Episode 6: A bumpy ride in South Africa

Speakers

Michael Bolliger

Head of asset allocation for emerging markets, UBS Wealth Management

Michael Bolliger heads the emerging markets asset allocation team at the UBS Chief Investment Office. The team is responsible for the asset allocation within the emerging markets and contributes to the UBS House View on emerging market assets. Bolliger is a regular contributor to numerous financial media.
Bolliger joined UBS Wealth Management Research in March 2009 as an emerging market analyst. Prior to joining UBS, he work at the Swiss National Bank and the Spanish central bank and at the University of St. Gallen. He holds a PhD in economics from the University of Basel and a master’s degree from the University of St. Gallen. He is married and has two children.

Text transcript

South Africa transcribed

[Yaelle]: Hello, my name is Yaelle Gang and I’m the editor of Canadian Investment Review.

[Martha]: And, I’m Martha Porado, associate editor of Canadian Investment Review and Benefits Canada.

[Martha]: Thanks for joining us for Pension Passport, where we’ll connect with investment experts from around to world to zero in on different countries. We’ll explore their economies, investment opportunities and risks – all with the lens of a pension investor.

[Yaelle]: In this episode, we’ll explore South Africa.

[Martha]: It’s been a quarter of a century since South Africa became a democracy, but there are still issues that exist. Inequity and unemployment are high and according to the World Economic Forum’s Global Competitiveness Report, South Africa ranks 67 out of 140 countries.

By MSCI’s standards, South Africa is an emerging market, but by FTSE Russell’s it’ s an advanced emerging market.

[Yaelle]: According to the OECD, growth was slow, in 2018 and the projections for 2019 and 2020 don’t look promising.

To explain more about why that is, we welcome our first guest Dr. Falilou Fall, who is a senior economist at the OECD.

Dr. Fall has written peer-reviewed articles on macroeconomics, pensions, inequality and African issues and has taught at leading universities and business schools.

Before we get started I also want to note that while Falilou works at the OECD, in his capacity on this podcast he is not representing the official view of the OECD or any member countries.

Thanks for joining us Falilou. Where are you calling in from today?

[Falilou]: Hello, I’m calling you from Paris.

[Martha]: So to start off, can you tell us about the macroeconomic factors that are driving South Africa’s economy that potential investors should be mindful of and how would you describe the health of the country’s economy?

[Falilou]: Yes, I think the recent outlook of the first quarter of 2019 don’t look very great. The economy was in recession minus 3.2 per cent and the main sectors in the economy were declining: manufacturing industry, also mining industry and even trade, catering and accommodation sector were declining. So I think the main factor behind all this declining is that has been investment has been on hold in the first quarter and even in last year. And the main factor behind that was policy uncertainty that we are hearing in South Africa in the last two years and that has a little bit continued through the election.

So that makes up the economy. The health of the economy has been so far like low mode or modest growth mode. But going forward, we can expect that there is little bit more clarity in the leadership of the country- clarity on the agenda the growth reform agenda. Some clear guidance has been given in terms of willingness to tackle issues in the electricity sector, issues with SOEs, to get out of mismanagement in SOEs. And all this will I think help bring in or to rekindle the investment. And if investment in the private sector and in the public sector comes we can expect that growth will start to pick up.

[Yaelle]: With that in mind, what sectors do you see particular opportunities in?

[Falilou]: There are in South Africa many sectors that I think are . . . where the prospects are good. I think that if we take the classical division we have in mind in terms of agriculture and agro-processing, in terms of mining and manufacturing, in all those sectors there are opportunities. In the agriculture and agro-processing sectors in particular, building in the regional integration through the Southern African Development Community, SADC, there are opportunities in processing for example, so in base products, organized vegetation, etc. fruit and vegetables and this is linked to also the development of the retail sector, the super market, which is expanding in all the SADC regions and which is available for exporting or distributing South African agri-food products.

So those are sectors with opportunities. The banking and the financial and insurance services is one of the best in the continent and also, which offers great opportunities for investment and development also links to the continent and the region. And in manufacturing also pharmaceuticals, even innovation links to health and there are opportunities. And also in the telecom sector there are opportunities because there is use potential to further develop the market.

[Martha]: Okay, and on the other hand, where do you see risks to the economy?

[Falilou]: There are different risks to the economy. Internal and external risks. I think on the internal side, there is a cross cutting risk which is linked to the electricity and power generation situation. I think if the government doesn’t follow in restructuring the main company and making sure that power generation is there on time that would be a risk to the economy. Also risk if I name some external risks, I think you know South Africa is a main export of mining and commodities and it would be hard hit by an escalation in protectionism and trade protectionism, escalation in tariff war especially when mining products are targeted. And you know some countries like China, India are export markets for South Africa mining and commodities and if those countries are hit through the value chain then South Africa could be hard hit also.

