Brace for a downgrade shock

South Africa’s financial markets will face a window of extreme pressure immediately following a sovereign credit ratings downgrade, despite the notion that a downgrade has largely been priced in already, according to Standard Bank chief economist, Goolam Ballim.

The reaction of South Africa’s equity market to a possible downgrade has been “astonishingly mild” when compared with countries that faced a similar prospect, where equity markets plummeted on average 60% in the 12 months leading up to the downgrade, according to Ballim.

Even beleaguered bank shares, which arguably most accurately capture the low growth and downgrade risks facing South Africa, have not reflected the same sharp drop experienced in other global equity markets.

The graph below reflects the average fall in equity markets across six countries in the 12 months prior to their downgrades, with Brazil indicated in blue.

The extent to which South Africa’s financial markets have in fact priced in a sovereign credit ratings downgrade remains to be seen.

“One is left wondering whether equity markets have fully priced in a downgrade,” Ballim said.

The “last mile of pressure”, which occurs in the immediate aftermath of a downgrade, has yet to unfold, Ballim told journalists on Monday, challenging the notion that markets have already priced in a downgrade.

He questioned whether, for example, South African retailers had fully priced in the risk of a recession over the coming 12 months and the impact that would have on consumer sentiment and, in turn, consumer spending.

Standard Bank forecasts that gross domestic product (GDP) will contract by 0.3% in 2016 if the country’s foreign scale credit rating is downgraded by Standard & Poor’s (S&P) next month.

The ratings agency, which will announce the results of its current review on June 3, has South Africa just one notch above junk status at BBB – with a negative outlook.

Arguably, spreads on credit default swaps (CDS), which refer to the cost of insuring against a default on bond repayments by South Africa, have priced a downgrade in.

In the ten years to 2014, South Africa’s CDS spread averaged 150 basis points (bps), but has since fallen to a present rate of 320 bps, Ballim noted, moving “noticeably higher” in the last few quarters.

Rand will end 2016 weaker

Extrapolating trends across 70 economies, the SA Reserve Bank (Sarb) estimates a 104-basis point increase in long-term bond yields in SA, which are currently at levels of around 9.4%, should the foreign-currency debt-rating fall to below investment grade.

“The Reserve Bank warned that higher long-term borrowing costs would result in government allocating more spending towards debt-service costs. The private sector would also face a higher cost of investment given the link between corporate borrowing costs and the sovereign rating,” Sanisha Packirisamy, economist at Momentum, said earlier this month.

“Over the medium term, higher borrowing costs would force the government either to raise more revenue via higher taxes or to cut spending in order to avoid widening the budget deficit. Consequently, ordinary South Africans could end up with somewhat lower disposable income, giving them less to save and invest,” commented Pieter Hugo, MD of Prudential Unit Trusts, in a note on the consequences for investors of a possible downgrade of SA’s credit rating.

In the face of higher borrowing costs, private companies would see profits negatively impacted and investor dividends harmed, which would trim equity returns, Hugo said.

Despite the Sarb’s recent “strident” statement that it remains in a tightening cycle, Ballim suspects that, following June, the Reserve Bank will have to recalibrate for an economy that is likely to be weaker.

“What would have been a pause is likely to become a peak. If they do tighten it is likely to be modest and temporary, attempting to restrain the rand from further relapse,” he said.

According to Ballim, the monetary policy rate peaks around the time of a downgrade, but remains quite sticky for about six months before a decline ensues off the back of lower consumer price inflation (CPI) and a contraction in the economy.

The rand/dollar exchange could spike to levels between R16.50 and R17 following a downgrade, Ballim said, noting that a burst of weakness of this kind is generally followed by a “grinding recovery” that can take weeks if not months.

Ballim believes the rand will end the year no better than R15.50 to the dollar.

Beyond financial markets Ballim warned that the “real economy” bears the brunt of a downgrade, as sectors contract in line with weak GDP growth (already one quarter of the economy is in contracting terrain), employment insecurity rises and real income growth shrinks.