July 2020 – ZA Economist

Relative and real – the price of goods, services and the rand

In goods and services as well as in currencies, it’s the relative price that matters

When it comes to prices, what matters is whether a good or service has become relatively more or less expensive, rather than the absolute price. Relative prices can change a great deal even as prices in general rise consistently or remain largely unchanged.

For example, the prices of food and non-alcoholic beverages in SA have risen much faster than the price of clothing. Since 1980, the prices of the goods and services bought by consumers have risen on average (weighted by their importance to household budget) by 31 times. Clothing and footwear prices are up a mere 8 times over the same 40 years. And food prices have increased 43 times since 1980, making food about 5.4 times more expensive than clothes.

Consumption of goods and services
LHS: Deflators for different categories (1980 = 100)
RHS: Multiple increases (1980 – 2019)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Inflation rates: All consumption goods and services, food and beverages, clothing and footwear (2010 – 2019)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Other relative price movements are worth noting. Over the 10 years 2010 to 2019, furnishings and household equipment became 20% cheaper in a relative sense, while education has become 25% more expensive. Utilities consumed by households (water, electricity) have increased by only 6% more than the average consumer good. Health services (surprisingly perhaps) have only become 3% more costly in a relative sense. More powerful pharmaceuticals and less invasive surgical procedures may well have compensated for these above average charges. Communication services have become about 37% cheaper in a relative sense, helped of course by the price of many a phone call falling to zero.

Relative prices (individual price deflators / consumption goods deflator) (2010 = 1)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment

Businesses that serve consumers (retailers and service providers) are likely to flourish when passing on declining real prices. Producers are likely to suffer declining profitability as the prices they are able to charge decline, relative to the costs they incur.

It will be the changing supply side forces that will dominate real price trends. Temporary surges of demand in response to changes in tastes that force real prices higher will tend to be competed away. Constantly improving intellectual property or technology can give producers the opportunity to consistently offer competitive real prices, yet sustain profit margins and returns on capital to fund their growth.

The dominance of China in manufacturing has been an important supply side force acting on real prices, for example on the real prices of clothing, household furnishings, equipment and communication hardware. Having to compete with lower real prices has decimated established manufacturers everywhere, including in SA though often to the benefit of consumers.

Predictably low inflation makes for more easily detected real price signals that consumers and producers should respond to. Unpredictable inflation rates make it harder for businesses to separate the real forces acting on prices from what is merely more inflation, common to all buyers and sellers.

There is however one important real price that shows no sign of stabilising. That is real value of the rand, in other words the rand after it has been adjusted for differences in SA inflation and inflation of our trading partners. The real, trade-weighted rand is now about 30% below its purchasing power parity level. SA producers exporting or competing with imports must hope that it stays as competitive, but there would be no reason to expect it to stay so. It is an important real price given that imports and exports are equivalent to 60% of SA GDP.

The real value of the rand moves in almost perfect synch with the market rates of exchange, which tend to be highly variable. The real and the nominal rand exchange rates have been almost equally variable. The average three month move in the real exchange rate calculated each month since 2010 has been 2.03% with a wide standard deviation of 19.8%.

For an economy open to foreign trade, this real exchange rate volatility adds great uncertainty to business decisions. It disturbs the price signals to which businesses must react. Until SA gets a higher degree of exchange rate stability, the price signals will remain highly disturbed, regardless of the inflation rate.
Quarterly percentage movements in the nominal and real traded-weighted rand exchange rate

Source: SA Reserve Bank and Investec Wealth & Investment

The SA bond market does not make a lot of sense. For borrowers, especially the RSA, to ignore the long end of the bond market would.

14^th July 2020

The SA bond market reacted sharply to the spread of Covid19 and the ever more likely prospect of a damaging economic lock-down. Long term interest rates were pushed higher earlier in 2020 in response to SA’s deteriorating fiscal trends even before the full damage to be caused by lock-downs to the economy and the budget deficits were recognized. Long rates then reversed as the crisis in financial markets passed by with lots of aid form central banks in the developed world. However the gap between long and short yields in SA had widened sharply and remained very wide, despite the bond market recovery, as the Reserve Bank cut its repo rate.

