Our monthly write-up of the markets.
Intense bond market roller coaster ride
For the local bond market, the fourth quarter of 2017 was dominated by two events. In October, a disastrous Medium Term Budget Policy Statement (MTBPS) served as the catalyst for a sharp rise in bond yields. A significant widening of the budget deficit, which consequently implies a weakening of South Africa’s creditworthiness, fed rising investor concern about the possibility of multiple sovereign credit downgrades. This concern manifested itself in some aggressive bond selling, both by local and foreign investors. As a result, the yield of the benchmark R186 (maturity 2026) increased sharply from a September close of 8.55% to its weakest closing level of 9.47% around mid-November.
SA local currency sovereign debt now rated sub-investment by two of the three major rating agencies
As a result, markets were not surprised when S&P Global Ratings announced on 24 November that it decided to downgrade the South African local currency sovereign credit rating from an investment grade rating of BBB- to a sub-investment grade level of BB+ (negative outlook maintained). In contrast, Moody’s rating agency opted to wait until after the ANC Elective Conference in December and the delivery of the 2018/2019 national budget in February before resolving their rating review (Baa3 with a negative outlook). The single downgrade resulted only in the exclusion of South Africa from the Barclays Global Aggregate Index and not the City Bank’s World Government Bond Index. Exclusion from the latter requires a sub-investment grade local currency rating from both rating agencies. Rand and bond strength immediately following these announcements suggest that some investors expected ratings downgrades from both S&P Global Ratings and Moody’s. The exclusion from both indices would have resulted in a sizeable forced sale by foreign bond investors.
Significant post-ANC Elective Conference relief rally
Following this, local currency and bond market sentiment received another boost when Mr Ramaphosa won election as the party’s new leader at the ANC’s Elective Conference. Investors were keen to jump to the conclusion that this outcome may prove to be a major turning point for the country. The rand strengthened against the US dollar to levels last recorded in the fourth quarter of 2015. Bonds moved in tandem and the yield of the R186 decreased sharply to close the quarter at 8.59%.
Very strong quarter for long-dated nominal bonds
In light of the above, the fourth quarter of 2017 turned out to be a very strong quarter for nominal bonds, and particularly so for long-duration nominal bonds. The JSE All Bond Index ended its fourth quarter rollercoaster ride with a decent return of 2.2% after reaching an intra-quarter worst point of -4.4%. Cash rendered a return of 1.6% for the same 3-month period. The post ANC Elective Conference relief rally had been strong enough to push the All Bond Index return for the calendar year to 10.2%, well above that of cash (6.8%). The 2017 calendar year was not a good year for inflation-linked bonds. The sharp drop in inflation and rising real yields kept this market on the back foot, with long-dated inflation-linked bonds taking the brunt of the losses. As a result, the JSE Inflation-linked Government Bond Index only managed to eke out a return of 2.6% for the year.
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 strong US economy still leading the way. Although improving, 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). Most emerging market economies are caught between an improved outlook for the developed world, the implication of structurally lower Chinese economic growth on commodity demand as well as the US Federal Reserve’s well telegraphed intent to normalise monetary policy. Therefore, commodity producers with external imbalances, such as SA, remain vulnerable. Locally, the biggest impediment to higher local growth remains of a more structural nature. Without urgent macroeconomic policy reform, any short-term cyclical upswing from the primary and secondary sectors of the economy will prove inadequate in addressing South Africa’s economic growth ills. The low growth trap largely remains the result of a serious policy vacuum, policy uncertainty and unpredictability, weak consumer and investor confidence and a rigid labour market. Poorly managed state-owned enterprises also remain a negative contributor. Although a new ANC leader has been well received by financial markets in particular, the jury is still out on the planned course and efficacy of corrective policy action. Given the tight margin of victory, as well as the fact that the NEC is relatively evenly split between the two factions, the road to reform may yet prove to be a bumpy one |
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Inflation |
The strong rise in energy and other raw material prices in the last few months has started showing in headline inflation numbers in many economies. The sharp rise in crude oil prices is particularly worth noting, especially on the local front. Although global reflation is welcomed, since this is what policy makers had aimed to achieve, the feed-through to underlying inflation remains unconvincing. Final demand is simply not yet strong enough. Locally, the telegraphed drop in food inflation and a broadly neutral currency view result in our 2017 annual average inflation forecast of 5.3%. Recent rand strength in response to the perceived market friendly outcome of the ANC Elective Conference as well as NERSA’s decision to only allow Eskom a 5.2% tariff increase, as opposed to the requested 19.9%, should contribute to a slightly better inflation outlook in 2018. |
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Balance |
