Global Multi-Asset Viewpoint A New Hope: From Stagnation to Growth in South Africa SOLUTIONS & MULTI-ASSET GLOBAL MULTI-ASSET TEAM MACRO INSIGHT JANUARY 2018 The 2011-2016 commodity bear market, coupled with poor policymaking over the past several years, has wreaked havoc on South Africa s economy, society and asset markets. However, in our view the country is on its way towards making the difficult policy adjustments necessary for sustainable growth, and the country s political outlook finally seems poised to improve. Cyril Ramaphosa s victory in the African National Congress (ANC) conference in December is potentially a major turning point for South Africa, as he has promised to fight corruption, restore investors faith, and bolster business confidence. We have been positive on South African assets since October 2017 and currently see the greatest opportunity in local currency bonds. We review our investment case below. Weakened Economy South Africa s economy has performed poorly since Zuma took office in 2009 and the commodities bear market began in 2011. Real GDP growth averaged just 1.5% per year since 2009, well below the 4.2% average during the preceding eight years. 1 South Africa fared poorly during this period like other similar commodity-exposed economies because of the difficult external environment. In addition, poor domestic economic policies exacerbated the slowdown. The public sector did not adjust to lower commodity prices government expenditures rose significantly in the aftermath of the Global Financial Crisis (GFC) and never came back down, despite declining tax revenues. The average budget deficit since 2010 has been 4.3% of GDP, a sharp increase from the 0.6% average during 2000-2008. 2 Debt to GDP ratios ballooned to 53% in 2017 from 26% in 2008, leading to several credit rating downgrades. 3 AUTHORS Display 1: South Africa: Low Inflation Will Lead to Rate Cuts Policy Rate vs. Core and Expected Inflation in 12 months Percent (%) 12 10 8 6 4 2 SERGEI PARMENOV Portfolio Manager Global Multi-Asset Team Managing Director EZEQUIEL AGUIRRE-CAPURRO EM Currency and Debt Analyst Global Multi-Asset Team Vice President 6.75% 4.96% 4.20% 0 2006 2008 2010 2012 2014 2016 2018 Policy Rate Core Inflation Expected 12m Inflation Source: MSIM Global Multi-Asset Team Analysis; Consensus Estimates. Haver Analytics. Data as of January 31, 2018.
MACRO INSIGHT Between 2011 and 2017, South African bonds were downgraded six times by Standard & Poor s from A+ to BB+, and three times by Moody s from A3 to Baa3. Investors shunned South African assets. During that time period, the rand lost almost half of its value, while high inflation near the upper bound of the South African Reserve Bank s (SARB) 3-6% target range for most of the last seven years kept long-term bond yields high at a time when global interest rates were trending consistently lower. 4 Widespread corruption and cronyism exacerbated the difficult external conditions, pushing consumer and business sentiment to the lower end of their ranges since 2000 (Display 2). Gross domestic fixed investment has stagnated in real terms since 2013. As a share of GDP, investment declined to 19% from slightly above 23% in 2008. 5 Slow economic growth has also negatively impacted the job market. The unemployment rate rose to 27.7% in 2017 from 21.5% in 2009. 6 Real wage gains, particularly among workers in the private sector, have stagnated. Display 2: Corruption Has Depressed Sentiment Consumer vs. Business Confidence Percent (%) Percent (%) 25 90 20 15 10 5 0-5 -10-15 2000 2003 2006 2009 2012 2015 2018 Consumer Confidence (% Balance, LHS) Business Confidence (% Balance, RHS) Source:. Data as of January 31, 2018. Scandals over murky state contract awards were exposed; it became clear that certain business figures had had undue influence on politicians and the political process. Zuma s administration s defensive maneuvering amplified political volatility. In 2015 Nhlanhla Nene, the widely respected finance minister at the time, was fired leading the South African rand to plunge by almost 10% in the following days. 7 Another highly regarded finance minister, Pravin Gordhan, was also fired in March 2017. State-owned companies were put under the direction of Zuma s cronies. By some estimates, as much as $10-15 billion in public funds has been misappropriated. 8 The government s contingent liabilities may run as high as 15% of GDP by some estimates. 9 Of these, 8% can be attributed to Eskom, the stateowned power utility, which has been facing several challenges, including declining revenues, corporate governance problems, 80 70 60 50 40 30 20 and corruption, which are threatening the financial solvency of the firm. 10 Living standards of black South Africans have not improved except for a small elite since the end of apartheid. The future of the ANC, which has governed South Africa virtually unopposed since the election of Nelson Mandela in 1994, is at stake. The 2016 municipal elections saw the ANC s worst performance since 1994, as it lost in three of the biggest metropolitan municipalities, Johannesburg among them. Unless the economy is turned around, the party may be at risk of losing the 2019 general election. Beaten Down Assets Unsurprisingly, South African assets have underperformed broader emerging markets since 2011. The rand has lost 45% of its value against the U.S. dollar since April 2011 even after taking into account the recent rally. It also underperformed emerging currencies (which also fell, but just by 33%). 11 South Africa s equity market has also substantially underperformed both global and emerging equities over the past three years. Local currency government bonds underperformed the aggregate emerging local currency bond index (GBI-EM) by 10% as investor confidence in the country plunged. 12 This underperformance has left South African government bonds significantly undervalued, in our view. Ten-year government bonds are yielding 3.5% in real terms (Display 3); that is around 100 basis points above the average since 2005 and almost 150 basis points above the emerging market average. 13 The real effective exchange rate is also undervalued on an historical basis it is now 14% below its average level since 1994, although declining productivity accounts for much of this. Equities, on the other hand, are closer to fair value. 14 Display 3: South Africa: High Real Bond Yields Real Yield (10Y Bond Yield Minus 12-M Ahead Inflation Expectations) Percent (%) 5.0 4.0 3.0 2.0 1.0 0.0-1.0 2008 2010 2012 2014 2016 2018 Source: MSIM Global Multi-Asset Team Analysis; Using Consensus Inflation Estimates; Bloomberg L.P. Data as of January 31, 2018. 3.5% Average Since 2005 2 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET
