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Ratings risk: Time is running out for SA

Dec 06 2016 18:56

Cape Town - The risks remain high of a credit ratings downgrade unless South Africa makes more than “piecemeal” progress on structural reforms, cautioned Overberg Asset Management.

It said in its weekly review while Standard & Poor’s Global Ratings (S&P) lowered South Africa’s local currency rating from BBB+ to BBB- this is still one notch above non-investment grade putting both local and foreign currency ratings on the same level.

The rand strengthened against major currencies over the past week, discounting expectations that S&P would affirm South Africa’s sovereign foreign currency rating at BBB-, one notch above non-investment grade.

READ: Junk breather for SA, but S&P lowers local currency rating

In its assessment S&P cited increased deficit financing needs, forecasting a rise in debt-to-GDP from the current level of 49% to 54% by 2019. S&P also cited political tensions and persistently weak GDP growth, it added.

READ: Further drop in GDP growth

South Africa economic review

• Standard & Poor’s Global Ratings (S&P) announced a downgrade to South Africa’s local currency sovereign debt rating from BBB+ to BBB-, one notch above non-investment grade, in line with its foreign currency bond rating, which it left unchanged. Despite a strikingly negative assessment the rating agency resisted a downgrade to “junk status”.

However, S&P like fellow rating agencies Fitch and Moody’s kept South Africa on “negative watch”. A negative credit ratings watch signals a strong chance of a downgrade at the next review in June 2017 unless there is concrete evidence of structural reforms to lift the country’s economic growth rate. (See Bottom Line for further analysis).  

• The Barclays manufacturing purchasing managers’ index (PMI) increased from 45.9 in October to 48.3 in November. Although in sub-50 contraction territory for a fourth straight month some of the sub-indices showed decent gains.

Manufacturers’ purchasing commitments increased from 46.7 to 50.0 and the forward-looking new sales orders and expected business conditions regained the key 50-level, rising from 44.5 to 51.4 and from 50.6 to 53.9. The data suggests the manufacturing sector, after contracting in the third quarter (Q3) by around 5% quarter-on-quarter, will trough in Q4 and improve into the first half of 2017.

• The trade balance reverted from a R6.9bn trade surplus in September to a -R4.4bn deficit in October although far less than the -R9.0bn consensus forecast. The month-on-month deterioration is attributed to a 10.1% decline in exports.

However, the longer term trend mirrors declining imports in response to weak consumer demand and poor business investment demand for imported capital goods. The cumulative trade deficit for the year-to-date has narrowed to -R14.3bn from -R59.5bn over the same period in 2015.

The recent uptick in the oil price following OPEC’s production cutback agreement may cause the trade deficit to widen again over coming months. South Africa’s mineral imports average around R12bn per month comprising almost entirely of oil. Higher oil prices may cause the current account deficit to increase from 3.1% of GDP in the second quarter to over 4% in the first two quarters of 2017.

• The BER business confidence index (BCI) fell from 42 in the third quarter (Q3) to 38 in Q4 giving back some of the previous quarter’s ten-point gain. The BCI has been below the key 50-level which demarcates expansion from contraction for eight straight quarters.

Among the five economic sectors surveyed, vehicle dealer confidence fared worst falling from 37 to 26, followed by the manufacturing sector unchanged at 30 and the retail sector, down from 43 to 34.

By contrast, the building sector improved from 44 to 48 and the wholesale sector fell marginally from 56 to a relatively elevated 53. The weak BCI figures are reflected in anemic private sector investment spending, which has contracted for four straight quarters.

• Total vehicle sales fell in November by 9.6% year-on-year marking the 20th straight month of decline. Passenger vehicle sales fared worst, down 13.8% on the year its 23rd straight decline. Commercial vehicle sales also fell by 2.0% on the year, with the brunt felt by medium and heavy commercial vehicles declining 18.7% and 17.1%, respectively.

The data reflects an extremely weak domestic environment stemming from challenging business conditions and poor consumer demand.

The National Association of Automobile Manufacturers (NAAMSA) stressed that conditions remain extremely challenging despite cash incentives for buyers. Fortunately, export demand remained robust contributing to a 12.4% year-on-year increase in total vehicle export sales, up from 11.1% in October.

The week ahead

• GDP growth: Due on Tuesday 6th December. Third quarter (Q3) GDP growth is expected to fall to 0.4% quarter-on-quarter annualised in sharp contrast to the 3.3% recorded in Q2.

While the contraction in agricultural output has slowed both mining and manufacturing sectors have been a drag on Q3 growth. Business and household expenditure have also been on a downtrend amid weak business and consumer confidence.

• Manufacturing production: Due Thursday 8th December. While the base effect of weak comparative year-ago numbers should ensure an improvement in year-on-year manufacturing production growth from 0.0% in September to 0.9% in October, month-on-month growth is expected to subside from 1.5% to 0.6%.

• Mining production: Due Thursday 8th December. Mining production growth is expected to slow slightly from 3.4% year-on-year in September to 2.8% in October due to the base effect of high year-ago comparative levels.  

• Current account deficit: Due Friday 9th December. The current account deficit is expected to widen slightly from -3.1% of GDP in the second quarter (Q2) to -3.6% in Q3 attributed to the quarter’s declining trade surplus.

Technical analysis

•  While the rand has broken below key resistance levels versus the dollar at R/$ 14.20 and 13.80 the strengthening trend is not confirmed by momentum indicators, signalling that the currency is overbought.

• 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.

• Following the Brexit vote the British pound hit its weakest level against the US dollar since 1985. The key £/$1.30 level support level has been broken opening up a £/$1.20-1.24 target.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield has broken back above the key support level of 2.0% endangering the multi-year bull trend in US bonds.

• The benchmark R186 SA Gilt yield is now testing the key support level of 9.0% endangering the mini-bull market in bonds which has been in place since the start of the year.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdqaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.  

• The Brent crude price is well supported at $40 a barrel and having broken key resistance at $50 is targeting further gains to the next key level at $60. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $5000 per ton.

• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1400 target level.

• 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 50 900 in turn opening a downside target of 45 000.

A break above 54 200 on the JSE All Share index would project an upward move to 60 000 marking a new high for the JSE.

The bottom line

S&P reported that” We could lower the ratings if GDP growth or the fiscal trajectory does not improve in line with our current expectations, for example if South Africa enters a recession in 2017…. We could also lower the ratings if we believed that institutions had become weaker due to political interference affecting the government’s policy framework.”

On the other hand, a reversion to a stable outlook would occur: “If we observed policy implementation leading to improving business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth and improving fiscal dynamics.”

• Despite keeping the foreign currency rating unchanged the tone of S&P’s assessment was strikingly negative, signaling a high risk of a downgrade at the next review in June 2017 unless South Africa makes more than “piecemeal” progress on structural reforms.

• Time is running out: The negative watch, which was put in place in December 2014, has a 24-month timeline indicating either a follow through to non-investment grade or reversion to “stable watch” by December 2017.

• President Zuma’s response to last week’s ANC National Executive Committee meeting, will be critical. A reshuffle of key cabinet posts, especially if Finance Minister Pravin Gordhan is removed from office, would cement a ratings downgrade in June 2017.

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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