The “Scourge” of Low Inflation

According to the world’s major central banks, low inflation is the main problem facing developed economies. Inflation is a measure of the increase in the cost of living, so the problem as defined by Central Banks is that the cost of living is not rising quickly enough.

A recent economic paper by the San Francisco Fed analysed which sectors are to “blame” for low inflation. It concludes that lower healthcare inflation is primary contributor. For most people this would be described as an unalloyed good. The article’s focus is on the drag to inflation from lower healthcare inflation, and how this makes it more difficult of the FED to reach its 2% inflation target.

I can’t help but feel that something has gone terribly wrong in the world of finance and economics for us to have ended up at this point.

The reason for the Central Bank viewpoint is that developed economies have high debt levels and need inflation to reduce the “real” value of debt. The current policy may be justified in the interest of economic stability. The problem is that the cure (low interest rates) just leads to debt levels rising even further.

There is no easy fix for the current predicament. However, economic policy makers have consistently favoured wall street over main street and the current obsession with higher inflation is a continuation of this pattern. We need to get to the point where policy makers are actively looking to reduce the cost of living in order to raise living standards. The world of finance should be a secondary consideration.


A R3500 Can of Worms

We seem to be inextricably moving towards the implementation of a national minimum wage in South Africa. While this discussion has been going on in the background for some time, it gained momentum this year as it was lumped into the broader issue of “labour reform”. It is clear that some sort of labour reform is necessary to deal with SA’s high level of income inequality and its position as a world leader in unemployment. However, minimum wage legislation will prove to be another economic headwind for the country and a gift to populist parties like the EFF.

“Labour reform” has been highlighted by S&P as a key factor in determining whether it is appropriate to downgrade SA to sub investment grade. Everyone honed on to the issue of a “secret strike ballot” as a way to reduce strike activity. A “secret strike ballot” means that the majority of union members have to vote in favour of a strike for it to proceed. This seems like an obvious requirement but it is contentious.

The secret strike ballot has been under negotiation for a number of years but has failed to progress as unions have been opposed to its introduction. With SA trying to avert a ratings downgrade the secret strike ballot was portrayed as the key labour reform which was going to improve industrial relations and reduce the number of days lost to strikes. This was going to be presented to the rating agencies as a sign that structural reforms are progressing. However, it was impossible to get the unions on board and it appears that the minimum wage issue was fast tracked as a form of quid pro quo. I believe that this will prove to be a very bad trade off.
The importance of a strike ballot in SA has been overstated as it will not solve the problem of illegal strikes, violence and intimidation. The minimum wage on the other hand will have a profound effect on the country. The task team for a minimum wage today put forward a proposal of R3500 per month. There is much research and debate on the effect of a minimum wage on unemployment, but anyone who is familiar with economic analysis and forecasts will know that one should place very little emphasis on results. Around half the SA population earn below the proposed minimum wage. This mean means that the effect on wages and employment will be dramatic once fully implemented.


As the minimum wage issue has come to the forefront in recent months the discussion has centred on the correct level and the economic impact. My concern is the much greater impact on politics and society. South Africa’s circumstances are somewhat unique given its history. We have amongst the highest levels of income inequality in the world and it is delineated by race. We have seen this discontent be expressed in increasingly militant ways by the EFF, AMCU and more recently the “Fees Must Fall” movement. The EFF have already rejected the amount of R3500 as too low and have called for a minimum of R4500.


Once the national minimum wage framework is in place, it will be easy for the EFF to base their election campaigning on the promise to increase it. The minimum wage number that they propose will be a powerful emotional anchor. Everyone earning below that level will see the EFF as fighting for them, while the ruling ANC will be perceived to be content with widespread poverty.
Regardless of what level the minimum wage is set at to begin with, I think it will turn out to be an economic and political calamity. In economic terms, the unequal structure of our society will result in consistent upward pressure on the minimum wage regardless of the economic impact. In political terms the EFF will initially be the main beneficiary of this framework as they use the initial R3500 as tool to attack the ANC. In the long run we will see populist parties attempt to trump both the ANC and EFF with even higher demands.


