The political economy analysis below I published on November 3, 2016. It only went out to a few people and clients on email, and wasn’t published on my employer’s letterhead. It was my personal view that some folks requested. Now that the economy is officially in recession, some 8 months later (and according to Bloomberg only 1 in 24 had anticipated this recession as late as two weeks ago), I am publishing my analysis here. In the future I will publish my thoughts on SA macro on this blog as these views are personal and not what I’m paid to write about at work (I’m paid to write about frontier markets). I will however charge a small fee to gain access to pay for this site’s maintenance and for the time taken to publish during my spare time, after-hours. The next instalment will be out in the next few weeks in which I update my thoughts on SA political economy and how I see the way forward. My view on the politics has evolved slightly since November, as the situation has evolved (it looks like something between scenario 2 and 3 presented below is playing out).

I hope you enjoy this article. I’ve taken all graphs out the article as they were drawn using my employer’s resources. The thoughts are however entirely mine (and didn’t win me any popularity contests).

South Africa macro outlook & outlook on the politics

November 3, 2016
By Chris Becker

There wasn’t anything particularly new in the Public Protector’s “State of Capture” report released yesterday. It was more confirmation that the President, and some of his family members, have been working closely with the Gupta family and other politicians to mutually beneficial personal enrichment at the expense of the taxpayer and the public. Eskom is heavily implicated in much of this corruption.

Soon after the report was released Thuli Madonsela, former public protector who is responsible for the report said she regrets not taking a harder line in it. It now makes sense that President Zuma withdrew his interdict because there was nothing too damning in it.

From here the Chief Justice has 30 days to appoint a judge to head a commission of inquiry into the allegations in the report. Within 180 days the findings of this inquiry must be handed to the public protector (ostensibly a Zuma ally at this point). Thereafter if criminal activity is uncovered the public protector hands it over to the National Prosecuting Authority and Hawks (both under Zuma control at this point) for prosecution.

It doesn’t instil confidence that this will be the fair outcome many have pinned their hopes on.

Meanwhile in the political arena the dam wall seems to have broken and Zuma support is flooding across to the Gordhan camp. Among others, the National Education Health and Allied Workers Union turned on Zuma earlier this week, a powerful labour union of 300,000 members. The more support shifts from Zuma to the Gordhan camp, the more existing Zuma support will question its conviction. It’s a fluid environment right now.

Meanwhile the ANC is still putting on a face of unity and the ANC National Executive member Zizi Kodwa, who also serves as the ANC’s national spokesperson saying the report did not recommend that the party remove its president and that “we have full confidence in the president…There is nowhere in the remedial action where it suggests that the ANC must not have confidence in the president…we must deal with factual issues at this point.” Maintaining unity and preventing factionalism from splitting the party up (that would benefit the EFF/DA) is a key priority of the ANC right now.

There are a few possible scenarios from here:

1. Zuma is ejected as national president through a vote of no confidence in parliament but then faces prosecution.
   • Lawmakers have called a vote on November 10th
   • Parliament needs to vote two-thirds in favour of this motion. Likelihood of this scenario is rising but without an anonymous vote many feel this outcome is still unlikely. EFF tried to get an anonymous vote to no avail a few months ago.
2. Zuma strikes a deal with the ANC to leave office with immunity from prosecution
   • Likelihood of this scenario low considering such a deal would further fuel anti ANC discontent and plays into EFF and DA’s hands
3. Zuma takes a stand and fights for survival
   • Does the 72 year old president have the will to fight? My take it’s not only him but also his allies like Molefe, Zwane, Moyane, van Rooyen, etc that also need to protect their political careers and it’s tricky for them to join the opposition at this point, their names pop up too often in the wrong places
   • Some say the president doesn’t have leverage, but remember a key Zuma ally, Tom Moyane, heads up the SA Revenue Service. SARS is an autonomous organ in terms of SARS act of 1997. It collects taxes based on policy set by NT. SARS payments go into private bank accounts held in SARS name, and then transferred to NT for spending.
     • I am speculating but perhaps as a last resort Zuma faction can bypass need to control NT and use SARS as it’s treasury (Angola/Sonangol style) – but this is extremely risky and triggers public backlash and probably a tax revolt
     • This means Zuma faction can use the strength and positive public perception of SARS as a bargaining chip to secure immunity or broker some form of deal to manage a transition. In other words, Zuma could say work with me or we destroy the SARS and its reputation, trigger a tax revolt, and destroy what you think is yours. Does tax penetration go the way of rest of Africa in this scenario?
     • Alternately (or maybe in combination with the above) the president could start a smear campaign against his opponents—are they all squeaky clean? Potentially devastating for the entire ANC.

I think scenario 3 is most likely (60%), followed by scenario 1 (30%), and lastly 2 (10%).

More importantly for the long-term growth outlook though I put less than a 10% probability on the possibility that the ruling party abandons the developmental state ideology that has been implemented in the past decade and led to the slide of SA down the ease of doing business and freedom indices. At its core this is leading to slow growth and widespread socio-economic issues. Unless this policy framework is abandoned SA’s potential and actual GDP growth will continue to slow and remain below population growth, and I don’t see a Zuma exit changing this policy framework.

Meanwhile all of this is happening in an environment where the economy is going into recession. Manufacturing, industry and agriculture have been in recession for several months already, and the next shoe to drop in the national accounts—in my view—is retail/private consumption. It’s already coming through in the cyclical, near-term data. Truworths posted a shock trade update this morning that like for like SA sales volumes dropped around 20% y/y. Edcon already went through a debt restructuring to continue trading, and the latest to confirm business rescue is the nearly 200 year old retailer, Stuttafords, after a major bank pulled a funding line. Discount retailer Massmart says trading conditions are the toughest they’ve seen in 15 years. Anecdotally, it’s unusual to see major retailers running specials BEFORE/DURING the Christmas shopping season.

