Investment Alchemy series: Assessing current fiscal and political risks to SA markets

Connie Queline

Investment Alchemy series: Assessing current fiscal and political risks to SA markets

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SIMON BROWN: I’m chatting with Meryl Pick, head of equities research at Old Mutual Investment Group. Meryl, I appreciate the time today. It’s been a busy week with the budget speech this past Wednesday [21 February], and we have an election date, 29 May. What key pronouncements perhaps caught your attention on the budget speech in relation to its impact on equity markets?

MERYL PICK: Simon, quite a few things. I think the headline, as it’s being discussed in the media now, is that it was quite a market-friendly budget. That is the consensus. That is quite comforting in an election year.

There were a few standouts. Probably five or six things caught my attention. First, no new allocations to SOEs [state-owned enterprises]. And the tone in the minister’s speech itself was basically encouraging discipline, rigour, governance within SOEs and playing a bit of carrot-and-stick within further allocations or further assistance and support to SOEs coming with conditions of them opening to private-sector participation. I think that is quite encouraging.

Perhaps the big surprise in an election year is no fiscal drag relief. Yes, we can talk about the impact on the consumer, but my net takeout is that this is positive.

Anything that leaves the market feeling that the fiscus is under control in the long run is better for the economy, better for investment, better for the rand.

There was a lot of speculation about the GFECRA [Gold and Foreign Exchange Contingency Reserve Account], whether it would be used, whether it would be announced now, what would it be used for? I think we’ve had a good outcome. If we are going to use these reserves to pay down debt rather than to fund consumption or perhaps even infrastructure, where we’re not 100% sure of the governance, I think this is the best application of these reserves that we could hope for. So, this was a positive.

And then quite a big bump up in expected infrastructure spend, certainly versus the actual spend of the last three years. It’s about a 50% increase in the medium-term framework versus what has been spent. So again, quite a strong injection into infrastructure and construction. Lower end job creation could come out of that.

And then the final thing that caught my eye was starting to talk about electric vehicle production – I found that quite interesting – and how to adapt. We’ve got a great incentive scheme. We’ve got a great auto manufacturing industry, again, a big carrier of jobs in the country, and it would certainly be a shame were we not to keep up with the times and be part of the green transition there. So, it’s good to see that minds are being applied on how to do that.

SIMON BROWN: I take the point. And particularly motor vehicle production is a significant part of our economy.

If we look at risks associated with South Africa right now, how is this budget for foreign investors? What you’re talking around there to me looked like a budget which I think foreigners can look at and say ‘This is sensible’. It’s not within a hundred miles of Turkey interfering with central bankers and some of the stuff out of Venezuela. It looks like a mature budget, which could catch the eye of international investors.

MERYL PICK: Absolutely. I think ‘mature’ is a good word. I was thinking conservative, but mature is certainly a good word. Even the GFECRA, my understanding is that this is global practice.

There’s been a lot of, maybe, sensationalism around ‘We are stealing the crown jewels to pay the expenses’. That is a narrative that one can construct, but there is global precedent for using this.

And the fact that it is specifically going to reduce debt, which, in the end, reduces our borrowing costs – I think even that is being done in a responsible and mature way.

Probably the scaremongering and the worst-case scenario would be to have expected big injections into grants, or infrastructure spending, borrowing to fund all of that to secure loyalty for the ruling party. And we haven’t seen that, which I think is quite commendable.

SIMON BROWN: Absolutely. What stood out for me, perhaps as much as anything else, was that it didn’t read or [come across] like an election-year budget.

MERYL PICK: Absolutely. I think what international investors are looking at [is that] we certainly need to get SOEs under control. I think that would increase confidence. We need to continue [with the] scrutiny and improve governance within those because, obviously, we need reliable ports, we need reliable rail, we need reliable electricity generation.

So I think the tone that Treasury is taking there would fill investors with some measure of confidence.

I think the one thing to watch would be the wage bill, but we don’t have negotiations this year.

So again, we’ve even seen budgets in the past where the debt-to-GDP ratios look amazing and everything is trending in the right direction; but when you scrutinise the growth assumptions, they just look ridiculously high. So even there, they haven’t tried to window-dress or cook the books to make the ratios look good. With a growth assumption of 1.3%, these are very sober assumptions – a very sober and mature budget.

SIMON BROWN: Yes, absolutely. You mentioned at the top of your list about the budget was that lack of allocation to state-owned enterprises – SOEs. Eskom got a scolding. Transnet was told ‘We have a plan, and you don’t need the money’. Is the minister doing enough to sort of start restoring investor confidence – something which I think is not going to happen overnight – and are these the right sort of steps?

MERYL PICK: I do believe it’s going in the right direction, and I suppose the thing that makes it quite market-friendly is this encouragement of privatisation and partnering with the private sector.

I think that goes a long way to buying a bit of goodwill and buying hope that there would be increased governance and increased efficiency of delivery.

Private investors would be looking to make a return, and so there would be – hopefully, if everything is executed above board – some objective and independent eyes on the accounts, on the processes. I think that will certainly be well received by international investors.

SIMON BROWN: Moving from the budget, as I said upfront, this is an election year. We’ve got a date set for May 29. There is a lot of talk/expectation that the ANC will fall below 50% for the first time since democracy in South Africa. How are you and your team looking at this potential political risk as the different scenarios play out – and there are a number of them? How are you looking at these potential risks?

MERYL PICK: If you look, the polling data from various sources certainly does point to the ANC [support] falling below 50%.

If you look at the municipal elections, the local government elections as well, that trend would suggest that, if you copy and paste [the data]. However, we know national elections can surprise, turnout can sway things. Electioneering and campaigning can sway things closer to the time.

