Category: SA Economy

Grist for the Bears

Doug Short has attracted enormous attention to his website http://www.dshort.com/ with his “Four Bad Bear Market Analysis” (shown below and updated to Friday 28 August by its originator). The natural bears took great satisfaction from the apparently severe regularity of past bear markets, especially that of the crash of 1929. The problem for the bear lovers, as may be seen in the accompanying diagrams is that the relationship, especially with the bad bear of 1929-32, appears to have broken down in the face of the rally in stock markets that began in March 2009. The recent recovery appears by now to have extended for too long and too far to be identified as a bear market rally or a bear trap.

Source: dshort.com

If at first you don’t succeed….

This break in the data led the inventive Doug Short (his real name assuredly) to realign the starting point for the analysis and the apparent regularities from the top of the markets before they collapsed to the following bottom, when the markets began their recovery. This new version of the analysis provided by Mr Short that demonstrates that the bottom after the crash of 1929 “failed” eleven months later, no doubt provided renewed comfort to the bears. However as may also be seen the recent rally has also by now taken the Dow beyond its gains of 1929. A new attempt to find regularities in the stock market patterns may (bulls hope) soon be called for.

Source: dshort.com

Bull and bear markets are only revealed with hindsight

The reality is that bear and bull markets are only identified after the event. Daily share market movements are a random walk and recent events prove no exception to this as we show below. A bear market is one when the random drift proves, well after the events, to have been generally lower and a bull market is identified after the event as a period of time when the drift was mostly higher.

In the figure below we show the pattern of daily percentage movements in the S&P 500 and the JSE All Share Indexes since the lows in the market on 9 March 2009 until the market close of Friday 28 August 2009. In the further figure we show the distribution of these daily moves about its daily average of a positive 0.02% per day with a large standard deviation of as much as 1.6% per day. The equivalent statistics for the S&P 500 are an average move of .03% per day with an even larger standard deviation of 1.7% per day. If we take the period back to the peak of the markets in May 2008 the average daily price move for the S&P 500 since then is a negative .09% per day and -0.06% per day for the JSE.

Daily percentage moves in the S&P 500 and the JSE ALSI since 9 March 2009

Source: I-net Bridge and Investec Private Client Securities

Histogram and Descriptive statistics for daily moves in the JSE ALSI March-August 2009

Source: I-net Bridge and Investec Private Client Securities

Beating the market demands careful judgment about the forces that will drive and surprise the markets

Predicting whether the continuous random drift in market indexes and share prices will be higher or lower calls for fundamental judgments about the information flows that will move the market over the following twelve or more months. The past provides us with our theories about the forces that drive markets – our theories then lead us to anticipate and predict the direction of the economic fundamentals that we believe will surprise market participants and lead the market to drift higher or lower in the course of the next twelve months or so. We have to make these predictions with humility about the difficult nature of the task of beating the well informed market.

Mining past moves in stock market indices for patterns that will repeat themselves in the future is often attempted, but in our judgment such attempts are unlikely to prove reliable in a consistent way.

A stubborn CPI – until you look deeper

Inflation in South Africa (6.7% in July down marginally from 6.9% in June 2009) might well be regarded as stubbornly high given the weakness of the SA economy and especially of aggregate demand. The Consumer Price Index (CPI) actually increased by as much as 1.1% in the month that if sustained would lead to an annual rate of inflation about 14%. However it hopefully will be noticed by the monetary authorities that almost all of the increase in prices in July can be attributed to increases in the charge for electricity to households and the increase in the costs of private transport.

Supply side shocks continue to drive the CPI higher

These are areas of the economy where prices are set by officials and regulators rather than market forces and are therefore not susceptible to monetary policy. These administered or regulated prices, especially electricity and water charges, are playing rapid catch up with the costs of adding to capacity to supply more such essential services. This adjustment has come after years of excess capacity and prices being regulated by reference to historic rather than replacement costs. Hopefully these supply side shocks to prices are temporary ones that end when replacement cost pricing is established. In the market place, if firms cannot realise prices that cover replacement costs – and provide a satisfactory return on capital invested – they go out of business. Publicly owned utilities with monopoly power do not go out of business – they charge higher tariffs and are infused with additional capital supplied by the tax payer.