The Economic Explanation for Trump’s Nomination Win

Much to the consternation of my friends and family, i have been a Trump “supporter” since August last year. Not so much a supporter as someone who was willing to defend his policies and often his behaviour. I defended his behaviour due to my intense dislike for career politicians. I defended his policies as I believed that globalisation has had a significant impact on the makeup of the United States economy and that Trump’s signature policies had the potential to gain support from those negatively impacted. Those who have been surprised by the rise of Trump, which is almost everyone in media and politics, have not been able to acknowledge the extent of and impact of the economic shifts which have taken place since the 1980’s.

Last August a GQ article by Drew Magary on a Trump rally in Oskaloosa Iowa highlighted to me the extent to which the resentment towards the current economic paradigm had grown . It showed how Trump was taking advantage of real economic concerns. Oskaloosa is a place i have never heard of but is emblematic of huge swathes of America that has been left behind economically and where the people are angry. Magary observes that “pretty much everyone at the Trump picnic believed that America sucks.” This level of disaffection is hardly surprising given the extent of the economic shifts since the 1980’s. Well-being is a relative concept and the economic policies of the recent decades has seen the middle class stagnate and income inequality skyrocket.

Around the same time as the GQ article, Scott Adams (the creator of Dilbert) began to blog about Donald Trump, predicting that he would win the general election. This was a point when no one was taking Trump seriously. It was a time when Ben Carson was “leading” in the polls. So while most of the media were taking a crazy person like Ben Carson seriously and writing off Trump as entertainment, Adams began chronicling the method to his apparent madness. Adams is trained hypnotist and was able to understand the levels at which Trump’s skills of persuasion were operating. Adams describes Trump as the “best persuader he has ever seen” and has been showing the world that Trump has the potential to win the election.

The Impact of Globalisation

In the U.S. there have been winners and losers of the move towards global free trade and the U.S. policy of uncontrolled inward immigration of low skilled workers. The mainstream economic view has been that immigration and free trade are an unalloyed good. Trade and immigration have helped grow total size of the U.S. economy, but the distribution of those gains has been highly inequitable. The US economy has grown 300% in the last 25 years while median household income is virtually unchanged. Corporate profits as a share of the economy have moved up to record highs while the share to salaries and wages has been moving lower. I believe that trade and immigration have been the driver of rising income inequality within the U.S. and the stagnation of the middle class.Household Income Growth

On Trade

Over the last 15 years the United States’ manufacturing base has been decimated as China have become the world’s factory. The number of US manufacturing jobs decreased by almost 6 million in the 2000’s. Manufacturing has historically been a large source of working class jobs so the impact of having a third of those jobs disappear should not be understated. The professional classes work higher up the value chain so they have retained jobs while benefiting from ever cheaper TV’s, clothes and phones. Unlike Donald Trump, I don’t believe that America has been a net loser from trade as U.S. companies profited from their access to global markets. Apple pays $200 to Chinese manufacturers to make the iPhone 6 and then sells it for $650+ all over the world. Where the U.S. has a competitive advantage they have benefited from an increase in exports. China has a competitive advantage in the cost of labour, so it is only natural that labour intensive areas of the economy like manufacturing would shift there. The segments of society which lost jobs to China are worse off. No discussion Ricardo’s theory of comparative advantage could convince them otherwise.

US Manu Employ

On Immigration

The working classes have been exposed to intense competition from unskilled immigration, which has driven down the cost of their labour. The professional class has been shielded as their jobs are more difficult to outsource and they are protected due to US visa policies for skilled labour. There are 85,000 H-1B visas per annum for skilled workers and they sell out in less than a week. Skilled labour is tightly controlled while unskilled labour can just walk across the border and get a low paying job. Driving down the cost of low skilled labour benefits the professional class as they get cheaper nannies, gardeners and fast food. The professional class views immigration as a cultural issue but for the middle to lower classes it is very much economic. I doubt the professional classes would retain their “enlightened” approach to immigration if Indian/Chinese lawyers, engineers and accountants had arrived in the same quantity as Mexican labourers.


