms have to add to their plant and equipment – which accounts for another 15% of GDP – is derived from the spending actions of households. A return to SA GDP growth rates of a mere 3.5% pa will have to be accompanied by an increase in household consumption growth rates.

A combination of a stable rand with stable interest rates is essential for this important purpose. A lift in exports, labour relations permitting, could help stimulate more GDP growth, but would have to be followed up by a recovery in household spending growth rates.

The further dilemma for the monetary authorities is that, even if the output gap were to widen further, it is quite possible that the inflation outlook could worsen rather than improve. It would worsen if the rand were to weaken further and the so-called pass through effect of the weaker rand pick up strength. There is no predictable relationship between SA interest rate moves and the value of the rand, as Holdsworth has again confirmed (see the chart below).

The Reserve Bank – will it undergo an economic reality check?

Changes in short term interest rates may therefore help hit or miss inflation targets even as changes in interest rates have the opposite impact on the growth in domestic spending and output. This leaves the Reserve Bank with uncomfortable trade offs between inflation and growth, which may encourage the MPC to take little or no action on interest rates, as has been its inclination recently.

The MPC may recognise the inadvisability of raising interest rates in current circumstances, having seen how the rand weakened further as interest rates rose in January and strengthened after the March meeting of the MPC when the rates were left on hold.

Global forces will drive the rand and the SA markets

The inflation rate outcomes for SA will be determined mostly by the direction taken by the rand, independent of SA interest rate settings. The global forces that influence the exchange value of the rand are the state of emerging market bond and equity markets. This pattern is highly consistent. These developments in emerging bond, equity and currency markets, in turn reflect the appetite for risk by global investors and the outlook for the global and emerging market economies. The better the outlook for emerging market economies, the more upside for commodity prices, emerging market equities and their currencies.

These helpful trends for emerging markets and currencies, led by lower long term interest rates in the US were a notable feature of the markets in March 2014, when the MSCI Emerging Market Index gained nearly 3% in the month. In January 2014, the Index lost nearly 7% of its value, before adding over 3% in February followed by another strong month in March 2014.

As we show below, these trends were especially helpful to the SA economy plays on the JSE in March 2014. In Q1 2014, we calculate that our grouping of SA Industrials and, to a degree, overlapping SA Interest Rate Plays in March, provided returns of over 9%, the Global Consumer Plays generated negative returns of about 1% and the Commodity Price Plays returned 1.5%. Were the rand to surprise on the upside again, a similar pattern of outperformance by SA economy plays is likely.

The forces that could drive emerging markets higher

Over the next six months, investors in emerging markets, including the JSE, should hope for minimal pressure from US and other developed market interest rates, especially from long bond yields. They should hope that Fed governor Janet Yellen and ECB president Mario Draghi continue to emphasise deflation rather than inflation until the prospect of stronger global growth is fully confirmed. This dovish approach seems a likely one and its realisation will be to the advantage of emerging market economies and the companies dependent on them. Over the longer term, faster growth in developed economies will bring higher interest rates, as demand for global capital improves and when faster growth in emerging markets can compensate for the higher costs of finance that should follow.

Breaking up the JSE by dependence on global or domestic economic forces

The large listed companies that dominate the JSE can be broken down by the degrees of dependence on global or domestic economic forces as indicated in the figure above. There are the Commodity Price Plays, made up of resource companies that depend on the US dollar prices of metals and minerals. This category of JSE-listed companies best excludes the gold mining companies that dance to the sometimes very different rhythms of the gold price. The Commodity Price Plays include the large diversified mining companies Anglo American (AGL), BHP Billiton (BIL) and Sasol (SOL), as well as the platinum, iron ore and coal mining companies.

Then there are the SA Interest Rate Plays: the banks, the credit retailers, property companies etc whose valuations are dependent on the direction of SA interest rates. They include the major banks like Standard Bank (SBK) and insurers like Sanlam (SLM).

A further category of SA economy plays are the less interest rate-exposed SA Industrials, including the cash retailers.

The other important category of Industrial companies listed on the JSE are those clear plays on the global economy. These include Naspers (NPN), Aspen (APN), Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI) and MTN, whose fortunes and valuation depend mostly on the profitability of their activities outside SA. We describe them them as Global Consumer Plays or as industrial hedges since they are hedged against the SA economy and the rand.

About 60% of the JSE All Share Index weighted by SA shareholders (the SWIX) is accounted for by a mere 10 companies, of whom only three companies may be described as heavily exposed to the SA economy: Standard Bank and Sanlam, both interest rate sensitive companies; and Sasol, a resource company, which generates much of its revenues and costs in SA but whose revenue is closely linked to the global US dollar price of oil.

2In this breakdown of the JSE we have combine the individual stocks into their various categories as follows:

Interest Rate Plays:
ABL, ASA, DSY, FSR, GRT, INL, INP, NED, RMH, SBK, SLM, BVT, IPL, MMI, MSM, PIK, SHP, TFG, TRU, WHL,

Commodity Plays:
AGL, AMS, ARI, BIL, IMP, LON, SOL, ACL, KIO

Industrial Hedges / Global Consumer Plays:
BTI, APN, SAB, NPN, SHF, CFR

S A Industrials:
BVT, IPL, SHP, TBS, VOD, BAW, LHC, AVI, SPP NPK

The case for SA economy plays – at current prices

The key question we now address is whether or not the JSE, taken as a whole, can be thought to offer the prospect of good returns for investors, at current valuations. The further issue is the valuation currently attached to the SA economy plays. Can they be considered demandingly valued at current valuations that incorporate the expectation that SA interest rates will rise over the next 24 months? Clearly there is upside for this class of shares should interest rates not rise as expected.

