Market volatility: Not a pretty picture at all

The equity markets late yesterday in Europe and also late in the New York day made a spectacle of themselves and it was not a pretty sight at all, especially when the futures on the DJ Industrials and S&P 500 moved sharply higher after the close. The biggest losers (on a day that saw the major markets down by more than 4%, having been up by the same percentage more or less the day before) were the European and US banks.

SocGen, a major French bank, was down over 26% by the close of the trading day on rumours, soon denied, that French sovereign debt was about to be downgraded by the rating agencies. BNP Paribas lost 11% on the day and Credit Agricole almost 15% off. On the other side of the Atlantic, Bank of America was down another 10.9% while Citi and Goldman Sachs both lost 10.5% on the day. JPMorgan escaped relatively lightly with a 5.6% loss and Wells Fargo was down 7.7% on the day.

Dow Jones Industrial Index, 10 August 2011
The Volatility Indicator (VIX) – a 12 month view

We have pointed out before that no national bank can hope to survive the default of its sovereign, or even in some senses, the serious expectation of its default if it were forced to revalue its assets at their reduced market value. This is because the presumed safest part of the banks’ balance sheets are committed and required by banking rules to be invested in significant proportions in sovereign debt.

The way governments and their banks usually avoid notional default on their debts is by printing money. This may mean more inflation, but also avoids banking failure since the banks’ assets and their liabilities also inflate more or less to the same degree.

The European Central Bank (ECB) is the only central bank in the euro system with the power to print euros. It continues to demonstrate a degree of reluctance to do so, out of fear (or perhaps German fears) of providing an easy way for European governments to get out of their fiscal crises and so avoid the necessity of cutting spending. The reality is that the ECB will have no alternative but to buy the bonds of threatened European governments if a banking crisis is to be avoided; or to indicate that it would be prepared to do so aggressively if called upon. Such unambiguous intentions might in themselves be more than enough to put the bond and bank short sellers to flight. The primary purpose of any central bank is to avoid a financial crisis and to use its considerable (and essential) power to print money without limits in order to prevent crisis. Further, when circumstances permit, they have the power to take the cash back again, usually with the profits that come with crisis resolution. The actions taken by the US Fed to pump money into the US financial system not only saved the system but did so at a profit to taxpayers. The ECB no doubt is well aware of this responsibility. Exercising it with vigour is well overdue. After all, financial instability is a threat not only to the financial system but to the real economy.

Equity and commodity markets this quarter (30 June = 100)

It is of interest to note that the emerging equity and the commodity markets (and so the rand) after having been engulfed by global fears on Monday, actually ended yesterday higher rather than lower. The volatility yesterday was clearly a crisis of confidence in European banks and in the willingness of the ECB to deal with it rather than new fears about the global economy. Commodity markets in general, as represented by the Reuters CRB Index can be regarded as having survived rather well the recent revival of risk aversion

Global markets: The risks are to the developed economies – not emerging ones

The world as reflected in equity markets has become a riskier environment. Day to day and even intraday, share price movements have become more pronounced (volatility or risks rising) with an inevitable and distinct downward bias. The outlook for the global economy has become more uncertain and this uncertainty has been demonstrated in the form of lower and more volatile valuations. In the figure below we show how much daily percentage moves in the S&P volatility indicator, the VIX, and daily per cent moves in the S&P 500 have increased over the past week.

Daily percentage moves in S&P volatility (VIX) and the S&P 500

In a clearly riskier environment such as this, a degree of rand weakness might have been expected. In fact the rand has held up very well against not only the US dollar and the euro, but also the Aussie dollar and the Brazilian real.

The rand vs the euro, Aussie dollar, US dollar and Brazilian real, Q3 2011 (Daily data)

The explanation for these unusual currency events – the rand strengthening in a riskier environment – deserves an explanation. The explanation is to be found in the behaviour of emerging equity markets from which the JSE and the rand take their cue. Emerging equity markets have held up better than the US market. It may be seen that this quarter and particularly this week, the emerging market (EM) Index has declined less than has the S&P 500. The average EM market by the close on 2 August was off by a mere one and a half per cent compared with 30 June. The S&P 500 had lost nearly 5% over this period and the JSE about 3% in US dollars.

The S&P 500, the MSCI EM and the JSE (USD), Q3 2011 (30 June =100)

Moreover the emerging markets have not been as volatile as the New York equity markets. The volatility priced into options traded on the JSE represented by the SAVI is now less than that of volatility priced into the S&P 500, as represented by the VIX that.

Volatility Indicators for the S&P 500 (VIX) and the JSE (SAVI)

And so when we run our model (utilising daily data since January 2009) to explain the rand/US dollar exchange rate with the EM Equity Index, the model predicts a rand/US dollar rate of R6.90 compared with an actual R6.80 on 2 August.

The rand and its value predicted by the EM Index

The enhanced risks therefore may be recognised as more uncertainty about the outlook for the US economy than anxiety about the prospects for emerging market economies (as well as the companies that serve them, including those listed on the JSE). This makes every sense. It is the developed world that needs to get its fiscal house in order, not the emerging economies that are mostly in comparatively good economic and fiscal shape.

Perhaps the agitated state of the developed equity markets indicates that there is now even less confidence in the ability of the Obama administration to sustain faster US growth, given the shenanigans that accompanied the lifting of the US debt ceiling. It was not the President’s nor his party’s finest hour.

It is surely up to President Obama to prove that the market is misjudging him. But he has little time to prove the market wrong before facing the US electorate in November 2012. To build the confidence that would revive spending plans of firms and households and employment, he would need to convince Americans that he can implement a realistic long term plan to deal with the US deficit without raising tax rates. Faster economic growth is essential to this purpose. Such a plan would have to include critical features like reining in the threatened runaway government spending on medical benefits under Obama care. This will not come easily.

Vehicle sales, house prices and credit: Operating below potential

New vehicle sales in South Africa in July rose from 44 880 in June to 45 703 units sold. On a seasonally adjusted basis this represents a marginal increase of about 70 units. As we also show below, the new vehicle cycle has clearly peaked and if present trends continue the level of new vehicle sales will remain more or less at current levels and growth will turn marginally negative (off its higher 2011 base) by early 2012.

New vehicle sales in South Africa

Growth in new vehicle sales

In 2010 SA Households increased their spending on durable consumer goods by 24% off a very depressed base. This growth in the first quarter of 2011 was maintained at a very robust 21.5% annual rate helped by particularly buoyant sales of new vehicles in March 2011. The impetus provided to the SA economy by increased sales of new vehicles and perhaps also sales of other durable consumer goods, is losing momentum.

Such lack of momentum is also revealed by very tepid growth in the supply of bank credit and money to June 2011, a trend confirmed by the results reported by the retail banks this week. The revenue line of the SA banks is growing very slowly because house prices and so demands for additional mortgage loans have increased at a very modest rate and growth in the supply of money and credit may be slowing down rather than picking up.

