Tighten up in the US – lighten up in SA

It is crunch time for most central banks – but not the SARB. Inflation rates escaped them and recapturing inflation will not be a comfortable or comforting exercise. Rising prices, rising wages and the prices of other inputs, can be very clearly blamed on the usual suspect- more money created than has been willingly held by households, business and banks. Excess money holdings (deposits at banks) have been exchanged for goods, services and other assets enough to raise their scarcity value. And supply has been unusually slow to respond to the unexpected strength of demand.

It will take higher interest rates and a sharp deceleration of the rate of growth of the money supply to reverse inflation trends. It will demand less be spent and borrowed by governments and more tax collected. Paying interest will account for an ever-larger share of government budgets to constrain the much more agreeable benefits that might otherwise be provided by governments.

Their further problem is that higher prices are part of the adjustment economies make to an excess of demand over supply. Higher prices have causes- they also have effects- they help absorb and restrain demands while they encourage additional output. Higher prices reduce the ability of households to spend and less spent may well register as temporarily slower growth – slow enough to make central bankers more hesitant to act. But if they fail to act they may encourage more inflation expected that will show up in higher long term borrowing costs.

A further complication is that there is a great deal of money sitting on the sidelines waiting to enter the markets. The ratio of money relative to income (GDP) in the US has exploded since the Global Financial Crisis and in response to Covid. There is now 80% more money – mostly in the form of bank deposits – per unit of income – than there was in 2008. A ratio of close to one to one between income and money was very much the understandable case before the GFC and before the brave new world of Quantitative Easing (central bank money creation on a vast scale) was discovered.  A new money/Income equilibrium will have to be established in the US – a mix of higher prices and less money added will have to bring this about.

The commercial banks play a large role in determining the supply of deposits, through their lending. And they have vast reserves of cash to convert to loans if they choose to do so in response to demands for credit to expand the money supply further. The last time the Fed reversed QE in 2015, to shrink its own balance sheet, the balance sheets of the commercial banks continued to rise as they reduced their cash holdings in exchange for other assets. They may do so again. It might take very much higher short term interest rates to discourage them.

 

Assets of the US Commercial banks and the Federal Reserve System 2008-2021. Monthly Data Billions

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

We have a clear case of monetary excess in the US and too much monetary constraint in SA, an explosion of the Money/Income ratio in the US and a contraction in SA. Enough to infer that the relationship between money and incomes has undergone a systemic change – in an inflationary direction for the US and contractionary one for SA.

The US and SA – the Money to Income Ratios. (2007.4=1) (Quarterly Data)

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Source; Federal Reserve Bank of St.Louis (Fred) South African Reserve Bank and Investec Wealth and Investment

The sense of systemic change in SA is reinforced by a comparison of growth rates in money and income before and after the GFC. Growth rates were much higher and far more variable before 2008. They have declined significantly since. The Fed will have to tighten up to control inflation and the SARB should lighten up to facilitate faster growth for which enough money- not too much and not too little- is essential to the purpose.

 

South Africa; Growth in Money Supply (M3) GDP and Prices ( Quarterly Data)

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Source; Federal Reserve Bank of St.Louis (Fred) South African Reserve Bank and Investec Wealth and Investment

Recent monetary policy: A monetarist perspective

Introduction – monetary developments before and after the GFC and Covid

Reports on the death of the Quantity Theory of Money now (February 2022) appear highly exaggerated. The extraordinary burst of additional money issued by the Fed intended to ameliorate the damage to incomes and economic activity caused by the Covid inspired lockdowns of March 2020 have been followed by a surge in inflation. The increase in the prices facing consumers in the US was running at over 7% p.a. by the end of 2021 The inflation of 2021 appears to have surprised all observers other than the near extinct tribe of monetarists.

Full article here: Recent monetary policy: A monetarist perspective

Global inflation – South Africa is not a typical case

While inflation rises across the globe, South Africa’s monetary and fiscal authorities should take note of the weak state of demand locally.

Prices are busting out all over the world. Prices charged by all US producers are 20% higher than they were a year before. Consumer prices were up by a ‘mere’ 5% in August, and that was before the recent tripling of natural gas prices.

US headline inflation rates (annual percentage growth in consumer and producer prices)

US headline inflation rates, (annual percentage growth in consumer and producer prices) chart

Source: Federal Reserve Bank of St Louis, Investec Wealth & Investment, 6 October 2021

US headline inflation rates (monthly percentage growth in consumer and producer prices)

US headline inflation rates, (monthly percentage growth in consumer and producer prices) chart

Source: Federal Reserve Bank of St Louis, Investec Wealth & Investment, 6 October 2021

The cause of higher prices is clear enough. They are a response to buoyant demands stimulated by Covid-inspired extra government spending and central bank funding of much larger fiscal deficits that have dramatically increased the supply of money (bank deposits) held by households and firms. In the US, these savings have also reduced the incentive for people to get a job – of which there is an unusual abundance, as firms struggle to match surprising strength in demand with extra output and willing workers.

This mixture of strong demand with constrained supply has caused prices to rise. The effect of higher prices is also predictable. Higher prices reduce demand while they serve to encourage extra output. They also act as a drain on disposable incomes and spending power. Higher prices, particularly when they respond to supply side shocks, can therefore lead to slower growth as these higher charges work their way through the economy.

What is critical therefore for the control of longer-term inflation trends is how the monetary and fiscal authorities react to this slower growth. Should they attempt to mitigate the impact of higher prices on growth by stimulating demand for goods, services and labour, then the temporary surge in inflation can become longer lasting. Firms and trade unions will then budget for expected and uncertain inflation.

Central bankers believe that inflation depends on inflation expected, modified by the state of the economy. Independent central banks accept responsibility for the state of demand, but they hope that inflation expectations are anchored at low rates, to make their task of containing inflation an easier one. The markets, to date, have largely believed that the observed rise in inflation is a temporary one. But the markets will be watching the reactions of the fiscal and monetary authorities closely for signs of the policy errors that can turn a temporary supply side shock into enduringly higher inflation.

South Africa – not a typical case

It is striking how the South African economic circumstances have not been typical. We too will have to deal with an energy price shock that will depress demand. But demand already remains depressed. Particularly depressed since 2016 have been the demands of firms, including the public corporations, for plant, equipment, workers and credit.

Real gross fixed capital formation by type of organisation

Real gross fixed capital formation by type of organisation chart

Source: Stats SA, SA Reserve Bank, 28 September 2021

Households have helped to sustain spending, but only a little. Total spending by households grew by 1% in the first quarter of this year, but only by half as much in the second quarter. Those in jobs have earned more, yet many more (over a million) have lost their jobs since the lock downs. Formal employment outside agriculture is now below 2009 levels.

Formal non-agricultural employment

Formal non-agricultural employment chart

Source: Stats SA, SA Reserve Bank, 28 September 2021

The money supply has flat lined as nominal GDP has grown strongly. The closely watched government debt-to-GDP ratio has been further reduced by extraordinary growth in government revenues. Tax receipts have accelerated in response to the global inflation of metal prices that make up the bulk of South Africa’s exports; so much so that the total borrowing requirement of the government in all its forms has declined from 13.5% of GDP in the first quarter of last year to as little as 1.8% of GDP in the second quarter of this year. Fiscal austerity has been practised in Covid-ravaged South Africa. And monetary policy, judged by its effects on money and credit supply, has not been accommodating enough.

Money supply and gross domestic product

Money supply and gross domestic product chart

Source: Stats SA, SA Reserve Bank, 28 September 2021

The output gap – the potential supply exceeding realised spending – is likely to remain persistently wide. Inflation expectations therefore remain unaltered. The case for higher interest rates to further depress demand seems weak in the circumstances. Yet the gap between short- and long-term interest rates has widened further in recent days. This implies an expected doubling of policy determined rates over the next three years.

The slope of the SA yield curve (SA 10-year yields minus money market rates)

The slope of the SA yield curve chart

Source: Bloomberg, Investec Wealth & Investment, 6 October 2021

The bond market indicates that any improvement in South Africa’s fiscal circumstances is sadly expected to be temporary rather than permanent. It can prove otherwise with fiscal discipline and sympathetic monetary policy.

No such thing as a cycle- only windfalls or their opposite- whiplash

The markets for industrial and precious metals are demonstrating some important truths. The price of iron ore, approximately USD 92 dollars per ton this week was more than twice as high, 200 dollars, in early July. Its price is as hard to predict today as it was a year ago when it sold for a mere USD85 ton. The pace of the recovery of the global economy after the lock downs was unusually unpredictable and proved surprisingly strong to increase the demand for steel and iron ore and other industrial metals. It is an expected slow down in global growth rates and so in the demand for steel and other industrial metals in the months to come that has caused prices to fall back as surprisingly.

