Mark Ingham: Banking shares vulnerable as risk of Nenegate II is rising

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Independent financial analyst Mark Ingham casts his eye over the “mini Nenegate” of the past week. The falling Rand and 50 basis point spike in bond rates was sparked by the Presidency’s second attempt to effect absolute control over the SA National Treasury and its State Owned Enterprises. Ingham advises investors to steer clear of SA banking stocks, explaining why another post-Nenegate plunge of 20% is not inconceivable. He shared his ideas with Biznews.com’s Alec Hogg.

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This special podcast is brought to you by EasyEquities and Mark Ingham, a financial analyst joins us on the line from Johannesburg. Mark, you’ve been very hard at work recently analysing the developments in the South African economy. Quite interesting just going back a week or so, 238 you say, or the 23rd of August could be 912 Light. Let’s just start off on what that cryptic headline means 912, the whole Nenegate saga.

Right, Alec and it was a very momentous occasion in South African economic history certainly. I recall I just got back from the United States shortly before that and I thought the currency was weak when I was over there, but I realised it could get a lot weaker. Developments I think in the last week or so, although they’re not on the same scale, certainly have had a very bad impact on confidence and we’ve seen markets react accordingly.

There is a way to play this as an investor and we’ll get into that in some detail, but just to refresh one’s memory, what exactly happened in the aftermath of the firing of Nhlanhla Nene as finance minister, how did the markets react?

It was immediate, it was swift, and on the Thursday and the Friday of that week, we saw bonds spike by over 200 basis points and in line with that, Alec interest rate sensitive stocks and in particular banks reacted accordingly. Pity because banks are very sensitive to the ups and downs and the long bond yields which is the primary driver of the valuation of the big four banks, particularly in South Africa and we saw values of stocks down by 25/30 percent. Subsequent to that over the weekend, with Pravin Gordhan appointed to stand in for the previous finance minister, we saw the markets stabilise somewhat but it took quite some time for confidence to rebuild again.

The 23rd of August last week or just over a week ago things started moving in a similar direction, hence the light part, being it isn’t a 20 percent plus decline in banking shares but they’re down about a third of that by seven to eight percent already.

Correct and in some cases if we go back just a few days before the 23rd we’ve seen some stocks off by ten percent or so. Although the effect isn’t as marked, we have seen long bond yields spike and so if we go pre the 23rd we currently have long bond yields and in particular the ten-year yield up by 35 basis points to 9 percent and so commensurate with that you’ve seen the present value of the earnings of banks and therefore the valuation associated with banks in line with that. From the base case pre that date to where we are now, that movement in ten-year government bonds hass approximately an eight percent impact on the value of these stocks.

Just before we go into the banking shares themselves, what happens to the man in the street, does he ever feel this in any way, the increase in bond rates?

I think yes. Firstly, these are very important price signals. We’ve also seen the currency move with this too. We’ve seen the currency move by approximately eight percent in this period and it’s remained weak. What we are looking at is a premium being demanded by investors for exposure to government bonds. We’re also seeing leakage of capital out of the country again, so in the period leading up to this we had a fairly positive sentiment returning to South Africa in the sense that the municipal elections went off very well. They were manifestly free and fair and I think the outcome was rather different to what many may have thought possible. That certainly got investor confidence up and we saw the currency move positively, we saw bonds move positively too, strengthening in yields, the yields falling and the price arriving but that’s been upended subsequent to the evening of last week.

What happened exactly, for those who haven’t been following the news that closely, why such a dramatic difference in the way the market is pricing the South African risk?

I think the market has perhaps been under-pricing South African risk. Possibly the significance of the municipal elections was a driver in that regard but I think what we also need to realise, Alec is that there are a number of pre-existing hazards there, not least the state of government finances and the need of course for us to assure foreign investors and the rating agencies that we’re working on a proper plan and we’re going to deliver on that plan. At this particular time, South Africa hasn’t been showing real delivery on the fiscal and economic commitments made a few months ago and this was coming up, from the 9/12 or the Nenegate situation.

We have to get our ducks in a row and we have to cut back government spending, we have to re-prioritise and we have to do this in advance of the rating agencies coming up with their revised thinking in so far as the country’s debt is concerned and the rating associated with that and so we need calm, we need everybody working together. Indeed, I think what’s quite interesting, is that a good number of people and this is a cross-sectoral cooperation thing. We’ve seen a good number of people from the private sector, that’s business and from the unions, from the public sector working together over the last few months to really build common calls and to get a proper plan in place.

