Beware deeper degrees of junk
The worst isn’t necessarily over for SA’s status
EQUITY markets tend to react negatively to a sub-investment downgrade; many of those watching local markets are surprised that there has not yet been a mass exodus of investment and that the rand has not been as hard hit as expected.
The latter, says Siboniso Nxumalo, joint manager of Old Mutual Investment Group’s Global Emerging Markets, is largely a result of the fact that the rand has been strengthening in line with the currencies of other emerging markets.
Markets don’t like uncertainty and tend to react badly to unexpected news. However, as Denker Capital’s Neal Smith explains, investors had anticipated that ratings agencies would downgrade South Africa to junk status and that Pravin Gordhan would be removed as minister of finance. Smith, the portfolio manager of the SIM Global Emerging Markets Fund, says a bigger sell-off could still happen.
Like Smith, Nxumalo has been taking a keen interest in how local equity markets have reacted to the fact that S&P Global Ratings and Fitch have downgraded South Africa.
“Don’t think the economic situation can’t get worse,” warns Nxumalo. “We can certainly get downgraded further if the ratings agencies don’t see proactive and positive changes.” In fact, he believes it’s the calm before the storm unless proactive and structural economic reforms are put in place.
Smith warns that there is a likelihood that the rand will be subjected to a double downgrade, which means global investors will pull out of the local bond market, resulting in a sharp currency depreciation.
South Africa’s downgrade needs to be considered in a context of low returns globally.
According to a Citigroup report, members of the Organisation for Economic Co-operation and Development, including the US, Canada, Japan and Australia, have around $80-trillion of unfunded pension liabilities. This spurs the drive towards investments that generate high returns. The alternative is that retiring individuals ready to cash out their retirement savings will receive significantly less than expected.
Global investors, says Nxumalo, are struggling to find attractive returns in developed markets, which is why they have been focusing on emerging markets with their significantly younger populations and greater growth potential. They have been a much more attractive investment destination compared to developed markets.
South Africa is the fourth emerging market to be downgraded after Russia, Turkey and Brazil.
“Post their downgrades, asset prices and the local currencies fell to levels that were attractive. Over the last year Brazil and Russia were some of best markets to invest in globally,” says Nxumalo.
“Russia’s market generated returns of around 23% in dollar terms, whilst Brazil’s market returned an impressive 39%. Compare this to returns of just 14% from the US market and it’s clear that emerging markets are an attractive proposition if you acquire them at the right valuations,” says Nxumalo.
In the case of Russia and Brazil, both markets stabilised after the initial negative reaction and it’s at this point that there can be good returns for brave investors who are prepared to be patient, advises Nxumalo.
The typical pattern that most economies tend to follow after a downgrade is that once the currency devalues and a sell-off occurs, assets tend to become cheaper for international investors. Bond yields go up, providing investors with a better return on their investment.
To date South Africa has not followed this pattern. “Markets learn lessons,” explains Nxumalo. “The firing of former finance minister Nhlanhla Nene in December 2015was unexpected, which is why the market reacted more severely. This time the firing of finance minister Pravin Gordhan and the downgrade were largely anticipated.”
Although South Africa has long been obsessing about the impact of a potential downgrade, Nxumalo insists the real issue is what South Africa does now to rebuild its structural inadequacies.
“International investors are still sitting tight and giving South Africa the benefit of the doubt — that is, until we do something erratic like sign a multitrillion nuclear deal, which the country can ill afford, or embark on a reckless government spending spree,” he says, adding that the full consequences of the downgrade have not yet been factored into equity market prices. He maintains that the most concerning issue now is the government’s reaction to the downgrade and the measures that are put in place to allay the fears of investors and rating agencies.
“We were in Brazil when their downgrade was announced,” says Nxumalo. “The country’s reaction was very clear in the aftermath of that event and they quickly and very publicly put a number of positive and proactive steps in place: the electorate were out in force protesting, with the result that the president got impeached and a number of corrupt government ministers were arrested.
“However, what was different was that Brazil was already suffering from very high unemployment as well as rising interest and inflation rates. The man in the street had been feeling the pain for a while in the form of high food prices.”
In contrast, says Nxumalo, the South African government has yet to respond in a way that provides investors or rating agencies with any degree of confidence, and corruption remains a key concern in state-owned enterprises.
In fact, points out Smith, out of all the emerging markets, South Africa is the most business-hostile environment. “The cost of labour is very high, there is a huge amount of policy uncertainty and unfriendly business legislation — so South Africa is not an investment-friendly destination.
“Like most emerging markets, South Africa is very dependent on capital investments, but unless we make a concerted effort to become more investment friendly, we’re unlikely to attract foreign investment.”
Nxumalo believes that until the full impact of South Africa’s downgrade is felt by the electorate, there is unlikely to be a positive government reaction.
“Government is unlikely to do anything for as long as the rand remains relatively stable.
“Only once welfare payments start being impacted, company profits and taxes come under pressure, inflation goes up and fuel prices are hiked will the full impact of the downgrade be felt by ordinary people.
“In other words, our economic situation has to get much worse before it will start getting better.”
Smith agrees that the economic situation will in all likelihood deteriorate further before it starts improving.
“South Africa is in a very tight spot right now given the huge gaps in wealth coupled with the fact that it is looking increasingly unlikely that there are going to be any policy changes in the short term,” he says.
“While many investors are anticipating a leadership change in South Africa and hoping that this is accompanied by a more market-friendly leadership, there is probably [still] a long way to go.”
However, it’s not all doom and gloom, insists Nxumalo. “There is always opportunity in the midst of chaos. South Africa should now be reflecting on its current economic path and implementing meaningful structural reform in the form of minimal public sector wage increases and stringent fiscal discipline while at the same time rooting out all corruption. The bottom line is that there will be less money to go around and government has to be more circumspect about how they spend public money.”
His fund is paying close attention to any opportunities presented in the South African equity market, although it’s still not as positive as that of Brazil, he says.