Geopolitics

Highlights Democrats are backing off from corporate tax hikes, a positive surprise for the earnings outlook. However, the reconciliation bill will be even more stimulating than expected at a time when the output gap is closed. Short-run inflation risks are high and Democratic bills will feed into that. Long-run inflation risks will need to be monitored. Compromises on legislation will help Democrats on the margin in the 2022 midterm elections but gridlock would freeze fiscal policy. Maintaining low corporate taxes while boosting government spending on infrastructure, R&D, renewables, and social safety should be good for productivity, potential growth, and the US dollar over the long run.   We still give 65% odds for the reconciliation bill to pass. Reconciliation is the critical means of avoiding a national debt default after the December 3 deadline. This assumes that bipartisan infrastructure passes (80% odds). With the market already pricing the impending Democratic agreement, we are closing our long renewable energy trade for a gain of 30% and our long infrastructure basket for a gain of 8%. Feature A major plot twist in Congress occurred over the past two weeks: corporate and individual tax cuts are on the chopping block as the December 3 deadline approaches for the Biden administration’s signature piece of legislation. This development is uncertain but not unlikely. It would fit with our annual theme of bipartisan structural reform in the sense that it would mark a further Democratic cooptation of the previous Republican administration’s policies for the sake of popular opinion. Investors should not bet on zero tax hikes but they should prepare for positive surprises relative to the 5.5%-7% corporate tax hike that was previously envisioned. Rotation from low-tax to high-tax sectors was already underway prior to this news, which favors that trend (Chart 1). Chart 1Democrats Scrap Corporate Tax Hike? In this report we update investors with the status of negotiations: what is in the bill, what is not, what remains undecided, what will be the net effect, and how will Wall Street respond? Details are subject to change up to the very moment before Congress votes. Here is what we know right now.   What’s Essential To The Bill? Before the reconciliation bill, the $550 billion bipartisan infrastructure bill still has a subjective 80% chance of passage. The Senate already approved it on August 10, with 19 Republicans in favor. It stalled in the House of Representatives because the left wing refused to vote for it until party leaders reached a framework agreement on the larger social spending bill. The latter can only pass via the partisan reconciliation process. That framework could be agreed any day now but even if it suffers a surprise delay the House can push through the infrastructure bill fairly quickly. Infrastructure stocks still have some room to rise in the lead-up to President Biden’s signature but their ability to outperform the market going forward will depend on a range of factors outside politics and policy (Chart 2). Chart 2Infrastructure Bill Already Priced As for the main reconciliation bill, House Speaker Nancy Pelosi claims that “more than 90 percent of everything is agreed to” in the framework agreement – but critical provisions are still in flux. The headline price tag has fallen from $3.5 trillion to $1.5-$2 trillion, leaving $1.75 trillion as the happy medium. The root of the disagreement is that the Democrats are a “big tent” party with two major factions of relatively equal strength. Moderates and conservatives have the upper hand on economics, whereas liberals have the upper hand on social issues (Chart 3). On the spending side, progressives have insisted on five policy priorities: the “care” economy (child care, elderly care), affordable housing, climate change, immigration, and health care. They say they can negotiate on the size and duration of the relevant programs but not on whether they are included.1 The Senate parliamentarian has already ruled out immigration so the other four priorities will be included, albeit watered down.  West Virginia Senator Joe Manchin’s initial demands to Senate Majority Leader Chuck Schumer are highlighted in Table 1. Manchin’s demands for a lower price tag are being met by the progressives’ willingness to pass smaller or short-lived programs with “sunset clauses.” The idea is that Republicans will suffer for allowing them to expire. History shows that it is very difficult to remove an entitlement once it is established. Table 1West Virginia Senator Joe Manchin’s Initial Demands For Biden’s Reconciliation Bill The following items look to be included but pared back in size: The Child Tax Credit (from $450 billion to ~$100 billion). This benefit was enhanced by COVID-19 stimulus and is likely to be kept in place, albeit for one year instead of five years. This sets up a “cliff” in December 2022.   