Author: Brian Kantor

The SA economy has more than a supply side problem

Second quarter GDP, announced on 3 September, was disappointingly smaller than the quarter before. The news sent the rand immediately weaker and the cost of servicing SA debt higher. The rand declined not only against the US dollar but also weakened against other emerging market currencies. This indicated SA-specific rather than global forces at work. And the spread between RSA yields and their US equivalents widened taking SA dollar denominated debt further into high yield, junk territory. SA dollar debt with five years to maturity offers investors about 2.5 percentage points more than US debt of the same duration. Investment grade debt would offer only about 1.5 percentage points more than US Treasury Bonds.

Some of the weakness in the USD/ZAR exchange rate and weakness in the rand against its emerging market peers has been reversed in recent days, as has the upward pressure on RSA and emerging market risk spreads.

The market logic that sent the rand weaker and spreads higher on the GDP news seems clear enough. Slower growth drives capital away from our economy helped by the rating agencies that are expected to officially downgrade our credit ratings because slower growth means less tax revenue collected and more government borrowing leading to capital outflow. And the weaker rand adds to inflation and is thought likely to lead the Reserve Bank to raise short term interest rates. Adding higher interest rates to higher prices is the recipe for still slower growth.

What then can be done to reverse the vicious circle in which SA finds itself, the slow growth that drives capital away, weakens the rand that adds to inflation? And leads seemingly inevitably to still slower growth in spending and output? Faster growth by the same market logic would do the opposite: attract capital, strengthen the rand and the Treasury and lower inflation.

South Africa clearly has a supply side problem. We are not producing enough (adding enough extra value) to generate additional incomes. The reasons for this failure may seem complex but I would argue that it is the result of policies that focus primarily on who benefits from the output produced, rather than on how to raise the levels of output, incomes and employment. In other words, redistribution undertaken or feared at the expense of output and incomes. South Africa needs to impress the world and its own citizens that we will care about raising output. The revised mining charter, to be made public soon, gives the timely opportunity to demonstrate a new pragmatic economic approach, one intended to attract rather than repel capital on internationally competitive terms.

But South Africa not only has the problem of too little supply. It also suffers much from too little demand. Too little demand was exacerbated in the Q2 GDP estimates by a large decline in the demand to hold inventories. Without the reduction in inventories of R14bn in constant prices, growth in GDP in Q2 would have been 2.9% higher. Reducing stock piles and goods and services in production to satisfy demands rather than increasing the output of them may however point to more rather than less output to come.

But even leaving aside declining investment in inventories or volatile quarterly changes in agricultural output – that could easily reverse themselves – the growth in final demand by households, firms and government is running well below even our limited potential supplies of good and services. And has been doing so for many years now. That is to say interest rates have been too high to match demand and potential supply even growing slowly. Interest rates have a predictable effect on the willingness of households to spend (out of after-mortgage payment income) and the willingness of firms to spend to satisfy those demands. Their influence on prices is much less predictable.

The link between interest rates, the exchange rate and inflation is highly unpredictable, given the forces that drive the exchange rate. That take their cue mostly from global rather than South African events. Indeed as the market has revealed the relationship between growth, inflation and interest rates is not what standard theory might predict. Slower growth leads to a weaker rand, more inflation and still higher interest rates that depress demand and growth further. The impact of less demand on prices is vitiated by the likely impact of the weaker exchange rate on prices.

Thus raising interest rates in response to rand weakness exaggerates the business cycle rather than smooths it. The Reserve Bank should have reduced interest rates much faster and sooner than it has, to help match weak levels of demand with potential supply. The best it can now do for the economy is to surprise the market by not raising rates. And then over the course of the next few years, if demand remains as weak as it has been, to reduce them without then being thought soft on inflation. This would help take SA closer to a virtuous circle of faster growth and less inflation and give the economy some head room to undertake the supply side reforms that are essential if its growth potential is to be raised permanently. 13 September 2018

GDP – Realism required

Parsing the GDP estimates and calling for more realism about them

The SA economy has now recorded two quarters of negative growth: it is in recession. The decline in real GDP of -0.7% in quarter 2 came as something of a surprise, enough to send the rand significantly weaker. Which in itself makes the growth outlook even less promising given the implications of a weaker rand for more inflation and higher interest rates. That the rand was weaker for South African rather than global reasons was apparent in the performance of the rand compared to other emerging market exchange rates. The rand by time of writing, 16h30 on 4 September, was 2.85% weaker vs the US dollar and only slightly less, 2.2% down on our nine emerging market currency basket.

The logic in the market reactions to the surprisingly low GDP growth estimates seems clear enough – slow growth adds risk to the fiscal outlook. It may encourage the rating agencies to downgrade SA debt further so encouraging capital outflows form the RSA debt market, hence the weaker rand. Though it should be appreciated RSA dollar denominated five year bonds were already trading in junk territory before the GDP release.

Insuring RSA dollar debt against default required paying a risk premium of 180bps. at the beginning of August 2018. The emerging market crisis took this risk premium to 230bps by the end of August. It is now 360bps – up from 330bps previously. The equivalent Turkish risk premium is now 580bps compared to 333bps in early August, up a mere 8bps on the day.

The GDP growth numbers themselves require careful consideration, perhaps more than they have received by the market place. Not only did highly volatile agricultural output drag the quarter to quarter seasonally adjusted annual output growth rates lower by 0.8%, but more important, a decline in estimated real inventories reduced expenditure on GDP by as much as 2.9% at an annual equivalent rate.

By definition output (GDP) is made up of value added by the different sectors of the economy. This estimate of output is by definition identical to the expenditure on this output and the incomes earned producing goods and services. Supply determines demand and demand determines supply – and gives us the national income identity- that is GDP is equal to expenditure on GDP.

This expenditure is made up of spending by households and government on consumption of goods and services and spending by firms and government on additional capital goods- known as gross fixed capital formation (GFCF). To which additional or in the case of Q2 2018 reduced investment in inventories is added or subtracted. Exports less imports are then added to make up the estimate of Expenditure on GDP (see figures 2 and 4 provided by Stats SA). This shows the contributions to the growth outcomes of the different sectors and categories of expenditure. It should be noted that net exports (exports volumes grew faster than imports and so were a positive contributor to growth in GDP in Q2. Perhaps some of these mining exports were sourced from stock piles (inventories) rather than current output- enough to reduce inventories at the rate indicated?

