The perceived risk associated with an adverse credit rating action waxes and wanes with investor sentiment, the currency, the political rhetoric of the day, and now load shedding. Power rationing has intensified in March; hence, it is no surprise that analysts and markets are assigning a higher probability to a negative outlook announcement by Moody’s next week.
Moody’s is required to publish two indicative dates for possible rating reviews of the sovereign credits it covers. South Africa’s dates for 2019 are 29 March and 1 November. The agency does not have to review the rating on these dates if nothing materially has changed relative to its current assessment, nor does it have to wait for these dates if something significant changes that may necessitate an adjustment to the rating or outlook.
In contrast to the short-termism often seen in financial markets, Moody’s takes a longer-term view on the rating drivers and will take six to twelve months to monitor the government’s commitments on the fiscal position and the support for Eskom. The tone of the latest Moody’s updates and public conversations has not revealed haste in altering the rating. There is a high degree of implementation risk, but a credit rating agency cannot make a call now on whether the government will succeed or not. So far, Moody’s views the National Treasury as having shown strong commitment to its expenditure ceiling and sees the breach in FY20 as a once-off, extraordinary event. Consequently, the fiscal slippage and higher debt ratio projected in the budget, while material, will not necessarily trigger a downgrade, particularly with the elections only seven weeks away. This is another key event that Moody’s has flagged.
The question now is whether the intensification of load shedding is enough for Moody’s to change the outlook to negative or, worse, downgrade South Africa. While the extent of load shedding required to stabilise the system has increased, it is important to remember that power rationing started in November last year. For the past four months Moody’s has known about the operational challenges at Eskom, so it is not a forgone conclusion that electricity shortages necessitate a rating response from Moody’s now.
While we still assign a less than 50% probability to a negative outlook on 29 March, we cannot ignore that the electricity constraints will dampen short-term growth (we think there will be an outright contraction in GDP in 1Q19) as well as long-term growth given the ongoing lack of productive fixed investment in the economy. The downside risk to growth could prompt Moody’s to shift the outlook to negative. The macro factors feature directly in the rating analysis, as well as indirectly via the fiscal position.
When we compare South Africa to a relevant peer group, it is clear that financial markets are already assigning some probability to a negative outlook announcement on 29 March. South Africa’s credit default swap, currency, and government bond yield are all trading wide relative to the levels implied by the emerging market and global backdrops. This discount in South African asset prices reveals a building risk premium as the Moody’s review date draws near. On an absolute basis, South Africa’s credit default swap spread is in line with a BB+ rating, leaving it correctly priced for South Africa’s average credit classification. Moody’s is the only major credit rating agency that rates the sovereign as investment grade (Baa3), while Fitch (BB+) and S&P (BB) already assign the country to sub-investment grade (based on the long-term foreign currency credit rating).
Yet this does not mean that an adverse rating action will not have a market impact.
Under our base case of no change in the rating or the outlook, there is scope for a modest (around 2%) rally (in the currency, bonds, and equities) as markets price out some of the excess risk. If Moody’s changes the outlook from stable to negative, then we expect the rand and bonds to weaken further (by around 2%). In the event of a rating downgrade, the sell-off will be severe, albeit temporary, with the rand 5% – 10% weaker and bonds down by around 5%. Credit spreads will be unresponsive in the short term, but as the economy weakens further (which usually happens when countries lose investment grade status) and the cost of borrowing rises (a consequence of junk status), credit spreads will widen. However, these effects will take many quarters to unfold and would not be an immediate consideration for credit bond holdings in a portfolio. The impact on equities is more difficult to assess, given the likely divergent reactions from the different sectors. Rand-hedge counters should at least partially hedge the sell-off in interest-rate sensitive and domestically oriented industries, such as financials and retailers.
From a balanced fund approach, a defensive asset allocation position – overweight cash, underweight duration, and neutral on equities – should weather the rating review under all three scenarios. Equity outperformance in the event of negative rating news would buttress the portfolio without an onerous penalty in the event of an unchanged rating and outlook.