Our monthly write-up of the markets.
WRITTEN: FUTUREGROWTH's INTEREST RATE TEAM
Global risk appetite remains undermined
Following a temporary reprieve in November, the fourth quarter eventually turned out to be a mere extension of most of what happened in 2018, in terms of market volatility and weakness. Emerging markets had to face the consequences of compromised international trade and its potentially negative impact on global economic growth, the continued shift away from global quantitative easing, a 40% drop in crude oil prices since October, and rising political risk - specifically the emergence of populist leaders in Latin America’s two biggest economies. As a result, investor caution manifested itself in net sales of emerging market bonds by foreign investors.
Local currency and bond markets were dragged along
Considering its own significant structural economic hurdles, South African financial markets got dragged along in this maelstrom of global risk aversion. This is best demonstrated by foreign net sales of local currency denominated bonds which, for the calendar year, reached the R71 billion mark. Apart from offshore developments, the net foreign selling was also in response to a disappointing but starkly realistic Medium Term Budget Policy Statement delivered by the newly appointed Minister of Finance in October. The acknowledgement that much needed fiscal consolidation has to be kicked down the road once again, caused longer-dated bond yields to rise sharply. The yield on the benchmark R186 (maturity 2026) spiked to 9.32%, its weakest point since November 2017.
Local central bank hawks won the day despite the weak economic backdrop
The fiscal disappointment was soon to be offset by a hawkish central bank. At the South African Reserve Bank (SARB)’s November Monetary Policy Committee meeting, it was decided to raise the repo rate by 25 basis points (bps) to 6.75%, the first time the Bank had raised rates since February 2016. This decision, mostly backed by concern about persistently high inflation expectations, 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 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 local investors who expressed their approval by buying long-dated nominal bonds at the higher, more attractively priced yields. This, coupled with a stronger rand, caused the yield on the R186 to decrease by around 30 bps from its weakest intra-quarterly point of 9.32%. Consequently, the yield on the benchmark R186 (maturity 2026) moved lower to 8.88% on 31 December; 9 bps lower than the September close of 8.99%.
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. The underlying inflation trend at both producer and consumer levels remained fairly subdued and is reflective of a rather strong disinflationary environment. On a negative note, the release of the latest external trade account data pointed to another significant current account deficit of -3.5%, putting a question mark on the ability to sustainably shrink the size of the negative current account balance.
Inflation-linked bonds underperformed both nominal bonds and cash
Inflation-linked bond yields receded marginally in the second half of November. Even so, 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 quarter at 2.92%, only marginally higher than the September close of 2.90%. 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 0.43% during the quarter, underperforming both nominal bonds and cash by a significant margin.
Nominal bonds render highest return during Q4 despite significant volatility
Despite significant intra-quarter nominal bond market volatility, the JSE ASSA All Bond Index managed to deliver a return of 2.8% over the three- month period ending December. Cash performance as measured by the STeFI total return index rendered a return of 1.8% for the quarter. The return profile of the three interest rate bearing asset classes for the 2018 calendar year follow the same pattern as the past quarter’s return. The inflation-linked bond index (0.3%) underperformed both nominal bonds (7.7%) and cash (7.3%) by a significant margin.
SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY
|
Key macroeconomic themes |
|
|
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, mounts. A sustained global recovery will also be hampered by compromised international trade. 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. While acknowledging the positive steps towards improved governance, marked by the reconfiguration of the boards of Eskom and Transnet and 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. |
|
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 reflation in the European Union 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 2019 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 for the targeted inflation rate to remain within the SARB’s 3% to 6% target range, although still above the more desirable mid-point of 4.5%. |
|
Balance |
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 R125bn cumulative net foreign selling of rand-denominated bonds and equities in the 2018 calendar 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 adversely impacting the balance of payments position, especially for a small open economy like South Africa, with strong Eurozone and Chinese trade links. |
|
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 SARB is expected to maintain its more cautious stance, which we fully support. Factors contributing to this stance include: some 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 fact 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. Even so, barring a significant financial crisis, a weak policy tightening cycle remains our base case. |
|
Fiscal |
Although fiscal year-to-date revenue performance up until the 2018 Medium Term Budget Policy Statement (MTBPS) had proved to be resilient and had guided expectations of a positive result, 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, SARS’ efforts to address legacy issues around Value Added Tax 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. |
|
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 and this may cause a slowing of the tightening monetary policy trend over the next year. This tightening trend also implies that global bond yields, more specifically the US Treasury market, may have already peaked and may hover in a tight, slightly lower 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 the government, which arises as a consequence of a lack of fiscal consolidation and therefore continues to threaten the country’s sovereign risk profile in addition to the pressure it places on domestic funding costs. 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 and consequently the state of health of the tax base, 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 MTBPS in October, where the newly appointed 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 now only 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. On balance, 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: |
|
