How could a ratings downgrade affect investors?
Inundated with reports of failing state-owned enterprises and spiralling government debt, investors are understandably concerned ahead of South Africa’s 2020 Budget Speech. Sehrish Khan explores how local investors might be affected if Moody’s rescinds South Africa’s remaining investment grade credit rating.
Sentiment around the likelihood of a credit ratings downgrade by Moody’s is overwhelmingly pessimistic. Although National Treasury, credit rating agencies and investors have long been concerned about South Africa’s widening fiscal gap, the threat of a downgrade has placed increased urgency on the need for significant structural reform. The Budget Speech, which is to be delivered by Finance Minister Tito Mboweni later this month, will be a key factor in determining whether South Africa will retain its sole investment grade credit rating.
In November 2019, international credit rating agencies Moody’s and S&P Global cut their outlook on South African debt from stable to negative. While the change in outlook was largely expected by the market following the dismal Medium-Term Budget Policy Statement (MTBPS), it ultimately placed South Africa one step closer to sub-investment grade or “junk” status. South Africa was downgraded to sub-investment grade by Fitch and S&P in 2017 and Moody's currently rates the country’s debt as just one notch above junk. In the next Moody’s assessment, the ratings committee will select from three possible credit ratings, only one of which is investment grade.
Foreign ownership of our government bonds is high, at close to 38%, and a credit downgrade by Moody’s would force some of these investors to sell our bonds as they are prohibited from investing in instruments which are assigned junk status. South African bonds would also fall out of the FTSE World Government Bond Index (WGBI), an index that requires an investment grade rating by either S&P or Moody’s. The resultant outflows, from both active and passive investors, would put pressure on bond prices, causing yields to rise. The quantum of outflows is difficult to determine at this stage, as it could be argued that foreigners have been selling South African bonds since the downgrades began in 2017.
Financial markets are typically forward looking and often price in the probability of a downgrade prior to an announcement by rating agencies. South African government bond yields have risen notably over the past few months and currently offer investors some of the highest real returns globally and the highest returns of all countries included in the WGBI. This suggests that foreign investors are already demanding a premium for the risk of investing in South Africa. While our debt will become riskier to bondholders, the combination of high yields and a weaker currency in response to a downgrade may provide an attractive investment opportunity for long-term investors who are willing to bear that risk.
A credit downgrade by Moody’s is, however, not a forgone conclusion. Recent developments suggest the situation is not as dire as the consensus maintains. The continued challenges at Eskom and the drag that further bailouts would have on state finances have certainly played a large role in the widespread pessimism. The proposal for the Public Investment Corporation and other developmental finance institutions to take over R250bn of Eskom debt would reduce the immediate burden on the state and will likely be welcomed by bond investors. The rapid rise in precious metal prices in recent months and the implications for our mining industry could have a dramatic impact on economic growth. At current prices, South Africa’s annual platinum group metal sales will be about R100bn greater than they were in the first half of 2019, providing a much-needed cash injection that could notably reduce the current account deficit.
As demonstrated by the recent developments in the South African economy, the future is highly uncertain and we do not believe we have any advantage in predicting the outcome of a credit rating review. Given the numerous complexities involved, we prefer to spend our time conducting in-depth research and formulating a view on the true underlying value of individual assets. This way, we are ready to take advantage of significant valuation disparities in the market if they arise.
What would a credit downgrade mean for our funds?
It is difficult to forecast the impact a downgrade would have on our funds. Negative sentiment around the credit downgrade and a challenging consumer environment have already impacted the share prices of South African companies. Domestic shares are consequently more attractive now than they have been for some time: At 3.6%, the average dividend yield offered by companies listed on the FTSE/JSE All Share Index is higher than it has been since 2009. Additionally, if economic growth were to improve, there could be an opportunity to benefit from the uplift to company earnings. It is, however, important to pick the right companies – and that is where we focus our research efforts: identifying good quality companies that are being priced by the market below their true underlying value.
In the event of a downgrade, investors may flee from our local equity market. There have been numerous political events in recent history that have been followed by panic selling. However, experience has shown us that times of market uncertainty often provide us with attractive investment opportunities. Some of our local companies, particularly the financial institutions, have proven their strength, having weathered such storms in the past. During the volatile Nenegate period, the share prices of local banks were severely impacted by the widespread sell-off of domestic assets. Purchasing some of these shares at very low valuations allowed us to generate pleasing subsequent returns for our clients.
In times like these, diversification is paramount. A well-diversified portfolio should include offshore investments and our global portfolios are maintaining maximum foreign exposure. Most of this foreign exposure comes from investments in our offshore partner Orbis’ funds. Orbis, like Allan Gray, focuses on valuations and has managed to find good businesses trading on low multiples. Orbis is consequently optimistic about the potential for future relative returns. If the rand were to depreciate, our foreign holdings would benefit, as would the small proportion of our portfolios invested in commodity ETFs.
Diversification within asset classes is also useful. Many of our large domestic holdings, such as British American Tobacco, Glencore and Sasol, generate a significant portion of their earnings offshore and a weaker exchange rate should support the underlying profit growth of these companies.
Our investment stance remains cautious as we look for opportunities to take advantage of changes in the yield curve. The sell-off of South African bonds post the MTBPS allowed us to purchase bonds across the long end of the curve for our multi-asset class portfolios. As such, our duration has increased, yet we continue to be more conservatively positioned with shorter duration than that of the JSE All Bond Index.
While the impact of a credit rating downgrade is daunting and the outcomes are uncertain, as long-term valuation-oriented investors, we have the advantage of looking past short-term volatility. We build our portfolios from the bottom up, aiming to protect our clients’ capital in a wide range of potential scenarios.