Our monthly write-up of the markets.
Interest rate bulls forced into hiding
The cabinet reshuffle at the end of March and South Africa’s sovereign credit rating downgrade by Standard & Poor’s Global Rating Agency (S&P) in early April overshadowed all other activities for the first three months of the year. These two closely linked events forced interest rate bulls into hiding as the rand and bond yields raced to weaker levels.
Bond yield spike wipes away significant gains
The general market trend prior to the disastrous political event had been for rand strength and falling bond yields. The yield of the benchmark R186 (maturity 2026) managed to drift lower to a closing level of 8.31% on 23 March, the lowest level since November 2015. This was 65 basis points below the closing level on 31 December 2016. At that point, the All Bond Index total return rose to 5.9% for the year to date, well above the cash return of 1.9%. Soon after, disaster struck, causing yields to spike and wiping all the gains up to that point in a matter of five days.
Inflation-linked bonds rendered the worst returns
As a result of the sharp rise in yields across the whole of the yield curve during the last week of March, the JSE All Bond Index ended the quarter with a significantly lower total return of 2.5%, but still slightly higher than the cash return of 1.9%. The nominal bond sell-off also sparked an upward movement in the real yields of inflation-linked bonds which more than offset any gains from the inflation carry. As a result, the JSE Inflation-linked Government Bond Index returned -0.6% for the quarter.
Prior to the reshuffle, market sentiment was boosted by local data
The decision by the US Federal Reserve to raise its policy rate for the first time in months had been well anticipated, even welcomed by financial markets. Locally, the most recent meeting of the South African Reserve Bank’s Monetary Policy Committee, mere days before the unfortunate cabinet reshuffle, caused market sentiment to change to reflect an expectation of possible rate cuts later this year. This had been priced out very quickly during the last week of March.
Both the Fed and SARB stayed the course
Other data releases were mixed, with the rate of inflation at both consumer and producer levels starting to slow, while the latest external trade account showed a larger than expected deficit. None of these data releases had a significant impact on market sentiment, though.
Summary of macroeconomic outlook, market view and investment strategy
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Key macroeconomic themes |
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Economic growth |
A mild, uneven global economic recovery remains our base case, with a relatively strong US economy still leading the way. The Trump presidential victory (together with a House and Senate Republican majority) boosted speculation that higher US fiscal spending will benefit the US growth trajectory. This remains to be seen and for now the risk is that markets may have to face disappointment with respect to both the timing and size of the much anticipated stimulus. We believe that the global recovery will be structurally lower than in previous cycles, mainly due to lower productivity growth, ongoing broad-based balance sheet repair (deleveraging) and shifting demographics (older populations tend to save more and spend less). Most emerging market economies are caught between an improved, but still mixed outlook for the developed world, the implication of structurally lower Chinese economic growth on commodity demand and the US Federal Reserve’s well telegraphed intent to normalise monetary policy. Therefore, commodity producers with external imbalances, such as SA, remain vulnerable. Locally, the biggest impediment to higher local growth remains of a more structural nature. Encouragingly, engagement between government, business and labour has resulted in agreement on South Africa’s national minimum wage. Continued engagement between this triumvirate – and practical follow through – remains essential to unbundling domestic growth potential. The cabinet reshuffle is likely to, firstly, slow the momentum of this process and secondly, negatively impact both consumer and particularly business sentiment. |
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Inflation |
Locally, the expected drop in food inflation and the stronger rand in the last few months has forced down our 2017 annual average inflation forecast to 5.4%. Recent rand weakness in response to the cabinet reshuffle and S&P’s sovereign credit ratings downgrade do not yet pose a threat as a weaker rand assumption has been accounted for in our consumer inflation forecasts. |
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Balance |
Significant rand depreciation until a few months ago and an improved terms of trade position are lending relief to the balance of payments position. As a result, we expect a narrowing of the current account deficit from an annual average of 3.3% in 2016 to 3.0% in 2017, followed by marginal widening to 3.5% in 2018. The surprisingly small deficit for the fourth quarter of 2016 is not sustainable. Our terms of trade is expected to weaken from current levels, while the unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners), remains a significant drag on a sustained and meaningful balance of payments correction. A stronger currency may also limit a significant further narrowing of the current account deficit over the medium term. |
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Monetary |