Higher charges lead to less spending – not more inflation

Households cannot avoid paying these higher charges and this makes them less rather than more capable of spending on other goods and services. This adds to the deflationary pressure currently acting on prices that are market determined. Such forces would normally – absent of inflexible inflation targets – call for lower rather than higher interest rates to encourage more spending so badly needed to lift the economy out of recession. These deflationary forces will be revealed in gory detail when lower prices realised at the farm, factory and port gates come through in the Producer Price Index (PPI) for July, to be updated today. PPI is expected to be more than 4% lower than twelve months ago. The threat to the SA economy as most economies world wide has been and remains deflation and recession not an inflationary boom.

Looking at the CPI in detail

In the calculation of the CPI the largest weight by far (22.7%) is given to the broad category Housing and Utilities. The prices of Food and non-alcoholic beverage that account for 15.68% of the Index actually fell 0.4% in July reducing the year on year change in Food and Beverage prices (Food Inflation) to a still above average 8.3% pa. Yet it has now become clear that lower prices at producer level are feeding into lower prices for consumers. The weight attached to the electricity and other fuels account is but 1.87% and to water and other services 3.31%. However the increases in electricity and water charges in July were extraordinarily high – as much as 21.5% for electricity and 8.8% for water.

Thus the monthly increase in electricity charges contributed 0.4% of the July month increase of 1.1% and higher water charges contributed another 0.29%. The increase in Private transport costs – mostly fuel – contributed 0.20% leaving all other items with an average monthly rate of increase of 0.11% – a very low rate of inflation. Thus almost all of the increase in prices in July can be attributed to prices that are beyond the influence of consumer spending and beyond the direct influence of monetary policy and interest rates.

Whither owners equivalent rent – the key to inflation to come

The largest component in the important housing cost category is Owners Equivalent Rent with a weight of 12.21% of the CPI. This item has replaced mortgage interest in the CPI and takes its cue form average house prices of which implicit rents are some assumed fraction. Owner equivalent rent is the statistician’s equivalent of the accountant’s mark to market adjustments that has no direct impact on cash flow but can be just as confusing in its implications.

Unlike when mortgage interest rates rise or fall and add or reduce measured inflation, as used to be the case in the calculation of headline CPI, households are likely to spend more when their wealth increases with higher house prices and a higher CPI and vice versa: spend less when house prices and owners equivalent rent is falling. The task of dealing with asset price inflation – especially house price inflation – has proved beyond the capabilities of central bankers. Asset prices are now a direct influence on the SA inflation rate and will need especially careful treatment when inflation targets are being aimed at.

Owner equivalent rent did not change in July – presumably because (declining) house prices were not sampled in the month. Actual rentals (weight 3.49%) also recorded a zero change for presumably the same reason. Presumably lower house prices when surveyed will help lower owner equivalent rents and measured CPI inflation.

The problem is recession and deflation – not inflation. Will the Reserve Bank act accordingly?

The direction of prices that have been influenced by monetary policy and interest rates is decidedly downwards and is currently still adding to the recessionary pressures acting on the economy. What is required is a full recognition by the Reserve Bank of these facts of SA economic life. The Reserve Bank needs to take a leaf from the play book of most other central banks that cut interest rates sooner and much more aggressively and eased quantitatively – that is printed more money – because they recognised the immediate deflationary and recessionary dangers to the well being of their economies posed by the global credit crisis. This recognition in SA has been far too long in coming – confused as it should not have been by very different signals emanating from the direction of consumer and producer prices. Hopefully the epiphany is upon us.

The Reserve Bank has indicated very clearly that it does not intend to provide any further relief for the hard pressed SA economy. Neither lower interest rates, nor quantitative easing, is on offer for the foreseeable future.

The Reserve Bank is relying on waiting to quote its release:

“….There are however signs that the downturn, both globally and domestically, may be nearing the lower turning point, but the recovery is expected to be slow and protracted…”

It added later that:

“….The composite leading indicator as compiled by the staff of the South African Reserve Bank increased slightly in April. The indicator suggests that the lower turning point in the cycle could be reached later in the year.”

