Growing pains

Image: Izak Odendaal.

By Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth.

South Africa’s economic performance made headlines for all the wrong reasons last week, hardly the start to the festive season we all would have liked. The reality is that the road to economic recovery for South Africa is going to be long and bumpy. In our final weekly commentary for the year, we look at what went wrong, what needs to happen for things to turn around and the implications for our investors.

Contraction

The local economy contracted at an annualised rate of 0.6% in the three months to end September compared to the previous quarter. This is the headline number reported in the media, and represents the real or after-inflation growth of gross domestic product (GDP), adjusted for seasonally. Quarterly numbers can be quite volatile, and since the second quarter was quite strong (3.2%), a repeat performance would be difficult. However, the GDP number was even worse than most economists expected. Year-on-year growth numbers are less volatile, but this time it was not much better: there was no growth in the four quarters to end September. It looks like 2019 growth will be even lower than last year’s already low 0.8%. It is truly a sad state of affairs.

Looking into some of the details, the quarterly contraction was driven mainly by sectors that can be volatile from quarter to quarter, namely agriculture, mining and manufacturing. Electricity, a small sector in the GDP numbers but a crucial input for the rest of the economy, also contracted as Eskom was forced to resume load-shedding, as was the case in the first quarter (and unfortunately last week too). The biggest sectors of the economy are service-orientated, less volatile, and driven largely by consumer spending. However, the underlying growth trend in services has also weakened as household finances have come under pressure. Household consumption spending grew just 0.2% quarter-on-quarter.

The reason for this is the decline in income growth. Employee compensation, or the economy’s wage bill, grew by only 4% from a year ago. This is a nominal number, not adjusted for inflation but rather reflecting the growth (or lack thereof) of the rand amounts paid out to South African workers. It was the lowest growth rate since the start of the data series in 1994, and largely reflects the dramatic decline in inflation over the past few years, as well as the lack of job creation. Nominal GDP growth similarly declined to a record low of 3.75% year-on-year. With zero real growth, it implies that GDP inflation (which is a broader measure than the consumer price index) was also 3.7%.

As recently as 2017, nominal economic growth was still consistently in the region of 7% per year. In fact, the February 2019 Budget was based on assumed growth of 7% for the coming three years. The collapse in inflation is therefore a big factor behind the government’s tax revenue shortfall. Together with the fact that budgeted spending has not been reduced, it explains the widening fiscal deficit.

Chart 1: Nominal economic and income growth

Source: Stats SA

Lower inflation is ultimately a good thing, but getting there can be painful. The adjustment to lower inflation is unevenly spread across the economy, but ultimately everyone will have to adjust to the new reality. For instance, unions at SAA recently still demanded an 8% wage increase, double the inflation rate. But in other sectors, unions have accepted lower increases and even at SAA, workers ultimately settled for less. In the end, they might get nothing as the beleaguered airline was finally placed in business rescue. Another example is retailers, whose nominal turnover growth has declined to 4%, but many are still locked into much higher rental escalations, and everyone faces double-digit electricity, water and municipal tariff increases. As the rents are renegotiated, landlords (mostly listed property companies) see their income growth declining.

The one party that has not yet adjusted to the lower inflation reality is the Reserve Bank, which has allowed real interest rates to rise even as economic growth has withered away.

Chart 2: Real interest rates and economic growth

Source: Refinitiv Datastream

If there was one sliver of good news in the GDP numbers, it was that real fixed investment spending increased for the second consecutive quarter. It was driven largely by business spending on machinery and equipment. Private sector fixed investment posted 11% growth in the quarter. In contrast, government investment spending declined for the seventh consecutive quarter. As government’s interest bill balloons due to rising debt levels, capital spending is being squeezed.

What can drive a turnaround?

For the economy to turn around, the improvement in private fixed investment spending needs to continue. This will require higher level of business confidence. Business confidence can benefit from greater policy certainty and more effective government.

Following the GDP numbers, a predictable refrain called out for faster implementation of structural reforms to improve the cost and ease of doing business. However, some reforms, such as restructuring loss-making SOEs, are likely to make things worse before making them better as jobs and spending are cut. The most important structural reform is probably just getting the basics right: reliable electricity and water supply; potholes fixed and rubbish collected; criminals in jail and children in school; trains running on time; shorter queues in clinics, Home Affairs offices and traffic departments. To use but one example of many, it was reported last week that Richards Bay Minerals halted operations and put expansion plans on ice due to violence in surrounding communities linked to poor service delivery and the general tough economic climate.

Beyond that, business confidence typically responds to rising demand. In other words, business sentiment is lifted as order books are filled and goods fly off the shelves. Unfortunately, it seems unlikely that household spending will pick up the pace meaningfully. This will require job creation, lower interest rates and higher income growth. An acceleration in household borrowing is also needed. The latest numbers show continued rapid growth in unsecured lending, and only somewhat faster growth in home loans. We need less of the former and more of the latter. In other words, there are lots of chickens and lots of eggs, but who comes first? 

What does all this mean for investors?

Clearly, economic stagnation is not good for companies that earn most of their income in the domestic economy. But as always, there are nuances. In a tough environment, stronger companies can benefit if weaker ones go out of business. Another trend likely to persist is the private sector continuing to make up for the public sector’s shortcomings, whether they are businesses providing health, education, electricity, transport or security services. Also remember that even within the weak local economy, some sectors are doing better than others. Services is performing much better than mining, manufacturing or construction, growing by 1.3% year-on-year while the goods-producing sectors have declined. Locally focused companies on the JSE tend to be concentrated in the services sector (retail, finance and communication).

In aggregate, the companies listed on the JSE largely earn their incomes by operating in foreign markets or selling dollar-based commodities, and are unaffected by domestic demand. The link between the poor performance of the JSE over the past five years and that of the local economy therefore tends to be overstated. Whether it’s boom or bust for the JSE in 2020 will largely depend on how global risk appetite evolves and how the global companies listed on the JSE grow their earnings. Remember also that many companies that traditionally focused on the local economy have expanded abroad in recent years (such as Woolworths) and the performance of their overseas acquisitions will matter.

For bonds, this is a very good environment as inflation falls and interest rates are high. The biggest risk is that economic weakness persists and results in ever-rising government debt. However, this is not an unknown risk and is therefore largely priced in. Hence South African government bond yields trading at multiples of developed country yields and even some emerging markets.

Chart 3: Rand-dollar exchange rate

Source: Refinitiv Datastream

A diversified portfolio should include a meaningful allocation to global investments as South African assets represent only a small fraction of all the options available. But that doesn’t mean it’s advisable to take all your money offshore. For one thing, that implies perfect foresight. The future might evolve very differently to how you imagine. Only slightly better than expected economic growth could see beaten-up local companies take off from seven-year low valuations (for what it’s worth, the 2020 consensus growth forecast is 1.3%). That is why diversification is important.

Secondly, it means missing out on very high local interest rates. Thirdly, there are still good growth opportunities here, even though they’ve become harder to find. Fourth, the rand is not a one-way bet. Four years ago, the nation was rocked by the shock axing of then Finance Minister Nene. At that point, few would predict that the currency would be back where it was on the eve of Nenegate four years later. It is also important to remember how far we’ve come since those dark days.

In the end it’s got nothing to do with hope, patriotism or rose-tinted spectacles, but all about applying sound investment principles. Happy holidays, and here’s to a better 2020!




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