Category: SA Economy

Ask not what you can do for the boss. Ask what your boss can do for you

An earlier study of the returns from investing in the best companies (BCs) to work for, as revealed by their employees, has been replicated with very similar results – as reported in the recent Financial Analysts Journal. An index of US companies that best satisfy their employees, would have provided market beating returns over an extended period to 2020, on average a meaningful extra 2-3% p.a. over the long run. Incidentally a similar methodology applied to selected groups of companies with very good ESG qualifications revealed slightly inferior returns. It is understandable why investors might have paid up for companies to feel better about themselves. Less obvious is why investors have so conspicuously spurned the advantages of investing in companies that are so well appreciated by their employees.

A different relationship between the causes and effects of companies that best satisfy their employees may explain the observed outcomes. It is the economic and financial performance of the best companies surveyed that perhaps explains their superior status with employees more than the other way round. The better the economic performance of a company, the better the company will be able and willing to look after their managers and workers and win their trust.

The same many hours devoted with the same energy and skills to a struggling business, are very likely to provide very inferior rewards over a lifetime of work. Promotion and training opportunities will be more limited. Initiatives to encourage self-improvement of the workforce will be unaffordable and the job itself will be much less secure. Bonuses and share option schemes that come with success and that make climbing the slippery corporate ladders so attractive will be largely absent.

It turns out that the best companies to work for are also unusually successful when measured by the other criteria for performance. To quote the study, “Overall, the main takeaway from these statistics is that BCs are rarely tiny-cap stocks, they are typically large, and a few are extremely large companies…… , we also see that, on average, BCs have relatively high market-to-book ratios of 12.44 and gross-profit-to-total-assets ratios of 38%, and that BCs spend relatively little on capital expenditures (4% of revenue) and have relatively large amounts of intangibles in their balance sheet (22% of total assets)….. BCs are large companies, with an average (median) market capitalization of $55bn. This shows that BCs tend to be large companies and the size distribution is skewed to the right….”

Most large companies were small to begin with and size is a measure of their success- able to sustain better still to improve their returns on additional capital employed. Such achievements characterize the true growth companies well worth being an early investor or employee in. The ideal business to invest in or work for would be a start-up that grows rapidly and becomes large and consistently successful on all dimensions. Perhaps what the list of BC’s – that change significantly from year to year- about 20% enter and leave the lists annually – include a biased sample of surprisingly successful companies- revealed in part by their superior employment practice. The best run companies are priced for success and therefore returns realized may not beat the share market. The surprisingly improved companies will do so. Identifying surprising strength before other investors do is the holy grail of investors and indeed also of workers with choices to make.

The key success factor in any business are the capabilities of its senior managers and directors. The employed insiders are in a very good position to evaluate them. The transfer market can serve those with competitive and marketable skills as well as it does in football should they have reason to doubt their leaders. Moreover, as they do in football, they should not resent the high rewards received by the best executors, the true and rare superstars that create and preserve so much value for workers and shareholders and as important for their valued customers.

When will inflation in the US (9.1% in June) peak? My answer is about now. And the surveys of inflation and the state of the financial markets support this proposition. If month to month increases in the US CPI revert to something like the 20 year average, inflation in the US will be trending well below 7% by year end and fall back to 2% p.a. by late 2023. Bloomberg surveys conducted in July indicate in inflation in Europe- now over 8% p.a. to recede to 2% by year end. Inflation in SA, still to peak at over 7%, is expected decline to 5% by late 2023.

The supply side disruptions that ramped up oil, grains, shipping costs and metal prices (unfortunately for the South African economy) have abated. They are all well off their recent peaks. Industrial Commodity and Metal prices are 50% lower than their peak values of January 2022. These prices may remain at high levels, but they are no longer rising to force inflation higher.

Industrial Commodity Price Index. January 2022=100. Daily Data

Source; Bloomberg and Investec Wealth and Investment

Prices have their supply and demand causes as they have had in our post Covid, post Russian invasion world. They also have their intended effects. They have helped repress demand for goods, more than for services, in the developed world and South Africa. Inflation is properly defined as a continuous increase in the CPI. It takes more than essentially temporary supply side shocks for inflation to proceed at persistently higher levels. Inflation can only be sustained with continued stimulation of demand. Without additional demand, the higher prices perhaps planned in advance by suppliers with price setting powers, cannot be sustained. Without support from the demand side of the economy, from further injections of demand, stimulated by central banks and governments, the market-place will not t absorb higher prices.  In the absence of supportive demand, prices will, perhaps only gradually, adjust lower in response to help sustain sales revenues and bottom lines.

Prices are not what firms would like them to be, higher usually, but are conditioned by what their customers will bear. Expecting more inflation and setting higher prices accordingly regardless of the stae of demand cannot be a self-fulfilling prophecy.  It is not consistent with economic rationality. The clear evidence from the recent surveys and the bond markets is that economic actors are not naively extrapolating recent inflation into the distant future. They are wisely seeing beyond current inflation to the longer-term demand and supply forces that will act on prices- including the role expected to be played by fiscal and monetary policy. As with the surveys, inflation expected, as priced in the market for US Treasury Bonds, so called break-even rates, have receded in the past week-despite higher realized inflation.

The US bond market expects inflation to average 2.1% p.a.  over the next five years and 2.3% p.a. over the next ten years- very close to the 2% p.a. Fed target for inflation. The SA bond market is now offering still higher rewards for bearing inflation risk- despite the inflation-fighting zeal of our Reserve Bank. The money and bond markets in the US are priced for a reversal of the direction of interest rates next year, with the peak in short rates having been brought sharply forward to January 2023 at 3.25%. The SA money market predicts much higher interest rates for a much more extended period. One hopes wrongly given the absence of demand side pressures on prices and the state of the economy.

