How fares the SA economy? An update to December

With new vehicle sales and the Reserve Bank note issue for December to hand, we can update our Hard Number Indicator (HNI) of the state of the economy at year end. The economy maintained its sedate pace in December. The forecast is for more of the same in the year ahead, that is for slow but not negative growth in 2016. Our HNI serves as a useful leading indicator of the Reserve Bank Business Cycle Indicator updated only to September 2015.

The HNI and the Reserve Bank coinciding business cycle indicator measure the level of economic activity. When these are converted into rates of change, we show below that the growth rate in the HNI has been declining since 2010 and is currently barely positive and is forecast to remain barely so. It is of some consolation to notice that the weak growth outlook has not deteriorated and is forecast no to do so. The consistent way in which growth in the HNI leads the Reserve Bank cycle helps to confirm its usefulness. It has the advantage of being very up to date and based on hard numbers not sample surveys.

Sales of new vehicles of all sizes in the SA market (that make up half of the HNI) are shown below. While sales are 4% down on a year before, sales volumes, which have averaged over 50 000 units a month, must be regarded as very satisfactory, given the state of the overall economy, especially for the SA manufacturers who also delivered 337 748 units to foreign markets in 2015, 20.5% up on a year before.

The other half of the HNI is made up of the growth in the real supply of and demand for cash. These demands for cash have been growing at a real 4% p.a as we show below. However the cash cycle appears to have peaked earlier in 2015, helped by lower inflation. The demands for cash, to spend on holidays and presents, rise strongly in November and December, though growth slowed this December off a very high base established in December 2014. The growth in demands for cash in SA, despite the heavy and growing use of electronic alternatives to cash, speak eloquently of the important role the informal economy plays in SA – a role however that is not reflected in official estimates of the size of the informal sector, as about 5% only of GDP.

The outlook for domestic spending has deteriorated, with the collapse in the exchange value of the rand. Higher rand prices for goods with high import or import replacement content or export potential will further discourage spending by households. That the oil price in dollars has declined by even more than the dollar value of a rand has been a welcome source of relief for households and firms. The inflation outlook has therefore not deteriorated as much as it would ordinarily have done with a rand this heavily damaged.

Hopefully this lesser inflation outlook will help restrain the Reserve Bank from raising interest rates as much as they would otherwise have done. Higher interest rates will do little to help the rand; they have not helped the rand to date that has been driven by global and SA forces well beyond the influence of monetary policy and interest rates. However higher interest rates will be sure to add to the contractionary forces slowing the economy- and undermine further the case for investing in SA. Is it too much to hope for a sanguine Reserve Bank- one that will allow the exchange rate to absorb the economic shocks- and not to add to them? And to happily surprise the market accordingly.

From Shanghai to Johannesburg – More than the weak rand at work

The JSE has, over the years, become less a play on the SA economy and much more a play on the global economy. This degree of independence for investors from the ups and downs of the SA economy and the value of the rand is provided by an important group of companies listed on the JSE that we describe as global consumer plays (GCPs). They comprise principally Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI), Naspers (NPN), which has become largely a Chinese internet company through its 35% holding in Tencent, listed in Hong Kong, and MTN, which generates much of its revenues and incurs costs outside of South Africa. To these we added Steinhoff (SNR), Aspen (APN), Mediclinic( MDC), Netcare (NTC) and Intu (ITU), a London based property company.

We combine these companies into an Index, using their Swix weights (the proportion of their shares on the SA register) as the basis of their inclusion in our GCP Index. This gives NPN by far the largest weight in our Index. Foreign owners of NPN hold their shares in NPN on the JSE register because NPN shares are not listed on other exchanges. This is not the case when the shares are also primarily listed on other exchanges, as is the case with BTI, CFR and SAB, where only a small proportion of SA owners would be registered as such by the JSE.

Such independence is helpful to shareholders when the rand weakens. It is even more helpful when the rand weakens for particularly South African reasons, as it did in December 2015. In these circumstances the dollar value of these shares is likely to be little affected by events in SA and so their dollar values translate into rands at a higher USD/ZAR rate. When the rand weakens in line with all emerging market currencies, because of increased global risk aversion, the dollar value of these shares may well come under pressure, giving them less of a rand hedge quality. In such circumstances the rand can weaken by less than the decline in the dollar value of such shares, meaning that their rand value can go down even as the rand weakens. Nonetheless their rand values are likely to hold up better than the purer SA economy plays. Thus it is better to describe these shares as South African economy hedges than as rand hedges.

In the figure below, we compare the performance of the GCP Index with that of the S&P 500, also measured in rands. The comparison was highly favourable to the GCPs until this year. It has become very unfavourable in January 2016 as the chart shows. The S&P 500, in devalued rands, continues to move ahead while the GCP Index has gone backwards.

The main reason for this recent underperformance has been the NPN share price. As we show below, NPN outperformed the S&P 500 over a long period, but this has not been the case since mid-2015. The Shanghai market weakness would appear to have extended to Tencent and so to NPN. The links between Shanghai and other global equity markets has become much stronger recently and NPN is clearly affected by this.

Some of the other important components of our GCP Index have done significantly worse than NPN, as we show below where we compare total returns over the past 12 months to 15 January 2016. The distinct underperformers are APN and MTN and the distinct outperformer SAB. Clearly as with any company, firm specific risks as well as market risks including risks to the rand can greatly affect performance – as they have done with APN and MTN in 2015.

In the figure below we compare the performance of other sectors of the JSE with that of the GCP Index. Both the group of Top 40 SA Industrials and the SA interest rate plays have also had a very poor January. The commodity price plays (excluding the gold mines) continue to underperform both absolutely and relatively. The weak rand and the higher interest rates that are expected to follow a weaker rand are unhelpful market forces for SA economy plays.

The one consolation in all this JSE weakness across the board is that the oil price has fallen by more than the rand (see below). Thus the inflationary pressures that usually follow a weaker rand and usually higher fuel and transport costs, are not present. This means less inflation to come. Interest rates in SA may not rise as much as they are expected to rise. If this turns out to be the case, the depressed SA plays may well offer value over the next 12 months.

Monetary policy and the MPC: Recognising the facts

The members of the Monetary Policy Committee (MPC) of the Reserve Bank will be even more perturbed about the behaviour of the rand than the rest of us. However they have had (and will have) as little influence over its direction as you or me. The link between short term interest rates that they control and the USD/ZAR exchange rate is shown in the chart below. As may be seen, they began a rate hiking cycle in January 2014 and since then, the higher the rates, the weaker the rand has been. It is very hard to argue that the rand would have been any weaker than it now is had interest rates remained on hold over this period.

There is no good reason to believe that this relationship between interest rates and the rand will be any more predictable in the year ahead than it has been. What is predictable is the impact of interest rates on spending and so GDP growth. Higher interest rates have served to slow the economy down over the past 24 months. Still higher rates will mean even slower growth – without necessarily supporting the rand – and perhaps might even encourage further rand weakness. The slower the growth, the less reason foreign and domestic owners or managers of capital have to invest in South Africa. Growth expected leads the capital flows that determine the value of the rand.

The sooner the members of the MPC fully recognise these facts of SA economic life, the less likely they are to damage the growth prospects of the economy. The exchange value of the rand and so the inflation rate and the expectation of inflation (that take their cue from the exchange rate, for good reasons also incorporated into the Reserve Bank forecasts of inflation) is beyond their influence. Raising interest rates at a time like this because it may support the rand makes no sense at all. The rand may or may not strengthen – for altogether other reasons – especially sentiment about the investment case for emerging markets generally.

More global risk tolerance will mean a stronger rand and vice versa as usual. But the rand has not behaved as usual since President Jacob Zuma intervened so dramatically in SA’s fiscal affairs last month. Without such intervention, the rand, given global risk appetites, would have been much closer to 14 to the US dollar than 17. Zuma’s actions caused financial markets to raise significantly the doubts it has about SA’s ability and willingness to fund its government expenditure without printing money – and so causing inflation.

Hence not only did the rand weaken dramatically, but the expected value of the rand weakened even further. The spread between RSA and US Treasury bond yields, that indicate the compensation for expected rand weakness in the bond market, widened with rand weakness. A weaker rand has resulted in an even weaker rand to come- expected to lose value vs the US dollar at an over 7% p.a rate on average over the next 10 years.

Furthermore the risks of default on SA’s dollar denominated debt widened significantly – enough to take SA dollar bond yields into junk territory. SA dollar-denominated interest rates have risen ahead of equivalent junk-rated Russian debt but are still below those on even more vulnerable Brazilian foreign currency denominated debt.

The newly appointed Minister of Finance, Pravin Gordhan, has committed himself and the country to fiscal sustainability. The market place should believe him, in my judgment. But the market as yet is not giving him the benefit of their doubts. They are going to take a great deal of convincing that SA can live within its means by sticking to the strict limits on government spending that it has set for itself. The role the Reserve Bank can play in this is a limited one. Monetary policy settings will not make much of a difference to perceptions of fiscal policy. They can make a difference to the state of the economy with their interest rate settings. Slower growth makes the task of funding the fiscal deficits even more difficult. They will not be doing Gordhan or you and me any favours hiking interest rates.

SA markets: The Zuma shock wave has not passed through

The Zuma shock wave of Wednesday 9 December 2015, when Nhlanhla Nene was replaced by the little-known David van Rooyen, only to be replaced that weekend by Pravin Gordhan, has had time to be absorbed by the markets.

As we show below, some recovery from the events of that day have been registered on the share, bond and currency markets. As may be seen below, the JSE All Share Index has recovered best: at one point in late December it was almost back to its month end November levels. The RSA bond market, represented by the All Bond Index, with a duration of about six years, was the most deeply affected at the time, but then recovered and is now trading at about 94% of its 1 December value. The trade weighted rand is worth about 8% less than it was on 1 December.

That the Zuma intervention in our fiscal affairs is not regarded by the market as a temporary aberration but more as a permanent danger, is fully reflected in the extra costs of insuring against a RSA default of its obligations on its foreign currency denominated debt. The five year Credit Default Swap (CDS) spreads on RSA debt widened sharply on 9 December and have remained at a highly elevated level of over 350bps. This spread has also increased sharply when compared to the spread on the Emerging Market Bond Index (EMBI – indicated by a narrower difference between the EMBI and RSA spreads) and also when compared to Russian spreads. SA is now regarded as more likely to default than Russia and Brazil. Our credit rating in the market place is thus of junk status. It appears to be only a matter of time before the credit rating agencies catch up with the market place.

