Lesetja Kganyago has finally walked the walk. After years of hawkish talk, the South African Reserve Bank (SARB) finally took an actual hawkish decision at the November Monetary Policy Committee (MPC) meeting when it decided to raise rates despite the stronger Rand and improved inflation outlook. The 25 basis point rate hike reverses the 25bp rate cut made earlier this year in March.

There was a reasonable case to be made for both hiking rates and remaining on hold. Prior to the meeting this was reflected in the forecasts on Bloomberg where 9 out of 18 economists expected rates to remain on hold, while the other 9 forecasted a hike. The MPC was split as well with 3 members favouring a hike and 3 preferring to keep rates on hold. Lesetja Kganyago as governor has the final decision, so his preference for hiking was decisive.

The case for and against the hike

The case for holding rates steady centred around an improved inflation outlook. The SARB’s inflation forecasts for 2019 was reduced from 5,7% to 5,5%. The majority of economists expect it to be even lower. Since the last MPC meeting in August the Rand had strengthened 5% against the USD. The oil price has also fallen by 25% in Rand terms, leaving a potential R2,40 petrol price cut on the cards.
The case for hiking focused on the need to move inflation expectations closer to the midpoint of the 3-6% target band. The other key factor was the global environment where liquidity conditions have tightened, and rates have been moving higher. Over the last year we have seen 4 rate hikes in the US. This has put pressure on a number of emerging markets and most of them have already started hiking cycles. The following chart shows the gap between US and SA rates.

With the FED hiking rates and the SARB cutting, the gap between the official rates had narrowed to its lowest level over the last decade. With the Fed expected to hike 25bp in December, and further in 2019, the SARB viewed it as inevitable that rates would have to move higher. Delaying hiking now could mean a greater number of hikes in the future and that is why they chose to react.

Has inflation target been adjusted?

The 3-6% target band has been in place since inception of February 2000. Throughout this period, it has been accepted by the SARB and the market that the goal was to keep inflation below the upper end of the 6% target. Rates were generally hiked when inflation was forecast to be above target, and there was room to cut when inflation was forecast to be below 6%. The lower bound of 3% and the midpoint of 4,5% were mostly irrelevant.

In speeches and investor meetings over the last two years there has been a change in the rhetoric. MPC members have consistently communicated the desire to shift inflation expectations from the 6% upper end of the target band towards the 4,5% midpoint. Lesetja Kganyago style and tone has been far more aggressive than under the previous governor Gill Marcus. But despite all the hawkish talk, the SARB cut rates in July 2017 and March 2018 in order to help a struggling economy. While inflation was supportive at the time, it was definitely a dovish action in an environment of rising global rates.

After all the talk, this November rate hike is the first action which indicates that the SARB is looking to manage inflation down towards 4,5%. They have indicated that it will take around 5 years to get there, so there is no intention to be very aggressive at the expense of the economy. This is an MPC that has been uncomfortable for some time with expectations being anchored towards the upper end of the range. They are willing to acknowledge that they have some responsibility for elevated inflation expectations in SA given that historically they have only reacted when the upper band was breached. Governer Kganyago has been talking about this for some time, so he is definitely on board with the new strategy. However, the 3-3 split for the last hike shows that not everyone is convinced with the new hawkish tilt.

This was a good opportunity for the SARB to hike rates as part of a normalization process and they took it. On balance it is positive for bonds, but I don’t think that one hawkish action, on a split decision, is enough to demonstrate a fundamental change in approach and I wouldn’t be adjusting my valuation models quite yet.

Is this the start of a hiking cycle?

The SARB’s quantitative Quarterly Projection Model (QPM) indicates a further 3 hikes, but they won’t materialise if inflation remains contained and the economy is weak. The SARB is slightly more hawkish and more focussed on the midpoint, but this is a long-term aim and they are unlikely to inflict pain on the economy in the process. The key driver will be the US where the market expects a further hike in December, and one more in 2019. The FED itself expects a hike in December and a further 3 in 2019. If those do materialise then the SARB will have to follow suit and we can expect the SARB to continue hiking rates next year.