It should be recognised that there is no predictable cycle of the price of any well traded metal, currency, share or bond to assist timing an entry or exit to the market. Were there any regular cycle of prices or indeed of economic activity, that is a predictable trend towards peak growth rates, followed by a slower growth then a recovery from the trough – it would greatly help traders,  producers or consumers to sell at the top and buy at the bottom. But such cycles are only revealed well after the events. They are the result of smoothing the data, comparing the outcomes to what occurred a year before, when almost all of the numbers overlap. Day to day, the data looks very different and the future of prices will not be at all obvious. They unfold as a random walk, with most prices having an almost 50% chance of rising or falling on any one day.

The annual and daily % movements iron ore spot price. USD per tonne.

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Source; Bloomberg and Investec Wealth and Investment

Whether these random moves are drifting higher or lower to establish some persistent trend will only be discovered well after the event- perhaps only a year later. All we can attempt – and there is no lack of such attempts – is to model the forces of supply and demand that will determine prices or quantities in the future – as rationally as possible. And perhaps be bold enough to believe that your model will prove more accurate than the opinions revealed by current prices- that we know will vary with the news.

What happened in-between last year and now to the price of iron ore and similarly to the value of the platinum group of metals has had important consequences for the SA economy. They greatly boosted the SA balance of payments, tax revenues and the GDP. Dependence on capital inflows have become large contributions from South Africans to the global savings pool of over USD100billion p.a. as the foreign trade balance improved. Tax revenues have been growing well ahead of budget projections, approaching an extraordinary extra R250 billion of taxes, if maintained over a year.

And the GDP in current prices has risen almost as high as long term interest rates to help reduce the debt to GDP ratios. Yet long term interest rates remain at very high levels and are still particularly high relative to short rates, implying a doubling of short-term interest rates in three years- which would be very bad news for the economy. It is very difficult to make sense of this view of SA interest rates and monetary policy.

While annual growth rates may well have peaked, there is a lot more global demand still in the wings. Post-Covid stimulus continues to this day. The market judgment may be too pessimistic about demand and so prices and revenues may continue to be helpful for resource companies and the SA Treasury that shares in its profits.

How then should SA and resource companies react to such a further windfall? The answer should be obvious. That is look through any temporary surge or reduction in revenues and for the companies to pay out the unexpected extra cash to share or debt holders. For the Treasury it would be to spend no more and borrow less. The benefits to both parties in the form of lower long-term costs of raising capital would be large and permanent.

Making Empowerment work

September 2021

Affirmative action programmes get in the way of competition for resources and promote economic in-efficiency. They assist a minority of favoured participants in the economy, easily identified, and harm the many more, mostly of the same pigmentation, who pay higher prices or taxes and earn less and sacrifice potential employment opportunities. Costs and opportunities foregone that can only be inferred – because it is so difficult to isolate the influence of one force amongst the many forces – that determine economic outcomes.  BEE in SA can have a powerful influence on the direction of economic policy itself. The very valuable rights to participate as essential BEE partners in government initiatives drives the policy agenda itself.

The incentives that encourage previously disadvantaged South Africans to acquire ownership stakes in SA businesses on artificially favourable terms must reduce the expected returns on capital. It means less upside and no less downside for established businesses or start-ups and so fewer projects qualify for additional investment in plant or people. An important source of capital for SA start-ups will be foreign investors. Demanding they give up potential rewards for bearing SA risks is surely discouraging to them. Moreover, imposing such conditions on ownership cannot be regarded as a form of restitution for the past injuries imposed on previously disadvantaged black South Africans. That might be regarded as the moral case for taking very arbitrarily from some South Africans to give to others. The new foreign owners are surely very unlikely to have benefitted from apartheid.

The typical empowerment deal taken to widen the composition of owners on racial grounds is funded by the established owners. They provide loans to the new BEE qualified owners to enable them to take up the shares on offer. The interest and the debt repayment are facilitated by a flow of dividend payments. If all goes well the empowerment shares will, intime, be unencumbered by debts and will have acquired significant value that may cashed in. If the dividends did not flow sufficiently and the value of the company lagged interest rates, the debts would be written off and the empowerment stake would be worth very little. Upside without downside may however encourage more risk taking than desirable. An empowerment state of mind that can be dangerous to all shareholders.

The idea for a better less discouraging way to meet empowerment objectives came to me from Erik Stern of Stern Value Management. That is don’t sell the shares, rather give them to an empowerment trust established for employees. One employee – one share in the Trust -regardless of status. No loans raised or interest to be paid, or dividend policies to be driven by the empowerment interests. The trust however would be imputed with a cost for the capital allocated to it. Regarded as a non-interest bearing loan capital, the notional value of which would increase at a rate equivalent to the required returns on such risky capital in SA, say of the order of 15% per annum.

The initial capital plus the compounding required returns on it would then be subtracted from the Asset Value of the Trust. On any liquidation of the assets of the Trust, only its net asset value would be paid out to its beneficiaries and the loan capital returned to the company. Employment incentives and bonuses would be based on the difference between realised and required risk adjusted returns. Potential dividends would ideally be reinvested in the company and allocated to cost of capital beating projects, so adding further to the value of the company and the Trust.

The potential upside to be given up by the original shareholders would then be in proportion to the Economic Value Added (EVA) delivered by the firm. That is the difference between the actual returns and the required returns, or cost of capital, multiplied by the capital invested and reinvested in the company, that would determine the value of the company and the NAV of the Trust. In a return on capital focused company this could amount to a very large capital sum to be happily shared, equally, with all employees

Living with risk

South African savers dependent ontheir pension and retirement plans will have become aware that the actions of the Chinese Communist Party are sometimes more important than the actions or non-actions of the ANC. This is because of their likely large stake in a Chinese Internet giant, Tencent, held through their shares they own in JSE listed Naspers, (NPN) and via its controlling stake in Amsterdam and JSE secondarily listed, Prosus. (PRX)

Because of the much greater uncertainty about the policies the Chinese will apply to the Tencents, the Alibabas and Baidus and their like, a share in NPN or PRX has become much more risky to hold and therefore less valuable. Shareholders taking on more risk require compensation in the form of higher expected returns, this almost always means a lower entry price, a lower current share price.

The risk to any asset holder is simply the risk that the price of the asset they hold may rise or fall from its current level, should they have to or be forced to cash in their investment at some perhaps unknown point in time. The chances of a rise or fall from the current market determined price, assuming a well-informed active market in them, will be about the same 50% on any one day. Market prices follow a random walk, rising and falling in an irregular sequence. Hopefully these random movements come with an upward drift to bring actual returns in line with the higher expected returns, that make holding risky assets a rational choice for the long-term investor.

In riskier times the daily or hourly moves in both directions, up and down, become significantly wider, while the average move over any extended period will still stay close to zero. When the sense of the future becomes less certain, volatility of share prices increase, the standard deviation of daily moves about the average of almost zero widens, and the cost of insuring against such changes in market prices in the form of an option to buy or sell an option on the share or Index inevitably increases. As it has done in the case of NPN.

The recent increase in the daily volatility of NPN has been of extraordinary dimensions. Daily share price declines of 7% and then an increases of 10% on August 10th are truly exceptional and reveal how difficult it has been for well informed investors to make up their minds about what the future will hold for Tencent, NPN and PRX. The standard deviation of daily moves in the NPN share price (30 day moving average) has almost trebled since June 2021.

Daily % Moves in NPN and their Volatility Standard Deviation of Daily price Moves (30 day moving average of the Daily SD) to August 9 2021

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Volatility compared;  S&P 500 (VIX) JSE Top 40 SAVI and NPN Standard Deviation of Daily price Moves (30 day moving average of the daily SD) to August 9 2021

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The rewards for holding on to your NPN or PRX shares remain to be seen. The China risks may decline to help add value. NPN management also hopes that the value of an NPN or PRX will be enhanced by the shares trading more closely to the market value of their Tencent Holdings. They are rejigging the allocation of its Tencent holding between Johannesburg and Amsterdam to attract stronger investor interest to reduce this discount to the sum of its parts, mostly Tencent.

My theory is that the value lost by shareholders is mostly because of scepticism about the value of the acquisitions and investments made by NPN/PRX. They are expected to return much less that the investors could earn for themselves taking on similar risks and so investors and analysts write down the value of this expensive investment programme when they estimate the value of NPN or PRX. The more invested, the more value destruction expected, the lower the value of an NPN or PRX share and the larger the discount. With the completion of the latest restructuring in sight we will see the alternative theories of the discount put to the market test.