The Hypocrisy of the Elites 

I don’t actually “support” Trump. Having seen footage of his rallies i doubt whether someone like me would be able to get out of one of them unscathed. My defence of Trump has not been due him or even his policies. I am actually in favour of globalisation given its positive impact on overall global prosperity and developing countries, even if the transition to open economies has been poorly managed and the gains have not been shared. My defence of Trump is due to the hypocrisy of the political and economic elites. They have implemented trade and immigration policies which protect them from competition while exposing the working classes to the full forces of globalisation. Drew Magary and Scott Adams helped me see how Trump could take advantage of this hypocrisy to win the Republican nomination and maybe even the upcoming general election.


Negative Interest Rates (or getting paid to borrow money)

Rashaad CNBC 22 feb 2016Asking a fixed income manager about negative interest rates is like getting a taxi driver’s opinion on self-driving cars. You know that they are going to tell you that it’s a bad idea. But with over $5 Trillion worth of bonds having negative yields they are now a firmly established reality. Japan recently joined the negative interest rate club alongside Sweden, Switzerland, Denmark and the 19 countries that fall under the European Central Bank. These are a few thoughts on how we got to the scarcely believable point where 30% of the Global Bond Index now effectively entails the bond investor PAYING interest.

Negative interest rates are relatively new development

Positive interest rates have been around for a very long time. The Code Of Hammurabi (2130-2088 BC) capped interest rates at 33%. More than 4000 years later in 2009 Sweden cut its interest rate to -0,25%. There used to be a belief that monetary policy was limited by a “zero lower bound“, the view that interest rates could not go below zero as it was easy to escape negative interest rates by moving money out of the bank and into cash. The zero lower bound also reflected the view that it was inconceivable that a lender could be the one paying interest on a loan.

There is a new (lower) lower bound

While we have broken through the zero lower bound, as long as cash exists there will be some lower bound. This will be determined by the not insignificant cost of moving and storing physical cash. JP Morgan recently estimated that rates could go down to -1,5% in the USA and potentially -4,5% in Europe without a massive flight to cash. Any attempt to move rates even further negative would need to be combined with moves to make cash even more expensive to hold or even an outright ban. Attempts along these lines have already begun as the European Central Bank (ECB) is considering scrapping the 500 Euro note. In the United States, former US Treasury secretary Laurence Summers has been talking about scrapping 100 USD note, which accounts for almost 80% of the value of currency in circulation. The nature of politics in the USA makes me believe that a move to negative rates in the USA will be far more difficult than what we have seen in Europe and Japan.

Central Banks are figuring it out as they go along

When the ECB cut rates to -0.1% in June 2014, Mario Draghi announced that they were at lower bound for all “practical purposes”. In September 2014 the ECB cut to -0,2% and Draghi then said it was a technical adjustment and “now we are at the lower bound, where technical adjustments are not going to be possible any longer.” Then in December 2015 the ECB cut again to -0,3% and this time Draghi refused to say whether he believed they were now at the lower bound. The consensus is that they will cut further in 2016. The moves by the ECB shows how Central Banks are still figuring out the effects of negative rates and the extent to which they can cut.

Even as negative rates become commonplace, I don’t think that they are good policy tool for three primary reasons: 

Reason 1: Negative rates are new and powerful weapon in the currency wars 

Central Banks are resorting to negative rates in order to devalue their currencies. Countries like Switzerland and Denmark experienced large capital inflows while being pegged to the Euro and negative rates were an attempt to stem these flows. More recent attempts to move to negative rates by Japan, Sweden and the ECB strike me as competitive devaluations, which are an attempt to devalue a currency in order to make a country more competitive in global trade. Any attempt to maintain the currency at artificially weak levels is obstructive as I believe that free floating currencies are one of the best stabilizers in the financial system. They rebalance trade and capital flows by causing the currencies of relatively strong economies to appreciate, and weak economies to depreciate. Losing this automatic stabilizer leads to imbalances in the global economy and a build up of risks in the financial system.

