A Dark Quarter with a Few Rays of Sunlight

Investor sentiment dipped to new lows

Loadshedding intensity remained elevated at the beginning of the quarter; however, the combination of reduced plant breakdowns and planned maintenance contributed to improved electricity generation in June. While navigating the blackouts has become part of the daily routine for the average South African, investor concerns about the negative impact on economic growth prospects and inflation reached a new peak in the past quarter. For foreign investors in particular, the growing possibility of a grid collapse and its devastating consequences severely dented risk appetite. This was expressed via an accelerated reduction of exposure to South African financial assets, including government bonds. As a result, the foreign shareholding of SA government bonds declined to 25.1% by the end of May, the lowest level in more than twelve years.

The domestic risk-off sentiment was also reflected in the significant weakening of the currency in the quarter, with the South African rand depreciating to R19.86 against the US dollar in May. Even more concerning from an inflation point of view is the broad-based weakening of the local currency against a trade-weighted basket of currencies. Diplomatic own goals like the alleged supply of weapons to Russia and the potential impact on international trade further contributed to the souring of foreign appetite for financial assets. While unsettling offshore developments such as the US debt ceiling debacle and sustained policy tightening by some of the developed world’s major central banks added to general risk aversion, the core driver of local discontent remained the impact of the developments described above on an already fragile fiscal situation. Thankfully, reduced loadshedding intensity in June contributed to improved market conditions into the quarter end.

Figure 1: Foreign investor shareholding of SA government bonds continued to trend lower

Source: National Treasury, Futuregrowth

The disinflation trend gains momentum

Encouragingly, Headline CPI data for May slowed to 6.3% year-on-year following a period of stickiness and is now well below the peak of 7.8% in July 2022. Moreover, the latest developments at the producer level continue to support our view of a more prominent consumer disinflation trend in the next few months. The May PPI data release showed that final manufactured goods prices at the producer level had increased at a rate of 7.3% year-on-year, significantly below the 10.6% recorded three months earlier. An even more pronounced disinflation trend was evident for intermediate manufactured goods and agriculture, which slowed to 4.4% and 2.2% year-on-year, respectively. While producer food prices at 8.8% year-on-year for May are still very high, base effects are expected to support the continuation of the recent sharp deceleration in the rate of increase.

Figure 2: The continued slowdown in food price increases at the producer level bodes well for consumer inflation

Source: IRESS, Futuregrowth

The South African Reserve Bank (SARB) keeps a firm foot on the tightening pedal

Even though the disinflation trend in domestic consumer prices has gained momentum, the fact that year-on-year consumer inflation remains outside of the official 3% to 6% target band, growing unease about rising and sustained costs associated with intensified loadshedding and the latest bout of significant rand depreciation, convinced all five members of the Monetary Policy Committee to vote for a 50 basis points (bps) repo rate increase at their May meeting. The latest increase took the repo rate to 8.25%, the highest point since 2009. The positive take from a nominal bond market perspective is that this increase, combined with the downtrend in CPI, pushed the real repo rate further into positive and thus restrictive territory. The repo rate is now well past the 7% peak we had called for earlier this year. This is mainly due to our underestimation of the impact of loadshedding on consumer prices.

Figure 3: The South African inflation-adjusted repo rate crept further into positive territory and is still expected to rise sharply to pre-COVID levels

Source: Bloomberg, Futuregrowth

Local economic activity remains surprisingly resilient

A slew of recent data releases suggests that the South African economy was more resilient than feared, considering the sharp decline in electricity generation. Not only was Gross Domestic Product (GDP) data for the first quarter of 2023 reported as modestly positive, but signs of economic resilience to loadshedding have also been evidenced by high frequency economic data throughout the second quarter. This specifically refers to wholesale trade, tourist accommodation, freight transport volumes and mining output. Moreover, registered company liquidations were down almost 20% year-on-year in May this year. This followed a decline of almost 19% the previous month. While liquidation data is a lagging indicator, the combination of the above suggests that the business sector in general has managed to find a way around the electricity supply hurdle. Although overall economic growth is still expected to disappoint this year, the latest high frequency data releases do hold the possibility of slightly better than expected economic outcomes. That said, the process of finding an alternative to unreliable Eskom power supply does come at a cost, which in turn will continue to impact profit margins and potentially contribute to price increases.

