Our monthly write-up of the markets.
Written by Futuregrowth's Interest Rate Team
The global outlook brightens – just a little
From a global perspective, recent data releases were mixed with the Eurozone and China delivering tentative upside surprises, while the US seems to be plodding along the economic slowdown path. It thus comes as little surprise that the US Federal Reserve (Fed) continued to emphasise patience with respect to monetary policy, pausing the hiking cycle, at least in the near term. The financial market went one step further as it started speculating about a possible halt to the Fed’s balance sheet unwinding as an additional measure. Meanwhile, the ongoing trade spat between the US and China remains a source of uncertainty for emerging market economies with strong trade links to the latter. The pause in the Fed’s hiking cycle, when combined with the commodities bull rally and the global reach for yield, has lent support to so-called higher yielding currencies like the rand.
Recent rand strength is undeserved, partly due to the deteriorating fiscal situation
It is debateable whether the rand deserved any of the recent support it received. From a fundamental point of view, the biggest drawdown remains the combination of sustained sub-trend economic growth and the country’s dire fiscal situation. The latter is of particular concern and is playing a major part in keeping South Africa on the list of the most vulnerable emerging markets. As we’ve indicated before, we are not particularly impressed by the latest budget. Government once again failed to facilitate much needed fiscal consolidation. Heaping the blame on the Eskom debacle for lifting the expenditure ceiling, once again widening the budget deficit, failing to engineer a primary surplus, and increasing the country’s debt load with mere intention of some consolidation down the line simply does not cut it in our minds. Although expenditure cuts are welcomed, especially the intention to shrink the public-sector wage bill, National Treasury fell short of what was required. The simple truth is that persistent fiscal slippage has increased the risk of a negative change in the sovereign credit ratings outlook for the country, more so from Moody’s Rating Agency, which is scheduled to reveal its latest stance on 29 March.
SA inflation once again slipped more than expected – but mostly due to sharply lower fuel prices
On the brighter side, the very subdued local inflation backdrop remains one of the few shining lights. The year-on-year rate of change for Headline CPI in January decelerated to 4.0%, which is well below the recent high of 5.2% in December. Admittedly, this was the second consecutive month where a large drop in fuel prices fed into the index, contributing largely to lower inflation. Even so, the underlying rate of inflation (CPI excluding administered prices) of 3.8% clearly demonstrates a strong disinflationary environment which in turn reduces pressure on the South African Reserve Bank (SARB) from raising the repo rate – at least in the near term. The current strong disinflationary trend is also observed at the producer level. In this case, Headline PPI inflation (final manufactured goods) printed 4.1% year-on-year in January. This was also largely due to falling prices in the petroleum goods category. Support for lower prices from this source is about to turn for the worse, as OPEC and its allies continue with output cuts.
Intra-month storm followed by a return of calm
Against this background, the local bond market found it particularly hard to settle during the month. The intra-month volatility was significant, with the yield of the benchmark R186 (maturity 2026) rising sharply from 8.58% at the end of January to a weakest level of 8.94% on the day of the budget speech, after which it dropped sharply to 8.69% on 28 February. In contrast, the yield offered by inflation-linked bonds drifted higher in a more orderly fashion, partly as lower than expected inflation reduced the demand for these bonds. Even so, both markets had to deal with increased primary issuance as a result of the expected widening of the budget deficit. In the case of the nominal bond market, National Treasury may once again be forced to focus on the issue of longer dated bonds which could exert upward pressure and thus lead to a steepening of the yield curve slope.
This bodes ill for the fiscus and thus local bonds
The net result of the above developments and market movements on market returns was negative. Both the ASSA JSE All Bond Index (ALBI) and JSE Inflation-linked Government Bond Index (IGOV) returned -0.4% compared to the cash return of 0.5%. Despite a relatively poor month, the ALBI is leading the pack of three for the first two months of the calendar year with a return of 2.4%. The IGOV and cash follow with 1.3% and 1.1% respectively.
SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY
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Key macroeconomic themes |
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Economic growth |
The global economic recovery of the last few years started losing momentum in the latter half of 2018 with fears of recession recently impacting investor sentiment in a significant way. We still do not foresee a broad-based collapse, partly due to late-cycle fiscal expansion in global growth engines such as the US and now China, while central banks remain sensitive to growth signals, especially in light of sustained low inflationary pressures, particularly in developed markets. That said, the risk to our base case is skewed to the downside. The two notable potential catalysts to this downside risk being sustained weak Euro area growth and continued global trade friction as a result of intensifying protectionism. Locally, the biggest impediment to higher local growth remains of a structural nature. The low growth trap is largely due to policy uncertainty, weak policy implementation, low levels of fixed capital investment and a rigid labour market. There have been positive steps towards improved governance, such as the reconfiguration of the Eskom and Transnet boards and the finalisation of the mining charter, but the perilous state of most state-owned enterprises remains a negative risk to the fiscus, and therefore to domestic economic growth. For now, the risk of a failed economic recovery continues to be the biggest threat to our current investment theme. Should a global growth slowdown culminate, it will worsen the local growth outlook in a significant way. |
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Inflation |
Slow rising global inflation over the last few years has been the result of a combination of firmer total demand, tighter production capacity, higher commodity prices and rising employment costs, brought on primarily by accommodative monetary conditions. However, despite an environment of ultra-accommodative monetary conditions, none of the drivers were strong enough to cause an overshoot of target levels. Considering the current moderation in global economic growth, our base case remains for inflation to remain relatively benign in most economies. Locally, the telegraphed drop in food inflation and a broadly neutral currency view results in our 2019 annual average inflation forecast of 4.6%. More importantly, there is strong evidence that the pass-through of rand weakness to inflation remains exceptionally weak, reflective of the weak economic growth and the inability of producers and retailers to pass on price increases to the end consumer. This continues to support the view that the near-term acceleration in the rate of inflation is expected to be relatively benign. The targeted inflation rate should remain within the SARB’s 3% to 6% range, although still above the more desirable mid-point of 4.5%. |
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Balance |
We expect the negative current account balance to have widened to 3.5% of GDP last year and to remain at similar levels for the following two years. Even with the significant R125bn cumulative net foreign selling of rand-denominated bonds and equities in the 2018 calendar year, the unfavourable income account deficit (primarily due to the large net dividend and interest payments to foreigners) remains a considerable drag on a sustained and meaningful balance of payments correction. An escalation of international trade tensions still represents the biggest risk to the balance of payments position, especially for a small open economy like South Africa, with strong Eurozone and Chinese trade links. |
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Monetary |
With unemployment in the US anchored around a historically low 4%, and moderate growth still seen as more likely than a recession, we believe that the Fed should not simply abandon its interest rate normalisation process, but rather opt to pause for appropriate periods of time bearing cognisance of the risks to US and global economic growth. We therefore disagree with the current market view of a possible rate reduction by the Fed this year. The SARB is expected to maintain its more cautious stance, which we fully support. Factors contributing to this stance include: some pressure on the balance of payments; the fact that inflation expectations remain above the mid-point of the target range; and the waning support provided by a decade of ultra-loose global monetary policy. This is at least partly balanced by the fact that the central bank is not completely ignorant of the fact that underlying economic activity remains very weak. All in all, the risk to our stable repo rate outlook is still skewed to the upside, mostly due to embedded high inflation expectations. Even so, barring a significant financial crisis, a stable to weak monetary policy tightening cycle remains our base case. |
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Fiscal |
The biggest news was the extraordinary fiscal support to Eskom: R69bn budgeted over the medium term expenditure framework (MTEF) as a “provisional allocation” for reconfiguring the entity, to be transferred as a cash injection of R23bn per year over a three year period. This allocation negates the benefit of departmental expenditure constraint in the 2018/19 fiscal year, and ultimately results in the lifting of the previously sacrosanct expenditure ceiling by R16bn over the MTEF. The net effect of the extraordinary support for Eskom ultimately results in a wider budget deficit over the MTEF (now budgeted to peak at -4.5%/GDP in 2019/20) and a gross debt-to-GDP profile now expected to peak in excess of 60% in 2023/24. Our reading of the latest budget would be kinder if we were convinced that the extraordinary support to Eskom would be enough to negate the fiscal and economic risk the entity poses over the medium term. This seems to be where we differ with the market in our reading of the budget. While over-delivering in its support of Eskom, relative to prior market expectations, we are of the view that this support still falls short of what is required to keep Eskom solvent over the medium term. The bottom line: Without improved domestic growth, South Africa’s debt burden looks increasingly unsustainable – particularly in light of the abandonment of two critical fiscal consolidation anchors (the expenditure ceiling and deficit-neutral SOE funding). |
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Our investment view and strategy Locally, our main concern with regards to the bond market remains the strong link between lacklustre economic growth and the lack of fiscal consolidation. More specifically, this points to the rising debt burden of the state, which arises as a consequence of a lack of fiscal consolidation. This continues to threaten the country’s sovereign risk profile and places pressure on domestic funding costs. The risk of a failed economic recovery has certainly not dissipated. Even when accounting for the strong second half rebound in GDP of 2.6% and 1.4% in the third and fourth quarters respectively, the underlying economy remains structurally weak with growth for the 2018 calendar year an uninspiring 0.8%. This makes us question the quality of tax revenue collections, and consequently the state of health of the tax base, which in turn keeps the risk of a budget deficit overrun at elevated levels. The financial burden of poorly managed state-owned enterprises on state finances has now reached a point where the delivery of a credible national budget was near impossible in the absence of a substantial remedial action to remedy the unfolding financial disaster. The proverbial chickens, mainly in the form of Eskom, are home to roast and this required more than the usual liquidity provision. Addressing solvency is an entirely different matter, requiring more than simply kicking the can down the road via more liquidity bail-outs. On the monetary policy front, we maintain our view, following the repo rate increase in November 2018, that the central bank will remain hostage to the opposite forces of a lacklustre economic growth outlook and limited upside risks to inflation in light of the strong disinflationary environment. For now, this suggests a stable policy path combined with a central bank that will keep warning of their response function to the threat of higher inflation outcomes. The underlying domestic disinflationary trend and the risk to the global growth outlook should not be ignored. On balance, the risk to the stable repo rate outlook is still skewed to the upside and our base case remains for stable rates for longer. The bull rally of late, combined with renewed concerns about the fiscal state, convinced us to reduce risk into bouts of market strength. In doing that, we endeavour to strike a balance between avoiding capital loss in the case of a market sell-off and losing out on the accrual offered by a steeply sloped yield curve. We have also considered the fact that nominal bonds are currently trading at an attractive real yield of around 4%. So, while our broad interest rate investment strategy remains defensive, the modified duration variance of -0.60 is still some way off the maximum allowed position of -1.0. In the case of our Core Bond Composite (benchmarked against the All Bond Index), this is expressed as follows:
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