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CYCLES
 
In this module we will look at some of the basic economics that affect the share market. To begin with we will consider the “business cycle”. The business cycle is the term used to describe the swings in the economy from growth to recession and back to growth again. These cycles are always in progress and it is important for you to know roughly where South Africa is in its business cycle and how that is likely to affect the share market.
 
Certain factors can have a significant impact on the SA economy, destabilising the cycle of growth and recession associated with the normal business cycle.
 
Of course, political decisions and developments can have a massive impact on business conditions – such as the firing of Finance Minister Nene in late 2015 which unexpectedly pushed the economy back towards recession when it was slowly recovering. Similarly, the accession of Cyril Ramaphosa as president and his efforts to bring in foreign direct investment (FDI) have had a positive major impact – for a period of time. The problems with Eskom are on-going and deeply impact confidence levels in the South Africa economy. The advent of COVID-19 and the lockdowns has had a major impact on the economy from which it is trying to recover. The emergence of a second wave of virus at the end of 2020 is a further negative. That news was counter-balanced to some extent by the development of a variety of vaccines and the probability that these will begin to impact South Africa towards the end of 2021.
The virus has also had the effect of accelerating a move towards working from home and shopping online. Together with a sharp reduction in business travel, these trends have impacted various listed companies in different ways. Some have benefited and others have been virtually wiped out. Those with a strong balance sheet prior to the advent of COVID-19 have done best almost irrespective of what industry they were in. COVID-19 is obviously a completely extraneous and unpredictable event, a “black swan” event – and one which is impacting the entire world. Its impact is likely to be brought to an end in due course by the widespread implementation of vaccines.
 
The collapse of commodity prices between 2008 and 2016 obviously had a massive impact on the economy – since we are still primarily a producer and exporter of raw materials. The recovery of commodity prices since the start of 2016 which is still on-going is and will have a corresponding positive impact. In the past, most recoveries in the South African economy have been export-led.
 
Cycles of agricultural bounty and drought can have a major impact on the economy. The el nino and el nina weather phenomena cause major disruptions to our normal rainy seasons and can force us to have to import maize – or in a bumper year can give us a major additional export.
 
THE BUSINESS CYCLE
 
The concepts explained here are very important and necessary for your understanding of the market. You should also understand that what we describe further in this module is the progress of our economy under normal circumstances – assuming no major crises locally or internationally (such as the COVID-19 pandemic).
 
As budding investors, you will be aware that there is a relationship between what the economy does and what share prices do. If the economy moves up, then share prices move up – right? So how come the economy was taking a cold-water bath in 2020, but share prices were breaking to new highs?
 
Going back in history, there was a severe financial crisis in 1998 known as the “dot-com” crash, with a number of Eastern banks going into liquidation and emerging market currencies came under severe pressure, yet a year later the JSE Overall Index was up 49%.
 
The key buzzword here is that because share prices were “discounting” future expected growth they did not reflect the current situation. We introduced you to the concept of discounting at a micro-level in <a href="/index.php/course-module/7">module 7</a>. If you are not sure about it go back and re-read this module. In this module we are talking about discounting at a macro-level where investors as a group anticipate the future progress of the economy and then either buy or sell shares accordingly.
 
In the first example above (the 2020 recession), investors were discounting an economic recovery that was only expected to begin in late 2021 and 2022 as the pandemic was brought under control. In the second example, the crises caused local interest rates to shoot up from 18% to 25% (a 40% increase), however, this rise was over-done, and interest rates quickly started to come down. The share prices were going up in anticipation of further declines in interest rates which indeed happened. Lower interest rates reduce the cost of borrowing and thereby stimulate economic growth. The word “discount” in this sense has nothing to do with the sort of thing that Pick ‘n Pay, Shoprite or Game do. Instead, it means to give or offer current value for a future reward in much the same way as a bank discounts a bill of exchange. This kind of behaviour is quite logical, as you can see from the following example.
 
Say that you have reason to believe that fishing shares are going to start earning good profits. What do you do? Obviously, you buy fishing shares, (a) so that you can already hold them when they start to earn those super profits, and (b) so that you can benefit from the capital appreciation (the increase in the share’s price) that will occur when other people also perceive that profits will be good and start to buy the shares, thereby pushing up the price.
 
But how do you get in ahead of the pack. Let us see if we can help by looking at some fairly easy economics. In the interests of simplicity, we are going to gloss over some detail that academics find indispensable – so relax.
 
You have probably heard people talking about the “economic cycle”; you know that times are either good, improving, bad, or getting worse. You may also have been aware that when things get really bad, it is not long before they start to improve, and that when things get really good, they soon start to go sour. We can show this as follows:
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/word_wave_pic.png" />
<figcaption class="figure-caption">Business/Economic Cycle</figcaption>
</figure>
 
It is no accident that this diagram shows a “wave” form. This form is known as a “cycle”, and like all waves, it is repeated time and time again.
 
The only things that really change are the size of the waves, and the time between the trough and the crest, and crest and trough.
 
