First Strut: South Africa's First Corporate Bond Default

Corporate default is described as a deceptively rare event. This is especially true in South Africa where the generally high quality of corporate bond issuers has meant that until now there have not been any defaults in the listed bond market. We avoided investing in this bond for our portfolios, and the rationale for this is spelled out in an article i wrote for Nedgroup Investment's quarterly newsletter:

http://nedgroupinvestments.co.za/insights/Single/660

Rashaad Tayob

The Central Bank Dilemma: Inflation vs Growth

Today I attended a meeting with an official from the South African Reserve Bank (SARB). It was a good opportunity to get some insight into their thinking given that the current stagflationary environment (the combination of low growth and high inflation) places conflicting demands on monetary policy. Low growth necessitates loose monetary policy, while inflation above the 6% upper target implies the need for rate hikes. Interest rates were left unchanged at last week's (19 Sep 2013) Monetary Policy Committee (MPC) meeting, but the Governor Gill Marcus gave a distinctly hawkish speech, which hinted at the real possibility of rate hikes in  the coming months.

I have long held the view that interest rates at 5% in SA are too low given the 3-6% inflation target and the fact that inflation is likely to remain close to or above the 6% upper threshold for the foreseeable future. A few months ago the dominant sentiments was that rates would remain low for an extended period due to the global interest rate environment. Despite a significant depreciation of the Rand and the ensuing inflationary pressure, in April 2013 the market had moved to price in a further rate cut.

This all changed in May when the Fed announced the potential for reduction in the bond purchases (tapering of quantitative easing), which caused the Rand depreciation to accelerate and yields to spike. While the market has since settle, the consensus view has been that a weak economy would preclude the need for rate hikes.

Last weeks MPC had economists scrambling to amend their interest rate forecasts as the MPC’s language seemed to be aimed at preparing the market for a rate hike in the coming months. Like all Central Banks, the SARB has to find a balance between controlling inflation and promoting growth, but in the last meeting the governor repeatedly reminded the market that maintaining inflation within the target band is the Reserve Bank’s primary mandate.

Given the outlook for continued inflationary pressure due to the depreciation of the Rand, as well as the shift in the Reserve Bank's focus back towards controlling inflation, I would not be surprised if the rate hiking cycle starts in the coming months.

A Public Service Announcement (Brought to you by a billionaire hedge fund manager)

Ray Dalio is the founder and head of one of the most successful hedge funds in the world. I first heard of him when i read his "Principles" document, which explains his belief system and how he incorporates these beliefs into the management of his his company. I was quite taken by this document and as a director of a small investment management firm I attempted to replicate several of the "principles" in our company.

http://www.bwater.com/Uploads/FileManager/Principles/Bridgewater-Associates-Ray-Dalio-Principles.pdf

Dalio doesn't appear in the press too often, but when i have heard him talk, his view his views on investments has been insightful. He has spoken before of the economy as a "machine" and he has now distilled his understanding into simple 30 minute YouTube video. Much of the content will be familiar to those in the markets, but the clarity with which the economic cycle is explained makes it worth watching regardless of one's level of financial understanding.

Currency Confidence Tricks

The beleaguered Rand has found some support in recent days, partially due to a resolution of several strikes in the mining sector, as well as a further announcement of the BRICS (Brazil/Russia/India/China/South Africa) "Contingency Reserve Arrangement" (CRA) which is meant to provide support to Emerging Market (EM) countries suffering from severe currency depreciation.

http://www.bdlive.co.za/economy/2013/09/05/south-africa-to-contribute-5bn-towards-brics-contingent-reserve-arrangement

Talk of a CRA was brought up earlier in the year at the BRICS summit held in Durban, and the strategy seems to be that the idea will be revived any time EM countries come under pressure. The recent depreciation of EM currencies in the wake of Fed tightening fears was the perfect time to bring up the matter again.

