What next for South Africa?  By Adrian Meager, General Manager of Warwick Wealth Asset Management.

What impact should we expect on financial markets now that South Africa’s local and foreign currency debt rating has been downgraded? Many pundits 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, an historical analysis of other emerging markets that have suffered a downgrade from investment to sub-investment grade, reflects something different.South Korea, Brazil, Russia, Greece and Uruguay, are all examples of emerging market economies that have been downgraded from investment to sub-investment grade. Examining their bond yields, currencies and equity markets in the 12 months before and after the downgrade makes for interesting reading.

The general trend in ten-year bond yields in these countries was for yields to expand leading up and immediately after the downgrade. Yields generally started to recover, however, about six months after the downgrade. In Russia, for example, ten-year bond yields were 6% lower a year before the downgrade, yet rallied by 4% in the following 12-month period. The only exceptions are Greece and Uruguay, where yields continued to rise as these two emerging markets suffered a series of downgrades over a relatively short period. As governments and Central Banks began to undo the poor policies leading to the downgrades, asset prices in those economies started to improve. We feel that there is a reasonably good chance that South African assets post the downgrade will perform similarly.

The real effective exchange rates of the currencies of these countries tells a similar story. There are examples where currencies have done poorly, Greece being one, but overall, the average currency on a real effective exchange rate basis increased relative to the time of the downgrade, with South Korea’s currency strengthening by 40%. South Korea set the standard for dealing with a downgrade, having managed to regain investment grade status within a year.

This demonstrates that if correct policies are applied, countries’ investment rating can recover relatively quickly. Yet even some countries whose policy response was not optimal, such as Brazil, rallied in real currency terms. The effect of a downgrade on equity markets in these countries has been more mixed, with significant losses being rare.

The average equity markets performance of the economies approaching sub-investment grade tend to be modest bear markets and then moving mostly sideways for the next 12 months.  This suggests that a downgrade will probably not be profoundly negative for South African financial markets in the short term. What will matter most is the longer-term policy response and how South Africa goes about getting back to investment grade status.

Making radical changes to investment portfolios during times of uncertainty is likely to lead to wealth destruction.  History has shown that despite regular shocks in financial markets, calmly sticking to well-constructed financial plans and staying invested through the short-term volatility provides the optimal wealth creation.

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