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Why I welcome South Africa's downgrade to ‘Junk' status…

by , 04 April 2016

On 16 December 2015 Brazil was downgraded to ‘junk' status by the Fitch credit ratings agency.

The country's large budget deficit and political turmoil were the main reasons for this move.

But guess what?

Far from being the train smash you'd expect it to be, the country's stock market is now one of the best performing ones in the world!

In fact, Brazil's stock market is UP 14.1% in dollar terms this year.

It's nearly triple the performance of the JSE…

That's why I don't see the threat of a downgrade in South Africa as the end of the world.

On the contrary, it's a great investment opportunity!

Why South Africa’s bound for a ratings downgrade

Now before I tell you why South Africa’s headed for a ratings downgrade, first have a look at Brazil’s situation and why it’s just been downgraded:
  • Brazil’s president, Dilma Rousseff is implicated in a corruption scandal. On 12 March three million Brazilians marched, calling for the president to be ousted.
  • Brazil’s inflation rate is at the highest it’s been for 13 years…
  • There’s a recession taking place in the country.
  • Brazil’s Petrobras (a semi-state-owned entity) reported massive losses.
  • The country’s finance minister quit in December 2015.
So looking at these fact, I’m certain you can see the resemblance between South Africa and Brazil at this stage.

Moody’s credit ratings agency put South Africa’s bond status on review, with the possibility of a downgrade to junk status on 8 March 2016.

The reason behind this is the fact that economic growth in South Africa is stagnating, inflation is high and a general lack of stability in South African government policy.

This follows the budget speech minister Pravin Gordhan gave in February.

Markets are already set for a downgrade to junk…

On 4 December 2015, S&P and Fitch ratings agencies downgraded South Africa’s status to a BBB negative rating from BBB stable.

This is one move away from junk status.

Just have a look at this chart.
 

 
It shows the rand/dollar exchange rate from the 1st December 2015.

What’s important to note is the massive spike that happened when the ratings downgrade was made.
  
Within four days the rand hit R15.38 to the dollar compared to R14.35.

The rand steadily kept weakening and soon after hit R16 to a dollar. This happened as investors and traders started discounting the chances of a downgrade to junk into the South African rand.

But by early February the rand started strengthening again.
 


On this chart you’ll see how the rand recovered from R16 back to around R15. 

Many news articles during this time claimed that the finance minister would raise taxes and cut budget spending. Thereby cutting the current account deficit and putting a stop to the increase of government debt.

The hope of these measures keeping South Africa above junk grade kept the rand at bay.

And the budget speech managed to do ‘just enough’ to keep investors at bay.

But credit ratings agencies are still not convinced. They’re taking the wait and see approach.

Firstly I don’t believe government will be able to keep the public sector wage bill in check. Public employees will just strike again later this year and have their wage demands met.

For those who thought the sugar tax will help the budget, it won’t.

You see, while government is implementing sugar tax, they’re also decreasing the excise duty on Brandy by 10%.

So while you’ll still be able to enjoy your brandy and coke at nearly the same price the entire move won’t do much for our country’s tax income.

The fact is South Africa’s debt can easily spiral out of control – more is needed to fix our problem

We needed a much more decisive budget speech. One that would’ve ensured ratings agencies we have control over our finances.

Spending cuts needs to be made to non-essential government expenditure.

Corruption needs to be exterminated.

And more needs to be spent on infrastructure like power, water and roads.

That would cut debt and increase economic growth.

But here I’m preaching to the converted…

All this means is South Africa is practically guaranteed a downgrade to junk

All this said, I’d be very surprised if we’re not downgraded to junk status this year.

But it would be a great thing when it happens.

Looking at the rand/dollar exchange rate and our stock market much of the downside of a ratings downgrade to junk has already been factored in.

Sure we might have another bit of a shock when it actually happens. But investors are actually already treating South Africa like its junk.

So an actual downgrade to junk just might be enough to shake our politicians awake and FORCE them to actually do something about the problems South Africa faces.

And that means things stand to get a lot better AFTER the downgrade to junk status.

Like the Brazilian market rallied after its downgrade the South African market will also rally.

I’d put my money into quality growing shares that have been hit hard because of negative sentiment.

There are a handful of them. Think about companies like Nedbank paying more than 6% in dividends at the moment. Or Merafe on a PE of only 6 after nearly doubling its annual profits.

Here’s to unleashing real value,


Francois Joubert
Investment Director, FSPInvest


Why I welcome South Africa's downgrade to ‘Junk' status…
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