A NEW HOPE: FROM STAGNATION TO GROWTH IN SOUTH AFRICA The Turn We believe that South Africa is now on the cusp of a political and economic transformation that would cause a rally in South African assets, driven by better domestic economic policies and expansionary monetary policy, and helped by an improved global environment. Pro-business Cyril Ramaphosa was elected president on February 15 after Zuma lost support within the ANC s National Executive Committee and was forced to resign. We expect Ramaphosa s leadership will lead to better policymaking which in turn will lead to higher investment, faster growth, improved budget balances and stable inflation. Ramaphosa has described the South African economy as moribund and in need of a plan to attract investment and reduce uncertainty. Pravin Gordhan, the highly-regarded former finance minister, is expected to take a prominent position in the new administration, although no formal announcements have been made. A new board of directors has already been announced at Eskom. The names have been very well received by market participants and should improve corporate governance and help reduce the size of contingent liabilities over time. We also expect new management at the tax authority, which should help improve tax collection. We also expect fiscal discipline to be restored, bolstering investor confidence. Budget deficits have widened to around 4% of GDP in 2017 from a 1% surplus in 2008. We estimate the government needs to improve the structural budget balance by only around 1.5-2.0% of GDP to stabilize debt ratios, since a cyclical growth recovery will likely lead to rising revenues as well. 15 A combination of tax increases and spending cuts will be required. A new budget will be presented on 21 February. A new plan may raise 0.3% of GDP in new revenues while cutting expenditures by 0.5% of GDP. 16 Revenue increases are likely to come from increases to gasoline levies, taxes on sugar, soft drinks and luxury goods, and by not adjusting progressive income tax brackets. The external environment has become more supportive since early 2016 which may make it easier to enact difficult reforms. South Africa s terms of trade have risen by 7% since late 2015. This has helped the trade balance improve to a surplus of 1.6% of GDP in 2017 from a 2% deficit in 2014. 17 The central bank s autonomy will likely be protected under Ramaphosa, in contrast to the Zuma s administration, which sought to nationalize SARB and re-direct its mandate away from price stability toward faster growth. Protecting the independence of the central bank will allow it to focus exclusively on keeping inflation low and stable within the 3-6% target range, in turn leading to potentially lower interest rates and risk premiums. The central bank cut its benchmark rate by 25 basis points to 6.75% in July, but refrained from further easing given the risks to the exchange rate that the December 2017 ANC conference vote represented. 18 The deceleration in growth and brief recession in 2016-2017 as well as the recent rally in the exchange rate (up 40% since early 2016 against the US dollar) brought inflation down to 4.7%, toward the center of the 3-6% target range. 19 The economy is already turning. Real GDP grew by an average of 2.4% in 17Q2-17Q3 after the 2016/17 recession. 20 Manufacturing production and retail sales are growing at rates of 2.1% and 7.6% YoY, respectively, according to November data. And activity should continue to accelerate given recent improvements in business surveys: the manufacturing PMI index jumped to 49.9 in January from 44.9 in December, while SACCI s business confidence index increased to 99.7 from 96.4. 21 Bonds to Benefit the Most We expect South African local bonds to be the greatest beneficiaries over the next 1-2 years of political and economic improvements, given cheap valuations, and sentiment which is still only modestly positive. We expect the ten-year bond yield to fall to 7.5% from 8.4%. 22 Inflation will likely continue to come down over the next 12-18 months due to high unemployment, a sizable output gap, and recent rand strength. It already has declined to 4.7% from 7.1% two years ago. 23 We expect inflation to decline to an average of 4.4% in 2018 and 2019 (below the consensus estimate of 5.1%), just below the mid-point of the central bank s 3-6% target range. 24 The output gap is negative and sizeable, at around 2%. The unemployment rate is at 28%, well above the 22% it reached before the global financial crisis. 25 We estimate the high unemployment rate could contribute 1 percentage point of disinflation. The capacity utilization rate in the manufacturing sector has risen to around 82% recently, but it is still below the pre-gfc peak of 86%. Resource utilization measures are likely to remain loose as we expect South Africa to grow below its 2.5% potential growth rate in 2018 and 2019. 26 In addition to the sizeable output gap, the recent strong performance of the South African rand will also put downward pressure on inflation. We estimate the exchange rate passthrough to inflation is around 8%, which suggests around 1 percentage point of disinflationary pressures due to the recent exchange rate strengthening the rand is up 15% just since November. 27 Given our expectation for lower inflation, we believe the market is underestimating the size of future interest rate cuts. The central bank estimates the short-term neutral real rate is around 1.5%, which implies a neutral policy rate of 6% given the inflation target of 4.5%. The benchmark repo rate is currently SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 3
