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Home / Investment Insights / Q2 2017 – Economic Commentary

Q2 2017 – Economic Commentary

Two key local developments in the past month were the release of the latest iteration of the Mining Charter, followed a day later by seemingly unwarranted comments by the Public Protector on the mandate of the South African Reserve Bank. Both events proved negative for the currency, continuing an unfortunate trend of negative news that has dented investor confidence in the South African market.

Previously noted, South Africa faces a capital allocation mismatch – owing to a lack of policy framework – to attract FDI flows into the country. The lack of a framework has reflected a lack of certainty as political battles have been fought in government during President Zuma’s term of office. After the Mining Charter was released, the finance minister expressed the hope that his colleague at Mineral Resources would consult more broadly and involve the Finance Ministry if necessary. What those comments betrayed was a troubling lack of coordination in government, and the lack of assurance by the President as these events unfolded raised concerns about leadership.

In the aftermath of the most recent Cabinet reshuffle we highlighted the possibility of a new front opening up in the battle for influence of key institutions of State. In particular, we discussed the outlook of the new political leadership at National Treasury, making pointed reference to the possibility that it may wish to seek to reduce the independence of the Reserve Bank. A little more than half way through June, the rand lost ground as the Public Protector made comments to the effect that South Africa’s Constitution should be changed to make the central bank’s mandate one of economic growth rather than price and financial stability. The comments were made in the context of a complaint about a lifeboat that Absa Bank and its forbear, Bankorp, received between 1985 and 1995. However, the complainant has pointed out that his complaint had nothing to do with the mandate of the Reserve Bank, thus, the Public Protector was “on a frolic of her own” in making those statements.

The trend unfortunately remains one of personalities in state institutions appearing to go on frolics of their own. Not long after the Public Protector’s widely criticised utterances did the Deputy Minister of Finance make similar remarks without apparently checking with his senior, the Minister of Finance. In our April note we highlighted the possibility that the Reserve Bank could be in the sights of the new political team at National Treasury, specifically saying that this team’s views “are relevant to investors to the degree that they have the potential to alter the known architecture of the South African financial sector”.

The recognition of South Africa as a good place to do business by international businesses, is not unconditional. The country has had a spotty record on industry-to-labour relations. Educational attainment is nearly two standard deviations worse than the global average yet annualised growth in the working age population is positive. The simple result is that more people are entering the labour pool with poorer than average skills to compete globally. Unsurprisingly, productivity growth in South Africa has been declining for much of the post-Apartheid period. Productivity growth globally has attracted more discussion in this past month, as economic theory suggests that the neutral rate of interest should decline as productivity slows. The origin of this idea is that over the long term interest rates will approach nominal GDP growth rates. Thus, lower productivity growth should lead to lower nominal GDP growth and therefore lower equilibrium interest rates. While that may happen initially, over time it has been observed that interest rates eventually rise, and this is how regions of the globe where long term productivity growth is low (such as Africa) also happen to have higher interest rates. Part of this may be tied to the expectation that low GDP growth will result in a country trying to inflate its way out of its debt, thus moving interest rate expectations upwards. Another part may be linked to higher interest rates needed to raise savings where low output leads to low national savings in the midst of high dependency ratios. The extent to which South Africans rely on debt to provide for themselves and their dependents is illustrated by the National Credit Regulator’s estimate that around 9.6 million borrowers had impaired credit records, out of 24.1 million credit consumers. Despite the recession in South Africa, private credit extension nevertheless grew at a faster pace in May than the median estimate of 10 economists compiled by Bloomberg.

In a sense, the South African Reserve Bank has to be concerned about interest rate expectations rising too much; productivity slow-down and negative politics can undermine perceptions of investors about the government’s management ability. Lately, the turmoil in the governing party has caused great concern among ordinary residents too. Nevertheless, foreign direct investment has now and again flowed into South Africa. For a more sustained interest in the country, we observe the importance of policy certainty. After years of parliament being accused of ineffectiveness, the National Assembly appears to be pressing the country’s executive for clearer answers. This happened at an oversight meeting with the board of Eskom. It happened again at a meeting of the Appropriations committee early in June, where it emerged that there was no consensus on how many state-owned entities (SOEs) there were, nor the policy framework in which they operated.

Without a clear understanding of its agencies and their priorities, it is more challenging for the country to understand its policy priorities. Even in matters that are well-understood to need investment such as education, the presence of programming priorities helps to sharpen the focus of efforts. A report of the Human Sciences Research Council (HSRC) to the parliamentary appropriations committee revealed that the Trends in International Mathematics and Science measure of 25 participating countries showed South Africa making the strongest improvement of the cohort. To be sure, South Africa remained last in the group, but the country is closing the gap. However, the parliamentary committee noted an apparent mismatch between the tertiary degrees on offer, the enrolment patterns, and what industry required. The committee also discussed policy and fiscal programming to improve health outcomes, bringing to light the strongest proportional budgetary commitment in Africa to tackling HIV. The theme coming out of the deliberations is that while Cabinet falls into factional discord, parliament is carving a more independent path of oversight. The ANC members are not yet so strong as to openly oppose their party president, but the Appropriations committee did take the step of empowering the HSRC to look into the efficiency of appropriations spending at SOEs. This has been identified as particularly important when the parliamentary committee has seen larger sums of appropriations being transferred from departments to the SOEs, leaving it up to an unknown number of dysfunctional SOEs to deliver the country’s developmental goals. A reinvigorated commitment to proper parliamentary oversight of SOEs is a very important economic opportunity for South Africa.