The one possible for shareholders – if my theory holds – though it would be a bitter consolation, is that the lower the Tencent share price and the weaker the NPN and PRX balance sheets, the more disciplined and constrained will be their investment and borrowing programmes. And the lower the discount.

Book chapter: The theory and practice of investment strategy

In this chapter I reflect on the role of the economist/strategist in the business of managing wealth. It is a role I have played since my first involvement with the financial markets in the early nineteen-nineties.
I share the ideas about financial markets and their relationship to the economy that have informed my work as an investment strategist and economist in the financial markets. I say a little about my personal involvement in the financial markets.
I explain the importance of a well-considered investment strategy, for not only the wealth owner or their agents, the portfolio managers, but for the greater good.
These thoughts are followed by a case study of how I go about my work reading the financial markets that I hope will be of interest and helpful to those with a close interest in financial markets. The analysis offered is an example of pattern recognition that analysts and indeed all businesses  rely upon to improve their predictions. This recognition has become so much easier over my years with the ready availability of low-cost computing power, most helpful software, and abundant data, easily downloaded. Exhausting the data, testing a theory, looking for evidence to support a  theory, becomes a matter of minutes rather than the years it took when I first took an interest in financial markets. Theory and observation run together, observations lead to theory and theory is tested by observation. My attempts to understand and explain the links between the financial markets and the economy and the economy and financial markets remains a work in progress that I hope to continue for as long as it makes sense for me to do so and worthwhile for those who engage with me.

Read the full chapter here: Chapter 10 – The theory and practice of investment strategy

More order – less law

The recent willingness of communities in South Africa to defend the property of others, their shopping malls, is of deep significance. At great danger to themselves they established a line that the looters and vandals feared to cross. They did so because what they were protecting was of great value to them. What was at stake was convenient access to the great variety of goods and services, necessities, and luxuries the shopping malls and their retail tenants supply them.

They were defending the market based economic system of which the last step in a supply chain is the well-stocked shop around the corner from which they benefit in a practical and important way, as they well understand.

hey are unlikely to be able to explain that the market delivers via a highly complicated well informed supply chain that reaches across the globe. One that is held together through the discipline of required returns on their owner’s capital put to risk in all the different enterprises that link producers and their customers. Or appreciate that the feed-back loops that keep the system going are not designed or directed by any leader issuing orders. That the process evolves continuously in response to the essential knowledge of how it works best that is highly diffused among many millions of decision makers. Who are required to respond to the preferences of their customers that are signalled when they make their selections at the malls. That it is indeed in large measure a consumer led system.

These are the abstractions used to make the case for free markets and privately held property. Abstractions that are not easily grasped and compete with the other, more easily grasped, abstraction of a centrally planned economy. One led by a presumably all-knowing and equality minded, selfless and highly competent bureaucracy.

But the market system delivers the goods in abundance as SA the communities know very well – and they do not need to know more than the practice. They should be aware that the alternative to the market-consumer led system, whenever tried, has failed to deliver, other than to its powerful elites, who maintain their power and very unequal living standards by their ability to brutally repress any opposition that might dare to challenge their interests.

While the mob was attacking our system, Cubans were also protesting politely on their streets. Protesting for more economic freedom, more access to the goods and services and higher incomes that they know a market system could provide them with. It was most unusual protest in Cuba because it will be severely punished as the protestors must expect to be. The well-heeled Cuban establishment has one of the most effective surveillance systems to keep their citizens in line.

The market system however does depend critically on the provision of law and order- to protect property and wealth. Without it the incentive to save and invest and to take risks with savings, that is capital, falls away and economic progress is stunted.

The priority for the SA government, is to not only restore order but to provide every confidence that it will be able to provide protection against disorder in the future. This is the essential reform agenda. South Africans and their ability to take full advantage of what the malls could offer them needs not so much more law and order, but rather more order itself. The economy could do with much less law, of fewer rules and regulations, and obstructions of freedoms to engage and contract freely and usefully with each other.

The signals from the financial markets indicate that the global investors have not changed their view of the SA economy this month. That all is by no means lost. The cost of insuring RSA dollar denominated debt this month has increased by 20 b.p. while the yield on a five-year RSA dollar bond is barely changed.

 

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Long term interest rates in SA are largely unchanged as are inflation expectations.

 

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The rand weakened against the dollar this month by 2.4% but so have most other EM exchange rates- on average by about a per cent. And EM equity markets have underperformed the JSE this month- in USD- by about 6%

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What remains very helpful to the SA are high metal prices. They have had a welcome pick-up since July 19th

 

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The investor opinion of SA remains un-flattering yet one of wait to see. Correctly so.

Anatomy of a crisis: lessons from 2008 and 2020

There are regularities of economic crises and their aftermaths that can help us to plot the way ahead.

Life has returned to normal in the US and UK – judged by the crowds attending Wimbledon, Wembley and Whistling Straits. With only the occasional mask to remind us of a crisis passed. The normal is once again guiding our expectations and economic actions, and is determining the value of the assets we own.

Normal for now, that is, and until the next crisis again moves the markets. Its timing, causes and consequences will remain one of the great known-unknowns, or perhaps it will even be an unknown- unknown (in the words of the recently passed Donald Rumsfeld). However, the successes of recent crisis management may help put us in a better position to cope.

We can define an economic crisis as a serious disruption of economic activity, leading to the severe loss of income and the benefits gained from producing and consuming goods and services. A crisis is therefore destructive of the value of the assets we own, which depend on such incomes.

A crisis is worse than your average recession, when GDP declines by a percent or two below trend for a year or so. The failures of the banks and insurance companies in 2008-2009 resulted in the Global Financial Crisis (GFC), which threatened to implode the real economy with them. In 2020, economies were shut down summarily to escape the pandemic, resulting in the loss of as much as a quarter of potential GDP, a large sacrifice of potential incomes and output.

Overcoming these two crises relied essentially on governments and their central banks. In the case of the GFC, it required central banks to shore up the global financial system buying assets from banks and financial institutions on a vast scale, in exchange for central bank money.

The responses to the crisis of 2020, at least in the developed world, were more immediate, less equivocal and on a larger scale than after 2008. They added much direct income relief to the monetary injections. They have surely succeeded not only in reducing the pain of lockdowns, but also in ensuring that demand for goods and services would recover with the supply of goods, that a return normality makes possible.

Judged by the signals provided by the markets in shares, bonds and commodities, the economic crisis is now well behind the developed world. US, emerging market (EM) and therefore South African companies are now worth significantly more than they were when the lockdowns became a reality in March 2020, when the US Index lost 13%, the EM Index 17% and the JSE gave up 27% of its US dollar value. The JSE had lost 14% of its value the month before.

The JSE from these lows has been a distinct outperformer, in dollars and in rands. The JSE has gained 50% compared to a 30% gain for the S&P and EM indices, when converted to rands. In dollars, the gains since the trough are even more impressive. The JSE is up 86% compared to the 66% and 61% gains for the S&P and EM since the crisis lows.

Regularities of a crisis
This indicates one of the crisis regularities for SA. South African assets and incomes are highly exposed to changes in global risk, losing more during a crisis and then gaining more than the average EM equity or bond when the crisis is over. It is also worth noting that the JSE has not moved much since March this year – another sign of normality. If only we had the gumption not to waste a good crisis.

The JSE compared to the S&P 500 and the MSCI EM in rands (January 2020=100) chart

This illustrates another regularity when an economic crisis is not of South African making. The rand is what we call a high beta EM currency – it does worse than its EM peers when risks are elevated and better when global risks decline, as has been the case with the JSE. During the height of the present crisis the rand/US dollar exchange rate and the JSE were 30% weaker compared with EM peers. They are now back to the normal long-term relationship of an average of one to one.

The rand and the JSE – Ratios to EM currencies and equity indices (2008 to 2010 and 2018 to July 2021) charts

 

Global market risks are easily identified by the volatility of the S&P 500 index, as represented by the well-known volatility index, the VIX. When these daily moves become more pronounced and share prices bounce around abnormally, the cost of insuring against market moves becomes ever more elevated – shares lose value when the future appears much less certain. Higher expected returns, and hence lower share prices, compensate for increased risks. In short, the VIX goes up and share prices go down in a crisis.

Volatility and the S&P 500 (2007 to 2010 and 2018 to July 2021) charts

The daily average for the VIX in the two years before the pandemic was 19 – it was over 80 at the height of both crises. It has recently moved back to 19.

