Corospondent - Trouble with the curve? - Coronation

 
Corospondent - Trouble with the curve? - Coronation
corospondent
                   The Global Quarterly

                        Trouble with
                         the curve?
OCTOBER 2019
Corospondent - Trouble with the curve? - Coronation
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references to targeted returns which we believe to be reasonable based on current market conditions, but no guarantees are being made the targets will be achieved or
that investors will not lose money.

On the cover: The US 10-year Treasury bond’s yield curve inversion has attracted much attention in recent months. Baseball is the quintessential US sport, and the
curve ball speaks to the uncertain outcome of the brief inversion.
Corospondent - Trouble with the curve? - Coronation
our path as custodians of the savings of millions
                                                                                         of South Africans. But more than that, we have
                                                                                         used our resources and influence to be a leader
                                                                                         and change agent in the South African retirement
                                                                                         industry. To this end, assisting in the transforma-
                                                                                         tion of our country has been deeply important to
                                                                                         us. This is why we have played a significant role
                                                                                         in transforming the financial services sector to be
                                                                                         more inclusive, in uplifting communities through
                                                                                         our CSI initiatives and ensuring our own business
                                                                                         reflects the demographics of our country.

                                                                                         During Women’s Month in August, we highlighted
                                                                                         the value and achievements of women in South
                                                                                         Africa by hosting a number of inspiring events.
                                                                                         I hosted our annual Women’s Day events for
                                                                                         clients and Grade 11 schoolgirls in Johannesburg
                                                                                         and Cape Town. Renowned US space engineer
                                                                                         Danielle Wood gave an inspirational talk on her
                                                                                         life and how she uses space technology to create
                                                                                         solutions for communities in need here on earth
                                                                                         and to address the UN’s Sustainable Development
                                                                                         Goals.

                                                                                         This was particularly meaningful given the

Kirshni on point
                                                                                         increased focus globally on issues of climate
                                                                                         change and sustainability. In South Africa, dia-
                                                                                         logue about these and other environmental,
                                                                                         social and governance (ESG) issues has certainly
We’re up for the challenge                                                               increased. The Financial Sector Conduct Authority
                                                                                         released its guidance note in June, requiring
                                                                                         pension funds to factor ESG concerns into their
                                                                                         investment strategy and monitoring. For us, this
By K I R S H N I T O T A R A M
                                                                                         means increased time spent understanding, arti-
                                                                                         culating a belief system, and reporting on these
                                                                                         matters – something that will become a standard
     Kirshni is Global           WELCOME to our latest Corospondent!                     part of the offering of managers around the world.
   Head of Institutional
   Business. She joined
   Coronation in 2000.           Not surprisingly, I again started this note with        We also welcomed South African athlete and
                                 penning thoughts about the uncertain times we           Olympic gold medallist Caster Semenya to our
                                 currently find ourselves in. And it dawned on me        Cape Town office as part of our mentorship pro-
                                 that it’s been this way for some time now. As an        gramme for employees. The story of her rise to
                                 individual and as a company, when you have              the top of her discipline speaks to the resilience
                                 navigated through years of challenging environ-         required to prosper over time. Her boldness in the
                                 ments in the local and global markets, as well as       face of adversity reveals deep self-acceptance
                                 in our industry, I think it’s important to pause and    and confidence. It was hugely inspirational to
                                 reflect from time to time.                              hear that to navigate successfully through tough
                                                                                         times takes immense grit. She taught us that it is
                                 I find it valuable to look at who we are and what       okay to be bold and acknowledge the awesome
                                 we continue to stand for. At Coronation, we have        things you do. As she said, “I believe in everything
                                 stayed true to our culture since starting out in 1993   I do”. And so do we.
                                 – an anchor which has served us well over the past
                                 quarter of a century. Always remaining singularly       However, the month concluded on a sombre and
                                 focused on our purpose of building long-term            dark note with cases of brutal gender-based
                                 wealth for our clients gives us great clarity in what   violence holding the headlines and our hearts,
                                 we need to achieve. And, while we acknowledge           with a subsequent rise in mass civilian protests.
                                 that uncertain times means that we still have a         We lend our voice in support of the calls to bring
                                 lot to do, we take pride in what we have achieved       about change that improves the treatment of and
                                 over the long term. We have never wavered from          respect shown to women everywhere.

                                                                                                                 TRUST IS EARNED™          3
Corospondent - Trouble with the curve? - Coronation
WHAT WE NEED IS LESS TALK, MORE ACTION                  preparing to take on Wales in the semi-finals of the
South Africa is in desperate need of some tangible      Rugby World Cup. Go Bokke!
action. For the past 18 months, we have not been
short of commissions and white papers identify-         IN THIS ISSUE
ing the real challenges we face as a country and        Economist Marie Antelme outlines her laundry
an economy. But to move us forward, we need to          list of concerns on page 12 . With the US 10-year
start acting. For this reason, the market welcomed      Treasury bond yield briefly inverting this quarter,
Finance Minister Tito Mboweni’s surprise release of     portfolio manager Seamus Vasey provides
the National Treasury’s plans to boost growth and       the logic behind the widely reported and eye-
create a million jobs.                                  brow-raising event on page 6.

Adding his weight, President Cyril Ramaphosa later      Back home, portfolio manager Tumi Motlanthe
announced the appointment of a new economic             outlines the investment case for Shoprite on page
advisory panel to help turn the ailing economy          26. Globally, investment analyst Chris Cheetham
around. In addition, in a move to increase both his     provides insight into the value we see in leading
leadership and communication to the country, the        US cable operators on page 16. Portfolio manager
President recently implemented a weekly news-           Suhail Suleman weighs in on China’s influence on
letter titled “From the desk of Ramaphosa”. While       the emerging market basket on page 33, while
these are all good and crucial steps, some tough        investment analyst Greg Longe points out why
decisions are overdue and much needed.                  it’s best to be circumspect about frontier market
                                                        IPOs on page 20.
A GLOBAL GEOPOLITICAL SPECTACLE
Globally, the world seems a mess. Ongoing geo-          TRUST IS EARNED
political theatrics would certainly provide enough      At Coronation, we continue to seek opportuni-
material for the next decade of soap operas. The        ties amid the challenges, and convert them into
Brexit deadline of 31 October is looming, while         value adds for our clients. I believe we are made
across the Atlantic, Trump’s tweets have turned         more resilient by the demanding environment in
into marathons as he voices his disdain for his         which we manage the money entrusted to us. We
impeachment enquiry. The simmering rivalry              remain steadfast in our purpose, with our clients’
between the US and China continues to play out          best interests at the core of what drives us.
with the trade wars, and increased military unrest
in Syria has raised concern from humanitarian           As we head into the last quarter of this decade,
groups. Looking further east, Hong Kong is facing       I wish you all the best and share my gratitude for
its first recession since the Global Financial Crisis   your ongoing support.
as the negative impact of anti-extradition law pro-
tests that have escalated to violent confrontations     Thank you
begins to weigh.

