News update - The impact of SA’s rating downgrade

President Zuma’s decision to remove the Finance Minister and undertake the most comprehensive Cabinet reshuffle since 1994 came as a shock to markets and investors, both locally and abroad, and put paid to speculation that he would temper his actions in the face of heated opposition from all quarters this week.

The consequences of these decisions

S&P Global Ratings immediately cut SA’s sovereign credit rating to junk following an emergency meeting over the weekend saying that “the divisions in the ANC-led government that have led to changes in the executive leadership have put policy continuity at risk”.

• They believe fiscal prudence could be set aside in favour of spending to achieve “radical” economic change.
• The President’s move and the rating downgrade could deal a serious blow to consumer and business confidence while the renewed rand weakness may result in less inflation relief.
• The credit downgrade has also dashed any hopes for lower interest rates and the highly-indebted consumer is likely to come under more pressure.

The market impact of these events was not surprising.

• The rand weakened sharply (R13.81 to the dollar at time of writing)
• Local bond yields rose above 9% as investors sold South African assets and demanded a higher premium/yield to own local bonds amidst the increased political risk and policy uncertainty.
• The equity markets, however, were left largely intact (and in fact have since risen) as investors bought shares that are positively impacted by rand weakness (gold miners, rand-hedge industrials)

Short term: It is difficult to say what the short-term impact on equity markets could be due to the local bourse having significant exposure to foreign earnings. Companies with exposure to the local consumer, however, will no doubt be negatively affected in the medium term as the country is on the verge of a politically-induced recession.

Medium term: In the medium term, the economy runs the risk of slowing down and a prolonged period of stagflation (low growth and high inflation) is now more likely despite some recent green shoots stemming from the collaboration of business, labour and government. The credit rating downgrade means that SA could fall off global investors’ radar screens, making any recovery more difficult. A sharp rise in borrowing costs for government would increase the amount spent on interest and reduce the money available to spend on basic services like healthcare, education and housing while a lack of financial discipline could divert even more funds away from necessary infrastructure to fanciful projects for the enrichment of a few. A sustained weaker rand may translate directly into higher food and fuel prices, hitting the poor hardest.

NFMW’s investment portfolios

The NFMW portfolios have significant exposure to assets that benefit from rand weakness, directly though offshore holdings and indirectly through local dual-listed stocks. This exposure could offset the weakness in domestic banks and interest rate sensitive companies like retailers. The portfolios are exposed to bonds at benchmark weight and this position could be the biggest negative contributor in the short term. This may impact the stable growth portfolio more than the others.

The Fund’s Tactical Asset Allocation (TAA) manager, however, believes that yields above 9.2% would create opportunities to buy bonds at attractive real yields as they still expect inflation to remain below 6% for the year. They believe it is irresponsible to bet everything against the rand and bonds in this volatile political environment as there is a serious risk of being underinvested in SA bonds (or overexposed to dollars) should President Zuma be removed from office.

The Fund’s equity managers will adapt to changing economic fortunes and invest on the Fund’s behalf accordingly while the TAA manager will buy exposure to bonds at attractive inflation-beating yields and re-establish currency hedges to protect against surprise rand strength. We believe this active asset allocation strategy will be a meaningful return generator in the long term.

Report prepared by Mosaic Investment Consulting for the National Fund for Municipal Workers

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