South Africa experienced tremors of the seismic, political and economic kind over the past two weeks. A few days after the midnight Cabinet reshuffle in which Finance Minister Pravin Gordhan and his deputy were replaced, S&P Global Ratings cut South Africa's sovereign credit ratings. Foreign currency bonds are now rated BB+, while local currency bonds are still investment grade at BBB-. The outlook on both ratings is negative. Fitch followed suit, cutting both foreign and local currency bonds to BB+, but with a stable outlook. Moody's has postponed its ratings announcement by one to two months. In other words, the much-feared drop to junk status has finally arrived. This is undoubtedly a negative development for South Africa, but there are also several misconceptions around the implications of a ratings downgrade.
No catastrophic market reaction
Let's first assess the market's reaction. The 10-year government bond yield had rallied to a 16-month low of 8.3% two weeks ago, but jumped to 9% post the downgrades (bond yields move inversely with prices). However, this is pretty much where it started the year. The year-to-date return of the All Bond Index has been cut to 2%, but it is still the leading asset class available to domestic investors with an 11% return over the past 12 months.
The rand traded at R12.31 per dollar just before the news broke that Pravin Gordhan was recalled from his international roadshow. It stabilised around R13.80 per dollar by the end of a volatile week, a decline of more than 10%. However, given all the shocks, many would have feared a worse reaction. It is clear that a lot of political risk had already been priced into the rand and South Africa's bonds prior to the recent developments. At the same time, favourable global conditions have helped. The rand is still 9% stronger against the US dollar than a year ago and is flat year-to-date.
Local equities have held up well, with the JSE benefiting from the rand-hedge industrial heavyweights and resources. Interest rate-sensitive shares have predictably fallen. Banks in particular were hard hit, as S&P also downgraded local banks to bring their ratings in line with Government's ratings.
In summary, the market reaction was unpleasant, but within the range of volatility we've become accustomed to. A diversified portfolio would have performed reasonably well over this tumultuous period. The next question is around the longer-term outlook for investors and the local economy. There is obviously a great deal of uncertainty since, as the saying goes, in politics a week can be a lifetime.
Outlook for the rand depends on global factors
The rand has historically been driven by global factors - sentiment towards emerging markets, commodity prices, US monetary policy - while local factors cause volatility. Therefore it is as much about keeping an eye on developments in Washington and Beijing as on the Union Buildings. The minutes of the latest monetary policy meeting of the US Federal Reserve (the Fed) showed plans to start reducing the size of its balance sheet (all the bonds it bought in its quantitative easing programme) later this year by not replacing maturing securities. The timing is earlier than previously thought.
A weaker rand has benefits and costs. The main cost is through higher import prices. It is notable that despite the massive currency depreciation between 2011 and 2015, inflation remains subdued. At this stage, inflation is still set to decline due to food prices peaking and the rand firming up over the past year. The petrol price was cut by 24 cents per litre last week, even after the increase in the fuel levy. However, given the weaker rand and higher global oil price, this looks set to be reversed in May. Friday's US airstrikes on Syria pushed oil prices up even further. Syria is not an oil producer, but rising Middle Eastern tensions typically raise concerns of oil supply interruptions.
The advantage of a weak rand is that it supports export revenues and income from foreign investments. The typical local pension fund is more than 50% global these days, and could benefit from a weaker rand.
JSE well positioned to weather the storm
In terms of local equities, two things are worth pointing out. Firstly, the JSE All Share is a global index these days. Therefore it provides local investors with a great degree of currency diversification without having to utilise their offshore allowances. Secondly, the All Share has moved sideways for almost three years, while earnings growth is expected to pick up (driven largely by resources), resulting in a more attractive entry point. The JSE has been flat for 10 years in US dollars terms, illustrating how a weaker rand has benefited, and not hurt, the JSE from the point of view of local investors.
Despite South Africa's turbulent and often tragic political history, long-term investors in local equities have done well. The average annual real return since the 1960s is 8%. Since 1995, when South Africans were allowed to invest abroad, local equities have beaten global equities in rand terms by about 1% per year despite the sustained depreciation of the rand against the dollar over this period (the rand traded at R3.50 per dollar when exchange controls were first eased slightly in March 1995).
Outlook for bonds
Ratings matter for bonds, but are by no means the most important factor. The direction of fiscal policy is key. The new Finance Minister stated that fiscal policy will not change but he will have his work cut out for him to convince markets. Credibility takes time to build and can quickly be destroyed. The resignation of the highly regarded Director General of Treasury has added to the unease, but there is a deep pool of talent at Treasury. If investors lose faith in Government's commitment to the fiscal targets set out in the February Budget, bonds could come under pressure. In terms of potential forced selling (passive investors who track an index) of bonds, it should only become a major problem if South Africa loses its local currency investment grade status.
Expected inflation matters greatly to the bond market, since the fixed coupon payments can be eroded. The fact that the SA Reserve Bank (SARB) remains committed to its inflation target even in the face of a weak economy is positive for long-term bondholders. S&P still rates monetary policy independence as a sign of strength.
Lastly, the main driver of bond returns over time is simply the starting yield. For longer-dated bonds, these are not just high relative to history and to expected inflation, but also to what else is available in the world. Political and downgrade risks have largely been priced in. The local yield curve remains steep, with higher yields available in longer-date bonds than shorter-term yields.
Falling inflation and stronger currencies have seen the bond yields in Russia and Brazil decline to levels lower than prevailing prior to their respective recent downgrades to junk status. Other emerging market yields are also declining, counteracting some of the upward pressure on local yields.
A blow to confidence
Some of the more extreme post-downgrade commentary has warned that interest rates will shoot up. South Africa can experience an interest rate shock in three ways. Firstly, if the SARB hikes the repo rate, forcing banks to push up their lending rates. This is very unlikely, unless there is a dramatic deterioration in the inflation outlook, but the SARB is also unlikely to cut rates until the political uncertainty recedes. Secondly, banks can increase the spread over the prime rate they charge borrowers if their own funding comes under pressure. This will only apply to new loans, and also seems unlikely at this stage. Thirdly, a substantial increase in bond yields will increase Government's future borrowing cost, and by implication that of other large corporate and parastatal borrowers. This has so far not transpired, as discussed above.
The biggest immediate impact of the ratings downgrade is therefore likely to be on confidence. To invest or expand, businesses must feel confident about the future. Similarly, to make big ticket purchases, households need to feel financially secure. This is where psychology intersects with economics. Surveys confirm that business and consumer confidence was already at recession-like levels before the recent events. Businesses have therefore chosen to invest abroad instead of in the local economy. The ratings downgrade and uncertain political environment is likely to continue weighing on sentiment.
Profile's Financial Markets 2014/15 is the companion volume to this website.
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