The Winter of Discontent
Izak Odendaal – Old Mutual Wealth Investment Strategist
“Now is the winter of our discontent” opens Shakespeare’s play about the rise and fall of the murderous and deceitful Richard III. South Africa is equally experiencing a season of unhappiness. Loadshedding, record high petrol prices, high food inflation, rising interest rates, shocking crimes, and above all, a sense that political leadership is absent (though thankfully not tyrannical, unlike Richard III). The past week also saw the anniversary of last year’s horrific unrest and looting in KZN and elsewhere. Many are worried that a repeat is likely.
To political historians, the Winter of Discontent generally refers to the UK in late 1978 and early 1979. The period saw widespread and very disruptive strikes, electricity rationing, and surging inflation compounded by unusually cold weather. It followed several difficult years for Britain, including a currency crisis in 1976 that resulted in an IMF bailout. As in South Africa today, divisions in the ruling party (then Labour) ruled out an effective response. Prime Minister James Callaghan was characterised by the media and opposition as out of touch, especially when he went on holiday in the Caribbean while people at home were freezing. His perceived indifference led to the famous “Crisis? What Crisis?” headline in The Sun. It ultimately led to Margaret Thatcher and the Conservatives coming to office later in 1979, and with them, a new set of market-friendly policies that changed Britain’s economy and society.
Shocks and aftershocks
South Africa has deep-seated problems from 370 years of unequal and exclusionary development but looming ever larger is the government’s failure to deliver the public goods that a competitive economy requires. This is particularly true of local government, where the inability to get the basics like water, sewage and roads right are an enormous drag on business activity and people’s quality of life. It is also true of electricity provision, where government for too long monopolised supply (through Eskom) while simultaneously failing to deliver adequately. A similar story is true of Transnet. Indeed, most State-Owned Companies are inefficient and unprofitable, though fortunately not all of them are monopolies with central roles in in the economy.
However, we mustn’t underestimate the role of the Covid-shock in the country’s woeful situation. The economic impact of the pandemic lingers globally, but in very different ways in different places. In South Africa, there are a million fewer formal jobs in a country where jobs were already scarce. Job losses were concentrated among low-income earners, further increasing inequality, already among the worst in the world.
Chart 1: Formal employment in South Africa
Source: Stats SA
Policy, not politics
Ahead of the ANC elective conference in December and the national general elections in 2024, politics is bound to be noisier than usual. Politics is noisy everywhere – witness the recent resignation of UK prime minister Boris Johnson and the tragic assassination of former Japanese Prime Minister Shinzo Abe. However, it can be particularly raucous in South Africa as the stakes are so high. With unemployment where it is, entering politics or staying close to politicians is potentially lucrative for someone with few other options. This is a problem throughout the developing world. Many people are attracted to politics and public service not out of principle but for personal gain amid a dearth of alternative opportunities. Hence the scourge of corruption is pervasive in poorer countries. South Africa is by no means the worst in our peer group.
Chart 2: Corruption Perceptions Index for selected developing economy
Source: Transparency International
The most important thing for investors to focus on at this stage is policy, not politics. The key policy reforms on the table to crowd in private investment in electricity, rail, ports and infrastructure in general look set to remain in place, as does a further liberalisation of the visa regime for skilled people and other forms of excessive red tape. In some cases, particularly electricity, we are likely to see an acceleration since it is the only way to quickly add more capacity to the grid. The government has neither the capital nor know-how to do so rapidly by itself.
This is good news for the longer-term growth outlook, though it does not help us get through the incredibly tough current moment. If politics leads to a change in policy, for instance if a new ruling coalition emerges after 2024 that decides to increase state intervention or threaten property rights, it will be a different matter. But for now, policy continuity looks to be the most likely outcome.