Average house prices and house price inflation
SA banks growth in assets and liabilities

These trends in vehicle sales, house prices and credit and money supply suggest that the SA economy will operate below its potential for some time to come. The potential stimulus to growth from the global economy and exports now also seems less likely to provide additional strength to incomes and employment. The MPC after its July meeting told us that it had not even considered lowering interest rates only raising them- a temptation that was strongly resisted as we were also told. Given these updates on the SA economy it should have considered lowering interest rates

US debt ceiling: Triumph of the Tea Party

The good news for the equity markets over the agreement to lift the US debt ceiling was overtaken by further doubts about the US and global economy due to the weak ISM manufacturing report that came in below expectations. The index indicated that manufacturing output in the US had barely expanded in July and the subsectors of the index reporting on orders and employment intentions offered little comfort about the outlook for the economy.

The agreement found overwhelming support in the House of Representatives from Republicans, while Democrats were evenly split 91-91. The Senate will undoubtedly follow suit today. The Republicans had successfully held the line against tax increases and the Wall Street Journal described the outcome as representing a new dawn for fiscal outcomes in the US (spending cuts without tax increases) and a triumph for the Tea Party activists.

It is clear that faster economic growth in the US and other debt assailed economies is what is needed. The debate in the US will be how to realise this faster growth. Higher tax rates (on the rich and highly paid) may be regarded by some as only fair but they are surely not good for growth. Extra government spending financed by higher taxes surely crowds out private spending over the longer run. And even when an economy is operating well below its potential the threat of more government spending (and the taxes to follow) may immediately frighten away business and household spending. That the limits to the ability of the Federal Government and of municipal and state governments in the US to raise tax rates have been reached might well be regarded as very good for growth.

Also good for growth everywhere would be reforms of the entitlement programmes that encouraged workers to retire later. Essential too would be to mean test medical benefits for the over 67s (or should it be over 70s?), and in so doing recognise much improved life expectancies. A genuine market place for medical services and for private insurance to cover medical expenses would help greatly to discipline spending on doctors and prescription drugs.

Finding the path to faster growth in the US need not be complex. What it does require is the appropriate political will. The will to resist higher tax rates, has been demonstrated in the US. However the will to pare back entitlements and to rationalise access to them has still to be demonstrated. This debate in the US will intensify as the elections of 2012 approach. President Obama knows his re-election prospects will be much diminished if the unemployment rate does not recede sharply from the current 9%. Unless he can encourage households and especially firms to spend more, he will not succeed in this. He might therefore well become a great deal more business friendly: this would also be good for US growth

Money and economic activity

In the eighties and early nineties a number of attempts were made to measure the relationship between various measures of money supply growth and the growth in GDP, GDE, Household Consumption Expenditure and Consumer Prices between 1966 and 1993. (82, 1984,1989, 1990b, 1993) This earlier work on the relationship between money economic activity and prices was concluded in 1990 with an attempt to separate monetary causes and effects. That is to estimate whether the money to expenditure and income link was stronger than the income to money link, given the accommodative nature of money supply responses. It was reported that the money to income link was stronger than the reverse income to money influence, using a vector auto-regression approach. (1990a). The purpose of this paper is to update this analysis to include the past twenty years of data to establish whether or not money still matters for the SA economy in the way it did.

The full paper is available here: Money supply and economic activity (2012)

The rand: No surprises

The recent strength of the rand should not have come as a surprise. The rand has continued to follow very closely the day to day the direction provided by emerging equity and bond markets.

A simple regression equation linking emerging equity markets (represented by the benchmark MSCI EM Index) to the rand explains over 95% of the daily value of the rand as we show below. This model predicted a value of R6.80 on Wednesday 27 July, slightly weaker than the R6.70 at which the rand traded that day.

This relationship seems obvious and persistent enough and very likely to continue: where emerging market (EM) equity markets go and where global growth and risk appetite take them, the rand will follow.

The explanation for the strength of the relationship is perhaps less than obvious. That the JSE All Share Index, especially when converted to US dollar, also follows the EM Index very closely, is part of the explanation. This connection that makes the JSE so highly representative of the average EM is by no means accidental. As we have pointed out, JSE earnings in US dollars follows average EM Index earnings as closely as does the Index. This is because the major companies listed on the JSE have a global and emerging market economy reach, rather than being dependent on the SA economy. And so capital tends to flow into and out of the JSE and the SA bond market, depending on the simultaneous direction being taken by the EM equity and bond markets generally.

It should moreover be recognised that the market in rands is a large, active and liquid global market. Each day up to US$20bn worth of rands is now being traded according the SA Reserve Bank. Much of this trade is conducted between third parties not directly engaged in SA trade or finance; they are presumably trading the rand because they can easily do so and are doing so because presumably the buying and selling of rands enables traders and investors to hedge exposure to Emerging Markets and their currencies that cannot be traded as easily.

This makes the rand much more of an emerging equity market currency and much less influenced by the direction of SA foreign trade and the implications that inflation differences, or purchasing power parity (PPP), can have for this trade. Exports are encouraged when the rand is undervalued – that is exchanged for the US dollar at a lower rate than its PPP equivalent; while imports are encouraged when the US dollar is cheaper and can be bought for less than its PPP equivalent value.

It all depends on where you start

The history of the rand relative to its PPP value, that is, its value explained by the difference between higher SA inflation and lower US inflation alone is shown below. In the decade of the 1990s the rand stayed close to PPP until 1995. Thereafter it depreciated at a much faster rate than PPP until the rand blew out in 2001. By then the rand was substantially undervalued relative to PPP. However by 2011, the rand was back to its 1990 PPP equivalent.

Thus if we begin the calculation of PPP in 2000 and carry it forward until now, the picture becomes very different. By 2011 the rand, compared with its PPP value, is substantially overvalued compared to its undervalued position in 2000 and 2001. The PPP value for the rand today (with January 2000 taken as the starting point) would be about R9 to the US dollar. But the strength of the rand over the last decade was due to the recoveries from two major shocks: the 2001 shock was almost completely domestic in origin – it was linked to the initiation of the asset swap facility. The shock in 2008 and the recovery thereafter represent the impact almost entirely of global forces (that is the impact of the global financial crisis on all emerging market currencies) including the rand and the subsequent recovery from this crisis.

As indicated, the rand cannot be well explained by PPP. Capital flows explain these differences from PPP and will continue to do so whatever the SA Reserve Bank might hope or try to do about this by interventions in the currency market. The market is just too big for the Bank to hope to muscle in one or other preferred direction.

These flows and their influence on the rand were severely restricted by exchange controls before 1995. Capital flows were captured within the financial rand pool and the financial rand exchange rate insulated the (commercial) rand. These controls were lifted for foreign investors in 1995 and gradually for SA investors ever since. The relief of the exchange control log jam after 1995 and panic demand for asset swaps by individuals in 2001 explains most of the persistent weakness of the rand between 1995 and 2001 (just as the global financial crisis explained the weakness and recovery in 2008-2010). By 2002 global forces had taken over the exchange value of the ZAR.

