Bridging the Gap to Offshore Opportunity
by Leigh Cunningham-Scott and Dave Sinclair, Debt Capital Market Transactors, Rand Merchant Bank
The global macroeconomic backdrop is currently characterised by uncertainty and volatility with limited potential of stabilising in the near term. The key theme that all economists can agree on is that this uncertainty and volatility is here to stay. However, uncertainty creates opportunity, particularly for South African corporates with existing bond structures or those looking to expand offshore.
Financial markets tend to overreact ahead of an event only to revert to normalised levels post the event. Surprises such as Brexit, create market uncertainty and subsequent volatility. While the initial market moves subsequent to Brexit have reverted, overall global growth and deflation fears have increased. Fundamentally this should result in a risk-off scenario where investors move out of emerging markets to invest in safe haven assets. Instead, the anticipated slowdown in developed countries such as the UK has driven renewed interest in emerging markets offering a yield pick-up.
Brexit, in the short term, is unlikely to have further significant effects barring what has already been discounted by the market. Over the longer term, the impact is likely to centre around trade, investment, tourism and aid flows. Domestically, some stabilisation has already been evident with the rand and JSE trading around pre-Brexit levels. Concern is rather focused on long-term financial flows and financial market volatility as investors carefully consider the growth prospects of emerging markets.
The South African economy is particularly vulnerable to capital flows and relies heavily on private-sector capital to finance its large current account deficit. As these flows are historically very volatile, this places the domestic financial markets at a greater risk of volatility relative to other emerging markets. As non-residents can hold up to 35% of government’s rand-denominated debt at any point in time, foreign investor sentiment is extremely important as a substantial outflow would have a significant impact on the underlying yields. The South African economy is already strained with low commodity prices and limited growth prospects, which could result in negative investor sentiment leading to a decoupling from other emerging markets.
Uncertainty surrounding the potential downgrade of the South African sovereign foreign currency credit rating remains. The key metrics that need to be considered in the evaluation of a sovereign downgrade include low growth, high youth unemployment, inflexible labour laws and a level of political resolve. The IMF recently indicated that it anticipates domestic growth at 0.1% for 2016, while the South African Reserve Bank recently indicated that 0% GDP growth is expected for 2016 and 1.1% for 2017. However, S&P indicated that government’s resolve to reduce the fiscal deficit with a target of 3.2% of GDP this year falling to 2.8% in 2017  is considered positive.
A rating downgrade could trigger a short-term forced sell-off as indexed tracker funds are rebalanced to exclude South African foreign currency bonds. The impact of the downgrade will be reflected in a widening of the credit spreads of the Republic of South Africa, South African state-owned enterprises and some corporates, particularly banks. Entities that are closely linked with government will be most impacted as their foreign ratings will be downgraded given the close reliance on the South African government.
1. S&P Global Ratings - South Africa Ratings Affirmed: Outlook Remains Negative on Weak Growth, June 2016