Armin Diem - MitonOptimal South AfricaWhat lies ahead for the Johannesburg Stock Exchange All Share Index in 2019/2020?

Financial theory says that equities are meant to be the best medium to long-term investments as the high short-term volatility of the asset class is overcome / reduced by time in the market; coupled with the ability of companies to grow their businesses, earnings, cash flows and thus ultimately their dividends. In South Africa, the All Share Index has underperformed cash, the least risky investment, over the past one year, three years and five years. Furthermore, if you had to exclude a handful of the big Rand hedge stocks such as Naspers, BHP, Richemont, Anheuser Busch and British American Tobacco, the overall JSE Index would have delivered meaningful negative returns over all these time periods. The stocks focused on the South African economy have delivered significant negative returns, as a combination of investors derating sectors, as well as an inability of domestic companies to grow earnings over the past two years in an increasingly difficult business environment, has resulted in capital losses. The questions we ponder in this week’s comment are;

  • Can we realistically expect this to change over the next 18 months?
  • Will the Rand hedge stocks still deliver the best returns going forward?
  • Will cash again outperform the All Share Index?

A good starting point in an attempt to get some answers to these questions could be to compare the travails of one of our emerging market peers, namely Brazil. Brazil has many of the same attributes as South Africa: both rank poorly on global corruption perception indices; both have had allegations and investigations around their past presidents with highly ranked party members abusing state companies and resources; both are vulnerable with their current account deficits and both face waning confidence from foreign investors.

In September 2015, Brazil’s sovereign credit rating was cut from investment grade to junk status and what followed was two consecutive years of negative GDP growth of -3.3% and -3.5%, with inflation rising from 5% and spiking close to 10%, and budget deficits swelling to 8% of GDP due to a shrinking economy. This economic pain forced new elections and new presidents and since 2016 the government has been attempting to pass legislation reforming their pension system to cut the budget deficits and help arrest the build-up of state debt that now stands at 88% of GDP. From 2017, when investors’ hopes of a radical change in economic policy surfaced, there has been a massive rally in the Bovespa equity index, as hopes build that Brazil’s economy is finally on the mend. President Bolsonaro and Finance Minister Guedes have promised to reform social security, reduce the national debt, cut public workers’ inflated salaries, reduce taxes and make labour laws more flexible. Brazil’s current budget deficit in 2019 presently stands at 6.7% of GDP.

The main lessons to be learnt in both Brazil and South Africa are that the root of their problems is political, not economic. Unless, the South African political environment is ‘fixed’, the country may / will follow in the footsteps of Brazil into a downward spiral of economic contraction and multiple sovereign debt rating downgrades. Due to pervasive and damaging control of State Owned Enterprises (SOE) – determined most often by ideology rather than pragmatic policy – both countries suffer from an overbearing state. A crisis in government has led to an economic crisis. Cyril Ramaphosa and his supporters in the ANC must be able to drive meaningful reform, as the state has steadily been growing its consumption of all resources available in South Africa and crowding out the private sector: if you include the projected SOEs’ debt it puts South Africa’s debt to GDP at over 70% in two years’ time, easily forcing ratings agencies into more downgrades. One factor in South Africa’s favour in 2019 is that global risk-free rates have tumbled, thus helping reduce the impact of credit downgrades, as the worldwide search for yield continues. The path that Brazil has trodden highlights clearly what can lie ahead for South Africa. Looking ahead, pressures on South Africa’s sovereign credit rating include very weak real GDP growth, public sector underperformance, twin deficits showing a shortfall in both the fiscus and current account, waning investor confidence, as well as the continued structural challenges of high unemployment, inequality and poverty.

Notwithstanding the current race to the bottom in global interest rates and bond yields as Central Bankers from the US Federal Reserve, the ECB, Australian Central Bank, Indian Central Bank and many other emerging market Central Banks cut interest rates and speak in dovish tones; lower credit ratings should result in higher borrowing rates for governments and naturally the SOE’s. Unless South Africa follows correct policy paths, business confidence and consumer confidence will not recover materially from these very low levels resulting in poor economic growth prospects and ultimately no  employment opportunities for the 27% of South Africa’s unemployed. This will eventually result in a debt crisis despite the current downward shift in global rates.

President Ramaphosa, South Africa’s economic future is in your hands and the time for action is upon us!

Download: Weekly comment, Armin Diem – 170619

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