Paid family and medical leave (from $225 billion to ~$100 billion). This benefit looks likely to be lowered from 12 weeks to four weeks and targeted toward low-income groups for a duration of three-to-four years. Medicare benefits expansion to include dental, vision, and hearing aid (from $358 billion to ~$200 billion or less). This provision is under pressure due to costs but Senator Bernie Sanders of Vermont insists that it will be included to some extent. Dental is likely to be slashed. This part of the bill was supposed to be paid for by allowing Medicare to negotiate drug prices, which is still being discussed. The Hill reports that the government may be given the power to negotiate prices for Medicare Part B but not Part D.2  On the revenue side, Pelosi says the deal will include a harmonization of overseas taxes. This would include a minimum 15% corporate tax rate on book earnings in keeping with the international agreement the Biden administration has negotiated. An estimated ~$400 billion in new revenue would be raised. Senators Manchin and Kyrsten Sinema of Arizona agree. Pelosi also claims agreement on tougher tax enforcement and a bulked-up Internal Revenue Service – a measure that is said to bring in $135 billion in revenue but which can be exaggerated to help cover the cost of new spending, at least on paper. What’s Already Been Chopped? Pelosi claims that the climate change disagreements are resolved. Manchin hails from a coal state where every single county favored President Trump for reelection. He  has nixed the Clean Energy Performance Program (CEPP) as well as any tax on carbon emissions.3 However, the $150 billion from CEPP will not be saved but redirected toward various other green energy projects. This solution confirms our view this year that Democrats would provide green subsidies but not punitive green measures. The US and global policy setting is favorable for renewable stocks, though the energy crunch in China and Europe is a sign that this trade is not a one-way trade since popular backlash against green policies is possible in future (Chart 4). Manchin is opposing the expansion of Medicaid to 12 states that have refused to expand it. The other 38 states had to pay 10% of the cost; a federal expansion would give it to the 12 laggards for free. Eliminating the provision entirely would put the onus back on the 12 states (useful for local Democrats) while cutting $141 billion from the overall cost of the reconciliation bill.4 Democrats have also agreed to cut the $88 billion proposal to make two years of community college tuition-free.   Chart 4Renewable Stocks Brush Off Energy Realism (For Now) Universal preschool (pre-kindergarten), which would cost $450 billion, is popular but now under fire. It is not in the list of progressive priorities and could be slashed. Housing aid at $300 billion is expected to be cut by half or more. Elderly care could fall from $400 billion to half or one-third of that. Immigration provisions are unlikely to appear in the final reconciliation bill, as noted above. The Senate Parliamentarian Elizabeth MacDonough has ruled that immigration is not germane to direct fiscal matters, which are the focus of the reconciliation process.5 The Democrats have a vested interest in immigration and are not acting with any urgency on the border in the meantime, setting up an immigration crisis in 2022 and beyond (Chart 5). Table 2 shows the original Democratic spending plan with annotations for the latest developments, which are all subject to change in the very near term. Chart 5Looming Crisis On Southern Border Table 2Senate Democratic Spending Plan Up For Negotiation What’s Next On The Chopping Block? On the revenue side, the following provisions are being debated: Corporate and Individual Tax Hikes: Senator Kyrsten Sinema of Arizona – who won her seat by a 2.4% margin in a state that President Biden carried by only 0.3% of the vote – has ostensibly succeeded in scrapping the corporate tax hike and individual income tax hike from the reconciliation package. Our guess is that these tax hikes will still somehow make it into the bill in a weaker form but if Sinema prevails then $710 billion in new revenue will be forgone.  Billionaire Tax: Democrats are also looking at a “billionaire tax,” although it would more accurately be called a hundred-millionaire tax based on what is known. It would be a yearly tax levied on the unrealized capital gains of those who own $1 billion in assets or who make $100 million in income over three consecutive years. Non-publicly traded assets would be taxed upon sale. This mark-to-market proposal is said to raise $250 billion in revenue, although nobody knows since tax evasion would be rife.6 It would be a popular tax but it is complex to administer, its constitutionality is uncertain, and it is being introduced in the eleventh hour. House negotiators would prefer straightforward corporate and high-income tax hikes.  Tax On Stock Buybacks: There is also a proposal to levy a 2% tax on stock buybacks, which would be popular and not so hard to implement as a wealth tax. But it is also being introduced late in the game. SALT Deduction Cap: Democrats from high tax states have relentlessly pushed to remove the cap on their deductions passed by Republicans. A temporary repeal for 2022-23 is being discussed but would be a handout to the upper and upper-middle class. Total repeal could deprive the overall package of $85 billion per year in revenue. Tobacco and E-Cigarettes: This tax is estimated to raise $97 billion but is regressive. Table 3 highlights the tax provisions according to the original Democratic plan along with annotations for recent developments. Table 3Democratic Tax Plan Up For Negotiation The Hyde amendment is lurking under the radar and could torpedo the entire bill – but we bet it will not. This provision has been included in legislation for half a century to prevent taxpayer money from directly funding abortion. President Biden, a Catholic, supported it until his 2020 presidential campaign when he caved to pressure from the progressives to remove it. However, Manchin insists on it.7 Since abortion is a moral dilemma, Manchin cannot compromise on it. Yet his “nay” would