Quarterly Publication - April 2017
SA IN CRISIS - April 2017
During our recent institutional roadshow, I was, for the first time in many years, fairly upbeat about our country's prospects for the year ahead. Commodity prices were up, heavy rains had resoundingly broken the drought and both consumer and manufacturer confidence indices were rising. All of these boded well for a pick-up in economic growth. With the rand having strengthened and inflation firmly under control and heading well below the top of the inflation target of 6%, the prospects were looking good for interest rate cuts that would further boost consumer spending power and the economy in general.
Post a recent investment conference hosted in March, where foreign investors met a broad array of local companies, it was clear that this confidence was shared: share prices of most SA-specific companies rose as foreign investors started backing the recovery with investment into the country. The rand strengthened further and bond yields dropped to a remarkable 8.2%; remarkable, as generally global bond yields were rising, not falling. All indications were that SA was pulling itself back on track post the shake-up in December 2015 when markets were shocked by Nenegate - the firing of finance minister Nhlanhla Nene and his replacement with little-known backbencher Desmond van Rooyen.
With this improved confidence would come stronger economic growth, which drives investment, which in turn would bring with it jobs and improving financial results, which then would boost overall tax revenues.
The ANC elective conference in December 2017 was the main risk to this improved outlook, with a clear high road/low road scenario depending on which faction within the ANC would come out on top. By mid-March, it still seemed that either faction had equal odds of winning the elective conference and setting ANC policy for the next five years.
All of this was completely derailed on Thursday, 30 March. In a surreal event, a midnight cabinet reshuffle was orchestrated, apparently without involving any of the senior members of the ANC national executive committee. The ANC secretary general was so shocked as to publicly state, “This reshuffle was not done in consultation with the ANC, we were given a list that was done elsewhere and then it was given to us.”¹ Ten ministers and ten deputy ministers were fired or moved to different portfolios and a number of new members, many of whom are fairly unknown were introduced. The main blow to the economy was the removal of both the finance minister and his deputy, despite their sterling job in staving off a ratings downgrade and delivering a properly funded budget, notwithstanding the economic challenges SA faced in the past year. They were replaced with Malusi Gigaba, previously minister of public enterprises and more recently home affairs, and Sfiso Buthelezi, a relatively unknown backbencher who was formerly an advisor to Zuma prior to his rise to the presidency. Interestingly, two of the new appointees, Gigaba and the new minister of police, Fikile Mbalula, were both past presidents of the ANC Youth League (ANCYL).
There has been much speculation as to where the new names came from, and what the intentions of all these various ministers will be. One can read plenty about their past connections and foibles in the popular press. It is more important to deal with the factual results of these appointments and what the economic impact will be. Perhaps most telling is the response of the current president of the ANCYL to ratings downgrades following these announcements: "We are welcoming the junk status. When the economy rises again, it will be held by us." The move to junk is nothing to be welcomed, and expectations of a rising economy an example of naivety in the extreme.
THE REAL EFFECTS
Since the cabinet changes, the yield on the benchmark 10-year government bond has pushed up to 9% and the rand has fallen from its recent peak of R12.20 to the dollar to R13.80. Domestic interest rate sensitive companies like banks and retailers have fallen by 10% to 15%. Expectations of rate cuts and a return to economic growth are disappearing and inflation is no longer going to ease as expected. Why is this the case?
Regardless of all the conspiracy theories doing the rounds about looming special deals for connected parties, we know that the president and new ministers are now talking about a radical economic transformation. These are the kinds of words and policies used by politicians with falling ratings to try to drum up support from the electorate. While it might succeed in appeasing the electorate, the only transformation to the economy is going to be a deterioration, ultimately impacting those self-same voters the most. Slicing up a pie in different ways does not grow the pie, but is certain to cause it to shrink.
State-owned enterprises (SOEs), which have been mismanaged and have consumed billions of rands over the past decade, are likely to be topped up by a newly compliant Treasury. This alone will increase the government debt burden by billions of rands. Ratings agencies have been very wary of these institutions given their potential to massively increase the debt burden of all South Africans. Over and above all of this, the mooted project to build six to eight nuclear reactors, with a projected cost exceeding R1 trillion, appears to be on track again. Under Gordhan, the National Treasury had been steadfastly blocking this project as unnecessary and unaffordable. Post his removal, Treasury is now supportive of it progressing, despite the fact that following demand-side measures and the two new coal-fired power stations coming on line, SA now has significant surplus power capacity. SA has gross debt to GDP levels of 51% (rising to 61% if guarantees issued to SOEs are included). If all existing SOE debt is included, it rises to 69% and with a potential R1 trillion nuclear build, debt to GDP exceeds 90%. Should this happen, we would be in a debt trap death spiral.