Yet a consideration of the downside risks to this class of shares needs consideration, as well as upside risks. Risks to the JSE All Share and SWIX Indexes, positive or negative, will impact to a lesser or greater degree on any subset of the market, including the SA economy plays.

Holdsworth shows that the JSE All Share Index is currently priced within the norms established since 1995. Cyclically adjusted or normalised earnings suggest an even less demanding rating for the market than do reported earnings. This is because the earnings from the Resource companies listed on the JSE are currently in only partial recovery mode from a deep, cyclical decline in normal earnings.

It would seem accurate to conclude that, by the standards of the recent past, the JSE was not demandingly valued at March 2014 month end, relative to trailing earnings (provided earnings from the Resource companies do in fact return to their cyclically adjusted norms). Clearly, such valuations also depend on the current state of emerging markets generally.

In our valuation models, we allow for an emerging market influence on the US dollar value of the JSE All Share Index and Financial & Industrial Index, in addition to factoring in the level of JSE earnings in US dollars and the interest rate spread between SA and the US. These valuation models, which have provided a good long run explanation of market value, suggest that the All Share Index is between 10 and 20% above the valuation predicted by the model.

Using a similar approach to valuing the S&P 500 indicates, by contrast, a high degree of undervaluation, 20% or so. This suggests that the better value for shareholders is for now still to be found in developed rather than emerging equity markets.

These currently stretched valuations of the JSE have been encouraged by the above long term average growth (of 10% pa) in Financial and Industrial rand earnings in recent years. This recent strong and predictable growth has been augmented by the exceptionally good earnings growth reported by the Global Consumer Plays. The SA Plays have also performed very well on the earnings front, especially in recent years.

Looking at Price/earnings ratios

In the figure below, we show the very different ratings enjoyed by these sub-sectors of the JSE. Global Consumer Plays now enjoy a much improved and exalted price/earnings rating compared to the other sectors.

While Naspers accounts for the largest share, 12.5% of the Top 40 companies included in the SWIX, its share of the Global Consumer Play sub-category is as high as 29%. Almost all of the value of Naspers can be attributed to its large shareholding in Tencent, a Hong Kong listed internet company. Without Naspers, which has recently traded at 65 times reported earnings, the Global Consumer Plays, taken together at SWIX weightings, would enjoy a still demanding 19 times earnings rating compared to the more demanding 24 times multiple when Naspers is included.

While the earnings performance of the SA Industrials has compared well with those of the Global Consumer Plays, these SA economy-dependent companies realise a significantly lower rating in the market. The Global Consumer Plays must be considered as growth companies while the group made up of SA Industrials and SA Interest Rate Plays can be considered as value stocks with much less demanding valuations.

Holdsworth has estimated that the trend earnings growth is 14% pa for the Commodity Price Plays, 9% p.a for the SA Interest rate plays, 15% pa for the Global Consumer Plays, 11% pa for the SA Industrials. The volatility of these earnings growth trends has been lowest for the SA Industrials at 17%, compared to 19% for the Global Consumer Plays, 23% for the SA Interest rate plays, 61% for the Commodity Price Plays and an extraordinarily high 158% for the Gold Mining Companies. Part of the case for the SA Industrials is thus their lower risk character. If these growth trends in earnings are sustained, current valuations of the SA economy plays cannot be regarded as demanding.

It may be argued therefore that, based on valuation metrics and given that the impact of higher interest rates is already factored into the valuations of the SA Industrials and Interest rate sensitive counters, the downside for these SA economy-dependent stocks is more limited than that of the Resource stocks or the Global Consumer Plays.

The upside is that the rand will be stronger than expected and interest rates lower than expected. All these sectors of the JSE will benefit from stronger global growth and strength in emerging market equities and commodity markets that would accompany any renewed appetite for bearing risks in emerging markets. But the SA economy plays as a group stand to benefit most from a strong rand and all that will follow a stronger rand, especially lower interest rates.

The SA balance of payments – a conundrum inside a mystery

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The improved return on capital invested by SA business

By Brian Kantor and David Holland

Why it is good economic news even though the new darling of the left, Thomas Piketty, thinks that high returns on capital raise income inequalities and thus should not be encouraged.

A success story – improved returns on capital realised by JSE listed companies

If a company can generate a return on capital that beats the opportunity cost of the capital it employs, it will create shareholder value. The market will reward the successful company with a value that exceeds the cash invested in the company.

The inflation-adjusted cash flow return on operating assets, CFROI®, for listed South African firms has improved consistently and impressively since the 1990s. Using CFROI® we have been able to demonstrate that political freedom has proved fruitful for SA businesses and their shareholders.

The economic return on capital has improved spectacularly over time, with today’s median firm reporting a very healthy CFROI of 10%. Until 1994, the average South African company was sporting a CFROI at or below the global average of 6%. South African companies were generally destroying shareholder value before 1994, especially when considering how much higher the real cost of capital would have been in those highly uncertain times.