It should be appreciated that with the almost complete lifting of exchange controls and the trading appetite for rands abroad, the rand is no longer a one way bet. It is much more a bet on emerging markets. Those who like to believe that rand weakness (given higher SA inflation) is a fact of economic life should think again. And they should also appreciate that a stable rand helps to reduce inflation pressures in SA.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 29 July

US earnings: The benefits of going global

A Wall Street Journal Report today by Kate Linebaugh and James Hagerty, Business Abroad Drives U.S. Profits, points to way foreign operations of leading US corporations have contributed to the very satisfactory second quarter earnings season now well under way in New York. One third through the earnings reporting season for the S&P 500 companies, earnings are the highest they have been in four years.

These S&P 500 earnings per share may well exceed $100 for the 2011 calendar year. The drivers for this earnings growth however, as the report points out, is not the struggling US economy, but the off shore operations of these companies.

About three quarters of the companies that have reported so far have done better than analysts expected. As the WSJ report states, “…Many of them – ranging from manufacturers Honeywell International Inc. and Caterpillar Inc. to drug maker Abbott Laboratories – raised their earnings forecasts for later in the year.

The report refers to the bellwether industrial giant GE that reported a 21% increase in earnings to $3.8bn for the second quarter. Yet US revenues in GE’s core industrial businesses shrank about 3.4% while international industrial revenue soared 23% to $13.4bn, accounting for about 59% of the company’s total industrial revenue. This translates into growth in capital expenditure and employment offshore rather than on US shores making the US economic recovery less likely to benefit from the financial strength of US corporations, many of whom have a strong global footprint.

We have been firmly of the view that the most compelling way to gain exposure to the global economy is via the companies listed on the S&P 500. The valuations of these companies appeared very undemanding of earnings growth, trading as they do well below their average price to trailing earnings multiples (which averaged as much as 21 times between 1980 and 2011). The current trailing S&P 500 earnings per share, calculated before higher second quarter earnings have been reported, is US$81.31. This puts the S&P on a trailing 16.5x earnings and a prospective forward PE of under 14 times earnings to be reported in the first quarter of 2012.

This advice has proven apposite as we show below. Since 1 January 2011, the S&P 500 has gained almost 7% (to 23 July) while the MSCI EM is flat and the JSE in US dollars is 2.5% weaker than on 1 January 2011.

However as we also show, S&P earnings year to date have significantly outpaced the share market index, adding to the case for investing in the S&P 500. We remain firmly of the view that the S&P 500 is still very undemanding of future earnings growth and even less demanding than it was. And the unsatisfactory state of the US economy can be expected to continue to keep down interest rates in the US (and so the competition for equities from fixed interest income)

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 25 July

Interest rates: Sombre is good

A sombre outlook for the domestic and the global economy was presented yesterday by Reserve Bank governor Gill Marcus, helping the case for leaving rates unchanged, as had been confidently expected. The case for higher rates any time soon was weakened by the arguments presented in the MPC statement and in the Q&A session that followed. The opportunity to lower rates was not considered, as we were informed, though perhaps it should have been. Cost push pressures on inflation were again emphasized in the statement – and second round effects of higher inflation expected (on inflation itself) were regarded as not in evidence. Inflationary expectations, as measured for the Bank, were reported as stable to lower.

The Reserve Bank expects the small breach of the upper 6% band of the inflation targets by the first quarter of 2012 but is of the view that this breach will be very temporary and therefore no reason in itself to raise the repo rate. Base effects are pushing inflation higher in the second half of 2011 and will reverse in 2012. The key to the inflation target remains the foreign exchange value of the rand and this is proving very helpful and we think will continue to be so – to the point that the Reserve Bank is over- rather than underestimating inflation.

Prominent reference was made in the statement and in the Q&A to the “core” rate of inflation, that is inflation excluding food and energy prices, which is of the order of just over 3%. An inflation target set in terms of core inflation rather than headline inflation is preferred by many of the leading authorities on inflation targeting and the Reserve Bank may well be moving in that direction. This represents an important and welcome departure from previous Governor Mboweni’s practice and rhetoric, who was determined to allow no such distinctions or escape clauses for meeting the inflation targets. This different mindset reinforces our argument for and prediction of low interest rates for longer. Moreover it raises the likelihood of generally more stable short term interest rates in the future which would be very helpful for SA business and its customers.

Closing the gap

At the Q&A, so called output gaps received interesting attention, that is the gap between potential GDP and actual levels of output. This gap is judged still to be open but is said to be closing with current growth rates ahead of potential growth. Potential output growth this year was indicated as only 3.5% with second half growth slowing down rather than picking up. This represents a very pessimistic view of SA’s long term growth potential and is not one consistent with much growth in employment and the government objectives for employment growth.

This Reserve Bank sense of potential growth is presumably derived from a limited estimate of SA’s ability to attract foreign capital, equivalent by definition to the sustainable size of the current account deficit – both usually measured as a share of GDP. We have argued that such pessimism may be unjustified and that growth can lead capital inflows that finance and sustain growth. In other words, grow faster to improve the returns on capital invested, and the capital from global sources will be forthcoming. There is a potential virtuous circle for SA that was in evidence between 2003 and 2007 (grow faster- attract more capital – sustain the value of the rand – holds down inflation and interest rates). But expressing faith or confidence in such possibilities of faster growth with less inflation aided by foreign capital, is not behaviour expected of inflation vigilant central bankers.

GDP growth is expected by the Reserve Bank to be about 3.7% in 2011 and 3.9% in 2012, increasing to 4.4% in 2013. When the presumed output gap is finally closed (on these assumptions) late in 2012 the case for raising rates will then be more confidently made. Pressures on global food inflation are however thought by the MPC to have peaked. The MPC outlook is for inflation at the upper band 6% rate by year end and is expected to remain above this 6% upper band for the inflation target until the second quarter of 2012 and receding thereafter.

Something in reserve …

Had we been at the Q&A session we would have asked the Governor and her bench of advisors why the Reserve Bank thinks it still useful to add to its already abundant supply of foreign exchange reserves. These are large enough for any conceivable emergency that might shock the SA balance of payments. The governor indicated her own confusion about the forces that drive the rand. Clearly Reserve Bank interventions in the currency market have had no predictable influence on the rand. The realised strength of the rand has made such intervention very expensive for the SA taxpayer on whose behalf the Treasury borrows rands at 6% to 8%, to offset the impact of dollar purchases on the money supply, for the Reserve Bank to invest in US dollars and Euros that return around 2% at best. It has been an expensive and futile exercise in trying to resist market forces.

We might suggest that the behaviour of the rand is not that mysterious and will continue to take its cue from global risk appetite, well reflected in emerging equity and bond markets. The well understood rand does not make it easier to predict. This remains the essential problem for monetary policy in SA, which is to hold inflation down not for its own sake but to encourage long term economic growth (lest we forget the purpose of inflation targeting).

