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November 23, 2020

Further into junk

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<p><strong>By: Sanisha Packirisamy, Economist at Momentum Investments and Herman van Papendorp, Head of Investment Research & Asset Allocation at Momentum Investments.</strong></p>

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<figure class="wp-block-gallery alignright columns-1 is-cropped"><ul class="blocks-gallery-grid"><li class="blocks-gallery-item"><figure><img src="https://cover.co.za/wp-content/uploads/2020/08/Sanisha-Packirisamy-Economist-at-Momentum-Investments-2-212x300.jpg" alt="" data-id="143830" data-full-url="https://cover.co.za/wp-content/uploads/2020/08/Sanisha-Packirisamy-Economist-at-Momentum-Investments-2.jpg" data-link="https://cover.co.za/sanisha-packirisamy-economist-at-momentum-investments-2/" class="wp-image-143830"/><figcaption class="blocks-gallery-item__caption">Sanisha Packirisamy</figcaption></figure></li><li class="blocks-gallery-item"><figure><img src="https://cover.co.za/wp-content/uploads/2020/10/Herman-228x300.jpeg" alt="" data-id="144407" data-full-url="https://cover.co.za/wp-content/uploads/2020/10/Herman-scaled.jpeg" data-link="https://cover.co.za/hard-choices-and-reform-implementation-key-to-achieving-five-year-stabilisation-plan/herman/" class="wp-image-144407"/><figcaption class="blocks-gallery-item__caption">Herman van Papendorp</figcaption></figure></li></ul></figure>

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<h3>Moody’s and Fitch downgraded SA’s foreign-currency sovereign rating and its local-currency rating</h3>

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<ol><li><strong>Outcome of rating:</strong> <ul><li>Standard and Poor’s Global Ratings (S&P) affirmed its SA foreign-currency sovereign rating at BB- and kept its local-currency rating steady at BB, which reflects known weaknesses in the economy - no change to its stable outlook on the rating</li><li>Moody’s downgraded both ratings to Ba2 and maintained a negative outlook, due to a further expected weakening in SA’s fiscal strength</li><li>Fitch downgraded both ratings to BB- and maintained a negative outlook to reflect high and rising debt, very low trend growth and extreme inequality</li></ul></li></ol>

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<ol start="2"><li><strong>Reasons for rating decision:</strong><ul><li>The pandemic has intensified SA’s economic challenges and social obstacles to reforms - lower capacity to mitigate the COVID-19 shock</li><li>Fiscal consolidation and the Economic Reconstruction and Recovery Plan face high implementation risk</li><li>Deterioration in debt affordability</li><li>Poor financial performance of state-owned enterprises (SoEs) - exacerbated by crisis</li><li>Challenges to business environment - labour market rigidities and unreliable power supply</li><li>Lofty expectations on freeze in government wage bill</li></ul></li></ol>

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<p><strong>Negative outlook reflective of:</strong></p>

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<ul><li> Larger-than-forecasted deterioration in debt burden and debt affordability</li><li>Chance of additional financial demands from SoEs</li><li>Potential for higher interest rates</li></ul>

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<ol start="3"><li><strong>Rating agency forecasts</strong><ul><li>Moody’s expects the SA economy to contract by 6.5% in 2020 (Fitch: negative 7.3%) before recovering by 4.5% (Fitch: 4.8%) in 2021</li><li>Moody's sees the budget deficit expanding to 15.4% of GDP in fiscal year (FY) 2020/2021 (Fitch: 16.3%) before narrowing to 11.8% in FY2021/22</li><li>Moody’s expects the government debt ratio to reach 93.3% by FY2021/22 from 70.8% in FY2019/20</li><li>Fitch forecasts a rise in government’s debt ratio to 94.8% by FY2022/23</li></ul></li></ol>

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<ol start="4"><li><strong>Triggers for negative ratings action</strong><ul><li>Materially faster rise in SA’s debt burden and further related pressures on debt affordability</li><li>Additional difficulties in implementing growth-enhancing reforms</li><li>Persistent shocks to primary expenditure or revenues</li><li>Sustained rise in the level or volatility of interest rates</li><li>Diminished access to funding at interest rates that would further endanger debt sustainability</li><li>Destabilising large net capital outflow</li></ul></li></ol>