Since 1994, the median CFROI has sloped upwards and remained above 6%. The new South Africa has been a value-creating South Africa! Note that at the peak of the commodity super cycle in 2007-8, the median CFROI was a stunning 12%. The top and bottom quintiles have also sloped upwards, indicating greater value creation for the best firms and less value destruction for the worst firms. Presently, 20% of South African firms are generating economic returns on capital above 15%, which is world-class profitability.

The benefits of efficient business and excellent returns on capital can be widely shared in inclusive share ownership, through pension and retirement plans as well as perhaps via a sovereign shareholding fund that can be built up to fund genuine poverty relief and opportunities for the poor. Broad-based empowerment in the form of employee- and community-based share options can be used to turn outsiders into insiders.

Such attempts to broaden the ownership of productive capital perhaps accord well with the recently revived critics of capitalism, following Piketty, who have found new reasons to question the advantages to society of high returns on capital. It is argued that such high returns on capital may well increase inequalities of income because they go mainly to the wealthy. Even should such high returns raise the rate at which national income is increasing, it makes such outcomes a mixed blessing, especially for those who have come to regard income equality as an important goal of economic policy.

Some facts about the distribution of SA incomes, taxes and government expenditure.

Let us give a South African nuance to this debate. Any discussion of the causes and consequences of economic growth and the distribution of benefits always has a distinctly racial bias in that white South Africans, on average, enjoy significantly higher incomes than black South Africans.

The distribution of wealth in South Africa is even more unevenly distributed in favour of white South Africans, given the much higher past incomes and the savings realised from them. The middle and higher income classes, those who are likely to become important sources of savings and contributors to pension and other funds, are increasingly made up of black South Africans. The times are changing and dramatically so, Loane Sharp, labour market analyst writing for Adcorp, indicates:

“Changes in the labour market after the end of apartheid have worked spectacularly well for blacks. Since 1995, on a like-for-like basis adjusting for skills, qualifications and work experience, blacks’ wages have been rising at 15% per annum whereas whites’ wages have been rising at just 4% per annum. Average wages for blacks and whites should converge as early as 2021 though, admittedly, average wages for entire race groups belie vast variations between individuals. The number of high-earning blacks – that is, those earning more than the average white – has increased from 180,000 in 2000 to 1.5 million today, with more than 40% of these employed in the public service, which has been used to great advantage, much like the predecessor apartheid state, to promote the welfare of a particular racial group.” (Source: Adcorp Employment Survey.)

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

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

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

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

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

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

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

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

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

Economic reality means tradeoffs, not least for economic policy

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

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

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

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

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

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

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

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

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

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

Pat on the back but much work needs to be done

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

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

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

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

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

Bernanke’s legacy: The great (and ongoing) monetary experiment

Ben Bernanke has now retired as Fed chairman, having rewritten the book on central banking.

He has done this not so much by what he and his fellow governors (including his successor Janet Yellen) did to address the Global Financial Crisis (GFC) that erupted in 2008, but by the enormous scale to which he supplied cash to the US and global financial system as well as in injecting new capital to shore up financial institutions whose failure would pose a risk to the financial system.

The scale of Fed interventions in the financial markets is indicated in the figure below which highlights the explosive growth in the asset side of its balance sheet. The initial actions taken after the collapse of Lehman Brothers in September 2008, what may be regarded as classical central bank assistance for a financial system in a crisis of liquidity, was superseded by further massive injections of cash into the US and global financial system as the figure makes clear. The cash made available by the central bank in exchange for securities supplied (discounted) by hard pressed banks, when only cash would satisfy depositors and other lenders to banks, alleviated the panic and allowed normally sound financial institutions to escape the run for cash. But Quantitiative Easing (QE) thereafter became much more than a temporary help to the financial system.


Chairman Bernanke recently took the opportunity to explain his actions and the reasoning behind them in a valedictory address to his own tribe (that of professional economists) gathered at the annual meeting of the American Economic Association (AEA) in early January 20141. On the role of a central bank in a financial crisis, he said:

“For the U.S. and global economies, the most important event of the past eight years was, of course, the global financial crisis and the deep recession that it triggered. As I have observed on other occasions, the crisis bore a strong family resemblance to a classic financial panic, except that it took place in the complex environment of the 21st century global financial system. Likewise, the tools used to fight the panic, though adapted to the modern context, were analogous to those that would have been used a century ago, including liquidity provision by the central bank, liability guarantees, recapitalization, and the provision of assurances and information to the public.”

Furthermore:

“The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions. However, the institutional context had changed substantially since Bagehot wrote. The panics of the 19th and early 20th centuries typically involved runs on commercial banks and other depository institutions. Prior to the recent crisis, in contrast, credit extension …….. Accordingly, to help calm the panic, the Federal Reserve provided liquidity not only to commercial banks, but also to other types of financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. .Because funding markets are global in scope and U.S. borrowers depend importantly on foreign lenders, the Federal Reserve also approved currency swap agreements with 14 foreign central banks.

“Providing liquidity represented only the first step in stabilizing the financial system. Subsequent efforts focused on rebuilding the public’s confidence, notably including public guarantees of bank debt by the Federal Deposit Insurance Corporation and of money market funds by the Treasury Department, as well as the injection of public capital into banking institutions. The bank stress test that the Federal Reserve led in the spring of 2009, which included detailed public disclosure of information regarding the solvency of our largest banks, further buttressed confidence in the banking system.”

