Changes in SA’s executive leadership have led to heightened political and institutional uncertainties
Although Standard and Poor’s Global Ratings (S&P) was scheduled to release a ratings review on SA on 2 June 2017, recent changes to the country’s executive leadership have, in its view, brought policy continuity into question. This has resulted in the ratings agency deciding to downgrade SA’s long-term foreign currency rating from BBB- to BB+ (junk status) after an interim review, while maintaining a negative outlook on the rating. SA’s long-term local currency rating was also dropped a notch from BBB to the lowest IG rung (BBB-). According to S&P, maintaining the negative outlook reflects the view that political risks will continue to remain elevated in 2017. It fears potential policy shifts, which could undermine SA’s growth and fiscal outcomes relative to current forecasts. Previously, in its December 2016 statement, S&P pointed out that the rating at the time was supported by its assumption that SA “will experience continued broad political institutional stability and macroeconomic policy continuity”.
The triggers behind S&P’s negative ratings action
S&P downgraded SA in light of the following:
Policy continuity at risk
S&P noted that the divisions within the African National Congress (ANC)-led government have brought about adverse changes to the country’s executive leadership, which has consequently raised the likelihood of unfavorable growth and fiscal outcomes.
Contingent liabilities on the rise
S&P remains wary of previous plans to improve the ailing financial position of public energy utility, Eskom(see chart 1). With the energy regulator capping Eskom’s allowable tariff increase at 2.2%, further financing risks have arisen. The ratings agency estimates that Eskom will have used R300 billion of its allowable guarantees by 2020. Moreover, the national road agency, Sanral, continues to battle with collection challenges for its Gauteng tolling system,while South African Airways will likely require additional government support.
Higher risks of fiscal slippage
A deterioration in SA’s expected macroeconomic performance poses a risk to the path of fiscal consolidation.
Political infighting could delay reforms
Despite some signs indicating that the trust deficit between business leaders and labour representatives was beginning to narrow,political infighting threatens to undo any progress that has already been made.Broader reforms to SA’s state-owned enterprises (SoEs) are not expected to be implemented in the near term.
Weak pace of economic growth
Heightened political tensions could continue to weigh negatively on business sentiment, causing businesses to delay investment decisions,dampening already-mild economic activity (forecasted at negative 0.2% on a per capita basis in 2017) and boding ill for trend growth.
Vulnerability to foreign investor sentiment
With 35% of SA’s rand-denominated debt in the hands of non-residents, financing costs remain vulnerable to foreign investor sentiment.
Large gross external financing needs
SA’s gross external financing requirement amounts to more than 100% of current account receipts (plus usable reserves). Although the current account deficit narrowed considerably in the final quarter of 2016, S&P anticipates the current account deficit ratio to gross domestic product (GDP) to expand to 3.7% of GDP in 2017(from 3.3% in 2016). S&P views any deterioration in SA’s fiscal and macroeconomic performance relative to its baseline projections as a reason to downgrade SA further.
SA’s list of strengths diminishing
While S&P was of the view that SA “maintains fairly strong and transparent political institutions” in December 2016,only the SA Reserve Bank (SARB) was mentioned in its latest April 2017 update. It suggested that the negative outlook could be revised back to stable if political risks reduce and growth and fiscal outcomes strengthen relative to its baseline forecasts. S&P expects the SA economy to grow at 1.4% in real terms in 2017, increasing steadily to 2% by 2019, while the fiscal deficit is anticipated to narrow from 3.2% of GDP in 2017 to 2.6% in 2019.
Junk status – what now for the economy?
SA has been consistently rated as an IG country by S&P since February 2000.Whether SA will regain its IG status in due course depends heavily on the response by those opposing President Zuma’s leadership, particularly from within the ruling ANC. In the event that the current political leadership is overhauled (either through a presidential recall or a successful vote of no confidence led by the opposition parties, a so-called ‘wake-up-call’ scenario could take hold. Apart from political leadership change, this would further require some basic economic reforms to be pushed through, allowing for the potential growth outlook to improve somewhat. These combined political and policy changes could restore a level of credibility in SA’s key institutions and bring about an improvement in SA’s investment climate.
In such a ‘wake-up-call’ scenario, Momentum Investments expects SA growth to average around 1.8% for the next five years, with economic activity steadily increasing towards 2.3% in the latter year of the forecast horizon. Growth will depend on an acceleration in crucial economic reforms and collaborative efforts by government and the private sector. The company expects inflation to be higher in the short term relative to its previous forecasts, given the negative effect of a sovereign ratings downgrade on the local currency. During the next five years, Momentum Investments expects inflation to average around 5.5%. Interest rate cuts, while still a possibility in this scenario, would likely be delayed until the currency begins to reflect a more stable investment climate. Fiscally, the company expects it to remain on track under the ‘wake-up-call’ scenario, with the fiscal deficit narrowing to 2.3% of GDP by the end of the five-year forecasted period. This view is based on an adherence to deficit-neutral spending and a resolve to implement bolder tax reforms to boost revenue growth. This suggests that SA’s debt ratio (relative to GDP) could still stabilise by 2019, before declining marginally. This more-favourable outcome could lead to a ratings reversal during the next five years, although Momentum Investments would expect the sub-IG rating to hold well into 2018, given that 2017 is likely to be marred by political uncertainty and any policy implementation will likely take some time to materialise.Unfortunately, there is also a high probability for a more adverse outcome, characterised by a prolonged period of heightened political uncertainty, as political infighting within the ANC ensues, resulting in policy paralysis and an inconclusive policy environment. In this ‘slippery-slope’ scenario, Momentum Investments expects increased factionalism to inhibit economic growth, resulting in economic growth that is nearly 1% weaker in the next five years compared to the ‘wake-up-call’ scenario. With headline inflation likely to average around 6.5% in the next five years in the ‘slippery-slope’ scenario, thanks to a more depreciated exchange rate, there would be limited scope for interest rate cuts.