Unless the SA government can convince the market place very soon that SA’s fiscal intentions have not changed permanently for the worse, the Zuma shock will prove very expensive for SA’s taxpayers who have to service significantly more expensive debts to come as current debts are matured. Nkandla is very small change compared to this potential bill. The market place will need assurance that SA’s tax base can withstand the higher interest expenses incurred. Evidence that the growth in government expenditure, especially the growth in spending on government sector employment benefits, is slowing down sharply, would be helpful to this end. More important still is any indication and that the growth outlook for SA is improving to help generate more tax revenue to ease the pain of higher taxes rates. The chances of more fiscal discipline seem better than a meaningful pick up in GDP growth. Though the dramatically more competitive rand could and should be helpful to this end, strikes and unhelpful policy interventions permitting. The Barmy Cricket Army are an advance tourist guard doing their best to improve export earnings.

The spread between the RSA 10 year bond yield and the yield on a 10 year US Treasury also widened sharply, to over 8% on the fateful day and has since narrowed to about 7.2% as may be seen in figure 5. This spread indicates that the rand is expected to depreciate by about 7.2% a year, on average, over the next 10 years.

The reactions in the market place to date indicate that the rand continues to respond to the usual daily forces, but off a significantly weaker base. The weaker emerging equity and bond markets are, the weaker the USD/ZAR exchange rate will be and vice versa. Commodity price trends will also be an influence on exchange rates. But these forces are acting off a weaker base, as we show below. The rand is now much weaker than would have been predicted before December 2015 using the Aussie / US dollar exchange rate and the EMBI spread as predictors. A value closer to R13 than R16 might have seemed more reasonable before 9 December. The question then arises: can we confidently expect the base value of the USD/ZAR to improve any time soon?

The answer appears to be an unfortunately negative one, absent an equally dramatic development on the political and economic policy fronts. It does not take much to imagine what that would have to be. The government however will be under few illusions that SA’s dependence on foreign capital remains as heavy as ever. Given the currently low base and highly depressed expectations of SA, the benefits of surprising the markets with good news could have an unusual upside. Good, credible news about fiscal sustainability and more market respecting (business friendly) dispositions- maybe even some privatisation of publicly owned assets to reduce public debt and improve economic efficiency, could much improve the mood. Call them public private partnerships if you have to. But actions and better intentions towards market forces, both inside and outside the country, are urgently called for.

The SA economy at month end November 2015. Do we thank the informal (unrecorded) sector?

We have received some useful information about the state of the SA economy at the end of November 2015. New motor vehicle sales and cash in circulation at month end November present something of a mixed picture. We examine both below and combine them to update our Hard Number Index (HNI) of the current state of the SA economy.

Vehicle volumes in November came in marginally ahead of sales a year before and on a seasonally adjusted basis were also slightly ahead of sales in October 2015. But the sales cycle, when seasonally adjusted and smoothed, continues to point lower, albeit only very gradually so.

The local industry is delivering new vehicles at an annual rate of about 600,000 units and the time series forecast indicates that this rate of sales may well be maintained to the end of 2016. Such an outcome would be regarded as highly satisfactory when compared to peak sales of about 700,000 units back in 2006. (See below) For the manufacturing arm of the SA motor industry, exports that are running at an impressive, about half the rate of domestic sales, are a further assist to activity levels. This series may be regarded as broadly representative of demand for durable goods and equipment.

New Unit Vehicle Sales in South Africa

Source; Naamsa, I-net Bridge and Investec Wealth and Investment.

The demand for and supply of cash in November by contrast has been growing very strongly. By a 10.6% p.a or 5.7% p.a rate when adjusted for headline inflation of 4.6%. This represents very strong growth in the demand for cash- to spend presumably. Though as may also be seen the cash cycle may have peaked.

The extra demands for cash presumably come mostly from economic actors outside the formal sector. The formal sector has very convenient electronic transfer facilities as alternatives to transferring cash. Electronic fund transfers have increased from a value of R4,919b in 2009, that is nearly 5 trillion, to R8.4t in 2014 or at a compound average rate of 8.9% p.a over the six years. Over the same period credit card transaction increased from R142,198b in 2009 to R258.6 by 2014 or by a compound average rate of 9.9% p.a while the use of cheques declined from a value of over R1.1t in 2009 to a mere R243b by 2014.

The supply of notes issued by the Reserve bank have grown from R75.2b in November 2009 to R134.7b in November 2015, that is at a compound average rate of 9.7% p.a. That is the demand for and supply of old fashioned cash has grown in line with the growth in electronic alternatives. Clearly there is a great deal of economic activity in South Africa that escapes electronic action or surveillance. We show the respective nominal and real note cycles below. Both show a strong acceleration in 2015.

The Cash Cycles- annual growth in the note issue.

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The note issue cycle and the retail sales cycle in money of the day are closely related as we show below. The advantage of observing the note issue is that it is a much more up to date statistic than is the estimate of retail sales, the most recent being for September 2009. The strength in the note issue in November 2015 bodes rather well for retail sales in December and perhaps especially so for sales made outside the electronic payments system.

The cash and retail cycles. Current prices

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

When we combine the vehicle cycle with the cash cycle we derive our Hard Number Index (HNI) of economic activity in SA. As may be seen the HNI indicates that the SA economy continues to maintain its current pedestrian pace, helped by strength in the note issue and not harmed too severely by the downturn in unit vehicle sales.

As indicated 2016 seems to offer a similar outcome. The HNI is compared to the Reserve Bank Business Cycle Indicator that has been updated only to August 2015. The HNI can be regarded as a helpful leading indicator for the SA economy-more helpful than the Reserve Bank’s own Leading Economic Indicator that consistently has been pointing to a slow down since 2009 – a leading indicator belied by the upward slope of the Business Cycle itself- and the HNI. ( See below)

S.A. Business Cycle Indicators (2010=100)

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The slow pace of economic growth in SA is partly attributable to the dictates of the global business cycle. The weak state of global commodity and emerging markets remains a drag on the SA economy. Any business cycle recovery in SA will have to come from a revival in emerging market economies linked to a pick-up in metal and mineral prices that will be accompanied by a stronger rand and less inflation and perhaps lower interest rates. This prospect now appears remote. Though a mixture of stronger growth in the US and Europe with less fear about the Chinese economy would be very helpful to this end. South Africa could help itself with growth improving, market friendly, structural reforms. This prospect unfortunately appears as remote as the recovery in global metal markets.

Another own goal for SA

The SA government seems determined to press ahead with a national minimum wage (NMW). This is apparently with the agreement of organised business and labour, though the minimum levels themselves are still in dispute. It however appears likely that the NMW will be set close to the incomes that define “the working poor”, those who earned less than about R4000 per month in 2015 for a 35 hour working week.

Not much poverty relief at R4000 per month, you may think. Yet the problem is that most of those with jobs in SA earn much less than this while a large number of potential workers are unemployed and earn no wage income at all. According to a comprehensive recent study of the Labour Market in SA1 , even after adding 40% to wage incomes to compensate for “underreporting” in the Labour Force Surveys undertaken by Stas SA, 48% of all wage incomes representing 5m workers fall below R4000 per month and 40% earn less than R3000 per month, about 2.7m workers out of a total employed of about 13m. The proportion of those employed who fall below R4000 are much higher in the rural areas, higher in agriculture (nearly 90%) and domestic services (95%). At the other end of the spectrum is mining, where 22% of the work force earn less than R4000 per month. Even in the comparatively well paid and well skilled manufacturing sector, about 48% of the work force are estimated to earn less than R4000 per month.

Unless the laws of supply and demand for labour can be repealed, it seems obvious that were the NMW to be made effective, the consequences for currently low paid workers would be very serious. Many will lose their jobs, while many more young workers hoping to enter the labour market will find it even more difficult to gain entry to formal employment. Some excluded from formal employment may find work in the unregulated informal sector and many others will be required to work fewer hours, as employers seek to make their work force more efficient, to compensate for an artificially higher hourly rate. This trend is already well under way, according to the study. Other employment benefits provided by employers, such as pensions, health, housing and food, may be reduced to compensate for higher take home pay.

Why then would the government wish to push ahead with such a predictably disastrous initiative, imposed without regard to labour market fundamentals? Can the government and its advisors truly believe that wages have little to do with employment or that some miracle of economic growth or currently unrealised productivity gains will come to raise the demand for labour? Surely not, though the support of trade unions and large businesses for an NMW, expecting less competition for jobs from low paid workers or firms able to hire them, is entirely rational self-interest at work. Unions attempt to maximise the wage bill they can draw member dues from and business seeks to maximise profit, not employment. Robots can replace workers very easily especially at higher wages or rather improved employment benefits.

The case for an NMW must be a political one. It cannot be an economic one. If an NMW, proclaimed at levels well above market determined wages could cure poverty, the economic problem of poverty in SA and everywhere else would have been solved by decree a long time ago. The government must believe that fewer but better paid, so called decent jobs, will mean more support for it at the ballot box. Nobody would thank a government for employment at wages that do not provide an escape from poverty, even if the alternative more poverty for now and more dependence on government hand-outs of cash and housing.

Our labour market regulations and interventions have long been pushing employment and employment benefits strongly in this direction. Fewer well paid private sector formal jobs have been provided – relative to GDP – and many people have joined the ranks of the unemployed or the informally employed, the latter not fully captured in GDP estimates.

NMW may be a recipe for political survival but is not a cure for poverty in SA. It will retard the rate of economic growth in SA that is the only long term cure for poverty. Economic growth, sustained at a rate well above population growth, would gradually lift all incomes in SA, including those of the worst paid, as well as skilled workers. Achieving higher growth rates demands a more flexible labour market. Unfortunately SA continues to move in the other direction.

Monetary policy in SA – the dangers of bad theory put into practice

The Reserve Bank is well aware that there are no demand side upward pressures on the inflation rate. In fact the opposite is very much the case. Weak demand is clearly constraining the power that sellers have to increase prices, not only in South Africa but globally. Hence for inflation forecasters, including those at the Bank, lower rather than higher than expected inflation.

Moreover, the price increases to come from Eskom and municipalities and perhaps also the Government (higher tax rates) can be expected to not only add to the CPI but deflate household spending even further in the months to come. But regardless of even slower growth to come, the Monetary Policy Committee (MPC) decided on a 4-2 count that a further sacrifice of expected growth was called for.

To quote the concluding remarks of its statement of 19 November:

“In the absence of demand pressures, the MPC had to decide whether to act now or later. On the one hand, given the relative stability in the underlying core inflation, delaying the adjustment could give the MPC room to re-assess these unfolding developments at the next meeting, and avoid possible additional headwinds to the weak growth outlook. On the other hand, delaying the adjustment further could lead to second-round effects and require an even stronger monetary policy response in the future, with more severe consequences for short-term growth.

