As another rating review loomed, many market participants thought South Africa was moving closer to the end of its investment grade status. Yet Moody’s decided not to review the sovereign now, enabling a rally in the rand and bonds despite numerous “own goals” over the past month.
We expected the rating reprieve based on Moody’s communications and the outcome of the rating methodology. Tellingly, the agency has repeatedly emphasised SA’s metrics relative to similarly rated peers. While analysts view the projected increase in the debt ratio to 60% of GDP as reason enough for a downgrade, from the agency’s perspective this is broadly in line with a Baa3 rating. Granted, downside risks have intensified, but Moody’s seems as patient as ever, which should lower the probability of a rating downgrade in 2019.
Operational challenges, diesel shortages, and lower power imports due to cyclone Idai in Mozambique triggered Stage 4 load shedding mid-March. The updated plan from the DPE and Eskom aims to stabilise supply during the high-demand winter period, but does not convince us that the end of electricity shortages is near. Stage 1 load shedding may not have an outsized impact on the economy, thanks to the forewarning and ability to plan around it, but the fact that energy-intensive industries must curtail power usage will trim in production and exports – mining and manufacturing combined contribute 20% to annual GDP.
While the direct hit to GDP may be limited, power rationing continues to dampen sentiment. The BER Business Confidence Index fell to 28 in Q1 – not far off the low of 23 seen during the global recession ten years ago. Our GDP tracker points to a contraction in 1Q19, which would weigh on SA asset prices given the implications for government revenues. SARS has already confirmed a R14.6bn tax shortfall for FY19. This would widen the budget deficit to 4.4% of GDP if some underspending does not offset it. The deterioration will not move the needle on the credit rating, for now, but with growth expected to oscillate around 1.0%, the chance of more pronounced slippage will rise.
Beyond Eskom, policy uncertainty has increased with the unresolved amendment to Section 25 of the Constitution, as well as President Ramaphosa’s commitment to nationalise the SARB. This may not necessarily threaten operational independence, but it will be a complicated and costly process. Finally, the ANC submitted a less-than-wholesome party list for the 8 May general elections that has led to doubt about Ramaphosa’s power within the ANC and his ability to pull South Africa out of the “New Dawn” into the sunlight.
The upshot of weak growth is that pricing power remains muted, leaving inflation close to the 4.5% implicit target. Low inflation, a notable moderation in inflation expectations, and a less hawkish Fed allowed the SARB to move to a neutral stance at its March meeting. The result was a unanimous decision to keep the repo rate unchanged, at 6.75%. The SARB’s primary repo rate model, the QPM, shows one hike, in 2019. If the SARB is able to progress through the middle of the year without hiking rates, then it is highly likely that the QPM will confirm that the hiking cycle has ended. It could even show that start of an easing cycle to align the SARB with the FRA market, which is discounting by the end of the year.
The Fed has been pivotal in giving risk assets and EM central banks some breathing room. The FOMC dot plot almost flat-lined in March as the median shifted to only one hike, in 2020. Moreover, quantitative tightening will end in September, and there is a high probability that substantial Treasury purchases will resume from 1Q20. The fall in the US 10-year yield, to 2.5%, may not be surprising, but a further decline would require another de-rating in US growth expectations. US yields remain attractive on an absolute basis and the US growth outlook is more robust than in Europe. This partly explains the resilience in the US dollar, which is counter to the anticipated impact of a dovish monetary policy shift and global growth recovery.
Yet we may be reaching the end of the cyclical slowdown, with China turning a corner based on the tick upwards in the manufacturing PMI, easier financial conditions, and a reversal in the credit impulse. This should bode well for Eurozone and EM growth, albeit with a lower beta and potentially a longer lag than in prior stimulus periods. The rebound in the Harper Shipping Index and the ascent in base metals prices could be harbingers of improving trade volume growth, but the elusive US/China trade deal has inhibited investment. The tedious process of Brexit may also be an underappreciated constraint on European growth. UK politicians have very little to show after almost three years of negotiations as the delay in Brexit has increased the tail events of a no-deal or a second referendum and a no-Brexit.
The inflection point for the dollar will have to come from stronger global growth that triggers a reassessment of ex-US global monetary policy. While renewed Fed balance sheet expansion should weigh on the greenback, the Fed’s assets are currently shrinking versus those of the ECB and BoJ. The persistent slowdown in Europe has delayed the timing of its first ECB hike to 2020. Fears of the “Japanification” of Europe escalated as the German (or should we say “Jerman”) 10-year yield fell to below 0% on the back of a slump in the PMI.
Lower Bund yields contributed to the descent in the US 10-year yield and the inversion, albeit temporary, in the US 10-year/3-month yield spread. Many analysts believe curve inversion portends a recession in 2020, but they acknowledge that risk assets can do very well in the final stretches of the expansion. The end may be near, but we are probably at the beginning of the end – in part, because the Fed has stopped its hiking cycle at neutral, rather than overtightening.
For SA, this is the end of the beginning of the leadership transition. All eyes will be on the 8 May elections as a gauge of structural reform, even if we know that reform is tough to implement, particularly with low growth, a divided party, and a vulnerable global economic backdrop.