Late on Friday night, 27 March 2020, the axe finally fell on South Africa’s sovereign credit rating as ratings agency Moody’s downgraded South Africa to sub-investment grade, often referred to as “junk” status.
This downgrade will now officially lead to South Africa’s exclusion from the World Government Bond Index (WGBI) and force index-tracking, passive investors to exit their South African bond holdings. This potential outflow has hung over South Africa’s head like the proverbial Sword of Damocles since Moody’s decided not to downgrade the country’s sovereign credit rating to sub-investment grade at the same time as other leading ratings agencies did, creating a split rating and keeping South Africa in the WGBI. Ultimately, however, the pain of this downgrade may actually have been made worse by the postponement of a decision long after it was warranted.
In their statement on Friday night, Moody’s cited “the country’s continuing deterioration in fiscal strength and structurally weak growth” as the main driver behind the downgrade. None of this is new. Electricity issues, labour concerns and structural problems have all been in the pipeline for some time now and, exacerbated by the deteriorating global outlook, mean South Africa is likely to remain in recession and unable to meet its targets.
More immediately, the downgrade now means that South Africa finds itself in the unenviable position of facing severe capital outflows amidst a deep and ongoing global financial crisis, caused by the COVID-19 pandemic and the financial market volatility that the COVID-19 outbreak has wrought on the world. Despite Moody’s having several previous opportunities to downgrade the country, in the face of deteriorating credit metrics and as promises of structural reform clearly became whimsical, they evidently ignored it all. Now, using the COVID-19 virus as the excuse, Moody’s has not only downgraded South Africa, but maintained a negative outlook. This implies that Moody’s has downgraded South Africa by two levels and are prepared to downgrade even more.
South Africa’s pain will, unfortunately, not be dealt with swiftly. FTSE Russell, the index calculation agent, has indicated it will postpone the rebalance of its indices due to the severe volatility being experienced in the financial markets at present. This will leave the South African bond market in a period of severe uncertainty as to the timing of actual flows that need to take place. Markets will attempt to price this fundamental change, which means that in the short term both the rand and South African bond yields will come under pressure. The South African equity market will have a divided response as the weaker currency will benefit some and hurt other counters. Ultimately, companies with short-term debt that needs to be rolled soon might face severe difficulty in doing so.
In the medium term, South Africa will face a severe sovereign funding crisis of its own. By now it is clear that February’s National Budget could, after a single month, effectively be torn up and thrown away for various reasons. The country’s sovereign debt, expressed as percentage of GDP, will very rapidly rise from the current 60% levels to over 90%, making all future debt much more difficult to obtain and at much higher interest rates. Whatever the budgeted interest cost over the medium term, will now be substantially higher. Interest cost will become the largest and fastest-growing component of the budget and will crowd out all other social wishes.
It is over the long term, however, that the downgrade to junk will be the toughest for an economy that was merely plodding along without realising the real threat of being “an outcast” in the global funding markets. This should be a wake-up call to our leadership and all our political and economic participants. It is time to stop squabbling and start implementing solutions to growth and the creation of real, productive and competitive employment. Only then will the weaker currency assist us in exporting the fruits of such growth to the world and, in so doing, heal the wounds of our country and get South Africa back into the A-team of the investment grade club.
At Citadel we’ve been expecting this downgrade for a long time. We’ve been extremely defensive towards all exposures affected by a downgrade by being thoroughly underweight South African bonds and overweight hard currency in all solutions. This positioning will help during the inevitable short-term market reactions, but the most important aspect for our clients is the state of global markets and global health. In this regard each and every client has a specific long-term goal and we urge you to engage with your advisor to ensure you remain firmly on that path.
This downgrade is but a minor – albeit long overdue – issue in the current global scheme of things. Once South Africa comes through the COVID-19 crisis there may well be lessons we can draw from the cooperation we are seeing in our response to tackling this pandemic. Could this herald a new approach which can be directed towards effectively getting our economy back on track swiftly and meaningfully?
We assure you that Citadel’s investment pillars and clear focus on never putting all financial eggs into one basket are structured to ride out challenging times such as these. This confluence of stressors will, in time, pass. Our focus now must be on riding out the storm.
Written by Citadel Chief Investment Officer, George Herman