South Africa's double whammy of bad news from rating agencies last Friday did not translate into the rout for the rand some had feared. The sovereign was downgraded by Standard & Poor's to BBB-, one notch above junk status, on the same day as Fitch changed its outlook to negative. Yet the reaction was muted.
“The rand is usually influenced by global risk appetite,” says Razia Khan, head of regional research for Africa at Standard Chartered. “It is less common for local drivers to have a great impact, although it can happen, and the S&P ratings downgrade might have been expected to be such an occasion.”
The downgrade was certainly bad news. S&P's rating is most important for South Africa, says Manik Narain, strategist at UBS. It already had the country on the lowest rating, suggesting downgrades from the other agencies might be imminent.
However, on this occasion, traders took heart that the bad news was relatively moderate. “Although South Africa was downgraded, the more important factor is that the outlook was upgraded to stable,” says Khan. “A lot of investors had been wondering if it would lose its investment-grade status with a two-notch downgrade, but the fact that looks safe – for now – is positive for the rand.”
In addition the reasons for the downgrade – the labour strike and falling domestic and external demand – were largely priced in, says Javier Corominas, head of economic research and FX strategy at Record Currency Management.
This view is supported by the CDS market. South Africa's five-year CDS trades at 184 basis points, about 40bp wider than that of Brazil, which has the same rating, and flat to lower-rated Turkey.
“South Africa has ridden on the coat-tails of Chinese growth for a decade and a half, supported at different times by European growth and QE,” says Narain.
The hope is that the downgrade will focus the minds of South Africa's politicians and push them into making the necessary market-friendly reforms required for a self-sustaining recovery, not dependent on foreign central banks providing cheap liquidity.
There are some positive signs. Progress has been made in resolving the platinum miners' wage dispute, which observers agree is encouraging. However, hopes that this could trigger a reversal of fortunes might prove misguided.
“The impact on exports should not be overstated,” says Narain. “To date demand has been met in large part with stockpiled inventory: export weakness has not been only about the strike, it also reflects structural issues. We think the market hasn't been paying enough attention to that.”
Even if the hoped-for pick-up in exports fails to materialize, it is doubtful that politicians have the stomach for economic reforms. The Economic Freedom Fighters party has been gaining ground and talk of a new Labour Party will provide greater competition to the ruling ANC. The government might therefore lack the political capital to push through potentially unpopular policies.
Neither are the authorities feeling the kind of market pressure that could force them to act. The country still has access to the international markets, liquidity is abundant and volatility is low. If no further downgrade materializes, South Africa's presence in benchmark bond indices such as WGBI and GBI-EM is under no immediate threat, which should ensure flows continue. Until that changes, appetite for policies that bring short-term pain before longer-term benefits are felt is likely to be absent.
“The vast majority of investors we speak with are attracted to the local debt market for its relative steepness in the belief that the South African Reserve Bank will not aggressively raise rates,” says Narain. “Today’s downgrade does not directly change that dynamic.”
The result is likely to be continued gradual deterioration. “South Africa's healing process has been limited compared with many of its emerging markets peers in terms of its fiscal performance, FDI, exports, GDP and policymaker focus on raising competitiveness,” says Narain. “There has been little to no improvement in these areas, which is worrying.”
Such countries as India and Mexico, which show more signs of progress by these measures, are likely to draw investor attention away from South Africa. In general, thogh, low US yields will provide cover for emerging markets.
How long this will continue remains to be seen. With the US Federal Reserve gradually reducing its QE programme, the European Central Bank showing no appetite for QE and neither Japan nor China looking likely to stimulate markets further, the days of limitless liquidity look numbered.
For now, UBS recommends traders go long the dollar against the rand.
Record agrees: “Although the rand has had a strong recovery period since the start of the year, we still think rand trades are attractive from a value perspective,” says Corominas. “The recent depreciation since mid-May might start to present good opportunities for entry into rand trades.”
However, he cautions that macro fundamentals suggest there is still a risk of further currency depreciation. With its large – though shrinking – current-account deficit and heightened inflationary pressure, a slight macroeconomic adjustment is needed via a continuation of real exchange rate depreciation and further cooling of domestic demand, he notes. “We currently take the view that the downside in ZAR is limited rather than an outright view of ZAR appreciation.”
Although the most stable pairing for the rand is the dollar, “for a higher-volatility trade with favourable directionality on both the short and long side we would recommend trading against the euro,” says Corominas. “With deflationary pressure in the euro area likely to keep a cap on euro strength, the increased exchange rate volatility could provide good risk to reward properties.”
Khan says: “In the long term we are bearish on the rand. We expect dollar/rand to reach 11.30 by the end of the quarter and in the longer term we expect it to move towards 11.10.”