South Africa is in a tough fiscal position and the outlook is perceived to carry more uncertainty than global peers. With weak growth, low consumer confidence, declining VAT receipts and an increasing fiscal deficit, it has become increasingly obvious that the credit rating of South Africa is in question.
There is approximately $14 bn invested in local bonds via index funds
In fact, one of the most prominent ratings agencies, Standard & Poor’s, provided their latest credit rating assessment for South Africa’s debt and now considers it to be “junk” status.
Moody’s have also warned that the rating is under close scrutiny and may be cut. This has implications and lessons for all investors.
Malusi Gigaba gave his first midterm budget speech as Minister of Finance to parliament in October. While a stark picture was painted by Gigaba, the revelations were in line with market expectations as Pravin Gordhan, former Minister of Finance, had already sketched out in February that South Africa was in a precarious position.
Further uncertainty rests in the political arena, with December expected to be a pivotal month. Specifically, the ANC is expected to elect a new president to lead the party for the next general election in 2019. The uncertainty as to who will be elected, and the possible consequences thereof, is of much debate. While speculation is rife, the ultimate outcomes and impacts are unpredictable and unknown.
This naturally adds uncertainty to the credit rating of South African debt. While it was always believed that the likelihood of local debt being downgraded to sub investment grade or “junk” status was quite high, the timing and magnitude of any cuts were largely unknown.
Therefore, while the direction of travel has been reasonably clear, the fact that the two rating agencies acted differently, S&P cutting while Moody’s issued a warning, shows the complex nature of South African economic and political landscape.
Why Credit Ratings Matter
The primary concern with the downgrades is the fact that South Africa’s local currency debt has been excluded from one of the major global indexes and is at risk of falling out of another. These indexes are the Barclay’s Global Aggregated Index and the Citibank World Government Bond Index respectively, which each attract substantial volumes and are very important in ensuring demand is sustained.
While it is impossible to comprehend the outflows at risk from any further downgrades, we do know that there is approximately $14 billion invested in local bonds via funds that track the indexes, of which these index funds would likely be forced sellers plus other fund managers using benchmarks could be discretionary sellers, so we could see a further spike in bond yields.
Are There Implications for South African Equities?
There are a lot of moving parts to the South African credit story, and the implications reach far beyond just debt markets. For instance, equity markets can also be expected to be impacted by any change.
In this sense, South African equities face some perplexing developments. With consumer and business confidence in South Africa near all-time lows, a sudden surge in local risk assets would generally be considered counterintuitive. Yet, in the period from 1 January 2017 to 31 October 2017, the South African equity market has produced a return of 19.6%, with the majority of this gain achieved in the last few months.
So, what has driven this sudden surge in the performance in the second half of 2017? If economic growth is weak, the outlook is poor, confidence is low, and politics are front of mind, how can the equity market reach new highs?
We believe the market strength is mainly due to two factors:
First, the large percentage of companies listed on the local stock exchange that generate their earnings outside of South Africa. These companies are more resilient to SA-specific problems, and in fact, benefit from a weakening rand. These companies are often referred to as rand hedge shares, as over 60% of the earnings of companies listed on the market are generated outside of South Africa’s borders. This figure has steadily increased over time and means that the performance of the stock market has increasingly become a function of global developments.
The South African equity story is therefore characterised by a two-speed market, where the majority of South African oriented businesses have performed poorly i.e. businesses that are dependent on the South African economy, often referred to as “SA Inc” shares, while a select few large rand hedge shares have excelled.
Second, the Naspers effect on market performance. The fact that one share makes up over 19% of the index demonstrates the concentration issues experienced. In fact, at the end of October 2017, the biggest four companies by market capitalisation made up 39.2% of the index. This means that the performance of Naspers, Richemont, BHP Billiton and Anglo American currently account for almost 40% of the returns of the index.
These companies generate significant earnings in offshore markets and are less reliant on the South African economy. If we take the average weight in the index of these four shares from the end of 2016 to the end of October 2017, these companies contributed 18.7% of the total return from the index, which returned 19.6%. In other words, approximately 95% of the returns from the index were delivered by only four shares.
This highlights that returns from the local equity “market” have been anything but broad based. There have been a small number of shares that have performed very well, mostly large rand hedge industrials and resource counters, whereas local or South African focused businesses, mostly SA banks and retailers, have fared much worse.
Keeping Perspective
When considering the plight of South African assets, one might also want to be reminded of the Brazilian debt downgrades through 2015/16 which eventually resulted in junk status from all three rating agencies, the same level it remains today, where bond yields initially spiked to as high as 16%, mostly in anticipation of the cuts, only to fall heavily in the aftermath of the downgrades.
More broadly, our conviction in emerging market assets, both for debt and equity, should only be expected to be impacted at the margin. It is a very small slice of the emerging market pie, equating to less than 10% exposure according to most emerging market indexes, and we must therefore be careful to be biased by one particular region.
