Market Commentary – April 2017

South Africa slips below investment grade after 17 years

The global macro-economic backdrop remains supportive with global GDP growth approaching its pre-financial crisis trend of 3.5%p.a.; a result of synchronous growth amongst the major economies, something notably absent in the past few years. The recovery in manufacturing activity is even stronger; as reflected by the Purchasing Manager Indices and Industrial Production series. In the particular cases of Europe and Japan, this is also likely to lead to a normalization of monetary policy, which is lagging the US Fed and thereby reducing global imbalances. The US economy has continued to outperform its developed world peers although expectations of realizing the ‘Trump effect’ are reducing following his failed attempt to repeal “Obamacare”. More recently, the US’ hard stance on North Korea and retaliatory strike on the Syrian regime have heightened risk aversion somewhat, with positive impacts on oil and gold prices. In the UK, Prime Minister triggered article 50 towards the end of the 1st quarter, starting the clock on BREXIT negotiations with the EU. While the impact of BREXIT have been relatively muted thus far, it must be considered in light of the fact that the actual event is long dated and impact thereof dependent on the outcome of the upcoming negotiations. Early in the second quarter, the UK Prime Minister called a snap general election, in attempt to consolidate power before those negotiations. This adds to an already heavy 2017 election calendar in Europe. Markets are cautious following the surprise BREXIT referendum and election of Donald Trump in the US despite polls predicting the opposite. Thus far European elections are passing without the feared rise of the “far right”, giving the ECB room to normalize monetary policy towards in the end of 2017.

South Africa has been precariously positioned given weak growth outcomes and rising political uncertainty. While structural impediments to growth seem unlikely to be resolved over the short term, the developing global tailwinds would seem to have bought the country some time (to preserve our investment grade credit rating). Towards the end of the first quarter, the presidency announced an extensive cabinet reshuffle affecting 20 cabinet positions; most notably replacing both the minister and deputy minister of finance. The response from the ratings agencies was swift with S&P downgrading our foreign currency rating to sub investment grade immediately. Fitch followed by downgrading the local and foreign rating to sub investment grade. Moody’s has delayed its scheduled review and will issue a new rating by the end of the second quarter. If either Moody’s or S&P lowers our local currency rating to junk, SA sovereign bonds will fall out of indices such as the WGBI (World Government Bond Index), which will trigger some forced selling. With the current fiscal constraints on government evident in the past few budget rounds, any incremental growth would require the investment from the private sector, which is already very depressed. The current increased uncertainty and likely increase in the costs of borrowing has made the chances of higher private sector investment even less likely thus dampening our growth outlook. Resolution is only likely to emerge post the ANC elective conference in December 2017.

Financials suffer from SA rating downgrade

Global equity markets were buoyant in the first quarter yielding total returns of 6.5% in US Dollars; driven mainly by strength in emerging markets, which returned 11.5%. MSCI South African equities index lagged emerging market peers, returning only 4.6% in USD. The Rand behaved in-line with the median for emerging market currencies, which broadly strengthened vs USD, reducing local currency returns by 2%. From an asset class perspective, SA equities performed in-line with bonds and slightly better than cash.

In terms of JSE sectors, industrials outperformed the general index, mainly due to strong showings from index heavyweights Naspers, Richemont and British American Tobacco. Richemont has benefitted from indications that global luxury spending may have reached a bottom. British American Tobacco is enjoying tailwinds from stronger emerging market currencies as well as anticipated value accretion from the acquisition of its associate Reynolds. The Reynolds acquisition will also give the group better geographic and product diversification, particularly exposure to next generation products in the US market. Naspers was driven by a strong recovery in Tencent, which rallied 19% during the quarter (after a weak last quarter of 2016) on the back of strong results released towards the end of the period. Healthcare was a notable exception within the industrial sector, featuring as one of the worst performing sub-sectors in the quarter. This was on the back of increased regulatory pressure, globally, weak organic performances locally and Life HealthCare’s discounted rights issue to fund its recent AMG acquisition. Netcare was particularly weak following a profit warning pointing to increased pressure from medical aids on authorizing hospital admissions.

After a strong performance in 2016, resources performed slightly below the overall market this quarter. The best performing shares, in the overall market, were the Kumba/Exxaro stable. Kumba benefitted from strong Rand iron ore prices which exceeded forecasts and strong 2016 financial results. Exxaro benefitted from the performance of Kumba’s assets as well recovering from a share overhang following the share placement during December 2016. Northam Platinum was also a strong performer, with the ramp-up of the Booysendaal mine still at an early stage. The company has completed some savvy deals recently, transforming the outlook for its mature Zondereinde mine, securing offtake for its UG2 Chrome ore and creating further optionality by acquiring the Eland Platinum mine.

Financials lagged the market over the quarter, declining 2%. Performance was positive until mid-March when rumors of an impending cabinet reshuffle started surfacing. Banks were the worst performing sub-sector, given their high sensitivity to interest rates. Considering the implications of junk status the current sell-off has been relatively muted. This can be put down to markets already partially pricing this scenario given the repeated warnings from ratings agencies since Nenegate. Further, South Africa’s dependence on foreign currency bond issues is limited (to around 15% of total) and these bonds had already been priced as junk. A 2nd downgrade of our local currency rating is likely to see more significant and forced selling of our local bonds, presenting a further risk to domestic equities.