Up in smoke!

Author: Ntsekhe Moiloa

Vunani Fund Manager comments on the 2018 Budget

Backbenchers in parliament may have yawned one more time as the minister of finance briefly touched on additional revenue measures involving tobacco products and alcoholic beverages. For our sins we pay taxes, and in South Africa we pay more and more each year when the products concerned attract so-called sin taxes. The delivery of the 2018 Budget confirmed that smokers and drinkers would face further sticker shock, yet for shareholders in companies such as British American Tobacco the news is good. When the tax goes up by a percentage point for example, a cigarette manufacturer may increase the packet price by a percent because smokers are quite demand inelastic; the addictiveness of tobacco products makes most tobacco users price-takers. But the proportion of the new, higher pack price that goes to SARS is less than the full price hike, resulting in margin expansion for the manufacturer. For clients who permit the holding of British American Tobacco, Vunani Fund Managers has an overweight exposure. In fairness, South African earnings are a reasonably small part of the overall earnings of British American Tobacco so a hike on the domestic cigarette tax alone does not make or break the investment case for the company. We joke that British American Tobacco is in fact a tax collector with a cigarette business on the side. How so? We estimate that it collects around ZAR 620 billion in actual revenues while reporting a net revenue line of over ZAR 330 billion, at current exchange rates. The difference between gross and net revenue of perhaps ZAR 290 billion is what the company hands over to tax agencies around the world before accounting for its own costs and profits. In South Africa additional revenues from excise taxes on tobacco products are expected to raise an additional ZAR 420 million which is a large number but set against ZAR 290 billion it is a minor ripple.

On the other side of the elasticity spectrum are companies such as PPC and Sasol. For our clients Vunani Fund Managers holds no PPC stock because PPC’s elasticity profile is quite different to a cigarette manufacturer, offering fewer prospects of margin expansion. Similarly, we are underweight Sasol partly because a higher carbon tax just adds a slightly larger cost item to its financials that is insufficiently recouped from customers.

For our investment professionals managing fixed income portfolios, sin and carbon taxes were an interesting yet minor event. The tortured departure of former president Jacob Zuma from office intensified speculation about the remaining tenure of finance minister, Malusi Gigaba. It also promoted concerns about whether a Budget delivered by a minister potentially on his way out, would be taken seriously by the markets. Nevertheless, our fixed interest portfolios were at neutral to slightly long duration on the view that the market was implying too high an estimate for future inflation.

Appointed to the portfolio at the end of March 2017, Minister Gigaba delivered his maiden Budget to the National Assembly with greater success than his delivery of the Medium-Term Budget Policy Statement this past October. Despite speculation about his personal ability to continue in the portfolio, there was a palpable sense that this Budget was crafted by a Treasury team that had recovered from the sense of gloom that was pervasive at this time last year when the political principals were under inordinate pressure from many members of Cabinet.

In the end, markets reacted very positively to the Budget, with bond yields dropping considerably. Our duration stance paid off handsomely. The relationship between South African bond yields and American bond yields, for example, has, more or less been restored to its longer-term equilibrium. Despite the lighter air, there was some difficult news embedded in the Budget. For consumers, VAT will rise by a percentage point to 15 percent from April. That adjustment is expected to raise an additional ZAR 22.9 billion in revenue. A total of ZAR 36 billion is expected to come from all additional revenue measures, including the change in the VAT rate, income tax adjustments, and selective adjustments to taxes that affect the wealthiest South African tax residents.

The aggregate impact is expected to narrow the budget deficit by more than half a percent. The budget deficit is expected to remain roughly flat over the next three fiscal years, at about 3.5 percent of GDP. Such a level is more sustainable than budget deficits above 4 percent a year, and if a fair approximation, should improve the trajectory of government debt-to-GDP ratios. It is worth pointing out that additions to the revenue base tell only part of the story of the debt-to-GDP trajectory. What the government is hoping for is that the revenue-raising measures do not add to the tax burden in a way that chokes off consumer confidence. The minister pointed out that corporate tax competitiveness will get a closer look, potentially lowering the burden on corporates, but for now it is consumers who will have to have confidence in the outlook for the economy in order to be enticed into spending more. If that spending comes through, a higher GDP base would improve the debt-to-GDP ratio. At present, National Treasury projects that it will be 55.1 percent for the coming fiscal year, on the back of a GDP growth figure that rises to 1 percent from a previous expectation of 0.7 percent. It remains to be seen if ratings agencies such as Moody’s agree. Come 23 March, Moody’s is expected to release its final ratings decision which could result in South Africa’s debt remaining or falling out of the World Government Bond Index.

Reading between the lines, it seems that a higher level of conviction has returned to the Budget’s authors. Worries about having to sell off Telkom shares were not expressed in the minister’s speech but that does not mean that ideas about restructuring the government’s interests in state-owned companies has evaporated. We can brace for more debate as government and the tripartite alliance engage on the state’s ownership model in state-owned entities, yet the subtle shift towards involving private business is likely to encourage business confidence and lend support to the local equity market.