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Climbing out of the Covid-19 hole

By: Old Mutual Wealth Investment Strategist Izak Odendaal and Dave Mohr

South Africa’s economy continues to climb out of the Covid-19 hole. Economic growth in the fourth quarter of 2020 was ahead of the expectations of most economists, and the 2020 contraction of 7%, though the worst on record, was not as bad as initially feared. This puts South Africa towards the bottom of the range of growth outcomes among major economies, but not the worst. China managed positive growth, while the US declined 3.5% in 2020. However, India contracted 8% and the UK 9.9%.

Stats SA’s gross domestic product (GDP) report shows that the local economy increased by 6.3% quarter-on-quarter on a seasonally adjusted and annualised basis, following an upwardly revised 67% third quarter growth rate.

Compared to the fourth quarter of 2019, the economy was 4.2% smaller in real terms. It will take at least a year for the level of real economic activity to return to where it was pre-pandemic. In nominal terms (before subtracting inflation), the economy is back to pre-pandemic levels. This distinction will seem academic to most but remember that it is nominal economic activity that counts for tax revenues, profits and household incomes.

Chart 1: Real GDP growth year-on-year %

Source: Stats SA

Sector recovery

Looking at the sectoral performance, the rebound in the second half of last year was broad-based, which makes sense since all sectors were affected simultaneously by the first wave lockdown. However, only three sectors have fully recovered: government, personal services and agriculture. The farming sector had a stellar year in 2020, growing 13% in real terms, but is the smallest of the 10 basic sectors. With good rainfall and elevated crop prices, 2021 should be another good year but clearly growth will come off a high base. Construction was the hardest hit sector, declining 20% last year. The boom in home renovations has not been enough to offset declines elsewhere and spending on both residential and non-residential was lower in the fourth quarter than a year ago.

Mining pulled back somewhat in the fourth quarter, which might seem surprising given the elevated commodity prices. However, mining output is volatile from quarter to quarter, impacted by safety stoppages, maintenance and load-shedding. It takes time for mines to ramp up production in response to higher prices, and often substantial investment and construction work is required.

From the expenditure side, household consumption recovered further in the fourth quarter and was just 2.4% below year-ago levels. Household spending on non-durable goods (food) had fully recovered by the fourth quarter, while spending on services was only 1% lower in real terms. It is spending on semi-durable goods (mostly clothing) that took the biggest hit in 2020 and was still 14% below pre-pandemic levels in the fourth quarter.

Trade boost

Exports were strongly positive in the fourth quarter, but imports rose even more on a quarterly basis. Exports are added to GDP and imports subtracted, hence the net impact of trade was negative for the quarter from a growth point of view.

In a separate report released last week, the SA Reserve Bank reported a second consecutive quarterly current account surplus in the fourth quarter, though it was smaller at R198 billion or 3.7% of GDP. It means the 2020 current account balance was positive at 2.2% of GDP.

This matters at a time of concerns over rising global bond yields and a repeat of the 2013 “taper tantrum” when emerging markets with twin current account and fiscal deficits saw their bonds and currencies hammered. While South Africa’s fiscal deficit has worsened considerably, the current account improvement from a 6% deficit in 2013 does reduce overall vulnerability to volatile global capital flows.   

Chart 2: Current account as % of GDP

Source: SA Reserve Bank

The main contributor to the current account surplus was the trade surplus. This should moderate during the course of the year as imports return to more normal levels, but strong global growth supporting exports will remain massively important for domestic economic prospects. The world can do very well without South Africa, but South Africa is not going to do well without a humming world economy.

The fact that President Biden signed the full $1.9 trillion fiscal relief bill into law last week is a massive shot in the arm for the US economy, and by extension, the global economy. The physical vaccine shots in arms is also continuing apace, though unevenly across countries.

Coronavirus uncertainty

We don’t know when foreign tourists will return to South Africa in large numbers. Perhaps towards the end of the year if vaccinations go well in our traditional tourist markets in Europe. Needless to say though, if that happens, the local hospitality industry will experience rapid growth off an extremely depressed base. However, a third or fourth wave of local infections could scare off visitors, and also result in renewed curfews and bans on alcohol sales, which will further hurt an industry that is already scraping by and dealing with immense uncertainty.

We really have no way of knowing what the coronavirus has in store for us. Some scientists and modellers say that we have already reached a level of herd immunity through prior infection that will be sufficient to prevent another deadly wave, even if it does not stop the spread altogether. Others argue that more waves are inevitable until there is mass vaccination.

What we do know looking at the economics is that the first wave was the devastating one for businesses and jobs, even if the second wave was worse from a public health point of view. Perhaps it means government over-reacted in March 2020 (admittedly acting under great uncertainty) by imposing a blanket lockdown, and under-reacted in December. Either way, a third wave remains a risk even if its economic impact is likely to be smaller than the first wave. The government will fine-tune its response, and consumers have largely learned to live with it. 

