Our monthly write-up of the markets.
Bond market manages to recover some lost ground after a bad start
The trend of rising bond yields that was triggered by a disastrous Medium Term Budget Policy Statement carried over into the month of November. Concerns about multiple sovereign credit rating downgrades forced yields significantly higher during the first three weeks of the month. The yield of the benchmark R186 (maturity 2026) increased sharply from the October close of 9.10%, reaching a weakest closing level of 9.47%. Although the market recovered some lost ground during the last week, it still ended the month at levels around 20 basis points higher than the October close.
SA local currency sovereign debt now rated sub-investment by two of the three major rating agencies
S&P Global Ratings announced on 24 November that it decided to downgrade the South African local currency sovereign credit rating to the sub-investment grade level of BB+. Moody’s rating agency opted to wait until after the ANC Elective Conference in December and the delivery of the 2018/2019 national budget in February before resolving their rating review (BBB- with a negative outlook). The single downgrade only resulted in the exclusion of South Africa from the Barclays Global Aggregate Index and not City Bank’s World Government Bond Index (WGBI). Exclusion from the latter would have been triggered by a sub-investment grade local currency credit rating from both rating agencies. Rand and bond strength immediately following these announcements suggests that some investors expected the worst outcome. The exclusion from both indices would have resulted in a sizeable forced sale by foreign bond investors. Following some net selling by these investors in October and early November, the JSE actually recorded a small net inflow towards the end of the month.
SARB remains cautious – we agree
On the monetary policy front, the South African Reserve Bank wisely decided to leave the repo rate unchanged at the recent Monetary Policy Committee meeting. Providing a fix for the structural impediments to a sustainably higher economic growth path is not as simple as cutting real rates (nominal rates adjusted for inflation) to the bone. A more hawkish than expected message from the Bank forced the forward interest rate market to re-think earlier unfounded expectations for further rate reductions following the surprise cut in July. Although the latest release of inflation data confirmed the widely expected resumption of the disinflationary trend, focus has already shifted to the more uncertain medium term outlook. In this instance, a rising US-dollar crude oil price and rand weakness are of particular importance.
Inflation-linked bond market remains under pressure
Even so, the market is clearly in no mood to purchase inflation protection in the form of inflation-linked bonds yet. As a matter of fact, real yields initially moved upwards in tandem with nominal bond yields, but kept rising when the nominal bond relief rally ensued. A tandem movement in nominal and real yields is not unprecedented, especially in a scenario similar to the current one where concerns about sovereign credit risk and higher primary issuance are on the forefront of investor minds. The yield of the benchmark R197 (maturity 2023) rose sharply from 2.47% to 2.78% over this period. The upward adjustment in yields affected the real yield curve as a whole, with long-dated inflation-linked bonds performing worse given their high modified duration.
Cash still king…for now
In light of the above, November turned out to be the second consecutive month of cash taking the honours for best performing interest-bearing asset class (0.5%). The All Bond Index (nominal bonds) ended in the second place with a return of -1.0% while the Inflation-linked Government Index ended way behind, rendering a return of -3.1%. Total return of the three interest bearing asset classes for the eleven months ending November had a similar order, with cash (6.3%) ahead of both the ALBI (4.3%and IGOV (-2.0%).
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, 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. 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 serious 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. The sharp rise in crude oil prices is particularly worth noting, especially on the local front. Although global reflation is welcomed, given that 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 results in our 2017 annual average inflation forecast of 5.3%. Recent rand weakness in response to the President’s 13th cabinet reshuffle, a disappointing MTBPS and worries about more rating downgrades 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, but at a slower pace. 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. Following the surprise repo rate reduction in July, the South African Reserve Bank has remained on a more cautious path. We fully support this more defensive stance. Considering the size of the balance of payments deficit (albeit improving), the stickiness of inflation (still in the upper end of the target range), higher crude oil prices and the increased risk of rand volatility (with a weakening bias), we deem a neutral policy stance 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. In our view, the Federal Reserve is in a position to lift their policy rate at the next meeting, but this is part of a gradual normalisation of monetary 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 the steady unwind will contribute to the lifting of the current ceiling on global bond rates over time. Locally, the downward trend to inflation is expected to slowly turn. Although we do not expect the rate of inflation to accelerate at a break-neck speed, even just a slightly higher future rate of increase does support the steady accumulation of inflation-linked bonds into bouts of market weakness. We are in agreement with the current cautious stance of the South African Reserve Bank. The external trade imbalance, albeit improving, is still too big to allow for a significantly lower real repo rate, especially when considered against the background of possible large scale foreign selling of local currency bonds in the event of City Bank’s WGBI. The lack of fiscal consolidation also makes it harder to ease monetary policy. From a fundamental perspective, 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 rating downgrades. The confirmation of these concerns with the tabling of the MTBPS does not imply that the theme has played out in full. As things stand, we expect Moody’s to resolve the ratings review with a downgrade to sub-investment grade by the end of the first quarter of 2018. Negative ratings momentum in the medium 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 potentially painful mix for the local bond market. Considering this, we shall continue to approach the market with caution. However, following the large post-MTBPS market correction, we have been utilising bouts of market weakness to reduce the size of our defensive interest rate position, and continue to do so. Although the investment theme has not changed for the better, improved market valuations makes us more comfortable to run our funds with smaller underweight modified duration and 12+ year positions. Our broad interest rate strategy for a core bond fund, benchmarked against the ALBI, is as follows:
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