“Complicating the decision was the deteriorating economic growth outlook. Although the change to the growth forecast was marginal, the risks to the outlook, which were more or less balanced at the previous meeting, are now assessed to be on the downside. Against this difficult backdrop, the MPC decided to increase the repurchase rate by 25 basis points to 6,25 per cent per annum effective from 20 November 2015. Four members preferred an increase, while two members favoured an unchanged stance. “
The Reserve Bank has again been guided by a theory of dubious logic and unbacked by evidence that inflation expected in SA can drive inflation ever higher – regardless of the state of demand in an economy. Or in other words firms and trade unions with price and wage setting power, in their budgets and plans for the future, having set their new demands on consumers and employers with expected inflation in mind – will stick to them. Stick to them, that is, and then ask for still more at the next round regardless of the ability or willingness of customers or employers to meet these demands. Without support from the demand side of the economy and highly accommodative monetary policy responses to higher expected and actual inflation, ever higher prices cannot stick, and will not stick because such behaviour is simply not consistent with income maximising behaviour. It has not done so to date and will not do so as the theory of prices, properly understood, would predict.

In simple theories of inflation used by most central banks, including the US Fed, and as explained very clearly in an important speech given by Fed Chair Yellen recently, the influence of inflationary expectations on prices – that find the way into prices asked for – are combined with and excess demand or supply variable, known as the output gap. The theory is that the wider the output gap, the less inflation – for any given inflation expected. The Reserve Bank has seen fit to deny the role of the output gap and its own already higher interest rate settings in restraining inflation. It is a peculiar monetary policy and, more important, theory of economic behaviour that is being applied by the Reserve Bank.

Furthermore, the evidence is very strong that inflation expected in SA is highly stable about the 6% level and is likely to remain so – if and when inflation in SA trends lower. It can and should do so if the rand strengthens – a force largely beyond Reserve Bank powers or powers to predict. Inflation leads inflation expected in SA, as it did between 2003 and 2006 when, thanks to a strong recovery in the rand, inflation receded and inflation expected followed.

We can only hope for a further episode of rand recovery, lower rates of inflation in SA to follow and less inflation expected as measured by the gap between conventional and inflation linked bond yields. If this should happen then the theory of inflation being driven by the mere thought of more inflation will be thoroughly and most helpfully disabused – as it should be.

As it happened on Thursday 19 November, the chances of this test of the theory improved for reasons, surely completely independently of the Reserve Bank decision that was taken at about 15h30 our time. As Bloomberg shows (see figures below) almost exactly at that time the MPC announced higher short term rates for SA, long term interest rates in the US fell quite sharply and long term rates in SA followed lower. A surprising combination of higher short term rates in SA and lower long term rates was to be observed. Also to be observed was a stronger rand. Again, this was caused by forces quite beyond Reserve Bank influence. Emerging equity markets enjoyed a nice bounce higher – consistently combined with the lower interest rates in the US – and even more consistently combined with a firmer rand. Clearly the fear of a Fed rate hike has been well priced into markets: the Fed decision to raise rates in December has become much more certain fact and its impact much less disturbing.

This confirms once more that the most important influence on inflation, the behaviour of the rand, is largely beyond the influence of short term interest rates in SA. Therefore the Reserve Bank can in practice only hope to influence the level of demand in SA, which it does consistently by raising or lowering interest rates. Given weak demand and the absence of demand side pressures on prices in SA, it should be lowering, not raising its repo rate. The Reserve Bank is relying on a theory that inflation in SA could become self-fulfilling and therefore demands higher interest rates, doing our economy a grave disservice in the process.

 

Global rates: The dropping of the shoe

The reactions of the Fed. The other shoe has dropped – thankfully for those living downstairs.

The first Fed shoe dropped in May 2013 when it announced it would soon be halting, or in its own words “tapering” QE, that is the purchase by the Fed of US government bonds and mortgage backed paper in the market place in exchange for its own deposits. In other words, the Fed signaled its intention to stop creating money, as it had been doing to the tune of an extra US$85bn a month. True to its word, by year end 2014, QE was suspended.

The reactions in the financial markets to this announcement in 2013 were quite dramatic, and especially so in emerging market (EM) equity, currency and bond markets, including South Africa. The rand lost over 12% of its US dollar value within a few weeks, from about R9 to the dollar at the beginning of May 2013 to about R10 at month end while the yield on the RSA 10 year increased from 6.3% p.a to 7.08% p.a by month end. The benchmark EM equity index, the MSCI EM, lost 10% of its value between May and June 2013 while the US dollar value of the JSE All Share Index lost 6.8% in US dollars over the two months.

The second Fed shoe has now dropped, which is perhaps just as well for those who have been waiting for it to hit the floor. The second shoe comes in the form of the upward move in the Fed’s short term rates, the first such increase since the financial crisis of 2008. An increase of 25bps in US short term rates in December now seems certain, or at least the market place has reacted as if it is almost certain.

Market reaction to this news have been far more muted than the responses described as the taper tantrums of 2013. The rand has lost about three percent of its dollar exchange value since the September month end. 10 year bond yields are about 30bps higher in response to the now firm prospect of higher short rates in the US.

The shoe having dropped, is there more damage in prospect for the rand and the borrowing costs of the SA government? The answer will depend largely on ongoing investor sentiment towards emerging markets. Higher interest rates in the US and elsewhere are not welcome in hard-pressed EM economies. But confirmation that the US economy is firmly on a recovery track, is surely encouraging to all those EM businesses that trade with the US. A combination of strength in the US and less anxiety about the Chinese economy would surely be better news for EM economies and their longer term prospects that now appear so poor (as reflected in EM share markets that in US dollars are well down on their levels of September 2009, while the New York benchmark S&P 500 has been racking higher ever since).

The rand remains an EM equity currency. It continues to move in response to the US dollar value of the EM equity benchmark as we show below. South African events do not appear to affect the rand in any consistent or significant way.

The rand is little changed versus other EM currencies over recent days, though both the Turkish lira and Brazilian real have recovered some of their weakness against the rand. On a trade weighted basis, the rand, in line with other EM currency and equity markets, has weakened significantly since mid-year, though much of the damage occurred in August rather than very recently.

The rand’s daily moves can be well explained by global market developments independently of SA political or economic developments (which cannot anyway be regarded as favourable). For example, as we show below, the rand rate against the US dollar can be predicted to closely follow trends in the US dollar / Australian dollar exchange rate, coupled with a measure of SA sovereign risk. Sovereign risk is measured as the premium investors would pay to ensure against SA government default on its debt. The results of such a model are shown below. It suggests that the rand, now trading at over R14 to the US dollar, has overshot its predicted value of R13.50 or so.

We get a similar result and a similarly satisfactory model of the rand when we replace the influence of the Australian dollar with the MSCI EM and combine this with the credit default spread on US dollar-denominated SA debt. The rand appears somewhat oversold using these models.

It is also clear that as the prospect of higher US rates has become more certain, the risks associated with EM debt, as measured by the spreads over US government debt, have also increased. The spreads attached to SA debt have widened largely in line with EM spreads generally. SA specific risks do not appear to have had a significant influence on these spreads recently. Higher spreads and higher interest rates in SA appear mostly as an EM rather than SA event. The Credit Default Swap (CDS) spread between SA dollar-denominated debt and the average EM (Brady Bond) spread has not altered recently. In a relative sense, SA debt lost some rating ground versus other EM borrowers by mid-year, however. The spread in favour of SA can be seen to have narrowed.

Long term interest rates in SA have followed modestly higher rates in the US as the near certain increase in short rates was priced into the debt markets. As we have mentioned, these increases can be regarded as modest to date.

The wider EM risk spreads have not led to any exaggerated movements in the yields on rand-denominated RSA debt. We must hope that the very little inflation expected in the US helps to continue to restrain the Fed from ratcheting up short rates and that long term rates in the US remain at historically low levels for an extended period of time. We expect very dovish Fed reactions, especially given the stronger dollar that will keep down the pressure on metal and mineral prices and make deflation rather than inflation the focus of Fed concerns.

Less upward pressure from US interest rates on SA rates (short and long) will be helpful for the rand and the inflation outlook in SA. Hopefully, less pressure will restrain the Reserve Bank from even thinking about higher interest rates. Higher rates in SA would not necessarily protect the rand should the dollar get stronger with higher rates in the US.

The other shoe – in the form of market reactions to higher interest rates in the US – may well have dropped. And the reactions in the market place to date reflect a much more relaxed response to the prospect of higher rates in the US than was the case in 2013. We must hope and encourage the Reserve Bank to also keep its composure.

Secular Stagnation or normalisation of the global economy? Giving the patient time to return to health

A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market. Our own view is somewhat different – the world is moving gradually along the road to normalisation.

The balanced portfolio – how should it be weighted for the next 18 months. More or less in equities – Risk on or risk off.

The global portfolio manager has become noticeably uncertain about the global growth outlook and the outlook for US interest rates. The day-to-day volatility of share, bond and currency markets reveals this. More risk means higher required returns and thus lower valuations, and vice versa.

The twin concerns (global growth and US rates) are not independent of each other. Faster growth would normally lead to higher interest rates and higher rates might then be regarded as a welcome indicator of faster growth under way. Slower growth would ordinarily lead to lower rates. In a normal environment, good economic news could mean higher interest rates, but also increased revenues and profits for listed companies, so would therefore be well received in financial markets.

But the times are not normal. The developed economies (apart possibly from the US) appear to be suffering from growth that is too low for comfort and inflation rates that are too low for the comfort of central banks. The emerging economies, particularly the commodity producers, are suffering from slow growth as well as weak demand and lower prices for their exports – leading to pressure on their exchange rates. Devaluation of emerging market currencies brings higher rather than lower prices in its wake and possibly (and ill advisedly), higher interest rates that in turn would reduce growth rates further. The emerging market policy makers would prefer faster growth in the developed economies they supply and lower interest rates to take pressure off their currencies and inflation rates.

Ideally, lower interest rates designed to stimulate faster growth in the high income world, would be broadly welcome in the financial markets. There is however the problem that interest rates, more particularly real, after-inflation interest rates, are already at historically low levels. How much further can they be made to fall? There are, for practical and theoretical reasons, lower bounds to interest rates.

Quantitative easing (QE) may become the only tool available to central banks when fighting deflation, has become their primary objective and when interest rates are very low, perhaps even below zero. But even supplying more cash to the banking system may not work if the banks prefer to hold the extra cash, in the form of extra deposits with the central bank, rather than put them to work funding additional loans and overdrafts. QE may have saved the financial system, but the rate of growth in bank credit has remained very weak in Europe while somewhat more robust in the US.

In a world where prices are falling, it might take interest rates well below zero, that is well below the rate of deflation, to stimulate more borrowing and spending; that is to effectively reduce the real costs of borrowing and repaying loans that rise as prices fall. Deflation is helpful to lenders and harmful to borrowers. Inflation does the opposite, which is why expected inflation and / or deflation would always be reflected in the terms lenders and borrowers could agree upon.

