Our monthly write-up of the markets.
Global bond markets stabilise following June scare
The last week of June was marked by the sharp upward correction of global bond yields in response to remarks by the President of the European Central Bank suggesting that the bank may be nearing the end of exceptionally loose monetary policy. During July, nothing of material interest came the way of market participants to cause another major shift in expectations.
SARB unexpectedly cuts the repo rate while fiscal data confirms our worst fear
Locally, the South African Reserve Bank (SARB) surprised most analysts, including us at Futuregrowth, with the 25 basis points (bps) repo rate cut. In our view, the local bond market responded appropriately as short- and medium-dated bonds moved in tandem with the cut, while long-dated bond yields ended July at similar levels to the previous month’s close. In the past month, the yield of the benchmark 10-year RSA government bond traded in a fairly wide range of 8.50% and 8.93% before closing the month at 8.61%, or 17bps lower than the June close. In contrast, the long-dated R2048 (maturity 2048) closed the month at 9.86%, a mere one basis point below the previous month’s close. Like us, the back end of the bond market is not sold on the rate cut and also remains concerned about the fiscal outlook. The latest monthly government finance data confirmed these concerns as the combination of a growing tax revenue shortfall and an expenditure overrun caused a larger than expected budget deficit for the first three months of the 2017/18 fiscal year.
Foreign bond buyers in full force
Even so, the higher nominal yield offered by the local bond market, new-found global bond market stability and the repo rate cut enticed foreign bond investors to turn net buyers of rand denominated government nominal bonds to the tune of almost R10bn in July. This more than reversed the net selling in June and lifted net nominal purchases for the first seven months of the year to R52bn, or nearly 40% of the total outstanding rand denominated debt issued by the South African government. This is a very significant holding considering that it is 5% higher than those of the combined holdings of the South African banking, long-term insurance and pension fund industries. It also clearly illustrates that the average foreign bond investor does not share the same concerns we have in respect of persistent low growth and its negative implications for fiscal consolidation and South Africa’s sovereign credit rating profile.
Inflation-linked bond market catches some breath
Although the rate of inflation at both consumer and producer level continued to decelerate, the inflation-linked bond market actually managed to consolidate its long losing streak that started in April last year. The yield of the benchmark R197 (maturity 2023) actually declined by 8 bps to close July at a yield of 2.47%.
Nominal bonds manage a respectable performance
As a result of the above developments, the JSE All Bond Index (ALBI) rendered a total return of 1.5% for the month of July. This is significantly better than cash (0.6%) and the JSE Inflation-linked Government Bond Index (IGOV) which only managed a mere 0.1%. The ALBI is leading the pack for the first seven months of this year with a very respectable 5.5%, especially considering the number of supposedly bond bearish events over this period. An investment in cash would have rendered a return of 4.0% over the period in question. The global reach for yield has once again saved the day.
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 proved 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. We can expect the central bank hawks to slowly gain some ground over the next few months. The South African Reserve Bank thought it wise to reduce the repo rate in July, taking its cue from 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 more cuts) as the most appropriate course for monetary policy right now. |
| Fiscal policy |
The market is potentially facing a very different new era, with more than enough reason to be very cynical about early efforts by the new Minister of Finance to reassure financial markets about maintaining the status quo. The significantly heightened fear of the risk to fiscal prudence aside; it would be neglectful of us to not highlight noteworthy concern; chief among which remains overly ambitious real GDP estimates which elevates 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 The modest global economic recovery sets the scene for limited inflationary pressure and a steady monetary tightening cycle for the few economies that are in a position to normalise policy. Our view remains that global bond markets in general are not appropriately priced, leaving room for rising yields. 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 surprised many with the timing of the recent cut, we still believe that a strong easing cycle should not be pursued. The external trade imbalance, albeit improving, is still too big to allow for a significantly lower real repo rate. Our main concern remains the strong link between the local low economic growth backdrop and tax revenue collection. 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 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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