SA Breweries with 90% or more of the beer sold in South Africa has intervened before the Competition Tribunal on the terms of the Heineken acquisition of Distell. SAB has argued that the Tribunal should force Heineken to dispose of its powerful Hunters and Savanah brands rather than, as Heineken has proposed, to dispose of its own weaker by sales, Strongbow cider brand, to a local consortium. That is in order to meet the likely Competition Policy objections to the deal of what would become a cider monopoly. Heineken’s intended local buyer is a consortium of the craft brewer Devil’s Peak and a BEE partner. SAB has argued that it would lack the “relevant expertise, financial muscle or distribution network”, to effectively compete with the other two ciders: Hunters and Savanna”
What is at work here is but another example of rivals or potential rivals hoping to influence competition policy to improve their own ability to compete in the market. In other words, to manipulate policies, intended presumably to enhance competition, to limit competition, in the interest of their owners, their shareholders. And why, it may be asked, should they not attempt to do so? They are simply playing by the rules made by their governments for them.
To expect corporations and their managers to do otherwise – other than to attempt to maximise the value of the assets including their brands – competing in all the ways they are permitted to do – including in the courts of law- is not only naïve but also unwise. Self-interest is the powerful driving force of the market led system that delivers the beer and the cider and everything else that consumers choose – subject to regulation.
It is competition that keeps the prices companies charge in close relationship to the costs they incur. Cost that they have every incentive in containing in the interest of holding down prices, improving service and realizing the profit maximizing, optimum scale of operations. Which may, when economies of scale present themselves, as it does in beer and cider production, lead to a degree of dominance in the markets served. When the competition policy or any policy outcomes are perverse, we should look to reforming the policy, not the business modus operandi that naturally competes in all the ways legitimately open to them.
That Advocate Jerome Wilson acting for Heinekens to quote BD “… accused SAB of being “opportunistic” and using the guise of competition concerns for its own business interests…” is a non-sequitur of the kind more easily made by lawyers than economists. It reinforces my concern that competition policy in SA has become such a fertile field for lawyers with precedent, not necessarily good economics, as the guide.
But there is a certain irony in SAB, now a wholly owned subsidiary of ABN-INBEV, choosing to compete in this way. The pioneers who built SAB to the great global company it became, as well as the dominant brewer in SA, effectively expanded the demand for and supply of beer in SA at what were surely attractive prices and terms for their customers. They could not have succeeded otherwise. Then in a final glorious act, agreed to sell their business at what has proved to be highly favourable terms for their highly appreciative shareholders. Pensioners living off the SAB shares they owned can well say cheers. They might not have thought it in their interest, or even perhaps, appropriate to invoke competition policy. The goose can easily become the gander.
SAB were fond of arguing evocatively that they were competing for a “share of throat” That is with every other beverage, alcoholic or non-alcoholic that competed with their beer for a share of household’s budgets. And that this gave them every motivation to expand, not restrict the supply of beer, with truly competitive pricing and related services. And they were right. And their successful practice proved it so. Market dominance was the outcome of serving the customer. They earned it and did not abuse the power it gave them. If we widen the definition of any market, as we should to be realistic, we reduce the share of any participant in it.
The competition will always be intense for the choices that households make, regulations permitting. The pursuit of self-interest will ensure a constant striving to beat the market and become very wealthy doing so. How consumers will come to choose from the unpredictable and changing menu placed before them is impossible to predict. Their larger interest is in changing the menu, in innovation and technology that can significantly alter how they spend over time. Best therefore to leave the mysterious forces of competition to evolve. To trust the pursuit of self-interest and competition – not its regulators- with possibly very different interests to those of consumers.
Competition policy would best ask the simple question, will some acquisition or arrangement be in the consumers’ interest? Will it mean lower prices, better service – enhanced supply and or quality – more R&D -more innovation or not? Chat-GPT might provide the answer.
The problem with competition policy in SA is that it pursues a broad public interest. And the public interests, very diverse public interests, may conflict with that of consumers. Maintaining employment (in the interest of workers) after an acquisition is likely to mean higher costs and higher prices and or less capable service delivery. And will in advance, given the likely constraints on efficiency, reduce the case for a potentially cost-saving merger that will not be in the interest of consumers. Cost saving is very much in the customer’s or potential customer’s interest.
Forcing the owners of any business, local or foreign owned to meet empowerment or any other criteria demanded of their potential investors, is likely to reduce the ability of an acquirer to raise capital on favourable terms. Capital with which to compete with established interests in the SA throat – as SAB is surely well-aware
In the early days of the economy wide lockdowns of 2020, I remarked that “Today is a time of epidemiologists, central bankers and yes, of schemers too…..” I added that we will discover in due course whose reputations will have survived the economic crisis better intact. I was alluding to Edmund Burke’s unenthusiastic Reflections on the Revolution in France (1790)
The pandemic, as we well know, has had many losers and more than a few beneficiaries. Perhaps economists who have long observed monetary events are among the less disadvantaged by Covid19. Inflation reared up dramatically and new evidence about its causes and consequences was on offer and demanded interpretation. The experience and analysis of the high inflation nineteen seventies when I learnt my monetary economics became relevant again. The problem for the US economy and those with much diminished wealth is that the Fed does not have a monetarist model of inflation [1] As inflation came down after 1980 and money supply growth rates became less variable, and the supply of and demand for money were mostly well matched, such neglect of the role of money in determining inflation was perhaps understandable. The neglect turned out to be anything but benign under the extreme behaviour of the money supply after 2020. History may well come to judge central bankers much less kindly than the commentators appear to be doing today.
The updated evidence on inflation to December 2022
The headline inflation rate in the US peaked at 9.1% in June 2022. It fell rapidly and was 6.5% in December 2022. The monthly increases in the price level, slowed down very significantly after June. The CPI, not seasonally adjusted, was no higher in December 2022 than they were in June. The seasonally adjusted version was only slightly higher over the six months and both versions of the CPI fell in December 2022. On a six-month view there was no inflation in the US. (see figures 1 and 2 below)
Fig. 1; US Headline Inflation 1970-2012
Fig.2; The US CPI Unadjusted and Seasonally Adjusted and Monthly percentage change in US Prices January 2021 to December 2022
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The convention of measuring inflation as the year-on-year growth in the CPI has not helped to understand inflation dynamics under current highly unusual and volatile circumstances. Six months can be a very long time for an economy. Waiting a year to see what happens may be too long for a business or a central bank making a judgment and adjusting accordingly. If these monthly increases in the CPI remain at these levels for a further six months, the headline inflation will recede (but gradually) to close to zero by June 2023. There would be no good reason to expect a reversal of these trends, absent any new supply side shocks to the economy. Shocks over which the Fed has no influence, should be ignored because they are temporary and reverse as the recent post -Covid supply side shocks have reversed.
The demand side of the US price equation will not pose an inflationary danger if recent subdued trends in spending and in the money supply and bank credit are maintained. Without any sharp reversal of short-term interest rates this seems highly likely. The Fed has done what it needed to do to contain inflation and that was to contain increases in aggregate spending.
Unfortunately, the Fed greatly underestimated inflation and its persistence on the way up and has almost as egregiously overestimated it on the way down. Monetarists will argue – with new evidence on their side- that these failures to forecast the direction of inflation – that the Fed paid too little attention to the sharp swings in the growth in the money supply post 2020. These money swings were of unprecedented magnitude, which was every reason to attempt to moderate them and to have anticipated their impact on demand and prices.
There would seem no reason to risk nor threaten a recession to maintain low rates of inflation in 2023. Nor to frighten investors and businesses about such possibilities, given the outlook for inflation. The fright has been severe enough to remove trillions of dollars off the value of US equities and government and other bonds. There is good reason for the Fed and the market to forecast satisfactorily low rates of inflation in 2023. On the evidence of inflation and its causes, the Fed guidance should be on the likely and reassuring prospect of a soft landing.
A unique experiment in fiscal and monetary policy – Government spending and money creation – a predictably inflationary combination
The US reactions to the lockdowns in the form of vast injections of income transfers and increases in the money supply provided a unique experiment in economic policy. In Q2 2020 current federal government expenditure grew by 4.1 trillion dollars, from 4.8tr to 8.9tr. The spending was funded mostly with debt a part was funded by running down the treasury balance with the Fed. Federal government debt increased by about 3 trillion dollars in Q2 2020. It grew further from 23 trillion pre-Covid to 32 trillion by Q3 2022.
The income sacrificed by the lock-down was immediately replaced and even exceeded by the generosity of government grants. As was reflected in an equally rapid increase in the deposits held by households at banks. Households initially saved much of the extra money transferred to them from the Treasury as Covid relief. The opportunity to spend more on services, face-to-face was restricted, as was the supply of goods by the anti-Covid repressions.
The broad money supply (M2) that includes most bank deposits and money market funds, increased from 15.5 trillion dollars in early 2020 to a peak of 21.7 trillion by February 2022, from which levels it declined in 2022. The growth in the money supply was as much as 27% p.a. in February 2021. This extra spending by the Federal Government, rapidly executed, was unprecedented even when compared to war times. The extraordinary growth in the money supply engineered by the Fed was also on a scale not previously known, even when compared to the actions taken during the Global Financial Crisis (GFC) of 2008-09 to share up the financial system with money.
Fig.3 US Federal Government Expenditures and Federal Debt. Quarterly Data
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Fig. 4: The US Money Supply (M2) and Annual growth rates (Monthly data)
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Quantitative easing (QE) that is the large-scale purchases by central banks of US government bonds was reversed and became quantitative tightening in late 2022, as may be seen in figure 5 below. To be noted also is the decline in the cash reserves of the US banking system- held with the Federal Reserve Banks in 2022. Nevertheless, the US banks continue to hold vast excess reserves, over the now redundant required reserves. They receive interest on these deposits with the Fed and judged by the absence of money supply and credit growth the banks have not been switching from cash to overdrafts and their like, as they might have done, had demands for credit been more buoyant.
Fig. 5; The Federal Reserve Banks. Federal Debt and Reserves of the Banking System
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Inflation surprises and their deflationary after-shocks.
Yet the rapid and persistent increase in spending and in prices that followed the lockdowns in 2021 came as a surprise to many, including the Fed. But less so to those few economists who regard changes in the money supply as a reliable leading indicator of economic activity and of the price level. Attention to the forces that influence the supply of and the demand for money now leads one to conclude that the inflationary danger to the US economy, the prospect of a process of continuously rising prices, sustained over an extended period-of-time, has passed. The problem for investors and the market in stocks and bonds, is that the Fed has not yet shared this view. It should be noticed in figure 6 that the Money Supply adjusted for consumer prices has declined since January 2022 having peaked in September 2021. The year-on-year growth in Real M2 was a negative ( -6%) in October 2022
Fig.6; Real Money Supply (M2/CPI) 2020=100
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The increase in the inflation rate revealed in 2021, surprising the Fed and most market participants and their economic forecasters and advisors, caused the Fed and other central banks to react vigorously with much higher short term interest rates, intended to fight the new inflation. And to restore the reputation of the Fed as an effective inflation fighter.
These higher borrowing costs, combined with higher prices, perhaps a more powerful influence on intentions to spend, has absorbed the spending power of households. Higher prices have also increased the demand for money and helped reduce the post-Covid excess supplies of money (deposits at banks) held by households. Higher price levels, higher incomes and greater wealth all serve to increase the demand to hold money in portfolios, or as transactions balances. Higher prices have their supply and demand causes. They also have their effects – they restrain the willingness and ability to continue to spend more- all other influences, including especially ongoing money supply growth, remaining unchanged. Which to repeat has largely been the case even if not intentioned by the Fed.
