S.A. Investment Note: Politics to the fore

PUBLISHED: Tue, 06 Sep 2016 13:59:54 GMT

Politics came to the fore in August, in both a positive and a negative way. On the positive side, the 2016 local government election was largely free and peaceful and voters showed that they were prepared to hold politicians accountable, especially in the metro areas. All parties involved also accepted the outcome of the polls. While local governments do not usually influence macroeconomic policy, it is notable that those parties with a radical economic agenda failed to make big inroads, showing that the risk of a major shift to populist policies seems limited.

On the negative side, fears that Finance Minister Pravin Gordhan would be arrested and removed from his post, and concerns over the direction of governance and economic policy in general, resulted in a sell-off of the rand and interest rate-sensitive assets. It also highlighted significant divisions within Cabinet, which does not bode well for implementing the reforms identified by ratings agencies as necessary to lift the economic growth rate and sustain our investment grade rating.

Data showed improvement, but recent numbers mixed

Renewed political uncertainty threatens to further dent confidence in the economy just as data seemed to be pointing to a slight upturn. StatsSA is expected to announce a fairly strong second quarter economic growth number this week, following the first quarter’s decline. However, data for the third quarter so far is mixed.       

The most recent Barclays purchasing managers’ index (PMI) focusing on manufacturing data is concerning. The PMI unexpectedly slumped from 52.5 index points in July to 46.3 in August (with 50 index points separating growth from contraction). This was surprising, given that the PMI remained above the neutral level for the previous five months, highlighting the vulnerability of the sector. A decline in new sales orders and business activity was the main reason for the much weaker PMI. However, businesses remain optimistic that conditions will improve over the next six months.

Credit growth slowed in July. Total loans and advances grew by 6.7% year-on-year in July, down from 7.2% in June. Although corporate borrowing is down from the previous month, it continues to be the big driver with 12.3% annual growth. Household borrowing has also slowed down dramatically with interest hikes of 200 basis points since January 2014. After adjusting to the removal of African Bank’s “bad bank” from the numbers, household credit growth was only 3.7% year-on-year, down from earlier in the year and well below inflation and income growth rates.

Mortgage lending grew by 5.7% year-on-year in July, but this was mainly driven by commercial mortgages. Banks’ home loan books only grew by 3%, pointing to further sluggishness in the domestic residential property market. Instalment credit, which is mainly used to finance vehicle purchases, grew by only 1% between July 2015 and July 2016.

According to industry body Naamsa, the number of new vehicles sold fell further in August. However, StatsSA data shows a significant increase in the value of used car sales this year, with consumers clearly shifting away from new to used cars. One reason is that new car prices are increasing sharply as a significant number of new vehicles and components are imported.

On the positive side, South Africa posted a R5 billion trade surplus in July, and the surplus for the year-to-date of R17 billion is still a remarkable improvement on the R24 billion deficit posted over the same period in 2015. The improvement stems from a 10% growth in exports, driven mainly by precious metals and vehicles (about half of locally manufactured vehicles are exported, compensating for the decline in domestic demand).

Imports grew only 3%, with the lower oil price contributing to a R22 billion saving on our oil import bill for the first seven months of 2016 compared to the first seven months of last year. At current levels, the rand is certainly weak enough to continue supporting export growth.

Rand under pressure

The rand’s response to renewed political uncertainty has been severe, but had a strong rally that was helped along by the positive reaction to the elections. It has also been worsened by increased uncertainty over the timing and extent of US interest rate increases following comments from key Federal Reserve officials over the past two weeks. However, Friday’s payroll numbers indicating the US economy added 151 000 jobs, less than expected, complicates the case for a US rate hike later this year.

Unlike December’s “Nenegate” episode, which occurred in the midst of a global sell-off of emerging market assets, the current standoff between Minister Gordhan and the Hawks is fortunately taking place against a more favourable global backdrop for emerging markets. Year-to-date, emerging market equities are also leading developed market equities in US dollars with a return of 15% against 5.5%.

With the weaker rand and the prospect of a ratings downgrade, it is no surprise that local interest rate-sensitive assets have been knocked hard. The 10-year South African government bond yield rose from 8.6% to 9% during the month of August, but was still well below 9.7% where it started the year. The All Bond Index lost 1.7% in August, cutting year-to-date returns to 11.7%. Over one year, the ALBI delivered a disappointing 4.5%, lagging cash and inflation.

Listed property followed bonds sharply lower, with a loss of 4.8% in August. Year-to-date, the asset class has returned a respectable 7.6% but the twelve-month number has rolled down to 3.5%. The JSE Financials Index lost 3.3% in August, wiping out most of the year-to-date gains. Over one year, the sector lost 4%. However, rand hedge industrials rallied in August and lifted the JSE All Share Index to positive territory for the month.

Living with political uncertainty – focus on valuations

Political uncertainty flared up over the past two weeks, causing anxiety for both investors and ordinary citizens.  However, the most important political development over the past month in terms of its longer-term implication for the country was the local government elections and not the Hawks’ treatment of Minister Gordhan. The latter is obviously unsettling, but it is important to focus on valuations. For example, the local bond market is clearly pricing in the uncertainty.

Credit default swaps on government bonds suggest that the market is already treating South Africa as a sub-investment grade economy. Real yields are elevated relative to where inflation is expected to be over time, while short-term interest rates are in peak territory. This suggests remaining overweight to local fixed income.

The rand volatility over the past year in particular is a reminder of the importance of diversification, since markets seldom move in one direction and can be unpredictable over the shorter term. When the rand weakens, offshore investments and rand-hedge shares tend to benefit. Interest rate-sensitive assets such as bonds, listed property and bank shares do well when the rand strengthens.

Nobody knows where exactly the exchange rate will be in the future, but the massive 16% annualised depreciation against the dollar over the past five years suggests that the worst is probably behind us.  A fearful concentrated portfolio of rand-hedges could therefore be a risk – we’ve seen how quickly the rand can rally when conditions were in its favour this year.

It also remains true that over longer investment horizons, short-term volatility fades away. The key for investors remains to have an appropriately diversified portfolio built around long-term goals and the time available to meet those goals. Our Strategy Funds provide such diversification on an ongoing basis, with a combination of local and global asset classes and a spread of fund managers. Once in place, the most important thing for investors (but often the most difficult) is to avoid making investment decisions based on emotional responses.

Chart 1: Rand-dollar exchange rate and South Africa’s 10-year government bond yield

Source: Datastream

Chart 2: South Africa’s imports and exports (R million, seasonally-adjusted and smoothed)

Source: SARS

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