Ratings call: The day SA has been dreading is finally upon us

Cape Town - There is a reasonable expectation that South Africa's sovereign credit rating will not be downgraded by Standard & Poor’s, says Overberg Asset Management (OAM).

In its weekly overview of the economic and political landscape in South Africa, OAM notes that it is reasonable to expect that S&P will allow SA more time to address the rating agency’s concerns.

Both local and foreign currency credit ratings are on negative outlook. However, while the foreign-currency rating is at BBB- just one notch away from “junk status” the local-currency rating is two levels higher at BBB+ and three notches away from junk status.

S&P’s will make the ratings announcement on Friday June 3.

South Africa economic review

• The SA Reserve Bank leading economic indicator (LEI) surprisingly increased from 91.6 in February to 91.9 in March marking the first increase since October last year offering some hope that the economy is stabilising. Four of the nine LEI components increased with the largest positive contributions an improvement in the US dollar based export commodity price index and an acceleration in money supply growth. The largest detractors were a decline in the number of residential building plans passed and a fall in job advertisement space. Although it may be too early to call the bottom in the economic cycle the gain in the leading economic indicator is supported by recent improvements in business and consumer confidence, growth in export volumes and stability in the rand.

• Foreign investors registered net sales of SA equities and bonds in the past week of –R1.5bn and –R0.8bn respectively. For the month of May to date foreign investors have sold a net –R14.9bn of equities and –R13.7bn of bonds, contributing to a steep drop in the rand over the month, from R/$14.61 to 15.71, from R/€16.30 to 17.46, and from R/£20.87 to 22.82. Foreign selling has gathered momentum due to increased domestic political uncertainty and rising global risk aversion, with the growing likelihood of a Fed rate hike on the 15th June. Foreign selling has been especially evident in the equity market, with total net sales of –R57.9 billion since the start of the year.

• Growth in money supply (M3) fell from 10.3% year-on-year in March, a level it had maintained for three straight months, to 9.0% in April. On a month-on-month basis money supply grew by just 0.1%. Growth in private sector credit extension (PSCE) slowed sharply from 8.7% year-on-year in March to 7.1% in April well below the 8.9% consensus forecast, attributed to a sharp drop in household credit. Household credit contracted -2.2% month-on-month and increased on a year-on-year basis by just 2.3%, a record low. Credit growth to companies fared better, rising 0.1% on the month and 12.1% on the year. Among the household credit categories, “all other loans and advances”, which includes unsecured loans, grew just 9.2% on the year its weakest growth since January 2011. Annual growth in mortgage advances slowed from 6.2% to 6.1%. The credit outlook is likely to remain weak amid poor economic prospects, and subdued business and consumer confidence, causing credit demand to drop and lending standards to tighten.

• Producer price inflation (PPI) moderated slightly from 7.1% year-on-year in March to 7.0% in April in line with consensus forecast and well below the recent high of 8.1% in February. However, on a month-on-month basis PPI increased by 0.8%. The lagged effect of the weaker rand and the drought signal an upturn in PPI in the months ahead. Food price inflation, which makes-up more than a quarter of the PPI basket, accelerated from 10.5% in March to 10.9% in April. Among the food sub-categories, the prices of oils and fats increased just under 26% on the year, grain mill products by 21%, and starches and animal feeds by 14.9%. The SA Reserve Bank has to combat rising inflationary pressures in an environment of weakening economic growth. Although facing a difficult balancing act the SARB is likely to announce two further 25 basis point rate hikes, one each at the July and September policy meetings.

The week ahead

• Trade balance: due Tuesday 31st May. Following the larger than expected R2.9bn trade surplus in March the trade balance is likely to revert to a small deficit of –R0.2bn in April, according to consensus forecast.

• Barclays manufacturing purchasing managers’ index (PMI): Wednesday 1st June. Following its surprise spike upwards in April to 54.9 the manufacturing PMI is likely to fall back slightly in May although still remain above the key 50-level which separates expansion from contraction.

• Vehicle sales: dues Wednesday 1st June. Markets will be watching closely for any improvement in vehicle sales in May following the steep -9.20% year-on-year decline in April.

