In recent years, South African investors facing a struggling local stock market have at least enjoyed some respite in local bonds. The FTSE/JSE All Bond Index is up 7.3% per annum over the past five years to the end of July, compared to the 4.7% annualised return from the FTSE/JSE All Share Index.
With the deterioration in South Africa’s fiscal position, however, the outlook for local government bonds is growing less certain.
“I don’t think cash and bonds are a safe hiding place, even though they are tempting,” said Jacques Plaut, co-portfolio manager of the Allan Gray Balanced fund during the Independent Insights webinar this week.
“If you are buying a bond, you are lending money to the South African government, and the first question you ask when lending someone money is if they can pay you back.
“Over the last five years, the odds of that have decreased quite a lot.”
After years of decline, the Covid-19 crisis has now pushed government finances to a precarious point.
“The deterioration of the South African fiscal position is signalling the possibility of a public sector debt trap,” Futuregrowth Asset Management said in a note. “Such a debt trap is considered to arise from an unsustainable fiscal position. In turn, an unsustainable fiscal position implies a situation where the increase in outstanding public sector debt can no longer be slowed by higher taxation and/or a decrease in discretionary expenditure (total expenditure excluding debt servicing costs).
“A failure to turn the tables will require the issuance of more debt in order to finance the repayment of maturing bonds and the payment of interest on outstanding debt, thereby forcing government into a catch-22 situation. Our analysis regarding the state of public finances increasingly points to a situation where the country has entered this twilight zone.”
This is not just a risk to bondholders.
“Additional red flags are raised in a scenario where the average interest rate payable on its outstanding debt exceeds the nominal rate at which the economy is growing,” said Futuregrowth.
“Failure to restructure the economy in general and the role of government specifically, for instance by cutting current expenditure sufficiently to turn the ship, will increase the probability of this debt being monetised.”
That would have implications for asset classes across the board.
This uncertainty only adds to the already challenging investment environment.
“It’s very difficult to call markets,” said Iain Power, CIO of Truffle Asset Management and co-portfolio manager of the Nedgroup Investments Balanced fund. “There are a lot of exogenous factors at play.”
What would undoubtedly make things clearer is some definitive action from the government. Nobody doubts that there is an appreciation of what is ailing the economy, or what needs to be done about it.
What is lacking is action.
Sandile Malinga, co-portfolio manager on the Prudential Balanced Fund, pointed out that it’s been 10 years since the National Development Plan was adopted. Yet it remains almost entirely unrealised.
“In my opinion we have enough plans,” Malinga said. “The most important thing right now is for the government to start with something. Pick any of the things that need to be done and just deliver them.
“We live in the real world. No one ever imagines all of the reform initiatives that need to be undertaken will be perfectly executed. But if you don’t shoot for something you miss 100%.”
Even though many South African assets – across equities, bonds and listed property – look optically cheap, they may well remain so without concerted action to address the structural problems in the economy.
“You need some of these things to happen to unlock that value and get some mean reversion,” said Power. “The data at the moment suggests indecisiveness and inaction. We are fast approaching the point where fiscal demands crowd out productive capital expenditure.”
What investors are looking for is the structural reform that will turn this around.
“These are the things we want to see addressed,” said Power. “That will then give the opportunity for South African investors to be part of a more inclusive economy, where there is value creation for all and ultimately results in a brighter future.”
Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.