The S&P 500 index is now in record territory in nominal and real terms. In inflation-adjusted terms, the S&P 500 is up about 7.4% a year since the low point of the financial crisis. Real earnings over the same period have grown at an annual average rate of 5.9% since 2009, an above average performance.

Looking for cover
Another regular feature of a crisis is the behaviour of the cover ratio – the normally very close relationship between earnings and dividends. The more cash retained (the less paid out) the more value that is added for shareholders.

 

The S&P 500 and the cover ratio (earnings/dividends) (2008 to 2010 and 2018 to July 2021) chart

 

We make the presumption that the extra cash retained is invested well and earns above its opportunity cost. S&P earnings are again rising much more rapidly than dividends (which held up better during the crises). Indeed, analysts, absent the usual guidance from the managers of the companies they report on, are still struggling to catch up with the buoyant earnings recovery now under way. Earnings surprises are the order of the day.

The cover ratio for the JSE follows a similar pattern in times of crisis and has a similarly negative impact on share valuations. The more companies pay out dividends relative to earnings, the less these companies are generally worth. The recent recovery in cover ratios to something like their longer-term averages is another sign of normality, as well as a support for share prices. Ideally, the JSE cover ratio declines in line with the increase in opportunities to invest in ways that would add value.

SA shows its metal
A further regular feature of the economic crises of recent times and the recovery from them has been the behaviour of commodity and metal prices that make up the bulk of SA’s exports. They fall during a crisis and they recover strongly as the crisis passes by as they are doing now. Metal and mineral prices lead the South African business cycle in a very regular way. Commodity prices lead, the rand follows, inflation is then contained and interest rates, at worst, do not rise. And the money and credit cycles accommodate the rising incomes that emanate initially from the mining sector.

We are far from the super cycle we benefitted from in the lead up to the GFC of 2008. But we can hope that above normal demand for metals will continue to impress itself on below normal supply responses, translating into higher prices.

Industrial commodity prices (2008 to 2010 and 2018 to July 2021) (January 2008=100) chart

 

While long-term interest rates in SA have recovered from their crisis-driven extremes, they remain discouragingly elevated. Discouraging because they imply high hurdles for capital expenditure budgets to leap over and hence low cover ratios and less cash retained for capex. The gap between short and long-term interest rates, the slope of the yield curve, has moreover remained at crisis levels.

The yield curve implies that short-term interest rates will double within three years. This is a prospect that seems completely out of line with the outlook for the SA economy. We can only hope that the market has got this badly wrong.

The crisis-driven SA economy should not be forced to adjust to higher interest rates. It would be inconsistent with the economic and financial stability that the Reserve Bank is constitutionally charged to secure. It takes much more than low inflation to overcome an economic crisis, as South Africa may still come to recognise.

 

SA long and short-term interest chart

 

 

 

 

The steps taken in the US to counter the destruction of incomes and output caused by the lockdowns of economic activity can be regarded as a resounding success. Real US output is now ahead of pre-covid levels. By the end of 2021, GDP could well surpass the GDP that might have been expected absent the lock downs. It took a great deal of income relief in the form of cheques in the post from Uncle Sam, supplemented by generous unemployment benefits and relief for businesses.

The extra income means an increase in deposits, in other words money placed with the US banks, to be spent later or exchanged for other financial assets.

Deposits held by banks with the Federal Reserve System have increased by 85%, and deposits at the commercial banks have grown by 26% since March 2020. The source of the extra cash, the deposits at the commercial banks and the Fed, has been additional purchases of government bonds and mortgage-backed securities in the debt markets from the banks and their clients, which are being maintained at the rate of US$120bn a month.

The assets and the liabilities of the Fed have increased by 36% over that period. This is money creation on an awe-inspiring scale and it has worked, as intended, to promote demand for goods and services. Providers of goods and services are struggling to keep up with demand, while also struggling to add to payrolls, leading to upward pressure on prices. The US CPI was up by 5% in May – a rate of inflation not seen since 2008 and before then only in the 1990s.

Inflation in the US – annual percentage changes in CPI

Inflation in the US - annual percentage changes in CPI chart

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment, 15/06/2021

However, the outlook for inflation in the US is less obvious than usual. The Fed has been surprised by the pick-up in the inflation rate, as was indicated by the Federal Open Market Committee and Fed chief Jerome Powell’s press conference on 16 June. Powell remains confident that the increase in inflation is transitory and the Fed does not intend raising interest rates any time soon, at least not until the economy has returned to full employment, which is judged to be some way off.

(It should be noted that full employment may mean a lower number than previously estimated, given that two million potential workers have withdrawn from the labour market since the lockdowns. They may however wish to return to employment should the opportunities to do so present themselves; this is one of the uncertainties the Fed is trying to deal with as it looks to understand the post-Covid world.)

A number of Fed officials however have brought forward the time when they think the Fed will first raise its key interest rates, to the first quarter of 2023, a revision that surprised the market and moved long-term interest rates higher. The bond market nonetheless remains of the view that inflation in the US over the next 10 years will remain no higher than the 2% average rate targeted by the Fed. The Fed will be alert to the prospect that more inflation than this will arise.

A tale of two central banks

The contrast of the actions of the Fed with those of the South African Reserve Bank (SARB) is striking. The SARB balance sheet contracted by R115bn, 10.8%, between March 2020 and May 2021. Since January 2020, the sum of notes issued plus deposits of the banks with the SARB (the money base) has declined by 6%, the supply of bank deposits (M3) has grown by a paltry 4% and bank credit by 2%. These are shocking figures for an economy struggling to escape a deep recession.

The SARB may be of the view that money and credit are less important for the economy, and that changes in interest rates are the only instrument they have to influence the economy.

Monetary comparisons between SA and the US (March 2020 = 100)

Monetary comparisons between SA and the US (March 2020 = 100) chart

Source: SA Reserve Bank, Federal Reserve Bank of St Louis and Investec Wealth & Investment, 15/06/2021

The SARB seems to believe their lower interest rate settings have been accommodative and helpful to the economy. Higher interest rates would, of course, have been unhelpful and lower rates were certainly called for. However, the money and credit numbers indicate deeply depressing influences on the economy, influences that the SARB could and should have done much more to relieve, following the US example.  There is more to monetary policy and its influence on the economy than movements in interest rates.

GDP in the US and SA (March 2000 = 100)

 GDP in the US and SA (March 2000 = 100) chart

Source: SA Reserve Bank, Federal Reserve Bank of St Louis and Investec Wealth & Investment, 15/06/2021

 

It would be easy to despair of the prospects for the SA economy given the current, discouraging trends in the supply of money and credit. However, we can draw hope from the possibility that the US cavalry (with some Chinese assistance) will rescue us, in the form of rising prices for metals and minerals that are very much part of the inflation process currently under way in the US.

Metal prices have always led the SA business cycle, in both directions. They may well lead us out of the current morass, after which the supply of money and credit will then pick up momentum to reinforce the recovery, as they have always done in a pro-cyclical way.  The responses to the lockdowns have made it clear how our monetary policy reacts to the real economy.  A favourable wind from offshore may lift the money supply and bank credit, without which faster growth is not possible.

A monetary tale of two economies

The steps taken in the US to counter the destruction of incomes and output caused by the lockdowns of economic activity must be regarded as a resounding success. Real US output is now ahead of pre-covid levels. By the end of 2021 GDP may well have surpassed the GDP that might have been expected absent the lock downs. It took lots of income relief, checks in the post from Uncle Sam, supplemented by generous unemployment benefits and relief for businesses. The extra income means extra deposits, that is money with the US banks, to be spent later or exchanged for other financial assets or real estate or bitcoins or precious metals.

It has also taken lots of extra money, money in the form of deposits held by Banks with the Federal Reserve System have increased by 85%, and deposits at the commercial banks have grown by 26% since March 2020. The source of the extra cash and the deposits at the commercial banks and the Fed, has been additional purchases of government bonds and mortgage-backed securities in the debt markets from the banks and their clients – insurance companies and the like, that are being maintained at the rate of 120 billion dollars a month. The Assets and the Liabilities of the Fed have increased by 36%. It has been money creation on an awe-inspiring scale and it has worked as intended to promote demand for goods and services as excess holdings of money are exchanged for goods and services, that businesses are stimulated to supply and to employ more workers to help do so. The fact that they are struggling to keep up with demand, also struggling to add to payrolls, has meant significant upward pressure on prices. The US CPI was up by 5% in May – a rate of inflation not seen since 2008 and before then only in the nineteen nineties.