sink the entire reconciliation bill. So this is a mini-crisis waiting to happen and Hyde will most likely be included to save the bill. What’s The Time Frame? There are three soft deadlines and one hard deadline for these bills to pass. The soft deadlines are the following: October 31 – Transportation Funding Expires: House members want to pass the bipartisan infrastructure bill by October 31, along with a renewal of transport funds. This is a good plan because it separates bipartisan infrastructure from partisan reconciliation. But a short-term extension is also an option for transportation funding. It may be necessary if reconciliation is further delayed and House progressives refuse to support an infrastructure vote. November 1-2 – World Leaders Summit and UN Climate Change Conference: Democrats want a climate deal before Biden arrives in Glasgow, Scotland for the COP26 climate talks. It looks as if this will be achieved as we go to press. If not, Biden can offer vague promises instead. There will be no shortage of promises at Glasgow. November 9 – US Special Elections: If Democrats passed something before the various off-year elections are held then they would give their candidates a badly needed boost. Biden’s collapsing approval rating has been an albatross for Democratic candidates, including in the Virginia gubernatorial race (Chart 6). A signing ceremony at the White House would help take it off their necks. But lawmakers cannot speed up complex and controversial legislation just to save Terry McAuliffe’s bacon. The hard deadline is December 3, the new deadline for funding the federal government and raising the national debt limit. Republicans are unlikely to vote to raise the debt ceiling a second time this year so Democrats will most likely be forced to include it in the reconciliation bill. Importantly, the debt ceiling will help to ensure the reconciliation bill’s passage. Any Democratic senator or lawmaker who votes against the bill will bear unique responsibility for a default on the national debt and financial turmoil, not to mention the doom of his or her party in the midterm elections.  If anything this extreme cost suggests that our 65% subjectively probability for the bill’s passage is too low. What Are The Investment Implications? Democrats are likely to produce a $1.75-$2 trillion spending bill that raises around $1 trillion in new tax revenue. Our previous estimates of a net deficit impact of $1.2-$1.6 trillion for both the infrastructure and reconciliation bills will be updated when the framework reconciliation bill is put into writing but so far does not look far off the mark. Estimates for fiscal multipliers range widely (Table 4). The bipartisan infrastructure bill, with traditional or “hard” public investments, could have a multiplier of 0.4 to 2.2, based on the CBO’s retrospective 2015 estimates for the American Recovery and Reinvestment Act (the stimulus passed during the Great Recession). The partisan reconciliation bill, with “human infrastructure” and social welfare spending, could have a fiscal multiplier ranging from 0.6x (the average of the COVID-19 relief in 2020) to 1.2 or 1.4 (Moody’s estimates of the impact of expanding the Child Tax Credit in 2010).  Table 4Range Of Fiscal Multipliers For Government Spending However, the US output gap is virtually closed and stands at a positive 1.5% of GDP, according to Bloomberg consensus estimates (Chart 7). Thus additional deficit spending is inflationary on the margin. Core inflation is elevated and there is no immediate prospect for commodity prices to fall drastically in the next few months given tight global supplies, the approach of winter weather, and the looming conflict over Iran’s nuclear program in the Persian Gulf. A future political liability is thus taking shape. American consumers and small businesses are becoming increasingly concerned about inflation, much more so than taxes and regulation (Chart 8). By the time of the midterm election in fall 2022, inflation may have subsided. But if it has not then the Democrats will take the blame. Chart 7The Vanishing Output Gap Chart 8The Inflation Threat The equity sectors that stood to suffer the most from any repeal of President Trump’s Tax Cuts And Jobs Act of 2017 were real estate, technology, health care, and utilities. The sectors that stood to suffer least were energy, industrials, consumer staples, and materials. If Democrats maintain Trump’s corporate rate then the former sectors will see a relief rally. However, Big Tech will suffer marginally from the imposition of a minimum global corporate tax. The global macro context favors cyclical sectors and value stocks over defensive sectors and growth stocks as long as bond yields and inflation expectations continue to rise. Chart 9 shows that companies that were formerly high tax companies rallied tremendously in the wake of Trump’s tax cuts, while those with high foreign tax risk underperformed. That process will likely be reaffirmed if Trump’s headline corporate rate is preserved while the minimum rate is imposed on companies with high foreign tax risk. Over the long run, inflation may or may not prove to be as big of a problem. The Biden bills should boost productivity, on top of the productivity improvement that has already occurred as a result of COVID-19 digitization efforts. US corporates would maintain a high degree of competitiveness if the corporate rate were to stay put. The original Biden plan would have put the US back at the highest level of integrated corporate income taxes out of all the OECD