Moodys Finally Pulls the Downgrade Trigger

When, not IF 

On Friday March 27th, South Africa (SA) lost its last investment grade rating as Moodys downgraded the country to “junk” status. Even before the Corona crisis, the deterioration of government finances made the downgrade inevitable; it was just a matter of time. Both Fitch and S&P had downgraded SA to junk status as far back as 2017. Moodys followed a more lenient methodology which gave credit to our low level of offshore debt, but with the SA economy set to go into a deep recession, the downgrade was unavoidable.

Potential Outflows


The question of the effect of the downgrade has been asked countless times over the last three years. While the Moodys action has been a dark cloud hanging over the market in recent years, the real issue has been the underlying fiscal deterioration. Government has been unable to take any positive steps to get spending under control in order to save the investment grade rating. Without an investment grade rating, SA would be removed from the World Government Bond Index (WGBI) and some outflows would result. The quantum of these flows has been estimated at anywhere between $1bn and $12bn. The majority of offshore investors in the SA market are emerging market (EM) investors who invest in both investment grade and sub-investment grade debt across countries. We believe that the outflow will be towards the lower end of the estimates.
We had previously indicated that the effect of the outflows would very much depend on the global environment. A downgrade last year, when global markets were rallying and risk premiums were low, would have had minimal impact (20-40 basis points). However, the timing of the downgrade now means that the impact is potentially bigger. However, we understand that the rebalancing of the WGBI has been delayed from the end of March to end of April given the global turmoil. This should help in spreading the outflows over a longer period.

The SARB Factor


The SARB surprised the market last week Wednesday by announcing that they would start a program of bond purchases in order to add liquidity and stabilise the bond market. It is very rare that an EM central bank is able to do quantitative easing (i.e. monetise debt). It would have previously led to a massive loss in confidence, but with almost all developed market (DM) central banks doing quantitative easing (QE), it looks like EMs will be able to engage in these policies, albeit on a much smaller scale. As long as inflation remains within target, the SARB will argue that they can continue with their purchases. The current SARB team is highly credible, we would expect that the market should respect their authority and give them the benefit of the doubt.
Details on the intervention are minimal thus far. The SARB has left it open-ended to give themselves flexibility. We have no idea the potential size, and at what levels on bond yields, they would look to intervene. We will probably have to wait for disclosure at month-end to see what they have done. We would expect them to absorb a significant amount of the foreign selling to come. However, if they accumulate too many bonds, they will lose credibility.

In the short term, it does give bond holders a bit of confidence that yields will not become unhinged. The risk last week was that bond yields were heading to 15%. Yields rallied 200bp after the announcement and we used the opportunity to trim our bond holdings. Globally, QE has been used to suppress bond yields and to date we haven’t seen anyone pay an economic price. However, the ability to buy your own debt opens Pandora’s box and is a ruinous policy when the wrong people are in charge. On balance, the SARB policy will lead to lower yields and weaker currency over time.

The fundamentals are what really matter

While we have warned about the fiscal deterioration for some time, the Corona crisis has brought forward SA’s debt crisis from 3-5 years in the future, to the present time. Expectations from economists indicate a contraction of 5% in GDP this year, which will lead to a fiscal deficit of 12%. This is clearly not sustainable, and we now need massive intervention from Treasury, likely in combination with cheap funding and a program from the IMF. The reason for the debt crisis is the inability of the government to control both its own spending and that of SOE’s. Plans for reform have so far achieved nothing. If you can’t reform, the market will force you to it, and it will be more painful. We are at the point where a severe restructuring can’t be avoided. The SARB intervention and some funding from the IMF may buy us some time, but it needs to be used effectively. We do not want the interventions to take the pressure of the government. The wage bill and SOE problems must be confronted now.

