SAFE FOR NOW, BUT RATINGS RISK REMAINS
DAVE MOHR & IZAK ODENDAAL, OLD MUTUAL MULTI-MANAGERS2
After a round of credit ratings reviews by the three major ratings agencies,
South African government bonds will remain part of the Citigroup World
Government Bond Index (WGBI), but only just. The immediate risk of
forced selling as a result of being excluded from this index has therefore
abated for the time being. While each of the agencies has its own
specific methodology for assessing creditworthiness, the common thread
through all three reviews is that economic growth is too low, leading to
pressure on Government’s finances, worsened by underperforming State
Owned Enterprises (SOEs).
Fitch kicked off the much anticipated (or dreaded) round of ratings reviews
by maintaining South Africa’s BB+ rating with a stable outlook. Fitch
noted that while the fiscal outlook weakened, the ship could be steadied
after the ANC’s elective conference. Failure to implement credible fiscal
consolidation measures in February’s Budget could see the outlook
changed to negative. To change the outlook to positive, the first step
to regaining investment grade status requires improving governance
(including of SOEs), reducing the budget deficit and, crucially, accelerating
DEEPER INTO JUNK STATUS
S&P Global Ratings were not so kind, cutting both South Africa’s local
and foreign currency ratings by one notch. It means the local rating
drops to BB+ and is no longer investment grade, as expected.
The foreign rating downgrade was unexpected, and places South Africa
on par with Turkey and Brazil at BB, two notches into so-called junk
status. Importantly though, S&P has a stable outlook on both local and
foreign currency ratings, implying that the worst is over. Unless there
is a further substantial deterioration in governance, debt metrics or growth,
there is no need for further downgrades as the rating already reflects
the current reality.
MOODY’S ON HOLD
Moody’s decision was therefore key. Moody’s placed South Africa’s
rating on negative watch, which means the next move is a downgrade.
But the rating for both local and foreign currency bonds remains investment
grade at Baa3, and therefore the local bonds still qualify for inclusion
into the WGBI. Moody’s will wait to see whether Government announces
credible fiscal consolidation measures and economic reforms in the
February budget. Failure to do so will lead to a downgrade.
WHAT ARE THE IMPLICATIONS?
The rand briefly lost around 2% against the dollar after the announcement,
but the overall market impact of the downgrades was limited as markets
respond to the factors that give rise to ratings changes – the growth and
fiscal outlook – long before the ratings agencies do. Much of the bad
news, including the downgrades, have been priced in. In terms of the
local economy, the main impact is negative sentiment. There has been
an unusually high level of attention given to what used to be a fairly
arcane corner of finance and South Africans have spent the better part
of the past two years worrying when the sword will drop (and we will
have to wait a few months more). There is no doubt that this has damaged
business and consumer confidence. But the downgrades have also
played a role in keeping interest rates higher than they need to be.
Ahead of the ratings reviews, the Reserve Bank’s Monetary Policy
Committee (MPC) kept the repo rate on hold as widely expected.
The Reserve Bank has also for long been concerned that potential capital
outflows due to downgrades could cause a sell-off in the rand. The firmer
global oil price has also emerged as a factor that will not only raise the
domestic inflation profile somewhat, but could also lift global inflation,
prompting faster interest rate increases in other countries, in turn causing
capital to leave South Africa.
The Reserve Bank lifted its inflation forecast somewhat, but the extent of
the increases is limited by conservative assumptions on electricity tariff
increases and global oil prices. Inflation is expected to remain below,
but close to the 6% upper end of the target range throughout 2018 and
average 5.5% in 2019.
Headline consumer inflation fell to 4.8% year-on-year in October from
5.1% in September. Food inflation has moderated to 5.3% from 11%
at the start of the year. Petrol inflation was 10.8% in October. It will dip
to around 8% in November due to base effects, but because of the
current average under-recovery of 70 cents per litre, petrol inflation could
rise to 15% in December.
CORE INFLATION AT FIVE-YEAR LOW
Core inflation – excluding food and fuel prices – fell to 4.5%, the lowest
level in five years. Over this five year-period, core inflation did not exceed
6%.The big swings in headline inflation over this period were mainly
caused by food and oil price volatility, worsened by the big fluctuations
in the exchange rate. But the fairly steady path of core inflation indicates
a lack of underlying inflationary pressures, partly because of a weak
The other notable driver of inflation over the past five years has been
electricity tariffs, rising on average 8% (13% over the past ten years)
although the pace of increase has slowed to 2.2%. But electricity tariffs
are not linked to domestic demand, and firms and consumers have very
few other options. It can therefore be considered to be closer to a tax
than a price increase. What the SARB is concerned about is whether
there are second-round effects of firms hiking their output prices in response
to higher tariffs. There is little evidence of this. Nersa is expected to make
an announcement on Eskom’s application for a 20% tariff increase
in early December.
The Reserve Bank’s view of economic growth is “subdued but positive”.
The 2017 GDP growth forecast was bumped up a touch from 0.6% to
0.7%. From this depressed level, real growth is expected to almost
double to 1.2% next year and 1.5% in 2019. These numbers are similar
to the three ratings agencies’ forecasts. The SARB’s composite leading
indicator increased further in September, confirming that growth is picking
For the first time, the Reserve Bank also published a forecast of interest
rates, generated by its economic model. It suggests three 25 basis points
increases in the next two years. Importantly, this is what the forecast
model suggests the MPC should do, not what the MPC plans on doing
or believes it should do. Interest rate decisions are based on incoming
data and therefore the MPC meets every two months to assess the latest
numbers and how they impact the outlook. However, the general public
is unlikely to understand this distinction, and likely to believe that the
SARB is signalling higher rates, and adjust behaviour accordingly.
This could achieve the aim of higher interest rates, without having to
actually hike rates. But unfortunately it does mean that rate cuts are all
but ruled out, despite inflation expected to be within the target range
over the next few years.
THE KINDNESS OF STRANGERS
Given our domestic frailties, South Africa continues to rely on the kindness
of strangers. Strong global growth could help lift our own growth rate
above the anaemic levels currently predicted. Crucially, demand for high
yielding emerging market assets still outweighs domestic factors such as
politics, fiscal risks and downgrades. Within our peer group, South
Africa has gone from one of the best-rated to the worst-rated in terms
of the spread (extra yield) investors demand over US bonds. But as long
as this demand persists – which in turn will depend greatly on the path
of interest rate hikes in the US, global growth, and investor risk appetite
– South Africa should benefit from capital inflows, irrespective of its rating.
RESPONDING TO DOWNGRADES
The muted market response to the downgrade reiterates that investors
should not over-react to negative news headlines. Often, as is the case
with the ratings changes too, the bad news is already reflected in market
prices. On Monday morning following the weekend’s ratings announcements,
bond yields were lower and the rand had strengthened. Investors’ longterm
returns often suffer greater damage from knee-jerk responses to such
events, than from the events themselves. However, if there were to be
further negative surprises, one would expect the rand to come under
pressure. Our strategies currently have more than 50% exposure to randhedges
directly and indirectly and should benefit from currency weakness.
November 28, 2017
The Wealth Room