JOHANNESBURG - How much of the cut to junk-status are already priced into South African financial markets?
South African investors are fretting about the potential damage that may be caused to their savings by a cut in credit rating of South Africa’s debt to junk or speculative grade by Moody’s soon. Such a cut will see South Africa exiting major global bond index trackers and a massive amount of South African government bonds are likely to hit financial markets, looking for new buyers of the bonds.
The big question at this stage is how much of the well-telegraphed cut to junk-status are already priced into South African financial markets? The three major South African markets are South African government bonds, South African equities and the external value of the rand.
We are all aware that global bond yield curves worldwide moved lower over the past 18 months as government bonds priced in slower economic growth. Emerging market groupings such as BRICS (Brazil, Russia, India, China and South Africa) were no exception given their respective credit ratings.
On 7 November 2018 South African 10-year government bonds traded in line with the other BRICS countries’ bond yields compared to their respective average corresponding credit ratings as per Fitch and Standard and Poors. Russia was slightly out of line and traded 100 basis points higher than the BRICS trend line suggested.
Now, 14 months later, the gradient of the trend line dropped significantly and major shifts of the bond yields compared to the respective corresponding credit ratings are evident. China’s 10-year government bond yield dropped by 50 basis points. Russia’s bond yield dropped a massive 300 basis points while the country’s credit rating improved slightly.
India’s bond yield dropped by about 150 basis points. Brazilian bond yields dropped by more than 350 basis points despite unchanged credit ratings as political and economic reforms found favour with global investors.
South Africa sticks out like a sore thumb. Despite the downward shift in global 10-year government bond yields compared to corresponding credit ratings, South Africa’s 10-year bond yield is virtually unchanged from November 2018. In light of the BRICS’ nominal 10-year government bond yield curve compared to the countries’ corresponding credit ratings, it is evident that global investors are pricing in at least one or two notched of downgrades by Fitch and Standard and Poors.
I am therefore of the opinion that a downgrade by Moody’s of South Africa’s credit rating to junk or speculative status is already priced in South African 10-year government bonds.
Or let’s put it the other way round. If the South African government, yes, Eskom included, had a good and credible story to tell and we got a buy-in from global investors, the yield to maturity of South African 10-year government bonds could fall by more than 150 basis points or below 7.5% from the current 9%.
Yes, the 150 basis points is the cost of uncertainty about the outlook for South Africa, obviously for well-known reasons. The impact on your retirement funds and savings is huge.
The issued fixed rate SA government bonds as at 31 December last year amounted to 1.8 trillion rands with a weighted average time to maturity of more than 14 years. The JSE
ASSA 12 years+ All Bond Index’ most recent modified duration was 8.5%. What it means is that a 100-basis point (1%) change in interest rates will change the capital values of the bond index by 8.5%.
The bottom line is that the opportunity cost of uncertainty to the investors in South African government bonds is around 216 billion rands or more than 12% of the value.
To compare equity markets I use Nobel Laureate Robert Shiller’s cyclically adjusted price earnings ratio (PE10) where the price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years.
When the JSE’s valuation as measured by the FTSEJSE All Share Index is compared to the MSCI World Index in US dollars (developed markets) it is evident that there is a relationship between the JSE’ valuation discount or premium relative to developed market equities and South Africa’s credit rating.
At this stage it seems that the JSE should be trading at a discount of around 20%, given South Africa’s current average credit rating (Fitch and Standard and Poors). That compares to a current discount of around 30%. As in the case of bonds, it is evident that global investors are pricing in at least one or two notches of downgrades by Fitch and Standard and Poors and that a downgrade by Moody’s of South Africa’s credit rating to junk or speculative status is already priced in South African equities.
10% valuation discount is the cost of uncertainty about the outlook for South Africa and the impact on your retirement funds and savings is even more frightening than in the case of South African bonds. Using the market capitalisation of seven trillion rands of the FTSEJSE All Share Index as an indication of the JSE as such, it means that in normal circumstances the stock market should have been 14% higher or nearly one trillion rands more than currently.
It is therefore little wonder why savers and specifically pensioners are struggling.
The rand is currently trading at a discount of 8% to a basket of emerging market currencies based on the MSCI Emerging Market Index in US dollars. It is interesting to note that the discount is virtually the same as after Gigaba’s horrific medium term budget speech in October 2017 which led to a downgrade. So, yes, the currency markets are already anticipating a downgrade in South Africa’s credit rating but not as much as South African bonds and equities.
As witnessed by the deepening discounts of South African assets, most major players, locally and global, have probably long ago hedged their and their clients’ funds ahead of the much anticipated downgrade by Moody’s and the other major credit rating agencies. Despite the right noises at long last emerging from Eskom and government, the risk of a rating cut remains at fifty percent plus.
I will not be surprised to see a major rally in our financial markets as and when the announcement is made. You just have to look at how Brazil’s bond market rallied – and that without a rating upgrade to investment grade. They had a good and credible story to tell and got a buy-in from global investors.
Ryk de Klerk is an analyst-at-large. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment advisor for advice.