Farming volumes while contributing about 2.5% of all value added in Q2 2018 are inherently variable, subject to drought and flood and may not have any seasonal regularity. The real output of agriculture forestry and fishing fell at an annual rate of 29% in Q2 and was down by 34% the quarter before. In Q4 2017 the growth was as much as 39% at an annual rate and 42% p.a. the quarter before that. For a better sense of sustainable growth rates it might be better to exclude agriculture from the GDP estimates

The run down in inventories had however a much more important influence on GDP growth than farming output in the second quarter as may be seen in the table above. Less invested in inventories reduced estimated GDP growth by 2.9% p.a in the quarter. Inventories fell by an estimated over R14 billion in constant price terms, at an annual rate. Enough to take the growth estimate into negative territory with such significant repercussions and despite the positive contribution of 3.7% p.a made by exports to the GDP growth recorded

The adjustments made for seasonal effects on the change in inventories were highly significant. It is very difficult to make economic sense of the very different estimates of changes in inventories when measured in current or constant prices, or when measured each quarter or alternatively at a seasonally adjusted annual rate. According to the statistics provided by Stats SA the actual quantity of inventories in Q2 grew by R6.7bn (at constant 2010 prices) in the quarter. In current prices and at an annual, seasonally adjusted rate inventories are estimated to have declined by R7.4bn in Q2 2018, (much less than the R14b decline when estimated in constant prices). Using quarterly statistics (not seasonally adjusted) the value of inventories, measured in money of the day, increased by R11.1bn in Q2.

It takes something of a leap of faith to accept and reconcile these very different estimates of inventory changes at face value. When growth in the other components of spending is at the understandably slow rates recorded in Q2 2108, estimates of investments- less or more – in inventories take on particular significance – as they did today on their release. They should perhaps be treated with much greater skepticism than has been the case.

Yet for all these reservations about the estimates of GDP growth, the weakness of household spending cannot be gainsaid. It is by far the largest contributor to expenditure on GDP and on GDP – equivalent to 59.4% of all expenditure in Q2 2018 at current prices. The reluctance of households to spend more is at the heart of South Africa’s inability to grow faster. Without a greater willingness and ability of households to spend more the economy and its output and incomes will not – cannot grow faster.

Household consumption expenditure declined at a 1.3% annualized rate in Q2 2018- taking 0.8% off the estimated growth of -0.7% p.a. The weaker rand and the higher inflation that will accompany the weaker rand will depress household spending further. It is surely inconceivable that interest rates could be raised in circumstances of this depressed kind.

The value of the rand is beyond the influence of interest rates. Surely as much is painfully apparent after events of the past few weeks. But interest rates do effect the ability of the households to spend more. If economic logic were to prevail interest rates in SA would be reduced not increased given the negative growth outlook. And if so the growth prospects would improve – not deteriorate. If so, it might lead to rand strength not further weakness. Weakness that comes with slower growth, as we saw today. 5 September 2018

Charts of the Week – The usual suspects

The week saw renewed pressure on emerging market (EM) exchange rates, led by the usual suspects, Argentina and Turkey. The rand did not escape the damage and did a little worse than the JP Morgan EM benchmark, that gives a large weight to the Chinese yuan and the Korean won. But it was much more a case of EM exchange rate weakness rather than US dollar strength.

Source: Bloomberg

The spread between US and German 10-year yields has stabilised (perhaps taking a little away from US dollar strength), while the US term structure of interest rates continues to flatten as the longer term rates fail to respond to higher short term rates. The cost of borrowing in the US beyond two years has not been increasing, despite the Fed’s intentions to raise rates in response to sustained US economic strength.

Source: Bloomberg

The pressure of capital withdrawn from EMs was reflected in a widening of the spreads on US dollar-denominated debt issued by EM borrowers, including SA. The spread on five-year RSA debt widened from around 202bps last week to 230, while Turkish debt of the same duration commands a risk premium of 562 bps – compared to 481 bps the week before. If only in a relative sense, SA’s credit rating has improved even as our debt trades as high yield (alias junk). The rating agencies, however, appear to be in no hurry to confirm this status for SA debt.

Part of the explanation of the weak rand and the decline in the value of the JSE, more in US dollars than in rands, has been the dramatic decline in the value of Naspers – up over 11% the week before last and down 7.7% last week. The Hong Kong market, where Tencent is the largest quoted company and in which Naspers holds over 30%, however returned 0.8% in US dollars last week. it is consistent that it is now among the weakest equity performers going into the new week. China and Chinese internet companies, in particular, have been a drag on emerging markets. More optimism about the Chinese economy is essential to the purpose of any emerging market currency and equity comeback.

Source: Bloomberg

The rand – causes and effects of weakness

How weak is the rand? Or to put it another way – how competitive is the rand? By my calculation the rand was at its weakest, most competitive and most undervalued in late 2001. At R11.98 for a US dollar or a mere 8.3 US cents for a rand, it was selling for about 23% less than its purchasing power (PPP) equivalent. If the dollar/rand exchange rate had merely compensated for differences between higher SA inflation and lower US inflation, the dollar would have cost no more than R7.70 in late 2001.

It was an expensive time for South Africans to visit New York and a bargain for Americans and Europeans traveling in SA. If differences in inflation were the only force driving the dollar/rand exchange rate we would now (in August 2018) be paying less than R10 for a dollar, rather than over R14.

The figure below tracks the real dollar and trade weighted rand since 1995, using December 2010 as the base month. A real exchange rate value of 100 would indicate an equilibrium for foreign traders. One where what is lost on the inflation front is fully made up with exchange rate weakness. As may be seen, the rand has been mostly undervalued since 1995 – the real rand has averaged about 90, or about 10% weaker than PPP on average and with a wide dispersion about the average.

The past performance of the real rand moreover suggests that theoretical PPP exchange rates are an unlikely outcome and not something exporters or importers should fear. Indeed they would be justified in assuming something of a permanent advantage in exporting – with rand prices for exports rising persistently faster than rand operating costs and vice versa. Implying a permanent competitive disadvantage for importers and their price offerings.

 

This history indicates that inflation differences cannot explain the direction the rand takes.  It is much more a case of (unpredictable) changes in the market determined exchange rates that drive inflation higher or sometimes lower and lead the widening or narrowing of inflation differences between SA and its trading partners.

 

What then drives the exchange value of the rand? It is surely not any strong tendency for exchange rates to revert to PPP? The answer is that capital flows to and from SA drive the exchange value of the rand – as they explain emerging market exchange rates generally. The rand mostly follows the direction taken by emerging market (EM) currencies vs the US dollar as we show blow. It is the limited extent to which the rand behaves independently of its peers vs the dollar that explains the specifically SA risks that can independently drive the dollar/rand. These are shown by the ratio of the dollar/rand to the US/EM basket.

 

As may be seen, when we compare the performance of the rand to a fixed weight basket of nine other EM exchange rates vs the dollar, the rand has been in very weak company since 2014. Though in better company after 2016 when EM currencies and the rand improved vs the US dollar. The rand, as may be seen, did weaken in a relative sense with the Zuma interventions in the Treasury, especially in late 2015 when he dismissed Finance Minister Nene. The positive reaction in the currency markets to the succession of Cyril Ramaphosa in late 2017 may also be identified by an improved rand/EM ratio. But despite the importance of these political events for South Africa it would appear that the predominant influence on the exchange value of the rand over the years have been global economic forces, common to many EM economies, rather than domestic politics and policy intentions.