Expected inflation brings higher interest rates and expected deflation would result in lower rates, even negative market-determined interest rates. In other words, you could be paid by lenders to issue debt (at negative rates of interest) as governments in Europe are being paid to do. The German government now to offers a positive rate of interest for Bunds that mature only after 2021. Recently the US Treasury has issued three month bills at a zero rate of interest, a record low.

The problem with negative interest rates imposed upon central banks is that negative rates of interest on bank deposits or other rewards for lending provided by financial institutions generally, would have to compete with cash in portfolios. Cash, or rather the notes issued by central banks as well as their deposits, will maintain their money value despite deflation, providing a highly competitive zero rate of interest, when other safe haven rates fall below zero. For wealth owners, holding cash rather than lending or spending it will not help an economy grow faster. Such problems for central banks are exacerbated when deflation is accompanied by a recession.

It is the problem with deflation, rather than inflation, that is occupying the central banks’ minds in the US and Europe. The target for the US Federal Reserve (Fed) is 2% inflation. Anything less than 2% would therefore call for lower interest rates for fear of what deflation could do to spending and economic growth.

The problem for the Fed and Fed watchers is that the Fed has strongly signaled that it will be increasing its key short term interest rates this year. But while such an increase might make sense for the US, given the economic recovery to date, it will not be helpful outside the US. It also makes less sense for the US if it leads to deflation, accompanied as it is likely to be by a stronger dollar and so more deflationary pressures inside and outside the US. There is moreover a more general concern that US growth may disappoint anyway and that any interest rate increase will not be called for.

These considerations, especially the explicit Fed concerns expressed about the state of the global economy, convinced the Fed to postpone any increase in short rates at the Federal Open Markets Committee meeting of 23 September. This decision at first was poorly received in the market place. Fed vacillation appeared to add something to the risk premium attached to equities and currencies. More recently, a weaker employment number for the US, that strengthened the case for a postponement of an interest rate increase, saw the risk premiums decline with a much better tone on the equity and currency markets, especially for emerging market currencies.

It seems clear that the developed equity markets would welcome a mixture of stable (or even lower than previously expected) interest rates in the US. The outlook for global economic growth has also been revised lower by the International Monetary Fund and other forecasters, including other central banks, making the case for lower, not higher, interest rates in the US.

Most important for portfolio selections, developed equity markets appear rather pessimistic about economic and earnings prospects. They appear to be already valued for very slow growth. Goldman Sachs, in a recent report on European equities, given an equity risk premium of 5% (that is expected returns from equities 5% above the risk free rate that is close to zero) infers that the Stoxx 600 index for European equities is priced for zero growth in earnings per share, compared to the long term average of 5.1% p.a.

If we apply the same 5% p.a equity risk premium to the S&P 500 Index, using the implied growth in earnings per share as the risk free rate, represented by the 10 year bond yield (currently about 2.10% p.a) plus 5%, less the S&P current earnings yield of 4.93%, we derive an implied permanent growth in earnings per share of about 2% p.a. This is well below the average annual growth rate realised since 1990. With 10 year US inflation-protected bonds currently offering a very low 0.55% p.a, and nominal 10 year US Treasury trading at 2.09% p.a, the compensation for bearing the risks of inflation, or inflation expected by the bond market, over the next 10 years is currently about 1.54% p.a. Thus the implied real growth in S&P earnings per share is less than 0.5% p.a. This confirms that US equities, like European equities, are currently priced for very slow growth.

It would appear that the market is expecting secular stagnation of the developed economies rather than any normalisation of growth rates. A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market.

Conclusion – our view is different

Our own view is somewhat different. While aware of what is a somewhat confused market place, we are still expecting a further gradual move to economic normalisation. This is a process that followed the global financial crisis of 2008. This will be reflected in a gradual increase in the willingness of households in developed economies to borrow to spend and of banks to lend to them. Household debt to income ratios are in continuous decline, as are household debt to debt service ratios. A decline in these debt ratios points to normalisation of household spending propensities. This process is essential, if aggregate demand is to grow at something like normal rates, given the importance of household spending for GDP in the developed world.

It seems to us that the global economic problem is one of too little demand rather than too little being produced or capable of being produced. The supply potential of developed economies is being continuously enhanced by innovation and improved technology. Addressing the problem of under spending, after the global financial crisis, we appreciate, has taken longer than normal and required very unconventional monetary policy. This may well have had something of a negative impact on business confidence and so slower growth in capital expenditure by firms that has held back economic growth. But if households came to spend more of their incomes and firms exercise more of their capital equipment, they would normally be inclined to add to their plant and machinery and perhaps also their labour forces. Capex, rather than buying back shares or engaging in acquisitions, would then make more economic sense.

Equity markets in the developed world appear undemandingly valued for current interest rates. Interest rate increases, we think, are unlikely to threaten these valuations. Any sense that the developed markets will not slip into recession or secular stagnation will be helpful for equity values. The emerging market economies, where GDP growth and particularly earnings growth, remain under pressure from lower commodity prices, may take longer to normalise. Their progress will depend on the same improved sentiment about global growth that would mean normalisation of developed economies rather than secular stagnation. Our recommendation therefore for the composition of balanced portfolios, those that mix equities, bonds, property and cash, is for a continued modest bias in favour of risk-on, rather than insurance assets.

Prices and Budget Reviews – all promising austerity rather than progress

Amid the pandemonium in and around Parliament yesterday, something may have been missed. What probably escaped notice was that for a third month the CPI was unchanged. It reached a value of 116.1 in July, remained 116.1 in August and prices maintained that level of 116.1 in September. In other words, average prices in SA since July 2015 have remained unchanged and so the inflation rate in Q3 2015 remained a round zero. Headline inflation, the percentage increase in the CPI over 12 months was 4.6%, also unchanged from August 2015.

The upward pressure on the CPI from rising utility bills and house rentals, including the rentals owner occupiers are assumed to pay themselves, that added 0.9% to the CPI in September, was offset by lower petrol and transport costs that took 1.6% off the index. The prices of food and non-alcoholic beverages rose by a mere 0.1% in the month.

These outcomes in Q3 must have come as a surprise to the Reserve Bank, which believes inflation is driven largely by inflationary expectations. Hence its tendency to impose higher interest rates on the economy, regardless of where the pressure on prices may be coming from, less supplied or more demanded, for fear that inflationary expectations are self-fulfilling.

These inflationary expectations, with a much weaker rand in the quarter, might have been expected to have been elevated in Q3. Judged by the gap between the yield on conventional and inflation-protected RSA bonds, reflecting compensation for bearing inflation risk, as good a measure of inflation expectations as any, have changed little, and remained very stable about the 6% level, in line with the upper band to the inflation targets, as it has done for many years.

It is clearly not expected inflation that stabilised the CPI at 116.1 (2012=100). It was the weakness of final demands for goods and services that has so limited the pricing power of firms supplying households and firms not only in SA but almost everywhere else too. This lack of demand has put pressure on the dollar prices of goods imported into SA, including that of oil and grains. The so-called pass through effect on prices of a weaker rand is running at about a fifth of the impact predicted by the Reserve Bank’s inflation forecasting model.

The Reserve Bank needs a better theory of how prices are formed in SA than are determined (mostly) by inflationary expectations. This will help it avoid imposing unwelcome extra burdens on the economy in the form of higher interest rates when too little, rather than too much, spending is part of the problem, as it has been doing ever since early 2014 when short term rates were first increased.

Yes, higher taxes on energy or higher charges for electricity or water or roads or imports may put upward pressure on prices charged (as may the budgets of firms with pricing power) that presume prices can be increased in line with inflation expected. But as is now highly apparent, prices charged and recognised in the CPI are not crudely equivalent to costs, including employment costs, plus some profit margin. They are much better explained as profit-maximising or perhaps loss-minimising prices – what the market will bear prices, which reveal highly variable operating profit margins.

The update from Shoprite, SA’s leading food retailer released on the morning of the CPI update, told the same story of pressure on food prices and operating margins. And the declining employment numbers tell of the pressure of higher wage demands on numbers employed rather than on prices charged.

It is the weak state of final demands from both SA households and firms that is holding down the CPI as well as the GDP that is barely growing. Higher taxes imposed by the national government and the higher charges for electricity etc. levied by municipalities and yes also the fees charged by educational and medical service providers that have monopoly type pricing power and also, most avoidably, higher interest rates set by the Reserve Bank, have all taken their toll on household budgets and spending power and so the pricing power of the firms supplying them.

This lack of demand for goods and services and labour is being exacerbated by the inability of the SA government to sensibly limit and manage its own spending on employment benefits for government workers, the largest item by far in its Budget. This outcome, understandable in the circumstances, and given conservative objectives for government debt ratios, means discouraging still higher taxes on the productive economic agents of the economy and less spending by government on other items, including on useful infrastructure.

The Budget statement to Parliament was eloquent in its admission that unexpectedly large employment benefit concessions to public sector employees greatly disturbed the Treasury’s Medium term expenditure and revenue plans. This disruption to sound fiscal policy was explained in the Budget Statement as somehow beyond the control of the government itself. The bargaining arrangements with public sector unions that led to such exorbitant outcomes post the main Budget in February 2015, may well have been out of the control of the Treasury and its fiscal constraints. As such it represents just another government failure.

It is the failure of the government to recognise that the path to faster growth in SA is not only through more effective government spending, but less of it, combined with less interference in the economy that so engages the well paid but now shrinking government workforce. It is less government and so lower taxes and much more reliance on business for solutions to poverty and growth that should be the way forward for SA. Resisting this direction, as it is being resisted in Budget after Budget, leads to higher taxes and charges and less rather than more spending and slower rather than faster growth. In other words more public and private austerity of the kind we are experiencing.

The price of good advice

Calculating the costs and benefits of financial advice – a dangerous exercise in the US and a necessary one in South Africa

 

It may be argued that one of the important functions managers of private wealth provide is that we can help save our clients from themselves. When we (the wealth managers) act on clients’ behalf, in a conservative way, conscious of risks as well as returns, with wealth entrusted to us, we may well help prevent them from making disastrous investment decisions all on their own. Such poor financial decisions may cost them far more than the fees we charge for our advice and record keeping. Earning extra returns for clients, ahead of the fees incurred, is not the only purpose of our fiduciary duties. Saving wealth owners from themselves is perhaps even more important.

 

A study made by US economist Robert Litan seems to agree. As reported in the Wall Street Journal (online edition, 4 October), Litan in July testified before the US Congress against a US Labor Department plan to regulate financial advisers. His cost-benefit analysis estimated that, during a market downturn, the proposed regulation of financial advisers, with associated higher fees for advice, could cost investors—especially those who aren’t wealthy—tens of billions of dollars. The cost to clients would be incurred by depriving them of good financial advice, such as advice against panic selling, that they may well have chosen were fees for advice lower.

