After the downgrade: Assessing the effects and the way ahead.

It's not all doom and gloom on the ratings front – while countries that have been downgraded to sub-investment grade often take years to win back their investment-grade status, a downgrade can often have the effect of focusing the minds of authorities.

By Patrick Lawlor, Investec Wealth & Investment

One of the effects of March's cabinet reshuffle has been the decision by two of the major rating agencies, Standard & Poor's and Fitch, to downgrade South Africa's foreign currency rating to sub-investment grade (Fitch also downgraded South Africa's domestic rating to sub-investment grade). The third major ratings agency, Moody's, recently cut its ratings, to one above sub-investment grade.

We go through some of the key issues around the downgrades in terms of what they mean for South African investors. Firstly, though, let's look at what the role of rating agencies is in the financial system.

Background – The role of rating agencies

Credit rating agencies have been around for many years, with the ‘big three' mentioned above having been founded in the early 20thcentury. It rates the debt of organisations, including countries, local governments, state-owned enterprises, corporations, banks, insurers and, indeed, any issuer of debt, whether in the private or public sector. These agencies help lenders to determine what sort of interest rate is reasonable for any debt issuer. A more risky company or state entity will clearly require a higher interest rate to compensate for that risk. Rating agencies help them to determine that level of risk.

It's important to note that rating agencies have no legal status in the decision to lend or invest. Lenders or investors in bonds can make that decision, however the rating will provide a guideline. Where the debt is traded in the market, the market will determine the rate, but, again, the rating will provide a guideline for the market price or yield. This is often expressed as a ‘spread' over and above a base rate, ie an entity or country with a better rating.

Moreover, because markets always try to anticipate events before it happens – think of the share price of a company going up ahead of profit announcements if analysts expect these to be good – the prices of bonds often move in advance of a rating change, if the markets believe there will be an upgrade or downgrade.

Notwithstanding the fact that markets set the rates, ratings do enjoy formal status in some cases. For example, certain pension funds or investing entities (for example, large foundations, endowment funds or sovereign wealth funds) will set its own rules, using the ratings as a guideline. Many forbid investment in government bonds that are not investment grade.

Similarly, bond indices have criteria for inclusion that are often linked to a country's sovereign rating. Some of the large indices only include government bonds that are rated investment grade by one or more of the ‘big three' agencies. With the rise in the number of large index-tracking funds, this has serious implications for the bonds of countries that experience downgrades.

Implications for South African bonds

As mentioned, markets usually anticipate a move in ratings in advance. This has certainly been the case in recent years when it comes to emerging markets. According to Investec Securities, data on ratings of emerging markets over the last 15 years show a widening of credit default swap (CDS) spreads of countries as much as six months before a downgrade (CDSs are effectively a market in insurance against default). This was certainly the case in the build-up to the downgrade by Standard & Poor's. Arguably, bond investors have been on guard since December 2015 at the time of ‘Nenegate' and during several episodes over the last year when it looked as if Pravin Gordhan might be relieved of his position as Finance Minister, until he eventually was in late March.

The big question now is the reaction of the big index-tracking funds that have grown in importance and size in recent years. Index-tracking funds would have to sell out of its South African positions once bonds are removed from the index. South Africa is in the process of falling out of two of the main emerging market government bond indices, which require bonds to have investment grade ratings from at least two of the three large rating agencies.

However, these indices represent about US$60 billion worth of bonds, compared with the Citi World Government Bond Index, which represents around US$20 trillion (of which South Africa makes up 0.43%). Exclusion from this index could knock South African bonds hard, but much would depend on the mix of holdings between active fund managers and passive (ie index tracking) funds. Most of the index tracking funds investing in South African bonds tend to track the Barclays Emerging Market Index, which is ratings agnostic in its inclusion criteria. Moreover, the Citi Index criteria for inclusion require an investment grade rating from either Standard & Poor's or Moody's. Moody's recently cut its foreign and local currency rating, but it remains one notch above sub-investment grade.

If and when a Moody's downgrade to sub-investment grade happens, the index trackers will presumably sell off their South African holdings accordingly, though the quantum of selling will depend on how much of the market it represents. Active managers, such as hedge funds and the leading global asset managers, will presumably already have positioned themselves, based on their perceptions of future South African economic policy.