It appears that the BRICS are mimicking the confidence tricks of central banks in the developed world, where forward guidance and the warnings of the power of central bank's balance sheets are often used to push the markets in a desired direction. The oft repeated Wall Street saying "Dont fight the Fed" reflects the market's view that one should never bet against the US Federal Reserve's ability to stimulate the economy and market, and this power has been assumed of Developed Market (DM) Central Banks in general. The European Central Bank (ECB) under Mario Draghi has been particularly successful in convincing the market of its power, with Draghi's "believe me it will be enough" statement to support the Euro in July 2012 helping to reverse the contagion that was underway in the peripheral European economies. Despite Draghi's limited ability to make good on his threats given the constraints of the ECB's mandate, the market's fear of central bank power was enough and the threat of action precluded the need for actual action.

This EM Currency Reserve talk shows that the BRICS have some way to go before they can flummox the market in the same way as their DM peers. A confidence trick in the central banking world requires assertiveness and the threat of aggressive action, but the vague announcement and extended time frames announced by the BRICS takes away much of the sting.

The BRICS announcement also suffers from a lack of credibility due to that fact that the BRICS circumstances vary substantially by country and they do not share a single currency. There is no ideal way to determine the quantum and timing of any intervention, which means that the support for individual countries is likely to be limited to their contribution. South Africa's $5bn contribution may as well remain with the South African Reserve Bank, who can choose to intervene in the currency markets should they feel it necessary.

The nature of the CRA announcements to date makes it seem unlikely that the fund will materialize as a central pool of assets, but would rather just be some form of non-binding pledge by the individual central banks. Any form of currency intervention is risky, and South Africa knows this as well as anyone given the experience of 1998 where then Reserve Bank governor Christ Stals squandered billions of dollars an attempt to stave of Rand depreciation. The lesson of 1998, 2001, 2006 and 2008 is that it is best to leave the Rand to find its own market level, given the difficulty of influencing a global currency market which trades over $4 Trillion a day. This attempted confidence trick lacks the necessary confidence, and is will therefore be quickly brushed aside by the markets.

Rashaad Tayob

The Prospects for a Social Pact in South Africa

Today I attended a discussion between Adam Habib and Judith February at the Open Book Festival in Cape Town. The topic was Habib's book, South Africa's Suspended Revolution, and the conversation revolved around Habib's view of the political and economic forces that have shaped post-apartheid South Africa, particularly the schisms that exist within society due to the level of inequality.  Habib's primary idea is that South Africa needs to develop a social pact between business, government and labour in order to make the compromises necessary to tackle the deeply embedded economic and social problems within the country.

Habib had harsh words for corporate leaders earning tens of millions a year while trying to push through 6% salary hikes for workers earning a few thousand rand a month. He also criticised the ANC as transitioning from a party of liberation towards an "enrichment mechanism for politicians and the politically connected". Habib believes that the poor have no leverage in the current political environment, and been the victims in this fight for resources between business and the state.

Habib is the newly appointed vice chancellor of Wits University, but I had heard him speak four years ago at a bank-organised conference and was impressed by solutions he presented for the South African economy. I have often repeated his idea that "South Africans should build an economy for the workforce we have, not the workforce we wish we had". Back then he had stressed the importance of a Social Pact, but in the ensuing years the progress has not materialised — and in fact, the malaise has worsened.

The question is whether there is sufficient leadership in South African government, business and labour needed to make the difficult decisions necessary to move the country forward. South African business since 1994 has been responsible for employment and wealth creation, but to date shown little interest in the long-term objective of creating a more equal and inclusive society. Businessmen would question whether this even their responsibility, but in the case that "suspended revolution" does materialise then those with capital the most to lose. The governing party has chosen to pursue various Growth and Development plans (NDP/NGP), which allow them to pay lip service to issues without having to actually do much. It would be better for them to focus on fixing the existing structures rather than creating new ones.

While it is tempting to rue the mistakes that have been made by both business and government since 1994, I believe that Habib's idea of a "social pact" has a big part to play in reversing the current course of the South African economy.

The Blog Resurrected

I started this blog almost two years ago with the intention of writing on the South African economy and fixed income markets. Over the years i have infrequently written commentary for clients, newspapers and magazines and this blog was an attempt to create some routine as i looked to improve my writing and increase my output. Unfortunately this blog, like 95% of blogs out there, died a quick death.

A short while after starting this blog i moved firms, joining ABAX Investments in early 2012. I continued to look after the same Fixed Income and Absolute Return funds that i had been managing for several years, but the processes of moving across to the new firm and taking on some new funds kept me quite busy, which meant that the blog was sidelined.

