Macro economic commentary – May 2018

Author: Ntsekhe Moiloa

|  Early in May came the news that the Nobel prize in literature would not be awarded this year as an externality of conflict arose in the adjudicating committee, conflict stemming from sexual harassment and corruption claims. The man at the centre of the storm was even accused of handling the bottom of Sweden’s crown princess. King Carl XVI Gustaf announced a review of the committee regulations, and alarmed, we scurried to check whether the equivalent prize for economics was in danger. Last year’s economics prize was announced only in October so there is some way to go before then. Nevertheless, what was interesting to discover was the research speciality of the economics committee’s chairman, Per Strömberg. Professor Strömberg’s research interests span corporate finance, private equity and financial distress. One of his more acclaimed publications won a distinguished paper prize along with Ulf Axelson, Tim Jenkinson and Michael Weisbach.

The Strömberg et al paper was titled, “Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts,” and published in the December 2013 edition of the Journal of Finance. Using nearly 30 years of data, the paper finds that the degree of leverage preferred by private equity funds was more related to general financial liquidity conditions than the opportunities present to optimise an investment’s capital structure. In theory, private equity investors should examine all tax-saving opportunities, all investment incentive opportunities, cash flow volatility, industry dynamics and other more micro matters to decide on how much leverage to add to an investee company. In practice, private equity investors do all those things but still give greater importance to credit conditions in the broader economy in deciding gearing. This finding by Strömberg et al first implies that availability of credit is not endogenous, and secondly, that a useful inverse relationship is at play: when private equity investors feel that credit conditions are easy, they tend to borrow more, overpay and down the line reap lower buyout returns. Conversely, when industry leverage reduces, we gain an inkling that financial conditions are worsening. It seems like such an obvious result; however, the utility of watching private equity gearing is that it appears to give us a different angle to consider, beyond more conventional measures of looseness and tightness such as interest-rate swap curves.

In the Middle East and Africa, deal count, volumes and premium metrics appear to all have an upward trajectory, according to Bloomberg data. A caveat though: data from the law firm Webber Wentzel suggest that large deals in Africa were substantially down in 2017 relative to 2016. Smaller deals may account for the healthier numbers reflected in the Bloomberg data. Nonetheless, if we looked at the Middle East and Africa in isolation we might conclude that there are no difficulties in procuring credit to do deals. Yet since a considerable amount of capital is sourced from investors in developed markets, we ought to pay closer attention to the evolution of liquidity conditions in the home markets of those investors. As it turns out, data from Pitchbook suggests that private equity gearing in the US has been coming down. As we try to look for canaries in coal mines, private equity data from Bloomberg also indicate that deal volumes have been trending lower for the past 4 quarters and deal counts are down as well. One metric that has been looking healthy is the average premium on deals; if financial conditions are generally tighter we would expect premiums to be under pressure. Looking to Europe, equity contributions have generally been substantially higher than in the US, deal count is trending lower and deal values as well, according to PwC data. Furthermore, despite generally lower levels of debt injection in Europe compared to the US, the trend is present too that even less debt is being put into buyouts according to Thomson Reuters LPC data.

The way that developed market investors into private equity are applying debt to buyouts confirms the first order view that liquidity conditions are starting to tighten. A consequence of this is that we might start to see some tightening in emerging markets where current conditions still look good. What one has to bear in mind is that private equity investors are adjusting debt application on the basis of existing paid-in capital. That could signal something else as well, namely, that there are fewer quality buyout opportunities to spread the equity capital around. The PwC European Private Equity Trend report covering the 2017 period indeed mentions that investors reported finding that fundraising was more difficult.

Local interest swap yields moved higher along with nominal bond yields. The R186 bond moved from a yield slightly south of 8.2 percent to a yield slightly north of 8.5 percent. It is worth pondering why local fixed income instruments tended to lose value in May when certain measures of financial conditions seemed to be benign to positive. There appear to be two possible triggers. The first is that US yields have been tracking higher, attracting investors towards dollar assets. The second seems to be a contagion effect as Argentinian and Turkish rates shot up on idiosyncratic factors. For Turkey in particular there was a view that President Erdogan was threatening the independence of Turkish monetary policymaking while simultaneously advocating bizarre notions about monetary policy. In South Africa, uncertainty has died down despite lingering questions about the land reform agenda going forward. Inflation remains subdued and the growth outlook is improved. The rand was more or less flat over the month, albeit with volatility that has seen the unit trade in a range between 12.20 and 12.90 to the US dollar. S&P Global Ratings saw fit to affirm South Africa’s credit rating and maintained a stable outlook for the country’s debt metrics.

The task ahead for South Africa is for the government to rebuild the state’s finances. This fiscal consolidation has to be done while meeting citizens’ expectations of improved service delivery. In that sense South Africa has limited adjustment space. Structurally, the country looks too much like the United Kingdom in that it does not produce enough of what is interesting to international markets, yet relies on a steady dose of foreign capital to fund its current account deficit. The risk, of course, is that funding markets appear to be getting frostier. Mid-month South Africa found itself having to offer a premium to sell Eurobonds at just the time offshore investors have started to dial down their appetite for emerging market debt. South Africans must have misunderstood how popular they were when FC Barcelona touched down in Johannesburg to play Mamelodi Sundowns. As if to underline how constrained the country’s options are, we learned in the succeeding days that National Treasury would backstop South African Airways’ recapitalisation plan which called for a sum of money almost equal what was raised in the Eurobond issue.

