South Africa back in junk territory
Dave Mohr & Izak Odendaal, Old Mutual Multi-Managers
Following last week’s dismissal of Finance Minister Pravin Gordhan and his deputy, S&P Global Ratings downgraded South Africa’s foreign currency credit rating to BB+, into speculative grade or so- called junk territory. The local currency rating was also downgraded but remains investment grade at BBB-. Around 90% of government borrowing is in local currency and there is little risk that the government will be shut out of capital markets, unable to borrow or maintain interest payments.
Risks to fiscal and growth outlook
S&P noted that President Zuma’s Cabinet reshuffle put South Africa’s fiscal and growth outlook at risk. It is particularly concerned about the government’s contingent liabilities that arise from its guarantees to State-Owned Enterprises. Both local and foreign currency ratings have a negative outlook, which means that there are risks of further downgrades unless there is more clarity on future fiscal policy.
S&P first granted South Africa an investment grade rating in February 2000. Moody’s is set to review South Africa’s rating this Friday. It is also likely to downgrade us, but currently rates South Africa two notches above junk status.
The immediate market response was a sell-off of around 2.5% in the rand against the dollar, while long bond yields rose to above 9%. The rand-dollar exchange rate and the government’s bond yields are well below their worst levels in the past 12 months. Local investors have braced themselves for a downgrade since President Zuma red former Finance Minister Nene in December 2015. Global markets have long priced South Africa as a junk status economy, with our credit default swaps (CDS) trading in the same region as BB-rated countries Brazil, Turkey and Russia and well above other BBB- countries.
The current global context is also favourable to South Africa. Emerging markets are back in favour due to better economic growth outlook, decent valuations and commodity prices have rebounded somewhat from bombed-out levels. The
US dollar also appears to have peaked, as only gradual interest rate hikes are expected from the US central bank.
The immediate impact on the domestic economy is likely to be negative as business and consumer confidence is likely to remain depressed. But a catastrophic currency or interest rate shock appears unlikely. However, the South African Reserve Bank will probably hold off on any interest rate cuts until there is less political uncertainty.
The downgrade is negative for South Africa, but life after junk is possible. Brazil was cut below investment grade by S&P in September 2015. Its bond yields have since declined substantially (meaning bond prices have risen) and its currency has appreciated. Brazil has bene ted from the same shift in global conditions. The global environment will probably remain more important than the evolving political situation in determining the outlook for local markets and the economy.
While it may feel safer fleeing to cash or taking all your assets overseas, such concentrated, fearful portfolios do not deliver the desired outcome over time.
Our Strategy Funds are well diversified, and have the maximum offshore allocation allowed by Regulation 28. This portion of the portfolio bene ts from a weaker rand. A weaker rand also bene ts more than half of the JSE, so our local equity allocation also offers substantial currency diversification. On the other hand, interest rate sensitive assets such as bonds and property should bene t from declining inflation, despite being knocked by the recent events. Bonds in particular have long priced a lot of negative news. The future is always uncertain, and therefore appropriate diversification is crucial and our Strategy Funds are well positioned.
April 4, 2017
The Wealth Room