Our monthly write-up of the markets.
A cruel quarter for emerging markets
The third quarter of this year was particularly cruel for emerging markets, mainly due to the barrage of negative news flow from Turkey and Argentina. This was in addition to existing headwinds like the escalating risk of more international trade restrictions between the United States (US) and key trading partners, which may have potentially dire consequences for emerging markets if they come to fruition. As market sentiment turned sour, foreign investors predictably responded by becoming large-scale sellers of emerging market bonds and currencies.
Large-scale foreign bond selling contributed to rand weakness
In the case of South Africa, foreign investors sold R17 billion of rand denominated RSA government bonds over this period, contributing to net sales of just short of R60 billion for the first nine months of this year. Although dwarfed by the excessively sharp depreciation of the new Turkish lira and Argentine peso, the rand, like most other emerging market currencies, failed to escape the carnage as it depreciated by approximately 11% against the US dollar from the end of June to early September. In the process, the local currency reached its weakest level against the greenback since June 2016. Although the rand retrieved some lost ground during the last three weeks of September, it is still about 20% weaker compared to its best level this year. This, in turn, contributed to heightened market fears of additional future inflationary pressure and a possible rate increase by the South African Reserve Bank (SARB). Although the SARB resisted the temptation to hike its policy rate, it utilised every opportunity to warn against the risks to higher inflation. This implies higher future monetary rates, should the rate of inflation accelerate too fast for its liking. A close 4:3 Monetary Policy Committee (MPC) voting split in favour of no interest rate increase at the September MPC meeting bears evidence of the Committee’s recent hawkish bias.
Local data releases largely played into the hands of the bears
While negative international developments were prominent, local data releases also contributed to negative market sentiment. The rate of inflation at both consumer and producer levels continued to climb higher, with the latter now just outside the top end of the inflation target range. Most disappointing was the release of gross domestic production data for the second quarter of this year which confirmed a “technical” recession, namely, a negative quarterly growth rate for two consecutive quarters. From a bond market perspective, it is noteworthy that weak economic growth could hamper tax revenue collection, particularly of Corporate Income Tax (CIT) which is already lagging behind the budget estimated growth of 6.0% with lacklustre cumulative year on year growth of only 2.8%. If this is unmatched by expenditure cuts, fiscal consolidation will be at risk. This, in turn, would lead to a higher funding requirement and possibly further sovereign credit rating downgrades. Fortunately, the latest available data shows that South Africa’s cumulative main budget fiscal deficit for the first five months of the 2018/19 fiscal year is still only marginally behind, relative to the budget presented in February this year.
Cash once again rendered the highest return in the interest rate bearing space
The events described above not only forced bond yields across the yield curve to higher levels, but also contributed to significant intra-quarter volatility. The extent of this volatility is demonstrated by the trading range of 8.57% to 9.25% of the benchmark R186 (maturity 2026). A late quarter relief rally caused the R186 to gain some lost ground, but it still closed the quarter 15 basis points higher at 8.99%. The net increase in yields during the quarter led to a disappointing JSE ASSA All Bond Index (ALBI) return of 0.8%. Although the inflation-linked bond market initially failed to escape negative market sentiment, real yields stabilised at higher levels towards the end of the quarter, bringing to an end the sharp rise in real yields that started in April this year. As a result, the JSE ASSA Government Inflation-linked Index (IGOV) returned only 0.5% for the quarter. However, this was a significant improvement considering the second quarter return of -4.6%. Cash retained the top position for the period under consideration, returning 1.6%.
SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY
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Key macroeconomic themes |
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Economic growth |
A moderate global economic recovery remains our base case, with a sustained, strong US economic recovery still leading the way. The significant loosening of US fiscal policy will continue to contribute positively to growth, although this expansionary attempt by the US Government could be moderated by tightening monetary policy. Even so, 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). In the short term, we expect the tension pertaining to international trade protectionism to escalate mainly on the back of a worsening China-US trade dispute, which currently sees no conciliatory efforts from either of the powerhouses. Compromised global trade relations, coupled with higher crude oil prices, could become a larger drag on the global growth outlook than initially anticipated. Locally, the biggest impediment to higher local growth remains of a structural nature. The low growth trap persists, largely due to policy vacuum, policy uncertainty, low levels of fixed capital investment, and a rigid labour market. While acknowledging the positive steps towards improved governance, marked by the reconfiguration of the boards of Eskom and Transnet boards and, most recently, the fast tracking of the finalisation of the mining charter, state-owned enterprises still remain a negative risk to the fiscus and, consequently, to domestic economic growth. For now, the risk of a failed economic recovery remains the biggest threat to our current investment theme. |
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Inflation |
The US remains at the forefront of the global reflation effort, with a decade of ultra-easy monetary policy and recent fiscal stimulus yielding satisfactory inflationary effects. Progress towards European reflation is also highlighted by the recent announcement of asset purchase tapering by the European Central Bank (ECB). Although global reflation is welcomed, since this is what policy makers had aimed to achieve, it is important that the feed-through to underlying inflation remains contained. It is noteworthy, however, that final demand is not yet strong enough to cause core inflation rates in most developed economies to sustainably breach central bank targets. Locally, the telegraphed drop in food inflation and a broadly neutral currency view results in our 2018 annual average inflation forecast of 4.8%. The net impact of recent tax changes, the one percentage point VAT hike in particular, has had an insignificant pass-through to consumer inflation thus far, and is therefore negligible to our inflation outlook. On the other hand, the sharp increase in the rand oil price and the threat of renewed currency weakness will contribute to upside inflation risk over the medium term. Even so, the pass-through of rand weakness to inflation still appears to be relatively weak, supporting the view that the near term acceleration in the rate of inflation may still turn out to be relatively benign, thus remaining within the SARB’s target range. |