countries. Keeping corporate rates low, combined with public investments in infrastructure, the digital economy, renewable energy, and the social safety net should boost productivity, potential growth, and the US dollar. Chart 9High-Tax Basket Stands To Benefit - Along With Value Stocks If Congress returns to gridlock after the 2022 midterm elections as expected, then the fiscal splurge may be on pause at least until 2025. In that case the inflation risk in coming years will depend more on global rather than domestic developments. We have long argued that inflation risks are rising due to populism and fiscal extravagance in the United States. The Biden administration’s legislation marks a return of Big Government and a net increase in the budget deficit over the coming decade. However, the latest developments suggest it will not be the extravagant democratic-socialist blowout originally envisioned. If that proves true, then its long-run impact will be beneficial for the US economy and politics.  On a deeper level, the most important takeaway from the above analysis is that the Democrats remain limited by checks and balances. Beneath all the partisan acrimony, a new consensus is emerging in the US in favor of proactive fiscal policy (infrastructure, social safety net) and more hawkish trade policy (supply chain resilience, onshoring). The drivers of this new consensus are powerful: the elites do not want rebellion, the masses want a more favorable domestic economy, and both want greater strategic security relative to foreign competitors. The likely passage of the Strategic Competition Act by the end of the year, or at least the semiconductor portion of it, and the passage of a bulked up annual defense bill despite Democrats’ allegedly dovish bias, will further emphasize this point.  By compromising the plan to come closer to moderate senators’ demands, the Democrats are courting the median US voter and likely to minimize their losses in the midterm elections. Even assuming they still lose the House of Representatives at least, the new policy consensus will continue to develop because it shares core elements with the Republican agenda.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix   Footnotes 1     See Congressional Progressive Caucus, “CPC Calls For 5 Key Priorities To Be Included In The American Jobs Plan,” April 9, 2021, progressives.house.gov. See also Tyler Stone, “Rep. Ilhan Omar: If Our Progressive Priorities Aren’t Met, No Legislation Will Pass,” July 30, 2021, realclearpolitics.com. 2     See Jennifer Scholtes, Marianne Levine, and Alice Miranda, “What’s Still In The Dem Megabill? Cheat Sheet On 12 Big Topics,” Politico, October 25, 2021, politico.com; Jordain Carney, “Sanders draws red lines on Medicare expansion, drug pricing plan in spending bill,” The Hill, October 26, 2021, thehill.com.  3    Benjamin J. Hulac, “Manchin Tries To Slow Clean Energy Shift As West Virginia Clings To Coal,” Roll Call, October 26, 2021, rollcall.com. 4    Jordain Carney, “Manchin Says Framework ‘Should’ Be Possible This Week,” The Hill, October 25, 2021, thehill.com. 5    Lisa Desjardins, “Read the Senate rules decision that blocks Democrats from putting immigration reform in the budget,” PBS, September 20, 2021, pbs.org.  6    See Naomi Jagoda, “Billonaire Tax Gains Momentum,” The Hill, October 26, 2021, thehill.com; Steven M. Rosenthal, “Wyden’s Billionaire Income Tax Is Ambitious But Problematic,” Tax Policy Center, October 25, 2021, taxpolicycenter.org; Scott A. Hodge, “The Rich Are Not Monolithic and Taxing Their Wealth Invites Tax Collection Volatility,” Tax Foundation, October 26, 2021, taxfoundation.org. 7     Sam Dorman, “Biden says he’d sign reconciliation package including Hyde Amendment,” Fox News, October 6, 2021, foxnews.com.   

Special Report

Highlights The ruling African National Congress will be difficult to displace in upcoming elections given the large economic role it plays in the public sector and in low-income households. Low growth outcomes will continue as the government navigates allocating state funds more efficiently, amid rising public debt, weak macroeconomic fundamentals and a fresh undertaking of fiscal austerity. The African National Congress is primed to claw back some lost voter support with President Ramaphosa at the helm. But Ramaphosa will also put a stop to fiscal austerity ahead of the 2024 general election. Our new South Africa Geopolitical Risk Indicator captures moments of significant political risk in the past and currently signals that the country is facing a geopolitical and political risk level last seen in 2016. The political status quo will remain for now, which is positive for investors. But China’s economic troubles and South Africa’s eventual need to inflate away its debt pose long-term risks for investors. Feature In the wake of COVID-19, South Africa has witnessed an increase of civil unrest. Severe looting in July 2021 only lasted a couple of days and was mostly contained to the central and eastern parts of the country but it nearly brought the country to a stand-still. The imprisonment of former President Jacob Zuma and a harsh lockdown amid resurging COVID-19 cases at the time fanned flames already lit by long-standing structural economic issues. The country has been stuck in a low growth trap for several years and government is facing constraints from rising debt levels. Yet the ruling party (the African National Congress, or ANC) will be difficult to displace in upcoming municipal elections and future general elections. It plays a large role in the