Rand Weakness to Resume After South African Budget

South Africa’s budget statement delivered bad news on all fronts today. We see downgrades ahead, including the loss of investment grade from Moody’s. On the other hand, lower than expected inflation may tempt the SARB into tilting more dovish, which would also be negative for the rand.

POLITICAL OUTLOOK

General elections will be held on May 8. All 400 seats in parliament will be contested. Seats will be awarded proportionately according to each party’s share of the popular vote. In turn, parliament will elect the next president.

Recent polls suggest the ANC’s popularity has rebounded after Ramaphosa replaced Zuma as its leader last year. The latest Ipsos poll suggests 61% would vote for the ANC. 14% would back the Democratic Alliance (DA), 9% would back the Economic Freedom Fighters (EFF), and 2% would back the Inkatha Freedom Party (IFP). Still, a lot can happen between now and the spring.

The ANC has seen its share of the popular vote fall in every election since 2004. The ANC only got 54% of the vote in the 2016 municipal elections, a record low and down from 62% at the last national election in 2014. Since seats are awarded proportionally to the popular vote, a 61% showing this year would be very positive for the ANC, to state the obvious.

 

BUDGET OUTLOOK

Finance Minister Mboweni has painted an even grimmer fiscal picture than his midterm budget review back in October. The FY2018/19 budget deficit was revised to -4.2% of GDP from -4.0% in October. The deficit is forecast to widen to -4.5% in FY2019/20 vs. -4.2% in October before narrowing back to -4.3% in FY2021/22 vs. -4.0% in October. With regards to gross national debt, it is seen peaking at 60.2% of GDP in FY2023/24. This is up from a peak of 59.6% forecast in October. Mboweni pledged to stabilize this ratio around 60%.

We wrote back in October that if the fiscal trajectory did not improve in the FY2019/20 budget statement, downgrades become more likely. Well, the trajectory got even worse and supports our call for imminent downgrades to the nation. GDP growth is forecast by the Finance Ministry at 1.5% in 2019 vs. 1.7% previously, 1.7% in 2020 vs. 2.1% previously, and 2.1% in 2021 vs. 2.3% previously.

Eskom will receive the largest bailout in South Africa’s history totaling ZAR69 bln (44.9 bln). Over the next three years, the company will receive cash injections of ZAR23 bln per annum from the government that will be used to service its debt and free up cash for its operations. In return, the company must cut costs by ZAR20 bln per annum excluding reductions in the wage bill.

As outlined previously, the government still intends to split Eskom into three (generation, transmission, and distribution). The budget suggests that transmission will be the first to be carved out, with private sector investors being invited to participate. There is no question that drastic measures are needed to improve the power sector in South Africa, with recent outages serving as a grim reminder.

The budget aims to cut ZAR50 bln in other areas to offset the Eskom bailout. The main area of reduction is ZAR27 bln in salaries via early retirement. The spending ceiling will remain intact in FY2019/20 but will be breached after that, mainly because of Eskom. The bailout was supposed to be deficit-neutral, but the numbers clearly say otherwise. No changes were made to income tax brackets.

 

ECONOMIC OUTLOOK

Growth remains sluggish. The IMF forecasts growth of 1.4% in 2019, 1.7% in 2020, and 1.8% in 2021. These forecasts are slightly more pessimistic than the new forecasts contained in the budget statement today. GDP rose 1.1% y/y in Q3, rebounding from the 0.4% trough in Q2. However, monthly data in Q4 suggest growth decelerated and so we see downside risks to the growth forecasts.

Price pressures are easing. CPI rose 4.0% y/y in January, lower than the expected 4.3% and the lowest since March 2018. Inflation is still within the 3-6% target range, however. PPI rose 5.2% y/y in December, down sharply from the cycle high of 6.9% y/y in October. As such, price pressures are likely to continue abating.

