An April’s fool tale

By Patrice Rassou, head of equities and Mokgatla Madisha, head of fixed interest at Sanlam Investment Management.

The murky world of political intrigue has certainly taken centre stage with the surprise removal of Finance Minister Nene at the end of 2015, which gave our financial markets a shock jolt, only to be revived by a spectacular volte-face and the appointment of a more experienced Pravin Gordhan, and yet another abrupt about-turn with Gordhan’s removal on the eve of 30 March.  This was followed hot on the heals by the S&P’s downgrading of SA to junk status last night.

Politics has undoubtedly been the dominant theme driving global financial markets in the past year.

Junk status: what it means

S&P’s lowering of South Africa’s credit rating to junk status last night sent the rand plummeting even further following the surprise Cabinet Reshuffle. South African banks lost R60-billion in the initial hours following President Jacob Zuma’s Cabinet reshuffle. But that is nothing compared to what the country still stands to lose if the government does not respond appropriately to rating agency Standard & Poor’s (S&P’s) decision to downgrade South Africa to junk status.

It is expected that newly-deployed Finance Minister Malusi Gigaba will band together with former Finance Minister Pravin Gordhan to explain the situation to the global investor community. Our policy response is more critical than ever, says Mokgatla Madisha, head of Fixed Interest at Sanlam Investment Management.

What have been the impact of recent announcements on the markets?

A weaker rand is not necessarily inflationary

The rand has lost about 10% since Minister Gordhan was recalled from his oversees trip and bond yields have risen about 90bps. A 10% weakening of the rand, if sustained, will result in inflation going up by about 0.70%. However, at current levels of about R13.90/USD the rand is still 5% stronger than last year’s average level of R14.70/USD. The current level of the rand is therefore not inflationary.

Bond markets have priced in the downgrade

The 90bps increase in yields over the last week has reduced bond portfolio values by about 6.6%. We have seen very little trading in corporate bonds but a number of auctions were postponed as a result of the volatility of the last week. We expect even more pressure on SOE spreads and possibly on bank bonds too.

A rating downgrade usually drives more selling as bonds no longer fall within mandates. South Africa is still rated investment grade (IG) on its local currency debt and our view is that we are not likely to see much more selling as a result of the S&P announcement. South Africa’s five-year dollar credit default swap (CDS) was already priced at the same level as Brazil, which is rated BB, around 225bps. Furthermore, Russia and Croatia, which are rated BB, are trading at 167bps and 181bps respectively. On a relative basis SA debt has been priced for the downgrade.

The negative outlook is worrying

S&P retained a negative outlook on the rating, suggesting that they see scope for further action if there are no corrective actions taken. How policymakers respond to the downgrade is going to be crucial. If South Africa is to regain investment grade status, tough decisions are needed. Faster fiscal consolidation is imperative and the budget needs to be more resilient, which means expenditure must be more aligned with revenue growth.

Sanlam Investment Management (SIM) remains overweight SA long bonds, as reflected in our flagship multi asset fund, the SIM Balanced capability. The real yield on offer remains attractive relative to that of other developed and emerging markets. And, yes, part of the high yield on offer can be ascribed to the political risk South Africa has been facing.

The fiscal restraint challenge

The decision to downgrade SA to junk status means the country will have to go into debt counselling for a number of years. National Treasury will now have a fine financial tightrope to walk. How to exercise fiscal restraint to keep our foreign creditors at bay while fulfilling the mandate of poverty alleviation will be the greatest challenge.

Wasteful expenditure has become the scourge of society, says Patrice Rassou, head of equities at Sanlam Investment management.  For all the juggling by our technocrats at the financial heart of government, the real economy is not creating enough jobs, growth has been lack-lustre as commodity producing economies took great strain driven by a severe correction in commodity prices. And in the real world, business confidence has remained low and an impediment to investment and job creation, with public sector enterprises unable to take on the baton of creating enough jobs to absorb growing youth unemployment.  Demands on the treasury are many – free tertiary education, better and more affordable healthcare for all among others.

Despite this, SA corporates are stalwart survivors

For over 8 million unemployed South Africans, an economy which is not growing and creating jobs is cause for much hardship. And this lack of growth is in stark contrast with financial markets, which seem disconnected from the real economy. Don’t be too surprised by this conundrum; Credit Suisse found that for the past century (1900 to 2016), the JSE delivered the best stock market returns in the world, outstripping the likes of the US, UK and all the European nations. This shows that our corporates have outlasted world wars, economic isolation and periods of extreme economic mismanagement. Today, the JSE is dominated by global companies that derive most of their earnings outside of our borders with the largest listed stock Naspers, owning a stake in Chinese internet giant Tencent, which is the largest emerging market stock by market cap!  So for our clients invested in a diversified portfolio of assets on the JSE, there is some matter of comfort that the SA Inc. has stood the test of time when it comes to financial performance.

Can we deliver the change the economy needs?

However, the bigger existential question that we face is whether the shift towards more radical economic transformation will deliver the changes we need in terms of better education and jobs to alleviate economic hardship. Our foreign creditors, who own over a third of our government’s debt, are watching closely. In a low-growth environment, Government’s job should be to focus on reducing wasteful expenditure in state-owned enterprises and incentivising the private sector to create jobs in South Africa – something President Trump made his election mantra.  Any economic misstep will hit the poor the hardest, resulting in foreign capital giving our shores a wide berth. Higher cost of servicing our debt will mean that there will be less money for social grants and a weaker exchange rate will fuel inflation, which will increase the cost of living for all South Africans. For those with pensions invested on the JSE, our philosophy is to invest in companies with solid business models trading at attractive valuations as the best way to protect your savings.  Good companies can withstand economic turmoil through a diversified business model and by focusing on defending their margins. Unfortunately, however, this could be at the expense of job creation.

Concludes Rassou, it was Buffett who advised on investing in businesses with safe ‘moats’, ie those with a sustainable competitive advantage because, he says, “you should invest in a company that even a fool can run, because someday a fool will”.