Mid-year fiscal update confirms fiscal consolidation
The tabling of the Medium Term Budget Policy Statement (MTBPS) on 26 October confirmed general market expectations of stronger fiscal consolidation for the current fiscal year. More specifically, tax revenue collection continued to steam ahead of initial conservative budget estimates. This - together with an adjustment to macro-economic assumptions, real GDP lower by 0.5% to 1.4% with inflation significantly higher at 6.8% from 4.5% for a higher nominal GDP estimate - contributed to a significant adjustment of the budget deficit to 4.9% from 6.0% for the current fiscal year. Expenditure was revised higher, but the net effect of the adjustments allowed for a decline of the gross loan debt to GDP ratio from 72.8% to 71.4%. However, disappointingly, no details were provided regarding the long-awaited transfer of a portion of Eskom debt onto the sovereign balance sheet. This will instead be furnished when the budget is tabled next year. Estimates for the forthcoming fiscal years are particularly optimistic, with the first primary surplus in fifteen years expected for the fiscal year 2023/24 and the consolidated budget deficit to narrow to 3.2% in 2025/26. This is mainly the result of expected sustained strong tax revenue collection and relatively contained expenditure. As a consequence, the gross debt to GDP ratio is expected to narrow to 70% in the outer years. The clear intention to accelerate fiscal consolidation is commendable and, at face value, good news for financial markets in general and the bond market in particular.
However, sustained fiscal improvement faces many hurdles
While the improved outlook (as envisioned by National Treasury) for the forthcoming years is welcomed, several factors unfortunately cast a dark shadow over prospects for the expected sustained fiscal consolidation. Firstly, more state-owned enterprises are knocking on National Treasury’s door for financial assistance, most concerning being Transnet. Secondly, the tax revenue boon of the past two fiscal years is unlikely to be repeated to the extent reflected in the latest budget estimates, especially in the outer years. At the macro level, local economic growth continues to face structural and increasingly cyclical headwinds. Structurally, the intensified negative impact of loadshedding and increasingly poor service delivery by Transnet with respect to the railway network and ports are obvious and very significant hurdles to economic activity. Slowing global economic growth and the resultant negative implication for global commodity demand and prices has also not been sufficiently considered. Moreover, the expenditure assumptions for the forthcoming fiscal years seem unrealistically low (even if opportunistic). Current expenditure pressure remains an ominous risk, specifically with regards to public sector wage bill growth and an ever-increasing burden of rising social spending pressure. It is also glaringly obvious that the full impact of the proposed Eskom debt take-on has not been incorporated in the forecast.
Figure 1: Despite recent progress, the total level of outstanding debt is still too high, with contingent liabilities still looming large
Source: National Treasury, Futuregrowth
Global bond markets recovered somewhat following a bout of significant weakness
The local bond market got swept up by a significant global bond sell-off, especially in the early part of the month. The rise in global yields gained momentum during October, mainly due to the same concerns about the speed and extent of global monetary policy tightening and, particularly, by the leader of the central bank pack, the US Federal Reserve (Fed). Against the general backdrop of persistent high inflation, hawkish central bank response, weakening fiscal positions and lower economic growth (more specific country dynamics) amplified pressure on bond markets. In the UK, the botched attempt by the Truss administration to address the unfolding economic crisis in that country served as a catalyst for a spike in UK government bond yields. The initial sell-off that caused long-dated gilt yields to trade at levels north of 5.0% forced the Bank of England to intervene in order in order to introduce some stability. Towards month end, global bond markets found some reprieve as weaker economic data served as a catalyst for newfound investor anticipation that central banks, particularly the Fed, may potentially dial down their current aggressive policy stance in the short term. This somewhat opportunistic expectation received some backing from central banks like the Bank of Canada, which recently increased its policy rate by 50 basis points (bps) instead of an expected 75 bps, in response to slowing economic growth.