Portfolio Positioning

We must remember that while SA’s fiscal position is dire, the entire world is dealing with the Corona crisis, and deficits and debt are a global problem. Bonds had already de-rated significantly prior to the Corona crisis. Our spread to EM peers had moved up from 2% to around 3% as the market moved to price in the downgrade. The Corona crisis has resulted in the sharpest bond move on record, the only comparable being the Asian crisis of 1998. We currently hold 10% of government bonds in our funds, with a yield of around 12%. This is a substantial risk premium given the SARB recently cut the repo rate to 5,25%. We will maintain this position as we believe that action on the deficit is due, and an IMF program will provide some credibility to the market. However, if we continue to see the lack of follow-through from Treasury and the Cabinet, we will look to mitigate the risk of a debt crisis by reducing bond exposure or increasing FX exposure from its current levels.

SA Bond Shift History


Are US stocks and bonds signalling a recession?

The final quarter of 2018 saw sharp moves in US equities and bonds. The S&P500 fell around 20% from its peak and the US 10-year bond yield declined from 3.24% to 2.55%. In view of the fact that asset prices are forward-looking, these moves have sparked fears of a US slowdown, or even a recession, in the coming year.

What is the probability of a US recession?

Based on asset class moves in previous recessions, JP Morgan recently published a report in which it estimated the probability of a recession currently priced in by markets across various asset classes. Their analysis shows that equities (S&P500) and bonds (USTs) are now pricing in over 60% chance of a recession based on the past 11 historical experiences.

Figure 1. Probability of a recession as currently priced in across asset classes

probability of us recession

Source: JP Morgan

While this analysis is informative, I do not believe that the probability of a recession is anywhere close to 60%.

The Equity Market Signal

In the case of equities, the market has fallen from high valuation levels. The chart below shows the Hussman PE of the S&P500 (PE ratio based on peak earnings).

Figure 2. Hussman PE – S&P500

s&p500 price to peak earnings

Source: Bloomberg

Based on this measure, the S&P500 reached its most expensive level since the 2000 tech-bubble in early 2018. Equity prices are a function of future earnings and the discount rate applied to those earnings. With rates shifting materially higher in 2018, the higher discount rate finally took its toll on the market resulting in lower valuations. Given how expensive the market was, a fall in the market is not as significant an indicator of recession as it would be during a more “normal” valuation period.

The Bond Market Signal

The bond market is also less informative in a world of quantitative easing and ultra-low interest rates. The US 10-year yield (currently 2.7%) is low in the context of US economic fundamentals. With the Federal Funds rate at 2.5%, US core inflation at 2.2%, wage growth at 3.2% and unemployment at its lowest level since 1969, the US 10-year yield should theoretically be much higher. In fact, the current 10-year yield is below money market yields (US LIBOR is at 2.79%).

However, the US 10-year yield is not low in the context of current developed market bond yields. Ten year bond yields in major economies such as Germany (0.22%), Japan (0.02%), Switzerland (-0.15%) and the UK (1.27%) are at much lower levels than the US. Within the developed market cohort, US bonds are attractive and there is a limit to how high US bond yields can rise in this global context.


Fears of a recession will dissipate in the coming months

The global economy is highly leveraged and has grown accustomed to ultra-low interest rates since 2008. In this context, the rise in US rates does increase the risk of a US – or even global – recession. However, given how expensive the equity market was, one cannot extrapolate an economic downturn from the recent correction. The market downturn has resulted in a more dovish tone from the US Fed. Whereas both the Fed and the market were previously expecting 3 rate hikes in 2019, the market is now indicating that rates will remain flat this year and are expected to be cut in 2020.

In my opinion, these recessionary fears are overblown and I would expect the recent sharp moves in interest rates to reverse in the coming months. Economic growth, inflation and wage growth all point to a resumption of the US rate hiking cycle by the middle of the year.


My perspective on what delivers performance

2018 was a good year from a performance perspective. In the Fixed Income space, the funds I currently manage (Income, Bond and Hedge Fund) outperformed their benchmarks and ended the year close to the top of their respective categories.

