Our monthly write-up of the markets.
Tentative recovery in risk appetite
The month of November witnessed the return of some market calm following the hysteria that resulted in broad global market weakness for most of the preceding months. The sharp drop in crude oil prices and a slightly dovish Federal Reserve stance were two important factors that helped calm nervous investors. This had a positive impact on most markets, including the US Treasury market where the yield of the ten- year bond declined by a meaningful 16 basis points (bps) to levels last recorded in September.
Local currency and bond markets regained some of the recent losses
In the case of South Africa, the slight improvement in global sentiment is reflected by net foreign buying of local currency government bonds in November. Although the monthly net purchases of R2.5bn are small compared to net sales of R65bn for the year to date, it is worth noting that this was the first time foreign investors had turned into net buyers since July this year. Even so, it is clear that strong local demand was the main driver behind the strong bull rally in the past month. The strength of the rally is illustrated by the sharp decline of the yield on the benchmark R186 (maturity 2026); from the October close of 9.36% to 8.93% at the end of November.
Local central bank hawks won the day
The decision by the South African Reserve Bank to raise the repo rate for the first time since February 2016 had a direct impact on both the level of bond yields and the shape of the nominal yield curve. Short- dated bond yields increased marginally in direct response to the 25 bps repo rate increase. At the back-end, the clear intention of the central bank to manage inflation expectations despite weak economic growth played into the hands of longer-term investors who expressed their approval by buying long-dated nominal bonds. The combination of rising short-dated bond yields and the decline in long-dated bond yields caused the slope of the yield curve to flatten somewhat.
Data releases had a limited impact on market sentiment
The most recent economic data releases did little to change our assessment of our broad investment theme: a benign inflation outlook amidst sustained weak economic activity. Although the October Producer Price Index accelerated by 6.9% on a year-on-year basis, this was mostly on the back of a sharp increase of petroleum product prices which have since more than reversed increases cited in previous months. The underlying inflation trend at both producer and consumer levels therefore remains fairly subdued and is reflective of a rather disinflationary environment. On the negative side, the release of the latest external trade account data pointed to another significant current account deficit of -3.5%, putting a question mark on South Africa’s ability to sustainably shrink the size of the negative current account balance.
Nominal bonds outperform by a significant margin
Despite inflation-linked bond yields receding marginally in the second half of November, market weakness in the first half of the month gave rise to a steepening of the real yield curve slope. The yield of the benchmark R197 (maturity 2023) initially increased to 3.05%, its weakest level since April 2010, before pulling back to close the month at 2.92%. Even so, the bearish steepening of the yield curve still caused the JSE ASSA Government Inflation-linked Index (IGOV) to render a poor return of -1.1%, underperforming both nominal bonds and cash by a significant margin. The strong nominal bond rally, which coincided with some yield curve flattening gave rise to a very strong JSE ASSA All Bond Index return of 3.9% for the month. Cash returned its usual stable 0.6% in November.
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 relatively stronger US economy leading the way. However, from a cyclical perspective, the downside risk to our base case has increased as concern over the sustainability of the global recovery in general, and the US in particular, is mounting. A sustained global recovery will be hampered by compromised international trade, lower productivity growth, ongoing broad-based balance sheet repair (deleveraging), and shifting demographics (ageing populations tend to save more and spend less). Locally, the biggest impediment to higher local growth remains of a structural nature. The low-growth trap is largely due to a 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, and most recently, the finalisation of the mining charter, the perilous state of most of the state-owned enterprises remains a negative risk to the fiscus - and as a consequence, 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 |
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 announcement of asset purchase tapering by the European Central Bank earlier in the year. 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. A possible global growth slowdown would also reduce the risk of sustained higher inflation. Locally, the telegraphed drop in food inflation and a broadly neutral currency view results in our 2018 annual average inflation forecast of 4.8%. More importantly, there is strong evidence that the pass-through of rand weakness to inflation appears to remain exceptionally weak, reflective of the weak economic growth and the inability of producers and retailers to pass on price increases to the end consumer in a significant way. This continues to support the view that the near-term acceleration in the rate of inflation is expected to be relatively benign, and that the inflation rate will remain well within the South African Reserve Bank’s 3% to 6% target range |
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Balance |
Strong rand appreciation in December 2017 and the first three months of 2018, and the 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 R110bn cumulative net foreign selling of rand-denominated bonds and equities 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. 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 the unemployment rate in the US below 4% and inflation pressures gradually building, we believe that the Federal Reserve should continue with its interest rate normalisation process, albeit at a very gradual pace, and bearing cognisance of the risks to global growth. The South African Reserve Bank (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 mid-point 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. This is at least partly balanced by the impression 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. |
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Fiscal |
Although fiscal year-to-date revenue performance had proved resilient and had guided expectations of a positive result during this year’s Medium Term Budget Policy Statement (MTBPS), the actual outcome was disappointing. National Treasury is still confronted by a very challenging fiscal path and continues to tread the fine line between balancing the need for fiscal consolidation and economic stimulus. As we have previously highlighted, structurally weak domestic growth is primarily responsible for severely impeding the consolidation of SA’s budget balance. Although likely to be positive over the longer term, the efforts the South African Revenue Service to address legacy issues around VAT refunds have also notably contributed to the slowing down of fiscal consolidation. We now look to the actual delivery of fiscal and wide-ranging state-owned enterprise reform to reinvigorate consumer and business confidence. |
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Investment view and strategy At a global level, the shift from quantitative easing to quantitative tightening remains the main trend for now. However, the risk to a sustained global economic recovery should not be ignored as this may cause a slowing of this tightening monetary policy trend over the next year. It also implies that global bond yields, more specifically the US Treasury market, may have already peaked and now hover in a tight range in the near term. 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 not dissipated, even when accounting for the strong third-quarter rebound in GDP of 2.2%, the underlying economy remains structurally weak. This makes us question the quality of tax revenue collections, which in turn keep the risk of a budget deficit overrun at elevated levels. This concern was proven well-founded following the tabling of the 2018 MTBPS in October, where the Minister of Finance announced a widening of the medium-term budget deficit estimates released in the tabling of February’s Main Budget, with the start of some fiscal consolidation only going to occur in the 2020/21 fiscal year. On the monetary policy front, we maintain our view that, following the recent repo rate increase in November, 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 to us 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. All in all, the risk to the stable repo rate outlook is still skewed to the upside, mostly due to stubbornly high inflation expectations. 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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