realcap quarterly investment report...labour opposition is backing a public vote on brexit, it is...

RealCap Quarterly Investment Report 28 February 2019

RealFin Capital Partners (Pty) Ltd is an authorised financial services provider (Licence No. 43784)

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RealFin Capital Partners Quarterly Investment Report

Dear Investor

General Market Overview

Over the quarter, US and European markets were positive, while the Japanese market, responding to Chinese economic data and trade tensions, was negative. The US S&P 500 returned 1.7%, the German DAX gained 1.9% after a major sell-off last quarter and the French CAC was up 4.7% which is also a substantial recovery following last quarter. The UK FTSE 100 returned a “just positive” 0.5% as Brexit concerns continue to create headwinds for British stocks.

Index Performance for the Quarter (Local Currency)

Source: Stock Rover

Japan’s exports recorded their biggest decline in more than two years falling to -8.4% year-on-year in January which weighed on Japanese equity market performance. However, recent developments in China’s manufacturing PMI point to potential stabilisation in the second quarter of this year.

Chinese Manufacturing PMI, Japanese Exports

Source: Reuters Datastream, Japan’s Ministry of Finance and the National Bureau of Statistics of China as at February 2019


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The Economist Intelligence Unit (EIU) has recently published their view of the top 10 risks to global markets for 2019. They rank the possibility of a US-China trade conflict resulting in a global trade war as the highest potential risk event for the year. US President, Donald Trump, has made threats that he would like to impose additional tariffs on cars imported into the United States from the EU. This is over and above the variety of potential tariffs and restrictions on the flow of goods between the US and China.

Should the EU take retaliatory steps, then it is easy to see how international supply chains could be disrupted. If this is coupled with the defence of domestic industries, then the situation could easily escalate into a global crisis. In this instance, global growth would stall, global trade would shrink, and consumer confidence and profit margins would be affected. The EIU assessment is that the likelihood of this event is moderate but that the impact would be high.

Global Risk Scenarios

Source: Economist Intelligence Unit

Their assessment of a Brexit political deadlock is low probability and low impact. As things currently stand in the UK, a delay of the Brexit date (end of March) and the potential for a second referendum have become more likely. Theresa May intends to get the British parliament to approve a revised deal by the 12th of March but given that the Labour opposition is backing a public vote on Brexit, it is unlikely that a parliamentary vote will pass. The most contentious aspect of the deal is the border between the Republic of Ireland (EU) and Northern Ireland (UK).

The uncertainty over Brexit is taking its toll on the British economy. The economy has slowed and inflation has increased relative to its G7 peer group. EU migration to the UK has declined sharply which is starting to be felt in the National Health Service (NHS) in particular which is highly dependent on skilled EU medics. The UK’s trade volumes with the EU, in both goods and services, is still significantly larger than trade with the US, so the economic impact of an EU-UK fallout really is material.

UK versus G7 Growth and Inflation

Source: National Institute of Economic and Social Research


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Another risk factor potentially brewing within financial markets is in the corporate bond sector. In a recently released report, the OECD examines corporate bond markets in what they describe as a time of “unconventional monetary policy”. The global outstanding debt in the form of corporate bonds issued by non-financial companies reached almost USD 13 trillion at the end of 2018. This is twice the amount in real terms that was outstanding in 2008. In the case of a downturn, highly leveraged companies would face difficulties in servicing their debt, which in turn, through lower investment and higher default rates may amplify the effects of a downturn.

Total Corporate Bone Issuance (USD)

Source: OECD Capital Markets

Corporate bond issuance by non-financial companies in emerging markets shows that China is by far the largest contributor to issuance growth. Within the global investment-grade rating category, an increasing portion of the market is BBB rated, which is on the investment grade/sub-investment grade cusp. This increase has been at the expense of AAA and AA rated bonds. A decline in average issuer quality is, by definition, a higher expected default rate in the case of a downturn.

Investment Grade Rating Categories

Source: OECD Capital Markets


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Household & Corporate Debt as % of GDP

Source: Bank for International Settlements, Crescat Capital LLC

Including household debt together with corporate debt, the chart above shows that the regions of the world most at risk from a credit perspective are Canada, China and Australia. A critical force within credit markets is the Federal Reserve. The Fed has made very dovish comments of late and this fuelled interest and flows in emerging markets. The chart below on the left shows the investment flows into emerging market asset classes while the right chart shows the US Dollar against various currency baskets. Stripping the pegged Chinese currency out of the emerging market currency basket (red line) indicates how weak emerging market currencies have been relative to the US Dollar. This currency weakness has been exacerbated by country-specific issues in Turkey, Argentina and Venezuela but the surge in flows together with a more accommodative stance from the Fed will likely give rise to a continuation of emerging market outperformance versus developed markets.

Flows into Emerging Markets US Dollar Versus Other Currency Baskets

Source: Institute of International Finance


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The Eurozone has disappointed from an economic perspective over 2018. Eurozone industrial production contracted at the end of last year and the services sector has also slowed. The outlook for 2019 is likely to be muted and potentially complicated by political outcomes. In May, Europeans will elect Members to the new European Parliament which raises the risk of more populist representation.

Eurozone Industrial Production

Source: Eurostat

Eurozone PMI

Source: IHS Markit

General Conclusion

As we stated last quarter, we are in the later stages of the global economic growth cycle and the slowing in

economic growth is evident in developed markets in particular. However, the continuation of the accommodative

monetary policy backdrop by the US Federal Reserve has added further impetus to emerging markets.