Fig. 1; RSA long and short rates Daily Data 2015-2020- July 10th

Source; Bloomberg, Iress, Investec Wealth and Investment

The RSA ten-year bond currently (July 10^th) yields 9.67% p.a. while the yield on a three month Treasury Bill is 3.96% p.a. a positive spread of 5.67% p.a. This means that the slope of the yield curve is far steeper than at any time over the past 15 years. close to 10% p.a. Another way of putting this is that the SA taxpayer has to pay an extra 5.67% p.a. to borrow long rather than short.

Fig.2: The slope of the RSA yield curve; 10 year – 3 month yields. Daily Data 2020 to July 10^th

Source; Bloomberg, Iress, Investec Wealth and Investment

On the face of it this would appear to be a very expensive exercise for the SA government to borrow for a longer-term rather than to roll over short term debt. Given the current strains on tax revenues and the rapidly widening fiscal deficit and the government borrowing requirements is it a choice the Treasury is likely to exercise? Or is it going to finance a much greater proportion of its growing debt at the cheaper short term end of the term structure of interest rates? We think the answer will be and should be yeas to this question. We will attempt to provide more insight as to the borrowing choices the SA Treasury is likely to exercise over the coming months and years.

The answer is perhaps less obvious than it appears at first glance. The expectations theory of interest rates would posit, with very good reason, that the long-term rate is but the average of the expected short term rates over the period of any loan. Hence in principle there would be no good reason to prefer long over short-term lending or borrowing. Borrowing long or short and having to roll over shorter term debts should be expected to turn out about the same for borrowers or lenders with choices.

However, if interest rates at the short end rise faster than expected, borrowing long (and lending short) would turn out to be the better option. And vice versa if interest rates were to rise less than expected borrowing short and then rolling over short term debt would have been the better option. As would lending long.

The chances of unexpected fast or slow increases in short rates over the relevant period must be about the same- if the market behaves consistently with the consensus of expectations. Choosing to borrow short or long or lending long or short, given the freedom to choose either option, then represents speculation, the belief that the borrower or lender can beat the market, a belief that may turn out right or wrong- with the same probabilities- given the rationality of the expectations of interest rates.

This notion of equilibrium in the capital market surely makes sense, lenders and borrowers with the option to lend or borrow for shorter or longer periods would presumably expect to pay out the same or earn the same, one way or the other. If you could lend or borrow for three months at a time or for six months at an agreed rate today the expected interest, to be received or paid out over two consecutive three-month periods must presumably be the same as the interest rate fixed for six months. Thus the average (compounding) interest received or paid if the contract was fixed for three months at a known rate and then re-negotiated after three months at a rate, only to be known in three months time, must be expected to be the same. If the current three- month rate is below the six-month rate then it follows that the three months rate in three-months must be expected to rise to make the expected returns on the interest paid or received equivalent.

If this is not the case there would be every incentive to borrow or lend for longer or shorter periods depending on which was expected to suit better. It is the attempts to minimize or maximise interest paid or received that eliminates any such obvious market beating opportunities.

Thus according to the theory, if the three-month rate is below the six-month rate, then the three- month rate must be expected to rise above the current fixed six month rate in order to average out at the higher rate. Thus a positively sloped yield curve, long rates above short, implies that short rates are expected to rise above the current longer term rate over the duration of the lending and borrowing contract. And vice-versa if the yield curve is sloping downwards, short rates must be expected to fall below the alternative longer fixed-term rate. The same logic applies to longer term contracts. If the ten year RSA bond yield is above the yield on a five year bond, the five year bond yields will be expected to rise over the ten year period enough to provide the same expected, compounding, average return.

The RSA yield curve has had a consistently positive slope since 2005 with the exception of the boom period of 2006-2008 when short rates rose sharply and the rapid growth in the economy was clearly expected to slow down and bring lower short rates with it. As transpired with the aid of the Global Financial Crisis and the recession in SA that followed. As may be seen in the figure below the slope of the RSA yield curve has been at its most positive in 2020. It would therefore for almost all of this period been helpful to have borrowed short rather than long.