The reaction of two of the global ratings agencies to these changes has been swift and brutal. Our foreign debt ratings have been slashed to subinvestment grade (junk) with immediate impact on the cost of our funding. This is not something only affecting the arcane world of finance, but also has real punitive effects on every South African. As the cost of funding our debt goes up, it takes away valuable resources that could be used to fund social services, healthcare and education. It also results in a decline in the value of existing SA bonds, impacting millions of pensioners. We expect the remaining ratings agency (Moody’s) to cut our foreign debt rating in the next few months. Meanwhile, SA debt has already been ejected from the JP Morgan Investment Grade Index. The biggest risk is still outstanding, however. Only one of the ratings agencies (Fitch) has moved our local currency debt rating to junk. Should another ratings agency cut this rating to junk, we will be ejected from the Barclays Global Aggregate Bond Index, resulting in the forced sale of approximately $5 billion of SA bonds. Should Moody’s and S&P downgrade our local currency bonds to junk status, then we will be ejected from the Citi World Government Bond Index (WGBI), triggering the forced sale of some $9 billion of our bonds. (At current exchange rates, this represents a cumulative outflow of R193 billion from the bond market.)
Do not hold your breath for any BRICS-friendly ratings agency to make an iota of a difference. As Warren Buffett famously said, never ask a barber whether you need a haircut. Similarly, global investors will not be swayed by the biased views of such an agency.
After Gordhan was reappointed as finance minister following the shock of Nenegate, corporate SA rallied around the National Treasury to deliver work streams to prevent a ratings downgrade and to drive economic growth through targeted investments in small businesses and various programmes designed to assist in alleviating service delivery and poverty. By and large, these initiatives were successful, certainly in managing the ratings agencies and in the establishment of a R1 billion fund to support SME development. Without a doubt these initiatives were instrumental in staving off the downgrade. As the Treasury shifts its focus to providing more funding to SOEs, including the unaffordable nuclear build, and amid its stated support for radical economic transformation, these initiatives are likely to stagnate and will ultimately be undone.
Given that the foreseeable outcomes of the radical cabinet changes, pushed through against the wishes of many senior ANC members, are all negative, why has the market reaction not been as negative as when Nene was fired? It is not obvious, but a couple of possibilities exist. Firstly, the sell-off after Nenegate proved a great buying opportunity as the market swung from despair to hope when Gordhan took control of the Treasury. Bonds and domestic shares, which were hardest hit, generated some of the best returns in 2016 as the market started to believe in the SA economic recovery story. There is definitely an element of hope playing out in markets currently where investors are buying these same assets in the hope that fiscal discipline is not going to be lost.
Secondly, as mentioned, the first quarter of 2017 was showing promising signs of recovery and many foreign investors were encouraged by a nascent economic turnaround. They may be viewing this sell-off as an opportunity to invest, not realising the significance of the change in our fiscal trajectory. All the major political surprises globally in 2016 have generally been buying opportunities, with UK and US equity markets rallying hard after their own political shocks. While South Africans are aware of how significant a blocking role the National Treasury and the incumbent finance minister had in the SA government, this is not common knowledge elsewhere.
Finally, one can only assume it is the 'frog in the pot' syndrome. According to the classic analogy, a frog thrown into a pot of boiling water will jump out in fright, saving itself, but if you put it in a pot of cold water and slowly turn up the heat, it will eventually die, not noticing the more subtle change in temperature until it is too late. Having been through a similar event before and having heard constant threats of Gordhan’s removal – have we all just become complacent to what is now, hot water?
One cannot overstate just how significant the change at the National Treasury is for SA. Since the dawn of democracy in SA, it has been a steadying force, applying fiscal conservatism as a guard against wasteful and profligate spending. The Public Finance Management Act is an important piece of legislation that required the finance ministry to have a final say in all major projects approved by other departments. Investors and all South Africans relied on the prudent actions of a well-respected finance team to control expenditure across government. If you look at countries around the world where radical government changes (led by populist parties with no fiscal restraint) have played out, the end game has been pretty predictable. Rampant growth in debt was followed by rampant printing of money and, ultimately, currency crises and defaults. While Zimbabwe is the obvious example, we have seen the same across many Latin American countries like Venezuela, Bolivia and Argentina. This is playing with fire, and it does not end well for the economy and the people.
We have for some time been managing our strategies with a high allocation to offshore assets. Most of our asset allocation strategies with mandates to invest offshore are at their maximum regulatory or mandated levels. Within our domestic equity allocation we have more recently had a high weighting to companies with earnings outside of SA or driven by dollar-based revenue lines (such as mining stocks).
In early 2016, we bought a lot of domestic shares as their prices fell in excess of 30% post Nenegate. As the year progressed and these shares did well and the rand strengthened, we felt that the return opportunity was once again more favourable, outside of the purely domestic shares. Given that the moves following the recent cabinet shake-up have not been as extreme, and the fact that we think the long-term changes in fiscal strategy are far less benign, we are not inclined to increase our purely domestic weighting.
Bonds, both globally and locally, have not looked attractive on a risk-return basis since the global financial crisis. We have avoided global bonds and, other than some tactical buying post Nenegate, we have generally avoided local bonds as well, due to our assessment that the yields did not offer sufficient return for the risk involved. We have preferred property instead where yields were as attractive, and well-managed companies are able to grow distributions in line or ahead of inflation. We have not been tempted to buy domestic bonds as yet given our concerns over the likelihood of our debt burden rising significantly, necessitating further debt issuance outside of the long-term projections of the budget office.
Our funds have performed well in volatile times, and the first quarter of 2017 has not been different. We have built portfolios based on a careful assessment of maximising returns at an acceptable level of risk. Still, this is cold comfort for the millions of South Africans facing a much bleaker future today as result of a stagnating economy and the reduced resources available for meeting social services.