We would agree that while the global economy may well have reached its lower turning point, we are not at all sure that the SA economy has done so. We do not share confidence in the predictive powers of a leading indicator much influenced by the stock market. The housing market is probably more important than the stock market in influencing the wealth and confidence of the SA consumer and trends there are not at all helpful.

The economy is very dependent on global trends

The reluctance to lower interest rates further or to engage in quantitative easing
(linked to attempts to restrain rand strength) has made the recovery of the SA economy dependent on global trends. The outlook for domestic spending remains bleak as the Reserve Bank has confirmed.

Unintended consequences

In response to the decision the rand responded favourably to the prospect of higher short term rates while higher long term rates followed short rates higher.

The compensation for inflation offered in the bond market, being the difference between the yields on the inflation linked government bonds and the vanilla variety (to which the Bank gives attention in its focus on inflationary expectations) rose yesterday. The yields on the inflation linkers declined reflecting the poorer growth outlook while the nominal yields rose.

A stronger rand and higher interest rates are surely not desirable outcomes of monetary policy settings. The stock market and also the exchange value of the rand however are responding to forces beyond the influence of SA monetary policy. The stock market is largely ignoring the deteriorating outlook for the earnings of SA economy dependent companies.

Global forces dominate the rand and the JSE

The dominant forces acting on the JSE and the rand are the direction of Emerging Equity Markets and commodity prices – they are running together in response to the outlook for the global economy. This outlook has improved significantly over the past few days in response to OECD economic forecasts that were revised higher rather lower.

The Reserve Bank is fighting inflationary expectations

The focus of the MPC statement was on inflation and inflationary expectations. The Reserve Bank argument against lowering interest rates is a familiar one. That is to contain inflationary expectations – even while recognising that the weak state of the economy – may well lead inflation lower. They also make reference to producer prices that are falling sharply and that unlike consumer prices, do decisively reveal the weak state of domestic demand as well as the influence of the strong rand on the competition for domestic producers. That producer prices might better reflect the thrust of monetary policy and that if they do, deflation may be a greater threat to the economy, does not receive consideration.

Are inflationary expectations self fulfilling?

The Reserve Bank is of the view that inflationary expectations are self fulfilling, even if the economy is suffering form excess supply rather than excess demand. The long run benefits of less inflation expected and therefore less inflation – as it is assumed – is thought to be the worth the short term sacrifices the economy has to make.

How the Reserve Bank could hold to this view now given producer prices, is very hard to appreciate. Our view is that inflationary expectations, when applying some naïve cost plus view of price determination, can only lead to permanently higher inflation when supported by a willingness of consumers to spend more.

The current unwillingness of SA consumers to pay more is obvious. The Bank also is well aware that the pressures on consumer prices are coming from prices that are regulated rather than market determined – and therefore well beyond the direct influence of monetary policy. Such price increases however act as a tax on expenditure and depress demands for less dispensable goods and service. Tax increases provide reason for lower rather than higher interest rates.

An alternative explanation for more inflation expected

The Reserve Bank might however consider another reason for the unhelpful trends in inflation expected, other than inflation trends themselves. That is a single minded focus on fighting inflation- in rhetoric perhaps more than in practice – is politically unsustainable. If so this is expected to damage the independence of the Reserve Bank to continue its fight against inflation over the long run. Apres moi le deluge is not an unrealistic conclusion, one leading to more inflation expected over the long run.

We share the view that low rates of inflation are helpful for economic growth in the long run. But to regard inflation as the end rather than the means of economic policy regardless of the state of the economy, is neither necessary or helpful to the cause. The decision of the Reserve Bank not to lower interest rates now will add doubts as to the usefulness of low rates of inflation when the sacrifices for it seem so heavy and do not make obvious sense. The political consequences of Reserve Bank inaction are not necessarily encouraging for the inflation outlook.