In the accompanying notes to his speech, the following explanations of shadow banking as well as the special arrangements made to boost liquidity were specified as follows:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and nonbank mortgage companies.

“ Liquidity tools employed by the Federal Reserve that were closely tied to the central bank’s traditional role as lender of last resort involved the provision of short-term liquidity to depository and other financial institutions and included the traditional discount window, the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). A second set of tools involved the provision of liquidity directly to borrowers and investors in those credit markets key to households and businesses where the expanding crisis threatened to materially impede the availability of financing. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF) fall into this category.”

The initial injections of liquidity by the Fed to deal with the crisis was followed by actions that did write a further new page to the central bankers’ play book. That is, in the form of very large and regular additional injections of additional cash into the financial system, made on the Fed’s own initiative, in the form of a massive bond and security buying programme, which accelerated in late 2011 and early 2013 (QE2 and QE3) that was undertaken not so much to shore up the financial system that had stabilized, but undertaken as conventional monetary policy to influence the state of the economy by managing key interest rates and especially mortgage rates.

Usually, monetary policy focuses on changes in short term interest rates, leaving long term interest rates and the slope of the yield curve to the market place. But in the US, the mortgage rate, so important for the US housing market, is a long term fixed rate of interest linked to long term interest rates and US Treasury Bond Yields. These long term fixed mortgage rates (30 year loans) available to homeowners are made possible only with the aid of government, in the form of the government sponsored mortgage lending bodies Fannie Mae and Freddy Mac, whose lending practices did so much to precipitate the housing boom and bust and were particularly in need of rescuing by the US Treasury. Their roles in the crisis do not feature in the Bernanke speech made to the AEA.

The state of the US housing market is a crucial ingredient for improving the state of US household balance sheets that are so necessary if households are to spend more in order that  that the US economy can recover from recession. Households account for over 70% of all final demands in the US and only when households lead can firms be expected to follow with their own spending plans. These household balance sheets had been devastated by the collapse in house prices, by 30% on average from the peak in 2006 to the trough in average house prices in 2011. It was this boom in house prices followed by a collapse in them that was the proximate cause of the financial crisis itself.

This bubble and bust, after all, happened on Bernanke’s watch as a governor and then as chairman of the Fed, for which the Fed does not take responsibility. A fuller explanation of the deeper causes of the GFC was offered by Bernanke in his speech to the AEA:

“The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.”

The obvious question for critics of Bernanke is why the Fed itself did not do more to slow down the increases in the supply of credit from banks and the so called shadow banks? Perhaps the Fed could not do more, given its lack of adherence to money and credit supply targets and its heavy reliance on interest rates as its principal instrument of policy.

Given what happened in the housing price boom, it seems clear that policy determined interest rates should have been much higher to slow down the growth in credit. But it may also be argued that interest rates themselves are insufficient to moderate a credit cycle. This is an essentially monetarist point not addressed by Bernanke. In other words, to say there is more to monetary policy than interest rates. The supply of money and bank credit is deserving of control according to the monetarist critique. The Bernanke remedy for protecting the system against the prospect of a future financial crisis is predictably familiar: better regulation and more equity on the books of banks and other lenders. It may be argued that there will always be enough capital, regulated or not, in normal times, and too little in any financial crisis regardless of generally well funded financial institutions. Prevention of a financial crisis may prove impossible and the attempt to do so may be costly in terms of too little, rather than too much, lending and leverage in normal conditions (when lenders are appropriately default risk-conscious and do not make bad loans on a scale that makes for a credit and asset price bubble that ends in tears). The cure for a crisis should always be on hand and the Bernanke recipe will hopefully not be forgotten in the good times.

Any current concern about monetary aggregates would have to be on the liabilities side of the Fed balance sheet, conspicuous not so much for the volume of deposits held by the member commercial banks with the Fed, but with the historically unprecedented volume or ratio of deposits (cash) held by these banks with the Fed, in excess of their regulated cash reserve requirements. Also conspicuous is the lack of growth in bank lending to businesses – despite the abundance of cash on hand (see figures 2 and 3).

 

As Bernanke explained:

“To provide additional monetary policy accommodation despite the constraint imposed by the effective lower bound on interest rates, the Federal Reserve turned to two alternative tools: enhanced forward guidance regarding the likely path of the federal funds rate and large-scale purchases of longer-term securities for the Federal Reserve’s portfolio. Other major central banks have responded to developments since 2008 in roughly similar ways. For example, the Bank of England and the Bank of Japan have employed detailed forward guidance and conducted large-scale asset purchases, while the European Central Bank has moved to reduce the perceived risk of sovereign debt, provided banks with substantial liquidity, and offered qualitative guidance regarding the future path of interest rates.”

