Hidden threat to South African investors

The escalating debt in two of the world’s largest economies, China and the US, is pushing investors to seek value in unexpected places.

Not only do these two countries have the world’s largest economies, but they also have an outsized impact on South Africa. 

As a small, very open economy reliant on trade, South Africa is highly exposed to external shocks. 

Furthermore, with a relatively shallow capital market, the country has few buffers from geopolitical tension and global investor sentiment. 

Events in China are especially important to South Africa’s economic prospects as it is the largest destination for the country’s exports. 

This makes it a vital source of foreign exchange earnings and the end of a value chain that employs hundreds of thousands of South Africans in mining, manufacturing, and logistics.

Thus, the performance of the world’s second-largest economy and its demand for commodities has an outsized impact on the returns generated by some of the largest companies on the JSE, particularly miners. 

China’s economic performance also indirectly impacts the rand, as increased demand for commodities boosts South Africa’s foreign exchange earnings, bolstering the local currency’s value. 

Conversely, the US, while also a large importer of South African goods, is the world’s largest capital market. 

This means that events in America ripple throughout global financial markets. For example, when the Federal Reserve cuts interest rates, it is an important factor that the Reserve Bank has to consider in local rates deliberations. 

Zain Wilson, Co-Portfolio Manager of the Old Mutual Maximum Return Fund, warned that the rising debt levels of these two economies will significantly impact the return from local assets. 

“China has accumulated much of its debt through the state banking system. However, the returns on debt-funded investments have been poor,” he said. 

He highlighted that debt and demographics, both historical drivers of China’s economic growth, are now faltering.

“Chinese growth is tied to the property market, and the property market depends on long-term demographic trends – as property development cools due to weaker demographics, the entire engine China uses to recycle capital will stutter.” 

“If China is unable to transition away from its current debt-driven model, the growth it has historically contributed to the commodity market and South Africa will weaken considerably,” Wilson warned.

South Africa faces an additional challenge in that US interest rates are likely to ‘fix’ at levels higher than previously expected due to the country’s massive debt pile of $30.1 trillion. 

“If we end up with higher average rates than we did between 2010 and 2020, it will become more challenging for South Africa to address its fiscal issues. There are limits to how much SA bond yields can decrease,” Wilson explained. 

Debt crisis looming and alternative assets

According to the Institute of International Finance, global debt has reached $305 trillion, a staggering $45 trillion increase since before the COVID-19 pandemic. 

The US holds the highest national debt globally at $30.1 trillion – more than the combined debt of the next four highest-debt nations – China ($14 trillion), Japan ($10.2 trillion), France ($3.1 trillion), and Italy ($2.9 trillion). 

Furthermore, as the November 2024 US Presidential Elections loom, there is a risk that US debt will become politicised, Wilson said. 

Wilson noted that investors are concerned about debt in both economies but for different reasons.

“The typical levers that the US government has used to manage debt include fixing interest rates to control funding costs, reducing spending, and incrementally raising taxes.” 

He expects the US to respond by capping bond yields and raising taxes, though the latter option is seen as politically unpopular.

Wilson also said investors are actively searching for risk-free returns outside of the debt issued by the US and China, given the increasing risk from their rising debt burdens. 

“Alongside gold, the Japanese Yen and German Bunds are among the intriguing options at present”, he said. 

Gold, the traditional safe haven, is negatively correlated with broader financial markets. 

It offers protection during significant equity market downturns and serves as a store of value in the event of US dollar depreciation.

Wilson points out that Japan is in a very different stage of its inflation and interest rate cycle compared to other developed economies. It should outperform in a scenario where US rates are capped by its debt burden.

“It helps to think of the yen as capital exported to the rest of the world. That money is going to start flowing back as US yields get squeezed,” Wilson explained. 

He added that German bunds remain a niche investment and are attractive due to the country’s fiscal prudence dating back to the late 1940s.