 

The regulation of financial advice can raise the cost of advice, perhaps through an extra fee, that many clients may prefer not to pay. Hence the greater likelihood of poor investment decisions made without useful advice: not only the mistake of buying at the top of the market and selling at the bottom, but also advice that should and would discourage any naïve or greedy propensity to ignore the relationship between a promised return and the associated risk of receiving much less, or indeed no return at all. The Litan evidence would have been in the form of an examination of the comparative track records of investors achieved with or without advice – in the light of the observed sensitivity of clients to the fees charged for that advice.

 

Political costs, too

 

The story in the WSJ is only partly about the benefits and costs of financial advice. It is also about how his testimony cost Litan his job. A veteran of 40 years with the Brookings Institution, Litan offended left-leaning Massachusetts Senator Elizabeth Warren, who is sponsoring the intended legislation. He was accused, in a letter Warren wrote to the head of Brookings, of concealing a conflict of interest by not disclosing that his study was supported by the Capital Group, a very large mutual fund manager in the US. This conflict of interest accusation, according to the WSJ, was made “notwithstanding” that the first page of Litan’s testimony says: “The study was supported by the Capital Group, one of the largest mutual fund asset managers in the U.S.”  Senator Warren called that disclosure “vague”—while the WSJ named this accusation “an obvious falsehood”.

 

A private company with an interest in opposing regulation may often sponsor research in think tanks or universities. Even more often, a government agency may sponsor research inside or outside of government itself with an equally obvious and opposing political and bureaucratic interest in implementing additional regulation. Ideally the research, regardless of its sponsor or conclusions, should be allowed to inform public opinion and the legislative outcomes that may follow. Disclosure of sponsorship is both ethical and wise so that any possibly convenient conflict of interest argument will not prove decisive in any adjudication process.

 

The quality of any research can surely be tested and cross examined regardless of its provenance, as is the evidence of the so-described “expert witnesses” in our courts, paid for by one or other of the litigating parties. An expert witness, talking to the book of a pay-master, in disregard of the evidence, will soon be found out as biased in any thorough cross- examination and such advice will be correctly ignored.

 

In South Africa, the Treasury and the Financial Services Board have been much involved in regulating the quality of investment advice provided to savers and by financial advisers. Clearly quality advice is desirable. But, as in the US, it also comes with a price, in the form of higher fees or costs, which potential clients may judge as not worth paying for.

 

One hopes (but doubts) that a similar analysis of the perhaps unintended costs and consequences, as well as the benefits of additional financial regulation in SA, has been undertaken for our market place. A study of the kind provided by Litan – that explores the danger that many more savers will go inexpertly or inadequately advised and so make poor and very costly financial decisions, because such advice is deemed too expensive – would be welcome.

 

There are always benefits to be had from every regulation of market forces. There are also always associated costs, some more obvious than others. Both the additional benefits and the full extra costs, associated with an intended regulation, should be calculated, as fully as they can, regardless of where the chips may fall.

Payrolls post mortem

Reading the changing market mind has become a more difficult exercise.

The report on US payrolls report on Friday, which was up 142 000 and well below the consensus estimate of 201 000, was not good news about the US economy.

The initial reaction of the equity and bond markets after the data release was to drive share prices sharply lower and bond values higher. But an hour later the share market reversed itself and ended the day 1.5% higher. Bad news about the economy had become good news for markets. These reactions, in the form of higher equity values to a weaker than expected employment number, might be a consistent response to a view that short term interest rates in the US would not now be rising any time soon.

The US dollar also weakened significantly through the day against the very hard pressed emerging market currencies, including the rand. Bad news was not only good news in New York; it was well received everywhere.

These market reactions on Friday – bad news for the economy translated into good news for markets, because interest rates would be lower than previously expected – were however in sharp contrast to the negative market reactions to the Fed decision on 23 September to delay any increase in interest rates for global rather than US economic weakness. Then, after initially welcoming the Fed decision, the equity markets turned sharply lower and emerging market currencies and equities were then particularly hard hit.

Other things being equal, lower interest or discount rates can justify higher equity (present) values. But the economic activity, or lack of it, that move interest rates are other things, especially the revenue and operating profit lines of companies. This means that other forces driving equity values cannot be assumed to remain unaffected by the state of the economy. Helpfully for shareholders, the market seems convinced for now that the lower US discount rate attached to expected operating earnings, as interest rates stay lower for longer, will more than offset any pressure on revenues and operating profits. Lower US interest rates relative to interest rates elsewhere, may well mean a weaker US dollar and also stronger emerging market currencies. Such prospects are helpful to emerging and commodity-producing economies.

Such very different reactions and market patterns revealed within a short period of time to market making news, makes for confusion about the state of the market mind. Will bad news about the US remain good news about the equity and bond markets and vice versa? Will the economic data releases confirm the strength of the US economy and send equities, currencies and bonds in the direction they mostly took in August and September 2015, for fear of higher interest rates? Ideally for shareholders around the world, the Fed will continue to worry more about slow growth and deflation than the reverse, and that such caution, reflected in consistently low short rates, will prove to be too pessimistic about both threats to the global economy, for an extended period of time.

Reflationary policies are usually helpful to share markets. The bullish argument for markets is that the Fed and the ECB (and indeed EM central banks) remain in a reflationary mood while growth prospects remain largely unchanged.

How well is the equity market reading the Fed?

 

The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.

While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.

Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?

We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.

The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.

The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.

The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.

It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders

Taking stock of GDP

The SA economy in Q2 2015 was not as it appeared – after taking an inventory

According to the first readings of gross domestic output (GDP), in real terms for Q2 2015, the SA economy performed very poorly. It is estimated by Stats SA to have shrunk by 1.3% on a seasonally adjusted annual rate in the quarter.

(All figures are taken from the Quarterly Bulletin of the SA Reserve Bank, September 2015.)

 

On a second reading for the second quarter of figures provided by the SA Reserve Bank, which include estimates of the demand side of the economy, the outcomes, on the face of it things. seem even worse. Gross Domestic Expenditure (GDE) is estimated to have declined by as much as a 7.2% rate in the quarter. The outcomes were not nearly as dire as might be inferred from either the GDP or GDE estimates. Final demand, the sum of spending by households, firms and the government sector, actually grew by about 1%. That final demands continued to grow at a very modest pace is consistent with our own measures of economic activity. What turned final demands into very weak GDE growth rates was a dramatic decline in inventories. Inventories in Q1 grew by R8.8bn on a seasonally adjusted annual rate. In Q2 they declined by the equivalent rate of over R38bn. This decline in inventories was enough to reduce real GDP in the quarter by as much as 6.2%.

Much of the action is attributable to the large seasonal adjustment factor interpolated to the estimates of inventories, the consistency of which may well be questioned. It is normally the case that the second and third quarters are periods when inventories are built up and the fourth and first quarters are normally associated with a general run down in inventories. But as the Reserve Bank comments, inventory events in Q2 were anything but normal in the mining and oil sectors. To quote the Economic Review of the Reserve Bank for Q2 2015:

Following a modest build-up in inventories in the first quarter of 2015, real inventory levels declined significantly at an annualised pace of R38,9 billion (at 2010 prices) in the second quarter. The rundown of real inventories in the second quarter of 2015 was mainly due to the destocking in the mining and manufacturing sectors, partly reflecting subdued business confidence levels and a decline in import volumes.

In the mining sector, inventory levels at platinum mines in particular contracted during the period on account of a significant increase in the exports of platinum in order to fulfil offshore export obligations. The rundown of inventories in the manufacturing sector partly reflected lower crude oil import volumes due to scheduled maintenance shutdowns at major oil refineries over the period. Consistent with a slower pace of increase in retail trade sales, the level of real inventories in the commerce sector rose in the second quarter. Industrial and commercial inventories as a percentage of the non-agricultural GDP remained unchanged at 13,8 per cent in the first and second quarters of 2015.

Inventories can run down because firms lacking confidence in future sales plan for a reduction in goods held on the shelves or in warehouses. They may also run down in an unplanned way because firms are surprised by the actual sales they were able to make. The planned reduction in inventories can represent bad news for the economy as orders decline. The unplanned reduction can mean better news should firms attempt to rebuild inventories. Similarly, a planned increase in inventories can reflect a more confident outlook for sales to come. An unplanned build-up of inventories may also reflect unexpectedly poor current sales volumes, and so fewer orders to come in the quarters ahead. Making the distinction between planned and unplanned inventory accumulation will be all important for any forecast of economic growth. In the case of the SA economy in Q2, it seems clear from the Reserve Bank statement that the run down in inventories in Q2 was for largely idiosyncratic reasons, making the application of seasonal adjustments particularly subject to error.

Judged by the estimated growth in final demand, the economy did not deteriorate in Q2 as the statistics on the pure face of it may suggest. In our judgment of the National Income Accounts released for Q2, the economy continues on its unsatisfactorily slow growth path as other indicators of the economic activity, included our own Hard Number Index, have revealed. The economy is growing slowly and not shrinking, nor is it about to do so. There is moreover at least one silver lining to be found in the latest statistics. As much as inventories subtracted from the growth rate, net exports added as much, due to the growth in export volumes and the stagnation of import volumes. The trade balance went into surplus and the current account deficit declined thanks to the weaker rand and the relative absence of strike action.

Another development this year, essential to lessening the tax burden on the productive part of South Africa, and so increasing potential growth, is the further decline in public sector employment in Q1 noted by the Reserve Bank. Lower tax rates and less spent on employment benefits for a bloated public sector, also lower interest rates, will help stimulate a recovery in the all-important household spending that is essential for faster, sustained growth over the longer run.

A combination of export growth and a stronger trade balance combined with a smaller budget deficit, accompanying fewer expensive public officials, of the kind revealed in Q2 2015, is some of the right stuff necessary to recalibrate the SA economy in the collective mind of the global capital market from a fragile to a resilient economy.

Time to change the narrative

The Reserve Bank needs to change the narrative on inflation and interest rates to take full account of the economic realities

The rand exchange rate since 1995 has proven to be anything but predictable. Despite this, with the help of hindsight it is possible to explain why the rand has behaved as it has over the years. It can be shown that, since 2014, it has been more a case of US dollar strength, against almost all currencies, than rand weakness that explains the rand/dollar exchange rate. In recent weeks the rand has also weakened against the euro, again also in line with almost all other emerging market currencies.

 

Explaining dollar strength is an art form all of its own. It has much to do with the superior performance of the US economy over the past few years, allowing US interest rates at the long end of the yield curve to rise relatively to rates prevailing in Europe and Japan. The strength of the US recovery has also led the money market to believe that short monetary policy determined rates in the US are soon about to rise – adding to the demand for US dollars.