The flat path of private consumption expenditure in 2022
The absence of further growth in the money supply and bank credit in 2022 has helped to restrain the growth in real private consumption expenditure (PCE) as we show below. PCE accounts for about 70 per cent of all US spending and the capital expenditure, spending on plant and equipment, undertaken by US facing businesses is also dependent on the expected pace of real PCE.
Fig. 7; US Real Private Consumption Expenditure and Growth. Monthly Data to December 2022.
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Fig.8; Growth in PCE. Annual and Monthly
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
Other measures of economic activity, for example the monthly surveys of activity in the manufacturing sector and now also for the service sector, indicate that the US economy is shrinking. Both the ISM and S&P Global services PMI readings are now below 50 for the US indicting a contraction in the supply of services that and have followed the contraction in US manufacturing PMI, a figure also below 50. The quarterly estimates of real GDP that draw upon higher frequency data are very likely to confirm that income and output growth is at best growing very slowly or is also in decline. If the future is to be like the past, these leading indicators of economic activity, contracting, portend a decline in real GDP, that is a recession.
The decline in the money supply and in the supply of and demand for bank credit (the asset side of bank balance sheets) was not an explicit intention of Fed policy – it has been an unintended consequence of higher prices and interest rates that have depressed the growth in spending by households and firms. The Fed does not target the growth in the money supply. Nor to my observation has the Fed ever referred to this slow growth in money as a cause or indicator of inflation to come.
Only persistent and continuous increases in aggregate demand- accompanied necessarily by increases in the supply of money – can perpetuate high rates of inflation
The Fed therefore may be said to have done its job containing permanently higher inflation. Inflation, defined as a continuous increase in prices, caused by an increase in the supply of money, in excess of the demand to willingly hold that money. That is a decision to hold money willingly in portfolios rather than convert the additional money supplied to the economy into additional demands for goods, services and assets, financial and real. An exchange of excess money for goods, services and assets of all kinds that are substitutes for cash in portfolios, causes their prices to rise. This transmission of extra money to extra aggregate demand surely explains a significant part of the higher prices realised for goods services and assets, financial and real of all kinds in the recovery from the lockdowns of early 2020. That is excess supplies of money led and inflation followed, as traditional monetary theory, would have predicted.
By mid-2022 enough of the extra excess money supplied earlier in response to the stimulus of 2020-21 had been added to US portfolios. With the aid of higher prices, the demand to hold money has caught up with the extra supplies of money The absence of excess real demands for goods and services, as revealed by the stagnation of real private consumption expenditures, indicates that the adjustment to higher inflation in the form of extra demands to hold money, has been made in the US.
It is only a further increase in the money supply that can keep aggregate demand growing fast enough to counter higher prices and to result in continuously rising prices. This danger has passed. Aggregate demand for goods and services in the US is now weak enough and will remain weak enough to call for a reversal of Fed actions taken to date- without causing permanently higher inflation. This inflation too will pass- absent accommodation of higher prices with faster money supply growth – which it is not receiving.
The Fed panicked and should have guided to a soft landing of less inflation to come without having to induce a recession.
The Fed has badly overreacted to its failure to contain inflation in the aftermath of Covid, as have other central bankers, including the Bank of England and the ECB. They have focused on inflation that has passed rather than the path of inflation to come. The Fed has failed to provide comfort that inflation is on the way down, as it is doing – given the absence of any strength in aggregate spending – that would be necessary to sustain continuous increases in prices.
Central bankers should not have been surprised as much as they were by post Covid stimulus and its impact on spending and on prices. Strains to complicated supply side chains and upward pressure on prices, given lockdowns were surely inevitable. Thereafter, the additional supply side shocks associated with the lockdowns and later with the Russian war on Ukraine became a further complicating factor driving prices still higher in 2022.
Yet the supply side shocks, most important, the impact of higher energy, also food and commodity prices, had clearly come to reverse by mid-2022. Accordingly headline inflation, the change in the CPI over twelve months, was bound to reverse sharply, as it has done, after the much higher prices of mid 2021 come to fall out of the Price Indexes.
Responding to supply side shocks to the price level.
Dealing appropriately with supply side shocks on the price level is a large part of the art of central banking. Central banks can only hope to influence the demand side of the price equation that equilibrates,with market clearing prices and quantities of all the many individual prices goods and services that make up the Consumer Price Index. The task set central banks is to help keep aggregate demand within the strict limits of the capacity of an economy to supply goods and services. This helps realise general price stability and full employment or potential output of the economy. It takes accurate forecasts of aggregate demand and supply to help fine-tune the economy with appropriately higher or lower interest rates, determined by the central bank. These interest rates act on the economy with a lag making forecasting the path of the economy essential to the purpose. It was a task admittedly made much more complicated in 2020 by the lockdowns of normal economic activity that were then overtaken by a major conflict in Europe.
Supply side shocks that will temporarily move the price level higher or indeed lower are therefore best ignored by policy setters and should be allowed to work their way gradually through the economy. Higher prices, as indicated earlier, are part of the normal adjustment process to less supplied or more demanded. Fewer than expected goods and services supplied to an economy could be the result of droughts or floods or famine or war. Or more usually, for less developed economies, a supply side price shock will be the result of a collapse in the foreign exchange value of a currency.
The case for ignoring supply- side shocks should be part of the forward-looking guidance central bankers offer the marketplace. It should therefore be carefully explained why the demand side of the economy may best be left as it was, not subject to higher or lower interest rates, given the absence of any demand side pressures on prices, should this be the case, as it has been the case in the US in 2022. And the central bankers should advise accordingly.
Steady as it goes is called for. A recognition of the limited powers of central bankers to always control prices within a narrow range- given the possibility of a severe supply side shocks -should be well understood and well communicated to the economy. The uncertain dynamics of inflation in 2021-2022 needed more sympathetic understanding and treatment than they appeared to receive from either the Fed or indeed most market commentators.
Post-Covid, central bankers including the Fed have continued to raise interest rates rapidly in response to higher prices, regardless of their supply side or demand side or mixture of both. They have not accommodated higher prices but allowed them to restrain demand and contain inflation – perhaps more than they needed to do. But they have not presented a confident front that inflation would and could be controlled without unnecessary damage to the economy.
It was surely possible to bring inflation back in line without a very costly recession as may still be the case. But with the right messaging it might also have been possible to do so without disrupting financial and asset markets that understandably became so fearful that the Fed would induce a recession.
Fanciful fears of self-perpetuating inflation explain the reactions of the Fed
Central bankers, rather than ignore the supply side shocks that partially explained the dramatic increase in the price level, fretted openly that economic actors would simply extrapolate their recent inflation experiences and can add continuously to prices. That higher inflation could lead to more inflation and so inflation becomes entrenched in the economy with highly damaging effects on economic growth over the long run. Much market commentary as well as Fed commentary has been about inflation becoming entrenched because of the danger of a higher wage- higher price spiral- that needed to be vigorously countered.
But such fears were highly exaggerated and have little evidence to support the notion of inflation simply feeding on itself. Absent a decision to react to a slow-down in an economy subject to the negative influence of higher prices, with still more of the money that initially caused prices to rise in the first place. It takes still more money to overcome the negative effect of higher prices themselves on demand and on the pace of economic growth. Prices will continue to rise only if the supply of money is allowed to continue to increase to offset the impact on spending of higher prices. This has not been the case in the US. The supply of money stopped increasing in 2022 and spending fell away to take the pressure off prices.
The determinants of inflation expected
It is surely not rational to set prices or wages regardless of what the market can be expected to bear. Economic actors with pricing power, including the power to demand higher wages, can easily be disappointed in their plans to charge more should demand for their goods and services at higher prices proves lacking. Slack being the difference between actual and potential GDP. [2] Economic slack can overcome more inflation expected as previously conventional central bank theories asserted. The highly reduced inflation equation in the Fed and other central bank models (Inflation = inflation expected – slack) indicates as such. The more slack, the less inflation, for any given expected inflation, is the theory.
Price setters would always like to raise prices or wages, to charge more, but they are restrained by the market for their offerings. They are forced to adjust their prices to what the market will bear, rather than what they might have expected their customers to have borne. The decline in inflation in the US recently helps make this important point. The US market in general is no longer able or willing to bear still higher prices for want of slack or potential slack.
The momentum of past inflation may well influence expected inflation. But it would not be rational to do so in some simple-minded way, given the possibility of slack in the economy. Any rational model of expected inflation would moderate inflation expected by slack expected. And the slack expected would depend upon the expected reactions of the central bank and might allow a role for the growth in money supply and bank credit.
We should expect more of a central bank than having to induce a recession to control inflation. The realistic promise should be one of a soft-landing and a central bank should acquire a reputation to deliver that. Inflation is to be avoided and can be avoided – but it should not have to take a highly destructive recession to do so.
Adding further increases in interest rates in the US and elsewhere to depress demand further in 2023 is a step too far- given the clear absence of buoyant demands from households. The opportunity exists for a soft-landing for the US economy, with inflation heading permanently lower to the 2% p.a. target of the Fed while avoiding a recession. But it will take an early pivot by the Fed to lower not higher interest rates by late 2023.
Employment, wages and prices- what is the relationship?
One other regular source of market moving news has been about the buoyant state of the labour market. The prospect of a recession, given very full employment, is a most unusual combination of circumstances. An un-employment rate below 4% and the growth in the numbers employed above 200,000 per month, as has been the case, are not normally consistent with a recession any time soon. (see figure 9 below)
As the financial markets were well-aware, a fully engaged labour force might well encourage the Fed to continue to worry more about the upside risks to inflation than the downside risks to growth. Especially if it held some conventional assumption about the higher wages that come with full employment will lead to further upward pressure on price- a wage-price spiral.
However interpreting the true state of the labour market- in particular the willingness of potential workers to supply labour – post Covid – is proving especially difficult. A taste for leisure rather than work has been facilitated by Covid relief and led to fewer potential employees seeking work. Given the lower participation rates in the labour force, employers particularly in the service sector, became unusually willing to pay-up to secure workers expected to remain in short supply.
The numbers employed outside agriculture appear to have caught up with pre-Covid levels. But are still below where pre-Covid trends in employment might have taken the labour market. The growth in the numbers employed month to month, which averaged a very steady 1.64% p.a. between 2011 and 2019. The post lockdown recovery saw the growth in US employment to peak at 10% in early 2021. The growth in the numbers employed now appears to be slowing down, consistently with a normal slow-down in spending.
Fig. 9; US employment and annual growth in employment. Monthly data
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment.
The Fed view on the relationship between wages and prices – a recent pivot – and back
Yet the Fed in August 2020 revealed a willingness to experiment with the relationship between inflation and the state of the US economy, and more particularly, to experiment with the relationship between the state of the US labour market and wages and prices. Chairman Jerome Powell opined [3] that there was no predictable relationship between them and so the Fed would tolerate, even encourage, lower rates of unemployment and higher levels of employment, without exposing the economy to more inflation. In short, Powell pronounced that the Phillips curve that posits a costly trade-off of extra employment for lower inflation does not exist or, in his words, the curve has flattened.
Economic theory has long explained the demise of the Phillips curve observed first in the high inflation slow growth, stagflation 1970s. Economic agents, be they firms or trade unions, or indeed highly paid executives, learn to build inflation into their price and wage settings. A view on inflation – inflationary expectations – are rationally baked into their budgets and plans, and current price and wage decisions. Thus it is not realised inflation that will have a real impact on hiring and production decisions. Since expected inflation will be reflected in the prices and wages agreed to in advance, it will be inflation surprises, higher or lower, that will invalidate, to a degree, the best-laid plans of businesses and their employees and force an adjustment to price and wage plans.
The financial markets and the outlook for inflation – fighting the Fed and losing
The marketplace, correctly in my opinion, has maintained a different more benign view of the outlook for inflation than has the Fed and its officers. Expectations of inflation over the long run are revealed by the differences between the yield on vanilla and inflation linked bonds. They have remained well contained and close to the 2% p.a. inflation target of the Fed.
