Markets Sober Up to Post-Election Reality in South Africa

new South AfricaThe market-friendly candidate won the ANC leadership contest.  Looking beyond the initial euphoria, we believe South Africa’s problems won’t be solved quickly, especially since Ramaphosa’s victory was so narrow.  We believe the post-election bounce in the rand is mostly over. 

POLITICAL OUTLOOK

In a close race, Deputy President Cyril Ramaphosa was elected as the new ANC President over opponent Nkosazana Dlamini-Zuma.  The vote was 52-48% in favor of Ramaphosa.  While the outcome deals a serious blow to President Zuma, the narrow margin of victory supports our view that Ramaphosa will face significant obstacles in governing.

Indeed, three of the six officials elected to the ANC’s top governing body are Zuma supporters.  Along with ANC President Ramaphosa, new ANC Deputy President Mabuza is a Ramaphosa ally, as is ANC Chairman Mantashe.  On the other hand, Secretary-General Magashule, Deputy Secretary-General Duarte, and Treasurer-General Mashatile are in the Dlamini-Zuma camp.  Furthermore, reports suggest Ramaphosa does not have majority support in the key ANC National Executive Committee (NEC).

Politics are now stuck in a limbo, as Zuma’s term isn’t scheduled to end for another year and a half.  If the ANC were to force him out earlier in favor of Ramaphosa, then that would be a good signal for the markets.  However, we suspect that Zuma will hang on to power given the makeup of the NEC.  As such, we look for an extended lame duck period where nothing good (and quite frankly, something bad) gets accomplished.

There is no date in set yet, but national elections will be held in Q2 2019.  In the past, the elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).  That gives Zuma a lot of time remaining to push populist policies in the hopes of boosting public support for the ANC.

Parliamentary seats are awarded proportionately to the party’s share of the popular vote.  Lawmakers are chosen from party lists.  Note that the President of South Africa is not directly elected by voters, but is instead chosen by a parliamentary vote.  If the ANC wins the 2019 elections, Ramaphosa would then become President of South Africa.

We say “if” because the ruling ANC has seen its share of the popular vote fall in every election since the end of apartheid.  The ANC only got 54% of the vote in last year’s municipal elections, down from 62% at the last national election in 2014.  A sub-50% would be a disaster for the ANC, to state the obvious.  This outcome is a realistic possibility if the ANC in-fighting continues.  Yet given how toxic the ANC has become under Zuma, we think markets would welcome an opposition win.

Corruption and inefficiency remain issues for the country.  South Africa scores low in the World Bank’s Ease of Doing Business rankings (82 out of 190 and down from 74 in 2017 and 72 in 2016).  The worst components are starting a business and trading across borders, while the best are protecting minority investors and paying taxes.  It also scores low in Transparency International’s Corruption Perceptions Index (64 out of 176 and tied with Montenegro, Oman, Senegal, and Suriname).

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to accelerate modestly to 0.7% in 2017 from 0.3% in 2016, before picking up again to 1.1% in 2018.  GDP rose 0.8% y/y in Q3, the weakest rate this year.  Whilst Ramaphosa has pledged to boost growth, his hands are tied by the need to rein in widening budget deficits.

Price pressures are easing, with CPI decelerating to 4.6% y/y in November from 4.8% in October.  This matches the low for the cycle, and puts inflation near the middle of the 3-6% target range.  Core and PPI inflation are also at cycle lows.

This supports the case for lower rates, and we believe the South African Reserve Bank is likely to resume its easing cycle in early 2018.  The central bank started the easing cycle in July with a 25 bp cut to 6.75%, but has been on hold since.  If the rand remains relatively firm, we think another 25 bp cut to 6.5% is likely at the next policy meeting January 18.

Fiscal policy remains an open question.  If President Zuma remains in power, we do not think that his Finance Minister Gigaba will make much of an effort to tighten fiscal policy.  On the other hand, it seems likely that Ramaphosa would bring in someone market-friendly if he were to take the reins.  The budget deficit came in at an estimated -4.1% of GDP in 2016, up from -3.8% 2015.  The OECD expects it to widen to around -4.8% of GDP in 2017 before narrowing to -4.6% in 2018, but much will depend on political developments.

The external accounts are likely to worsen.  Low commodity prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was about -3.3% of GDP in 2016, and the OECD expects it to narrow to -2.6% in 2017 before widening to -3.6% in 2018 and -3.8% in 2018.

Foreign reserves have risen to record highs.  At $50.3 bln in November, they cover 5 ½ months of imports and are about equal to the stock of short-term external debt.

INVESTMENT OUTLOOK

The rand has done well this year after a strong 2016.  In 2016, ZAR rose 13% vs. USD and was behind only the best performers BRL (22%) and RUB (20%).  So far in 2017, ZAR is up 8% YTD and is behind only the top EM performers KRW (11.5%), MYR (10%), and THB (+9%).  Our EM FX model shows the rand to have VERY WEAK fundamentals, so this year’s outperformance is likely to ebb.

At the very least, we look for the pair to move back to the 13.31 area in the coming weeks.  Retracement objectives for USD/ZAR from the November-December drop come in near 13.3130 (38%), 13.5540 (50%), and 13.7950 (62%).  Note that the 200-day moving average comes in near 13.3325, so a clean break of the 13.30 area would likely set up a quick test of the 13.5540 level.

South African equities are underperforming EM for the second straight year.  In 2016, MSCI South Africa rose 0.6% vs. 7.3% for MSCI EM.  So far this year, MSCI South Africa is up 17.5% YTD and compares to 32% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has South Africa at a VERY UNDERWEIGHT position.

South African bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -22 bp YTD.  This is in the middle of the EM pack.  The worst performers are Czech Republic (+115 bp) and China (+88 bp), while the best are Indonesia (-151 bp) and Hungary (-114 bp).  With inflation likely to continue easing and the central bank posed to restart the easing cycle, we think South African bonds will start outperforming more.

Our own sovereign ratings model showed South Africa’s implied rating falling a notch this past quarter to BB-/Ba3/BB-.  As such, we believe actual ratings of BB/Baa3/BB+ are seeing even greater downgrade risk.  Finance Minister Gigaba’s October mid-term budget statement did not prevent a S&P downgrade, and its new BB+ local currency rating led to ejection from Barclays Global Aggregate Index.

The loss of investment grade from Moody’s seems likely after the February budget is released.  However, Moody’s have been very patient and may wait to see how the political outlook shapes up before making any moves.  If Moody’s were to downgrade next year as it eventually should, South Africa would be ejected from Citi’s WGBI.