By: Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth
The Springboks’ incredible World Cup triumph was a welcome distraction from a week dominated by the gloomy Medium Term Budget Policy Statement (MTBPS). A huge tax revenue shortfall, combined with support for Eskom, means that the government’s budget deficit will be larger than expected, averaging 6% of national income over the next three years. The deficit – the gap between government spending and revenue – has to be plugged largely by borrowing. As a result, government’s debt level will rise faster than economic growth for the foreseeable future, unless something is done to address the situation.
No easy options
The biggest disappointment of the MTBPS was therefore the lack of action to address the rising debt burden. To be clear, there are no easy options. The persistent weakness of the economy is the main reason tax revenue is falling behind target (by an expected R52 billion this year).
Increasing tax rates, as was done for personal income tax in 2015 and VAT in 2018, have not made a big difference, and it could be counterproductive to raise them again. The other option is to cut spending. The government did reduce spending by R21 billion in the current fiscal year compared to the February Budget projection, but this was more than offset by bailouts for Eskom and other parastatals. Treasury proposed that non-interest spending and revenue should balance by 2022, which will require R150bn in spending cuts and/or additional revenue over this period. However, we’ll have to wait until February to hear if and how this will happen. Presumably there will be some tough conversations with public sector unions before then. Minister Mboweni emphasised the unsustainable growth in the public sector wage bill, and the need to reduce it. The lack of concrete announcements in the MTBPS and the Eskom ‘road-map’ released the day before suggests that there is still a large degree of contestation around key policy issues within the ruling alliance. Although there has been some progress (Eskom will definitely be unbundled into three parts), it is taking longer than most South Africans probably have the patience for. Time is running out.
Chart 1: Projected debt to gross domestic product ratio, %
Source: National Treasury
The lack of concrete action also tested Moody’s patience, and they understandably cut the outlook on the government’s credit rating from stable to negative. It warned that a failure to deliver steps that will stabilise government’s debt in February will likely lead to a downgrade to so-called junk status. Are we headed for a debt trap as the Minister suggested? South Africa’s biggest problem is not debtper se, but rather very high interest rates. The interest rate the government pays, which we can proxy as the yield on the All Bond Index, is much higher than the economy’s growth rate, even including inflation (chart 2). Any borrower whose interest rates are higher than their income growth faces trouble. Interest payments will be the fastest-growing spending item in the budget over the next three years amounting to almost R800 billion in total over this period.
Chart 2: Nominal economic growth and government borrowing cost, %
Source: National Treasury
Longer-term interest rates (bond yields) are set by the market. (Short-term interest rates more closely reflect the SA Reserve Bank’s repo rate.) Government cannot control these, it can only try to influence market perceptions. Given the adverse market reaction and the risk of a Moody’s downgrade, the Reserve Bank is likely to adopt a cautious stance, with the expected November rate cut now probably postponed until after the February Budget. Ultimately, the solution is faster economic growth. If the economy can pick up speed, we can grow into our debt. Government is also not able to directly control economic growth, but it can limit the negative impact of its own regulations and policies. The measures announced so far (such as relaxing visa requirements) should help over time, not immediately. If the market recognises faster growth, bond yields should also come down, a positive double whammy for the debt situation.
So what are the investment implications? The immediate market reaction was negative, and the rand lost 2% against the US dollar on the day as investors digested the speech. However, we should remember that the most important event for local financial markets on Wednesday did not take place in Parliament in Cape Town, but rather in Washington, D.C. While he grabbed local headlines, the South African finance minister does not influence the price of global money. That job is left to the US Federal Reserve, which guides interest rates for the US economy and the US dollar, the global reserve currency. The Fed guides rates, because its policy interest rate is only implemented in the interbank market. The rates that consumers and business pay are determined in larger bond and credit markets. Nonetheless, its actions reverberate through global markets, including the flow of capital in and out of developing countries like ours, in the process typically outweighing the actions of local policymakers.
A year ago, the Federal Reserve was still projecting three rate hikes in 2019. Instead, it has delivered three cuts. This reflects a global economy that is much weaker than anticipated, but the turnaround in Fed policy (and that of other central banks) will also cushion the slowdown and should prevent it from turning into something nasty. The Fed will probably now pause for a few months to see how the economic outlook evolves. Importantly, the world’s major central banks have been pragmatic and prepared to change direction if need be. The experience of the past decade – contrary perhaps to their own stated beliefs – is that central banks cannot engineer a surge in growth and inflation, but they can reduce downside risks. That is exactly what they’re doing now. Lower (even negative) rates are unlikely to stimulate much new borrowing given high debt levels and consumer uncertainty. Just as you can lead a horse to water, but not force it to drink, you can cut rates but not force banks to lend and households to borrow. Companies have been happier to borrow, in part to buy back their own shares. Low longer-term bond yields probably reflect the market’s view that inflation will be low for many years despite the best efforts of central banks.
All this might seem completely irrelevant to a discussion of South Africa’s government finances, but it matters. Low and negative international bond yields prevent South African yields from blowing out completely. Even some of our peers with higher debt ratios have lower bond yields. Brazil can borrow over 10 years at 6.4% and India at 6.6%. While bonds sold off after the MTBPS, the high initial yield still protects investors. The All Bond Index lost 0.4% in October, but the return over 12 months was still 13%, well ahead of cash. Until the government implements tangible reforms to boost growth and stabilise debt one should not expect capital gains from local bonds (i.e. rising prices and falling yields). However, the prospective return from the yield of 9% is still attractive. That high yield results from the market pricing in slow growth, fiscal risks, downgrades and Eskom bailouts for some time. It also means the market is largely ignoring the inflation outlook. Local inflation is slowly and steadily converging on low global inflation.
Low inflation, in turn, has impacted government’s financial position much more than people realise. Treasury expects the economy to grow by just 0.5% in real terms this year, a full percentage point lower than what they forecast in February. The inflation forecast is also a percentage point lower. This matters since inflation pushes up incomes and therefore tax revenues. If there was one positive element of the MTBPS, it was that the economic assumptions on which the budget projections are based are now much more realistic, and the scope for further nasty surprises limited. Local equities followed global markets higher, while rand-hedges benefited from the sharp decline in the currency (though to put it in full perspective, the rand ended October only 3% weaker than a year ago). The 12-month return of the FTSE/JSE All Share Index increased to 12%, partly due to the slump in equities a year ago. It trades on a 3.7% dividend yield, i.e. even if there is no price appreciation, you’ll still get a 3.7% return. Dividends paid have increased 7% per year over the past five years, despite the tough economy, since local equities are mostly exposed to economic activity outside South African borders.
Chart 3: SA equity and bond returns over the past year: not bad despite the negativity
Source: Refinifiv Datastream
Stick to the plan
In summary, the MTBPS made for unpleasant reading and as citizens and taxpayers we have every reason to be concerned about the sustainability of the government’s finances. In our capacity as investors, it is important not to throw the baby out with the bathwater. Firstly, most diversified portfolios have plenty of global and rand hedge exposure. Secondly, though the MTBPS forecasts were worse than expected, the general trends of sluggish growth and rising debt was priced into South African assets already. These are offering value – bond and property yields are high and equity valuations the lowest in seven years – and history suggests they are priced for solid future returns. It doesn’t make sense to sell out now unless personal circumstances have changed, requiring a change in investment strategy. And while you should be careful of stretching conclusions from the rugby field to the world of investing, it is worth noting that the Springboks were written off as hopeless a year or two ago, much like the local economy and local markets are today, and now they are world champions. Things can turn around with astonishing results.