South African Finance Minister Gordhan will present the annual budget for FY2017/18 this Wednesday. We believe tensions between Gordhan and President Zuma remain high, and that this budget could be the spark that triggers a final showdown between the two officials. POLITICAL OUTLOOK
We think markets are being too sanguine about political risk in South Africa. An ouster of Gordhan remains quite possible, and his replacement would likely follow more populist policies as per Zuma’s wishes. Furthermore, it’s not clear what direction the ANC will go after Zuma’s term ends. To us, there are too many political risks to go along with very weak economic fundamentals.
President Zuma is due to step down as the ANC leader this December. His second and last term as president will end in 2019. However, he wants to hand over the reins to his successor under good terms, and so Gordhan will be under pressure to deliver a populist, expansionary budget. So far, he has resisted these calls but it remains to be seen whether he can continue to do so.
Indeed, the National Treasury last week claimed that there were efforts to discredit its leadership ahead of the budget. Two days later, the ANC’s youth wing said Gordhan had failed to exercise proper oversight over a dozen banks accused by the nation’s regulator of rigging FX trades, and called for him to be held accountable.
Local press reports that a cabinet shuffle is imminent. Zuma may reportedly tap Brian Molefe to replace either Finance Minister Gordhan or Deputy Finance Minister Jonas. Gordhan later said that he is “not indispensable.” Markets would probably disagree.
The economy is still sluggish. GDP growth was an estimated 0.3% in 2016, and is forecast by the IMF to accelerate modestly to 0.8% in 2017 and 1.6% in 2018. In the October midterm budget statement, Finance Minister Gordhan cut his growth forecasts to 0.5% in 2016, 1.3% in 2017, and 2.0% in 2018. Market consensus (as measured by Bloomberg) is currently at 0.4%, 1.1%, and 1.6%, respectively. This is more pessimistic than Gordhan’s October forecasts.
Price pressures may have topped out, with CPI decelerating to 6.6% y/y in January. This is down from the cycle high of 6.7% in December, but remains above the 3-6% target range for the fifth straight month and for 11 of the past 13 months. Core inflation also decelerated to 5.5% y/y from the cycle high 5.9% in December.
The tightening cycle has likely ended, but easing seems likely to be a late 2017 story, if not early 2018. The central bank last hiked rates 25 bp to 7.0% in March 2016 but has been on hold since. Next policy meeting is March 30, and no change is expected then.
Fiscal policy has remained prudent despite pressure on Gordhan. In the face of populist pressures from Zuma and his wing of the ANC, Gordhan has been able to deliver substantial spending cuts and tax hikes in his efforts to prevent a blowout in the budget deficit.
Given the state of the economy, we believe Gordhan will have to acknowledge downside growth risks and upside budget deficit risks in the FY2017/18 budget. In last October’s midterm review, Gordhan had to introduce a variety of spending cuts (ZAR26 bln) and revenue measures (ZAR43 bln) to keep a lid on the budget gap. For the initial FY2016/17 budget submitted last February, Gordhan forecast deficits of -3.2% of GDP, -2.8%, and -2.4% in FY2016/17, FY2017/18, and FY 2018/19, respectively.
In the midterm speech in October, he had to revise these forecasts to -3.4%, -3.1%, and -2.7%, respectively. However, Gordhan stuck to the forecast -2.5% in FY2019/20. Market consensus is slightly more pessimistic. According to Bloomberg’s survey, the budget deficit is seen at -3.5% of GDP in FY2016/17, -3.2% in FY2017/18, and -2.8% in FY2018/19.
The external accounts bear watching. Lower commodity prices have hurt exports, but low energy prices and the sluggish economy have helped reduce imports. The current account gap was about -4.1% of GDP in 2016, but is expected by the OECD to widen to -4.2% in 2017 and -4.3% in 2018. Foreign reserves fell to $46.7 bln in January, the lowest since August. They cover 4 months of import and but barely cover the country’s stock of short-term external debt.
The rand has outperformed after a poor 2015. In 2015, ZAR lost -25% vs. USD. This was one of the worst performers after ARS (-35%), BRL (-33%), and COP (-25%). In 2016, ZAR rose 12.5% vs. USD and was behind only BRL (+22%) and RUB (+20%). So far in 2017, ZAR is up nearly 5% YTD and is behind only RUB (+6%), KRW (+5%), and BRL (+5%). Our EM FX model shows the rand to have WEAK fundamentals, so this year’s outperformance is likely to ebb.
South African equities have underperformed after a relatively good 2015. In 2015, MSCI South Africa was -2% while MSCI EM was -17%. In 2016, MSCI South Africa rose less than 1% vs. a 7% gain for MSCI EM. So far this year, MSCI South Africa is up 2% YTD and compares to a 10% YTD gain for MSCI EM. This underperformance should continue, as our EM Equity model has South Africa at a VERY UNDERWEIGHT position.
South Africa bonds have performed OK this year. The yield on 10-year local currency government bonds is about -12 bp YTD. This is in the middle of the EM pack compared to the best performers Argentina (-239 bp) and Brazil (-109 bp) as well as the worst India (+39 bp) and Hungary (+36 bp). If inflation continues to fall and the central bank moves closer to cutting rates towards the end of this year, we think South African bonds may continue outperforming.
Our own sovereign ratings model shows South Africa’s implied ratings at BB/Ba2/BB. As such, we believe actual ratings of BBB-/Baa2/BBB- remain subject to significant downgrade risk. The loss of investment grade seems likely this year as the growth and fiscal outlook remains poor.