But the wave, or cycle, repeats itself. Successful long-term investment (unlike speculation) depends on getting the timing of the wave right, knowing whether things are really bad, or only plain bad, and then putting your money into the market, or taking it out before share prices move too far against you. As Warren Buffett has famously said, “You must be greedy when others are fearful and fearful when others are greedy”.
 
Must there always be a cycle? Yes, always – although sometimes it is temporarily obscured by major external events. So, if you go in too soon, do not worry because eventually the cycle will reach the bottom and start to turn up. If you go in too late you might consider getting out again quickly (i.e., on stop-loss), and waiting for a more appropriate time, even if this takes a year or two. If you do not get out again quickly, then you must be prepared to sit it out in the market, getting steadily poorer on paper – but do not take fright just when things are about to improve. If you do that then you are an amateur!
 
BOOM SYMPTOMS
 
Going back to the cycle, let us look at some of the things that happen along the way, and some of the things that stop the rise and reverse the fall. The problem with a cycle is knowing where to get in, because a cycle is an on-going process that has no natural beginning or end. So, let us start at the top. That means good times, when big businessmen are importing their new Porsches, Ferraris et al, more plant for their factories, stock to sell at a fat profit, “ ‘cos they can make a killing”, cigars, whisky, caviar and French champagne. What fun! But this cannot go on for long, because the reserves of gold and foreign exchange are not big enough to stand it – and it is inflationary. The Reserve Bank, through the monetary policy committee (MPC), will realise that prices are starting to go up too quickly and they will stamp their foot on the brakes by increasing interest rates.
 
So eventually the boom comes to an end, and the authorities clamp down on this wild abandonment.
 
Some other symptoms of the top are:
 
High interest rates – “Let’s borrow the money. It doesn’t matter what it costs ‘cos we’re going to clean up!”
 
High inflation – “Just buy! It’ll only cost more tomorrow!”
 
Shortage of goods – “If you want a blue one, you’ll have to wait for it, and the price is going up next month.”
 
Big increases in profits – “Your directors have pleasure in announcing that they have made twice as much money out of the public as they did last year”.
 
High staff turnover – “Harry’s working so hard these days – he just can’t get staff. But he’s leaving at the end of the month.”
 
And so it goes….you can spot these symptoms easily when they happen, but it is difficult to measure them. The only real measure is the effect that this psychology has on the balance of payments – which will be moving into deficit (i.e., exports are lower than imports) – and the reserves of gold and foreign exchange, which will be falling.
 
Going from “really good” to “worsening”, interest rates will start to go really high, pushed up by the Reserve Bank and people will scratch around to find the money to pay for things they thought they could afford, but can no longer - and in the meantime the authorities will be taking money out of the system (using open market operations) in an attempt to cool down the economy.
 
Usually, the Minister of Finance can be counted on to say things like “Everything is still fine, but we must curb these excesses”, and “South Africa is living beyond its means”. Share prices will be falling, and you should be out of the market, especially for industrials.
 
SYMPTOMS NEAR THE BOTTOM
 
When the situation turns from “worsening” to “bad”, the newspapers will be writing about “XYZ retrenches 500”, “Bankruptcies Soar”, “We are in recession”, etc.
 
Economists will warn about the perilous state of the “Reserves”, and the IMF will surely be tapped for a loan, if it has not already been (which it was in 2020). The international ratings agencies will be considering a downgrade (which they did). Prophecies of doom abound, but interest rates have probably started to move down (which they did in 2020), and there are the first glimmerings of an improvement in the balance of payments. This was the situation that existed at the end of 2020 when the ratings agencies had already decided that South Africa was “junk status”, the second wave of the virus was gaining momentum, and everyone was negative about the economy. Interest rates had already been brought down by the monetary policy committee (MPC) but had not yet impacted on the economy significantly. The first “green shoots” in the economy were beginning to be visible to the astute observer.
 
Typically, at this time, exports rise a little, and imports fall a lot, often accompanied by an import surcharge – designed, we are told, to discourage imports – and we should ignore the fact that it conveniently swells government coffers. Imports fall because we have all got the message that new Porsches and Ferraris are out of fashion, and “..our new plant has arrived, has been commissioned, and is now wrapped up in mothballs because the demand we thought was there is not, and we cannot sell all that the old plant can produce anyway..”. Over-stocking is a classical sign of the bottom of the market. Retailers, especially, get caught with stock that they cannot sell.
 
So, because we do not want a newer plant, and we have been desperately running our stock down, and telling our debtors we’ll sue them if they don’t pay up, while keeping our creditors waiting as long as we dare, we are very flush with cash. By the end of 2020, it was estimated that non-financial companies in South Africa were sitting on more than R700bn in cash. Consumer spending falls too (we all know that consumers are under enormous pressure). Now, theoretically, the economy starts to create “liquidity” by repaying debt, hoarding cash, reducing expenses, and pressurising debtors to pay up. This increased liquidity is felt in the whole system and because we have all got cash, and do not want to borrow, the supply of money rises, the demand falls and interest rates (which are the “price” you pay for money) come down (as indeed they have).
 
