Nedbank Group Ltd., South Africa's fourth-largest bank by assets, issued a bleak assessment of the country's economy in the preface to its first half results, warning that "economic and fiscal deterioration" could lead to a sovereign credit rating downgrade.
Yet lenders remain resilient and are attractive investments, according to analysts, despite a sagging economy, increasing credit losses and pressure on margins.
South Africa has the largest banking sector on the continent, with combined assets of $482.71 billion, according to S&P Global Market Intelligence data. It is one of Africa's powerhouses but President Cyril Ramaphosa faces numerous challenges, not least an unemployment rate of 29%, according to government statistics. The country is beset with other macroeconomic problems as its economy shrank 3.1% in the first quarter of 2019 versus the preceding three months, while year on year it was unchanged. The second quarter was better, with an uptick of 3.1% quarter on quarter and 0.9% year on year.
The economic malaise is not a recent problem. S&P Global Ratings, Fitch Ratings and Moody's all downgraded the country's credit ratings in 2017 and another downgrade would come "at great cost to all South Africans as a result of higher inflation and higher interest rates, as well as lower growth and lower levels of employment," Nedbank said.

'Earnings growth is quite a feat'
Although a downgrade is unlikely this year, with Moody's warning of downside risks from 2020 onward, economic conditions remain challenging. Yet the "big four" banks still managed to grow their earnings in the first half.
Nedbank's headline earnings in the first six months of 2019 expanded 2.6% to 6.87 billion rand. The country's largest lender, Standard Bank Group Ltd., reported a 6% increase, Absa Group Ltd.'s rose 4.5% and FirstRand Ltd.'s headline earnings were up 5.2%.
"It's a very low growth environment for banks in which they've had to manage costs judiciously," said Patrice Rassou, head of equities at Sanlam Investment Management in Cape Town.
"Banks have also faced a fairly hefty increase in credit losses, so being able to deliver earnings growth is quite a feat, especially when you consider how much pressure companies in other sectors have come under. Banks have displayed a greater resilience," he said.

Nedbank's credit impairments jumped 40.1% to 2.54 billion rand at June 30, 2019, versus the prior year, with the bank highlighting stresses in multiple sectors including construction, retail and agriculture, plus some state-owned enterprises.
"Private sector credit extension is weak, both in the household and business sectors. Private sector confidence is low, with companies waiting for evidence of an uptick in economic growth before borrowing further," said Adrian Saville, CEO of Cannon Asset Managers in Johannesburg. "The companies that want to increase their borrowing tend to be strained businesses rather than those who need credit to expand."
Cash-strapped arms manufacturer Denel SOC Ltd. is one such example. The state-owned firm sold a 50 million rand two-year bond in August, despite an investigation into its former management team for alleged fraud. State-owned utility Eskom Holdings SOC Ltd., meanwhile, is seeking a government bailout as it struggles under the weight of debts totaling around $30 billion.
"It's tough to talk about potential positive surprises, but the most plausible would be if state-owned enterprises find a stronger footing," said Rassou.
Is a downgrade priced in?
Nedbank blamed the slow progress of state reforms for a deepening slump in fixed-investment activity as companies and government institutions reduced spending, while also highlighting lower consumer spending that it said was partly caused by rising unemployment and higher fuel prices.
"It could be argued that a downgrade is already factored into South Africa's bond prices, but there's little doubt that an announcement of a credit downgrade would unsettle the market," said Saville.
Absa and Nedbank said their net interest margins fell 17 and 10 basis points respectively, although both also reported higher net interest income than in the prior-year period. Falling margins are due to stiffer competition for deposits, said Rassou, which is forcing banks to pay higher rates to savers.
"This margin pressure will continue — it's structural, with all banks trying to increase their deposit market share," Rassou said.
South Africa's banks may also seek further foreign expansion to offset lackluster performance at home and domestic problems.
"Regional markets are still relatively small compared with South Africa, so the business that banks find in these markets will be beneficial but it's not of a sufficient size to supplant or replace South Africa in terms of revenues," said Saville. "Nevertheless, there's renewed vigor, particularly at Absa, to expand into Africa."
'Attractive pricing territory'
In terms of valuations, Nedbank and Absa have price-to-earnings ratios of 9.0 and 9.4, respectively, while Standard Bank is at 11.8 and FirstRand's at 12.1, according to data from S&P Global Market Intelligence.
"From a valuations perspective, the pessimistic mood has put banks as an asset class into attractive pricing territory. This is an environment that makes banks a compelling investment option even if it's a tough market right now," Saville said.
"South Africa's banks are well-capitalized and well-run — their earnings are unlikely to deliver anything to get too excited about, but they're also likely to maintain their performance."
Jaap Meijer, managing director of research at Dubai's Arqaam Capital, described banks' profits as "quite solid," albeit helped by relatively high interest rates.
"Banking is a popular industry with investors, because other sectors are suffering a lot," said Meijer. There are few interesting stories in the market, so investors are overweight on the banks due to a lack of alternatives."
As of Sept. 16, US$1 was equivalent to 14.61 South African rand.
