South Africa Hindered By Worsening Fundamentals and Heightened Political Risks

South AfricaThe South African economy is slowing sharply.  Markets have turned more negative on the rand, as so-called “Ramaphoria” wears off.  Corruption will remain in the spotlight along with heightened political risk, as Zuma has vowed to reveal corruption within his “enemies” as his trial proceeds.

POLITICAL OUTLOOK

Cyril Ramaphosa’s honeymoon period in the markets appears to have ended.  The economy worsened in Q1, and if the growth outlook doesn’t improve, he and the ANC will be hobbled as we head into the elections next year.  Unemployment remains stubbornly high at 26.7% in Q1, even as unions have won some wage concessions.

There is no date in set yet, but national elections will be held in Q2 2019.  Post-apartheid elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).  That does not give Ramaphosa very much time to boost public support for the ANC.

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.  If the ANC wins the 2019 elections, Ramaphosa would remain President of South Africa.

We say “if” because the ruling ANC has seen its share of the popular vote fall in every election since 2004.  The ANC only got 54% of the vote in the 2016 municipal elections, a record low and down from 62% at the last national election in 2014.  A sub-50% showing next year would be a disaster for the ANC, to state the obvious.  This outcome is a realistic possibility and yet given how dysfunctional the ANC became under Zuma, we think markets might welcome an opposition win.

Corruption will remain one of the country’s biggest challenges.  South Africa scores low in the World Bank’s Ease of Doing Business rankings (82 out of 190 and down from 74 in 2017 and 72 in 2016).  The worst components are starting a business and trading across borders, while the best are protecting minority investors and paying taxes.  It does only slightly better in Transparency International’s Corruption Perceptions Index (71 out of 176 and tied with Bulgaria and Vanuatu).      

A BRIEF HISTORY LESSON

Apartheid was institutionalized after the National Party came to power in 1948.  Prior to that, many aspects of apartheid were already in place but they quickly became enshrined in law.  The first to be introduced was the Prohibition of Mixed Marriages Act of 1949, which was followed by the Immorality Act of 1950.  The Population Registration Act of 1950 then classified all South Africans into four racial groups:  black, white, colored, and Indian.  Forced segregation along racial lines quickly followed.

The African National Congress (ANC) was originally formed in 1912 as the South African Native National Congress.  Its primary goal was originally to get voting rights for South Africa’s minorities.  Nelson Mandela joined the ANC in 1943 and quickly became active in its efforts to end apartheid.  In 1960, the ANC was banned and expelled from the country.  Mandela was arrested in 1962 for conspiring to overthrow the government and was sentenced to life in prison.

The National Party remained in power throughout the apartheid era.  Faced with growing global opposition to apartheid, the National Party saw the writing on the wall and began making a series of concessions in the 1980s.  President de Klerk released Mandela from prison in 1990, and the two negotiated an end to white-only rule.  Apartheid was ended in 1992, and this led to all minorities being able to vote in the historic 1994 election.

The ANC ran in 1994 and has won every election since.  The ANC won 63% of the vote in 1994, giving the ANC 252 seats in the newly-created 400-seat parliament.  Mandela was chosen by parliament to be President of South Africa.  The next two largest parties were the National Party (20% of the vote and 82 seats) and the Inkatha Freedom Party (11% and 43 seats).

In the 1999 election, the ANC won 66% of the vote and chose Mandela’s deputy Thabo Mbeki to succeed him as president when he declared that he would not seek reelection.  The National Party had been re-named the New National Party but still saw its vote share fall to a mere 7%.  The liberal Democratic Party became the second-largest bloc in parliament with 10% of the vote, overtaking the Inkatha Freedom Party with 9%.

Thabo Mbeki had also fought hard against apartheid.  His father was active in the ANC, leading Mbeki to often say he was “born into the struggle.”  Whilst Mandela was jailed, Mbeki and many others went into exile and helped turn international opinion against apartheid.  At one point, the National Party reportedly tried to assassinate Mbeki in 1986 but was foiled by Zambian police.

