Investors spared hard landing after downgrade
Friday last week was Black Friday in more ways than one. On the positive side, online and brick-and-mortar retailers experienced high sales of mostly electronic goods sold at reduced prices, presumably putting them “in the black” if they had been in the red until then. On the negative side, South Africa received further bad news regarding the status of its government debt: credit ratings agency Standard & Poor’s downgraded our local-currency bonds to sub-investment grade (“junk”), and Moody’s kept its ratings unchanged but with a view to a downgrade in the new year. The third big agency, Fitch, left its ratings unchanged at sub-investment grade.
Foreign-investor money was expected to flow out of the country, resulting in, among other things, a drop in the value of the rand.
However, although the rand dipped on the news of the downgrade, it has since largely recovered, and the stock exchange was not affected to any great extent.
Patrice Rassou, the head of equities at Sanlam Investment Management, says the reason the JSE has not shown a dramatic response to the downgrade could be because almost 60% of the income earned by companies listed on the exchange today is from offshore sources. “Our stock market has therefore become less reliant on the fate of the local economy,” he says.
Taking a longer-term perspective, Rassou says the JSE has generously outperformed inflation over the past decades. “Our market has withstood credit downgrades, political and economic isolation, and worse phases of economic turmoil,” he says.
Lesiba Mothata and Gyongyi King, respectively executive chief economist and chief investment officer at Alexander Forbes Investments, say the net outflows might not be as bad as expected, because “not every investor is obliged to replicate the holding of South African debt commensurate to the weightings in indices. These investors, who are speculative in nature, are not obliged to sell South African debt following the downgrade. It is, therefore, not a given that substantial outflows will become an eventuality following this downgrade.”
Mothata and King say data from the Institute of International Finance indicates that the euro area accounts for most of the debt inflows into emerging market countries. Given that about half of outstanding debt in Europe is yielding negative interest rates, demand for emerging-market debt, including South Africa’s, has a natural underpin, they say.
Mothata and King say the downgrade of South Africa’s local-currency debt has been long anticipated, with fund managers taking money offshore and scaling down their investments in local bonds.
Data from the Alexander Forbes Manager Watch Effective Asset Allocation Survey indicates there has been an increased allocation towards offshore assets to the maximum level allowable by regulation, 25%, up from about 17% in 2009. The allocation to South African bonds was about 10% for most of the period between 2009 and 2014.
Since Nenegate (at the end of 2014), there was an increase in the bond allocations to as high as 15%, Mothata and King say, but, since the beginning of this year, there has been a notable decline in bond allocations.
Andrew Davison, the head of investment consulting at Old Mutual Corporate Consultants, says the key for South Africans now is not to dwell on the downgrade.
“Although the downgrade does have implications for the cost of government borrowing and the ability to continue servicing existing debt, the downgrade itself is not the issue. Rather, we should focus on the underlying problem, which is that our financial affairs as a country aren’t in good shape.
“To regain our status as an investment-grade country, we need to focus on how we can grow our economy, on each doing our bit to ensure that we are competitive in relation to other countries. This is critical in order to reduce the possibility of having to consider an International Monetary Fund bailout in the future, as this may affect the State’s ability to pursue its developmental objectives.”
Advice for investors
Davison says it isn’t simple to predict the impact of the downgrades on various investments.
“The short-term impact is sometimes quite different to the medium-term impact. As a result of the fact that downgrades relate to our ability to repay our debt, bond markets are always affected and this, in turn, affects the rand. Bank shares are also often affected because of the potential impact on interest rates.
“However, trying to react to events like this by switching or making changes to one’s investments is not advised, and, while it may be difficult to keep emotions in check, it is far better to stay focused on the long-term objectives and leave it to the asset managers to navigate your investments through this environment.”
Investment experts agree that, for investors, diversification is essential. Davison says: “During times of heightened uncertainty like we are experiencing, it’s essential not to take excessive risks by investing heavily in any one investment. Spreading your investments across different types of assets that might react differently to the events as they unfold will protect your savings from large fluctuations and hopefully allow you to ride out the volatility and any short term dips in values.
“Diversification ensures that you have exposure to growth assets like equities and property and not only conservative assets. These investments might feel risky, but they offer protection against inflation, especially in the longer term. If your investment strategy isn’t sufficiently diversified, you should consider introducing some investments that are likely to behave differently to the ones you already have.”
THREE POST-ANC-CONFERENCE SCENARIOS
An economy thrives on confidence, says Mark Appleton, the head of South African strategy and multi asset at Ashburton Investment. “When confidence is high, businesses invest and consumers spend money. This boosts economic growth. Right now, policy uncertainty is high and confidence is low, and it is not a great surprise to see a lack of private-sector investment as a result.”
Appleton says the importance of the ANC’s elective conference in December cannot be overstated. There are three scenarios worth considering:
• A business-friendly outcome with the uncompromised promise of meaningful reform could catapult South Africa onto a higher growth trajectory. The rand would likely strengthen, bond yields would decline, private-sector investment would rise and South African-sensitive equities would re-rate upwards. “This is clearly a high-road outcome, although it carries a relatively low probability in its purest form,” Appleton says.
• A compromised outcome where party unity is favoured and the patronage faction is protected. This is the most probable outcome, Appleton says. Matters don’t get worse, but the outlook does not brighten. Potential growth remains sub-par and a credit rating downgrade is inevitable. The rand would continue to weaken gradually in line with inflation differentials. “We think the market is priced for this, to a large degree,” he says.
• A low-road outcome where the patronage faction comes to the fore without any business-friendly compromise. Appleton says: “While we think this has a relatively low probability, the investment implications are significant. In this scenario, there would be meaningful fiscal erosion. We would be firmly on a credit downgrade path (many downgrades). The rand would weaken, bond yields would rise and the Reserve Bank, assuming it remains independent, would respond with a tightening monetary policy. South African-sensitive equities would de-rate, as would South African property.”
REIN IN YOUR SPENDING
Unless something “spectacular” happens, it is highly likely that Moody’s will follow Standard & Poor’s in downgrading our locally denominated bonds to junk early next year, says Neil Roets, the chief executive of debt counselling company Debt Rescue.
“This will lead to an almost immediate sell-off of bonds, leading to higher interest rates and an even further slowdown in the economy,” Roets says.
“This is not the time to go on spending sprees. For the past several years, we have seen the impact that Black Friday and Christmas shopping sprees have had on consumers.”
Roets warns that January was the month of “the big reckoning”, when the chickens came home to roost.
“In the credit industry, January is known as the longest month of the year because many wage earners are paid early in December and many also get a 13th cheque. This creates a sudden sense of well-being, and, even before the advent of Black Friday, it led to reckless spending.
“In January, suddenly Christmas spending is reflected on credit cards and store cards. This is also the time when school fees and other unexpected expenses become due. This is the time when we see the greatest increase of debt-distressed consumers knocking on our doors for assistance in getting out from under their massive debt loads.
“Fortunately, the debt review process offers hope in that it allows them to repay their debts in smaller amounts over a longer period and sometimes even at a discount.”