Category: Global Financial Markets

The odds on a US recession in the next twelve months have receded in the light of the continued willingness of US households to spend more- despite much higher interest rates and reductions in the supply of money and bank credit.  Spending on goods and food services rose by 0.7% in September on top of a robust increase of 0.8% in August. The annual increase in retail sales is 3.7% and the increase over the past three months is running at an annual equivalent of 8% p.a. Prices at retail level are falling. They stimulate demand but they also devalue the inventories held to satisfy demand. Prices have their supply and demand causes. They also have their effects on demand- and supply. Lower prices stimulate demand and incomes are now growing faster than prices.

All that is holding up the US CPI – now 3.7% up on a year ago – are house prices – and what are imputed as owners’ equivalent rent. That is at what the owners could earn if they rented their homes  They are up 7% on a year before. They have a huge weight in the CPI – over 25% – and if excluded from the CPI – would have headline inflation running in the US below the 2% target. Cash rentals account for a further 7% of the US CPI. By contrast food eaten at home carries a weight of only 8.6% in the CPI and food eaten out is 4.8% of the US CPI Index. SA also includes owners’ equivalent rent in its CPI with a weight of 12.99% and actual rentals account for only 3.5% of the index. Both rental series in SA are up by a below average 2.6% on a year before. The headline inflation rate in SA was 5.4% in September.

Owners equivalent rent is a very different animal to other prices. Higher implicit rentals based on the improved value of an owner’s home are not the usual drag on spending. The extra wealth in homes, as would all increases in household wealth, more valuable  pension plans, more valuable share portfolios, etc. will encourage more, not less spending. The boom in US house prices post Covid has had much to do with the ability and willingness of US households to spend more and help push up prices generally. Average house prices in the US are now falling under pressure form much higher mortgage rates and house price inflation to date will be falling away rapidly as will owner’s equivalent rentals. Thus helping to reduce headline inflation.

The question investors are asking about both inflation (falling) and the state of the economy ( holding up) is what will it all mean for interest rates. The stronger the economy the lesser the pressure on the Fed to lower short rates. And the greater will be the pressure on long term rates in the US. The key ten-year Treasury Bond is now offering 4.9% p.a. reaching a 16 year high.  In the share market what is expected to be gained on the swings of earnings may be lost on the roundabouts of higher interest rates, used to discount future earnings. But if inflation is subdued, any visible weakness in the economy, can be followed immediately by lower interest rates. This thought will be consoling to investors.

The attention paid to GDP by investors is fully justified. Where GDP goes so will the earnings reported by companies. Their correlation since 1970 is (R=0.97) Though helpfully to shareholders in recent years earnings have been running well ahead of earnings indicating widening profit margins from the IT giants. GDP , on a quarter-to-quarter basis, is a highly volatile series. Though growth in earnings is much more volatile.

US GDP and S&P 500 Earnings. Current values. (1970=100)

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

The underlying trend in GDP and earnings will never be obvious. To make sense of their momentum, to recognize some persistent cycle, the data has to be smoothed and compared to a year before. Thus we will know only in a year or more whether the US economy has escaped a recession. It is not recessions that move markets, only expected recessions do so. And the jury will always remain out.

GDP and S&P 500 Earnings Growth Quarter to Quarter % Annualised.

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

Politicians propose spending and revenue plans – but the bond market disposes and not always kindly. In the UK plans to combine tax reforms that only work gradually with an immediate massive increase in subsidizing the consumption of energy with borrowed money was apparently a step too far for lenders to HMG and the governing party.  

Yet long term interest rates in the US and Europe were also rising rapidly. In Germany Ten-year money yielding negative rates in January had increased to 2% p.a. by October. US   US Treasury Bonds that offered 1% p.a. in early January 2022 now yield over 4% p.a. and indeed offer more interest in US dollars than the much battered 10 year gilts.

Long Term (10 Year) Interest Rates in the US, UK and Germany. Daily Data to October 25th

Source; Bloomberg and Investec Wealth and Investment

Blaming all this wealth destruction on a potentially profligate UK government is further complicated by the fact that not only were nominal interest rates on the rise – more so were real rates. Real ten-year yields in the US now deliver a yield of close to 2% p.a. – they offered a negative 1% in January 2022. They now exceed the returns on a UK ten year inflation linker that has increased from a negative -3% in early 2022 to the current much higher 0% p.a. Equivalent Inflation protected German Bunds also now offer about 0% p.a. – compared to -2% early in 2022.

Real Inflation Protected 10 year Bond Yields

Source; Bloomberg and Investec Wealth and Investment

It is the real cost of funding developed government debt that have been driven much higher this year -not more inflation expected. Expectations of more inflation to come would have found expression in higher interest rates for inflation exposed lenders and not necessarily in higher real yields. Expected inflation measured as the difference in nominal and real yields for equivalent bonds has not increased this year in the US,UK or Europe. Inflation expected in the in the UK over the next ten years has remained about 4% p.a. this year, higher than inflation expected in Germany and the US that have varied about the 2.5% p.a. rate.

Source; Bloomberg and Investec Wealth and Investment

It is not easy to explain why real interest rates in the developed world have risen so significantly this year. Additional competing demands for capital to fund capital expenditure that might ordinarily help explain higher costs of capital and rewards for savers have been notably absent. An alternative explanation is that greater risks to lenders has forced yields higher and bond prices lower to compensate lenders for assuming extra risks – that more risk demands higher returns and forces bond values lower. The risks posed by central banks struggling to cope with inflation have made bond markets far more volatile. The negative correlation between the increases in US bond market volatility Index and the Global Bond Index is strikingly large this year. The link between increased volatility and lower bond and equity valuations seems highly relevant. If it is the risk of central bank policy errors that have driven up required returns it may be hoped that a more predictable Fed will be accompanied by lower government bond yields.

