When do we run? South African vs Debt Markets
Gerhard le Roux
February 2021
In this months letter, I try to piece together my understanding of South African post-Covid finances and my expectation for the future of debt investments.
South African bonds have dominated the Le Roux International portfolios following the pandemic’s substantial global risk-off response. where South African bonds and the Rand were sold indiscriminately in favour of the USD, presenting significant capital appreciation opportunities along with bond yields above 10%. The investment thesis was that South African bonds yields would narrow to its emerging market peers, providing the potential for an excellent return at low risk. To illustrate below is the spread between South Africa and Brazil’s bond yields for the last year.
The investment played out as we expected, providing investors with 10-12% capital appreciation along with 9-10% interest return from bonds over the past year, depending on when you invested.
With solid returns in the bank, a question got stuck in my mind. With the divergence in global economic recoveries as wealthy nations acquired the COVID vaccines and at the same time, our bumbling state reneged on their governance responsibilities. Where is the line where South Africa is no longer able to sustain its debt levels? When do we move, and what are the investment alternatives?
The forces at play
South Africa is wrestling with the positive influence of high commodity prices (leading to significant revenue from mining operations and taxes) and the global low yield environment, directing flows to the high investment returns on offer on South African debt; against the opposing force of systemically low growth, high debt levels and persistently high government expenditure.
In recent months we have seen the positive effects of exceptional mining revenue on tax collection and a global search for yield on the Rand. Whereas the government has at best only managed pedestrian improvements to expenditure.
A bit on growth
2020 was a horrible year economically for South Africa. The lack of medical capacity left authorities with only the blunt tools of lockdowns to manage infections. The state passed an emergency budget, and South Africa’s debt ballooned while Orwell’s pigs gorged themselves on crisis response funding.
By the end of the year, our economy contracted by 7.5%, and the countries debt position spiked beyond 80% debt to GDP. The saving grace is that the vast majority of counties have experienced similar contractions and a flood of stimulus to support their economies, inflating debt positions almost everywhere. However, the South African economic recovery is likely to be slower as we have little money to stimulate actual growth. The IMF expects SA to be back to 2019 GDP levels only by the end of 2024 when by Moody’s estimation, we will reach a 100% debt to GDP ratio.
Below is an estimate from Ninety-One, a lot more optimistic than Moodys; however, in their estimation, South Africa will add R500Bn in new debt each year, for the next eight years, to stay afloat.
The 2021 Budget
Tito’s 2021 budget was well received by markets. South Africa’s fiscal position would not be as catastrophic as described in the medium-term budget speech last year. The government tax collection was surprised to the upside due to mining.
However, as investors pondered the state’s plan, it became clear that it is more of the same. Lofty promises to reduce expenditure, but the government has little to show for actual follow-through on plans. The state wage bill is 34% of state expenditure and will be the most important item to track into the future. To change that burden, you need to make unpopular political decisions, grow a backbone. South Africa cannot afford to continue to borrow money to pay ineffective public servants.
South Africa does not have developed nations’ flexibility with record-low interest rates, and we pay 9% today. Interest payments on debt is a significant feature of budgets from now on, with interest payments at 20% of government expenditure. At R500bn additional debt per annum, that number will increase.
As South Africans, we are a hopeful bunch, and we believe that a prosperous future is possible for the country, and it is. However, I agree with Moody’s that there is little to get excited about, and our debt to GDP will continue to rise to 100% around 2025.
How to position your portfolio
The search for yield persists as the central theme in global markets as Sovereigns continue to expand their balance sheets to stimulate their economies. The international forces are a net positive influence on South Africa’s debt market and our currency.
I am still comfortable with the returns on offer in the South African bond market, but the investment is no longer as sweet. The yields at 9% are attractive, giving any portfolio a solid annual base return. However, I no longer see significant capital appreciation opportunities from SA bonds ceteris paribus. The 9% yield is an accurate reflection of South Africas’ precarious debt position.
The landscape will evolve over the next 6-12 months, and we will reposition the portfolios to accommodate increased risk as they arise. Inflation-linked bonds or international exposure are the most likely candidates from now.
So, do we run? Not yet; however, we are lacing up our shoes.
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Le Roux International turned one year old in February. Thank you for placing your trust in us. It is a real pleasure to be on this journey with you.
With your support, I do not doubt that we will realise our potential and create a market where consistent well-considered financial advice becomes the norm. And clients can finally be free from hidden fees and plundering insurance companies.
Until our next letter. Gerhard.