RONAK GOPALDAS: Hazards ahead if African eurobond rally comes to a sudden, nasty end

It was a good year for African financial markets in 2017. On the whole a feelgood factor returned to the continent after more than two years of subpar performance, with average yields for sub-Saharan African eurobonds dropping from lows of 8.13% in 2015 to 5.87% at the end of 2017. So far in 2018 currency and foreign currency bonds have continued to perform well, and new eurobond issuances have been oversubscribed and are attractively priced.

Yet despite these improved performances, it is uncertain now whether this rosy outlook will continue or come to a sudden end.

On observing these dynamics closely, three major disconnects stand out. First, financial markets rallied despite regressive domestic political developments in many countries. Second, the performance of real economies (negative) and those of their financial markets (positive). Third, a major gap has emerged between the old normal and new normal, specifically around what constitutes "unpalatable" risk.

Intrigued? Let me explain.

African eurobond and currency markets enjoyed a buoyant 2017 despite unsavoury political developments on many fronts. For example, despite a de facto state of emergency and the detention of an opposition leader on treason charges in Zambia, markets bubbled along, largely ignoring these issues.

Similarly, deaths, postponements and annulments during Kenya’s election saga failed to generate any real sell-off in the market, despite significant and prolonged uncertainty.

This deterioration in sovereign ratings reflects the fact that most commodity-dependent economies now have significantly weaker buffers and policy toolkits at their disposal to protect their economies relative to previous shocks

And in Ivory Coast, at least eight mutinies in 2017 elicited nothing more than a short-term spike in its sovereign debt.

Similarly, in SA, if one compares the violent currency sell-off and spike in foreign currency bond yields when Nhlanhla Nene was fired with that of Pravin Gordhan’s dismissal, one would be forgiven for thinking that markets had gone deaf. Despite political risk being elevated in all these jurisdictions on account of these events, investors simply shrugged off these concerns as noise rather than as a clear deterioration in governance.

Second, the performance of financial markets was disconnected from the performance of real economies. Paradoxically, despite credit quality in Africa deteriorating to the extent that there are no longer any investment-grade sovereign issuers in Africa, in an August 2017 article Bloomberg observed that African eurobonds were trading at their lowest levels in two years.

This deterioration in sovereign ratings reflects the fact that most commodity-dependent economies now have significantly weaker buffers and policy toolkits at their disposal to protect their economies relative to previous shocks.

It also means the cost of capital and financing constraints increased. Yet, despite riskier profiles, foreign investors were piling into these assets and sovereigns paid lower rates for new issuances — a bizarre state of affairs.

While an argument can be put forward to say that this is simply the new normal and that investors have adjusted to a higher political risk threshold given the occurrence of wildcard events such as Brexit and the election of Donald Trump, the reality is that in years gone by such developments would probably have generated very different outcomes.

This desensitisation to political risk — perhaps because it is no longer simply perceived to be an emerging or frontier market phenomenon, is cited as one core reason why this is the case. Indeed, the muted reaction of major indices to the threat of nuclear missile launches in an age of Twitter diplomacy suggests that something fundamental has shifted.

According to Sean West, the CEO of Eurasia Group’s EGX, the world is in a global geopolitical recession, which can be interpreted as a net downwards shift in the entire risk universe. However, another compelling view put forward as to why this is the case is the fact that the global economy finds itself in a Goldilocks phase, meaning that it is neither too hot nor too cold. It can sustain moderate economic growth and maintain low inflation. In this way it allows for market-friendly monetary policy.

This benign environment is conducive to risk-taking behaviour.

According to Pavel Mamai, a portfolio manager at Promeritum Investment Management, it’s not that these assets are without risk, but "it’s all relative". He says African sovereign eurobonds exhibit typical emerging market (EM) debt characteristics, "albeit sometimes in a concentrated form. These often include domestic political risk, low quality of economic policy making and, as a result, vulnerabilities of credit fundamentals to external shocks. As these weaknesses are more pronounced in many African countries versus EM average, African eurobonds should offer a yield premium over many other EM countries to be attractive on a relative value basis."

While for now it seems likely that the risk-on party will go on, it is important to note that the buoyant sub-Saharan African eurobond performance is being driven by external factors, specifically a global search for yield, rather than intrinsic ones. Therefore, one should be wary of a Cinderella effect, whereby the carriage very quickly turns into a pumpkin when the proverbial clock strikes 12. Countries with bad politics and bad economics will be in the firing line when the hot money heads for the exit doors.

In reality, despite significant improvements from 2015 lows, many of the underlying issues remain masked. And importantly, the balance sheets of African sovereigns have weakened dramatically over this period. With this in mind, investors should be wary of complacency

Consequently, the concern is about whether this sense of complacency will persist in 2018. Recall, it would not be the first time. We have been here before with both the taper tantrum in 2013 as well as China growth fears in 2015. Though the consensus is that a sharp reversal is unlikely (Federal Reserve hiking and China deleveraging are managed transitions), both headwinds remain in play, which means capital flight from emerging markets due to a change in sentiment remains a key risk. Furthermore, with a number of geopolitical issues bubbling beneath the surface, not to mention wildcard factors, any surprise could trigger a shock to expectations and a consequent exodus of capital, resulting in a flight to safety. In such a scenario the spotlight will shift to domestic issues as investors become more discriminating with their capital.

In the light of this, two key questions emerge for investors in Africa. How likely is a reversal and are African policy makers adequately prepared to deal with the fallout?

According to Aly-Khan Satchu, a Nairobi-based investment analyst, "liquidity has so far muted political risk and concerns from some bond vigilantes are that African governments are dangerously overloaded on debt. Therefore this could well be the calm before a storm. The question is what might trigger this pivot. A non-benign interest rate structure, a sharp deterioration in the US-China trade war or big ticket blow-up in any African country might all be the catalyst [Zambia looks a likely candidate].

I think the rally has farther to go, that there will be more granularity and pricing about African eurobond pricing, which has become very homogenous and that we are at some point in the future going to witness a big asymmetric downside move."

In reality, despite significant improvements from 2015 lows, many of the underlying issues remain masked. And importantly, the balance sheets of African sovereigns have weakened dramatically over this period. With this in mind, investors should be wary of complacency.

Though the positivity seems set to continue for now, these three disconnects and the manner in which they are ultimately resolved will determine whether the story of African eurobonds ends in a fairytale or a nightmare.

• Gopaldas is a director at Signal Risk.