US Bond market volatility and the Global Bond Market Index

Source; Bloomberg and Investec Wealth and Investment

Thanks to the inflation panicking Fed, government bonds have proved anything but a safe haven for pension and retirement funds in the developed world. But in high bond yield, high risk South Africa, RSA  bonds have performed much better than equities for pension and retirement funds. The increase in long bond yields have been offset by much higher initial yields, leaving the bond market total return indexes in rands unchanged year to date while the JSE Swix Index has cost investors about 4% this year. RSA 10 year nominal yields started 2022 at 9.73% and have risen to 11.5% while the real yield on the inflation protected bonds are up from 3.63% to an elevated 4.6% p.a.

JSE Bond and Equity, Total Return Indexes January 2022=100. Daily Data

Source; Bloomberg and Investec Wealth and Investment

These high yields mean very expensive debt for SA taxpayers and offer high risk premiums to compensate for what has been a seriously deteriorating fiscal stance since 2010. The MTBS just presented represents a serious attempt to regain fiscal sustainability. If the plans are realized the debt to GDP ratios will decline to levels well below that of the US or UK. A primary budget surplus – revenues exceeding all but interest expenses – has come surprisingly in sight. Achieved this would surely represent fiscal sustainability and help bring down RSA yields closer to those of the developed market borrowers.

The financial market reactions to the US CPI news on 13^th September provides an extreme example of how surprising news plays out in the day-to-day movements of share prices, interest and exchange rates. The key global equity benchmark, the S&P 500 lost nearly 5% of its opening value after the announcement that inflation in August had been slightly higher than expected. Implying that the Fed that sets short term interest rates in the US would be more aggressive in its anti-inflationary resolve, making a recession inevitable and more severe.

By the recent trends in GDP the US economy was already in recession despite a fully employed labour force. Recession without rising un-employment would have been unimaginable before the Covid lockdowns. The Fed failed to imagine the inflation that would follow the stimulus it, and the US Treasury, had provided to the post covid economy and this has become the problem for investors and speculators required to anticipate what the Fed will be doing to protect the value of the assets entrusted to them.

Yet it should be recognized that the US CPI Index in fact is no longer rising – average prices fell marginally in August as it had done the month before. But perhaps not as much as had been expected. The headline inflation rate- the rate most noticed by the households and the politicians had reached a peak of 9.1% in June and has since fallen to 8.3% as the CPI moved sideways. The increase in prices over the past three months was lower – 5.3% p.a.

Inflation in the US. Headline % p.a.  Monthly % and three monthly % p.a.

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

Yet even if the average prices faced by consumers stabilized at current levels until June 2023 the headline rate of inflation would remain elevated- at 6% p.a. by year end and could return to zero only by June 2023. One wonders just how realistic are the Fed’s plans to reduce inflation rates in shorter order. Patience is called for

The outlook for Inflation if the US CPI stabilized at current levels.

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

The true surprise in the inflation print was the trend in prices that exclude volatile food and energy prices. It was these supply side shocks to prices that had helped to drive the index higher and they are reversing sharply. However, the inflation of prices, excluding food and energy remains elevated. They are now 6% ahead of price a year ago. The Fed is known to focus on core rather than headline inflation.

Headline and “Core” inflation in the US

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

The largest weight in the US CPI Index is given to the costs of Shelter. They account for over 32% of the Index of which 28% is attributed to the implied rentals owner occupiers pay to themselves. The equivalent weight in the SA CPI is much lower – 13%. Where house prices go – so do rents – and the implicit costs – rather the rewards – of home ownership – and inflation. But surely the reactions of those who own more valuable homes are very different to those who rent?  Higher explicit rentals drain household budgets – and lead to less spent on other goods and services- and are resented accordingly as are all price increases. Higher implicit owner-occupied rentals do the opposite. They are welcomed and lead to more spending and borrowing. House price inflation in the US has been very rapid until recently- and rents may be catching up- meaning higher than otherwise inflation rates.

Prices always reflect a mix of demand and supply side forces. But ever higher prices- inflation – cannot perpetuate itself unless accompanied by continuous increases in demand. It is the impact of higher prices on the willingness and ability of households to spend more that is already weighing on the US economy. Incomes are barely keeping up with inflation. And the supply of money (bank deposits) and bank lending in the US has stopped growing further constrains spending.  If inflation is caused by too much money chasing too few goods the US is already well on the way to permanently lower inflation. The danger is that the Fed does not recognize this in good time  – and as the market place fears.

US Money Growth (M2 seasonally adjusted)

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

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

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

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

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

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

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

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

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

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

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

If we are to take seriously the signals from global bond markets- as we should- savers should expect a decade or more of very low returns. The decline in bond yields due to mature in 10 years or more accelerated dramatically during and after the Global Financial Crisis (GFC) (see below)

Less inflation expected is part of the explanation for these lower yields. But it is more than lower expected inflation at work. Yields on inflation protected securities – those that add realized inflation to a semi-annual payment – have declined to rates below zero. Before the GFC the US offered savers up to a risk free 3% p.a. return for 10 years, after inflation. The equivalent real yield today is a negative one of (-0.11% p.a). (see below)

Real Yields in the US 10 year Inflation Linked Bonds ( TIPS)

Source; Bloomberg and Investec Wealth and Investment

These low risk-free rates also mean that firms investing the capital of their shareholders have very low investment hurdles to clear to justify their investment decisions. A 6% internal rate of return would be enough to satisfy the average shareholder given the competition from fixed interest. Equity returns might also be expected to gravitate to these lower levels.

