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Downgraded Countries: Top emerging-market performers last year.

Business Report

THE RECENT sovereign rating downgrade makes South Africa the third Brics nation to have received a junk credit assessment from Standard and Poor’s (S&P) Global Ratings. However, before making any impulsive investment decisions, it is important to note that Brazil and Russia - the other two countries to have experienced downgrades of this nature - were the top emerging-market performers last year.

A downgrade can present investors, particularly those who invest in emerging markets, with attractive buying opportunities.

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The Standard & Poor's building is seen in New York. Picture: Jessica Rinaldi

When a country is downgraded, both its stock market and its currency tend to sell off significantly.

Typically, the selling is largely indiscriminate and, as such, is likely to include some high-quality shares, which results in some very attractive investment opportunities.

Both S&P and Moody’s downgraded Brazil to sub-investment grade in 2015 at the height of political unrest over a massive corruption scandal that ultimately resulted in the impeachment of then president Dilma Rousseff.

This downgrade led to major capital outflows and worsened Brazil’s growth outlook, reducing its gross domestic product to -3.5percent last year. Despite this, Brazil was the best-performing emerging market last year, returning 66percent in dollar terms.

Slight sell-off

Although there has been a slight sell-off of South African bonds and equities following the downgrades - along with an initial weakening of the rand - the extent of this has been far less than what occurred in Brazil.

At this point, South Africa is not displaying the effects typically associated with a downgrade; in fact, the rand has moved back to its long-term average. However, this could change, depending on Moody’s looming rating decision.

Concerning the seemingly unaffected currency, the rand’s strength of late is a function of dollar weakness. The rand’s recovery has very little to do with South Africa, but is related to the weakening of the dollar against all emerging-market currencies.

What this all means from an investment point of view is that there are not massive buying opportunities in South Africa.

Diversification

South Africa is currently not a screaming buy, which raises the question of how best to diversify away from South Africa.

Typically, global equity funds would be an obvious choice. However, a large weighting of these funds is in the US market, which, on a risk-adjusted basis, does not offer investors attractive growth prospects.

As such, a better option for clients looking to diversify away from South Africa are global emerging-market funds.

On a risk-adjusted basis, emerging markets are trading at a far lower price-earning (PE) multiple than US and global equities, which means that global emerging-market funds come at a lower price, with the opportunity for greater returns.

This is largely because the demographics in emerging markets are characterised by a booming middle class and growing consumer sector, driving profit growth going forward.

Superior returns

In light of this, while market sentiment around South Africa remains uncertain for the time being, there is undoubtedly potential for superior returns to be made in other emerging markets.

Based on GDP growth, increasing consumption, attractive demographics and the starting valuation, emerging markets appear to offer great potential on a three- to five-year basis.

The Old Mutual Global Emerging Market Fund’s ability to pick the right emerging-market stocks from a bottom-up perspective adds additional value. This has resulted in the fund being ranked in the top 10 globally over the past four years.


Feroz Basa is a joint fund manager of the Old Mutual Global Emerging Markets Fund at Old Mutual Investment Group.

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