Reason 2: Negative rates encourage greater leverage

Negative rates are an extension of the ultra easy monetary policy environment that has been in place since 2008. Monetary policy was used to save the banking system during the financial crisis, but is now seems to be the primary tool for driving economic growth. Monetary policy has substituted for fiscal policy or any form of structural reform. The problem with low (negative) interest rates, as the primary tool for growth is that, by design, it encourages an increase in borrowing. I believe that demand is weak because of excessive leverage, and any approach that increases leverage further is unlikely to solve the problem but just create greater financial risks. Structural reforms or some form of explicit wealth transfer (helicopter money) is more direct way of dealing with weak demand and the poor growth outlook.

Reason 3: We have reached a limit where there is little benefit to even lower rates

Japan’s recent attempts at monetary easing failed miserably and highlighted the limits to further monetary easing. The Bank of Japan cut to negative interest rates at the end of January in order to ease monetary policy and stimulate the economy. Subsequently, the currency appreciated 8% and the stock market fell 12%. That is exactly the OPPOSITE effect of what they had intended. Since 2009, Central banks have engaged in unprecedented monetary stimulus across the developed world. The example of Japan shows that we reaching a limit to how much monetary policy can do.


Book Clippings – The Righteous Mind – Jonathan Haidt

“Morality binds and blinds. It binds us into ideological teams that fight each other as though the fate of the world depended on our side winning each battle. It blinds us to the fact that each team is composed of good people who have something important to say.”


I read “The Righteous Mind” some time ago, but with all the polarization around student protests here and in the USA the issues seem very relevant. I thought i should copy some clippings from my kindle so that people get some of the (my) highlights and maybe they are encouraged to read the book:

Clippings from “The Righteous Mind”

The book defines a theory of morality and attempts to explain why people have such different ideas of right and wrong. Haidt believes that moral judgments are an automatic, intuitive, response. The reasoning for the response comes after. You make a moral judgement first, and then afterwards look for facts to support your decision. That is why it is almost impossible to change someone’s mind with a debate or argument. The facts are almost irrelevant.
It was his theory of the 6 forms of “morality’ that was most useful to me:

• The Care/harm foundation makes us sensitive to signs of suffering and need; it makes us despise cruelty and want to care for those who are suffering.
• The Fairness/cheating foundation makes us sensitive to indications that another person is likely to be a good (or bad) partner for collaboration and reciprocal altruism. It makes us want to shun or punish cheaters.
• The Loyalty/betrayal foundation evolved in response to the adaptive challenge of forming and maintaining coalitions. It makes us sensitive to signs that another person is (or is not) a team player. It makes us trust and reward such people, and it makes us want to hurt, ostracize, or even kill those who betray us or our group.
• The Authority/subversion foundation evolved in response to the adaptive challenge of forging relationships that will benefit us within social hierarchies. It makes us sensitive to signs of rank or status, and to signs that other people are (or are not) behaving properly, given their position.
• The Sanctity/degradation foundation evolved initially in response to the adaptive challenge of the omnivore’s dilemma, and then to the broader challenge of living in a world of pathogens and parasites. It includes the behavioral immune system, which can make us wary of a diverse array of symbolic objects and threats. It makes it possible for people to invest objects with irrational and extreme values—both positive and negative—which are important for binding groups together.
•The Liberty foundation obviously operates in tension with the Authority foundation. We all recognize some kinds of authority as legitimate in some contexts, but we are also wary of those who claim to be leaders unless they have first earned our trust. We’re vigilant for signs that they’ve crossed the line into self-aggrandizement and tyranny
Liberals focus on the Care and Liberty foundations, while they are not too concerned with the rest. They may even question whether loyalty and authority are even forms of morality. Haidt argues that conservatives have a broader view of morality as they use all six forms of morality almost equally. This creates “moral capital”, which he is essential to nation building, as it leads to a suppression of free riders. But it can have a downside in that does not necessarily lead to the equality of opportunity. Conservatives also may not notice victims or understand the need for change.

I personally think that this is a very useful framework and that it makes this book essential reading.


Can Bono Save the World? (Again)

As growth slows and currencies depreciate, African countries which have borrowed in foreign currencies risk falling into the same debt traps they barely escaped. Bono, are you paying attention?