A consistently important influence on the foreign exchange value of the rand is the state of global capital markets. When global allocators of capital feel more secure about the state of the global economy, they favour riskier assets and riskier currencies. And vice versa: when caution rules, funds flow in the opposite direction to safer havens. The rand as a well traded emerging market currency (as well as rand denominated bonds and equities) falls into the category of one of the more risky, that is volatile, currencies and markets, as do most other emerging markets (EM) currencies. Currency moves associated with the Global Financial Crisis (GFC) of 2008-09, shown in the figure above, illustrate the vulnerability of the rand to such events.

It is possible to measure such risks in the bond markets. Measures in the form of a wider or narrower interest rate spread between South African or other EM debt can help identify the degree of risk aversion or appetite prevailing in the global capital markets. RSA and other EM US dollar-denominated debt trades at higher yields than US Treasury Bonds. These higher yields compensate investors for the risk that the debt issued in US dollar may not be honoured.

Foreign investors may also hold local currency denominated debt, for example rand debt, and so receive interest income in rands and other local currencies rather than dollars. Since the local central banks print their own currency and as much as they choose, there is no danger of any formal default on such debt, only that they may lose some of their US dollar value should inflation accelerate. The risk to these offshore investors holding local currency denominated securities is that the guaranteed interest income paid in a local currency will lose dollar value should the higher interest currency depreciate over time. The higher interest rates on rand-denominated debt compensate investors for expected rand weakness. The equilibrium and relationship between the difference in the interest rate for securities of the same duration and risk class and the contemporaneous percentage difference between spot and forward exchange rates is known as interest parity. Arbitrage maintains this relationship.

It can be demonstrated that the spot rand will generally weaken as these interest rate spreads widen – and vice versa when the spreads narrow. In the figure below we show two measures of SA risk: exchange rate risk and sovereign or default risk. The yield spread between RSA 10 year bonds and US Treasury bonds of the same duration is shown on the left hand scale while the cost of insuring RSA dollar debt of five years duration against default, known as the Collateralised Debt Security (CDS) spread issued by global banks, is shown on the right hand scale. Higher spreads of either kind are generally associated with rand weakness and vice versa for rand strength. It may be noticed how these spreads widened dramatically in 2008. Both spreads have moved in a narrower band since 2010 while the CDS spread fell back towards about 200bps.

It is possible to identify risks of default associated more specifically with SA rather than with EM bonds generally by comparing the CDS spread for RSA bonds with the spreads attached to all other EM debt, as estimated by JPMorgan. As may be seen in the figures below, SA risk and EM risk measures are highly correlated over time, indicating very similar forces at work. A wider difference between the EM Index spread and the RSA CDS spread, indicates a more favourable relative status for SA and vice versa. It may be noticed that this difference narrowed after August 2012 indicating a deterioration in RSA credit rating. However it may also be seen that the credit standing of SA has improved relative to other EM debt over the past year. Russia, Brazil, Turkey, Malaysia and Indonesia have all been making heavy recent weather of their connections to global finance. It may also be noticed that SA’s relative standing in the debt markets deteriorated before the GFC, as the repo rate increased and then improved in a relative sense compared to the EM average during and after the global crisis.

The rand may however also weaken or strengthen in response to perceptions of SA specific risks, independently of developments in global markets. Political and economic developments in SA may cause the market to sell or buy rand-denominated securities, leading to wider or narrower spreads or for the debt rating agencies to change their credit ratings.

The unrest and violence at the Marikana platinum mine in August 2012 was one such unfortunate SA event that weakened the rand against all currencies, including other emerging market currencies. It can be shown that the rand has traded off the weaker post-Marikana base ever since; though much of the direction of the rand exchange rate since can be explained by global rather than further SA influences.

Economic theory suggests that a primary influence on the exchange value of a currency is the difference between the rate of inflation in the home currency and inflation experienced by its trading partners. The exchange rate is expected, in theory, to move to compensate for these differences in inflation in order to maintain global competitiveness for producers and distributors in both the domestic and foreign markets. What is lost or gained by relatively fast or slow inflation of prices and costs, is expected to be offset by compensating movements in the exchange rate, thus maintaining Purchasing Power Parity (PPP). Unfortunately for the theory and the SA economy, PPP can contribute very little to any explanation of the exchange value of the rand since 1995.

It is the capital account rather than the trade account of the SA balance of payments (BOP) that has dominated the rand exchange rate ever since the capital account was integrated with the trade account of the BOP in 1995. The figure below makes the point very clearly. The difference between the theoretical PPP equivalent rand and the market rand makes for the real rand exchange. It is the deviation from PPP that makes a real difference to exporters and importers. A weak real rand makes exports more profitable and imports more expensive. According to Reserve Bank estimates, the real trade weighted rand is now about 20% weaker than its PPP equivalent and 10% weaker against the US dollar according to our own calculations, using comparative CPIs in SA and the US to infer the theoretical PPP USD/ZAR exchange rate.

The reality is that the highly unpredictable exchange rate leads changes in the SA CPI. Currency depreciation does not accompany or follow changes in the CPI as PPP theory would presume, it tends rather to lead inflation. How much inflation will actually follow a weaker rand will also depend on the underlying trends in the global commodity markets. Also important for subsequent inflation will be the impact of changes in tax rates and administered prices, also hard to predict

As we show below, there is a highly variable relationship between changes in import prices and consumer prices in SA, even as changes in import prices tending to lead changes in headline inflation, the lags are also variable. Hence to forecast inflation in SA, with any degree of accuracy or conviction, would require not only an accurate prediction of the essentially unpredictable exchange rate, but also of the almost equally difficult to predict pass through effect of a weaker rand on the CPI. Import price inflation is now running well below headline inflation, so helping to contain the inflation impact of the weaker rand.

If inflation in SA in say two years cannot be predicted with any degree of accuracy or conviction, as would appear obvious given all the unknowns that could impact on consumer prices over any 24 month period, then one can have little confidence that monetary policy and changes in the repo rate will help realise some narrowly targeted rate of inflation. The fan charts of the Reserve Bank published in its 2015 Monetary Policy Review that indicate the possible inflation outcomes, confirm the difficulty in forecasting inflation with any confidence. The chart below shows that there is a 90% chance of inflation in SA in 2017 being somewhere between 3% and 10%.

In practice in these unpredictable circumstances, all the Reserve Bank can do is react to inflation, rather than anticipate inflation and act appropriately to help stabilise inflation and the economy. In reacting to realised inflation by raising its repo rate when inflation is accelerating, the Reserve Bank has a further problem. The impact of interest rate changes on the rand is itself unpredictable. The impact of higher interest rates on the exchange value of the rand is as likely to weaken as strengthen the rand. Higher interest rates, if they are regarded as likely to slow down the economy, may well imply lower returns to capital and discourage capital inflows. If this turns out to be the case, higher interest rates may well be associated with more inflation.

However what can be predicted with conviction is that higher interest rates will suppress spending and reduce the rate of economic growth. Hence it is possible that higher interest rates will lead to no less inflation and perhaps lead to more inflation, given what might subsequently happen to the rand, and could be accompanied by slower growth.

The policy implication of the unpredictable rand and inflation is that the Reserve Bank should only react to inflation when prices are rising because domestic demand is increasing faster than domestic supplies, perhaps because money and credit supplies are growing too rapidly. It should not react to higher prices irrespective of the cause of such higher prices. For example, higher prices that follow exchange rate or other supply side shocks, following droughts or higher taxes on domestic goods or services. These shocks depress demand and higher interest rates will depress demand even further to no useful anti-inflationary effect.

The Reserve Bank might argue that if it didn’t react to higher inflation, whatever its cause, inflation would trend higher because of so-called second round effects. If it failed to react, more inflation would come to be expected and in turn lead by some self-fulfilling prophecy and producer pricing power, to more inflation itself. There is no evidence to support the view that more inflation expected leads to more inflation.

Indeed inflation expected in SA has remained remarkably stable around the 6% level, the upper range of the inflation targets. Expected inflation is a constant rather than a variable in the SA inflation story.

The problem for policy makers is that the market has been conditioned to expect higher interest rates, irrespective of the cause of higher inflation and the implications this may have for the economy. The task for the Reserve Bank is to change the narrative to take full account of the economic realities. The value of the rand and its impact on inflation is unpredictable and monetary policy should not be expected to react to it or other supply side shocks to the CPI that are of a temporary nature. The flexible exchange rate should be regarded as a shock absorber for the economy – not a threat to it. The proper task for the Reserve Bank is to manage aggregate spending in SA in a counter cyclical way. Chasing inflation targets, regardless of their provenance, can lead to pro-cyclical monetary policy.

Extraordinary volatility in all markets – causes and effects

The past week or two of exceptional market volatility was not so much a case of China sneezing and the world catching cold – but the sense that China may have little idea of how to cope with a cold. Its feverish interventions in the Shanghai stock market and perhaps also the currency market did not make a good impression. Surely the advice – starve a fever but feed a cold – holds everywhere.

Clearly there is much room for further slips before China becomes more of a fully market and service-driven economy – policy errors that will continue to complicate the calculation of market values in and outside of the Middle Kingdom. Fortunately, the US economy, despite some doubts about possible China contagion, remains well set on its recovery path. A major upward revision of US Q2 GDP growth rates released yesterday would have served as a helpful vapor rub for unnecessarily troubled breasts.

It remains for the Fed to get its long heralded first interest rate hike out of the way – to help confirm that the US economy has normalised, even when accompanied by below normal inflation rates. Our sense is that the markets will be reassured rather than troubled buy a 25bp increase in the Federal Funds rate, while giving the Fed ample time to consider its next move on the path to normality.

It is emerging market (EM) equities that have lagged far behind the progress made in developed equity markets since 2011. They have most to gain from a US recovery that can be expected to promote faster growth everywhere. EM equities and currencies, South Africa naturally included, lost relatively most in the recent turmoil. It is encouraging to observe that EM equities (priced in US dollars) have recovered as much as (or more) than the US market in recent days.

 

Also coming back with the recovery in equity markets was the volatility indicator for the S&P 500 (the VIX) and the risk premium for SA and the rand – indicated by the spread between RSA and US bond yields. There is clearly scope for further declines in these risk indicators and if they do decline to anything like normal levels, we will see further strength in the S&P 500 – and also in the rand.

 

What also may have been noticed in all the turbulence and rand weakness was that there was only one place to hide in the equity markets from rand weakness – in gold shares. In other words, there were no rand hedges, other than the gold shares. The rand value of even the most globally exposed counters, the global consumer plays and their like, declined with the cost of a US dollar.

