Recent high frequency data and ongoing structural headwinds suggest that economic growth in South Africa (NYSE:EZA) is likely to slow once again following a short-lived cyclical rebound in the second-half of 2018.
South Africa - Quarterly GDP Growth (Seasonally Adjusted and Annualised)
Recent manufacturing production data for January showed a sharp 2% m/m contraction, while on a y/y comparative basis, output growth has also once again stalled printing at 0% y/y in December and 0.3% y/y in January.
Source: Statistics South Africa
Furthermore, the outlook for the rest of the quarter appears bleak, with recent survey data covering the manufacturing sector suggesting that the sector may see a renewed contraction in the first quarter of this year. The ABSA manufacturing PMI declined in February to 46, four points lower than the prior month and back in contraction territory.
Source: Absa PMI Survey, Tradingeconomics
More notably perhaps, a confidence survey of the entire economy and a fairly accurate leading indicator, the RMB/BER confidence index reported a renewed decline for Q1 2019 to 28 from 31 in the prior quarter. This was the lowest print since the second quarter of 2017 and before that, the deep recession of 2009.
RMB/BER Business Confidence
Source: Bureau of Economic Research (BER)
Ominously, looking at the breakdown within the RMB/BER confidence survey, the survey results showed a severe deterioration in confidence in the building or construction industry compared to the final quarter of 2018, with the sub-index printing at the lowest level in eight years. We have previously highlighted that a key structural factor suppressing the country’s growth rate is the lack of fixed investment. Despite the rebound in GDP growth in H2 2018, fixed investment spending continued to contract and subtract from overall growth.
Source: Statistics South Africa
The slump in the RMB/BER building confidence index as well as other leading indicators such as the real value of building plans passed (declining by 5.3% y/y) suggest that any recovery in fixed investment spending is not on the horizon at present.
Source: Statistics South Africa
The outlook for domestic consumption and retail sales also appears to have deteriorated with the retail trade confidence sub-index falling by 9pts, back down to 24 from 33 in Q4 2018, the lowest readings since 2013. The slump in retail sector confidence also correlates with the actual decline in new vehicle sales registered during the first two months of the year, which decreased by 7% y/y compared to the same two-month period one year ago.
It is also worth noting that the deterioration in some of the recent high frequency data is before the imposition of a new round of electricity tariff hikes. The National Energy Regulator (Nersa) was recently forced to award the embattled and insolvent state-owned utility operator Eskom a series of large tariff increases over the next three years. Electricity tariff increases are set to increase by 13.8% this year (From April/July), compared to a more moderate 5% increase last year. This will undoubtedly further suppress business confidence and investment, as well as erode the real disposable income of consumers even further.
In this context, it is extremely challenging to forecast any real durable economic upturn in 2019 and given the large increase in electricity tariffs there is a real possibility that the growth outcome for 2019 will not exceed the growth reported for calendar 2018 (0.8%). All of this ignores the increasing likelihood that South Africa’ s sovereign debt rating will likely be downgraded this year.
Of particular relevance will be what Moody's decides this year, given that it is the last major ratings agency that still has South Africa’ s sovereign rating at investment grade. However, the poor growth performance and further fiscal slippage (including a further bailout and cash injection of ZAR 69bn for Eskom) over the past two years as well as growing contingent liabilities associated with the various state-owned companies has led to a marked deterioration in the country’ s medium-term debt sustainability, as depicted in the chart below.
Source: National Treasury
More importantly, as the chart below published in a recent note from Moody’s also depicts, sovereign debt including debt owed by the various state-owned entities (SOEs) already exceeds 70% of GDP. Assuming gross public debt reaches 60% over the next few years, total non-financial public sector debt will likely exceed 80% of GDP and more than 90% including certain contingent liabilities such as those accrued by the Road Accident Fund.
Source: South Africa National Treasury and Moody’s Investors Service
This debt level is comparable with many other emerging-market peers such as Brazil that are all rated below investment grade status.
Source: IMF, Brazil Article IV consultation
In Brazil’ s case there is also a considerable quantum of public corporation debt outstanding, but with most of it owed by Petrobras (NYSE:PBR), arguably a more sustainable energy business when compared to Eskom, the immediate risk to the sovereign is distinctly more remote than when compared to the current situation as it pertains to South Africa and Eskom. South Africa also exhibits the same kind of structural“ faultlines” as Brazil, including an out-sized public sector wage bill and chronically depressed fixed investment.