Some positives

Apart from strong commodity prices, near-record crops and continued low inflation and interest rates, there are two more items in the GDP report that point to better growth ahead. One is that businesses ran down inventory levels last year at a record pace. The prior two years also saw declines in inventories. This cannot last. At some point, likely during the course of the year, firms will need to restock, giving a boost to production. The other is the recovery in the operating surplus of private companies, a rough measure of profitability. While this showed positive growth of 4% year-on-year, fixed investment spending was 10% lower. Profits are a good leading indicator for investment spending, which should start rising.

Chart 3: Private gross operating surplus (profits) and private fixed investment growth %

Source: Stats SA

However, business confidence remains subdued. The RMB/BER Business Confidence Index declined from 40 to 35 in the first quarter. Most of the 1 300 surveyed businesspeople remain dissatisfied with current business conditions. A robust improvement in fixed investment spending by business requires improved confidence, which in turn usually rests on rising sales. Nothing lifts spirits better than an improving bottom line. 

Chart 4: RMB/BER Business Confidence Index

Source: Bureau for Economic Research

Investment implications

How should we think about all this in investment terms? When looking at markets and economies, there are two important analytical distinctions that need to be made. This might seem a bit technical but bear with us.

The first is the distinction between structural and cyclical changes. Some things are inherently cyclical. Think of interest rates, food prices, or fund manager outperformance. Some things are structural, more or less permanent. Dam levels rise and fall seasonally and also over longer cycles of drought and plenty, but the storage capacity of a dam is fixed. Unless the dam wall is raised, in which case it will have a structurally higher capacity.

One of the reasons for the extreme pessimism about South Africa in recent years is that many people assume the cyclical downturn we’ve experienced since 2013 is permanent in nature. In other words, that we are destined (or doomed) to grow at 0.5% forever. In fact, the same factors that caused the downturn – low commodity prices, high interest rates, electricity shortages and policy uncertainty – have or are unwinding, providing support for an upswing.

In the case of interest rates and commodity prices, the change came quickly and unexpectedly. In the case of policy and electricity, the change is slower but still meaningful. Of course, the biggest negative shock by far came from the early 2020 lockdowns that have already been substantially eased. This doesn’t mean the underlying structural problems in the economy – high youth unemployment, crime, corruption, spatial inequality, low skill levels, infrastructure bottlenecks, and poor service delivery – have changed. They will remain even as the economy experiences a higher rate of growth over the next few years. It is up to policymakers to address these structural issues, but investors should keep an eye on cycles. The opposite is also true. After a few good years, people often assume this is a permanent state of affairs. Be careful not to project inherently cyclical forces unchanged into the future.

The second analytical distinction is between levels and growth rates. Both are important, but for different reasons. The level of economic activity matters for policymakers as a proxy for wellbeing: the number of people who work, the number of schools, the level of healthcare spending etc. Markets, on the other hand, generally care about growth rates. The baseline is already priced in, and what counts is whether or not things improve relative to expectations. A company’s share price often rallies, not when its operational performance goes from good to great, but when it improves from terrible to merely bad.

Even though South Africa’s economy is smaller in real terms (the level) than before the pandemic struck, the fact that it is now growing faster than expected is of more importance to markets. While 2021 growth will probably be in the region of 4% (or even more) due to the rebound off the low base, if 2022 and 2023 growth can stay around 2% – not a tall order – it will be a significant step-up from pre-pandemic rates of growth. South African assets don’t need 5% GDP growth to perform well.

Don’t be shy, diversify

Having said that, it is worth repeating that while the state of the domestic economy matters greatly for all South Africans, global market dynamics matter more for local investors. It might seem strange, but the US economy, its direction and its policy changes have a greater influence on the returns local investors see in their statements than similar changes locally.

In terms of local equities, the JSE is dominated by companies that operate globally and its overall performance is only partly exposed to the local economy. Only about 40% of JSE Capped SWIX earnings are generated in South Africa on a look-through basis. The other 60% does give investors good rand-hedge exposure, but it’s quite different to a typical global equity portfolio and very concentrated.

The global exposure on the JSE is concentrated in Naspers/Prosus/Tencent,  the  other massive consumer companies selling tobacco, beer and luxury goods respectively (BAT, AB InBev and Richemont), mining, and some property. A broader global portfolio will be more diversified and have exposure to many other different sectors providing not only different sources of profits but also reducing sector concentration risk.

For local bonds, a stronger local economy is unambiguously good as the government will earn more tax revenue and will need to borrow less. But our bond prices are set in an international context and will still be heavily influenced by global risk appetite and changes in US yields. For this reason, even if we are optimistic about improved domestic growth prospects, we retain a full global exposure for diversification. 

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