Cape Town - With both Russia and Brazil downgraded to “junk” status, markets are already discounting that South Africa will lose its investment grade credit rating.
This is evident in the significant decline in the share price of Mr Price, says Overberg Asset Management (OAM) in its weekly overview of the SA economic landscape.
"Since 'Nenegate' on 9 December, SA’s credit default spread has remained consistently higher, at 350 basis points, than the equivalent rates in Russia and Brazil, both at around 320 basis points. The credit default swap market indicates SA has a higher chance of defaulting than either Russia or Brazil and since both countries have already been downgraded to 'junk' status markets have started discounting that SA will lose its investment grade credit rating."
According to OAM the high probability of a credit rating downgrade largely explains the 19% decline in Mr Price shares last Friday. Although the company’s trading statement was slightly disappointing the share price reaction appears disproportionate and is most likely explained by forced foreign selling.
Prior to last Friday’s selloff, foreign investors owned over 50% of Mr Price shares making the share especially vulnerable to foreign selling. Most foreign investors have a mandate to invest in countries with an investment grade and without one these investors will be forced to withdraw funds from SA, says OAM.
South Africa economic review
• Senzeni Zokwana, Minister of Agriculture, Forestry and Fisheries, reported that SA will need to import between 5-6 million tonnes of maize higher than the earlier estimate of 4 million. At current prices the cost would be equivalent to 0.5% of GDP and could increase the cost of the basic food basket by as much as 25%. Grain SA reported that the price tag of maize imports could exceed R20bn. Meanwhile calls for additional drought assistance to farmers will add to the Treasury’s challenge in meeting its budget deficit projections.
• The Forward Rate Agreement market is currently pricing-in a 92% probability of a 50 basis point interest rate increase at the SA Reserve Bank’s (SARB) next policy meeting on 29 January. Inflationary pressures have deteriorated since the central bank’s last policy meeting with the rand depreciating against the US dollar by 11.07% over the past month and by 8.19% since the start of the year.
The intensifying drought is also causing a larger than expected maize harvest shortfall which will produce sharply higher food price inflation.
SARB Deputy Governor Daniel Mminele noted on Monday in a speech in London that: “The risks to the inflation outlook for 2016 remain tilted to the upside and have recently deteriorated further.” However, the low oil price should mitigate some of the inflationary pressure. The rand oil price has declined 11.6% over the past month.
• The Barclays manufacturing purchasing managers’ index (PMI) staged a slight recovery from its six-year low of 43.3 in November to 45.5 in December although still well in sub-50 contractionary territory. Among the sub-indices business activity improved from 41.4 to 42.4 and the expected business conditions by a larger margin from 43.2 to 46.1 although still woefully below the 64 long-term average. Encouragingly the employment index gained the most from 40.7 to 46.5.
Despite the contractionary environment the prices index showed a continued increase in inflationary pressure, rising from 75.1 to 77.2. Although the weaker rand should theoretically boost the manufacturing sector increased global competitiveness is being constrained by the lackluster global demand environment.
• Mining production was surprisingly strong in November rising 2.4% month-on-month building on the 1.7% growth in October. On a year-on-year basis mining output fell by just -0.8% far better than the -3.7% consensus forecast and an impressive performance given the sharp decline in commodity prices and electricity supply outages. Among the four main mining sectors, coal production increased by a substantial 9.3% month-on-month, gold and iron ore production by 5.3% and platinum by 1.6%. Although encouraging, the mining production data tends to be volatile around year-end and susceptible to revisions in January and February. Moreover the platinum sector will be vulnerable to further disruptions in 2016 due to the resumption of wage negotiations.
• In contrast with the relatively buoyant mining sector, manufacturing production missed expectations in November, declining -1.2% month-on-month following the -1.7% contraction in October. On a year-on-year basis manufacturing production contracted -1.0%, worse than the -0.3% consensus forecast. November’s decline is attributed to falls of -4.3% in food production and -2.1% in petrochemicals. Some sectors defied the downward manufacturing trend including vehicle and parts with growth of +2.8% on the month, wood and paper with +1.4% growth, and basic iron and steel with +0.9% growth.
