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The big picture on SA’s debt

04 February 2021 Gareth Stokes

Fixed income managers entered 2021 with plenty of attractive yield on the table; but there are growing concerns about the risk attaching to these yields. Peter Kent, Co-Head of SA & Africa Fixed Income at Ninety One, used the asset manager’s 2021 Insights presentation to reflect on various challenges to the domestic economy including government’s obsession with governance rather than growth, and the looming fiscal crisis. He observed that the US Federal Reserve’s ongoing response to the global pandemic would have a significant impact on both emerging and developed market asset prices. This is evidenced by the ‘breather’ enjoyed by emerging markets on the back of dollar weakness, in turn caused by record quantitative easing (QE) through 2020.

A feeling of déjà vu

Financial advisers and their clients can be excused for feeling as if the 2020 market dynamics have played out in a previous lifetime… “We are facing similar fiscal circumstances to those experienced in 2013; but the yields are different,” said Kent. He noted that in 2013 local fixed income managers faced 6% inflation, with cash yields and the yield on the R186 government bond at the same level. “[At the time] we had to invest in 10-year government bonds to beat inflation, which meant taking on a lot of capital risk,” he said. Nowadays fund managers can match or beat inflation, currently at around 4%, at virtually every bond duration: “You have to take a lot less duration risk, from an income perspective, to beat inflation”. 

The above scenario explains why South Africa-based fixed income funds have lured in so much capital over the past 12 months. Unfortunately, the high yield / high income environment is counterbalanced by higher risk. According to Kent the main risk centres on the country’s fiscal outlook. Ninety One has completed a number of case studies into debt sustainability in an attempt to gain a clearer understanding of the risk facing fixed income managers. The baseline case, informed by South Africa’s Medium Term Budget Policy Statement (MTBPS), is that government will have to borrow R572 billion per annum over the next eight years. This compares to around R200 billion in 2018, R300 billion in 2019 and a staggering R780 billion last year. 

The bigger issue: Can we afford the debt?

“Will the bond market be there to sustain that level of borrowing in each of the next eight years?” asked Kent. Being able to borrow enough to fund country’s spending is one side of the equation, the other is whether we can afford to repay the interest on this amount. South Africa has historically spent about 12-15% of tax revenues on servicing debt interest. “Under the new base case we are nearing 25% of revenues spent on interest payments which is a big chunk compared to our spending on social needs,” said Kent. He observed that developed economies could borrow much more due to the lower prevailing interest rates in those markets. The interest side of the equation is the binding constraint. 

There are six fiscal approaches or policy positions that government, National Treasury and the South African Reserve Bank (SARB) might use to alleviate the borrowing and repayment burden. We will discuss each of them in bullet points below. 

  • Option 1: Financial repression. Government introduces measures to channel funds from the private sector to the public sector in attempts to reduce its overall debt burden. We can think of two major financial repression initiatives currently taking place domestically, being the months-long debate about prescribed assets and the establishment of a National Health Insurance Fund. The former policy will allow government a cheap source of funds for major infrastructure projects and the latter is a stealthy reallocation of private healthcare resources to the public sector. Foreign exchange controls are a third example. 
  • Option 2: Inflation. It is possible to mitigate the effects of a high debt burden by allowing inflation to trend higher. This is something that both developed and emerging markets seem reluctant to do, thankfully. “The difficulty with this option is that you cannot create a little more inflation without damaging the bond markets,” said Kent. Ninety One said that the domestic inflation outlook was stable through 2021/22; but that it was unlikely the SARB would announce further rate cuts from the current Repo of just 3.5%. 
  • Option 3: Economic growth. A return to 3% per annum GDP growth will solve many of South Africa’s debt and interest problems. Under this scenario government could reduce its borrowing requirements over the next eight years to R409 billion per year. The interest servicing charge would also reduce to 21% of revenues. 
  • Option 4: Taxation. There is a growing consensus among market commentators and economists that further tax hikes will be unsustainable. Tax revenues have been eroded by the number of job losses through pandemic and the knock-on impact of pay-cuts and falling business profits, among other factors. It is therefore unlikely that revenue shortfalls through pandemic will be recoverable by raising taxes. Government will most likely explore additional wealth taxes as an easy win following a year in which sin taxes plummeted due to lengthy alcohol and tobacco bans. 
  • Option 5: Reduce spending. Your clients are familiar with the concept of balancing their monthly incomes with expenditures; government not so much. The mainstream news is chock full of reports about the above-inflation increases enjoyed by public sector workers and the cost-inflation due to corrupt and incompetent procurement processes. These ‘ills’ have established and grown over the past two decades. Not surprisingly, government’s attempts to rein in public sector wages are being met with resistance, with court battles looming. Success is non-negotiable but not guaranteed. 
  • Option 6: Funny money. This policy is best described as wanton money printing by a country’s central bank. This money is then used to buy bonds and underpin other expansive monetary policy initiatives. Central bank printing and buying bonds is dangerous because without fiscal discipline we end up with currency devaluation and inflation. 

Kent said that South Africa needed to focus on Option 3 and Option 5. “We need to increase economic growth and reduce spending,” he said, before warning that the country’s debt was close to the edge in terms of sustainability. Failure to exercise these options will push the country nearer the fiscal cliff. What should income fund investors expect from 2021? 

According to Kent, Ninety One has a yield of close to 6.5% “baked in” for 2021 in fixed income portfolios that are designed to participate in the yield on offer and protect investors from unexpected shocks. These portfolios are characterised by limited duration bonds; small risk-mitigating offshore exposures diversified against dollar weakness; and low exposure to property. They said that in the event the US Federal Reserve implemented reforms through 2021 investors might see bond yields dip 100 basis points lower; but that there are “circuit breakers” in place if these reforms do not emerge. “2020 was a year during which the impact of years of corruption and state incapacitation really came to the fore,” concluded Kent. “A capable state is crucial to growth and what we want to achieve as a country in 2021 and beyond”. 

Writer’s thoughts:
Local fixed income fund managers seem confident they will deliver inflation-beating returns from their diversified portfolios. And they are promising 2.5% real returns despite the risks in the domestic bond market. Will you be steering your clients towards fixed income opportunities through 2021, or do you believe they are better served in riskier asset classes? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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