On 4 December 2015, the international credit rating agency Standard & Poor’s (S&P) revised SA’s credit outlook to negative. This means there is an elevated chance that S&P’s next credit rating change may be a downgrade. If this happens, the SA government’s long-term foreign currency debt rating will fall one notch below the level at which the debt is rated ‘investment grade’.
The term ‘junk’ is commonly, and perhaps harshly, used to describe any debt rated below investment grade. It would be more correct to describe debt as ‘junk’ when the likelihood of default is high and carries a debt rating much lower than the one S&P is likely to assign SA post a downgrade.
Nevertheless, a downgrade by S&P will breach a psychologically important level for SA, with potential negative ramifications for the country. These include:
- Forced disposals by bondholders who are restricted by their investment mandates to invest in non-investment grade rated debt.
- Higher interest rates that government will have to pay on newly issued debt, placing further pressure on the fiscus at a time when government finances are already strained.
- A weaker rand as a result of capital withdrawals from the country, putting upward pressure on inflation and ultimately interest rates that will negatively affect consumers.
- A knock to business and consumer confidence, leading to lower business investment and consumer spending, placing further pressure on economic growth.
It’s hard to find any positive outcomes for the SA economy in the event of a downgrade. In a recent Reuters poll, fifteen out of sixteen economists expected SA to be downgraded to sub-investment grade by at least one rating agency this year. So it seems the downgrade is the default expectation. This isn’t surprising, as S&P said in December that it might downgrade SA in the near future if GDP growth turns out to be weaker than its forecast. Economists are currently pencilling in 0.7% growth for this year (and we believe they are overly optimistic), already well below S&P’s 1.6% forecast at the time of its last review in December.
How will a likely downgrade in our credit rating impact local financial markets? The damage to a car involved in a collision depends greatly on the speed at which the collision takes place. The speed of the impact will in turn depend on the car’s speed prior to the driver becoming aware of the danger and how much time the driver had to react. Serious collisions seldom occur when danger has been anticipated in advance and caution applied. Similarly, the actual downgrade may in fact have little impact on the market if it was expected and accounted for in asset prices.
SA wouldn’t be the first country to lose its investment grade rating in recent years. The table below shows other countries that have recently become ‘junk’. A study on how their markets performed before and after the downgrade highlights that, in general, the currency, equity prices, budget and current account deficits deteriorated in the run-up to being downgraded, but then stabilised and often improved after the event. The muted reaction of the markets after the downgrades was as a result of asset prices moving ahead of the event.
The most direct impact of a lower credit rating should be seen in the cost of SA’s foreign- denominated debt. The chart below shows a comparison of the cost to insure certain governments’ foreign currency debt against default. It’s noteworthy that SA is already priced in line with other countries that are rated ‘junk’ by one or more rating agencies.
It’s also important to distinguish between the credit ratings of local versus foreign currency debt. The table below shows the difference in ratings between South Africa’s local and foreign currency debt by the three main rating agencies. Our government’s rand-denominated debt is rated higher than its foreign currency debt and therefore has a lower chance of losing its investment grade status. The rand debt rating is also more relevant, as only 10% of government debt is denominated in foreign currency.
Investors’ focus should be on whether the downgrade is already reflected in asset prices rather than to assume that prices will continue to fall because of the downgrade. Banking shares probably risk the most loss from a downgrade as a result of higher funding costs and have indeed performed poorly in the second half of 2015. In fact, this performance mirrored that of the already junk status Brazilian banks. However, the JSE banks index has already recovered 15% in 2016, simply because banks have become too cheap, notwithstanding the fact that the risk of a downgrade has not declined. We’ve recently added to banks in our house view equity portfolio, taking our overweight position to about 4%. We expect the sector to outperform the general market over the medium term, despite an expected slowdown in profits. This is because the sector is trading well below normal levels on most valuation metrics and a return to long-term averages should support share price growth despite lacklustre profits.