Key near-term macro indicators confirm the downturn with household credit extension flat in the past year, hitting record low growth rates.

Going back in time passenger car sales volumes have been closely correlated with retail sales volumes, and tends to lead by a few months. With car sales contracting >10% y/y at the moment while 3-month smoothed retail sales volume growth still hovers around 3% y/y, the risk for retail sales is still sharply tilted to the downside.

Long-time friend and former colleague, Russell Lamberti (chief strategist at ETM Analytics) shows that in periods where the real effective ZAR exchange rate strengthens, retail tends to outperform real GDP growth, and vice versa. As the following chart shows (CLB note: deleted for this blog post), recent weakness of ZAR on a REER basis suggests that retail is set to underperform GDP for several quarters. With other sectors already misfiring, there’s no catalyst for a growth recovery in 2017.

It’s now important to pull the lens back on the secular retail environment.

Between 1970 to 1985, SA retail sales volumes doubled. Then it stalled for the following 15 years, and in the 15 years since 2001 volumes doubled again. Notice a roughly 15-year cycle in the past 45 years? (CLB note: charts deleted for this blog post).

The growth of SA retail was not funded by growth in industry and goods-producing sectors domestically, highlighted by the following chart (CLB note: charts deleted). In order of importance we reckon a dishoarding of household savings (savings rates/GDP halved from 1980-2015, and household gross DIS-savings are running at -$2bn/quarter since 2007), capital consumption (hard to measure but anecdotal evidence strong, value of SA assets down in hard currency terms), and an increase of borrowing from foreigners through both local currency and hard currency government and corporate bonds funded the consumption spending (funding SA’s twin deficits). Net Direct investment flows has already been leaving SA steadily in the last two years, meaning that portfolio inflows are the primary source of funding for the current account deficit. Rating downgrades, messy politics, recessions are not things that tend to attract strong portfolio flows.

The reality then for the GDP growth outlook is that retail is not going to be the driver it was in the past 15 years (household consumption growth outstripped real GDP growth consistently in last 10-15 years). Other sources of income and profits will be required to drive real GDP growth, and that can’t happen without structural economic reforms, yet the ruling party faces existential and public legitimacy crises leading to a policy status quo (an ongoing leftward shift in policy). If anything the political environment hurts a reallocation of capital away from consumption/retail toward goods producing sectors as entrepreneurs worry about their property rights over the long-term. Stringent labour laws will also mean jobs aren’t efficiently reallocated from the overinvested/malinvested retail sector toward other areas of the economy. As a result if many jobs are lost in this recession they may never be replaced as there is also a clear trend toward automation still in progress. We’ve seen a major reallocation of commercial real estate away from industry/manufacturing toward services in the metropolitan centres to hedge against long-term property rights risks, but are these services business able to decouple from slowing growth and incomes in other sectors? We doubt it.

In my view, the economy is heading into recession in 2017. It’s not a consensus view at this point as a Bloomberg poll of 24 economists sees growth at 1.1% in 2017 and 1.8% in 2018. National Treasury itself pencils growth of 1.3% in 2017, another optimistic growth forecast that’s likely to be missed (again). NT has been perma-bullish on growth in the past six years (see graph below; deleted for this blog post). This means the economy would be going into a recession in a historically wide fiscal deficit position, while recessions typically see the fiscal surplus/deficit drop by around 4 percentage points.

After pricing a steep rate hike cycle at end-2015 (nearly 200bps of hikes were priced in before end-2016), the market is priced for a 50% chance of another 50bps rate hike before end-2017. There are obviously clear ZAR risks introduced by the politics that could drive a final flurry of hikes from SARB. With the economy going into recession, a weaker USD that leads to ZAR strength, and a weak retail environment that contains price inflation, the SARB is likely to turn less hawkish. Moreover, we continue to expect that the central bank theme of 2017 will be one of policy CONvergence where the Fed joins the loosening party again. This feeds into our bearish tactical USD view that feeds into a lower USD-ZAR and lower SA inflation expectations. If this cocktail is served to the SARB governor, Mr Kganyago, we reckon it’s likely to eventually lead to the commencement of a rate cutting cycle.

The last time I predicted a major directional trend shift call to policy rates was in mid-2013 by calling an end of the cutting cycle and spoke about the clear risks that a short-term rate hiking cycle would commence (consensus disagreed—see this interview—back in the days when USD-ZAR was steady at 9, and the policy rate 200bps lower than today). The call was 6 months early but bonds reacted to this view early. With respect to my panellists in that interview I believe what they were missing at the time was to correctly account for the global macro dynamics that would drive the hiking cycle that I elaborate on in Part 2 of the interview. Right now, as I’ve argued consistently in recent months, I foresee global macro relief coming from a more dovish Fed and weaker USD, and recovery in emerging markets (eg. look at the pick-up of leading indicators across the board in Brazil, Russia, Turkey and China at the moment). Coupled with flat inflation in SA and an economy going into recession, the 10yr bond yield could drop from 8.9% currently to 7.5% before turning back into its long-term uptrend. I wouldn’t chase this short-term rally, though, as it is likely to be short-lived once governments of developed economies (and SA) abandon austerity policies and embrace helicopter money in earnest (curve steepeners and higher inflation expectations). Other EM’s not following developmental state ideologies that allow their private sectors to drive growth are likely outperform SA on the growth front (eg. Brazil and India).

Kind regards,

Chris