The year started on a high-note, buoyed by the strong rally following the ANC elective conference in December 2017 – an upshot of a welcomed political change coined as “Ramaphoria”. Bonds started the New Year around fair value, while the Rand had already moved to expensive levels. As the rally continued in the first quarter, the Rand strengthened below R12/USD and SA 10-year bond yields lowered to around 8%. At these levels, local bonds and currency were regarded as expensive – belying the severity of South Africa’s fiscal problems and poor growth prospects. Against this backdrop, we trimmed our SA risk position and increased USD exposure. The market corrected in the second quarter and remained mostly range-bound in the second half of the year.


Our Fixed Income funds have performed around the top quartile in most years, which has seen the longer term performance come in around the top decile. We have achieved this with a low level of volatility and drawdown relative to peers. A client recently asked for a comment on the drivers of our long term performance and I put it down to 3 main reasons:

  1. The “Diversified Alpha” process – An allocation to a range of Fixed Income asset classes (money market, bonds, credit, inflation-linked bonds (ILBs) etc.), without taking excessive risk in any one asset class. We generate alpha from a broad range of sources and never put all our eggs in one basket.
  2. A focus on avoiding expensive asset classes – Drawdowns generally occur when an asset class corrects from overvalued levels. We focus on fundamental valuation and will aggressively reduce or sell out of asset classes like bonds, ILBs, property and/or currency. While we may miss out on a portion of the rally, this discipline has enabled us to avoid the drawdowns associated with the market correction. Examples include the “taper tantrum” which adversely affected the bond market in 2013, avoiding expensive ILBs from 2014-2017 and very low exposure to the overvalued property sector in 2013 and again in 2018.
  3. A high level of credit quality – Our funds focus on high quality assets with a maximum 5 year maturity. We have never bought any asset below single “A” grade credit quality. Our funds do not venture into the sub-investment grade credit space. Adhering to this conservative investment philosophy and robust credit process has enabled the fund to avoid the credit pitfalls (African Bank, PPC, First Strut, Eqstra etc.) that have affected the SA credit market.

The philosophy of “Diversified Alpha” has delivered an attractive performance signature over the long term, despite a blip in late 2017. This philosophy, combined with high credit quality and a focus on avoiding expensive asset classes, has controlled volatility and limited drawdowns. While our funds tend to forego a portion of the rally and may never experience blowout years, our Fixed Income approach is robust and sustainable over the long term.


Has South Africa’s Inflation Target Shifted?

Lesetja Kganyago has finally walked the walk. After years of hawkish talk, the South African Reserve Bank (SARB) finally took an actual hawkish decision at the November Monetary Policy Committee (MPC) meeting when it decided to raise rates despite the stronger Rand and improved inflation outlook. The 25 basis point rate hike reverses the 25bp rate cut made earlier this year in March.

SA Repo Rate

There was a reasonable case to be made for both hiking rates and remaining on hold. Prior to the meeting this was reflected in the forecasts on Bloomberg where 9 out of 18 economists expected rates to remain on hold, while the other 9 forecasted a hike. The MPC was split as well with 3 members favouring a hike and 3 preferring to keep rates on hold. Lesetja Kganyago as governor has the final decision, so his preference for hiking was decisive.

The case for and against the hike

The case for holding rates steady centred around an improved inflation outlook. The SARB’s inflation forecasts for 2019 was reduced from 5,7% to 5,5%. The majority of economists expect it to be even lower. Since the last MPC meeting in August the Rand had strengthened 5% against the USD. The oil price has also fallen by 25% in Rand terms, leaving a potential R2,40 petrol price cut on the cards.
The case for hiking focused on the need to move inflation expectations closer to the midpoint of the 3-6% target band. The other key factor was the global environment where liquidity conditions have tightened, and rates have been moving higher. Over the last year we have seen 4 rate hikes in the US. This has put pressure on a number of emerging markets and most of them have already started hiking cycles. The following chart shows the gap between US and SA rates.

