Source: FactSet

Perhaps more surprising was the unusual steps taken by the Reserve Bank to intervene in the domestic bond market when purchasing government bonds, which experienced significant selling from foreign investors while liquidity dried up at the same time as investors started hoarding cash.

Although the Reserve Bank did not call it Quantitative Easing, it made its intensions clear. It would continue buying bonds to ensure a well functioning fixed income market. This is an important step, which, if successful, will assist in keeping Government’s cost of funding under wraps. The Central Bank also encouraged domestic banks to relax regulatory measures to keep credit and funding lines open to households, companies and small and medium sized enterprises that are expected to draw on the facilities to overcome the current cash crunch experienced from the lockdown.

Indeed, an unusual environment that requires extraordinary intervention from policymakers. Banks have obliged to Governments’ call and have announced various payment holidays on the loans for students, households and companies. Investors should note that these measures could very well impact the cash distributions to shareholders in the coming year.

Unfortunately, from a fiscal perspective, Government does not have a lot of room to manoeuvre in order to stimulate the economy, given the poor state of its balance sheet and record high debt levels which, under the current environment, are expected to drastically deteriorate (more on that below).

Innovative initiatives such as the formation of a Solidarity Fund, which has already received significant donations from influential families and companies, will assist with supporting the healthcare system which is expected to come under significant pressure as the pandemic spreads across the population.

The funds will assist in buying much needed ventilators and ICU beds, but much more intervention will be required to provide a safety net to a contracting economy where large-scale job losses are expected.

At a minimum, National Treasury will be forced to reallocate funds which were previously earmarked for growth initiatives, to supporting the poor, faltering companies and SA’s healthcare system. One of the options mentioned by the Governor of the Reserve Bank was to approach the International Monetary Fund (IMF) which has made funding without any conditions and low interest costs available to support countries that need assistance during the COVID-19 pandemic. Time will tell which route government decides to take, but one thing that has become abundantly clear is that strong leadership and a much tighter working relationship between the public and private sector will be required to navigate the economy through what is expected to be a very challenging environment.

South Africa officially downgraded to non-investment grade

Moody’s patience finally ran out when they cut South Africa’s credit rating a notch lower to non-investment grade (Ba1) with a negative outlook – this was shortly followed by Fitch a week later, when the rating agency, which had already rated South Africa as non-investment grade, downgraded the country by another notch and maintained its negative outlook. The key driver behind the ratings downgrade is the continuing deterioration in South Africa’s fiscal strength and the structurally weak economic growth trajectory. The decision brought to an end a 26-year romance with Moody’s which has been the only one of the three rating agents that has kept the country’s credit rating consistently at investment grade. Fitch and S&P downgraded South Africa to non-investment grade in 2017, in the aftermath of the Nenegate saga.

SA sovereign ratings

Moody’s indicated that it would change the country’s credit outlook to stable if the fiscal consolidation path is broadly in line with its current expectations.

• The agent now expects a 2.5% GDP contraction in 2020, followed by only a 1.1% growth rebound in 2021. 
• It foresees a gradual compression in primary fiscal deficits, with its government debt-to-GDP measure (which includes some guaranteed SOE debt) rising from 69.3% in FY19/20 to 82.6% by FY21/22 and 91% of GDP by FY23/24, where it expects it to stabilise.

Moody’s indicated that it would downgrade South Africa further if economic growth remains very weak, with a widening primary deficit and higher funding costs.

South Africa is a member of the FTSE World Government Bond Index (WGBI). To be eligible for inclusion into this index both Moody’s and S&P must rate the issuer and issuance at investment grade. To remain in the index one of the two agents must hold the issuer/issuance at investment grade.

South Africa was kept in the WGBI because Moody’s still rated the sovereign at investment grade whilst S&P had long downgraded South Africa to non-investment grade. The implication of Moody’s decision is that South Africa will fall out of the index at the next index rebalancing date with index tracking funds forced to sell their entire South African holdings in the WGBI. The FTSE has announced that the next index rebalancing will be at the end of April.