• Foreign investors bought a net R861m worth of SA government bonds in the past week taking total net purchases for the year-to-date to R2.1bn, almost as much as last year’s R2.8bn. However, the inflows pale in comparison to the record inflows of R88bn in 2012 when SA was included in the Citi World Government Bond Index. Equity outflows appear to be gaining momentum with net foreign selling of JSE listed shares rising to R7.4bn in the past week lifting total net outflows for the year-to-date to R13bn (see “Bottom line” for further coverage).
The week ahead
• Consumer price inflation (CPI): Due on Wednesday, 20 January. According to consensus forecast CPI is expected to accelerate from 4.8% in November to 5.4% in December, its fastest pace in a year. The rise in inflation is becoming more broad-based although the weak rand and drought is placing particular pressure on food price inflation. With the rand falling around 17% over the past month alone, the inflation outlook has deteriorated significantly and may breach the upper end of the SA Reserve Bank’s 3-6% target for more than an isolated quarter as previously expected.
• Retail sales: Due on Wednesday, 20 January. Having increased to 3.3% year-on-year in October, retail sales growth is expected to slow to 2.7% in November, according to consensus forecast. Consumer disposable income is being negatively affected by rising inflation and interest rates, while weak employment growth is denting consumer confidence.
• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation. Although the rate of the rand’s depreciation is accelerating there is little sign so far of panic selling or capitulation. This stage needs to be reached before a reversal in the rand’s move can occur.
• 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 2.0% and 2.2%. 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 wedge formation 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.
• Brent crude’s break below the key $30 support level suggests a continuation of the weakening long-term trend to a downside target of $25. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the key $4 500 support level suggesting further downside ahead.
• Despite recent advances, gold is in a protracted bear market signalled by rapid declines through successive support levels at $1 300, $1 250 and $1 100. Gold’s next target is $1 000 which is likely to be breached before the bear market ends.
• The JSE All Share index remains below the 24-month moving average at 50 600. The recent consolidation pattern between 47 000 and 49 000 is likely to be resolved with a break to the downside to an initial target of 45 000 and an ultimate target of 43 000.
Bottom line• According to market pricing the perceived risk of SA defaulting on its foreign currency sovereign bonds has not recovered since spiking higher after President Zuma replaced Minister of Finance Nhlanhla Nene with David van Rooyen. The price of default insurance is reflected in the “credit default swap” (CDS) spread, which remains at the same elevated levels of 9-10 December.
• Since “Nenegate” on 9 December, SA’s credit default spread has remained consistently higher, at 350 basis points, than the equivalent rates in Russia and Brazil, both at around 320 basis points. The credit default swap market indicates SA has a higher chance of defaulting than either Russia or Brazil and since both countries have already been downgraded to “junk” status markets are already discounting that SA will lose its investment grade credit rating.
• The high probability of a credit rating downgrade largely explains the 19% decline in Mr Price shares last Friday. Although the company’s trading statement was slightly disappointing the share price reaction appears disproportionate and is most likely explained by forced foreign selling. Prior to last Friday’s selloff, foreign investors owned over 50% of Mr Price shares making the share especially vulnerable to foreign selling. Most foreign investors have a mandate to invest in countries with an investment grade and without one these investors will be forced to withdraw funds from SA.
• Besides Mr Price what other SA-listed shares are susceptible to heavy foreign selling? Those with high existing foreign ownership are most at risk. Excluding dual-listed shares and foreign-owned subsidiaries, and pure rand-hedge stocks, the following All-Share Top 40 shares have foreign ownership greater than 40%: Aspen, Bidvest, Mr Price, MTN, Old Mutual, Sanlam, Shoprite, Standard Bank, Tiger Brands and Woollies.
• While foreign ownership is normally viewed positively, for existing investors in the current environment it may be more of a burden than a blessing. The exodus by foreign investors has already begun, aimed at pre-empting the massive selling pressure which will undoubtedly prevail once the credit rating downgrade is formally announced in June. Foreign investors sold a net R7.4bn worth of JSE listed shares last week bringing total net sales since the start of the year to R13bn.
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* 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.
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