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<ol start="5"><li><strong>Trigger for positive ratings action</strong><ul><li>A rating upgrade is unlikely in the near future, given the negative outlook by Moody’s and Fitch</li><li>An outlook change to stable could occur on:<ul><li>Efforts to arrest the increase in government’s debt burden</li><li>Confidence in stronger growth prospects</li><li>Labour market or power sector reforms</li><li>Agreement with labour unions on a wage deal that moderates future wage increases</li></ul></li></ul></li></ol>

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<ol start="6"><li><strong>Rating strengths</strong><ul><li>Well-regulated and resilient banking sector - despite likely rise in credit losses</li><li>Fully flexible exchange rate regime</li><li>Favourable debt structure - long tenure of 13 years and mostly denominated in local currency</li><li>Low share of foreign-currency denominated debt - 11.8% of total government debt</li><li>Net external debt in line with peers</li><li>Very large local non-bank financial sector - assets = 160% of GDP</li><li>Caps on foreign holdings contain external financing risks</li><li>Societal openness and smooth political changes</li><li>Effectiveness of core institutions - judiciary and the central bank</li></ul></li></ol>

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<ol start="7"><li><strong>Rand implications</strong><ul><li>Only five out of the 23 analysts surveyed by Bloomberg expected a rating downgrade, given the pending outcome of the ongoing government wage bill negotiations and the broad-based effect of COVID-19 on SA’s peer group</li><li>The rand temporarily spiked to R15.47/US$ - hopes for an early dissemination of a viable COVID-19 vaccine has alleviated volatility in markets, prompting investors to participate in riskier asset classes, including the SA rand</li><li>Non-residents share of total local government bonds has fallen from a peak of more than 40% in early 2018 to 29% - any outflows following the recent downgrade are likely to be small given previous outflows</li></ul></li></ol>

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<ol start="8"><li><strong>Investment Implications</strong><ul><li>By definition, the rating downgrades further into junk status imply that holders of SA sovereign debt should include a higher risk premium in the valuation of the asset class to reflect a higher future risk of default - however, international precedent has shown that ratings downgrades within the non-investment grade bracket is less consequential for sovereign yield levels than a downgrade from investment grade status to junk, as the latter move could have mandate implications for bond holders and, hence, trigger forced selling - as such, SA’s exclusion from global bond indices after it was downgraded into junk status by Moody’s in March this year was of more importance to yields</li><li>In addition, the current downgrades happen against a general risk-on global backdrop, driven by the US election outcome and indications that the approval of efficient vaccines against the COVID-19 virus is not too far off - this has ignited a global capital flow into risky asset classes, including emerging market bonds</li><li>Furthermore, the expectation that SA inflation is likely to sustainably remain below the mid-point of the inflation target (4.5%) in the coming years has provided a positive fundamental underpin for SA bond yields and assures attractive prospective real yields for investors in the asset class - as such, we only expect a marginal negative effect on local yields, if any, due to the negative rating action</li></ul></li></ol>

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<ol start="9"><li><strong>What does this mean for SA?</strong><ul><li>Higher borrowing costs for government will crowd out spending on much-needed social and<br>economic programmes</li><li>A further knock to business sentiment could lead to lower rates of fixed investment, weaker growth and increased downward pressure on employment</li><li>A further negative bias on ratings could lead to a more depreciated currency - higher cost of imported goods - raised inflation and limited extent to which the SA Reserve Bank can keep monetary policy accommodative</li><li>On Moody’s scale, SA's sovereign rating is now in line with Brazil, but above Turkey (B2) - on Fitch’s scale, SA ranks in line with Turkey and Brazil</li><li>At 234 points, SA’s five-year corporate default swap spread (CDS) is 263 points below the April 2020 COVID-19-related peak - it is trading 60 points higher than Brazil’s CDS and 143 points below Turkey’s CDS</li></ul></li></ol>

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