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 22 July

Employment: The annual strike (that is the loss of jobs) season is well under way

The annual strike season is well under way. The usual well above inflation increases are being demanded accompanied by the usual marches, highly rhythmical toi-toing and some violent intimidation of workers, less inclined to put their jobs at risk. And after losses of production and presumably also of wages, management and unions settle on still significant increases above recent inflation rates.

The season might well be called the season of further loss of permanent jobs in the formal sector of the economy. Wages and benefits improve for those who keep their jobs, while management are strongly encouraged to proceed with operating strategies that rely less and less on unskilled labour and more on capital equipment employed.

The outcomes are plain to see in the ever widening gap between output growth and formal employment growth. This has become ever more conspicuous after 1995, due to more onerous regulation of the SA labour market (for management).

The labour saving logic practised by management is sensible enough – including their willingness to concede well above inflation increases. The logic driving union action is less obvious to those outside the ranks of union leaders and presumably their generally supportive rank and file who seem to appreciate a good fight with their bosses. One might be inclined to think, given the long established employment trends, that the leaders would rather wish to encourage employment (perhaps of their sons and daughters) and so union membership and the dues they collect with less militancy and less aggressive demands for more. Clearly there is something else at work that makes union militancy, rather than co-operation, the action that keeps the union leadership in their jobs. And so the history repeats itself: higher real employment benefits, fewer formal sector jobs and productivity gains to compensate for more expensive labour.

Shareholders by contrast have no reason to be immediately concerned about these trends, unless they fear, as they may well, the instability threatened by the growing divide between those in good jobs and those increasingly excluded from gaining access to them. But this is an issue that the management of any one firm cannot address. The reality is that management teams have adopted labour saving or especially unskilled labour saving policies that have proved to be consistently profitable and can be expected to continue to be profitable.

Over recent years the share of operating surpluses in the gross value added by the SA corporate sector has if anything tended to rise while that of employees (including managers) in the form of wages in cash and kind has tended to fall. In other words operating profits have been improving despite higher wages for those who hold on to their jobs.

The share of the operating surplus in the value added by non-financial corporations in SA and their gross cash savings is shown below. As may be seen it is a much improved picture, especially in the form of cash flow generated by these firms that has no doubt added to balance sheet strength and added value for shareholders.

The issue confronting the firms, the unions and SA generally, is how these cash flows and profits should best be employed – in reducing debt, paying dividends, making acquisitions or (much more helpfully) for economic growth adding to capital equipment or workers employed.

The answer for SA is obvious enough to all – more jobs. The uncomfortable truth is that management has no good reason to alter its ways. They are reacting to the fact of economic life in SA that the real cost of capital, in the form of a lower risk premium paid by SA firms, has come down materially, given a most helpful political transformation. Over the same period their real cost of hiring labour has increased materially.

It would seem obvious to all but those who find it convenient to deny the relationship between employment levels and employment benefits. That is to say. in the interest of more formal jobs, it is the unions that need to become less militant and more co-operative with management. The unions need to promote employment by encouraging the adoption of policies that would make for a more flexible labour market and a much more mobile labour force that could adapt appropriately to the state of the economy. Maybe only an economic policy Codesa will lead to this.


To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 21 July

Gold is for the risk averse, gold shares for the risk loving

The gold price in US dollars and in rands has moved ever higher while JSE listed gold shares have moved mostly sideways over recent years. The explanation seems obvious enough. The cost of mining gold in SA has risen every bit as rapidly as the price of gold while the volume of gold mined in SA has declined consistently with these higher costs and the lower grade of ore being crushed. In 1970, before the price of gold escaped the constraints of the gold standard that set the price at $35 or approximately R27 per troy ounce, SA mines produced over 600 metric tonnes of gold a year.

SA gold mines now produce fewer than 200 tonnes of gold a year and this output is falling. The only consolation in this sad tale of events is that presumably the US dollar and rand price of gold would be a lot lower had SA continued to produce as much as it did before.

But the hope that the gold mines will be able to take advantage of the higher gold price in the form of profits and dividends seems to rest eternal. Investors have consistently paid up more for the dividends actually paid by the gold mines. Currently the mines are selling at 122 times their trailing dividends or at a dividend yield of less than a third of one per cent. Gold mining accounting earnings follow no consistent pattern and have often been negative in recent years. For the record , the JSE Gold index reported earnings per share have been positive over the past 12 months and the share prices are on average 315 times their trailing earnings.

The hope clearly implicit in these extraordinary market ratings is that gold mining companies will some day, maybe soon, be able to get more valuable gold out of the ground at greatly improved margins. This makes gold shares the ones with the longest odds in the equity markets. This taste for risk may well continue to provide support for gold shares for some time to come. Presumably the risk lovers assign only a small proportion of their portfolios to this gamble.

Accordingly the relationship between the gold price (much higher) and gold shares (sideways) is therefore a very weak one and may remain so until the mines actually deliver much improved dividends. Since January 2008, for every one per cent daily move in the rand gold price, the JSE Gold Mining Index has moved on average by only 0.42% (the so called gold price beta). However the gold price explains only about 7% of the daily move in gold shares over this period. There is clearly much more than the influence of the gold price at work on gold shares. The gold price expressed in US dollars does only a marginally better job explaining the JSE Gold index (in rands) with a beta close to 0.75 but still with very low R squared or explanatory power of 0.16%.

Gold shares are clearly only for the risk lovers. Gold itself however would have served the risk averse very well over this period. This is because, on average, when the market was down the gold price was up and vice versa. The correlation between daily moves in the JSE All share and the rand gold price was a negative (-0.16). Negative correlations of this order of magnitude provide outstandingly good risk reducing diversification benefits for portfolio managers. The correlation between daily changes in the rand gold price and the S&P 500 in US dollars has been even more negative (-0.44). Thus for South Africans with exposure to developed equity markets, gold would have provided especially good insurance. For the offshore investor the correlation of daily changes in the dollar price of gold and the S&P 500 was close to zero (0.04) over the period indicating that gold would also have provided very good insurance for the US dollar investor.

Past performance may not be a guide to future performance. But if the past is anything to go by the case for investing in gold, especially for South Africans, has been greatly strengthened while the case for investing in gold shares remains at best unproven.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 20 July

The JSE, rand and emerging markets: Following the same path

The JSE and emerging equity markets (as measured by the MSCI EM Index) have moved sideways this year. However, in something that is consistent with the now very well established pattern, the two markets indices have moved closely together day to day and month to month. Furthermore the rand, confirming another well established relationship, has continued to move closely in line with the emerging market Index.

Our model of the rand/US dollar (which includes only the MSCI EM Index as its explanation) indicates that fair value for the rand/US dollar on 12 July (given the level of the EM Index) was R6.90 compared to a closing value that day of R6.85. The fit of this model run with daily data since 1 January 2009 is extraordinarily good.

The strength of the association between the value of the MSCI EM and the JSE is explained only in small part by the fact that JSE listed shares constitute 8% of the EM Index itself and therefore attract the interest of emerging market (EM) fund managers. The relationship is more fundamentally explained by the fact that the stream of JSE All Share Index earnings per share, in US dollars, approximates very closely those of the earnings per share generated by the EM universe itself. Thus the values attached to these expected streams of earnings, by global portfolio managers, are highly comparable.

