Ané Craig – Assistant Fund Manager at PSG Asset Management

PSG Asset Management believes there are real reasons for concern about the country’s trajectory, but these do not yet point to a permanent loss of capital.

Sovereign debt represents a sizable portion of the investable universe for local fixed income investors. It is therefore no surprise that debates about the South African fixed income sector can be considered a reflection on South Africa as an investment destination as a whole. And for many, it feels as if Investment SA has been trapped in something of a perfect storm.

The well documented list of challenges and ailments of our economy mean that our ‘economic vessel’ doesn’t seem very seaworthy, to both local and foreign investors. These challenges include load shedding and the toll it takes on economic growth, the spectre of grid failure, failing infrastructure, inflation, a high repo rate and distressed consumers.

Foreigners in particular have been net sellers of local assets for a prolonged period of time as is shown by the graphics below.

However, we have often argued that when issues are known, they can be priced for – and that with a sufficiently large discount to fair value, risks become skewed to the upside and therefore a lot more palatable. This is what we refer to as a “margin of safety”.

The margin of safety argument can still be a tough nut for investors to swallow in the current market context. The question remains whether a margin of safety ever adequately compensates an investor when the risks seem to be so extreme?

It is firstly important to remember that tough market conditions do not automatically equate to low or negative returns for investors. At PSG Asset Management, we find sketching out the scenarios that would result in a catastrophic loss of investor capital a useful exercise. By identifying each factor that could contribute to such a scenario for South Africa, and by assessing where the country is relative to these measures, we are able to gauge the risk to investor capital. After all, there are many local companies and investment classes that have proven their ability to generate exceptional returns, despite the tough local economic conditions.

By taking a macro view, we believe the factors that would cause bond investors to lose large amounts of capital centre on the ‘failed state’ narrative. While the term is bandied about frequently in popular media, and is often linked to the spectre of grid collapse, the failure of one key piece of infrastructure (to which we do not assign a high probability) does not automatically make for a failed state.

However, we closely watch the following key indicators, as we believe investors would be likely to suffer large losses should these be realised:

• A debt spiral, in which South African government is required to raise an increasingly large amount of new debt to pay for government expenditure and to service existing debt, but the market is unable or unwilling to absorb the new debt issuance.
• Hyperinflation, which erodes the real returns that accrue to investors and negatively impacts economic growth.
• SA entering failed state territory. When the various state institutions cease to operate effectively and the government is no longer able to exercise control over its territory, a country enters failed state territory. For example, a government that can no longer effectively collect tax revenue (and thus meet its fiscal obligations) would be a grave source of concern. As we head into the 2024 election year, we expect political posturing and grandstanding as a beleaguered ruling party seeks to secure re-election. However, for us a key consideration is the extent to which state institutions which are key to our financial sustainability are able to retain their credibility and independence despite such short-term political instability.
• Rising populism that translates to poor economic decision making.

While we believe that there are real reasons for concern about the country’s trajectory, these do not yet point to a permanent loss of capital.

Our long-term debt maturity profile and minimal amount of foreign currency debt have long been hailed as a positive in terms of South Africa’s creditworthiness. Low near-term refinancing needs give South Africa ample space to increase government debt, especially in comparison with the AA+-rated United States. We estimate that South Africa only needs to refinance 2% of existing debt every year to the 2027 fiscal year. Redemptions peak at 4% of existing debt in the 2030 fiscal year, which we believe the market (even starved of foreign investment) could easily absorb.

Our inflation rate is also under control, compared to global peers. The South African Reserve Bank (SARB) has a long and credible track record of addressing inflation.  We have seen strong evidence that the SARB has succeeded in bringing inflation under control, through cycles,  since adopting their inflation-focused mandate in the early 2000s.

We furthermore see the growing realisation that Government is unable to go it alone as a positive and are encouraged by recent changes in regulation easing the way for private/public sector partnerships that aim to address infrastructural issues like electricity and transport infrastructure.

The Minister of Finance, Enoch Godongwana, has also demonstrated his commitment to maintaining fiscal discipline and has repeatedly highlighted the need for trade-offs in terms of the National Budget.

Considering this backdrop, we believe the crucial advantage our investment process offers is identifying and pricing risks correctly. We understand that opportunities arise from the market’s tendency to price based on sentiment, which allows for wide deviations from fair value. Consequently, we often find excellent risk-adjusted opportunities during challenging markets, where we can exploit deviations from fair value, and focus on buying quality assets below what they are worth. Ironically, we find that the best opportunities often arise precisely when negative sentiment drives most investors out of the market, leaving diligent and patient investors spoilt for choice.

While it is easy to be blown off course by the headwinds of a volatile macro environment and negative sentiment, we believe there are always opportunities within a globally integrated process like ours, provided you know where to look and focus on pricing risk correctly.

ENDS