Reserve Bank governor Lesetja Kganyago File photo
JOHANNESBURG - Lesetja Kganyago, the governor of the SA Reserve Bank (SARB), at the 5th SA Tomorrow Investor Conference in New York on November 9, 2017, said that the SARB remained concerned about the weak economic outlook and that “although most of the (economic) growth problems are structural there is some scope to provide countercyclical stimulus”.

By implication it means that the SARB is ready to ease its monetary policy to kick-start the economy. He also acknowledged that the 25-point reduction in the repo rate in July only had a positive impact on growth at the margin. It is quite possible that the SARB will embark on a new interest rate-cutting cycle at the next meeting of the monetary policy committee today.

Top of the range of the repo-rate adjusted for inflation in 2016 was 1.6% and that compares to 2.1% currently. There is, therefore, scope to cut the repo rate by as much as 100 basis points, but it depends how aggressive the bank will be.

The big question is whether the monetary policy committee will have the stomach to cut rates a day before the credit agencies announce their decision on South Africa’s rating.

Appease

A reduction of 25 basis points may appease the credit rating agencies, but may only have a limited positive impact on growth, business and consumer confidence. Meaningful stimulus will be a cut of 50 basis points or more.

In light of the probable new interest rate-cutting cycle and the incipient economic recovery, the important question is where to invest to make the most of it.

Domestic economically cyclical stocks, especially those in the consumer discretionary and industrial sectors, were the hardest hit by the interest rate hikes since 2015 as the interest rate burden and increasing unemployment devoured consumer spending. Take the FTSE/JSE Africa General Retailers Index (GRI) as an example.

Since the interest rate hike in July 2015 the index lost more than 23% in value while the sector also underperformed the FTSE/JSE All Share index and the FTSE/JSE Financial and Industrial index by 35% and 31% respectively with dividends reinvested. From a valuation point of view the FTSE/JSE GRI with a price-to-earnings ratio of 21 times earnings traded at a premium to the FTSE/JSE Financial and Industrial index’s 18 times earnings in July 2015.

Currently the FTSE/JSE GRI is trading at a price-to-earnings ratio of 14.6 compared to the FTSE/JSE Financial and Industrial Index’s 22.6 times earnings and the FTSE/JSE All Share Index’s 20.4 times earnings.

The current discount of 7.94 times earnings to the FTSE/JSE Financial and Industrial Index is the deepest since 1996.

Sure, the discount may narrow due to weaker earnings, but any improvement in investor sentiment in regard to the outlook for the South African economy is likely to feed directly through to the companies listed in that sector - the same with other domestic economically cyclical stocks.

There could be an opportunity developing in South African bonds. The real bond yield spread between South African 10-year Government Bonds and US treasuries had risen sharply by 80 points to 4.2% since the end of September. The possible cut in South Africa’s credit rating has been well telegraphed over the past few months and the minister of finance’s medium-term budget speech was heavily criticised by the agencies.

Statistics

Bond Exchange of South Africa statistics show that foreigners were heavy sellers of South African bonds since mid-October.

A further derating of South Africa is likely to lead to a further spike in South African bond yields, but it may be short-lived as in the past the bond yield spreads of Russia and Brazil to US treasuries had almost always increased ahead of rating downgrades and decreased significantly afterwards - “sell the rumour, buy the fact”.

For South African investors the current interest yield on the All Bond index of 9.5% offers an opportunity, especially in light of the consumer price inflation rate of 5% and the prospect of declining short-term interest rates, which will affect savings rates.

Domestic real estate investment trusts (Reits) are also on the radar screen. The rating of the trusts is heavily influenced by long bond yields. The rising bond yields led to the FTSE/JSE Reits under-performing the FTSE/JSE All Share Index by 18% since July 2015 and returned a paltry 4.1% (1.7% annualised) with income distributions reinvested. Any strength in the SA bond market is likely to feed through to the South African Reits.

There are downside risks in the bond market and South African Reits, though. It is a fallacy to think that South Africa’s junk status in the eyes of ratings agencies will change over the short and even medium term. Furthermore, the prospect of rising bond yields in developed countries down the line may exert upward pressure on our bond market rates.

If the SARB embarks on a new interest rate-cutting cycle it is likely that the external value of the rand may remain relatively weak as foreign investors in developed countries who earn virtually zero interest in their cash markets will be less eager to park their cash in South African rand.

The investors will also be less inclined to do carry trades whereby they (the investors) borrow money at a low interest rates offshore to invest in South African interest-related investments. Domestic exporters of goods and services will therefore be able to survive. The ailing platinum producers come to mind. The lives of the mines will be extended and layoffs of workers will be limited.

Risk

There is a short-term risk, though. While a further derating of South Africa is likely to lead to a downward spike in the external value of the rand, it may be short lived, as in the past the bond yield spread to US treasuries may decrease significantly afterwards as foreign investors return to the market to take advantage of the exceptional high bond yields and thereby causing the rand to strengthen.

The South African economy is at a turning point and investments that have underperformed over the past two years due to the adverse economic conditions may shine again.

Ryk de Klerk was co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.

-BUSINESS REPORT