South African Politics to Trigger Downgrade

South Africa

Investors have been buying the South African rand in recent weeks, overlooking political risk that simmered and has now boiled over. These heightened risks are likely to cement a downgrade to sub-investment grade.

POLITICAL OUTLOOK

Reports suggest Finance Minister Gordhan is facing criminal charges. He was summoned to appear in court on November 2 to face fraud charges stemming from his first stint as Finance Minister. The matter relates to his approval of the retirement and subsequent reappointment of a former colleague that allegedly led to “fruitless” expenditures of ZAR1.1 mln ($77,000).

The head of the National Prosecuting Authority said there has been no political interference in the current matter, but we believe most investors see President Zuma’s fingerprints on this. Earlier this year, Gordhan was reportedly close to being charged on corruption charges stemming from his time as head of the South African Revenue Service. That issue remains alive as well, according to local press. This latest twist is just part of the ongoing split between Gordhan and Zuma.

Running parallel to the Gordhan developments is the ongoing Gupta saga. President Zuma has been linked to the influential Gupta family. Indeed, there are some who believe that Zuma purposely turns up the heat on Gordhan anytime that the spotlight shines on the Guptas. Last week, Public Protector Thuli Madonsela questioned Zuma in relation to her investigation into whether the Guptas wielded undue influence over government affairs.

Zuma has faced many political challenges and corruption scandals before, and so far he has prevailed. This time is probably no different, as there does not seem to be anyone strong enough to challenge his leadership of the ruling ANC. Zuma cannot run again and so a new leader will be chosen at the party summit in December 2017. That choice will set the tone for the party in the post-Zuma period. Populist or pragmatic? Only time will tell.

We believe that the ANC’s losses in the recent local and municipal elections have serious implications for policy. At 53.9%, the ANC’s support is the lowest it’s been in the post-apartheid period. Our base case is that the ANC will lean more populist ahead of the 2019 general elections, in an effort to buy back popular support.

ECONOMIC OUTLOOK

The economy remains weak. GDP growth is forecast by the IMF at 0.1% in 2016, down from 1.3% in 2015. Growth is seen picking up to 0.8% in 2017 and 2.7% in 2018. GDP rose 0.6% y/y in Q2, after a -0.1% y/y reading in Q1. So far, Q3 indications suggest that the slowdown is carrying over into H2.

Price pressures are easing, with CPI rising 5.9% y/y in August. This is the lowest rate since December and back within the 3-6% target range. This should allow the SARB to keep rates steady for now. However, the rand is the wild card and recent weakness (if it persists) suggests upside risks to inflation ahead.

Monetary easing is unlikely to be contemplated until we are well into 2017. The central bank next meets November 24, and no change is expected. The central bank has been on hold since the last 25 bp hike back in March took the policy rate to the current 7.0%.

Fiscal policy has remained prudent under Gordhan, but that may change. Gordhan is scheduled to present his Medium Term Budget Policy Statement to parliament on October 26, but this has been thrown into confusion by these latest reports of Gordhan being charged. At the core of the conflict is Zuma’s reluctance for further austerity measures. Whatever the outcome of the current investigations, it’s clear that Gordhan’s hands are likely to be tied and that further austerity is unlikely.

The IMF estimates that the budget deficit was around -4% of GDP in 2015. It is expected to narrow slightly to around -3.5% this year and -3% in 2017. This seems way too optimistic, as the economy is barely expanding. Gordhan has announced several rounds of spending cuts already, but we feel that pro-cyclical fiscal policy rarely works. Revenue growth is slowing, pushing the 12-month budget deficit up to -ZAR172 bln in August, the highest since January 2015 and around -4% of GDP.

The external accounts have improved but bear watching. Lower commodity and gold prices have hurt exports, but low energy prices and sluggish growth have helped reduce imports. The current account gap was around -4.5% of GDP in both 2014 and 2015, but is expected by the IMF to narrow to -3.3% in 2016 and -3.2% in 2017. With oil and energy prices on the rise, we see upside risks to the external imbalances.

Foreign reserves have risen modestly. At $47.25 bln in September, they cover only 4 months of import and are only about 1.25 times larger than short-term external debt. FDI remains low, and so as the current account deficit widens, the nation will have to rely more on hot money flows to finance it.

INVESTMENT OUTLOOK

The rand has generally outperformed this year after a poor 2015. In 2015, ZAR lost -25% vs. USD. This compares to the worst performers ARS (-35%), BRL (-33%), COP (-25%), and RUB (-20%). So far this year, ZAR is still up 8% YTD and is lagging only the best performers BRL (+23%), RUB (+17%), and COP (+9%). Our EM FX model shows the rand to have VERY WEAK fundamentals, so this year’s outperformance is not warranted.

USD/ZAR is up nearly 4% today. The pair is on track to test the September 12 high near 14.59. After that is the September 1 high near 14.75. Recent buyers of ZAR have blissfully ignored political risk at their own peril.

South African equities have underperformed this year after a solid 2015. Last year, MSCI South Africa was -2% while MSCI EM was -17%. So far in 2016, MSCI South Africa is up 4% YTD and compares to +13% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has South Africa at a VERY UNDERWEIGHT position.

South African bonds have outperformed slightly this year. The yield on 10-year local currency government bonds is about -73 bp YTD. This is behind the best performers Brazil (-522 bp), Indonesia (-163 bp), and Colombia (-159 bp) and ahead of the worst performers Poland (+13 bp), the Philippines (-3bp) and China (-17 bp). With inflation likely to remain elevated and the central bank on hold for the time being, we think South African bonds will start to underperform, especially with political risk picking up.

Our own sovereign ratings model has South Africa at BB/Ba2/BB. The agencies have been very patient with South Africa, but we think these latest political convulsions may be the last straw and trigger downgrades to sub-investment grade. Recent downgrades to Turkey underscore the fact that 1) politics are important and 2) agencies won’t hesitate to take away investment grade ratings.

Where do the agencies stand currently? Moody’s put its Baa2 rating on review for possible downgrade in early 2016, and is scheduled to publish its rating review November 25. S&P moved the outlook on its BBB- rating from stable to negative late last year, and it warned last month that “there is a concern that political tension stifles the reform effort, so that must be watched.” S&P is scheduled to publish its rating review December 2. Elsewhere, Fitch cut its local currency rating by a notch to BBB- back in July, matching its foreign currency rating that it affirmed in June. Both ratings have stable outlooks, which we find very surprising.