By year end 2022 the difference between the nominal yield offered by a 10 year US Treasury and the real, fully inflation protected, yield on a 10 year US bond, a TIPS, (Treasury Inflation Protected Security) was of the order of 2.25% p.a. Investors exposed to the risk that inflation would erode the purchasing power of their fixed interest income, of 3.7% p.a. for ten years were offered an extra 2.25% p.a. to accept this inflation risk. Investors in either the vanilla or inflation protected bonds would breakeven if inflation turned out to average 2.25% p.a over the next ten years as expected in the bond market. This inflation compensation -the breakeven yield spread provides a highly objective view of inflation from investors with much to gain or lose should inflation turn out higher or lower than expected.
The surprising feature of the behaviour of the long bond yields through a period of much higher inflation is that real as well as nominal bond yields have risen sharply- helping to close the gap between them. Higher nominal yields to accompany more inflation and to provide compensation for more inflation expected is not a surprise. The surprise is the increase in real yields that have accompanied more inflation and amidst widespread expectations of slower growth – even recession to come. Forces that might ordinarily be expected to reduce the case for businesses to raise more capital and lead to lower rather than higher real interest rates.
My explanation for this anomaly was that volatility as measured in the bond markets had also risen with uncertainty about the actions the Fed might take to control inflation. Therefore, all yields, nominal and real, rose to compensate investors for the extra risks they believed they were taking. More perceived risk means lower bond and equity values in 2022 that are necessary to provide higher expected returns in both the equity and bond markets in 2022. Subject to these increased risks to interest rates the bond markets in 2022 proved anything but safe havens for investors.
Fig.10; US Bond Market; 10 year Conventional and Inflation Protected Treasury Bonds. Yields and inflation compensation (break- evens)
Source; Bloomberg and Investec Wealth and Investment.
Fig. 11; US Bond market volatility index (Move) and the Bond Index. Daily Data
Source; Bloomberg and Investec Wealth and Investment.
Fig. 12. The S&P 500 index and the Volatility Index (Vix) Log Values Daily Data 2020- 2022
Source; Bloomberg and Investec Wealth and Investment.
Conclusion – The Fed is now following rather than leading the data
Expected inflation or expected GDP influences current valuations and business operations. The future is all in the price as may be said, but the future may turn out very differently. It is only surprises that move financial markets and the real economy as in the expectations adjusted Philips curve discussed earlier. These ideas were incorporated into economic theory in the nineteen seventies and eighties and the developers of the theory were rewarded with a number of Nobel Prizes for economics. [4]The task of central banks following the expectations sensitive and now conventional central bank wisdom, is to help anchor inflationary expectations to avoid such surprises. The Fed hopes to do so by providing forward guidance on central bank policy intentions with which the market hopefully concurs and behaves accordingly providing a higher degree of market stability. Thus, by reducing uncertainty about the future path of inflation and the real economy helpful guidance helps make business plans more accurate and less subject to alterations in output and employment plans. Closing the potential gap between expectations and economic and financial market outcomes is thought to reduce risk and required returns and therefore helps promote economic growth.
However, the Fed in its recent latest post- rapid inflation incantation, has been very disinclined to offer any comfort to investors about its intentions. Fears of unknown, and what are presented as highly unpredictable inflation, rather than slow growth, remain uppermost in its thinking.
The notion that higher inflation could be self-fulfilling and harmfully so for the economy over the long run appears to dominate their approach. The Fed appears willing to accept a recession if necessary to the purpose of reducing inflation expected and so inflation. A view that the market is understandably fearful of. And to some extent the market has not accepted the Fed view as has been revealed in forward interest rates, lower forward rates, than appear in Fed Open Market Committee guidance (the so-called dot plots of OMC members)
My own view is that the market is very likely to be closer to the truth on inflation and therefore on the path of interest rates than the Fed. That the Fed, more than the market, is likely to be surprised by the inflation and interest rate outcomes.
Central bankers are unlikely to emerge from Covid with their reputations for sound judgment about inflation fully intact. No more than the epidemiologists whose predictions of disaster proved highly fallible. The case for economic lockdowns given their cost and collateral damage has become increasingly suspect with the knowledge since gained.
Perhaps the next time society is threatened by an epidemic the cost-benefit analysis of economists may carry more weight with the politicians and their officials who appear so independently powerful to exercise executive authority. And maybe next time, without the lockdowns, the temptation to add as much stimulus as was added post-Covid – with all its consequences – inflation followed perhaps by recession – will be resisted to a greater extent.
The Jury will stay out on these issues through much of 2023. My contention that inflation is heading lower because the money supply is decreasing is well supported by the latest trends as of December 2022. The monthly increases in the US CPI are all pointing to much lower headline inflation. A trend that will become ever more obvious to all observers including those at the Fed. The case for higher short term interest rates will then surely have been lost. The case for assisting the US economy with lower interest and a pick-up in money supply growth rates will then become irresistible.
[1] I offered a monetarist interpretation of these developments in early 2022
Brian Kantor, Recent Monetary History; A Monetarist Perspective, Journal of Applied Corporate Finance • Volume 34 Number 2 Spring 2022
[2] I wrote about the beliefs of central bankers in 2016
Brian Kantor, The Beliefs of Central Bankers About Inflation and the Business Cycle—and Some Reasons to Question the Faith. Journal of Applied Corporate Finance • Volume 28 Number 1 Winter 2016.
[3] All references to Chairman Powell and his thoughts are taken from his speech to the symposium on economic policy organized by the Federal Reserve Bank of Kansas City 8/27/2020;
New Economic Challenges and the Fed’s Monetary Policy Review
Chair Jerome H. Powell. At “Navigating the Decade Ahead: Implications for Monetary Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (via webcast)
[4] My own attempt to follow the chain and train of such new thoughts can be found in Rational Expectations and Economic Thought, Brian Kantor, Journal of Economic Literature, Vol. XVII, December 1979,pp 1422-1441
South Africa needs a plan to reduce the national debt and interest bill
The national debt and the interest bill for SA taxpayers have grown sharply since 2010 – the national debt grew by over R200bn before the Covid-19 lockdowns and by over R400bn in 2021. This year, taxpayers’ interest bill will be of the order of R300bn, compared with R57bn in 2008, while the national debt will approach R4 trillion, equivalent to about 60% of GDP – from a mere 18% in 2008. This is a dangerous trend that needs to be reversed.
In 2008, the interest bill accounted for 8% of all government spending but has since doubled to 16%. At an average 8% yield on the debt, every 1% increase in the average cost of funding the debt adds about R32bn to the interest bill. As the real national debt increases, taxpayers and voters may become unwilling to keep paying this overwhelming interest bill. Destruction of wealth through inflation of the value of the outstanding local currency-denominated debt will then follow. These types of developments do not come as a surprise to investors. History has made them aware of the dangers of default and they demand compensation for the risks of funding national debts, in the form of higher interest rates paid for upfront.
SA government growth in expenditure, revenue and national debt
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
In this context, South Africa has been penalised for its presumed inability to reverse course on its fiscal trajectory. High interest rates paid by the government and then passed on to businesses have compensated lenders for expected inflation and the expected accompanying weakness of its currency. The expected weaker rand detracts significantly from the expected returns of foreign investors earning rand incomes when converted to US dollars at some future point in time.
Government interest paid (R billions – LHS) and the ratio of interest paid to total debt (RHS)
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Looking closer at the cause of the rise in the national debt and interest bill, the chief culprit was government spending, which was sustained at a generous rate relative to real GDP after the recession of 2009 and 2010, while the revenue growth lagged. This problem was exacerbated by the lockdowns of 2021. Between 2008 and 2021, government spending after inflation grew by an average of 4% a year, while growth in real revenues increased by an average of 1.2% a year. Real revenues declined by 10% in 2010 and by 16% in 2021. The recession was bad news for the Treasury and higher tax rates were bad news for the economy.
Real growth in national government expenditure and revenue
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Much of the extra borrowing undertaken by the government since 2008 has been used to fund consumption spending rather than capital expenditure, a situation that is not helpful for growth. Real spending on compensation for government employees grew by about 30% between 2010 and 2018. Real capex by the government fell away sharply after 2015 and is now 25% below 2015 levels. The numbers employed in government have not increased meaningfully – it is average real employment benefits that have. An expensive patronage system seems to be at work.
Real general government spending on employee compensation and capital expenditure (2010=100, LHS) and the ratio of compensation to capex (RHS)
Source: SA Reserve Bank (Production and income accounts) and Investec Wealth & Investment, 10/11/2022
The call for fiscal sustainability made by Minister of Finance Enoch Godongwana in his recent mid-term Budget update is founded on the principle of restraining government spending on employee benefits. This is a restraint that is essential for promoting the long-term interests of all South Africans in economic development, including those who now work for or hope to work for the government.
Fiscal reform will be needed to achieve this sustainability. For example, it could extend beyond the objective of reducing the gap between government expenditure and revenue. The government could publish a capital budget and commit to raising national debt only to fund capex. This would help to permanently close the gap between government borrowing and government capex that was allowed to open up after 2008. Honest procurement of well-selected cost-of-capital beating projects should not be regarded as an impossible task.
Growth in national debt and capital expenditure by government
Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022
Abundant summer rain in SA has taken the weather forecasters and climatologists by surprise. They did not expect La Nina to persist for a third successive year- which was thought highly unlikely. La Nina describes an upswelling of cooler water in the Pacific Ocean that brings more precipitation with it – in Southern Africa – and less in other parts of South America. Its opposite is the little boy- La Nino – associated with warmer seas – and a drier South Africa. The quality of the weather forecasts has apparently been improving but the predictions of the climate models more than 10 days ahead are surely not to be described as confidently made with little margin for error.
Therefore, what confidence should we attach to forecasts of climate over the next fifty or more years? Yet society is being called upon very vociferously to believe in the climate models and their predictions of very harmful global warming. We are therefore being called upon – perhaps better described as being forcefully instructed so by our betters – to eliminate emissions of carbon dioxide – at enormous expense – to limit global warming. Costs of the astronomical order of 200 trillion dollars are bandied about. Which incidentally makes it extremely unlikely that resources of that order of magnitude will be willingly supplied by still highly constrained economies – and their dependents. Many billions of whom still lack clean and affordable energy to heat their shelters and cook their food.
The climate models will not only have to accurately estimate the volume of Co2 and other gas emissions to come and estimate within narrow limits their impact on average temperatures, and also predict how different parts of the planet will respond differently. They will also have to estimate the influence of the other powerful natural forces that will simultaneously and powerfully act on climate. Forces prominent in any climate model will have to include estimates of the variable influence of our lucky old Sun on climate. I am told by an expert that there is significant disagreement on whether we are about to enter a relatively quiet sunspot cycle, which normally leads to a period of cooling.
Another persistently powerful forces on climate will be ocean flux of which the Ninas and Ninos are an example. To quote the same authority “- the Atlantic Multi-decadal Oscillation (AMO) is a cyclic phenomenon of sea surface temperature anomalies in the North Atlantic Ocean. They switch between positive and negative temperature phases over ~80-year periods. The consensus view is that the AMO is about to shift to a cool phase”.
Climate models are necessarily highly complex and hence prone to error. The climatologists carry grave responsibility for the accuracy of their models. And the politicians will be held responsible for the expected trade-offs of present costs (higher taxes and energy prices) for future- always less than certain – benefits. I am no climate expert. However, I am well-aware of the fallibility of long-term forecasts of the state of any economy. And of the weakness of scenario building that inevitably attaches too much weight to recently observed phenomena. I am conscious that the planning horizon of any firm that commits to capital expenditure is seldom beyond 20 years for very good reasons. Relying on benefits beyond twenty years are too uncertain to influence current outcomes- it is also true of governments and its plans.
