Market Solutions – August: The middle kingdom can’t remedy South Africa’s public sector ills.

By Rob Price on Aug 17, 2018 in Market and Economic Commentary

The BRICS Summit caught news headlines in July. From a South African perspective, the biggest talking point was the R33bn loan that Eskom secured from the Chinese Development Bank. In the short term, this loan is good news because it relieves funding pressure on the embattled state-owned enterprise (SOE), which could reduce broader credit risk at the margin. President Cyril Ramaphosa will be delighted that he has already secured $35bn of the $100bn he hopes to receive from international investors over the next five years. Alexander Forbes’ Executive Chief Economist Isaah Mhlanga outlined the risks to the President’s strategy clearly in his recent Pursuit of Certainty roadshow.

In the longer term, the impact of the loan is a little less certain. Sceptics will question the terms of the loan with China and the economic/political motives of the world’s second largest economy, which is clearly on a drive to secure assets across emerging markets. Time will reveal the true intentions of the Middle Kingdom and the benefits of the arrangement. No matter the terms of the loan, it is questionable whether further funding is the silver bullet to Eskom’s troubles. The power utility incurred losses of R2.3bn in the 2017/2018 financial year with R19.6bn worth of irregular expenditures discovered. Overspending, irregular spending and inefficient capital allocation are the real problem, not a lack of funding. These issues are commonplace across the public sector and, until they are fixed, government will pressure the tax base and request debt financing to plug the gap. Higher taxes and more debt aren’t conducive to stronger economic growth and employment creation. We remain concerned by South Africa’s growth prospects and are using the off-shore investment opportunity set to mitigate against these risks.

Returning to the impact of the loan, it could possibly reduce short-term funding constraints. Credit risk isn’t currently the major concern in the South African bond markets, so we don’t expect a big impact on the bond market in the short term. Local bond investors have placed greater focus on currency, inflation and interest rate risk lately. In this regard, the ZAR gained slightly in July from a period of USD weakness, taking the USD-ZAR back towards 13.00. Rand strength and lower inflation expectations supported the local bond market, taking the benchmark 10-year bond yield towards 8.5%. We noted in the second quarter that potential rand weakness could hurt South African bonds – this scenario has now played out. Given the still contained rate of domestic inflation, the rise in 10-year bond yields above 9% made them quite attractive again. This perspective is now playing out, assisted by the slightly stronger rand.

Broadly speaking, there were further moves towards BRICS co-operation but any challenge to developed market dominance was more subtle than explicit. Considering the trade-war rhetoric, global investors were interested in the BRICS leaders’ commitment to an open world economy. The comments were toned down and didn’t really tell us anything new. Perhaps more noticeable is the recent weakness in the Chinese Yuan (CNY). The CNY has weakened more relative to the USD than a broad basket of emerging market currencies. The Chinese have added liquidity to their financial system, which caused the currency weakness. Whether the stimulus is directly in response the potential negative impact of trade tariffs, or whether the authorities are frustrated by the slowdown in domestic credit growth, is uncertain. No matter the actual intention, CNY weakness could be taken by US President Donald Trump as a sign of trade war retaliation. We’ll keep a close eye on these developments as further trade-war rhetoric could precipitate further dollar strength if it intensifies. USD strength remains a big risk to asset class performance, and this trend has fundamental backing from elevated real interest rate differentials between the US and the EU.

Trade wars fears subsided slightly in global markets in July as both China and the US announced measures to support their domestic economies. Internal stimulus might negate the impact of trade barriers but isn’t nearly as efficient as free trade. These actions also don’t rule out the potential for further cross-border tension.

Going forward, the slight improvement in global economic growth numbers relative to expectations in July, combined with the Chinese stimulus measures, could provide support to risk assets such as emerging markets, the ZAR and equities (local and global) in the short term. Major accumulation portfolios still have substantial exposure to these assets and should benefit from any improvement in risk appetite. We remain concerned by the late-cycle dynamics in developed markets, elevated valuations in major equity markets, and tightening central bank activity, which creates a backdrop against which risk management is favoured over chasing returns. Holistically we continue to favour cautious asset allocations with higher allocations to private equity and hedge funds as part of our risk management approach.

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Rob Price

Rob Price

Rob Price heads up asset allocation within the investment team. In short, asset allocation determines which asset classes are appropriate for a client’s risk and return objectives and at what percentages we should allocate to each asset class. This outcome a critical aspect of the investment process and a tool through which Alexander Forbes demonstrates its risk management approach. Rob is a trained economist and a CFA charter holder but he believes that the best education isn’t necessarily found in the classroom. He loves all things macro, appreciates ideas that challenge the status quo and is relentlessly in pursuit of practical answers to difficult questions.

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