 

Inflation in the US – Annual percentage changes in the CPI (Monthly Data)

f1

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

The outlook for inflation in the US is much less obvious than usual. The Fed has been surprised by the pick-up in the inflation rate as was indicated by its Open Market Committee and Governor Powell’s press conference held yesterday 16th June. But Powell remains confident that the increase in inflation is transitory and the Fed does not intend raising interest rates anytime soon, and not until the economy has returned to full employment which is judged to be some way off. Though full employment may mean fewer workers employed given that two million potential workers have withdrawn from the labour market since the lockdowns. They may however wish to return to employment should the opportunities to do so present themselves and is one of the uncertainties the Fed is trying to cope with post Covid for which there are no precedents as the Fed points out. A number of Fed officials however have brought forward the time when they think the Fed will first raise its key interest rates to Q1 2023, a revision that surprised the market and moved long term interest rates higher. Though the bond market remains of the view that inflation in the US over the next ten years will remain no higher than the 2% p.a. average rate targeted by the Fed. The fed as the market will be highly alert to the prospect that more inflation than this will come to be expected.

The contrast of the actions of the Fed with that of the South African Reserve Bank is striking. The SARB balance sheet contracted between March 2020 and May 2021 by R115b or by 10.8%. The sum of notes issued plus deposits of the banks with the SARB (the money base) has declined by 6% since January 2020 and the supply of bank deposits M3 has grown by a paltry 4% and bank credit by 2% since. Truly shocking figures for an economy struggling to escape a deep recession of the government’s making. The Reserve Bank must be of the view that money and credit do not matter for the economy, that changes in interest rates are the only instrument they have with which to influence the economy and that they have declined far enough. These are serious errors of judgment that have punished the economy unnecessarily severely. 

South Africa and the USA Monetary Comparisons; March 2020=100

 

f2

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

 

The Reserve Bank likes to believe their lower interest rate settings have been accommodative, that is helpful to the economy. Higher interest rates would have been very unhelpful and lower rates were called for. The money and credit numbers indicate only deeply depressing influences on the economy that the SARB could and should have done much more to relieve, following the US example.  There is more to monetary policy and its influence on the economy than movements in interest rates.

GDP in the USA and South Africa. March 2000=100.  Quarterly Data

 

f3

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

It would be easy to despair of the prospects for the SA economy given the current trends in the supply of money and credit that are highly discouraging. But for the possibility that the US cavalry with some Chinese assistance may well rescue us in the form of rising prices for metals and minerals that are very much part of the inflation under way in the US. Metal prices have always led the SA business cycle in both directions. They may well lead us out of the current morass- and the supply of money and credit will then pick up momentum to reinforce the recovery- as they have always done in a highly pro-cyclical way.  The responses to the lockdowns have made it very clear how our monetary policy leads with not against the winds blowing from the real economy.  A favourable wind from offshore may lift the money supply and bank credit without which faster growth is not possible.

Pursuing a public interest in the wrong way

The Competition Commission has prohibited Grand Parade (GP), a JSE listed company, from selling its assets and obligations in the Burger King franchise to a private equity company. The reason why the transaction was prohibited was, to quote the media release,  “ …the Commission is concerned that the proposed merger will have a substantial negative effect on the promotion of greater spread of ownership, in particular to increase the levels of ownership by historically disadvantaged persons in firms in the market as contemplated in section 12A(3)(e) of the Competition Act. Thus, the proposed merger cannot be justified on substantial public interest grounds” Grand Parade has a large 68% historically disadvantaged body of shareholders (HDP’s) , ECP Africa Fund IV has none.

The qualification substantial public interest grounds, not just prohibited on an unqualified and damaged public interest is revealing. The problem with public interest arguments is that the public is inevitably made up of a variety of private interests some of whom will benefit from a particular agreement and others who may be harmed.  For examples common to the modus operandi of the competition authorities in SA, one can refer to cases of M&A activity that are only approved, subject to the acquirer not reducing the numbers employed in the merged operations. Clearly a restriction in the limited private interest of those who would not lose their jobs that they might otherwise have done. But one that makes the merged operation less efficient and competitive than it would otherwise have been, given the cost saving synergies of a merger, which would be its essential justification in the broad public interest.

Any lack of efficiency is clearly not in the interest of many consumers who may have benefitted from lower prices or better quality or more convenient locations that a more competitive business might have offered its many customers. Suppliers of goods services or credit to the less efficient operation and their employees would also have been compromised by a less capable business to engage with. And  restrictions on cost savings would be obviously unhelpful to its shareholders who may be many and include historically disadvantaged persons (HDP’s) who are quite likely to be members of collective investment schemes with widely spread ownership claims increasingly exercised by HDP’s through retirement plans. Does the competition commission look through to the members of pension and other collective investment schemes to establish their racial composition?  Or are the only empowerment interests recognised by them and the government more widely, are those held directly? Which is to conveniently understate the numbers of beneficial owners of SA businesses of all races and open-up the opportunity to do more deals to empowerment entrepreneurs, who are small in number, influential and politically important, but hardly representative of the public at large.

The winners and losers in this deal prohibited by the commission are obvious enough. The losers are the owners of GP, heavily and genuinely empowered, who are prohibited from realising part of their risky investment in GP. Their shares lost 60 cents on the news and with 430 million shares in issue this was a damaging loss to them of the order R300m. Surely not a sacrifice they would willingly make in some vague public interest. Another case of expropriation without compensation through regulation. The chances of their realising the same value with another deal, with a company similarly broadly enough empowered to satisfy the commission, is surely remote.

As indicated by the commission there are very few if any such broadly constituted and empowered groups of shareholders around. The shareholders and managers of GP are in effect compelled to do nothing but hold on to their investment in Burger King which may well end up destroying all of their investment.

But are such sacrifices forced on the shareholders of GP likely to promote similar such widely owned enterprise in the public interest? Denying risk taking investors the fruits of their risk taking, or the ability to mitigate their losses, which is the case with this transaction, is surely setting a very discouraging precedent for further broad-based empowerment. It suggests that HDP’s can take the risk of investing their savings in a broadly based and empowered venture but you are prohibited from cashing in on its success or from reducing your potential losses. Hardly an enticing prospect.

Because you will only be allowed to sell assets or the company to a very restricted number of buyers- presumably then at a knockdown price.  Surely not a restriction any business with current or prospective empowerment credentials would welcome.

The logic of the competition commission therefore defies me. Even if such interventions in agreements willingly reached, by parties fully capable of recognising their own self-interests that have no implications for competition, can ever be against the public interest – which I seriously doubt. The commission should protect competition and efficiency and the genuine public interest in well-functioning markets they are set up to protect. The public interest in competitive markets is not the same as a political interest interfering in them. One that is usually narrowly defined to supporters and sponsors of a party and best left to the politicians and the voters to pursue.

More and better public private partnerships please

The value of your home only partly depends on is location, size and the quality of all its fittings and fixtures. It also depends crucially on the quality of the services provided by your local municipality. By how much they charge for services they deliver or fail to  deliver and how much of a wealth tax they impose for your right to own. The better the services provided the more valuable will be your home. And the more you are charged the less the home will be worth to others for any services provided. Negative feedback effects on home values are painfully apparent to home-owners in most parts of the country. The real value of homes of all kinds and types are falling because of the growing in-balance between what is being extracted by municipal governments compared to what they deliver.

But not in Cape Town. Where service delivery is holding up well, as are home values. The difference between what you get for a home or apartment owned or rented in Cape Town and in the other major urban centres is strikingly wide. Despite the charges levied by the City that have been rising well ahead of inflation. In 2010 Rates collected by the city were R3.84b. By 2020 these had grown to R10.08b, that is at an average compound rate of growth of 8.8% p.a. Well ahead of inflation that averaged about 5% over the period. Evidence surely of more valuable real estate. Revenue from electricity water etc compounded from R8.7b to R19.8 at an average rate of 7.5%  p.a. over this period. They took a knock from Covid, declining by R329m in 2020. Which begs a question – what is the present value of a predictable income stream of R10b growing at a real 3% p.a? Perhaps twenty times current revenues or possibly R200b. It is this potential value that secures any borrowing the City or any city might want to do to support its growth with well-designed and honestly executed capex.

The City of Cape Town does however have a spending problem. It has spent far too little on its infrastructure over many years now. Capex (PP&E) was R4.7b in 2010 and only R6b in 2020. Capex in Cape Town has been declining in real terms by about 2.5% per annum on average. Surely not nearly good enough to support and encourage a growing metropole and its property values.