Investec Securities has created its own large market cap EM Index of about 190 individual EM companies and aggregated their earnings per share to derive both an Index called the IBICEMI and its associated Index earnings per share. As may be seen below, the IBICEMI tracks the benchmark MSCI EM Index very closely and may be considered fully representative of benchmark earnings per share.

It may also be seen how closely JSE earnings per share and EM earnings per share have been related over the years. Both earnings series demonstrated extraordinarily rapid growth in earnings measured in US dollar through the boom years of 2002-2007 before the onset of the global financial crisis in 2008. Moreover EM and JSE earnings survived the crisis in much better shape than the S&P 500 and earnings per share now exceed their pre-crisis peak levels in US dollars. The JSE Index in US dollars is now above its pre crisis peak values while the MSCI EM has still to reach pre crisis levels. This re-rating of the JSE relative to the EM ( values rising ahead of earnings ) may be seen below with the JSE trading at a 14.85 times reported earnings and the IBICEMI EM Index trading at a lower 11.21 times trailing earnings.

This rerating of the JSE may be explained by the respective earnings cycles. JSE earnings per share, while following a similar path, have grown significantly faster over the past 12 months than EM earnings represented by their large caps. JSE earnings per share measured in US dollars grew by about 46% in the 12 months to June 2011 while EM earnings growth was a less robust 26% over the same period. Clearly the relatively greater dependence of the JSE on Resource companies and their earnings has served the JSE very well as metal and commodity prices moved ahead of their year ago levels.

It can be confidently predicted that the values attached to Emerging Markets and the JSE will continue to be strongly influenced by earnings reported and expected. It can also be predicted, though perhaps somewhat less confidently, that the foreign exchange value of the rand will continue to be determined in large measure by the state of emerging equity markets. The JSE, the EM equity Indexes and the rand can be confidently predicted to remain highly responsive to the outlook for the global economy, to which emerging market economies contribute most of the growth.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 15 July 2011: The JSE, rand and emerging markets: Following the same path

The Hard Number Index: Satisfactory but not improving

Economic activity in SA expanded in June, but according to our Hard Number Index of Economic Activity (HNI) the pace of growth may well have slowed marginally rather than picked up momentum.

Our HNI attaches equal weights to two very up to date hard numbers, namely new vehicle sales for June, as released by NAAMSA, and the size of the note issue as at the end of June. The HNI may be compared to the Coinciding Indicator of the SA Business Cycle calculated by the SA Reserve Bank. This indicator, with a very similar lower turning point for the current cycle, is however only updated to March 2011, leaving it well behind current economic events.

Vehicle sales began a very strong recovery in late 2009. Sales of all new vehicles were particularly strong in March 2011. Actual sales that month were 53 478 units, which, since March is usually a very good month for vehicle sales, translated into a seasonally adjusted 50 101 units. Since March 2011 vehicle sales have fallen back significantly from these levels, though sales in June were modestly up on those of May. On a seasonally adjusted basis sales had fallen from the over 50 000 units sold in March to 43 108 units sold in May and recovered to 44 359 units sold in June 2011. The vehicle sales growth cycle appears to have declined significantly with the current annual growth trend around the 10% annual rate, perhaps to recede further.

We have mentioned before that the Combined Motor Holdings (CMH) share price has consistently provided a very good, even leading, indicator of the state of the new vehicle market. This relationship appears to be holding up with the CMH share price having peaked late last year, consistent with the peak in the new vehicle cycle.

While the news about vehicle sales may be regarded as somewhat less encouraging about the current state of the SA economy, the demand for and supply of notes in June is somewhat more encouraging. The Reserve Bank, when it issues notes, satisfies the extra demands of the public for notes, presumably to spend, and from the banks for cash reserves, presumably so that they are able to lend more. Banks in SA do not hold excess cash reserves of any magnitude and so the supply of notes, adjusted for cash reserve requirements, is equivalent to the money base of the system, adjusted for cash reserve requirements, or what is also described as high powered money. This makes the note issue a reliable coinciding indicator of economic activity, with the great advantage of being a highly up to date indicator.

The growth in supply of notes to the economy slowed down consistently between early 2009 and early 2011. This growth cycle appears to have picked up momentum recently. The slower growth in the supply of notes, until recently, was however offset by lower inflation, providing scope for acceleration in the growth in the real supply of notes. This growth was necessary to sustain the economic recovery under way. Now a mixture of slightly higher inflation and slightly faster growth in the note issue has helped stabilise the real money base cycle at about a four per cent rate.

If the economy is to sustain a growth rate that is still below its potential or sustainable rate, a further increase in the rate of growth in the demands for cash, well ahead of inflation is called for. No help in this regard can be expected from lower interest rates. SA does not (alas) engage in money supply targeting or quantitative easing. However it may be hoped that any increase in short term interest rates will be postponed until the demands for and supply of bank credit and the demands for the banks and the public for more cash indicate a clear case for tightening. The case for tightening based on the most recent money supply and credit numbers remains, a very week one. Faster growth in the supply of narrow money, broad money and bank credit deserves encouragement.


To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:Daily View 13 July

Eskom: Surprise, Surprise – Eskom is awash with cash

A Business Day leader (29 June) referring to the more than doubling of Eskom’s reported profits in 2010-11 to R8.5bn raised the question of whether the electricity utility should have been granted the large increases it was.

Reference in this regard might have been better made to the cash flow generated by Eskom’s operations. These amounted to the very substantial flow of R28.3bn, representing an increase of R12.3bn or 77% from the year before.

However the net cash flow generated for the company was reduced to R22.3bn, after accounting for the cash lost through so called embedded derivatives (that is the cash cost of meeting Eskom’s contractual obligations to the aluminium smelters) and cash lost and gained from Eskom’s considerable trading activity in financial assets and liabilities, that is in its own debt. The equivalent net cash flow number the year before was a mere R9.1bn, making for an even larger percentage increase of 245% in internally generated cash flow in 2010-2011.

Most impressive of all in pure financial terms is that this R22bn went a long way, more than half the way, to funding the very large R44.3bn of capital expenditure incurred in 2010-2011. In other words, current consumers are now financing more than half of the very large capital expenditure being incurred by Eskom to meet future demands for electricity (for which future consumers will be expected to pay an appropriate price). Next year, after a further 25% increase in its regulated tariff, the revenues and cash flows and the contribution of internal funding can be expected to increase by similar large proportions and amounts.

These financial outcomes should not have come as a surprise to anyone familiar with Eskom’s established generating and distribution capacity.

Once Eskom ran out of its excess supplies of generating capacity and new capacity had to be installed, it became essential to adjust tariffs from those based on historical costs to charges based on the returns required to justify the essential investment in additional generating and distribution capacity. This would inevitably mean large increases in revenue produced by the established power stations for as long as they remain economically viable (that is can cover their direct operational costs) and so in the accounting profits and cash flows delivered by Eskom.