Inflation expectations revealed in the Treasury and RSA bond markets. Daily data.

Source; Bloomberg and Investec Wealth and Investment

The best reason to expect inflation to subside in the US, Europe and South Africa is that the demands for goods and many services are already well depressed, thanks to higher prices. Spending is no longer being supported by additional income subsidies or by rapid growth in the money supply and bank credit. The money supply in the US (M2) has ground to a halt. The essential question is still to be answered. Is the US and Europe heading for recession aided and abetted by central banks intent on raising interest rates too aggressively and indeed unnecessarily fighting the last war? Central banks should know better than to lead their economies into recession while inflation is moving in the right direction and their economies head in the wrong direction.

A growing number of employers have insisted that their employees must come back to their work- places. Elon Musk, has demanded that Tesla or Space Ex staff spend at least 40 hours in their offices and that those who do not want to do so “…. Should pretend to work somewhere else…” He also wrote “Tesla has and will create and actually manufacture the most exciting and meaningful products of any company on Earth, this will not happen by phoning it in.”  Many other firms, feel the same disillusionment.

WFH is an option – not a compulsion. But an option modern technology has now made possible in ways that were not possible before. Homework was hardly unknown before.  Writers, composers and artists as well as weavers and sewers, home bakers, worked from home long before the gig-workers who congregate at the internet café. You may you noticed how the coffee mavens all look up from their laptops to appraise the new arrivals? Seeking company no doubt that they could find at the water cooler.

Being able to measure accurately the relationship between how they reward their employees and how much they contribute to the output and profits of the firm is an essential responsibility of any business. It could not hope to survive without accurate calculations of the costs and benefits of alternative working arrangements. And the firms faced with WFH preferences have been learning by doing as they always do.

It can be assumed with great confidence that the great majority of employees will be paid no more or less than the value they will be expected to add for their employer – be it from the office or home. Furthermore, as clearly, nobody will be rewarded for the time they spend commuting. It is paid for in  income or leisure sacrificed by the commuter. Recent evidence that the revealed willingness to go back to the office in the US is inversely related to the time spent commuting is no surprise. The lucky winners from the enforced lockdowns have been those who to live far from the office – that they chose to do for – their own good reasons – pre the lockdowns.

Employers are not the only party with the right to choose where best to work. Workers will make their own choices. The ratio of job openings to work seekers in the US has never been higher and the opportunity to work from home has not been greater this century.  

The Tesla office worker who has remained in California, even though the Tesla office is now in Texas, may well tell Elon what to do with his job. They may even accept a lower salary to WFH – the cost of the commute is their bargaining chip. As is the saved rental and all other not at all insignificant costs of supplying an office desk that may improve their case to WFH. They may even be able to do two jobs from home- as many do- given the time freed up and the absence of supervision or whistle blowers. Elon and other collaboration mindful employers may have to offer a premium to get the preferred workers to the office- if they are more productive there.

The individual households who choose where and how they live will help determine how the world of work will look in ten years or more. The developers of offices and homes and retail space will respond rationally to the choices and ongoing experiments of all those who hire and supply labour of all kinds- billions of decisions will prove decisive. The world of work and production evolves continuously, usually in an imperceptible way, to the signals provided from the market for labour. There is no design – just efficient outcomes. Employers no longer requiring office workers to attend on Saturdays, or offering extended annual holidays, are not providing charity but are making a considered response to market forces- necessary to attract workers of the right kind and at the right price.  They will continue to respond accordingly.

The responses to the opportunity to work from home that technology has made possible- and made the lockdowns possible – will evolve sensibly and rationally. Provided freedom to choose is respected as the essential ingredient for a successful, highly adaptive economy.

Global stock markets have done well for investors over the years. We look at what will be required for them to continue to do so.

The compounding growth of the West is powered by business enterprises and savers share in the wealth created.

The economic history of Western economies is an admirable one. Their standard of living has been transformed over the past 200 years by consistently positive year-by-year growth in output and in incomes per head, despite the rapid growth in population over the same period. And all of this was achieved despite the destruction of life and capital, buildings and valuable infrastructure by periodic wars. The Russian war in Ukraine is an awful reminder of how destructive war is. It will take many years of sacrificing consumption – of saving and productive investment in capital equipment and infrastructure – to make up for these losses.

Privately owned businesses are responsible for much of the growth in incomes earned, and in the extra goods and services supplied to the western economies over time. Their most decisive stakeholder is the consumer of this growing cornucopia of goods and services that they produce. Their owners earn a surplus after all contracted-for costs of production have been met and revenues have been collected. There is the risk of a loss, though a growing economy makes losses less likely. More efficient businesses will also compete on the prices for and quality of goods and services they provide their customers, at the possible expense of the revenue line. Improvements in the productivity of capital will be widely shared.

A stock exchange enables the ownership rights in larger businesses to be widely and conveniently shared and traded. It provides the average saver the opportunity to plug into these surpluses and the wealth-creating machine of immense force that is business enterprise, mostly via their pension and mutual funds. These widely dispersed owners have realised much more wealth creation than they would have done by investing their savings in the money market, bank deposits or in the bonds and bills issued by governments. And they would have done even better had they further postponed consumption and reinvested the dividend income they received, as well as conserving their capital gains by staying in the stock market.