The result is a very strong City balance sheet. The financial assets on the 2019 CTC balance sheet, cash, other financial assets less debts meant net financial reserves of a positive R10.1b. The equivalent amount on the 2015 balance sheet was a mere R2.3b. Debts have remained constant at about R6b since 2015 while cash reserves grew from R3.2 to R8.4b.  It is a build-up in financial strength that should be hard to justify to property owners and residents. Perhaps it is the self-evident hopelessness of the potential competition to run the City that explains such parsimony. The reserves did come in useful in 2020. The City had budgeted to raise an extra 2.5b in debt in 2020. It did not have to do so. It drew down its cash reserves by R2.6b still leaving it a large cash pile of R5.8b.

The City is now realistically budgeting for a significant increase in its capex. It plans to increase its capex to over R11b in three years. To be funded in part by an extra R7b of debt that will cost the City a very manageable net financial charge of 573m in 2023-4. Cash reserves nevertheless are planned to increase to R9b by the end of the three-year planning horizon. I would suggest that the City urgently needs help with its capital expenditure problem. It should partner closely and usefully with the businesses that could help plan and undertake the spending programmes.

Voters at the next municipal elections should choose their mayors and councillors on local not national issues. Essentially by what they can be expected to do to protect, perhaps even enhance, the value of their highly vulnerable homes.

Of higher metals prices, inflation and (hopefully) better years to come

Higher metals prices in previous times have been good for the SA economy. There is little reason to believe this will not be the case again, even if global inflation rises.

Inflation is busting out all over the world. The US dollar prices of industrial metals traded in London are up 30% and commodity prices are up 20% this year. These higher prices are not a cause of inflation. They are inflation. Larger amounts of money have stimulated demand and supply is struggling to catch up. Too much money chasing too few goods is the obvious explanation of higher prices.

Rising prices and interest rates absorb excess holdings of cash and, sooner or later, will slow down demand and the pace of growth. Governments might respond to this slowdown with yet more money and spending. If that happens, a temporary phase of rising prices will morph into a much longer phase of continuously rising prices. The US jury is out on this and when they return, South Africans should hope for a guilty verdict – guilty of causing more inflation and the rising metal prices that come with it.

Metal and commodity prices in 2021 graph

Converting the SA mining sector price index (the mining deflator) into US dollars helps identify these important global forces at work on our economy. In the 1970s, the dollar prices of the metals we produced (then mostly gold), increased by 10 times. Metal prices then fell away sharply after 1981 and remained depressed until the early 2000s. Thereafter they exploded by nearly five times, in what was a super cycle, until rudely interrupted by the Global Financial Crisis (GFC) in 2008.  Hard times for SA followed the consistent downward pressure on metal prices after 2011. The recent modest recovery of SA metal prices, off what became a low base, is thus especially welcome.
The South African mining deflator in US dollars graph
Good times for the SA economy follow when metal prices rise much faster than prices in general – as they are doing now. The extra income earned by mining in SA, the profits earned, the dividends, wages and royalties and taxes paid, rise faster and (conversely) fall further with this cycle. In the 1970s, the real price of SA metals, the ratio of the metal price index over consumer prices, increased by nearly five times. Between 1981 and 1996, it then more than halved, damaging the economy severely in the process.

The one genuine recent SA boom between 2003 and 2008 followed a doubling of SA’s real metal prices.  Real national incomes grew on average by 5% a year over these six years, until interrupted by the GFC. Chinese stimulus helped hold up metal prices until 2011 but their decline until 2016 made for more difficult local economic conditions. A degree of relief came from a recovery in metal prices after 2016, a prospective recovery that was overtaken in turn by the lockdowns of 2020. The advances on the metal front make the outlook for the coming years promising for the SA economy.

Metals, consumer goods and services prices in SA and their relationship graph
Real growth in SA national income and the metal price cycle in US dollars graph
The exchange rate takes its cue from the global forces that drive metal prices. And the inflation rate in SA, with variable lags depending on global prices (especially the oil price), follows the exchange rate.  Interest rates follow inflation – in both directions. These forces strongly reinforce the metal price effects on the direction of the SA economy.
The SA mining price cycle (US dollars) and the rand cycle graph
The exchange rate cycle, interest rates and inflation in SA graph
Much of what drives the SA business cycle, metal prices, our international terms of foreign trade and the exchange rate is unpredictable and beyond our control. What matters is how we react to such circumstances. Our policies should be anti-cyclical and focus on moderating the direction of spending.

Exchange rate strength both stimulates domestic demand and dampens prices, led by the price of imports. Exchange rate weakness does the opposite. It weakens demand by pushing up prices.

Interest rates should not respond to exchange rate shocks on inflation in either direction: they work themselves out over a year or two. The stagnation of the economy post-2014, the depressing effect of lower metal prices and a weaker rand, was intensified by exchange rate weakness. This weaker rand led to higher prices and to higher interest rates, which in turn were kept consistently too high, given the weakness of demand.

The cause of higher prices was a weak rand and the effect was to depress spending and interest rates. This placed further pressure on demand. The economy paid a high price for countering an inflation rate that had nothing to do with the demand side of the price equation, in fighting so-called second round effects of inflation for which there is no evidence. Economic actors are more than capable of differentiating between temporary and permanent increases in inflation. The permanently higher rates of inflation come from too much demand, not too little supply. They are waiting to make that judgment about inflation in the US.

Hopefully the next phase will be one of faster growth with low inflation that will accompany a strong rand. The risk then may then be of interest rates being kept too low for too long. This was possibly a monetary policy error committed between 2005-2008, a case of too much rather than too little stimulus. It will however be a much higher-level problem to have to deal with in the years to come. Let us hope for such a challenge.

The rand is no tale of mystery

Movements in the exchange value of the dollar itself explains the direction of emerging market exchange rates.

South Africans are inclined to regard the highly variable foreign exchange value of the rand as a deep mystery. Yet there is nothing mysterious about the currency’s behaviour.

The daily dollar value of a rand has been closely tied to the value of other emerging market currencies ever since 1995, when SA opened up to global capital flows. When the ratio trends above or below the emerging market line the direction of the rand predictably reverts back to the average relationship of one to one. We have done no worse or better against the US dollar than the average emerging market economy.

Rand exchange value graph
The correlation between the daily rand-dollar exchange rate and a basket of other emerging market exchange rates — an equally weighted mix of the dollar exchange rates against the currencies of Brazil, Chile, Hungary, India, Malaysia, Mexico, Philippines, Russia and Turkey — has been close to one since 1995.

Changes in SA-specific risks can help explain temporary differences between the rand and the other emerging market exchange rates, but more important is the force that has moved all such currencies, including the rand, in the same direction. The movements in the exchange value of the dollar itself explain the direction of emerging market exchange rates.

Dollar comparison graph
Relative dollar strength vs the euro and other developed market currencies has brought emerging market weakness, and vice versa. And exchange rate weakness brings more inflation. Exchange rates lead inflation. It is not the other way round.

The greater difficulty is explaining the exchange value of the dollar. The problem for all businesses that trade globally is that the exchange value of the dollar itself is highly variable. However, it too has had a strong tendency to revert to square one relative to other developed market exchange rates, though the time taken varies.

The behaviour of the rand since March conforms well to these forces. The dollar weakened until very recently, emerging market currencies gained ground, and the rand did a little better than the average emerging market until late April, after which  it has moved back into line.

Compared with a year ago these exchange rate movements are dramatic. The US dollar index (DXY), a measure of the value of the dollar relative to a basket of other currencies, is down 8%; the rand has gained 23% against the dollar; and the average emerging market currency is now worth about 6% more than the dollar.

The rand appears to be a high beta exchange rate. It does worse than the average in more difficult times, as it did during the global financial crisis, and does relatively well after the crisis appears to have been resolved, as has been the case since the global lockdowns.

Exchange rates graph
These exchange rate patterns are likely to persist, though SA can help itself by adopting a set of policies that are more sympathetic to suppliers of capital. A reduction in still exceptionally high long-term interest rates would also be helpful — they continue to reflect a persistently large risk premium and the expectation of rapid inflation.

The SA government pays more than 2% more per annum to borrow dollars for five years than does the US, because of doubts about our fiscal responsibility. The accordingly high cost of capital discourages the capital expenditure by private business that is so necessary for faster growth.

Yet something is stirring to improve the outlook. Much higher metal prices are boosting SA incomes and tax revenues. Higher growth rates in nominal GDP and tax revenues will improve the critical debt-to-GDP ratio. Sticking firmly to government expenditure targets will further improve our fiscal reputation and help reduce the risk premium. The future is in our own hands (partly at least), not only written in the stars.