It makes good sense to wait and see what dangers and the opportunities that climate change may bring over the long run. A stronger better endowed economy will have the capacity to better manage adversity. The potential danger of global warming adds to the case for faster not slower growth- for more, rather than less resilience. Humans are well practiced in adapting to natural challenges. We can rely on them to cope with continuous climate change.
Relying on ambitious plans imposed top down has not yet proved a useful strategy for humanity. The plan to control climate through intervening severely in the global market for energy is highly ambitious and top down in a manner not ever embraced before. Yet the search for cheaper, less noxious, less dangerous, and more reliable energy is one of the positive steps for mankind that are still worth taking. What South Africa could be doing with great urgency would be to bring the oil and gas recently discovered off our shores onshore
The market reaction to the release of US CPI data shows the extent to which the inflation dynamics have changed. Central banks should take note.
New York on 10 November was one of those days that will be fondly remembered by those with skin in the game, in the form of investments in the equity and fixed-income markets. This was the day that the key S&P 500 index added 5.54% to its value by the close of trading and the more IT-exposed Nasdaq added even more, 7.35%. These moves were the largest on any one day since the world came to realistic terms with the damage caused to their economies by the lockdowns of 2020.
Government bonds, which typically make up 40% of any conservatively managed portfolio, also became significantly more valuable as longer-term interest rates receded sharply. The yield on the benchmark 10-year Treasury fell from 4.14% to 3.82, on the same day, the largest such daily move since 2009 (the dollar value of bonds moves higher as yields decline). On the following day, as an illustration, the JSE All Share Index had gained 3.2% by 11h15, while the rand was up 2. 7% against the US dollar by mid-morning.
The source of all the good news was unusually obvious. US inflation for October reported that day was surprisingly low. Simply put, the (new) expectation of less inflation implied less aggressive Federal Reserve policies and lower-than-previously-expected short-term interest rates. Furthermore, the higher probability of the US avoiding recession added present value to stocks and bonds. The trend to lower inflation was further confirmed later, with similarly favourable market reactions: producer prices also surprised on the downside with prices rising by a month-on-month 0.2% in October, half the rate expected by the market.
The Fed, having been so completely surprised by the surge in inflation in 2021, seems determined to march the US economy into recession to eliminate an inflation that they seemed unable to forecast with any degree of confidence. Monetary policy has become data-driven, guided by the view through the rear window. This has been accompanied by the fear that persistently high inflation could become a self-fulfilling tragedy for the US economy. The approach of the Fed seemed to be that, if a recession was the price to pay for avoiding permanently higher inflation, then recession it would have to be, much to the discomfort of the US share and bond markets. For the year to 15 November, the S&P 500 is down by 17% and the benchmark bond index is about 12% lower.
US stocks and bonds in 2022. (1 January 2022 = 100)
Source: Bloomberg and Investec Wealth & Investment, 16/11/2022
But should the Fed and the market have been so surprised? Surely not – if it had been closely following recent trends in inflation and spending by households and firms, then it would have appreciated why inflation had come to a screeching halt since its peak of 9.1% in June 2022. A year can be a very long time for an economy. The consumer price index (CPI), which was 9% higher in June 2022 than a year before, has flat-lined since June 2022. Consumer prices had stopped increasing in June and the increase over a rolling three-month period has slowed to a 2.3% annualised rate. If this trend in the CPI continues, then the inflation rate will still be a high 6.9% at year-end, but will then fall away sharply to less than 1% by June next year. US headline inflation is apparently on a path to zero.
Inflation in the US
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment, 16/11/2022
The Fed should be acting accordingly, by recognising that aggregate spending in the US by households and firms has already slowed down markedly and does not threaten higher prices to come. The weakness of aggregate demand is restraining price increases. Higher prices to date have largely absorbed the spending power that was so boosted by vastly extra money supply and Treasury handouts provided in response to the lockdowns. Higher prices have their demand and supply side causes, but higher prices have their negative effects on spending power. Higher prices absorb disposable incomes and spending power. Higher wages – even given full employment in the US – have not fully kept up with higher prices, further restraining spending.
Inflation cannot perpetuate itself unless it’s accompanied by continuous increases in the demand for goods, which has not been the case in the US or Europe. The notion, endorsed by the Fed and many other central bankers (including the SA Reserve Bank), that higher prices and wages can simply perpetuate themselves, is a false notion. Inflation expectations soon run aground on the rock of deficient demand and unintended excess inventories. This theory of self-perpetuating inflation will not pass the test of evidence. The Fed and the market should be following the weak trends in spending closely. Ever higher interest rates could in these circumstances turn minimal growth in spending into spending declines – truly the stuff of recessions.
The Fed and the market would also be well advised to pay close attention to the trends in money supply growth. Inflation may be defined as a continuous increase in prices caused by an increase in the supply of money over the willingness to hold that extra money. All inflation is associated with excess supplies of money and the recent inflation in the US is no exception to this well-established rule.
A money supply explanation of the weakness of aggregate spending in the US also helps to explain why the demand for goods and services is growing so slowly. The important monetary facts are that money supply, broadly defined as M2 in the US, is now no larger than it was at the beginning of 2022. M2 amounted to US$21.62 trillion in January. By September, M2 had declined to US$21.46 trillion. The year-on-year growth in M2 that had peaked at an extraordinary 27% in early 2021 has slowed to a barely positive 3%, with the three-month growth rates now negative. Growth in commercial bank credit has also slowed down markedly. Year-on-year growth in bank credit was 7.6% in October 2022 while growth in bank credit provided has slowed to an annualised 1.6% over the past there months. The monetary, credit and price trends are pointing strongly to deflation rather than inflation by the end of next year. The market hopes that the Fed will recognise this in good enough time and avoid recession.
Money supply in the US (M2)
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment, 16/11/2022
Politicians propose spending and revenue plans – but the bond market disposes and not always kindly. In the UK plans to combine tax reforms that only work gradually with an immediate massive increase in subsidizing the consumption of energy with borrowed money was apparently a step too far for lenders to HMG and the governing party.
Yet long term interest rates in the US and Europe were also rising rapidly. In Germany Ten-year money yielding negative rates in January had increased to 2% p.a. by October. US US Treasury Bonds that offered 1% p.a. in early January 2022 now yield over 4% p.a. and indeed offer more interest in US dollars than the much battered 10 year gilts.
Long Term (10 Year) Interest Rates in the US, UK and Germany. Daily Data to October 25th
Source; Bloomberg and Investec Wealth and Investment
Blaming all this wealth destruction on a potentially profligate UK government is further complicated by the fact that not only were nominal interest rates on the rise – more so were real rates. Real ten-year yields in the US now deliver a yield of close to 2% p.a. – they offered a negative 1% in January 2022. They now exceed the returns on a UK ten year inflation linker that has increased from a negative -3% in early 2022 to the current much higher 0% p.a. Equivalent Inflation protected German Bunds also now offer about 0% p.a. – compared to -2% early in 2022.
Real Inflation Protected 10 year Bond Yields
Source; Bloomberg and Investec Wealth and Investment
It is the real cost of funding developed government debt that have been driven much higher this year -not more inflation expected. Expectations of more inflation to come would have found expression in higher interest rates for inflation exposed lenders and not necessarily in higher real yields. Expected inflation measured as the difference in nominal and real yields for equivalent bonds has not increased this year in the US,UK or Europe. Inflation expected in the in the UK over the next ten years has remained about 4% p.a. this year, higher than inflation expected in Germany and the US that have varied about the 2.5% p.a. rate.
Source; Bloomberg and Investec Wealth and Investment
It is not easy to explain why real interest rates in the developed world have risen so significantly this year. Additional competing demands for capital to fund capital expenditure that might ordinarily help explain higher costs of capital and rewards for savers have been notably absent. An alternative explanation is that greater risks to lenders has forced yields higher and bond prices lower to compensate lenders for assuming extra risks – that more risk demands higher returns and forces bond values lower. The risks posed by central banks struggling to cope with inflation have made bond markets far more volatile. The negative correlation between the increases in US bond market volatility Index and the Global Bond Index is strikingly large this year. The link between increased volatility and lower bond and equity valuations seems highly relevant. If it is the risk of central bank policy errors that have driven up required returns it may be hoped that a more predictable Fed will be accompanied by lower government bond yields.
US Bond market volatility and the Global Bond Market Index
Source; Bloomberg and Investec Wealth and Investment
Thanks to the inflation panicking Fed, government bonds have proved anything but a safe haven for pension and retirement funds in the developed world. But in high bond yield, high risk South Africa, RSA bonds have performed much better than equities for pension and retirement funds. The increase in long bond yields have been offset by much higher initial yields, leaving the bond market total return indexes in rands unchanged year to date while the JSE Swix Index has cost investors about 4% this year. RSA 10 year nominal yields started 2022 at 9.73% and have risen to 11.5% while the real yield on the inflation protected bonds are up from 3.63% to an elevated 4.6% p.a.
JSE Bond and Equity, Total Return Indexes January 2022=100. Daily Data
Source; Bloomberg and Investec Wealth and Investment
These high yields mean very expensive debt for SA taxpayers and offer high risk premiums to compensate for what has been a seriously deteriorating fiscal stance since 2010. The MTBS just presented represents a serious attempt to regain fiscal sustainability. If the plans are realized the debt to GDP ratios will decline to levels well below that of the US or UK. A primary budget surplus – revenues exceeding all but interest expenses – has come surprisingly in sight. Achieved this would surely represent fiscal sustainability and help bring down RSA yields closer to those of the developed market borrowers.
Risk is an elusive concept to pin down and for investors to grapple with in practical, measurable terms.
Investors who take a position on the stock market understand clearly what it means when they’re told their investment has produced a particular return over a particular period.
Most will also tell you they understand the notion of investment risk as an uncertainty of outcome; in particular, the higher the risk one is exposed to, the higher the chance that one loses one’s money. However, it is also accepted that in order to obtain good returns, one needs to take on extra risk. Then, in hindsight, risk is often used to explain why the realised return on an investment is high, on the one hand, or sometimes disastrously low on the other.
Underlying these perceptions of risk is the fundamental market tenet that one must expect to get rewarded for taking a position on an uncertain future. Therefore, markets must “price” risk into a share price, so that the higher the perceived risk of that investment, the higher the required future return on the investment. The problem is that neither this market-determined required return nor the associated risk is objectively measurable.
Still, plenty of people have tried. Quantitative financial analysts and the pioneering work of Nobel prize-winning economist Harry Markowitz use a statistical measure known as standard deviation (of return) as a proxy for risk. Typically, researchers in financial analysis will calculate an estimate of this standard deviation by using past values of share price returns.
In other words, to calculate the risk of a quoted company they would first compute the daily (or weekly) return of the share price over a certain period, and then compute the standard deviation of those returns. This measure, often termed volatility, is then taken as a measure of company risk. We will discuss below the flaws in this approach to measuring risk, but first consider some examples of situations where risk is much more precisely measurable.
In the game of roulette, played in casinos and assuming, of course, an unbiased wheel, we have constant probabilities of the ball landing on any of 36 numbers and zero at each spin of the wheel. It will be easily accepted that the risk involved in a bet on, say, red is much less than the risk of betting on the number 8-black, and one is rewarded accordingly.
If a red number comes up and you’ve bet R1 on red, you get R2 back. If you bet R1 on black and it comes up, you get R36 back.
Because the probabilities are fixed at each spin of the wheel, you could precisely calculate the expected return of your bet and the associated standard deviation of that return, which proxies for risk.
When one plays a game with fixed probabilities, one always knows precisely what one’s expected return is. But in financial markets, event probabilities are not known precisely and change over time.
The key point is that when one plays a game with fixed and known probabilities, and places a particular bet in that game, one always knows precisely what one’s expected return is, and also the risk one is exposed to.