The South African Reserve Bank (SARB) started a tightening cycle in November with a 25 bp hike to 6.75%. The vote was split 3-3. This ended a very shallow easing cycle that took the policy rate from 7.0% in mid-2017 to 6.5% in early 2018.

At the January 17 meeting, SARB delivered a dovish hold. Its model forecast only one more hike by end-2021 vs. three hikes by end-2020 that it forecast at the November meeting. Inflation forecasts were also cut last month. The decision to hold then was unanimous, suggesting it will take some doing to get another rate hike anytime soon.

Next policy meeting will be March 28 and the SARB is widely expected to keep rates steady at 6.75%. We would not be surprised if the SARB were to tilt even more dovish. Much will depend on the rand, but one could argue that the next move in rates is more likely to be down than up.

The external accounts are likely to worsen. The current account deficit was an estimated -3.7% of GDP in 2018, and the SARB expects the deficit to widen to -3.9% this year and -4.1% in 2020. Export growth slowed noticeably last year, leading the trade surplus to narrow sharply. The 12-month total is almost in deficit, something we haven’t seen since late 2016.

Foreign reserves are near record highs, but vulnerabilities remain. At $50.8 bln in January, they cover nearly 4 1/2 months of imports but are only equal to around 95% of the stock of short-term external debt. Thus, the country is vulnerable to shifts in sentiment and so-called hot money. One mitigating factor is South Africa’s Net International Investment Position (NIIP), which has risen to an all-time high near 15% GDP.

 

INVESTMENT OUTLOOK

The rand is outperforming after a poor 2018. In 2018, ZAR fell -14% vs. USD and was ahead of only the worst EM performers ARS (-51%), TRY (-28%), RYB (-17%), and BRL (-15%). So far in 2019, ZAR is up 2.5% and is behind only the best performers CLP (6%), RUB (6%), THB (5%), COP (4.5%), and BRL (4%). Our EM FX model shows the rand to have WEAK fundamentals, and so we expect this outperformance to ebb.

Right after the budget, USD/ZAR traded at its highest level since January 3 before reversing lower. The pair posted an outside down day that suggests further dollar losses ahead. However, support is likely to be seen at the 200-day moving average near 13.94. Our gut feeling is to fade this rand rally as we see this pair rising again to test the January high near 14.7015.

South African equities are underperforming. In 2018, MSCI South Africa was -15.5% vs. -17.5% for MSCI EM. So far this year, MSCI South Africa is up 5.5% YTD and compares to 10% YTD for MSCI EM. Our EM Equity Allocation Model puts South Africa at VERY UNDERWEIGHT, and so we expect South African equities to continue underperforming.

South African bonds are in the middle of the EM pack. The yield on 10-year local currency government bonds is -16 bp YTD. This compares to the worst EM performers Colombia (+11 bp), India (+6 bp), and Korea (+4 bp) as well as the best EM performers Argentina (-202 bp), Turkey (-105 bp), and Chile (-46 bp). With inflation expected to remain low and the central bank potentially tilting more dovish, we think South African bonds will outperform more in the coming weeks.

Our own sovereign ratings model shows South Africa’s implied rating steady at BB/Ba2/BB. We still believe Moody’s and Fitch’s ratings of Baa3 and BB+, respectively, are too high while S&P’s BB rating appears to be on target. Moody’s is scheduled to assess South Africa March 29. Its rating is very important, as the loss of investment grade would lead to ejection from the World Government Bond Index (WGBI) which in turn would result in some forced selling of South African bonds.

After the October midterm budget review, Moody’s stated that the weaker fiscal outlook was credit-negative. The agency wrote then that “The revenue assumptions underpinning the medium-term fiscal projections are achievable, but the broadly unchanged spending ceilings will be challenging to meet as the government aims to strike a balance between economic, social, and fiscal objectives.” The FY2019/20 budget presents an even worse fiscal picture and so we think Moody’s will have to cut South Africa to sub-investment grade.