State of the nation

23 November 2017

The State of the Nation, the Medium-Term Budget Policy Statement and positioning ahead of the ANC elective conference in December

There will be few who disagree that South Africa (SA) faces significant economic and investment challenges in the days, months and years ahead. 

South Africa has been left behind as most parts of the world experience renewed economic growth. While the rest of the planet is on average enjoying growth rates of circa 3.5%, SA will be lucky to achieve growth anywhere close to 1% this year and only marginally more in 2018. The South African Reserve Bank (SARB) has estimated potential growth over the next three years at less than 1.5% per annum which is a huge underachievement given that we are an emerging market (EM) with a strong young potential employable demographic.  South Africa’s potential growth used to be in the region of 3.5% per annum and the extent of underachievement is notable when considering that the National Development Plan (NDP) has a growth target of 5.3%.

A snapshot of SA does not reveal a pretty picture. South Africa has a stubbornly high unemployment rate of 27% and an expanded unemployment rate (including those who would like to work but are just too discouraged to even look) of around 37%, while the average global unemployment rate is around 6%. The economic and social costs of this are very significant. Grinding poverty is a hotbed for political instability. There are millions of South Africans who are so poor that they are classed as being below the food poverty line (cannot afford proper nutrition). Over 16 million social grants are dispensed monthly. This puts significant strain on the economy.

So what’s the problem?

In a nut-shell, it’s poor governance.  South Africa’s score for worldwide governance indicators has plummeted. These indicators include government effectiveness, rule of law, control of corruption, and political stability. The most problematic factors for doing business (as per business surveys) are cited in ascending order as; an inadequately educated workforce, restrictive labour regulations, inefficient Government Bureaucracy, high tax rates, government instability, crime and theft, and corruption.

An economy thrives on confidence. When confidence is high, businesses invest and consumers spend money. This boosts economic growth. Right now, policy uncertainty is high and confidence is low which has resulted in a lack of private sector investment.

So how has this poor state of affairs affected South Africa’s financial position?

The Medium-Term Budget Policy Statement (MTBPS) revealed by Finance Minister Malusi Gigaba provided us with some honest insight in this regard. There has clearly been fiscal deterioration. Tax revenues are lagging as a result of weak economic growth and fiscal deficit forecasts have been revised sharply higher. Debt to gross domestic product levels are also forecast to move significantly higher in the absence of any remedial action. The finance minister highlighted the challenges but did not present any specific plan of action. This was clearly not positive from a credit rating agency perspective and the possibility of an earlier than initially anticipated downgrade to junk status has increased. As might have been anticipated, the rand weakened, bond yields spiked up and the outlook for short term interest rates deteriorated. It seems now any prospect for further interest rate cuts are firmly off the table. 

What has become abundantly clear is that the only way to get out of this conundrum is to prioritise economic growth.

Politics and policy are key here. The importance of the ANC policy conference in December cannot be overstated. There are several scenarios worth considering here.

What is the outlook? 

Politics and policy are key here. The importance of the ANC policy conference in December cannot be overstated. There are several scenarios worth considering here.

 A business-friendly outcome with the uncompromised promise of meaningful reform could well catapult SA onto a higher potential growth trajectory. The currency would likely strengthen, bond yields would decline, private sector investment would rise and SA - sensitive equities would re-rate upwards.  This is clearly a high road outcome although it carries a relatively low probability in its purest form.

A compromised outcome where unity is favoured and the patronage faction is protected is probably the most likely outcome. Matters don’t get worse but the outlook does not brighten. Potential growth remains sub-par and a credit rating downgrade is inevitable. The rand would continue to gradually weaken in line with inflation differentials. We think the market is priced for this to a large degree.

A low road outcome is where the patronage faction comes to the forefront without any business- friendly compromise. While we think this is a relatively low probability, the investment implications are significant. In this scenario, the government becomes populist and there would be meaningful fiscal erosion. We would be firmly on a credit downgrade path (many downgrades). The rand would weaken, bond yields would rise and the SARB, assuming it remains independent, would respond with a tightening monetary policy. South Africa sensitive equities would de-rate as would SA property.

So how are we positioned going into this all- important event? 

Diversification, understanding driving influences, and ensuring efficient cross correlations are important here.

From an asset allocation perspective, going into a crucial but uncertain event it is important to ensure that our asset class valuations are based on our assessment of the most likely outcome. In this instance, our base case middle road outcome is reflected in asset class valuations to a large degree and weightings are not too far from their respective benchmarks. More specifically: bond yields have already more than priced in junk status. We are close to a neutral positioning here.

Equity positions (neutral weighting) are very well diversified. There is a natural rand hedge bias with 65% of the portfolio likely to benefit from a weakening rand. Of this 57% reflects positions where assets, costs and revenues are derived from offshore, 6% reflect positions where costs are rand based but revenues flow from offshore, and 2% where positions reflect an element of import substitution. Exposure to SA economic sensitives where revenues and costs are SA based make up 28% of the portfolio, while a further 8% of the portfolio reflect positions with an import cost component but where revenues are SA based. 

The SA listed property reflects a slight underweight position given the very challenging SA economic outlook. There is, however, a significant rand hedge component with 41% of the portfolio exposed to offshore assets.  

Offshore exposures also reflect a neutral stance right now going into the conference.

South Africa cash exposures are slightly elevated to ensure that we have some powder dry to invest on any meaningful market moving outcomes.