Source: Free Market Foundation
More notably, stagnant growth over the next two years will likely result in further fiscal slippage, while the embattled utility parastatal is more than likely going to require a further bailout at some point. Although the energy regulator has awarded Eskom fairly hefty tariff increases for the next three years, these are still much lower (nevertheless - the correct policy decision) than what the parastatal requires in order to remain solvent. Based on Eskom’ s own estimates shown below (which remain quite optimistic with regard to the annual cost inflation estimates for employee compensation) and penciling in the recent tariff awards, we estimate that Eskom will still be cash negative at an operational level (before taking into account the bailout cash) after interest and capital investment in FY 2022. The recently announced cash bailout from the Treasury thus effectively only offsets the likely negative cash outflow for financial years FY20 to FY22.
This implies that Eskom’ s debt balance will remain at a record level around ZAR 500bn (10% of GDP) over the three-year forecast period, based on a best-case scenario. However, without further large electricity tariff increases beyond FY 2022 and/or additional bailout cash, Eskom’ s debt levels will grow once more, leaving little room for any further capital investment in new power plants. As we noted in this earlier article, Eskom’ s existing power fleet is ageing and a considerable portion of its installed fleet will have to be replaced over the next ten years.
Source: Eskom, MYPD 4 Tariff Application presentation
Some might view the large projected fiscal deficits as being stimulatory for domestic growth going forward. However, it is worth pointing out that the main factor behind the large fiscal deficits has been continued under-performance in terms of tax revenue collection, the bailout of insolvent state-owned entities as well as growing interest bill. These do not provide any real stimulus and in fact as the chart below shows, excluding the bailout cash awarded to Eskom, the current fiscal plan (assuming planned expenditure cuts are implemented) will actually prove mildly contractionary, further undermining the growth outlook.
Source : https://twitter.com/UgrasUlkuIIF
Therefore, it remains a mystery (to us at least) how Moody's is currently able to rate Brazil’ s sovereign debt two notches below that of South Africa's and also in the context of the lower ratings applied by both S&P and Fitch. In part it reflects some optimism that the new Ramaphosa administration can and will enact dynamic reform and rapidly turn the ship around. However, the political reality on the ground suggests that even if the Ramaphosa administration is successful it will take many years and many painful political battles to achieve this.
Firstly, as we outlined in this prior article, an attempt at fiscal consolidation combined with tight monetary policy and large real electricity tariff increases will almost assuredly see the economy mired in a slow or near-zero growth trajectory for years. This will inevitably erode the current administration’ s political capital even further. Secondly, current President Ramaphosa’s own political capital and grass roots support within his party remains fragile. The country’ s trade unions played an important role in his ascent to power at the African National Congress’s (ANC) elective conference in December 2017. However, his recent announcement and intention to reform Eskom including breaking it up into three components has met with stiff resistance from the trade union movement.
A further indication of the factional divisions within the ANC was also recently reflected by comments from the country’ s deputy president (effectively elected independently of Ramaphosa at the party’ s elective conference) with regard to comments made by current finance minister Tito Mboweni, in which Mboweni expressed support for the privatization of state-owned entities. These dynamics suggest that the dynamic reform that many expect from the Ramaphosa administration will likely fail to materialise.
As such, we would argue that a downgrade by Moody's is long overdue and largely unavoidable, the only question is to what extent it is already priced into the market? As the below chart shows, South Africa’ s 5-year CDS swap spread already trades at a wider spread than that of Brazil, despite the latter being rated two notches below South Africa.This suggests that a further downgrade may already be mostly priced into financial markets.
Nevertheless, with foreigners accounting for a large portion of the country’ s overall public debt stock there is still likely to be at least some short-lived negative impact from a further downgrade. As the chart below shows, South Africa still has the largest (as a % of GDP) stock of foreign portfolio investment in the emerging market universe.
Although the impact of further ratings downgrade will primarily be felt in the financial markets, it will in all likelihood impart a further negative confidence shock on the economy, at least over the shorter-term. This will further undermine growth projections for the next 12 to 18 months. As such it provides continued support for our long-held view that taking all of the above into account, a fair value for the Rand is significantly lower than present levels. Prudent investors should continue to avoid the listed ETF (NYSE:EZA), while more agile traders should look to short on any cyclical rally.
Ultimately, as we have argued, further ratings downgrades are inevitable and arguably the sooner they occur the better. Any associated currency devaluation will at least, on the positive side, impart a reflationary impulse throughout the economy. Indeed, the continuing economic stagnation suggests this is an economy in dire need of significant reflation, not only in order to reduce the nominal debt burden of the public sector, but also ensuring that the real cost of important production inputs such as electricity and labour remain competitive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.