SA Repo vs Fed Funds

With the FED hiking rates and the SARB cutting, the gap between the official rates had narrowed to its lowest level over the last decade. With the Fed expected to hike 25bp in December, and further in 2019, the SARB viewed it as inevitable that rates would have to move higher. Delaying hiking now could mean a greater number of hikes in the future and that is why they chose to react.

Has inflation target been adjusted?

The 3-6% target band has been in place since inception of February 2000. Throughout this period, it has been accepted by the SARB and the market that the goal was to keep inflation below the upper end of the 6% target. Rates were generally hiked when inflation was forecast to be above target, and there was room to cut when inflation was forecast to be below 6%. The lower bound of 3% and the midpoint of 4,5% were mostly irrelevant.

In speeches and investor meetings over the last two years there has been a change in the rhetoric. MPC members have consistently communicated the desire to shift inflation expectations from the 6% upper end of the target band towards the 4,5% midpoint. Lesetja Kganyago style and tone has been far more aggressive than under the previous governor Gill Marcus. But despite all the hawkish talk, the SARB cut rates in July 2017 and March 2018 in order to help a struggling economy. While inflation was supportive at the time, it was definitely a dovish action in an environment of rising global rates.

After all the talk, this November rate hike is the first action which indicates that the SARB is looking to manage inflation down towards 4,5%. They have indicated that it will take around 5 years to get there, so there is no intention to be very aggressive at the expense of the economy. This is an MPC that has been uncomfortable for some time with expectations being anchored towards the upper end of the range. They are willing to acknowledge that they have some responsibility for elevated inflation expectations in SA given that historically they have only reacted when the upper band was breached. Governer Kganyago has been talking about this for some time, so he is definitely on board with the new strategy. However, the 3-3 split for the last hike shows that not everyone is convinced with the new hawkish tilt.

This was a good opportunity for the SARB to hike rates as part of a normalization process and they took it. On balance it is positive for bonds, but I don’t think that one hawkish action, on a split decision, is enough to demonstrate a fundamental change in approach and I wouldn’t be adjusting my valuation models quite yet.

Is this the start of a hiking cycle?

The SARB’s quantitative Quarterly Projection Model (QPM) indicates a further 3 hikes, but they won’t materialise if inflation remains contained and the economy is weak. The SARB is slightly more hawkish and more focussed on the midpoint, but this is a long-term aim and they are unlikely to inflict pain on the economy in the process. The key driver will be the US where the market expects a further hike in December, and one more in 2019. The FED itself expects a hike in December and a further 3 in 2019. If those do materialise then the SARB will have to follow suit and we can expect the SARB to continue hiking rates next year.


Netflix and the Credit Cycle

Netflix recently issued $2bn worth of new bonds to add to their existing $8.3bn worth of debt. These new bonds have a term of 10.5 years, so the return prospects of the bonds are tied to the long-term success of the company. The strategy of the company has been to spend massive amounts on original content (around $9bn per year at the current rate). This can’t be covered by gross profits which is why they have had to issue $4bn worth of debt this year. Free cash flow is expected to be negative $3bn per annum going forward, although they have consistently exceeded their forecasted cash burn. Netflix has explicitly told shareholders that it will be Free Cash Flow Negative “for many years”. In 2017 CEO Reed Hastings said that: “In some senses the negative free cash flow will be an indicator of enormous success.” Quotes like this give flashbacks to the tech bubble. Talk of profit is irrelevant when the metrics are revenue and subscriber growth.

Netflix Total Debt and FCF

Netflix’s risky strategy

The merits of Netflix’s strategy are debatable. They are willing to spend lavishly on content in the hope of building a dominant media and streaming business. The cash that they are able to spend has already changed the media business. For example, stand-up comedy is a genre that they have totally upended in just a few years. Historically, the one-hour special was the ultimate achievement for a stand-up comedian. It is what elevated comedians like Eddie Murphy and Chris Rock into superstars.

