What happens after a market downgrade?

There has been much murmuring in the financial field as of late regarding queries with respect to investing locally, or shifting all portfolios offshore, specifically in the light of the widespread media coverage and speculation regarding South Africa’s credit rating and the likelihood of a downgrade to “junk status” – which could happen as soon as the third quarter.

While there is some speculation about when it might happen the general consensus seems to be that it is no longer a question of “if”, but “when”. It is thought that South Africa’s sovereign debt rating will be cut below investment grade in either June or December.

Why is this happening and what does it mean?

As I have been following, South Africa is facing a downgrade for two reasons:

1. Slow growth – along with the rest of the world, SA faces lower levels of growth than forecast (and these forecasts continue to fall). There are a multitude of reasons for the slowdown including depressed commodity prices and reduced global demand for commodities, but also a lack of willingness to invest with all the current uncertainty around government policy.
2. Fiscal outlook – effectively this relates to the ability of the country to control spending given the tax base so that excess spending does not need to be covered by issuing more debt. With low growth and high unemployment, tax revenue is under pressure and spending on benefits is rising. The government’s target to limit gross debt to 50% of GDP is going to be very difficult to achieve.

Many experts have suggested that the immediate impact of a credit downgrade would be a flight of capital, a spike in bond yields, rapid currency depreciation and a fall in equity markets. However, looking at a historical analysis of emerging markets who suffered a similar downgrade returns a somewhat unexpected trend (based on a group of emerging markets that had all been downgraded from investment to sub-investment grade and their performance in the 12 months before and after the move).

Markets are very good at anticipating what is going to happen, in the period preceding the downgrade they tend to perform poorly, but after the fact they gradually perform better – generally speaking.

The trend is clearly that yields expand leading up to a downgrade, but generally recover afterwards. The average currency on a real effective exchange rate basis tells a similar story, increasing relative to where it was at the time of the downgrade.

Countries that are downgraded to sub-investment grade go into recession, almost without exception. It takes years to earn back their credit rating. This is the real challenge that South Africa faces, the policy response will be critical.

Investors should not be overly influenced by the short-term commotion, but rather set their sights further on their investment horizons. There is a tough road ahead, but it is a difficult year for local and international economies alike.

I realize that this blog contains a large amount of technical terms and concepts – if you\’re concerned about your investments or would like to discuss off-shore options – then let\’s get in touch!

Source: moneyweb