Anchor Capital says that following last week’s Medium-Term Budget Policy Statement(MTBPS), “we need to adjust our base case to be that South Africa will be kicked out of the Citigroup World Government Bond Index (WGBI)”. By its estimates, a base case scenario of further downgrades and the exit from WGBI will trigger “approximately R100 billion of forced sales, and likely results in our R186 (10 year) bond yield pushing out to 10%+”.
Simply, Anchor says in a report the expectation should be that rates will gravitate towards 10.25% and the rand towards 15 [against the US dollar] at some point in the next year”. Yields on the R186 area are already over 9%, from 8.6% a month ago. Following the MTBPS, yields spiked by 40 basis points to close at 9.27% on Thursday. The rand spiked to 14.35 versus the dollar on Friday, from levels of 13.70 before the MTBPS.
Anchor says the “most stark aspect” of the MTBPS was the unsustainable plan to run a deficit of 3.9% a year going forward. The numbers don’t add up. “In an economy that grows at a rate of anywhere between 1% and 2% per year, we would expect that debt will accumulate at a rate of between 2% and 3% of GDP per annum.”
“…It appears it has merely been assumed that government can continue to accumulate an extra 2% of debt per annum without a meaningful deterioration in the cost of funding.” As this writer previously highlighted, the “straight-lining” of the increase in debt-service costs to around R20 billion a year in each of the next three years is clear evidence of this somewhat misguided assumption.
“Without the current credit ratings, the risk of a failed government bond auction is quite high,” warns Anchor. “The market will soon say no more.”
Chief investment officer Sean Ashton and analyst Nolan Wapenaar write that the “greater debate for SA equity investors [aside from the structural dominance of rand hedges] recently has been wrestling with two key contrasting risks:
- The ANC national elective conference in December could possibly resemble a “Brazil moment” if Cyril Ramaphosa wins. This “would likely lead to a significant rally in “risk” assets such as banks, retailers and listed property on the expectation that structural reform could follow”. Many analysts, including Peter Attard Montalto of Nomura, maintain that the market “remains too optimistic overall about options for change through December” although this view is beginning to soften.
- Contrast this with the “perilous” fiscal position the country is in. “While the absolute quantum of the revenue shortfall should not have been met with surprise by anybody, what is unequivocally negative versus our expectations is the lack of any plan presented to deal with the issue, with Treasury seemingly abandoning the idea of fiscal consolidation in favour of further bond issuance. To our minds, this has materially raised the odds of SA remaining firmly on a low-road economic path versus what we would have previously expected.”
Anchor says its portfolio positioning (pre-MTBPS) had “attempted to strike a balance between these two factors, dictating that while we – on balance – retain a global (rand hedge) bias to our equity funds, it is too risky to have no exposure to “risk on” assets in the form of SA banks and retailers”.
However, finance minister Malusi Gigaba’s MTBPS “by itself, lowers the probability of a very strong performance from these SA assets, with the impact being felt most acutely via a compression of valuation multiples in a scenario of bond yields stretching to 10% and beyond”.
As a result, Anchor says it has trimmed its exposure to listed banks and retailers and “allocated the difference to rand hedge counters such as Bidcorp and Astoria”.
Anchor has done a basic sensitivity analysis assuming a bond yield of 10% “as a starting point in building out a valuation model”. The results of this exercise highlight the “downside risk should this scenario play out. It should be noted that banks are the equity sector class most sensitive to changes in long-term interest rates. We are now underweight banks in our equity CIS funds and believe our portfolio positioning is consistent with a continued depreciation of the rand and selloff of fixed income yields.”
|Spot||Fair value||Implied price/book value (FY17)||Downside|
Source: Anchor Capital
Anchor says that on bonds, it is “focusing on the right exit rather than opportunities to buy”. But, there is “no reason to rush for the exits, however, given real yields of above 4%”.
“A [recent peak] real yield of 4.4% means that we have now matched the cheapness of bonds achieved by Brazil towards the height of their crises. Without a change in direction of policy (we can safely conclude that the policies of the last decade have failed) we do not see a reason to hold long-dated bonds. Our portfolios were already very underweight duration and we expect that we will further reduce exposure in the coming days and weeks.”
Brought to you by Moneyweb