An improved terms of trade position and a pick-up in global economic activity are still lending relief to the South African balance of payments position. Weaker local consumer demand also proved to be a drag on merchandise imports. As a result, we expect a narrowing of the current account deficit from an annual average of 3.3% in 2016 to 2.2% in 2017, followed by a widening to 3.0% in 2018. The unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners) remains a considerable drag on a sustained and meaningful fundamental balance of payments correction. A stronger currency may limit a significant further narrowing of the current account deficit over the medium term. |
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Monetary |
Now firmly down the path of monetary policy normalisation in the US, we agree with the Federal Reserve’s continued intent to follow a slow and gradual process. With an unemployment rate seemingly stuck below 5%, slowly-rising wages and the PCE core inflation rate slowly tending towards 2%, we believe that the Federal Reserve should continue with its interest rate normalisation process, but, for obvious reasons, at an appropriate pace. We believe that the imminent shrinking of the Federal Reserve’s large balance sheet (the largest since the Second World War in response to the aftermath of the 2008 financial crisis) will be conducted in an interest rate neutral manner. Even so, this process should over time contribute to a gradual lift in the ceiling for US Treasury yields, especially if US economic growth remains on the path to recovery. The current trend of global monetary policy divergence is expected to continue over the next year or so. With more policy tightening in the US on the cards, the European Central Bank (ECB) and Bank of Japan will retain their respective quantitative easing and negative interest rate policy programmes, but with some tweaks. More recently, financial markets had to absorb slightly less dovish signals from the ECB and the Bank of England. We expect the central bank hawks to slowly gain some ground over the next few months. The South African Reserve Bank thought it wise to reduce the repo rate in July, taking its cue from the weak economic growth backdrop, low levels of credit extension growth and limited evidence of demand-led inflation. However, considering the size of the balance of payments deficit (albeit improving) and the stickiness of inflation (still in the upper end of the target range), we deem a neutral policy stance (thus no more cuts) as the most appropriate course for monetary policy right now. |
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Fiscal |
National Treasury still confronts a challenging fiscal path, as outlined in the tabling of a disappointing Medium Term Budget. As we’ve previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the urgent delivery of fiscal and SOE reform to reinvigorate consumer and business confidence as the scope to steer SA Inc. towards a sustainable growth path quickly narrows. Addressing the contingent liability overhang to the fiscus provided by SOEs is critical to regaining fiscal prudence. The recent reconstitution of the SAA board is a positive development in this regard and we look forward to the continuation of similar strong action on SOE governance. For now, the very significant financial assistance required by a growing number of badly managed SOEs and tax revenue under-collection remain the two main threats to fiscal consolidation, and thus an improvement in the credit worthiness of the country. |
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Investment view and strategy Locally, the downward trend to inflation is expected to slowly turn. Although we do not expect the rate of inflation to accelerate at a break-neck speed, even just a slightly higher future rate of increase does support the steady accumulation of inflation-linked bonds into bouts of market weakness. We are in agreement with the current cautious stance of the South African Reserve Bank. The external trade imbalance, albeit improving, is still too big to allow for a significantly lower real repo rate, especially when considered against the background of possible large scale foreign selling of local currency bonds. The lack of fiscal consolidation also makes it harder to ease monetary policy. From a fundamental perspective, our main concern with regards to the bond market remains the strong link between the local low economic growth backdrop and tax revenue collection. Persistent sub-trend economic growth and macro policy uncertainty have negative implications for fiscal consolidation and eventually sovereign credit rating downgrades. The confirmation of these concerns with the tabling of the MTBPS does not imply that the theme has played out in full. As things stand, we expected Moody’s to resolve the ratings review with a downgrade to sub-investment by the end of the first quarter. The change of political leadership is welcomed with caution. However, the structural nature and extent of the country’s ills require significant policy adjustment and time to be resolved. For now, we fear that markets got ahead of themselves with unrealistic expectations. Negative ratings momentum in the medium to longer term, caused mainly by sustained sub-trend economic growth as well as uncertainty about the fiscal outlook, does not match the continued aggressive accumulation of local currency bonds by foreign investors. This mismatch presents a potential lethal mix for the local bond market. Considering this, we shall continue to approach the market with extreme caution. That said, we have been utilising bouts of market weakness post the MTBPS to reduce the size of the defensive position. This is based on the fact that market valuation following the post MTBPS correction had improved significantly. Following the strong late December relief rally, this is not the case anymore. As a result, we opted to pause the accumulation of stock until market valuation improves again. Our broad interest rate investment strategy for a core bond fund, benchmarked against the ALBI, is as follows:
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