Where SOE reform might be an internal opportunity, an external opportunity is that tourism has been firm from countries in Europe, for example, where the reasoning is that as long as the political impasse does not spill over into violence, South Africa is a good place to visit and spend money. Travel agents in Europe report that bombings in Turkey and abductions in Thailand and Indonesia have garnered travel advisories from some European governments warning citizens against travel to those tourism destinations. For instance, the UK Foreign and Commonwealth Office makes specific mention of places to avoid in Asia Pacific countries while of South Africa it writes that “[m]ost visits to South Africa are trouble-free, but [one] should take sensible precautions to protect [one’s] safety.” Where government is considered largely competent and reliable, these warnings can come as public relations nightmares for tourism destinations because of the power they have to discourage potential tourists. The United States has simultaneously become less interesting for European leisure travellers since the election of Donald Trump as president. South Africa is importantly in the same time zone, relatively safe and not as far away as Australia and New Zealand, thereby attracting the interest of Europeans wishing to travel overseas.

Indeed, the Misery Index which is a sum of inflation and unemployment rates, has been coming lower this year in South Africa, and is expected to come further down. As for a collapse in markets, that would likely happen in conjunction with a decline in markets around the world. At present we assess that likelihood as reasonably low, because though OECD gross fixed capital formation is flat-lining, capacity utilisation rates remain healthy in South Africa, Europe and the United States. Despite the legislative setback that Trump has suffered on the health bill, we expect Republicans to come back fighting to deliver on defence and infrastructure spending. The fly in the ointment remains China, as we have highlighted over the past few months, more so because while the US promises to stimulate demand, China is known to be more effective in getting it done.

We have pointed out above that iron ore stockpiles are growing at Chinese ports. Some China watchers are of the view that the property-investment cycle is close to the peak, leaving fewer destinations for the steel that might come from all that iron ore. We ourselves have previously taken the view that China’s intent to reduce pollution and drive steel-milling efficiencies will necessarily reduce the throughput of iron ore in the near to medium term. If Chinese markets increasingly come around to our view that the risks are that China will underwhelm on its growth targets, then Chinese shares could drop substantially as they did between June and August 2015. It is interesting to note that the Shanghai Composite has more or less traded sideways relative to its August 2015 levels. We believe that this is in part because of systemic issues that have yet to be satisfactorily resolved, in particular, a substantial expansion in debt directed through the banking system.

Chinese  credit-to-GDP  continues  to  expand  but  most recently the Chinese unit has stopped losing ground to the US dollar and Chinese foreign reserves have stabilised after two and a half years of reductions. Capital flows out of China continue but at apparently lower rates that can be funded out of forex earnings. It  may  also  help that China a compelling thesis that examines particular market segments rather than China as a whole. In our domestic and global portfolios, we have exposure to companies that have demonstrated strength in mobile gaming. In domestic portfolios the exposure comes through Naspers whose most significant asset is a stake in Tencent. Not only does Tencent offer mobile games but it also owns WeChat, China’s dominant messaging platform. So dominant is WeChat that it occupies the place in the communication sphere that most of the rest of the world reserves for e-mail. Remarkably, nearly 900 million monthly users make WeChat the place to socialise and conduct business. The app is even the most popular place to publish as well as to effect mobile payments. Seemingly unrelated activities come together through WeChat and that is down to Tencent having understood its market well. Both Tencent and Netease shares have done very well in 2017, with Tencent helping to propel Naspers to a nearly 26 percent gain in the year-to-date. Nevertheless, so much of the performance of Naspers has been tied to Tencent that one is prompted to wonder about the health of the rest of the business.

Caution is not only pertinent to Naspers. At the end of the month, H&M disclosed that it grew South African interim sales by 32%; it also disclosed that global inventory was 16.1% of sales, representing a 27% increase on a year ago. As a result, the company planned to increase markdown sales to clear stock ahead of the Northern hemisphere autumn season. Local retailers have experienced negative sales growth. The developing narrative is clearly that the global economy is scheduled for a cool-down in growth. Locally, Stats SA announced that the economy shed about 48,000 jobs in the first quarter of 2017 and mining giant, AngloGold has indicated that it may add to the losses by shedding about a third of its workforce. The room for policy error has narrowed and South Africa’s political class has to sit up and take note.

 

Source: Tony Bell – KI, MiPlan; Fund Manager & CIO, Vunani Fund Managers

Nothing expressed in this commentary shall be construed as advice and no liability accepted should any reliance be placed on the information provided.  All disclosures and conditions as set out on www.miplan.co.za shall apply and such commentary is read assuming acceptance thereof.