Fig.3; Long and Short Term interest rates in SA and the Slope of the Yield curve. Daily Data 2005- July 10^th 2020.

Source; Bloomberg, Iress, Investec Wealth and Investment

The slope of the term structure of interest rates, the differences between longer and shorter yields, allows us to interpolate the shorter-term interest rates expected in-between. Thus for a portfolio manager at a SA insurance company to prefer the 3.44% p.a. received currently for a 12 month RSA Treasury Note Bill rather than the 7.07% on offer for a RSA bond fixed for five years, or the fixed 10.05 % p.a. available from a ten year RSA bond, must mean that the one year yield is expected to rise sharply over the next five or ten years. That is to make lending short rather than long the sensible choice to make.

To provide equivalent returns lending long or short and rolling over each year the one year rate (now 3.4%) would have to more than doubled to 7.31% in two years. Then increased further to 8.91% after three years and then on to to 11.5% after five years. After ten years the one-year rate would need to be as much as 14.75% to make preferring one-year loans to five or ten year ones the sensible decision. (See figure below)

Fig.4; RSA one year (forward rates) implicit in the current slope of the yield (for on to ten years)

Source; Thompson-Reuters, Investec Wealth and Investment

It is very difficult to reconcile such expectations with the likely reactions of the Reserve Bank over the next few crucial years. The outlook for GDP growth is very grim and the expectations for inflation over the next few years remain highly subdued. The compensation for taking on inflation risk in the RSA bond market is currently only an extra 3.9% p.a. to be earned over five years. That is 3.9% is the extra yield available from a nominal 5 year bond over its inflation protected alternative.

Fig.5; RSA nominal and real 5 year bond yields and their spread- inflation compensation for five years.

Source; Bloomberg, Investec Wealth and Investment

Therefore if we subtract this estimate of average inflation expected over the next five years implied in the bond market, from the one year interest rate expected in five-year’s time, we get an after inflation expected return that year 5 of about 6%. This measure of inflation expected is now very close to actual inflation. As are the inflation expectations surveyed and reported by the Reserve Bank and forecast by them. They will all have declined further since the beginning of the year given the global pressures on inflation and the likely reluctance of SA households and firms to spend more over the next few years.

It is very difficult to imagine that the SA economy will be strong enough, or the Reserve Bank aggressive enough, over the next few years, to tolerate real interest rates of the order implied by the yield curve and the spread between nominal and real yields now available in the bond market. Therefore many borrowers, especially the SA government, is surely likely to take the risk that short term interest will not rise nearly as rapidly as implied by the current slope of the yield curve. After all short-term rates are directly controlled by the Reserve Bank itself.

Borrowing long can be avoided and the growing SA government debt can much better be funded short rather than long, and by rolling over short term debt for as long, provided the level of long-term rates remains where they are. Drawing further on the government deposits at the Reserve Bank is a further low interest cost option. The Reserve Bank can also provide the banks with enough extra cash, on favourable enough terms, to have them support the growing market in short-term debt. Any reduced supply of longer-term paper will help take pressure off longer term yields.

For the government to elect to borrow long rather than short in current circumstances would surely now seem the wrong, very expensive option. The current state of the bond market could be argued to be something of an aberration in a world of global bond markets that have been monetized to an extraordinary degree. In the longer run the task for the SA government is to prove to the world that it can manage its debt in a sensible way. This means convincing potential lenders that it can bring government spending closely in line with its ability to raise tax revenues. This will help to bring down the long-term cost of raising RSA debt. In the short term, until the crisis is over, and the economy normalizes, what is called for from the government and its Reserve Bank, is the ability to manage the unavoidably larger national debt and short-term interest rates in a sensible way. If we call it good debt management rather than money creation- that it will be to some degree- then so describe it that way

The pandemic of debt

How to get SA growing again post Covid-19

Fear debt – not raising equity capital – when it makes economic sense.

