Muddle-through scenario most likely after ANC leaders’ election
• Fund managers prepare portfolios for compromise outcome rather than full-throttle growth
Few would disagree that SA faces significant economic and investment challenges in the days, months and even years ahead. SA has been left behind in a world that has generally experienced renewed economic vitality. While the rest of the planet is on average enjoying growth rates of about 5%, SA will be lucky to achieve growth anywhere close to 1% in 2017 and only marginally more in 2018.
The South African Reserve Bank has estimated potential growth over the next three years at less than 1.5% a year, which is a huge underachievement, given that we are an emerging market with a strong, young, potentially employable demographic.
SA’s potential annual growth used to be in the region of 3.5%, and the extent of underachievement is even more marked when considering that the National Development Plan has a growth target of 5.3%.
A snapshot of SA does not reveal a pretty picture. We have 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 about 37%. This compares with an average global unemployment rate of about 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 not only poor but so poor that they are classed as being below the food poverty line (cannot afford proper nutrition). More than 16-million social grants are dispensed every month. This puts significant strain on the economy.
So what’s the problem? In a nutshell, it is poor governance. SA’s score for worldwide governance indicators has plummeted. These 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 the biggest problem of them all, corruption.
An economy thrives on confidence. When confidence is high, businesses invest and consumers spend. This boosts economic growth. Right now policy uncertainty is high and confidence is low, and it is not a great surprise to see a lack of private sector investment as the result.
So how has this poor state of affairs affected SA’s financial position? The medium-term budget policy statement provided us with some honest insight. 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-toGDP levels are 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.
What has become abundantly clear is that the only way to get out of this conundrum is to prioritise economic growth. So what is the outlook? Politics and policy are key here. The importance of the ANC policy conference in December cannot be overstated. There are a number of scenarios worth considering:
A business-friendly outcome with the uncompromised promise of meaningful reform could well catapult SA onto a higher potential growth trajectory. The currency would probably strengthen, bond yields would decline, private sector investment would rise and
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equities sensitive to SA would rerate 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 the most likely outcome. Matters don’t get worse, but the outlook does not brighten. Potential growth remains subpar and a further 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 fore without any business-friendly compromise. While we think this is a relatively low probability, the investment implications are significant. In this scenario, the government
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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 South African Reserve Bank, assuming it remains independent, would respond with a tightening monetary policy. Property and equities sensitive to SA would derate.
So how are we as asset managers positioned going into this all-important event? Diversification, understanding influences and ensuring efficient crosscorrelations are important. From an asset allocation perspective ahead of 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 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 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% reflects positions where costs are rand-based but revenues flow from offshore, and 2% reflects an element of import substitution. Exposure to South African economic sensitives — where revenues and costs are based in SA — makes up 28% of the portfolio, while 8% reflects positions with an import cost component but where revenues are based in SA.
South African listed property reflects a slight underweight position given the very challenging 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 going into the conference. South African cash exposures are slightly elevated to ensure that we have some powder dry to invest on any meaningful market-moving outcomes.
IN THIS SCENARIO THE GOVERNMENT BECOMES POPULIST AND THERE WOULD BE MEANINGFUL FISCAL EROSION