The turn of the millennium saw the Jubilee campaign, a massive effort to write off third-world debt. Bono was a leader of an admirable initiative to relieve highly indebted countries of financial burdens which were crippling their abilities to reduce poverty and grow. Much of the debt had been built up illegitimately in countries with weak institutions where the risk of borrowing was not understood; dictators such as Mabuto Sese Seko (Congo) and Idi Amin (Uganda) also amassed large debts which impoverished their respective countries.

The Jubilee campaign was largely successful, as it saw G7 countries pledge to cancel $50bn worth of debt. The true cost of the write-down is far less, given how little of the debt was actually being serviced. The Jubilee debt campaign has also worked against “vulture funds”, which buy the debt of defaulted countries and then attempt to bring judgements through legal systems in the developed world. Zambia faced an example of this when in 2007 one of its defaulted loans was bought for $3.3 million by a vulture fund, which then sued for $55 million — the full amount, plus interest and costs. Debt relief and campaigns like Jubilee are not a panacea, but they have reduced the debt burden of highly indebted countries and limited the ability of vulture funds to profit at the expense of poor countries.

As the quality of U2’s songs declined into the new millennium, Africa’s growth picked up on the back of the commodity boom. Unfortunately, debt relief and rising commodity prices were not sufficient to ensure sustainable growth, as institutions in Africa remain weak. With commodity prices declining since 2008, growth in Africa has slowed while government spending pressure has not abated. This has led to large deficits, which have to be financed with borrowing. With global yields at record lows, there has been a temptation to borrow in foreign currencies (specifically USD), as the issued interest rate is far lower than domestic borrowing. In recent years, we have seen USD bond issues by a broad range of countries including Ghana, Zambia, Ivory Coast, Kenya, Senegal, Ethiopia and Gabon. These enticing low-interest rates come at the expense of immense currency risk, which has now materialised with the depreciation of African currencies against the US dollar. The following chart shows the performance of the African universe against the USD since 2013.

How costly this depreciation is can be seen in the example of Zambia, where a $750m bond was issued in 2012 when the exchange rate was 5 kwacha to the dollar. Since the time of the bond issue, the exchange rate has weakened by 53% to 7,63 kwacha to the USD. The value of the debt has therefore ballooned from 3,75bn kwacha to 5,7bn kwacha. If the currency depreciates further, this debt burden will continue to rise.

The growth of foreign-currency debt in Africa since 2012 has increased the risk that certain countries find themselves once again in a debt trap. Weak institutions and a culture of patronage in Zambia have led to a mismanagement of the economy, as parties buy votes with populist policies in order to win elections. Michael Sata’s Patriotic Front (PF) made some impossible promises regarding employment, poverty and cost of living in order to get elected in 2011. A ruling party that campaigns with the slogan “More money in your pockets” will always be under pressure to deliver.

Once in power, the PF set about rewarding voters by ramping up spending. The total budget has grown by 45% between 2013 and 2015, which has caused a large increase in the fiscal deficit. Against a backdrop of falling commodity prices (copper is 85% of exports), the debt-to-GDP ratio increased from 26% to 40.5% between 2012 and 2015. The following chart from Barclays shows the past and present: a history of the fiscal deficit dating back to 2008 and the forecast looking to 2016. The fiscal deficit is projected to stay at high levels (8%+) in coming years, and Zambia has reached the point where it is difficult to finance its high level of spending.

These difficulties were emphasised last week when Zambia launched a bond that has the unwelcome distinction of being the most expensive dollar debt ever for an African government. They issued at a yield of 9,38%, which is far more expensive than the 2012 bond which was issued at a yield of 5,625%. The desperation of Zambia to borrow is highlighted by the $38,4m “costs” incurred for the bond issue. This is a phenomenal level of expenses for a bond issue, and is an astounding 27 times the $1,4m cost of the 2012 bond issue. The additional “costs” bring the effective cost of debt closer to 9,85%.

Zambia is not alone amongst African countries which have ramped up spending in recent years through the build-up of foreign-currency debt. Ghana finds itself in a similar situation as it tries to launch another USD bond in order to meet it spending requirements, and it is likely to pay a significant price for this. There is a reason that foreign-currency debt is referred to as the “original sin”, since it has a history of triggering financial crisis.