Asking the right questions

The Monetary Policy Committee of the Reserve Bank will be asking this question of the economy today and tomorrow. They will be well aware that despite a severe decline in household spending (household spending declined at a real 4.9% rate in Q1 2009) net flows of capital to SA continued at near record rates, equivalent to 7% of GDP. All other things remaining the same, had spending growth been anything like normal, the flows of capital from abroad would have to have been even greater.

Avoiding the wrong answers

Perhaps it will be suggested by committee members that it would be unrealistic to expect capital flows of larger orders of magnitude – so limiting severely the scope for more household spending – and by implication the scope for lower interest rates that are urgently called for to encourage households to spend more and banks to lend more. We will argue that this would be the conclusion to draw from what is an inappropriate line of enquiry. Such thinking has caused the economy unnecessary distress in the recent past.

These are not normal times

Normally such a severe reduction in spending as occurred in Q1 2009, would have led to fewer goods and services imported, an improvement in the balance of trade and so less capital imported. The problem however was that the volume of exports declined at an even faster rate than real imports in Q1 – the result obviously of the global recession that reduced in particular demands for metals, minerals and motor cars from SA. The weaker trade balance dragged down GDP, which declined at a very depressing 6.4% rate in the quarter.

Spending in general held up in Q1 2009

However not all categories of domestic spending were in retreat in Q1. Surprisingly and somewhat anomalously, household spending on services actually grew at a brisk 7.5% rate amidst the consumer gloom – implying that spending on consumer goods will have declined at an over 12% annual rate. Gross fixed capital formation continued to increase, though at a very sedate pace compared to a year before, and government consumption spending also rose marginally.

Final demands, being the sum of household and government consumption spending and fixed capital formation, declined at only a net 1.5% rate. The disinvestment in Inventories of -R10.2bn, half the decline estimated for Q4 2008, meant that Gross Domestic Expenditure actually grew at a 2.2% annual rate in Q1 2009. (See the tables below sourced from the Quarterly Bulletin of the SA Reserve Bank June 2009)

Spending held up as did capital inflows and prices came down

Thus aggregate demand in general held up much better than aggregate output and this was made possible by robust capital flows. These capital flows also helped to strengthen the rand and by so doing lowered the rand prices of imported goods and services including capital goods. Without these more favourable trends in the prices of goods, particularly at the ports and the factory and farm gates, spending presumably would have been even weaker.

Guesses about the pace of capital flows have been wrong and may continue to be wrong

Trying to second guess the ability of the SA economy to attract capital and to set monetary and fiscal policy accordingly is in our view quite the wrong way to steer the SA economy. Yet such concerns have been an important and unhelpful influence on monetary policy in the recent past. They led to a much weaker rand in 2006-7 as higher interest rates came to threaten the growth outlook for the economy.

The guesses about the attractions of the SA economy to foreign capital are very likely to be wrong ones. Such guestimates have almost certainly underestimated actual capital flows to SA in recent years. They have not taken into full account the favourable feedback loop from faster growth to increased flows of capital into account. If growth can be kept going with sympathetic monetary policy settings, that emphasise the objective of sustaining growth, more capital can flow in to make that growth possible. And more capital means a stronger rand and less rather more inflation to accompany faster growth. That the SA economy could attract net foreign capital flows, at the rate equivalent to 7% of GDP in a recession as it did last quarter, would have been inconceivable to balance of payments model builders.

The conclusion the MPC should come to

The conclusion we believe the MPC should come to about its room for manoeuvre is to do all it can to revive household spending. Lower interest rates combined with quantitative easing is called for. If this should however mean a weaker rand because the extra foreign capital is not forthcoming this would mean a weaker rand and so be it. This would unfortunately mean higher prices and counter the stimulatory influence of lower interest rates.

Do not second guess the rand

The rand however should not be the objective of policy either directly, when the Reserve Bank intervenes in the currency market, or indirectly when it makes judgments about the sustainability of capital flows and sets interest rates accordingly. The rand should be allowed to find a value that is consistent with achieving a good balance between potential and actual domestic output. This is the only proper goal for fiscal and monetary policy with low inflation seen as a means to this end rather than an objective of policy itself.

The rand as we have indicated may well stand up well if faster growth were achieved and so more capital is attracted. The Reserve Bank should never feel constrained by fear of capital flows when encouraging domestic spending providing such spending is insufficient to the purpose of maintaining potential output and employment.

