Our monthly write-up of the markets.
Earlier undertaking of fiscal consolidation proved to be very unrealistic
The overwhelming driver of local bond market sentiment over the last month has been the Medium Term Budget Policy Statement (MTBPS). As we feared, the Minister of Finance could not hide the fact that the earlier undertaking of fiscal consolidation had been very unrealistic. Our investment theme, “When sustained low economic growth becomes bond bearish”, unfortunately continues to play out. The latest fiscal numbers once again confirmed the undeniably strong link between economic growth and tax revenue collection. For now, significant tax revenue under-collection will force government to turn hat-in-hand to capital markets forcing the outstanding debt to GDP ratio much higher than previously anticipated. On the positive side, we believe that the latest estimates are more realistic and stand a better chance of lending some credibility to the budget process
Bond yields spike on worse than expected mid-term budget update
As could be expected, the bond market response was vicious. The yield of the benchmark R186 (maturity 2026) spiked by more than 40 basis points to 9.27%, the highest level in more than a year. Although yields did pull back at month-end, the R186 yield still ended October 55bps weaker at 9.095%. More importantly, the yields of longer-dated bonds rose more than those of shorter-dated bonds, causing the slope of the nominal bond yield curve to steepen.
Bearish yield curve steepening reflecting fear of rising debt issuance and ratings downgrade
As a result, nominal bonds with a term to maturity of 12 years and longer, returned -2.7% compared to a significantly smaller loss of 0.2% for bonds in the 1-3 year maturity band. The All Bond Index rendered a return of -2.3%, well below the cash return of +0.6%. The forced selling around the budget points in the direction of foreign investors, who had been eager buyers of local currency bonds in the months leading up to the October event. Even so, the size of the post-MTBPS foreign sales was fairly small relative to the more than R70 billion accumulated since the start of this year by these investors, which implies that bond yields may rise a lot more should foreign investors decide to commence with more selling.
Our view of another round of rating downgrades closer to reality
One possible catalyst for continued foreign selling would be in response to international rating agencies’ action, particularly Moody’s and Standard and Poor’s, who still have South African local currency bonds listed on the lowest step of the investment grade ladder. A local currency ratings downgrade is required by both agencies to result in South Africa’s exclusion from some international bond indices, in turn forcing passive investors to liquidate their holdings.
Steady increase in global bond yields
Other noticeable happenings the past month include the steady increase in US and Euro bond yields, confirmation of stable local inflation in the short term and some tentative signs that local economic growth has lifted somewhat in the third quarter. However, none of these were strong enough to offset the negative implications of a significantly higher budget deficit on the South African economy in general and the local bond market in particular.
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. Although improving, 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. Without 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 telegraphed drop in food inflation and a broadly neutral currency view result in our 2017 annual average inflation forecast of 5.3%. Recent rand weakness in response to the President’s 13th cabinet reshuffle as well as a disappointing MTBPS do not yet pose a meaningful threat to our medium-term inflation outlook, given that 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 2.2% in 2017, followed by a widening to 3.0% in 2018. The unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners) remains a considerable 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 |
Now firmly down the path of monetary policy normalisation in the US, we agree with the Federal Reserve’s continued intent to follow a slow and gradual process. With an unemployment rate seemingly stuck below 5%, slowly-rising wages and the PCE core inflation rate slowly tending towards 2%, 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 will 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 |
National Treasury now confronts a challenging fiscal path, as outlined in the tabling of a disappointing Medium Term Budget. As we’ve previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the urgent delivery of fiscal and SOE reform to reinvigorate consumer and business confidence as the scope to steer SA Inc. towards a sustainable growth path quickly narrows. Addressing the contingent liability overhang to the fiscus provided by SOEs is critical to regaining fiscal prudence. The recent reconstitution of the SAA board is a positive development in this regard and we look to the continuation of similar strong action on SOE governance. Lastly, we remain concerned about flagging revenue collections by the South African Revenue Service as recent efficiency gains by the agency seemingly unwind. We’ll continue to cast a keen eye on monthly revenue performance statistics. |
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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 long process will contribute to the lifting of the current 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 July 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. The confirmation of these concerns with the tabling of the MTBPS does not imply that the theme has played out in full. 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. So, most market participants, including us at Futuregrowth, expect a noticeable sell-off fuelled by foreign investors when an imminent further credit rating downgrade forces the exclusion of the country from certain global bond indices. This selling refers specifically to the so-called benchmark constrained investor, who makes up more than half of the foreign holding of Rand denominated government bonds. However, it is worthwhile to consider the role the so-called benchmark-unconstrained investor could play in capping a bond sell-off.
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