DARKEST BEFORE DAWN
 
As “bad” turns to “really bad”, share prices start to respond to the increased liquidity and rise (at the end of 2020 the JSE was close to its all-time record high). As we have seen in an earlier module, a falling share price means a rising dividend yield (if you are not sure about dividend yields go back and re-read <a href="/index.php/course-module/8">module 8</a>). And because interest rates have been falling, this high dividend yield (like 8% or more) begins to look very attractive, bearing in mind that they are tax free and relative to a fixed deposit of say between 5% and 6%, which offers no growth and is taxable. Here you should bear in mind that, over the long term, the average dividend yield on blue chip shares is normally around 2,5% - so any dividend yield in a quality share which is close to or above 5% indicates that the share is relatively cheap. Big institutions will tend to buy up any blue-chip share which is on a dividend yield of over 5%, causing its share price to rise and the dividend yield to fall.
 
High dividend yields are one reason for share prices to rise, but another reason is that smart investors know that after “really bad” comes “improving” and improving means better profits and hence better dividends and share prices, and thus the market, starts to “discount” the recovery – which brings us back to where we began this discussion.
 
Often too, at this stage, exports start to rise, either because the gold price goes up, or because foreign economies start to improve and there is demand for our base metals and minerals. We start to run a strong surplus on the balance of payments and the reserves rise, giving us the wherewithal to finance the next boom.
 
At this stage, interest rates go right down, business profits are under severe pressure, bankruptcies rise, there are some spectacular crashes among both listed and unlisted companies (consider the collapse of Edcon or the various construction companies in business rescue), unemployment is very high (now officially over 30%), the media tells us how green the grass is on the other side of the ocean, and as long as no one does something silly, like letting foreigners take their money out of the country, we can expect a recovery to begin in about six to nine months.
 
THE DEBT CYCLE
 
You may have noticed that there is also a cycle of debt and repayment that goes on in the economy. Sometimes consumers and businesses are over-extended. They have borrowed too much and spent too much. This is normally followed by a period of repayment and accumulation when consumers and business try to reduce their debt levels or even get completely out of debt.
 
And this debt-repayment alternation is dependent on confidence. When most consumers and businesses are feeling confident of the future, they will tend to spend more. They will buy those big-ticket items like motor cars and furniture. They will buy more and more on credit because they are confident of their future flow of income. On the other hand, when confidence begins to waver, people generally spend less and try to cut back on their overheads. They seek to pay off their debts and even build up a little “nest-egg” for emergencies.
 
Of course, when people and businesses are borrowing and spending freely because they have confidence in the future, then the economy will generally be in a boom and vice versa. So, the incurring and repaying of debt explains the alternation between growth and recession under normal circumstances. The job of the monetary policy committee (MPC) of the Reserve Bank is to manage this cycle of over- and under-spending by using a combination of interest rate adjustments and open market operations.
 
EXTRANEOUS FACTORS
 
Of course, when considering the South African economy, you also need to keep in mind the fact that it is a very small economy and that it is hugely impacted by developments in the world economy. For example, the decision by the American President in 2019 to enter into a trade war with China (and other countries) caused investors world-wide to move towards “risk-off”. This means that as a group they became more risk averse. They moved their money out what they perceived to be risky investments (like emerging economies) and into what they perceived to be safe assets (like US Treasury bills and gold).
 
The alternation of international investors between being “risk-on” and “risk-off” has a huge impact on South Africa because we are seen as being one of the best emerging markets – so during a period of risk-on international money flows quickly into this country seeking the exceptionally high returns which we offer (for example, our leading long-term government bond generally offers better than 9% interest compared to less than 1% on the equivalent US T-Bill). At the same time, when sentiment shifts towards risk-off, money flies out of South Africa causing pressure on the rand and falling shares prices on the JSE.
 
The rand is one of the most liquid of the emerging market currencies and so this has made it a favourite plaything for international currency speculators – who regularly buy and sell Rands to make short-term capital gains. The rand trades roughly R50bn per trading day – which means that it is almost impossible for the South African Reserve Bank to manage or control our currency in the open market (bearing in mind that our total national reserves of foreign currency and gold are only worth about R50bn).
 
EXPORT-LED RECOVERIES
 
Because the South African economy is still essentially a commodity exporter, it means that our economic prosperity (or otherwise) is usually dictated by the state of the world economy. When the world economy is booming there is a greater demand for our raw materials (such as coal, iron, platinum, manganese, and chrome). For this reason, economic recoveries here tend to be “export-led”.
 
And in the commodity markets we are a price-taker rather than a price-maker. This means that the prices of the various commodities that we produce are not determined here – but rather on international commodity exchanges in other parts of the world.
 
For many years, the South African government has been trying to encourage the beneficiation of our raw materials – and they have had some limited success. This is especially true in the motor industry where we now export more motor vehicles than we consume locally. But it has not been true in many other markets – most notably, for example, in the steel market. Here we are exporting iron ore, manganese and chrome and then importing steel – while we have roughly 40 furnaces lying idle – mainly because of the 500% increase in the cost of electricity since 2006. Obviously, the inability to beneficiate costs this country thousands of jobs.