Power plants, once constructed, can be expected to have very long economic lives as Eskom’s history confirms. We have argued that the right price to charge current consumers for electricity today is the tariff that would provide the owners of Eskom (the RSA government) with an appropriate risk adjusted return on capital. We have judged this to be about 2% p.a. above the government’s own cost of raising long term capital, as represented by the yield on long term RSA bonds. That is to say, an extra return of about 2% pa over the cost of borrowing, given the low risk nature of an electric utility Eskom with monopoly powers, would seem the right price.

We also argued that the issue of the right tariff and the appropriateness of the real investment decisions to be made in additional electricity capacity should not be confused with how the additional capacity should best be funded (that is, with debt or equity capital). We argued that the SA government should either provide the capital in the form of an infusion of equity capital or by guaranteeing the debts of its wholly owned subsidiary – so reducing the funding costs to its potential minimum. We also indicated that a low risk business like an electricity utility could be expected to fund most of its expansion with debt rather than equity capital. We argued that it would be poor economics and unhelpful economic policy to overcharge, that is to tax current consumers for electricity, to finance the expansion of Eskom. Current and future consumers could be expected to pay the right price for electricity. That is, enough to provide an appropriate return on capital: no more or no less.

When we simulated the operational costs of a new power station of the scale planned by Eskom with a required return of 10% pa, we came up with a tariff to be charged today of the order of the 40c per Kilowatt Hour currently being charged. Our own sense is that inflation adjusting this tariff over the foreseeable future would be sufficient to the purpose of recovering the full cost of generating and distributing electricity in SA. We would be inclined to agree that a further 25% increase in the tariff would be a step too far. Economic growth would benefit greatly from competitively priced electricity in SA.

We would also recommend that Eskom maintains an appropriately high debt to equity ratio of the order of 90% debt and 10% equity. Further, to maintain this recommended debt to equity ratio, current tax payers could benefit from their profitable stake in Eskom through a substantial flow of dividends and tax payments. This year, despite its much improved finances, Eskom is not paying a dividend nor is it paying much by way of actual taxes. The income tax reported in its accounts is an impressive R3.3bn. The actual cash tax paid reported in its cash flow statement is a mere R151m and even less than the cash tax of R210m paid the year before.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 30 June: Eskom: Surprise, Surprise – Eskom is awash with cash

The economy: Steady as it goes

The Reserve Bank Quarterly Bulletin published yesterday has provided further detail on the highly satisfactory performance of the SA economy in the first quarter. Household spending growth has led the economic recovery and was sustained in the quarter at an above 5% rate. Government consumption spending also grew strongly.

The weakest spot in the economy remained the reluctance of the private sector to add to its plant and equipment. However the consistent run down in inventories had come to a natural end in the fourth quarter of 2010 and a sharp buildup in inventories, from highly depressed levels relative to output saw Gross Domestic Expenditure (GDE) rise by over 8% at an annual rate, much faster than Gross Domestic Output (GDP) that as was previously announced grew by 4.8% in the quarter.

If one is to draw a bottom line on the update provided by the Reserve Bank, it is that the economy is growing satisfactorily enough led by household and government spending. However if these growth rates are to be sustained and improved, as must be the objective of policy, the economy needs a stronger commitment by business to additional capital expenditure and to the provision of more employment. More formal employment would help the housing market and highly depressed construction of housing activity that is labour intensive. A business friendly approach by government and its agencies seems to be an essential and urgent requirement for economic and employment growth.

The almost stagnant money and credit numbers indicate very clearly the lack of demand for plant and equipment and for new homes. They also confirm that the economy is not yet operating at what might be regarded as its growth potential. The balance of trade, including the weakness in demand for imports, also confirms that the economy could be growing faster (given easy access to foreign capital on favourable terms). There is moreover little indication that the economy is picking up momentum.

The concern rather, given recent trends, must be that the economy could easily lose momentum (depending in part on the uncertain state of the global economy and demands for exports). The fragility of business confidence could be another negative influence. The best monetary policy could do in the circumstances, would be leave interest rates well alone and unchanged.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:Daily View: The economy: Steady as it goes

The rand: Remarkably unaffected by global risk aversion

The benchmark Emerging Equity Index lost a further 2.2% last week in response to the uncertainties associated with the ongoing Greek debt saga. The New York indexes held their ground as the news about the state of the US economy improved marginally.

The SA component of this index, the MSCI SA, as may be noticed, did better than the average emerging market thanks to a rand that held up very well in the circumstances of the increased risks being priced into global markets. Both the volatility priced into options on the S&P 500, the VIX index and the emerging market bond spread reflected the lesser appetite for risk late last week.

The trade weighted value of the rand last week was only fractionally weaker by the weekend which in the circumstances of elevated global risk must be regarded as a surprisingly good outcome. The rand/US dollar exchange rate can be very well explained by the emerging market equity index and on this basis the rand can be regarded as very marginally overvalued, to the order of about 3.5%. In the figure below we show the results of this model that predicts the value of the rand/US dollar using the MSCI Index as its only explanation. The fit of this model using daily data since early 2009 has been exceptionally good, as may be seen.

It seems to us that the equity markets are well supported by undemanding valuations relative to earnings and dividends. The fixed interest markets continue to offer very little competition for savings and seem unlikely to do so within the next 12 months. It seems to us also that despite the crisis in Europe, the outlook for the global economy, US weakness taken into account, remains satisfactory enough to make further good growth in earnings from globally focused companies a very likely reality. Currently lower oil prices will help materially to this end.

The future of the euro, or rather, the continued participation of Greece in the Eurozone remains uncertain. How far the German and French leaders are prepared to go to avoid what appears unthinkable to them, and that is a breakup of the euro, and how much help they will be getting from the Greeks to this ideological end, remains unresolved. The likelihood of Europe (that is, Northern European taxpayers) footing ever more of the bill for European unity seems to us somewhat more, rather than less, likely post this weekend’s deliberations. The equity markets would surely like confirmation of their willingness to pay the price for the failure to date of Europe to co-ordinate fiscal and monetary policy. It is a failure that will have to be addressed with or without the active commitment of Greece

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:
Daily View 20 June: The rand: Remarkably unaffected by global risk aversion

Bonds and property: The case for the defence

The past two weeks have been difficult ones for equity investors on the JSE. RSA Bonds, represented by the All Bond Index (ALBI) have however proved highly defensive. Recently listed property on the JSE has proved even more defensive against underperforming equities. As we show below the value of property this turbulent quarter has performed in line with bonds and significantly outperformed bonds in May and June to date.

The JSE Property Loan Stock (PLS) index has long proved to be significantly more sensitive to long term interest rates than to the equity market. Over the past three years every one percent move in the bond market has seen the PLS Index increase or decrease by about 1.6%. Every one per cent move in the JSE Top 40 Index has seen the PLS move on average by less than one half a per cent (0.5%) over the same period.