There is an important difference between equities that can be regarded as rand hedges (rand values that rise with rand weakness\) and SA economy hedges. When the rand weakens for global reasons the dollar and the rand value of most equities and bonds will decline, as recent trends confirm. Hence there are no rand hedges outside the gold mines when the global risk outlook deteriorates. When the rand declines for South African specific reasons – those companies on the JSE with a largely global footprint – will see the US dollar value of their activities largely unaffected; hence rand weakness for SA reasons can then translate into higher rand values.

Gold is different. Its price and the value of gold mines, in US dollars, tends to rise in troubled times. Hence the extreme behaviour of JSE-listed gold mines in August. Between 17 August and 24 August, the JSE mold miners gained 27.8%. This was while the USD/ZAR exchange rate moved from R12.90 to R13.21 – down some 2.3%. Over the same few days of rand weakness the All Share Index went from 50751 to 47631, a decline of 6.3%. Over the next three days the Gold Mine Index gave up 19.25% of its rand value at the close on the 24 August as the All Share Index added 3.1% and the rand stabilised.

Clearly, SA gold shares can protect portfolios meaningfully against global risk aversion, even though they have proved to be a very expensive form of portfolio insurance over the longer run. The SA gold mines have suffered from not only higher costs of production and declining grades of ore mined, they have also proved vulnerable to SA events (strikes and the like) that limit production. Investors in SA mines should wish for a weaker rand in response to additional global risk aversion, unaccompanied by greater SA risks to their production.

South African shareholders should therefore wish for rand strength – not for rand weakness – unless they have an unhealthy weight in gold shares. But they should wish even more for rand strength that might follow a reduction in SA specific risks. If perceptions of SA risk, currently reflected in a high discount rate used to value company profits realised from SA activities, were to decline in response to better economic governance, the US dollar value of the rand would rise and the rand and the US dollar value of SA securities would rise. And most important, SA would be able to attract more foreign capital of all kinds on improved terms to help realise faster growth.

An avoidable trade off

Less growth for no less inflation: a trade off that could have been avoided with lower, not higher, interest rates

Since the Monetary Policy Committee (MPC) of the Reserve Bank decided to raise its repo rate by 0.25 percentage points on Thursday, the outlook for SA growth has deteriorated, because of the likely impact of higher interest rates on spending; while the outlook for inflation has deteriorated, because the rand has weakened. Less growth for more inflation hardly seems like a useful tradeoff, but that is what the SA economy has to confront.

Can we however blame the Reserve Bank for the weaker rand? We can, if the prospect of slower growth is expected to reduce the case for investing in SA and therefore is associated with the weaker rand. But the rand may have weakened for other reasons unrelated to the Reserve Bank decision. Emerging market risks may have simultaneously increased, thus discouraging capital inflows, or something the MPC also worries about – interest rates in the US may increase, so driving capital away from emerging markets leading to a weaker rand.

Neither of these forces since Thursday last week can explain the fact that the rand lost a little ground to other emerging market currencies, while interest rates in the US fell rather than rose. Moreover, while long term rates in SA remained little changed, the spread between RSA and US rates widened since the interest rate increase, indicating an increase in the SA risk premium (a wider spread is usually associated with rand weakness).

Furthermore short term rates – up to one year duration – all rose in tandem after the MPC meeting, indicating that the outlook for interest rates to come has not changed in response to Reserve Bank action or explanation. The interest rate carry in favour of the rand, AKA the SA risk premium, remains as it was. The forward looking stance of monetary policy, in the collective view of the money market, has therefore not softened – a softening that might have served to explain the weaker rand, but does not.

All of this indicates another point we have made repeatedly. The impact of any move in policy-determined SA interest rates on the exchange value of the rand is essentially unpredictable. This makes the relationship between interest rate changes and inflation also highly unpredictable, so undermining the logic of inflation targets. Inflation targets, if they are to be met with interest rate settings, demand a predictable relationship between interest rate movements and inflation itself. This predictability does not exist.

The unpredictable reactions in the currency markets help vitiate the presumption that interest rates can be a useful instrument for realising inflation targets. Upredictable increases in administered prices, the price of electricity, water, municipal services etc. that may drive inflation temporarily higher (as might a weaker maize harvest) are supply side forces that do not respond to higher interest rates. The notion that interest rates should rise in response to an economically damaging drought is surely risible. Higher interest rates in SA do have one highly predictable effect and that is to reduce spending.

The latest surprise for the inflation forecasting model of the Reserve Bank from which interest rate settings take their cue, is that the so called pass through effect from a weaker rand to higher prices is about half as strong as predicted by the model. Both the rand prices of imports (helpfully) and exports (unhelpfully for the domestic economy) are lower than they were a year ago, reducing rather than adding to the pressure on the CPI. This time round it is not the weaker rand that can be blamed for higher inflation to date- but a still weaker rand clearly imposes the risk of more inflation to come.

The MPC, by increasing short term interest rates, willingly added to the risks of still lower growth rates. Our view is that this represents a distinct error of judgment.

To quote the MPC statement:

“The MPC has indicated for some time that it is in a hiking cycle in response to rising inflation risks, and a normalisation of the policy rate over time. The MPC is cognisant of the fact that domestic inflation is not driven by demand factors, and the outlook for household consumption expenditure remains subdued. Economic growth remains subdued, constrained by electricity supply disruptions and low business and consumer confidence and the risks to the outlook remain on the downside. However, as emphasised previously, we have to be mindful of the risk of second-round effects on inflation, and the committee is concerned that failure to act against these heightened pressures and risks will cause inflation expectations to become entrenched at higher levels.”

We would take issue with the relevance of the so defined second round effects that is so important to the Reserve Bank view of how inflation comes about. That is the notion that more inflation expected can lead to more inflation as a kind of self fulfilling process and that it takes, if necessary, painfully higher interest rates to control such expectations. The reality, in our view, is that these inflation expectations held in SA are particularly well entrenched and highly stable at around the 6% level, the upper end of the inflation target band. That is, if we infer inflation expected from the actions of investors in the bond market, being the difference in yields offered by vanilla bonds and their inflation protected alternatives of similar duration. These differences are shown below for 10 year bond yields.

Thus, the remarkable fact about the extra rewards for taking on inflation risk – the difference between a coupon exposed to unexpected inflation and one completely protected against actual inflation – I is how stable it has been, around about 6%, the period of the global financial crisis in 2008 excluded. The daily average spread since 2009 has been 5.95%, with a maximum yield spread of 6.92% and a minimum of 4.55%, with a Standard Deviation of 0.41%. It would seem to us that the inflation leads inflation expected – not the other way round- and that it would take an extended period of inflation well below 6% p.a to reduce inflation expected. These second round effects are a theory without empirical support that is preventing monetary policy from acting in a usefully counter cyclical way. A cycle that calls for lower not higher interest rates to encourage not discourage growth that attracts capital and might support not weaken the rand.

Furthermore, the MPC should recognise that price setters, that is most firms, set prices according to what the market will bear, that prices are not simply cost or wages plus sum pre-determined profit margin. Higher costs will lead to lower margins if demands from the market restrict pricing power, and higher wages can lead to fewer people employed in the presence of weak demand and the absence of pricing power.

In the distinct presence of weak demand, fully recognised by the MPC, neither expected inflation nor higher wages explain higher inflation in SA. Nor does money or credit growth help explain why inflation in SA is currently as high as it is. Households are borrowing very little more than they did a year ago and firms are borrowing more, but to invest abroad not locally. Money supply growth remains subdued.

Higher taxes, in the form of higher administered prices, explain much of inflation to date and help explain much of the inflation forecast by the Reserve Bank Model. Administered prices, petrol and electricity for example, are assumed to increase by 11.7% and 12.5% respectively in 2016. Yet these price increases add further to the pressure on household and business budgets and further inhibit spending. Yet the MPC seems convinced their monetary policy settings remain supportive of the economy rather than a threat to it. To quote the PMC statement further:

“The expected inflation trajectory implies that the real repurchase rate remains low and possibly still slightly negative at times, and below its longer term average. The monetary policy stance therefore remains supportive of the domestic economy. The continuing challenge is for monetary policy to achieve a fine balance between achieving our core mandate of price stability and not undermining short term growth unduly. Monetary policy actions will continue to be sensitive, to the extent possible, to the fragile state of the economy. As before, any future moves will therefore be highly data dependent.”

We must beg to differ about the measured stance of monetary policy. A prime rate of 9.25% is well ahead of the price increases most private businesses are able to charge their customers. They do not have the monopoly powers of an Eskom or a municipality to charge more regardless of the state of demand. Keeping prices rising in line with headline inflation (not of their making) is becoming much more difficult, so making monetary policy ever less supportive of the domestic economy.

The economy is fragile and higher interest rates have made it still more so. Had the Reserve Bank been more sensitive to the state of the economy and more data dependent (and not embarked on a premature path to higher interest rates) the economy would have better prospects and a stronger not weaker rand might well have reflected this.

Unleashing the household sector

The state of the SA economy – reading the tea leaves and providing a recipe for a stronger reviving brew

The trend in retail sales volumes in 2015, now updated to May, help confirm that the SA economic engine is stuck in a slow growth gear of between 2% and 2.5% a year. Year on year retail inflation is also fairly stable between 4% and 5%.

Our Hard Number Index (HNI) of SA economic activity, based on new vehicle sales and cash issued by the Reserve Bank, adjusted for consumer prices, updated to the June month end, indicates a very similar pattern to that of retail, a pattern of slow growth. This is predicted to continue for the next 12 months at its current very pedestrian pace. We add the Reserve Bank Co-incident Business Cycle Indicator, based on 12 economic time series, for comparison, also smoothed and extrapolated beyond March 2015, the latest data point for this series. All of these indicators of reveal similar trends and cyclical turning points that provide very little sense of a cyclical upswing. The HNI shows up as a very reliable leading indicator of retail volumes and the more broadly measured business cycle.

It may be of some consolation that the indicators still predict some positive growth, though higher interest rates, if imposed by the Reserve Bank, may threaten even these predictions of slow growth. There is no suggestion that spending growth is about to pick up to add to inflationary pressures that are almost entirely the result of higher taxes on fuel and energy and municipal services generally.

The series for import and export prices to March 2015 suggest deflation rather than inflation emanating from the balance of payments and the exchange rate. The rand is weaker against the US dollar but stronger against the euro and only marginally weaker on a trade weighted basis compared to a year ago. Import or export prices (measured by the export or import deflator) were lower in Q1 2015 than they were a year before and so are not adding pressure to SA inflation rates: nor is domestic spending. The tax increases and the drought in the maize belt that have pushed the CPI temporarily higher, will not respond favourably to higher interest rates that the Reserve Bank seems intent on imposing on a highly fragile economy.

The case for raising short term interest rates in these circumstances is, in our judgment. a very poor one. It is certain only to further depress domestic spending without promising to have any predictably favourable influence on inflation or inflation expected over the next 12 – 18 months. As we will show SA needs lower rather than higher interest rates if it is to escape from slow growth forever.

