South Africa’s sovereign debt rating has been continually downgraded by credit ratings agencies over the past few years. These ratings agencies have been sounding alarms about the policies, finances and pedestrian economic growth of the country.
With no indication that economic prospects will soon improve to halt the rising government debt levels and deteriorating fiscus, there is a real possibility of South Africa remaining in such a position for some time to come.
The answer lies in whether this possible downgrade is already priced in and reflected in the current financial markets or not. In a case where the downgrade is already priced in, it should have limited adverse effects on the asset prices of the local investment markets.
The downgrade by Moody’s might lead to South Africa dropping out of the World Government Bond Index (WGBI), which will result in an outflow of assets from offshore Investors who only hold a mandate to invest in debt instruments with an investment grade. This will result in short-term pressure on the rand against the US dollar and the yields in the local bond market. South Africa has a 0.45% weighting in the WGBI as per the latest data from National Treasury. Speculative status implies that there is a bigger chance that government won’t be able to pay back its creditors, as the country’s debt to GDP is projected to grow to 80% by 2023.
More pressure on the cost of government debt doesn’t bode well for the outlook of the South African fiscus. Although a ratings downgrade is not an ideal situation, there are Investors for every market and instrument. The downgrade would present Investors that invest in sub-investment grade instruments with an opportunity to allocate their assets to local bonds. The local bond market still offers attractive real yields relative to other markets, and as such, a downgrade could cause the yields to creep higher alongside a weaker rand and create a buying opportunity for foreign Investors. The foreign investor at this stage is also hungry for yield, as many developed countries offer unattractive or negative real bond yields.
For retirement funds, the reaction of members to an event like the Moody’s credit rating downgrade of South Africa’s government debt is more important than the actual event itself. Should South Africa’s sovereign debt get downgraded to speculative status by Moody’s, it will immediately be reflected in the exchange rate and result in market volatility. The markets will take some time to settle, and fund allocators will assess the impact on the medium-to long-term economic and investment landscape. However, retirement fund members should not consider changing their investment strategies and move to the sidelines by switching to a cash portfolio. Regulation 28 limits retirement funds to a 30% foreign investments exposure.
This regulation is meant to ensure that member’s funds are invested in a sustainable, diversified and risk conscious manner. Most retirement funds allow their members to only invest in Regulation 28 compliant global balanced portfolios as part of a life stage model.
The local equity and listed property market have a strong hedge component with offshore earnings, thus a typical global balanced portfolio could easily have an effective exposure of 50% to offshore markets.”
The exposure to foreign assets in global balanced portfolios provides the attractive feature of diversifying retirement fund members’ investment portfolios and accessing a wider universe of global markets, currencies, asset classes, stocks and instruments. This broad investment opportunity set combined with protection against market risk, will allow the portfolios to achieve their expected real investment return targets over appropriate time periods. The local equity and listed property market have a strong hedge component with offshore earnings, thus a typical global balanced portfolio could easily have an effective exposure of 50% to offshore markets. This kind of portfolio provides a local investor with both direct and indirect offshore exposure.
A downgrade will come with an anticipated sell off in the local bond and equity markets in the short term. The impact of a ratings downgrade on a fund member’s portfolio will depend on the extent to which the portfolio has exposure to local and offshore assets. The negative short-term effects of a downgrade would be offset by the gains in rand hedged stocks and offshore investments. Pre-retirement, it is always important for fund members to match the asset allocation to the term to retirement by considering how much risk they can afford to take. It is also important to consider what type of Annuity they will be purchasing at retirement for their income needs.
Members that are close to retirement and are planning on purchasing a guaranteed Annuity at retirement, will be more sensitive to risk than members looking to purchase a Living Annuity. Post-retirement members who are drawing a regular income from a Living Annuity, should keep their drawdown rates to a minimum, and ensure their strategies remain diversified across global markets and asset classes.
For most local investors, the debate of how much should be invested offshore has become a reflection of the weak domestic confidence that has resulted from years and years of deteriorating economic conditions. People know the importance of diversification, and for good reason – it’s one of the few free lunches in the world of investments. But with that said, how much foreign exposure should an Investor have during a credit ratings downgrade? It’s not an easy question to answer for various reasons.
The ’optimal allocation‘ for an investor is driven by their personal circumstances, spending habits, investment objectives and horizon, risk tolerance, and other investment constraints such as tax, liquidity needs, etc. For investors who have discretionary monies outside their retirement savings plans, it may make sense to use the discretionary assets to increase the offshore exposure and access the offshore markets through non-rand denominated offshore funds. To diversify away from this risk, investors can use up their R10m foreign investment allowance per calendar year.
Whilst market sentiment does play a role in the markets, a more measured process and approach when deciding on where and when to invest often yields better outcomes. When making investment decisions, investors should consider their overall long-term strategy and bear in mind that offshore investing is only one component of their overall portfolio.
Many retirement fund members do feel nervous and unsettled at this stage, but the call to invest offshore should not only be influenced by sentiment, but rather a holistic long-term investment plan. For a South African retirement fund member to cushion against the worst-case scenario, there is a great need to invest in quality assets as part of a resilient portfolio.
"Speculative status implies that there is a bigger chance that government won’t be able to pay back its creditors, as the country’s debt to GDP is projected to grow to 80% by 2023.”
A resilient portfolio seeks to find the balance between reducing investment risk, but still generating the necessary real returns for fund members to achieve their long-term investment goals. It is important for every retirement fund member to consult their financial advisor before they make any decisions about making material changes to their long-term investment strategy.
