Our monthly write-up of the markets
Written by Futuregrowth's Interest Rate Team
The South African yield curve has steepened in a significant way
During the second quarter of this year, short-dated nominal bond yields decreased sharply, while those of the ultra-long-dated bonds increased, albeit only marginally. As far as constituents of the All Bond Index (ALBI) are concerned, the yield of the shortest-dated bond, the R208 (maturity 2021), decreased by a very significant 53 basis points (bps) to close the quarter at 6.33%. This was an extension of the short end rally that started in November last year, when the yield of the R208 turned at its most recent peak of 8.12%. In contrast, the yield of the longest dated R2048 (maturity 2048) increased by 9bps to end the quarter at a level of 9.67%. The yield curve change and individual stock characteristics (such as modified duration, coupon rate and curve position) benefited stocks in the 2026 to 2031 maturity band most. In particular, the R186 (maturity 2026) was best positioned, and this is reflected by the highest individual RSA Government bond return of 5.31%.
Short end supported by bullish repo rate expectations
The strong bull rally at the short to medium area of the yield curve was mainly a result of bullish rate expectations as local investors started positioning for a repo rate reduction in the near term, possibly as soon as mid-July. This sentiment was also strongly expressed in both the spot and forward money market. At the time of writing, 12-month bank non-negotiable certificates of deposit (NCDs) were offered at around 7.8%, well below the 8.2% demanded by a more jittery investor community until around the middle of May.
Local election outcome overshadowed by global events
The local bond market got caught up between the global risk-off trade and onshore developments. It was no surprise that the outcome of the national elections and the all-important and much anticipated announcement of the new cabinet took centre stage. At face value, the outcome offers a good start to the process of re-building trust and addressing the many structural impediments capping growth potential. Although the jury is still out with respect to delivery by the newly assembled executive, the importance of global events was clearly illustrated by the fact that developments in the global market overshadowed the important local political event, to some extent.
These bullish expectations are well-founded
Reasons for the strong bullish sentiment are wide ranging. Globally, the lingering concern of a failed economic growth recovery prompted actual policy easing, or at least firm talk, of such a move in a number of developed and emerging economies. This, combined with very weak local growth, as evidenced by the -3.2% quarter-on-quarter annualised rate of growth for the first quarter of this year as well as a seemingly sustained benign inflation backdrop, made it hard for the South African Reserve Bank (SARB) to persist with hawkish messaging. Unsurprisingly, two of the five SARB voting members voted in favour of a rate reduction at the May monetary policy committee meeting. That said, we agree with the SARB Governor’s sentiment that weak growth is mainly the result of structural issues which cannot be resolved by simply lowering interest rates. On the inflation front, the Consumer Price Index continues to hover around 4.5%; the mid-point of the SARB’s inflation target range.
In contrast, long-dated bonds had to navigate some headwinds, more specifically on the fiscal side
In contrast to the short end bull rally, the tail end of the yield curve reflected global risk volatility, partly linked to the ongoing China/US trade spat, coupled with the precarious local fiscal situation. Following the breach of the 2018/19 fiscal target earlier this year, the first month of the current fiscal year was not the best of starts, even though this was partly offset by a better than expected deficit in May. At face value, this is another disappointing outcome. However, we would caution against reading too much into two months’ data in light of the following two factors. Firstly, the net VAT collection drop was the result of a sharp year-on-year rise in VAT refunds, which have increased by 30% on a fiscal YTD basis when compared to the same period in 2018/19, as the South African Revenue Service (SARS) is still addressing the backlog accumulated in the past. Secondly, seasonality, especially with respect to expenditure which appeared to be markedly higher, calls for caution when interpreting two months’ data. That said, we remain concerned about the fiscal situation, especially with an eye on the state-owned enterprise (SOE) fiasco, while persistent weak economic growth and low inflation present major risks to current budget estimates. The fact that the CEOs of both Eskom and South African Airways have recently resigned, raises more red flags with regards to the risk some of these SOEs hold for the sovereign balance sheet and the country’s creditworthiness
Foreign investors turn net sellers of rand denominated government bonds
Sustained fiscal slippage explains why foreign investors, who still hold around 38% of local currency denominated government bonds, reduced their exposure. Although the net sales figure of R16bn for the first six months of the year is relatively small, it is nonetheless noteworthy, considering the renewed global search for yield as global yields drift lower. In light of the fact that this investor group mainly hold longer-dated nominal bonds, the net selling did contribute to weakness at the back end of the yield curve.
