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INVESTING IN 2021:
WHAT TO EXPECT
Sanlam Private Wealth
Feb 18, 2021
Watch a recording of the webinar below, and read the comments by Arthur Kamp, Chief Investment Economist at Sanlam Investment Group, on the outlook for the South African economy and what to expect from the rand in 2021.
Also read the views of our Director of Investments, Alwyn van der Merwe, on how investors should position their portfolios in a world plagued by uncertainty, here.
Arthur: It’s not often we can say this, but there certainly are some ‘bright spots’ in the South African economy at the moment. In the wake of the second wave of the pandemic, the first-quarter economic data probably aren’t going to look too rosy, but with the receding level of COVID-19 infections and easing of restrictions, I think it’s reasonable to look forward to a bounce-back in the economy from the second quarter onwards.
There are several reasons for an improved outlook for our economy this year – the first of which is the long-term decline in inflation, which means the South African Reserve Bank (SARB) can remain relaxed for a while in terms of interest rate hikes. The projection models of the SARB do show increases in both the second and third quarters, but given the current state of our economy and our high levels of unemployment, I believe the Bank may well keep interest rates low for an extended period.
The one thing that’s really negative about the South African economy is the long-term decline in potential growth since 2007, when the ‘developmental state’ idea was introduced. Since then we’ve had more than a decade of increasing government spending, and we’re at the point now where this is absorbing a lot of savings from the economy. However, a positive development of late is higher export commodity prices – combined with last year’s lower oil prices, this has given our terms of trade a tremendous boost.
You might question the significance of this, given that mining is only a small component of gross domestic product (GDP). However, higher export commodity prices mean an increase in income reflected on the balance of payments, and since wages are a consistently large portion of total income in the economy, it permeates through to households. It therefore also has an impact on consumption spending, and the GDP level more broadly.
The strong bounce in the terms of trade has also had a positive effect on our country’s fiscal accounts. We of course still have a significant fiscal problem, but relative to previous expectations, the data are looking better than expected. In terms of revenue collection, in last year’s Medium-term Budget Policy Statement (MTBPS), Treasury was predicting an under-collection of around R300 billion relative to the 2020 Budget. Up to December last year, however, there’s been an upside surprise with a collection of R80 billion more than would have been expected for that stage of the fiscal year. And the reason for this is that the impact of the improved terms of trade is being reflected in the GDP deflator, the inflation component of GDP. In nominal terms, GDP is now expected to contract by around 4% this year relative to Treasury’s expectation in the MTBPS of -5.6%.
Another positive development is that the tax take relative to the level of GDP is better than anticipated. Because of all the uncertainty last year, what Treasury worked with was a tax take similar to what we saw during the global financial crisis, and a sharp decline from 26.3% of GDP in the previous fiscal year to 22.9% in the current year. But it now appears that the decline in the ratio will be only around 1.9%. For the full year, this could mean a tax take of around R100 billion better than expected. If Treasury doesn’t adjust its expenditure numbers going forward, then the budget deficit could drop next year to 8.9% of GDP from 12.5% this year.
Another important point is that our government is sitting on significantly more cash than previously projected. At the start of the fiscal year, the government had around R263 billion in cash, but the January numbers show a figure of R378 billion. The reason for this is partly the better-than-expected revenue collection, but there’s also been a fairly high level of issuance. While the government may need to hold on to these high cash levels to honour foreign currency debt commitments and to provide for contingent liabilities and cash flow, at least the numbers are looking better relative to expectations. Treasury may also lower issuance in the year ahead. Unfortunately, however, the government’s long-term debt dynamic is still going in the wrong direction.
What risks does South Africa face other than those related to fiscal policy? It depends to a large extent on where the global economy is going, and levels of foreign capital inflow. If we have a growing economy in the year ahead as we expect, we’ll be running a current account deficit, and we’ll need foreign capital inflows to cover this. This means South Africa will have to continue with economic reform to raise the potential returns in South Africa and to lower the risks of investing here.
Another risk relates to the bounce in the terms of trade – continued improvement in this sphere would depend very much on the ability of the global economy to keep growing. We think it will, for a few reasons: the weakening link between pandemic-related restrictions and economic activity, fewer restrictions in the coming year due to the roll-out of vaccines, an additional stimulus package by the US, and the impact of income transfers in Europe and the US last year, which resulted in a sharp increase in savings among households that should support consumption spending.
A last risk, of course, would be any change in global financial conditions. Developed economy central banks want some inflation back in the system, and if we do see start seeing some pickup in inflation or, importantly, if the global economic recovery becomes entrenched as we expect it will, central banks may start talking about tapering their balance sheets and it’s possible that interest rates may begin to rise at some point.
Will inflation go up? Coming off last year’s low base, we can probably expect higher inflation in the first half of the year. However, viewed over the year and going into next year, there are still significant negative output gaps – usually a powerful disinflationary force. Over the long term, the potential for more inflation in the system is related to fiscal policy. Viewed through a historical lens, the worst inflationary episodes were when governments had unsustainable fiscal policies.
In a nutshell, investors can’t ignore the latent risks, both domestically and globally. At least for now, however, the South African economy is in a positive patch, boosted by our improved terms of trade. The fiscal numbers remain highly concerning – there are deep deficits and the long-term debt dynamic is still in the wrong direction – but in the near term, the numbers are looking a bit better than previously expected, offering some respite.
Arthur: In our view, it’s always best to try and take a long-term view on the currency – there are just too many influences in the short term that drive the currency away from what is regarded as its fair value. How do we measure the fair value of the rand? In an ideal world, the currency should over the long term track purchasing power parity (PPP). According to this method, the value of a currency should track the inflation differential of the home currency versus that of its most important trading partners. Over the short term, the currency could deviate wildly around the theoretical line for extended periods, especially in a small, open economy such as South Africa.
If our inflation rate remains higher than that of our major trading partners, the rand should continue to depreciate over time. Indeed, the US$/rand exchange rate has, historically, tended to revert to its PPP level over the long term.
So if we look at the movement of the rand over time, it has had very sharp periods of weakness, and also sharp periods of appreciation, although these vary by a couple of years in length. Typically, in response to a period of sharp depreciation in the currency, the SARB steps in and raises short-term interest rates in order to keep inflation expectations low. And, if long-term inflation expectations remain well anchored, you’d expect the currency to shift back towards the PPP line.
This time around the Bank has been cutting interest rates. Remember, however, that in April and May last year, when the rand was heavily undervalued, South Africa received a R70 billion loan from the International Monetary Fund. The stability that this produced on the balance of payments helped the currency to appreciate. Also, of course, inflation expectations in South Africa were still coming down, and there’s continued faith in the SARB to hold the long-term inflation rate at a reasonably low level.
So while there will be blowouts in the currency, it’s the long-term inflation expectation being anchored that pulls the rand back to the PPP line. At the moment our currency is trading at around R14.60 to the US dollar, so it’s not that far off from what we would consider its fair value of around R14.00. In our view, the big move has therefore already taken place. From here on, over the long term, we’d be looking for that inflation differential once again. Overall, though, given near-term volatility, one can only have conviction if the currency is either far overvalued or undervalued.
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