And of course, before we get into this issue of
Corospondent, here’s a strong shout-out to our boys
in green and gold. At the time of writing, they are

                                             IN THIS ISSUE

            03                                    16                                  30
      Kirshni on point                      Next-generation                   South African bonds
                                             entertainment                        attractive in
                                                                                low-yield world
            05
       Trust is earned                            20
                                              Buyer beware                            33
                                                                                      China
            06
                                                  24
         Yield curves
                                          National imperatives                        36
                                                                               2019 third quarter
             12                                   26                               in review
     Economic comment
                                                Shoprite

4      COROSPONDENT
Corospondent - Trouble with the curve? - Coronation
TRUST IS EARNED
  When Coronation opened its doors back in 1993 and commit-                                     We are a homegrown South African business and have become
  ted wholeheartedly to the future of South Africa, the country                                 one of the leading investment managers in our country. We are
  was moving through uncertain times. As we head into the next                                  privileged to manage the savings of millions of South Africans,
  decade, that sense of uncertainty is again palpable, both at                                  a responsibility that we take very seriously. Our unique culture
  home and globally. But navigating through challenging times                                   and values, instilled from inception, drive how we show up every
  takes courage, confidence and a strong sense of clarity of                                    single day to earn our clients’ trust. Here are ways in which we
  purpose.                                                                                      honour our long-term commitments to clients and stakeholders:

                                                     Long-term performance matters
        Building                                                                                                                                                97.5%
      our clients’
                                                                                                                                    12x
                                           PERFORMANCE

                                                                                                                                                    of client assets1 have
                                                                                                                                    7x               outperformed their
     wealth over                                                                                                                                 benchmarks since inception

   the long term
                                                                                                                                                   1
                                                                                                                                                       As at 30 September 2019; funds with a
                                                                                                                                                                  10-year+ history

                                                                                                YEARS

                We have generated                           Coronation Houseview Equity
                                                            JSE Capped Shareholder Weighted Index
                                                                                                                                                12x purchasing
         long-term outperformance
                   for our investors.
                                                         Source: Coronation, as at 30 September 2019                                              power after
                                                         Based on R100m invested in Coronation Houseview Equity Strategy on
                                                         1 Oct 1993, compounding at a real rate of 9.9% gross of fees
                                                         Note: This portfolio is only available to South African investors. It is
                                                                                                                                                   26 years
                                                         included for illustrative purposes only.

    Transforming                                     Level 2 B-BBEE contributor*
                                                     Successfully recruited, trained and retained exceptional black and female talent
     our business                                    across our business since 1993.

      from within                                               56%                                  49%                                  78%
                                                                                                                                                                >R210bn2
                                                                                                                                                             of total AUM managed
               We are a proud South                                                                                                                           by black investment
                   African business.                            black                               female                            of our board                professionals
                                                              employees                            employees                        members are black               2
                                                                                                                                                                        As at 31 August 2019

                                                               Established 3                                Since 2006, we have                   Over the past decade, we

     Advancing                                              independent black
                                                                businesses
                                                                                                                 allocated                        have funded and trained

transformation                                                                                                   >R300
                                                               African Harvest                                   million                                           120
 in our industry                                               Fund Managers
                                                                                                            in brokerage to black
                                                                                                                                                 black IFA practices through
 Pre-dating BEE legislation in South                                                                        stockbrokers through
                                                                Kagiso Asset                                                                     the ASISA IFA Development
      Africa, we pioneered corporate                                                                            the Coronation                           Programme
                                                                Management
 initiatives that have contributed to                                                                          Business Support
 meaningful transformation and the                                                                                programme
development of skills in the financial                           Intembeko
                                                                Investment
                                                                                                                                                                     27
                    services industry.
                                                               Administrators
                                                                                                                                                 analysts through the Vunani
                                                                                                                                                 Securities Training Academy

                                                         *as measured by the revised Financial Sector Code
                                                         All figures are as at 30 September 2019, unless otherwise stated.                             TRUST IS EARNED™                        5
Corospondent - Trouble with the curve? - Coronation
INSIGHTS

     Yield curves
     Inverted yield curves, negative
     bond yields, liquidity everywhere
     and not a drop to drink

     By S E A M U S VA S E Y

                                                               The post-GFC                   Times are
                                  An inverted US                                                                         It’s not insane to invest
          THE                                                   central bank              unprecedented;
                                 10-year Treasury                                                                          in negative-yielding
                                                              monetary arsenal           more than 25% of
         QUICK                   bond yield curve
                                                               may well prove             the global bond
                                                                                                                             bonds; in current
         TAKE                    can not only be a                                                                      conditions it would be a
                                                                ineffective in           market now trades
                               predictor, but a cause                                                                   pity if SA missed the bus
                                                             current conditions          at a negative yield

                                SMALL FORESTS HAVE been razed to the ground              THE ORACLE
                                and squids worldwide have been sucked dry to             But it’s not just the success of this indicator that’s
                                help support the volumes that have been written          attractive to market watchers; it’s the extent of
                                about bond yield curve inversions in recent              the forewarning the signal provides. While many
                                times. This reached a peak at the beginning of           other harbingers of a slump in economic activity
                                September when the US 10-year Treasury bond              tend to be practically contemporaneous with the
       Seamus is a fixed        yield briefly fell below that of its short-dated coun-   slowdown itself, the yield curve is seemingly able
       income portfolio         terpart, the two-year bond, for the first time since     to look over the horizon and provide several quar-
     manager and analyst
        with 15 years of        2006. The ensuing frenzy of handwringing and             ters’ advance warning.
    investment experience.      woeful prognostications from market commen-
                                tators has certainly been eyebrow raising. Yet are       Just as important as the reliability and predictive
                                they wrong?                                              strength of this indicator are its simplicity and
                                                                                         plausibility. These latter benefits are related. The
                                There are respectable justifications for taking          difference between a long-term interest rate (typi-
                                heed when long-term interest rates in the US fall        cally the 10-year bond) and a short-term interest
                                below the level of short-term rates. This is a rare      rate (alternatively the policy rate, a T-bill rate or
                                occurrence and has been – without contest – the          yield on the two-year bond) is the entire metric.
                                most reliable early warning signal of an impen-
                                ding recession. Out of the 10 instances that the         Hence, even as macroeconomic, external and
                                curve has inverted since World War II, only once         regulatory conditions varied considerably at
                                (in the mid-1960s) did the slope of the curve turn       the times when the yield curve became down-
                                negative without an ensuing recession; conversely,       ward sloping over the past seven decades, all
                                there haven’t been any modern US recessions that         these influences were arguably already incor-
                                weren’t preceded by an inverted yield curve (see         porated into interest rates. The uncondition-
                                Figure 1 on page 7).                                     ality of this metric shouldn’t be too surprising.