But in financial markets, event probabilities are not known precisely and, in fact, change continuously over time. What’s more, there is no possible repetition within an economic system as there is in roulette; the clock cannot be put back, and no process can ever be repeated in exactly the same way.
However, in the case of measuring risk and return in financial markets, we can make some headway in certain circumstances.
For example, assuming the SA government does not default on its contractual payment obligation, one can calculate the exact realised return on an RSA government bond held to maturity.
This required return must reflect the chance of a country default (if there is a default, the return is zero). Apart from its local rand borrowing, the SA government also borrows money on foreign markets denominated in dollars. These SA “Yankee bonds” are traded in New York, along with similar dollar-denominated bonds from other countries.
The required premium of the return (the spread) over and above the return an investor obtains on US government bonds of similar tenure is termed the sovereign risk. It is a measure of the probability of the bonds being paid out, according to contract, in dollars.
One can then calculate the spreads for the different countries which have issued dollar bonds. So, in this case, one can quite precisely compare the market’s perceived risk of default for different countries in paying these dollar-denominated bonds, and compare sovereign risk across different countries.
In the share market, there is no similarly definitive way to obtain the expected return or the risk of any company share on the basis of share market prices. Market analysts often use proxies for comparative value (and hence comparative risk) such as p:es and various measures of yield, such as dividend yield or earnings yield. The underlying principle is that a high-risk company should be reflected in a comparatively low market price, given the current earnings or the dividend payout.
Quantitative portfolio analysts are, however, given the even more challenging task of combining different shares and instruments into a portfolio of assets expected to yield some overall return for some, often pre-mandated, risk.
They are thus faced with the problem of estimating portfolio (or share) risk in order to construct portfolios that fall within their given risk mandate. Given this problem, analysts almost always opt for using the estimated standard deviation of historical share price returns as a measure of volatility, which are then used as a proxy for risk.
There are plenty of problems associated with using past market data to measure risk or return But there are plenty of problems associated with using past market data to measure risk or return; the underlying issue is that markets are assumed to be efficient. This means the share price at any time can be assumed to reflect known information about the underlying company, but that price will continuously change as new information flows into the market.
Given that this new information is, by definition, unexpected and hence not predictable in any way, the resulting movement in share prices is, in turn, unpredictable. Therefore, past returns can give no indication of what future returns might be.
Risk, in contrast, may have some momentum in that a dramatic event, such as 9/11, will generally give rise to an extended period of return volatility, as markets grapple to understand and price in the impact of the event on share values.
However, though we may be able to anticipate volatility in the short term, the ability to do so over time is confounded by the statistical requirement of parameter stationarity.
In other words, if one wants to estimate a parameter using observations of that parameter over time, the parameter one is measuring cannot itself change over that period.
It’s a bit like locating a target when it’s moving, but your locating method must assume that the target is stationary. In the case of share price (or portfolio) volatility, this is an untenable assumption.
The conclusion is that any attempt to measure risk is problematic, especially in the context of listed companies.
However, there is little acknowledgment of this fact by analysts. Analysts require estimates of risk as a key input into almost any comparative share valuation or portfolio recommendation, but carefully avoid any interrogation of the validity of their estimates of risk. Individual investors may believe they understand risk, but their perceptions are often governed by whatever return they receive.
So: risk is an elusive concept to pin down and for investors to grapple with in practical, measurable terms. Fortunately, investors can usually take comfort in the one clear truth offered up by financial analysis. This is that the only sensible investment strategy is to carefully diversify one’s portfolio across as many asset classes as possible.
Then, assuming the world continues to advance technologically in the same innovative and productive ways it has in the past, irrespective of what unexpected challenges may arise, one’s investment will yield attractive returns over a long period.
Barr is emeritus professor of statistical sciences at the University of Cape Town (UCT);
Kantor chairs the Investec Wealth & Investment Research Institute and is emeritus professor of economics at UCT
The Covid lockdowns has quite dramatically altered the relationships between the South African economy and its global trading and financial partners. What followed Covid was a dramatic improvement in the balance of exports and imports. After 2020 exports, helped by higher prices, grew significantly faster than imports to take the balance of trade to a mammoth, nearly 10% of GDP by Q2 2021. As export prices have fallen off more recently the trade surplus has declined to a still impressive 4.8% of GDP in Q2 2022.
The difference between exports and imports is also the difference between GDP- output or equivalently incomes – earned producing that output – and Gross Domestic Expenditure –mostly on consumption by households and partially on capital goods by firms – that can be funded with loans to supplement current incomes. The trade balance – when positive -represents an excess of local supply over local demands- a contributor to global supply chains- rather than a drawer or absorber of them. The SA economy has thus helped dampen global inflation.
The closely watched current account of the balance of payments adds foreign mostly investment income to the trade balance. South African borrowers and capital raisers pay out interest and dividends at higher rates and yields than they typically receive from their foreign investments. Even though South African’s foreign assets roughly match their foreign liabilities (thanks to Naspers and its Ten Cent investment) This force usually turns trade surpluses into current account deficits – being the sum of the trade balance and the net foreign income accounts.
By definition of the balance of payments accounting system the current account deficits (or surpluses) are equal to foreign capital inflows or outflows. Instead of drawing on global capital markets to fund its capital expenditure budgets South African savers- almost all realized by its corporations to offset very marginal surpluses of the household sector and public sector deficits, became a significant source of savings for world capital markets. Instead of drawing on global capital markets to fund capital expenditure budgets we became a significant source of savings for world capital markets- some 300 billion rands worth since Covid. The current account is now in rough balance.
The trade balance, the current account and net foreign income. South African Balance of Payments Statistics. Quarterly Data
Source; SA Reserve Bank and Investec Wealth and Investment
Rather a lender than a borrower is conventionally good news for balance sheets and credit ratings- – provided all else remains the same. Ideally raising capital even debt – to spend on capital goods with long productive lives that earn above the cost of debt- is good for any company or government and all its dependents. It means faster growth- and faster growth is the key to attract capital – especially equity capital – on favourable risk adjusted terms. Though the influence of removing one of the SA deficits, the capital account deficit – and improving the fiscal deficit, also with the help of the exporters, has not been conspicuous in the market for rands. The exchange rate of the ZAR with the USD, as for all other currencies, is being dominated by the dollar and the actions of the US Fed.
There is a dark side to South Africa’s lesser dependence on foreign capital. The reason the SA trade balance has improved as much as it has is because the rate at which South African’s have saved since Covid disrupted incomes and output has held up much better than the rate at which the economy has added to its capital stock. The ratio of Capital Expenditure to GDP has very worryingly continued to decline – from the 20% of GDP range before 2016 to the current 14% of GDP rate. The savings rate appears to have stabilized at the 14% rate.
These capital expenditure trends portend very poorly for the economy. They imply persistently slow growth that will continue to threaten the ability of the SA government to raise revenues to fund its ambitious welfare programmes. Slow growth adds to the risk of investing in SA and the cost of raising capital from all sources domestic and foreign. It means less capital expenditure and slower growth. Ideally South Africa should be raising its capital expenditure rate and funding more of it by attracting foreign capital on favourable terms, growing faster by reducing the risk premium with appropriate actions. Current account deficits and capital inflows to fund growth would then be very welcome.
The trade balance and the difference between savings and capital expenditure. Quarterly Data
Source; SA Reserve Bank and Investec Wealth and Investment
Savings and Capital Expenditure. Ratio to GDP. Quarterly Data
Source; SA Reserve Bank and Investec Wealth and Investment
The financial market reactions to the US CPI news on 13th September provides an extreme example of how surprising news plays out in the day-to-day movements of share prices, interest and exchange rates. The key global equity benchmark, the S&P 500 lost nearly 5% of its opening value after the announcement that inflation in August had been slightly higher than expected. Implying that the Fed that sets short term interest rates in the US would be more aggressive in its anti-inflationary resolve, making a recession inevitable and more severe.
By the recent trends in GDP the US economy was already in recession despite a fully employed labour force. Recession without rising un-employment would have been unimaginable before the Covid lockdowns. The Fed failed to imagine the inflation that would follow the stimulus it, and the US Treasury, had provided to the post covid economy and this has become the problem for investors and speculators required to anticipate what the Fed will be doing to protect the value of the assets entrusted to them.
Yet it should be recognized that the US CPI Index in fact is no longer rising – average prices fell marginally in August as it had done the month before. But perhaps not as much as had been expected. The headline inflation rate- the rate most noticed by the households and the politicians had reached a peak of 9.1% in June and has since fallen to 8.3% as the CPI moved sideways. The increase in prices over the past three months was lower – 5.3% p.a.
Inflation in the US. Headline % p.a. Monthly % and three monthly % p.a.
Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment
Yet even if the average prices faced by consumers stabilized at current levels until June 2023 the headline rate of inflation would remain elevated- at 6% p.a. by year end and could return to zero only by June 2023. One wonders just how realistic are the Fed’s plans to reduce inflation rates in shorter order. Patience is called for
The outlook for Inflation if the US CPI stabilized at current levels.
Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment
The true surprise in the inflation print was the trend in prices that exclude volatile food and energy prices. It was these supply side shocks to prices that had helped to drive the index higher and they are reversing sharply. However, the inflation of prices, excluding food and energy remains elevated. They are now 6% ahead of price a year ago. The Fed is known to focus on core rather than headline inflation.
Headline and “Core” inflation in the US
Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment
The largest weight in the US CPI Index is given to the costs of Shelter. They account for over 32% of the Index of which 28% is attributed to the implied rentals owner occupiers pay to themselves. The equivalent weight in the SA CPI is much lower – 13%. Where house prices go – so do rents – and the implicit costs – rather the rewards – of home ownership – and inflation. But surely the reactions of those who own more valuable homes are very different to those who rent? Higher explicit rentals drain household budgets – and lead to less spent on other goods and services- and are resented accordingly as are all price increases. Higher implicit owner-occupied rentals do the opposite. They are welcomed and lead to more spending and borrowing. House price inflation in the US has been very rapid until recently- and rents may be catching up- meaning higher than otherwise inflation rates.
Prices always reflect a mix of demand and supply side forces. But ever higher prices- inflation – cannot perpetuate itself unless accompanied by continuous increases in demand. It is the impact of higher prices on the willingness and ability of households to spend more that is already weighing on the US economy. Incomes are barely keeping up with inflation. And the supply of money (bank deposits) and bank lending in the US has stopped growing further constrains spending. If inflation is caused by too much money chasing too few goods the US is already well on the way to permanently lower inflation. The danger is that the Fed does not recognize this in good time – and as the market place fears.
US Money Growth (M2 seasonally adjusted)
Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment
The rand has consistently declined by more than its purchasing power parity equivalent rate against leading currencies over the years. Strong action is needed to change this.
South Africans travelling abroad should not blame the rand for their lack of purchasing power, at least not lately. In mid-January 2016, a US dollar exchanged for R16.80, a British pound then cost R24. Observers of the gyrations of the foreign exchange value of the rand should know that its exchange rate has had very little to do with the differences in inflation between SA and its trading partners. The rand has consistently bought less abroad than it has at home.
The exchange value of the rand with the US dollar or sterling has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995, when SA’s capital market was opened up, though with varying degrees of weakness. Had the rand simply followed the ratio of the SA consumer price index (CPI) to the US CPI since 1995 a dollar would now cost a mere R8. Similarly, since 1995 the difference between SA and UK inflation has been an average of 3.3% a year while the pound on average has cost an average 8.2% extra a year in rands since 1995.