Another way to describe these capital market realities is that the rate at which the value of pension and retirement plans can be expected to compound is expected to be at a much slower one than they have  been in the recent past. Savers will need to save significantly more of their incomes to realise the same post-retirement benefits.

The past decade has in fact been particularly good for global pension funds.  In the ten years after 2010 the global equity index  returned 10.5% p.a. on average while a 60-40 blend of global equities and global bonds returned an average 6.4% p.a. with less risk. US equities would have served investors even better, realizing average returns of 13.4% p.a,  well ahead of US inflation of 1.8% p.a. over the period.

Total portfolio returns 2010-2019 (January 2010 =100)

Source; Bloomberg and Investec Wealth and Investment

Why then has global capital become so abundant and cheap over recent years? Many would think that Quantitative Easing  (QE) the creation of money on a vast scale by the global central bankers, has driven up asset prices and depressed expected returns. An additional three and more trillion US dollars-worth has been added to the stock of cash since the GFC.

Global Money Creation

Source; Bloomberg and Investec Wealth and Investment

But almost all of this cash has been added to the cash reserves of banks- and not exchanged for financial securities or used to supply credit to businesses that could have stimulated extra spending. Bank credit growth has remained muted in the US and even more muted in Europe and Japan.

The supply of global savings has in fact held up rather better than the demand for them, helped by an extraordinary increase in the gross savings to GDP ratio in Germany. These savings have increased from about 22% of GDP in 2000 to 30% of GDP in 2018- while the investment ratio has remained at around 22% of GDP. Government budget surpluses have contributed to this surplus of savings in Germany. For advanced economies the share of government expenditure in GDP has fallen from 42% in 2010 to 38% in 2018 while the share of revenue has remained stable at about a lower 35% of GDP. This could be described as global fiscal austerity  -post the confidence sapping GFC.

Germany – Gross Savings and Investment to GDP ratios

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

IMF – All Advanced Economies – Ratio of Government Expenditure and Revenue to GDP

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

Perhaps depressing the demand for capital may be the changing nature of business investment. Production of goods and more so of the services that command a growing share of GDP, may well have become capital light.  Investment in R&D may not be counted as capital at all. Nor is intangible capital as easily leveraged.

Lower interest rates have their causes -they also have their effects. They are very likely to encourage more spending – by governments and firms and households. Mr.Trump does not practice fiscal austerity. Boris Johnson also appears eager to spend and borrow more. It would be surprising if firms and many more governments did not respond to the incentive to borrow and spend more and compete more actively for capital. Permanently low interest rates and returns and low inflation may be expected – but they are not inevitable. The cure for low interest rates (high asset prices) might well be low interest rates.

Shorter version published in Business Day, Friday 15^th November

The market value of any business will surely  be determined by its economic performance. The most commonly applied and highly accessible proxy for performance are the earnings reported by its accountants and auditors. Cash dividends paid might be a superior indicator given how the definition of bottom line earnings has changed over time. Cash flows may be better still but are less readily available.

Robert Shiller provides 148 years and 1776 months of US stock market data. US S&P Index values, index earnings and dividends per share have followed a very similar path. The correlation between monthly prices, earnings and dividends, all up nearly 20,000 times since 1871, is close to one. [1]

Share Prices, Earnings and Dividends per Share (1871=100) Log Scale

Source; Shiller Data, Investec Wealth and Investment

The P/E ratio for the S&P has averaged 15.76 over the long period with a low of 5 in 1917 and a high of 124 after earnings had collapsed in May 2009 while the Index held up to a degree. And dividends held up much better than earnings.

Source; Shiller Data, Investec Wealth and Investment

If we run a regression equation relating the Index to earnings or dividends per share the residual of these equations (that what is not explained by the model) has a strong tendency to trend to zero- given enough time. Or in other words the price-earnings ratios have tended to revert to their long-term average of 15.8  over time but with variable lags.

The higher the P/E multiple the faster earnings must be expected to grow when they to make up for the low initial yield E/P and vice versa. Expected earnings drive current market prices. Surprisingly higher or lower revealed earnings will tend to move prices in the opposite direction. Earnings may catch up with prices or prices follow earnings. The move to any long-term equilibrium can come from either  direction, with advantage or disadvantage to shareholders.

Therefore be warned. Knowing that a PE ratio is above or below a long term average is not going to make you rich or poor speculating in the share market. The correlation of starting PE and returns realized over the next twelve months is close to zero.

The starting PE appears to become more helpful as a guide to investors when returns realized over an extended period are compared to it.  High starting PE’s are associated with generally lower returns and vice versa over three or five year subsequent windows. When we relate starting PE’s 36 or 60 periods before with returns realized three or five years afterwards over the entire period we do get a statistically supportive result. Choosing the right entry point to the market and waiting patiently for the outcomes would have been generally helpful to investors.

Examining the relationship between prices and earnings in the US does reveal some extreme cases. In the late forties and late seventies the market would have appeared as very cheap. But these were not good times for the US. The US was fighting and possibly losing a war in Korea. In the mid and late seventies the US was subject to stagflation- rapidly rising prices and slow growth. Also very un-promising times for shareholders.

However normality returned to the great advantage of those who did not share the prevailing pessimism and stayed in the market.  Between 1950 and 1953 the S&P PE crept up from seven to eleven times helping the total returns on the Index to average 22% p.a. In early 1978 the P/E was 8 times. Over the next three years the S&P delivered over 11% p.a on average as the US got its inflation under control.

By contrast in early 2000 at the height of IT optimism the S&P was trading at an extreme 33 times. Over the subsequent three years the S&P delivered negative twelve returns of -8.7% p.a. The IT bubble was only apparent after the event when expected earnings proved highly elusive.