Having finally started the long awaited and well telegraphed monetary policy normalisation process, we agree with the Federal Reserve’s intent to follow a slow and gradual process. With an unemployment rate seemingly stuck below 5%, slowly-rising wages and the more stable PCE core inflation rate now hovering at 1.8%, we believe that the Federal Reserve should continue with its interest rate normalisation process, but for obvious reasons at an appropriate pace. The recent pick-up in market chatter about the imminent shrinking of the Federal Reserve’s large balance sheet (the largest since the Second World War following its response in the aftermath of the 2008 financial crisis) is premature to our minds. The current trend of global monetary policy divergence is expected to continue over the next year or so. With more policy tightening in the US on the cards, the European Central Bank and Bank of Japan will retain their respective quantitative easing and negative interest rate policy programmes, with some tweaks. At the same time, some of the smaller advanced and commodity-driven economies may be forced to ease policy, mainly due to below-trend economic growth and a modest inflation backdrop. On the positive side, monetary policy divergence will act to soften the impact of higher US rates on global growth. In the case of SA, we feel comfortable with the prospects of the South African Reserve Bank (SARB) being at the peak of the interest rate tightening cycle. A cautious approach is supported by the weak economic growth backdrop, low levels of credit extension growth and limited evidence of demand-led inflation. However, considering the size of the balance of payments deficit and the stickiness of inflation (in the upper end of the target range), we deem a neutral policy stance (thus no cuts) as the most appropriate course for monetary policy right now. Recent market turmoil should also add to the list of reasons for the central bank to remain cautious about reducing the repo rate. |
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Fiscal |
Under a cloud of challenging circumstances, of both a political and economic nature, the now ex-Minister of Finance, followed the delivery of a reasonable Medium Term Budget in October 2016 with an equally reassuring performance in February. Of course, all of this has been for nothing as the market is potentially facing a very different new era, with more than enough reason to be very cynical about any early efforts by the new Minister of Finance to reassure financial markets about maintaining the status quo. Absent of the significantly heightened risk to fiscal prudence, it would be neglectful of us not to highlight further noteworthy concerns; chief among which remains overly ambitious nominal GDP estimates which elevates Treasury’s execution risk in the outer years of the Medium Term Expenditure Framework. It also remains a concern that little mention was given to unresolved governance and financial sustainability concerns at a number of state-owned enterprises. Our concern about the implication of this on already elevated national contingent liabilities remains high. Lastly, despite the addition of a new income tax bracket, revenue collections by the South African Revenue Service bear the risk of increasingly underperforming fiscal targets over the medium term as efficiency gains in this state department seemingly unwind. We’ll pay close attention to tax collection trends in the coming months. With this in mind, S&P had very little option but to retain a negative outlook following the sovereign ratings downgrade, thereby keeping open the door for a deeper slide into non-investment grade territory over the medium term. |
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Investment view and strategy With the exception of the US, and more encouraging signs of some improvement in other G10 countries, the global growth recovery remains fragile. This sets the scene for a modest rise in inflation as well as monetary policy divergence. It also implies a steady tightening cycle for the few economies that are in a position to normalise monetary policy, especially the US. This should limit significant upside to global bond yields, especially following the recent bearish correction. On the negative side, the continued uncertainty about the global, and particularly the Chinese, growth outlook remains a risk − especially for emerging market commodity producers with a weak external position in both absolute and relative terms. The anti-global trade tirade by the Trump administration is expected to add uncertainty to the mix. Locally, the downward trend to inflation is imminent, supported mostly by significantly lower food price increases. While the South African Reserve Bank has now adopted a neutral bias, it is unlikely that they would consider interest rate cuts soon. The external imbalance is simply too big to allow for a lower real repo rate, while unpredictable currency swings continue to pose a risk to the more benign inflation outlook. Recent market turmoil have muddied the outlook. Although the newly appointed Minister of Finance is doing his best to downplay risks to the previously carefully managed fiscal consolidation, it would take far more to convince us that all is indeed well on that front. The sovereign credit rating downgrade did not come as a complete surprise. In fact, the move had been priced by the credit default swap market months in advance. What concerns us more is the decision to maintain the outlook as negative, which clearly points to the risk of another downgrade at some point. Local political developments will continue to remain a source of market volatility, with focus in the short term on the possible removal of the President, an outcome we deem as very unlikely. Considering the above, we will continue to approach the market with extreme caution. The main risk to this defensive strategy is the revival of the global reach for yield trade, while an early removal of President Zuma will also be considered as a significant boost to both the rand and bond markets. We regard the probability of the former significantly higher than the latter. Our broad interest rate investment strategy for a core bond fund benchmarked against the ALBI is as follows:
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