Unfortunately, I think this has been partially sabotaged by certain quarters and as a consequence of that I think what we saw on the 23rd of August had unravelled, I think, a lot of that good work and therefore, I think the concern of those who are working to put South Africa on an even keel to maintain the rating is very justified and I think the calls for calm and for the process to be ongoing in a positive sense, is actually very important and the markets can send very strong signals and you know that very well. Markets reward but they can also punish too.

Read also: Fresh Zupta attacks on SA banks: Judicial enquiry coming. Madness continues.

Indeed, they’re in the process of doing that right now. We heard yesterday that Futuregrowth has become the first asset manager to say it’s not going to lend money to the state-owned enterprises anymore. It’s anticipated that others will follow. In fact, we’ve already heard of one more that’s a foreign group that said the same thing. If this becomes a route, if there are financial institutions who say they are not happy at the governance of state-owned enterprises like Eskom, they’re not happy with the developments there, what could the implications of that be?

A lot of movements that we’ve seen in the last week and a half or so are not commensurate with the route that we saw following 912, but if there is a repeat of that then the selloff will probably be as bad if not worse and I think particularly because we won’t get a second chance to lay out our store. Confidence will be lost and there’ll be no coming back from that, so I think it’s becoming increasingly concerning particularly given the fact that the presidency now has taken a view that it should have oversight on all this data and organisations, the SOEs, the Transnets of this world.

I think concerns around governance were already there, the concerns were rising, but I think events such as the oversight issue and I think concerns around Treasury, around the role of the Finance Minister and the fact that many of these state-owned organisations are not in a particularly strong financial position, has made a number of people who have exposure from a lending point of view to take stock review and hence the announcement last night. Although that’s a relatively small amount, it’s the proverbial canary in the coalmine.

Therefore, I think SOE governance concerns and financial concerns are there, I think they’re going to multiply given what we’re seeing at the moment in the local political situation. I think that the days when you could get a loan on the basis of a government guarantee are gone, what lenders need to know now is that not only is there proper governance, but there is the cash flow capability to service the obligations and this applies to a number of state-owned organisations, SAA particularly. It’s going to be increasingly difficult now for state-owned organisations to procure funding to the extent that they would like and therefore the need for proper management of these entities has come into stark focus.

From an investor’s point of view, you’ve already said in the last few days that you should stay away from interest rate sensitive stocks. Using the banks as the most obvious example of that, how does one quantify movements in interest rates generally and the valuations of banks?

What we’re seeing at the moment is the likelihood of potentially binary outcomes, in the sense that it’s very difficult to predict what will happen with unfolding little events out there. There are a number of political issues at the moment that could unwind to the detriment of confidence in the economy. Therefore, markets send very quick signals and going back to my point earlier, we saw that very quickly with bonds moving out by over 50 basis points just simply on that news. The reason that banks are so sensitive to movement in the underlying risk-free rate as it’s called because the long bond, the R186 is deemed to be a risk-free rate and therefore a lot of valuation by analysts such as myself is based on that. Fundamentally, it’s actually based on that and so movements north and south have a present value effect on banks particularly.

Therefore, even relatively smaller movements, 55 or so basis points may not seem terribly much, it’s half a percent, but for a present value point of view in so far as cash flow modelling is concerned, it has quite a major effect, approximately eight percent, so for instance if we had a movement of approximately 200 basis points or two percent which is exactly what we had with Nenegate, then the present value of your stock falls by approximately 23 percent, it’s that dramatic and in fact, if those higher yields are banked in they become the new normal rather than retreating to what they were. Then that means that the value of your stock, be it Standard Bank or Barclays Group Africa or Nedbank, any of these would be that much lower than it was pre that actual event happening.

BIG HITS FOR SA’s BIG 4 BANKS
Mkt cap 19 Aug (Rm) Mkt cap now (Rm) Loss (Rm)
     
FIRSTRAND 281 708 243 844 – 37 864
STANBANK 242 741 210 692 – 32 049
B-AFRICA 139 879 121 228 – 18 651
NEDBANK 111 999 100 786 – 11 213
TOTAL – 99 777

Now that’s wiping a fifth or more than a fifth off the capital value of the investment of a bank, not a good signal.

No, it’s not and that’s exactly what happened in December. I think that’s the point I’m trying to make. Given the heightened risk, the valuation hazards have been reignited by the political situation. It’s unpredictable and we saw yesterday, as you mentioned with Futuregrowth. That was something that nobody really saw. Already markets are reacting to that. It may not be the first and so there’s a number of unfolding developments at the moment that make holding stocks like this potentially hazardous to your financial health.