6         COROSPONDENT
Corospondent - Trouble with the curve? - Coronation
After all, bond yields are really just aggregated                Figure 1
market expectations of all the macroeconomic                     HISTORIC YIELD CURVE INVERSIONS
factors that influence growth, inflation and                           % daily, not seasonally adjusted
policy, and savings and investment decisions.                      3

And if that weren’t enough to solidify confidence                  2

in the importance of this measure, there is a cau-
sality argument. Most analysts view an inverted                    1

yield curve as being anticipatory of an approach-
                                                                   0
ing economic slump. However, there is some vali-
dity to the notion that an inverted yield curve
                                                                  -1
itself can help promote a negative feedback loop
within the broader real economy.                                  -2

So, it’s not just the collective foresight of the US              -3
bond market that – for all intents and purposes                    1976           1982          1988        1994        2000         2006   2012   2018

– predicts recessions each and every time, but it                         US yield curve slope (10-year maturity minus 2-year maturity)
is the very occurrence of long-term interest rates                        US recessions
being less than short-term rates that helps bring
                                                                Source: Federal Reserve Bank of St. Louis
about the slump. This negative effect would most
clearly permeate through the banking system,
which relies on an upward-sloping yield curve to
be profitable.
                                                       in applying additional scepticism to the signals
Weakness in the ability of the economy to gen-         being sent by the US yield curve. So, to return
erate credit almost inevitably harms economic          to the original question: is the intense concern
growth, so it’s quite conceivable that yield curve     generated by yield curve inversion in the US
inversion may actually help bring about reces-         justified or not? For most people, the concise
sions – which would certainly bolster the metric’s     answer would still be ‘yes’, despite the counter-
predictive ability!                                    arguments. But for long-term investors, the origi-
                                                       nal question itself is largely irrelevant.
IS THIS TIME DIFFERENT?
But what are the counterarguments to the impli-        A US RECESSION: WHEN, NOT IF
cations of the ‘true’ US yield curve inversion that    Long-term investors are always interested in
recently arose, or equivalently, to invoke the most    what’s beyond the next phase of the business
dangerous question in economics: is this time          cycle. It isn’t controversial to suggest that the US is                      IS THE INTENSE
different?                                             facing a slowdown. Exactly when it will occur and                            CONCERN
                                                       how deep the slump will be are important cycli-                              GENERATED BY
There are two key differences for the US bond          cal questions, but there are far more significant,                           YIELD CURVE
market between the current era and prior               secular uncertainties to contemplate.                                        INVERSION IN THE
decades. The first is financial repression – the                                                                                    US JUSTIFIED OR
extent to which policymakers have actively influ-      Indeed, these structural questions are already                               NOT?
enced bond yields through direct, unconventional       being posed in many economies and bond
means. The second is the substantially globalised      markets around the world. The US will very likely
nature of G10 sovereign debt markets and how           face these same challenges in time, but they are
distorted these markets have become through            immediate for most other developed markets.
their own central bank involvement.
                                                       Underlying these concerns are two interrelated
The former simply means that one can’t nec-            questions: what is the effectiveness of monetary
essarily trust the signals being provided by a         policy from this point and how (un)sustainable are
market that has been deliberately distorted            negative interest rates?
by the Federal Reserve Board (the Fed), princi-
pally through its quantitative easing (QE) pro-        THE FUTURE OF MONETARY POLICY
gramme. The latter implies that, even when the         The key is to recognise that the current, syn-
Fed isn’t directly influencing US Treasury yields,     chronised global slowdown is substantially dif-
the substitutability among G10 sovereign bonds         ferent to the downturn that materialised in the
means that central bank interference anywhere          wake of the 2008/2009 Global Financial Crisis
will filter through to other markets, including        (GFC). Central bank optimists will highlight
the US. These differences certainly lend weight        that this is a positive starting point: the vastly

                                                                                                                               TRUST IS EARNED™       7
Corospondent - Trouble with the curve? - Coronation
expanded toolboxes of the European Central             NEGATIVE-YIELDING BONDS ARE OBVIOUSLY
                                           Bank (ECB), the Bank of Japan, the Bank of             IRRATIONAL … OR ARE THEY?
                                           England and the Swiss National Bank, among             It seems absurd that literally thousands of
                                           others, can be more quickly and assertively            billions of dollars’ worth of bonds are trading
                                           deployed. Previously, short-term policy rates          with negative yields; has the global bond market
                                           were really the only primary tool to ease mon-         collectively lost its mind, quaffed generously
                                           etary conditions, but, through dire necessity, a       from a “Drink Me” potion and willingly plunged
                                           much broader set of interventions came to frui-        down the infamous rabbit hole (as suggested by
                                           tion, along with a greater willingness to embrace      the long- and very long-term yields in figures 3
    HAS THE GLOBAL                         unorthodox methods. The problem is whether the         and 4 on page 9)?
      BOND MARKET
                                           limits of even these unconventional interventions
      COLLECTIVELY
    LOST ITS MIND ...                      might already have been reached.                       The answer is: maybe not. There is a variety
     AND WILLINGLY                                                                                of rationalisations for holding negative-
    PLUNGED DOWN                           The most blatant sign that monetary policy             yielding bonds. The first fallacy to displace is
      THE INFAMOUS                         in many parts of the world may be pushing up           the overwhelmingly widespread notion that
       RABBIT HOLE?                        against an effective limit can be seen in the          buying a negative-yielding bond guarantees
                                           extent of negative interest rates.                     a loss-making investment. This is patently not
                                                                                                  true for holding periods of less than maturity
                                           The landscape is unprecedented. Over a quarter         where capital gains outpace the losses from
                                           of the global bond market (c. $15 trillion of the      negative yields. It is also not necessarily true
                                           Bloomberg Barclays Global Aggregate Bond               for bonds bought with a negative yield and
                                           Index) now trades with a negative yield (see           held till maturity. Provided a bond has an initial
                                           Figure 2). And with the US being the second-to-        non-negative coupon (as all bonds currently do)
                                           last major bond market with an all-positive yield      and reinvestment rates aren’t always negative,
                                           curve (the UK is the other), this means that nearly    the total return over the life of the bond may still
                                           90% of the positive yield being generated from         be positive.
                                           the global investment-grade bond market comes
                                           from America.                                          As such, if bondholders were momentum-driven
                                                                                                  investors with short-term horizons or long-term
                                           Furthermore, unlike previous episodes of nega-         holders not overly concerned by market-to-
                                           tive-yielding debt, not only are large proportions     market losses in the intervening period, a strange
                                           of sovereign and investment-grade corporate            equilibrium could be sustained whereby views for
                                           bond markets trading at below-zero interest rate       a return to positive rates and even more deeply
                                           levels, but this has even infected some parts of       negative rates could co-exist and negative yields
                                           ‘high-yield’ bond markets (subinvestment grade         could be maintained.
                                           or junk), making a mockery of price-based risk dis-
                                           crimination within certain jurisdictions.              A less far-fetched rationalisation for the
                                                                                                  sustainability of negative-yielding bonds for an
                                                                                                  extended period lies with a more entrenched
                                                                                                  fear of deflation. In the face of a potentially
Figure 2                                                                                          protracted period of negative inflation, nominal
A PROXY FOR NEGATIVE-YIELDING DEBT IN THE GLOBAL BOND MARKET                                      bonds are typically the superior asset class to
        %                                                                                         hold. With declining price levels, any asset that
 35                                                                                               can provide a sustained nominal cash payout
                                                                                                  becomes very valuable.
 30

 25                                                                                               Another way to see this is to focus on the real
                                                                                                  yields provided by nominal, fixed-coupon bonds;
 20
                                                                                                  these can very well be positive in a deflationary
 15                                                                                               environment. And aside from the fixed cash-flow
                                                                                                  profile that nominal bonds provide, they become
 10                                                                                               even more valuable relative to other asset
    5
                                                                                                  classes, which tend to struggle in the macro-
                                                                                                  economic climate that accompanies an
    0                                                                                             extended period of deflation. This is the
    Dec 09     Dec 10   Dec 11    Dec 12    Dec 13   Dec 14   Dec 15   Dec 16   Dec 17   Dec 18
                                                                                                  ‘Japanification’ scenario whereby a similar fate
            Proportion of Bloomberg Barclays Global Aggregate Bond Index that has a               that befell Japan over its lost decade strikes
            negative yield
                                                                                                  elsewhere, with Western Europe being highest
Source: Bloomberg                                                                                 ranking on the candidate list.