Rand exchange rates against the US dollar (1995-2022)
Source: Federal Reserve Bank of St Louis, Bloomberg and Investec Wealth & Investment, 17/08/2022
Yet not only has the rand depreciated by more than the differences in inflation over the past 27 years, it is also expected to carry on weakening by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% a year over the next 10 years and at an average 6% rate a year over the next five years. This is known as the interest carry: the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets (and to incoming tourists) this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand-denominated debt, increasing the required return on securities. Expected rand weakness sharply reduces the expected return from the RSA (government) 10-year bond to under 3% a year (10.4% nominal yield less 7.6%). This is less than the same return in US dollars offered by a US Treasury.
The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation-protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% a year for a five-year bond and 5.91% a year extra for rand investors in RSA bonds. This difference in expected inflation of 3.2% a year is significantly less than the 6% rate at which the rand is expected to weaken against the dollar over the same five years. PPP does not only not hold, but it is not expected to hold in the future. Sadly therefore, even reducing expectations of inflation may not much improve the outlook for the rand – a major issue if the cost of raising foreign or domestic capital is to be reduced.
Inflation compensation in SA and US 10-year bond markets and differences in expected inflation
Source: Bloomberg and Investec Wealth and Investment, 17/08/2022
The interest carry (difference in nominal yields) and the difference in inflation expected (2010-2022)
Source: Bloomberg and Investec Wealth and Investment, 17/08/2022
The full explanation for the exchange value of the rand is thus not to be found in the PPP rate but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA-specific risks move the ratio of the rand to other emerging market currencies about this long-term one-to-one ratio. Both the rand and the other emerging market currencies respond similarly to the same degrees of global risk tolerances that drives the US dollar stronger or weaker.
The task for SA lies in promoting capex (and so economic growth) by improving the outlook for the rand. It could do so by adopting policies that would make SA a superior emerging market attracting a much lower risk premium. SA’s recent impressive successes in the competitive businesses of international rugby and cricket, provide the case study to be emulated widely.
The exchange value of the rand vs other emerging market currencies (1996-2022) (Higher numbers indicate rand weakness)
South Africans travelling abroad should not blame the rand for their lack of purchasing power- at least not lately. In mid-January 2016, a USD exchanged for 16.8 rands, the pound then cost R24. Observers of the gyrations of the foreign exchange value of the ZAR should know that the ZAR rate has had very little to do with differences in inflation between SA and its trading partners. The rand has consistently bought less abroad than at home.
The exchange value of the ZAR with the US dollar or UK pound has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995 when the capital market was opened up. Though with varying degrees of weakness. Had the rand simply followed the ratio of the SA CPI to the US or UK CPI since 1995 a USD would now cost a mere R8. Since 1995 the difference between SA and UK inflation has been an average 3.3% p.a. while the pound on average has cost an average 8.2% p.a. extra in rands since 1995.
Exchange rates with the US dollar. 1995-2022. Monthly Data
Source; Federal Reserve Bank of St.Louis, Bloomberg and Investec Wealth and Investment
Yet it is not merely that the ZAR has depreciated by more than differences in inflation – it is expected to continue to weaken by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% p.a. over the next 10 years and at an average 6% p.a. rate over the next five years. Known as the interest carry – these are the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets – and to incoming tourists – this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand denominated debt, increasing the required return on securities that are expected to lose their dollar value at a rapid rate. Expected rand weakness sharply reduces the expected return from the RSA 10 year bond to under 3% p.a. (10.4 nominal yield less 7.6) Less than the same return in USD offered by a US Treasury.
The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% p.a. for a five-year bond and 5.91% p.a. extra for rand investors in RSA’s. This difference in inflation expected of 3.2% p.a. is significantly less than the 6% rate at which the USD/ZAR is expected to weaken over the same five years. PPP does not only not hold- it is not expected to hold in the future. Sadly therefore even reducing inflation expected may not much improve the outlook for the ZAR- essential if the cost of raising foreign or domestic capital is to be reduced.
Inflation compensation in SA and US bond markets and differences in inflation expected
Source; Bloomberg and Investec Wealth and Investment
The interest carry (difference in nominal yields) and the difference in inflation expected. Daily data- 2010-2022.
Source; Bloomberg and Investec Wealth and Investment
The full explanation for the exchange value of the ZAR is to be found not in PPP but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA specific risks move the ratio ZAR/EM about this long term one to one ratio. Both the ZAR and the other EM currencies respond very similarly to the same degrees of global risk tolerances that drives the USD stronger or weaker.
The task for South Africa hoping to promote capex and so economic growth by improving the outlook for the ZAR. It could do so by adopting policies that would make SA a superior emerging market attracting a much lower risk premium. SA’s impressive success in the highly competitive business of international rugby, provides the case study – to be emulated widely.
The exchange value of the ZAR compared to other EM currencies. Higher numbers indicate rand weakness. Daily Data 1995-2022
Source; Bloomberg , Investec Wealth and Investment
A most extraordinary feature of the SA economy is how large a proportion of the adult population, some 58% or over 22 million of working age in early 2020, reported no income earned from employment. These estimates are abnormally high when compared to other similarly undeveloped economies. The adult population has been growing faster than the numbers employed and the participation rate in the economy has accordingly declined. A large number of South Africans including the great majority of those reporting no income, are also objectively poor. South Africa has an employment and a poverty problem. It is only when you reach the upper end of the third quintile of the income distribution that income from work becomes significant. The SA economy has served those in employment well enough in what is a dual labour market of insiders and outsiders who struggle to break in. It has failed to absorb vast numbers of potential workers into employment. A consequence but also a primary cause of slow growth.
It may be asked – how do so many survive- merely survive – with no income? The answer is mostly in the support received from the SA government or rather its taxpayers in the form of benefits in kind- education, health care, housing water and electricity and in form of cash grants for those over 60 and mothers with dependent children and for the disabled on a means or asset tested basis.
Some 50% of all government spending, currently 1.1 trillion rands, is the welfare bill of which a roughly a quarter is distributed as cash. These cash grants now include monthly payments of R350 to able bodied adults as Covid relief for which 9 million applications were made and are bound to continue indefinitely. The intention is to extend meaningfully these benefits for able bodied adults in the form of a Basic Income Grant. (BIG) The bigger the BIG in terms of benefits and coverage the more negative however will be the impact on the willingness to work of low skilled low paid workers. It will mean fewer jobs sought and provided and widen the income and cultural gaps between the fully employed skilled and, the more or less permanently, not employed.
Improved welfare benefits raise the reservation wage of all potential workers. That is the rewards required to make work a sensible choice, especially for those with limited skills or capabilities. The improved income rewards sought and realized by better welfare endowed potential workers – with limited productivity – makes them less attractive to employ. They lack the skills and training to justify higher rewards sought from understandably cost-conscious employers. Capabilities that their expensive education (provided by taxpayers) has failed to provide them with. Employers are also reluctant to stand accused of paying “starvation” wages. Who therefore prefer to employ better paid, more productive workers and hence fewer of them.
The South Africa has chosen improved welfare rather than work to relieve poverty – and has failed to do so – for want of the economic growth that would have provided a larger tax base. For which the higher tax rates needed to fund the welfare budgets are in part responsible. We should recognize the full causes of the failure to exercise our economic potential employing more workers. Ideally, with private sector involvement, we could reform education and training to deliver better qualified entrants to the labour market. And we could subsidise their employment more heavily.
Any significant increase in the tax burden to improve welfare or subsidise employment would however have to borne by formal sector workers in the form of a significant social security tax – that is a by a proportional sacrifice of their wages and salaries. There will be no other realistic place to look for additional tax revenue. It is therefore unlikely to be popular with the formally employed, the insiders whose interests, well supported by their Trade Unions, that have dominated the regulation of the demand for labour, adding further to the sacrifice of employment opportunities.
Ask not what you can do for the boss. Ask what your boss can do for you
An earlier study of the returns from investing in the best companies (BCs) to work for, as revealed by their employees, has been replicated with very similar results – as reported in the recent Financial Analysts Journal. An index of US companies that best satisfy their employees, would have provided market beating returns over an extended period to 2020, on average a meaningful extra 2-3% p.a. over the long run. Incidentally a similar methodology applied to selected groups of companies with very good ESG qualifications revealed slightly inferior returns. It is understandable why investors might have paid up for companies to feel better about themselves. Less obvious is why investors have so conspicuously spurned the advantages of investing in companies that are so well appreciated by their employees.
A different relationship between the causes and effects of companies that best satisfy their employees may explain the observed outcomes. It is the economic and financial performance of the best companies surveyed that perhaps explains their superior status with employees more than the other way round. The better the economic performance of a company, the better the company will be able and willing to look after their managers and workers and win their trust.
The same many hours devoted with the same energy and skills to a struggling business, are very likely to provide very inferior rewards over a lifetime of work. Promotion and training opportunities will be more limited. Initiatives to encourage self-improvement of the workforce will be unaffordable and the job itself will be much less secure. Bonuses and share option schemes that come with success and that make climbing the slippery corporate ladders so attractive will be largely absent.
It turns out that the best companies to work for are also unusually successful when measured by the other criteria for performance. To quote the study, “Overall, the main takeaway from these statistics is that BCs are rarely tiny-cap stocks, they are typically large, and a few are extremely large companies…… , we also see that, on average, BCs have relatively high market-to-book ratios of 12.44 and gross-profit-to-total-assets ratios of 38%, and that BCs spend relatively little on capital expenditures (4% of revenue) and have relatively large amounts of intangibles in their balance sheet (22% of total assets)….. BCs are large companies, with an average (median) market capitalization of $55bn. This shows that BCs tend to be large companies and the size distribution is skewed to the right….”
Most large companies were small to begin with and size is a measure of their success- able to sustain better still to improve their returns on additional capital employed. Such achievements characterize the true growth companies well worth being an early investor or employee in. The ideal business to invest in or work for would be a start-up that grows rapidly and becomes large and consistently successful on all dimensions. Perhaps what the list of BC’s – that change significantly from year to year- about 20% enter and leave the lists annually – include a biased sample of surprisingly successful companies- revealed in part by their superior employment practice. The best run companies are priced for success and therefore returns realized may not beat the share market. The surprisingly improved companies will do so. Identifying surprising strength before other investors do is the holy grail of investors and indeed also of workers with choices to make.
The key success factor in any business are the capabilities of its senior managers and directors. The employed insiders are in a very good position to evaluate them. The transfer market can serve those with competitive and marketable skills as well as it does in football should they have reason to doubt their leaders. Moreover, as they do in football, they should not resent the high rewards received by the best executors, the true and rare superstars that create and preserve so much value for workers and shareholders and as important for their valued customers.
When will inflation in the US (9.1% in June) peak? My answer is about now. And the surveys of inflation and the state of the financial markets support this proposition. If month to month increases in the US CPI revert to something like the 20 year average, inflation in the US will be trending well below 7% by year end and fall back to 2% p.a. by late 2023. Bloomberg surveys conducted in July indicate in inflation in Europe- now over 8% p.a. to recede to 2% by year end. Inflation in SA, still to peak at over 7%, is expected decline to 5% by late 2023.
The supply side disruptions that ramped up oil, grains, shipping costs and metal prices (unfortunately for the South African economy) have abated. They are all well off their recent peaks. Industrial Commodity and Metal prices are 50% lower than their peak values of January 2022. These prices may remain at high levels, but they are no longer rising to force inflation higher.
Industrial Commodity Price Index. January 2022=100. Daily Data
Source; Bloomberg and Investec Wealth and Investment
Prices have their supply and demand causes as they have had in our post Covid, post Russian invasion world. They also have their intended effects. They have helped repress demand for goods, more than for services, in the developed world and South Africa. Inflation is properly defined as a continuous increase in the CPI. It takes more than essentially temporary supply side shocks for inflation to proceed at persistently higher levels. Inflation can only be sustained with continued stimulation of demand. Without additional demand, the higher prices perhaps planned in advance by suppliers with price setting powers, cannot be sustained. Without support from the demand side of the economy, from further injections of demand, stimulated by central banks and governments, the market-place will not t absorb higher prices. In the absence of supportive demand, prices will, perhaps only gradually, adjust lower in response to help sustain sales revenues and bottom lines.