Moreover the potentially helpful effect of a weaker, inflation-adjusted rand on SA exports have been overwhelmed by unfavourable price trends themselves. Especially of the US dollar prices of metals and minerals that make up such a large part of our exports. These price trends linked to global growth trends themselves help explain capital flows. Capital flows in when the outlook for the mining sector and the economy improves and vice versa when the outlook deteriorates and prices fall away

As we show in the chart below exports and imports, valued in US dollars, grew very strongly, by about three times, between 2002 and 2010. The prices SA exporters received in US dollars more than doubled over the same period, as is also shown. The price and volume trends since then have been in the reverse direction – until very recently. The super commodity price cycle came and then went and the exchange rates went inevitably in the same weaker direction.

Yet not all has been bad news for SA exporters, especially those supplying foreign tourists – for whom the undervalued rand has proved a great attraction. The travel statistics of the balance of payments show a dramatic improvement in recent years. Travel receipts from foreigners, measured in US dollars, have been well sustained as payments for foreign travel by South Africans have trailed away (see below).

SA receipts from travel by foreign visitors are now running at about a US$10bn rate that now compares quite well with the value added by the mining sector- also shown in dollars below.

Would it be unfair to say that the achievements of SA tourism – extra income, employment and taxes paid – owe something to the exchange rate and perhaps as much or more to the helpful absence of any Tourism Charter? Conventional property rights have been more than sufficient to the purpose of increased supplies. As they would be helpful to mining output, threatened as it has been by the Mining Charter. 30 August 2018

Of liras and rands

Moves in emerging market currencies like the rand and Turkish lira show that countries that depend on foreign capital need to play by the rules governing international trade and flows of capital

Emerging market (EM) currencies have been caught up in the political and now financial crisis confronting the Turkish economy and its leader. But some EM exchange rates have suffered more than others. The rand, alas, has been one of the worst performers, especially on Wednesday (15 August). It is a trend that continued yesterday morning. The Turkish lira has re-gained some ground against the still strong US dollar and significantly more against the weaker rand.

At its worst this month, on 13 August, the lira had fallen from 4.99 to 6.88 against the US dollar – a decline of 37%. That same day the rand was about 9% weaker against the US dollar since 1 August and so 21% up on the lira. As I write at mid-morning on 16 August, the lira is now stronger than it was, at 5.81 to the dollar while the rand has weakened to R14.511 (see below).

 

The rand has now lost about 4.6% of its beginning of August US dollar value. This is not good news for the SA economy. It means more inflation and less spending power for hard pressed households and firms. Hopefully it will not lead to higher interest rates, which would depress domestic demand further.

The Turkish and SA economies have something in common: a continuing dependence on foreign capital to fund expenditure. But that is where the current similarities end. The Turkish economy has experienced a boom (over 7% real GDP growth in 2017) led by rapidly rising private sector capex funded increasingly with short-term borrowed dollars. This growth, accompanied by rapidly rising inflation and a widening ratio of current account deficit and so capital inflows to GDP. Interest rates lagged well behind inflation, now running about 16%.

The contrast with a depressed SA economy could not be greater. Our private sector capex cycle is even more depressed than household spending. Inflation (especially at retail level) remains well below interest rates and the current account deficit has stabilised at about 3.5% of GDP. The borrowing SA does is mostly by government and its agencies and is predominantly undertaken in rands.

Foreign lenders, rather than local borrowers, are exposed to the risk of the rand weakening, for which they collect a wide risk spread – of the order of 6% more than US dollar yields. SA business savings (cash retained) runs at about the same rate as stagnant or declining capital expenditure. Our fiscal deficits and the ratio of government debt to GDP are wider than those of Turkey – and may be getting wider, according to Moody’s. This is not an opinion helpful to the rand or the cost of borrowing dollars for five years: currently running at 2.17% above US five year yields. Turkish debt in US dollars is offering an extra 4.88% for five years – even more junky than RSA debt.

So what went wrong with Turkish economy that was so encouraged with abundant inflows of short term loans until recently and that were withdrawn so abruptly? The answer is fairly obvious – it is the result of a serious disagreement with the US about the arrest of a US pastor. He has possibly been imprisoned as a bargaining chip for President Ergodan’s public enemy number 1, Fethullah Gulen, who lives in the US, whose followers are accused of fomenting a coup. And so many thousands of whom are languishing in jail.

This indicates very clearly that countries that depend on foreign capital need to play by the rules (US inspired or enforced) that govern international trade and flows of capital and legal practice. This surely applies also to SA. By proclaiming upon the ANC’s intentions to expropriate farming land without compensation – definitely against the rules, and given the turmoil in the markets – ANC chairman Gwede Mantashe did SA and its growth prospects enormous harm. As Minister of Mineral Resources he could however immediately undo the damage. That is by signaling reforms of the mining charter that made mining in SA properly investor and owner-friendly. 17 August 2018

Talking Turkey about the rand

How best to respond to rand weakness that has nothing much to do with SA

The SA economy has been subject to a new sharp burst of unwelcome rand weakness. Weakness that would appear to have little to do with events political or economic in SA itself. It has been a reaction to the shocks that have overwhelmed the Turkish lira. Weakness in other emerging market exchange rates has been part of the collateral damage.

The Turkish lira has lost 34.79% of its US dollar value since the July month end – from USD/TRY4.91 to USD/TRY6.96 by 14h00 on 13 August. The USD/ZAR was 13.27 on the morning of 1 August and was at 14.38 yesterday afternoon, a decline of 7.97%. But it should be recognised that the rand has been a marginal underperformer within the emerging market (EM) peer group. The JPMorgan EM currency benchmark, which includes the Chinese Yuan with a 11% weight, has lost 6.1 per cent of its USD value over the same period (see figures below where in the second, the relative to other EM currencies underperformance by the rand, shows up as a higher ratio).

 

 

A weaker rand leads to more inflation that depresses the spending power of households. It may also lead to higher interest rates, given the reaction function of the Reserve Bank. The Reserve Bank believes that higher inflation will lead to still more inflation expected and hence still more inflation as a self-fulfilling process. That is unless demand is suppressed even further with higher interest rates. This is described as the danger of so-called second round effects of inflation itself (for which incidentally there is little evidence, when demand is already so depressed). The typical SA business now has very limited power to raise prices, as has been revealed by little inflation at retail level. A still weaker rand is likely to further restrain operating margins and the willingness of SA business to invest in plant or people.

We have long argued that this represents a particularly baleful approach by the Reserve Bank to its responsibilities. We have recommended that the Reserve Bank not react to exchange rate shocks, over which they have little influence. Moreover, that raising interest rates can further depress demand without having any predictable influence on the exchange rate itself.

Indeed we have argued that slow growth itself weakens the case for investing in South Africa. Slow growth to which monetary policy can contribute adds investment risk without any predictable influence on inflation because the value of the rand is itself so unpredictable.

The best the Reserve Bank can do for the economy at times like this, when the rand is shocked weaker, is to say very little and do even less and wait for the shock to pass through – as it will in a year or so. The statement of the Deputy Governor, Daniel Mminele, made yesterday that “The South African Reserve Bank won’t intervene to prop up the rand unless the orderly functioning of markets is threatened” is to be welcomed.

