Global sector risk downgrades point to trouble ahead including South Africa?

Ludovic Subran, chief economist at Euler Hermes.

• Analyzes 18 sectors in 72 countries (~1300 industries): 1 in 4 industries in sensitive or high- risk territory in 2016 • Metals and machinery & equipment sectors experienced notable worsening risk of non-payments in 2015. Pharmaceuticals and IT services fared better. • Latin America, GCC countries and Russia faced the strongest 2015 deterioration in their sector risk profiles. Europe the only region with a slight improvement. • 5 must-haves for businesses: Resilience to prolonged low commodity prices; Precision in targeting markets amid China, Brazil and Russia turmoil; Strength to face increasing debt and credit risk; Speed to tackle disruption; Agility to cope with the upcoming M&A wave and fiercer price pressures. • The business environment in South Africa remains clouded by ongoing structural rigidities and current economic and political uncertainties.

2016 is turning out to be a tough year for corporates as companies face a series of short- and long-term challenges, as analyzed by Euler Hermes, the worldwide leader in trade credit insurance. A report, titled Let the Sector Games Begin - Companies are having an early start at their own Olympics, offers insights into the daily life of companies in South Africa and worldwide who did not wait for the Rio Olympics to be put to the test. The report analyzed sector risk changes for 18 economic sectors in 72 countries (~1,300 industries).

South Africa: short-term factors add to structural reforms

The business environment in South Africa is clouded by ongoing structural rigidities, including uneasy labor relations and periodic disruptions to power supplies, and is compounded by at least four other factors: (i) weak international commodity prices, with commodities accounting for 14% of total GDP; (ii) slowdown in China, the country’s largest trade partner; (iii) drought conditions, with weakened agricultural output and import of maize and other foodstuffs; and (iv) uncertainties relating to U.S. monetary policy tightening.

GDP growth was an annual average +5.4% in 2004-07 but the ten-year average to end-2015 was +2.6%. Rates of expansion of around +5% are required to make meaningful improvements in incomes and living standards. However, structural impediments have generally limited GDP growth to below that rate. These constraints include a lack of skilled labor, limited job creation (capital intensive industry), high unemployment and underemployment, infrastructure bottlenecks, weak public sector delivery and disruptions to power supplies. An official estimate puts potential growth within a range of +1.9% to +2.3% but Euler Hermes expects annual GDP growth is likely to be below the lower limit of this range in 2016 and 2017.

“Against this background, said Ludovic Subran, chief economist at Euler Hermes –business failures are more likely and insolvencies in South Africa will increase by +10% y/y in 2016, which will be the first outright deterioration since 2009 and the global financial crisis. The construction sector is already registering an increase in insolvencies. Moreover, a significant lengthening in Days Sales Outstanding (DSO, the average number of days that receivables remain outstanding before they are collected) is already apparent in several sectors such as retail, food and technology”.

“Management teams will need to keep a cool head in the coming months, after the adrenaline rush caused by volatile financial markets. In 2015, 148 industries were downgraded in our analysis, and only 76 were upgraded. As a result, 2016 started with 1 in 4 industries in sensitive or high-risk territory. For South Africa, Euler Hermes downgraded three sectors: automobiles, computers & telecom and metals”.

Euler Hermes identified five macro challenges for corporates for the remainder of 2016, using its sector risk approach:

1. Protracted period of low commodity prices

Euler Hermes forecasts subdued oil prices will prompt an estimated 25 per cent fall in oil-related investment activity, which will weigh heavily on the machinery & equipment sector. In contrast, transportation is the big winner due to low oil prices - with 8 upgrades in 2015, especially in Europe. Other commodities such as iron ore are predicted to face a further price decrease. This will continue to impact the metal sector, for which most countries (61 of 72 monitored) already have a sensitive or high risk rating by Euler Hermes underwriters. South Africa is a significant mining economy, so any positives deriving from low oil prices are offset by negatives resulting from weak ore and metal prices.

2. Turmoil in emerging markets

Emerging markets witnessed an unprecedented number of sector risk downgrades (122) in 2015, vs a limited number of upgrades. Africa and the Middle East, and Latin America experienced 39 and 34 sector downgrades, respectively. Brazil is in the eye of the storm with 15 out of 18 industries facing a sensitive or high risk of non-payment. In contrast, Western Europe helped balance the global risk profile with 24 sector upgrades.

3. Increasing debt, payment terms and credit risk

Days sales outstanding (DSO), a key indicator of cash flow as well as insolvencies, are increasing worldwide. In China, DSO already increased by almost 20 days since 2009 to exceed 80 days in 2015; insolvencies are expected to increase by +20% in 2016. Alarms are sounding for debt levels, even adjusted for cash. Indeed, net gearing ratios are as high as 108% for metal, and 92% for both machinery & equipment and paper. For South Africa, DSO in 2015 remained slightly above 45 in average, but EH forecasts deterioration of 2 days in 2016.

4. More disruption

While the investment cycle has remained subdued amid global volatility and economic uncertainty, disruption entails further risk for traditional industries. Retail is one striking example, with the rise of e-commerce and mobile technology already representing USD 3.5tn. Distance to the consumer, divestment from R&D and dependence on infrastructure are the three determinants for growing risk of disruption when comparing industries worldwide.

5. Another M&A wave

Increasingly, corporates are exploring acquisition options as organic growth opportunities diminish. Euler Hermes expects global M&A to exceed again USD 4tn this year, with deal volumes rising 10% to 20,000 transactions. These figures are driven by buoyant activity in the chemicals, pharmaceuticals and technologies sectors. Cross-border deals driven by Asian corporates targeting European firms were particularly dynamic in 2015 -- a +17% increase. For some time, South African corporates faced with limited growth potential in their domestic markets have sought M&A opportunities elsewhere in Sub-Saharan Africa and further afield.

Chart 3: Sector sensitivity to top 5 economic challenges in 2016

Source: Euler Hermes

“In some sectors – such as energy, machinery & equipment and metals - companies are caught between short-term challenges including low commodity prices, erratic emerging market demand and debt overhang, as well as rapid disruption and unwanted consolidation over the medium term,” concluded Subran.