The JSE, very much part of a global capital market, has provided comparably excellent returns over the many years of its existence and has repeated the performance this century.  As illustrated below, the average annual total returns with dividends reinvested from the JSE since 2000 have been nearly twice as high as the interest earned on cash and paid out: 13.5% annually vs 7.6% annually. The compounding effect has been so powerful because the returns on extra capital invested by privately owned businesses have been so positive. Economists therefore go further, given past performance. They regard these high expected returns over the long run, as part of the cost of capital employed. They add these higher expected returns to the returns that should be required of any company contemplating an investment decision. It is called the (expected) equity risk premium. If the proposed project cannot promise to leap over this higher hurdle of required returns on capital, the advice is not to go ahead.

JSE All Share Index, with or without reinvesting dividends, and money market returns (three-month Johannesburg Inter Bank Rate) (2000 = 100)

Source: Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022

JSE All Share Index total returns vs cash (three-month Johannesburg Inter Bank Rate) 2000 to 2021

Source; Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022

It is not only returns that matter – so does risk. Human nature says (expected) return and estimates of risk are positively related.

So, the obvious conclusion would seem to be to invest in the stock market, since, based on past experience it can be expected to perform well in the long-term, even if there are some short-term blips. It is these short-term blips however that discourage investment in the share market. Between 2000 and 2021 the annual total return on the JSE was 13.5% a year and that provided by the money market was a much less 7.6% a year return on average. However judged by the movement about this average return, the JSE was nearly seven times as risky, as measured by the standard deviation about these returns (see figure above) – the risk that your shares may be worth much less in a few days or months, when you might be forced by circumstances to liquidate your wealth. This can be a major deterrent to share ownership.

The greater the risk aversion, the less comfort wealth owners and potential share owners have in the outlook for assets, the less time they wish to spend in the stock market, the less valuable businesses become. And the greater will be the risk premium earned by those willing and able to stay in the stock market. Bearing extra risk will likely bring extra returns because the entry price to the share market is reduced by the risk aversion of other potential investors. It has been true of the share market over the long run and market volatility, or risk, is likely to continue to negatively influence the long-term value of shares, so improving realised rates of return for those with an extended time in the market.

Albert Einstein famously described the power of compounding interest or returns as the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn’t, pays for it.” This powerful force of low-digit exponential growth, of growth compounding on growth, year on year, is well demonstrated by the long-term ability of the major stock exchanges to grow wealth for shareholders in a consistent way over the same long run.

It is the return on owners’ capital that is the source of all interest income

But where do these good compounding share market returns come from? From businesses who are entrusted with much of the accumulated savings or wealth, described as capital employed in any market-led economy. The owners and managers of businesses are incentivised to husband scarce capital, as best they know how. The rate of return they realise on the capital employed, the productivity of that capital, is the foundation upon which all rewards from saving and owning capital or wealth is built. Firms experiment continuously in improving the return on the capital they utilise. They aim to improve the relationship between the cash value of the resources they invest in, called operating costs and what comes out as revenues, and they apply their fixed and working capital to the purpose. The results of such efforts are measured, hopefully in a consistent and comparative way, as return on capital employed inside the firm. The rewards for savers who supply the firms with capital to invest, come not only in the form of dividends paid, but in offers of interest payments that firms are able and willing to make to attract capital, in competition with other firms for the same potentially productive capital.

The less risky interest income offered by all other borrowers, the banks and the government, is therefore strongly influenced by the same return on capital realised by the business enterprise that employs a large proportion of the capital available. The banks, the money market funds, or the government as a borrower, would not offer the interest they do, unless the firms were able to earn a positive rate of return on all the capital they utilise and have to compete for. This includes competing for the overdrafts and mortgage loans provided by banks and other financial intermediaries.  The higher the expected real returns from all the capital employed in businesses, the more competition from firms for additional capital to invest, the larger will be the real rewards for all saving. Be it named interest or dividends or lease payments or capital gains depending on the financial arrangements agreed to between suppliers and raisers of capital.

The internal return on capital is what is converted into market value and market returns

It is the positive internal rates of return on capital realised by the business enterprise, not share market returns, that reveals the productivity of the capital it employs. The share market in turn translates expected internal returns on capital into current share market values. The market value of the firm should be understood as the present value of future operating or cash surpluses over operating costs, expected from the firm, discounted by the required returns expected from likely alternative investments.  The most valuable firms in the market-place – measured as the ratio of its current market valuation to current earnings or better current cash flows – are those firms that are expected to consistently improve their internal returns on capital and to add more capital by doing so. In other words, they are expected to consistently improve the productivity of capital they utilise and are able and willing to attract more capital, both loan and equity capital, to realise the growth opportunity, and to successfully hold the competition at bay that always threatens prices and operating margins.

The two measures of performance (the internal and market returns) are likely to be highly correlated over the long run. But such present value calculations made by the buyers and sellers of shares in companies are subject to considerable uncertainty from day to day and week to week or quarter to quarter. There is uncertainty about flows of revenue, operating costs and returns from alternative investments that determine the discount rate. There are more than enough unknowns to make estimating the future value of a firm or a market of them, a risky business. Risky returns help to direct savings to the lower return, less risky alternatives, for example to cash or cash like assets.

Knowledge (technology) improves the productivity of capital. Will it continue to do so, and will shareholders receive as valuable a share of the surplus generated?

The force that has driven the extraordinary and consistently unpredicted improvements in income and wealth and in the supply of goods and services delivered, is the success of technology and its application by the business organisation in sustaining and improving the (internal) return on capital, year by year and decade by decade. From railroads to electricity to the motor car, computers and the internet, technology has provided the opportunity to improve returns on capital and increase incomes and wealth, of which a large part is held in the form of shares of companies. A further explanation for consistently good returns to capital over time is perhaps that technology has consistently delivered more than most investors thought technology would deliver over the last two centuries. Stock markets have done so well because the productivity improvements from innovative technology have been at least what the market hoped they might deliver, and consistently delivered at least the productivity enhancements that it is expected to deliver, and typically considerably more. We have had few technology disappointments and technology has overwhelmingly surprised on the upside.