Jacob Zuma was also active in fighting apartheid, joining the ANC in 1959.  He was sentenced to ten years in prison in 1963 for conspiring to overthrow the government and served his time in the same prison as Mandela.  After serving his sentence, Zuma left the country and meet Mbeki in 1975.  The two ended up working closely together, and conducted secret talks in the 1980s with members of the National Party.

Thabo Mbeki remained president after the 2004 election.  The ANC won a record high 70% of the vote, followed by the Democratic Alliance (formerly the Democratic Party) with 12% and the Inkatha Freedom Party with 9%.  At that point, support for the New National Party had fallen to less than 2%, putting it in sixth place.

Mbeki did not serve out his full second term, resigning in September 2008 with only nine months left.  He had been recalled by the National Executive Committee of the ANC.  Mbeki’s term was served out by Kgalema Motlanthe, who was seen as a caretaker until the elections the following year.  Mbeki was ousted by ANC members loyal to Zuma.

Why?  Most observers believe Zuma’s populist thrust was more popular amongst the ANC than Mbeki’s more orthodox approach.  Trevor Manuel was Finance Minister under Mandela, but stayed on and deepened his market-friendly policies under Mbeki.

Zuma was Mbeki’s Deputy President from 1999-2005.  He was dismissed on corruption charges, but still retained a great deal of support within the ANC.  The split within the ANC widened after Mbeki sought a third term as ANC president even as he denied seeking a third term as the nation’s president.  Zuma prevailed over Mbeki to become president of the ANC in December 2007.

Jacob Zuma was elected president in 2009 after the ANC won 66% vote.  The Democratic Alliance won 17% of the vote, while the new Congress of the People (another ANC offshoot) won 7% and the Inkatha Freedom party won 5%.  Motlanthe was chosen as Zuma’s Deputy President.

Zuma was reelected in 2014 with 62% of the vote.  The Democratic Alliance won 22%, while the Economic Freedom Fighters (EFF) won 6%.  Former leader of the ANC youth wing Julius Malema formed the EFF in 2013 and so this was the first time it ran in national elections.  Motlanthe had challenged Zuma but was soundly defeated.  Cyril Ramaphosa became Zuma’s Deputy for his second term.

Zuma’s ouster does not need to be rehashed here.  However, we believe that the ANC remains deeply divided.  Indeed, one might say that this divide has even widened since the 2008 split between the Mbeki and Zuma factions.  Note that Ramaphosa was elected ANC leader in December 2017, defeating Nkosazana Dlamini-Zuma (Zuma’s ex-wife) by a narrow margin of 2440 to 2261.

The country itself remains divided.  Ramaphosa went on to win the Presidency of South Africa after Zuma resigned in February.  The two main opposition parties refused to vote for Ramaphosa as President, despite both pushing for Zuma’s ouster.  The opposition Democratic Alliance and EFF had wanted early elections to be called, as they clearly wanted to hold a vote now before Ramaphosa had a chance to increase support for the ANC.

Ramaphosa and the ANC are now pursuing corruption charges against Zuma.  We suspect many in the ANC may be caught up in any investigations of so-called “state capture.”  Indeed, at a recent court hearing, Zuma warned that he stands ready to expose the corrupt activities of his “enemies.”  The Democratic Alliance has been critical of the ANC response so far, as the case has been adjourned until July 27.

ECONOMIC OUTLOOK

The economy remains sluggish.  GDP growth is forecast by the IMF at 1.5% in 2018 and 1.7% in 2019 vs. 1.3% in 2017.  GDP rose only 0.8% y/y in Q1, down from 1.5% peak in Q4 and the weakest since Q2 2016.  In annualized terms, the outlook is even worse as GDP contracted -2.2%, the worst since Q1 2009 amidst the Great Financial Crisis.  As such, we see downside risks to the growth forecasts.

Price pressures are rising.  CPI rose 4.5% y/y in April, the highest since December and likely to move higher in light of the weak rand.  PPI rose 4.4% y/y in April, up from the 3.7% trough in March.  May inflation data will be reported on June 20, and is likely to tick higher into the top half of the 3-6% target range.   Note that state workers just won a three-year wage deal with raises of 6-7% for the current fiscal year.

