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SONA: So near, yet so far

18 February 2020 Izak Odendaal and Dave Mohr, Investment Strategies Old Mutual Wealth

It’s February, and Cape Town is hot and windy. It is also full of politicians.

The annual State of the Nation Address (SONA), which coincides with the opening of Parliament for the year, took place last week with the usual pomp and circumstance. It also marked the 30th anniversary of the release of Nelson Mandela and the start of far-reaching changes as the country moved away from apartheid towards democracy. Yet the mood was hardly festive.

The current and future state of the nation
The country faces challenges on many fronts, both short-term and long-term in nature. Unemployment is at 29.1% and youth unemployment is even higher, horrifically so. The associated ills of poverty, inequality, crime and substance abuse remain widespread. Meanwhile, the global environment is undergoing potentially deep changes. The trend toward openness and globalisation that allowed emerging economies to grow by tapping into global supply chains appears to be going into reverse.

South Africa might be forced to choose between a US-led or China-led sphere when it comes to trade and technology systems. Looking further ahead, climate change risks are massive for an arid country like South Africa that already struggles to maintain its water infrastructure. Our vast coal reserves might also end up being worthless. And, of course, there are worries that artificial intelligence will eventually replace those of us still lucky enough to have jobs today.

Chart 1: South Africa unemployment rate, %
Source: Stats SA

The most severe immediate challenge, however, is electricity. December’s shocking manufacturing production numbers (-5.9% year-on-year) are a testament to the impact of load-shedding. Eskom cannot postpone maintenance on its ageing fleet of coal-fired power stations any longer, while unplanned outages also remain high.

Load-shedding is therefore expected to be persistent for the remainder of the year. Kusile and Medupi, the giant new power stations, are still beset with problems and some way away from completion. Meanwhile, the billions of Rands that Eskom borrowed to build them threatens the financial viability of the company. President Ramaphosa spent a lot of time on the electricity crisis in his address and repeated the positive announcements of recent weeks, namely that companies and some municipalities will be allowed to generate their own electricity, the next bidding round for renewable energy projects will be opened and the government is looking at stop-gap measures to soften the blow of rolling blackouts in the interim.

Chart 2: South Africa electricity production index (smoothed)
Source: Refinitiv Datastream

Deeds, not words
Other than that, did SONA deliver for investors? SONA is largely ceremonial and typically lacks both big-bang announcements and granular details. This year was no different. But when it finally got going, after a long interruption, the emphasis on specific initiatives rather than grand visions was good.

But as usual, it is implementation, not promises, which count. Some of these initiatives have been on the cards for years, particularly the rationalisation and right-sizing of State-Owned Enterprises. President Ramaphosa also acknowledged that the Umzimvubu Dam in the Eastern Cape was first promised in the 2012 SONA, with precious little progress to date. This time it’s really going to be built (perhaps).

Be realistic
The clamouring has grown ever louder for President Ramaphosa to “do something,” “be bold” and make “tough decisions”. But we need to be realistic. Unions have a disproportionate influence in South Africa and also form his political base inside the ruling alliance. It is inconceivable that he will “take them on”. Such a step would be doomed from the start. His preferred approach, to build consensus among the various social partners around key reforms, is extremely slow-moving and thus frustrating to outsiders but ensures that reforms will stick. The old proverb is apt, “ If you want to go fast, go alone; if you want to go far, go together.”

President Ramaphosa, therefore, placed a big emphasis on social compacting in his speech. Recent talks between unions, big business and government on the issue of Eskom’s debt are promising. Even if the proposal of using the Government Employees Pension Fund – which is a defined benefit fund and therefore also a form of state liability – to absorb some of Eskom’s debt proves to be unworkable, the fact that negotiations are taking place is important. Ultimately, to fix the country, everyone will have to give up something. The burden of reforms cannot fall on one group alone. That would be politically untenable.

With reference to the dire state of public finances, the President raised expectations that Finance Minister Mboweni will announce spending cuts and a moderation in the growth of the public sector wage bill in next week’s Budget Speech. The latter, in particular, will need buy-in from unions, and there is no indication yet that this has been achieved. We’ll have to wait and see.