public sector and low-income households depend heavily on government grants. Moreover, the ruling party also enjoys a “liberator” status, with voters pledging support to the ANC based on the party’s historical achievement of playing a major role in ending the apartheid regime. Unless the party implodes from within – possible but unlikely – the ANC will continue to rule, which is also the best outcome for investors at the current juncture. Low Growth Continues Amid High Debt The South African economy was straining before the pandemic and will continue to underperform going forward. Plagued by rampant corruption, misused state funds, and a lack of political leadership, the public sector has dragged on growth for several years now. Coupled with poor productivity in the primary and secondary sectors, South Africa’s economy faces headwinds which will affect future growth outcomes for years to come (Chart 1A).   In the mining sector, the country’s top foreign exchange earner, output has been in a structural decline since 1980 even as the country has benefited from several commodity price booms (Chart 1B). More recently, Ramaphosa’s 2018 investment drive to rebuild South African industries has failed to galvanize a turnaround.1 Manufacturing is much of the same story as mining. Output has been in decline from 1990 and has reached its lowest level since mid-1960 (Chart 1C). The National Union of Metal Workers have recently undertaken a protracted strike that has lasted three weeks already – with many industry bodies citing the dangers of irreparable harm to production and severe job losses should the strike continue for much longer. Other factors such as intermittent electricity outages across the country will subtract from productivity going forward. Chart 1BPrimary Sector Productivity In Structural Downfall... Chart 1C...Followed By The Secondary Sector Chart 2Public Debt Is Ballooning Fast From longstanding misuse of public funds comes the ballooning public government debt (Chart 2). Our colleagues over at the BCA Emerging Markets Strategy team have assessed the state of fiscal policy and debt in South Africa and the outlook is bleak. The government is currently pursuing fiscal austerity measures to rein in debt. However, these measures are unlikely to be enough and will become politically untenable over time. Otherwise, to stabilize debt, policy makers will have to inflate their way out of debt servicing costs or increase fiscal spending to boost nominal GDP growth. According to the 2021 budget speech, real spending is projected to contract each year over the next three years. This marks the first cut to nominal noninterest government expenditure in at least 20 years. Other items such as health care will see spending cuts over the next three years and remain lower than 2013 levels. Social protection and job creation initiatives will also see spending cuts. Another large budgetary item that will see spending cuts is the public sector wage bill. The government has reiterated its commitment to curb this growing expense. Recent negotiations with civil servants saw only a 1.5% wage increase over the next year compared to an average growth rate of 7% over the last five years. Chart 3Government Spending Important To Demand Austerity measures will lower public sector demand and ultimately growth. However, if successful, they will bolster both potential economic growth and the ruling party’s support. The problem is the timing of the general election in 2024. The economic backdrop in the country remains weak. Assuming more civil unrest takes place, government finances will be burdened with picking up the cost again and appeasing the masses through higher social spending. Austerity measures will presumably be relaxed ahead of the 2024 vote. Government debt needs to be curtailed considering that debt servicing costs are the second largest expenditure item of the country’s national economic budget. But given how large the public sector contributes to local demand (Chart 3), the ANC will see pushback by trade unions and those that have been in its growing employ. However, pushback will not necessarily translate into an irreversible breakdown of political support. Trade unions have been part and parcel of the ANC since the party’s inception. The party will have to strike a balance to keep the unions on its side. Bottom Line: Under Ramaphosa’s leadership, government austerity measures will continue at least over the short to medium term but will most likely be balanced to ensure the ANC maintains control through the 2024 elections. Ramaphosa Strengthens The ANC Civil unrest is nothing new in South Africa. There have been various displays of civil unrest and riots in recent years. The most recent civil unrest led to over 300 civilian casualties, the deadliest since the apartheid era. However, casualties were mostly a result of public stampeding civilian-on-civilian violence. The government did not play a major role in these deaths compared to the Marikana massacre of 2012.2 Even then, despite the ANC facing backlash from the immediate community, the party suffered no major fallout nationally. Recent unrest was more widely spread this time around and serves as an early warning signal to the ANC that social risks are high and not abating. But as things stand, these events will not displace the ANC from power. Such events would need to occur more regularly across the entire country, for them to pose a real threat to ANC rule. Since taking the helm of the ruling party in late 2017, Ramaphosa is viewed a lot more favorably than his