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SA Ratings decision

  • Emerging Market Fixed Income

    Moody’s gives SA three months to get house in order, but S&P cuts to junk

    Nazmeera Moola, co-Head of Fixed Income, Investec Asset Management

    The three major global credit rating agencies updated their opinion on South Africa’s credit worthiness last week. Fitch left their ratings unchanged, with both the hard currency and local currency ratings at one notch below investment grade with a stable outlook.

    S&P downgraded both ratings by one notch: foreign currency to BB and local currency to BB+. Both now have a stable outlook. Moody's placed South Africa’s Baa3 foreign and local-currency ratings on review for a downgrade, with a decision expected to follow by the end of March 2018.

    Credit Ratings: Foreign vs Local Currency Debt

    S&P Fitch Moody's
    Foreign
    Local
      Foreign
    Local
      Foreign
    Local
    Sep-15 BBB-
    (stable)
    BBB
    (stable)
    Sep-15 BBB
    (neg)
    BBB
    (neg)
    Dec-15 Baa2
    (stable)
    Baa2
    (stable)
    Dec-15 BBB-
    (neg)
    BBB
    (neg)
    Dec-15 BBB-
    (stable)
    BBB-
    (stable)
    Jan-16 Baa2
    (neg)
    Baa2
    (neg)
    Apr-17 BB+
    (neg)
    BBB -
    (neg)
    Nov-16 BBB-
    (neg)
    BBB-
    (neg)
    June-17 Baa3
    (neg)
    Baa3
    (neg)
    Nov-17 BB
    (stable)
    BB+
    (stable)
    Apr-17 BB+
    (stable)
    BB+
    (stable)
    Nov-17 Baa3
    (neg watch)
    Baa3
    (neg watch)



    The base case for Moody’s is that they will conclude the review in the month following the release of the 2018 Budget, which is currently scheduled for 21st February 2018. They noted that this gives them time “to assess the policy implications of political developments during the review period and the likelihood of pressures on South Africa's key policymaking institutions persisting.” While S&P believes that South Africa’s poor policy making in recent years has done so much damage to the country’s competitiveness that this cannot be reversed in the next six months, Moody’s is providing South Africa with a 3-month window to provide evidence of policy responses that will result in higher growth and ultimately stabilise the debt-to-GDP ratio.

    This highlights the importance of the outcome of the ANC electoral conference scheduled for 16th-20th December and the subsequent response from the ANC’s newly elected president in January 2018. Only by a significant show of leadership in key areas will a downgrade from Moody’s be averted.

    Flow implications of the ratings changes

    A downgrade of the local currency rating by S&P, but not by Moody's, implies that South Africa's sovereign bonds will fall out of the Barclays Global Aggregate Bond Index (BGAI), but not out of the Citi World Government Bond Index (WGBI). This will likely result in forced sales of US$1bn-1.5bn in the next two weeks. However, the much bigger risk is WGBI exclusion – estimates of forced selling from such a move vary between US$6bn-US$10bn.

    In a favourable global environment, net outflows over the next six months could be limited. However, the downgrades coupled with a potential ejection from the WGBI leave South Africa vulnerable to any potential change in the global environment. Emerging Market debt funds have received inflows of US$65bn since the start of 2017. Foreign investors own 40% of all South African government bonds outstanding. South Africa is dependent on the kindness of strangers to finance its deficit. As South Africa falls out of BGAI and potentially the WGBI, foreign high yield investors may displace investment grade investors. However, foreign investment grade investors are ultimately far more reliable than foreign high yield investors.

    Finally, credit ratings are the report card – not the cause of the problem. The deterioration in the credit environment in recent years reflected by these rating changes has already resulted in South Africa paying ZAR5bn more for the debt it has issued in this year alone. This will compound sharply in the coming years, unless the trend is reversed.

    S&P downgrades on weak growth outlook

    In making their decision, S&P assessed the risks of weak growth and the deteriorating fiscal position and decided to act. The positive points S&P notes are:

    • Monetary flexibility and the freely floating exchange rate
    • Deep capital markets
    • 90% of South Africa’s government debt is denominated in rand
    • An improved external position, as the current account deficit has narrowed in 2017
    • A profitable and well capitalised financial sector

    Their concerns are:

    • Weaker growth than they had previously projected, with little likelihood of a strong pick-up in 2018. Moreover they are concerned that consolidation moves in the 2018 budget will further exacerbate the weak growth outlook.
    • High income inequality, which is likely to put pressure on government spending. The pressure for free higher education is a case in point.
    • No structural reforms. Little evidence of moves to decrease income inequality, such as ambitious structural reforms to education and labour markets, or a recomposition of public spending away from public sector wage increases and toward social and education programmes.
    • High contingent liabilities. Weak balance sheets of state-owned companies, notably Eskom, although SAA and the SA Post Office are also mentioned. S&P notes that “Over the next six months, we anticipate that appropriations may be required to shore up Eskom's very weak financial position.”

