Commendable Fiscal Consolidation Effort, but ...

Confirmation of Intent to Return Government Finances to a More Sustainable Path

The annual delivery of the National Budget by the Minister of Finance remains a critical event on the economic calendar, more so for the local bond market, which remains the primary funding source for the South African government. The latest estimates for the 2022/23 fiscal year confirmed broad-based expectations of a stronger outcome relative to the estimates tabled in February last year. The combination of buoyant corporate tax receipts and efficiency gains at the South African Revenue Services, which propelled tax revenue gains to an historic peak of 25.8% of GDP, were the main contributors to the revised main budget deficit estimate of 4.5% of GDP, well below the initial estimate of 6.0% a year ago.

While the outcome for the current fiscal year is commendable, investor focus has already turned to the forthcoming fiscal years. This year, the main challenge had been to strike a balance between maintaining a credible commitment to fiscal probity and finding a comprehensive solution to the huge Eskom debt overhang. Our first cautious take is that the Ministry of Finance managed to credibly deliver on committing to a primary surplus, despite freeing Eskom of an estimated 60% of its debt and interest payment obligations over the Medium-term Expenditure Framework (MTEF) that stretches over a three-year period. 

Please see here for a more comprehensive note on our thoughts on the latest budget.

Of course, many hurdles are scattered across this fiscal path. An exceptionally weak economic backdrop, worsened by an intensifying energy crisis and a weakening terms of trade, pose downside risk to tax revenue estimates. Additional pressure on expenditure, including challenging wage negotiations and ongoing support to poorly managed state-owned enterprises, also remains a challenge. While we acknowledge the commitment to continued fiscal consolidation, our base-case view for now remains one of “good intentions, but with significant execution risk”. The impact on bond market sentiment and activity had been muted since the outcome was broadly in line with expectations. Please see here for a more comprehensive note on our thoughts on the latest budget.

Figure 1: Weak economic growth, a large and rising public sector debt load and consequently high debt service costs give rise to a fragile fiscal situation

The Local Disinflation Trend Maintains its Momentum

The headline Consumer Price Index (CPI) slowed to a year-on-year rate of increase of 6.9% in January from 7.2 % the previous month. As broadly expected, the disinflation trend is progressing well, as last year’s high base lends a helping hand to year-on-year CPI moderation from the 7.8% peak reached in July last year. However, on a more concerning note are disturbing renewed price pressures related to food (load shedding related?) and the more rand-sensitive components of the CPI basket. On the production side of the economy, the January Producer Price Index (PPI) data release also confirmed the disinflation trend. While still at a high level compared to CPI, the rate of increase for final manufactured goods eased to 12.7% year-on-year from 13.5% in December. The deceleration in the rate of increase was across a broad range of products, including intermediate manufactured goods (5.6%) and agriculture inflation (11.7%).

Figure 2: The South African inflation-adjusted repo rate back into positive territory and comparing well with the rest of the world

External Trade Account Balance Rolls Over More Decisively

The January external trade balance plunged to deficit of R23.1 billion, a significant swing from December’s R5.4bn surplus. This was the largest monthly trade deficit since April 2020 and the latest in a weakening trend. The January trade deficit was mainly the result of a 14% month-on-month (m-on-m) decrease in exports, as imports only rose by around 3% m-on-m. While seasonal factors explain some of the weak export performance, the sharp drop in exports had been worse than expected and may also point to logistical constraints and inefficiencies at Transnet and South African ports. While a worsening terms of trade and its impact on the external trade account do not come as a surprise, the faster-than-expected acceleration in the pace of current account deterioration adds to a growing list of South African macro-economic challenges.

As Feared, South Africa Got Grey Listed

The Financial Action Task Force (FATF) evaluated South Africa in October 2021 and found several deficiencies in the country’s policies and efforts to combat money laundering and terrorism financing. Although the FATF, at its February plenary meeting, acknowledged that the country had made significant progress towards addressing most of the deficiencies, eight areas were highlighted as problematic. This forced it to add South Africa to the grey list. While National Treasury and the South African Reserve Bank (SARB) have committed to addressing these urgently, our view remains that a turnaround from a law enforcement implementation perspective will take some time. While this outcome adds to the already dented confidence deficit in the country, we maintain that the direct market impact will be limited as none of this comes as a surprise.

Global Developments Dent Local Currency and Bond Performance

Some of the more prominent global bond markets, including the US Treasury market, had to contend with a more challenging backdrop, which exerted upward pressure on bond yields. In the US, the combination of slower-than-expected disinflation, and more evidence that earlier recession risk had faded somewhat, lured interest rate bears back. In turn, expectations of policy easing as early as later this year had to pared back. The tweak in rate expectations contributed to a stronger US dollar and higher US Treasury yields, which in turn contributed to renewed rand weakness and some upward pressure on local bond yields.

A Weak Month Follows the Strong Start for the Year

The nominal bond market got out of the 2023 starting blocks at pace. However, the net effect of the above events forced bond yields back to slightly higher levels in February and, in the process, detracted from the exceptionally strong performance earlier this year. The FTSE JSE All Bond Index (ALBI) rendered a return of -0.87% for the month, with bonds in the 7- to 12-year maturity band performing the worst. In contrast, the inflation-linked bond market (ILB) managed to recover some lost ground as real yields grinded lower despite a lower inflation carry. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned +0.45%, a significant swing from the -1.05% recorded in January. Cash rendered a return of 0.53%, well above that of nominal bonds and still slightly better than the returns offered by ILBs. However, nominal bonds retained podium position for the first two months of 2023, with a return of 2.04%, followed by cash (+1.10%) and inflation-linked bonds (-0.61%).

Figure 3: Bond market index returns (periods ending 28 February 2023)

The Takeout

The Ministry of Finance managed to strike a commendable balance between an ongoing commitment to fiscal consolidation and addressing the Eskom debacle. While the South African disinflation trend still seems on track, food prices and more rand-sensitive components of the Consumer Price Inflation Index raise some concerns. A much larger than expected monthly trade account deficit adds to downside pressure on the balance of payments. To add insult to injury, South Africa also got grey-listed by the Financial Action Task Force. The combination of sticker inflation and reduced risks of global recession forced global bond yields higher as earlier expectations of a peak in policy rates and even policy easing had to be curtailed. Against this backdrop, nominal bonds (ALBI) lost some ground in February following the strong start for the year, with a return of -0.87%, below the +0.45% rendered by inflation-linked bonds (IGOV) and cash (+0.53%).