The question the Reserve Bank should be considering – as should all those with responsibility for economic policy – is how can the economy hope to break out of this seemingly indefinite prospect of slow growth? Ideally it would be increased exports that lead the economy to faster growth. But exports from SA will be constrained by the weakness in metal and mineral prices associated with slow global growth and the fact that global supplies of metals have caught up with the extra demand that came from China in the boom years before 2008, though as we have seen recently, merely keeping the factories and mines working rather than shut down through strike action can help to add to exports and employment and incomes.

Stimulus from government spending has also run its course – it was ended by rising government debt and interest payments and threats to credit ratings accompanying these adverse trends. Increased duties on fuel and energy as well as higher income tax rates are not only adding to inflation- they are an extra burden on household budgets. And to look to the capital expenditure programmes of publicly owned corporations to lift the economy, as was the official case made a few years ago, would seem only to court further disaster. The clear reluctance of private business to invest more in their SA operations will continue until their capacity to produce more is challenged by increased demands form their customers. Private businesses in Q1 2015 reduced their capital expenditure and their payrolls.

The essential condition for any step up in SA growth rates is an increased willingness of households to spend and borrow more. Household spending accounts for about 60% of all spending and without encouragement for the rest of the economy from the household sector (encouragement now clearly lacking), the economy will not grow faster. How then could this come about? A look back at how the economy managed to grow much faster between 2003 and 2008 may be instructive.

In figure 3 below we show how spending in 2008 collapsed as retail prices rose sharply after the rand weakened in response to the Global Financial Crisis. Notice also the extraordinary growth in retail volumes between 2003 and 2007 as retail inflation subsided. Inflation subsided then as the rand strengthened and lower interest rates followed lower inflation so stimulating consumption spending further. Bank lending, as mentioned (particularly mortgage lending to households), grew even faster than consumption spending, so providing strong support for the spending intentions of households.

At the peak of the growth cycle in mid 2006, bank lending to the private sector was 26% up on a year before and mortgage lending had grown by about 30% on a year before. The value of residences owned by households increased by an average 21% a year between 2003 and 2007, adding significantly to the willingness of households to borrow and spend and banks to lend to them on the security of rising house prices. See figure 5 below that illustrates these housing and household wealth effects.

SA spending grew faster than output between 2003 and 2008 and the current account went into deficit, having remained in balance throughout the slow growth years that preceded the boom. Foreign capital more than made up the shortfall in domestic savings. The boom in spending and growth between 2003 and 2008 could not have continued without support from foreign capital that proved very forthcoming.

This helps make an essential point: growth improves returns on capital and attracts additional savings from all sources, domestic and foreign, to fund faster growth and benefit from higher returns on capital invested. Slow growth repels capital because expected returns fall away. The limits to spending and growth are set by the supply of savings from domestic and foreign sources. But to attract capital, conditions for it need to be attractive. Expected growth rather than stagnation or worse is the essential lure for capital.

If the economy were to grow faster in response to a pick-up in household spending, the lack of domestic savings might prove a constraint, should foreign capital not be fully forthcoming. If this were to happen, the rand would come under pressure and higher inflation would then call for higher interest rates – trends that would in turn inhibit any incipient recovery in household spending.

The point to be recognised is that unless the economy asks for more foreign capital the answer as to how much would be made available, only time and evidence would be able to tell. But there would be no point in inhibiting any recovery in household spending for fear that it might soon run into the sands. Entry into a virtuous circle of something like the 2003-2007 episode of faster growth will hopefully be attempted sometime in the not too distant future and would have to be led by faster growth in household spending. South Africans can only hope for the chance to test the market for capital to fund our growth.

One positive influence on spending will be the improved state of household balance sheets. The household ratios of debts to assets have declined – helped by a recent improvement in the value of houses, which are up by about 10%.

Lower, not higher short term and mortgage interest rates, would be helpful to this end. A recovery in the prospects for emerging equity and bond markets that have underperformed developed markets since 2011 would be very helpful indeed. The rand would attract a share of additional flows into emerging markets and so help add strength to its value, improve the outlook for lower inflation and lower interest rates. In other words, 2003-2007 reprised. We live in hope for more favourable tail winds from off shore.

But there is much South Africa could do to improve its economic prospects and its attractions to foreign capital, which are essential to any attempt to lift growth rates. They come under the broad rubric of reducing the risks of investing in SA business. Planning for more competitive labour and energy markets (less power to the unions and privatisation of generating capacity very much included) would go a long way to raising the bar for the SA economy and attracting capital to the all-important purpose of faster growth in incomes.

SA economy: Household help

Faster growth will have to be led by SA consumers. Adding to household indebtedness is the solution, not the problem.

The SA economy added neither jobs nor capital equipment in Q1 2015. The business sector is unlikely to come to the rescue of the economy unless households lead the way forward and prove able and willing to spend more. Growth in household spending growth, that contributes about 60% to GDP, has been trending lower ever since the post-recession recovery of 2010. Though in the latest quarter to be reported, Q1 2015, growth in household consumption spending estimated at an annual rate of 2.8% actually helped, raise rather than depressed GDP, which grew at a very pedestrian 1.3% rate in Q1, 2015. The national income statistics reveal the great reluctance of the corporate sector to spend more on equipment or workers. In Q1 2015 fixed capital expenditure by private businesses declined as did their payrolls.

The statistics on bank lending to the private sector are very consistent with the revealed reluctance of households to spend more and to borrow to the purpose. Yet the banks are lending far more freely to the SA corporate sector at a well over 10% rate of growth. However this corporate borrowing is not showing up as additional spending on fixed or working capital, that is, to employ more workers.

It would therefore appear that SA businesses are using their strong balance sheets to fund offshore rather than on shore operations. The significant increase in mortgage borrowing by SA corporations, presumably to this end, is noteworthy. By contrast household borrowing from the banks, including mortgage borrowing, has long grown more slowly, in fact declining in recent years when loans are adjusted for inflation. The price of the average house in SA has also been falling in real terms, so discouraging households to borrow or banks to lend to them in a secured way.

Much attention is usually given to the rising debt levels and ratios of households. The rising ratio of SA household indebtedness to disposable incomes is often referred to as a signal of the over indebted state of the average SA household. As may be seen below, this debt ratio increased markedly between 2003 and 2007 when the economy enjoyed something of a boom. This boom was led inevitably by a surge in household consumption spending , funded increasingly with credit, especially mortgage credit, linked to rising house prices of the period.

Also often referred to is the debt service to disposable incomes ratio, which has declined in recent years as interest rates have fallen- presumably a positive influence on spending. But this ratio ignores interest received by households that has fallen with lower interest rates- presumably to the detriment of household spending.

Much less attention unfortunately is paid to the other side of their balance sheet. As we show below the asset side of the SA balance sheet strengthened consistently before and after the meltdown in equity markets in 2008-09. A mixture of good returns in the equity and bond markets and a diminished appetite for debt has seen the household debt to asset ratio fall significantly.

The reluctance of SA households to borrow more and or the banks to provide more credit for them is being maintained despite a marked improvement in the balance sheets of SA households. Hopefully at some point soon, this balance sheet strength will translate into more household spending and borrowing. These improved balance sheets may well have helped sustain household spending in the face of deteriorating employment and profit prospects in Q1 2015.

As may be seen in the figure above the ratio of household wealth to disposable incomes fell between 1980 and 1996. These were very difficult years of political transition for the SA economy, made all the more difficult by declining metal prices. This wealth ratio has since risen significantly to the peak levels associated with the gold and gold share boom of the 1979-1981. Access by SA companies and individuals to global markets and global capital that came with the transition to democracy has clearly been wealth adding and so helpful to SA wealth owners. The value of their shares, homes and retirement plans has more than kept up with after tax incomes in recent years.

In the figures below, we show the composition of the asset side of the household balance sheet in 2014 and also how the mix of assets has been changing. The largest share of household wealth is held in the form of claims on pension funds and life insurance with ownership of residential buildings following closely in importance. The fastest growing component of household wealth is holdings of other financial assets, investments in shares and bonds mostly via unit trusts, while bank deposits lag well behind in importance.

In the figure below we compare the real, after inflation growth in household assets, in household debts, household consumption expenditure and real household per capita incomes. These growth rates move in much the same direction. More household borrowing is associated with greater wealth, more spending and most importantly, a faster rate of growth in real per capita incomes. This virtuous circle that is initiated by more household spending and more borrowing to the purpose is particularly well illustrated through the boom years of 2003-2007, the only recent period when the SA economy could be described as performing well. Over this five year period, household assets in real terms increased at an average rate of 11.9% a year, household debts by an astonishing real rate of 15.6% a year, while household consumption spending grew by 5.9% a year on average and household per capita real incomes were up at a welcome average real rate of 3.9% a year. Without the extra credit, all this good stuff could not have happened. So what is not to like about a credit accommodating boon to spending and economic growth?

One possible regret would be that such rapid growth rates cannot be sustained in the absence of an increase in domestic savings as well as of wealth. The ratio of gross savings to GDP in SA has been in more or less continuous decline since the peak rates realised in 1980 as is shown below.

This declining savings rate has meant a greater dependence on foreign capital inflows to maintain growth rates. Even the slow growth of recent years has had to be accompanied by deficits on the current account of the balance of foreign payments and equilibrating capital inflows that have funded these deficits and more – also adding to foreign exchange reserves.

Given the low rate of domestic savings, South Africans have had to sell more debt to foreign investors and shares to foreign investors. More interest and dividend payments have gone offshore in consequence. But what is not well recognised by those who concern themselves (unnecessarily) with the sustainability of faster growth is that faster economic growth attracts capital and slower growth frightens capital away (Unnecessary because the sustainability of the growth will either be supported by the capital market or will not be, in which case the potential growth will not materialise, leaving nothing to worry about, except slow growth).

In the boom years after 2003 the inflation rate in fact came down as the rand strengthened with inflows of capital. SA enjoyed faster growth and lower inflation until the boom ended with much higher interest rates, imposed by the Reserve Bank, before not after, the Global Financial Crisis frightened capital away.

If SA is to re-enter the virtuous circle of faster growth and supportive capital inflows of the kind enjoyed after 2003, it will have to be accompanied by a renewed appetite for household borrowing and lending. Strong balance sheets may help initiate a recovery in the household credit cycle. Higher short term interest rates will do the opposite. A test of the hypothesis that faster growth in SA can be self sustaining when supported by capital inflows is overdue. Hopefully conditions in global capital markets will become more risk tolerant and more inclined to fund growth in SA. A growth encouraging agenda, initiated by the SA government, would be a much needed further stimulus to raising SA growth rates and attracting foreign investment.