The threat to the value of SA retailers as cash has drained away during the lock downs has been as damaging to their landlords. The value of the average market weighted general retailer and property company on the JSE is less than 40 % of what they were worth in January 2018. The damage to the balance sheets of the property company of Covid19 is perhaps far greater than that of the average retailer. Who have shown a greater willingness to raise fresh equity capital to repair their balance sheets

The Value of JSE listed Property Companies and General Retailers January 2018 =100 Month end data to June 2020.

Source; Iress and Investec Wealth and Investment

A number of these JSE listed Real Estate Investment Trusts (Reits) with seemingly little growth in expected to come from SA assets, sought faster growth offshore. These offshore investments were funded very largely sometimes exclusively with foreign currency denominated debt.

The market value of average JSE Reit assets less debts, their net asset value (NAV) had fallen away before the Covid crisis that then decimated their rental revenues at home and abroad. A number of these JSE listed Reits now lack a sufficient buffer of equity to absorb the losses from COVID 19 related shutdowns. Debt to market value ratios have risen and NAV fallen further.

To qualify as Reits and avoid corporate taxes they are required to pay out at least 75% of their income after interest and all other expenses. They are appealing for an exemption from the Treasury and the JSE to skip dividends to conserve cash and still retain their Reit status.

They might do much better to raise equity capital, if they can, issue more shares for cash and pay off foreign and domestic debts. Even if the saving on foreign interest paid is minimal, provided the rand holds up, the improvements to their survival prospects and so market value could be substantial. Shareholders supported by stronger balance sheets could be well served facing up to a reduction in cash distributions per share. They would receive less income per share, but with lower risks attached to expectations of future distributions, this could add value to all the shares issued – even when there are more of them.

The purpose in raising capital may be, ideally, to grow a business successfully. Successful businesses mostly fund their growth from the cash they generate from operations. More unusually they may have to raise additional debt or equity capital secure the survival of a still potentially successful business.

The same fundamental question needs to be asked in both circumstances. Will in other words the increase in the market value of the company, plus the dividends paid, both measured in extra rands come to exceed the amount of extra capital raised. also in rands. Plus something extra to cover the opportunity cost of the capita raised. That is will the investment of extra capital return as much as could be expected from any alternative, as risky, a SA investment? Equal that is to the return from the bond market plus an equity risk premium- of about 5% p.a. (About 13% p.a.) If so investors will get all their capital back – and more – and perhaps very quickly as share prices could respond immediately to the expectation of good returns to come.

Any potential capital raise needed to save or de-risk a business will be reflected in the ongoing survival value of a company. Any surprising refusal of its owners to refuse to supply extra capital, when needed to secure the business as a going concern, will provide a very negative signal and surely damage the share price. Preventing the downside will be part of the upside of any capital raise.

A successful secondary issue, especially when underwritten by bankers exercising due diligence, is perhaps an even stronger signal of favourable longer- term prospects for any company. More so than a rights issue supported by established shareholders with everything to lose. With a successful secondary issue raising capital for the right value adding reasons, established shareholders can expect to have a smaller share of a larger cake and be better off for it.

The obvious way to maintain the share of established shareholders in a company is to raise extra debt, rather than equity capital. But more debt, makes any company more risky, and may destroy rather than add market value for shareholders. Debt only looks cheaper than equity with hindsight, after the good times have rolled by. And the good times may not last- as we have been so cruelly reminded.

A time to demand and supply extra capital for capital hungry business – post Covid19

A PS on the fundamentals of capital raising

The past quarter has been record breaking. Records have been set in extra spending by governments measured as a share of (normal) GDP. For the developed world this additional emergency spending by governments has ranged between an extra 5 to as much as 15 per cent of GDP. Another record has been set in money created by central banks. Of the order of an extra 5 trillion dollars worth. Included in their current bout of QE have been substantial purchases of corporate debt.

