All three of the major rating agencies are due to visit South Africa and confirm their rating stance before year end. Fitch was the first to do so on Friday
. The market is very focused on the outcome of the Standard and Poor’s assessment due on Friday, 2 December (as they are considering whether to cut our rating to junk status). Moody’s might cut us to Baa3 (which is still considered investment grade), whilst Fitch moved us towards a negative outlook (signaling a possible cut to junk status by them as well). Whilst one agency might cut us to junk, with the other two putting us on the lowest rung of investment grade, it is the direction of the negative trend that is possibly of more concern than the absolute rating level.
Rating agencies do not have a set formula for determining our rating. The rating is in part driven by subjective views of the committee at each of these agencies. In assessing the ratings, they will look at a number of factors including the economic trends, debt dynamics, political environments and the quality of institutions (like the judiciary) in each country.
Typically they would compare South Africa to a basket of investment grade countries and also of junk countries. The committee will assess which basket of countries is more closely aligned to South Africa’s current dynamics. They will then move our rating to be the same as that of the countries that they consider to be our natural peers.
Our view – fixed income & FX perspective
Brazil and Turkey (which might be considered to be our peers) have both been downgraded over the last year. This will make avoiding a downgrade more difficult in time to come.
Under regulations, Standard and Poor’s has until December next year (2017) before they are required to make a final decision on our rating. The combination of recent political events and recent business and government cooperation to avoid the downgrade might be enough for them to grant us more time before committing to a rating action. In our view, whilst we might be given more time in December this year, we maintain that a downgrade by the end of 2017 is still more likely than not.
Market reaction to a downgrade
We believe that a downgrade is largely priced into fixed income assets and the rand. Our view is that the current South African Credit Default Swap Spread of 2.53% would imply that the market is pricing in approximately a 85% chance of a downgrade.
In the above chart we show the market pricing of the risk premiums of a number of junk rated countries. It is worth noting that the risk premiums associated with Brazil (junk rated) and Turkey (junk rated) are in line with those of South Africa. This means that the market is already pricing in a rating downgrade to junk.
Following the election of Donald Trump to the White House the sentiment towards emerging markets has become negative. This means that we would expect a stronger market reaction to the bad news of a downgrade, with the rand and bonds likely to overshoot towards the downside. The currency and bond markets are expected to see a kneejerk reaction but are likely return to current levels as the dust settles over time.
Should we see the unlikely scenario of all three rating agencies downgrade South Africa, then this would constitute a more severe downside risk. We would expect the extreme negativity of such an event to have a moderately negative impact on asset prices – we could see a further 5% downside in bonds and inwardly focused equities.
We consider it more plausible that all three rating agencies give us further time. This would be quite positive for the rand and domestically focused equities. Conversely, the rand hedge equities could be exposed to the risk of further rand strength, as we explain below.
By holding a portion of our funds in US dollar denominated assets, we are insulating the funds from the extreme downside risks, even though we consider the risk to be remote. We are currently positioned to be neutral rather than taking a strong directional view on this issue.
World Government Bond Index
Some commentators have raised the prospect of South Africa being removed from the World Government Bond Index (WGBI Index). This could, according to the commentators, result in a number of forced sellers of South African assets and significantly drive down the value of our financial assets (bonds in particular).
We believe that these assertions may be misplaced. The rules for the WGBI are clear: two rating agencies need to downgrade our domestic debt to junk before we are removed from the index. Even if all three agencies act, only one will have our debt as junk, by the end of 2016.
It is also important to note that we have different ratings for our domestic and foreign debt. We are all talking about our foreign debt being downgraded to junk. In all likelihood, the domestic debt will remain investment grade at all three agencies. Therefore, we are still some way off being removed from the WGBI Index which focuses on the rating of the domestic bonds.
It is fair to say the market will not like that the cushion between South Africa being removed from the index is being eroded, however, even in the worst case scenario of all three agencies downgrading us by one notch, we will still remain in the index.
Implications for equity markets and our current positioning
It is logical to assume that any downgrade potential which is priced into the bond and FX markets, should also largely be reflected in equities, by extension. Consequently, we believe the bigger market reaction would result from a downgrade being averted – this is likely to have effects that may seem counterintuitive to many casual observers. In the event of a reprieve, we believe equity markets locally are likely to be softer at an index level due to rand strength.
We believe it is generally acknowledged (and indeed it is our view) that the South African equity market is not a typical “domestic” emerging market equity market. Thus is due to the high concentration of global businesses whose valuations depend on neither South African fundamentals nor domestic cost of capital considerations (with government bond yields being the ultimate starting point here).
Figure 1 below highlights that a substantial portion of the SWIX index by market value comprises what could be regarded as having non-rand drivers of value.
It is clear from the analysis above and on the following page that our equity market is dominated by companies that benefit from rand weakness – which weakness stems from South African specific factors. The reason we make this caveat is that rand weakness which correlates with emerging market currency weakness may not benefit commodity producers (despite possessing dollar revenue streams) as it may mean a period of commodity price weakness.
Naturally, the converse applies. For this reason, we believe that if South Africa manages to avoid a downgrade of its credit rating and the downgrade was priced into FX markets, the equity market at an index level may well actually suffer because of an acute bout of rand strength.
Calculating the precise market impact of a 10% strengthening of the rand in a short time period (say, 3 months) is tricky because some companies have a leveraged financial impact from rand strength or weakness. Nevertheless, we have attempted to estimate the potential impact on the SWIX of a 10% strengthening of the rand by taking cognisance of three factors:
1) The direct translation effect of assets which are mostly priced offshore or do not have FX leverage (i.e. only translation effects of offshore income statements) – good examples include Naspers and Mediclinic. In the SWIX, most of these companies would fall into the Industrial sector rather than Financials or Basic Materials.
2) The likely impact on JSE-listed businesses with dollar revenue streams and rand costs – hence leverage to a movement in currency. These will mostly be shares in the Basic Materials sector.
3) The ‘typical’ response experienced by high-beta domestic sectors such as banks, insurers and retailers to an abrupt strengthening of the rand. For this, rather than assessing valuations at a point in time we have relied on historical experience. For example, in the analysis below, we highlight that over the past ten years in instances where the rand has strengthened by 10% or more during a three month horizon, SA bank share prices have tended to have risen by on average 1.6x the movement in the exchange rate. These three factors will naturally have offsetting effects.
It should be noted that the above table makes reference to the leveraged effect to resource sector earnings of a 10% strengthening of the rand – in reality, it is unlikely share prices would uniformly discount this into perpetuity, so the actual price response would likely be more moderate than indicated above.
From the above, we conclude that SA’s equity market favours a weakening currency over time. As a result, to the extent SA dodges a sovereign downgrade and a favourable solution is reached to the current political crisis in the country, we would expect pressure on the broader index, in local currency. In this event, it will likely pay to be overweight sectors such as Banks, Insurers and General Retailers. In the case of the latter, recent results and trading updates have highlighted substantial downside risk to earnings across the sector, but we believe current valuations have mostly priced this in.