Our monthly write-up of the markets.
US-dollar weakness and lower global bond yields favour local bulls
US-dollar weakness and falling global bond yields stood out as two of the more significant market drivers for bond investors in the past month. In the US, the yield of the benchmark 10-year Treasury bond drifted lower from 2.30% to 2.13%; back to levels last seen in November 2016. In the case of the US bond bull rally, flows into so-called safe-haven assets are linked to the North Korean missile testing as well as growing evidence of stubbornly low US inflation. The latter forced interest rate bears to reconsider their stance on the near-term path of US monetary policy. Moreover, persistent low inflation appears to be widespread among developed markets in particular, causing bond yields to test lower levels.
Yet, local bonds had relatively muted response
Although the rand did respond to sustained US dollar weakness, the local bond market had a more muted reaction. The yield of the benchmark R186 (maturity 2026) initially rallied from 8.61%, its closing level at the end of July, to an intra-month low of 8.50%, only to lose ground and eventually close August at 8.57%. Clearly, bond investors had very little interest in following the bullish trends in global bond markets and the rand, even though both domestic consumer and producer rates of inflation continued to decelerate.
Perhaps due to rising risks to fiscal consolidation plans
So, why not? We strongly suspect that the reason could be found in market perceptions of the risk to the National Treasury’s commitment to fiscal consolidation. Although admittedly still early days, main budget data to the end of July points to a significant shortfall relative to the budget that was tabled in February this year. As we feared, low economic growth already has a large negative impact on tax revenue collections. In addition, the more optimistic nominal GDP assumption National Treasury used at the tabling of the current fiscal year’s budget is coming home to roost as reality is turning out to be a lot worse.
Nominal bonds still managed a decent return
Even so, the JSE All Bond Index (ALBI) still managed to render a reasonably decent total return of 1.0% for the month of August. This is significantly better than cash (0.6%) and the JSE Inflation-linked Government Bond Index (IGOV), which again only managed to eke out 0.1%. The ALBI is leading the pack for the first eight months of this year with a very respectable 6.6%. An investment in cash would have rendered a return of 4.6% over the same period.
Nominal bonds manage a respectable performance
Even so, the JSE All Bond Index (ALBI) still managed to render a reasonably decent total return of 1.0% for the month of August. This is significantly better than cash (0.6%) and the JSE Inflation-linked Government Bond Index (IGOV), which again only managed to eke out 0.1%. The ALBI is leading the pack for the first eight months of this year with a very respectable 6.6%. An investment in cash would have rendered a return of 4.6% over the same period.
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 would 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 anticipated stimulus. We believe that the global recovery will continue to 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. 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 2.5% in 2017, followed by a widening to 3.5% in 2018. The unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners), remains a 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 |
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 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. |
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Fiscal |
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 not to highlight noteworthy concerns; chief among them being overly ambitious real 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 African 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 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:
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