Coalition Nation

GNU buoys market expectations

The age of single party dominance in South African politics is over. The pre-election polls were accurate in their predictions of the African National Congress’s (ANC) sharp electoral decline and the meteoric rise of the recently formed uMkhonto we Sizwe party. This rejection of incumbency and the political centre by the electorate mirrors the experience across peer emerging markets that have recently gone to the polls, including Mexico and India. While the composition of the 7th democratic government remains unclear – with lingering risk that ideological differences may still yield policy and implementation gridlocks – bond markets have been buoyed by the promise of a Government of National Unity (GNU) and the advocacy for constitutionalism and the reform agenda driven by Operation Vulindlela by the major parties at the negotiation table.

While political uncertainty lingers both domestically and abroad, with more than 2 billion people due to vote in 2024 , the path for interest rates became clearer with the European Central Bank (ECB) Governing Council confirming the peak in its monetary policy cycle by cutting the nominal policy rate by 25 basis points in May. Christine Lagarde and her Governing Council colleagues were clear to caution the market against expectations of sequential interest rate cuts, but the move confirms the peak in the interest rate cycle. Monetary policy calibration will remain highly data dependent, with a further cooling of inflation expectations necessary to spur a faster and deeper interest rate cutting cycle. Until then, real rates will remain elevated.

Figure 1: Real central bank policy rates

Source: Bloomberg, Futuregrowth

The Federal Reserve Bank (Fed) faces a wider inflation gap, with year-on-year consumer price inflation stuck well above its 2% target level. However, inflation expectations remain reasonably contained, and provide room for policy cuts once Chairman Jerome Powel and his Federal Open Market Committee colleagues find comfort with the sustainability of the disinflation trend. Outsized consumer savings have coincided with the stickiness in consumer prices in recent years. Indications that these savings have now been depleted lays the grounds for moderating consumer spending and an eventual slow and shallow interest rate cutting cycle.

Rates have peaked, shallow cuts to follow

Domestic headline consumer price Inflation (CPI) receded marginally to 5.2% year on year in April from 5.3% in March. While consumer inflation remains elevated and sticky, April marks the second consecutive month of inflation surprising to the downside relative to median market expectations. These downside surprises have been aided by muted food price pressures, against our expectations of upside risk stemming primarily from the El Niño weather pattern and the related cuts to expected maize harvests. Contained global food inflation, when lagged by 7 to 9 months, is highly correlated to domestic food inflation and will continually serve to stem domestic price pressures in the medium-term.

We remain of the view that the local nominal repo rate has peaked at 8.25% in the current interest rate cycle. Despite the already elevated real rate environment, the South African Reserve Bank (SARB) will remain hawkish until convinced that domestic consumer price inflation has moved sustainably towards the 4.5% year-on-year midpoint of the inflation target band. We think that this comfort can be reached in the third or fourth quarter of 2024, allowing for a shallow and gradual interest rate cutting cycle.

Figure 2: South Africa Forward Rate Agreement (FRA) Rates

Source: Bloomberg, Futuregrowth

Macro reforms remain key to stimulating growth

Domestic macroeconomic headwinds persisted in the first quarter, evidenced by the contraction in Gross Domestic Product (GDP) growth in the period, despite the relenting electricity constraint. GDP growth surprised to the downside, contracting by 0.1% quarter on quarter, relative to surveyed expectations of 0.1% growth. Year-on-year growth also grew by a modest 0.5%. Expenditure data points to a broad-based contraction in aggregate economic activity, heavily influenced by the impact of port, rail and logistics disruptions and inefficiencies. The reforms driven by Operation Vulindlela remain key to loosening these constraints and liberating economic activity.

High frequency macroeconomic indicators in April and May don’t suggest a change in fortunes for aggregate growth in the second quarter of the year, with modest and volatile manufacturing and mining production growth statistics. Consumer readings also continue to paint a mixed picture in the second quarter, with wholesale and retail trade gaining in year-on-year terms in March, but passenger vehicle sales remaining sluggish. Against expectations of modest growth, private sector credit extension also moderated in April, growing at a sluggish 3.9% year on year relative to 5.2% in March. In real terms, credit extension has stalled, and will remain a continued headwind to aggregate economic growth with monetary policy anchored in restrictive territory. Credit lending standards have not been key determinants of monetary policy in the current hiking cycle, but they nonetheless highlight the weakness of aggregated demand (particularly for households) and will lend support to the arguments for monetary policy easing in the second half of 2024.

NHI muddies the waters

Monthly fiscal data for April met expectations of a seasonally large budget deficit of -R78 billion. This follows the confirmation of a 4.6% budget deficit relative to GDP for the for the 2023/24 fiscal year relative to the 4.7% tabled in the national budget in February. This improvement on expectations was supported by both expenditure constraint (against our expectations in an election year) and revenue outperformance – the hallmark of an increasingly capacitated and efficient revenue service. The expenditure outperformance is particularly commendable, with spending having exceeded our fiscal year-to-date estimates by 0.2% - 0.3% for the greater part of the year.

Fiscal flexibility remains a constraint for government finances in the medium term. The hasty, pre-election, signing in of the National Health Insurance (NHI) bill will serve to further constrain government finances – although implementation was always due to be phased in over time and might yet be hindered by litigation. In our estimation, based on the current fiscal framework, debt sustainability will only be achieved when real GDP growth approaches 3% per annum – a low water mark in an emerging market context, yet meaningfully removed from South Africa’s growth trend of 1% - 2% in the past decade. The liberation of electricity production is a first important step to stimulating growth, with the now prolonged absence of loadshedding lending hope to better days ahead. The other policy initiatives driven by Operation Vulindlela also remain key to stimulating aggregate growth, in particular the stabilisation and eventual improvement of port and rail logistics. This remains a key watchpoint for us in the soon to be constituted 7th administration of the Republic of South Africa.

Figure 3: Main budget balance

Source: National Treasury, Futuregrowth

Short-dated bonds lead the charge

The domestic nominal yield curve bull steepened in May, driven by improved risk appetite from local and foreign market participants. ALBI 1-3 years was the best performing segment of the nominal bond curve, rendering a total return of 1.03% relative to the ALBI total return of 0.75%. Cash, proxied by the SteFI Call Deposit Index, rendered a return of 0.67% for the month, with the IGOV Index, comprised of sovereign issued local currency inflation-linked bonds (ILBs), rendering a return of -0.83%.

Figure 4: Bond market index returns (periods ending May 2024)

Source: IRESS, Futuregrowth

/// THE TAKEOUT: The age of single party dominance in South African politics is over. While the composition of the 7th democratic government remains unclear, bond markets have been buoyed by the promise of a Government of National Unity and the advocacy for constitutionalism and reforms. While political uncertainty lingers both domestically and abroad, the path for interest rates became clearer with the ECB confirming the peak in its interest rate cycle. We expect the Fed to follow suit in the second half of 2024, once it is comfortable with the sustainability of the disinflation trend. Domestically, we deem the nominal repo rate to have peaked at 8.25% in the current interest rate cycle and we continue to expect a modest interest rate cutting cycle beginning in the second half of 2024. While fiscal metrics have recently outperformed market expectations, the hasty, pre-election signing of the NHI bill into law muddies the fiscal outlook, and risks further constraining fiscal flexibility.