Similarly, while Treasury’s economic growth plan was punted, it is not clear whether there is strong backing for this throughout the ruling alliance. Implementing these reforms can see South Africa returning to real growth rates of 2% to 3%. To get to the mythical 5% to 6% growth rates, the ideological preference for heavy state intervention in the economy – despite evidence of its ineffectiveness – will need to be abandoned.

There are, however, a number of economic reforms that are not politically or ideologically contested and can take place immediately. Making it easier for tourists to visit the country is an obvious example. Nobody wins from unnecessary red tape and steps are underway to address these. The issue here is one of bureaucratic inefficiency, rather than interest groups fiercely protecting their turf. Similarly, the release of spectrum to lower broadband costs is not politically contentious and this process is currently being run by regulator Icasa. These steps can raise the economic growth rate over time, but are unlikely to give the economy a short-term boost.

In summary then, there is progress, but it is slow going. That is simply the reality. Growth will remain subpar for some time as government does not have money to stimulate the economy. (It is not clear where the money for the mooted sovereign wealth fund will come from. Perhaps the government is anticipating a bonanza from oil and gas production.)

Operation Orange Overall
For many people, only the prosecution of ‘state capturers’ will be tangible evidence that things are changing. The lack thereof is a source of anger and frustration. However, this is the one area where the President should absolutely not get involved. The government should ensure that the investigative and prosecuting authorities are properly resourced – which is happening – and then leave them to work independently without political interference. The wheels of justice always turn slowly.

Portfolio implications
How much does all of this matter from an investment point of view? As important as these things are for us as citizens and taxpayers, as investors, our perspective should be global.

This is because we can invest in global markets (up to 30% in a retirement fund, more in non-regulation 28 funds), but more importantly, because global market developments shape what happens on local financial markets. For instance, what US Federal Reserve Chair Jerome Powell said in semi-annual testimony before Congress last week is more important for the rand than what President Ramaphosa said in Parliament. The local currency has similarly been batted about as investors grapple to establish just how serious a threat the newly renamed Covid-19 coronavirus is for the global economy. SONA is small fry compared to these global forces.

For local equity investors, the continued depressed state of the local economy has weighed on returns from JSE-listed shares, but probably not as much as most would imagine. For instance, the fact that Sasol’s share price is at a 12-year low has more to do with the botched delivery of its new American ethanol plant than anything domestically. Many other major JSE-listed shares have little or no exposure to the local economy and their performance or lack thereof is unconnected to local developments. But for the rest, the local economy matters, both in their ability to generate earnings, and for how much investors are prepared to pay for each rand of earnings.

In other words, what matters is both profitability and sentiment. Both are at low levels and this is reflected by the fact that many locally-focused companies trade on low price:earnings multiples. The initiatives announced in the SONA could raise the economic growth rate over time if properly implemented and if not contradicted by different policies. However, the time frames involved are probably years, not months. We are therefore not in a rush to change our underweight allocation to local equity and property.

While the rapidly increasing government debt and shaky credit rating poses a risk to local bonds, it is a known risk. Known risks tend to be priced into markets. Moreover, we are still in a global lower-for-longer interest rate scenario. Major central banks are more afraid of deflation than inflation (and ready to go even lower should Covid-19 cause deep economic damage). This puts a lid on how high local yields can rise even if South Africa’s fiscal deterioration is not halted. Case in point: last week Greek 10-year bond yields fell below 1% for the first time.

The spread over equivalent German yields, another key indicator of how risky Greece is considered by investors, fell back to levels last seen before its crisis started in 2010. Partly this reflects the fact that Greece, having taken its very bitter medicine, has stabilised debt, albeit at very high levels (about 180% of GDP, compared with 60% for South Africa). This stabilisation effort, which required running a budget surplus, has seen its Moody’s credit rating improve from Caa3 to B1, still four notches below South Africa. But the sub-1% yield also reflects the low global interest rate environment. South African bonds are therefore still extremely attractive for their real yields. When the economy does eventually turn around, they can deliver price gains as well.

 

Chart 3: 10-year local currency government bond yields, %
Source: Refinitiv Datastream

Time for change
Greece’s real per capita income is 15% below pre-crisis levels and was written off by many, but as soon as some progress was visible, markets responded positively. The fact that this is now happening, almost a decade later, is evidence that time can heal even deep wounds. Locally, the process of local institutional rebuilding and economic reform is also underway, if in fits and starts. This also needs time, so don’t give up.

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