Our monthly write-up of the markets.
March cabinet reshuffle adds to heightened policy uncertainty
The second quarter got off to a poor start as the South African bond market was still reeling from the cabinet reshuffle that cost Mr Pravin Gordhan the post of finance minister. This event served as catalyst for sovereign credit rating downgrades by both S&P Global and Moody’s. In the case of the former, its foreign currency rating is now aligned with Fitch which downgraded the country to the non-investment grade category earlier this year. In light of the low economic growth trap the country finds itself and heightened concerns about policy stability, both S&P and Moody’s retained a negative outlook on the respective foreign and local currency ratings. This means that the next ratings action is either a change to a stable outlook or for all ratings to become non-investment grade. We believe that circumstances, particularly the precarious economic growth situation and policy unpredictability, favour the latter.
The low growth trap risks fiscal consolidation and SA’s creditworthiness
In support of this view, the release of first quarter GDP data confirmed that the country officially entered a technical recession (negative rate of growth for two consecutive quarters). This served to raise concerns about persistent sub-par economic growth, with an array of implications for the creditworthiness of the country in the long run. In the short term, sustained weak economic growth will negatively impact plans to consolidate the fiscal situation as low growth limits tax collection. The impact of the worsening weak growth backdrop partly offset the good news on the continued narrowing of the current account deficit. In the meantime, the rate of inflation kept grinding lower to 5.4% in response to lower food prices, a stronger rand compared to a year ago as well as weak consumer demand. This combination of weak growth and lower inflation continue to spur speculation of possible repo rate reductions by the South African Reserve Bank (SARB) before the end of this year.
Fading optimism about US recovery assisted bond bulls after an initial poor start
After ending the first quarter at a yield of 8.84%, the benchmark R186 government bond weakened to 9.0% in early April at which point the global reach for yield, once again, came to the rescue. Linked to this had been other external developments such as the weaker US-dollar and sharply falling US Treasury yields, which in turn had mainly been the result of fading optimism about the strength of the US economic recovery and its implications for the path of official interest rates. Global bond bulls also received support from sticky inflation at relatively low levels in most of the developed world. Against this backdrop, yield-seeking foreign investors brushed aside local political developments and the sovereign rating downgrades. This demand drove local bond yields sharply lower and the R186 yield reached an intra-quarter low of 8.39% by the middle of June.
Large non-resident bond holding risks market stability
The latest non-resident bond buying spree caused the foreign ownership of total outstanding rand denominated South African government bonds, which include both nominal and inflation-linked bonds, to reach an all-time high of almost 40%. In the case of nominal fixed rate RSA government bonds, the foreign share is now a whopping 48%, well above the 20% held by local pension funds. To us, the very large foreign holding endangers future market stability considering the weak local fundamental situation, negative ratings momentum and its impact on global index changes. Moreover, a future correction to extremely loose global monetary policy still holds a significant risk to overvalued bond markets in general.
SA nominal yield curve ended the period at steeper slope
This risk came to the fore in the last week of June when influential central banks including the European Central Bank and the Bank of England suggested that the extent of current loose monetary policy requires reconsideration. This forced bond holders to re-think and lighten up on exposure. The rise in global bond yields as well as unwelcome speculation about possible changes to the SARB’s mandate caused a late quarter wave of bond selling. As a result, the R186 yield retraced to 8.78%, just six basis points lower than the closing yield at the end of March. More importantly, the slope of the bond yield curve steepened as long-dated bond yields rose by more than short-dated bonds. Nonetheless, the ASSA JSE All Bond Index still managed to render a positive return of 1.5% for the quarter, the result of fairly stable returns offered by short-dated nominal bonds. Cash delivered a slightly better return of 1.7%.
Poor run of inflation-linked bonds continue
The re-pricing of inflation-linked bonds gained momentum on the back of lower inflation during the second quarter. Reduced demand for inflation protection and the weekly primary issuance of inflation-linked bonds as part of the financing of the national budget deficit pushed real yields higher. As a result, the ASSA JSE Government Inflation-linked Bond Index only managed to eke out a return of 0.9%. 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
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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. 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. The low growth trap largely remains the result of a serious policy vacuum, policy uncertainty and unpredictability, weak consumer and investor confidence and a sclerotic labour market. Poorly managed state owned enterprises also remain a negative contributor. |
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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. 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 5.3%. 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. |
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Balance |
Significant rand depreciation until about 18 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. Weaker local consumer demand also proves to be a drag on merchandise imports. 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. Our terms of trade are 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 1.4%, 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. |
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Fiscal |
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. |
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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 continued monetary policy divergence, but with some tweaks. It also implies a steady tightening cycle for the few economies that are in a position to normalise monetary policy, especially the US and now perhaps the UK. Our view remains that the US Treasury market is underestimating the extent of monetary policy tightening by the Federal Reserve, leaving investors vulnerable to fast rising bond yields from current low levels. In light of this, the US 10-year Treasury bond yield should be closer to 3% as opposed to the current 2.3%. Moreover, any movement by other influential central banks to reduce the extent of the excessive monetary policy assistance will force bond investors to re-price the risk of future higher short-term rates. Locally, the downward trend to inflation is entrenched, supported mostly by significantly lower food price increases while weak consumer demand is also playing a role. 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. 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. 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, the level of outstanding government debt 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 presents a potential lethal mix for the local bond market. Considering the above, 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:
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