Moody’s decision did not come as a surprise with the market having expected such an outcome and reflecting it in bond prices. As a result, post the decision and after an initial sell off in the domestic bond market, the following Monday morning saw a subsequent pullback in bond yields. Moody’s decision comes during a market rout brought about by COVID-19 with a damaging impact on South Africa’s economy and fiscal position. The decision was made on the same day that the country began a twenty-one-day lockdown period to contain the spread of the virus.

Since the market had been expecting a Moody’s downgrade, we believe that investors including index trackers had by and large been reducing their exposure to South Africa over time. This was exacerbated by the selloff in risky assets as a result of flight to quality brought about by contingent effects of COVID-19. The bond market, in line with other asset classes, experienced the fastest sell off in a very short space of time in recent history and at some point, during March the losses were as high as 20% before recouping some of those losses to end the month at 9.75% down. We believe the forced selling at the end of April due to Moody’s decision will not be as severe as was initially thought, however, it is difficult at this stage to put an absolute figure on how much portfolio outflows will occur but we expect the impact on oversold bond prices will be rather muted. The same may not be true for the rand as the global economy enters its worst recession since 1947.

Source: FactSet

Implications for investors

The impact of South Africa’s sovereign downgrade on the economy, monetary policy, government finances and asset valuations should not be underestimated. The downgrade to “junk” has just made the country a riskier investment proposition and foreign investors will demand a higher rate of return on their investments in South Africa which includes funding of Government’s ever-growing debt profile.

The increased cost of capital will immediately affect the whole economy as it results in an increase in the cost of doing business, which will leave the private sector, households and government with less (disposable) income in their coffers and, more importantly, less willing and able to drive large scale investment spending – not good news for South Africa’s deteriorating infrastructure, troubling unemployment and socio-political challenges.

For Government, the downgrade will be a real challenge given the extent of debt accumulation since the Global Financial Crisis. The higher cost of borrowing should also be viewed against a backdrop where debt service costs are the fastest-growing expenditure item for government, crowding out other forms of public spending such as infrastructure spending and social upliftment.

Governor Kganyago will be constrained from lowering interest rates too aggressively to bolster the economy. Given the deteriorating external backdrop and SA’s vulnerable fiscal position, the near-term focus for the Reserve Bank will be to maintain financial stability and prevent continued large-scale capital outflows. Unfortunately, this will have a negative effect (opportunity cost) on the near-term growth outlook for an already struggling economy, but an important development to anchor inflation expectations and to showcase the Central Bank’s independence.

Finally, and in addition to the above, investors will also have to be content with lower valuation multiples than what they have ordinarily been accustomed to in the past, as the discount rate used to value companies, bonds or any other asset’s future cash flows, has increased, resulting in lower valuations.

Where to from here?

South Africa’s growth trajectory is on a slippery slope with the nearterm outlook expected to deteriorate. Although lower interest rates will be helpful, an improvement in business and consumer confidence would be even more powerful, but none of this will be possible in the immediate future given that the world and South Africa have entered an unusually deep and painful recession.

But in every crisis, opportunities present themselves. Winston Churchill once famously said, “Never let a good crisis go to waste” and that is exactly what investors should be focusing on during these trying times.

Asset prices have fallen sharply and offer good value for patient long term investors. We don’t try to “time the market” and have very little visibility in terms of when exactly the bottom in asset prices will be reached, or indeed if we haven’t already experienced it. But what is very evident, even adjusting for a deep global recession and South Africa’s higher cost of capital which has been a result of the recent downgrade, is that investment opportunities are starting to present themselves.

Take domestic government bonds as an example. South Africa’s government bonds have since 2017, after Fitch and Standard & Poor’s downgraded the sovereign credit to junk, been trading in line and, in some cases, at a discount to our non-investment grade peer group. The COVID-19 crisis resulted in large amounts of capital fleeing Emerging Markets and caused SA bonds to sell off sharply. At one stage as much as 15%, when the 10-year government bond reached a 12% yield to maturity. In real terms after adjusting for inflation, yields are currently in excess of 6% and more attractive than what was experienced during the GFC.

As a result, we have been selectively adding to the duration in government bonds and believe that the asset class at current valuations should form a significant component of any investor’s portfolio, especially for those that are nearing retirement or for pensioners.