The weaker rand, for whatever reason, discourages spending and weakens the case for investing in any company that derives much of its revenue from South African sources. Companies listed on the JSE that derive much of their sales offshore stand to benefit from higher revenues recorded in the weaker rand. These include the large global industrial plays that dominate the Industrial Index of the JSE by market value. Included in their ranks are Richemont, British American Tobacco and AB Inbev.

Even better placed to benefit from a weaker rand will be companies with revenues offshore but with costs incurred in rands. The increase in these rand costs of production may well lag behind the higher revenues being earned in rands, so adding to the operating margins enjoyed. Resource companies quoted on the JSE with SA operations fall into this category. Kumba and the platinum companies, as well as Sasol, are examples of businesses of this kind.

But the appeal of global and resource plays for investors will also depend on the prevailing state of global markets. Global strength will add to their value measured in USD and even more so when these stable or higher dollar values are translated into rands at a weaker rate of exchange. In such circumstances, when the rand weakens for SA specific reasons, rather than for adverse circumstances associated with a weaker global economy, the global and resource plays on the JSE have additional appeal.

The additional weakness of the rand, when compared to other EM currencies, may well have added to the appeal of JSE global and resource companies. The movements on the JSE on 13 August – at least up until mid-afternoon – do suggest that a degree of rand weakness for partly SA specific reasons- has been helpful for the rand values of the JSE global and resource plays. This is shown below. The global industrial plays and Naspers, another very important global play, have moved higher with JSE Resources. The SA plays have weakened as may also be seen and would have been predicted.

The news about the global economy may not have improved with the Turkish crisis. Nor however is the global economy greatly threatened by the state of the Turkish economy. The weakness of the Turkish Lira would appear to have much to do with the unsatisfactory state of Turkish politics. The risk is that Turkey is less willing to play by the rules of international diplomacy and business and may be isolated accordingly. A serious spat with the USA has led to economic sanctions being placed on leading Turkish politicians to which Turkey has responded with outrage rather than negotiations with the US.

The lesson for South Africa is to remain fully committed to global trading and financial conventions. To reinforce its attractions as an investment destination at times like this when the rand comes under pressure. This will help support the rand and the prospects for the SA economy. 14 August 2018

Naspers managers – how to play defence

There is a much better defence for the R1.6bn of employment benefits received recently by Naspers CEO Bob Van Dijk than that only R32m so far has been taken in cash, as Naspers has argued so extraordinarily. Try telling Steinhoff or Facebook shareholders that they have not in fact made a loss until they cash out, or for that matter inform Naspers shareholders who have held on to their shares that they paid R300 a share for in early 2010, now worth over R3000, that they are not now much better off.

The defence I would make on behalf of Naspers managers is that the difference between the market value of Naspers and the market value of its stake in Tencent and other listed entities has narrowed sharply, to the clear benefit of Naspers shareholders. This difference between the value Naspers and the value of its stake in Tencent has been widening almost continuously since 2014 and was as much as R800bn in early 2018. It has recently however halved to about R400bn.

 

I would argue that such an improved rating in the market is to the credit of the Naspers managers. Clearly they have very little ability to influence the market value of its stake in Tencent, by far its most important asset. Were they to have done nothing but hold their 30% plus stake in Tencent, their shareholders would now be R400bn better off.

But the Naspers managers have done much more than this. They have undertaken a very active and ambitiously expensive investment programme. They have invested the growing flow of dividends they receive from Tencent into this programme and have raised much extra equity and debt capital in order to fund their investments.

Given the difference between the value of Naspers and the value of its listed assets (overwhelmingly Tencent) it is clear that the market place has a very poor regard for the ability of this investment programme to add value for shareholders. That is to say, to earn returns from it that will exceed the returns shareholders could realise for themselves if the cash derived from Tencent were distributed to them. And the extra equity or debt capital had not been raised on their behalf. The share market expects Naspers to lose rather than add value with its investments and ongoing business activity. Hence the company is valued at much less than the sum of its parts. But the value gap has closed significantly recentl,y for which management deserves credit.

The difference between the market value of its assets net of debts and the market value of Naspers itself can be attributed to one of three essential forces and judgments of them. Firstly, and surely the most important influence, is the expected net present value (NPV) of its investment programme. That is the market’s negative estimate of the difference between what the (large) sum of capital expected to be allocated and the value to shareholders these investments (however funded) are expected to deliver. All such estimations will be calculations of expected present values – that is estimates of cash out and cash expected to flow back to the company in the future, with all such flows discounted with the appropriate discount rate or cost of capital to repreasent the opportunity cost of the investments.

Ideally the expected NPV would have a positive value. In the case of Naspers, given the R400bn value gap, the estimated NPV can be presumed to register a large negative number. Though this pessimism about the value of the investment programme may not be the only drag on the market value of Naspers. The expected cost to shareholders of maintaining the Naspers head office – including the benefits provided to its CEO in cash or in shares or in options on shares – also reduces the value of a Naspers share- as it does for all companies.

A further factor adding to the gap between the sum of parts valuation and the market value of a holding company might be differences between the book or directors’ value attached to unlisted investments by the holding company and the market’s perhaps lower estimate of their value. Listing the assets and/or unbundling or disposing of them may prove that the market had been underestimating their value, and so help to close the value gap.

All these value adding or destroying activities (including deciding how much to reward themselves) are the responsibility of the senior managers and the directors of Naspers. It would appear that, in the opinion of the market place, their recent efforts in these regards have been more rewarding for shareholders, some R400bn worth. It’s the result, perhaps, of a more disciplined approach to allocating fresh capital that the market place has appreciated. It may reflect the more favourable market reaction to a more predictable, less dilutive approach taken by managers to rewarding themselves with additional shares. And also perhaps by a greater apparent willingness to list and sell off subsidiaries capable of standing on their own two feet.

We would suggest to Naspers that incentives provided for managers in the future be based upon one critical performance measure: closing the gap between the sum of parts value of Naspers, that is its NAV and its market value. Shareholders would surely appreciate such an alignment of interests. 30 July 2018

 

 

Dangerous curves

The danger in the US is not rising interest rates themselves, but rises that surprise

US President Donald Trump, being the businessman he was (or is), woke up one recent morning worrying about interest rates and what the Fed might do to the US economy (or perhaps his real estate portfolio) with higher interest rates.

Being Trump, he immediately Tweeted his concerns to the world at large, so defying the convention that the Fed should be independent of political forces, causing predictable consternation. But with more reflection he might have noticed that the market place was doing the job for him: of actively restraining the upward march of interest rates expected in the future.

While short term rates, under the direct influence of the Fed, have been on the rise and are confidently expected to rise further over the next 12 months, the pace of further increases is expected to slow down to very gradual increases over the next three years. The current yield on a one-year US Treasury Bond is 2.42%. In a year’s time this yield is expected to be 2.87% but in three years’ time it is expected to be only a little higher, at 2.94%.

One can interpolate the expected rate of interest from the term structure of interest rates. Investing in a one year to maturity Treasury will yield 2.42%. A Treasury Bond with two years to run now offers little more, or 2.64%, and a three year Treasury Bond yields but 2.73%. An investor can secure 2.73% by committing to a three year investment, or alternatively invest for a year at 2.42% and then reinvest for a further year at what will be the one year rate in a year. The expected returns must therefore be very similar given the alternatives of investing for longer or shorter periods.