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Balance |
Strong rand appreciation in December 2017 and the first three months of 2018 (and a resultant loss of competitiveness relative to peers) is undoing some of the previous benefit of rand weakness to the overall balance of payments. As a result, we expect a marginal widening of the current account balance from an annual average of -2.5% of Gross Domestic Product (GDP) in 2017, to -3.5% in both 2018 and 2019. Even with the significant cumulative net selling of rand denominated bonds and equities of R76 billion that we’ve seen thus far this 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. Rising international trade tension and the sharp increase in crude oil prices are cumulatively negative developments that will adversely impact the balance of payments, especially for a small open economy like South Africa, with strong eurozone and Chinese trade links. |
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Monetary |
With the unemployment rate in the US now officially below 4% and inflation pressures gradually building, we believe that the Federal Reserve should continue with its interest rate normalisation process. While the Federal Reserve intends to reduce the size of its balance sheet in an interest rate neutral manner, we are of the opinion that the sheer size of this reduction should contribute to a gradual lift in the ceiling for US Treasury yields (which is already visible, with the 10-year Treasury Bond once again surpassing the 3% mark in the latter part of September), especially if the economic recovery continues to gather momentum. In addition, the expected widening of the Federal budget deficit for the forthcoming fiscal year on the back of strong economic growth momentum will create additional scope for monetary policy normalisation. The current trend of global monetary policy divergence is slowly changing from an overall quantitative easing stance to moderate tightening - with more policy tightening in the US on the cards, and the ECB confirming that it will continue to taper its bond buying programme. All told, we expect central bank hawks to slowly gain some ground over the next few months. The SARB is expected to maintain its more cautious stance, which we fully support. Factors contributing to this stance include: renewed pressure on the balance of payments; the fact that actual inflation is back above the midpoint of the target range (which the SARB has consistently telegraphed as the desired target point); inflation expectations remaining stubbornly close to the top end of the target band; and the waning support provided by a decade of ultra-loose global monetary policy. The risk to the stable repo rate outlook is skewed to the upside, mostly due to upside risks to the current inflation outlook. Even so, the central bank is not prone to respond in a panicked manner to shocks such as the recent emerging market sell-off. |
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Fiscal |
Following the tabling of a less alarming national budget in February, National Treasury is still confronted by a very challenging fiscal path. As we have previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the actual delivery of fiscal and wide-ranging state-owned enterprise reform to reinvigorate consumer and business confidence. On the brighter side, main budget numbers for the first five months of the 2018/19 fiscal year are tracking the budget estimates closely, with only a marginal shortfall due to a combination of underspending and significant resilience from VAT (and personal income tax receipts, to a lesser extent). Even so, we remain concerned about the sustainability of fiscal consolidation, due to the weak growth backdrop and the quality of tax revenue collections, specifically related to CIT. |
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Investment view and strategy The recent, more sustained pick-up in global bond yields notwithstanding, our view remains that most developed bond markets are still not appropriately priced. In the case of the US, the strong pace of economic growth, the low level of unemployment and evidence of sustained higher inflation support further US monetary policy tightening. We believe that the Federal Reserve is in a position to lift its policy rate by at least another 25 basis points this year. More importantly, at a global level, the trend continues to gradually shift from quantitative easing to quantitative tightening. Locally, our main concern with regards to the bond market remains the strong link between lacklustre economic growth and fiscal consolidation, or, more specifically, the rising debt burden of government, which arises as a consequence of a lack of fiscal consolidation and therefore continues to threaten the country’s sovereign risk profile. The risk of a failed economic recovery has risen following a slew of disappointing data releases over the past quarter. This makes us question the quality of tax revenue collections, which, in turn, keeps the risk of a budget deficit overrun at elevated levels. On the monetary policy front, we maintain our view that the SARB will remain hostage to the opposite forces of a lacklustre economic growth outlook and upside risks to inflation. For now, this, to us, suggests a stable policy path. The risk to this view is skewed in favour of some upside risk to inflation and thus interest rates. While the observable investment theme and related real time developments mostly have negative consequences for the local bond market, it is important to note that current market valuation is largely reflective of this. Cheaper market valuations following the sell-off during the second quarter afforded us an opportunity to cautiously increase risk by selectively buying bonds. We shall continue to look for opportunities to increase bond market exposure, but only into bouts of weakness, considering the level of uncertainty discussed above. As a result, our broad interest rate investment strategy remains defensive. In the case of our Core Bond Composite (benchmarked against the All Bond Index), this is expressed as follows:
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