The use of forward guidance to help the market place forecast the path of interest rates more accurately, so reducing uncertainties in the market place leading hopefully to better financial decisions, predates the Bernanke chairmanship of the Fed. However, he should be credited with taking the Fed to new levels of transparency and much improved communication with both the marketplace and the politicians. In Bernanke’s words:

“The crisis and its aftermath, however, raised the need for communication and explanation by the Federal Reserve to a new level. We took extraordinary measures to meet extraordinary economic challenges, and we had to explain those measures to earn the public’s support and confidence. Talking only to the Congress and to market participants would not have been enough. The effort to inform the public engaged the whole institution, including both Board members and the staff. As Chairman, I did my part, by appearing on television programs, holding town halls, taking student questions at universities, and visiting a military base to talk to soldiers and their families. The Federal Reserve Banks also played key roles in providing public information in their Districts, through programs, publications, speeches, and other media.

The crisis has passed, but I think the Fed’s need to educate and explain will only grow.”

Historically US banks held minimum excess cash reserves, meeting any demand for cash by borrowing reserves in the Federal Funds market (the interbank market for cash), so making the Fed Funds rate the key money market rate and the instrument of Fed monetary policy. Holding idle cash is not usually profitable banking – but it has become so to an extraordinary degree. Furthermore, the large volume of excess reserves means that short term interest rates fall to zero from which they cannot fall any further. The reason they have remained above zero is that the Fed has been willing to reward the banks for their excess reserves by offering 0.25% p.a on their deposits with the Fed.

Every purchase of bonds or mortgage backed securities made by the Fed in its asset purchase programme must end up on the books of a bank as a deposit with the Fed. But before the extra phases of QE, the banks would make every effort to put their cash to work earning interest rather than holding them largely idle (as they are now doing). But it would appear that the Fed expects the demand for excess cash to remain a permanent feature of the financial landscape and can cope accordingly.

According to Bernanke:

“Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC’s ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate. It is possible, however, that some specific aspects of the Federal Reserve’s operating framework will change; the Committee will be considering this question in the future, taking into account what it learned from its experience with an expanded balance sheet and new tools for managing interest rates.”

It seems clear that the market is not frightened by the prospect that abundant supplies of cash will in turn lead to more inflation as the cash is lent and spent, as monetary history foretells. The market clearly believes in the capacity of the Fed to remove the proverbial punchbowl before the party gets going. Judged by the difference between yields on vanilla Treasury bonds and their inflation protected alternatives, inflation of no more than 2% a year is expected in the US over the next 20 years. According to Bernanke, who is much more concerned with the dangers of deflation, arguing that inflation of less than 2% should be regarded as deflation (given the hard to measure improvements in the quality of goods and services). Therefore if inflation is less than 2% this becomes an argument for more, rather than less, accommodative monetary policy by the Fed.

The market clearly finds the Bernanke arguments and guidance highly convincing. These expectations are a measure of Bernanke’s success as a central banker. He has surely helped save the financial system from a potential disaster and has done so without adding to fears of inflation.

The US economy has not however enjoyed the strong recovery that usually follows a recession. Bernanke has some explanation for this tepid growth:

“In retrospect, at least, many of the factors that held back the recovery can be identified. Some of these factors were difficult or impossible to anticipate, such as the resurgence in financial volatility associated with the European sovereign debt and banking crisis and the economic effects of natural disasters in Japan and elsewhere. Other factors were more predictable; in particular, we appreciated early on, though perhaps to a lesser extent than we might have, that the boom and bust left severe imbalances that would take time to work off. As Carmen Reinhart and Ken Rogoff noted in their prescient research, economic activity following financial crises tends to be anemic, especially when the preceding economic expansion was accompanied by rapid growth in credit and real estate prices.16 Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.”

He also blames the slow recovery on the unintended consequence of unplanned government fiscal austerity:

“To this list of reasons for the slow recovery–the effects of the financial crisis, problems in the housing and mortgage markets, weaker-than-expected productivity growth, and events in Europe and elsewhere–I would add one more significant factor– – 18 – Since that time, however, federal fiscal policy has turned quite restrictive; according to the Congressional Budget Office, tax increases and spending cuts likely lowered output growth in 2013 by as much as 1-1/2 percentage points. In addition, throughout much of the recovery, state and local government budgets have been highly contractionary, reflecting their adjustment to sharply declining tax revenues. To illustrate the extent of fiscal tightness, at the current point in the recovery from the 2001 recession, employment at all levels of government had increased by nearly 600,000 workers; in contrast, in the current recovery, government employment has declined by more than 700,000 jobs, a net difference of more than 1.3 million jobs. There have been corresponding cuts in government investment, in infrastructure for example, as well as increases in taxes and reductions in transfers.

“Although long-term fiscal sustainability is a critical objective, excessively tight near-term fiscal policies have likely been counterproductive. Most importantly, with fiscal and monetary policy working in opposite directions, the recovery is weaker than it otherwise would be. But the current policy mix is particularly problematic when interest rates are very low, as is the case today. Monetary policy has less room to maneuver when interest rates are close to zero, while expansionary fiscal policy is likely both more effective and less costly in terms of increased debt burden when interest rates are pinned at low levels. A more balanced policy mix might also avoid some of the costs of very low interest rates, such as potential risks to financial stability, without sacrificing jobs and growth.”

