by Rashaad Tayob, Portfolio Manager
Nedgroup Investments Flexible Income Fund
30th March 2020
When, not If
On Friday March 27th, South Africa lost its last investment grade rating as Moody’s downgraded the country to Junk status. Even before the COVID-19 crisis, the deterioration of the government finances made the downgrade inevitable, it was just a matter of time. Fitch and S&P had downgraded South Africa to “junk” status in 2017. Moody’s follow a more lenient methodology which gave credit to South Africa’s low level of offshore debt, but with the economy set to go into a steep recession, the downgrade was unavoidable.
Potential outflows from capital markets
The question of the effect of the downgrade has been asked countless times over the last 3-years. While the Moody’s rating has been a factor in the market in recent years, government has been unable to take any positive steps to try to save the investment grade rating. The issue has created a lot of undue concern and negativity in the market, which may have constrained investment. Without an investment grade rating, South Africa will be removed from the World Government Bond Index (WGBI) and some outflows will result.
The quantum of these flows has been estimated at anywhere between $1bn and $12bn. Most offshore investors in the South African markets are Emerging Market (EM) investors who invest in both investment grade and sub-investment grade debt across countries. The investment team at Abax believes that the outflow will be towards the lower end of the estimates.
The portfolio manager had previously indicated that the effect of the outflows would very much depend on the global environment. A downgrade last year when global markets were rallying, and risk premiums were low, would have had minimal impact (20-40 basis points). However, the timing of the downgrade now means that the impact is potentially bigger. However, it is understood that the rebalancing of the WGBI has been delayed from end of March to end of April given the global turmoil. This should help in spreading the outflows over a longer period.
The South African Reserve Bank (SARB) factor
The SARB surprised the market last week Wednesday by announcing that they would start a program of bond purchases in order to add liquidity and stabilise the bond market. It is very rare that an EM central bank can initiate quantitative easing (QE). It would have previously led to a massive loss in confidence, but with almost all Developed Market (DM) central banks doing QE, it looks like EM’s will be able to engage in these policies, albeit on a much smaller scale. As long as inflation remains within target, the SARB will argue that they can continue with their purchases. The current SARB team is highly credible, and it is expected that the markets should respect their authority and give them the benefit of the doubt.
Details on the intervention are minimal thus far. The SARB has left it open ended to give themselves flexibility. No indications of the potential size and what levels on bond yields they would look to intervene have been provided to the market. Investors will probably have to wait for disclosure at month end to see what they have done, although they would be expected to absorb a significant amount of the foreign selling to come. The risk the SARB must balance is that if they accumulate too much debt, they will lose credibility, as markets begin to question if the policy move has shifted towards a government debt bailout.
In the short term, it does give bond holders a bit of confidence that yields will not become unhinged. The risk was that we were heading to 15%. Yields rallied 200 basis points after the announcement, which was used as an opportunity to trim the portfolio’s bond holdings. Globally, QE has been used to suppress bond yields and to date we haven’t seen anyone pay an economic price. However, the ability to buy your own debt opens a Pandora’s box and is a ruinous policy when the wrong people are in charge. On balance the SARB policy will lead to lower yields and weaker currency over time.
The fundamentals are what really matter
While the fixed income team at Abax has warned about the fiscal deterioration for some time, the COVID-19 crisis has brought forward South Africa’s debt crisis from 3-5 years in the future to now. Expectations from economists indicate a contraction of 5% in GDP this year, which leads to a fiscal deficit of 12%. This is clearly not sustainable, and we now need massive intervention from Treasury, likely in combination with cheap funding and a program from the International Monetary Fund (IMF).
The reason for the debt crisis is the inability of the government to control both its own spending and that of the SOE’s. If you can’t reform, the market will force you to do it, and it will be more painful. South Africa are at the point where a severe restructuring can’t be avoided. The SARB intervention and some funding from the IMF may buy South Africa some time, but it now needs to be used effectively. As a country, we do not want the interventions to take the pressure off the government. The wage bill and SOE problems must be confronted now.
Portfolio positioning
It must be remembered that while SA’s fiscal position is dire, the entire world is dealing with the COVID-19 crisis and deficits and debt are a global problem. Bonds had de-rated significantly prior to the virus outbreak turned into a crisis. The spread of South African debt to EM peers had moved up from 2% to around 3% as the market moved to price in the downgrade. The COVID-19 crisis has resulted in the sharpest bond move on record, the only comparable being the Asian crisis of 1998. The Flexible Income Fund currently holds 8.8% of government bonds in the portfolio, with a yield of around 12%. This is a substantial risk premium given the SARB recently cut the repo rate to 5,25%. The fund will maintain this position on the bellief that action on the deficit is due and an IMF program will provide some credibility to the market. However, if we continue to see the lack of follow through from Treasury and the Cabinet, we will look to mitigate the risk by reducing government bond exposure or increasing FX exposure from its current 6% level.
With acknowledgements to the team at Nedbank Private Wealth……..
