Good news has been in short supply in South Africa lately. The best so far is that the Covid-19 curve is finally flattening, prompting President Ramaphosa on Saturday evening to further ease lockdown restrictions and lift the economically damaging alcohol and tobacco bans.
In a roundabout way, the fury over corruption and nepotism in emergency pandemic procurement is also good news. It may finally spur more decisive action on corruption.
An interesting recent snippet of news was the arrival of a giant gas exploration vessel in Cape Town harbour on its way to continue drilling work in the Outeniqua basin south of Mossel Bay for French petro-giant Total. This despite depressed global energy markets, the lack of regulatory certainty, and very challenging onsite conditions. Perhaps Total knows something we don’t.
However, bad tidings and stories of woe continue to dominate the news. Eskom was forced to reintroduce load-shedding, a cruel blow not long after the High Court ruled that it could slap another 10% on its tariff increase this year. That is multiple times the current inflation rate. The Council for Scientific and Industrial Research (CSIR) reported that load-shedding in 2020 has already surpassed that of 2019, previously the country’s worst-ever year for load-shedding. It warned that unless urgent action was taken, particularly lifting the regulatory constraints on self-generation by businesses, municipalities and households, load-shedding could persist for at least two more years.
We also now have a clearer idea of how badly the economy contracted in the second quarter, following the release of key sector updates. Manufacturing output and mining production were 16% and 28% lower than a year ago respectively in June, while real retail sales were 7.5% lower. When the overall economic growth (GDP) numbers are released early next month, it will show a historic contraction. It will also be the fourth consecutive negative quarter.
With that comes a historically steep decline in tax revenues, compounded by the alcohol and tobacco bans (in normal times, these ‘sin taxes’ contribute about 3% of total tax revenues). While the government has shifted around some spending and is attempting to get out of an agreement to raise public sector salaries this year, overall spending levels are not falling. This will result in a historically wide budget deficit, the gap between government spending and tax revenue. South Africa’s government debt-to-GDP ratio is set to jump by around 20 percentage points this year.
It is important to note that virtually all countries will see a surge in public debt levels this year. South Africa stands out not because of the magnitude of the increase but because of the cost: Long-term borrowing costs are substantially above those of other major emerging and developed markets. (Turkey and Argentina are notable exceptions, more about this below.)
Despite all this gloom, local equities moved into positive territory for the year last week. The FTSE/JSE All Share Index closed above the 57 000 points level it started the year at. And despite dividend cuts or suspensions from many companies, overall dividend payments are positive, lifting the total return for 2020 to 2%. That is obviously nothing to write home about in isolation, but seen in the context of the pandemic-induced global recession, it’s remarkable.
Clearly, the 50% gain in domestic equities since late March has very little to do with the local economy. To use one obvious example, British American Tobacco’s share price increased after the local tobacco ban was instituted in March. Its South African operations barely moved the needle on its overall profitability.
Winners and losers
Those companies and sectors most closely connected with the local economy continue to languish. Bank shares are still down almost 40% this year and the diversified industrial and logistics groups are down 30%. In other words, they already reflect the domestic economic crisis. Many are trading at single digit price: earnings ratios.
The big winners have been Naspers/Prosus, up 40% year-to-date on the strong performance of Tencent in China. The combination of Naspers and Prosus account for almost a quarter of the overall market cap.
The biggest winner, by some distance, has been the gold sector, which has doubled this year even with the recent pull-back in the dollar gold price.
Our mining shares have also performed strongly on the back of rising dollar commodity prices and a weaker rand.
As a result of the rising mining and global consumer shares, and struggling domestically focused shares, the overall weight of the latter in the main JSE indices has declined further. In other words, exposure to the domestic economy has declined further.
Chart 1: Winning and losing sectors on the JSE
Source: Refinitiv Datastream
Yet the overall market – the high-flyers and the stragglers – is trading at a very reasonable valuation, certainly compared to the much higher price: earnings ratio of US equities in particular.
Starting valuation, and not current macroeconomic and political conditions, remains the best predictor of future returns we have (though it is not perfect). Therefore, a basket of JSE-listed companies should be able to generate a good long-term real return.
Chart 2: South African and global forward price: earnings ratio
Source: Refinitiv Datastream
The local market remains very concentrated, however, and subject to a range of very idiosyncratic risks. There are only a hundred or so truly liquid stocks listed on the JSE, compared to thousands on global exchanges. It still makes sense to maintain substantial global equity exposure. Also, if South Africa were to have a full-blown fiscal crisis, the rand would be the first casualty and offshore exposure the best defence. JSE-listed rand hedges should also benefit. However, it makes much less sense to sell a relatively cheap rand and cheap local shares now.