The monetization of much debt has meant very low interest rates with which to fund rapidly growing fiscal deficits and rising debt to GDP ratios. Records are therefore also being set in the amount of cash raised by businesses. Since the end of March, U.S.-listed firms have raised a quarterly record beating $148 billion of extra capital. Monetary policy has made capital raising on a vast scale possible on increasingly favourable terms. And without which a strong recovery from the lockdowns would be impossible.

Loan guarantee schemes, provided to commercial banks by central banks backed up by their Treasuries, has been an important component of the financial relief promised. These loan guarantees – should they be fully required to offset defaults – which is not at all expected – are available on a very large scale. In normally fiscally conservative Germany extra government spending on relief is of the order of 15% of GDP while the loan guarantee provision is of the order of 30% of GDP. For the US the stimulus plan is equivalent to 7% of GDP with the guarantee adding another 8% of GDP to the package.

It makes every economic sense that ordinarily sound and profitable businesses in SA as elsewhere not be forced out of the economy for an inability to service or roll over their debts for reasons entirely beyond their control. And are able to start up again by recapitalising their operations – given how much capital has been lost during the lock downs

The South African economy has not benefitted from fiscal and monetary relief on anything like the scale offered elsewhere. The additional borrowing requirement of the SA government has surged to over 14% of GDP more than double the deficit planned in February as we learned from the Minister of Finance yesterday June 24^th. Largely because largely because tax revenues have declined so sharply- by over R300b with further declines expected. Extra government spending on its adjusted Budget is estimated as but R36b.

Despite a relative lack of encouragement of the kind offered in the US and elsewhere to the market for corporate debt, the capital market in SA has been active. We have seen something of a flurry of capital raising by JSE listed companies. The issue of relevance to shareholders (and the banks underwriting the issues) is whether the extra capital intended to be raised can pay for itself. That is will the extra capital raised earn a return that will covers the (opportunity) cost of the capital raised. That is equivalent to the high long-term RSA bond yield of 8% plus a equity risk premium of 4% or more for the least risky of businesses- something ahead of 12% p.a. returns for the least risky of enterprises.

If the answer is a positive one a rights issue or indeed any secondary issue to raise capital or indeed debts – should go ahead. And the hope must be that the market immediately shares this justifiable optimism and re-prices the company’s shares accordingly. That is prices the businesses raising additional capital them now for more likely survival rather than extinction.

The same positive answer is required of any business large or small that needs to raise capital to resume business post-Covid. Will the essential extra capital raised cover its risk-adjusted costs? We must hope that the SA financial markets, especially the banks, can help meet these additional, calls for extra capital. The loan guarantee scheme offered by the Reserve Bank in SA is perhaps the best hope for business and economic rescue.

The government has the task of ensuring that the capital market is up to this vital task of funding both government and business on sensible terms. Without which the prospects for a post-Covid recovery in SA, absent fiscal stimulation, remain especially bleak. The burden of economic relief has passed to monetary policy.

Postscript on capital raising on the JSE

We have seen something of a flurry of intentions to raise additional capital raising by JSE listed companies. The latest by retailers the Foschini Group (TFG) and Pepkor in the form of rights issues to their shareholders. Mister Price (MPR) another retailer has also indicated an intention to raise more equity capital.

TFG announced plans on June 18^th 2020 to raise R3.95b from its shareholders, equivalent to 22% of its current market value of approximately R17.5b. A market value that has shrunk by more than half this year on fears of exposure to Covid19 accompanied by a seemingly debt laden balance sheet. The market has however reacted somewhat favourably to the announcement. The share price has held up since the announcement and regained a little lost ground when compared to the Truworths (TRU) share price, a rival retailer. ( See below the figures that chart the market value of TFG over recent years and where we compare the TFG share price to that of clothing retail rival Truworths (TRU)

TFG Market Value of Company Daily Data; 2016- June 22nd 2020

Source; Iress and Investec Wealth and Investment

TFG Share price and Ratio of TFG to TRU share prices – Daily Data 2020 to June 24th

Source; Iress and Investec Wealth and Investment

The terms of the TFG rights issue (to be underwritten by a consortium of banks) will only be announced should the proposal gain shareholder approval on the 16^th July. It should be understood that as a rights issue this extra capital cannot reduce the share of the established shareholders in the company, should they follow their rights. They may however prefer to sell such rights to subscribe extra capital. This benefit in selling the rights to subscribe can be regarded as compensation for giving up a share of the company’s profits and dividends and market value in the future.