Another risk is a disorderly exit of the U.K. from the European Union. The U.K. is one of the first partners of South Africa in Europe and a disorder exit of U.K. could create complications with South Africa also.

[Yaelle]: Thank you so much Falilou for your insights on the macro economy in South Africa. Before we bring on our next guest I’ve got a pop quiz for you Martha.

[Martha]: I’m ready.

[Yaelle]: So South Africa actually has three capital cities. Can you name two of the three?

[Martha]: Okay well one of them is definitely Cape Town.

[Yaelle]: That is correct.

[Martha]: And I’m going to guess that the second one is Johannesburg?

[Yaelle]: That is incorrect. So the three capital cities are Cape Town, Pretoria and Bloemfontein.

[Martha]: How come it has three capital cities. What’s that about?

[Yaelle]: So it has three capital cities because one’s the capital for each branch of government. So Pretoria’s the administrative capital, Cape Town is the legislative capital and Bloemfontein is the judicial capital.

[Martha]: Okay, okay. I think we need to get back to the experts.

[Yaelle]: Great.

[Martha]: We’d now like to welcome our next guest, Michael Bolliger, head of the emerging market asset allocation team at UBS Wealth Management’s chief investment office. His team is responsible for asset allocation within the emerging markets. Michael joined UBS Wealth Management Research in March 2009 as an emerging market analyst. Prior to joining UBS he worked with the Swiss National Bank and the Spanish central bank as well as at the University of St. Gallen. Thanks for joining us Michael.

[Yaelle]: So Michael, politics are playing an increasingly major role in asset management. Can you zero in on the most important things foreign institutional investors looking to South Africa should understand about its political realities.

[Michael]: Yeah, that’s something we observed as well and this is by the way true as much for local markets like South Africa, but also on the global scale we can see this almost on a daily basis these days.

Now focus on South Africa locally, I think the main takeaway for investors is really to understand that South Africa is in high need for structural reforms and the reason here is simply that its potential growth rate, so the long-term equilibrium growth rate that the country can deliver at this point is around one to 1.5 per cent and that’s simply not enough for an emerging economy like South Africa.

Now, some of these reforms that President Cyril Ramaphosa and his team have to do they might be highly unpopular. You know, they can result in layoffs or in real wage cuts or, and I think that even equally if not more important, they might mean that some of the fellow party members might be squeezed out of you know interesting deals that historically they could benefit from. So that means the ANC, the African National [Congress], the local party, the ruling party, they will have to implement these reforms against the pressures from the various factions within the party against maybe a growing and increasingly unhappy electorate that sees high unemployment and that sees very low if not negative per capita growth. And so this can give rise to all sorts of initiatives, some of them being controversial, like the recently-initiated land expropriation without compensation that was brought up by the Economic Freedom Fighters, which is an opposition party. And so this will find very likely its way into the South African constitution. Now, I think it’s not a major disaster but still it’s something that has created quite a bit of turbulence in financial markets.

And so summarizing this, Cyril Ramaphosa, he has to act in a challenging environment where he faces opposition for much-needed reforms for both the electorate and his own party. And that makes it difficult. But still, we have the base case that he can succeed and so hopefully we’ll see a gradual pick-up in South Africa’s potential growth rates in the years ahead.

[Martha]: So politics aside, what challenges are there for institutional investors looking to invest in South Africa?

[Michael]: Well there’s first I think an important focus on how South African assets are exposed to global developments. So one is that simply the currency for example, the South African rand, but also the other assets, they’re high beta assets. So whenever there’s big shifts in market sentiment these will be effected strongly through that. Second, South Africa is closely linked to trade and specifically to trade and commodities. And that builds a direct exposure to what’s happening in Asia and specifically what’s happening in China. And from there, there’s a direct link also to the current tensions between the U.S. and China over trade.

And then third, South Africa is a current account deficit nation. So they rely on foreign investors funding their deficit, which these days typically come via portfolio investments into the local fixed income markets. So for example that means whenever there is growing expectation that monetary policy becomes more dovish, the rand, the currency, will strengthen, and whenever there is expectation that they will become more hawkish i.e. the Fed will hike interest rates, the ECB will hike interest rates, the European Central Bank, then that can be a headwind for the currency and also for local assets. And domestically, the main challenge is really around what I explained before on South Africa’s structural growth rate- which is at this point too low for an economy of the development stage of South Africa. And so the key challenge will be to fix this and hopefully have a path towards higher growth in the future.

[Yaelle]: Thanks and how do these challenges inform risk premia for South African assets. Is there a premium for investors?