The SARB would likely be forced to increase interest rates to a higher peak to curb currency-induced inflation pressures. Under the new administration, fiscal prudence would likely come under scrutiny. Government’s willingness and ability to stabilise debt in this scenario would likely falter in a weaker growth environment and, as such, a degree of fiscal slippage is expected. Accordingly, net government debt (as a share of GDP) is likely to peak at a higher level towards the end of the five-year forecast horizon at around 55% (compared to 47% under the ‘wake-up-call’ scenario). Additional SoE funding needs could exacerbate this profile. With obstacles to a higher growth path remaining firmly in place (and a failure to restore confidence) under the ‘slippery-slope’ scenario, further downgrades are likely to follow in the medium term.
SA’s immediate ratings outlook
Moody’s is scheduled to release its review on 7 April 2017. It is more likely than not that it will shift SA’s foreign and local currency ratings one notch lower (but remaining in IG). While Fitch has not specified a review date, it is expected that it will lower SA’s foreign and local currency rating to sub-IG in due course.With all the ratings agencies still rating SA’s local currency debt as IG at this stage, there should be no immediate selling pressure on global investors that are benchmarked against various global bond indices, as SA’s exit from these indices is some way off. RMB Morgan Stanley points out that should SA lose one IG local currency rating, it could exit the JP Morgan Government Bond Index-Emerging Markets Index Global. Should the country lose two IG local currency ratings, it could exit the Barclays Global Aggregate Index, while S&P and Moody’s would need to cut the local currency rating to sub-IG for SA to exit the Citi World Government Bond Index.
Investment implications of ratings downgrades
The likely broad investment implications of downgrades to South Africa’s sovereign ratings also very much depend on the subsequent response of the broader ANC leadership to the ratings actions. If there are positive political and economic policy responses forthcoming from within the ANC (the so-called ‘wake-up-call’ scenario), favourable political developments could be followed relatively soon by a ratings outlook change from negative to stable, while policy adjustments could eventually result in a return to IG territory within a couple of years. As such, a ‘wake-up-call’ scenario is likely to be accompanied by a period of rand strength, once perceived-favourable political and policy responses are effected, with local asset classes expected to outperform global asset classes (including commodity exchange-traded funds) in such an outcome, ceteris paribus.
More specifically, local government bonds and listed property should perform particularly well, with locally focused equities outpacing foreign-driven shares. In contrast, should there be a denialist response from within the ANC and government to the ratings downgrades, accompanied by ongoing factionalism, patronage and fiscal slippage, there is likely to be a trend of continual ratings downgrades in coming years (the ‘slippery-slope’ scenario). Such a scenario would likely entail ongoing rand weakness, with global asset classes outperforming local asset classes, while local cash and equities (particularly those shares with large global revenue bases) should outperform local fixed-income investments.
Sticking calmly to long-term investment plans within an outcomes-based framework enhances
While human nature favours strong reactive behaviour to system shocks, radical changes to investment portfolios
in response to developments that have uncertain long-term implications are likely to destroy wealth. History has shown that despite the regular occurrence of shocks in financial markets, the optimal wealth-maximising strategy for investors over time has been to calmly stick to well-constructed financial plans and stay invested throughout short-term volatility.In Momentum Investments’ view, the diametrically different implications for financial investments, depending on the response from the ANC leadership to South Africa’s ratings downgrade to junk (the ‘wake-up-call’ compared to ‘slippery-slope’ scenarios), can best be managed when investors have well-diversified portfolios with exposure to a wide range of asset classes that will each behave differently depending on the outcome, hence, collectively minimising the volatility of the portfolio during uncertain times and making the investment experience less stressful. In this regard, the outcome-based investment philosophy adopted by Momentum Investments provides a framework and process that inherently have diversification embedded as a central principle in the approach to portfolio construction.
As a result of this diversification, different asset classes and investments will either benefit or have an adverse experience depending on how markets react and which scenario transpires. The outcome-based investment philosophy therefore represents a prudent approach to provide a robust investment experience through the through the current economic and political uncertainty. Furthermore, as custodians of Momentum Investments’ clients’ savings, the company continually looks for potential attractive risk/reward opportunities in asset classes that might be forthcoming from any investment price weakness to enhance the long-term return potential of portfolios, hence, enhancing the long-term financial wellness of its clients.
-The Macro Research Desk: Herman Van Papendorp( Head of Investment research and Asset Allocation)
and Sanisha Packrisamy( Economist)