predecessor, Zuma, by most South Africans. Ramaphosa is more business friendly, transparent, and is at least trying to weed out corruption in government. The public view of Ramaphosa’s handing of COVID-19 has been improving. Even supporters of the Democratic Alliance, the official opposition, and the Economic Freedom Fighters, a radical far-left party, have shown a large improvement in their approval of Ramaphosa’s handling of the pandemic (Chart 4). The Economic Freedom Fighter’s growth has largely been driven by disgruntled ANC supporters in recent years. Seeing supporters of the Economic Freedom Fighters improve their approval of Ramaphosa is positive for the ANC in upcoming elections. The ANC has two significant backstops to any deep erosion of their voter base: feudalism and social grants. Feudalism is defined as a socioeconomic structure in which people work for a leader of a community or tribe who in return, give them protection and use of land. It still runs deep in South Africa and across its cultures and tribes. It gives life to the ANC, a strong base that the Economic Freedom Fighters will always have a tough time chipping away at. Rural voters matter most to the ANC and mostly live under feudal rule. Tribal leaders and village chiefs play a major part in everyday life for rural people. There is overwhelming support among these leaders for the ANC because the ruling party provides them with access to land, among other things. By contrast, the Democratic Alliance and the Economic Freedom Fighters have had little success in penetrating these barriers. Support for both of these parties is driven by urban dwellers. The overarching royal Zulu family is the biggest factor contributing to feudalism. The Zulu family will always support the ANC and ensure their people do too. The Zulus are the largest tribe of black South Africans and have significant interests in the ANC maintaining power, such as access to land and financial resources. Obviously they have historic ties to the founding of the ANC and past leaders of the ANC, including Zuma (but not Ramaphosa). Additionally, the tripartite alliance of trade unions, the South African Communist Party, and the ANC has always ensured that workers represented in labor unions across the country voted for the ANC. The candidate elected president of the ANC, and ultimately the country, has always had the backing of trade unions, represented by the largest, the Congress of South African Trade Unions.3 The Congress of South African Trade Unions has never waived their support of the ANC in any elections and have shown no interest in supporting any other parties. The social grants system is the second backstop. The ANC provides social payments to 22% of the population, of which approximately 76% of recipients vote for the ANC (Chart 5, top panel). That’s a significant amount of the population that will forego a large part of their economic livelihoods if they vote for the Economic Freedom Fighters or another party to rule the country. In the current climate of COVID-19, foregoing government grants in order to vote for another party will not happen. Voters are increasingly worried about losing their social grants if another party comes into power (Chart 5, bottom panel). While other parties like the Economic Freedom Fighters have promised to more than double the going social grant rate if they come to power, social grant recipients and ANC voters at large have not budged on this “promise.” A sure thing today is better than a gamble tomorrow. But, if the fiscal standing of the country teeters into a position whereby the ANC fails to meet its growing social grant liabilities, then the Economic Freedom Fighters will gain the most, even if its promises will be extremely difficult to back up. Upcoming municipal elections in November 2021 will put to the test whether the ANC will shed support like it did in the 2016 election (Chart 6, top panel). Under Zuma, the ANC’s losses were the Economic Freedom Fighter’s gains. In the 2019 general election this transfer of votes lost some momentum because of Ramaphosa’s ability to galvanize support for the ANC (Chart 6, bottom panel). The Economic Freedom Fighter’s rise has been driven by the party’s ability to berate the ANC on its systemic corruption, embodied in Zuma. With Zuma in jail and Ramaphosa cleaning up the party and government, the Economic Freedom Fighters will lose momentum in forthcoming elections.4 To the ANC’s benefit, opposition parties that won some significant metros in the 2016 municipal elections subsequently formed coalitions that have largely failed to govern well. Specifically, in the economic capital of Johannesburg, the ANC reclaimed a majority to govern the city through coalitions with smaller parties, after the Democratic Alliance and Economic Freedom Fighters governed the city following the 2016 election. While the ANC has only reclaimed one of three metros lost in the 2016 municipal elections, they have benefited from lackluster service delivery by opposition parties which has shown that there is no realistic alternative to the ANC right now.5 Bottom Line: As Ramaphosa cleans up the ANC and government, the ANC will shed less support to the EFF and look to claw back lost voters in forthcoming elections. Introducing Our South Africa GeoRisk Indicator Recent civil unrest in South Africa presents an ideal backdrop to introduce a new GeoRisk Indicator to our existing suite of thirteen indicators. Our newly devised South Africa GeoRisk Indicator captures moments of significant political risk in the