Insights

Key macroeconomic themes

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 elevated crude oil prices, could potentially 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 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 fast tracking of the finalisation of the mining charter, state-owned enterprises remain 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.

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. 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 value added tax (VAT) hike in particular, has thus far been evidenced to have an insignificant pass-through to consumer inflation, 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, and thus remain within the SARB’s target range.

Balance
of
payments 

Strong rand appreciation in December 2017 and the first three months of 2018, and a 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 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 R94bn 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.

Monetary
policy

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 direction is slowly changing from an overall quantitative easing stance to moderate tightening, with more policy tightening in the US on the cards, and the European Central Bank (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 South African Reserve Bank 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. 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 August emerging market sell-off.

Fiscal 
policy

Although fiscal year-to-date revenue performance had proved robust and had guided expectations for a positive result (albeit at a higher deficit) during this year’s Medium Term Budget Policy Statement, the actual outcome was disappointing. National Treasury is still confronted by a very challenging fiscal path and continues to tread along 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 positive over the longer term, efforts to address legacy issues around VAT refunds have also 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.

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. This concern was proven well founded following the tabling of the 2018 Medium Term Budget Policy Statement in October, when the Minister of Finance announced a widening of the budget deficit estimate released in February this year. 

On the monetary policy front, we maintain our view that the central bank will remain hostage to the opposite forces of a lacklustre economic growth outlook and upside risks to inflation. For now, this suggests to us a stable policy path combined with a central bank that will keep on warning about the risk of inflation to its policy rate. 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: