SA downgrade: In the aftermath

By Frederick White, head of Balanced at Sanlam Investment Management

And so the long anticipated downgrade has happened – and despite the fact that it came as no surprise, investors are reeling and somewhat shocked. Financial markets are driven by human emotions, especially fear and greed, and at the moment fear is the dominant emotion influencing market pricing.

But let’s step back and assess the situation objectively, specifically addressing the question: ‘If a downgrade was always a real probability, why did the event impact the bond and currency markets so intensely?’

Our previous assessments of the possibility of a downgrade and the likely impact thereof considered the following factors:

• Distinguishing between local currency and foreign currency ratings: The local currency rating was deemed more important, since its impact on global bond indices and actual foreign investments is significantly bigger than that of the foreign currency rating. The local rating was deemed much more secure, with a lower probability of being cut to junk status than the foreign currency rating. This was helped by the fact that our ability to repay rand-denominated debt was less uncertain and there was a greater margin of safety (S&P rated us two notches above junk and would need two downgrades to lead to index exclusion).
• What seemed to be priced in: Comparing SA bonds to the bonds of other emerging market countries that had been cut to junk status, SA seemed to have already been priced for a downgrade.
• Distilling the core issue: The downgrade itself would not be the most important development, but rather the response to it. South Africa was making continuous progress in this regard – this very progress was itself helping to postpone (and hopefully avoid) a downgrade. In the event of a downgrade, a positive response would mitigate negative developments in financial markets post the event.

Until a week ago, not only was a downgrade priced in and the likely impact of it muted, but the probability of a downgrade was not increasing. The response to the downgrade threat was gaining traction and the global economic cycle was on the margin improving the outlook for the metrics that ratings agencies would normally consider.

But then the analysis was dealt a blow from a political perspective.  When President Zuma reshuffled his cabinet and dismissed Minister Gordhan, the “core issue” received a serious setback:  a near certain halt to the progress made in the last year as well as doubt over future improvement. The statement that accompanied the S&P downgrade made it clear that the main consideration for the downgrade was this severe political development and the impact it had on the outlook for SA’s public sector debt position. All of a sudden the outlook for fiscal prudence at state owned enterprises deteriorated significantly and, with it, the government’s ability to stabilise its debt ratio (including the government guarantees supporting SOEs).

The downgrade itself is not driving weaker markets

By itself, the downgrade is still not the most material development and all else being equal it should not have influenced the markets that much. And if it did, it would be a buying opportunity more than anything else.

But the core issue, now even more pronounced than before, is what the official response to the downgrade will be.

And this is where the negativity gets amplified.  Treasury’s initial written response disappointed. It did not give the downgrade message the gravity or the respect it deserved. And the apparent disregard for prudent political, financial and economic management when the recent week’s political changes were effected, is what filled ratings agencies and the markets with serious doubt of an improvement.

Will sanity prevail?

After Minister Nene’s dismissal, the quick removal of Des van Rooyen and reappointment of Minister Gordhan was seen as ‘sanity prevailing’ and the disruption to pricing in financial markets turned out to be a great buying opportunity. This time around, some assets are again offering great value, but there is significantly more doubt that sanity will prevail and prove the current pricing levels to be another great buying opportunity.

As value oriented investors it certainly is the natural bias in our approach to buy more assets when they seem to offer above-average returns. But this time around it is with more hesitation that we actually do so.

How the response to the downgrade impacted us

 Many people ask what the impacts of the past week’s market movements have been on our balanced portfolios, such as the SIM Balanced Fund.  Surprisingly it has not been the train smash one might have expected it to be – to the contrary. Obviously our substantial domestic bond position was hurt by the jump in bond yields. Local bonds lost about 4% during the last week and a half (since President Zuma recalled Minister Gordhan from his international roadshow). But interestingly, despite the upward move in bond yields combined with a 10% weakening of the currency, the year-to-date performance of local bonds is still positive and still in line with that of global bonds in rand terms – a reminder that one must not forget the benefit you get (continuously) from a high running yield.

Furthermore our entire offshore position, which we increased to the near-maximum position of 25% just days before Minister Gordhan’s recall, benefitted from the movement in the currency. This more than offset the loss in our local bond holdings. Lastly, our local equity holding benefitted from a solid exposure to rand hedge stocks and increased in value during this week of turmoil. All of this illustrates again the benefit of a diversified multi-asset portfolio.

Looking ahead

The outlook for markets is again uncertain. The global backdrop is one of improvement on the margin, which all else being equal should be to the benefit of SA assets and the currency. Relative to this support, the risk of additional downgrades to SA’s credit ratings will now cast a new shadow over SA assets. Should a ‘sanity prevails’ event occur in the near future, the impact of that on SA bonds and the currency could be material. But in the absence thereof, investors will be faced with the impossible question of whether local assets are priced cheaply enough to reward investments in them despite the additional downgrade risk that President Zuma’s actions have brought.

We are cautiously optimistic but uncertain enough to not bet the farm.