How well will SA’s resilient listed companies weather the junk-status storm?
SA equities have kept investors’ faith through years of turmoil. A downgrade won’t necessarily change that — but investors will need reassurance
The state’s reduced capacity to formulate business policy, political uncertainty and a leadership vacuum continue to hamper SA’s economic growth.
A consensus downgrade of the country’s foreign and local currency to sub-investment grade, or junk status, is now possible either on Friday or early next year, from ratings agencies Moody’s and S&P Global Ratings, with Fitch already having awarded the country a junk rating.
Yet despite the volatile political and economic environment, SA’s capital and equity markets still work surprisingly well.
The JSE recently reached new heights, with the all share index passing the 60,000-point mark, while local companies have raised a total of R152bn from investors during 2017, the second-highest level after the R161bn raised in 2015.
The JSE also recently had the largest listing in SA’s history, when Steinhoff African Retail Limited (Star) raising R16bn.
Other large capital raisings this year include Vodacom’s share placement at R14.9bn; Sibanye Gold’s rights offer, R13.5bn; Life Healthcare’s rights offer, R9bn; and African Rainbow Capital Investments listing, R4.3bn.
Investors saw enough value and opportunity in these offerings to ensure they were taken up and not affected by negative news, even though some of these are now trading below their offer prices.
The financial markets also continue to perform despite SA having some of the worst economic fundamentals among the emerging markets against which equity investors measure its investment potential.
These fundamentals include government plus total state-owned enterprise debt, which has risen to about 72% of gross domestic product (GDP). Five years ago, that number was in the region of 57%. A higher stock of debt implies a higher interest bill and hence even more burden on the tax payer and less revenue available for productive investment. This leaves South Africa in a vicious circle of low investment, low growth and high unemployment.
One of the main reasons capital and equity markets continue to ignore the bad news is that SA’s financial markets are regulated by some of the best corporate governance practices among all emerging markets.
SA ranks as one of the highest of all the emerging markets on the World Economic Forum global competitiveness index for "strength of investor protection". These practices are governed by the King report and codes on corporate governance, which ensure investors still feel the markets are a secure place to invest.
But good governance is not the only reason investors remain interested. South African companies are attractive investments because of their high levels of profitability compared with their emerging-market peers.
Despite the country’s slow GDP growth and a rand that has continued to drift weaker over the long term, South African companies have, in many instances, delivered growth in earnings per share in US dollar terms that has handsomely outperformed emerging market peers.
In addition, South African companies are well known for their ability to generate cash flow. The average South African dividend payout is about 55% of the company’s income — against 35% at their emerging-market peers.
Good returns in listed companies do not rely solely on local market conditions. Almost all of the JSE’s top 40 companies have a degree of foreign investment as corporations have sought to diversify their revenues.
Specifically, 71% of the top 40’s exposure is foreign, while the ratio of offshore exposure for the broader SWIX index sits at 57%.
The track record of offshore investments has been undeniably mixed: some have worked well (Naspers’s investment in Chinese internet services company Tencent); while for others returns have been disappointing.
However, the offshore angle acts as a significant buffer for South African equity performance in times of domestic economic and political volatility which is usually reflected in rand weakness.
The next five weeks are set to see a number of significant macroeconomic events unfold for SA. An investment downgrade is just one of them. On November 24, S&P is expected to downgrade SA’s local debt to junk. Moody’s could leave ratings unchanged for now but many investors expect a downgrade to junk at some stage over the next seven months.
But will junk status put the brakes on SA’s capital markets?
It’s likely to cause significant forced selling from the debt tracker (or passive) funds which are mandated to hold only investment grade paper. Estimates of the amount of forced selling range between $6bn and $10bn.
Other markets that have suffered the downgrade to junk have experienced sharp spikes in bond yields and a sell-off in their currencies as tracker money makes a forced exit.
But the lessons from elsewhere show junk status alone does not determine investors’ appetite for exposure to a country. Rather, it is the direction of political leadership and macroeconomic policy that sets the tone.
In Brazil, for instance, S&P awarded the country junk status on September 9 2015 in the wake of deteriorating fiscal fundamentals and a major corruption scandal at local energy company Petrobras.
The market continued to sell after the downgrade as political leaders failed to act decisively in addressing investors’ concerns.
However, it found a floor in early 2016 and started to rally as it became apparent that Brazil was on the cusp of a change in leadership, and economic reform.
Even when Moody’s belatedly cut Brazilian debt to junk on February 24 2016, the market continued to rally strongly in response to the fundamentally better outlook linked to leadership change.
The key lesson for SA is that junk status is bad news but far from the end of the story for financial markets, providing policy makers are prepared to respond with appropriate measures.
Of course, the opposite is also true. Junk status, followed by political disarray and policy inertia, is the worst recipe for market returns — as Greece experienced in 2010.
Investors still have confidence in SA’s financial markets which, at many levels, continue to function better than emerging market peers.
World-class corporate governance, combined with corporate focus on cash flow, profitability and returns to shareholders, are key.
But only policy certainty and strong political leadership can build confidence and ensure the long-term performance of SA’s capital markets.
• Formby is CEO at Rand Merchant Bank.