The recent strength in the bond market has been very helpful for the PLS index, as could have been expected on the basis of recent past performance. But forces fundamental to the property loan stock companies listed on the JSE have perhaps also been as helpful to property valuations. The dividends per share distributed by the PLS companies since the global financial crisis of 2008 compare more than well with the dividends per share paid by JSE listed companies generally. As we also show these dividends continue to keep pace with inflation.

And so holders of the PLS Index since 2008 have realised an initial dividend yield in line with that of long term interest rates, with inflation linked growth in dividends paid. An inflation protected yield of between seven and eight per cent is highly attractive and has been highly protective of the value of PLS stocks. Were investors confident that such inflation linked or beating distributions could continue, the initial yield on PLS stocks could be expected to fall significantly and the value of PLS stocks be expected to rise.

The week that was: US equity and corporate debt markets continue to diverge

It was another poor week for equities with the S&P 500 off by over 2% while emerging markets and the JSE were not spared the more bearish sentiment.

Metal and commodity prices however ended the week largely unaffected by the sense that the global economy was slowing down. Metal prices are still well ahead of year ago levels. The IMF updated its outlook for the global economy last week and left its forecasts very much as they were. Faster growth in Europe is making up for softness in the US. This should be consoling to those inclined to believe that the soft patch in US data releases are more than a temporary pause. The oil price as always will play an important role in the months to come in determining the spending power and state of mind of the US consumer. A modest pullback in US gasoline prices, while other commodity prices retain current levels, would be very helpful for the US consumer and the market mood.

Unless US earnings and dividends actually disappoint – index earnings are currently about US$81 per share and are expected to breach the US$100 level by year end 2011 – the US share market now offers even more value than it did a month ago with a prospective PE multiple of less than 13 times. Any threat to valuations from higher interest rates seems to have been put off for longer and the spreads over US Treasuries offered by investment grade and high yield corporate borrowers in the US barely budged last week. Despite very heavy issuance of new corporate debt and despite the thought that the US economy may be slowing down, high levels of confidence in the strength of US corporate balance sheets has been maintained. The performance of the US economy and the equity markets will depend on confidence: US business leaders have to deploy their strong balance sheets. Washington DC could help by dealing effectively with its fiscal deficits.

Industrial and employment policy: A new dawn or a false dawn?

The long awaited subsidy for Job Creation has become a reality. The Jobs Fund will make available R9bn over the next three
years as a subsidy for jobs to be created and encouraged with R2bn available this financial year. The fund will be administered by
the Development Bank (DBSA). It will be “…targeted at established companies with a good track record and plans to expand
existing programmes or pilot innovative approaches to employment creation, with a special focus on opportunities for young
people..” (Q&A, Media Briefing, Houses of Parliament, 7 June 2011).

The four areas of focus are Enterprise Development, Infrastructure Investment, Support for Work Seekers and Institutional
Capacity Building, including internship and mentorship programmes. The focus seems broad enough to cover almost any aspect
of business activity.

The approved programmes will be “..cost and risk shared by participants..to ensure real ownership..” In other words, private sector
participants will have to provide matching funds on a 1 to 1 ratio. A reduced own contribution is intended for “non-private sector
applicants” These would include municipalities and public enterprises. It may presumably include NGOs and their like. Applications
must be made by 31 July for funding this year.

The scheme will clearly be employment creating among the ranks of the consultants. It should prove particularly welcome to firms
with well established training programmes. “Support for Work Seekers; assistance with job search, mobilisation and enhancement
of training activities, support for career guidance and placement services” (Media briefing) will surely prove a boon to the well
established and much maligned labour brokers. The statement above reads like an accurate description of their business model.
The SA government is trading off a significant proportion of its corporate tax base for new industrial projects and subsidies for
employment. In addition to the R9bn Jobs Fund the newly defined s12i Tax incentives are backed by a 2011-12 Budget allocation
of R20bn. These are by no means trivial amounts in absolute terms, or relative to all the tax collected from SA companies. It would
be of interest to know the proportion of company taxes paid by manufacturers. Would it be as much as R20bn allocated in the
2011-2012 Budget?

In the 2010-11 Budget estimated revenue from companies was R150bn or 24% of all estimated tax revenues of R643bn. The SA
government’s dependence on income from companies is unusually large. In many other tax regimes the corporate tax rate may be
comparable to the rates levied on company profits in South Africa. But when taxes actually paid are reduced by investment and
many other allowances provided by government to stimulate investment and job creation, the effective (economic) tax rate
becomes much lower than the nominal company tax rate.

SA is following this route. More subsidy and allowances provided for companies, in one way and another, tax concessions and job
subsidies included, that lead to less tax paid and a lower effective tax on business profits. No doubt these lower taxes paid will be
very welcome to businesses that are able to engage skilfully with the system.

If however the path of government spending is to remain unaffected, as would appear likely, the taxes saved or the subsidies
provided to the companies that benefit, would have to be made up by taxes collected from other taxpayers. This must mean
increased taxes on consumption expenditure or on individual incomes; or companies outside the sectors favoured by industrial
policy will be forced to pay up for the benefits provided to industry.

The SA government clearly thinks, as do governments almost everywhere, that it can do better than simply providing an
encouraging tax and regulation environment for business in general. It clearly believes it can pick the winners in the industrial
space rather than leaving the investment and employment decisions to participants in the market place on a field levelled by
equally generous tax treatment, irrespective of the designated activity and location in which it takes place.

It would promote economic growth in SA if more generous investment or depreciation allowances were offered to business in
general rather than those judged particularly worthy by the bureaucrats involved. This would encourage companies to save and
invest more of their after tax earnings or cash flow. Investment allowances reduce the taxable income of companies, leading to
less tax paid and more cash retained and invested. This would lead in turn to more output and employment. But this is an
argument for lower business taxes in general rather than for particular benefits or subsidies.

One has to question the ability of the government through the Department of Trade and Industry (DTI) or any other of its agencies,
the Development Bank or the IDC, to pick the winners, without fear or favour, among the many proposals that are bound to be
made to it. As indicated there will be a great deal of taxpayer’s money at stake.

The government has proved itself much more capable of raising tax revenues than spending them effectively. The subsidies or tax
concessions will surely add to industrial output and employment. But we will never know how much better the economy might have
done and the employment created had much less discretion been exercised over tax concessions or subsidies. As the saying goes if you want more of something subsidise it, if you want less tax it. SA is doing both – extracting more tax from some
employers, employees and consumers, while subsidising other businesses and their employment decisions more generously.

The government through the DTI (and organs like the competition authorities) seems to show a marked and regrettable lack of
respect for the creative powers of private businesses. The simple recipe for economic growth is one that relies on businesses
directed by their owners and senior managers, to pursue their self interest, constrained essentially by the competition provided by
other businesses for their customers, workers and providers of capital. Economic history has surely proved that the recipe works.
But governing best by governing least does not serve the interest of ambitious policy makers. There is a constant flow of new
regulations and intrusions that SA business has to manage which adds to their costs and reduces their competitiveness with
imported goods. There moreover appears no popular ground swell of support for activist economic policies. The impetus seems to
come directly from officials and their consultants.