Given the alternative of investing for a longer period or a shorter period and then reinvesting the proceeds, the longer-term rates can be regarded as the (geometric – allowing for compounding of interest) average of the expected short term rates. The difference between the fixed yield on a two year bond and the fixed yield on a three year bond can be used to calculate the one year rate expected in three years’ time and so on for any one year period in the future. We have reported these expected one year rates above from a table provided by Bloomberg (The US Treasury Active Curve).

Thus the steeper the yield curve – the greater the difference between long and short term – the more short rates must be expected to rise. The flatter the yield curve – the smaller the difference between long and short rates – the smaller must be the expected increase in short rates. Should the yield curve turn negative, that is when short rates are above longer term rates, this means that short rates must be expected to decline in the future to provide average returns in line with the currently lower longer-term fixed rates.

Borrowers typically incur debts with extended repayment terms. So what is expected of interest rates (more than current interest rates) will influence current decisions to borrow and to spend. Such modest increases in the expected cost of servicing debts in the US is unlikely to be a deterrent to current borrowing and lending decisions undertaken by firms, households and banks or other suppliers of credit.

In the US, the gap between longer and shorter term interest has been narrowing sharply as we show below. Short-term rates have been rising much faster than long term rates – the yield curve has therefore flattened – giving rise to very modest further expected increases in short-term rates reported upon earlier. The difference between the fixed yield on a 10-year US Treasury Bond (2.93%) and a two-year bond (2.64%) is currently a mere 27 basis points (0.27 of a percentage point). The extra rewards for investing currently at a fixed rate for 30 years in a US Treasury Bond (3.05%) rather than 10 years is therefore a very scant 12 basis points. Clearly this reflects a very flat yield curve beyond two years and very limited expected increases in interest rates to come.

 

We therefore need to consider the causes as well as the effects of rising or falling interest rates. Short-term rates can be expected to rise with economic strength and the upswings in the business cycle and fall as economic activity slows down. A sharply positive yield curve implies faster growth and higher interest rates expected. And these higher interest rates can then be expected to slow down the pace of economic growth, hopefully to a rate of growth that can be sustained over the long term. A flat or negative yield implies slower growth to come and in turn lower interest rates to come; that is to help stimulate economic activity enough to enable the economy realise its long term growth potential without deflationary pressures.

The flattening of the US yield curve, while encouraging current spending by restraining the expected cost of debt service, may portend slower growth to come and therefore less reason for the Fed to raise short-term rates in the future and so act as the market expects it to act.

The danger to the US economy however does not come from higher or lower interest rates – provided that they behave as expected – and so move consistently with the expected state of the economy. If this were to happen, interest rates would have little real effect on borrowing, lending, spending and the economy. The danger is therefore not that interest rates may rise, but rather that they rise unexpectedly rapidly. This would disturb the economy and slow down growth unnecessarily rapidly. Trump might have noticed just how carefully the Fed has been to make its actions as predictable as possible, so aligning actual and expected interest rates. His and our concern as economy watchers should be about the danger of interest rate surprises – not interest rate levels. 26 July 2018

 

Is pessimism about the SA economy overdone?

The SA economy: will it gain relief from a stronger rand and less inflation?

The SA economy (no surprise here) continues to move mostly sideways. Growth in economic activity is perhaps still slightly positive but remains subdued. Two hard numbers are now available for the June 2018 month end: for new vehicle sales and the real supply of cash – the notes in issue adjusted for prices that we combine to form our Hard Number Index (HNI) of economic activity. Because it is up to date, the HNI can be regarded as a leading indicator of economic activity that is still to be reported upon.

Its progress to date is shown below. It shows a falling off in activity in 2016 and a more recent stability at lower levels. It is compared to the Reserve Bank’s business cycle indicator based on a larger number of time series that continued to move higher in 2016-17 but has also levelled off in recent months. The problem with the Reserve Bank series is that it is only available up to the March month end for which GDP data is also available.

 

We show the growth in the HNI and the Reserve Bank cycle below with an extrapolation 12 months ahead. The HNI cycle suggests growth of about 1% in 2019 while the Reserve Bank cycle is pointing lower.

 

 

It is striking how well the real cash cycle (included in the HNI) can help predict the cycle of real retail sales. Retail sales volumes gathered momentum in late 2017 stimulated it would seem by an increasing supply of real cash. This momentum has however slowed more recently as inflation turned higher in the face of a weaker rand. Retail sales have been reported only to April 2018.

The key to any revival in domestic spending will be less SA inflation. And inflation will, as always, take much of its momentum from the exchange rate. The recent weakness in the rand has been a body blow for the SA consumer. It has little to do with events in SA and much to do with slower growth expected in emerging market economies, especially China. Where the dollar goes, driven higher by relatively stronger growth and higher interest rate prospects in the US, emerging market currencies, including the rand, move in the opposite direction.

The best hope for the rand and for the SA consumer is that the pessimism about emerging market growth has been overdone. If so some recovery in EM exchange rates can be expected – and that the rand will appreciate in line with capital flowing in rather than out of emerging markets. Some of these forces have been at work this week, helping the rand recover some of its losses and improving the outlook for inflation in SA. It may also if sustained even lead to lower interest rates in SA – essential if any cyclical recovery is to be had.

The importance of inflation for the business cycle is captured in this correlation table of key growth rates in SA. Inflation may be seen to be negatively correlated (and significantly so) with the growth in retail volumes and new vehicle sales. It is even more correlated (0.85) with the growth in the supply of real cash – that is in turn highly correlated with the growth in retail activity. And as may be seen, the growth in retail activity is also strongly correlated with growth the Reserve Bank’s cyclical indicator (Resbank) (0.80 correlated):

 

The problem for South Africa and the Reserve Bank that targets inflation, is that so little of the inflation experienced in SA is under its control. The exchange rate takes its own course – driven by global sentiment – so pushing prices higher or lower, that in turn drives spending lower or higher. Interest rates that may rise with more inflation and then fall with less inflation make monetary policy pro-cyclical rather than counter cyclical. 11 July 2018

Why China is so important to SA

The outlook for the SA economy depends on China

Emerging markets (EMs) and their currencies enjoyed a strong comeback in 2017, after years of underperformance when compared to the S&P 500. The JSE All Share Index kept pace with the S&P 500 in 2017 in US dollars. An EM benchmark-tracking stock would have returned over 40% in the 12 months to January 2018 while the S&P 500 delivered an impressive 26%, less than the 28% delivered to the dollar investor in a JSE tracker.

Investor enthusiasm for equity markets in general and for EM securities and currencies in particular however ended abruptly in January 2018 and waned further in April. The EM equity drawdowns since January have been depressingly large. The MSCI EM Index and the JSE have now lost about the same 16.5% of their end January US dollar values, while the S&P 500 was down by a mere 4% at June month-end.

