Spend less, build up and preserve your savings, diversify your investments to reduce risk and stick to your long-term investment goals. This is the advice from two investment professionals on how to weather the extreme market volatility that could occur if the country’s sovereign (government) debt is downgraded to “junk” status.
They were addressing a meeting of the Actuarial Society of South Africa this week on the possible consequences of credit rating agency Standard & Poor’s (S&P) downgrading South Africa’s debt from its current investment-grade rating of BBB- to a non-investment grade (or junk) rating of BB+.
International institutional investors, such as retirement funds, regard S&P’s ratings as the most important, and it is likely that S&P will be the first ratings agency to announce a downgrade.
Lesiba Mothata, the chief economist at Investment Solutions, and David Knee, the head of fixed income at Prudential Investment Managers, say the downgrade could take place in June or as late as December.
The main consequences of a downgrade will be:
* Large foreign institutional investors will either not invest in South Africa or withdraw their existing investments. This will be exacerbated by South African companies investing abroad rather than locally.
* It will cost the government and corporates more to borrow money, which will leave less to spend on job creation and meeting other demands. For every rand in tax paid, the government will have to spend about 12 cents to pay interest on debt.
Mothata and Knee say the impact of a downgrade on your long-term financial well-being will depend on how the government and the country as a whole responds to it.
The rand and investment markets have already discounted most of the consequences of a possible downgrade, they say.
Knee says that, if anything, there has been an over-reaction to the possibility of a downgrade.
The Big Mac Index is an informal measure of the purchasing power parity between currencies and is a test of the extent to which exchange rates result in goods costing the same in different countries. The index takes its name from the Big Mac hamburger sold at McDonald’s restaurants. Knee says that, according to the index, South Africa has the second-cheapest Big Mac in the world. A Big Mac is 40 percent cheaper here than in the United States.
Mothata says although the rand has strengthened recently, it remains one of the most under-valued currencies in the world.
Mothata and Knee say the big question is how the government will respond to a downgrade. If it puts off making difficult decisions about restructuring the economy, South Africa could see further downgrades, which will make the situation worse for consumers.
Knee says about one million South Africans lost their jobs as a result of the global financial meltdown in 2008. In a worst-case scenario, a long recovery to investment-grade status could see the economy moving into recession, with serious consequences for employment.
In many countries that have been downgraded to junk, the investment markets recovered, because investors over-reacted before the downgrade, he says. In many cases, there was a mild bear market before a downgrade and then equity markets moved sideways for about 12 months.
Knee and Mothata say South Africa is not solely responsible for the problems that could result in a downgrade. The main factors include the consequences of the 2008 financial crisis and the fall in commodity prices, which is a result of over-investment during the commodity price boom that ended in 2007.
Mothata says all emerging-market countries have been affected by the slump in commodity prices; about US$1.1 trillion flowed out of these countries between the fourth quarter of 2014 and the third quarter of 2015.
Countries that have been downgraded, but which implemented painful policy changes, have recovered their investment-grade status quickly, he says. For example, South Korea, which was downgraded to junk in December 1997, took corrective action quickly and recovered its investment grade within a year. But Colombia, which was reduced to junk status in September 1999, took 12 years to get back to investment-grade status, because it did not implement the necessary reforms.
Mothata says that, whether or not South Africa is downgraded, your best strategy is to diversify your investments across asset classes and invest for the long term.
Knee says that although junk status will have a significant impact on the economy, this does not mean you should not invest in bonds.
The first level of junk status, BB+, means the probability of the government defaulting on its loan repayments is only about five percent. The lowest rating, CCC, means there is a 50-percent chance of default, he says.
South African bonds are already under-valued and provide a sound real (after-inflation) return of three percent, and this could improve, Knee says.
A ratings downgrade could result in extreme market volatility, particularly if the government does not respond appropriately. Risk-averse investors could consider enhanced cash funds, which may provide higher yields than other asset classes, such as bonds, while limiting capital risk, Knee says.
Equity investments should be made with an investment horizon of at least five years, while bond investments should have a horizon of three years, he says.