Bernanke then went on to paint an optimistic picture of the US economy:

“I have discussed the factors that have held back the recovery, not only to better understand the recent past but also to think about the economy’s prospects. The encouraging news is that the headwinds I have mentioned may now be abating. Near-term fiscal policy at the federal level remains restrictive, but the degree of restraint on economic growth seems likely to lessen somewhat in 2014 and even more so in 2015; meanwhile, the budgetary situations of state and local governments have improved, reducing the need for further sharp cuts. The aftereffects of the housing bust also appear to have waned. For example, notwithstanding the effects of somewhat higher mortgage rates, house prices have rebounded, with one consequence being that the number of homeowners with “underwater” mortgages has dropped significantly, as have foreclosures and mortgage delinquencies. Household balance sheets have strengthened considerably, with wealth and income rising and the household debt-service burden at its lowest level in decades. Partly as a result of households’ improved finances, lending standards to households are showing signs of easing, though potential mortgage borrowers still face impediments. Businesses, especially larger ones, are also in good financial shape. The combination of financial healing, greater balance in the housing market, less fiscal restraint, and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters. But, of course, if the experience of the past few years teaches us anything, it is that we should be cautious in our forecasts.”

It can be argued by his critics that the Bernanke innovations have been part of the problem rather than the solution. It would be very hard to argue that injecting liquidity and capital into the financial system to avert an incipient financial crisis in 2008-09 was the wrong thing to do. But it may yet be asked, then, if QE2 and QE3 were also necessary? Would not a sooner return to monetary normality have been confidence boosting, rather than undermining, business confidence, which is essential to any sustained recovery? Further bouts of QE have led to large additions to the excess cash held by banks, rather than additional lending undertaken by them that would have helped the economy along. Would the banks and the US corporations have put more of their strong balance sheets to work to help the economy along had monetary policy been less innovative, or at least had QE not been advanced as strongly as it was? Growth in bank credit and money supply (M2) has slowed down rather than picked up in recent years, despite the creation of so much more base money (see the figure on bank lending). That the banks have been able to earn 0.25% on their vast cash balances has surely encouraged them to hold rather than lend out their cash.

Furthermore, while fiscal policy could have been less restrictive in the short run, would any political failure to implement a modest degree of austerity at Federal and State level, not have made households even more anxious about their economic futures and the tax burdens accompanying them, leading to still less private spending?

The performance of the US economy over the next few years will be the test of the Bernanke years. If the US economy regains momentum without inflation, the Bernanke innovations will have proved their worth. They would then provide the concrete evidence that it is possible to create money, à outrance, and then take away the juice when that becomes necessary. Tapering of QE, the initial thought of which that so disturbed the markets in May 2013, is but a first tentative step to the actual withdrawal of cash from the system and the shrinking of the Fed balance sheet. The monetary experiment, conducted with deep knowledge of monetary history and theory that fortunately characterised the Bernanke years, remains an experiment. We must hope for the sake of continued economic progress both in the US and elsewhere that it proves a highly successful experiment.

1The Federal Reserve: Looking Back, Looking Forward, Remarks by Ben S. Bernanke, Chairman Board of Governors of the Federal Reserve System at
Annual Meeting of the American Economic Association
Philadelphia, Pennsylvania
3 January 2014
Source: Federal Reserve System of the United States, Speeches of Governors. All quotations referred to are taken from the published version of this speech.

Easter effects and the economy: A moveable feast

That moveable feast, Easter, is always a complicating factor for economists relying on monthly updates, coming as it often does at different times in either March or April.

Easter is late this year, and this can cause problems for economists, forecasters and policymakers. The President of the European Central Bank, Mario Draghi, informed an interrogator accordingly at his most recent press conference last week of Easter effects – when discussing the of the timing of ECB quantitative easing, an all important issue for the market place.

Question: Can you describe a little bit more what kind of information you are looking for on whether or not these latest inflation figures are changing your medium-term outlook? If you’re not going to act when its 0.5%, what does it take to get you to act on some of these things? And my second question is: you clearly changed the rhetoric a little bit in terms of your willingness to act swiftly – being resolute – but do your rhetoric and your easing bias lose credibility each passing month that you do nothing in the face of these very low inflation rates?

Draghi: On the first point: there are a couple of factors that somehow clouded the analysis of whether this latest inflation data would actually be a material change in our medium-term outlook or not. One has to do with the volatility of services prices and the fact that Easter time this year comes remarkably later than last year. The explanation is that, around Easter time, services expenditure usually goes up – demand for services goes up – especially travel, and this affected last year’s prices and it’s going to affect this year’s prices. So you have a base effect which produced much lower inflation data in March and may well produce higher inflation data next month.

Easter holidays always have an impact on spending in South Africa and flows through shops and show rooms. With Easter coming later this year, economic statistics for March 2014, especially when compared to March last year need to be treated with particular caution. Perhaps the best approach to reading the state of the economy around Easter time would be to take an average of March and April activity.

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

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

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

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

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

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

Economic reality and the MPC – coming together?

The first and second meetings of the Monetary Policy Committee (MPC) of the Reserve Bank in 2014 have come and gone and been accompanied by very different reactions in the money market.

The first meeting on 29 January produced a significant interest rate surprise on the upside when the MPC decided to raise its key repo rate by 50bps. The second meeting on 27 March produced a much smaller surprise in the other direction. Note in the chart below that the first upside interest rate surprise in January 2014 was associated with a significantly weaker rand while the surprising downside move in short term interest rates in March was accompanied by a stronger rand. Short term rates are represented in the figure by the Johannesburg interbank rate (Jibar) expected in three months – that is the forward rate of interest implicit in the relationship between the three month and six month JIBAR rate. Changes in this rate indicate interest rate surprises. Hence the inflation outlook deteriorated as interest rates moved higher and improved as interest rates were kept on hold.