8             COROSPONDENT
Corospondent - Trouble with the curve? - Coronation
Figure 3                                                                                                      capital preservation and negative correlation to
10-YEAR GOVERNMENT BOND YIELDS – HISTORICALLY COORDINATED                                                     growth assets) within a multi-asset class context.
AND DEPRESSED                                                                                                 And it is these latter characteristics that are
       %                                                                                                      highly sought after within any holistic invest-
 20                                                                                                           ment portfolio. Indeed, they are scarce enough
                                                                                                              that investors may even be prepared to pay up
 15
                                                                                                              for these features; a cost potentially represented
                                                                                                              by negative yields.

 10
                                                                                                              But perhaps the most feasible validation for
                                                                                                              seeing sustained negative global bond yields
   5                                                                                                          lies with market expectations. In the context
                                                                                                              that the short-end policy rates of major central
  0
                                                                                                              banks were increasingly seen as being set
                                                                                                              around or below zero for an extended period, it
                                                                                                              would be rational to anticipate equally subdued
  -5
                                                                           2000           2008         2016
                                                                                                              long-term rates. Indeed, provided the equilib-
   1960            1968          1976          1984         1992
                                                                                                              rium real rate of interest (or ‘R-star’ in econo-
           Australia        Canada            Switzerland          Germany             Spain      UK
                                                                                                              mists’ jargon) was believed to have reset to a
           Japan          Norway            New Zealand          Sweden           US
                                                                                                              very low level, the danger posed by bond yields
Source: Federal Reserve Bank of St. Louis                                                                     ‘normalising’ to some pre-GFC long-term neutral
                                                                                                              level is effectively neutered. Hence it is the
                                                                                                              notion – increasingly more plausible to inves-
Figure 4                                                                                                      tors – that structural factors are responsible for
HISTORY OF LONG-TERM UK BOND YIELDS                                                                           a lower equilibrium real rate (essentially where
       %
                                                                                                              inflation and unemployment are in balance in
 16                                                                                                           an economy).
 14
                                                                                                              In particular, globalisation; technological
  12                                                                                                          changes, through digitisation; demographics,
 10
                                                                                                              through the ageing developed world; and even
                                                                                                              the wage-bargaining process, through the shift
   8
                                                                                                              in the relative balance of power between capital
   6                                                                                                          and labour, have lowered inflation and altered
                                                                                                              the relationship between inflation and other
   4
                                                                                                              economic variables. And regardless of where
   2                                                                                                          the balance lies in these explanations, provided
  0                                                                                                           belief in lower inflation is increasingly attributed
   1703        1738       1773      1808       1843       1878      1913      1948         1983   2018        to structural rather than cyclical causes, then the
           Long-term UK bond yield
                                                                                                              more justified the notion of entrenched low inter-
                                                                                                              est rates becomes.
Source: Federal Reserve Bank of St. Louis

                                                                                                              NOT A REVIVAL OF THE POST-GFC CENTRAL
                                                                                                              BANK PLAYBOOK
                                                                                                              It appears that central banks and markets have
                                            An even more reasonable class of justifications                   been rapidly adjusting in preparation for a rerun
                                            for the viability of negative-yielding bonds lies                 of the post-GFC interval that saw exceptional
                                            with investment portfolio dynamics. What many                     monetary easing over a protracted period. After
                                            bondholders will have found reassuring in recent                  all, policy rates have been cut widely, lending
                                            months is that the ‘safe-haven’ characteristics of                operations have been revived, asset purchase
                                            bonds trading with negative yields have been                      programmes reinvigorated and forward guid-
                                            sustained. This means that these are still reliable               ance is open-ended once again. However, there
                                            defensive assets.                                                 is a crucial difference this time around.

                                            So, from a portfolio construction basis, while                    There is significantly more widespread recogni-
                                            these bonds may well be vulnerable due to excep-                  tion that monetary policy has reached some – if
                                            tionally high valuations, they also continue to                   not all – of its effective limits. Perhaps the greater
                                            provide a nominal income stream and offer their                   area of dispute now is around whether excep-
                                            traditional diversification benefits (including                   tional monetary easing, especially negative rates,

                                                                                                                                       TRUST IS EARNED™           9
Corospondent - Trouble with the curve? - Coronation
is actually counterproductive to its own aims or                  Figure 5
whether these ill effects are long term enough in                 HAVE THE LIMITS OF MONETARY POLICY BEEN REACHED?
nature (or manageable) that aggressively loose                          %                                                                                       %
monetary policy is still better than nothing – even                45                                                                                                   120
if it’ll do little to solve deeper productivity issues             40
facing most economies.                                                                                                                                                  100
                                                                   35
                                                                                                  Extent of extraordinary monetary
                                                                                                         policy since the GFC
This complexity was highlighted at the ECB’s                       30                                                                                                   80

September policy meeting. Much of the atten-                       25
                                                                                                                                                                        60
tion was focused on the Bank’s monetary policy                     20
adjustments, especially the de facto open-
                                                                   15                                                                                                   40
ended revival of bond purchases to the tune of
                                                                   10
€20 billion per month. However, the underly-                                                                                                                            20
ing messaging was very clear: monetary policy                       5

cannot be the only heavy lifter.                                    0                                                                                                   0

                                                                      2000

                                                                                  2002

                                                                                           2004

                                                                                                         2006

                                                                                                                    2008

                                                                                                                               2010

                                                                                                                                       2012

                                                                                                                                                2014

                                                                                                                                                        2016

                                                                                                                                                                 2018
Without fiscal expansion, European growth
will remain anaemic and a form of secular                                    Federal Reserve Board (US)            Bank of England (UK)

stagnation will likely take hold. The depart-                                European Central Bank (Euro area)             Bank of Japan (Japan, RHS)