A discouraging start to the new fiscal year

The budget deficit for the fiscal year ending March 2023 ended at 4.7% of GDP, slightly wider than the 4.5% formal estimate by National Treasury. Even though this is still the smallest budget deficit since 2019, upward expenditure pressure and waning tax revenue performance against a background of sustained weak economic growth continue to highlight our long-held concern about the country’s fiscal health.

The slightly worse than expected end to the 2022/23 fiscal year was followed by a particularly poor start to the new fiscal year. April monthly data confirmed our long-held and rising concerns about the knock-on effect of structural hurdles to economic activity, falling commodity prices and weaker global growth on tax revenue collections, with specific reference to corporate taxes. National Treasury reported a main budget deficit of R67.5 billion for the first month of the new fiscal year, which is significantly larger than the R45 billion for the same month last year. The wider deficit was the result of a significant year-on-year shrinkage in tax revenue receipts, which included a 10% decrease in VAT receipts. While May monthly data reflected a slightly better picture, the fact remains that sustained weak economic growth poses a significant risk to domestic fiscal sustainability.

Following a bad start, the local bond market regained some lost ground by quarter end

While bond yields started rising in April, the biggest damage to returns occurred in May, when yield curve bear steepening caused longer-dated bonds in the 7- to 12-year and 12+ year maturity bands of the FTSE JSE All Bond Index (ALBI) to render returns of -5.33% and -5.77%, respectively. The inflation-linked bond (ILB) market did not manage to escape the investor flight out of RSA Government bonds. The negative capital impact of rising real yields more than offset the buffer from inflation carry, causing the FTSE JSE Government Inflation-linked Bond Index (IGOV) to render a return of -2.40% in May. The market weakness during April and May dragged both ALBI and IGOV returns down to levels well below that of cash for the first five months of this year.

Improved market conditions in June, following the sharp increase in yields in April and May, contributed to limiting the losses in an otherwise tumultuous quarter. The improved local backdrop was on the back of increased momentum to the local disinflation trend, both at the consumer and producer levels - evidence of some resilience to economic activity and a marked improvement in the electricity supply situation in June. This forced some short covering in both the currency and bond markets and a partial pull-back in nominal bond yields.

As a result, the nominal bond curve bull flattened in June (with shorter-dated yields decreasing more than longer-dated yields) and partly offset the capital losses incurred earlier in the quarter. Over the quarter, the ALBI rendered a return of -1.53%, with the highest drawdown of -2.59% by bonds in the 12+ year maturity band. The IGOV rendered a return of -0.84%, with a cash return of 1.87% topping the pile of the interest-bearing asset class for the quarter.

Figure 4: Bond market index returns (periods ending 30 June 2023)

Source: IRESS, Futuregrowth

THE TAKEOUT: While the rate of inflation, both at consumer and producer levels, was ever so slowly grinding lower, investors turned their focus to the devastating impact of the numerous structural failures on South Africa’s economic growth prospects and performance. Apart from the continued weakening of the economic backdrop, at least in part due to poor macroeconomic management, the political fall-out from the South African/Russian alliance also contributed to a sharply weakening currency. Concern about the impact of sustained intensified loadshedding on costs and a sharply weaker rand compelled the SARB to increase the repo rate by another 50bps to 8.25%. While the US deficit ceiling played a role, sharply worsened investor appetite for South African financial assets caused a significant jump in both nominal and inflation-linked bond yields in April and May. Some improvement to the backdrop in June, including a significant reduction in the intensity of loadshedding together with cheaper market valuation, lured investors back into bonds, which allowed the bond market to regain some lost ground. Even so, the performance of the ALBI for the second quarter was still a dismal -1.53%, bettered by the IGOV which rendered a return of -0.84%. Cash ended in first position across the interest-bearing asset class, with a decent 1.87% return for the quarter.