Junk status doesn't necessarily mean junk returns

Feroz Basa, Joint Fund Manager of the Old Mutual Global Emerging Markets.

The recent sovereign rating downgrade makes South Africa the third BRICS nation to have received a junk credit assessment at S&P Global Ratings. However, before falling victim to any impulsive investment decisions, it is imperative to note that Brazil and Russia – the two other countries to have previously experienced downgrades of this nature – were the top emerging market performers in 2016.

This is according to Feroz Basa, Joint Fund Manager of the Old Mutual Global Emerging Markets (GEM) Fund at Old Mutual Investment Group, who says that a downgrade can present investors with attractive buying opportunities, particularly for Emerging Markets investors. “When a country gets downgraded, both the stock market and currency will tend to sell off significantly. Typically, the selling which occurs in these markets during this time is largely indiscriminate and, as such, will likely include some high quality shares, which brings about some very attractive investment opportunities.”

Using Brazil as an example, Basa explains why GDP growth and credit status can, during times of such uncertainty, be very misleading. “Brazil was downgraded by both S&P and Moody’s to sub-investment grade status in 2015 at the height of political unrest over a massive corruption scandal that ultimately resulted in the impeachment of then President Dilma Rousseff.

“This downgrade led to major capital outflows and further worsened Brazil’s growth outlook, bringing their GDP down to -3.5% last year. Despite this, Brazil was the best performing Emerging Market in 2016, returning 66% in dollar terms.”

Bringing the focus back to South Africa, Basa says that while there has been a slight selloff in bonds and equity post the downgrade decisions, along with an initial weakening of the rand, this has been to a far lesser extent than what was seen in Brazil. “At this point, South Africa is not displaying the typical effects of a downgrade, with the rand having actually moved back to its long-term average. This could, however, still change depending on Moody’s looming rating decision.”

Basa also points out, with regards to South Africa’s seemingly unaffected currency, that the rand’s strength of late is a function of dollar weakness. “The rand’s recovery actually has very little to do with South Africa, but rather is related to the weakening of the dollar versus all Emerging Market currencies.”

When asked about what this all means from an investment point of view, Basa says that there currently are not massive buying opportunities in South Africa. “South Africa is not a screaming buy at the moment, which brings about the question of how best to diversify away from South Africa.

“Typically, global equity funds would be an obvious choice, however, a large weighting of these funds is in the US market, which, on a risk-adjusted basis, does not offer investors attractive growth prospects.”

As such, a better option for clients looking to diversify away from South Africa, according to Basa, would be Global Emerging Market (GEM) funds. “On a risk-adjusted basis, Emerging Markets are trading at a far lower price earning (PE) multiple than what the US and global equities are currently trading at, which means GEM funds come at a lower price with the opportunity for greater return. This is due largely to the demographics in Emerging Markets being characterised by a booming middle class and growing consumer sector, driving profit growth going forward.”

In light of this, Basa concludes that while the market sentiment around South Africa remains uncertain for the time being, there is undoubtedly potential for superior returns to be made in other Emerging Markets. “Based on GDP growth in these regions, increasing consumption, attractive demographics, and the starting valuation, Emerging Markets appear to offer great potential on a three to five-year basis. The Old Mutual Global Emerging Market Fund’s ability to pick the right stocks in Emerging Markets from a bottom-up perspective then adds additional value, which has resulted in the Fund being ranked in the top 10, globally over the last 4 years.”