SA's low economic growth shrinking tax base

Cape Town - Moody’s currently rates SA’s sovereign bonds two notches above junk status but has the country on a 'negative outlook' for a potential downgrade, says Overberg Asset Management (OAM) in its weekly overview of the SA economic landscape.

According to OAM Moody’s credit rating agency warned that SA’s low economic growth rate is weighing on the country’s credit worthiness by shrinking its tax base.

"The announcement raises the likelihood that Moody’s will follow through with a rating downgrade unless Finance Minister Pravin Gordhan’s state budget on 24th February provides concrete measures to narrow the deficit without further harming the economy’s growth profile, OAM said.

South Africa economic review

• In his quarterly Systems Update Eskom CEO Brian Molefe reported solid progress in the last quarter 2015 with planned outages down -10% compared to the previous year, falling to 13.8% of generating capacity, the lowest since July 2014.

Although the first unit of the new 1 300 megawatt Ingula power station will only be in commercial operation by March 2017 rather than 2016 Molefe indicated Eskom would be able to avoid load shedding even during the coming winter months.

Analysts were quick to point out that the absence of load shedding has as much to do with slowing electricity demand due to the weak economy and reduced mining activity and metal smelting. Moreover, businesses and households are easing pressure on Eskom by increasingly moving off the grid.

• The Markit composite purchasing managers’ index, measuring conditions in both manufacturing and services sectors, improved slightly from 49.1 in December to 49.6 in January beating the 49.0 consensus. However, the PMI remained in contractionary sub-50 territory for the eighth straight month.

According to Markit: “While the weak rand helped exports to stabilize, it also exerted some upward pressure on input costs, resulting in the steepest increase in overall costs for five months.” On the other hand new sales orders, output and employment all showed some improvement relative to the December readings.

The week ahead

• Mining production: Due Thursday 11th February. According to consensus forecast the stagnation in mining production is expected to continue from -0.80% year-on-year in November to -1.0% in December constrained by subdued global trade and the ensuing collapse in commodity prices.

• Manufacturing production: Due Thursday 11th February. According to consensus forecast the contraction in manufacturing production is expected to deepen from -1.0% year-on-year in November to -1.5% in December due to weakening domestic and global demand.

• State-of-the-nation address: Due Thursday 11th February. President Zuma may use the state-of-the-nation address as an opportunity to address ebbing business confidence and potentially announce bold measures to boost the economy’s long-term growth potential.

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation. Although the rate of the rand’s depreciation is accelerating there is little sign so far of panic selling or capitulation. This stage needs to be reached before a reversal in the rand’s move can occur.

• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.

• Despite the recent uptick in bond yields the long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.

• The US 10-year Treasury yield has broken above key resistance levels of 2.0% and 2.2%. However, there is unlikely to be a major bear trend in US bonds as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield broke out of its long-term bull trend as a result of “Nenegate”. The new bear trend for the R186 is underpinned by resistance at 9.0% with a risk of further upside to 10.50%. While SA bond yields may fall in line with global bonds they are unlikely to return to the bull trend.

• The MSCI World Equity index has broken downward from a rising wedge formation which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1 400.

• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle is likely to have just occurred. The next major wave down will complete the 16-17 year secular bear market that started in 2 000. The secular bottom should occur around June 2016.

• The S&P 500 index has broken downward from a rising wedge pattern, which is traditionally a trend-changing pattern. The downward trend is likely to remain intact unless the index decisively regains the 2070 level. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is leading the broader market lower on the downside.

• Brent crude’s break below the key $30 support level suggests a continuation of the weakening long-term trend to a downside target of $25. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the key $4 500 support level suggesting further downside ahead.  

• Gold has broken its recent downtrend by rising decisively above the $1 100 resistance level. An extended break above $1 250 is needed to confirm the end of gold’s bear market.

• The JSE All Share index remains below the 24-month moving average at 50 600. The recent consolidation pattern between 47 000 and 49 000 is likely to be resolved with a break to the downside to an initial target of 45 000 and an ultimate target of 43 000.

Bottom line

• Last week the World Bank and Moody’s credit rating agency joined the litany of doomsayers cautioning against SA’s deteriorating economic prospects. Moody’s warned that weak economic growth and lower tax revenues would lead to a credit rating downgrade.

The World Bank, in its economic update on SA warned that “The economy is flirting with stagnation if not recession,” adding that “a downgrade to sub-investment grade would trigger higher borrowing costs, capital outflows, and risk a recession with knock-on implications for poverty reduction and possibly social stability in the longer-term.”

• The government acknowledges the severity of the current crisis and that an economic recession and credit rating downgrade could be imminent realities. At the ANC National Executive Committee lekgotla ANC Secretary General Gwede Mantashe admitted that “everything” must be done to avoid an economic recession. There is a growing urgency to build better communication and lines of cooperation between the government and private sector.

In the past fortnight Finance Minister Pravin Gordhan and senior National Treasury colleagues have met with a large group of 60 senior business executives to discuss ways for averting a sovereign credit rating downgrade.

This week business leaders have been invited to meet with President Zuma at the “Presidential Investor Working Luncheon and World Economic Review” ahead of his state of the nation address on Thursday.

• The improved communication between government and the private sector is having a beneficial effect on the bond market. Foreign investors are responding favourably. After being consistent net sellers of SA sovereign bonds since the start of the year foreign investors turned net buyers in the week ended Tuesday 2nd February with a net inflow of +R3.1bn.

Outflows at the start of the year were largely reversed by the end of January with a net monthly outflow of just –R0.3bn. This is a great improvement on the net outflows of –R8.2bn in December and –R6.1bn in November.

• Although investors are warming to government’s charm offensive and conciliatory approach to the private sector the risk of a credit rating downgrade remains very real and will likely only be averted through bold reforms.

In an environment of weakening global trade and declining demand for commodities SA will, in the words of the World Bank, need “bold reforms” in order to restore confidence and encourage investment and “lift the long-term growth trajectory.”

• Bold reforms would dramatically reduce the likelihood of a credit rating downgrade and provide the catalyst for a stabilization in the rand exchange rate. The 11th February when President Zuma presents the state of the nation address and the 24th February when Finance Minister Pravin Gordhan’s presents the state budget potentially provide key opportunities for the government to announce bold economic reforms.

It is rumoured that the state budget will break with tradition and include significant expenditure cuts in addition to the usual revenue increases. This would be extremely good news and welcomed by financial markets.

• Although the state of the nation address traditionally steers clear of new economic policy announcements this week’s address may hint at bold reforms. Such reforms could include improved infrastructure investment structures, a reduction in regulatory red-tape, enhanced labour market flexibility, better standards of education, or even suggestions of privatisation.

Last week Finance Minister Gordhan argued for the sale of a stake in Eskom suggesting private shareholders should be able to buy up to 49% of the state-owned enterprise. A privatisation programme would be a sure way of keeping the credit rating agencies at bay.

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.

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