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SA heading for junk status unless GDP grows

Dec 08 2015 20:00

Cape Town - With SA now officially on negative watch the next rating is likely to be junk unless action is taken to promote higher GDP growth, says Overberg Asset Management (OAM) in its weekly overview of the SA economic landscape.

Ratings agency S&P said that in order to avoid junk status SA should "observe policy implementation leading to improved business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth.”

OAM says that in the absence of an investment grade rating most foreign investors will withdraw funds from SA making it harder for the country to fund its large current account deficit.

"With foreign investors owning around 40% of outstanding rand denominated government bonds (up from 14% in 2009), and a majority stake in almost half the JSE’s top 40 stocks, the volume of foreign disinvestment resulting from a rating downgrade could be massive," according to OAM.

South Africa economic review

• As anticipated Fitch credit rating agency downgraded SA’s sovereign foreign currency debt rating from BBB to BBB- just one notch above speculative grade or “junk status”. The downgrade had been expected bringing the Fitch rating in line with the rating of Moody’s and Standard & Poor’s.

Surprisingly, Standard & Poor’s (S&P) in its biannual credit review replaced its “stable” outlook for SA’s credit rating with a “negative watch.” A negative watch normally precedes an actual downgrade and in this instance paves the way for a downgrade to speculative grade.

S&P cited weakness in economic growth as the key reason for the change in outlook and warned that a downgrade could follow if growth underperformed its modest expectations of 1.6% growth in 2016 and 2.1% growth in 2017. (Please see the “Bottom Line” at the end of this weekly report for more in-depth analysis).

• New passenger vehicle sales fell on a year-on-year basis in November for a ninth straight month although the pace of decline moderated from -10.8% to -0.6%. Total vehicle sales managed to eke out a slight increase on the year of 0.4% substantially better than October's -8.6% contraction and the -8.6% consensus forecast.

Commercial vehicle sales increased 2.3% on the year partly reversing the previous month’s -3.7% decline. Vehicle exports continued to increase although the pace of growth slowed from 23.4% to 14.8% on the year due to a model transition at one of the key exporters. Although the overall data was better than expected the outlook remains constrained by weak domestic household and business confidence and rising funding costs.

• The Barclays manufacturing purchasing managers’ index (PMI) tumbled from 48.1 in October to 43.3 in November deeper into sub-50 contractionary territory and well below the 48.4 consensus forecast increase. The PMI is at its lowest since August 2009, which is surprising given the boost which had been anticipated in the absence of further load shedding.

The decline is attributed to broad-based weakness in domestic demand and policy uncertainty. Among the sub-indices the business activity index fell from 47.7 to 41.4 and the employment index from 44.0 to 40.7.

The forward-looking new sales orders index fell from 50.5 to 43.5 and the expected business conditions index to 43.2 signaling a continuation of the weakening trend in the months ahead. At the same time the prices index gained from 73.8 to 75.1 indicating rising inflationary pressure despite the lackluster demand environment.

• The trade balance registered a worse than expected –R21.4bn deficit in October markedly higher than the –R7.8bn consensus forecast. Exports contracted -6.0% month-on-month attributed to a -19.3% fall in exports of precious metals and gemstones, and -6.5% fall in mineral product exports.

At the same time imports increased 15.7% on the month driven by a 19.2% increase in imports of machinery and electronics and 45.1% jump in transport equipment imports. Following months of improving trade data the latest reversal is disappointing given the beneficial effect of the weakening rand on the country’s terms of trade. The trade data suggests the rand’s depreciation is still not sufficient to compensate for the rapid decline in global commodity prices.

The week ahead

• SA Reserve Bank Quarterly Bulletin: Due Tuesday 8th December. Of particular interest will be the current account deficit, which according to consensus forecast is expected to deteriorate from -3.1% of GDP in the second quarter (Q2) to -4.0% in Q3.

• Mining production: Due Tuesday 8th December. According to consensus forecast September’s -4.8% year-on-year contraction in mining production is expected to continue at -4.2% in October reflecting persistent weakness in commodity prices and global demand.

