Everybody expected that Moody’s Investor Service would reduce its investment rating for SA government bonds this year, so the announcement to this effect over the weekend came as no surprise.
Amid groans that it could not have happened at a worse time, everybody also agreed that the cut of our last investment grade rating played second fiddle to the unfolding economic crisis caused by the global coronavirus epidemic.
That all three major rating agencies now advise the investment world that SA bonds are very risky instruments and, by implication, that fund managers should not include SA bonds in pension and investment funds, sent yields on bonds to the highest levels in 20 years.
Despite the South African Reserve Bank’s announcement of a larger than expected reduction in the repurchase rate a week earlier, the yield on 10-year government bonds increased to 12.355% by March 24, when it became clear that Moody’s had no other choice than to react to the significantly worsening economic scenario.
Yield on SA 10-year bonds
The drop in bond prices was sharp, considering that the yield was at 8.875% at the beginning of March. It is now significantly higher than in 2008 when SA 10-year bonds traded at 10.678% following the worldwide financial crisis that hatched in the bond markets, albeit not the market for government bonds.
SA bonds strengthened slightly after the Moody’s announcement removed uncertainty in the market, even with the added ‘negative outlook’ tag that warns of a possible further cut in the rating.
Attention moved to local economic issues, especially the impact of the health lockdown on the economy and government finances.
For once, economists are all in agreement: The SA economy is facing the worst crisis in decades.
Izak Odendaal, investment strategist at Old Mutual Wealth, says the Moody’s downgrading was widely expected to happen, even before the global outbreak of coronavirus. “But of course, the severe economic damage caused by [the] lockdown made this downgrade all but inevitable. Still, because it was widely expected, it was probably priced into financial markets,” he says, indicating that a large part of the sudden jump in the bond yield could be as a result of the developing economic crisis.
Downgrade impact eclipsed
“Many people feared that when Moody’s downgraded SA, you would see a much weaker rand and a surge in bond yields. But that happened prior to the downgrade because of the global coronavirus crisis. In all likelihood, this [the downgrade] probably does not change anything.
“In fact, Moody’s decision will probably be completely overwhelmed by global developments related to the virus in the next couple of weeks. We should also note that S&P and Fitch downgraded South Africa to junk a few years ago already,” says Odendaal.
Christo Luüs, economist at Ecoquant, warns of severe economic hardship brought about by the 21-day lockdown and some of the unreasonable rules imposed by authorities.
He says the economy is facing big challenges already. “Government is overly indebted and spending can hardly be increased. Thus, we have to rely on monetary policy to a large extent.
“The problem is that lower interest rates will not do much if people cannot spend money because of the lockdown,” says Luüs.
“Jobs will be lost, supply chains are being compromised – we may experience shortages.”
He tells of a complaint from a farmer who was prohibited from buying a basic tool he needed for repairs to a water tank. “Production need inputs – tools, material, and intermediate goods. Closing one factory impacts on the whole value chain.”
His message is that the weakest-link analogy is applicable to the supply chain as well in that the supply chain is just as strong as the weakest link. “We have to guard against a total shutdown of the economy,” he warned in a telephonic interview with Moneyweb.
“The lockdown may have been required – but the control over what people may buy is a bit over the top.
“Why not allow people to buy clothing, crockery, a drill or a kettle? A ban on meetings and public gatherings may have sufficed.
“How can anyone be ‘infected’ if I walk with my dog in the street?” he asks.
Luüs says the economic lockdown may compromise exports. “Are we exporting coal and iron ore at the moment? Is shipping operational with [the] restrictions at harbours?”
His sentiments are shared by others, such as Wichard Cilliers, chief of dealing at bond specialists TreasuryOne. “The world economy is heading to its worst downturn in almost a century as we are heading for a similar depression that was seen in the 1930s,” says Cilliers.
“Moody’s expects the SA economy to contract by 2.5% in 2020 and our debt-to-GDP to rise to 91% in 2023. The big worry is that the latest downgrade will see South Africa kicked out of the benchmark World Government Bond Index [WGBI] of local-currency debt, which could trigger a massive outflow of an estimated $11 billion.
“While the rebalancing of the WGBI has been postponed until the end of April, it will only delay the selling by passive index trackers. The active managers could potentially already have rebalanced themselves as we have seen net outflows of around $4 billion in foreigners transactions over the past month,” says Cilliers.
In addition, he says the rand has been the worst performing emerging market currency over the past week and traded at its weakest level ever at R18.05 in Asia early Monday morning following the Moody’s announcement.
The rand is 17% weaker than a month ago.
All the economists that Moneyweb contacted had the same message – that we must hope that government has the political will to act decisively. Most appealed that the lockdown ends after three weeks and that government cuts unnecessary spending, stamps out corruption, and rethinks the unending and nonsensical bailout of state-owned companies.
Cilliers sums it up accurately when he says that “we do not want to go to the IMF [International Monetary Fund] for a bailout as the restrictions they will impose will not be pretty”.
Jacques Nel, head of Africa Macro at NKC African Economics, points out that the downgrade of SA dollar and local-currency sovereign bonds was largely expected, but “considerable uncertainty remains regarding the size of forced divestment once SA bonds fall out of the WGBI, particularly at a time when a global flight to safety has already scared off the more risk averse capital.
“We have previously argued that much of the downgrade has already been priced in and that we do not expect a capital exodus following the decision. However, the global economic environment has changed considerably since the start of March.
“The local economy had already entered 2020 on a very fragile footing before the dramatic external developments related to the Covid-19 pandemic emerged. Domestic policy uncertainty and supply-side constraints have now been accompanied by a global deterioration in business sentiment and a drop in demand for South African goods, all weighing on the country’s economic recovery prospects,” says Nel.
Deep contraction fears
He expects that these factors will push the country into a deep economic contraction this year with NKC African Economics expecting real GDP to contract by 4.9% in 2020. This is much worse than the SA Reserve Bank or Moody’s’ forecasts, but still not the worst out there. A worst-case estimate of a 10% contraction has been touted if the predicted severe economic recession in the US becomes a reality.
Nel makes the point that weak local economic activity will feed into lower fiscal revenue, and together with government efforts to support the economy from the fiscal side (albeit paltry compared with what we’ve seen in other countries), will see the fiscal deficit reach around 10% of GDP this year.
Listening to economists and looking at market prices makes a doctorate in economic modelling totally unnecessary for a simple forecast: An increase in unemployment, lower tax revenues, more pressure on the government to “do something” and an overall fall in income for everybody.
Fighting the scary virus might turn out to be the easy part of the battle ahead.