I have been meaning to restart the blog for some time and this article by Matt Phillips in Quartz finally riled me up enough to go through with it:

"The crisis enveloping India’s currency just got serious. Here’s how to stop it"
Matt Phillips
http://qz.com/119057/india-currency-crisis-rupee/

Matt Phillips's suggestions to combat India's currency crisis by "fighting the market", "borrowing" and "clamping down on flows" are some of the most counterproductive imaginable. The Indian response has been a poorly planned, with a string of makeshift policies which have only served to exacerbate the currency weakness. The challenges facing the Indian economy are similar to those in South Africa and this will be the focus of my comeback post due in the coming days.

Rashaad Tayob

Last Chance for MPC action

South Africa’s structural inflation problem is about to rear its head once more. The benign level of SA inflation in recent years has been aided by the Rand, which has strengthened significantly since early 2009, depressing goods inflation and therefore the headline number. Over the course of the current year inflation has moved strongly upward. Inflation is now expected to breach the 6% upper limit of the target band, a view held by market participants even before the Rand’s sharp depreciation in September 2011. The depreciated exchange rate increases the risk that inflation stays out of the band for an extended period over the course of next year. Notwithstanding these negative inflation expectations, there is a still good case for a 50bp cut at this weeks MPC meeting.

Global interest rates remain at extremely low levels, with much of the developed world running highly negative real interest rates (interest rates below the inflation rate). While central bankers usually signal to the market that future interest rate decisions will be determined by the progression of inflation and growth, Ben Bernanke has taken the highly unorthodox step of setting a time period for which the Fed Funds rate will remain low. He has promised to keep rates near zero until mid 2013. This hard cap on US rates will serve to suppress interest rates globally. Despite the low level of global interest rates, growth concerns have recently led to rate cuts in Europe, Brazil, and Australia. For South Africa to run a relatively high level of rates in this environment, risks provoking Rand strength and stalling the weak economic recovery.

The last MPC meeting contained a very dovish statement by the MPC, and it was clear from comments made by Governor Gill Marcus that, save for the extreme market volatility and Rand depreciation that was occurring throughout their deliberations, the MPC would have cut rates on growth concerns. While we haven’t seen the Reserve Bank’s updated inflation projections, they are no doubt aware that the Rand depreciation has increased the risks to the upside. While inflation is currently below the target at 5,7%, it is projected to breach the target when November’s inflation data is released next month. This means that when the MPC meets in 2012, inflation will in all likelihood be above the 6% target, with a deteriorated outlook. If the MPC cuts rates while inflation is above 6%, it would serve to damage some of the inflation fighting credibility that has been painstakingly built up over many years. While many have pushed their rate cut projections out to next year, we believe that developments in inflation will soon shut the door on cuts. If the Reserve Bank does intend to cut rates to support the economic recovery, the November MPC meeting presents their last credible opportunity to do so.  

Rashaad Tayob

Referendums are the Solution to the European Debt Crisis

The most recent “comprehensive package” for the Euro lasted all of four days as the Greek Prime Minister George Papandreou announced plans to put the bailout package to a referendum on the 31^st of October. Three days later, he was forced to backtrack on this initiative under pressure from both the European leadership and the opposition in his own country. The decision by Papandreou on the referendum took everyone by surprise and while he was roundly criticised for it, we view this move towards a referendum as a positive step and one that should be quickly implemented in Italy, Spain, Portugal and Ireland. While it may create uncertainty in the short term, it does push Europe to a resolution, and forces all parties to take the tough decisions which have to date been avoided.

Both Greece and the European powers are still convinced that they can manoeuvre themselves out of Greece’s current debt situation, but in reality there are only simple but tough choices which exist.  Current polls show that 60% of Greeks reject the summit deal, and 70% of them want to remain in the Euro. Unfortunately those numbers don’t add up. Greece can either accept the bailout and implement the austerity measures that come with it, or negotiate their exit from the Euro.