 

The carnage was widespread across the EM universe. The SA component of the EM Index, with a weight of 6.5%, has been an averagely poor EM performer in 2018, as shown in the figure below. Turkey is the worst performer in 2018, down nearly 30% in US dollars in the year to June. The All China component of the EM benchmark, with a large weight of 31.7%, has lost about 12% over the same period, with much of this loss suffered since March, including a large 7% decline in June. The Brazil Index has suffered a heavy 27% decline in its US dollar value in the past quarter.

 

 

The capital that had flooded into EMs and their currencies in 2017 has rushed out even more rapidly, presumably back to the US, so driving the US dollar higher and other currencies, especially emerging market currencies (including the rand) weaker. The rand has traded mostly in line with its peers in 2018, though it has lost ground to them recently.

 

 

It should also be recognised that the similar flows of dividends and earnings from the JSE and EMs over many years, in US dollars shown in the figure above, is not some co-incidence. It is the result of the similar economic performance of the companies represented in the two indices.

The JSE has been well representative of the EM universe taken as a whole, when measured in US dollars. Naspers, with a 20% weight in the JSE All Share Index and a close to 30% weight in the SA component of the EM benchmark, is largely a Chinese IT company. Naspers is riding on the coattails of its subsidiary Tencent, and this helps account the similar behaviour of the respective indices.

In the long run, it is past performance reflected by earnings, dividends and return on capital invested that drives equity valuations, not sentiment. Reported dividends, discounted by prevailing interest rates, do a very good fundamental job in explaining the level of an equity index over time. In the short run, expectations of future performance (sentiment), will move markets one way or another, as they have moved equity markets in the past.

The sell-off in EM equity markets is not explained by their recent performance, which has benefited from synchronised global growth. It reflects uncertainty about the prospective growth in dividends and earnings and therefore global growth rates to come. We may hope that pessimism is being overdone.

The impact of the performance of companies that operate in China, on the outcomes for EMs generally (including SA), cannot be overestimated. Not only is the direct weight of China in the equity and currency indices a large one, but China is an important trading partner for all other emerging market economies.

Therefore the ability of China to maintain its growth and trading relationships successfully and manage its exchange rate predictably and responsibly will be a vital contributor to the prospects for all EMs. Realised global growth, including growth in the US, Europe and China, will determine the outcomes for EM equity and bond markets and exchange rates. The performance of the global economy and the companies dependent upon it are as good or better than they were a year ago.

The performance of the SA economy would be assisted by a stronger rand and damaged by a weaker rand that moves inflation, interest rates and spending faster or slower. Exchange rate and inflation trends in SA are bound to follow the direction taken in all EM economies, especially China. We must hope that renewed respect for growth in China will make this happen. Our immediate economic future depends more on what happens in Beijing than in Pretoria. 5 July 2018

The mining charter- its true purpose

Version published in Business Day 23rd June 2018

 

There is much to be gained from a thriving mining sector. Its promise for growing incomes is as great- perhaps greater than any other sector of the SA economy- given the opportunity. There would be extra income to be earned on the mines and rigs and additional taxes paid by many more workers. There would be more jobs gained and increased incomes earned supplying goods and services to additional mining enterprises.

 

Exports would grow and the balance of payments would benefit from inflows of permanent mining capital. The exchange value of the rand would become less vulnerable to outflows of portfolio capital – to the advantage of all businesses and their customers in our economy.

 

The recipe to stimulate rapid growth in mining activity is simple It is to make the rules and regulations applied to the owners of mining companies at least as attractive as anywhere in the world.. Applied to capital that realistically can only be expected from well-established, well-diversified global mining companies with the appetite for taking on mining risks and the balance sheets and borrowing capacity to do so.

 

And wouldn’t it be a game changer for exploration activity were ownership of the rights to the potential value below the surface be transferred from the state to the owner of the land above. Including to communities with traditional rights to graze or plant land that could be far more valuable than they can possibly know before exploration. Rights ceded in exchange for a significant betterment tax should ownership be transferred to a mining company received on transfer from the buyer.

 

However the newly proposed and amended mining charter informs us very clearly that this more competitive landscape for mining is not about to happen. The intention is to put onerous constraints on the powers of owners to manage a mine as best they might. Owners will be required to contract with suppliers, directors and managers and partners with preferred legal status rather than chosen on merit. It imposes further controls on how they have to share the benefits of ownership and the capital they will have put at risk. With partners not necessarily of their own choosing or on terms chosen by them should the mine prove successful.

 

They will be required to pay taxes and royalties and declare dividends based on cash flows, not on normal accounting principles. For fear – not doubt legitimate – that taxable income might be minimised by transfer pricing – reducing revenues and raising costs. Or by exaggerating the interest paid on loans provided by holding companies residing in no tax or low tax jurisdictions. Interest payments (expensed for tax purposes) that are intentionally more like capital repaid.

 

Eliminating tax avoidance and applying the complex regulations will take a costly to taxpayers and owners army of competent officials on both sides of the fence to hopefully ensure compliance.

 

It would be much more sensible if mining companies in SA were not subject to any income taxes at all. This would eliminate all attempts to minimise tax payments and protect the tax base. All income distributed by companies as employment benefits, rents, interest dividends or capital repayments can instead be taxed in the hands of the receivers- reported by the company making the payments. Compliance becomes much less onerous and the case for investing much improved – to the great advantage of mining output.

 

It should be very clear therefore that the intentions of the mining charter are not to stimulate mining output and employment. Its primary purpose is to redistribute its benefits. The mining charter is symptomatic of this approach to economic development in South Africa. Redistribution at the expense of potential growth. The consequential sacrifice of growth, so balefully apparent, should not be regarded as unintended.

Looking at the hard numbers

Our review of the state of the SA economy indicates a modest but welcome pick-up in economic activity. This was driven by lower levels of inflation particularly at retail level where even some lower prices helped spur spending by households.

Unfortunately the suddenly weak rand will reverse inflation trends and slow down spending all over again. As Mike Tyson said, everybody has a plan in the ring until they get hit in the face. Consumers have had to take another punch in the form of a weaker rand that will soon show up at the stores. They will depend on the Reserve Bank rolling with the punch: leaving interest rates unchanged to soften the blow of higher prices. The real danger is that the Bank will do the opposite and raise rates, doing nothing for the rand and only depressing spending further.

We have updated our index of the current state of the SA economy with data released for May 2018. We call it the Hard Number Index (HNI) because it relies on two hard numbers that are provided very close to the month end. The data we rely upon and combine to form our Index are new vehicle sales, provided by the National Association of Vehicle Manufacturers (NAAMSA) and the cash (notes) in circulation issued by the Reserve Bank. The note issue is a liability on the Reserve Bank balance sheet, reported soon after each month end.

These are hard numbers and not the result of sample surveys that inevitably take time to collect and estimate. A further advantage in the May releases is that they are less likely to be influenced by the Easter effect that comes at different times in March or April, and so always makes seasonal adjustments very difficult to claculate accurately for those months. The seasons of the year do make a difference to vehicle sales and even more so on demands for cash that tend to rise as consumers intend to spend more on holidays, especially at Easter and Christmas.

