Investment Postcards from Cape Town

By André Coetzee, Kagiso Securities.

After remaining stuck below 40 index points between February and August 2009, the seasonally adjusted Kagiso PMI posted the second biggest monthly increase on record (8.7 points) to reach 48.0 during September. The latest reading is the highest since May 2008 and indicates that SA’s manufacturing sector - after an initial lag - is catching up to the sharp PMI gains witnessed in our major trading partners in the last number of months. The global PMI rose to 53.1 index points during August 2009.

The September SA PMI data is particularly encouraging given signs of life in almost all of the sub-indices. Especially noteworthy is that output volumes did not contract any further: the seasonally adjusted business activity and new sales orders indices rose from very low levels to 49.4 and 50.7 respectively.

Near-term demand indicators also bounced back from their previous lows: the seasonally adjusted inventories index increased from 37.0 in August to 47.6 points during September. The backlog of sales orders and purchasing commitments indices increased by similar magnitudes, rising to 34.4 and 44.3 index points respectively. Job losses slowed down with the seasonally adjusted employment indexincreasing to 42.7 points - the highest since January 2009 - from 37.5 in August.

Purchasing managers’ optimism regarding business conditions in 6 month’s time continued to increase: the index rose for the seventh consecutive month to 70.3 during September. One has to go back to February 2007 to find expectations at a higher level.

Source: Kagiso Securities, September 30, 2009.

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By Cees Bruggemans, Chief Economist FNB

Are we really fighting inflation?

There are times when understanding inflation is easy. Big demands are placed on all resources, shortages arise, profit margins can be inflated, cost and price increases easily passed on, in a spiraling kind of way.

Expectations of accelerating price increases (faster inflation) become embedded and feed the inflation spiral.

Handling that is easy. You hit it on the head. Less easy to handle is the output sacrifice incurred along the way as demand falls, resource slack builds up, discipline is restored to expectations and price acceleration is with difficulty transformed into price deceleration, even price freezing or declines.

Output sacrifice implies pain. Reduced real wages. Unemployment. Hardship. Always difficult to accommodate, especially in a democracy where leadership incompetence is quickly criticized (”You owe me full employment, a rising living standard and everything I haven’t got yet. Deliver or be gone”).

Our current inflation reality still has elements of what is depicted here. But hitting it on the head is another matter. For who, pray, would we be hitting on the head? A market economy responds to price signals, but a political movement doesn’t take kindly to spiked clubs. And the larger world is outside our control.

In certain respects we remain price makers, in others we are price takers. As to hitting it over the head, forget it. Instead, ride shotgun and hope for the best.

We are hardly at present experiencing overstressed demand conditions, resulting shortages and free and easy pricing mannerisms, and haven’t done so for two years now. Yet the nature of the inflation process hasn’t changed, even if its propulsion mechanism has.

The following themes are evident. Redistribution. Public incompetence and inefficiency. Global resource dynamics. State of the world economy and trade competition. Rand exchange rate. And not forgetting Mother Nature.

The first two of these themes are domestic and non-market driven. Undisciplined redistribution is a powerful force for change.

Municipalities, education, health care and airport charging do not seem to be connected to any market processes. There is resource hunger, budget shortfalls are perennial and there are free and easy ways of meeting these challenges (tax, borrow, charge, spent).

Closely connected are other forms of redistribution and inefficiency. The catch-up of our electricity and water realities foremost.

If these extremes making for high price increases (double or triple average inflation as norm) weren’t bad enough, we face even greater uncontrolled urges from the outside world. Here the prognosis is either feast or famine.

Last year saw oil climbing to $150, then collapsing to $35. Agricultural commodity prices rose steeply and then also collapsed. The Rand moved from 6.80:$ to 11.85:$.

This year oil has doubled (again) to $70, but foodstuff prices have moderated further. The Rand has recovered to 7.40:$ territory. The world encountered a deep recession, creating disinflation tendencies, in any case present in intense global trade competition, with us importing the resulting traded goods deflation.

Most of our labour force and business owners are price takers, not price makers, facing this political and global onslaught. Some are better positioned than others to defend their interests.

Unionised labour (one quarter of the deployed labour force), politically protected workers (another quarter) and scarce skills (another quarter) insist on historic inflation compensation plus an opportunistic ‘living wage’ premium, which can vary, depending on the degree of opportunism.

Some employers accept this stoically because they are big and strong enough to be able to pass on such demands in their charging (the state and public monopolies foremost, less so large private businesses as these ultimately still have to face constrained consumers and/or compete with the outside world).