Prices are not what firms would like them to be, higher usually, but are conditioned by what their customers will bear. Expecting more inflation and setting higher prices accordingly regardless of the stae of demand cannot be a self-fulfilling prophecy. It is not consistent with economic rationality. The clear evidence from the recent surveys and the bond markets is that economic actors are not naively extrapolating recent inflation into the distant future. They are wisely seeing beyond current inflation to the longer-term demand and supply forces that will act on prices- including the role expected to be played by fiscal and monetary policy. As with the surveys, inflation expected, as priced in the market for US Treasury Bonds, so called break-even rates, have receded in the past week-despite higher realized inflation.
The US bond market expects inflation to average 2.1% p.a. over the next five years and 2.3% p.a. over the next ten years- very close to the 2% p.a. Fed target for inflation. The SA bond market is now offering still higher rewards for bearing inflation risk- despite the inflation-fighting zeal of our Reserve Bank. The money and bond markets in the US are priced for a reversal of the direction of interest rates next year, with the peak in short rates having been brought sharply forward to January 2023 at 3.25%. The SA money market predicts much higher interest rates for a much more extended period. One hopes wrongly given the absence of demand side pressures on prices and the state of the economy.
Inflation expectations revealed in the Treasury and RSA bond markets. Daily data.
Source; Bloomberg and Investec Wealth and Investment
The best reason to expect inflation to subside in the US, Europe and South Africa is that the demands for goods and many services are already well depressed, thanks to higher prices. Spending is no longer being supported by additional income subsidies or by rapid growth in the money supply and bank credit. The money supply in the US (M2) has ground to a halt. The essential question is still to be answered. Is the US and Europe heading for recession aided and abetted by central banks intent on raising interest rates too aggressively and indeed unnecessarily fighting the last war? Central banks should know better than to lead their economies into recession while inflation is moving in the right direction and their economies head in the wrong direction.
We like to think that evidence changes beliefs. The problem with beliefs or rather opinions about economic life is that the economy never stands still to conduct experiments with. The management of Naspers conducted an experiment in September 2019 to reduce the huge gap between the value of the assets on its books, its Net Asset Value (NAV) or sum of its parts, mostly in the form of its enormously valuable shareholding in Tencent a fabulously successful internet company listed in Hong Kong, and the market value of its shares listed on the JSE.
The board and its management have seemingly learned a great deal from the expensive experiment – unexpectedly so surely – because restructuring its shareholding, establishing a subsidiary company in Amsterdam Prosus (PRX) to hold its Tencent shares and other offshore investments went so badly. The value gap, the difference between the NAV and Market Value(MV) of both NPN and PRX rather than narrow had widened significantly after 2019 despite or rather in small part because of the restructuring. By early June 2022 the discount for NPN (NAV- MV)/NAV)*100 was of the order of 62% and 51% for PRX
Such new awareness has been received with great appreciation and delight of its shareholders these past few weeks. As a result of its change of mind, in the form of a mea-culpa about past actions and the much more tangible decision to sell as much as 2% a year of its holding in Tencent shares, worth potentially USD 10 billion a year, and to return the cash realized to shareholders buying back its shares. Since the announcement of June 23rd, shareholders in NPN have seen their shares appreciate by 34% adding 323 billion rands to its market value by July 5th while shares in the associate company Prosus (PRX) are up by 26% worth a extra R520 billion rand and the discount has substantially narrowed to the 30% range for PRX and 40% for NPN. A further decision to include success in narrowing the value gap as a key management performance indicator was also helpful. All achieved in days while the JSE has moved sideways.
Daily share price moves and the JSE All Share Index June 23rd – July 5th (June 23rd=100)
Source; Bloomberg and Investec Wealth and Investment
Market Value; Naspers and Prosus, Rand millions
Source; Bloomberg and Investec Wealth and Investment
Naspers and the Value Gap 2010 – 2019 Month end data.
Source; Bloomberg and Investec Wealth and Investment
The Naspers board had been of the view that it was the South African and JSE connections, higher SA risk premiums and a limited shareholding opportunity in SA, where NPN featured so largely, stood in the way of their receiving proper recognition for their vigorous efforts in diversifying their balance sheets. Hence the restructuring. My opinion, long shared with whoever might read or listen to them,[1] was that the difference between the market value of the sum of parts of any investment holding company and its share market value including NPN and PRX could be largely attributed to three factors. And that where a company was domiciled or listed would be of minor consequence.
Firstly that the reported value of unlisted subsidiary companies could be over-estimated to exaggerate NAV. Secondly that the estimated future costs of maintain a head office, including the employment benefits (including share options and issues) expected to be realized to senior management would be present valued to reduce the market value of the holding company shares. Managers can prove very expensive stakeholders.
And thirdly and most importantly would be the investors or potential investors estimate of the present value of the investment programme of the holding company. They might well judge and expect that the future value of the investments and acquisitions to be made by the Holding Company will be worth less, perhaps much less, than they will cost shareholders in cash or returns foregone. And the more investments undertaken the more value destruction and the lower the value of the shares in the holding company priced lower to promise a market related return for shareholders. If such were the market view the less cash invested, the more returned to shareholders by way of dividends, share buy backs or via the unbundling of mature investments, the more value created for shareholders. Naspers/Prosus is helping to prove my theory.
A growing number of employers have insisted that their employees must come back to their work- places. Elon Musk, has demanded that Tesla or Space Ex staff spend at least 40 hours in their offices and that those who do not want to do so “…. Should pretend to work somewhere else…” He also wrote “Tesla has and will create and actually manufacture the most exciting and meaningful products of any company on Earth, this will not happen by phoning it in.” Many other firms, feel the same disillusionment.
WFH is an option – not a compulsion. But an option modern technology has now made possible in ways that were not possible before. Homework was hardly unknown before. Writers, composers and artists as well as weavers and sewers, home bakers, worked from home long before the gig-workers who congregate at the internet café. You may you noticed how the coffee mavens all look up from their laptops to appraise the new arrivals? Seeking company no doubt that they could find at the water cooler.
Being able to measure accurately the relationship between how they reward their employees and how much they contribute to the output and profits of the firm is an essential responsibility of any business. It could not hope to survive without accurate calculations of the costs and benefits of alternative working arrangements. And the firms faced with WFH preferences have been learning by doing as they always do.
It can be assumed with great confidence that the great majority of employees will be paid no more or less than the value they will be expected to add for their employer – be it from the office or home. Furthermore, as clearly, nobody will be rewarded for the time they spend commuting. It is paid for in income or leisure sacrificed by the commuter. Recent evidence that the revealed willingness to go back to the office in the US is inversely related to the time spent commuting is no surprise. The lucky winners from the enforced lockdowns have been those who to live far from the office – that they chose to do for – their own good reasons – pre the lockdowns.
Employers are not the only party with the right to choose where best to work. Workers will make their own choices. The ratio of job openings to work seekers in the US has never been higher and the opportunity to work from home has not been greater this century.
The Tesla office worker who has remained in California, even though the Tesla office is now in Texas, may well tell Elon what to do with his job. They may even accept a lower salary to WFH – the cost of the commute is their bargaining chip. As is the saved rental and all other not at all insignificant costs of supplying an office desk that may improve their case to WFH. They may even be able to do two jobs from home- as many do- given the time freed up and the absence of supervision or whistle blowers. Elon and other collaboration mindful employers may have to offer a premium to get the preferred workers to the office- if they are more productive there.
The individual households who choose where and how they live will help determine how the world of work will look in ten years or more. The developers of offices and homes and retail space will respond rationally to the choices and ongoing experiments of all those who hire and supply labour of all kinds- billions of decisions will prove decisive. The world of work and production evolves continuously, usually in an imperceptible way, to the signals provided from the market for labour. There is no design – just efficient outcomes. Employers no longer requiring office workers to attend on Saturdays, or offering extended annual holidays, are not providing charity but are making a considered response to market forces- necessary to attract workers of the right kind and at the right price. They will continue to respond accordingly.
The responses to the opportunity to work from home that technology has made possible- and made the lockdowns possible – will evolve sensibly and rationally. Provided freedom to choose is respected as the essential ingredient for a successful, highly adaptive economy.
The financial markets have been roiled by the prospect of recession in the US. The market makers fear that the Fed, having allowed prices to explode in the US will now reverse course abruptly enough to bust the economy. They are right to worry.
Managing the level of demand in an economy well enough to exercise the full potential of an economy – and to avoid continuous increases in the price level, inflation, or its opposite deflation, is a central bank ideal. The more stable the environment, the more accurate become the plans of business, the more predictable their earnings and their values- and vice -versa.
The reality is often very different. The proclivity of central banks to exaggerate the swings of the business cycle is a constant danger to businesses and investors. In some senses the fear of recession may be more disturbing than recession itself. Were a recession to seriously threaten the US economy any time soon, policy determined interest rates in the US would not rise as much and soon go into sharp reverse and equity and bond valuations would rerate on improving prospects. Sell the rumour (of recession) – buy the facts (a recession itself) might well be an appropriate strategy for turbulent times.
The intention of central bank policy interventions should be to smooth the business cycle, avoiding booms and busts – while containing inflation. Central banks can hope to do this by anticipating and then influencing aggregate spending- over which they claim influence. And to ignore temporary supply side shocks (exchange rate or food or energy price shocks for example) that may also cause prices to rise and fall.
Policy settings should not add higher interest rates to the downward, recessionary pressures on demand when prices have risen temporarily. Or vice versa when the supply side of the economy (lower prices) are stimulating demand to lower the cost of credit to push spending still higher. Navigating successfully between supply side shocks- with a temporary impact on the price level – to be ignored – and actions that could cause continuous rises in prices, permanently excess spending- to be actively countered is the true art of central banking. Highly relevant also for the SA Reserve Bank that wrongly believes temporary price increases lead to permanently higher inflation.
The impact of an extraordinary surge in demand to counter Covid on prices, led by an even more extraordinary increase in the money supply, should not have been anything like the surprise it was inside and outside the FED. The growth in the money supply (M2) peaked at an mind blowing 27% in early 2020. Any sense of monetary history would have regarded much more inflation as inevitable.
The Fed and market watchers had been lulled into ignoring the growth in the money supply and bank lending by years of modest and declining growth in the money supply since 2010 – with declining rates of inflation. Though this record is not without serious blemishes. The run up in money and bank credit growth prior to the GFC should surely have been avoided- as should the abrupt decline in money growth that exaggerated the post GFC recession.
US Money Supply (M2) growth and inflation 2000-2022
Source; Federal Reserve Bank of St.Louis and Investec Wealth and Investment
The Fed should be paying the closest possible attention to the current trends in money supply and bank credit growth and set its interest rates accordingly. It should be aiming to stabilize money supply growth at about 6% a year- consistent with average inflation of 2% a year as was the case to 2019. And to reach that goal – from the current 10 to 6 per cent p.a. growth – as gradually as possible. It should communicate clearly that both money supply and prices are heading in that direction. And that higher prices have already restrained the demand for goods and services.
The marketplace should be paying the same close attention to the growth in the money supply and in bank lending as a leading indicator of the state of the economy. Readings sharply below 6% p.a. growth in the money supply will give ample warning of trouble to come.
Monthly % Growth in US Money Supply (M2) and Consumer Prices
Global stock markets have done well for investors over the years. We look at what will be required for them to continue to do so.
The compounding growth of the West is powered by business enterprises and savers share in the wealth created.
