South Africa – What Now?

new south africaSouth African President Zuma survived the no confidence vote.  What now?  We remain negative.   

POLITICAL OUTLOOK

The vote was very close.  With 201 votes needed to pass the motion, Zuma’s opponents got 177.  Holding only 151 seats, that means that the opposition was joined by nearly 30 lawmakers from the ANC in rejecting Zuma.  Note that the final vote was 198-177 with 9 abstentions.  With 395 lawmakers present, this means that 11 votes were either not cast or somehow nullified.

The next important event is the ANC leadership vote in December.  Term limits dictate that Zuma steps down as ANC leader in December and as president in 2019.  In reality, Zuma is now fighting for his post-presidency survival.  He needs to make sure that the next leader won’t go after him and put him in jail, and so Zuma is intent on having an ally as his successor.

President Zuma favors his ex-wife Nkosazana Dlamini-Zuma, while Deputy President Cyril Ramaphosa would be the market-friendly choice.  Top ANC officials are pushing to reach an agreement on who will succeed Zuma, rather than risk yet another split in the party that ultimately weakens its chances to win.

It seems likely that President Zuma will serve out his term until the 2019 elections.  There is no date set yet, but national elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).

Parliamentary seats are awarded proportionately to the party’s share of the popular vote.  Lawmakers are chosen from party lists.  Note that the President of South Africa is not directly elected by voters, but is instead chosen by a parliamentary vote.

The ANC is particularly worried because its share of the vote has fallen to its lowest level since the end of apartheid.  The ANC only got 54% of the vote in last year’s municipal elections, down from 62% at the last national election in 2014.  A sub-50% would be a disaster for the ANC, to state the obvious.  This outcome is a realistic possibility if the ANC in-fighting continues.  Yet given how toxic Zuma has become, we think markets would welcome an opposition win.

Corruption remains an issue for the country.  South Africa scores fairly low in the World Bank’s Ease of Doing Business rankings (74 out of 190 and down from 72 in 2016).  It also scores low in Transparency International’s Corruption Perceptions Index (64 out of 176 and tied with Montenegro, Oman, Senegal, and Suriname).

ECONOMIC OUTLOOK

The economy is still sluggish.  On an annualized q/q basis, GDP has contracted two straight quarters.  GDP growth is forecast by the IMF to accelerate modestly to 1.0% in 2017 from 0.3% in 2016, before picking up to 1.2% in 2018.  GDP rose 1.0% y/y in Q1, the strongest rate since Q2 2015.  Monthly data so far in Q2 suggest some modest weakening, and we see downside risks to the growth forecasts.

Price pressures are falling, with CPI decelerating to 5.1% y/y in June from 5.4% in May.  This was the lowest rate since November 2015 and moves further into the 3-6% target range.  PPI rose 4% y/y in June, the lowest since September 2015 and suggesting little in the way of pipeline price pressures.

This has allowed the SARB to start the easing cycle with an unexpected 25 bp cut to 6.75% in July.  The next policy meetings are September 21 and November 23.  If current trends continue, we would expect 25 bp cuts at both meetings, taking the policy rate down to 6.25%.  This would be the lowest since December 2015.

Fiscal policy has remained prudent despite turmoil at the Treasury.  Former Finance Ministers Nene and Gordhan enacted several rounds of tightening in recent years to help prevent fiscal slippage.  Yet their efforts were offset by sluggish growth, as the budget gap widened to -3.4% of GDP in FY2016/17.  The government expects the deficit to narrow to -3.1% of GDP in FY2017/18 and -2.8% in FY2018/19, but we believe these forecasts are too optimistic.

Current Finance Minister Gigaba has yet to make much of a mark.  His next opportunity will likely be the mid-term budget speech in October.  At his last budget presentation in February, Gordhan targeted a budget deficit of -ZAR149 bln (-3.1% of GDP) for FY2017/18.  The 12-month total was -ZAR177 bln in June and growing, and so Gigaba should announce some tightening measures in his mid-term speech.

The external accounts are likely to worsen.  Low commodity prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was -1.7% of GDP in 2016.  The OECD expects it to widen to -2.7% in 2017 and -3.0% in 2018.  What’s worse, the gap will likely be covered by hot money flows as FDI inflows remain low.

Foreign reserves have steadied around $47 bln.  They cover nearly 5 months of import and are just about equal to the stock of short-term external debt.

INVESTMENT OUTLOOK

The rand is underperforming after a strong 2016.  In 2016, ZAR rose 13% vs. USD and was behind only the best performers BRL (+22%) and RUB (+20%).  So far in 2017, ZAR is up 2% YTD and is amongst the worst EM performers.  The next worst are IDR (+1%), COP (flat), TRY (-0.5%), HKD (-1%), PHP (-2%), and ARS (-11%).  Our EM FX model shows the rand to have VERY WEAK fundamentals, so this year’s underperformance is likely to continue.

USD/ZAR today broke above 13.50 for the first time since July 12.  The pair is on track to test the July high near 13.63.  A break of that level would set up a test of the April high near 13.96.  We have long felt that high interest rates were the only thing supporting the rand.  With the SARB likely to continue easing, this will further erode support for the rand.

South African equities are underperforming EM after a similar performance in 2016.  In 2016, MSCI South Africa rose 0.6% vs. 7.3% for MSCI EM.  So far this year, MSCI South Africa is up 11% YTD and compares to 24.3% 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 performed well recently.  The yield on 10-year local currency government bonds is about -35 bp YTD.  This is amongst the best EM performers and behind only Brazil (-142 bp), Indonesia (-104 bp), Peru (-90 bp), Turkey (-58 bp), and Russia (-57 bp).  While low inflation and central bank easing should support South African bonds, we believe they are vulnerable to downgrade risks.  Why?

After Gordhan was fired in March, the agencies reacted quickly.  S&P downgraded South Africa a notch to BB+ with negative outlook, while Fitch downgraded it a notch to BB+ with stable outlook.  Moody’s put its Baa2 rating on review for a downgrade and then followed up with a one notch cut to Baa3 with negative outlook.

South Africa’s inclusion in Citibank’s World Government Bond Index (WGBI) hinges on retaining investment grade local currency ratings from both S&P and Moody’s.  We have always believed that the two should be equal.  Moody’s agrees and has a Baa3 rating on both its local and foreign currency ratings.  However, S&P has a BB+ foreign currency rating along with a BBB- local currency rating.

Moody’s is due to give another rating decision this Friday, and should cut both the local and foreign currency ratings by another notch to Ba1.  If so, South Africa would be ejected from WGBI and this would likely lead to some forced selling.  Our model rating for South Africa remains at BB/Ba2/BB, and so further downgrades are warranted by all three agencies.