• Manufacturing production: Due Tuesday 8th December. According to consensus forecast manufacturing production is expected to have declined in October by -0.7% year-on-year partially reversing September’s 0.9% increase.

• Consumer price inflation (CPI): Due Wednesday 9th December. According to consensus forecast CPI is expected to show a slight acceleration from 4.7% year-on-year in October to 4.8% in November.

• Retail sales: Due Wednesday 9th December. According to consensus forecast retail sales growth is expected to have moderated slightly from 2.7% year-on-year in September to 2.5% in October.

• BER Consumer confidence index: Due Thursday 10th December. According to consensus forecast consumer confidence is expected to have deteriorated from -5 in the third quarter (Q3) to -7 in Q4 aggravated by weak employment conditions amid interest rate increases and rising inflation.

Technical analysis

• 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 no sign yet 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 is testing support at 8.70% which if broken could open a new target of 9.5%.

• Although recently recovered the MSCI World Equity index broke downward from a rising wedge formation which has been intact since the 2008/09 global financial crisis. It is unlikely that the downward move is over as the correction was too small for a bull market of the magnitude and duration of the 2009-2015 bull market. The downside target for the MSCI World Equity index is 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 can be expected in the next year. 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.

• Although recently recovered the S&P 500 index broke 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 $50 support level suggests a continuation of the weakening long-term trend. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the key $5 000 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.  

• Although recently recovered the All Share index broke below its bull market support level which has been intact since 2009. The downside target for the All Share index is 43 000.

Bottom line

• The SA Barclays manufacturing purchasing managers’ index (PMI) tumbled from the third quarter’s (Q3) already weak 48.1 (in sub-50 contractionary territory) to 43.3 in Q4 its weakest reading since August 2009.

The PMI is in contrast to the consensus forecast increase to 48.4 which had been expected in the absence of load shedding during Q3.

Given that manufacturing was a key driver of the 0.7% annualised GDP growth in Q3 the dismal Q4 manufacturing PMI reading will surely prompt economists to lower their GDP forecasts for the final quarter of the year.

• Standard & Poor’s (S&P) cited GDP weakness as one of the main concerns which prompted the credit rating agency to lower SA’s long-term credit rating outlook from “stable” to “negative”. While S&P acknowledged that “the National Treasury is broadly maintaining its prudent fiscal consolidation through hard expenditure ceilings,” it confirmed that “we could lower the ratings if GDP growth does not improve in line with our expectations.” Lower GDP would put pressure on state finances at a time that state-owned enterprises are rapidly increasing their demands for government support.

• SA’s investment grade sovereign credit rating is just one notch above speculative grade (“junk” status). The rating agencies traditionally put a country on negative watch before actually downgrading.

With SA now officially on negative watch the next rating is likely to be speculative grade unless, according to S&P: “We observe policy implementation leading to improved business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth.”

• A downgrade to speculative grade would affect government borrowing costs, lead to capital flight and currency weakness. Most foreign investors have a mandate to invest in countries with an investment grade. In the absence of an investment grade rating most foreign investors will withdraw funds from SA making it harder for the country to fund its large current account deficit.

• With foreign investors owning around 40% of outstanding rand denominated government bonds (up from 14% in 2009), and a majority stake in almost half the JSE’s top 40 stocks, the volume of foreign disinvestment resulting from a rating downgrade could be massive.

• The consequences for the rand and interest rates would be crippling. It would not be the first time that SA has had a speculative grade rating. SA had a speculative grade rating in 1994 but understandably at this stage, so soon after years of economic sanctions, there was very little foreign ownership of either domestic bonds or equities. As a result the amount of foreign disinvestment which ensued was negligible. This time may be different.

• A rating downgrade would cause a spike in government borrowing costs. Households would also be affected by a rating downgrade. The rand weakness ensuing from massive foreign investor selling would fuel inflation, ultimately leading to higher interest rates and further erosion of disposable income.

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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