Back to the past – downgrade time

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Under cover of darkness on Thursday 30 March, President Jacob Zuma announced the long-awaited cabinet reshuffle that has been on the cards since his disasterous appointment of Des van Rooyen as finance minister in December of 2015. While a number of the new appointments were rather contentious, the appointment of Malusi Gigaba as new finance minister was the most alarming. Business Day reports that at a Saturday morning media conference, called less than 36 hours after his appointment, Gigaba made it quite clear that things would be very different at the Treasury from now on.

Gigaba set out an agenda that is “unapologetically” focused on using the state’s R500bn procurement bill and public infrastructure spend to drive business to black enterprises and professionals.

He reportedly went out of his way on Saturday to emphasise that he was committed to continued fiscal prudence and to maintain the country’s investment grade rating, and that “everything we do will be done within fiscal constraints”. But he signalled the Treasury could no longer “belong to orthodox economists, big business, powerful interests and international investors” as it was perceived to do. Gigaba apparently had “good and cordial, but robust” discussions with all three ratings agencies at the weekend.

On the evening of Monday 3 April, Standard & Poor’s Global Ratings (S&P) downgraded SA’s foreign currency rating to sub-investment grade, at BB+. New Finance Minister Gigaba not only stumbled at his very first hurdle, but it seems that he never even saw it. The ratings agency, whose next ratings review had been due only in June, departed from its schedule to do the downgrade, saying the executive changes initiated by President Jacob Zuma has put at risk the country’s fiscal and growth outcomes, increasing the risk of policy shifts that could be negative for economic growth and fiscal discipline. What was even more worrying about the downgrade announcement, is that it came with a negative outlook attached (as opposed to positive or stable), suggesting that a further downgrade could be on the cards if it sees deterioration in SA’s economic and fiscal performance.

The downgrade will make it more expensive for the government, state-owned enterprises and the private sector to borrow on international markets and is likely to dent confidence and growth prospects.

However, even more disturbing than the downgrade itself was the speed at which it happened.

S&P said its action also reflected its view that contingent liabilities to the state, particularly in the energy sector, were on the rise and previous plans to improve Eskom’s financial position might not be implemented in a comprehensive and timely manner. Guarantees utilised by public enterprises are expected to reach R500 billion in 2020, or 10% of GDP in 2017. These are the loans guaranteed by the government taken out by state-owned enterprises. The main issue is Eskom, which currently has a R350 billion guarantee framework. S&P estimates that Eskom will have to fund a revenue gap of R75 billion.

“In our view, higher risks of budgetary slippage will also put pressure on SA’s cost of capital, further dampening already modest growth”. Internal government and party divisions could erode the trust that has been established between business and labour. However, S&P said it could revise the outlook to stable if it saw political risks reduce and economic growth and/or fiscal outcomes strengthened.

Stanlib points out that four and a half years ago, SA’s government bonds were included in the highly influential Citigroup World Government Bond Index (WGBI), leading to large inflows as investors assumed exposure to SA. Inclusion in the WGBI is based on a country’s local currency rating, not its foreign currency rating. South Africa’s local currency rating is rated higher than that of its foreign currency rating. S&P’s latest local currency rating for SA is at the lowest level of investment grade, BBB-. Investors in South African bonds who are benchmarked against the WGBI can still hold these instruments as long as the local rating remains one of investment grade.  South Africa can only be excluded from this index if both S&P and Moody’s downgraded the country’s local debt to sub-investment grade.

With President Jacob Zuma and his followers clearly believing that they have the necessary political capital to act in such a unilateral fashion, the ANC now appears to be in crisis mode. The party has called in its provincial chairmen and secretaries for a meeting today (Tuesday, 4 April). The ANC is clearly divided over the actions of President Zuma and his followers,  and  the  extension of the National Working Committee (NWC) meeting, to include provincial chairmen and their secretaries, indicates the seriousness of the situation and suggests a reinforcement of Zuma’s backers. Deputy president Cyril Ramaphosa, secretary-general Gwede Mantashe and treasurer-general Zweli Mkhize innitialy openly disagreed with Zuma on the cabinet reshuffle. Zuma removed Pravin Gordhan using a bogus intelligence report to justify the move to ANC officials. While Zuma’s opponents say his reasoning for the reshuffle was flawed, his allies told Business Day that the removal of Gordhan had “neutralised” both Ramaphosa and the president’s opponents in the South African Communist Party (SACP) ahead of the ANC’s December elective conference.

This tragic political soap-opera will no doubt dominate headlines for the rest of 2017. However, we must not allow the fog of political gamesmanship to obscure the improved fundamentals of investment markets, local and offshore.

Since the election of Donald Trump as president of the United State of America, equity markets in the USA have performed very well. Many have referred to the “Trump trade” when describing the positive move in US equities, but his election victory may just have masked some very supportive fundamentals that include an end to the earnings recession that started at the end of 2014, the ability of China to now export inflation through a surging Producer Price Index, the rise in bond yields as core inflation hovers just above the target rate of 2% and growth prospects improve, and the decision by the Open Market Committee of the US Federal Reserve to increase the benchmark interest rate as the economy approaches full employment. The end of the earnings recession is also clear in Emerging Market equities. Since the beginning of 2016 Emerging Markets have staged a bit of a revival with equities in a recovery phase, driven by a positive outlook for future earnings, currencies in a stronger trend in aggregate and bond yield spreads much narrower than they were at the end of December 2015. The only warning sign in Developed Market economies is the rise in bond yields, possibly signaling an end to the 30-year bull market.

The South African equity market has been in the doldrums for the last three years as the global earnings recession took its toll. However, encouraging signs have recently emerged as positive earnings growth starts to appear once again. Local bond yields have now priced in significant political risk and have absorbed much of the downgrade and subsequent fallout. Relative to inflation, our local bond market now offers attractive real yields. Longer term cash also offers good yields as well as another risk management tool in multi-asset portfolios.

On 11 December 2015, the 10-year South African benchmark government bond yield closed at 10.38% and the risk spread of this bond to its US 10-year Treasury counterpart was 8.25%. As we write this note, that yield sits at 9.11% and the risk spread sits at 6.70%, both considerably lower than 15 months ago. On 18 January 2016, the rand peaked against the US dollar at R16.87/$. The exchange rate is now at R13.74/$, considerably stronger.

In hindsight it has become clear that huge risk was priced into our currency and bond markets after the Van Rooyen debacle.

Since then, bond yields have fallen and the rand has strengthened against the US dollar. While these two trends have been very volatile over the last 2 years, we have used the volatility and directional correlations to build political-risk-resilience into our portfolios. As an Emerging Market economy, we have the luxury of a “shock absorber” currency that can be used to good effect to build buffers into our portfolios that can shield investors against the kind of risks that we have been exposed to as a country over the last few days.

While the South African political games may only just have begun to get serious, local and global investment markets are not without opportunity.

Source: APS Economic Commentary