The current state of the economy, according to the HNI, as of the May month end, is shown in the chart below (Figure 1). The HNI is compared with the Reserve Bank Business Cycle Indicator that has only been updated to February 2018 (an especially out of date measure given that disappointing first quarter GDP estimates have already been released). The disappoinment was that in the first quarter GDP, declined at a 2.2% annual rate. the economy will have moved on – hopefully forward.

The HNI may be regarded as a leading indicator of the SA business cycle and has served very well in this regard as may be seen in figures one and two. However the two series parted company to a degree after 2016. The HNI has pointed to lower levels of activity than the Reserve Bank Indicator. However in late 2017 the HNI stabilised and picked up some momentum. These trends, when extrapolated, suggest that the economy will stabilise at its current pedestrian pace for the next 12 months.

We show the second derivative of the business cycle in figure 2, the growth in the economic indicators. As may be seen the growth in the Reserve Bank activity indicator has been slow but persistently slow in 2017 and 2018. The HNI has recently turned from negative to positive growth.

The components of the HNI have shown a different direction. Supply (and demand) for cash, adjusted for prices, has shown a welcome upward direction, and is forecast to be sustained over the next 12 months. However vehicle sales, while they have shown a modest recovery in 2017, are pointing marginally lower: down from their current annual rate of about 546 000 new passenger cars sold, to a marginally lower rate of sales of 535 000 cars forecast to be sold this time next year. See figures 3 and 4.

The pick-up in the real cash cycle was assisted by less inflation in 2017. Figure 5 compares the growth in the value of notes issued (at face value) with the slower inflation adjusted rate of growth.

The increase in prices at retail level has been unusually lower than headline inflation in recent months. In March 2018, retail inflation was running at 1.6% compared to headline inflation that month of 3.8% that increased to 4.5% in April. This pick up in what are spending intentions, hence demands for cash, would be faster if prices were measured at retail rather than headline inflation.

Lower levels of retail inflation in 2017 owed much to the end of the drought, the recovery of the rand and the weakness of spending at retail level that gave retailers very little pricing power. The consequently lower inflation rates at retail level – sometimes deflation – undoubtedly helped stimulate extra spending at retail level in late 2017. The real money cycle is almost always closely linked to the cycle of retail sales volumes as we show in figure 6.

As we show in figure 7, measuring the increases in the real supply of cash using retail prices rather than the CPI accords better with the faster pace of retail sales volumes in recent months.

It may also be seen in figure 8 that the forecast for both is for slower growth over the next 12 months. Both the growth rates in real cash and real retail sales are forecast to slow towards a three per cent per annum pace by early 2019.

The recent weakness in the rand will not be helpful in this regard. It will mean more inflation and so more pressure on the spending power of households. We may hope that the Reserve Bank will not be adding to this depressing effect on spending by raising interest rates and also doing nothing to help the rand while only slowing down economic growth further. 13 June 2018

Keep Cities Connected

A successful city is pro- rich and pro-poor. It budgets for growth to serve all who live there.

Cities bring people together in what becomes very crowded space. They come together to make better connections: helping employees connect with employers and helping customers and clients to connect with the suppliers of important services. The physicians are helped to connect with their essential patients. Lawyers, accountants, consultants of great variety, can connect with their clients who rely on their skills and experience for which they willingly pay and make practice possible. Restaurateurs, with their chefs and waitrons, connect the many who they feed and amuse. And artists of all kinds connect with the audiences they may only find in the large city, to mutual delight.

Cities offer valuable choices to all their citizens, rich and poor and those in between, that are not available outside. We complement each other and we combine together to make as sure as we can that our crowded space can serve our purpose to connect. And so we establish and maintain a grid of one kind or another to deliver essential services – water, energy, roads and other forms of transport – more cost effectively than if we somehow had to do it for ourselves, off grid so to speak.

The essential purpose of local government is to maintain and improve the quality of the vital connections by providing the grid efficiently. Elected civic leaders should compete on this basis for the votes that elect them to office. Successful cities will attract migrants from outside to join in and share in the success. They manage the growth well enough to preserve the advantages of city life for all who choose to live there, including the poor who cannot or will not pay enough to be connected to the grid. Yet it is essential to keep them well connected, for the sake of the city and all including the well-off who live nearby. Making these connections possible is not charity – it is good sense.

And the South African city would surely do better if it were given fuller responsibility for policing, schooling and securing the bulk supplies of water and energy for their grids – that has proved not nearly secure or capable enough when provided by the central government or by proxy provincial governments.

City success will be revealed in the value attached to the buildings of the city, the houses, offices, factories and warehouses that make up the city. More accurately it is revealed in the value of the land under the buildings and the vacant land that can be put to more valuable uses over time. Development and re-development increase the supply of buildings, helping hold down land values and the rentals attached to them. They help keep more people flowing in rather than out of the city.

There is a virtuous civic circle to be sustained. The better the city delivers, the more its land will be worth and the more revenue it can collect to maintain and improve its connections and grid. And failure to deliver soon shows up in deteriorating property values and increasing financial strain, harming all, perhaps especially the poor.

Cape Town has been the success story of SA cities, judged by the flow of migrants to it (rich and poor) and by the growing value of real estate that is so supportive of its balance sheet and income. The city borrows very little and its net interest bill, after investment income, is very small compared to its revenue and expenditure.

Yet the city budget proposes to fund the significant capital expenditure needed to guarantee sufficient water with permanently higher tariffs. Lower tariffs would serve the city much better by helping to preserve on-grid demands. It would also generate enough extra revenue to pay the extra interest and repay the loans. This would be possible with more borrowing that in no way would threaten financial stability. Rather it will help by improving the growth potential of the city that depends upon its grid – especially so when competitively priced.

Making sense of the earnings and dividend cycle

The JSE earnings and dividend cycles – a May 2018 update. What the market may be telling us

The growth in reported JSE All Share Index earnings per share appear to have peaked. The year on year growth in earnings have fallen back from the 30% rate realised in late 2017 to the current rate of 10% realised by the May 2018 month end. Index dividends per JSE share were growing at a 20% annual rate at the May month end. A time series forecast of both earnings and dividends suggests that their growth will slow down to less than 5% in the next 12 months.

 

The resource companies listed on the JSE have grown their earnings and dividends more rapidly than the other sectors over the past year – off a lower base. Resource earnings in January 2017 were 34% down on earnings the year before, while All Share Index earnings were 15% lower in January 2017 than in January 2016.

We show some of the trends in sectoral earnings growth rates in figure 2 below. Industrial Index earnings were trending higher at a 19% a year rate by May 2018, Banks at a 7% rate while the General Retail Index earnings per share were declining at a 3% rate. Resource earnings were trending at a 34% rate in May 2018 – though well down on the peaks of 80% growth realiised in late 2017.

 

When calculating an earnings cycle the base effects- what happened a year before – is important for current growth. It is much easier (more difficult) to realise high (low) rates of growth when growth was subdued (or buoyant) in the same month the year before. Perhaps it is more helpful when interpreting the performance of listed companies and the values attached to them to examine the level of rather reported earnings.