Will technology continue to consistently surprise on the upside in future and benefit the owners of the representative business enterprise and its customers and employees (and government treasuries) in the same way it has done over the last 200 years? There are some caveats.

Productivity has been dramatically driven by improving and ever cheaper computer power. Moore’s law, which predicts that computer power per dollar invested in a chip will increase at an exponential rate, has been shown to be approximately true for around 50 years. But such increases in the power of computer chips must necessarily face physical limitations because of the finite nature of matter.

Similarly, can one assume that the efficiency of food production will continue to improve at the rates it has in the past? The finite resources of planet earth may put a brake on the pace of technological improvement (unless we extend ourselves by settling the planets and beyond, and investing in knowledge itself may defeat the law of diminishing returns). Moreover, will humanity attach as much importance to increasing further our command over goods and services through productive capital expenditure as much as we have in the past and tolerate the share of output going to owners of capital as we have in the past? Capital and its application may be given a lower priority and if so, growth rates will subside.

That the SA economy has performed quite as poorly as it has in recent years is not easily explained. The rate of growth of less than 2% a year represents a very poor outcome, with alas little prospect of any lift off, according to the economic forecasters in and outside government. Yet there are more corrupt economies with much less of an endowment of capital and skills that grow faster.

Fixed capital formation and employment offered by private businesses is at best in a holding pattern – capital formation being maintained at levels first reached in 2008. Capital formation by the public sector is in sharp decline- necessarily so – given past performance. The unwillingness of SA business to invest in future output and income generation and in their workforces – describes slow growth – but does not explain its causes. Such reluctance needs to be understood and addressed if the outlook for the economy is to improve.

Fixed Capital Formation Constant 2015 Prices

Source; SA Reserve Bank and Investec Wealth and Investment

Total Real Fixed Capital Formation (2000=100)

Source; SA Reserve Bank and Investec Wealth and Investment

We need look no further for a large part of the explanation of unusually slow growth than to the disastrous failures of the SA public sector.   South Africa relies heavily on the State as a producer of essential services, including electricity, water, transport, ports and education. More heavily than is wise or necessary. The inability of Eskom to meet depressed demands for electricity clearly sets limits to growth as do the failures of Transnet to run the railways and ports anything like competently.

These operational failures have meant very large amounts of wasted, taxpayer and consumer provided capital and opportunity. The relationship between what has been spent on the large new electricity generating stations Medupi and Kusile and what has come out as additional electricity is especially egregious and damaging. As much as 1.1 trillion rands was invested in electricity, water and gas between 2000 and 2021. Much of it in electricity generation. Shockingly, almost unbelievably, the real output of electricity etc. has declined by 20% since 2000.

Electricity, gas and water. Capital Formation;  Constant (2015) and Current Prices

Source; SA Reserve Bank and Investec Wealth and Investment

Electricity, gas and water. Capital Formation and Valued Added 2000- 2020. Constant 2015 Prices

Source; SA Reserve Bank and Investec Wealth and Investment

The abject failures of other government agencies – of the provinces and in particular municipalities – to maintain the quality of the essential services they are tasked to provide, water, roads, sewage, building plans, education training and health care etc. has become ever more destructive of the opportunities open to business and households. Such failures are also reflected in the declining real value of the homes South Africans own –a large percentage of the wealth of the average household – which has made them less able and willing to demand additional goods and services from SA business.

Hopefully the economy will not stay on these destructive paths. Restructuring the ownership and incentive structures facing the public sector is an obvious and urgent requirement for faster growth- for more capital formation of the human and physical kind. As is reducing the reliance on the public sector to deliver the essentials.

But we need a meta explanation and understanding of why the public sector has failed South Africans so particularly badly to move forward.   The key political objective on which the public sector leaders were evaluated was clearly not the efficient use of resources, with quality of delivery related rewards, within sensibly constrained budgets. The Scandinavian model, if you like, did not apply. The primary objective set the new leaders of the public sector – and for which they were presumably judged and rewarded – was the transformation of the racial character of the public sector workforce. 

It is an economic truism that you get from people (managers and workers) what you pay them for. This key performance indicator, transformation, has been achieved with huge waste, financial and in foregone opportunities. Losses that were exaggerated by the opportunities the lack of attention to the costs of operations, and their value to consumers, offered for theft, fraud and the patronage of the incompetent.

The continued enthusiasm for demanding that the private sector to transform further and faster seems uninhibited by any comparison of the cost and benefits of forcing transformation. There is perhaps one consolation in all this- the private sector cannot ignore the bottom line in the way the public sector was able to do for so long.

Much notice is being given to the disruption of supply chains by lockdowns and by war in Ukraine. With hindsight, producing more of the essential components in-house or holding larger inventories to avoid relying on just-in -time delivery would have been a superior, that is less costly choice to have made. But very few firms are fully integrated. The steel mills are likely to outsource their sources of coking coal and the gold mines their sources of power -for obvious reasons- outsourcing is expected to be cheaper. A continuous comparison will be made of the expected costs of in or outsourcing all the different operations that lead to the final delivery of any product or service supplied. Such decisions help to determine the optimum size and scope of any enterprise. Less can well be more for shareholders.