S&P earnings collapsed during the GFC of 2008-09. From about $80 per index share in 2006 to less than $7 in early 2009. This sent the P/E multiple to 124 even as the Index fell sharply to a value of 757 by March 2009.  According to earnings the S&P was greatly overvalued. According to dividends that held up much better through the crisis, the market appeared as deeply undervalued. The dividend buy signal proved the right one as the economy recovered (unexpectedly) with lots of (unexpected) help from the Fed and the Treasury. The S&P Index since those dark days has that provided returns that have compounded on average at of over 13% p.a.

What is very different about the share market today in the US are the extraordinarily low interest rates- both long and short rates – that have surely helped drive the market higher as competition for shares from the money and bond markets fell away. What may appear as a demanding PE of about 22 times becomes much more understandable given abnormally low interest rates. Is this the permanently new normal for interest rates. Or will interest rates mean revert? And what is normal? Only time will tell.

[1] http://www.econ.yale.edu/~shiller/data.htm

Brian Kantor 3^rd April 2019

The state of the US economy gets very close attention from investors in the stock market. The market moved sharply lower in late December on fears of a US slowdown. More recently it has bounced back strongly as the outlook became less threatening as the Fed came to share some of the market anxieties and indicated it would not now be raising short term interest rates.

This raises a question. Could you make a fortune buying or selling shares accurately forecasting US GDP growth rates over the next few years? The answer is a highly qualified yes.  It would take very surprising – to others – very fast growth to deliver well above average returns in the stock market or, as surprising to all but yourself, very slow growth to deliver unusually poor returns.

Such phases of very fast or very slow growth, that presumably could confound the forecasters and investors, have in fact been very rare events. Since 1967 there have only been seven recessions in the US.  There have been about the same number of so-called technical recessions – defined as two or more consecutive quarters when the real GDP declined.

I count 20 quarters since 1967 when growth in the US was less than 1% per annum. Average annual returns on the S&P over these low growth quarters was a negative 11.8%. The worst quarter for shareholders was Q1 2009 when the market was down 47% on the same quarter a year before. However slow growth was not always bad news for investors. In Q2 1981, when growth fell at a 2.9% rate, the S&P 500 Index was up by 19.4% on a year before. Yet the statistical relationship between growth and returns over these low growth quarters was a generally very weak one with a simple positive correlation of only 0.07- not nearly enough  regularity to rely upon as an investment policy.

Slow growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

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

I have also identified 98 quarters when growth in the US was a strong over 3% p.a. On average over these quarters the annual returns averaged an impressive 14.7% p.a. But this high average came with a great deal of variability around this average. The best annual return of 46.7% came in Q3 1982 and the worst -17.7% in Q4 1973. The statistical relationship between strong quarterly growth and annual returns is also very weak with a correlation close to zero.

Fast growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns

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

The statistical relationship between quarterly growth and returns over the entire period 1967-2018 is altogether a very weak one. Linear regression equations that explain annual index returns with quarterly growth rates have very little explanatory power. Using smoother annual GDP growth rates in the equation do little better. R squares of no more than 0.16 indicate that there is much more than growth determining annual or even more variable quarterly returns. Generally accurate forecasts of GDP growth are simply not going to cut the returns mustard.

The problem for any reliance on patterns of past performance is that the markets are always forward looking. The well-considered, forecasts of the economy and of the companies dependent on it, will already have helped determine the current value of any company and of any Index average of them. Hence only economic surprises- indeed only large surprises in the GDP numbers can move the market.  But anticipating these surprises is largely beyond the capabilities of the collective of forecasters – who will employ similar methods evaluating the widely available data that anticipates and makes up the GDP itself. Any surprises are going to surprise the forecasters as much as the market

However as recent developments on the share market indicate- down and up with not so much the GDP itself – but with expectations of it- what matters over any short period of time in the markets is not so much the forecasts themselves, but the confidence held in such forecasts. These will never be in a constant state. Any additional uncertainty about the state of the economy (less confidence in the forecasts) adds volatility to the market. That is wider daily moves in the market up and down. And when the market moves through a wider daily range share prices will move in the opposite direction in a statistically very consistent way.

The impact of risk (changes in the VIX) on S&P returns 2016-2019; Daily Data. Correlation (-0.74)

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

Such changes in sentiment are not easily forecast. If they could be reliably anticipated this would undoubtedly be wealth enhancing to the forecaster or rather the sage. They are however best ignored by long term investors in favour of as good a forecast of the economy over the long run, as you can hope to make or receive.

 New York, November 21^st 2018

It is Thanksgiving this Thursday in the US – a truly inter-denominational holiday when Americans of all beliefs, secular and religious, give thanks for being American – as well they should.

This is a particularly important week for American retailers. They do not need not to be reminded of the competitive forces that threaten their established ways of doing business. Nor do investors who puzzle over the business models that can bring retail success or failure.

The day after thanksgiving is known as Black Friday, when sales and the profit margins on them will hopefully turn their cumulative bottom lines from red to black. It has been black Friday all week and month and advertised to extend well into December. Presumably, to bring sales forward, that is to make retailers less dependent on the last few trading days of the year.

