Currency markets anticipating credit rating downgrade for SA, says Ryk de Klerk |

But how much of the cut to junk status is already priced into the financial markets?

SOUTH African investors are fretting about the potential damage to their savings by a cut in the country’s credit rating debt to junk or speculative grade by Moody’s soon. This will see South Africa exiting major global bond index trackers and a massive amount of government bonds are likely to hit financial markets, looking for new buyers.

The big question is how much of the well-telegraphed cut to junk status is already priced into South African financial markets? The three major South African markets are its government bonds; equities; and the external value of the rand. We are all aware that global bond-yield curves worldwide moved lower over the past 18 months, as government bonds priced in slower economic growth. Emerging market groupings such as BRICS (Brazil, Russia, India, China and South Africa) were no exception given their respective credit ratings.

On November 7, 2018 South African 10-year government bonds traded in line with the other BRICS countries’ bond yields compared to their respective average corresponding credit ratings as per Fitch and Standard and Poor’s. Russia was slightly out of line and traded 100 basis points higher than the BRICS trend line suggested.

Now, 14 months later, the gradient of the trend line dropped significantly and major shifts of the bond yields compared to the respective corresponding credit ratings are evident.

China’s 10-year government bond yield dropped by 50 basis points. Russia’s bond yield dropped a massive 300 basis points, while it’s credit rating improved slightly. India’s bond yield dropped by about 150 basis points. Brazilian bond yields dropped by more than 350 basis points despite unchanged credit ratings, as political and economic reforms found favour with global investors.

South Africa sticks out like a sore thumb. Despite the downwards shift in global 10-year government bond yields compared to corresponding credit ratings, South Africa’s 10-year bond yield is virtually unchanged from November 2018. In light of BRICS’s nominal 10-year government bond-yield curve compared to their corresponding credit ratings, it is evident that global investors are pricing in at least one or two notches of downgrades by Fitch and Standard & Poor’s.

I am therefore of the opinion that a downgrade by Moody’s to junk or speculative status is already priced into the South African 10-year government bonds. Or let’s put it the other way round. If the South African government, yes Eskom included, had a good and credible story to tell and we got a buy-in from global investors, the yield to maturity of South African 10-year government bonds could fall by more than 150 basis points or below 7.5 percent from the current 9 percent.

Yes, the 150 basis points is the cost of uncertainty about the outlook for South Africa for reasons that are well known. The impact on your retirement funds and savings is huge. The issued fixed-rate SA government bonds as at December 31 amounted to R1.8 trillion, with a weighted average time to maturity of more than 14 years.

The JSE ASSA 12 years+ All Bond Index’s most recent modified duration was 8.5 percent. What it means is that a 100-basis point (1 percent) change in interest rates will change the capital values of the bond index by 8.5 percent. The bottom line is that the opportunity cost of uncertainty to the investors in South African government bonds is around R216 billion or more than 12 percent of the value.

To compare equity markets, I use Nobel laureate Robert Shiller’s cyclically adjusted price-earnings ratio (PE10) where the price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years.

When the JSE’s valuation as measured by the FTSE/JSE All Share Index is compared to the MSCI World Index in US dollars (developed markets), it is evident that there is a relationship between the JSE’s valuation discount or premium relative to developed market equities and South Africa’s credit rating.

At this stage it seems that the JSE should be trading at a discount of around 20 percent given South Africa’s current average credit rating (Fitch and Standard and Poor’s). That compares to a current discount of about 30 percent.

As in the case of bonds, global investors are pricing in at least one or two notches of downgrades by Fitch and Standard & Poor’s, and that a downgrade by Moody’s of South Africa’s credit rating to junk or speculative status is already priced into South African equities.

A 10 percent valuation discount is the cost of uncertainty about the outlook for South Africa, and the impact on your retirement funds and savings is even more frightening than in the case of South African bonds.

Using the market capitalisation of R7 trillion of the FTSE/JSE All Share Index as an indication of the JSE, it means that in normal circumstances the stock market should have been 14 percent higher or nearly R1 trillion more than it is currently.

It is therefore little wonder why savers, and specifically pensioners, are struggling.

The rand is currently trading at a discount of 8 percent to a basket of emerging market currencies based on the MSCI Emerging Market Index in US dollars. It is interesting to note that the discount is virtually the same as after Malusi Gigaba’s horrific Medium-Term Budget speech in October 2017 as then finance minister, which led to a downgrade.

So yes, the currency markets are already anticipating a downgrade in South Africa’s credit rating, but not as much as South African bonds and equities. As witnessed by the deepening discounts of South African assets, most major players – locally and globally – have probably long ago hedged their and their clients’ funds ahead of the much anticipated downgrade.