ing ECB President, Mario Draghi, even while                       Sources: Bloomberg, US Federal Reserve Board, Bank of England, Bank of Japan, European Central Bank
reviving easing mechanisms for the Euro-area
(and adding a few monetary innovations too),
unequivocally emphasised that fiscal policy
needs to become the main instrument to stimu-
late demand.                                             THROUGH THE LOOKING GLASS – THE SOUTH
                                                         AFRICAN CONTEXT
This clear and forceful endorsement from such            South Africa doesn’t face quite the same mone-
an eminent policymaker should – in an ideal              tary policy restraints as those seen in developed
world – have significant traction in finance min-        markets. Real rates are still very much positive
istries across the Continent. Yet this is not a given.   across the curve, inflation is low but set to remain
Resistance to perceived sovereign profligacy has         in the upper end of the target band over the fore-
been legendary in Northern Europe. After all, it         seeable future, and fiscal expansion certainly
isn’t coincidental that the German word for ‘debt’       hasn’t been kept unduly restrained – in fact, quite
(Schuld) is the same for ‘guilt’.                        the opposite. But it would be absolutely accurate
                                                         to emphasise that South Africa’s growth issues
The most that can be said is that the debate has         go well beyond what monetary policy can suffi-
already begun to shift. But while this has been a        ciently address – just like in much of the rest of
global phenomenon, it has unfortunately been             the world.
slowest to evolve in Europe – the developed world
geography that most urgently needs a different           However, with the globalised nature of fixed
policy configuration.                                    income markets, the direct influence of G3 (the
                                                         US, Japan and the EU) risk-free rates on domestic
And so, the market’s answers to the imperative           bond yields always needs careful consideration.
questions facing bond investors reflect deep             As such, it is instructive to consider the counter-
scepticism about the effectiveness of monetary           factual: what would South African bond yields
policy tools, both interest rates and unconven-          have looked like if there hadn’t been the most
tional interventions, from this point (see Figure 5).    widespread and prolific reduction in developed
As such, the potential for an extended period of         market bond yields over the past three quarters
exceptionally low interest rates is seen as quite        or so?
high, as the political courage to forego extra-
ordinarily easy monetary conditions is seen as           Even with other countervailing forces, it is highly
absent.                                                  improbable that South African bonds that have
                                                         fared particularly well in a world that was pursu-
Rates may be negative or slightly positive, but          ing a continued de-escalation away from extra-
what isn’t doubted by the market is that they’ll         ordinarily easy monetary conditions.
remain so for a protracted extent. This itself
reflects cynicism about policymakers’ willingness        A higher level of global risk-free rates would have
and ability to rebalance policy interventions to         necessitated a commensurate adjustment to South
favourably boost growth and raise inflation.             African bond yields, while a reversal of capital

10      COROSPONDENT
flows from emerging markets back to a US dollar        these difficulties in a more coherent and defini-
base would likely have exacerbated this process.       tive manner than has been seen to date.

So, it’s fair to characterise this episode of global   If the market’s prognostication for ineffective
interest rate and spread compression as both a         monetary policy and an extended period of
blessing and curse for South Africa. Without the       very low developed-market interest rates pans
offsetting gravitational pull of lower developed       out, South Africa has a window of opportu-
market yields, South African bonds would have          nity to structurally turn around its current fiscal
almost certainly struggled to overcome the inten-      predicament and avoid a far more rapid and
sification of domestic fiscal difficulties.            jarring correction to an unsustainable debt tra-
                                                       jectory. It would be deeply regrettable if this
The curse is that the market signal that this would    passing moment of grace were to be squan-
have provided may have prompted a quicker and          dered and a crisis were necessary to correct the
more compelling political response to address          imbalance. +

                                                                                                             TRUST IS EARNED™   11
ECONOMIC COMMENT

     My laundry
     list of concerns
     Restoring confidence is key to growth recovery

     By M A R I E A N T E L M E

          THE                      We’re experiencing              Policy inertia            The government            The world at large is
         QUICK                      a perfect storm of             continues to            debt-to-expenditure        in a state of upheaval;
                                  economic headwinds              dog growth and             ratio is of grave         quantitative easing
         TAKE                        to global growth               confidence                   concern                       is back

                                  TO SAY THAT we are living in uncertain times            decisively or think creatively when the economy
                                  seems more than ever a gross understatement.            needs it most.
                                  South Africa’s political landscape is in transition
                                  from a decade of maladministration towards              When Cyril Ramaphosa won the ANC presi-
                                  painful stabilisation. Economic growth has              dency at the ANC’s 2017 National Conference at
                                  suffered and the path to recovery is still unclear.     NASREC, the country was euphoric, expecting (or
          Marie is an                                                                     hoping against hope?) one man to transform a
        economist with            EXODUS                                                  corrupt state and a growthless economy into an
          18 years of
         experience in            People are leaving and at times the political           accountable state and a growing economy. To
      financial markets.          narrative is toxic. Globally, populist politics and     date, progress has been slow at best, and expec-
                                  protectionism are weakening traditional alle-           tations have been disappointed. Several reasons
                                  giances; while against a backdrop of slowing            for this sluggishness have emerged in the inter-
                                  economic growth, traditional policy instruments         vening 19 months:
                                  seem stretched beyond effectiveness. This turbu-
                                  lent combination finds us in choppy, unchartered        1. The degree and depth of corruption in both
                                  waters. In this note, I try to distil the issues that      the public and private sectors were much
                                  concern me most.                                           worse than suspected. The Zondo Commission,
                                                                                             among others, has revealed this, and recent
                                  OVER THE RAINBOW                                           public statements by the President have con-
                                  My most immediate concern is the outlook for               firmed it.
                                  domestic politics. Importantly, whether this
                                  administration will deliver sustainable policies        2. The President has had to opt for a strategic,
                                  that are necessary to improve domestic growth.             reformist approach, which takes time to imple-
                                  This extends beyond the President, through an              ment. His narrow NASREC victory, coupled
                                  administration which has thus far failed to act            with ongoing opposition from his detractors,

12        COROSPONDENT
both within and from outside the ANC, means                   Figure 1
   he has had to use commissions and review                      REAL GDP GROWTH COMPARISON
   committees, the mechanism of the courts, and                          %
   the slow attrition of opponents to reach deci-                 10
   sions and make appointments. This has taken
   time.                                                           8

                                                                   6
3. Unfortunately for the President, his ability
   to build an economic dialogue with enough                       4

   momentum has been thwarted by a number of
                                                                    2
   other distractions. These constraints seem to
   be easing, as he recently confirmed the immi-                   0
   nent announcement of new policies; however,
                                                                   -2
   we still await key decisions.
                                                                   -4
4. There have been some notable successes,