Building a better tomorrow – the economics of preserving historic buildings

The destruction by fire of historic buildings on the campus of my alma mater, the University of Cape Town, has brought home for many the cultural and societal value that lives in so many historic buildings.

It’s not just runaway fires that destroy beautiful old buildings though. Humans willfully do so too. My wonderful wife Shirley and I frequently regret the demolition of those interesting older Cape Town inner-city buildings we fondly remember; buildings that have been replaced by non-descript office blocks. The ornate faux Granada, Alhambra, on lower Riebeeck Street that doubled as a cinema and was our largest concert venue (seating about 3,000), provides one set of memories of times past.

It was replaced by a very conventional and boring office block that now looks and will probably soon qualify for demolition or conversion into apartments. It has no redeeming architectural features and I would suggest not even decent rentals to justify its survival or maintenance.

The willing – and at the time quite uncontroversial – destruction of many an iconic Cape Town building was a reflection of a very limited cultural sensitivity. The redevelopment and widening of lower Adderley Street, a once charming, essentially narrow main shopping street for the city, to make way for a new railway terminus, was a particularly egregious example of insensitive narrow-minded urban planning.

Master plans that often go wrong are a danger to the natural evolution of the built environment, as it proved to be, for inner city Cape Town. The old Cape Town railway terminus was a Georgian masterpiece. It was demolished to make way for an expanse of uninteresting, and completely out of place, a bit of lawn, for looking at not sitting down upon.

Are preservation orders a fair process?

The cost of preserving an interesting building should be borne by the taxpayer not its owner. In other words, full market value should be offered when making a compulsory purchase of a building of historical interest, a market value that would include the value of the redevelopment opportunity. The loss of wealth that would come with freezing the development opportunity, so reducing the value of the house or commercial building, should not be imposed on the owner. Owners who will see the value of their home, perhaps representing a large part of their savings that they were depending on for retirement, decline significantly because redevelopment of the site has now become impossible.

Scarcity that comes with time and redevelopment can add value to an older structure

A particular building style that was once commonplace, for example Victorian, Georgian or Cape Dutch homes that were the fashion of their day, become less common over time with redevelopment and the introduction of newer, more favoured styles. Styles change understandably and naturally in response to newly available technologies and materials. This fading away of the past and the falling number of structures that reflect the past therefore should add to the rarity (and scarcity value) of traditional buildings and hence their resistance to redevelopment.

Scarcity and the higher rents the iconic building might attract can add to the business case for preserving at least the facades of such increasingly rare and admired buildings. The more valuable the building, the less likely it will be demolished.

I think of the attractive facades of the still many art deco apartment blocks in Vredehoek, an inner city suburb of Cape Town, that must make them more desirable to rent and therefore more valuable to their owner-occupiers (Incidentally, the particular walk-up block of flats in Vredehoek where I spent my first five years (1942- 47) is still intact).

I wonder how well these then unusual art deco blocks of flats were received in the 1930s and 1940s when they were constructed, on mostly vacant land. Perhaps they were welcomed as representing worldly progress, not resisted as a threat to established land and home owners.

The economics of redeveloping property and the case for demolition

The test of the quality of any building or architectural feature will be its ability to command interest and respect from later generations. Most new buildings are commissioned with an expected economic life of about 20 years, given current interest rates. A building would be given a much longer life to prove itself, if the interest rates and political and inflation risk premiums incorporated in high borrowing costs in SA were lower. If an investment in a new structure in SA cannot be justified with 20 years of expected rental income, enough net rental income to cover the costs of a new building, plus the costs of purchase of the land or the building to be demolished, it will not now be built. If it can last beyond 20 years, it will be evidence of the superiority of the original design that will have added value to the building.

A building might be demolished when it is worth less than the land it occupies. A building would be valued as the present value of the expected or implicit rental income it could generate when owner-occupied, and discounted by prevailing interest rates (or more generally discounted by the returns available from similarly risky investment opportunities, by so called capitilisation rates). Demolishing the building releases the land for alternative use. It makes new buildings possible, with the potential to create a greater stream of net rental income with a higher present value: a present value of net rental income value that would have to be expected by some risk-taking developer to be high enough to make a profit. In other words, a building whose subsequent market value would exceed the value of the lost income from the existing structure, after adding demolition costs and to recover the cost of the new building.

At any point in time, the vast majority of buildings do not qualify in this way for redevelopment and demolition. Hence, as can be observed, older buildings mostly remain standing for much longer than the 20 years of economic life that brought them into being. A burst of property redevelopment activity is always a good sign of economic progress under way. It informs us that the land is becoming more productive and capable of commanding higher rental incomes, or the equivalent, capable of bearing higher implicit rentals for their owner-occupiers. It is a trend that’s helpful to property owners but a threat to those hiring accommodation or intending to enter the ranks of owner-occupiers.

How to deal with the “nimby” crowd and facilitate value-adding property developments

Therefore politics, plus the expected higher costs of renting or owning, may frustrate the intending developer. The “nimby” crowd (“not in my back yard”), may not favour redevelopment because it threatens the value of their own real estate nearby. But frustrating the conversion of land from less to more productive uses, as with all such interventions that prevent value adding innovations, will mean wasted opportunity and slower economic growth.

I have long thought that the higher wealth tax receipts that come with more valuable real estate should be shared in part with the owners of property in the neighbourhood. Extra revenue generated by higher wealth taxes collected on more valuable property can be shared with the local owners as compensation for the extra noise or traffic that the redevelopments may bring. Tax revenue that could be used to improve local parks or provide better local security or better access roads, in an obviously earmarked way, would help reduce resistance to redevelopment of the back yard that then becomes more desirable. This will mean more valuable buildings and gains in wealth for the owners of surrounding property.

It is also my contention that every generation of architects and builders should have the opportunity to impress upon the world the strength and beauty of their designs. Not all changes in design will be for the worse. Many may turn out for the better – only time can tell. A city must live and evolve – it cannot be frozen in time and kept as a museum for tourists. And a lively, economically successful city that can sustain good services to its citizens, with a mixture of the new and not-so-new structures, that have been allowed to respond to essentially market forces, can surely attract visitors as well as migrants from other cities.

Property development is part of an evolutionary process that will add to the capabilities of the city to provide additional work and income earning opportunities. Developments can add to the value of real estate to be shared between its owners (paying higher wealth taxes) and the local authority, applying additional tax revenue in generally useful ways.

Still chasing the corporate tax tail

Written after being fully frustrated listening to an Interview on how we can and should collect more taxes from SA companies that Michael Avery conducted with Keith Engers, Edward Kieswetter and Dennis Davis on Business Day TV Tuesday 20 th April 2021.

Janet Yellen the US Secretary of the Treasury wants to collect more tax from US corporations She is lobbying for the same minimum rate of corporate tax to be applied everywhere to prevent competition between different tax regimes. Edward Kieswetter, SARS Commissioner, as unsurprisingly, also wishes to collect more tax from companies who do international business from SA. But he knows better than to believe that standardising tax rates would mean more tax collected. He points out that the amount of taxable income these companies report is much more important than the rate at which they are taxed. He intends to employ more skilled tax collectors, armed with more powerful algos to closely examine the company spread sheets, to ensure more income is reported. To make sure that local costs are not inflated by off-share head office levies or by overstated imports – or indeed overstated exports that are not included in value added and so on and so forth ad infinitum, given the ingenuity of the CFO’s.

What would be required to eliminate the competition is an internationally code of generally agreed standard to measure taxable income. But more important, for any economy, is how well will taxable income as defined for tax purposes, accord with the after-tax income that drives the income and wealth producing actions of the economic decision makers? How consistently does it treat investment allowances that can exceed or fall well short of the decline in the market value of any asset employed be treated that can make a large difference to true economic income? Or how will incentives of one kind or another, tax concessions made to employ more workers, and employ more of them in special zones, or differences in the tax treatment of R&D expenditure be managed? It all calls for a standardisation of fiscal policy that seems very unlikely.

Furthermore, will the calculation of business income under a new standard include an allowance for the opportunity cost of employing equity capital in a business, as it does for interest paid on debt? An unlikely but essential treatment of business costs that are not only measured in cash paid out. Such irrationality about the treatment of economic, as opposed to cash costs, is meat and bread and taxable income to the legion of analysts and investors who know better. Only by providing true economic returns that cover all costs including opportunity costs of own capital employed, is a business likely to gain market value. And provide capital gains- including unrealised gains, which is as useful a form of income as any other even if not paid out in cash. And is only taxed when realised and so best postponed, or used as collateral to fund spending or investments. And helpfully too the interest incurred on the extra borrowings may be regarded as a business expense. And then the gains in cash are only taxed when realised by the private investor or company, not by the pension funds and other investment collectives who own most of the large, listed companies.

