South Africa: Opportunities Galore

Michael Kafe | London

We expect 2007 to be another year of opportunities in South Africa. Four major risk events to watch out for are (i) the South African Reserve Bank (SARB)’s first monetary policy meeting on 14 February; (ii) a peak in the inflation cycle during the first half of 2007; (iii) developments in the country’s current account deficit composition towards the middle of the year; and finally, (iv) the ANC’s party presidential elections in December.

The Macroeconomic Dynamics

This week, we took a final look at our macroeconomic forecasts for 2007. We revised our 2006 GDP growth number from 4% to 4.9%, thanks largely to historical data revisions by Statistics South Africa, but we have kept our 2007 forecast unchanged at 4.3%. Quite importantly, we look for consumption growth to slow down to 4.5% by the end of next year, as the 200bps of tightening seen earlier this year takes its toll on consumers. Also, Gross Domestic Capital Formation (GDFI) will likely decelerate from 13.8% in 3Q06 as private investment slows, but should remain above 8% — supported in large measure by investment spending under the government’s capital expenditure program. The external sector is also likely to show some improvement, with the current account deficit coming in only marginally above 5% of GDP as exports see some volume growth, thanks to capacity enhancements, and as the import bill sees moderate relief from low oil prices. Finally, a continuation of sound fiscal management will likely result in a government budget surplus in 2007. With the government already sitting cash-flush, we expect central government borrowing to shrink. Positive sentiment here could place a cap on bond yields.

Curve Normalization (Bull Steepening) in 2007

With the above scenario in mind, we do not see justification for any further rate hikes in 2007. However, the market is still pricing in a 50bps rate hike in February. We would seriously regard this as an excellent trading opportunity to receive ZAR rates. We look for the SARB to be on hold for the greater part of the year, and expect it to consider easing no earlier than December 2007. But if our view on declining oil prices and benign food inflation in H2 2007 is correct, then the market could start discounting prospects of easier money long before it actually happens. Importantly, therefore, we expect the next big move in South African interest rates during 2007 to be a normalizing yield curve (bull-steepening). Timing the move is always tricky, but one should consider looking for entry opportunities from as early as February/March 2007 (i.e., just before inflation peaks).

Positive Metamorphosis in Current Account Mix

Another important thing to watch is the external accounts. In 2007, although lower oil prices will no doubt take some pressure off import spend, we expect the country’s import bill to remain under pressure as the government’s capital expenditure program kicks off in earnest. The government plans to spend R372bn on infrastructure over a three-year horizon. With the first year already behind us, it is clear that it will need to step up its act in 2007. This means we could see some huge increases in capital imports over the course of next year, particularly given that the import penetration ratios for some of the projects (especially railways and ports) are as high as 40–60%. The bigger question though, is, will the market still penalize South Africa for running a current account deficit that is in excess of 5% of GDP as it did in 2006? Or will the switch in the current account mix, from consumption goods to capital goods that have positive implications for the country’s growth trajectory placate the market? Also important is the funding of the deficit. Will the huge net outflows that were reported on the FDI line of the capital accounts this year continue into 2007, forcing further downward adjustments in the currency?

Morgan Stanley’s view is positive on both counts. We expect the market to become more sympathetic as it gets its mind around the composition of the current account deficit. We also expect the haemorrhage in FDI to dry up next year as local companies slow their foreign acquisition drive, and as private equity inflows gather steam. At the same time the ‘sweeter’ carry in the interest rate market as South African rates rose in the second half of 2006 should continue to attract more offshore portfolio inflows. Against this background, we have revised our outlook for the Rand, and are now looking for no more than 6.5% depreciation next year — down from 8% previously.

Risks:

As always, however, there are some risks. For 2007, we think the biggest risk is politics. This is not because we think South Africa is headed for a political stalemate — as a matter of fact, there is no shortage of able leadership in South Africa. Even so, we think that uncertainties surrounding important political events could send some jitters through the market.

First is the ANC’s Economic Policy Congress in June: The market is likely to be concerned that the African National Congress (ANC) will give in to rising pressure from labour, particularly in the wake of the Jacob Zuma saga. We don’t think they will.

Second is the ruling ANC party’s presidential elections in December: The elected president of the party will in all likelihood become the next president of the country following national elections in April 2009. Key issue of concern here would be whether the left succeeds in pushing ousted deputy president Jacob Zuma into the top seat.

Third, an appeal by Zuma’s alleged accomplice-in-crime was dismissed in November 2006, thereby opening the way for the National Prosecution Authority (NPA) to reinstitute corruption charges against Zuma. A re-opening of the case will likely be resisted by the trade unions, and union attempts to either challenge the validity of the charges or to influence the outcome of his trial could send wrong signals that upset the currency markets. Conversely, and perhaps more importantly, any reluctance on the part of the NPA to pursue the case could also be viewed negatively by the international community.