                                                                        2006

                                                                                 2007

                                                                                        2008

                                                                                                 2009

                                                                                                        2010

                                                                                                               2011

                                                                                                                      2012

                                                                                                                             2013

                                                                                                                                    2014

                                                                                                                                           2015

                                                                                                                                                   2016

                                                                                                                                                          2017

                                                                                                                                                                 2018

                                                                                                                                                                        2019
   including the appointment of a credible
   commissioner of the South African Revenue                                   World           Developed markets        Emerging markets          South Africa
   Service, a renewed and credible head of the                   Source: IMF
   National Prosecuting Authority, and the reha-
   bilitation of various institutional investigative
   units. These are all important, positive steps to
   restoring institutional resilience.
                                                        pre-crisis rates; only it didn’t. The result is that
A STATE OF INERTIA                                      revenue has fallen much faster than expenditure
A decade of poor policy setting and weak imple-         has been able to adjust, and the shortfall has
mentation, exacerbated by state rent seeking,           been met by an accelerated accumulation of
has led to a considerable depletion of domestic         debt. And, in spite of all the best efforts of the
resources. Offshoring by local companies, and an        National Treasury, this continues to be the case. It
acceleration in emigration have hollowed out the        means that the two fastest-growing expenditure
financial and skills bases. It is unclear whether the   lines in the budget are the public sector wage bill
economy will be able to make a full recovery, but       and the price of servicing government debt.
the result has been a protracted period of very
low growth.                                             DROWNING IN DEBT
                                                        This brings me to my next biggest concern,
Low nominal growth is the next concern. Achieving       because the two are linked – rising government
better, stronger growth really is the most import-      debt combined with the financial and operational
ant economic challenge for South Africa at this         condition of state-owned enterprises (SOEs). In the
critical stage. It is the means by which econo-         case of the former, because growth has been so
mies generate opportunities and government the          much weaker than expected, revenues have con-
resources by which to provide for people where          sistently underperformed budgeted amounts and
economic allocations fail. It doesn’t fix inequal-      the allocation to expenditure, and government
ity, but it allows the state to make provision for      has funded the shortfall by raising debt.
the most vulnerable. Without growth we have no
options. The South African economy has under-           Government debt is expected to hit 60% of GDP
performed global growth, across developed and           in the current fiscal year, excluding the debt owed
emerging markets, since the 2008/2009 Global            by the SOEs. Alone this is not alarming, but the
Financial Crisis (GFC). This became (and has            trajectory is: government debt bottomed at
stayed) more pronounced in 2012 (see Figure 1).         24.6% of GDP in the third quarter of 2008; since
                                                        then, it has increased to 56.7%, a compound
This at least partly reflects the effects of post-      annual rate of 7.9%. As we stand, government
GCF policy choices: at the time, government             debt will not stabilise, but will continue to build
spending accelerated as revenue collapsed. This         over the medium term (refer to figures 2 and 3 on
was the right thing to do in a crisis. However, the     page 14).
way in which government spent, hiring many
people and expanding their incomes at a rate            Why does it matter? The bigger the debt burden
well ahead of inflation, had a permanently neg-         becomes, the greater the cost it exacts on the
ative effect on government expenditure. At the          economy. Not only are financial resources directed
time, government expected growth to return to           away from productivity-promoting investment to

                                                                                                                                       TRUST IS EARNED™                    13
finance the debt; but it must ultimately be repaid.                                                                              Outside of a cumbersome wage bill, the costs to
                                                                       We can already see that increased debt is weigh-                                                                                 the fiscus of troubled SOEs have increased enor-
                                                                       ing on the economy’s ability to grow. Rising issu-                                                                               mously. Eskom remains the biggest challenge.
                                                                       ance puts pressure on long-term interest rates,                                                                                  This is the next big concern – the financial and op-
                                                                       which affect borrowing costs across the economy                                                                                  erational viability of Eskom and the risk this poses
                                                                       by raising the cost of debt and debt service.                                                                                    to both sustainable growth and government
                                                                                                                                                                                                        finances.
                                                                       Taken together, the increased cost of debt, coupled
                                                                       with a rising risk that the situation will become                                                                                DARK MATTER
                                                                       increasingly unsustainable, undermines any appe-                                                                                 In February, the National Treasury allocated an
                                                                       tite for investment. Less investment now means                                                                                   additional R23 billion per annum of taxpayers’
                                                                       less growth later, which means high levels of debt                                                                               money over the next decade to keep Eskom afloat.
                                                                       have a lasting impact on both realised and poten-                                                                                By March (the very next month) it became clear
                                                                       tial growth. As this happens, living standards fall.                                                                             that this wasn’t enough, and government front-
                                                                                                                                                                                                        loaded R13 billion of this year’s annual allocation
                                                                                                                                                                                                        to the entity. At the end of July, Finance Minister
                                                                                                                                                                                                        Tito Mboweni tabled a Special Appropriation
Figure 2
                                                                                                                                                                                                        Bill, allocating an additional R26 billion transfer
GOVERNMENT DEBT, PERCENTAGE OF GDP
                                                                                                                                                                                                        to Eskom in the current fiscal year, and a further
       %
                                                                                                                                                                                                        R33 billion in 2020/2021. Despite promises that
 70
                                                                                                                                                                                                        these transfers would be made on condition that
 60                                                                                                                                                                                                     certain reforms be met, further details have not
                                                                                                                                                                                                        been forthcoming.
 50

 40
                                                                                                                                                                                                        Eskom’s financial and operational fragility really
                                                                                                                                                                                                        emerged at the start of Ramaphosa’s presidency
 30                                                                                                                                                                                                     in mid-2018. While the causes pre-date this, the
                                                                                                                                                                                                        situation has deteriorated visibly since, and the
 20
                                                                                                                                                                                                        complex nature of Eskom’s challenges has become
 10                                                                                                                                                                                                     more apparent:

  0
                                                                                                                                                                                                        1. Eskom is insolvent. Years of corruption, coupled
        2000/1

                 2001/2

                          2002/3

                                   2003/4

                                            2004/5

                                                     2005/6

                                                              2006/7

                                                                       2007/8

                                                                                2008/9

                                                                                         2009/10

                                                                                                   2010/11

                                                                                                             2011/12

                                                                                                                       2012/13

                                                                                                                                 2013/14

                                                                                                                                           2014 /15

                                                                                                                                                      2015/16

                                                                                                                                                                2016/17

                                                                                                                                                                          2017/18

                                                                                                                                                                                    2018/19

                                                                                                                                                                                              2019/20

                                                                                                                                                                                                           with a failure to invest in adequate capacity,
                                                                                                                                                                                                           and falling revenues have resulted in a debt
            South Africa’s gross debt, % of GDP                                                    Eskom guarantees, % of GDP                                                                              stock of R420 billion, and its revenues cannot
            Emerging markets’ gross debt, % of GDP                                                                                                                                                         meet the combined cost of servicing this debt
Source: South African Reserve Bank                                                                                                                                                                         and its operating expenses. By our estimates,
                                                                                                                                                                                                           without dramatic remedial intervention, Eskom
                                                                                                                                                                                                           will need direct financial assistance (taxpayers’
                                                                                                                                                                                                           transfers) for the foreseeable future.
Figure 3
GDP PER CAPITA                                                                                                                                                                                          2. The remedy requires difficult decisions. At
       %, year on year                                                                                                                                                                                     group level, recurrent expenditure (wages and
 20                                                                                                                                                                                                        debt service) continues to rise, and there is
                                                                                                                                                                                                           little appetite to reduce these costs. To add to
 15
                                                                                                                                                                                                           these woes, revenue is constrained by a shrink-
                                                                                                                                                                                                           ing customer base and chronic non-payment.

 10
                                                                                                                                                                                                        3. Eskom as an entity is an anachronism and
                                                                                                                                                                                                           needs to be restructured. This includes verti-
  5                                                                                                                                                                                                        cal disintegration, higher tariffs, and, impor-
                                                                                                                                                                                                           tantly, a new way of managing its excessive
                                                                                                                                                                                                           debt burden.
  0

                                                                                                                                                                                                        4. Eskom is unable to meet the energy needs of a
  -5                                                                                                                                                                                                       growing economy.
       2000                        2003                       2006                       2009                          2012                           2015                          2018

            GDP per capita, constant                                      GDP per capita, nominal                                                                                                       5. It isn’t clear that decision makers realise the
Source: IMF                                                                                                                                                                                                urgency with which this needs to be addressed.

14               COROSPONDENT
Figure 4                                                                                           moderation in China, compounded by falling
GLOBAL POLICY RATES                                                                                global trade volumes and the escalation in trade
       %                                                                                           tensions between the US and China. At the same
 2.5                                                                                               time, political tensions remain high. China-
                                                                                                   related protests in Hong Kong are ongoing, with
2.0                                                                                                little obvious source of diffusion; the Middle East
                                                                                                   remains a source of great potential unrest; and
 1.5
                                                                                                   the UK’s EU exit date is fast approaching, with
 1.0                                                                                               its own fraught political uncertainty. And, US
                                                                                                   President Donald Trump continues to be a dis-
0.5                                                                                                ruptor across a range of issues and geographies.