The competition as we all know has become increasingly internet based  from distributors of product near and far, and yet only a day or two away. E commerce sales have grown by over three times since 2010 while total retail sales including E commerce transaction are 50%up since 2010.  Total US retail sales, excluding food service are currently over $440b and E commerce sales are over $120b (see figures 1 below)

Fig 1; US Retail and E Commerce sales (2010=100) Current prices

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

The growth in E Commerce sales appears to have stabilised at about 10% per annum. (see figure 1)

Fig 2; Annual growth in total retail and E commerce sales in the US (current prices)

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

Retail sales of all kinds have been growing strongly – though the growth cycle may have peaked- as may have GDP growth- leading perhaps to a more cautious Fed. How slowly growth rates will fall off the peak is the essential question for the Fed as well as Fed watchers and answers to which are moving the stock and bond markets. (see figure 3)

Fig.3: The US retail growth cycle

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

The inportance of on-line trade is conspicuous in the flow of cardboard boxes of all sizes that overflow the parcel room of our apartment building. Including boxes of fresh food from neighbouring supermarkets. The neighbourhood stores of all kinds are under huge threat from the distant competition that competes on highly transparent prices on easily searched for goods on offer as well as convenient delivery.  As much is obvious from the many retail premises on ground level now standing vacant on the affluent upper East side of New York. The conveniently located service establishments survive, even flourish, while the local clothing store goes out of business because they lack the scale (and traffic both real and on the web) to offer a credible offering.

But spare a thought for SA retailers for whom sales volumes in December are much more important than they are for US retailers. November sales for US retailers – helped by Thanksgiving promotions – are significantly more buoyant than December volumes. According to my calculations of seasonal effects since 2010, US retail sales in December are now running at only 90 per cent of the average month while November sales are well above average, at 116% of the average month.  Retail sales in the US however include motor vehicle and gasoline sales that are excluded from the SA statistics. December sales in SA are as much as 137% above the average month helped as they are by summer holiday business as well as Christmas gifts. (See figure 4 below that shows the different seasonal pattern of sales in the US and SA)

Fig.4; The seasonal pattern of retail sales in SA and the US (2015=100)

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

In the black Friday for SA retailers thus comes later than it does in the US.  And perhaps makes the case for adding promotions in November to smooth the sales cycle and reduce the stress of running a retail business. They may also hope that the Reserve Bank is not the grinch that spoils Christmas- though the answer to this will come on Thanksgiving.

Things became more active on the global interest rate front last week, led by an advance of US yields. The key 10-year US Treasury yield was below 3% earlier in the week, but was at 3.12% onThursday before pulling back to 3.05% on Friday (it was ar 3.07% this morning). Not only have yields moved higher, but the spread between US Treasury and German Bund yields have widened further, to 2.5%.

This may be thought to be enough of a carry (enough US dollar weakness priced in, that is) to attract funds to the US and restrain the upward march in US rates and the US dollar. The US dollar has gained not only against the euro and other developed market currencies, it has gained against emerging market (EM) currencies, like the rand, as is usual when the dollar rises against the euro, yen and sterling. A strong dollar is a particular threat to EM currencies. The JP Morgan EM exchange rate index is now at 66.1 while the the US vs developed market currencies index (DXY) is trading at 93.87.

The rand has been among the better EM performers in the face of the advancing dollar as we show in figures 4 and 5 below (all rates in these charts up to 18 May – though the rand did come under motre pressure than other EM currencies on Friday). The ratio of the USD/ZAR to our own construct of eight other EM currencies and their exchange rates with the US dollar, improved significantly between November 2017 and March 2018 and the USD/ZAR has maintained its rating since then. The story of the rand has once more become a story of the US dollar rather than of South African politics. And seems very likely to remain so.

This ratio was 0.917 on the Monday 14 May – it weakened to 0.934 by the Friday. The story of the rand has once more become a story of the US dollar rather than of South African politics, and seems very likely to remain so.

Interest rates in the US have risen (and the dollar has strengthened) because the acceleration in US growth has been confirmed by recent labour market trends and by the strength in retail sales volumes reported last week. The state of economies outside the US, in Europe and even in emerging markets however, appears less certain. Global growth appears, at least for now, less synchronised – making for fewer correlated movements in short- and long-term interest rates.

It is of interest to note that US shorter term interest rates have been rising faster than long rates. The spread between the 10 and two-year Treasury bond yields have narrowed further. This flatter yield curve indicates that the US may be getting closer to the end of the cycle of rising short rates. Or in other words the GDP growth rates that justify higher short rates may well have peaked and are slowing down- which if so will cause short rates to decline from higher levels in the not too distant future. (See figure 6 below)

It is of particular importance to note that the recent increase in US yields have not been a response to more inflation expected. Inflation-protected real yields offered by the Treasury (TIPS) have increased in line with vanilla bond yields. The spread between nominal and real 10-year treasury yields has remained largely unchanged around 2.2%. That is to say, the bond market continues to expect inflation to remain at the 2% level for the next 10 years. So what is driving nominal yields higher is more growth, rather than the expectation of more inflation, thus representing interest rate developments that are less dangerous to equity valuations than if it were only inflationary expectations that were driving yields higher. The more GDP (and so earnings growth) expected, the more it improves the numerator of any present value calculation, perhaps enough to compensate for higher discount rates.

South African bond yields, as well as the USD/ZAR, have moved higher in response to US yields. However the spread between RSA and Treasury yields has remained largely unchanged. The spread, which indicates by how much the rand is expected to weaken against the US dollar over the years, narrowed sharply after November 2017. In other words, as the political news out of South Africa improved. Figure 8 below shows the SA exchange rate risks and the more favourable trends in RSA and US long bond yields, and in exchange rate expectations since January 2017.

Conclusion: how best to react to dollar strength

A stronger US dollar is seldom good news for the growth prospects of emerging market economies, including South Africa. It puts upward pressure on prices and downward pressure on spending. It furthermore raises the danger of monetary policy errors of the kind Argentina has been making: raising interest rates to fight exchange rate weakness and the (temporarily) higher prices that follow. This then slows down economic growth further, without helping and maybe even harming the exchange rate. Slower growth drives capital away and interest rates, become less attractive when a still weaker exchange rate is expected.