All firms are defined by some mixture of in-house activity and goods and services contracted for. Even the accounting and human resource function may be outsourced to specialist service providers as easily as the company canteen. Decisions to outsource may hopefully mean a better focus on what are properly understood to be the essential ingredients for any thriving business. The objective should be to be realistic and prescient about how best to release the key competencies that make the firm competitive and are its essential reason for being and surviving. Strategic decisions to insource that make the firm larger and less specialised – or outsourcing to other firms- that makes it smaller and more specialised – cannot be outsourced.

Technological change alters the optimum size of any firm. That the decision to outsource the IT function to the computer cloud is seen as the right decision now, would not have been feasible twenty years ago. Then firms with heavy demands on data collection and processing would have had no choice but to invest in mainframes and tinker with legacy systems with large in-house IT departments. That may be very difficult to abandon. The operators in the cloud can reduce the danger of excess or deficient computing capacity by attracting a well-diversified customer base.  The market share gains of one customer can offset the losses of another competing with it, so adding to the predictability of the demand for an outsourced service or component. Such a pooling of business risks can be a great driver of economies of scale and allow the concentrator to offer competitive terms to a more specialised operation.

A similar explanation fits the component manufacturers who supply a variety of competing assemblers of appliances or automobiles whose core capabilities may be in the design and marketing of their badges – not in in-house manufacture at which they may not excel. Every entrant into the burgeoning electric vehicle industry is having to answer the important question – how much of our production could or should we outsource? The answer Tesla provided- producing its own batteries in its own very large factories with very substantial and fixed overhead costs – may no longer best serve the purpose. The enhanced scale of the specialist provider may also facilitate R&D on a scale that any inhouse department could not justify and could leave the integrated firm behind in the development of intellectual property – that can be hired on reasonable terms from the inventors. Firms no longer have to run their own warehousing and distribution systems. The delivery of goods produced is increasingly outsourced to specialist logistic providers who can deliver more cheaply or more conveniently to a variety of customers than can a firm hope to do running its own trucks and warehouses.  They can fill the return legs. Sales online to a global market have been made possible not only by the internet but by outsourcing delivery to the specialised courier.

These opportunities to outsource essential inputs in production or service provision are a huge boon to the entrepreneurs whose barrier to entry was traditionally limited access to capital- understandably – given their unknown potential. By outsourcing – by staying lean and capital light and highly focused – the start-up’s plans to compete become more viable. Good for them their customers and very good for the economy that hosts them.

Brian Kantor March 30^th 2022

The Quarterly Labour Force Survey released this week provides estimates of employment and unemployment that are way beyond the norm for developed economies for which employment surveys are designed. They come as no surprise. In Q4 2021, 262,000 more jobs were provided in SA  compared to the quarter before, while an additional 278000 more workers were declared unemployed, taking the unemployment rate marginally  higher to an extraordinary 35.03%. The SA labour force is estimated as 22.4 persons, of whom 14.5 million are working and 7.9 million are actively seeking work. The labour force represents but 57% of the working age population (ages 15-65)  which leaves 17 million adult South Africans not economically active

There is more to the depressed employment statistics in SA than slow growth. In 2000 there was 40% more persons employed per unit of GDP than there were in 2000. These latest estimates continue to show employment in SA lagging well behind GDP. Employment has flatlined at about 94% of their pre-lockdown levels.  GDP by contrast fell sharply to 84% of its pre-Covid levels by Q2 2020, but has since recovered to 98.3% of its pre-Covid level.

Employment and GDP (2019=100)

Source; SA Reserve Bank and Investec Wealth and Investment

The ratio of employment to GDP (2019=1)

Source; SA Reserve Bank and Investec Wealth and Investment

How are these employment statistics, particularly the unemployment estimatesto be interpreted and reconciled with estimates of income and expenditure in SA? Part of the problem with estimating unemployment, especially where the unemployed are not simply and conveniently measured when collecting unemployment benefits, is that the unemployed are largely self-defined in SA. One may be not working, yet very willing and able to work at short notice and indicate as such to a telephone enquiry from Stats SA and so be classified as unemployed. But such a respondent (perhaps in a rural area) may only be willing to work for rewards that are unavailable and unrealistic to expect.  Hence such a potential worker is not part of the labour force and more accurately should be regarded as not economically active, not as unemployed. South Africa may have an employment problem – not an unemployment problem on anything like the same scale.

The more the consumption power provided to households in kind and cash, other than via income from work, the higher will tend to be the wage that would makes it sensible for potential workers to supply and accept employment- what economists describe as the reservation wage below which it makes little sense to supply labour. Welfare benefits provided by the taxpayer, housing, medical care and cash grants, education, or help provided by an extended family, all help to raise the wage rates that employers have to offer when seeking a supply of workers. The tragedy is that so few South Africans qualify for the well-paid decent work offered by employers that would, if available, encourage many more of them to actively join the labour market. The excluded workers should blame the failures of the education system to qualify them for the decent work and accompanying benefits that formal employers mostly prefer to provide.

South Africa chose to address poverty with welfare rather than by encouraging employment. It was a humane response and SA was economically able to redistribute consumption power on a meaningful scale. But it has had consequences. The more generous the welfare system, the better the employment benefits that have to provided by firms seeking labour, the higher will be the level of wages and so the fewer workers employed. South Africa’s recent economic history of improved welfare and a smaller proportion of the population employed confirms this prediction. There is a negative relationship between the price of labour and the demand for it, even if denied by the economists (nogal) who advocate and regulate higher minimum wages.

