South Africa’s Outperformance Unsustainable as Fundamentals Worsen

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Despite weak fundamentals, South Africa assets continue to outperform. We not think this can be sustained, as this liquidity-driven rally can only go so far as the economic outlook deteriorates.

POLITICAL OUTLOOK

For now, Finance Minister Gordhan seems secure in his post. However, he has the unenviable task of maintaining budgetary discipline even as the economy flirts with recession. Gordhan recently said that it may be time to rethink austerity, suggesting that even the pragmatic Finance Minister has reached his limits.

The institutional framework in South Africa is backsliding. The World Bank’s Ease of Doing Business Index ranks South Africa at 73 out of 189 countries covered in 2016, down from 69 in 2015. Its raw score worsened too, dragged down by starting a business, dealing with construction permits, and getting credit.

The unemployment rate fell marginally to 26.6% in Q2. However, it remains near the all-time high of 26.7% in Q1. Furthermore, the drop was largely due to a lower participation rate. The number of total employed actually fell in Q2. Social tensions should remain high as a result.

Despite numerous scandals, President Zuma looks likely to serve out his second and final term. The next elections are scheduled for 2019, with the ruling ANC likely to continue its dominance. However, municipal elections on August 3 will be watched closely for clues. The populist splinter group Economic Freedom Fighters (led by ex-ANC youth leader Julius Malema) will be contesting municipal polls for the first time. Elsewhere, the main opposition Democratic Alliance will be looking to increase its share of the vote.

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast to be stagnant in 2016 before it accelerates modestly to around 1% in 2017 and 2% in 2017 from 3.2% in 2015. GDP contracted -0.2% y/y (-1.2% q/q annualized) in Q1. This was weaker than expected, and points to downside risk to these forecasts.

Power shortages continue to hamper the economy. State power company Eskom is building two coal-fired plants, but they have run over budget and are years behind schedule. Yet Eskom CEO Molefe recently questioned the role of renewable energy. Eskom produces about 85% of the nation’s power from coal.

Price pressures are still evident, with CPI rising 6.3% y/y in June. This is the highest rate since March and suggests that the SARB will maintain a hawkish bias since inflation is still above the 3-6% target range. Still, with the economy so weak, the central bank has opted to keep rates steady for two straight meetings now, the most recent meeting being just last week. The SARB next meets September 22. A lot can happen between now and then, and we think the major factor will be the exchange rate.

Despite the Finance Ministry fiascos, fiscal policy has remained fairly prudent. Yet Gordhan is tasked with tightening fiscal policy in the midst of a no or slow growth environment. The IMF estimates that the overall budget deficit came in around-4% of GDP in 2015. It is expected to narrow slightly to around -3.7% this year and -3.6% in 2017. We think these forecasts are too optimistic. Both gross government debt and total external debt rose to more than 50% of GDP this year, and both are seen climbing further in 2017.

The external accounts bear watching. Lower commodity prices have hurt exports, but low energy prices and a sluggish economy have helped reduce imports. The current account gap was about -4.5% of GDP in 2015, and is expected to narrow slightly in 2016 before widening to around -5% in 2017. The gap stood at -5% of GDP in Q1 and has risen three straight quarters, so we see risks of wider than expected deficits ahead.

Foreign reserves remained steady, around $46 bln in June. They cover 4 months of import and are only about 1.2 times larger than short-term external debt. This makes South Africa particularly vulnerable to swings in market sentiment and hot money flows.

INVESTMENT OUTLOOK

The rand has performed well this year after a poor 2015. Last year, ZAR lost -25% vs. USD and was one of the worst performers in a group that included ARS (-35%), BRL (-33%), COP (-25%), and RUB (-20%). So far this year, ZAR is +9% YTD and is lagging only the best performers BRL (+21%) and RUB (+10.5%). Our EM FX model shows the rand to have VERY WEAK fundamentals, so this year’s outperformance should ebb.

South African equities have tended to outperform within EM. Last year, MSCI South Africa was -2% while MSCI EM was -17%. So far in 2016, MSCI South Africa is +11% YTD, and compares to +9% YTD for MSCI EM. This outperformance should also ebb a bit, as our EM Equity model has South Africa at a VERY UNDERWEIGHT position.

South African bonds have outperformed this year. The yield on 10-year local currency government bonds is -101 bp YTD. This is behind only Brazil (-458 bp), Indonesia (-173 bp), Peru (-158 bp), Russia (-104 bp), and Colombia (-102 bp). With inflation likely to remain high and SARB potential resuming its tightening cycle, we think South African bonds will start underperforming.

Fitch recently downgraded South Africa’s local currency rating by one notch to BBB- with a stable outlook. This moves it into line with its foreign currency rating. Fitch said it was part of a review applying new criteria. We have always felt that the local and foreign currency ratings should in general match up for every country. In addition, this move is a clear reminder that sub-investment grade ratings are likely to be seen this year from at least one agency. Our own model rates South Africa as BB/Ba2/BB.