    Moody's concerns: Budgetary shortfalls and governance

    The two primary concerns that Moody’s highlighted were:

    • Weaker growth than they had previously forecast. This has resulted in a large undershoot in revenue collection and the subsequent increase in the debt burden. Moody’s now expects Debt-to-GDP to reach 60% by 2020/21. This is sharply higher from their previous expectation that the debt ratio would still be around 55% of GDP at that time.
    • High contingent liabilities. The threat that high contingent liabilities present due to guarantees provided to State Owned Enterprises. Chief amongst these is Eskom, where there has been no progress in permanently removing previous management or the appointment of a new board.
    • Institutional erosion. Political decision-making has led to the erosion of institutions, most notably at the National Treasury, which prior to the March 2017 cabinet reshuffle was such a success of the post-1994 ANC government.

    However, the agency also noted that South Africa's credit profile retains a number of features that support a Baa3 [investment grade] rating. These include:

    • A large, well-diversified economy
    • Deep domestic financial markets
    • Well capitalised banking sector
    • Well-developed macroeconomic framework
    • Current debt levels are consistent with Baa3 peers
    • Flexible exchange rate
    • Low foreign currency debt
    • Core institutions remain strong, although they are concerned about the “recent encroachments”
    • Well-functioning civil society
    • Adherence to the constitution

    Looking forward to the resolution of the negative watch, the agency would opt to downgrade should they conclude that South Africa’s economic, institutional and fiscal strength continues to weaken. The factors they will be assessing are:

     

    • Measures to address the funding gap. Given the magnitude of the revenue shortfall, strong and credible measures are required
    • Structural reforms that ease domestic bottlenecks to growth
    • SoE governance. The progress on SoE governance, particularly at Eskom
    • Institutional credibility. “Any developments which cast further doubt over the independence and credibility of core institutions including the National Treasury and the Reserve Bank would be strongly credit negative.”
    • The agency concluded its three-page note by stating that they would affirm the Baa3 rating if they concluded that “developments in the political economy offer the prospect of a more stable, growth-friendly institutional backdrop.”

    SA Rates positioning

    The market is deadlocked between what appear to be decent valuations given the low inflation outlook versus considerable political and fiscal uncertainty. Our positioning has generally been conservative and will remain so until we feel confident the deadlock will be broken.


    Important information

    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 adviser or in a fiduciary capacity. No one should act upon such information or opinion without appropriate professional advice after a thorough examination of a particular situation. We endeavour to provide accurate and timely information but we make no representation or warranty, express or implied, with respect to the correctness, accuracy or completeness of the information and opinions. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate. Any representation or opinion is provided for information purposes only. Investec Asset Management is an authorised financial services provider. 

  • Quality

    Quality

    Clyde Rossouw, Portfolio Manager

    In order to assess the implications of a downgrade of South Africa’s local debt rating the following should be noted:

    1. The yield on longer dated rand denominated government bonds is a function of an appropriate real yield which captures credit risk and inflation expectations.
    2. Credit risk in turn should be an assessment of the willingness and ability of a creditor to repay its interest and debt obligations.

    In order to assess the market impactions of a change in the credit rating we have to answer why the ability of SA to repay debt would be reduced and why the willingness would be impaired. The ability of a government to repay would primarily be a function of how fast the economy is growing, which determines the base for tax revenues and to a lesser degree whether government overspends this revenue collection creating a budget deficit that requires ongoing financing. The South African economy is not growing as fast as it could (near stall-speed) due to a moderation in the commodity cycle and high real short term interest rates. Interest rates are set by the SARB and motivated by a declining trend in inflation courtesy of lower food prices and a recent 18-month period of a strong exchange rate curbing imported inflation. As inflation moderates into 2018, this creates economic room for the SARB to cut rates, cyclically raising the economic growth rate, which is one important aspect of the credit consideration in the first place.