Yet higher wages have also much encouraged the supply of and demand for immigrant labour who arrive in SA with lower reservation wages determined to support their families earning and transferring income to them. And who are more easily hired because that can be more easily fired. The unregulated, employment intensive sectors of the economy are heavily populated by migrants – perhaps unknown and un-estimated millions of them – many working illegally. And whose employment status will not be answered with a phone call. The employment problem is concentrated on South Africans with access to welfare benefits. How many are employed in South Africa is an unknown  

Cadre deployment is to be expected everywhere. Incoming US administrations do it as a matter of course. But why have so many of the most influential of the SA cadres proved so very fallible, as revealed in full gory detail by Zondo.? It is the leaders after all who set the standard. That crime may be expected to pay, given kickbacks to the right places, is part of an explanation. Short-term horizons “ if I don’t take advantage then my insider competitors will do so” may help explain some of the observed behaviour. There has been no lack of competition for the material opportunities offered in the South Africa that have gone well beyond what could be regarded as decent salaries and other employment benefits. Including the generous rewards provided for serving on the boards or management teams of the semi-autonomous government boards responsible for regulating private conduct. Of which many became notorious for providing opportunity for shopping/conference trips abroad and for contrived multiple Board meetings, for which valuable hourly attendance fees are unnecessarily charged.

The key posts in SA government departments and agencies turnover very rapidly with changes in the direction of the political winds – so paranoia of those in office is not irrational. The large financial gains observed coming from BEE – without any obvious relationship between input and benefits realized – may be a further influence. That you become be fabulously rich when lucky in your partnerships –obtained through your political connections rather than your observable efforts or skills – and through doing business with government on highly favourable terms because of these connections – is morally debilitating. And indicates for wide notice that competence or dedication is not necessarily rewarded nor essential to the purpose of getting on in life.

Repeat business is the most valuable source of sales and profits for any business. It helps to keep their owners and workers honest and competitive striving to enhance valuable reputations for fair dealing. Governments departments or agencies however have monopoly power. A trust in their good practice is to be heavily relied upon. It is a trust demanded of those teaching a class, serving in a public hospital or in a police or border post enforcing the law. Yet we need them at more than they seem to need us. We wait in line or on-line patiently and smile obediently. We are not customers but supplicants of the government agencies with great influence over us. Imagine life without a passport, visa, vaccination certificate or a driving license, a good education, or a well-organized casualty ward? We would like to believe that the public servants are trying as hard as they know how, to please us. Because that is the right respectful way.

Unconstrained self-interest cannot fully explain what has gone on in SA. It calls for explanations made better by psychologists. philosophers or historians than economists. Do we understand the derivation of the values that determine the culture of the workplace? Can we explain how a sense of honour, honesty, patriotism or duty is developed to help set the reasonable and realistic expectations of the supplier and user of services of all kinds? Helpful attitudes and good performance are encouraged by a strong sense of vocation- a sense of a job worth doing well. For what are widely recognized as appropriate material rewards that can be well understood and accepted by all parties involved. How are they cultivated? They are part of the implicit employment, or what can be understood more broadly, as a social contract. The best standards do not emerge overnight and should be actively cultivated. Ethics has to be well taught.

When regimes change and the power structures change radically with it, a strong sense of life changing opportunities can become overwhelming and corrupting. The large gains achieved in SA via misgovernment have been highly very damaging to the incomes and prospects of most South Africans. It will take acknowledgement and understanding of it as the path to an agreed much improved moral order and stronger economy. It calls for a new social contract, the hope for a Zondo inspired devotion to doing your duty for fair reward and for obeying and enforcing laws justly made and deservedly respected. A community of those wanting to give service rather than take unfair advantage of their favoured status could become the new morality.

September 2021

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Are preservation orders a fair process?

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

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

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

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

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

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

The economics of redeveloping property and the case for demolition

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

There is more to tax than what appears on the surface – ask National Treasury and South African homeowners.

National Treasury has had an epiphany. It has acknowledged that higher taxes can lead to slower growth and that lower taxes can lead to faster growth. Hence the decision to forgo R40bn of planned income tax increases and to propose a reduction in the corporate tax rate to 27%. All in the interests of faster growth. Hallelujah.

The Budget Review recognises that taxes have complicated feedback effects. It recognises that the burden of higher corporate taxes ends up being passed on to consumers of goods and services, in the form of higher prices and lower incomes for those who provide labour and other services to the corporation. The supply of capital to the SA enterprise and hence the supply of goods, services and the demand for labour and land, is determined by the required after-tax returns of investors. Higher taxes will reduce expected returns and so the supply of capital, goods, services and the demand for labour. The supply of capital for SA is sourced globally and the required returns are determined in the global market, as the Review recognises.

The Review could have added that personal income tax rates have supply side effects. It is the after-tax benefits provided to taxpayers by governments that establish the standard of living, which in turn determines the willingness to supply labour to an economy. The more internationally mobile the providers of labour services are, the more of a global market South African firms have to compete in for the supply of indispensable skills. Raising income tax rates at the margin drives the emigration of human capital and leads to higher prices to cover higher after-tax costs of inputs. Lower taxes could help do the opposite, that is increase supply of capital and skills. Faster growth becomes possible with a lower tax burden.

The share of income of those who will report taxable income of more than R1.5m in 2021-02 (a mere 113,192 taxpayers) are in the highest of nine tax brackets. They report 12% of all income and will pay over 26% of all personal income tax. Only when annual incomes are above R500,000 does the share of income taxes paid exceed the share of incomes earned. The numbers of high earners and taxpayers in SA have been stagnating. We need more of them to help grow the economy and provide for the relief of poverty.

