South Africa Finally Cut to Sub-Investment Grade; More to Come

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South African President Zuma’s decision to fire Finance Minister Gordhan could be a watershed moment for the country.  The move has already triggered a cut to sub-investment grade BB+ by S&P, and we see more downgrades ahead.

POLITICAL OUTLOOK

President Zuma instituted a cabinet shuffle last week that included the long-rumored ouster of Finance Minister Gordhan.  He was replaced by Home Affairs Minister Gigami, who is seen as a Zuma loyalist with no financial or market experience.  Gordhan’s Deputy Jonas was also fired.  Zuma also sacked the Ministers of Tourism, Energy, Transport, and Public Service while retaining those thought to be his strongest supporters.

The split in the ruling ANC is getting wider.  Zuma’s decision to shuffle the cabinet was made without consulting the ANC.  ANC Deputy President Ramaphosa, Secretary-General Mantashe, and Treasurer-General Mkhize (3 of the top 6 party officials) have all publicly opposed Zuma’s decision.  Andrew Mlangeni, chairman of the ANC’s Integrity Commission, has asked Zuma to step down as ANC leader.  So too has ex-President Motlanthe, who served as Deputy President to Zuma until May 2014.

Parliamentary Speaker Mbete said that she’s considering a request to recall lawmakers to debate an opposition-sponsored no confidence motion against Zuma.  Parliament is currently on break until May.  Zuma has fended off several no confidence motions in the past, due to the ANC’s overwhelming parliamentary majority.  Yet cracks within the ANC means that Zuma can take nothing for granted.

Zuma is in the final year of his second and final term as head of the ANC.  As such, any of his machinations should be seen through the lens of shaping his post-presidential life.  Clearly, Zuma wants to install someone who is loyal and will leave him alone.  A new ANC leader will be chosen in December 2017, who will then lead the party into the 2019 general elections.  The President is not directly elected by voters, but is instead chosen by parliamentary vote.

Vice President Cyril Ramaphosa is seen as the market-friendly candidate that will stick with fiscal austerity.  On the other hand, Zuma’s ex-wife Dlamini-Zuma seems to be the preferred choice for Zuma, and she would likely be viewed as a continuation of the status quo.  There have been press reports that Dlamini-Zuma will be given a cabinet position to help with the transition to party leader.  These two are the clear frontrunners now, though a lot can happen between now and December.

The only positive scenario we can draw from recent developments is if popular and parliamentary opposition leads to Zuma’s early exit a la Brazil’s Rousseff.  Perhaps the more orthodox wing of the ANC can wrest control from the Zuma wing, as Brazil’s Temer did.  Yet we cannot say this is the base case yet.  Perhaps we are giving him too much credit, but Zuma probably wouldn’t have made such controversial moves if he hadn’t shored up his support first.  Only time will tell.

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to accelerate modestly to 0.8% in 2017 from 0.3% in 2016.  GDP rose 0.7% y/y in both Q3 and Q4.  Monthly data so far in Q1 suggest some slowing in activity and so there are downside risks near-term.  Unemployment remains dangerously high at 26.5% in Q4, down from the 27.1% peak in Q4 but still very elevated.

Price pressures are falling, with CPI decelerating to 6.3% y/y in February.  This is the lowest rate since September, but has remained above the 3-6% target range since January 2016.  Governor Kganyago sees inflation falling back into the target range in Q2 and averaging 5.9% for the year.  However, the weak rand poses upside risks to inflation and bears watching.

Thus, the current inflation outlook supports the case for steady rates for the time being.  After its decision to keep rates at 7.0% last week, the bank signaled that the tightening cycle was over.  Indeed, one MPC member voted for a 25 bp cut then.  However, we think it’s too early to consider a rate cut.  Indeed, over the past few days of turmoil, FRAs have started to price in more tightening ahead, not easing.  The central bank last hiked rates 25 bp to 7.0% in March 2016 but has been on hold since.

Fiscal policy has remained prudent under Gordhan, but is clearly at risk going forward.  With a poor growth performance weighing on revenues, Gordhan and his predecessor Nene were forced to enact several rounds of fiscal tightening.  In last October’s midterm review, Gordhan introduced a variety of spending cuts (ZAR26 bln) and revenue measures (ZAR43 bln) to keep a lid on the budget gap.  Yet he still had revise his deficit forecasts higher to -3.1%, and -2.7% for FY2017/18 and FY2018/19, respectively.

In the latest budget statement in February, Gordhan stuck to the -3.1% deficit forecast for FY2017/18 but raised it to -2.8% in FY2018/19.  Market consensus is slightly more pessimistic.  According to Bloomberg’s survey, the budget deficit is seen at -3.2% in FY2017/18 and -2.9% in FY2018/19.  With Gordhan’s ouster, all of these forecasts are now subject to upside risks.  We have warned that Zuma will likely follow a more populist path ahead of the 2019 elections, and now the last obstacle may now have been removed.

The external accounts bear watching.  Lower gold and commodity prices have hurt exports, but low energy prices and the sluggish economy have helped reduce imports.  The current account gap was about -2% of GDP in 2016, but is expected by the IMF to widen to over -3% in 2017 and around -4.5% in 2018.  Foreign reserves have remained fairly steady and at around $47 bln in February, they cover over 4 months of import.  However, reserves barely cover the country’s stock of external short-term debt.

INVESTMENT OUTLOOK

The rand has started to underperform after a strong 2016.  In 2016, ZAR rose 13% vs. USD and was behind only BRL (+22%) and RUB (+20%).  So far in 2017, ZAR is up only 0.2% YTD and is ahead of only TRY (-3.3%) and PHP (-1%).  Our EM FX model shows the rand to have WEAK fundamentals, so we see greater underperformance in the coming weeks.

USD/ZAR is closing in on the 200-day MA near 13.7530.  That level also coincides with the 62% retracement objective of the big November-March drop for USD/ZAR.  Break above this area would set up a test of the November 18 high near 14.65.

South African equities continue to underperform.  In 2016, MSCI South Africa was up 0.6% vs. 7.3% for MSCI EM.  So far this year, MSCI South Africa is up 2.1% YTD and compares to 12.2% 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 underperformed recently.  The yield on 10-year local currency government bonds is +9 bp YTD.  This is ahead of only the worst performers Czech Republic (+43 bp), China (+26 bp), India (+13 bp), and Hungary (+11 bp).  If inflation continues to fall, allowing the central bank to cut rates late this year or early next year, then we think South African bonds can start outperforming more in H2.  However, this is a very big “if” in light of renewed ZAR weakness.

S&P was the first of the agencies to move, cutting South Africa one notch today to sub-investment grade BB+.  This should not come as a big surprise, as it has been long overdue.  We also agree with S&P’s decision to keep the outlook at negative.  The agency noted that “The downgrade reflects our view that the divisions in the ANC-led government that have led to changes in the executive leadership, including the finance minister, have put policy continuity at risk.  This has increased the likelihood that economic growth and fiscal outcomes could suffer.”

Our own sovereign ratings model shows South Africa’s implied ratings at BB/Ba2/BB.  We think Fitch will cut it one notch to BB+ soon.  Moody’s gives its review this Friday, and we believe a one notch cut to Baa3 is a done deal.  However, there is a small chance of a two notch cut to Ba1.  Two notch moves are very unusual, but they have been seen in the past.  Still, our base case is for a one notch cut from Moody’s this week followed by another one notch move to sub-investment grade in H2.