According to their announcement, Moody's based its decision on the deterioration in South Africa's debt profile, very weak growth outlook and a lack of structural reforms, including "labour market rigidities and uncertainty over property rights”. The cut has some significant consequences for the country, its cost of borrowing in the future and investor sentiment towards our equity and bond markets.
The rating agency Moody's has finally cut South Africa's sovereign credit rating to below-investment-grade status, or so-called “junk”, level. Both Fitch and S&P downgraded South Africa to below investment grade in 2017, but Moody's has always had a soft spot for
South Africa. According to their announcement, Moody's based its decision on the deterioration in South Africa's debt profile, very weak growth outlook and a lack of structural reforms, including "labour market rigidities and uncertainty over property rights”. The cut has some significant consequences for the country, its cost of borrowing in the future and investor sentiment towards our equity and bond markets.
One of the first consequences is that South Africa's government bonds will be excluded from the FTSE World Government Bond Index (WGBI), and 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 unfortunately uncertain, with estimates ranging from USD1.5bn to USD13bn. In addition, active asset managers investing in emerging market debt, where their mandates prohibit investment in “junk” bonds, will follow. However, the impact of both is likely to be fairly limited relative to the recent Covid-19-related bond market weakness. South Africa’s real bond yields remain amongst the highest in the world, more than pricing in
the downgrade when compared to other junk status economies. The fact that most of South Africa’s debt is rand-denominated provides further shelter in the face of the battered currency.
Sygnia’s Expectations and Positioning Prior to the Downgrade
Two years ago, Sygnia positioned its portfolios to harness volatility in just such a low-return environment as we are currently experiencing. We cut listed property exposure and increased our income and offshore allocations in order to implement a more diversified and stable strategy. Towards the end of January 2020, we further increased our offshore holding by investing in the Sygnia International ESG portfolio, which has proved to be very defensive in current market conditions. In our low-risk portfolios, we added inflation-linked bonds, which offer protection on a relative basis.
We have been underweight bonds for a very long time, but in the past week, given the extraordinary weakness in the bond market and a cut in money market rates by 100 basis points, we have now moved to a small overweight position in South African bonds. There is a very high likelihood that now that the Moody's cut is 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.
Expected Effect on Sygnia’s Portfolios
The Covid-19 combat measures and simultaneous oil shock following the breakup of OPEC+ have accelerated the pace of global “Japanification” through a global deflationary supply shock, accelerating the move of bond yields in most developed markets towards zero. It
is likely that many major developed nations will follow the same trajectory as Japan, where the central bank and government have consistently committed to reducing their budget deficit over the long term, but the budget deficit has instead continued to grow over the past three decades, with the Bank of Japan issuing more debt. This has led to general expectations that the position is unsustainable, leading to massive debt and currency crisis – and yet this
has not come to pass. Bond yields have continued to fall and inflation has not materialised. Thus, the “search for yield” could continue over the medium to long term, with South Africa being at the top of the list.
We expect that the rating cut will have a limited impact on the Sygnia Enhanced Income Fund, which does not invest in long-term bonds. We are, however, monitoring its exposure to corporate credit, given that many South African corporates are coming under stress as a
consequence of the shutdown. Fortunately, the Reserve Bank has allowed South African banks to work together to find solutions for corporates struggling with debt repayments; an advantage of having a concentrated banking system is that coordinated action is possible.
Investment Strategy Looking Forward
It is important to avoid the natural inclination to “time the bottom of the market” when investing, and panic can destroy long-term performance. Although we have increased the level of capital protection within our portfolios, we believe that our well-diversified strategy
is the correct course to take and that we are well-poised for any recovery. We do have some cash to deploy and will do so in a sensible manner, particularly if bond prices weaken further. All our portfolios remain overweight offshore exposure, with a weak rand providing some cushion against recent market weakness.
In conclusion, we believe our portfolios are well positioned to withstand the Moody’s downgrade, which has been anticipated by the markets. Although South Africa will go through some tough times, we remain constantly vigilant for opportunities with which to add incremental returns to each portfolio. Our relative performance against our peer group remains strong, a fact we attribute to diversification and prudence. This approach has served
us well in the past and is likely to continue to do so.