  0
                                                                                                   Central banks in the US, the EU, Japan and across
-0.5
                                                                                                   emerging markets have increased monetary
  Jan 16         Jul 16       Jan 17      Jul 17     Jan 18        Jul 18     Jan 19      Jul 19   support for their economies in response to this
           Australia      European Central Bank    Bank of Japan        Bank of England
                                                                                                   weakness and the uncertainty it poses to domes-
           US Federal Reserve Board
                                                                                                   tic growth. At the September news conference
                                                                                                   of the Federal Open Market Committee, Jerome
Source: Haver
                                                                                                   Powell, Chairman of the Federal Reserve Board,
                                                                                                   reiterated that the decision to cut the fund’s rate
                                                                                                   for the second time this year, despite decent
                                                                                                   growth in the US, was due to a weaker external
                                         Probably the most important parallel require-             environment, with growing risk and inflation per-
                                         ments for stability are a detailed (and agreed)           sistently below the 2% target.
                                         turnaround strategy for a disintegrated entity,
                                         and what Eskom and the government propose                 Similarly, outgoing European Central Bank
                                         to do with its debt. The former is up to the              President, Mario Draghi, announced not only a
                                         Department of Public Enterprises, the President           deposit rate reduction into deeper negative ter-
                                         and stakeholders; the latter requires that these          ritory, but open-ended direct support for asset
                                         agree and then negotiate with the bondholders.            markets in the form of a renewed targeted longer-
                                         At this late stage, while there has clearly been a        term refinancing operation. Japan’s stance is also
                                         lot of consultation, there seems to be little agree-      accommodative and “more keen to ease than
                                         ment. As we head into the tabling of the Medium-          before since overseas risks are heightening” (see
                                         Term Budget Policy Statement in October, we               Figure 4).
                                         have yet to see any evidence of real progress.
                                                                                                   Ultimately, the outlook for global growth in
                                         This means that there is real risk that Minister          coming quarters will be in the balance between
                                         Mboweni will table a policy statement with a              supportive monetary and fiscal policies for rea-
                                         fiscal position considerably worse than was esti-         sonably solid domestic demand, and an ongoing
                                         mated at the time of the February National                deterioration and heightened escalation in
                                         Budget (which is widely expected), but with few           uncertainty playing out in global trade.
                                         compensating measures. In this case, domestic
                                         debt to GDP will not only rise above 60% this             For now, we expect global growth to stabilise at
                                         year, but is also unlikely to reflect the necessary       weaker levels as policy support matures, acknow-
                                         conditions for stabilisation. In this dim light,          ledging the pronounced uncertainty.
                                         growth prospects are further diminished. And
                                         there is little relief in looking to the rest of the      For South Africa, there is much to be gained
                                         world to find it. This time, there is cold comfort to     from clarified policy direction, despite rising
                                         be found abroad.                                          global headwinds. In particular, decisive action
                                                                                                   on Eskom could go a long way to restoring confi-
                                         A WORLD AT SEA                                            dence among businesses and consumers. Recent
                                         South Africa is a small, open economy operat-             data from the Bureau for Economic Research con-
                                         ing in a very uncertain world. More than ever,            firmed that confidence among these key growth
                                         political signalling is driving asset markets and         drivers hit multi-decade lows in the third quarter
                                         economic policy in a global environment that is           of 2019, inhibiting consumption and capex deci-
                                         more disconnected than it has ever been in the            sions. With few easy short-term drivers of growth
                                         post-war period. Across economies, growth has             available, restoring confidence is key to the start
                                         decelerated since late-2018, owing mostly to              of any growth recovery. +

                                                                                                                           TRUST IS EARNED™        15
S T O C K A N A LY S I S

     Next-generation
     entertainment
     Cable operators leading US broadband
     internet momentum

     By C H R I S C H E E T H A M

                                      The TV shift from                                                                Broadband is now the
          THE                                                      The average US          Broadband internet
                                     linear to OTT is still                                                            primary product sold
                                                                   cable household         will be the backbone
         QUICK                         nascent in the US
                                                                    consumes over          of next-generation
                                                                                                                        by cable operators,
         TAKE                       and momentum will                                                                   while pay TV is less
                                                                  250GB per month             entertainment
                                           increase                                                                          relevant

                                    IN THE LAST edition of Corospondent, we               entertainment, the importance of which will
                                    discussed how consumer habits have evolved            continue to rise, and our view is that the cable
                                    with respect to entertainment and how viewer-         investment case is misunderstood and under-
                                    ship continues to shift away from traditional live    appreciated by the market.
                                    television to on-demand video streamed over
                                    the internet. The transition of entertainment and     As reflected in Figure 1 on page 17, these strong
     Chris is a global              communication to online is still in its infancy and   structural trends have resulted in a rapid increase
   developed markets                we expect the trend to continue. Against this back-   in data demand, with the average US cable
    analyst with more
   than eight years of              drop, we believe cable operators are well placed      household consuming over 250 Gigabytes (GB) of
 investment experience.             as the leading providers of broadband internet in     data per month, while households that don’t sub-
                                    the US.                                               scribe to traditional pay TV use roughly double
                                                                                          that.
                                    Both Charter Communications and Altice USA
                                    have materially outperformed the market year          This is a clear illustration that cord cutters
                                    to date, up around 45% and 70%, respectively,         consume more data as video content is streamed
                                    and we continue to hold both as core positions        via the likes of Netflix and other over-the-top
                                    in our active global equity portfolios. Although      (OTT) providers. Data consumption is only set
                                    the market has traditionally focused on cable’s       to increase further, with Altice USA disclosing
                                    declining pay-TV business, broadband internet is      that its most data-hungry homes (the top 10% of
                                    the primary product sold into the home. With the      users) consume one Terabyte of data per month
                                    strong growth in its customer base, broadband         and have 15 or more connected devices. In time,
                                    now contributes almost all of the free cash flow      it’s fair to expect this to become the norm as
                                    generated by the cable opera­tors. As consumers       streaming-use cases expand to include higher-
                                    continue to shift to streamed video, broadband        quality video as well as connected home and
                                    will become the backbone of next-generation           gaming applications.

16        COROSPONDENT
Figure 1                                                                                               The cable-use case soon shifted from broad-
AVERAGE DATA USAGE PER HOUSEHOLD PER MONTH                                                             cast to pay TV, leading to the establishment of
                                                                                                       well-known channels such as ESPN and HBO.
      GB
300
                                                                                           Average     For many subsequent years, cable was primar-
                                                                                          data usage
                                                                                                       ily focused on selling a traditional bundle of
250                                                                                                    pay-TV channels, as DSTV does today. Cable is a
                               Data usage
                               growth p.a.                                                             scale game, and years of footprint consolidation
                                    c.25%
200                                                                                                    means that the three major listed US operators
                                                                                                       – Charter Communications, Comcast and Altice
150
                                                                                                       USA – now pass 51 million, 58 million and nine
                                                                                                       million homes or businesses, respectively!
100

                                                                                                       THE SHIFT TO BROADBAND
 50
                                                                                                       It’s no secret that traditional, ‘linear’ TV sub-
  0                                                                                                    scriber numbers are declining, and we expect this
 Q4 2013                 Q4 2014            Q4 2015         Q4 2016          Q4 2017        Q4 2018    to continue. Cable operators have repositioned
Source: Altice USA 2018 results presentation                                                           themselves with broadband as the primary
                                                                                                       focus, enabled by extensive plant upgrades that
                                                                                                       started at the turn of the century and continue
                                                                                                       to this day.

