Mar­kets priced for tame down­grade, not a big dis­rup­tion, in­vest­ment fundi says

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South Africa’s fi­nan­cial mar­kets may be priced for a pos­si­ble one-notch down­grade of our for­eign-cur­rency bonds, but they are nowhere close to be­ing priced for an un­af­ford­able nu­clear pro­gramme or a down­grade of our rand-de­nom­i­nated bonds.

This is the view of Peter Kent, the co-head of fixed in­come for South Africa and Africa at In­vestec As­set Man­age­ment (IAM), who ad­dressed the Morn­ingstar in­vest­ment con­fer­ence in Cape Town this week. ( For­eign- cur­rency bonds are long-term gov­ern­ment bonds de­nom­i­nated in for­eign cur­ren­cies.)

The rea­son a rat­ings agency down­grades a coun­try’s gov­ern­ment debt – for ex­am­ple, be­cause of the poor state of the econ­omy or the gov­ern­ment’s fi­nances, or be­cause of po­lit­i­cal risk – is far more im­por­tant than the down­grade it­self, Kent says. A down­grade be­cause the econ­omy has a slow punc­ture will have much less ef­fect on fi­nan­cial mar­kets than a down­grade due to the loss of cred­i­bil­ity of an in­sti­tu­tion such as the Na­tional Trea­sury.

Any plunge in share or bond prices that may re­sult from a down­grade re­sult­ing from, for ex­am­ple, a po­lit­i­cal event, is cur­rently not priced into the mar­kets, Kent says.

Kent was re­spond­ing to a ques­tion from Morn­ingstar’s direc­tor and se­nior in­vest­ment con­sul­tant, Vic­to­ria Reu­vers, who noted that in­vestors in lo­cal mar­kets have not re­sponded too harshly to the news that Fi­nance Min­isiter Pravin Gord­han is to face fraud charges and asked whether this means that the mar­kets are al­ready priced for a down­grade.

If a down­grade re­sult­ing from the ex­pected eco­nomic de­te­ri­o­ra­tion has al­ready been fac­tored into the prices of shares or bonds, there will be less im­pact on your in­vest­ments if a down­grade does, in fact, take place.

Kent said that, on the day the Hawks made the an­nounce­ment about Gord­han, the rand de­pre­ci­ated more than three per­cent against the United States dol­lar, and the eq­uity, bond and listed prop­erty mar­kets were all down.

This re­sponse was far more muted than when Nh­lanhla Nene was fired as fi­nance min­is­ter in De­cem­ber last year, he said. The rea­son is that civil so­ci­ety has mounted a pretty good de­fence to a num­ber of po­lit­i­cal in­ter­ven­tions over the past year.

“Peo­ple will look at the charges against Gord­han and find them hard to prove. Our team’s le­gal view is that they will be pretty hard to prove. There are holes in the ar­gu­ments,” Kent said.

The mar­kets are tak­ing some com­fort from this, but they will take very lit­tle com­fort from the on­go­ing at­tacks on cred­i­ble in­sti­tu­tions such as Na­tional Trea­sury, which has its hands on the purse strings, he says.

This mes­sage was echoed by Nazmeera Moola, the co-head of South Africa and Africa fixed in­come at IAM, who spoke at an As­so­ci­a­tion for Sav­ings & In­vest­ment South Africa brief­ing last month on the cru­cial role of in­sti­tu­tions such as Trea­sury. Moola said that un­der­min­ing these in­sti­tu­ions and re­vers­ing the gains the gov­ern­ment has made in man­ag­ing the coun­try’s fi­nances could af­fect all South Africans, not only in­vestors in lo­cal mar­kets.

Moola said South Africa is al­ready pay­ing 1.2 per­cent­age points more in in­ter­est on its bonds than other emerging-mar­ket coun­tries are pay­ing, the re­sult be­ing that less money is avail­able for the gov­ern­ment to spend on ser­vices such as health, ed­u­ca­tion and hous­ing.