HBO generally did 5 or 6 comedy specials a year and Comedy Central did 10 to 15. This year Netflix has already released 66 comedy specials on their own with more to come. They are also paying comedians a multiple of what other media companies can offer. $40m to Chris Rock, $60m to Dave Chapelle and $100m deal with Jerry Seinfeld. No one can compete.

If you are an equity holder, you are betting that the content that they are producing is valuable and there is a large potential upside if they succeed. Regardless of whether you believe in their strategy or not, what is not in doubt is that without positive cash flows or tangible assets this is a risky strategy. Going forward, Netflix will face intense competition from established studios (Disney/Time Warner etc) as well as technology giants like Apple and Amazon who have competing streaming services.

High risk strategies and intense competition are the reasons that many technology companies fail and die out, while a few survivors are very successful. Therefore technology companies have generally funded their capex with equity; either venture capital or via the listed market. This time around, companies like Netflix, Uber and WeWork are financing their cash burn in the debt markets.

Where are we in the Credit Cycle?

The ultra-low interest rate environment since 2008 has resulted in a chase for yield by investors. While rates have bottomed, spreads on high yield bonds are still close to record lows. This environment has allowed technology companies to fund risky investments with debt instead of equity. At this point in the credit cycle, investors are willing to accept low spreads for risky investments, but this can change if the cycle turns. The following chart shows the average spread for US Corporate Sub Investment Grade bonds.

US High Yield Spread


What does this mean for Bond Investors?

The USD Netflix bond currently yields 6.1%, which is around 3% higher than the equivalent US Treasury bond. The potential outperformance over a risk free investment is therefore 3% per annum. (or 30% over a 10 year horizon). Investors in the Netflix bond are taking a lot of risk for only 30% worth of upside. If Netflix succeeds, they will be able to service and repay the bond, but the upside is limited to the credit spread. With limited upside, the downside scenario is what is critical for bondholders. If Netflix is not successful, then the billions of dollars spent on content is likely to have little value and the bondholders will lose their capital in the same way as equity holders.

Investors should be wary of taking equity type risk for limited upside

One of the selling points of the recent Netflix bond deal was their $125bn market value, which is large relative to the $10bn debt level. This valuation is a function of their expensive (high PE) equity price. However, the current high market value is totally irrelevant in the downside scenario that is relevant for bondholders.

I believe that bond investors should be naturally cautious. Equity investors have unlimited upside, so they can justify buying into high growth stories. The nature of fixed income investing is that your upside is limited to the yield pickup, while the downside risk is losing your entire capital. We are at the point in the cycle where equity market values are being used to sell bond deals and investors are ignoring fundamentals like free cash flow and assets. This is the time to be extra cautious.


South African Listed Property – Better Value, but the Growth has Disappeared

SA Property has been a consistently high performing asset class for the last two decades, with returns only briefly interrupted by the financial crisis of 2008. SA property investors have experienced annual dividend growth of 8% since 2005 and this has driven capital growth in the sector.

This year the property sector has experience a significant draw-down with a fall of close to 30% year to date. The first quarter saw the collapse in value of the Resilient stable of companies. The extent of fraudulent activity within these companies remains to be seen, but the price fall is largely due to the fact that these stocks were trading at large premiums to their Net Asset Value. We avoided all the Resilient related stocks as they were extremely expensive, and we believed that the growth reported was unsustainable.

Once the Resilient story had played out, the rest of the sector came under pressure as the market began to realise that growth had vanished.

