How will the ratings downgrade affect me?


Written by 2IP Independent Investment Partners

Executive Summary

Two topics that have gripped the local media of late (and rightly so) are, of course, the reaction of the markets to the (what would seem endless) ripple effect of the Coronavirus as well as the floundering oil price.

There has been much speculation for some time that South Africa could be downgraded by Moody’s to sub-investment grade or “junk” and this has now at long last occurred as at the end of March. The Moody’s rating has been notable in that it is the only one of the three major ratings agencies that had not yet downgraded SA’s foreign rating.

In the brief overview below we examine the perceived risk that the downgrade presents and pertinently also briefly discuss what the likely potential impact (if any) would be on end consumers and clients, taking into account the concurrent global economic impact of COVID-19.

Introduction

A South African ratings downgrade has been hotly debated for quite some time and largely anticipated (and priced in) by markets. In our in-house quarterly macro overview we started to review this possibility and its potential impact as early already as January 2016. We looked at how other emerging markets such as Brazil, Russia and Hungary felt the brunt of their downgrade pressure in the run-up to the downgrade event. Whereas the market did invariably react post the downgrade announcements to “junk” or sub-investment grade, the impact was typically acute yet relatively short-lived (see “2IP Investment Committee Meeting Q1 2016, page 124”).

Fast forward to 2020 and both S&P and Fitch have delivered the abovementioned downgrades, whereas the market has both nervously and keenly awaited the completion of the ratings agencies trifecta in Moody’s final deliberation, which has now arrived at the end of March. With the resultant downgrade to sub-investment grade – a whole rating notch (and with Moody’s maintaining their negative watch outlook) many market participants have argued that the resultant exclusion of SA bonds from global bond indices would result in bonds sales of well north of $2bn. While this posited figure is indeed very significant, economists have also pointed out that these same bonds may then also be purchased, albeit likely to a lesser extent, by other sub-investment grade funds and investors searching for yield during the current global low- and negative rate environment. The indexing firms as of 30 March have also put a hold on any month-end and quarter-end rebalances – more the result of fear of passive ETFs being forced sellers of equities globally in general rather than anything to do specifically with South Africa – which means that this outcome has now also been delayed.

Regardless of the above and for the balance of this article, we will examine what the effects on the man in the street might be, now that the downgrade has occurred.

Now that a SA downgrade has occurred – how are markets likely to react?

As previously eluded to and also looking at how investors have historically reacted to other emerging markets when they have been downgraded to junk, much of the bad news is typically already priced in by the market in advance of the announcement occurring. South Africa is unlikely to be an exception, although we would still expect to see markets spike (yields upwards, equities downwards) in the days following such an announcement.

As we have actually stated in our commentary on a few occasions, depending on the state of the global economy, the aforementioned local market spikes may actually represent good buying opportunities, although this would need to be viewed within the context of the now rapidly deteriorating global economic backdrop in the wake of COVID-19.

If market rates suddenly increase, will this affect my house mortgage lending rate?

There is no direct link between bond rates as traded in the open market (which we fully expect will now briefly again spike higher following the downgrade announcement) and the lending rates as set by the commercial banks, which are a product of the Repo rate as determined by the South African Reserve Bank.

As such if market rates increase due to a downgrade it is extremely unlikely that we will see even near similar increases in mortgage or retail lending rates. If anything, given the recent Repo rate cuts by the SA Reserve Bank, mortgage rates should actually decline, not increase.

For those folks who like to get into the technical aspects however, one could argue that in the event of a simultaneous strong sell-off of the Rand (as we have seen recently) – particularly if there are substantial inflationary pressures which are brought to bear (currently absent however) – then the SA Reserve Bank could opt to increase rates independently of the above, which would in turn translate into higher lending rates for clients. This is currently very unlike however even with the Rand trading as weak as it currently is.

Why don’t we simply “reduce risk” and move clients into cash?

Whereas we often hear clients positing this as a solution there are several reasons why this might be a very bad idea and why one needs to be very careful in understanding the risk of doing this – particularly now with markets in turmoil as they are. Most clients need to achieve substantive real-returns over the longer term (which cash typically always underperforms over any meaningful investment period) and as such one might actually be placing clients at greater risk by moving to cash, not less.

For clients whose long-term return objectives are very close to inflation only, the risk of moving into cash is not as material. However for clients who are targeting a long-term return in excess of inflation, a wholesale or material move to cash could pose a very real risk to their ability to achieving their long-term return objectives. This is only further exacerbated when one looks at the research of how badly clients typically time these moves sadly. By far the majority, if not almost all clients, typically not only go into cash at highly inopportune times (e.g. after a market sell-off event has occurred), but then also wait too long to reinvest back into risk assets, which undermines their long-term investment goals.

Last but not least, recall also that we mentioned that the market moves resulting from a downgrade announcement are empirically typically relatively short-lived (separate from other simultaneous factors such as rapidly deteriorating domestic or global growth).

How will an increase in market rates resulting from a downgrade affect South Africa and SA multi-nationals?

Whereas private mortgage rates are not likely to be affected directly as mentioned, there is however a potential impact on future borrowing costs for corporates and government (or any entities that rely on the bond market to raise capital), should market rates remain elevated for any significant period. In this scenario it would increase future funding rates both for government, parastatals and for corporates. In the case of government it would manifest in the higher interest rates they would need to pay to make our bonds attractive to investors, whereas in the case of corporates it would similarly increase their cost of capital and flow through to an eventual reduction in profitability.

Conclusion

Whereas South Africa has now at long last been downgraded by Moody’s as long predicted, the impact of the downgrade in isolation on consumers is likely to be very limited. Historic data from other emerging markets that have undergone similar transitions (and local experiences such as “Nenegate” at the end of 2015) indicate that while the short-term market reaction might be material, this is likely to be transient in isolation (currently the COVID-19 outbreak and its economic impacts are substantially more material).

Furthermore, personal lending rates should not be impacted directly, nor will the downgrade warrant any drastic asset class changes by clients compared to their long-term asset allocation requirements.