Our monthly write-up of the markets.
Offshore investors still reaching for yield
Rand and bond bulls had the upper hand in May. With the US dollar on the back foot, emerging market currencies like the rand gained ground. Rand strength and the global reach for yield, also referred to as the carry trade, lent a helping hand to the local bond market. Net non-resident bond purchases now total around R45bn for the first five months of 2017. This is a large number and to add perspective: this would cover a third of the portion of the 2017/18 fiscal year’s expected funding requirement which is to be financed via the issue of nominal bonds.
SARB on hold
Other positive sentiment drivers included falling US Treasury bond yields and better than expected local inflation data. The South African Reserve Bank’s monetary policy committee’s decision to leave the repo rate unchanged at its most recent meeting had little market impact as the outcome was widely anticipated.
Nominal bond return tops for the month
The drift of bond yields to lower levels resulted in an All Bond Index return of 1% for the month of May; well above the cash return of 0.6%. However, it should be noted that most of the ALBI return was sourced from the 3-12 year area of the curve, with the long end only contributing 0.9% despite strong foreign buying.
Poor run of inflation-linked bonds continue
Meanwhile, the inflation-linked bond market’s re-pricing gained momentum on the back of lower inflation. Reduced demand for inflation protection and the ongoing weekly addition to the pool of inflation-linked bonds as part of the financing of the national budget deficit continue to push real yields higher. As bond yields rise, prices drop. This resulted in a -0.1% monthly return of the IGOV Index. In an environment of lower inflation and rising concern about a possible future higher national government financing requirement, the relative poor performance of this asset class makes perfect sense
SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY
|
Key macroeconomic themes |
|
|
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. The current technical recession South Africa finds itself in bears testament to the broad-based structural weakness we’ve seen over the past few quarters. Absent of urgent macroeconomic policy reform, any short term cyclical upswing from the primary and secondary sectors of the economy will prove inadequate in addressing South Africa’s economic growth ills. |
|
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. 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 5.6%. 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 price inflation forecasts. |
|
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. |
|
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 1.4%, 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 (ECB) and Bank of Japan may retain their respective quantitative easing and negative interest rate policy programmes, but with some tweaks. More recently, financial markets had to absorb slightly less dovish signals from the ECB and the Bank of England. Expect the central bank hawks to slowly gain some ground over the next few months. 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. |
| Fiscal policy |
The market is potentially facing a new and very different era, with more than enough reason to be cynical about early efforts by the new Minister of Finance to reassure financial markets about maintaining the status quo. The significantly heightened fear about the risk to fiscal prudence aside, it would be neglectful of us not to highlight noteworthy concern, chief among which remains overly ambitious nominal GDP estimates which elevate Treasury’s execution risk in the current and outer years of the Medium Term expenditure framework. Our concern about the implications of an already elevated level of national contingent liabilities remains high. Lastly, despite the addition of a new income tax bracket, revenue collections by the South Africa Revenue Service bear the risk of increasingly underperforming fiscal targets over the medium term as efficiency gains in this state department seemingly unwind. |
|
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 continued 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. Nonetheless, we are of the view that the US Treasury market is now underestimating the extent of monetary policy tightening by the Federal Reserve, leaving investors vulnerable to fast rising bond yields from current low levels. We remain of the view that the US 10-year Treasury bond yield should be closer to 3% as opposed to the current 2.2%. 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 than a political undertaking to convince us that all is indeed well. While acknowledging the expected lift in economic growth this year, this is cyclical and in turn largely due to the agricultural sector recovery from a very low base. We remain particularly concerned about the inability to lift the underlying economic growth rate to the much higher levels required. Persistent sub-trend economic growth and macro policy uncertainty have negative implications for fiscal consolidation and eventually sovereign credit ratings. Negative ratings momentum in the medium to longer term caused mainly by sustained sub-trend economic growth as well as uncertainty about the fiscal outlook does not match the continued aggressive accumulation of local currency bonds by foreign investors. This mismatch continues to present a potential lethal mix for the local bond market. Considering this, we shall continue to approach the market with extreme caution. Our broad interest rate investment strategy for a core bond fund benchmarked against the ALBI is as follows:
|
|
