SA can't afford to be in transition for much longer
This month South Africa was hit with the news that the country had been in a technical recession for the first half of the year. While the announcement may not have surprised many people, it was nevertheless an unwelcome shock to the overall sentiment towards South Africa.
Bear in mind that in the February budget, National Treasury projected GDP growth of 1.5% for 2018. In an environment where Jacob Zuma had just been removed as president and the newly-installed Cyril Ramaphosa was promising a “new dawn”, some commentators were even suggesting this might be conservative.
However, many years of economic miss-steps are not easily corrected in the space of a few months. And while Ramaphosa has argued that the recession is a result of “transitional issues”, the country cannot afford to be in transition for too long.
That is because Moody's remains the only one of the three major ratings agencies to still have South Africa on investment grade, and it is due to deliver a review next month. Already the firm has cut its own forecast for South Africa's GDP growth rate for this year from 1.6% to between 0.7% and 1.0%.
While National Treasury appears to be back in safe hands and work has begun to restore the integrity and efficiency of the South African Revenue Service, the ratings agencies still have a great deal to worry about. Not least of these are the amount of debt South Africa has accumulated, and the stretched financial position of many state-owned enterprises.
If the economy was showing robust growth, these concerns would not be so serious. A strong economy would mean a growing tax base, which would deliver more money for the government to meet its debt obligations and, if necessary, those of the likes of Eskom.
However, the weakness of the economy means that Moody's will have to reconsider just how secure the country's debt is. We will once again have to start talking about the possibility of being downgraded to “junk” status. This has a real effect on the local currency. While the problems in fellow emerging markets Argentina and Turkey have been the primary reason for recent rand weakness, this additional stress means that the currency is unlikely to strengthen substantially even if emerging market sentiment improves. The more likely scenario is that it could weaken further.
It's important to remember that if Moody's downgraded South Africa's debt, the country would fall out of the FTSE World Government Bond Index. That would mean many funds would have to sell out of local government bonds, and that would impact on the rand.
In this environment, it is vital for investors to be well diversified. Having all of your money exposed to South Africa and the rand is a risky strategy.
No one can forecast with absolute certainty where markets will go, but having international exposure means that you will be protected if the local economy does continue to struggle and the rand weakens. And given the ease with which local investors can now access overseas markets through low cost index trackers, they have every reason to be confident about making the decision to do so.