Based on Investec Securities' analysis of CDS spreads, most emerging market countries see spreads narrowing after a downgrade. This often reflects a positive response by countries to a downgrade, as they attempt to put their houses in order. Will this be the case in South Africa? This will depend on developments in the coming months. Time will tell.

The effect on the economy

As noted, it's the policy response to ratings and not necessarily the ratings that are important. Ultimately, investor confidence – whether in the bond, currency or equity markets – reflects confidence in the stewardship of the economy, not only in terms of fiscal management (how the government balances the books) but also in terms of economic policy. Does economic policy foster economic growth or does it hinder it? This involves questions like regulation, taxation and promotion of key sectors of the economy. Furthermore, for a commodity-exporting country like South Africa, the outlook for commodity prices will also be key.

Dealing with the latter first, there are some positive tailwinds behind South Africa. There appear to be signs of synchronised growth around the world, with the US, Europe and China all showing signs of sustainable growth. Higher growth rates in the key global nodes means greater demand for commodities and for South African exports. Indeed, these positive signs had all helped push the rand to multi-month best levels in the days leading up to the cabinet reshuffle. It also appears to have limited the extent of the rand's weakness subsequent to that event. It's interesting to note that the negative impact of Gordhan's removal, on the rand, bonds and local equities, was far less than following ‘Nenegate'. Emerging markets and commodities were far weaker in December 2015 than in March 2016.

A strong rand is important from another perspective because it affects inflation and the inflation outlook. A weak rand from here would potentially keep inflation above the inflation band of 3% to 6%, leading to possible rate hikes by the Reserve Bank. This would squeeze demand and weigh on the economy.

Poor fiscal management (should it arise) would lead to higher budget deficits and would itself be inflationary (bond yields would rise, pushing up the costs to the fiscus). Poor policy decisions would also have an impact on growth, while higher tax rates to help fund rising expenditure levels would also have a harmful effect.

The mere expectation of poor fiscal management and policy would also undermine business and consumer confidence. Businesses hoping to roll out new initiatives would presumably hold back until there is clarity on policy. Consumers would hold back on major purchases, such as buying homes. Employment rates would be affected, which in turn would increase the strain on the fiscus in the form of grants for the destitute.

Investors may seek to channel more of their investments offshore rather than into local enterprises, which would also have an impact on growth and employment.

Conclusion

A downgrade to sub-investment grade does not in itself condemn countries to economic decline, but can help to focus the minds of government on policy and the importance of an being an investor-friendly destination. The key is how government and other agents of policy now react.

As investors, we cannot predict which way this will go. However, we can say that a well-diversified balanced portfolio, with a good mix of local and foreign investments across the asset classes, remains one of the best shock absorbers in volatile times.One of the effects of March's cabinet reshuffle has been the decision by two of the major rating agencies, Standard & Poor's and Fitch, to downgrade South Africa's foreign currency rating to sub-investment grade (Fitch also downgraded South Africa's domestic rating to sub-investment grade). The third major ratings agency, Moody's, recently cut its ratings, to one above sub-investment grade.

We go through some of the key issues around the downgrades in terms of what they mean for South African investors. Firstly, though, let's look at what the role of rating agencies is in the financial system.

Investors are typically attracted to return and pay too little attention to the current environment. What does this mean for your investments? You should think about how much risk you are prepared to take on. Think about your risk capacity, i.e. how much risk you can afford to take and your risk appetite, i.e. how much risk you are willing to accept in pursuit of superior returns. Your answers should inform your investment decisions.

Good, independent financial adviser can help you to choose a model portfolio with a risk profile that most closely matches your own. If you invest for the right reasons at the outset, and choose your investments carefully, it should be easier to resist the herd.

How are investment managers managing portfolios in the current environment? Flexibility is key, with a good mix of local and foreign investments across the asset classes, remains one of the best shock absorbers in volatile times. Allowing investment manager to invest in more than one kind of asset, managers can then avoid expensive assets in either local or offshore markets - and if everything is expensive, they can retreat to cash. This saves investors having to decide when is the best time to enter or exit the market.

Our integrated wealthcare approach is based on your personal priorities and aspirations. This process is designed to give you a clear course of action for pursuing your goals that span various time horizons and life stages to empower you to do extraordinary things with your wealth, both now and in the future.

I look forward to talking with you again soon.

Regards,

Shane Thom, CFP^® GTP(SA)™
Managing Partner: Integrated Wealthcare Advisor