Market Commentary

Q4 2015

Flagship_Market_Commentary_Q4_2015

Talk about a perfect storm!! The tragi-comedy that is South Africa deteriorated into a horror story as our self-serving President did the unthinkable by firing the wellrespected finance minister and appointing a lowly lap-dog in his stead. It could hardly have come at a worse time: the rating agencies had just downgraded the country’s outlook to a notch above junk status, the Barclays PMI had plummeted to a six year low, a severe drought had sent maize prices rocketing, interest rates were rising, and the currency was already weakening.

The action would have been foolhardy at any time, but against this exceedingly fragile background it was simply incomprehensible. (But then so was Nkandla, Zuma’s proposed presidential jet, ‘Guptagate’ etc., etc.) The intervention of the private sector and the recall of Pravin Gordhan has brought us back from the brink, but the damage has been done. Although the Minister made it clear that Treasury will continue along its previous trajectory of prudent fiscal policy, trying to control ‘devil-may-care’ government departments and excessive public sector wage demands is an almost impossible task. Cutbacks in key areas (such as infrastructure and housing) will be necessary to plug the excesses in other politically sensitive areas.

The rand:dollar rate blew out to an intra-day high of 16.02. Gordhan’s re-appointment allowed a gradual recovery to 14.92 this proved short-lived and further falls have taken it down to 16.65. [CHART 1] Our bonds weakened sharply as the benchmark R186 yield soared to 10.41% from 8.84%. [CHART 2] Foreign investors sold a huge net R8.7 billion of our bonds over the month. Their view of the risk in investing in SA is encapsulated in the 5-year CDS spreads (the price paid to insure against default) which skyrocketed on the news from 2.86% to 3.51%. [CHART 3]

The equity market initially fell by just 2% as the rand’s collapse bolstered prices of the dual listeds and export-oriented mining shares (JSE earnings derived from offshore are around 71%). However, banking shares (which faced potential credit downgrades if SA’s rating was cut to junk) plummeted by 19% in the two days that followed the shock announcement. [CHART 4] Net foreign equity sales over the month totaled R8.1 billion compared with net inflows for the year to date before the announcement of R5.1 billion, contributing to the ongoing weakness thereafter.

The heightened downgrade risk is the most serious potential impact arising from the debacle. Rating agencies, having already lowered our outlook, will need convincing that a similar event will not recur and will need to see that the control of Government expenditure is not undermined by political irresponsibility.

Being cut to junk status has dramatic implications. Close to 40% of our bonds are foreign owned. Almost all these investors will be governed by mandates that restrict them to investment-grade bonds, so they would be forced sellers. In addition, the SA component of the World Government Bond index is around +-R130 billion – approximately 10% of our bond market. A downgrade would thus trigger massive sales of our bonds. Given that local institutions would be reluctant buyers in the circumstances, bond prices would collapse and yields would soar. Foreign repatriation of the very considerable sale proceeds would cause the rand to plummet to even lower levels. And then, of course, equities are also heavily owned by foreign investors (almost 50%): wholesale selling would be inevitable and catastrophic.

The reintroduction of ‘prescribed investments’ (compulsory minimum holdings of government bonds by local institutions), and a cancellation of offshore investment allowances, would be the obvious Government response. The plunging rand would cause inflation to soar. Social security payments would need to rise sharply to compensate, but there would be no funds available. Civil strife would be the unavoidable outcome. South Africa’s ‘Arab spring’ moment would be upon us.

Clearly this is the worst case scenario, but sufficiently plausible to concentrate the minds of those in power. Hopefully . . .