Both Zambia and Ghana seemed to have reached the point where they are willing to borrow recklessly for political reasons. They need to satisfy the electorate in order to remain in power, and have used borrowed foreign money in a futile attempt to contain currency depreciation. While governments are thinking short term, the debts that they are building up in the present will not disappear after the next election, and citizens will suffer the consequences down the line. The extent of financial mismanagement means that both Zambia and Ghana are headed towards a financial collapse. They will soon find themselves in debt trap, beholden to their creditors and institutions like the IMF.

Bono’s services will be required shortly, and they should hope that U2 is done touring by then.


The Significance of China’s Stock Market Crash

1) These Chinese Stock market has crashed after a phenomenal bull run.
2) The Chinese equity bubble had the potential to boost growth, but now that the market has crashed this hope disappearing.
3) Growth has been driven by debt since 2007, which means an increased risk of financial crisis.
4) China has been the main driver of world  growth in recent years, but that growth will slow with knock on effects on global growth.

While the financial markets have been occupied with the turmoil in Greece, a potentially more serious development is the crash of the Chinese stock market after its  phenomenal run. Up to May 2015 the Chinese market had delivered 154% over a 12 month period and valuations of medium and small companies reached extremes. The market began selling off on the 15th of June and the crash continued despite measures by the central bank and government to prop up the market through the use of interest rate cuts and stock buying programs. The broad market has fallen 32% from its peak, a tremendous destruction of value given that the Chinese market is second only to the US in terms of size. Many companies have taken the strategic decision of suspending trading in their stock in order to prevent them falling further. Currently over 1000 stocks, out of a listed universe of around 3000, have suspended trading in recent days. This level of of suspension of trading is unprecedented as the action generally used for companies in Liquidation or Business rescue. As a comparison there have been 5 suspensions on the Johannesburg Stock Exchange for 2015 to date. While the market has fallen 32% in less than a month, the crash is actually understated due to the number of stock suspensions. 
China’s economy slowed during the 2008 financial crisis, but then recovered strongly due to government stimulus and credit growth. Growth has slowed significantly in recent years, but at 7% it is still very high for an economy of its size. Expectations are that economic growth in China will remain strong (between 6% and 7% in coming years) and the equity bull market reinforced these beliefs.
The Chinese equity market crash is significant as the bull market had the potential to boost economic growth. New stock offerings (IPO’s) and stock issues by listed companies pull savings into businesses, which they can can then invest. High valuations lower the cost of equity and therefore the required return on prospective investments. This causes companies to ramp up investment and this in turn drives growth. There was some hope that the deluge of money being pumped into the equities would stem the decline in GDP growth, but with the market crash this hope has now disappeared. 
It is critical for China that their growth does not slow as since 2007 they have amassed a large amount of debt. In the 5 years leading up to the financial crisis, China grew at over 10% p.a. The economy began to slow in 2007 and growth dipped to 6% in 2009. China reacted to this by significantly increasing borrowing and investment in an attempt to maintain its high growth rates.  They succeeded in boosting growth, but at the expense of massive increase in the debt levels. A McKinsey report earlier this year highlighted the extent of the borrowing binge ( The debt to GDP ratio has increased from 158% in 2007 to 282% in 2014, which means that debt levels in China now exceed those is developed markets such as the United States, Germany and Canada. 
The speed and quantum of the debt increase has only a few precedents in history, with no nation in a comparable position able to escape an an economic slowdown and most experiencing a credit crisis. ( A country with a high level of debt is very dependent on growth as any slowdown can impact the ability to service the debt load, which would precipitate a financial crisis.
While China’s debt fueled boom has been under scrutiny for several years, investors have generally believe that the government will be able to deal with any fallout due to the low level of government debt (55% of GDP), the current account surplus (more exports than imports) and the size of their foreign exchange reserves ($3,7 Trillion) . Despite these fundamental positives and the fact that the economy and credit growth has continued to grow at a rapid pace this year, I believe that a slowdown is now inevitable and there is a meaningful risk of a hard landing brought about by a financial crisis. Over the last 5 years China has contributed 30-40% of the world’s economic growth and the consensus among economists and market participants is that this is likely to continue. A significant slowdown will be quite unexpected with massive knock effects for the global economy.