Nkareng Mpobane, Fund Manager at Ashburton Investments reflects on South Africa and the global ratings agencies.
Against what has become a progressively worrisome backdrop to South Africa’s macroeconomic outlook, it is probably not surprising that we are currently receiving the undesirable attention of global ratings agencies. This year the country is expected to grow by a meagre 0.5%, with risks to the downside.
Low commodity prices, domestic constraints and weak business confidence all raise the threat of continued subpar growth, which in turn leaves ratings agencies no choice but to downgrade the country’s credit rating. While regrettably much of our misfortunes are our own, lacklustre growth across many emerging markets has also had a hand in our current situation. In 2000, SA achieved investment grade status just as global economies prepared to enter a prolonged period of synchronised economic growth. October 2012 marked the first downgrade to the country’s sovereign rating since 1994.
As it stands, a credit rating downgrade into sub-investment grade is likely by year-end and this could potentially result in further asset price volatility in the build-up to this event.
The question being, how much has already been priced into these assets. Without a doubt, investors have already increased the risk they assign to investing in South Africa and this means that they require higher returns. Within equity markets, one sector that is often credited with having deep roots in an economy is the banking sector – the transmitters of economic participation and activity. The question remains, what does sub-investment grade mean for South African banks and is it all priced in?
Two major risks that faced the banking sector following the dismissal of Mr Nhlanhla Nene were what would happen with interest rates and inflation. Currency depreciation was an immediate indicator of a worsened investment climate, which ultimately feeds through into higher inflation. The South African Reserve Bank responded by raising interest rates. What we want to avoid is Brazilian-style emergency rate hikes, an outcome that would not augur well for SA banks. Almost six months on, interest rates have risen by a relatively modest 75bps and the currency is yet to reach the peak levels of R16.86 to the dollar. These outcomes can be attributed to a few positive developments that unfolded at the start of the year, such as greater engagement between business and government and a tighter fiscal budget which reflected a desire to rein in a growing civil labour force. This, amid a few other developments, has arguably allowed SA’s sovereign rating a stay of execution – following the latest visit by the S&P Global Ratings agency held earlier this month. Banks however are not out of the woods, as evidently voted on by market participants and the flat returns on a year-to-date basis.
There are however justifiable concerns in the sector that have centred on the upcoming 12 to 18 months earnings cycle. From a corporate book perspective, a higher interest rate environment (albeit not aggressive) means higher funding costs, more so for corporate deposits (wholesale funding) rather than for retail deposits. Overlay this with the revenue erosion that has occurred on certain foreign denominated corporate transactions given a weaker currency, where certain projects may have been rendered non-viable. On fee and commission earnings, slower economic growth and low business confidence has in the past indicated lower transactions occurring in banking, especially from corporates rather than retail. The net impact of these factors implies a decline in margins. This follows the first half of the 2015 reporting cycle, where banking margins had already come under pressure from the cost of holding increased liquidity, as per the latest capitalisation requirements. From a retail book perspective, loan growth by the big four banks would be expected to be constrained as the appetite for taking on greater risk wanes when operating in an emerging economy that is expected to deliver sub-par GDP growth. Having earlier cited greater funding cost pressure for the banks when interest rates are higher; banks have also been known to benefit from a rate hiking cycle. Simplistically, loans will re-price more than deposits (be it an upward or downward interest rate cycle), therefore margins tend to compress in a downward cycle and open up in an upward cycle. This is known as the endowment effect and while this should protect margin erosion to a certain degree, a rising interest rate environment tends to bring with it worsening bad debts – especially when faced with a consumer already under significant strain.
Despite all this, it can be said that doomsday is not upon us.
South Africa’s banking sector is perhaps in the best shape it has been in since the fallout of the global financial system in 2008. The sector remains far better capitalised and one could stake greater confidence in the sustainability of each bank’s dividend pay-out profile than most other sectors on the JSE. As shown in the chart below, the sector dividend yield is at 5.4%, close to levels last seen since the 2008 Global Financial Crisis. Certainly, following the momentous Brexit vote, these yields should screen even more attractive over the short term. Added to this, the return-on-equity (ROE) ratios and price-to-book multiples rank relatively well when compared to other emerging market peers. Presented with such valuations, the comment often made is the presumption that the bad news has been priced into current share prices. It would be hard to disagree.