The investment mood in SA is low, but could get worse. Fund managers surveyed by Moneyweb say they are not particularly surprised by the recent credit downgrades announced by ratings agencies. Though the rand has recovered some of its recent losses, suggesting a return to some kind of normal, fund managers have their eyes on less risky markets abroad.
For some, President Zuma’s firing of finance minister Pravin Gordhan and the country’s subsequent credit downgrade antics evokes memories of then President PW Botha’s infamous “Rubicon” speech in 1985. That’s when he was expected to announce a softening in apartheid laws, but instead decided to give the middle finger to the world. Scores of foreign companies and billions of rands drained out of the country as a result. A few years later apartheid and PW Botha were history.
Those who haven’t already shock-proofed their portfolios by taking up most or all of their foreign investment allocation, will certainly be moving in that direction now.
David Shapiro, deputy chairman of Sasfin Securities, says he will make no changes following the credit downgrade and will continue, as he has done for the last several years, to seek opportunities abroad.
“At Citadel, we are not looking at rand hedges more intently now, because we have been negative on the credit metrics for South Africa for quite some time. We expected a downgrade, but we believe that it has not been fully priced in already,” says George Herman, chief investment manager at Citadel. “Our long-term view of the currency is one of weakening over time and this is applied to the long-term investment case. We continue to hold rand hedge shares in our portfolios and we anticipate only making changes when valuations can no longer be justified.”
In a low-growth environment, investors will have to pay closer attention to balance sheet risk, as a downgrade could trigger higher interest rates. Retailers and banks are more vulnerable in this situation, especially where credit sales and indebtedness may become an issue, says Herman. Among retailers, Herman says Dis-Chem has defensive qualities due to its solid earnings growth pattern. Among the rand hedges, Naspers has been an outstanding performer.
Stephen Meintjes, head of research at Momentum SP Reid Securities, says most investment professionals will have thought seriously about how a downgrade would affect their portfolios but, few would have anticipated the level of irrationality that finally manifested. “Whereas a few weeks ago there were expectations of lower inflation leading to lower interest rates which, together with some uplift in the global economy and, hopefully, not too sharp a correction in soaring commodity prices, would lead to a little more than 1% GDP growth, current expectations are more likely to be for more of the same.
“Granted, politicians can’t reverse the rains we have had but they have wilfully reversed the country’s access to foreign capital. So real investment, both local and foreign direct investment, will continue to be missing in action, leaving investors back to choosing winners from sectors such as consumer staples, resources, some oversold financials, banks in particular, special situations and selected property stocks. In the latter category, care must be taken not to invest in ‘over-malled’ areas.”
Dave Mohr, chief investment strategist at Old Mutual Multi Managers, says most fund managers were already assuming a weaker rand over time and were typically invested maximum off shore in terms of allowable offshore investment limits. “Some momentum-driven funds might have been a bit underweight rand hedges as the rand appreciated the past 15 months, and they would probably be loading up on rand hedges. Pension fund surveys also indicate that local fund managers were underweight bonds at the time of the downgrade. So there has not been a major sell-off in bonds – in fact foreigners have been buying. The behaviour of bond yields after the downgrade suggest that the downgrade was mostly priced in.”
Local rand plays like banks and retailers have suffered, but with the economy not likely to slip into a protracted recession, there could be many managers buying these shares.
Mohr says the downgrade by one notch is not an earth-shattering event, as it still allows investors to participate in some SA investment-grade products, however limited. There is currently a strong expectation that rand bonds will be downgraded in due course – so current bond yields probably discount such a potential move.
“It is important to realise that many factors influence interest rates – not only a potential grade change. The Sarb will only hike rates if inflation threatens to exceed the target range for a prolonged period. Despite the recent fall in the rand the currency is still where it started the year and much better than a year ago. International investor sentiment towards emerging markets also play a major role in determining bond yields and the rand – as do commodity prices,” says Mohr.
In a recent note to investors, Coronation says it takes much longer to regain a lost investment grade rating than to lose it. “Only a minority of countries that have lost their investment rating over recent decades have succeeded in gaining it back. SA’s investment grade rating was achieved following many years of hard discipline and tough decisions by the ANC government. After inheriting a dysfunctional and over-indebted economy, the first democratic government reined in spending, recapitalised the state pension fund (which had been plundered), and created a transparent long-term budgeting process which anchored fiscal policy to a sustainable path.”
Over time, ratings agencies acknowledged the progress and upgraded their sovereign ratings for South Africa, with Moody’s awarding an investment grade status in 1998, and S&P following later in 1999. This helped lower the cost of borrowing and enabled the state to provide basic services and welfare grants to the poor and to reduce its debt.
“These achievements have now been undermined. In recent years, there has been considerable fiscal slippage, exacerbated by poorly-managed state-owned enterprises. Low growth and deteriorating confidence has in turn contributed to weak employment growth (outside of the state), low private sector investment and growing inequality,” says Coronation.
Looking ahead, there are a number of ongoing risks. The first is that ratings downgrades do not tend to happen in isolation – the factors that prompt a downgrade, especially below investment grade, tend to have taken time to develop and carry some momentum, while sufficient remedial action can take years to implement. Secondly, South Africa’s inclusion in the Citi World Government Bond Index (WGBI) – which is a considerable boon for domestic funding – is contingent on two agencies holding the country’s local currency rating above investment grade. At this stage, both S&P and Fitch determine the fate of these ratings. A downgrade of these investment assets may be some way off, but things can deteriorate quickly. Coronation says the solution is to remain committed to building a diversified portfolio that can withstand shocks.
In a note to investors, Sandy McGregor, fund manager at Allan Gray, says the ratings downgrades of recent weeks have seriously eroded investor confidence in SA, both domestically and internationally.
“Further downgrades from the other rating agencies are probable. The immediate consequence has been a weaker rand. Currency depreciation creates an environment which promotes higher inflation and higher interest rates. It imposes a cost on all South Africans and has disproportionately negative consequences for the poor because it increases the cost of petrol and food. In the longer run the erosion of business confidence has a cost in the form of less investment and slower economic growth.”