Market and economic highlights
- There was a sustained appreciation in the rand following an initial blow-out to near R19.80 per dollar following accusations that South Africa had sold weapons to Russia. The risks attached to South Africa’s suspension from AGOA and possible sanctions appear to be dissipating. The materiality of the threat of South Africa’s suspension has potentially fallen for amongst other reasons.
- This is not the first time South Africa has faced suspension. AGOA is reserved for low-income countries and thus the questions around South Africa’s eligibility date back to 2015.
- Suspension from AGOA is relatively insignificant given that only around 20% of South Africa’s exports to the US are subject to AGOA. The US accounts for around 9% of South Africa’s total exports, and thus just under 2% of our exports would be affected.
- The US (and the West broadly) may wish to continue to protect its positioning on the African continent, which would be impacted by suspending South Africa without due cause.
- Whilst South Africa has instituted an independent judicial inquiry, the burden of proof remains with the US. The US is yet to provide conclusive evidence that South Africa supplied arms to Russia despite claims by its Ambassador to South Africa.
- The US economy continues to show its resilience, with Q1 GDP surprising significantly to the upside. Consensus estimates were that US GDP would grow 1.4% in Q1, but the number came in at 2%. Broadly speaking, the US economy, amongst a group of other developed markets is expected to have benign growth in 2023. The latest GDP print has fuelled bets that the US Federal Open Market Committee (FOMC) will raise rates by 25bps at its next meeting with market-implied odds at over 85% at the time of writing. The print is somewhat boggling because of the following.
- Several leading indicators in the US suggest the US may be approaching a recession. Yield curve inversion considered an accurate indicator of recession in the US, occurred eight months ago. Manufacturing has been weak for most of the year. The leading indicator, manufacturing orders and consumer confidence have been drifting lower. But initial jobless claims, a proxy for employment, have been resilient implying employment is still strong in the US.
- Several coincident indicators suggest a 50/50 probability that the US is in recession. The only coincident indicators conclusively implying that the US economy is not in a recession are non-farm payrolls and the US employment level.
- The Bank of England was forced to hike interest rates with inflation in the UK remaining elevated in April, and still uncomfortably higher than the central bank target. Interest rate expectations remain elevated in the UK, with interest rates expected to peak at around 6% through to the end of the year. The US Federal Reserve Federal Open Market Committee (FOMC) is expected to hike rates by another 25bps this month before pausing, The European Central Bank has a tough task of balancing interest rate expectations in Europe with large variations in inflation across the euro-bloc and economic slowdown across the board.
Thematic view: A possible first inflection point for South Africa
The last few weeks have offered a glimpse of hope for the South African economy. While the operational performance of Transnet continues to be a binding constraint on South African exports, the incremental improvement to the performance of Eskom, as revealed by the Energy Availability Factor (EAF), allows us to look at the prospects for South Africa through a new lens.
Chart 1: Eskom Energy Availability Factor
Date sampled: 29 June 2023
Source: Investec Wealth & Investment, Minerals Council South Africa
South Africa has been experiencing a sustained decrease in the energy availability factor since 2017. Chart 1 above shows the extent of the collapse of energy security in South Africa, from a near 80% EAF to below 50% on average in 2023 so far. The economic implications are estimated to be between R200m and R1bn in GDP lost per day dependent on the stage of loadshedding, with an exponential rise per higher stage.
Chart 2: Energy Availability Factor relative to previous years
Date sampled: 27 June 2023
Source: Investec Wealth & Investment, ESKOM
A month or two ago, the Minister for Electricity claimed that the EAF was improving towards 60%. Chart 2 above supports his theory, as between weeks 21 and 23 of the year, the EAF trended upwards toward 60%. The EAF is currently at 59%. The Minister now estimates that the EAF is trending toward 70%. This is a key number because once the EAF reaches 70% or more, the performance of Eskom ceases to be a binding constraint on economic growth up until the point at which GDP growth is around 3%. This can be a catalyst for economic growth in South Africa. The consensus estimate for GDP growth this year is sitting at 0.2% but this number could turn out to be materially higher if the performance of Eskom is maintained through the third and fourth quarters of 2023, and this would turn out to be a net positive for GDP growth expectations in South Africa. It would also have positive implications for the risk premium attached to South African assets.
Chart 3: SA 10-year bond yield trend since before accusations SA had supplied weapons to Russia
Date sampled: 3 July 2023
Source: Investec Wealth & Investment, Bloomberg
Chart 4: SA 10-year bond yield trends since the start of the year
Date sampled: 3 July 2023
Source: Investec Wealth & Investment, Bloomberg
In chart 4 above, we show how bond yields on government bonds have fallen of late, partly because of lowering concerns around our potential expulsion from AGOA and the imposition of sanctions because of our alleged ties with Russia, but also because of consistent better energy security. However, we are not completely out of the woods. South African 10-year bond yields are still high relative to the start of the year, coinciding with the unexpectedly higher levels of loadshedding seen throughout the first six months of the year.