Source: FactSet

Domestic equities have felt the brunt of the pain this year. The JSE All-Share index was down 21% at the end of March 2020, and when expressed in US dollars the result was even worse as the index declined by 38%. The performance from the rand hedge counters were slightly better as the depreciation in the rand provided some buffer, leaving domestically orientated shares exposed. Banks, property and retail stocks were particularly hard hit as many communicated either significant cuts to dividends this year and in some cases no dividend payments for the coming year, as these companies turned their immediate focus to Balance Sheet and cash preservation. Although these measures won’t persist indefinitely, the cost to shareholders in the near term is expected to be significant.

Source: FactSet

Having said that the adjustment to valuations appears overdone. Wehave used the Financial Sector charts above to illustrate the point.The charts depict the dividend yield (DY) and price to earnings (PE)ratio for this sector. On both metrics, valuations do look extreme. Forinvestors that can stomach the current volatility and are in a fortunateposition to take a slightly longer-term investment view, the math issimple. The forward PE ratio has de-rated to six times (from 15 timesin 2015) and the historic dividend yield has increased to just over 9%.

Another way to express this is through Earnings Yield, which is the inverse of price to earnings, and at current levels is just over 15% (1/6), well above the cost of equity for these shares and an indication that “the market” does not believe that these companies can sustainably grow their earnings profitably. That may be the case in the near term, but unlikely to be sustained in perpetuity.

Turning to another favourite valuation metric, namely dividend yield. At a 9% dividend yield, we believe that a whole lot of bad news is already reflected in the sector’s valuations. Granted, earnings this year will be down significantly and so will dividend payments and it is quite possible that both earnings and dividends will only return to last year’s levels (which were already depressed) in two or perhaps three years from now. But even so, investors stand to earn very attractive income yields in future by committing capital today. This is just one of many examples of attractive investment opportunities on the local bourse, and we have been adjusting portfolios accordingly to benefit from the dislocation in share prices.

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffet

Our response

It has indeed been extremely testing times for investors, but the history of financial markets has demonstrated time-and-again that such sell-offs provide excellent investment opportunities for disciplined investors with robust investment processes. We have not wasted this opportunity and have already acted to build on the quality of portfolios as communicated in our two mid-month strategy updates sent in March.

Our focus going into this crisis was to increase the underlying quality and defensiveness of portfolios by reducing exposure to pro-cyclical businesses and companies that could be vulnerable from a protracted slowdown. Furthermore, the indiscriminate sell-off has allowed us to consolidate our holdings in portfolios. We have been able to increase exposures to higher quality shares which have sold off just as much as some of the more cyclical holdings, resulting in the construction of even higher quality portfolios with significant upside potential. Prudent diversification across asset classes, currencies and regions, has played an important role in stabilising portfolios, and will continue to do so.

During this period, we will be keeping a close eye on the following factors which could result in changes to the current asset allocation strategy:

• Asset price valuations at historic extremes  
• A positive turn in leading indicators, such as the global manufacturing and services PMI indices
• A peak in the number of active COVID-19 cases signalling that the efforts to contain the virus have been successful – active cases refers to individuals that have tested positive for the virus minus the number of fatalities and recoveries
• The extent of monetary and fiscal support to buffer the fallout from the government enforced isolation measures

Conclusion

Our tried and tested investment philosophy, of focusing on quality and fundamentals, will stand our clients in good stead during these extremely challenging times. We therefore do not believe that it pays to try and “time” the market. It is a well-known fact that spending time in the market is significantly more profitable than attempting to take short term views, partly because the majority of returns are obtained in the period immediately after markets have bottomed. Missing out on a few of the top trading days is proven to be costly for investors. Diversification, and keeping to known long-term investment objectives, are much more important when navigating through these periods of extreme volatility.

The virus will be overcome, as history has shown with previous pandemics, and when it happens, the recovery in financial markets will be swift. But for now, and given all the uncertainties, patience and caution continues to be warranted until there is enough evidence that the number of new COVID-19 infections has stabilised, allowing leading economic indicators to turn positive.

We hope all our clients stay safe and as always, we are available at any time to answer any of your questions or concerns.