I certainly wouldn’t be buying into banks at this stage given where we are at the moment. We’ve already seen a number of them off, eight, nine percent plus. We’ve seen other interest rate sensitives stocks such as insurers, (the Sanlams of this world), also softer on this news, and so I think the overall political risk trumps the underlying economics of these businesses at the moment and should this turn into a route similar to what we had with 912 then there’s frankly very little place to hide. All bits are off on the downside.

I suppose the problem and the difference between what happened at Nenegate is you don’t have a Pravin Gordhan in the sidelines who can reassure the markets. One wonders whom any of the replacements that have been mooted, if any of them were to take over whether the markets would actually believe that they would have the ability to tighten the fiscal screws as it were.

We don’t have the benefit of the doubt, there’s no benefit of the doubt premium to SA and therefore, we really have to watch our proverbial P’s and Q’s. The state of government finances is poor, mismanagement is rife in a number of areas and so you need the technocrats to get on with what they do and that is to bring about greater discipline, You need improved governance, you need to prioritise spending and you need to curtail the cash that’s flowing out a number of entities. The alternative if you don’t do that, (although that’s difficult in itself), the alternative is way more painful and the implications for interest rates and the value of shares linked to interest rates is painful to see.

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Therefore, I think it’s a positive thing in that we have twin forces that hopefully will prevail and those twin forces are democratic accountability and that was the very manifest in the recent elections, but we have free markets too. We have deep liquid sophisticated financial markets and if government cannot impose discipline on itself and proper credential management, then markets are going to do it the hard way but those twin forces are I think a very effective counterweight to misrule. Those price signals are quick and I think that’s exactly what we’re seeing at this time, which is a positive but if we don’t get our act in order markets are going to take this down a lot further.

It would be nice for you to unpack just for a moment, exactly how markets work in this regard because there is this suspicion among some people that there’s a cabal who are engineering all of this just to get rid of Zuma so they can have their way with the economy in a way that he’s accused of having it right now. How exactly, in the real world, how does it work?

The markets are quite diverse and they represent a number of interested parties both domestically and abroad. You could almost call it faceless, but it’s very widespread. Demand and supply obviously plays a key role, but I think it would be stretching a point to say that there’s a cabal who are working effectively through these interest rate mechanisms and the pricing thereof to send a signal. Ultimately, many pension funds, many people who have private portfolios have exposure to the bond market. We have a very large bond market and as I indicated it’s not only deep, it’s very liquid as well and very closely linked to the equity market too, so they’re not divisible. The two are very closely intertwined, which is why movements in so-called risk fees do have implications for the overall equity market and indeed for the currency market. Everything is interlinked.

The foreign investors play, (as you well know), a very significant role in the local bond market, a good chunk of bond owned by foreign investors and indeed with a good proportion of the equity market, a very sizeable chunk is held by overseas investors and that’s a healthy development and what it does do, is it creates the fluidity that we need to have proper price discovery and indeed, I think when we do have a situation where confidence is restored that is in turn reflected in the pricing of risk under that this applies too. What we’re seeing at the moment is these deepened liquid markets that don’t have any particular axe to grind but for who risk mitigation is very important.

The risk mitigation and particularly if you’re a foreign investor sitting in New York or London would entail taking money off the table and that’s exactly what we’re actually seeing. So those price signals up and down are a very valuable signal I think to resolve as to what that very deep and liquid market out there is thinking about SA and that’s the case whether we’re talking about the bond market, the equity market or the currency.

It’s more of a dashboard, watch the way the speedometer is going, and you should be acting accordingly, not getting all paranoid that somebody is trying to effect change or differences. It’s a dashboard for you, but I’d like to ask you just to conclude, upside and downside, if you were locked into banking shares, say you worked for a bank and you had share options what’s the best possible outcome from here?

I think the point I’ve made in the last few months and in particular my more recent note is that if one is looking to buy into this market, I would be extremely cautious about that given the fact that there’s a good chance that prevailing political developments would go awry and that would send the price signals that I’ve just said and that would have implications for further downside. We’ve seen the downside in the shares already and it could go down further. We simply don’t know but the risk has been heightened and the hazards are very clearly there. However, if you’re a fund manager with a dispersed portfolio you can’t just simply go out there and sell your shares.

Read also: Zuma on Nenegate: “Markets over-reacted to the firing.” Rand tanks again.