Netflix recently issued $2bn worth of new bonds to add to their existing $8.3bn worth of debt. These new bonds have a term of 10.5 years, so the return prospects of the bonds are tied to the long-term success of the company. The strategy of the company has been to spend massive amounts on original content (around $9bn per year at the current rate). This can’t be covered by gross profits which is why they have had to issue $4bn worth of debt this year. Free cash flow is expected to be negative $3bn per annum going forward, although they have consistently exceeded their forecasted cash burn. Netflix has explicitly told shareholders that it will be Free Cash Flow Negative “for many years”. In 2017 CEO Reed Hastings said that: “In some senses the negative free cash flow will be an indicator of enormous success.” Quotes like this give flashbacks to the tech bubble. Talk of profit is irrelevant when the metrics are revenue and subscriber growth.

Netflix’s risky strategy

The merits of Netflix’s strategy are debatable. They are willing to spend lavishly on content in the hope of building a dominant media and streaming business. The cash that they are able to spend has already changed the media business. For example, stand-up comedy is a genre that they have totally upended in just a few years. Historically, the one-hour special was the ultimate achievement for a stand-up comedian. It is what elevated comedians like Eddie Murphy and Chris Rock into superstars.

HBO generally did 5 or 6 comedy specials a year and Comedy Central did 10 to 15. This year Netflix has already released 66 comedy specials on their own with more to come. They are also paying comedians a multiple of what other media companies can offer. $40m to Chris Rock, $60m to Dave Chapelle and $100m deal with Jerry Seinfeld. No one can compete.

If you are an equity holder, you are betting that the content that they are producing is valuable and there is a large potential upside if they succeed. Regardless of whether you believe in their strategy or not, what is not in doubt is that without positive cash flows or tangible assets this is a risky strategy. Going forward, Netflix will face intense competition from established studios (Disney/Time Warner etc) as well as technology giants like Apple and Amazon who have competing streaming services.

High risk strategies and intense competition are the reasons that many technology companies fail and die out, while a few survivors are very successful. Therefore technology companies have generally funded their capex with equity; either venture capital or via the listed market. This time around, companies like Netflix, Uber and WeWork are financing their cash burn in the debt markets.

Where are we in the Credit Cycle?

The ultra-low interest rate environment since 2008 has resulted in a chase for yield by investors. While rates have bottomed, spreads on high yield bonds are still close to record lows. This environment has allowed technology companies to fund risky investments with debt instead of equity. At this point in the credit cycle, investors are willing to accept low spreads for risky investments, but this can change if the cycle turns. The following chart shows the average spread for US Corporate Sub Investment Grade bonds.

What does this mean for Bond Investors?

The USD Netflix bond currently yields 6.1%, which is around 3% higher than the equivalent US Treasury bond. The potential outperformance over a risk free investment is therefore 3% per annum. (or 30% over a 10 year horizon). Investors in the Netflix bond are taking a lot of risk for only 30% worth of upside. If Netflix succeeds, they will be able to service and repay the bond, but the upside is limited to the credit spread. With limited upside, the downside scenario is what is critical for bondholders. If Netflix is not successful, then the billions of dollars spent on content is likely to have little value and the bondholders will lose their capital in the same way as equity holders.

Investors should be wary of taking equity type risk for limited upside

One of the selling points of the recent Netflix bond deal was their $125bn market value, which is large relative to the $10bn debt level. This valuation is a function of their expensive (high PE) equity price. However, the current high market value is totally irrelevant in the downside scenario that is relevant for bondholders.

I believe that bond investors should be naturally cautious. Equity investors have unlimited upside, so they can justify buying into high growth stories. The nature of fixed income investing is that your upside is limited to the yield pickup, while the downside risk is losing your entire capital. We are at the point in the cycle where equity market values are being used to sell bond deals and investors are ignoring fundamentals like free cash flow and assets. This is the time to be extra cautious.