Monday, 30 March
Just over three years ago, the removal of Pravin Gordhan as finance minister by then president Jacob Zuma set the wheels in motion towards junk status. Following a late-night cabinet reshuffle in March 2017, Standard & Poor’s (S&P) and then Fitch downgraded South Africa to junk status. On Friday night, 27 March 2020, the last rating agency to rate South Africa as investment grade, downgraded our long-term foreign and local currency sovereign rating to below investment grade. The downgrade was also accompanied by a negative outlook, which suggests that further downgrades could be in store.
All events such as these carry investment consequences in one way or another and as such, we would like to reiterate our commitment to you to navigate these tough times with the utmost care and diligence.
Let’s take a closer look as to what this means for our South African economy:
Structurally very weak growth and constrained capacity to stimulate the economy
According to a statement released by the rating agency “the key driver behind the rating downgrade to Ba1 is the continuing deterioration in fiscal strength and structurally very weak growth, which Moody’s does not expect current policy settings to address effectively”. Moody’s also highlighted that South Africa’s unreliable electricity supply, persistent weak business confidence and investment as well as long-standing structural labour market rigidities continued to undermine the country’s economic growth. Furthermore, the unprecedented deterioration in the global economic outlook caused by the spread of COVID-19 will exacerbate South Africa’s economic and fiscal challenges. South Africa simply does not have the fiscal capacity to address the current shock effectively.
Inexorable rise in government debt over the medium term
Another reason for Moody’s downgrade is that South Africa’s debt burden “will rise over the next five years under any plausible economic and fiscal scenario”. Moody’s expects South Africa’s fiscal deficit to widen to approximately 8.5% of GDP in 2020 and for the country’s debt burden to increase from 69% of GDP to an eye-watering 91% of GDP by 2023, inclusive of guarantees to state-owned enterprises.
South Africa to leave the FTSE World Government Bond Index (WGBI)
A downgrade to sub-investment grade means that South African government bonds will be removed from important global bond indices tracked by global institutional investors such as the FTSE World Government Bond Index. However, unprecedented moves in global markets following the rapid spread of the coronavirus has prompted the FTSE Russel, which administers the global bond index, to postpone the rebalancing of the index for at least a month. This means that South Africa will remain in the WGBI until the end of April. Thereafter South African government bonds could be included in various broad-based emerging market bond indices that include both investment grade and sub-investment grade issuers. Furthermore, our government bonds could also receive support from foreign investors who may invest in sub investment grade debt.
Further turmoil for the rand and bond markets
Credit sensitive global investors whose mandates prohibit investment in sub-investment grade bonds will start to rebalance their portfolios. This could see a further weakening in the currency and a rise in domestic bond yields as global investors sell their South African bonds. However, the impact of this move may be offset to some extent as the rand has already depreciated by 25% since the beginning of the year and bond yields have risen from 9% to a high of 12.40% on 24 March. This could possibly suggest that some of this rebalancing has already occurred. The delay in the rebalancing of the WGBI, however, means the uncertainty of the full impact of South Africa’s departure from the WGBI is still unknown and as such we expect the rand and the bond market to remain under pressure.
South Africa will become poorer
Forced selling of domestic bonds by foreigners will require them to sell their rands which will result in a weaker rand. The risk of a weaker currency is its impact on inflation. All goods imported into the country may become more expensive. A downgrade may also result in higher borrowing costs, which means more of the fiscus will be allocated to servicing debt costs instead of investing in productive assets such as infrastructure. Weak growth means lower tax revenue and coupled with higher government expenditure, including higher debt servicing costs, may require another hike in taxes in future. Collectively, this means South Africa and its citizens become poorer.
A silver lining, albeit a very thin one
Last night, Finance Minister Tito Mboweni and Reserve Bank Governor Lesetja Kganyago held a virtual media conference. Mr Mboweni had a ‘Hallelujah’ moment when President Cyril Ramaphosa gave him the green light to pursue structural reforms. A new unit in the Ministry of Finance called the Vulindlela unit is to be established today that will drive structural reforms in the economy. Under normal circumstances, this would be a momentous task given the conflicting ideologies within the ANC and our poor track record for execution. Under a COVID-19 scenario, cutting the public sector wage bill, making it easier to hire and fire labour and a raft of austerity measures amounts to an almost impossible mission in our view.
What the downgrade means for investors
Foreign selling of our bonds may push bond yields higher in the short term. Demand for SA government bonds is well supported by the domestic financial market and once conditions start to normalize after COVID-19, foreign investors who are prepared to accept sub-investment debt may find our bond yields very attractive. If we expect inflation to average 4.5% in 2020, at current bond yields of 11.68%, government bonds offer a real yield (i.e. after inflation) of more than 7%. Once global conditions normalize, South African bonds should recover (i.e. yields decline), offering very attractive investment opportunities for patient investors.
The outlook is less clear in respect of South African equities. Domestic conditions were challenging prior to the outbreak of COVID-19. A 21-day lockdown will put further pressure on company earnings for the foreseeable future. Certainly, South African equities are looking cheap from a valuation perspective, however, the outlook for company earnings has become more ominous. South Africa’s downgrade to sub-investment grade also means that the cost of capital has increased, and unless structural reforms are implemented, private sector investment will remain elusive. A tough operating environment, now exacerbated by a lockdown, higher cost of debt, possible corporate failures and a lack of structural reform, for now, underpins our current underweight position in South African equities.