The notion that South Africa is on the verge of being a failed state has been gaining traction in recent years and will with no doubt get fresh impetus. However, the failed state is an analytically problematic concept for several reasons that we can’t get into here. In simple terms, an inefficient government is by no means the same thing as a failed state. Governments come and go, states rarely do. What is important is the ability to hold the government of the day accountable and replace it if needs be. South Africa is a country where people can speak their minds and the problems are known and hidden. The constitution guarantees individual liberties and rights, and is underscored by a strong judiciary, free media and active civil society. A massive plus is the sophisticated financial system managed by an independent central bank. We rank above our peers on many measures of institutional strength.
Chart 3: Human Freedom Index scores for selected developing countries
Source: Fraser Institute
Falling off a cliff
The other pervasive fear, linked directly and indirectly to the above, is that of a fiscal cliff or similar debt-related calamity. The government’s debt level was rising alarmingly even before Covid hit, but in the darkest days of lockdown it seemed to be heading towards 100% of GDP. The latest projections suggest that debt will peak around 75% before stabilising. This is a vast improvement, but we’re not out of the woods yet. With government’s borrowing cost well above the country’s nominal growth rate, spending discipline will remain crucial. There is little scope to increase taxes on the beleaguered middle class, and the commodity boom that bailed the fiscus out over the past two years is fading.
Michael Sachs, the former budget guru at National Treasury, argued that the country does not face a fiscal cliff, but a fiscal swamp. Spending cuts entail a lower quality of public service delivery, which will feel like walking through mud. They are also politically difficult and can be contractionary and therefore counterproductive. However, the alternative, letting debt rise exponentially is worse. The only way to square this circle is to dramatically raise private investment in the economy, and this means letting go of the monopolies described above.
For many, the rand’s recent weakness is proof of the country’s slide. However, the bigger cause is the rocketing US dollar in anticipation of further interest rate increases from the Federal Reserve as US inflation has hit 9%. Notably, the euro now trades below $1 for the first time in 20 years.
Meanwhile, the currency plays an important role as shock absorber. When it falls, it discourages imports and raises export revenues. South Africa also has a substantial global asset base (a positive net international investment position, to use the technical term) including the offshore assets held by pension funds and international investors. This means a weaker currency doesn’t necessarily make us all poorer, though it does make some people poorer. Importantly, the country generates more than enough hard currency to fund imports, and deep domestic capital markets mean government and corporates don’t need to borrow abroad. Therefore, South Africa is very unlikely to run into the sort of combination currency-debt-balance of payments crisis Sri Lanka is experiencing.
The rand is likely to respond negatively to political or economic deterioration, and for this reason and others, offshore investment in the context of a diversified portfolio makes sense. However, it should again be emphasised that the exchange rate is usually much more sensitive to global factors than local. Often when the rand is weak, like now, it is a time of risk aversion on global markets. The rand is usually strong when global markets rally. Trying to get too clever with timing the exchange rate when making offshore investments can be counterproductive.
Winter to summer
The Winter of Discontent in the late 1970s was a terrible time for existing investors but was a great time for new investors. How is that possible? The poor economic climate with high inflation and weak growth destroyed real returns in the UK, but also the US and elsewhere. It also dragged valuations down to rock bottom levels. By late 1979, the UK equity market was trading on a single digit price: earnings ratio. A 10-year government bond could be bought at a yield of 13% (today 2%). Anyone brave enough to buy when sentiment was this poor was handsomely rewarded. Winter gave way to spring and eventually summer.
We have similar valuations in South Africa today. The 10-year bond yield has increased sharply in the past few weeks to 11%. However, the longer-term inflation outlook remains unchanged – with the Reserve Bank a conservative guardian of monetary integrity – suggesting that patient investors can earn hefty real returns in the years ahead. South African equities trade on a single digit price: earnings ratio and a 4% dividend yield, well above the 3% long-term average. Both equities, and to a lesser extent, bonds are likely to experience short-term volatility. Diversification remains important.
Nothing in this article is trying to sugar-coat the numerous well-known and widely discussed problems South Africa faces. This truly is a moment of discontent. But our job as investors is not to ask if the news is bad, but whether the bad news is priced in. Since everyone has the freedom to raise these issues loudly and publicly – a freedom you cannot take for granted in places like Russia, China, Egypt and Turkey – they must surely be discounted in markets already.