Marie An­telme, an econ­o­mist at Corona­tion Fund Man­agers, told the Morn­ingstar con­fer­ence that the rat­ings are an as­sess­ment of the gov­ern­ment’s abil­ity to meet its obli­ga­tions to re­pay its debt on time.

Kent said most of South Africa’s debt is cov­ered by rand-de­nom­i­nated bonds, rather than for­eign-cur­rency bonds. The three most im­por­tant rat­ings agen­cies that rate South Africa’s abil­ity to meet its obli­ga­tions to re­pay these bonds on time are Stan­dard & Poor’s (S&P), Fitch and Moody’s.

S&P and Fitch have South Africa’s for­eign-cur­rency debt at one notch above junk sta­tus (BBB–). S&P also has the coun­try’s for­eign debt on a neg­a­tive-rat­ings watch.

An­telme said al­though S&P will re­view its rat­ings this De­cem­ber, it has un­til De­cem­ber next year to de­cide whether to im­ple­ment the down­grade, which means there is time for po­lit­i­cal events to un­fold and for the coun­try to prove that its econ­omy is grow­ing.

Kent said it was fair to say that S&P is try­ing to give South Africa as much time as pos­si­ble to prove that it is ad­dress­ing the prob­lems sti­fling eco­nomic growth.

Moody’s has rated South Africa’s for­eign-cur­rency debt at two grades above junk sta­tus.

RAND-DE­NOM­I­NATED BONDS

Kent said that, cru­cially, S&P’s rat­ing for rand-de­nom­i­nated bonds is two notches higher than that for for­eign-cur­rency bonds. Much of the for­eign in­vest­ment inflows over the past few years have been into rand-de­nom­i­nated bonds and these are the ones in­cluded in the Citi World Gov­ern­ment Bond In­dex. The in­clu­sion of South African bonds in this in­dex in 2012 re­sulted in large inflows, which could be at risk if the lo­cal bonds were down­graded sig­nif­i­cantly.

Kent said Turkey’s for­eign and lo­cal bonds were re­cently down­graded, but this did not re­sult in sig­nif­i­cant dis­in­vest­ment.

He said the rat­ing of the for­eign-cur­rency bonds is like a ther­mome­ter that mea­sures a fever. The cause of the cur­rent fever is the poor state of the econ­omy.

If South Africa’s bonds are down­graded be­cause of a nu­clear deal, for ex­am­ple, the mar­kets are nowhere near ready for this. The cur­rency and se­cu­ri­ties on South African mar­kets would fall, al­though shares with off­shore earn­ings would fare bet­ter.

If the rat­ing of rand-de­nom­i­nated bonds moved closer to the for­eign-cur­rency rat­ing, that is a dif­fer­ent story. Again, the mar­kets are not priced for that, he says.

He says that, iron­i­cally, al­though the un­der­ly­ing eco­nomic con­di­tions or fun­da­men­tals that de­ter­mine the coun­try’s abil­ity to meet its debt obli­ga­tions are not great, they are the best they have been for the past three years.

An­telme said the econ­omy is un­der pres­sure and jobs are be­ing lost, which af­fects house­hold spend­ing, which, in turn, ac­counts for more than two-thirds of growth. How­ever, there are some pos­i­tive fac­tors that may be enough to per­suade the rat­ings agen­cies not to im­ple­ment a down­grade.

An­telme said she be­lieves that in­fla­tion has peaked, and apart from some ac­cel­er­a­tion to­wards the end of the year as food and petrol prices catch up with the de­pre­ci­a­tion in the rand and sea­sonal fac­tors in­flu­ence prices, in­fla­tion is likely to start mov­ing lower next year.

In­ter­est rates have there­fore also prob­a­bly peaked, al­though there is still some risk that pol­i­tics and the value of the rand could af­fect them, she said.

Other pos­i­tives are Trea­sury’s in­ter­ven­tion and par­tial vic­tory on chang­ing the board of South African Air­ways, the im­prove­ment in the elec­tric­ity sup­ply and fewer strikes dur­ing this year’s wage ne­go­ti­a­tions.

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