So, what happened? I’ve been living under a rock.
A few nights ago, South African President Jacob Zuma fired Finance Minister Pravin Gordhan and made sweeping changes to his administration. He kept us waiting till near midnight, before revealing the news. It was more chainsaw than guillotine, in a high-stakes power play that saw with 10 ministers and 10 deputies axed and or shuffled around. Zuma replaced Gordhan, with whom he feuded over state finances, with Home Affairs Minister Malusi Gigaba, who has no financial or business experience. He also named lawmaker S’fiso Buthelezi to take over from Mcebisi Jonas as deputy finance minister. This move capped a dramatic week which began with President Zuma ordering Gordhan on Monday to cancel a series of meetings with investors in the U.K. and the U.S. and return home.
Many see this move as the last fortifications between the Treasury and those in power with nefarious objectives. Only time will tell if this is so. It’s hard to argue against the fact as this was a move that saw a cabinet formed, filled with Zuma supporters; an unknown quantity that will leave markets on edge. The key questions are: Will there be a backlash within the ANC? Are we going to see any ministers resigning in protest? What will the rating agencies say? Does the pending ‘no confidence’ vote in parliament have a chance on passing (50% plus 1 vote required)? When will we hear from the new Finance Minister and what will he say? It’s important to note that President Zuma didn’t bring in Nkosazana Dlamini-Zuma, the former head of the African Union Commission and his ex-wife, who is seen with Deputy President Cyril Ramaphosa as a leading contender for ANC president at a party electoral meeting at the end of the year. Atleast not yet.
It is not our role to make pronouncements on the political outcomes of presidential decrees except to the extent that they impact the portfolios we manage for our clients. It’s almost instinctive to want to want to jump on the current band-wagon, choose a side and make proclamations which for us at Luthuli Capital only serves to distract from the real question. Why was this done? The honest truth is we don’t know and enough columns have been dedicated to the speculation. History will judge this reshuffle as damaging or beneficial for the country and its economy when the Presidents’ vision for RADICAL ECONOMIC TRANSFORMATION is rolled out, implemented and left bare for us to judge and inherently live with it consequences. Until then, any judgement is based on pure speculation. That’s why at Luthuli Capital we firmly believe that optimal asset allocation is about sitting on the fence, constructing a fluid portfolio that can react to a multiple of possible outcomes. Portfolio management is all about achieving balance and positioning the portfolio so that it is not dependent on a single outcome. For some time, we have favoured offshore investments both directly and through domestic rand-hedged stocks and have steered clear of domestic long bonds. We’re not political analysts, we’re investment managers.
What should I be focusing on?
Don’t get distracted, focus on the fundamentals. The political situation in South Africa has been fluid for quite some time so the events of this week are not all that surprising. They serve merely to distract government and business from focusing on the real issues we need to solve if South African is to deliver the kind of growth that is going to reduce unemployment and poverty. The early market reaction to the cabinet reshuffle has seen a 5% weakening in the currency and 0.5% increase in bond yields. Relatively speaking, this is a much more muted response compared to when minister Nene was removed. The main difference between this week’s events and December 2015 is that the markets were better prepared this time around.
The second the President recalled the former Finance Minister he created an expectation. An expectation that he would act in some form. Nobody who claims to be in any form a financial analyst can say they were surprised by this move. Perhaps what is surprising was the extent of the cull. It’s also worth noting that the removal of this Finance Minister comes under slightly different circumstances. The economic backdrop is “considerably” improved, valuations of South African assets are at a discount (compared to their global counter-parts), inflation is falling (or was expected to hence the SARB kept rates unchanged), and terms of trade are significantly better. It’s by no means a complete reversal or a time of substantial economic growth but the landscape is different. I only highlight this to remind you that markets are forever changing, recovering and correcting, they survived 2008, they survived Nenegate and they will survive this so let’s just all calm down, focus on the fundamentals and prepare ourselves to tackle what awaits us ahead.
As an investor, you should look for signs that current policies will be maintained. For the bond market, what is most crucial is that government should stick to the expenditure ceiling as outlined in their February Budget and look to reducing debt thereafter. If, however, the market gets hints that this will not be the case then asset values will re-price lower and as an investor you should be prepared to react. The Rand will depreciate even more, long bond rates will rise, and interest-rate sensitive shares will suffer. The long-term outlook will be gloomy given that South Africa is already in a low growth, inflation-sensitive phase and unlikely to grow out of that environment anytime soon. In addition, the downgrade of SA’s foreign-denominated bonds is definitely back on the table.
Don’t say you were caught off guard or you didn’t see it coming, whatever the outcome. The biggest favour that the President has given us is that he has at least notified us that there’s a storm coming. It’s all speculation at the moment but the constant themes currently being touted are that the President has the following objectives:
He wants to commit South Africa to a nuclear-build deal with Russia and most probably benefit by a personal deal with the Russians;
He wants a finance ministry that will not impede his benefactors, the Gupta family, in their banking transactions (all South African banks have closed Gupta bank accounts due to money-laundering suspicions); and
He wants to engineer his hand-picked replacement come December’s ANC Elective Conference that will elect his successor so that he can continue to avoid prosecution.
You must decide which, if not all, of the above you believe. All of them are probable and likely but nobody knows. Time will tell so be ready to react. Our long-term view of the Rand is still one of steady but predictable depreciation. No matter the outcome over the following weeks or months.
What about the credit downgrade!
The cabinet changes will leave South Africa’s credit rating vulnerable. South Africa’s credit rating is up for review by Moody’s who will likely announce their decision next week Friday on the 7th of April. The chances have now increased that they could downgrade South Africa’s credit rating by one or two notches. Moody’s rates South Africa local currency debt at Baa (or BBB) two notches above junk. The foreign currency debt is also rated two notches above junk. S&P is due to announce the result of their rating review in June. They have been more vocal than Moody’s or Fitch about the possibility of SA being downgraded to junk status and, given that SA is only one notch above junk by their assessment, they may well downgrade in June.
Why should you care? A downgrade will increase the cost of debt throughout the entire economy. Interest rates on government bonds will be have to rise to compensate investors for the increased risk and the Reserve Bank will have to keep interest rates higher than it ought to, to compensate for a weaker currency. A higher repo rate will result in higher borrowing costs for consumers too. If you have debt, you should care.
Tell me about the Rand.
So far, the rand has managed to avoid a total free-fall. How we proceed from here will depend largely on how some of the key questions pan out during the week ahead. The rand extended losses, heading for its worst week in more than a year. The rand tumbled, weakening as much as 2.6 percent against the dollar and was at 13.4421 by 10:34 a.m. in Johannesburg on Friday. It has plunged 7.5 percent this week, the most of more than 140 currencies tracked by Bloomberg.
Gareth Frye of Currencies Direct writes the following:
It’s important to look at the facts and past history, straying from emotion, fake news and hysteria. Nenegate saw the rand lose 15% over the preceding month (December 2015). If we apply the same train of thought, the rand could end up near 14.20/$. But its 2017, and the rand’s fundamentals are vastly different to that of 2015. The rand is in a strengthening cycle (weakening in 2015), SA’s current account has narrowed sharply, commodity prices have stabilised and GDP prospects are improving. Nenegate accelerate the rand’s weakening trend, where Gordhangate will be working against a strengthening cycle. The rand has lost 5% since last week, but in a more favourable climate rand losses from a Gordhan axing should be significantly smaller. A further 5% weakness could see the rand test 13.60/$. If news emerges that Gordhan will be keeping his job, we could see the rand snap back to 12.50/$.