• Standard Bank composite purchasing managers’ index (PMI): Due Friday 3rd June. The composite PMI, measuring conditions across both manufacturing and services sectors, registered just 47.9 in April well below the Barclays manufacturing PMI at 54.9. As a forward-looking leading indicator the composite PMI will be closely watched for guidance over the broader economy’s performance over the next three-to-six months.
• Standard & Poor’s (S&P) credit rating review: Due Friday 3rd June. S&P put SA’s sovereign foreign-currency credit rating on negative outlook at its last review in December, suggesting the next rating change will be a downgrade. If S&P downgrades, SA will lose its foreign-currency investment grade rating. The rand would weaken, bond yields would rise and SA’s debt servicing costs would increase.  

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation.

• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.

• Despite the recent uptick in bond yields the long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.

• The US 10-year Treasury yield has broken above key resistance levels of 1.8% and 2.0%. However, there is unlikely to be a major bear trend in US bonds as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield broke out of its long-term bull trend as a result of “Nenegate”. The new bear trend for the R186 is underpinned by resistance at 9.0% with a risk of further upside to 10.50%. While SA bond yields may fall in line with global bonds they are unlikely to return to the bull trend.

• The MSCI World Equity index has broken downward from a rising trendline which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1 400.

• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle is likely to have just occurred. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur around June 2016.

• The S&P 500 index has broken downward from a rising wedge pattern, which is traditionally a trend-changing pattern. The downward trend is likely to remain intact unless the index decisively regains the 2070 level. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is leading the broader market lower on the downside.

• Despite the recent price rally Brent crude’s break below the key $30 support level in February suggests a continuation of the weakening long-term trend to a downside $25 target. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. Despite its recent rally the copper price broke below the key $4 500 support level in February suggesting further downside ahead.  

• Gold has broken its recent downtrend by rising decisively above the $1 100 resistance level. An extended break above $1 250 is needed to confirm the end of gold’s bear market.

• The JSE All Share index is testing an important resistance line but if this remains unbroken the index is likely to move back below the 24-month moving average at 50 700 in turn opening a downside target of 45 000 and an ultimate target of 43 000.

The bottom line

• The day that we have all been dreading is finally upon us. Standard & Poor’s (S&P) credit rating agency will deliver its review of SA’s sovereign credit rating on Friday 3rd June. Both local and foreign currency credit ratings are on negative outlook. However, while the foreign-currency rating is at BBB- just one notch away from “junk status” the local-currency rating is two levels higher at BBB+ and three notches away from junk status.

• S&P’s concerns center around SA’s weak GDP growth, potential deterioration of its public finances, and exposure to the weak balance sheets of state-owned enterprises (SOEs). At its last review S&P forecast SA GDP growth of 0.8% in 2016 while the SA Reserve Bank last week reduced its forecast to 0.6%, and many economists have even lower forecasts. The GDP outlook has deteriorated since S&P’s December review. Moreover, the political crisis has intensified.

• However, in the face of growing political uncertainty SA has displayed the strength of its institutions in particular the judiciary, the Reserve Bank and the Treasury. This fact was cited in the recent review by Moody’s rating agency, which kept SA’s foreign-currency rating unchanged and a notch above S&P.

• The foreign-currency rating was given a negative outlook in December last year so if a rating downgrade occurs on Friday the time between outlook change and downgrade would be six months. While it is not impossible for a rating downgrade to follow-on so soon after a negative outlook the delay is normally longer, usually around 18 months. It is reasonable to expect that S&P will allow SA more time to address the rating agency’s concerns.

• The 2016/2017 State Budget tabled in February promised reform of SOEs. It is likely that S&P will give the Treasury until the Medium-Term Budget Policy Statement in October to report on progress made. S&P may also want to wait until after the local elections in August for any sign of change, before committing itself to a downgrade.

• The credit default swap spread, which measures the cost of insuring against default on SA’s foreign-currency bonds, is higher than other countries which already have a junk rating, including Russia, Turkey, Indonesia and Hungary. The credit default swap market has discounted a credit rating downgrade. Therefore, in the event of there being no downgrade on Friday which seems to be a reasonable expectation, SA bonds and the rand may rally over the short-term.

• S&P is likely to leave the foreign-currency rating unchanged but with a negative outlook for a potential downgrade in December. The local-currency rating is likely to be downgraded from BBB+ to BBB but will still be one notch above the foreign-currency rating at BBB- and therefore still safely in investment grade territory.  

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.

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