INVESTING AFTER THE DOWNGRADES
31 May 2017
THABI LEOKA
Economic Strategist,
Argon Asset Management
After the unexpected cabinet reshuffl e
which occurred in the middle of the
night on 30 March, it was obvious
that a downgrade was imminent. The
reshuffl e aff ected 10 ministers and
10 deputy ministers, including then
Finance Minister Pravin Gordhan and
his deputy Mcebisi Jonas.
In response to the cabinet reshuffl e,
S&P downgraded South Africa’s
long-term foreign currency rating to
sub-investment grade (BBB- to BB+
with a negative outlook) on 3 April in an
unscheduled review. The ratings agency
also downgraded South Africa’s local
currency rating by one notch to BBB-
with a negative outlook. The downgrade
has contributed to increased infi ghting
in government that casts doubts on
whether policymakers will be able to
eff ectively implement the required
policies for reform. S&P also believes
that the aftermath of the reshuffl e will
negatively aff ect business confi dence
and investment, therefore slowing
economic growth. In addition, they are
13
JP Morgan removes
SA from bond index
concerned about the government’s
growing contingent liability risk.
On Friday 7 April, ratings agency Fitch
downgraded South Africa’s long-term
foreign and local currency rating from
BBB- to BB+ with a stable outlook.
This was also an out-of-schedule
review. Unlike S&P, Fitch gives one
rating to both local and foreign debt.
According to this ratings agency, the
cabinet reshuffl e will likely change
the direction of economic policy and
undermine or even reverse progress
in the governance of state-owned
enterprises (SOEs). This raises the risk
that SOE debt could migrate onto the
government’s balance sheet.
Moody’s decided to initiate a review
for a downgrade, and their decision
will be made known within 90 days.
This was also prompted by the abrupt
cabinet reshuffl e.
The rand weakened by about 4% on
27 March, after Gordhan was called
back from the roadshow in London.
On 30 March, the rand weakened
roughly a further 5%, following the
cabinet reshuffl e. Although this was a
signifi cant softening of the currency,
it was not as severe as the weakening
that followed ‘Nenegate’ in 2015.
The downgrades led to JP Morgan
removing South Africa from its Global
Bond Index-Emerging Market (GBI-EM)
at the end of April. According to JP
Morgan, roughly $49 billion worth of
South African bonds are benchmarked
against its investment grade-only
emerging market bond indexes, and
$10 billion of debt is linked to its global
bond index.
The biggest risk, in our view, is if
S&P downgrades South Africa’s local
currency rating to ‘junk’ status.
This would result in the removal of the
country from the Citi World Global
Bond Index (WGBI). South Africa
represents 0.45% of the market
value of the WGBI and ranks 17 th by
market weight. The index includes
12 South African government bonds,
with a market value of $93.82 billion.
South Africa has enjoyed more than
R80 billion in foreign purchases of its
government bonds since it entered
the WGBI in October 2012 and more
than R260 billion in purchases since
2010. An outfl ow of these funds will
be catastrophic.
Consider the long term in uncertain times
S
outh Africa’s recent sovereign rating downgrades
to sub-investment grade or ‘junk’ status
highlights the crossroads that our young
democracy fi nds itself at. At this point, it is hard to
predict the direction that we will end up taking.
Th is is according to Old Mutual Balanced Fund
Manager, Graham Tucker. He was speaking at
the launch of the annual Long-Term Perspectives
publication, a summary of long-term asset class
data compiled by Old Mutual Investment Group’s
MacroSolutions Boutique. Tucker says the resultant
market volatility is going to be with us for some time
to come, and in such times of uncertainty, it is crucial
to take a long-term view and be well diversifi ed.
“When it comes to investments, sometimes bad
news can become good news and one should be
investing in exactly the opposite way to your initial
gut reaction. Past and recent political events have
taught us this,” he explains.
“When the President fi red Finance Minister Nene
in December 2015, markets fell sharply over the next
few days. Th e rand depreciated 9%, bonds fell by 10%,
listed property by 14% and within equities, banks fell
by 19%. Importantly, however, investors who remained
invested in these assets have since retraced and
recouped these losses and more,” he says.
“Th e current market performance we’re seeing
following recent political and economic events might
not even feature as a signifi cant event on a long-term
graph,” Tucker points out. “And while we could face
a signifi cantly volatile time in the short term, with
potentially divergent outcomes, volatility may create
opportunity within a mispriced market.”
Tucker believes that the local equity market could
deliver better returns going forward, although it is not
possible to say when that will happen. “Short-term
movements are extremely diffi cult to forecast as they
are driven more by sentiment than fundamentals.
However, given that the global economic environment
is improving, the recent period of low or no returns
from equities has allowed the market to regain some
value,” he says. “Th is should enable multi-asset funds
like the Old Mutual Balanced Fund to deliver a real
return (aft er infl ation) of 4% over the next fi ve years in
line with the performance objective.”
Tucker highlights that infl ation is the investor’s
enemy. He expects infl ation to continue to move lower
through the remainder of 2017. “Despite the Cabinet
reshuffl e and recent downgrades, we have seen a
relatively muted currency reaction and a very diff erent
environment to what we saw in December 2015 when
the currency plummeted,” he says. “Th e real problem is
South Africa’s structural ly high infl ation rate compared
to the rest of the world.”
Th e Long-term Perspectives review sets out how
infl ation erodes spending power. So how does
one counter this? Tucker says investors need to be
invested in growth assets like equity and property,
rather than cash. “Cash might make you feel safe in
an environment like the one we’re currently in, but
history has shown us that it is poor at fi ghting infl ation,
especially aft er taking tax into the equation. Your
likelihood of achieving fi nancial freedom decreases the
longer you are sitting in cash.”
Tucker believes that a rating downgrade spiral could
result in a sharply weaker currency, thereby putting
upward pressure on infl ation. “In this environment
South African pension funds should be relatively
secure given the high exposure to off shore assets. For
example, the Old Mutual Balanced Fund, in addition
to a 25% off shore allowance, has signifi cant additional
exposure to rand hedges, including locally-listed
equities like British American Tobacco and Naspers,
as well as to other assets like gold. Taking this into
account, this kind of investing will benefi t from
rand weakness and this will provide investors with
considerable protection.”
Nonetheless, Tucker says that Long-term
Perspectives data illustrates the critical need for
patience as an investor. “Financial freedom isn’t
achieved overnight and the old adage holds true that
its time in the market, not timing the markets, that
counts. Ultimately, sentiment drives shorter term
market movements and investment fundamentals
need time in order to play out.”
Graham Tucker,
Balanced Fund
Manager, Old Mutual