If we are to reform our tax system sensibly, the truth to be recognised is that taxes of all kinds are ill suited for redistributing income. They end up influencing pre-tax incomes and so the prices of goods and services, including wages and salaries. It is the distribution of government expenditure that should be used to help the poor and deserving. To tax the corporation, as well as its beneficiaries, the dividend receivers, some more than others, is unnecessary, inconsistent, and harmful to the economy.

The corporation can be treated as a limited liability partnership and be required to act as an efficient tax collector. By withholding tax from all the dividend, interest and rental payments it makes to all parties, without exception, as it does now from its employees and its suppliers. With the tax collected reconciled in tax returns as is the case with PAYE. The lesson to be learned from the tax havens, and how best to compete with them, is to adopt the same zero rate of corporate tax. It then becomes a simple matter for the tax authority to measure what is paid out, and it will not have to police the tax legitimacy of revenues or costs. No well-paid tax sleuths need be employed. The tough measurements of economic returns and what should be done with them, how much cash should be retained and how much paid out are then well left to the business organisation. They will know very well how well they have really done for their shareholders and will measure their results accurately. Economic rationality will rule. Not after-tax rationality. With very helpful consequences for the economy. More will be invested wisely, more paid out in dividends and wages and salaries and more wealth (capital gained) will be created. And the tax base of the economy would become a much wider one. The tax dog, however pedigreed, having to chase the tail of corporate income will be of the past.

But alas do not hold your breath that SA will adopt policies that are truly radical and useful. Our ability to think creatively for ourselves is not well developed.

Why property rights matter

Property rights underpin wealth creation and are essential for attracting investment and helping communities to escape deprivation.

I once asked a meeting of law students if they knew why we have laws to protect our wealth and enforce the sanctity of contracts. They appeared to have little idea why, other than that it was morally wrong to steal, to perpetuate a fraud or not to be true to your word. Nobody had told them that protecting the rights to wealth was essential if wealth was to be created in the first instance.

If you saved and invested in a home, farm, mine or business enterprise, and somebody, stronger than you, could simply take it away, there would be no reason to save and invest in productive, long-lasting assets. Protection of wealth to encourage wealth creation is essential if any community is to become more productive and escape deprivation.

The power of a government to take what might be yours, gained fairly in exchange, is one of the obvious dangers to be averted in the public interest of increasing saving and capital expenditure. While there might be good cause for a compulsory purchase to advance a broad public interest, it should be facilitated by offering the market value of the asset as compensation. No compulsory expropriation without compensation is enshrined in our Constitution and legal practice, for good, income-enhancing reasons.

Having to offer full compensation to any owner is something of a deterrent to exercising any compulsory purchase order. The taxpayer, who also has political influence, will have to pay up for the assets. It’s an influence that is resented by those who have ambitions to change the world for what they believe will be the better and are frustrated by the lack of the means to do so. Just pay for what you wish to take, is the principle we should defend and honour.

South Africans are not just reluctant taxpayers. We are reluctant savers and maintain an unsatisfactory rate of capital accumulation. We still have to rely on foreign savings on a significant scale. We are dependent on capital that can be freely invested anywhere and is easily frightened off by threats to its being taken away by expropriation, or by changes in regulations affecting its market value.

The mere hint of expropriation of land and real estate, without compensation, makes foreign capital more expensive. Foreign investors command high expected returns to compensate for the risk of our taking it away or interfering with it. Hence our low rate of capital formation. An on-average risky JSE-listed company, to justify any addition to its plant and equipment, would have to offer a return of over 15% a year, or about at least a real 9% after expected inflation of about 6%. These are returns that few companies can confidently budget for.

Hence businesses are investing less, and saving less, by paying out more of their earnings in dividends. The ratio of JSE earnings to dividends has halved since 2010. They are retaining less because they are investing less in capex, for understandable reasons.

Figure 1: Ratio of JSE All Share Index earnings per share to dividends per share

Ratio of JSE All Share Index earnings per share to dividends per share chart

Ratio of JSE All Share Index earnings per share to dividends per share chart
Source: Iress and Investec Wealth & Investment, 12/04/2021

It has taken Covid-19 to bring the low rate at which South Africa saves above the dismal rate at which we are currently adding to plant and equipment, adding capital at the rate only of 12% of GDP in 2020. Accordingly, we have become a net lender to the world.

Reducing the risks of investing in SA will encourage more capital expenditure and savings in the form of earnings retained by business. We could then attract the necessary foreign capital at a lower cost than we are paying now. Reducing risks means sensibly reducing the threat of taking, not adding to it.

 

Figure 2: South African annual net foreign borrowing (-) or lending (+), 2000-2020 (R billion)

South African annual net foreign borrowing (-) or lending (+) chart

Source: SA Reserve Bank and Investec Wealth & Investment, 12/04/2021
Figure 3: South African ratio of annual capital expenditure and gross savings to GDP, 2000-2020

South African ratio of annual capital expenditure and gross savings to GDP chart

Source: SA Reserve Bank and Investec Wealth & Investment, 12/04/2021

Inflation expectations will determine the success of the US stimulus package

Thanks largely to low interest rates, the US’s stimulus package is fiscally manageable. Fiscal restraint will be required however, to ensure it remains so.
The US not only has old-fashioned cheques (checks), but checks in the post (mail) nogal. No fewer than 90 million cheques worth $1,400 each have been mailed so far to Americans earning less than $400,000, with more to come.  The dollars will find their way out of the Federal Reserve Bank (Fed) into individual banking accounts, or cashed in, which will add to both bank deposits and the cash reserves of the banks with the Fed. Deposits with US banks are up by 26% since January 2020 and the cash reserves of US banks are up by 92%. Both represent huge firepower for additional spending on goods and services, and bank lending over the next year.
US growth in cash reserves of the banking system and growth in bank deposits
US growth in cash reserves of the banking system and growth in bank deposits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
The debt-to-GDP ratio will rise to over 130% and the fiscal deficit will soon approach 30% of current GDP. But interest rates remain exceptionally low – the average interest paid on all US debt is only 2% a year and interest payments account for 9% of all federal spending. In 1990, interest payments accounted for 23% of the federal budget at an average interest rate on the debt of about 10%. In short, these are now comfortable fiscal conditions. These ratios improved appreciably in the 1990s, thanks to lower deficits. The borrowing requirements of governments can and indeed have to be restrained by some mixture of spending less and taxing more – both hard to do.  Another $3 trillion of US government spending on so-called infrastructure is coming down the pike. There will be no fiscal crisis for the US on the horizon, if US borrowing costs remain low. But can they?
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
It will depend on how much inflation is expected over the next 10 years. The higher the expectation of inflation, the higher the cost of raising government debt will be. Interest rates rise with higher inflation expectations in an almost lockstep way. The expected annual inflation rate over the next 10 years in the bond market is of the order of an unthreatening 2.2%. The higher the cost of borrowing, the more likely governments may resort to printing more money to fund their spending, which in turn will reinforce spending and increase the rate of inflation (and raise expectations of inflation).

All will depend on the scale of US borrowing expected over the next 10 years.  It will have to slow down to something like normal to prevent the US Budget from being overwhelmed by higher interest rates. Janet Yellen, the Treasury Secretary, told Congress that taxes will have to rise to pay for the extra $3 trillion. Will they, or will the unpopular prospect of higher taxes restrain spending ambition? It will take more than taxing the rich to pay the piper.

US ratio of Federal government debt and fiscal deficits to GDP
US ratio of Federal government debt and fiscal deficits to GDP chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
US Federal government deficits
US Federal government deficits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
Fed Chairman Jerome Powell is relaxed about inflation for now and he remains determined to help the US economy get back to full employment. He is waiting to see what will happen and he believes he has the tools to dial inflation back should it rise temporarily – as is widely expected.

So what are these tools? Mainly, it is the power to control short-term interest rates by adding or taking away dollars from the system. He does not however control how much the government spends, how much it taxes and how much it will have to borrow. The higher he sets short-term interest rates, of course, the less popular he will become. His political independence should not be taken as a permanent given.

Powell is confident that inflation is well anchored around the current 2% annual rate, the Fed target for inflation. Actual inflation however depends on expected inflation and on the difference between actual GDP and potential GDP – the output gap. Powell believes the Fed has this gap under control. But without active co-operation from fiscal policy to restrain government spending over the long run, this inflation anchor could easily slip away. As with the Fed, we will wait and watch.