It is the mix of taxes and the benefits supplied by governments that determines the standard of living and that drives the migration of labour and capital. The burden of income taxes in South Africa is highly progressive, as are the benefits of government spending. Higher income earners in South African pay much of the personal income tax and draw very little on government benefits provided.

Figure 1: Population by the nine income tax brackets (millions)

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Figure 2: Share of income and income tax paid of the nine income tax brackets (percent)

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Figure 3: Average income tax saved (rand per annum) per member of each tax bracket (total income tax saving = R51bn)

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

For evidence of the relationship between taxes paid and benefits provided by government, one need only compare residential property prices in Cape Town with those in the other cities and towns. They can watch the business television channels, to be aware that magnificent homes in Johannesburg or Durban can be had for the price of a small two-bedroomed apartment in Cape Town. This is because of the more favourable mix of higher property taxes (not necessarily higher wealth tax rates) that are paid in return for comparatively good services provided by the local government.

Homeowners should be aware that higher taxes can more than pay for themselves when there is good government. And higher taxes will destroy their wealth when the service is inadequate for the taxes paid.

Higher commodity prices could bring about higher global inflation. That would not necessarily be bad news for South Africa.

There is a hint of inflation in the frigid northern air. It’s being reflected in the long-end of the bond markets, the part of the yield curve that is vulnerable to signals of high inflation and the higher interest rates and lower bond values that follow. The compensation offered for bearing the risk that inflation may surprise on the upside is reflected in the spread between nominal and inflation-linked bond yields. These spreads have been widening in the US, and in low inflation countries like Germany and Japan.

This spread for 10-year bonds in the US was as little as 0.80% at the height of the Covid-19 crisis, was 1.63% at the end of September, and at the time of writing is at 2.14%. It has averaged 1.97% since 2010. The spread has widened because investors have forced the real yield lower, to -1.03%, further than they have pushed the nominal yield higher now, to 1.15%. This is still well below the post 2010 daily average of 2.25% (see figure below).

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

Investors are paying up to insure themselves against higher inflation by buying inflation linkers and forcing real yields ever more negative. Clearly, the nominal yields continue to be repressed by Fed Bond buying (currently at a $120 billion monthly rate). One might think it’s easier to fight the Fed with inflation linkers, than via higher long bond yields, to which the currently low mortgage rates and a buoyant housing market are linked.

The Fed is insistent that it is not even thinking yet of tapering its bond purchases. The Treasury, now led by Janet Yellen, previously in charge of the Fed, insists that a new stimulus package of US$1.9 trillion is still needed for a US recovery.

Metal and commodity prices, grains and oil are all rising sharply off depressed levels. Industrial metals are 45% up on the lows of last year, while a broader commodity price index that includes oil is up 51% off its lows of 2020.

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

These higher input prices will not automatically lead to higher prices at the factory gate or at the supermarket. Manufacturers and retailers might prefer to pass on higher input costs. But they know better than to ignore the state of demand for their goods and services. They can only charge what their markets will bear, which will depend on demand that in turn will reflect policy settings.

Higher inflation rates cannot be sustained without consistent support from the demand side of the economy. Yet supply side-driven price shocks that depress spending on other goods and services can become inflationary, if accommodated by consistently easier monetary and fiscal policy. In the 1970s, it was not the oil price shocks that were inflationary. They were a severe tax on consumers and producers in the oil importing economies, which in turn depressed demand for all other goods and services. It was the easy monetary policy designed to counter these depressing effects that led to continuous increases in most prices. That was until Fed chief Paul Volker decided otherwise and was able to shut down demand with high interest rates and a contraction in money supply growth that reversed the inflation trends for some 40 years.

The financial markets will be alert to the prospects that demand for goods and services will prove excessive and inflationary in the years to come – and that they may not be dialed back quickly enough to hold back inflation.

There is consolation for South Africa should global inflation accelerate. It will be accompanied by higher metal prices and perhaps bring a stronger rand to dampen our own inflation. It may also help reduce the large South Africa risk premium that so weakens the incentive to undertake capital expenditure as well as the value of South African business. Our inflation-linked 10-year bonds now yield a real 4.13%, a near record 5.15 percentage points more than US inflation linkers of the same duration. Any reduction in South African risk would thus be welcome.

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

January 27, 2021

There is some very good news to cheer South Africans up. They are a lot wealthier than they were when the lockdowns were announced in March. And wealthier than they were on January 1^st 2020. If their wealth has been diversified through the JSE, the average shareholder will be 70% better off than they were in March. And 13% up on their portfolios of the 1^st January 2020. The All Bond Index has returned 31% since March and 9% since January 2020. Those with shares off-shore would also have done well, but not as well. They would be up 59% if they held an MSCI EM benchmark tracker or 46% if they had tracked the S&P 500 March. That foreign holiday plan sadly disrupted in March would now be about 16% cheaper in USD. Since the ZAR/USD bottom of April the mighty ZAR has also done a lot better than the average EM currency.

To what should South African wealth owners attribute their much improved financial condition? The usual global suspects can be interrogated. A weaker dollar in a more risk on environment and so buoyant EM stock markets, to which the JSE is umbilically attached, is a large part of the explanation. A rising S&P 500 is a tide that lifts all boats, though some higher than others, as we have seen of the JSE and the ZAR.

