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August 26, 2020

Life Beyond Covid-19

Alan Wood, Head: Investment Consulting

Retirement funds have a role to play to help restructure our economy towards inclusive growth beyond the COVID-19 pandemic.

“The sustainable financing of South Africa’s economic recovery plans will require close co-ordination of fiscal and monetary policy to ensure ongoing access to capital markets and to reduce the cost of borrowing…”1

Economic backdrop

South Africa is knee-deep in the COVID-19 storm. Based on total reported cases so far, we are firmly in the top 5 worst-hit countries in the world. At the time of writing this article, our daily reported COVID-19 cases had not yet peaked, but total reported cases already far exceeds countries like the UK, France, Spain and even Italy, where panic over the pandemic started earlier this year. Thankfully, our death rate is low, especially when compared with countries in Europe that have an ageing population.

By the time you read this article, if we follow international trends, the peak of the COVID-19 storm in South Africa will be behind us. Some argue that the pandemic will accelerate our inevitable economic demise, others optimistically hope it will prove to be the catalyst for much-needed structural changes in our economy. Unfortunately, our track record over the last decade supports a lower-road, rather than a higher-road scenario.

At the beginning of 2020, the world economy appeared to be robust. Upon closer examination, it had been fraying at the edges for some time. In 2018, the US started a process to unwind unsustainably low interest rates. However, a US/China trade war ensued, there was rising populism in Europe, and uncertainty created by unresolved Brexit issues put a halt to that strategy. In a surprise move, the US Federal Reserve (the Fed) changed course early in 2019, easing monetary policy in an attempt to ward off a possible recession in the US in 2020 or 2021. Despite the frayed economic edges, in the latter stages of 2019, global equity markets began to discount a very favourable economic environment for 2020. In South Africa, there was even a hint of optimism that the worst would be behind us and we would enter a period of positive economic structural reforms, tilted in a market-friendly direction.

The Great Lockdown that started in March 2020, brought about by the COVID-19 pandemic, brutally destroyed any hint of economic optimism in the world and hit us hard in South Africa.

In April 2020, the International Monetary Fund (IMF) reduced its base case 2020 global economic growth forecast from +3.3% to -3.1%. This number has since been reduced to -4.9% in June 2020, because “The COVID-19 pandemic has had a more negative impact on activity in the first half of 2020 than anticipated.”2 The outlook for 2021 was also moderated from +5.8% to +5.3%. Based on these estimates, the size of the global economy at the end of 2021 will still be smaller than it was at the beginning of 2020, with China being the only country in the world with a growing economy over this period.

Global equity market response

At a headline level, global equity markets appear to be discounting a much more optimistic outlook, believing that the worst of the pandemic is behind us and we should be a lot more optimistic on the bounce back in economic activity into 2021.

When we dig a bit deeper beyond the headlines, we find much more nuanced details. Unpredicted, massive global fiscal and monetary stimulus has driven the equity recovery. At the same time, even though the earnings of most companies around the world will be decimated by the lockdown, the pandemic has in fact been a tailwind for some companies, especially dominant technology platforms. The “FAANG’s” – Facebook, Amazon, Apple, Netflix and Google (Alphabet) – supported by of Tencent, Naspers and Prosus collectively make up over 30% of the SWIX. Microsoft have driven a large part of the equity market recovery, to the extent that the top 5 companies by market capitalisation now make up more than 20% of the S&P 500 Index. In South Africa, thanks to the stellar performance

Graph 1: S&P 500 and SA Equity from January 2020 to date (USD and ZAR)

Source: IRESS

Graph 2: FAANG performance YTD

Source: IRESS

Turning to the South African economy – a debt trap

The economic situation for South Africa is worse than for the rest of the world. Our business confidence index slumped to its lowest level ever recorded since the index started in 1985, and even optimistic forecasts are predicting -8% GDP growth for the year, the worst ever recorded.

South Africa was already in a very weak economic position at the start of the year, thanks to bad economic policies over the past decade. Perhaps COVID-19 will prove to be the “straw”, or maybe the “log”, which “breaks the camel’s back”.  Graph 3 shows that our debt level, which had already been revised upwards in the 2020 National Budget, is expected to skyrocket due to the impact of financial support and a decline in taxes, because of the COVID-19 lockdown. Many governments around the world are also facing increasing debt levels, but our debt levels are much higher than those of other emerging market peers and the additional debt burden is not being deployed into improving our production capacity.