The Quality of Earnings Growth has Fallen Sharply

The reality is that most companies in the sector have been struggling to grow earnings for a number of years due a lack of economic growth and low business confidence. Lower rent escalations and negative reversions (lower rent) on expired leases have become the norm. Property companies have been under pressure to continue showing high dividend growth and they have engaged in a number of financial “shenanigans” in order to report a higher growth number to investors. These financial engineering strategies include:

• Highly leveraged offshore acquisitions
• Debt/Swap Restructurings
• Cross Currency Swaps
• Distributing Fees and Once off gains (at expense of property values)

Property companies have also increased the concessions they have been willing to give tenants for both new leases and renewals. They are giving longer rent-free periods and have increased their contribution to tenant installation costs. The effect of these concessions has been to overstate rental levels and hide some of the weakness in the sector.
We have been cautious on the property sector for the last three years given the deteriorated letting prospects in a poorly performing economy. The market has finally realised that much of the growth in recent years has been an illusion.

Valuations are Beginning to Catch Up with Reality

The decline in growth prospects for the sector is finally being reflected in valuations as the starting yield on the sector has increased significantly. Since the beginning of 2017, the trailing yield on the JSE REIT Index has increased from 6,5% to its current level of over 9%. While this is partially attributed to the derating of the Resilient stable, the yield on all stocks has shifted higher to compensate for the diminished growth prospects.


With the headwind of lower, or even negative growth from property companies, we continue to remain cautious on the sector. SA investors have been spoilt with very attractive returns for a long time, and the adjustment to a lower growth environment will take time. However, much cheaper valuations warrant some additional exposure and we have been adding SA property to our funds at these cheaper levels.


An Uber Valuation for Uber is Unwarranted

Uber is preparing for an IPO and the bankers are delivering initial valuation estimates of around $120bn. While investment banks compete to secure the deal by pitching increasingly unrealistic valuation numbers, the IPO is likely to be pitched well above the last valuation level of $68bn.


The $68bn valuation is a fictional starting point

The story around how UBER maintained its $68bn valuation, even as its sold shares at a $48bn valuation, reflects the irrational state of the market. Summary: Softbank wanted to buy $10bn worth of UBER while it was theoretically valued at $68bn on the private market. Softbank bought $9bn at a $48bn valuation and after that bought $1bn at a $68bn valuation. Uber gets to maintain the illusion of being worth $68bn. Softbank gets an immediate gain on the $9bn it bought at the cheaper price. Everyone wins.

What is a realistic valuation for UBER?

Professor Aswath Damodaran of NYU has done a number of valuations of UBER  and he shares the spreadsheet used to calculate the his value of $36bn.  The spreadsheet has very useful data on a operating margins in a range of industries. Damodaran uses a sustainable margin for UBER of 20%, which is almost twice the market average of 10,5%. Even with his generous assumptions he gets a valuation well short of what the banks are indicating for the IPO.

What if people stop using the UBER app?

UBER has spent almost $11bn over the last years in building a strong lead in the car service market. However, it is not clear that they have a sustainable competitive advantage. Despite its current dominance, there are no network effects, so they don’t “own” the customer. Using UBER in Europe I have seen many taxi drivers with 3 phones who are happy to pick up any passenger whether its UBER/Lyft/Mytaxi, depending on what is most profitable. Recently, Taxify has integrated with google maps in South Africa so it is very easy to do the comparison of taxi services in terms of cost and time to pickup. These are screenshots of the google maps app looking for a taxi from my work to the waterfront. I see that in the UK google maps gives you three options (UBER/Mytaxi/Gett). With this integration there is no longer any reason to go straight to the UBER app when you need a taxi.

Ride Hailing Will be a Commoditized Service

You now have a commodification of the ride hailing service on both the drivers and the rider side. The cost of developing a competing app is trivial, and if google maps (or apple maps) is the new access point for passengers, then new entrants will be able to compete directly with UBER from day one. All they need to do is give google a cut. In this environment a high margin for ride sharing companies is unsustainable, and it is likely to be lower than the average in the economy. If that is the case, then UBER is only worth only a tenth of the $120bn that its bankers are currently pitching.