past, including this year’s civil unrest, and currently signals that the country is facing a geopolitical and political risk level last seen in 2016, when President Zuma was on his way out of office (Chart 7). Chart 7South Africa Geopolitical Risk Indicator The South Africa indicator is based on the rand and US dollar exchange rate (ZAR/USD) and its deviation from four underlying macro variables that should otherwise explain its economic trend. These variables are: gold prices, emerging market equities, industrial production, and retail sales. The four variables cover South Africa’s commodity dependency, financial sector, and the supply and demand side of the domestic economy. All four variables exhibit sufficient correlation with the ZAR/USD for use in this indicator. If the ZAR/USD weakens relative to these variables, then a South Africa-specific risk premium is apparent. As with previous indicators, we ascribe that premium to politics and geopolitics, although this is a generalization, and a qualitative assessment must always be made. The indicator is effective in tracking the country’s recent history too. Events such as ex-President Zuma’s general election win in 2009, and his controversial firing of several finance ministers in late 2015, signal an increase in risk. Meanwhile, lower risk was implied when current president, Ramaphosa, was elected president of the ANC in late 2017, and later, in 2019, as president of the country. Some additional events worth highlighting include: (1) In late 2001 to mid-2002, the local currency lost significant value relative to the US dollar for several reasons. First, the 1998 Asia financial crisis continued to send aftershocks throughout the emerging markets. The ZAR was put through the ringer in forward markets by speculators on a frequent basis, buying cheaper in the spot and driving speculation in the forward market, making easy returns. This speculation was only compounded by the South African Reserve Bank’s intervention in the local currency market to curtail speculation through regulatory action. Second, money supply grew substantially from mid-2001 to early 2002, which is associated with exchange rate undershooting.6 Thirdly, adding to these factors, contagion risk from neighboring Zimbabwe, which was dealing with land seizures and food shortages at the time, played into risk aversion toward regional and South African assets. (2) Eskom, South Africa’s state-owned power utility company, implements more regular power outages amid struggles to supply rising demand. (3) Despite allegations of corruption, former President Zuma wins the ANC presidential nomination. Zuma becomes party president. (4) Former President Zuma wins the general election (5) Former President Zuma fires well-respected then finance minister Nhlanhla Nene (6) Former President Zuma fires well-respected then finance minister Pravin Gordhan (7) President Ramaphosa wins the ANC presidential nomination. Ramaphosa becomes party president. (8) Former President Zuma resigns from the presidency (9) Former US President Donald Trump tweets on white farm murders in South Africa7 (10) President Ramaphosa wins the general election (11) First COVID-19 case is reported (12) Civil unrest and looting In terms of South African assets, when geopolitical and political risk rises, investors favor alternative emerging market assets (Chart 8). In 2021, South African equities have climbed to levels last seen in 2018 on the back of an improving global growth outlook and swelling commodity prices. But recent civil unrest has seen local equities pull back a notch. If risks escalate further, local assets will continue to retreat. Chart 8Geopolitical Risk Signals Move To Alternative Bourses Investment Takeaways Table 1 provides a snapshot of equity performance, volatility, and relative valuations and momentum in South Africa compared to frontier markets, including African frontier markets, and emerging markets. Table 1South Africa And African Frontier Markets: Valuations, Momentum, Volatility Chart 9Wait And See On Frontier Markets Equity returns in South Africa have notched good gains as global growth picks up alongside rising commodity prices. On a risk-adjusted basis, however, Nigeria and Kenya are more attractive. The general aggregates of Frontier and African frontier markets are more attractive on the same basis. Price and timing wise, Table 1 shows valuations and momentum relative to other markets. South Africa is cheap but Nigeria is cheaper. On a cyclical basis, South Africa has more to offer than Nigeria. African countries such as Nigeria and Ghana are all prepped to move higher in the wake of cheaper currencies. But a widening financial crisis in China is a risk to these countries given how they have trended closely with Chinese total social financing (Chart 9). Meanwhile, Kenyan equities have outperformed. South African equities in US dollar terms have retreated somewhat following recent civil unrest and some contagion linked to China’s Evergrande crisis (Chart 9, second panel). If China secures its economic recovery, then higher commodity prices will boost miners and industrial stocks going forward. But this is not guaranteed. Upcoming municipal elections will aid investors in determining what to expect from the policy backdrop. We expect that the ANC will stabilize, i.e. not lose control of more cities, and this should throw some impetus back into local equities. Conclusion This year’s civil unrest was stark and disruptive but does not spell fundamental political destabilization or the end of ANC rule in upcoming