Graph 3: Government gross debt to GDP – 2019 and 2020 budget projections

Sources: National Treasury and Prescient Asset Management

National Treasury pointed out in a Supplementary Budget Review, released in June 2020, that if nothing is done about the current situation undesirably low economic growth will persist even after the COVID-19 crisis, and the cost of servicing debt will increase to crowd out other public spending on health, education and other policy priorities. They have termed this the “passive scenario”, where debt levels are projected to spiral out of control as shown by the graph above.

The passive scenario will lead to a vicious cycle where Government will be unable to pay its debt. Business confidence will plummet further, the private sector will be reluctant to invest in the economy and there will be a flight of capital. It is scary to consider that National Treasury has openly admitted that we are already on a path to destruction, which they say we need to reverse through active intervention. The alternative scenario is an “active scenario” under which Government stabilises debt and speedily implements substantial reforms to boost economic growth.

It is clear that our country requires substantial economic structural reforms to be implemented, to move closer to the active scenario. Detailed proposed reforms have already been put forward by National Treasury in 2019.3 The ANC has recently issued a discussion document1 to outline an economic transformation plan supported by large-scale investment into infrastructure.

Infrastructure spending is a powerful tool that can be used by an efficient government to stimulate economic growth. Now, more than ever, South Africa needs to make use of this tool. Infrastructure spending has been declining significantly since the run-up to the 2010 FIFA World Cup as indicated in the graph 4.

Unfortunately, the spike in our government debt burden will now make it impossible for Government to make use of this policy tool without accessing other pools of capital. If Government is able to facilitate an efficient process to access private capital, this could be a catalyst for growth.

Graph 4: Fixed Capital Formation Insert fixed capital formation graph

Source: The World Bank, 2020 number is our own estimate

Discussions on implementing a sustainable infrastructure programme to be supported by private pension funds started gaining traction in February 2020. In his address during the Sustainable Infrastructure Development Symposium of South Africa in June 2020, President Ramaphosa mentioned that infrastructure spending could reduce the cost of doing business, create jobs, increase capacity in the economy, increase productivity and improve sentiment and business confidence. It could even attract foreign investment into South Africa.

Retirement funds are very long-term investors. It is important that trustees carefully consider long-term infrastructure investment opportunities that will emerge from this initiative. For anyone who is able to look beyond a “failed state” scenario for South Africa, these opportunities should provide healthy long-term risk-adjusted returns.

It is important to consider broad scenarios within which possible investment opportunities can be outlined. The fact that National Treasury has labelled a low-road scenario as “passive” is worrying. This implies that we are already on the path to a failed economic state and positive interventions are required to change course. Any rational long-term investor has to assign a meaningful probability to a low-road scenario. This is problematic, because rational investors do not willingly invest in a failed economic state, which may explain why there has been so much discussion and debate around prescribed assets.

An alternative scenario is the active strategy, where Government is able to implement economic policies that enable the economy to grow and contain debt levels. Under this scenario, business confidence improves and investors become willing participants in helping the economy recover from the destruction of the past decade followed by the sudden, massive impact COVID-19 has had.

As with all scenario planning, it is likely that we will end up somewhere in between the two extremes. However, sentiment is unfortunately currently swayed towards the low-road scenario. Investment opportunities built around the South African economic recovery theme are emerging from the private sector and Government.

“It will be necessary for leaders in society to articulate the interests of the country and the economy as a whole, rather than sectoral interests. Short-term tactical compromises are required from all stakeholders, in order to achieve longer-term strategic goals and objectives. In this regard, business will be required to look beyond profits, workers beyond the next round of wage negotiations, and Government must have the capability to reprioritise and restructure where needed.”1

For a long time, retirement funds have participated in infrastructure funding such as electricity, water and road projects. The return profile of these projects matches the liability profile of the retirement fund.

We know that the South African retirement savings pool is not adequate to provide sufficient pension income for most members. Requiring retirement funds to compromise on their reasonable return objectives will worsen the problem of inadequate retirement provision and poverty in the country.

It will be necessary for trustees to step out of their comfort zones and seriously consider impact investment opportunities that will emerge around the theme of “rebuilding and restructuring our economy to achieve inclusive growth” without comprising on an adequate risk-adjusted, return-seeking objective.

We also need Government to act decisively and speedily to build an investment-friendly enabling environment and unambiguously clarify that prescribed assets are not the answer to solve their funding needs.

1 Reconstruction, Growth and Transformation: Building a New, Inclusive Economy – A discussion document prepared by the ANC’s Economic Transformation Committee (ANC, July 2020)

2 IMF World Economic Update, June 2020: A Crisis Like No Other, An Uncertain Recovery (IMF, June 2020)

3 Economic Transformation, Inclusive Growth, and Competitiveness (National Treasury, August 2019)