The value of their rights will depend on the difference between the subscription price and the ruling market price. The larger this discount, the more shares will have to be issued to raise the required 3.95b – but only from its own shareholders. Hence there need be no dilution of shareholders. The market value of TFG must have increased by at least R3.95b for the shareholders to break even on their additional investment. They will be hoping for more upside over time. And some of the upside may even have been registered already in anticipation of the rights issue going through, even before the announcement of the rights issue itself, because of the better times it portends for the company.

The larger the difference between the ruling market price and the price at which the additional shares will be offered (the larger the discount) the more likely the rights will have value and be taken up. This outcome is only of importance to the underwriters. The more enthusiastic the response, the fewer shares the banks will have to take up. Presumably in this case the intention of the underwriters is not to hold shares in TFG.

A rights issue is equivalent to an additional investment by a sole shareholder in a company. The nominal value attached to the additional shares will be of no consequence other than to determine the number of extra shares issued, as identified in the books- all with the same owner. In practice the additional capital invested in a non-listed business is very likely to be identified as loan rather than share capital, to enable the owner to rank equally with other creditors in the event of a business failure

The issue of relevance to shareholders is will the extra R3.95b. of capital raised will pay for itself over time. That is earn a return over time on the R3.95b of additional capital that more than covers the cost of the capital raised. To add value for shareholders such future returns would need to average around 12-13 per cent per annum. That is to presume that the required returns from a retailer in SA would have to be at least equal to the returns certainly offered by a long dated government bond (currently about 9% p.a) plus a risk premium of 4% premium. They could hope to realise similar returns from any other JSE company taking similar risks with their capital. If the answer is a positive one, that is to say expected returns promise economic profits or economic value added (EVA) the rights issue or indeed any secondary issue (regardless of any dilution that might take place) should be approved.

There is a further consideration that established shareholders will bear in mind when approached for additional capital. The value of their shares will have declined in response to the damage caused to earnings and cash flow by the disruption of their ordinary activities caused by the lock down. Hence the need for additional capital. Companies that entered the lock down with relatively debt laden balance sheets will be recognised as more vulnerable to financial stress. However the prospect of a rights issue that would mitigate this danger would always be reflected, favourably, in the current value of the shares.

Any unexpected failure of shareholders to approve a share issue of this kind would surely raise the likelihood of default and immediately reduce the value of a shareholding. Not throwing good money after bad may be the right decision. But if it comes as a surprise to the market place such a refusal will provides a very negative signal. Vice versa if a surprising rights issue is successfully launched.

A successful secondary issue, underwritten by bankers, that does not demand participation by possibly jaundiced established shareholders, is perhaps an even stronger signal of favourable longer- term prospects for any company. The avoidance of dilution should not be a primary consideration in any capital raise. If the additional capital is expected to realise an economic profit, established shareholders will benefit in line with newly attracted shareholders. They can expect to have a smaller share of a larger cake and be better off for it.

The more obvious way to avoid dilution of established shareholders is to raise extra debt rather than equity capital. But the market for debt issues may not be as open as the equity market. As would appear to be the case in SA, but not in the USA. But more debt as we have seen makes any company r more risky. Andwhen business as usual is disrupted debt becomes particularly burdensome. Debt is not always cheaper than equity. It may appear so in the good times that may not last.

The same positive answer is required of any business large or small post Covid that needs to raise debt or equity capital to resume business post Covid. That is will it earn economic profits in the true opportunity cost sense? Will the investment beat its cost of capital, that is return more than is required to justify the investment? We must hope that the SA financial markets, including most importantly the banks, can meet these additional, fully justifiable calls for extra capital. The government with its central bank has the task of ensuring that the capital market is up to this vital task.