South Africa’s financial markets may be priced for a possible one-notch downgrade of our foreign-currency bonds, but they are nowhere close to being priced for an unaffordable nuclear programme or a downgrade of our rand-denominated bonds.
This is the view of Peter Kent, the co-head of fixed income for South Africa and Africa at Investec Asset Management (IAM), who addressed the Morningstar investment conference in Cape Town this week. (Foreign-currency bonds are long-term government bonds denominated in foreign currencies.)
The reason a ratings agency downgrades a country’s government debt – for example, because of the poor state of the economy or the government’s finances, or because of political risk – is far more important than the downgrade itself, Kent says. A downgrade because the economy has a slow puncture will have much less effect on financial markets than a downgrade due to the loss of credibility of an institution such as the National Treasury.
Any plunge in share or bond prices that may result from a downgrade resulting from, for example, a political event, is currently not priced into the markets, Kent says.
Kent was responding to a question from Morningstar’s director and senior investment consultant, Victoria Reuvers, who noted that investors in local markets have not responded too harshly to the news that Finance Minister Pravin Gordhan is to face fraud charges and asked whether this means that the markets are already priced for a downgrade.
If a downgrade resulting from the expected economic deterioration has already been factored into the prices of shares or bonds, there will be less impact on your investments if a downgrade does, in fact, take place.
Kent said that, on the day the Hawks made the announcement about Gordhan, the rand depreciated more than three percent against the United States dollar, and the equity, bond and listed property markets were all down.
This response was far more muted than when Nhlanhla Nene was fired as finance minister in December last year, he said. The reason is that civil society has mounted a pretty good defence to a number of political interventions over the past year.
“People will look at the charges against Gordhan and find them hard to prove. Our team’s legal view is that they will be pretty hard to prove. There are holes in the arguments,” Kent said.
The markets are taking some comfort from this, but they will take very little comfort from the ongoing attacks on credible institutions such as National Treasury, which has its hands on the purse strings, he says.
This message was echoed by Nazmeera Moola, the co-head of South Africa and Africa fixed income at IAM, who spoke at an Association for Savings & Investment South Africa briefing last month on the crucial role of institutions such as Treasury. Moola said that undermining these instituions and reversing the gains the government has made in managing the country’s finances could affect all South Africans, not only investors in local markets.
Moola said South Africa is already paying 1.2 percentage points more in interest on its bonds than other emerging-market countries are paying, the result being that less money is available for the government to spend on services such as health, education and housing.
Marie Antelme, an economist at Coronation Fund Managers, told the Morningstar conference that the ratings are an assessment of the government’s ability to meet its obligations to repay its debt on time.
Kent said most of South Africa’s debt is covered by rand-denominated bonds, rather than foreign-currency bonds. The three most important ratings agencies that rate South Africa’s ability to meet its obligations to repay these bonds on time are Standard & Poor’s (S&P), Fitch and Moody’s.
S&P and Fitch have South Africa’s foreign-currency debt at one notch above junk status (BBB–). S&P also has the country’s foreign debt on a negative-ratings watch.
Antelme said although S&P will review its ratings this December, it has until December next year to decide whether to implement the downgrade, which means there is time for political events to unfold and for the country to prove that its economy is growing.
Kent said it was fair to say that S&P is trying to give South Africa as much time as possible to prove that it is addressing the problems stifling economic growth.
Moody’s has rated South Africa’s foreign-currency debt at two grades above junk status.
Kent said that, crucially, S&P’s rating for rand-denominated bonds is two notches higher than that for foreign-currency bonds. Much of the foreign investment inflows over the past few years have been into rand-denominated bonds and these are the ones included in the Citi World Government Bond Index. The inclusion of South African bonds in this index in 2012 resulted in large inflows, which could be at risk if the local bonds were downgraded significantly.
Kent said Turkey’s foreign and local bonds were recently downgraded, but this did not result in significant disinvestment.
He said the rating of the foreign-currency bonds is like a thermometer that measures a fever. The cause of the current fever is the poor state of the economy.
If South Africa’s bonds are downgraded because of a nuclear deal, for example, the markets are nowhere near ready for this. The currency and securities on South African markets would fall, although shares with offshore earnings would fare better.
If the rating of rand-denominated bonds moved closer to the foreign-currency rating, that is a different story. Again, the markets are not priced for that, he says.
He says that, ironically, although the underlying economic conditions or fundamentals that determine the country’s ability to meet its debt obligations are not great, they are the best they have been for the past three years.
Antelme said the economy is under pressure and jobs are being lost, which affects household spending, which, in turn, accounts for more than two-thirds of growth. However, there are some positive factors that may be enough to persuade the ratings agencies not to implement a downgrade.
Antelme said she believes that inflation has peaked, and apart from some acceleration towards the end of the year as food and petrol prices catch up with the depreciation in the rand and seasonal factors influence prices, inflation is likely to start moving lower next year.
Interest rates have therefore also probably peaked, although there is still some risk that politics and the value of the rand could affect them, she said.
Other positives are Treasury’s intervention and partial victory on changing the board of South African Airways, the improvement in the electricity supply and fewer strikes during this year’s wage negotiations.