    The second issue is a willingness to repay, and a qualitative assessment of institutional quality, and here is the more contentious issue of state capture and ‘leakage’ stemming from a diversion of tax revenues. On this issue, there is little evidence that in the absence of a government leadership change, the current course of action is credit positive.

    None of these issues are unknown by the markets and a series of cabinet reshuffles in addition to a more adverse global environment favouring less capital flows to emerging markets have caused SA yields to rise to the point at which we need to answer what is priced in to current markets.

    Chart one reveals that offshore SA government debt is already priced in the market as sub-investment grade, with the yields in line with other sub-investment countries like Turkey (Ba1/BB) and Brazil (Ba2/BB).

    Chart 1: A bad neighborhood: SA Offshore debt along with Turkey and Brazil already priced as sub-investment grade

    Source: Bloomberg as at end 08.11.17.

     

    The next question is the impact on local yields of rand denominated debt. The chart of the real yield on inflation protection securities measures the markets view of an assessment of credit risk in rand. On Chart 2 Yields have moved up to 2.7%, which can be compared to US real yields at less than 0.5%.

    Chart 2: It is rational to conclude that heightened credit risk is priced into this level of real yield spread

    Source: Bloomberg as at end 08.11.17.

     

    Chart 3: Comparing the real yields on Turkey to South Africa on chart 3 also suggests yield convergence, once again suggesting that equivalent sub-investment grade credit quality is priced in

    Bloomberg as at end 20.11.17.

     

    Chart 4:

    It would be remiss not to consider a possible positive December ANC electoral outcome, in addition to ignoring the evolution on inflation. Nominal bonds are pricing in a forward inflation rate of 6.5%, which exceeds the current inflation rate of 5.1% and 2018 forecast inflation rate of 4.5% by materially large margins.

    Source: Bloomberg as at end 08.11.17.

    Nominal bonds therefore offer absolute value, price in the negative credit quality outlook (sub- investment grade) and do not price in the positive inflation outlook. Our domestic balanced fund peers do not own material weightings in government bonds.

    We therefore retain our large exposure to domestic government bonds in our portfolios.

     

     


    Important information

    All information is as at 31.10.17 unless stated otherwise.

    All information provided is product related, and is 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 without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security.

    Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing, up to 10% of fund net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down.

    A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund.
    Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. 

    Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).

    This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission.

  • SA Equity & Multi-Asset

    SA Equity & Multi-Asset

    Hannes Van Den Berg, Portfolio Manager, SA Equity & Multi-Asset 

    S&P Global Ratings said their downgrade “reflects our opinion of further deterioration of South Africa’s economic outlook and its public finances. Economic decisions in recent years have largely focused on the distribution - rather than the growth of - national income. As a consequence, South Africa’s economy has stagnated and external competitiveness has eroded”. Moody’s who stayed on Hold, said it will assess the government’s “willingness and ability to respond to rising pressures through growth-supportive fiscal adjustments that raise revenues and contain expenditures”. The agency noted that revenue shortfall, in combination with rising poverty and unemployment, put increasing pressure on expenditure.

    Binary events like these are “only priced into the market UNTIL they are not”. Despite 56% of economists expecting the downgrade Bloomberg has the South African Rand at 14.15 (from 13.85 shortly before). It will be very interesting to see how our South African ZAR trades when our Bond market opens this week. 

    South Africa's sovereign bonds will now fall out of the Barclays Global Aggregate Bond Index (BGAI) and we estimate ~$1,5bn of passive flows (we have a 0.18% weight in this index). One month after Turkey was excluded from Barclays Global Aggregate in September 2016 (Moody’s downgraded Turkey on 23 September), Turkey had about $1bn outflows from foreigners. South Africa’s bond market is slightly bigger than that of Turkey (South Africa $90bn vs Turkey’s $70bn) and investors generally have more positions in South Africa than in Turkey.

    At the moment we stay in the WGBI index (where we have a 0.42% weight) which we think equates to ~$5bn (R70bn) of potential outflows if we were to leave this index. Official data shows YTD inflows (up to August) is R100bn ($8bn). 

    While the outcome of the ruling African National Congress’s elective conference next month will be of interest to ratings companies, they’ll also be watching the February budget for more information on the nation’s debt trajectory.

     


    Important information

    All information is as at 31.10.17 unless stated otherwise.

    All information provided is product related, and is 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 without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security.Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing, up to 10% of fund net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down.

    A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund.

    Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, atwww.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. 

    Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).

    This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. 2017.