The time for South Africa’s next round of credit rating reviews is drawing nearer. Despite efforts to show a united front, the constant mix of political surprises and agendas poses a threat to the country’s investment grade status.
This week, the majority of the market may still be seeing South Africa side-step a downgrade to junk this year, but as we’ve witnessed in the past the market’s view can be changed very quickly. If the country were to face a downgrade to junk status, where can investors hide in the banking sector (if at all)?
The first rule here is to be forward looking, because any effect of a downgrade could likely already be priced in by the time we get to the reviews. If the market is split in its expectations of a downgrade, then there is probably going to be a lot of movement on the day credit rating agencies make their announcement.
Why will a downgrade to junk be negative for banks?
Firstly, the credit rating of banks is also downgraded along with that of the sovereign. This makes borrowing more expensive for banks and consequently more expensive for consumers. Higher interest rates increase the risk of bad loans (especially mortgages on property) and 2016 was already a year where impairments showed a worryingly large increase. On top of that, economic growth is likely to fall due to lower investment from businesses and lower consumption due to reduced credit, further placing pressure on banks’ revenue.
We have already witnessed events that markets expected could trigger a downgrade, and on those days, there was nowhere to hide from the pain as all four of the big banks fell sharply. Nenegate on the 10-11th December 2015 was the biggest of these events, and more recently the Pravin Gordhan summons to court on the 24th of August raised fresh downgrade panic. The below table summarises the effect on the share price of banks on these two events.
How might SA banks cope?
It almost goes without saying that a downgrade will probably lead to all four banks feeling the wrath of the markets, which means that cash is probably your best option here. Looking at the other side of the coin, economic growth is showing signs of recovery as commodity prices increase, and South Africa may still keep its investment grade status. Perhaps a better question to ask is: which bank is best positioned for growth?
- FirstRand was the hardest hit on negative news flow (Nenegate & Gordhan summons), possibly because the bank is the biggest of the four and is generally priced more expensive due to its high return on equity, which also makes it the top pick in the sector for most analysts.
- Standard Bank was one of the surprises in the sector with higher earnings, but on closer look the company’s write-down of impairments gave the numbers a little more colour than deserved. The best performer of the sector in 2016, Standard Bank does not appear to be as attractively positioned as its peers to unlock growth over the next 2-3 years, and Africa, which once seemed like a golden egg, has hatched into something with high risk that doesn’t justify the reward.
- Nedbank has really climbed on the technology train and can provide detailed customer data for its merchants, potentially helping it gain market share.
- Barclays Africa Group remains constrained by the overhang of Barclays UK looking to sell its stake in the bank. A downgrade could narrow the pool of potential buyers that can take over the ownership of the SA bank.
The two banks that look the best positioned for growth are FirstRand and Nedbank. The biggest positive for these banks will be a recovery in the economic outlook; keeping an investment grade sovereign rating; and a turning from an interest rate hike cycle to a period of monetary expansion (rate cuts). The biggest risk is the credit downgrade, which would put all the other factors into jeopardy, but how much is the risk of a downgrade to junk already priced in?
Considering the price to book value of the JSE Banks Index, the market price of banks relative to their assets is pretty much in line with the values seen through 2011-2014, while it is currently 30% lower than a peak (relatively expensive) reached in early 2015.
The choice investors could face
In summary, a credit downgrade is partially priced in, which means the effect of a downgrade could be less severe (although markets tend to overreact sometimes).
In the long run, the economy will recover and then you want to be invested in the banks best geared for growth. That recovery could be next year if rating agencies show mercy on SA, so which is the bigger risk: losing due to a downgrade or missing out on a recovery?
Quantitative Investment Analyst
Ian Stiglingh is a full time quantitative analyst, responsible for research of equities across all industries. Ian completed his degree in Mathematical Science in 2013 and his Honours degree in Financial Risk Management in 2014, both at the University of Stellenbosch. During his studies, Ian worked as an intern at Old Mutual Actuaries & Consultants as well as J.P. Morgan in Johannesburg, and is currently a CFA candidate