The South African Reserve Bank (SARB) started an easing cycle last July with a 25 bp cut to 6.75%.  Heightened political risk forced the bank to remain on hold until this March, when it followed up with another 25 bp cut to the current 6.5%.  Next policy meeting will be held July 19, and a lot can happen between now and then.  The economy is very weak and so we don’t think there is much appetite to hike if they can avoid it.  However, the market may force its hand.  We can safely rule out any more rate cuts for the time being, however.

The fiscal outlook bears watching.  Under Finance Minister Nene, fiscal tightening had continued, but that was the major reason he was replaced by the little-known David van Rooyen in 2015.  Pravin Gordhan was brought back after four days as markets revolted, with solid fiscal policy continuing with the return of Nene under new President Ramaphosa.

Fiscal tightening was announced this year in the first budget under President Ramaphosa.  Key takeaways from South Africa’s budget statement:  1) VAT will be raised one percentage point to 15%, 2) other measures will impact income and estate taxes, 3) spending will be cut ZAR85 bln over next three years, 4) growth forecasts were raised modestly, and 5) the deficit forecast for FY2018/19 was cut to -3.6% of GDP from -3.9% previously.

The external accounts are likely to worsen.  The current account deficit was -2.9% of GDP in 2017, and the IMF expects the deficit to remain steady this year and widen modestly to -3.1% in 2019.  However, export growth has been slowing noticeably this year, leading the trade surplus to narrow.  The current account gap widened to -2.9% of GDP in Q4, suggesting upside risks to the forecasts.

Foreign reserves have risen to record highs but vulnerabilities remain.  At $51.1 bln in May, they cover nearly 5 ½ months of imports but are only equal to around 90% of its the stock of short-term external debt.  Thus, the country is vulnerable to shifts in sentiment and so-called hot money.  Indeed, FDI slumped to $1.3 bln in 2017, the lowest in eleven years.

INVESTMENT OUTLOOK

The rand is underperforming after a stellar 2017.  In 2017, ZAR rose 10% vs. USD and was behind only the best EM performers KRW (13%), MYR (11%), and THB (10%).  So far in 2018, ZAR is -5.5% and is ahead of only the worst performers ARS (-27%), TRY (-16%), BRL (-10%), and RUB (-8%).  Our EM FX model shows the rand to have WEAK fundamentals, and so we expect this underperformance to continue.

USD/ZAR is trading at its highest levels since December 18, which is the day that “Ramaphoria” officially began when he won leadership of the ANC.  Using the big November-February drop in USD/ZAR, the last major retracement objective comes in near 13.4030.  Break of that area would set up a test of the November 13 high near 14.5740.

South African equities continue to underperform.  In 2017, MSCI South Africa was up 19% vs. 34% for MSCI EM.  So far this year, MSCI South Africa is -6.5% YTD and compares to -1.3% YTD for MSCI EM.  Our EM Equity Allocation Model puts South Africa at VERY UNDERWEIGHT, and so we expect South African equities to continue underperforming.

South African bonds are around the middle of the EM pack.  The yield on 10-year local currency government bonds is +43 bp YTD.  This compares to the worst EM performers Turkey (+342 bp) and Brazil (+132 bp), as well as the best performers China (-24 bp) and Russia (-7 bp).  With the weak rand likely to feed into higher inflation and the central bank possibly forced into hiking rates again, we think South African bonds will underperform near-term.

Our own sovereign ratings model shows South Africa’s implied rating steady at BB/Ba2/BB after rising a notch last quarter.  We still believe Moody’s and Fitch’s ratings of Baa3 and BB+, respectively, are seeing continued downgrade risk.  S&P’s BB rating appears to be on target.  Moody’s just affirmed its rating in March but inexplicably moved the outlook from negative to stable.

Recent data from the National Treasury show foreigners hold nearly 45% of South African government debt.  This is up from only 10% ten years ago, and illustrates the country’s heavy reliance on external financing.  Moody’s rating is very important, as the loss of investment grade would likely lead to forced selling of South African bonds.