Budget impact on markets and asset classes SCM

Budget impact on Markets and Asset
Classes

Dear Client
After an incredibly tough number of weeks for Eskom, the Government and the country at
large, Finance Minister Tito Mboweni deliver a credible budget, if somewhat uneventful, that
not only sought to appease the rating agencies, but give credence to President Ramaphosa’s
reform promises while keeping the electorate, as well as the ANC factions, on side. No small
feat. Based on the market reaction, including a brief sell-off in the rand and bonds (and
subsequent recovery), investors view this Budget as a credible projection of how to balance
the books while bailing out Eskom – indeed a measured budget that took into account the
country’s stark economic realities.
The hard reality however remains that the underlying fiscal position remains extremely fragile.
The R 23 billion earmarked for Eskom is very likely not sufficient. Full details remain sketchy
and we will likely only receive more clarity after the national elections. We are risking service
delivery and national debt stabilisation to stand in for Eskom’s debts. Overall the minister is
probably too optimistic about the country’s financial position and another sovereign credit
downgrade becomes increasingly likely.

What emerged starkly from the budget is that SA’s lack of economic growth is hurting tax
revenue. In 2018/19 tax revenue was R42.8 billion less than budgeted, across most revenue
categories. Without higher economic growth, the country will struggle to generate the revenue
it needs to make structural changes.

The next immediate hurdle in the road is the country’s assessment on 29 March by Moody’s,
which is the only rating agency to maintain SA on an investment grade, with a stable outlook.
It is likely that Moody’s will downgrade the outlook to negative in March and will make another
assessment later of how the government is fulfilling its promises. If there is no economic
growth, an increase in the deficit and a worsening of the debt burden, SA is very likely to face
a ratings downgrade. The national debt ratio is projected to marginally break through 60% of
GDP, historically a key level for the ratings agencies.

Impact on markets

Markets were initially on edge, unsure of what to expect from the budget. At first glance higher
budget deficits, higher debt levels, some interesting taxes (like those on e-cigarettes), and lower
revenue forecasts for the medium-term caused the rand to depreciate towards levels close to
R14.40 and the JSE to drop almost a percentage point. In the end markets approved of the
radical decisions and the rand strengthened back to below R14.00 and the JSE ended up by a
percentage point. With radical we mean the government’s decision to keep wages fixed, the
discourse about not outright taking on Eskom’s debt, restructuring plans, and the few other
subtle mindset changes government continues to make; like being concerned about keeping
skills in SA, something that wasn’t considered important a decade ago.

Implications for Asset Classes

SA Bonds
The risk of a further credit downgrade somewhere in the not too distant future is a real one and
fixed income investors in long duration instruments (i.e. bonds) should take care and calibrate
their exposures to reflect the risks prevailing.
However, we are of the opinion that ratings agencies will only re-asses our credit rating after
the elections.

SA Equities
One should however assess the prospects for domestic risk assets like South African equities
on their own merits. The valuations of South African shares have materially improved over the
past number of years, partly as a result of the paltry returns earned and partly because of the
global market weakness experienced at the end of 2018. Valuations are now far cheaper than
a number of years ago and many local asset managers comment on the significant upside that
they now see in domestic shares. Coupled with this is the fact that more than 60% of the
collective earnings of JSE listed companies emanate from overseas. These foreign earnings
are more dependent on the global macro-economic backdrop than strictly on South African
domestic fundamentals. Although global markets corrected towards the end of 2018 in what
reflected a growth scare about the health of the Chinese economy, and uncertainty about US
and global recession risks, trade tariffs and central bank policy, we remain of the opinion that
global growth remains largely intact, even though it has lost some momentum.

Global Equities
We still believe Global equity will provide satisfactory or even strong returns typical of the late
stage of the business cycle, albeit with increased volatility
Emerging Market Equities
Emerging Markets have materially fallen in 2018 and are pricing in a lot of bad news. Any
positive developments on the trade war front and/or traction from aggressive economic
stimulus measures by China may cause a material re-rating in emerging markets. In this
scenario the South Africa market and our currency will be de facto beneficiaries.
Regards,
Sequoia Capital Management Team
25 February 2019

Sequoia Capital Management is an
authorised financial service provider, FSP 49393