Our monthly write-up of the markets.
Written by Futuregrowth's Interest Rate Team
Growth angst forces major central banks to join the dovish policy tide
Broad-based weak economic data coupled with a very muted inflation backdrop forced some of the world’s major central banks to abandon their intentions of future policy tightening. Fragile market sentiment was sent into a tailspin following the Federal Reserve (Fed)’s decision to err on the side of caution and signal no rate increases for the remainder of this year. The Fed went one step further by announcing that the current central bank balance sheet runoff will end in September. This was close on the heels of the European Central Bank (ECB) which earlier in March reiterated a cautious monetary policy stance and restarted a crisis-era bank lending programme in response to a streak of underwhelming Eurozone economic data.
In response, bond yields tumbled across major markets
The major global bond markets entered a bull trend in November last year as investors responded to a downbeat growth outlook. Even so, the most recent policy stance change by two of the world’s major central banks forced yields even lower as investors scurried towards the perceived safety of sovereign government bonds. In the Eurozone, the head-over-heels rally forced the yield of the 10-year German Bund into negative territory for the first time in three years. However, this rush into perceived safety comes at an obscure price: investors who bought at the negative yield are guaranteed a nominal loss should they hold the bonds to maturity. In the US, the 10-year Treasury yield reached the lowest level since December 2017 as it decreased sharply to 2.41% at the end of March. This is a very significant 83 basis points below the recent high of 3.24% recorded in October last year.
The strong global bond rally enticed foreign investors into local bonds
The global developments discussed above present somewhat of a dilemma from an emerging market point of view. On the one hand, the weaker global growth outlook bodes ill for vulnerable, small open economies like South Africa, specifically from an economic growth and a balance of payments perspective. Moreover, in the case of South Africa, downside risk to an already anaemic economic growth outlook is of particular concern considering the fragile state of South Africa’s government finances. In contrast, an ease in global monetary policy in a benign inflation environment often leads to lower global bond yields, while it also holds the promise of an improved growth outlook as a result of policy stimulation. Typically, it is the latter that investors tend to focus on. This time was no different and foreign buying interest in domestic bonds during the quarter amounted to a net R9bn. This lent much-needed support to the bond market. As a result, the non-resident share of total marketable rand-denominated RSA government debt stabilised at just above 38%, still well below the peak of 43% reached in March 2018.
Investors had to deal with significant rand volatility
Even though the short-term correlation between the rand exchange rate and the local bond market has weakened considerably in recent times, as a result of a substantial breakdown between local currency movements and inflation, it remains difficult for a bond bull rally to be sustained in the presence of significant rand weakness/volatility. Although the exchange rate of the rand against the US dollar is back at year-end levels, the intra-quarter range of R13.25 to R14.65 made it one of the world’s most volatile currencies thus far this year. Nervousness around Moody’s biannual scheduled credit rating review for South Africa and contagion from the volatile Turkish Lira amid concerns regarding the country’s central bank intervention in supporting the currency were some of the noisy negative developments that contributed largely to recent volatility.
Urgently required fiscal consolidation still illusive as ever
Investors in the local bond market had to take particular care to process this year’s tabling of the national budget. 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 this extraordinary fiscal support for Eskom is a wider budget deficit over the MTEF – now budgeted to peak at -4.5%/GDP in 2019/20. As a result, the gross debt-to-GDP profile is now expected to peak in excess of 60% in 2023/24. To us, this clearly points to sustained fiscal slippage with no near-term prospect of urgent consolidation. Using the phrase “going over the fiscal cliff” is arguably melodramatic, but it is hard to simply brush this risk aside, especially considering the fundamental challenges to persistent anaemic economic growth.
Inflation-linked bond yields continued to drift higher
In contrast, the market yield offered by inflation-linked bonds has been under renewed upward pressure. The combination of sharply lower inflation, a benign inflation outlook and the fragile fiscal situation did the inflation-linked market no favours. Following a brief respite in January, real yields resumed their drift to higher levels. The yield of the medium dated R197 (maturity 2023) increased from 2.90% at the end of 2018 to 3.17%, the weakest level since November last year. The real yield curve slope also steepened as long-dated real yields increased more than that of shorter-dated bonds.
Nominal bonds delivered a strong performance
The net result of the above developments and market movements on market returns was mixed. The net decrease in medium and long- dated nominal bond yields during the quarter resulted in a strong performance, with the ASSA JSE All Bond Index (ALBI) rendering a total return of 3.8% for the first three months of the year. This was significantly higher than both cash (1.7%) and the JSE Inflation-linked Government Bond Index (IGOV) which returned a mere 0.5%.
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 recent fears of recession 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 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, 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. This includes the negative impact of the acute operational challenges at 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 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 in 2018 and to remain at similar levels for the following two years. 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 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 completely ignorant of persistently weak underlying economic activity. Barring a significant financial crisis, a stable to weak monetary policy tightening cycle remains our base case. |
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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, 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. Even when accounting for the strong second half rebound in 2018 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 reached a point where the delivery of a credible national budget is near impossible in the absence of a 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 repo rate increase in November 2018, 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. 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, but our base case remains for a stable repo rate. 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. Real yields have retraced enough to entice us to close some of our underweight positions. In the case of our Core Bond Composite (benchmarked against the All Bond Index), our view is expressed as follows:
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