Inflation-linked bonds managed to recover some of their losses towards quarter end
Following the poor performance during the last nine months of 2018, the local inflation-linked bond market continued to recover some lost ground, although the recovery was marked by more volatility in the last quarter. While the benign inflation outlook presents a weak theme for inflation hedging, real yields have increased by enough over this period to entice investors into this market. Overall, real yields drifted lower on a net basis. For instance, the 10-year I2029 bond closed the quarter at a yield of 3.17%, a downward movement of 12bps.
In the end, nominal bonds weathered the Q2 storm best
The performance of nominal bonds in the 2026 to 2035 maturity band made the biggest contribution to the 3.7% rendered by the JSE ASSA ALBI during the second quarter. This was followed by a reasonable 2.8% outcome for the JSE Inflation-linked Government Bond Index (IGOV). Both outperformed the cash return of 1.6% by a significant margin, albeit amidst significantly higher volatility. Returns for the first six months of the year are 7.7%, 3.3% and 3.2% 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, and recent fears of recession have impacted 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 China. Central banks also 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 are sustained weak Euro area growth and continued global trade friction. 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, the appointment of a new SARS commissioner and the finalisation of the mining charter. However, the perilous state of a number of state-owned enterprises (SOEs) remains a negative risk to the fiscus, and therefore to domestic economic growth. This includes the negative impact of the acute operational challenges at Eskom – this was clearly evidenced in the April budget deficit figure which came in markedly higher due to an emergency payment of R13.5bn made to Eskom. 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 past 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 continues 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 4.4%. 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 inflation expectations still remain 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 3.3% of GDP in 2019 and to have increased to 4% by 2021. 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 3.6%, 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. That said, the broader market is priced for rate cuts. Should this fail to materialise, US market rates will head upwards from current low levels. The SARB is expected to maintain its more cautious stance, which we fully support. Factors contributing to this stance include sustained pressure on the balance of payments, the fact that inflation expectations remain above the mid-point of the target range, and the possibility that inflation has bottomed, for now. This is at least partly balanced by the fact that the central bank is not ignorant of persistently weak underlying economic activity. Barring a significant financial crisis, a stable to weak monetary policy tightening cycle remains our base case. Similar to market expectations in the US, the local market is priced for rate cuts and is thus at risk should these fail to materialise. |
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Fiscal |
Our reading of the February budget would have been 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 differed from 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 government 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, namely, the expenditure ceiling and deficit-neutral SOE funding. |
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Investment view and strategy At a global level, the shift from quantitative easing to tightening has stalled, and in some cases even reversed, due to fear of a global growth slowdown. Even so, we are of the view that authorities are prepared to adjust relatively quickly, and in some cases are already responding, to avoid a broad-based collapse in economic growth. This implies that global bond yields, and more specifically the US Treasury market, have already responded as if an easing cycle has commenced. Our view is somewhat different in the sense that, although we agree with a global growth slowdown, the risk of a collapse is small enough to argue in favour of higher bond yields and steeper curves than current levels. However, given the level of uncertainty about the growth outlook, and especially the role that international trade friction plays, developed market government bond yields may be trapped at the lower levels for a while. Locally, our main concern regarding 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 the 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; with this firmly supported by disappointing first quarter GDP data. 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 SOEs on state finances has reached a point where the delivery of a credible national budget is nearly impossible in the absence of substantial remedial action for the unfolding financial disaster. The proverbial chickens, mainly in the form of Eskom, have come home to roost, and this requires 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 Monetary Policy Committee (MPC)’s decision to keep the repo rate stable in May 2019, that the central bank will remain hostage to the opposing forces of a lacklustre economic growth outlook and limited upside risks to inflation in light of the strong disinflationary environment. This is best reflected by the recent split decision by the MPC members, with two members voting for a rate cut. Although this implies a higher probability of a rate cut in the near term, we are sticking to a stable policy path for now, but acknowledging that the risk is to the downside, in light of weak economic growth and strong disinflationary forces. With the above in mind, we continue to 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 long-dated 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 -0.2 is some way off the maximum allowed position of -1.0. This acknowledges reasonable valuation which partly offsets the relatively poor investment theme. In the case of our Core Bond Composite (benchmarked against the All Bond Index), our view is expressed as follows: |
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