The wise policy approach is to ignore of exchange rate weakness that is caused by dollar strength and not by excessive domestic spending. South Africa made such monetary policy errors during the last period of US dollar strength between 2011 and 2016. We may hope that such errors are not repeated. We may hope even that this period of dollar and US strength is a temporary one – and that growth outside the US resumes an upward trajectory. 21 May 2018

What the world needs now is more than love- there is also too little spending. [1]More of that would also be very welcome. Particularly welcome would be extra spending by business enterprises on capital equipment. This lack of demand, combined with a rising global savings rate, has created an abundance of saving that explains the exceptionally low interest rate rewards for saving in developed economies. This glut of savings followed the global financial crisis (GFC) of 2008-09 that made managers more fearful to spend or lend while additional regulations restricted their freedom to do so.

The story of the global glut of savings can be told in a few pictures provided by the World Bank shown below. When will then consider how the bond market in the US may be indicating some incipient revival of the animal spirits of US corporations. Encouraged, as they attest, by lower tax rates and much more sympathetic regulators.

Figure 1 charts gross global savings as a per cent of gross global incomes. (GNI) As may be seen share of savings of income has been rising steadily over the years. The GFC hit savings even harder than incomes (upon which savings depend) but since then savings have made an ever larger claim on incomes (26% in 2015). The global savings rate was only about 21% of incomes in the fast growing and higher interest rate world of the mid-nineties. It has been on a generally upward trend since, as may be seen.

Gross savings – (savings before amortisation of capital that turns gross into net savings) are dominated by the cash retained by corporations. Households may save – but other households over the same period may be large borrowers and reduce the net contribution households make to the capital market. And most governments are net borrowers- borrowing even more than they spend on infrastructure that is counted as saving.

Fig 1; Gross savings as per cent of Gross Global Income  

As we show below in figure 2, the rate at which real capital – plant and infrastructure – has been accumulated has been trending in very much the opposite lower direction. There was a brief surge in the rate of capital formation in 2005 – a boom year for the global economy – but this was not sustained and was but 24% of global incomes in 2016- compared to a higher global savings rate of 26%.

Fig.2; Gross Capital Formation (% of GDP)

Source; World Bank

In the case of South Africa, with a lower gross savings rate of less than 18% of GDP, the cash retained by the corporate sector (including state owned enterprises) accounts for more than 100% of all gross savings. The household sector’s net contribution to gross savings flows is barely positive and the government sector is a net dis-saver. We show the trends in the SA savings rate below. The profits from the gold booms of the seventies and early eighties were responsible for the very high savings rates then.

Fig 3; South Africa – Gross Savings Rate

Source; World Bank

South Africa cannot realistically hope to raise its savings rate significantly. It can however hope to raise the rate at which capital expenditure is undertaken. That is by reducing the risks of investing in SA- and growing faster and attracting the savings to fund more rapid growth. That would be freely available from the large pool of global savings anxiously seeking better returns- given the right incentives and protections to do so. There is, as indicated, no global shortage of capital – only of attractive investment opportunities that SA could be offering.

The current rate of capital formation currently in SA is only slightly higher than the low savings rate – hence the small net inflows of foreign capital. The difference between any nation’s gross savings and capital formation is approximately equal to the net capital inflow and so the current account deficit on the balance of payments. The item that balances the current account deficit (exports-imports +debt service) – is the change in forex reserves- usually a comparatively small number.

South Africa could do with much faster growth that would encourage more capital formation and attract the foreign savings to fund this growth. And higher corporate incomes would mean more corporate savings. It is slow growth that is at the core of SA’s economic issues. Not the lack of savings. If we grew faster both the current account deficit and the capital inflows would be larger and the rate of capital formation higher. And a larger capital stock would bring more employment and higher incomes for a more productive labour force.

The US despite a relatively low and fairly stable savings rate (currently also around 18% of GNI as in South Africa) is, given the scale of its economy, still a large saver on the global stage. Though the US economy is the largest by far drawer on the global capital market to fund its spending as we show below in figure 8. While the US has been saving absolutely more recently, Chinese savings have now far overtaken US savings in absolute magnitude. Germany is another large saver, adding significantly to global savings in recent years, as we show below.

 Fig. 4; Global Savings Rates

Source; World Bank

Fig.5; Gross savings (current US dollars) by economy

Source; World Bank

The Chinese are not only the largest contributor to global savings, saving an extraordinary 45% of their GNI – a rate that as may be seen has been declining from above 50%- they are also undertaking by far the largest share of global capital formation. They created plant and equipment – real capital – worth over USD 5 trillion in 2016 or at a rate equivalent to 45% of GNI, similar to the investment rate- meaning that most of the Chinese savings were utilised domestically.

Fig.6; China Gross Capital Formation (% GDP)

Source; World Bank

But this raises a very important issue for the Chinese. Given the rate at which they save and invest in real capital the realised growth in Chinese incomes must be regarded as disappointingly poor- even when about a 7 per cent p.a rate. It suggests that much of the capital formed is still unproductively utilised. The full discipline of western style capital markets is surely something still to be introduced to China to improve returns on savings. But for all the relative inefficiency of Chines capital, the sheer volume of Chinese capital formation has made it the dominant force in the market for minerals and metals that are used to create  capital goods.

Fig.7; Gross capital formation by economy – current US dollars

Source; World Bank

In figure 8 below we show how The US dominates the demand side of the flows through global capital market- and the thrifty Europeans –  the supply side. As may be seen these trends that made US economic actors the dominant utilisers of global capital are predominatly a post 2000 development.

It is these capital flows that drive the US dollar exchange rate – and by implication all other exchange rates. Trade flows react to exchange rates- rather than the other way round. This is also the case for SA. With one important difference- foreign trade for the US economy is equivalent to about 25% of GDP. In SA imports and exports – valued at unpredictable exchange rates are equal to about 50% of GDP.