                                             WHAT IS CABLE?                                            Much of the original footprint has been replaced
                                             Cable was initially conceived to bring free broad-        with fibre, and networks have been digitised
                                             cast television to mountainous areas unable               and upgraded, resulting in speeds of one
                                             to receive adequate signal through the air via            Gigabit per second (Gbps) being readily avail-
                                             antenna systems. A cable system can be thought            able. Operators have already identified a real-
                                             of as an electricity grid transmitting data from          istic, low-cost path to 10Gbps.
                                             one point to another, and at its core consists
                                             of a mix of copper and fibre transmission lines.          As a result of its well-established position and
                                             Today, most US homes and businesses have                  advantaged infrastructure, cable has contin-
                                             cable running past them, dug into the pavement            ued to take share of the US broadband market
                                             decades before, and cable has both an advan-              and today serves two thirds of all broadband-
                                             taged infrastructure and natural monopoly in              connected homes. Most US homes are passed by
                                             most US towns and cities. The rapid construction          both cable and a telco line offering DSL (think
                                             of cable infrastructure started in the mid-50s and        Telkom); the latter offers insufficient speeds and
                                             was followed by decades of footprint expansion            continues to lose market share as data consump-
                                             and consolidation led by players such as the              tion explodes.
                                             legendary John Malone.
                                                                                                       New competition is unlikely due to the cost of
                                                                                                       laying fibre and the questionable return on
                                                                                                       investment in doing so because of the difficulty
Figure 2
                                                                                                       in prying customers away from entrenched pro-
CHARTER: STEADY GROWTH IN BROADBAND SUBSCRIBERS IN THE US                                              viders. Much of this cable was originally put
      million                                                                                          down decades ago and it’s often near impossible
 30
                                                                                         28.2
                                                                                                       to overbuild this infrastructure from a town plan-
                                                                           27.4
                                                            26.6                                       ning or regulatory perspective. Today, the pro-
                                              25.8
 25        23.6
                             24.8
                                                                                                       vision of broadband internet is cable’s primary
                                                                                                       cash generator.
 20
                                                                                                       WHAT ABOUT CABLE’S TRADITIONAL VIDEO
                  16.1              15.7             15.2                                              BUSINESS?
                                                                    14.7
 15                                                                               14.2
                                                                                                13.7
                                                                                                       Figure 2 illustrates that while broadband is now
                                                                                                       clearly the primary service being sold into the
 10                                                                                                    home, video still comprises a significant pro-
                                                                                                       portion of cable operator revenue, although
  5                                                                                                    video users continue to decline by 2% to 3%
            2018              2019             2020           2021          2022          2023
                                                                                                       per year. The video backdrop is one of intense
           Broadband subscribers                Video subscribers                                      competition, with traditional distributors like
Source: Coronation estimates                                                                           cable and satellite losing out to OTT platforms.

                                                                                                                               TRUST IS EARNED™        17
Furthermore, new services from deep-pocketed                          Table 1
companies such as Disney and Apple are due to
                                                                      CONTRIBUTION TO REVENUE, EBITDA AND FREE CASH FLOW
launch imminently.
                                                                                                                                 Altice USA   Charter
This fight for eyeballs is driving content costs
                                                                      Revenue contribution
up, with timeless shows like Seinfeld and Friends
recently costing around the $400 million to                            Video                                                       42%         38%

$500 million mark for new multiyear carriage                           Broadband, business services and other                      58%         62%
deals, according to press reports, while Apple is
                                                                      EBITDA contribution
reportedly spending over $15 million an episode
on The Morning Show starring Jennifer Aniston                          Video                                                       17%         8%
and Reese Witherspoon.                                                 Broadband, business services and other                      83%         92%

IS IT VIDEO’S TURN TO DIE?                                            Estimated 2020 free cash flow yield                            9%         7%

What does this challenging backdrop mean for                          Sources: Published financials and Coronation estimates
cable operators?

Table 1 clearly shows that video’s contribution to
cable is smaller than the revenue headline sug-
gests. Due to significant programming costs paid       moves to leverage its primary broadband rela-
to channel and content owners, video is a very         tionship into being the aggregator of choice in
low-margin business and is estimated to contri-        the modern world of streamed video, with set-top
bute under 20% of total earnings before interest,      boxes now including OTT options in an easily
tax, depreciation and amortisation (EBITDA) for        searchable format.
the likes of Charter and Altice USA. Content costs
are paid on a per-subscriber basis, and so natu-       WHAT ARE THE KEY RISKS TO CONSIDER?
rally decrease in line with declines in the video      Could technological change challenge cable’s
subscriber base, smoothing the overall impact of       advantage in the provision of broadband inter-
video’s downward trajectory.                           net? We continue to monitor global develop-
                                                       ments around 5G and its potential to allow
Furthermore, video contributes only marginal free      mobile operators to play a larger role in home
cash flow to cable operators due to the high cost      broadband. 5G is the next generation of radio
of putting set-top boxes into homes. We believe        network technology and should bring signifi-
that the current pace of video subscriber declines     cant benefits to the average mobile phone user,
is very manageable, and that new cable initia-         including higher speeds and increased capacity.
tives, such as the launch of aggressively-priced       US telecom giants like Verizon and T-Mobile have
bundled mobile plans, will bring benefits such as      different strategies, but both envisage using 5G
broadband churn reduction, filling the gap that        technology to provide home broadband. While
video once filled. While video is still an important   we are not dismissive of this threat, the amount of
element of the cable triple-play bundle, its contri-   data consumed by the average US household and
bution to free cash flow and therefore company         the growth thereof make it difficult for mobile
valuation must not be overestimated.                   technology to compete with fixed alternatives
                                                       such as cable and fibre.
TRADITIONAL VIDEO’S LOSS IS BROADBAND’S
GAIN                                                   The average US mobile customer uses under 10GB
While content owners slug it out for eyeballs and      of data per month; even a tenfold increase in
continue to write bigger cheques for new shows,        mobile capacity – the upper range suggested by
a fast and consistent internet connection remains      industry experts – will struggle to compete with
paramount to delivering the required streaming         the average cable household consuming over
experience. It’s estimated that over 75% of inter-     250GB per month and growing rapidly. 5G will
net traffic is video use, which clearly illustrates    also allow the use of previously untapped spec-
how a traditional video subscriber loss is broad-      trum1 bands, and certain use cases will enable
band’s gain.                                           high-capacity home broadband solutions in
                                                       limited circumstances. This high-frequency signal
As the traditional television bundle is replaced       does not travel far and therefore requires more
with skinnier online options and individual apps,      towers (connected with fibre) near to the end-
a complicated experience arises for consum-
ers used to having all their video needs met in        1
                                                           Spectrum refers to a range of radio waves used by telecommunication
one place. In response, cable is making the right          providers for wireless communication purposes.

18     COROSPONDENT
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