The economic history of Western economies is an admirable one. Their standard of living has been transformed over the past 200 years by consistently positive year-by-year growth in output and in incomes per head, despite the rapid growth in population over the same period. And all of this was achieved despite the destruction of life and capital, buildings and valuable infrastructure by periodic wars. The Russian war in Ukraine is an awful reminder of how destructive war is. It will take many years of sacrificing consumption – of saving and productive investment in capital equipment and infrastructure – to make up for these losses.
Privately owned businesses are responsible for much of the growth in incomes earned, and in the extra goods and services supplied to the western economies over time. Their most decisive stakeholder is the consumer of this growing cornucopia of goods and services that they produce. Their owners earn a surplus after all contracted-for costs of production have been met and revenues have been collected. There is the risk of a loss, though a growing economy makes losses less likely. More efficient businesses will also compete on the prices for and quality of goods and services they provide their customers, at the possible expense of the revenue line. Improvements in the productivity of capital will be widely shared.
A stock exchange enables the ownership rights in larger businesses to be widely and conveniently shared and traded. It provides the average saver the opportunity to plug into these surpluses and the wealth-creating machine of immense force that is business enterprise, mostly via their pension and mutual funds. These widely dispersed owners have realised much more wealth creation than they would have done by investing their savings in the money market, bank deposits or in the bonds and bills issued by governments. And they would have done even better had they further postponed consumption and reinvested the dividend income they received, as well as conserving their capital gains by staying in the stock market.
The JSE, very much part of a global capital market, has provided comparably excellent returns over the many years of its existence and has repeated the performance this century. As illustrated below, the average annual total returns with dividends reinvested from the JSE since 2000 have been nearly twice as high as the interest earned on cash and paid out: 13.5% annually vs 7.6% annually. The compounding effect has been so powerful because the returns on extra capital invested by privately owned businesses have been so positive. Economists therefore go further, given past performance. They regard these high expected returns over the long run, as part of the cost of capital employed. They add these higher expected returns to the returns that should be required of any company contemplating an investment decision. It is called the (expected) equity risk premium. If the proposed project cannot promise to leap over this higher hurdle of required returns on capital, the advice is not to go ahead.
JSE All Share Index, with or without reinvesting dividends, and money market returns (three-month Johannesburg Inter Bank Rate) (2000 = 100)
Source: Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022
JSE All Share Index total returns vs cash (three-month Johannesburg Inter Bank Rate) 2000 to 2021
Source; Iress, Bloomberg and Investec Wealth & Investment, 9 May 2022
It is not only returns that matter – so does risk. Human nature says (expected) return and estimates of risk are positively related.
So, the obvious conclusion would seem to be to invest in the stock market, since, based on past experience it can be expected to perform well in the long-term, even if there are some short-term blips. It is these short-term blips however that discourage investment in the share market. Between 2000 and 2021 the annual total return on the JSE was 13.5% a year and that provided by the money market was a much less 7.6% a year return on average. However judged by the movement about this average return, the JSE was nearly seven times as risky, as measured by the standard deviation about these returns (see figure above) – the risk that your shares may be worth much less in a few days or months, when you might be forced by circumstances to liquidate your wealth. This can be a major deterrent to share ownership.
The greater the risk aversion, the less comfort wealth owners and potential share owners have in the outlook for assets, the less time they wish to spend in the stock market, the less valuable businesses become. And the greater will be the risk premium earned by those willing and able to stay in the stock market. Bearing extra risk will likely bring extra returns because the entry price to the share market is reduced by the risk aversion of other potential investors. It has been true of the share market over the long run and market volatility, or risk, is likely to continue to negatively influence the long-term value of shares, so improving realised rates of return for those with an extended time in the market.
Albert Einstein famously described the power of compounding interest or returns as the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn’t, pays for it.” This powerful force of low-digit exponential growth, of growth compounding on growth, year on year, is well demonstrated by the long-term ability of the major stock exchanges to grow wealth for shareholders in a consistent way over the same long run.
It is the return on owners’ capital that is the source of all interest income
But where do these good compounding share market returns come from? From businesses who are entrusted with much of the accumulated savings or wealth, described as capital employed in any market-led economy. The owners and managers of businesses are incentivised to husband scarce capital, as best they know how. The rate of return they realise on the capital employed, the productivity of that capital, is the foundation upon which all rewards from saving and owning capital or wealth is built. Firms experiment continuously in improving the return on the capital they utilise. They aim to improve the relationship between the cash value of the resources they invest in, called operating costs and what comes out as revenues, and they apply their fixed and working capital to the purpose. The results of such efforts are measured, hopefully in a consistent and comparative way, as return on capital employed inside the firm. The rewards for savers who supply the firms with capital to invest, come not only in the form of dividends paid, but in offers of interest payments that firms are able and willing to make to attract capital, in competition with other firms for the same potentially productive capital.
The less risky interest income offered by all other borrowers, the banks and the government, is therefore strongly influenced by the same return on capital realised by the business enterprise that employs a large proportion of the capital available. The banks, the money market funds, or the government as a borrower, would not offer the interest they do, unless the firms were able to earn a positive rate of return on all the capital they utilise and have to compete for. This includes competing for the overdrafts and mortgage loans provided by banks and other financial intermediaries. The higher the expected real returns from all the capital employed in businesses, the more competition from firms for additional capital to invest, the larger will be the real rewards for all saving. Be it named interest or dividends or lease payments or capital gains depending on the financial arrangements agreed to between suppliers and raisers of capital.
The internal return on capital is what is converted into market value and market returns
It is the positive internal rates of return on capital realised by the business enterprise, not share market returns, that reveals the productivity of the capital it employs. The share market in turn translates expected internal returns on capital into current share market values. The market value of the firm should be understood as the present value of future operating or cash surpluses over operating costs, expected from the firm, discounted by the required returns expected from likely alternative investments. The most valuable firms in the market-place – measured as the ratio of its current market valuation to current earnings or better current cash flows – are those firms that are expected to consistently improve their internal returns on capital and to add more capital by doing so. In other words, they are expected to consistently improve the productivity of capital they utilise and are able and willing to attract more capital, both loan and equity capital, to realise the growth opportunity, and to successfully hold the competition at bay that always threatens prices and operating margins.
The two measures of performance (the internal and market returns) are likely to be highly correlated over the long run. But such present value calculations made by the buyers and sellers of shares in companies are subject to considerable uncertainty from day to day and week to week or quarter to quarter. There is uncertainty about flows of revenue, operating costs and returns from alternative investments that determine the discount rate. There are more than enough unknowns to make estimating the future value of a firm or a market of them, a risky business. Risky returns help to direct savings to the lower return, less risky alternatives, for example to cash or cash like assets.
Knowledge (technology) improves the productivity of capital. Will it continue to do so, and will shareholders receive as valuable a share of the surplus generated?
The force that has driven the extraordinary and consistently unpredicted improvements in income and wealth and in the supply of goods and services delivered, is the success of technology and its application by the business organisation in sustaining and improving the (internal) return on capital, year by year and decade by decade. From railroads to electricity to the motor car, computers and the internet, technology has provided the opportunity to improve returns on capital and increase incomes and wealth, of which a large part is held in the form of shares of companies. A further explanation for consistently good returns to capital over time is perhaps that technology has consistently delivered more than most investors thought technology would deliver over the last two centuries. Stock markets have done so well because the productivity improvements from innovative technology have been at least what the market hoped they might deliver, and consistently delivered at least the productivity enhancements that it is expected to deliver, and typically considerably more. We have had few technology disappointments and technology has overwhelmingly surprised on the upside.
Will technology continue to consistently surprise on the upside in future and benefit the owners of the representative business enterprise and its customers and employees (and government treasuries) in the same way it has done over the last 200 years? There are some caveats.
Productivity has been dramatically driven by improving and ever cheaper computer power. Moore’s law, which predicts that computer power per dollar invested in a chip will increase at an exponential rate, has been shown to be approximately true for around 50 years. But such increases in the power of computer chips must necessarily face physical limitations because of the finite nature of matter.
Similarly, can one assume that the efficiency of food production will continue to improve at the rates it has in the past? The finite resources of planet earth may put a brake on the pace of technological improvement (unless we extend ourselves by settling the planets and beyond, and investing in knowledge itself may defeat the law of diminishing returns). Moreover, will humanity attach as much importance to increasing further our command over goods and services through productive capital expenditure as much as we have in the past and tolerate the share of output going to owners of capital as we have in the past? Capital and its application may be given a lower priority and if so, growth rates will subside.
That the SA economy has performed quite as poorly as it has in recent years is not easily explained. The rate of growth of less than 2% a year represents a very poor outcome, with alas little prospect of any lift off, according to the economic forecasters in and outside government. Yet there are more corrupt economies with much less of an endowment of capital and skills that grow faster.
Fixed capital formation and employment offered by private businesses is at best in a holding pattern – capital formation being maintained at levels first reached in 2008. Capital formation by the public sector is in sharp decline- necessarily so – given past performance. The unwillingness of SA business to invest in future output and income generation and in their workforces – describes slow growth – but does not explain its causes. Such reluctance needs to be understood and addressed if the outlook for the economy is to improve.
Fixed Capital Formation Constant 2015 Prices
Source; SA Reserve Bank and Investec Wealth and Investment
Total Real Fixed Capital Formation (2000=100)
Source; SA Reserve Bank and Investec Wealth and Investment
We need look no further for a large part of the explanation of unusually slow growth than to the disastrous failures of the SA public sector. South Africa relies heavily on the State as a producer of essential services, including electricity, water, transport, ports and education. More heavily than is wise or necessary. The inability of Eskom to meet depressed demands for electricity clearly sets limits to growth as do the failures of Transnet to run the railways and ports anything like competently.
These operational failures have meant very large amounts of wasted, taxpayer and consumer provided capital and opportunity. The relationship between what has been spent on the large new electricity generating stations Medupi and Kusile and what has come out as additional electricity is especially egregious and damaging. As much as 1.1 trillion rands was invested in electricity, water and gas between 2000 and 2021. Much of it in electricity generation. Shockingly, almost unbelievably, the real output of electricity etc. has declined by 20% since 2000.
Electricity, gas and water. Capital Formation; Constant (2015) and Current Prices
Source; SA Reserve Bank and Investec Wealth and Investment
Electricity, gas and water. Capital Formation and Valued Added 2000- 2020. Constant 2015 Prices
Source; SA Reserve Bank and Investec Wealth and Investment
The abject failures of other government agencies – of the provinces and in particular municipalities – to maintain the quality of the essential services they are tasked to provide, water, roads, sewage, building plans, education training and health care etc. has become ever more destructive of the opportunities open to business and households. Such failures are also reflected in the declining real value of the homes South Africans own –a large percentage of the wealth of the average household – which has made them less able and willing to demand additional goods and services from SA business.
Hopefully the economy will not stay on these destructive paths. Restructuring the ownership and incentive structures facing the public sector is an obvious and urgent requirement for faster growth- for more capital formation of the human and physical kind. As is reducing the reliance on the public sector to deliver the essentials.
But we need a meta explanation and understanding of why the public sector has failed South Africans so particularly badly to move forward. The key political objective on which the public sector leaders were evaluated was clearly not the efficient use of resources, with quality of delivery related rewards, within sensibly constrained budgets. The Scandinavian model, if you like, did not apply. The primary objective set the new leaders of the public sector – and for which they were presumably judged and rewarded – was the transformation of the racial character of the public sector workforce.
It is an economic truism that you get from people (managers and workers) what you pay them for. This key performance indicator, transformation, has been achieved with huge waste, financial and in foregone opportunities. Losses that were exaggerated by the opportunities the lack of attention to the costs of operations, and their value to consumers, offered for theft, fraud and the patronage of the incompetent.
The continued enthusiasm for demanding that the private sector to transform further and faster seems uninhibited by any comparison of the cost and benefits of forcing transformation. There is perhaps one consolation in all this- the private sector cannot ignore the bottom line in the way the public sector was able to do for so long.