Perhaps even more illuminating about the state of play on the JSE would be to examine the level of earnings or dividends in constant prices, as we do in figure 3 below.

 

 

Real dividends have outpaced real earnings – they are now close to peak real dividends of 2014, while real earnings are still well below real earnings realised before the global financial crisis and recessions of 2009. This is surely a very sobering statistic- it shows that the real earnings front of the JSE have moved backwards since 2006.

The movement of the JSE since 2000 therefore appears to be better explained by dividends than earnings. Were it not for the stellar performance of Naspers, a play on Chinese internet firm Tencent the JSE All Share Index, in which Naspers has comprised an ever more important weight, would have fallen back.

It would appear that JSE-listed companies have performed better than the SA economy. They have accordingly returned relatively more cash to shareholders, presumably for want of investment opportunities. A corollary is that had they invested more of their cash in South Africa, the economy would have performed better. However it is unrealistic to expect capital expenditure of business enterprises to lead household spending (accounting for 60% of all spending in SA) that has remained consistently depressed by the standards of the past.

In figure 3 above we compare real JSE Index earnings and dividends with the real value of the JSE. The All Share Index seems better explained by the upward trend in real dividends than the sideways move in real earnings. We can confirm this by regression analysis. An equation that links the nominal value of the JSE All Share Index with the contemporaneous level of reported dividends and short term interest rates provides a good statistical fit. Indeed the current level of the JSE is almost precisely as would be predicted by this valuation model. When we add the rand value of emerging markets (EM) generally as an additional explanation of the level of the JSE – we get an even better fit. The R squared rises from 94% to 99% with all the explanatory variables attaining highly significant and plausible values.

 

This provides for the conclusion that the JSE may be slightly undervalued by the standards of the past, given the level of the EM benchmark that the JSE has lagged behind. Perhaps giving a degree of safety to the JSE at current levels. Yet as before, the strength of the JSE will depend upon the flow of dividends, interest rates, the value of the rand and the level of the EM benchmark that the JSE always tracks closely.

We could add as a further important influence the value of Information Technology stocks worldwide that Naspers will follow closely. Perhaps it is easier to be confident about the supportive role to be played by the EM benchmarks and the role of IT within them, than the benefits a stronger rand and accompanying lower interest rates could bring to the flow of dividends and earnings from the JSE All Share Index. The strong dollar and therefore the weaker rand and the more inflation that will follow it has become a headwind for the SA economy and the companies dependent on it. 5 June 2018

Italy, Europe and beyond

Renewed volatility in bond and currency markets. Learning the lessons of monetary history.

Europe (especially Italy, but also Spain) rather than emerging markets (especially Turkey) has become the new focus of attention in financial markets. Bond yields in Italy and Spain have increased sharply in recent days. The two year Italian bond yield is up from zero a few days ago to the current 2.82% while the spread between 10 year Italian bonds and German Bund yields have risen from 1% to 2.87% in three days.

Rising US interest rates were the proximate cause of some earlier distress in emerging bond markets and now in the past few days have reversed course. From a recent high of 3.12% the yield on the key 10-year US Treasury Bond has fallen back to 2.83%. RSA bond yields have also receded in line with Treasury bond yields. Yesterday they were at 8.59% and about 28 basis points lower than their recent high of 8.87% on 21 May. However the risk spread with US Treasuries has widened marginally, from recent lows.

 

While long term interest rates in the US have fallen back, the US dollar has strengthened further against the euro and most currencies, including emerging market (EM) currencies like the rand. German Bunds are another safe haven and the 10-year Bund yield has also declined, from 0.64% earlier this month to the current 0.33%. This has allowed the spread between Treasuries and Bunds to widen further – to 2.6%, helping to add strength to the US dollar.

 

It should be appreciated that RSA bonds have held up well under increased pressure from US rates and now also some European interest rates. In figure 4 we compare RSA dollar denominated five year (Yankee) bond yields with those of five year dollar bonds issued Turkey and Brazil. While all the yields on these dollar denominated bonds have risen and also very recently have fallen back, the RSAs have performed relatively well.

 

The US dollar went through an extended period of weakness against its developed market peers and EM currencies between mid-2016 and the first quarter of 2018, after which the dollar gained renewed strength. Dollar strength can be a particular strength to EM currencies and the recent episode of dollar strength has proved no exception in this regard.

As we show below in figures 5 and 6, the rand performed significantly better than the EM Currency Index from December 2017 and has recently performed in line with the average EM currency vs the US dollar and much better than the Argentine peso and the Turkish lira recently. In figure 6 the declining ratio EM/ZAR indicates relative rand strength.

 

We may hope that the rand will not be subject to any crisis of confidence. So far so good. But were the rand to come under similarly severe pressure as has the Turkish lira, one would hope that the Reserve Bank would avoid the vain and expensive attempts to defend exchange rates that Argentina and Turkey have made. Throwing limited forex reserves and much higher short term interest rates at the problem can only do further harm to the real economy – and very little to stem an outflow of capital. As has been the latest case with Turkey and Argentina.

It was the mistake the Governor of the Reserve Bank Chris Stals made in 1998 when failing to defend the rand during that emerging market crisis. The best way to deal with a run on a currency – caused by exposure to a suddenly stronger dollar – is to ignore it. That is to let the exchange rate absorb the shock and live with the (temporary) consequences for inflation. Defending the currency provides speculators with a one way bet against the central bank attempting to defend the indefensible. It is much better to let them bet against each other and let the market find its own equilibrium. The renewed volatility in Europe, we may also hope, will continue to hold down US and RSA interest rates – and deflect attention from emerging markets. 30 May 2018

Recent Research

Much of my recent research output has been published in the Journal of Applied Corporate Finance, now published for Columbia Business School by Wiley. (See references below) Some earlier versions of this work may be found on the Blog- but copyright prevents me from posting the published versions.

Global Trade – Hostage to the Volatile US Dollar, Journal of Applied Corporate Finance, Volume 30, Number 1, Winter 2018

The Beliefs of Central Bankers about Inflation and the Business Cycle—and Some Reasons to Question the Faith, Journal of Applied Corporate Finance; Volume 28, Number 1, Winter 2016

A South African Success Story; Excellence in the  Corporate use of capital and its Social Benefits with David Holland, Journal of Applied Corporate Finance, Volume 26, Number 2, Spring 2014

2013 Nobel Prize Revisited: Do Shiller’s Models Really Have Predictive Power? with Christopher Holdsworth, Journal of Applied Corporate Finance, Volume 26 Number 2 Spring 2014

Lessons from the Global Financial Crisis (Or Why Capital Structure Is Too Important to Be Left to Regulation) with Christopher Holdsworth, Journal of Applied Corporate Finance, Volume 22, Number 3, Summer 2010

Podcast: The case for looking beyond the large caps quoted on the JSE

Find below a link to a podcast with Barry Shamley, Portfolio Manager. Investec Wealth and Investment  discuss the case for looking beyond the large caps quoted on the JSE . This is the first trail of a series of podcasts that I will be conducting and posting on the website.

https://investecam.kuluvalley.com/view/kTdb9BFjT4H#/