Fig. 8, Net Financial Flows from Europe and to the US. Current US dollars

Source; World Bank

The flows of savings and flows into the US have not only moved the dollar they have moved interest rates. Perhaps the best measure of the global rewards for saving are found in the direction of the real rates of interest offered by an inflation linked bond issued by the US Treasury. Such a bond may be regarded as free of default as well as inflation risk. The risks of inflation are reflected in the yield on a vanilla bond. In the figure 9 below we compare the yield on a 10 Year US Treasury Bond and its inflation protected alternative with the same duration. As may be seen the nominal and real yields have both trended lower. The vanilla treasury bond was offering over 5% p.a in 2005- now the yield for a ten year loan provided the US is about 2.7% p.a. Real yields were over 2%. p.a. in 2005-06. They are now about a half of one per cent p.a. – after a period of negative returns in 2012-2013.

More important these yields have been rising in 2018 indicating some small degree of greater demands for capital. The real and nominal yields however remain very low by historic standards as will be appreciated. Normality – that is any sustained higher global growth rates, must mean much  higher real yields. Higher nominal yields will also depend on how much inflation comes to be added to real yields.

Fig. 9; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2005- 2018)

Source; Bloomberg and Investec Wealth and Investment

Fig. 10; Nominal and Real 10 Year US Treasury Bond Yields (Daily Data 2018)

Source; Bloomberg and Investec Wealth and Investment

In figure 11 below we show the difference between these nominal and real interest rates. These differences represent the extra compensation bond investors receive for taking on inflation risk. It may be regarded as a highly objective measure of inflationary expectations. The more inflation expected the wider must be the spread between nominal and real yields. As may be seen- excluding the impact of the GFC this spread or inflation expected has remained between two and three per cent per annum. It is important to recognise that these inflationary expectations remain very subdued despite a recent increase. Equity investors as well as bond investors must hope that inflation expectations remain subdued enough to hold down nominal interest rates even as real yields rise to reflect a stronger global economy and a revival of capital formation. Low inflation with faster growth is an especially favourable scenario for equity markets.

Fig.11; Inflation compensation in the US Treasury Bond Market – spread between nominal and real 10 year US Treasury Bond Yields

Source; Bloomberg and Investec Wealth and Investment

[1] With acknowledgement to Burt Bacharach

The success of any business enterprise is measured by the return realised on the capital entrusted to it. The managers of an enterprise will rationally direct the capital provided them to particular business purposes in the expectation of a return on the capital invested that exceeds its opportunity cost, that is greater than the expected return from the next best alternative project with similar risks of success or failure. The more risk of failure, the greater must be the required (breakeven) return.

Measuring the internal rates of return delivered by an operating enterprise in a consistent way over any short period of time, for example a year or six months, has its own accounting for performance complications. The fullness of time, or until the venture is sold or liquidated, may be necessary for calculating how well the owners have done with their capital. However calculating the risks of failure of any potential project is much more a matter of judgement and sound process, than any precise measurement.

The only returns that can be measured with accuracy are those realised for investors in listed and well-traded companies. Returns come explicitly in the form of capital gains or losses and dividends or capital repayments received. And risks to potential returns are measured by the variability of these (monthly) returns over time that hopefully have a consistent enough pattern. A consistency furthermore that identifies the returns from a company as more or less risky compared to the pattern of average returns realized on the stock market. These measures can then form the basis of a required risk-adjusted return for a company or an investor to aim at.

These so-called betas that compare returns on individual shares to market returns as above or below averagely risky may in fact be quite unstable variables when measured over different time periods. Furthermore, these equations that relate company returns to market returns may or may not explain a great deal of past realised returns. The alpha of the total return equation that reveals company specific influences on total returns may account for much of realised returns.

This may be as well when judging the competence of the managers deciding and executing on projects. If the share market returns are mostly alpha (under the control of manager) and not the result of market wide developments over which managers have no influence, then determining the contribution of managers to realised returns becomes a consistent process.

Those buying a share from a willing seller are mostly gaining a share in the established assets and liabilities of an operating company – a share that the seller is willingly giving up – at a price that satisfies both. They are not providing extra capital for the firm to employ.

By establishing a price for a share they are however providing information about the market value of the company’s operations and so by implication the terms on which the company could raise further share or debt capital, should they wish to do so to supplement the company’s own savings to be invested in ongoing projects. The additional capital invested by operating companies will mostly be funded through cash retained by the firm, that is from additional savings provided by established shareholders.

The secondary share market transactions, through their influence on share prices, converts the internal rates of return realised by and expected of an operating company, into expected market returns. The superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company. The higher (lower) the share price the lower (higher) must be the expected returns for any given operating outcomes.

In this way through share price action, higher costs of entry into the investment opportunity, companies and their managers that are expected to generate way above average returns on the capital they invest in on-going operations and projects, may in reality only provide market-related average returns to share owners over any reporting period, say the next year or two. The further implication of these market expectations, incorporated into share prices, is that only a surprisingly good or disappointing operating results will move the market. The expected will already be reflected be in the price of a share or loan.

The implications of these expectations and their influence on share market prices and share market returns for managers and their rewards, provided by shareholders, seems obvious. Managers should be rewarded for their ability to realise or exceed the required internally generated returns on capital invested: charged to exceed targets for internal rates of return that are set presumably and consistently by a board of directors, acting in the interest of their shareholders.