[Michael]: Yes, investors definitely demand a risk premium for investing in a country like South Africa, which is simply because volatility and risks, therefore are higher in absolute terms. One example that we pay a lot of attention to these days is the risk that South Africa might lose its investment grade rating from Moody’s, a rating agency, which can obviously trigger quite a bit of volatility in the fixed income market if it happens. Or you can also see that there’s more volatility in macro-economic data, so the first quarter GDP data was as low as 3.2 per cent, minus 3.2 per cent, which is significantly linked to the significant part and cultural production that tends to be more volatile in nature, but also the mining industry that can be volatile and so for all these things together typically investors demand a risk premia.

Now of course that also creates interesting opportunities. At this point, for example, we think the local bond market and the currency, the rand, is interesting. It offers an interesting tactical opportunity. And we’re overweight these markets in a global tactical asset allocation simply because we believe it will generate extra returns over the next six to twelve months.

[Martha]: So how would you characterize South Africa in terms of the role that it plays in the overall EM component of an institutional portfolio?

[Michael]: So South Africa is as I said, within CEMEA, so this is Central and Eastern Europe, middle east, Africa, it’s this group of countries of emerging developing countries in the European time zone it’s one of the largest most liquid markets, which makes it a very interesting country for people to gain exposure to. Also it is home to some very interesting companies, so those investors that can do bottom-up selection, they might have good opportunities there to look at the different index constituents and I think a highlight is finding interesting names to get exposure to.

Now, when we look at the bigger context we see that clearly South Africa is large and important in Africa, in the CEMEA part, but in say overall emerging market portfolio this is dominated by countries in Asia, specifically on the stock side where you have these very large and important markets in China, India, Taiwan, Korea. So I’d say it’s a relatively large and important market within the context of EM. But in a globally diversified portfolio, it’s relevance is not going to be nearly as high as the one of China, of say Korea, Taiwan, India because these economies simply are a lot bigger than South Africa.

[Yaelle]: Thank you. And then drilling down into specific asset classes, where might it make sense for a pension plan to allocate within South Africa.

[Michael]: Yeah, we don’t provide specific guidance for pension funds, but I think our strategic asset allocation, which is a five to seven-year asset allocation that we use as a starting point for almost all the portfolios we manage, I think that’s a good proxy to answer this question.

And there, South Africa is part of the exposure we have in the emerging markets that can be, depending on the risk appetites, up to 10 per cent on the equities and maybe five, six per cent on the bonds. The rest is developed markets and then also maybe a bit of exposure via non-public markets so private debt, private equity, where we invest as well.

So in all these buckets I think South Africa plays a role, it plays an interesting role, but in the context of a global portfolio I would still characterize it as a rather niche play in this context.

[Martha]: Okay, and where do you see the most opportunity for institutional investors like pension plans?

[Michael]: I think there’s two things to say. So, on the one hand specifically given the nature of a pension fund or a pension plan, it should be longer term. And I think in this context it’s very important that not only for South Africa, but for the emerging markets more broadly to look at this strategically, to think of say what can this market do on a five to ten-year horizon? And again what we do on our side is we build a strategic asset allocation that we take as a starting point. And there I think having exposure to this market is really interesting. What I think specifically for the pension funds can be interesting is to engage in local fixed income markets because they have relatively high return and also at this point in time they provide a rather good entry point. That’s what we think tactically as well. And so that can nicely add to the long-term return potential of a pension fund.

And then the second message and I think that’s equally important, and again that does not only apply to South Africa, but to the emerging markets more broadly is simply that, often we find it’s worth being active when we invest in emerging markets and in South Africa specifically as well. So you know, it can mean that as a pension fund you have the means to look at this in-house, and to bring this up in your investment process or in your investment committees and really manage this actively that you can benefit from say the shifts in risk premia that we discussed, or alternatively you can also maybe outsource this and have someone else looking at this.

And I think there, again, you have a fair chance to deliver higher returns than just being invested passively.

[Yaelle]: Thank you.

[Martha]: So before we go, Yaelle, we both know how much news get generated when index-makers like MSCI and FTSE Russell change the make-up of one of their products.

[Yaelle]: Absolutely, we’ve seen a lot of talk about MSCI’s emerging market index introducing China A Shares and Saudi Arabian stocks.

[Martha]: Well the growth in those countries’ representation on the indexes has come at the expense of foreign investors owning stocks from other markets, including South Africa. When the MSCI re-weighted its index is May, South Africa’s stock market saw a sell-off to the tune of $894 million USD.

[Yaelle]: Just goes to show, there’s only so much room in a portfolio. Well, outflows or not, I’m glad we got to learn more about South Africa today.

[Martha]: So am I. And for all you listeners who enjoyed today learning about South Africa- don’t forget to tune into our other episodes of Pension Passport by going to www.investmentreview.com/podcasts.

Thanks for joining us, and as they say in Afrikaans, one of South Africa’s 11 official languages, totsiens.