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South Africa: Hope beyond the threat of a downgrade

While South Africa’s market performance has been unremarkable so far in 2016, political and economic events within the country have been more dramatic. With its sovereign credit ratings under scrutiny, we discuss the ongoing challenges and opportunities in a nation facing significant upheaval.

South Africa has performed broadly in line with the rest of the emerging markets this year (see Figure 1). Yet delve deeper and it is clear that the country and its economy have had a much more turbulent year, and now face the glare of the three leading credit ratings agencies. With the three agencies threatening to re-rate South Africa if change is not made, the need for reform is acute.

A country in crisis

Economically, South Africa is struggling more than it has in decades. In the first quarter of 2016, GDP growth turned negative for only the second time in 20 years and for the first time since the financial crisis. Stagflation, rising debt, twin deficits and political setbacks add to the rating agencies’ concerns about its economy and its prospects.

Figure 1. South Africa vs Emerging Markets
Indexed year-to-date performance in USD

sa-vs-gems-chart

Source: Bloomberg as at November 2016.

There are chronic structural issues that are preventing South Africa from developing its economy. These include a problematic labour market where unemployment is rife – standing at 27.1% in Q3 –  strikes are frequent and collective wage bargaining is common. Weak state-owned enterprises (SOEs), corruption, inadequate infrastructure, a high public-sector wage bill, poor education, and the prevalence of several oligopolies also undermine progress. South Africa has also fallen short in reducing inequality and the myriad problems associated with it.

The political landscape is unstable, too. In the last few months the African National Congress (ANC) has lost municipal elections in Pretoria, Johannesburg, Port Elizabeth and President Jacob Zuma’s hometown Nkandla for the first time since sweeping to power after the end of apartheid in 1994. Meanwhile, Zuma has been found to have misused government funds to upgrade his private home. This has prompted a new wave of criticism from opposition parties and the ANC itself and social unrest. The repeated strong-arming by Zuma – including his contempt for the Constitutional Court and appointments of three finance ministers in four days – has deterred external investors.

Downgrade to junk?

The combined political and economic turmoil has prompted speculation that Standard & Poor’s may downgrade the country’s foreign currency denominated bonds to junk status. However, the government has made some progress on reforming its SOEs and its spending, which include delaying big projects in the weeks leading up to the rating agency’s judgment. This may have contributed to Moody’s decision to hold South Africa’s rating at Baa2 on 25 November, although it warned that the country’s bonds would be downgraded “in the absence of fundamental structural reforms”.

The weakening position of Jacob Zuma and the ANC is potentially positive for the country. While Zuma survived a vote of confidence by the ANC’s National Executive Committee this week, his support has diminished substantially, with his own cabinet ministers openly criticising him. The candidates to replace him support the status quo, and so are market neutral, or are pro-reforms and pro-business. If a pro-reforms candidate is elected, he could boost social and economic sentiment in the country and benefit the performance of the stock market.

Further, the country’s economy has shown some resilience, growing 3.3% on an annualised basis in the second quarter to exceed expectations. Much of that growth was driven by an 18.1% increase in exports, particularly of precious metals, reflecting South Africa’s ongoing reliance on mining. Overall, the country is forecasted to have grown 0.5% over the course of 2016.

Opportunities in the upheaval

This turmoil has uncovered potential opportunities for investors. The South African apparel industry has been in a downturn for some time due to the weak economic situation, alongside rising interest rates, high consumer price inflation, slower real-wage growth, reduced access to credit, tougher competition and the political uncertainties miring the nation. However, this downturn has also affected stock prices and many companies in the sector are trading at attractive valuations.

With the potential for the political situation to improve in 2017, the likely introduction of a national minimum wage, fewer restrictions on credit, and the economy expanding, albeit tentatively, we believe that there are strong prospects for select stocks in this sector to rally.

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