Reichtec April 2017 Newsletter

Junk Status?

The end of March and start of April saw a major cabinet reshuffle in South Africa with the removal of the Finance Minister and his deputy

This would appear to have been the “straw that broke the camel’s back” and in the wake of this political turmoil, two of the three main ratings agencies immediately downgraded South Africa’s debt to “sub-investment grade” or “junk” status.

Over the course of a week the Rand weakened by about 10% from about R12,30/$ to close to R13,50/$, but since then has recovered some of this lost ground to the current level of approx. R13/$.

While this downgrade is definitely negative for the country as it will really impact on the ability of the government in particular to borrow money in the future, there is a good chance that some good will come from this.

The downgrade has already proved to be a rallying call for those opposed to the current state of politics in SA and we have seen unity in the marches and demonstrations against the current corruption and “State Capture”. There is a saying “Never let a Good Crisis go to waste”, and this seems to be happening in SA. It may turn out that this “crisis” proves to be a major turning point – only time will tell, but I am certainly more optimistic having seen the reaction to these developments.

Ratings Agencies

The 3 major Ratings Agencies, Moody’s, Fitch and Standard and Poor’s are companies which try to assess the ability of debtor’s ability to repay debt (interest payments as well as the underlying debt).

Governments typically spend more than they receive from taxes, and fund this shortfall by borrowing (issuing bonds). The expectation is that in the future the economy will grow and government income will increase making it easier to repay the debt. This is very similar to a home loan – over time it should become easier to make the repayments as your income rises.

The rating assigned to a debtor is an indication of how “risky” it is to lend more money to that debtor. Factors such as future growth, debt levels and political stability can influence the risk rating.

The greater the risk, the higher the expected return so where a country has a poor credit rating they need to pay a higher interest rate to compensate for the risk and “attract” investors.

Certain investors (mainly pension funds) are only allowed to buy bonds which have an “investment grade” rating and thus a downgrade could result in some “forced” selling of SA bonds – this could add to the problems with money leaving the country.

Market Commentary

It has been interesting to see how the market has reacted to the latest political turmoil and the ratings downgrade.

Unlike December 2015 when the cabinet changes were totally unexpected, the latest changes were to a certain extent predicted. The ratings downgrade was already factored into the bond market (SA bonds were priced very similarly to bonds from countries such as Brazil and Turkey which had already been downgraded), and the only surprise was the timing (the downgrade was expected in June or December).

As expected there was an initial knee-jerk reaction and the currency weakened from close to R12,30 to over R13,50 to the US$. Subsequently however the Rand has once again strengthened a bit to the current level around R13/$. Remember that a year ago the Rand was trading at close to R15/$ (around 15% stronger than April 2016)

The initial weakness of the Rand was actually positive for the local stock market (if you recall last month’s comments about the local market struggling due to the strength of the Rand), as most of the large companies earn a significant portion of their income internationally – the weaker Rand means they earn more once this is converted back to Rands…

There obviously were some “losers” – mainly the local banking and retail shares which are more dependent on the local economy performance (and the cost of imported goods).

Internationally the focus has been on European elections in the Netherlands and France as well as the announcement if snap elections in the UK to be held in June.

It is easy to get very wrapped up in the fortunes of South Africa, but ultimately remember that SA represents just a tiny fraction (less than 1%) of the global economy. Amidst all the “noise” in the media it does seem as if there is a gradual improvement in the outlook for the global economy. Ultimately this will “pull” SA along – obviously if we are able to resolve our own problems then we will benefit more.

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