Closing the parade is Mother Nature periodically showing her hand with abundance or famine.

This hotchpotch of unlikely alliances (political interests, public ineptitude, global commodity dynamics, global trading conditions, the Rand, Mother Nature, defensive and opportunistic labour elements and strong business franchises) create an inflation reality which in turn gets absorbed into general expectations, driving the next round of defensive and opportunistic behaviours.

During 2006-2008, CPI inflation rose nearly five-fold to 13.5%, this year more than halving to 6.4% (so far). Some more sagging lies ahead in 2010, CPI probably falling by another third or more, mostly externally driven (Rand, possibly oil, certainly trade deflation). Backward-looking wage settlements will ease even as productivity rises in a jobless recovering economy, halving unit labour cost increases to below 5%.

Interest rate policy gives the impression of mostly helplessly riding shotgun on this miasma of forces. Can’t change any of it, but merely ensure that its expectation consequences don’t give rise to yet more distortions if money were to become underpriced.

For the rest, global output shocks, Rand overvaluation, loss of confidence, restrained credit, postponement of replacement decisions and reduced risk-taking appetite has opened up a new output gap and will likely maintain this through an anemic recovery process that won’t start reabsorbing resource slack anytime soon.

Such underperformance is known to exert its own political pressures. It may yet move policy goalposts, though the Minister of Finance has done everything he can.

There remains the guard riding shotgun over our inflation expectations. Here the heavens are steadily turning, with oil potentially facing a longer stay in purgatory (dare we believe $50-$60?), the Rand is steadily streaking firmer towards 6-7:$ territory, global trade deflation is awesome and unit labour cost inflation probably to halve.

Though we won’t overcome political redistribution or ineptitude, this need not prevent further general inflation collapse accompanying a yawning output gap (much resource slack).

Such an outlook offers its own promises regarding our interest rate prospects where we may not as yet have reached bottom. Prime 10.5% continues to look rich.

Source: Cees Bruggemans, FNB, September 28, 2009.

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By Shaun le Roux

The Credit Crisis was at the heart of the monumental collapse in global stock markets in 2008.

The credit-specific crisis has largely been averted by extraordinary government and central bank intervention, which has seen a massive expansion in the monetary base, and credit markets are now operating on pre-crisis terms. Now that we have that particularly ugly episode behind us, we can turn our attention to real world economics and try to assess what financial markets have in store for us over the years ahead.

We are of the view that no rational investment decision can be made today without first recognizing the major secular changes that are busy taking place in the world. In two key areas, the balance of power is in the process of shifting. We believe that you ignore these shifts at your peril.

Firstly, we believe that the world is becoming increasing dependant on the emerging world for growth. Emerging markets, on a combined basis, have grown at more than double the pace of developed markets over the past twenty years. It is, however, a foregone conclusion that few countries in the world will match their growth rates of the more recent years in the decade ahead. This is largely because key ingredients of the supercharged growth up until last year were cheap credit and financial leverage.

The world of massively leveraged financial institutions and over-extended western consumers has seen its demise, and we believe that the foreseeable future will unequivocally witness a return to generally higher levels of savings and much tighter credit standards. This means that most countries will need to revise their anticipated trend growth rates downwards. At this stage the South African Treasury’s anticipated trend growth rate of 4% and target of 6% now starts to look like a pipe dream.

Notwithstanding the above, recent months have made it clear that emerging markets as a whole do have the capacity to continue to out-perform in the future. Levels of foreign reserves are healthy, infrastructural development continues and a significant middle class has emerged. South Africans only need to drive around Johannesburg today and compare it to ten years ago to assess both the changes that have taken place and the development that is underway.

Emerging Markets have seen their contribution to the MSCI World Index rise from 2% in 1998 to over 13% today. We expect this relative growth trend to continue.

The second major shift we see in the balance of power is away from the financial sector to other real economy sectors. The chart below illustrates profits earned by the financial sector together with US total debt, both as a percentage of GDP. As can be seen, the rise of financial profits went hand-in-hand with an implosion of savings levels, to the degree that, in 2005, the savings rate in the US was negative.

We expect both trends to normalize in the decades ahead and anticipate it taking quite a while for global financial firms to match their level of profitability in 2007.

We expect both trends to normalize in the decades ahead and anticipate it taking quite a while for global financial firms to match their level of profitability in 2007.

We believe that investors need to carefully consider the implications that the shifts described above will have on their investments.

Firstly, investors will need to appreciate that lower growth rates and lower levels of leverage inevitably will mean lower real returns for equities. There will be many sectors that will take a long time to return to the levels of profitability of recent years, so stock selection in an equity portfolio will be very important.

