It is extraordinary to think that just two weeks ago there seemed a far more buoyant mood in this country with regard to our economic prospects. We had seen a narrowing of the trade deficit, inflation had shown a marginal improvement – down to 6.3% with every prospect of a further downward move to 5.5% in the middle of the year – and the rand was holding steady having appreciated some 30% against the USD since the early part of 2016; it was considered at last to be trading at “fair value” at R12.50/USD. There was even talk of a possible interest rate cut in the near term.
Such was the new found confidence that less than a month ago over 80% of fund managers said they did not expect the much threatened investment downgrade to occur at all in 2017!
Then came the bombshell in the form of first Minster Gordhan’s recall from London and then the subsequent cabinet re-shuffle. S&P, which together with the other rating agencies had shown considerable patience and indeed trust in Gordhan’s message, were quick to downgrade South Africa’s foreign currency debt to sub-investment grade. Whilst Moody’s were prepared to hold off for the time being, Fitch followed S&P some days later.
So what might be the effects of so-called junk status?
- Higher interest rates – possibly by as much as 3%
- Cost of government borrowing set to increase significantly.
- Higher inflation – due to increased cost of borrowing and higher import costs.
- A weaker currency – perhaps as low as R17/USD
- Greater volatility in local financial markets and in the political arena
- SA debt sell- off by offshore funds which cannot hold junk status bonds. As much as R10bn could leave SA
- Foreign investors disinclined to invest in a country with junk status because of perceived risk.
- Generally reduced government spending, including on much needed development projects.
- Whilst imports become more expensive there will be less government support for the manufacturing industry as it tries to rein in spending.
- Almost certainly a recession will be the outcome.
Will the future be that bad?
At this juncture it is very difficult to tell although it doesn’t augur well it has to be said.
According to economist Dawie Roodt, the downgrades confirm a disaster which has been in the making for some time now. SA has been experiencing hardships over a number of years and therefore the current status was not unexpected and the reason why markets have so far reacted relatively mildly.
For now, Moody’s, the last of the big three ratings agencies, has held off making a final decision on junk status for perhaps as much as three months. This decision is based on the improved economic fundamentals prior to the events at the end of March and a “wait and see” approach as to how the SA government will react to the new economic scenario.
Whilst SA’s improved economic position prior to 30 March should not be overstated, the overall picture at that time still carries some weight. The currency has of course since depreciated but it hasn’t crashed as yet. In fact, against the USD, it is currently at levels last seen only at the beginning of December last year. The All Share index has improved some 2% since just before Pravin Gordhan’s recall.
A major consideration too is whether or not our local currency denominated debt is also downgraded. If it is then funds will be forced to sell their holdings and this will result in substantial outflows. We have not reached that stage yet.
The other factor to consider in all this is the general state of global events. From the Middle East to Russia; from the US to Europe, there is great uncertainty at this time. Indeed, the grass is not always greenest on the other side.
Hopes of global economic recovery appears focused in emerging markets, which is encouraging a “risk on” approach for now and which, in turn, may well have encouraged investors to continue using SA as a destination for their investments. In fact there have been record SA bond purchases from foreign investors recently as they continue to seek yield in a low global interest rate environment.
This can change if we return to a “risk off” scenario as a result of heightened global geo-political risks and a strengthening USD as a consequence. It will also change if our local currency debt is also downgraded to so-called junk.
Many countries have been downgraded and in some cases it has been beneficial because it has brought about positive economic and even political change.
Major SA companies have increased their offshore operations and investments considerably in recent years. This will benefit them and their shareholders (including asset managers) in a period of local uncertainty and a weaker currency.
How long will SA’s sovereign debt be rated junk and what is needed to return to investment grade?
It all depends what the government does and how quickly. It will have to cut back on spending and adopt a generally frugal approach including reducing the size of government itself. There are too many civil servants as it is and the accompanying wage bill is excessive resulting in rising state debt levels.
Serious attention should be given to the far more efficient running of “State Owned Enterprises” such as Eskom and SAA which need frequent government bail -outs. Once again plans to privatise SOEs wholly or partially should be seriously considered and implemented.
Ill-defined and seemingly alarming policy calls for “Radical Economic Transformation” should be dropped or encapsulated in a more investment friendly policy. In general policy uncertainty must be stopped.
Unless it is abandoned or substantially modified, the proposed nuclear deal and the vast expenditure involved – most of it borrowed – does not augur well as regards a more frugal approach.
In 1998 South Korea was downgraded. Having then opened the country up more, economically, South Korea returned to investment grade within 24 months.
By contrast, a country such as Colombia, with “complex internal political structures and a lethargic fiscal policy”, took 12 years to return to investment grade.
It is very much up to South Africa as to how long the downgrade will last and how painful the experience will be.
We leave it to you to decide what you think the likelihood is of the government taking adequate and appropriate action as outlined here.
So what should individuals do now?
Above all – don’t panic!
Maintain your long term investment strategy and ensure that your overall portfolio is well diversified. Take advantage of the still generous off- shore allowances as part of your diversification strategy. The rand has depreciated about 10.5% against the USD since the current difficulties arose. Whilst this is bad enough it is still up by nearly 20% on the USD when compared with the beginning of last year. So far it hasn’t completely crashed so there may still be a window of opportunity in the next while to move further into foreign assets.
Review your monthly budget and start to cut down on any wasteful expenditure. Keep your essentials going – particularly investments and insurance policies – and keep in mind diversification as the key overall strategy.
Ensure that you are getting the most out of any tax concessions which might be applicable to you, including of course maximising your deductible retirement annuity contributions.