SA downgrade: What happens now?
By Frederick White, head of Balanced at Sanlam Investment Management
Despite the fact that the long anticipated downgrade came as no surprise, investors are reeling and somewhat shocked. Financial markets are driven by human emotions, especially fear and greed, and at the moment fear is the dominant emotion influencing market pricing.
But let’s step back and assess the situation objectively, specifically addressing the question: ‘If a downgrade was always a real probability, why did the event impact the bond and currency markets so intensely?’
Our previous assessments of the possibility of a downgrade and the likely impact thereof considered the following factors:
- Distinguishing between local currency and foreign currency ratings: The local currency rating was deemed more important, since its impact on global bond indices and actual foreign investments is significantly bigger than that of the foreign currency rating. The local rating was deemed much more secure, with a lower probability of being cut to junk status than the foreign currency rating. This was helped by the fact that our ability to repay rand-denominated debt was less uncertain and there was a greater margin of safety (S&P rated us two notches above junk and would need two downgrades to lead to index exclusion).
- What seemed to be priced in: Comparing SA bonds to the bonds of other emerging market countries that had been cut to junk status, SA seemed to have already been priced for a downgrade.
- Distilling the core issue: The downgrade itself would not be the most important development, but rather the response to it. South Africa was making continuous progress in this regard – this very progress was itself helping to postpone (and hopefully avoid) a downgrade. In the event of a downgrade, a positive response would mitigate negative developments in financial markets post the event.
Until a week ago, not only was a downgrade priced in and the likely impact of it muted, but the probability of a downgrade was not increasing. The response to the downgrade threat was gaining traction and the global economic cycle was on the margin improving the outlook for the metrics that ratings agencies would normally consider.
But then the analysis was dealt a blow from a political perspective. When President Zuma reshuffled his cabinet and dismissed Minister Gordhan, the “core issue” received a serious setback: a near certain halt to the progress made in the last year as well as doubt over future improvement. The statement that accompanied the S&P downgrade made it clear that the main consideration for the downgrade was this severe political development and the impact it had on the outlook for SA’s public sector debt position. All of a sudden the outlook for fiscal prudence at state owned enterprises deteriorated significantly and, with it, the government’s ability to stabilise its debt ratio (including the government guarantees supporting SOEs).
The downgrade itself is not driving weaker markets
By itself, the downgrade is still not the most material development and all else being equal it should not have influenced the markets that much. And if it did, it would be a buying opportunity more than anything else.
But the core issue, now even more pronounced than before, is what the official response to the downgrade will be.
And this is where the negativity gets amplified. Treasury’s initial written response disappointed. It did not give the downgrade message the gravity or the respect it deserved. And the apparent disregard for prudent political, financial and economic management when the recent week’s political changes were effected, is what filled ratings agencies and the markets with serious doubt of an improvement.
Will sanity prevail?
After Minister Nene’s dismissal, the quick removal of Des van Rooyen and reappointment of Minister Gordhan was seen as ‘sanity prevailing’ and the disruption to pricing in financial markets turned out to be a great buying opportunity. This time around, some assets are again offering great value, but there is significantly more doubt that sanity will prevail and prove the current pricing levels to be another great buying opportunity.
As value oriented investors it certainly is the natural bias in our approach to buy more assets when they seem to offer above-average returns. But this time around it is with more hesitation that we actually do so.
How the response to the downgrade impacted us
Many people ask what the impacts of the past week’s market movements have been on our balanced portfolios, such as the SIM Balanced Fund. Surprisingly it has not been the train smash one might have expected it to be – to the contrary. Obviously our substantial domestic bond position was hurt by the jump in bond yields. Local bonds lost about 4% during the last week and a half (since President Zuma recalled Minister Gordhan from his international roadshow). But interestingly, despite the upward move in bond yields combined with a 10% weakening of the currency, the year-to-date performance of local bonds is still positive and still in line with that of global bonds in rand terms – a reminder that one must not forget the benefit you get (continuously) from a high running yield.
Furthermore our entire offshore position, which we increased to the near-maximum position of 25% just days before Minister Gordhan’s recall, benefitted from the movement in the currency. This more than offset the loss in our local bond holdings. Lastly, our local equity holding benefitted from a solid exposure to rand hedge stocks and increased in value during this week of turmoil. All of this illustrates again the benefit of a diversified multi-asset portfolio.
The outlook for markets is again uncertain. The global backdrop is one of improvement on the margin, which all else being equal should be to the benefit of SA assets and the currency. Relative to this support, the risk of additional downgrades to SA’s credit ratings will now cast a new shadow over SA assets. Should a ‘sanity prevails’ event occur in the near future, the impact of that on SA bonds and the currency could be material. But in the absence thereof, investors will be faced with the impossible question of whether local assets are priced cheaply enough to reward investments in them despite the additional downgrade risk that President Zuma’s actions have brought.
We are cautiously optimistic but uncertain enough to not bet the farm.
All information and opinions provided are of a general nature and are not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information or opinion without appropriate advice after a thorough examination of a particular situation. We endeavor to provide accurate and timely information but make no representation or warranty, express or implied, with respect to the correctness, accuracy or completeness of the information or opinions. Any representation or opinion is provided for information purposes only. Unit trusts are generally medium to long-term investments. Past performance of the investment in no guarantee of future returns. Unit trusts are traded at a ruling price and can engage in borrowing and scrip lending. Sanlam Investments consists of the following authorised Financial Services Providers: Sanlam Investment Management (Pty) Ltd (“SIM”), Sanlam Multi Manager International (Pty) Ltd (“SMMI”), Satrix Managers (RF) (Pty) Ltd, Graviton Wealth Management (Pty) Ltd (“GWM”), Graviton Financial Partners (Pty) Ltd (“GFP”), Radius Administrative Services (Pty) Ltd (“Radius”), Blue Ink Investments (Pty) Ltd (“Blue Ink”), Sanlam Capital Markets (Pty) Ltd (“SCM”), Sanlam Private Wealth (Pty) Ltd (“SPW”) and Sanlam Employee Benefits (Pty) Ltd (“SEB”), a division of Sanlam Life Insurance Limited; and has the following approved Management Companies under the Collective Investment Schemes Control Act: Sanlam Collective Investments (RF) (Pty) Ltd (“SCI”) and Satrix Managers (RF) (Pty) Ltd (“Satrix”). Although all reasonable steps have been taken to ensure the information in this document is accurate, Sanlam Collective Investments (RF) (Pty) Ltd (“Sanlam Collective Investments”) does not accept any responsibility for any claim, damages, loss or expense; however it arises, out of or in connection with the information. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information. The information to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. Sanlam Group is a full member of the Association for Savings and Investment SA (ASISA). Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments may go down as well as up. A schedule of fees and charges and maximum commissions is available from the Manager, Sanlam Collective Investments, and a registered and approved Manager in Collective Investment Schemes in Securities. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-div date. Lump sum investment performances are quoted. The portfolio may invest in other unit trust portfolios which levy their own fees, and may result is a higher fee structure for our portfolio. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002. International investments or investments in foreign securities could be accompanied by additional risks such as potential constraints on liquidity and repatriation of funds, macroeconomic risk, political risk, foreign exchange risk, tax risk, settlement risk as well as potential limitations on the availability of market information. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. The portfolio management of all the portfolios is outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments Scheme.