Looking to 2020 and beyond a Moody’s downgrade

3 Dec 2019
It’s unlikely that South African fiscal policy will be enough by early 2020 to convince Moody’s not to downgrade the country’s sovereign credit rating to junk status.

However, with a sub-investment grade eventuality already priced into the markets, and with slow and steady reforms underway, a Moody’s downgrade is not the disaster that many expect it to be. This is according to Old Mutual Investment Group market and economic commentators who believe that while 2020 is still likely to see weak growth, the foundations being built are better for 2021 and beyond.

Speaking at the asset manager’s fourth quarterly media investment briefing for the year, Old Mutual Investment Group Chief Economist, Johann Els, says that a Moody’s ratings downgrade is now more likely than ever by early next year, unless the February budget moves the dial substantially. “Despite what we saw in the disappointing Medium-term Budget, expenditure cuts could still be on the cards, but they would have to be significant to make any kind of impact.

“Treasury’s options for getting the Budget and SA debt under control include printing money, which is highly unlikely; allowing higher inflation, which is also highly unlikely; raising taxes, which is difficult in the current environment; selling assets, which is unlikely on a large scale and will take time; selling of spectrum, which will have a small impact and will take time; and then cutting expenditure and lifting growth,” explains Els. “Considering these options, cutting expenditure and lifting growth through structural policy adjustments remain Government’s most viable solutions.”

Els adds that it would be difficult to make meaningful expenditure cuts without addressing the Wage Bill. “Limiting growth in the Wage Bill is probably going to be easier that cutting jobs or freezing wage increases. This could lead to a lower Budget deficit fairly quickly. Limiting growth to 4% per annum could mean cumulative savings of R104 billion and a deficit of -5.1%, compared to the Mini Budget target of -5.9%,” he points out. “How likely is this to happen, however?”

What we could see is a levy on income tax as a trade-off for some kind of wage freeze in the public sector, says Els. “While February’s Budget will likely see a serious attempt to rein in the Deficit and stabilize debt through combined expenditure and revenue measures, this is not going to be enough to satisfy Moody’s,” he says. “A ratings downgrade is sub-investment grade is therefore our base case for early 2020, but this is widely expected and priced in already. Despite much anxiety around this, a downgrade will not derail the economy, attempts at reform or fiscal improvement for 2020 and beyond.”

Old Mutual Investment Group Portfolio Manager, John Orford agrees, pointing out that while a downgrade to junk status is almost guaranteed in 2020, we are seeing some positive steps forward from a more reform-minded Government, with investment opportunities still to be found within a sub-investment grade environment.

“South Africa continues to see political and governance improvements like the impact of various commissions of Inquiry and more high profile prosecutions that are at last starting to get underway – such as the recent arrests of the Chair of Parliament’s Home Affairs Committee and ex-Minister of State Security, Bongani Bongo, and key leadership changes.

“There have also been incremental reforms, although no clear plan yet on how to cut Government spending and resolve Eskom’s debt problem. Examples of reforms undertaken include the introduction of a secret strike ballot taking labour a step in the right direction; a planned introduction of teacher assessments, which is a positive for education; and game changing energy reforms envisaged in the IRP 2019, shifting to a ‘least cost’ basis for energy procurement, which will see a much greater role for renewables and the private sector in energy production. Also underway is Eskom’s sensible restructuring plan – although detail on debt restructuring and operational improvement is still largely absent; the finalisation of Government’s spectrum policy. Lastly, while government has sadly not yet embraced privatization it is clear that there is some warming within the ANC towards a greater role of the private sector in, for example energy, and even some appetite for targeted asset sales, notably SAA,” he adds.

However, Orford says this is all probably too little too late for Moody’s. “But local USD bonds and rand bonds have already priced in a sub-investment grade rating following the announcement of Moody’s decision in February next year. Indeed this is typical of markets which look forward and with SA already rated sub-investment by Fitch and S&P, markets will hardly be surprised by Moody’s downgrading South Africa. For markets what is more important is the future – if Government actually implements favourable reforms, in particular showing its ability to stabilise the debt to GDP path and to resolve the Eskom crisis, then South African assets could perform well regardless of the Moody’s downgrade.”

Orford summed up his investment outlook by saying: “The US is likely to underperform, with earnings currently peaking and expensive valuations. The economy is slowing and therefore margins are likely to fall,” he explains. “In the context of very low global yields SA bonds offer very attractive real yield into 2020. South African assets have underperformed for a number of years now and consequently now offer better prospective returns heading into 2020.”