Checking the downgrade scoreboard

By Dave Mohr, Chief Investment Strategist, and Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers (OMMM)

Just over a month has passed since South Africa joined the junk status economies’ club. What does the scoreboard say?

There have been no discernible changes in government policy. The new Finance Minister has been talking the talk (his controversial adviser aside) on maintaining the commitment to fiscal prudence. October’s Medium Term Budget Policy Statement will be the first opportunity to see if he walks the walk.

Financial markets driven by global events
Financial markets responded negatively to the political events surrounding the downgrades, but there was no collapse in bonds or the rand. This is partly because a lot of political risk was (and is) already priced into local assets, and global developments quickly overtook this initial response. For one thing, global investors bought billions of rands worth of local bonds during March and April, shrugging off the Cabinet reshuffle and ratings agencies.

The current global environment is still favourable to South Africa on balance, although it is not all moonshine and roses.

Political risk – which is clearly not unique to South Africa – has receded with centrist Emmanuel Macron’s emphatic victory in the French presidential election over the weekend. This outcome, which was expected, together with solid first quarter corporate earnings results, has seen global equities rally. The MSCI World Index has hit new record-high levels in the past two weeks. Emerging markets are outperforming developed markets (in US dollars). Despite this, the MSCI Emerging Markets Index is still some 20% below its record high of a decade ago.

Global growth is pretty solid. The US disappointed in the first quarter’s gross domestic product growth number, but the underlying growth rate is still fairly stable at slightly less than 2% per year.

Eurozone economic growth was 1.7% year-on-year in the first quarter. After lagging US growth since 2011, the Eurozone economy is finally growing at a similar pace, and appears to be accelerating. The Eurozone Purchasing Managers’ Index increased in April, alone among major economies.

China posted the best economic growth numbers in a year in the first quarter, with the economy expanding 6.9% year-on-year in real terms. However, with the stronger growth comes concern that the property sector is again running too fast and that authorities will have to tap the brakes. Regulators are also increasingly clamping down on leverage in the banking sector and in financial markets. Certain commodity prices (notably iron ore) ran well ahead of this growth improvement, supported by leverage, and have recently fallen back. The oil price also took a tumble last week as US shale production is increasing faster than expected. This places pressure on the OPEC countries to agree to further output cuts.

Gradual US rate hikes, but no rate shock for SA
The US Federal Reserve appears on track to hike interest rates in June. Its monetary policy meeting and statement last week did not deliver any news, except the opinion that the slowdown in the first quarter was transitory. With data showing that the US added 211 000 jobs in April, more than expected, and the unemployment rate falling to 4.4%, market pricing of a June hike jumped from less than 50% to almost 100%. Nonetheless, despite the low unemployment, wage growth is stubbornly low at 2.5% year-on-year. Historically, low unemployment put upward pressure on wages which in turn put upward pressure on inflation and, ultimately, interest rates. In the absence of this process, interest rate increases should remain very gradual.

With a Fed hike looming, and commodity prices lower, the rand closed last week at R13.40 per US dollar, down from the post-downgrade closing best of R13 per dollar (the rand fell to a closing low of R13.92 per US dollar after the Fitch downgrades, as seen on chart 1). Government’s borrowing costs, as indicated by the yield on the benchmark R186, are still below the average 2017 level. To reiterate: there has been no currency or interest rate shock since South Africa lost its investment grade status.

Economic outlook has not changed much
Where does this leave the economic outlook? It is worth reminding ourselves that the local economy was hit by a number of shocks in recent years, including load-shedding, plunging commodity prices, a food price spike, the worst drought in decades, prolonged strikes, capital outflows (along with other emerging markets) and rising interest rates. While the real economic growth rate declined from 2.5% in 2013 to only 0.3% last year, there has been no recession despite these shocks, demonstrating an underlying robustness that many seem unwilling to recognise. To expect the economy to go into recession now because of a change in credit rating is overly pessimistic.

Economic data is released with a lag, and mostly still predates the downgrades. Manufacturing production, retail sales and wholesale sales numbers were negative on a year-on-year basis in February. Mining production was positive, supported by a rebound in platinum output. However, these numbers point to a sluggish first quarter GDP growth number. Credit growth continues to slow, with household borrowing growth barely positive in March.

The Reserve Bank’s composite leading indicator, which points to the trend of economic activity in six to 12 months, increased further to the highest level in two years in February. This is positive.

Also positive is that South Africa posted a substantial trade surplus in March. The trade surplus for the first quarter as a whole is also larger than for the fourth quarter on a seasonally-adjusted basis. This suggests that the recent narrowing of the current account deficit can be sustained.

The three available post-downgrade data releases were sharply lower, indicating a blow to the confidence of consumers and business. New vehicle sales fell to a seven-year low in April, while the Absa Manufacturing Purchasing Managers’ Index slumped to 44.7 index points, below the 50 neutral level. The Standard Bank Private Sector Purchasing Managers’ Index (covering a broader number of sectors) was lower but still above 50. However, the high number of public holidays in April probably also contributed to less selling and production activity, which would have weighed on both indicators. Therefore, May’s data will give a better reflection.

One bit of good news is that the inflation outlook continues to improve. Local consumer inflation declined to 6.1% in March, with lower food inflation contributing. However, core inflation – excluding food and energy – declined meaningfully to below 5%. Headline producer inflation fell to 5.2% while StatsSA’s import price index fell 9% year-on-year in February, due to a combination of the firmer rand and low global inflation.

Maize prices have fallen substantially as the 2017 crop is expected to be twice as large as last year’s. This is yet to completely feed into food prices at the consumer level. Against this backdrop, the Reserve Bank is likely to keep rates unchanged for most of the year. In fact, the inflation outlook and weak growth calls for modest rate cuts, but the SARB remains focused on the potential risks to the rand from further political uncertainty.

Keep calm and carry on
It is not junk status per se that should concern us. After all, South Africa did not even have a credit rating prior to 1995, and many of our international peers are not investment grade. An unexpected change in rating can cause volatility in financial markets but it does not by itself limit government’s ability to fund itself or cause its borrowing costs to rise. What we should monitor are the conditions that gave rise to the downgrades. Until these fundamentals change, there is no reason to make knee-jerk adjustments to portfolios. South Africa remains a vibrant and noisy democracy, with a free press and independent judiciary. Crucially for investors, the Reserve Bank is also independent and committed to stable inflation over time.

Checks and balances exist, they just work slowly sometimes. The court ruling that sent Government’s nuclear ambitions back to the drawing board is a good recent example since concerns over Eskom’s government guarantees were a key reason for the downgrades. The court did not rule on whether or not we should invest in more nuclear energy, only on the unlawful process that was followed to date.

Chart 1: Rand-dollar exchange rate and SA government bond yield

Source: Datastream

Chart 2: South Africa’s imports, exports and trade balance, seasonally-adjusted

Source: Datastream