But there are more than global risk-on forces at work. SA specific risks, as measured in global bond markets, have declined, notably so since October. They have also have declined relatively, by more than the risks attached to Brazil, Mexico and Russia bonds of the same duration. In April, at the height of market turbulence, the yield on RSA USD denominated 5y bonds had risen to over 7% p.a. And the risk spread, the extra yield over US Treasuries, was about 6.5% p.a. These bonds now offer 3.1% p.a. and an extra 2.7% p.a. over US T Bonds, less than half their levels in March 2020 with much of the improvement also registered after October. Insuring RSA Yankee bonds against default now costs but 1.1% p.a. more than it would cost to insure the average of Brazilian, Mexican and Russian debt. This extra insurance premium to cover SA default SA was 1.5% in October.

The reasons for lower SA risks are not at all as obvious as the benefits. By reducing risk and helping to add to the wealth of South Africans they encourage more spending needed to encourage output and employment. Lower risks moreover reduce the returns required of business adding to their capital stock in SA, so much more of which is needed to permanently raise output employment and incomes. And tax revenues rise with income.

Such improved prospects will be completely reversed by an additional wealth tax. It will not be expected to be a once off event. It will mean more SA risk and demand higher returns on the cash firms invest, meaning still less capex. It will reduce the value of SA companies so that they can meet such higher required risk adjusted returns for investors and immediately reduce the rewards for saving and the value of pensions. It will encourage the export of the savings of tax paying wealth owners and the emigration of skilled taxpayers. Tighter controls on capital flows would inevitably have to follow that would undermine the depth of our capital markets. Have those who advise wealth tax increases estimated how much collateral damage will be done to tax revenues over the longer run?

The sensible way to fund an unavoidable increase in government spending is to call further on the R160b of Treasury cash held at the Reserve Bank. And to raise a temporary overdraft from the Reserve Bank to supplement this cash balance, should this become at all necessary.  Adding more money to the wealth portfolios of South Africans, including to their deposits at the banks, created this way, would further stimulate spending, income growth and tax revenues. It would be growth enhancing and therefore risk reducing.

The failure to secure a large supply of vaccines to help South Africa to reach herd immunity quickly, reveals a vacuity in thinking about the cost to the economy.

The fiasco over the supply of vaccines reveals fully the vacuity of South Africa’s approach to Covid-19. The deposit of R283m to secure a supply of vaccines was not budgeted for because we didn’t have the money for it – even though money for much else was found in the adjusted Budget.

In this context, I observe that the Treasury deposits at the Reserve Bank amounted to R160bn in October, boosted by loans from the IMF and other agencies with anti-pandemic action front of their minds. Has anyone in the Treasury or government attempted to calculate how much additional income will be lost for want of the vaccine – and how much tax revenue the Treasury will not be able to collect?

It will be many times more than the R20bn to be spent on the vaccine. Bear in mind too, that R7bn of this is to be funded by members of medical schemes, which in effect makes it a tax increase or expropriation by any other name, unhelpful given the state of the economy.

Yet a supply of additional money could have been made available by the Reserve Bank, in the same way that money is being created on a large scale by central banks all over the world to fund the extra spending that the lockdowns have made imperative. And the Bank could still do so, to help the Treasury fund the vaccine and the money cost of rolling it out. The idea of raising taxes to fund the extra spending when the economy is under such pressure makes little sense. A higher tax rate or taxing specific incomes will slow the economy even further and might lead to lower tax revenues of all kinds.

Moreover, there is little prospect of more inflation to come. Should inflation emerge at some point, a reversion to normal funding arrangements would be called for. The danger then is that central banks like our Reserve Bank might not act soon enough and inflation picks up. But it is a danger that pales into insignificance when compared with the present danger posed by the pandemic.

Governments around the world know enough economics to know that spending more to help employ workers (and machines) who would otherwise be idle was a costless exercise – costless in the true opportunity cost sense. But South Africa seemingly cannot bring itself to think through the problem this way. The upshot is that South Africa lacks the essential self-confidence to do what would be right now.

The monetary and financial market statistics tell us how unready the economy is to sustain any recovery of output and employment. The supply of extra Reserve Bank money in the form of notes and deposits by banks with the Reserve Bank, what is described as the money base or M0, rose by 8% in 2020. There was a flurry of extra such money in March and July 2020, since reversed. In the US, the money base is up by 43% (See figure 1).

Figure 1: Annual growth in central bank money, SA and US

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis and Investec Wealth & Investment

The SA banking system is hunkering down, not gearing up. Bank deposits have been growing at about an 8% rate, while lending to the private sector is up a mere 3%. The banks are building balance sheet strength, raising deposits and are cautious about lending more. They are relying less on repurchase agreements made with the Reserve Bank and other lenders, reserving more against potential bad debts while not paying dividends and hence adding to their reserves of equity capital. All of these act to depress growth.

Figure 2: SA bank deposits and lending (R million)

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 3: SA banks – adding to equity capital

Source: SA Reserve Bank and Investec Wealth & Investment

The financial metrics continue to paint a grim picture of the prospects for the SA economy. Long-term interest rates remain above 9%, even as inflation is expected to average 5% over the next 10 years. This makes capital expensive for potential investors who are therefore less likely to add to their plant and equipment. The difference between borrowing long and short remains wide, implying sharp increases in short-term interest rates to come and expensive funding for the government (that is taxpayers) at the long end. The risk of South Africa defaulting on its US dollar debt demands that we pay an extra 2.3% more a year than the US government for dollars over five years.

Figure 4: Key financial metrics in 2020-21

Source: Bloomberg and Invested Wealth & Investment

Poorly judged parsimony and monetary conservatism have brought SA great harm in the fight against Covid-19. They have made the prospects for a recovery in GDP and government revenue appear bleak. It is not too late to change course. We should be funding the extra unavoidable spending on the vaccine and its roll out by drawing on the cash reserves of the government or by raising an overdraft form the Reserve Bank.