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South Africa’s economic outlook – is there light at the end of the tunnel?

| Market Forces, Market News

Adapted from the articles ‘An April fool’s tale’ by Patrice Rassou, Head of Equities and ‘SA downgrade: In the aftermath’ by Frederick White, Head of Balanced Funds, from Sanlam Investment Management
Politics has become the dominant theme driving financial markets
The recent downgrade of South Africa’s credit rating to junk status was not completely unexpected. Before the surprise cabinet reshuffle by President Zuma, a downgrade itself was not going to be the most important development, but rather the response to it. South Africa was making continuous progress in this regard – not only was a downgrade priced in and the likely impact of it muted, but the probability of a downgrade was not increasing. In the event of a downgrade, a positive response would mitigate the negative impact on financial markets.
But when President Zuma reshuffled his cabinet, this analysis was dealt a serious setback: it brought the progress made in the last year to a halt and cast doubt over future improvement. The statement that accompanied Standard & Poor’s (S&P) downgrade made it clear that the main consideration for the downgrade was this severe political development and the impact it had on the outlook for South Africa’s public sector debt position.
What has been the impact on the markets so far?

  • A weaker rand, but not necessarily inflationary: The rand has lost about 10% since former Finance Minister Gordhan was recalled from his overseas trip. A 10.0% weakening of the rand, if sustained, will result in inflation going up by about 0.7%. However, at current levels of about R13.90/$, the rand is still 5% stronger than last year’s average level of R14.70/$. The current level of the rand is therefore not inflationary.
  • Bond markets have priced in the downgrade, which means there hasn’t been a significant sell-off: A rating downgrade usually drives more selling, as bonds no longer fall within mandates. However, we have seen very little trading in corporate bonds. In fact, if we compare local bonds to the bonds of other emerging market countries that had been cut to junk status, it becomes evident that South Africa was already priced for a downgrade.

What are the key concerns going forward?

  • If policymakers don’t respond appropriately, we could face another downgrade: S&P retained a negative outlook on the rating, suggesting that they may act again if there are no corrective actions taken. How policymakers respond to the downgrade is therefore going to be crucial. Unfortunately, National Treasury’s initial written response disappointed. It did not give the downgrade message the gravity or the respect it deserved. Going forward, faster fiscal consolidation and a more resilient budget will be critical, which means expenditure will have to be more aligned with revenue growth.
  • National Treasury will have to exercise fiscal restraint while facing demands for poverty alleviation: South Africa now has to go into debt counselling for a number of years, which means National Treasury will have a fine financial tightrope to walk. The greatest challenge will be exercising fiscal restraint to keep South Africa’s foreign creditors at bay while fulfilling the mandate of poverty alleviation and meeting education and healthcare demands.

What must government do and what will happen if they don’t get it right?
Our foreign creditors, who own over a third of government’s debt, are watching closely to see whether the necessary economic transformation is taking place. In a low-growth environment, government should focus on reducing wasteful expenditure in state-owned enterprises and incentivising the private sector to create jobs. Any economic misstep will hit the poor the hardest, resulting in outflows of foreign capital. Higher cost of servicing our debt will mean that there will be less money for social grants and a weaker exchange rate will fuel inflation, which will increase the cost of living for all South Africans.
The outlook for markets remain uncertain
The global backdrop is improving on the margin. All else being equal, this should be to the benefit of South African assets and the rand. The risk of additional downgrades to South Africa’s credit ratings, however, casts a new shadow over local assets. If sanity prevails and government takes steps in the right direction in the near future, this could have a significant impact on local bonds and the rand. But if there are no corrective actions, investors will be faced with the impossible challenge of determining whether local assets are priced cheaply enough to be rewarding despite the additional downgrade risk. At this stage, it’s best to stay cautiously optimistic.
The silver lining – South African corporates are stalwart survivors
The lack of growth of the local economy is in stark contrast with financial markets, which seem disconnected from the real economy. The JSE has delivered the best stock market returns in the world for the past century (1900 to 2016), outstripping the likes of the US, UK and all the European nations. This shows that our corporates have outlasted world wars, economic isolation and periods of extreme economic mismanagement. Today, the JSE is dominated by global companies that derive most of their earnings outside of our borders. For South Africans invested in a diversified portfolio of assets on the JSE, this should provide some level of comfort.

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