While the European powers are panicked at the thought of Greece exiting the Euro, the bailout packages they have put forward have always left Greece with unsustainable levels of debt. The latest offer was painted as generous, but even under highly optimistic scenarios it leaves Greece with debt of 120% of GDP. In essence then, as in the case of Greece, the Euro powers can either choose to subsidise the weak economies or they can negotiate their exit from the Euro.

While these decisions are obviously difficult, postponing them is no longer feasible and risks further damage to an already poor economic outlook. Papandreou has been cast as a pariah for bringing up the possibility of a referendum but with virulent opposition to austerity in Greece it is difficult to see if he has any other choice. The power of the referendum is the fact that it gives the government the mandate to fully implement the required reforms should the Greeks vote to remain in the Euro; essentially it amounts to a buy-in from the Greek people themselves. It also gives lenders certainty that there is a will to repay borrowed money, and not just repudiate the debts later when it is politically convenient. In turn, should Greece choose to leave the Euro, a well defined exit mechanism for the common monetary area can ensure that this is done in an orderly fashion. While Greece’s debt levels are beyond reprieve, Italy can still be saved and should arguably also move quickly to a referendum: Rising Italian bond yields risks making their debt service costs unsustainable too, and the political impasse means that economic reforms have stalled.

While the market has been pricing in a Greek default since the middle of last year, the European leadership has been too slow to react. They have continued to be in denial as to the extent of the debt problem, while attempting to buy time with ineffectual bailout packages. Time has run out, and the difficult decisions have to be made now. Giving the people the decision through the referendum process and forcing them to live with the outcomes is the only credible step to a full resolution of the crisis.

Rashaad Tayob

South Africa, the IMF and European Bailouts

"I would not join any club that would have someone like me for a member."

  --  Groucho Marx

Earlier this year, emerging markets reacted with giddy excitement at the prospect of being given greater representation and voting rights at the IMF. Several, including South Africa, put forward their own candidates to head the IMF after Dominique Strauss-Kahn’s resignation. While a small emerging market country such as South Africa may feel exalted to sit at the table with the world powers, it is going to come with a steep bill. Given the level of indebtedness of the developed economies; it is clear which way money is going to flow in the coming years. After his return from the IMF conference in Washington, South African finance minister Pravin Gordhan has recently stated that South Africa would contribute “a couple of hundred million US dollars” to the EU rescue package.

This ‘contribution’ cannot be allowed to happen for two reasons. Firstly, it effectively involves the transfer of wealth from the poor to the rich. South Africa is a developing market with a per capita income of around 6000USD, and a highly skewed income distribution. The per capita income of Europe at over 30000USD is at least 5 times ours. Why our Finance Minister feels that we should ‘contribute’ to improving the living standards of those 5 times richer than ourselves is inexplicable. The second reason we should not be willing to contribute to any EU bailout package is due to the fact that IMF bailouts have always been creditor bailouts, with the focus on repaying bank loans. These country “bail outs” are simply bank bailouts in disguise, and the proposals being floated for the EU ‘rescue package’ are no different.

The term ‘bailout’ was used to define the IMF involvement in the 1997 Asian financial crisis in order to imply that the they were “bailing out” or assisting countries with their economic problems. However, the nature of the programs implemented by the IMF merely served to bail out the western banks who had taken excessive exposure to companies in Thailand, South Korea and Indonesia during the years of high growth. The prescribed IMF policies of high interest rates, maintaining currency pegs and allowing the failure of weak banks served to exacerbate the economic crisis. With IMF policies designed to increase the ability to repay western debtors, it is hardly surprising that per capita income in countries such as Thailand, Malaysia and South Korea fell around 10%. The 20% fall in Indonesia was particularly severe, with the impact in their country similar to that of the great depression. 

When the credit crisis hit the developed world in 2008, policies were and continue to be precisely the opposite of what was implemented in emerging markets in 1997. The prescriptions are now currency devaluation instead of currency pegs, zero interest rates instead of rate hikes, and bank bailouts instead of failures. The IMF has always existed to forward the interests of the US and Europe, and it is particularly galling that after years of being victims of IMF policies, emerging markets are now expected to contribute to funding the organisation. South Africa has its own pressing economic concerns, and any funds which the South African treasury intends to send to Europe are better used to aid our own development.

Rashaad Tayob