South Africa is the most industrialized country in Africa, with strong macroeconomic management and independent institutions, deep domestic capital markets and first-rate corporates with strong footprints in the continent.

At the same time, it has deep-rooted structural problems, most of which are legacies of the apartheid era. After more than two decades since the end of apartheid, the country has changed politically, but economically, there is not much to show for in terms of growth and income equality—and this fact is rightly worrying. Social divisions are visible to any visitor, as seen by miles and miles of shanty towns outside of large cities—with their rampant unemployment and bare-minimum infrastructure—in contrast with gated suburbs with electric fences, protected by an army of private security officers that lock themselves up in their own world.

Without economic growth that is more broad-based and equitable, South Africa risks the fate of many of its continental peers, with increasing political instability adding to its economic challenges. Since the end of the commodity boom in 2014, this resource-rich country has registered negative average annual per-capita income growth, in contrast with other emerging markets, where incomes grew by more than 2% per capita despite the global slowdown (Exhibit 1).

South Africa Investment Opportunity

In the medium term, this slow growth is unsustainable—especially in a country where more than 17 million people rely on government support to lift them out of extreme poverty; only 6.6 million of a population of 56 million pay personal income taxes; the unemployment rate has reached about 27%; and more than 54% of youth are out of work. This worrying situation is reflected in South Africa’s credit rating, which is at the bottom of the investment-grade bracket with a negative outlook. But perhaps even more importantly, it is increasingly reflected in the country’s unruly domestic politics and a shrinking window of opportunity to enact policies that would improve its growth prospects.

On the policy front, South Africa’s government debt is too high compared with its peers, and it will need fiscal consolidation to continue bringing its debt down to sustainable levels. Yet this consolidation will limit the government’s ability to spend and boost economic growth. At the same time, inflation is structurally high and inflation expectations are stuck at around 6%, at the upper band of the central bank’s inflation target range.

The government has articulated an ambitious National Development Plan (NDP), which seems more like a blueprint rather than a policy instrument so far. NDP lists too many priorities with too little focus on addressing the country’s structural challenges in a lasting way. There are much-hyped legislative drafts of labor and mining laws in the works that promise more flexibility in labor arrangements and more clarity in mining-sector ownership and taxation. At the same time, populist voices are asking for land restitution without compensation and other radical changes in asset ownership.

However, on a cyclical basis, things are looking up.

Economic growth: The economy likely bottomed out in 2016 and growth is expected to pick up from only 0.3% in 2016 to about 1%-1.2% in 2017. Energy shortages have been resolved and labor strikes, especially in the mining sector, have been subdued since 2015.

Inflation: The drought that has afflicted the country’s agriculture is subsiding and this should help reduce food-price inflation later in the year and bring the headline inflation within the target zone of the central bank, assuming oil prices also remain stable.

External stability: The current account deficit is finally coming down from its peak of 5.7% in 2012 to an expected 3.9% this year. But South Africa’s external financing will remain an issue, with net outflows in foreign direct investment due to large acquisitions abroad, though the country’s net positive international assets are a source of strength. Should the rebound in economic growth continue as expected, with the recent stabilization of commodity prices, Standard & Poor’s (S&P) is unlikely to change the country’s credit rating at its June review. At its next review in December, S&P is expected to resolve its rating outlook—either by a downgrade to non-investment-grade, or an upgrade to a stable outlook.

Macroeconomic policy: On fiscal policy—and despite significant headwinds from increasing government guarantees to weak state-owned enterprises—gradual fiscal consolidation is on track. On the monetary policy front, expectations are building that an interest-rate cut may be coming later in the year or in early 2018, if inflation continues to come down.

Politics: Despite this cyclical uptick in economic growth, South Africa’s longer-term growth problem is not likely to subside anytime soon until its political leadership embarks on a clear change that addresses the country’s structural challenges. President Jacob Zuma’s government has been battered by scandals of corruption, fraud and mismanagement. The broad frustration led the governing African National Congress (ANC) party to sustain defeat in key local government elections for the first time since 1994. The ANC’s recent policy documents—ahead of its policy conference in June—acknowledge the lost trust among its vast voter base, but offer few new ideas about how to gain that lost ground and reform the party to root out state capture and corruption, let alone enact any new policy initiatives.

The party will see its leadership change at the ANC conference in December this year, before the elections in 2019. Expectations are that a change in leadership toward a more stable and less corrupt government will improve investor sentiment and private capital that has been on the sidelines for long will be deployed again to create much needed jobs as the economy recovers. This is our hope, too, but the divisions within the ANC don’t suggest a clear policy direction under any leadership outcome from the party’s conference in the short term. Nonetheless, any outcome is likely to be better than the status quo, and will likely be positively perceived by the markets.

After that, the real test for the ANC’s leadership will be in its ability to live up to longer-term priorities, which include investing in education for South Africa’s vast majority of unskilled youth; reforms in product and financial markets to level the playing field and improve small companies’ access to finance in a marketplace dominated by a few large corporations; land reform within the constitutional guidelines of fair compensation; and widely anticipated reforms in labor and mining laws.

Portfolio Implications

Until the ANC’s leadership conference in December, we will consider South Africa only as a short-term tactical play for our portfolio. And we will continue watching the extent of the cyclical recovery and the “political noise” that is likely to reach a crescendo as we approach December.

* All economic data in this blog is sourced from the World Bank as of 2/1/2017.

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