Our monthly write-up of the markets.
Bond market made up some lost ground in April
April turned out to be a month of consolidation following a turbulent end to the first quarter. The yield of the benchmark 10-year RSA Government bond closed the month at 8.69%, 15 basis points lower than the level on 31 March 2017. This happened amid significant market volatility, clearly illustrated by the wide trading range of 8.46% to 9.21% for this instrument. As yields declined across the full term structure, the JSE All Bond Index managed to render a positive return of 1.5% for the month. This was well above the cash return of 0.6%, making up some of the lost ground to nominal bonds caused by the cabinet reshuffle and negative credit ratings action during March.
Still no end to strong foreign demand for high yielding bonds
A host of factors contributed to the better monthly bond performance. Yields in the main developed bond markets, led by the US Treasury market, declined as investors reconsidered earlier more aggressive reflation views. In turn, this contributed to higher global risk appetite which boosted the reach for higher yield assets to the benefit of most emerging markets. In the case of South Africa, net purchases of rand-denominated RSA bonds by foreign investors totalled just over R16bn during April. This boosted net non-resident purchases to R35bn for the first four months of the year leaving almost two-fifths of local currency government bond issuance in foreign hands. To put this in perspective: the R35bn roughly equates to 13 weekly government bond auctions. A partial, yet strong recovery of the rand on international currency markets and the release of interest-rate positive local data also contributed to the relief bond rally.
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.
LOCAL ECONOMIC DATA RELEASES WERE ALSO GENERALLY BOND SUPPORTIVE
From a bond market perspective, the quicker than expected deceleration of both the consumer and producer price rates of inflation are probably the most noteworthy. The confirmation that the government met its budget targets for the fiscal year 2016/17 helped to ease concern about the fiscal outlook. However, it is important to note that the tax revenue collection effort received a large, unexpected and probably unsustainable last minute boost from dividend tax receipts. The monthly international trade data also continues to point to an improving current account position.
Poor run of inflation-linked bonds continue
In contrast to nominal bonds, the inflation-linked bond market, which until a few months ago benefitted from a relatively high rate of inflation, continues to lag in terms of performance. The recent deceleration in the rate of inflation and concern about significantly lower inflation in the short term, which works its way into the valuation calculations of these bonds via a three-month lagged inflation carry component, reduced demand and caused real yields to drift higher. Another, but more indirect driver is concern about government’s commitment to continued fiscal consolidation. An inability to stick to the latest budget estimate could force government to fund a wider deficit by tapping into markets, thus leading to an increase in both nominal and inflation-linked bond issuance. If this leads to a demand/supply imbalance, yields would have to rise to attract potential investors. It is also worth noting that, unlike in the case of nominal bonds, foreign investor involvement in the inflation-linked bond market has always been very limited. Therefore, this market did not benefit from the recent spike in offshore bond demand.
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 |
The strong rise in energy and other raw material prices in the last few months has started showing in headline inflation numbers in many economies. Although reflation is welcomed with open arms, since this is what policy makers had aimed to achieve, the feed-through to underlying inflation is still not entirely convincing. Final demand is simply not yet strong enough. |
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Balance |
Significant rand depreciation until a few months ago, an improved terms of trade position and a pick-up in global economic activity 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 1.6%, 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. We have also taken the view that the Fed, when they commence with the process, will conduct this in an interest rate neutral manner. 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 monetary policy 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 (albeit improving) and the stickiness of inflation (still 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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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. 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. Locally, the downward trend to inflation is entrenched, supported mostly by significantly lower food price increases. While the South African Reserve Bank has adopted a neutral bias, it is unlikely that they would consider interest rate cuts soon. The external imbalance, albeit improving, is still too big to allow for a lower real repo rate. Unpredictable currency swings also continue to pose a risk to the more benign inflation 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. The combination of negative ratings momentum, uncertainty about the fiscal outlook and the continued aggressive accumulation of local currency bonds by foreign investors, remains a potential lethal mix for the local bond market. Of particular concern is the risk of a double ratings downgrade by rating agency Moody’s. This will force international passive fund managers to reduce their large South African bond exposure. Considering this, we shall continue to approach the market with caution. Our broad interest rate investment strategy for a core bond fund benchmarked against the ALBI is as follows:
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