elections. The South African economy is structurally weak and, aside from a bounceback on the post-pandemic recovery, will continue to lag its peers until the ANC and Ramaphosa get a solid grip on allocating state funds more efficiently, promoting a more friendly and stable business environment, and fighting corruption. Undertaking fiscal austerity now is not a bad thing for the ANC, but it will become an increasing political liability leading up to the next general election. Ramaphosa will have to pull the plug on fiscal cost cutting as soon as 2023, so as to allow demand to recover before voters head to the polls again in 2024. But this has longer term economic implications. Public debt will continue to rise in this case and add to debt default risk and debt servicing costs. If austerity is reinstated after elections, the South African economy will remain in a low growth trap. For now, tightening the fiscal belt is doable because of the dynamic created by the downfall of Zuma, giving support to austerity as a means of cutting back corruption, and the pandemic, which reinforces the ANC as the institutional ruling party during a time of national crisis.   Guy Russell Research Analyst GuyR@bcaresearch.com Appendix The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our South African GeoRisk Indicator (see Chart 8 above) makes use of the same methodology used for all thirteen of our other indicators. The methodology avoids the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the ZAR/USD, and compare its movement against several fundamental factors. These factors are the price of gold in US dollars, emerging market equities in US dollar terms, South African industrial production, and South African retail sales. Like our recently added Australia GeoRisk Indicator, South Africa is a commodity exporting country. South Africa is the largest producer of platinum in the world, and was the seventh largest gold producer by volume in 2019. Gold is South Africa’s largest export and the ZAR has a strong historic correlation to gold prices.8 Hence we use gold prices instead of platinum, which is less well correlated. South Africa also has a deep financial market, with lose capital controls and easy flow of funds. When sentiment toward EM equities is high, the ZAR benefits, and hence our inclusion of emerging market equities. On the supply and demand side of the economy, both industrial production and retail sales show a strong relationship with the ZAR. We include these as the last two variables measured in our indicator. All four variables exhibit strong correlation with the local currency. If the currency sharply underperforms them, then it must be weighed down by some risk premium, which we ascribe to domestic political and policy developments or the general geopolitical environment. Footnotes 1 In 2018, President Cyril Ramaphosa laid out a target of $100 billion in new investments over the next five years, primarily targeting primary and secondary industries. According to The United Nations Conference on Trade and Development, foreign direct investment flows into South Africa in 2020 almost halved to $2.5 billion from $4.6 billion in 2019, which was a 15% decline from around $5.4 billion in 2018. 2 The Marikana massacre was the killing of 34 miners by the South African Police Service. It took place on 16 August 2012 and was the most lethal use of force by South African security forces against civilians since 1976. 3 According to the International Labour Organization, South Africa’s union density rate was 28.1% in 2016. Strikingly, the public sector union density rate was approximately 70.1% compared to 29.1% in the private sector. 4 In June 2021, ex-President Jacob Zuma was sentenced to 15 months imprisonment for contempt of court, by failing to legally attend a tribunal on corruption in South Africa. Zuma has recently been released on medical parole. 5 In the 2016 municipal elections, the ANC lost control of three major metros. Pretoria (political capital), Johannesburg (economic capital) and (Port Elizabeth, or Nelson Mandela Bay). The official opposition (the Democratic Alliance) and the Economic Freedom Fighters formed governing coalitions in all three of the lost ANC metros. Opposition coalitions have struggled to govern more effectively than what the ANC did, given how far apart they are ideologically. In Pretoria and Nelson Mandela Bay, service delivery has been poor since, in line with ANC rule prior to 2016. In Johannesburg, the ANC won back the metro by forming a coalition with several smaller parties. Opposition coalitions are still in force in Pretoria and Nelson Mandela Bay. 6 Bhundia, A.J. and Ricci, L.A., 2005. The Rand Crises of 1998 and 2001: What have we learned. Post-apartheid South Africa: The first ten years, pp.156-173. 7 Donald Trump tweets "I have asked Secretary of State @SecPompeo to closely study the South Africa land and farm seizures and expropriations and the large scale killing of farmers." The South African government have not seized any farms nor have there been any recordings of large-scale farm killings. The tweet caused a minor sell-off in local assets at the time. 8 Arezki, Rabah & Dumitrescu, Elena-Ivona & Freytag, Andreas & Quintyn, Marc. (2012). Commodity Prices and Exchange Rate Volatility: Lessons from South Africa’s Capital Account Liberalization. Emerging Markets Review. 19. Jordaan, F. Y., & Van Rooyen, J. H. (2011). An empirical investigation into the correlation between rand currency indices and changing gold prices. Corporate Ownership & Control, 9(1-1), 172-183.