This inconsistent and essentially unpredictable relationship between movements in SA interest rates and the rand is clearly coincidental – it is not a causal relationship because the value of the rand is determined by global or (more particularly) emerging market economic forces rather than domestic policy decisions. As we show below, where emerging market equities go, the rand follows. And emerging equity and bond markets are led by global risk appetite. The more inclined global investors are to take on more risk, the better emerging market equities and bonds perform, including those listed on the JSE. The behaviour of SA stocks and bonds and the exchange value of the rand is highly consistent with that of emerging markets genrally as we show in the chart below. The rand follows the Emerging Market Equity Index (MSCI EM) as does the JSE All Share Index (both in US dollars) while both the rand and the JSE respond to the spread between RSA and US Treasury 10 year bond yields that can be regarded as a measure of SA specific exchange rate risk. The wider the spread the more exchange rate weakness expected.

But what does this all mean for monetary policy in SA and for the direction of short term interest rates? As we are all well aware Reserve Bank interest rate settings are meant to hold inflation within its target band of three to six per cent per annum. But inflation takes its cue mostly from the direction of the rand, which is beyond any predictable influence of interest rates – as has been demonstrated once more.

And so the Reserve Bank remains essentially powerless to manage inflation in the face of exchange rate shocks (over which it has no obvious or predictable influence). Interest rates can influence spending in SA, causing the economy to grow faster or slower without necessarily influencing the direction of prices. In other words inflation can rise, as it has done recently, even though the economy has operated well below its potential and will continue to do so. Therefore higher interest rates can  slow the economy down further without causing inflation to fall. This is a painful dilemma of which the MPC seems only too well aware. To quote its statement of 27 March:

“The Monetary Policy Committee is acutely aware of the policy dilemma of rising inflation pressures in a subdued economic growth environment.

“The main upside risk to the forecast continues to come from the exchange rate, which, despite the recent relative stability, remains vulnerable to global rebalancing. The expected normalisation of monetary policy in advanced economies is unlikely to be linear or smooth, and the timing and pace is uncertain.

“The rand is also vulnerable to domestic idiosyncratic factors, including protracted work stoppages, electricity supply constraints, and the slow adjustment of the current account deficit. Pass-through from the exchange rate to prices has been relatively muted to date but there is some evidence that it is accelerating. However, the forecast already incorporates a higher pass-through than has been experienced up to now.

“At the same time, the domestic economic outlook remains fragile, with the risks assessed to be on the downside. Demand pressures remain benign as consumption expenditure continues to slow amid weakening credit extension to households and high levels of household indebtedness. The upward trend in the core inflation forecast is assessed to reflect exchange rate pressures rather than underlying demand pressures.”

So then how should the MPC respond to exchange rate-driven price increases? The obvious answer would appear to be to accept the limitations of inflation targeting in the absence of any predictable reaction of exchange rates to interest rate settings. That is to ignore completely the exchange rate shock effect on inflation and focus on domestic forces that influence the inflation rate: lowering rates when the economy is operating below potential and raising them when spending (led by money and credit growth) is growing so rapidly as to add to inflationary pressures. And to explain very clearly why it would be acting this way.

But this unfortunately is not the way the MPC is still inclined to think. It worries about the inflationary effect of inflationary expectations. To quote its recent statement again:

“Given the lags with which monetary policy operates, the MPC will continue to focus on the medium term inflation trajectory. The committee is aware that too slow a pace of tightening could undermine inflation expectations and may require more aggressive tightening in the future. Consistent with our mandate, a fine balance is required to ensure that inflation is contained while minimising the cost to output”.

The MPC would be well advised to accept another bit of SA economic reality, which is that not only does the exchange rate lead inflation, but inflation itself leads inflation expectations – not the other other way round. There is no evidence that inflationary expectations lead inflation higher or lower. More SA inflation leads to more inflation expected though, as the MPC is well aware, inflation expected has remained remarkably constant over the years: around six per cent per annum that is the upper end of the inflation target band.

The MPC did the right thing this time round not to raise its repo rate. It made a mistake to raise its repo rate at the January meeting. The money market made the mistake of immediately anticipating a further 200bp increase in interest rates by January 2015. The Governor has done very good work guiding the market away from such interest rate expectations that, if realised, would be even more costly to the economy. The money market now expects only a 100bp increase in short term rates by early next year. The market may again be very wrong about this, dependent as the direction of inflation and interest rates are on the behaviour of the rand over the next 12 months. But even good news for the exchange rate will still leave monetary policy in SA on a fundamentally wrong tack. The interest rate cycle in SA, as in any normal economic state of affairs, should be led by the state of the domestic economy, not by the direction of unpredictable global capital.

National income accounts: Challenges – and some helpful responses

The SA national income accounts – updated to 2013 – indicate the challenges facing the economy and helpful responses being made by some of the important economic actors.

The better, if not exactly comforting, news from the SA Reserve Bank’s March 2014 Quarterly Bulletin, about the economy in 2013, is that export revenues (in current rands) picked up and are now growing a little faster than imports, having lagged well behind imports in recent years.