MACRO INSIGHT 6.75% and the market is pricing just one 25 basis point rate cut over the next 12 months. 28 We expect at least 75 basis points of rate cuts and possibly more: core inflation is already below target and the output gap is negative, which should call for belowneutral real rates in the near term. 29 Beyond the current disinflationary forces, long-term bonds will also likely benefit from risk premium compression. Rising deficits and debt levels have raised the risk of a credit rating agency downgrade, and have been the main driver of South Africa s yield curve steepening. On current trends, gross government debt will reach 60% by 2020-2021 (from just above 50% today). 30 This has prompted credit rating agencies to put South Africa s debt on negative watch. Agencies could potentially downgrade it to below investment grade as soon as March, which would result in automatic exclusion from major global bond indices, and bond outflows of as much as $8-10 billion given South Africa s weight in the WGBI index. As a result of these downgrade fears, we estimate the term premium in ten-year bond yields is 60 basis points above fair value after accounting for the cycle in short-term interest rates. 31 However, we expect credit rating agencies will grant the new administration time to introduce new policies before making a decision. As stated above, we expect Ramaphosa s administration to address budget deficits with a combination of tax increases and spending cuts. This would limit debt growth and reduce the term premium which we suspect can decline by half, or 30 bps. In sum, we expect ten-year bond yields to decline by roughly 100 basis points to 7.5%, as a result of central bank rate cuts and a decline in the risk premium. (Other South African assets which also stand to benefit from improved conditions, are less attractive: we expect roughly flat returns from the currency and think that South African equities will likely perform in line with other emerging markets). 32 Many Risks Remain Ramaphosa s ability to effect change may become compromised. Only slightly more than 50% of the 96 members of the powerful National Executive Committee the top decision body of the ANC are Ramaphosa supporters. Zuma still has powerful figures backing him and he remains popular among a sizeable share of the population. From an economic standpoint, a decline in commodities prices and rising global interest rates are the main risks to our view since they would put downward pressure on the exchange rate, leading to higher inflation expectations. 4 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET
A NEW HOPE: FROM STAGNATION TO GROWTH IN SOUTH AFRICA RISK CONSIDERATIONS There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. In general, equity securities values fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longerterm securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities (MBS and ABS) are sensitive t early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Portfolio, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the United States. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Sovereign debt securities. The issuer or governmental authority that controls the repayment of sovereign debt may not be willing or able to repay the principal and/ or pay interest when due in accordance with the terms of such obligations. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Real estate investment trusts are subject to risks similar to those associated with the direct ownership of real estate and they are sensitive to such factors as management skills and changes in tax laws. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the Portfolio s performance. Trading in, and investment exposure to, the commodities markets may involve substantial risks and subject the Portfolio to greater volatility. Nondiversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company s portfolio securities. In addition to the Portfolio s fees and expenses, the Portfolio generally would bear its share of the investment company s fees and expenses. Subsidiary and Tax Risk The Portfolio may seek to gain exposure to the commodity markets through investments in the Subsidiary or commodity index-linked structured notes. The Subsidiary is not registered under the 1940 Act and is not subject to all the investor protections of the 1940 Act. Historically, the Internal Revenue Service ( IRS ) has issued private letter rulings in which the IRS specifically concluded that income and gains from investments in commodity index-linked structured notes or a wholly-owned foreign subsidiary that invests in commoditylinked instruments are qualifying income for purposes of compliance with Subchapter M of the Internal Revenue Code of 1986, as amended (the Code ). The Portfolio has not received such a private letter ruling, and is not able to rely on private letter rulings issued to other taxpayers. If the Portfolio failed to qualify as a regulated investment company, it would be subject to federal and state income tax on all of its taxable income at regular corporate tax rates with no deduction for any distributions paid to shareholders, which would significantly adversely affect the returns to, and could cause substantial losses for, Portfolio shareholders. SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 5
MACRO INSIGHT FOOTNOTES 1 2 3 4 5 6 7 8 9 10 11 12 13 Using consensus inflation forecasts for the next 12 months. MSIM Global Multi-Asset Team Analysis; Haver Analytics 14 15 16 17 18 19 20 21 SACCI = South African Chamber of Commerce and Industry 22 23 24 25 26 27 28 29 30 31 32 IBID. DEFINITIONS The S&P GSCI Total Return Index is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. IMPORTANT DISCLOSURES The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. 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