Can SA remain investment grade?
The threat of a ratings downgrade hung over SA markets throughout 2016. Despite concerted efforts to unseat Pravin Gordhan as Minister of finance, he managed to survive, along with our investment grade rating. On the back of this, the currency and bond markets staged a remarkable recovery: the rand ended the year below R14 to the dollar, having traded weaker than R17 to the dollar in January 2016, and bonds rallied over 15%. However, a repeat performance in 2017 is unlikely as valuations are no longer as supportive, and the country continues to face significant political and economic headwinds.
The survival of Pravin Gordhan as the Minister of Finance was a critical element in maintaining the investment grade rating. National Treasury has been at the forefront of efforts to avert the downgrade as they understand the impact of rising debt costs on the budget. While there has been very little delivery on structural reform from government, National Treasury has delivered reasonably good budgets and this has been sufficient to placate the rating agencies. However, the situation remains precarious due to heightened political risk, poor growth prospects and deteriorating debt metrics.
S&P, Fitch, and Moody’s all have South Africa on a negative outlook. Both S&P and Fitch rate South Africa one notch above junk status. It will therefore be a challenge for SA to maintain its investment grade rating in 2017. A summary of the current ratings position is depicted in the table below:
SA fundamentals constrained by the inability to grow
SA has struggled to generate economic growth since the 2008 crisis. Lower commodity prices and muted global growth have had a negative impact, but this has been exacerbated by a severe deterioration in the governance under the Zuma administration. The effect has been a sharp fall in business confidence and reluctance by the private sector to invest in the economy. In recent years government has attempted to maintain growth through higher spending and investment, but this policy has reached its limit given the need to contain the debt burden. Without business confidence (see graph below), private sector investment will not increase and growth will remain subdued.
Government spending and a lack of growth have had a severe impact on SA’s debt metrics. The second graph (see below) shows the rapid rise in debt to GDP since the financial crisis of 2008.
SA’s fiscal deficit has averaged 4.5% of GDP over the past five years and this has taken a toll on the overall debt burden. SA’s revenue and expenditure measures, totalling 1% of GDP, were announced in the October 2016 Medium Term Budget Policy Statement (MTBPS) in order to bring the forecast fiscal deficit down from 4.0% to 3.0% of GDP. We expect Pravin Gordhan to announce a number of tax, duty, and fuel levy hikes in order to raise revenue. Tax measures will continue to focus on high-income earners as opposed to a socially unpopular VAT hike. While Treasury has stabilised the budget through spending control and incremental revenue measures, the lack of growth makes it difficult to stabilise the debt burden. The debt/GDP ratio will continue to move higher and put further pressure on SA’s credit rating.
Political risk will remain elevated
Politics will remain the key risk for SA in 2017 as the succession battle within the ANC is likely to heat up over the course of the year. The ANC holds its elective conference in December 2017 where it will choose its party leader, who will inevitably be the president of the country. The jostling has already begun with factions in the ANC rallying behind their preferred candidate. Deputy President Cyril Ramaphosa and Nkosazana Dlamini-Zuma are the current front-runners, but there remains the potential for other candidates (perhaps Zweli Mkhize and Baleka Mbete) to emerge over the course of the year. While this succession battle is being played out, it is unlikely that we will see any progress on structural reforms. Given how much is at stake for President Zuma and his allies, there is the potential for severe negative shocks, and sentiment is likely to remain weak.
Headwinds from the US
US rates could prove to be a further headwind for SA fixed income markets. In the final quarter of 2016, the 10-year US bond yield jumped from 1.6 % to nearly 2.5%. This repricing was largely due to the election of Donald Trump. The market is now pricing in higher levels of nominal growth and larger budget deficits.
To date the hiking cycle in the US has been very slow. The Fed hiked rates in December 2015 and then waited a full year to hike again. However, inflation in the US is set to move sharply higher in the coming months. Recent market pricing action also gives the Fed greater room to hike, with the S&P 500 close to record highs and higher bond yields pricing out the risk of deflation. We expect the Fed hiking cycle to accelerate, which will significantly constrain the ability of the South African Reserve Bank (SARB) to cut rates in SA.
The outlook for 2017
The recovery of 2016 and the strong performance of the rand and bonds have caused markets to become overly optimistic on the outlook for 2017. The consensus is now for a strong rand, lower inflation, and rate cuts later in the year. We believe that this is highly optimistic and it is more likely that rates will be on hold for some time. The SARB has repeatedly stated that the bar for rate cuts is very high. They are only likely to cut if they see inflation close to 5% on a sustainable basis. Inflation is likely to move lower on a cyclical basis, but a level of 5% is not sustainable given structural inflation pressure and elevated core inflation.
Fund strategy and positioning
The outlook for fundamentals and a challenging political environment urges caution on SA assets. One must ensure that the risk premiums are sufficient to compensate for fundamental risks going forward. SA assets have priced in a positive outcome for growth and inflation, while the political risk premium has also fallen. The recovery in the currency and bonds has moved them close to our fair value estimates. SA assets are not expensive, but at these levels we believe the return is negatively skewed (moderate upside and significant downside) due to political risks and a continued deterioration in fundamentals.
For the Nedgroup Investments Flexible Income Fund we aim to deliver an attractive yield (currently 8.6% gross) through allocating to assets and strategies when they offer good upside with low downside risk. Current market valuations call for low risk positioning within the fund and a focus on downside protection.
The current duration is similar to a money market fund as we do not want to take on interest rate risk with yields at current levels. We have focused on maximising the yield of the fund by accumulating good-quality floating rate assets at very attractive levels. In recent months we have increased exposure to solid names such as Old Mutual, Santam, Naspers, Telkom, and Steinhoff credit. Our currency exposure is currently 4% with nearly 3% allocated to UK and European property assets that have fallen precipitously post the unexpected Brexit referendum. We maintain our position in Eskom and Old Mutual offshore bonds as we believe they provide a very favourable return profile with an acceptable level of risk. We have an allocation to the Impala convertible bond, which is yielding 16% and matures in a year.
We will continue to focus on maximising yield, while looking continually for opportunities to deploy assets to the various income-generating asset classes should risk premiums improve.