Moody’s ‘junk’ downgrade is the kick SA’s economy needs right now

Moody’s decision to downgrade South Africa to “junk” status on the eve of the nation’s 21 day lockdown was a real double-whammy. After the initial shock, Sygnia’s Head of Asset Allocation Kyle Hulett reckons Moody’s has handed South Africa a gift of opportunity at exactly the right time.

Ratings agency Moody has finally dropped the hovering axe and downgraded South Africa to “junk” level – below investor grade status. With Fitch and S&P downgrading South Africa to below investment grade in 2017, the only real surprise here is that Moody’s didn’t do it sooner.

There’s no denying the cut has some significant consequences for the country: our cost of borrowing will be higher and investor sentiment towards our equity and bond markets will be lower.

However, while I’m in no way downplaying the difficult times ahead, I’d argue that it won’t be as painful as expected, and that this final downgrade may be the not-so-gentle push that government needs to fast-track structural reforms and make real inroads in turning around the economy.

SA is free to move on

Now that the threat of a junk downgrade has finally been realised, we can all stop hedging our bets on whether it will or won’t happen, and government can deal with the status quo by getting down to the urgent business of serious structural reform.

The case studies for countries that have done just this bode well for South Africa. Portugal and Greece, for example, were downgraded to “junk” after the 2008 financial crisis. While Greece went the anti-austerity route and landed in even more trouble, Portugal went for hard-line reform. The political beating the Portuguese government took as a result paid off and the country quickly regained its investment grade rating.

Then there’s Brazil, which proved that “junk” status isn’t an economic death knell. After losing its credit rating in 2016, there was an initial outflow of capital, forcing the Brazilian government to tackle issues that should sound all-too-familiar to South Africans: corruption, rampant public spending and widening deficits.

Encouraged by the progress made in these three crucial indicators, capital trickled and then steadily poured back into the country and bonds rallied: at the time of the downgrade, Brazil’s bond yields were at around 16%; by 2019 that figure stood at 6.8%.

Brazil and Portugal both demonstrate that a downgrade can be the hard push a government needs to make unpopular political decisions (think South Africa’s public sector wage bill) in order to drag a country out of the economic doldrums.

Recession dwarfs downgrade

While the Moody’s downgrade may seem like a kick while we’re already down on the ground, the timing is, in some respects, to South Africa’s benefit.

Firstly, in comparison to the enclosing global recession, the Moody’s downgrade is but a drop in the ocean for South Africa. I realise that’s not encouraging, but we should take solace in the fact that South Africa is not alone in this: around US$92.5 billion of portfolio investments drained out of emerging markets from 21 January, when the Coronavirus outbreak began sweeping across China, according to data from the Institute of International Finance (IIF).

Yes, the Moody’s downgrade does make things worse on the margin, but its impact is being dwarfed by the global recession.

Secondly, government is tackling the virus head on. If successful and coupled with meaningful structural reform, South Africa is likely to benefit from re-investment sooner than other emerging markets that are not being as stringent.

Downgrade priced in to borrowing rates

One of the first consequences of the downgrade is that South Africa’s government bonds will be excluded from the FTSE World Government Bond Index (WGBI), which means investment funds tracking the index have up to three months to disinvest from their holdings of South African bonds. The exact amount of forced sales is uncertain, with estimates ranging from US$1.5bn to US$13bn. In addition, active asset managers investing in emerging market debt, where their mandates prohibit investment in “junk” bonds, will follow suit.

This coupled with currency depreciation means that, in theory, it is much more expensive for the country to borrow money – a particular pain-point for most emerging markets, as IFF data shows around 13% of all emerging-market corporate debt is dollar-denominated.

However, South Africa’s cost of borrowing has been high for some time due to Moody’s sitting on our shoulder, and the market has forward priced this in for at least six months, meaning we won’t feel the full impact as heavily as other emerging markets.

That’s not to say it’s all rosy – March saw the worst daily fall (-10.2%) in the All Share Index since 1997. However, there is a very high likelihood that, because the Moody’s cut is now behind us, active foreign investors will start buying South African bonds in a renewed effort to find “yield”. This is premised on the unprecedented quantitative easing measures undertaken by the US, the EU and other countries.

Importantly, while no one could have foreseen the Covid calamity, South African investment houses have anticipated the downgrade and forward-thinking investors have factored this risk into portfolios. Two years ago, Sygnia positioned its portfolios to harness volatility in a low-return environment, so we are well positioned to withstand the downgrade. In a cruelly ironic way, the threat of a Moody’s downgrade has, to a small extent, prepared diversified portfolios for the Covid-caused recession.