Global leading indicators and purchasing manager indices seem to suggest that the world economy is shifting to a slower pace. We know that global debt has grown substantially over the past decade. On the face of matters it seems reasonable to expect that debt-raising for corporates and even for countries like South Africa might not be as easy as it has been over the last decade.

From reading the press and investment pieces, the typical thinking in investment communities around the world seems to be that despite indications of slow-down, the global economy is on a solid footing and that the pre-eminent risk to investment markets at present is a trade war.

Of the major economies, the US is among the least exposed to global trade as measured by the fraction of the economy that is composed of exports. In this sense, the US can endure a trade war for longer than many people reckon. On the other hand, China’s strength in this increasingly bilateral trade war is that the government is more unified than America’s government. When Trump announced tariffs, the Chinese responded with intentions to tariff sectors and regions that have formed the core of Trump’s political support, such as agriculture and Midwestern manufacturing. American farmers and the politicians who represent them have, amongst others, been naturally alarmed.

While many Americans are concerned about the potential fallout of a trade war, China would not emerge unscathed either. For a long time, we have been concerned about the amount of debt in the Chinese economy relative to output. The figures are breath-taking and unprecedented, yet China remains remarkable in its ability to grow its economic base.

We have often wondered aloud about worrying signs in the Chinese economy, particularly the nature and level of debt in that system. News came a year ago that Moody’s had downgraded the sovereign rating of China, citing mounting debt pressures in particular. While the Chinese government accused Moody’s of using a flawed approach at the time, the evidence we have continues to suggest that China’s quasi-governmental debt casts a long shadow even while central government debt itself remains within reason. Smaller Chinese banks have been especially exposed, having entered into areas such as off-balance sheet wealth management products to attract deposits. With the central government taking subsequent steps to dial back off-balance sheet financing, these banks have been increasingly exposed as their wholesale funding options narrow to NCDs. As these NCDs mature banks are compelled to raise deposit rates on vanilla deposits to keep existing depositors from departing. Smaller banks are estimated to have accounted for all but a single percent of NCD issuance. These smaller banks have been offering premiums of as much as 30 percent above benchmark rates to attract retail deposits, fearing that the government would introduce limits to their ability to continue issuing large amounts of NCDs.

Combine a massive expansion of banking assets with more expensive liabilities for the banks and it becomes hard to imagine how this all ends well. With greater amounts of credit comes the elevated risk of capital misallocation. If the Chinese economy were more open we might have seen the Chinese currency weaken as a partial response, yet instead capital is trapped internally and generally understood to be causing asset bubbles in various segments of the economy. Such a situation makes it difficult to discern good investment opportunities.

In our search for good investment opportunities, we valorise the pursuit: often we elaborate and say that we search for well-managed companies with positive growth vectors. The financials of a company will often reflect myriad other decisions that have led to positive results, yet it remains important for investors to peer behind the financials to see how a company operates. The retail industry provides a tangible example.

Bricks and mortar retail businesses have been under pressure for some time as the local economy has struggled. Despite prognoses of an economic recovery underway, generating sales has remained difficult. Unsecured lenders have told us that they see no signs of consumer swagger as customers remain focused on managing down existing debt. Overseas, traditional retail businesses in the United States have been closing at an accelerated rate as more shopping has moved online, leaving in the wake of their demise not only lost retail jobs but at times vacant shopping centres. Importantly, these business failures such as Toys ‘R’ Us as well as Claire’s Stores have been happening outside of a recession. Claire’s filed for bankruptcy in March while the US operations of Toys ‘R’ Us filed in September last year but applied to finally liquidate in March this year. In light of our earlier discussion on private equity, it is worth mentioning somewhat ironically that these two examples were laden with debt in private equity buyouts. While the debt itself was cheap compared to history, Amazon and the whole online shopping model was not the Brobdingnagian threat that it has become today. Thus we are alert to the possibility that declining debt-to-equity in private equity deals signals both tightening financial conditions and deteriorating SWOT analysis results.

In South Africa there has been concern for a while now that the rapid roll-out of shopping nodes has left some areas oversupplied, reducing the average demand at any one centre. Well-managed retail companies have adapted by swiftly curtailing orders to buy and carefully setting their product price points. Some retailers have been more successful in this than others, and the difference has often come down to experience. The planning departments of some retailers are populated by relatively younger managers who feel that stores must be given stretch targets and when the sales fall short, find themselves having to discount more steeply than they would have liked. More experienced planners who have worked through previous down-cycles have understood that sometimes winning market share comes at an unfavourable price, and planning must be nimble enough to protect margins. In our view, it is these kinds of managements that we consider good, and those who are able to simultaneously gain sales from growing segments such as online sales, we consider in an even more favourable light. For a time, it was reasonably easy in South Africa to be highly cash generative as a retailer because of a fairly limited choice of chains and a customer base that was regionally already in the best country for shopping. South Africans did not need to cross a border to shop well. Today, however, the supply side has to offer more incentives – often price incentives – to move volumes. The recovery of the demand side of the South African economy still requires careful monitoring.