We have more confirmation that South African inflation peaked in July
The South African Headline Consumer Price Index (CPI) accelerated by 7.5% year-on-year in September from 7.6% the previous month, for the second consecutive month of marginal and tentative slowing. Even so, this confirmed the probable peak of 7.8% in July. In contrast, Core CPI accelerated by 4.7% from 4.4% the previous month, primarily driven by higher food inflation. The year-on-year increase in Producer Price Index (PPI) for final manufactured goods also slowed by 16.3% in September from 16.6% the previous month. Although the deceleration was slower than market expectations, the most recent data release is well below the PPI cycle peak of 18.0%. So far, both CPI and PPI data confirm the disinflation trend.
Figure 2: South African inflation is expected to head lower from here on
Source: OMIG, Futuregrowth
The South African Reserve Bank is likely to remain vigilant
While the slowdown in the rate of inflation at consumer and producer level is encouraging, the South African Reserve Bank (SARB) is unlikely to stand back yet on policy tightening. As clearly communicated, the SARB remains concerned about the possible impact of high actual inflation on inflation expectations, which, in turn, may cause cost-push pressure to morph into demand-led inflation. While most inflation expectation surveys are still at levels below the top end of the 3% - 6% inflation target range, they are heading higher, and, most concerning, particularly so in the case of labour unions. Our estimate of the terminal nominal repo rate suggests that the SARB should raise rates by at least another 50 bps. That said, we acknowledge that the risk remains for a slightly higher increase in the short term, especially should the majority of central banks keep raising rates. This should also be seen against the background of a weakening South African balance of payments situation and the grey listing red flag, which, in turn, will inhibit foreign capital flows.
Grey listing has become our base case
The Financial Action task Force (FAFT) evaluated South Africa in October last year and found several deficiencies in the country’s policies and efforts to combat money laundering and terrorism financing. Although significant progress has been made in terms of addressing the deficiencies pointed out by the FATF, most of this has been merely on the legislative side. The FATF reviewed South Africa in October this year to gauge if enough progress has been made to combat money laundering and terrorism financing, and to assess whether the country has a credible action plan to deal with areas of concern. The FATF will have a plenary meeting in February 2023 where it will be decided whether or not to add South Africa to the grey list. Our view is that, although the legislative changes are a positive step, a turnaround from a law enforcement perspective will take some time. As a result, we see it as probable that South Africa will be added to the grey list. Please see here for a more comprehensive analysis. Suffice to say that grey listing is more than likely to inhibit much-needed foreign capital flows.
The SA Inflation-linked bond market suffered a brutal set-back
October turned out to be another volatile month for local bond markets, at least partly due to the global bond sell-off. On the nominal side, a month-end recovery - following an initial yield spike to levels north of 12% for longer-dated bonds - saved the day. The FTSE JSE All Bond Index (ALBI) returned a respectable 1.07%. Following exceptionally strong performance for an extended period since the end of last year, inflation-linked bond yields rose sharply during the last week in October. Earlier support from high inflation accrual and strong demand for inflation protection suddenly waned, leaving a notoriously illiquid market vulnerable. The increase in real yields more than offset any support from the inflation accrual. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned -1.27%, underperforming both nominal bonds and cash (+0.49%) by a significant margin. The IGOV returned 0.68% for the year ending October, a sizeable decrease from the 1.98% it returned for the first nine months of the year.
Figure 3: Bond market index returns (periods ending 31 October 2022)
Source: IRESS, Futuregrowth
// THE TAKEOUT
Globally, monetary policy tightening has kept gaining momentum, with central banks focused on getting the inflation genie back into the proverbial bottle. Global bond markets experienced significant volatility, with an initial yield spike followed by some reprieve as weak economic data dampened policy tightening expectations. Locally, both CPI and PPI data prints confirmed the start of the disinflation trend. On the fiscal front, the release of the Medium Term Budget Policy Statement confirmed market expectations of a smaller budget deficit for the current fiscal year. National Treasury released more upbeat estimates for the forthcoming fiscal years compared to the February budget estimates. The impact on market sentiment has been muted, as the market, like us, questions the reasonability of the assumptions, both in terms of revenue and expenditure. Even so, the nominal bond market performed relatively well as yields managed to drift lower at month end. In contrast, the inflation-linked bond market suffered a setback during the last week of October as aggressive selling caused long-dated bond yields to spike. As a result, the ALBI rendered a recent return of 1.07%, outperforming both cash (+0.49%) and the IGOV (-1.27%) in October.