Realism called for

Yet the MPC will have to be realistic about how much influence it can have today on the economy. Any immediate revival in domestic spending growth is unlikely even with lower interest rates and quantitative easing. The confidence and wealth of SA households have suffered too much recent damage to expect any immediate response. Paradoxically even if the MPC does not share our view of the world the thought that spending is unlikely to revive soon will encourage the Committee to lower interest rates.

Therefore the relief for GDP growth is much more likely to come from exporting into a reviving global economy than from household spending. We expect the MPC to cut its repo rate by 50bps and by another 50bps in July. Any deeper cut now would be very welcome to us and the markets.

Our Hard Number Index (HNI) can now be updated for May 2009 with the release of two hard numbers, vehicle sales and the notes issued by the Reserve Bank at May month end. As we show below there is no sign of any improving trend in the SA economy to be derived from the HNI. The Index attempts to replicate the pace of growth – higher numbers indicate that growth is picking up momentum that is accelerating while lower numbers indicate that growth is slowing down.

The HNI peaked in late 2006 at a value of over 165 indicating that the economy was then moving ahead at a very rapid rate. The latest reading for May 2009 is 106.06 and down from its 109.06 reading in April. This indicates that not only has the economy slowed down but that it is in now in reverse and probably going backward more rapidly than earlier in the year.

The HNI may be regarded as representing the first derivative of the economy. The second derivative, that is the rate of change of the rate of change in economic activity, is still pointing lower indicating little sign of a bottoming out in the pace of economic activity.

The Hard Number Index May 2009

Source: Investec Securities

The SA Business Cycle – The second derivative

Source: Investec Securities

New vehicle sales are still in decline

Vehicle sales in May provide very little cause for comfort that interest rate sensitive spending is responding to lower interest rates. The growth measured as the change in vehicles sold in May 2009 over May 2008 showed a further decline compared to April growth. More discouraging is that the underlying trend in vehicle sales is still pointing down rather than up. We calculate this trend by smoothing vehicle sales and then annualising the monthly growth in this smoothed measure.

Growth in New Vehicle Sales

Source: NAAMSA, Investec Securities

Not all bad news – the money cycle is pointing up

It is fortunately not all bad news. There is some consolation to be derived from the latest trends in the cash, that is Reserve Bank money supplied to the SA economy. Adjusted for the inflation trend, we can now observe an improving trend as may be seen below. Annual growth has turned marginally positive and the underlying trend has improved suggesting that a sustainable recovery in the supply of cash is under way. The driver of this series is lower inflation rather than any pick up in the cash supply itself as we also show. The growth in the actual cash supply (not adjusted for inflation) has been trending marginally lower as may be seen.

The real money supply cycle

Source: Investec Securities

The cash cycle

Source: Investec Securities

Is the Bank undertaking quantitative easing?

In this regard it is to be noted that the gross foreign exchange reserves of the Reserve Bank increased by a large US$1.724bn in May 2009. This indicates that the bank was very active resisting rand strength last month, notwithstanding the recent remarks from the Governor about intervention in the currency market. Of greater interest is that these purchases to not appear to have been sterilised by treasury open market sales of government securities.

The government deposits at the Reserve Bank that would indicate such operations actually fell in May to R66.153bn from R66.402bn in April. This may indicate that the bank and the treasury agree with us that quantitative easing, that is supplying the banks with more cash via operations in the currency market, to encourage them to lend more freely, is a good idea, given the weak state of the economy. A recovery in the supply of money and bank credit is essential to the purpose of reviving the SA economy.

Grim news from the shop keepers

Retail sales statistics were updated yesterday 13 May. The state of the retail sector in March 2009 provides no comfort at all about the state of the SA economy. The statistics indicate that sales adjusted for inflation are still falling at an accelerating rate. Interpreting retail activity is always complicated by the Easter holidays that may come in March or April, as they did this year. We will need to wait for the April numbers to fully adjust for Easter.

Continue reading No room for complacency about the state of the SA economy – aggressive policy action is called for