Our monthly write-up of the markets.
Sharp correction follows earlier US-dollar weakness and lower global bond
US-dollar weakness and falling global bond yields, followed by a late sharp correction late in September, stood out for bond investors during the third quarter. The yield of the benchmark 10-year Treasury bond initially defied gravity by drifting down from 2.39% to a low of 2.05%, levels last seen in November 2016, before rac- ing back in a matter of days to close the quarter at 2.32%. The swings in investor sentiment were the result of a number of developments. Stubbornly low US infla- tion, speculation about the timing and extent of US monetary policy tightening, the well telegraphed unwinding of the Federal Reserve balance sheet, ongoing speculation about near-term US fiscal policy changes (including the much moot- ed Trump tax plan) and USA/North Korean tension, all at one time or another, had a role to
Emerging market borrowers keen to feed frantic global reach for yield
The lack of inflation momentum, despite stronger economic growth, turned out to be a more widespread phenomenon among industrialised nations. As a result, government bond yields in the developed world, even after considering short- term volatility, still languish near their lowest levels since 2013. This continued to feed the frantic global reach for yield offered by more risky corporate and emerg- ing market sovereign bonds. In response, emerging-market borrowers had been issuing bonds at the fastest pace in history this year with hard-currency bond sales already past the $500bn mark.
Local market buoyed by rate cut and foreign demand
Locally, the rand exchange rates and local government bond yields moved in tan- dem with global markets, with local developments largely taking a back seat. One reason is persistent buying of rand-denominated government bonds by foreign investors, which now totals R72bn for the first nine months of this year. The wide- ly expected deceleration of the local inflation rate, the continued trade account improvement and weak economic growth, convinced the South African Reserve Bank to reduce the repo rate by 25 basis points in July, and keep rates unchanged at its September meeting. Against this background, the yield of the benchmark R186 (maturity 2026), fluctuated in a wide range of 8.38% and 8.93%, before clos- ing the quarter at 8.55%, or 23bps lower than the closing yield at the end of June.
A worsening fiscal situation is largely ignored
The events described above turned out to be enough to offset the major negative factor: rising risks to National Treasury’s commitment to fiscal consolidation. Main national budget data to the end of August points to a significant shortfall relative to the budget that was tabled in February this year. As we feared, evidence of low economic growth is already bearing negative consequences to tax revenue collec- tion. 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 points to a weakening trend growth rate. The worsening financial turmoil at too many state-owned enterprises is not helpful either.
All boats are lifted by the tide of foreign buyers
With this in mind, the reasonable successful placement of Euro-denominated bonds by the RSA government in September should be seen in light of the fran- tic global reach for yield. It most certainly is not an acknowledgement by these investors of prudent local fiscal management. South Africa is merely one of many borrowers of lesser quality that managed to place debt in international markets at reasonably favourable terms over the last few months. Let’s not be fooled by greedy, blindfolded foreign investors, who seem to be endlessly spurred on by still extremely loose monetary conditions in the developed world.
Leading to a better quarter for nominal bonds
As a result, the JSE All Bond Index (ALBI) managed to render a strong return of 3.7% for the three months ending September. This is significantly better than cash (1.7%) and the JSE Inflation-linked Government Bond Index (IGOV), which man- aged to return 1.3%. The inflation-linked bond market was boosted by lower real yields which managed to offset the negative impact of falling inflation.
SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY
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Key macroeconomic themes |
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Economic growth |
A moderate, 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) initially 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 (ageing 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 as well as 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 mak- ers 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 narrow- ing 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 |
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 be- low 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. We believe that the imminent shrinking of the Federal Reserve’s large balance sheet (the largest since the Second World War in response to the aftermath of the 2008 financial crisis) will be conducted in an interest rate neutral manner. Even so, this process should, over time, contribute to a gradual lift in the ceiling for US Treasury yields, especially if US economic growth remains on the path to recovery. 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. How- ever, 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 exe- cution 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 are not appropriately priced, leaving some room for rising yields. Although the Federal Reserve and European Central Bank are both adamant that the unwinding of their respective balance sheets will be done in an interest rate neutral way, we believe that this will contribute to the gradual lifting of the ceiling on global bond rates over time. 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 remain of the view 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 reve- nue collection. Persistent sub-trend economic growth and macro policy uncertainty have negative implica- tions 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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