This smaller difference between imports and exports in Q4 2013 added significantly to GDP, which was 3.8% larger in Q4 than a year ago.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The markets in 2014: Identifying the key performance drivers and drawing some scenarios

Developed and emerging equity markets, including the JSE, came under pressure in January 2014 but recovered strongly in February and early March. The JSE in February did especially well for both rand and US dollar investors.

We show in the figures below how these developments on the JSE – a poor January followed by a recovery since – are strongly associated with movements in the bond markets. In January, long dated US Treasury yields were falling while SA yields in rands (unusually) were rising. In February, US yields moved sideways while SA yields fell. Hence the yield spread between SA bonds and US Treasuries widened sharply in January and narrowed in February, to the advantage of the JSE (in rands and US dollars) and the rand. These relationships between interest rates, the rand and the JSE developments are not coincidental. They are causal.

 

The yield spread is the risk premium attached to SA assets. The wider the risk premium, the higher the discount rate attached to rand income, and the lower the value of the rand and the US dollar value of SA assets. In the figures below we show how the rand/US dollar exchange rate and emerging market (EM) equities responded to the yield spread in 2014. The rand responds to capital flows into and out of the SA bond market and the JSE.

If we could accurately predict the direction of US interest rates and the risk premium, we would be able to accurately predict the direction of the rand and the JSE.

In the figures below we demonstrate these relationships since January 2013, using daily data. The S&P 500 has been an outperformer over this period and the JSE in US dollars consistently tracks the EM average very closely. This relationship is not coincidental either. JSE earnings and dividends in US dollars track the EM average closely because JSE earnings are more dependent on the state of the world than on the SA economy – as is the case for most EM listed companies. The JSE and EMs generally have performed better relative to the S&P 500 recently after lagging behind badly in 2013.

 

The patterns may be more or less regular, but predicting the direction of US rates and the yield spread is anything less than obvious. We can however suggest alternative scenarios and their implications, and assign our sense of the probabilities.

Four possible scenarios for the US economy:
+ = above expected growth or inflation
– = unexpectedly low growth and inflation.

1. Growth + Inflation – The triumph of Bernanke

2. Growth – Inflation + The scourge of Stagflation stalks the land

3. Growth – Inflation – More of the recent same?

4. Growth + Inflation + Punchbowl not removed in time

 

Scenario 1: Unexpectedly strong growth with no more inflation. This implies higher US nominal and real interest rates and will call for an early reversal of quantitative easing (QE)

Implications: Good for US equities and cash but bad for long dated bonds, yield plays, inflation linkers and EM. Good for the US dollar. EM currencies will come under pressure. Risk spreads may decline, helping higher yield credit, including EM credit, given less default risk. The preference then would be for developed market equities over EM equities since they are more able to win the tug of war against the higher cost of capital (though in due course EM equities will also benefit from a stronger global economy).

Assigned probability: 30%

Scenario 2: Stagflation – slow growth with more inflation

This implies low real interest rates with a steep yield curve as higher expected inflation gets priced into the long end of the bond market. This is ideal for inflation linkers: risk spreads widen and more inflation will be better for equities than bonds, though not good for either. Stagflation will be better for EM equities that offer more growth at lower real discount rates. Cash will have appeal if short rates stay above inflation. Fears will enter the markets of not only inflation but also of inflation fighting responses that will further reduce the US and global growth outlook. Bad for the US dollar, good for precious metals.

Probability: 10%

Scenario 3: More of the recent same. Below par growth – below par inflation

More QE will mean low real and nominal rates (the failure of QE will raise policy issues and encourage more direct intervention in markets, adding risk and volatility). Bonds to be preferred over equities – EM equities and currencies will be preferred to developed markets and currencies and defensive stocks may be worth paying up for. Gold will have appeal given low real rates and danger of intervention.

Probability: 25%

Scenario 4: Punchbowl not removed in time; QE overshoots, meaning above par growth with above par inflation

Real and nominal interest rates will kick up. Equities will be preferred over all bonds – credit may offer equity like returns. Developed market equities will be preferred over emerging markets. Cash will be better than bonds – high real interest rates will counter inflation expected in the gold price. Real estate with rental growth prospects will have strong appeal as an inflation hedge.

Probability: 35%

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.

The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.

For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.

Hard Number Index: The economy is growing – but the pace of growth has slowed

Our Hard Number Index of economic activity (HNI) was little changed in February 2014. As the chart below shows, the SA economy as indicated by the HNI is growing (numbers above 100 based on January 2010, indicate growth) but the pace of growth is slowing down slowed and that its forward momentum has stabilized at the slower pace first registered in January 2014 .

The HNI is compared to the Reserve Bank Coinciding Business Cycle Indicator that is based upon a larger set of data derived from sample surveys. As the chart shows, the Reserve Bank Indicator is only updated to November 2013. It also indicates a growing economy with the pace of growth picking up in November 2013.

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

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

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

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

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

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

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

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

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

Resource companies: The earnings tide has turned

The JSE All Share (ALSI) Index earnings per share are growing again. As the chart below shows, nominal earnings are now back at the record levels of 2012, while real earnings and earnings valued in US dollars (at current exchange rates), while increasing,still have some way to go to get back to their peak levels of 2007-08.

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

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

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

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

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

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

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

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

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

 

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

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

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