There are risks in the global economy as we have highlighted. The rise of nationalist sentiment and the

accompanying protection of domestic industries could have very material effects on global trade and thus global

markets.

The perception of risks is often just as important as the reality, as perception drives sentiment which drives market

prices away from the underlying fundamentals – on both the upside and the downside. Dislocations from


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fundamentals create great investment opportunities. With a global investment universe, there is almost always

something cheap and compelling.

Rand Overview

The Rand has been volatile over the quarter with highs and lows almost R1.50 per US Dollar apart in just three

months. In the first Monetary Policy Committee (MPC) meeting of the year, the South African Reserve Bank (SARB)

decided unanimously to keep the repo rate unchanged at 6.75% with the prime rate at 10.25%.

Rand-US Dollar (12 Months)

Source: Trading Economics

Of concern to the South African economy is the further fall in mining production for December. Year-on-year,

mining production is down 4.8% with output dropping for iron ore, other non-metallic minerals and gold.

Mining Production

Source: Trading Economics

The big South African news focus for the quarter was the State of the Nation Address (SONA) delivered by President

Cyril Ramaphosa. He announced that Eskom would be divided into three separate state-owned entities dealing


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with generation, transmission and distribution all housed under a holding company. The state has committed to

providing financial support to Eskom. Following SONA, attention moved to the Budget, waiting for detail on just

how much financial support the state would provide to Eskom. Eskom has R420 billion in debt and has been plagued

by a myriad of corruption scandals and mismanagement. The Treasury has allocated R69 billion to Eskom over the

next 3 years. Despite being overstaffed with as many as 27,500 employees, Ramaphosa stated in parliament that

cost-cutting at Eskom should not include retrenchments.

The rating agencies remain concerned about South Africa’s position – Fitch warned that “Eskom's high debt and

SA's large contingent liabilities are a risk to public finances. Failure to implement the turnaround plan at Eskom to

stem annual losses and which will limit the future growth of contingent liabilities would add downward pressure

on sovereign ratings”.

The comment from Moody's following the budget: “The budget shows a further erosion in fiscal strength after the

October medium-term budget policy statement already pointed to wider deficits for longer.”

The primary concern from the ratings agency’s perspective is the government debt level. Since the 2018 budget,

the gross borrowing requirement has risen to R239.5 billion for 2018/19 and R335.3 billion for 2019/20. Contingent

liabilities (guarantees to public entities) are projected to reach R879.6 billion on 31 March 2019. Guarantees to

state-owned companies amount to R529.4 billion, of which Eskom accounts for 55.7%. These guarantees remain a

major risk to economic stability. The borrowing requirements consist of the difference between revenue (tax

collection) and expenditure as well as payments for maturing debt. As can be seen in the chart below, 2019/20 has

R80 billion of debt maturing (i.e. the capital needs to be repaid).

Loan Debt Maturity Profile

Source: South African National Treasury

Worth considering, particularly from a currency and rating agency perspective, is the ownership of South African

domestic-issued bonds. 37.7% of South Africa’s domestic debt is owned by foreigners. While domestic holders


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(pension funds, insurers and other financial institutions) may be prepared to remain holders through a rating

downgrade, foreign owners will be far less likely to hold downgraded debt.

Ownership of Domestic Government Bonds

Source: South African National Treasury

If we review the “revenue section” of the data from the National Treasury, the pressure is on from South Africa’s

tax base. National Treasury reports that South Africa has 7.6 million registered taxpayers but nearly 83% of tax

revenue is collected from only 2.1 million contributors.

On the surface, it appears that the budget left the tax brackets alone, perhaps recognising that taxpayers are

“tapped out”, but there is a somewhat stealthy increase known as bracket creep. Most salaried employees receive

inflation-adjusted salary increases each year, however, the tax brackets did not undergo an inflation adjustment.

This means that with a higher salary, taxpayers may now “creep” into a higher tax bracket than they were in the

prior year, increasing their tax burden.

Top 10 Global Tax to GDP Burdens (ex Oil Exporters)

Source World Bank

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Daniel Mminele, deputy governor of SARB, when speaking at a global Bloomberg FX conference at the end of

November last year, anticipates continued currency volatility in 2019. The Bloomberg median forecast for the Rand

over 2019 is R14.50 to the US Dollar but the forecast range is wide – a further demonstration of the volatility

inherent in the currency. The MPC has stated it will remain flexible in its response to the currency level and

economic conditions. They are forecasting 2019 growth of 1.7% and 2.0% in 2020 but assesses the risks to the

growth forecast to be on the downside.

Real GDP Growth (Annual %)

Source IMF

While the SARB is forecasting positive growth for 2019 and 2020, it is worth bearing in mind that our emerging

market peers and other developing nations are currently growing at 4.7% year-on-year in real terms in a backdrop

of world growth of 3.7% and developed market growth of 2.4%. In real terms, the South African economy grew just

0.8% year-on-year. A weak economy, political uncertainty with the upcoming May elections and caution being

expressed by the rating agencies does not paint a positive longer-term picture for the Rand. While the moves will

be volatile, we anticipate progressive Rand weakness against hard currencies.

realcap quarterly investment report...labour opposition is backing a public vote on brexit, it is...

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