We favour a core portfolio of high dividend payers where our analysis indicates growth and sustainability of those dividend payments.

Capital will be harder to come by and bond investors will require higher yields. Country allocation in global portfolios will have a massive bearing on returns. Long term investors should be over-weighting Emerging Markets.  Stock selection will be critical to success.

Source:  Shaun le Roux, Alphen Asset Management, July 3, 2009.

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By Cees Bruggemans, Chief Economist, FNB

The goal posts, they are a-moving (paraphrasing Bob Dylan about the changing times he lived in).

If we take for granted that the SARB prefers a constant real interest rate over time as a stability anchor for the broader economy, what else gives?

Mostly inflation, output gap and feedback loops from the firming Rand (these past six months, but especially the next 12-18 months).

CPI inflation was 6.7% but is this week expected to drop to 6.3% (or lower). That gives an inflation gap of 6.3% minus 4.5% (midpoint target range) equals +1.8%.

The inflation forecast for 4Q2010 is a moving feast. For the past year most observers have been punting 5%. But that has been eroding in recent weeks towards 4.5% (or even lower). And to this we must still add a seriously firmer Rand outlook.

The Aussie Dollar is currently 1.153:$. For those liking clean benchmarks, the Aussie Dollar could potentially be heading back towards parity with the Dollar in coming months. If we were to keep pace (why not?), it suggests a Rand near 6.30:$.

That should suppress especially our PPI inflation, but even CPI inflation should see its effects, heading for 4% (or even lower) by late 2010.

Meanwhile our output gap (estimated at -4% to -5% below potential) is not getting any smaller, with the South African economy only in recent weeks emerging from recession.

Labour slack could by yearend be as much as 10% of deployed labour, when making assumptions about formal jobs lost in this cyclical dip (some 350 000), employable new entrants to the labour market (some 250 000 or two-out-of-three who passed matric this year, and allowing for tertiary pass-through), some 100 000 skilled returnees from abroad and overall an equivalent number of unskilled unemployed seeking work (including many eager immigrants from Africa).

With the economy barely recovering to trend growth next year (3%-3.5%), the output gap will not start shrinking (indeed probably for some while) as we will need ABOVE trend growth for that.

As to asset price gains, it may be way too early to get overly excited from a policy point of view.

Our house prices have dropped some 10% from their nominal peak and are effectively stabilizing, with some nominal gain possible from next year. No early resurgence is expected. If anything, according to Erwin Rode, real house prices have still some downward adjustment to absorb in coming years from demand/supply realities prevailing.

As to the JSE, our shares prices are ‘only’ up by 40% since their October 2008 and March 2009 lows, compared to the 100% gain for the FTSE Emerging Index and the 60% gain for the S&P500 index. Then again, our share market never fell as far as overseas markets and is today about 20% from its all time high (and as such one of a clutch of global outperformers).

Yes, corporate earnings are off, as are dividend payouts, but the price/earnings ratio isn’t unduly overpriced. This is one way of saying that we may no longer be pricing in recession, but pricing in exuberance (bubble) would be something else entirely.

As such it remains early days to incorporate an asset term along side inflation, output and exchange rate gaps in estimating Taylor.

Lastly, I do assume an unchanging real interest rate as stability anchor over time, but a case can be made for tweaking this a bit, up in good times, down in bad times (and they don’t get worse than the present).

But in order not to upset any purists, let us not start messing with stability anchors supposedly dampening the cycle (rather than injecting even a hint of pro-cyclicality into the proceedings).

Adding all these components together we get a proximate hint of what the prime interest rate ’should’ be today:

* real rate stability anchor (long-term average)     5.5%

* expected CPI inflation 4Q2010                           4.0%-4.5%

* half current inflation gap 0.5(6.3%-4.5%)          0.9%

* half current output gap 0.5(-4% to -5%)            -2.0% to -2.5%

This adds up to an estimated current prime interest rate of 8.5% TODAY as suggested by applying a rough-and-ready Taylor Rule.

As things stand, prime is still 10.5% and the SARB’s Monetary Policy Committee is this week bending its collective head over the vexed question whether or not to keep interest rates unchanged.

In light of the reducing upside risks and the increasing downside risks to the inflation forecast from global forces via the firming Rand, the large prevailing output gap and the likely slow return to modest growth in the economy, there remain excellent reasons to expect further interest rate cuts.

Whether these materialize this week is entirely up to the committee. One wishes them well in their important deliberations.

Source: Cees Bruggemans, FNB, September 21, 2009.

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