So what is the risk of a full-blown fiscal crisis? It is clear that the current fiscal trajectory is unsustainable in the sense that interest payments will end up consuming an ever greater share of tax revenue (this year it will be about 20 cents in every rand of tax collected). The government knows this. It has projected that debt will reach 140% of GDP in a decade if nothing is done. It is planning to take steps to address it, and these are set to be announced in the upcoming Medium Term Budget. It is vitally important that detailed and credible plans are presented next month, and that the announcement is not postponed yet again.
However, it is important to remember a number of key strengths that sets South Africa apart from other countries that have recently found themselves in some version of a debt or financial crisis. Lebanon and Argentina have both defaulted on government debt this year, Egypt is a recent recipient of a full-scale IMF bailout and of course Greece’s troubles dominated investor radar screens for a large part of the last decade.
High debt levels per se don’t cause a crisis. The crisis is caused by a loss of market confidence, in other words the market refusing to roll over maturing debt or absorbing newly issued debt. This loss of confidence can come out of the blue, but often is associated with some other deep imbalance tipping over. A large and persistent current account deficit is one such imbalance.
Unsustainably strong or pegged exchange rates is another classic culprit. Lebanon’s central bank ran what has been described as a Ponzi scheme to attract continued inflows of dollars to sustain its currency peg. Turkey’s central bank borrowed hard currency from domestic banks to try prop up the lira. Last week it seemed to give up after burning through tens of billions of foreign exchange reserves. It is often forgotten that Greece suffered through its crisis with a very strong real exchange rate, due largely to sharing a currency with Germany.
In contrast, the rand is volatile and currently somewhat undervalued. This allows it to act as a shock-absorber. When things go wrong, it is the first macro variable to adjust and it does so with gusto. This immediately boosts foreign export and investment revenues (and South Africa has a positive Net International Investment Position, meaning total foreign assets exceed foreign liabilities). A second, underrated feature of the volatility is that it discourages excessive foreign borrowing. A large portion of emerging market crises stem from the “original sin” of borrowing externally in hard currency.
It is hard to overstate the importance of South Africa’s well-run and well-regulated domestic banking system, a large pool of domestic savings, and liquid and deep capital markets. And crucially, they all operate in a domestic currency. Even while government debt is increasing at an alarming pace, it is still mostly rand-denominated, which makes the problem manageable as long as there is political will to address it.
Finally, a credible and independent central bank is crucial. The SA Reserve Bank’s conservatism has been frustrating in the deepest recession in living memory, but in the broader context, it is a stabilising factor. In its current make-up, the Reserve Bank will not tolerate any Lebanon or Turkey-style shenanigans.
None of these strengths will save us on their own, but they do give us some room to fix our problems.
What is in the price?
The other big question for investors is simply how much of all this is priced into the local bond market? After all, South Africa’s fiscal problems have been well known and widely discussed for a long time. Local long bond yields trade at 9.5%. That is not only well above short-term (money market) interest rates and expected inflation for the next few years, but also above that of other countries, including countries with higher debt levels. The market can hardly be said to be complacent.
Chart 3: Emerging market 10-year government bond yields.
Source: Refinitiv Datastream
Change the narrative
Let’s face it, markets are driven by narratives. As much as we like to believe it is all about hard-nosed number crunching, the stories investors tell themselves and others are key. The surging gold price represents one such story: that of looming inflation and dollar weakness. The continued, mysterious allure of cryptocurrencies represents another (the collapse of fiat money). A third example is how work-from-home changes everything, as if people will never want to get dressed and venture outside again.
The all-too-brief ‘Ramaphoria’ narrative of impending reform saw the rand and local bonds surge in early 2018. It didn’t last and has been replaced by a very worrying narrative that South Africa is destined for a future of low growth and high debt, while the government lacks the will to make tough decisions and implement them.
As a consequence, South African investors are scrambling to take money out of the country, businesses are not expanding and foreigners are overlooking opportunities here. We need to turn this narrative around and tell a simple and believable story to the world of how we are going to get government finances under control and grow the economy. Against the backdrop of global developed market interest rates near zero, if we have only marginal success in doing so, South African bonds yields can decline from their current elevated levels towards those of our emerging market peers (such as Brazil, Russia and India).
As long-term borrowing costs decline, economic growth should accelerate further and local interest-rate sensitive stocks should rally. In other words, once in motion, it can have a very positive snowball effect. But the reverse is also true and as investors we need to be prepared for either scenario.