The higher stages of loadshedding have resulted in materially lower GDP growth expectations (0.2% for the year as noted above). Nonetheless, South Africa avoided a technical recession in the first quarter, proving the embedded resilience of the economy. For the economy to create jobs, GDP must grow by more than 2%. A better performance at Eskom may lead to upward revisions to GDP growth expectations, which would lead to job growth, as we demonstrate below.
At the end of March 2023, we showed the relationship between GDP growth and employment illustrated by charts 5 and 6 below. These show that GDP growth is correlated with improved employment outcomes one year later. It similarly shows that the only meaningful level of GDP growth that has an impact on unemployment alleviation is GDP growth which is above 2%. According to StatsSA, the unemployment rate for South Africa was 32.7% in the first quarter. For illustrative purposes, if we use an estimate of 4% GDP growth in South Africa, we would expect the unemployment rate to fall by around 3%. In this environment, total employment would rise by around 3% too. Improved GDP has a material impact on employment, but only if the hurdle of 2% is cleared.
Charts 5: Change in unemployment rate versus GDP
Date sampled: 28 March 2023
Source: Investec Wealth & Investment, World Bank
Chart 6: Change in employment & GDP Growth
Date sampled: 29 March 2023
Source: Investec Wealth & Investment, World Bank
What about equity market returns? Chart 7 below shows the operating margin trends of the JSE All Share since 2007. Operating margins are currently sitting at around 10%, 400bps (four percentage points) below the historic average. Among the reasons for the decline in operating margins, particularly in 2023, have been loadshedding and the requirement for businesses to continue business operations through the use of diesel. We would expect a material uplift to earnings expectations for businesses, specifically on the cost side if the improvement of operations at Eskom is more lasting. Production/input costs are set to drift lower if the improved performance of Eskom persists, driven by the fact that retailers, manufacturers, miners, and other industries will spend less on running diesel generators to keep operations going. Additionally, Brent crude has fallen materially over the last year or so from over $100/barrel to around $80/barrel.
Chart 7: Operating margins on the JSE All Share
Date sampled: 3 July 2023
Source: Investec Wealth & Investment, Bloomberg
Two further points should be made. Firstly, formal sector wage growth is low at around 5%. Containment in the rise in salaries and wages would be supportive of lowering operating costs. Therefore, through the combination of these factors, the costs component of the income statement should decrease, operating margins expand and improve company earnings. Additionally, lower production costs would be deflationary.
Secondly, improvements in the performance of Eskom and the subsequent impact on earnings potential would be positive for tax collection. Since the Covid-19 pandemic, a key driver of higher tax revenues has been the relative performance of mining companies given the rise in commodity prices. Falling commodity prices will harm tax revenue projections and outcomes. There has been a sustained moderation in taxes collected from mining companies, shown in chart 8 below. Increased profitability of other companies in other industries due to the better performance of Eskom would increase the taxable revenue base for SARS, which would be positive for tax collections in the current environment. Higher tax collections are critical for delivery of services.
Chart 8: Payments from mining companies to SARS
Date sampled: 29 June 2023
Source: Investec Wealth & Investment, Minerals Council South Africa
Our final point relates to our export capacity and the relative impact of operational issues at Transnet on the South African economy. Charts 9 and 10 below highlight the collapse in South Africa’s iron ore and coal volumes since 2017/2018. As mining companies enter a period of softer commodity prices, the revenue lines of these companies are set to take a hit from a price perspective. A compounding impact will be the volumes of export goods. A hit to both price and volumes will have a material impact on mining company profits.
Chart 9: South Africa iron ore exports
Date sampled: 29 June 2023
Source: Investec Wealth & Investment, Minerals Council South Africa
Chart 10: South Africa coal exports
Date sampled: 29 June 2023
Source: Investec Wealth & Investment, Minerals Council South Africa
The important point here is that export volume growth is positively correlated with GDP growth. Chart 11 below shows that higher export volume growth is, as expected, positively related to higher GDP growth. Therefore, should the operational issues at Transnet be resolved, this would lead to higher GDP growth.
Chart 11: Exports and GDP growth
Date sampled: 28 March 2023
Source: Investec Wealth & Investment, World Bank
In summary, incremental and/or sustained improvement in energy supply and capacity at Eskom will have a positive impact on South Africa in general. A sustained energy availability factor of 70% can result in material upwards adjustment to GDP growth expectations and GDP growth of around 1% or more is not outside the realm of possibility. We emphasise that for meaningful job creation, GDP must grow at 2% or more and therefore more work needs to be done, but it appears that Eskom is moving in the right direction. It is important that operational issues at Transnet get resolved to help improve exports and has a compounding effect on GDP growth potential. Lastly, operating margin expansion will be positive for South Africa and specifically taxable revenues for SARS. This is ever more important given commodity price dynamics, and the likely hit to tax revenues which could ensue and ultimately impact South Africa’s fiscal position and ability to fund government activities and deliver services.
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