And if we look at the performance, if you knew nothing else and just looked at the trajectory of the national election scores since 1994, or the ANC’s majority, it suggests that they may still come in slightly above 50%. I think perhaps that is a base case with a close to 50% probability. I don’t think it’s a higher confidence base case, as it would’ve been in the years gone by.

I suppose the scenario that people would be most afraid of – and the most pessimistic scenario – would be quite a shortfall below 50%, such that the EFF becomes an attractive partner.

We know that there are factions within the ANC, the more radical economic transformation factions, that probably would look at a budget like we’ve just had [last] week, and perhaps not be content with that, leaning in a more populous direction. I think that is the fear, and I would say that’s the bear case.

The need for small parties to just make up a few percentage points or, more interestingly, partnering with the DA, is not necessarily a bad outcome. I think it’s just an unfamiliar outcome to us as South Africans.

But when we look at many countries in Europe, almost every country is run through coalition.

Every liberation party in the history of time has eventually lost its majority, and we are coming up on that 30-year mark.

If you look at the Indian Congress, it took some 27 to 30 years. Ataturk’s party in Turkey took about 30 years. In Mexico – I forget the name of the liberation party – they had, I think about a 70-year rule and eventually the transition. But they went through quite a few periods of violence and militants to get a transition. So I think the outcomes are quite broad.

But when we look at what’s come out of a budget like this, if you think back to the last year or two, we’ve had moves like everybody speculating about conscription of pension assets, etc. Instead, what did we get? You may [now] take 45% of your money offshore.

So the headlines, and what one reads and what the market feels, what average South Africans feel – in the end, what transpires a lot of the time is reasonably moderate. So, if we look at that we’ve got to tie up the rhetoric and look at the policy. The speed with which the ANC has executed more populist policies has been slow.

The allocation in this budget even to the NHI [National Health Insurance] was quite small.

SIMON BROWN: It was tiny.

MERYL PICK: Yes. You’ve got to look at that and ask ‘Could an outcome here with the DA be even possible?’ A blink response might be ‘Absolutely no’.

But we’ve seen a lot of research that suggests that even many ANC supporters would not be violently opposed to that, where there does seem to be less appetite for the radicalism that the EFF brings for many ANC supporters – and who knows what cabinet itself thinks?

In those various scenarios, I think so much negativity has already been priced into the rand, into bond yields.

Sentiment is low, offshore investors have run away. We’ve fallen out of many indices globally. If we see a peaceful election, either a small ANC majority or tie-ups with very small parties or a tie-up with a moderate opposition, potentially, we could see a rally of great proportions in the more local-facing equities and in bonds.

SIMON BROWN: Is that how, then, you and your team are sort of positioning around it? I take your point – there is the extreme sort of nightmare scenario, and absolutely that’s not impossible. We can put a likelihood to it. But I take your point around you saying that the ANC, almost in a sense, says one thing but does something else. And what they’re doing – and I go back to the word ‘mature’ – is doing that conservative sort of mature stuff, the responsible management. Taking that into account, how are you looking at positioning portfolios ahead of the election?

MERYL PICK: We’ve certainly been adding to the banks and the clothing retailers, partly also out of a view that we think we are reaching – or have reached – peak interest rates. Now, we cannot call when the cut will come.

So, if we take the election out of it, last year set quite a terrible base in terms of load shedding and the additional operating costs that many companies had to bear, or consumers had to bear. That is now in the base.

South African consumers, households, companies, cabinets – the one thing that we are is resilient and adaptable. So I think companies have figured out – management teams, particularly the good ones – have figured out how to navigate load shedding. So this is in the base. At least in the six weeks this year so far, we haven’t had the level or the frequency of Stage 6 that we had at one point in time.

So, potentially, we are looking at a better year, anyway, because of the level of load shedding that’s in the base. We’re not going to see the same scale of some of the commodity inflation in food and oil, in energy.

So things are getting slightly better for consumers, perhaps slightly better for growth prospects – and therefore those interest-rate sensitives are appealing to us.

We don’t look to position around an election; really, anything can happen. So we’ve got a diversified portfolio right now. Certainly, within the equity space, we have some exposure to gold. We do have defensive rand-hedge counters like BTI [British American Tobacco plc] and Anheuser-Busch.

But yes, we have been incrementally tilting the portfolio back to SA Inc. And I think how we think through the risk is that we would not want to build a portfolio that needs a specific election outcome or returns fall apart.

So we are also looking for companies that have a specific story that, regardless of the macroeconomic environment, can deliver returns. So, which are the companies that are innovating, that are taking market share, that are consolidating, that are potential buyout targets? Those stories are there.

We’ve held the construction names for quite some time. Our view has been that the construction sector has been so hollowed out – after a decade or more of a lack of infrastructure spend – that companies like Wilson Bayly [Holmes] and Raubex are the last ones with the balance sheet to accommodate big projects.

So to see a budget that is also forecasting a kick-up in infrastructure, some of that doesn’t have to come from government. Private sector is spending, renewable spend buildout is proceeding. These companies are sitting at record order books as it is, without the infrastructure announcements that we’ve seen this week.

Shoprite is innovating and taking market share while Pick n Pay is falling apart. So, regardless of the economic backdrop, there are always returns to be had in the SA Inc space.

SIMON BROWN: I take your point. We don’t know what the election will bring us. So it’s almost kind of ‘investing in spite of’. And perhaps that’s why the budget is in the immediate [sense] more important.

We’ll leave it there. Meryl Pick, head of equities research at Old Mutual Investment Group, I really appreciate the time.

MERYL PICK: Fantastic.

This podcast series, Investment Alchemy, is brought to you by the Old Mutual Investment Group. In relentless pursuit of investment excellence.

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