There are mandate issues around that and therefore any fund manager would have probably taken an appropriate positioning and there may have been a sense that a underweight position in banking stocks particularly wouldn’t have been a bad thing to do, given what’s currently happening, but I think if you’re working for a bank and you have share options and stuff, well it’s business as usual as best is possible. Over the longer run (and here we are talking over a period of years rather than days or weeks), I would not see any real concern on that, if as it typically happens in South Africa, we do finally get our act together.

We have a long history in South Africa of staring into the downside, but stepping back from the abyss, and then I think things will right themselves. We have a very strong banking industry. It’s been through a number of crises historically, good capital ratios, good risk management. From that point of view, from the fundamental economics of these businesses, they’re in very good hands, but ultimately Macro has considerations coming to play. I think in the shorter term that’s what we’ve seen and we will continue to see until there is some certainty and there’s a re-emergence of investor confidence.

From what I’m hearing the best possible scenario is as per usual we’ll muddle our way through. There could be some turbulence along the road, but what about the worst-case scenario, what would that be from your perspective?

The fiscal position is worrisome and we shouldn’t kid ourselves. It’s why this cross-sectoral team has been working so closely to make sure that we can stem the fiscal meterage if I can put it that way that we have. In my note, I quoted Treasury as saying that debt service loss remains the fastest growing spending category and they continue to crowd out resources for policy and the priority that you bring to that. Given the increase in debt in South Africa and they’re not talking about consumer debt, we’re talking about government debt which is pushing to 50 percent of GDP, with high interest rates because people are also demanding a risk premium for holding South African government bonds.

We’ve seen the cost of servicing that debt increase markedly over the last number of years and indeed the projection by Treasury which is arguably a little more on the positive side given the fact it was emptied a few months ago, is looking to see that increase in debt continue for the foreseeable future and so the cost of servicing that has been a rising trend and I think if investors look at that situation it means that with interest being 11 percent of total government spending, which is up from about seven percent a few years ago, it means that one Rand in every nine goes to service debt. You can’t continue with that.

While there are positives around the recent elections the fiscal situation isn’t getting any better and the latitude for government to manoeuvre is extremely thin and hence the need for the fiscal discipline that I actually spoke about, so I think if people really start to look under the bonnet you will at these factors will start to play out also, I think given the governance concerns and the political in-fighting, it starts to give an extra risk overlay to this. I felt for a while that the markets have been perhaps under-pricing risk in the SA market and given the fact that we don’t have that for the benefit of the doubt premium but we historically had.

By and large, it took a long time for South Africa to get its investment rating back and I think it steadily built a very good market reputation around the world. We are in danger of losing that. It’s easy to lose and it’s very difficult to get back and so that is quite concerning. The real issues around the fiscal situation have to be faced head on, they have to be acknowledged from the presidency downwards, and there has to be a plan of action to get back in check. Not overnight, but there has to be a proper urgent, deliberately thought out plan to get that back on track and in the process build confidence.

The worst-case scenario, would that be another Nenegate, another 20 percent in banking shares?

It’s quite feasible. As I say we have no room to move, it’s quite feasible that you could see that and you need to position yourself accordingly. We don’t know, we can look at scenarios and analysts like myself can have a look at scenarios, what if and then you guide people accordingly. In that worst-case scenario where all confidence is lost, where it’s heading for the exit and those price signals that I referred to come to the fore, then 200 basis points is quite conceivable, possibly even more. What would be concerning however, is if that spike becomes a permanent fixture where new is normal, the implication on government debt servicing in that case would be quite real given the fact that with debt at the moment at R2 trillion a 200 basis point or more move in bonds. If you’re issuing new debt into the market comes at a debt servicing cost of R40bn higher than it otherwise would have been.

In that context, there would be grave concern about the government’s ability to keep servicing that, so we have a window of opportunity and South Africa as you correctly indicated has a history of muddling through. Just as you think it’s really going to go pear-shaped, things seem to come back and I’m hopeful that, that would be the case this time, but I think it does raise hazards for those exposed to the market and particularly the people who are exposed to the bond market where real losses are eventuating.

A movement in yields upwards needs capital losses and so we’ve already seen that. If we go back to last December, the actual capital losses were very real and it wiped off billions from the value of people’s pension funds and other assets. It’s very important for people to be aware that not only are we facing this difficult government situation, we need political stability and we need a proper plan of action.

Mark Ingham, Independent Financial Analyst and this special podcast brought to you by Easy Equities.

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