The poor protest about the lack of delivery of basic services by government not about the lack of delivery of basic goods and
services by businesses. SA Business, unlike the SA government, delivers very effectively. It would deliver more jobs if the labour
market were less heavily regulated to encourage them to do so.

Industrial policy and the Job Fund have become an expensive and counterproductive alternative to sensible, employment growth
encouraging, de-regulation of the labour market. The intervention by the competition authorities in the employment and
procurement decisions to be made by Massmart and Wal-Mart provide an obvious case in point and a further example of
government officials thinking they know better how business should be run in the interest of more employment. The goods and
services market has been made less competitive to make up for the lack of competition in the labour market. The employment
problem is one of the government’s own making, acting as it has done to entrench the rights of established workers, at the
expense of potential entrants to the ranks of the formally employed.

The government and its officials will no doubt point to the jobs gained through subsidy and perhaps also compulsion to employ
more labour demanded of the government departments themselves and publicly owned enterprises. The jobs lost because of
higher taxes and job destroying regulation will be much less obvious and ignored to the great disadvantage of the poor in SA who
need jobs – not handouts to lift them out of poverty.

The solution to the failures of the SA economy, or rather its formal businesses to provide jobs would seem obvious to all but those
with an interest in the status quo – the trade unions and the officials who write and implement interventions in the labour and other
markets of the economy. This is to rely less on government and its regulatory, taxing and subsidy powers and more on private
business to deliver more of the essential goods and services demanded in a modern economy.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 8 June: Industrial and employment policy: A new dawn or a false dawn?

Global markets and the rand: Not all bad news

The flow of disappointing US economic data continued with the Payroll report of Friday that reported a gain of 54 000 in May, well below the monthly average gain in 2011 of 182 000, and an increase in the unemployment rate from 9% to 9.1%. The unemployment rate was not all bad news as, according to the US Survey of households, an extra 272 000 workers joined the labour force only partly offset by a 105 000 increase in household employment.

More people entered the labour force, presumably because they thought they could realistically find work, but not all did so. Hourly earnings in the US are rising very slowly, by 0.1% in April and 0.3% in May. With little growth in wages, any perceived inflationary threat from the labour market has dissipated, providing further reason for postponing higher interest rates and hence the weaker US dollar.

Not all the recent news about the US economy was bad, The ISM non-manufacturing index that covers 90% of the US economy rose from 52.8 to 54.6, marginally ahead of consensus. Numbers above 50 indicate growth. More encouraging was that the employment component of this Index rose from 51.9 to 54, consistent with payroll growth of 175 000, and faster than that indicated by the official payroll report.

The weaker numbers and their implications for low interest rates for longer weakened the dollar and strengthened the euro and emerging market currencies, including the rand. This made the week a better one for US dollar investors on the JSE and emerging markets generally than it was for investors in the S&P 500, that after an extended period of outperformance lost ground to emerging markets last week.

The rand during the week had turned out to be a particularly strong emerging market currency. The rand made gains not only against the US dollar, the euro and the Aussie dollar but also gained about 3% against our basket of other emerging market currencies.

It would appear that the rand had gained from the approval of the Competition Tribunal of the Wal-Mart / Massmart deal after having weakened relative to the Aussie dollar and other emerging markets in the weeks leading up to the decision. SA specific risks, that is policies more or less friendly to foreign investment, would appear to have a modest influence on the exchange value of the rand in recent weeks. The more important influence on the rand will remain those emanating from global markets in the form of commodity prices and flows into emerging market bonds and equities.

The news from the commodity markets was not unsatisfactory as prices held up, helped by the weaker US dollar. The oil price in US dollars was largely unchanged.

The stronger rand and the more uncertain outlook for the US and global economy weakens further the case for higher interest rates in SA. This has been partly recognised in the bond market with a downward shift of the term structure of interest rates. The probability of an increase in the repo rate this year receded the week before last but remained largely unaffected by the news last week.

The US equity markets are undemandingly valued relative to earnings and interest rates and have become less so this past week. The weaker data disturbs the outlook for future earnings as the performance of the S&P 500 this past week made perfectly clear. The key to the outlook for the US economy and the equity markets will be the willingness of US business to put their strong balance sheets to work hiring workers and buying equipment.

The confidence of US business would be greatly assisted by the belief that Washington will deal effectively with the US Budget and US government debt. Any sense that China is loosening rather than tightening its monetary stance will be very helpful too.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View – June 6: Global markets and the rand: Not all bad news

Vehicle sales: Not much vroom

Naamsa released its new units sold statistics for May 2011 yesterday. The numbers are not encouraging. April 2011 was a poor month for sales, especially when compared to sales in March 2011, and the fall off in monthly sales, when seasonally adjusted, continued in May as we show below.

The sales quarter to quarter and seasonally adjusted have fallen sharply from a very strong March 2011 as we also show. The growth in sales is now barely positive, compared to a year ago, which is a long time in the motor dealing business, and in fact negative on a three month moving quarterly basis as may also be seen.

Making the seasonal adjustment for two months with an unusual number of public holidays, including the Easter holidays that fell in April, has no doubt complicated the analysis of the underlying cyclical trend. Holidays are good for shopping malls but not vehicle show rooms. Also adding complexity are disruptions in the supply chains that start North of Tokyo. Is it a relative lack of demand or an inability to supply that is holding back sales? The Naamsa explanation quoted below appears to attach some (though not major) importance to negative supply side forces.

“..During May, 2011 – constraints on the availability of components from Japan impacted on the production of certain product lines in South Africa and, together with shortages of various models sourced from Japan, this would have contributed to the slow down in the rate of growth in the new car and light commercial vehicle sales cycle for the month. These factors would also have contributed to lower aggregate industry exports. It was anticipated that the supply position would normalize over the medium term..”

Our own interpretation is that the peak of the vehicle cycle has been reached and the growth trend is now a significantly lower one. The market for new vehicles seems to be stabilising at a monthly pace of approximately 47 000 new units sold, well below the heady pace of 60 000 units sold at the peak of the previous motor vehicle cycle of early 2007. That is to say, year on year growth in December 2011 on December 2010 will be about 5%.

The current and projected level of vehicle sales help confirm our impression of an SA economy that is growing satisfactorily, but that the growth is not accelerating. There would appear to be no danger of excess demand materialising any time soon.

The economy, on the basis of these May vehicle sales and the April credit, money supply and house price data, appears to be taking longer to reach its growth potential than previously thought. Moreover the risks have increased recently that the global economy will not support export volumes and prices strongly enough to help take up the slack in domestic demand over potential supply. The danger of a global slowdown has risen in response to signs of slowing rather than accelerating growth in the US. The case for higher interest rates in SA, in the light of domestic vehicle sales and exports of vehicles, has weakened further.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 3 June: Vehicle sales: Not much vroom