Better still, targets set for managers that are made public and well understood and can be defended when exceeded and managers who are then rewarded accordingly. By contrast, share market returns that anticipate good or poor performance, cannot reveal how well or poorly operating managers have done with capital entrusted to them. Rewarding operating managers on the basis of how their shares performed is not a good method. Excellent companies that are expected to maintain their excellence and perform as expected to very high standards may only generate average returns. And poor management can wrongly benefit from above normal returns if expectations and share prices are set low enough. The correct basis for recording the value of managers to their shareholders is to recognise as accurately as possible, the realised internal rates of return on the shareholders capital they have employed.

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds – can however be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro or PSG or a Naspers, are endowed with permanent capital by original shareholders that cannot be recalled. This allows them to invest capital in operating companies for the long run. They, the managers of the holding company, when allocating capital to one or other purpose, must expect that the managers of these operating companies they invest in are capable of realising above average (internal) returns on the capital they invest. If indeed this proves so, they must hope that the share market comes to share this optimism and prices the holding company shares accordingly, to reflect the increased value of the assets it owns. Other things being equal, the greater the market value of their investments the greater will be the market value of the holding company.

But other things may nor remain the same. The market place is always a hard task master. Past performance, even good investment management performance, may only be a partial guide to expected performance. The capabilities of the holding companies’ managers to add value by the additional investment decisions they are expected to make today and tomorrow – not only the investments they made in the past – will also be reflected in the value attached to their shares.

These can stand at a discount or at a premium to the market value of the assets they own. The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect this pessimism about the expected value of their future investment decisions.

A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns. It is a market reproach that the managers of holding companies should always attempt to overcome, by making better investment decisions. And by exercising better management of their portfolios, including converting unlisted assets into potentially more valuable listed assets and also by indicating a willingness to unbundle successful listed assets to shareholders when these investments have matured. And be rewarded appropriately when they succeed in doing so.

21 December 2017

*Published in Business Day on 4 August 2017 (Published version available here)

Offshore diversification by SA firms is not necessarily the best way for investors to diversify their risks.

South African business leaders are demonstrating a heightened taste for expansion offshore. They are borrowing more locally and abroad to fund this growth. The reasons for doing so seem obvious enough. The stagnant SA economy now offers them minimal growth opportunities, yet they are likely to be well rewarded for growing earnings. Clearly such growth would be helpful to managers – is it as likely to be helpful to their shareholders?

It all depends on how much of their capital or debt incurred on their behalf is employed to pursue earnings growth. Unless the extra cash generated by expansion abroad or domestically can be confidently expected to provide a cash return in excess of the opportunity cost of the extra cash invested (cash in for expected cash out, all properly discounted to the present with proper allowance for the maintenance and replacement of the assets acquired) the investment should not be made. One wonders how many of the offshore acquisitions by SA companies offshore can confidently offer cost-of-capital-beating returns for their SA shareholders?

Why then the near flood of such acquisition activity?  Every director acting as the custodian of the capital of shareholders should know that growing earnings or earnings per share may not be helpful to shareholders, if too much capital has been expended to realise growth in earnings.  If managers are incentivised to grow earnings regardless of the extra capital employed to do so, they should not be surprised when managers seek growth wherever it can be found, regardless of how much it costs and whether or not it destroys wealth for shareholders. The golden rule of finance is always relevant: positive net present value (NPV) strategies are worthy of consideration but negative NPV strategies should be declined, especially if they are being made for “strategic reasons” (when an investment is made for “strategic reasons” it often means that there are no “financial reasons” for pursuing it).

A further benefit to managers from expansion offshore will come in the form of a more diversified flow of earnings when these include earnings generated independently of their SA operations. Full exposure to SA risk may threaten the survival of a business and so their own employment prospects. Shareholders however may have no need for managers to diversify their risks. They diversify their portfolios by holding small stakes in a large number of companies. The more specialised and efficient the companies they are able to invest in, the better. Conglomeration in principle comes at a price – that of the cost of a head office or holding company discount. Executives who diversify earnings on behalf of their shareholders are not doing them a favour. Shareholders can do it themselves at a fraction of the cost, e.g., no expensive investment bankers are required, and they can exit when they wish by simply selling assets in their portfolio.

South African shareholders, especially private shareholders, have enjoyed much greater freedom in recent years to invest directly in companies listed offshore. The case for their SA managers investing offshore on their behalf as part of a diversification strategy is therefore a weak one.

SA institutional portfolios subject to a 25% limit to their offshore holdings may have a stronger case for JSE-listed companies investing offshore on their behalf. Indeed, the case for what are essentially offshore companies having a listing on the JSE, primary or secondary listings, is predicated on this constraint on their asset allocations. These companies, with minimal exposure to the SA economy, can raise capital on the JSE on superior terms to those available to them elsewhere. Or, to put it alternatively, they can benefit from a higher share price (in US dollars, on the JSE) by catering to the SA institutional investor. For the private SA investor able to invest abroad, essentially without limit, it makes little sense to pay any premium for access to offshore earnings, dividends or the capital appreciation provided by a JSE listing. The private investor can diversify directly, without exchange control constraints, by investing in the most promising of companies listed offshore.

All this is not to suggest that SA companies and their managers cannot succeed offshore. Some exceptional managers have created a lot of wealth for their SA shareholders by doing so. Rather it is to argue that such attempts should be made on their own strict investment merits; that is, they offer a return (cash in/cash out) that exceeds the risk-adjusted returns their shareholders could hope to achieve independently. Chasing earnings growth regardless of properly measured returns on the capital at risk, or because it offers diversification, is not nearly a good enough reason to go offshore. Without such good reason and given the lack of growth opportunities in SA onshore, it would be better to return excess cash (excess capital) to their SA shareholders by paying dividends or buying back shares or debt. Let shareholders decide for themselves how they wish to diversify their risks.

*David Holland is from Fractal Value Advisors