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Cyclical gains to buffer structural pains

  • 14 August 2023
  • 10 min read
cyclical gains to buffer structural pains desktop

Investor sentiment rebounds in July

Loadshedding intensity remained arduous to growth in July, but the combination of constrained demand, reduced plant breakdowns and planned maintenance contributed to improved energy availability during the month. The reduction in this idiosyncratic risk was accompanied by a moderate revival in broader financial market risk sentiment, as the dollar index reversed some of its recent gains and foreign selling of local government bonds abated. Nonetheless, the share of foreign holdings of SA government bonds remained at a near multidecade low of 25.6% in July, a participation rate that will need to perk up to sustain a significant contraction in nominal bonds yields from their prevailing highs.

While the domestic macroeconomic backdrop remains challenging, the cyclical support provided by a strong disinflation trend should lend support to the stabilisation and marginal receding of bond yields, particularly for short-to-medium dated fixed rate bonds. From a strategic perspective, the receding of longer-dated yields bears heavier reliance on the fiscal backdrop, with the year-to-date evidence increasingly confirming the significant execution risk relative to National Treasury’s expectations of moderate fiscal consolidation for the current year and years ahead.

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

Source: National Treasury, Futuregrowth

The disinflation trend gains momentum

Headline consumer price inflation for June slowed to 5.4% year-on-year, marginally undershooting our and market expectations and moved back within the South African Reserve Bank (SARB)’s 3-6% inflation target band for the first time since April 2022. Inflation at the Producer level also surprised to the downside in June, with the headline rate declining to 4.8% year-on-year, its lowest level since February 2021. While now comfortably within the target band and considerably below the 7.8% peak in July 2022, consumer price inflation remains higher than the 4.5% mid-point preferred by the SARB Monetary Policy Committee. Moreover, the SARB will remain uncomfortable with the recent uptrend in inflation expectations that was reported in the Q2 Bureau of Economic Research (BER) survey.

Figure 2: Consumer and producer price inflation are rapidly rolling over

Source: IRESS, Futuregrowth 

The South African Reserve Bank takes a hawkish pause

The SARB MPC voted to retain the nominal repo rate at 8.25% in July, with two members voting for a further 25 basis point (bps) increase and the remaining three members voting to maintain the current policy stance. Despite easing inflation at the consumer level, the Governor delivered a decidedly hawkish statement, highlighting the prevailing upside inflation risk and heightened data dependency of forthcoming monetary policy decisions. While we acknowledge the risks, particularly those posed by loadshedding and rand depreciation, the pause in the hiking cycle heightens our conviction that a nominal repo rate of 8.25% marks the peak in this cycle, with a prolonged pause in the nominal policy rate in the months ahead. The combination of a hawkish SARB, unlikely to cut interest rates quickly or materially, and only marginal moderation in headline consumer price inflation in the months ahead will contribute to an elevated and thus restrictive real monetary policy rate in the medium-term.

Figure 3: The South African inflation-adjusted repo rate moved deeper into positive territory in July 

Source: Bloomberg, Futuregrowth 

Local economic activity paints a mixed picture in July

A broad trend throughout the second quarter was the surprising resilience in high frequency economic data to the sharp decline in electricity generation. Unfortunately, the evidence for the quarter-to-date period paints a slightly more varied picture. Manufacturing production grew by 2.5% year-on-year in May, only the second positive annual growth rate for the year, but also meaningfully propped up by the base effects of the destructive flooding in KwaZulu-Natal a year go that negatively impacted the sector. On a month-on-month basis, mining, and manufacturing production both contracted, by -3.8% and -1.3%, respectively. These contractions coincided with the continued significant receding in electricity consumption and production, which declined by -7.8% and -9.0% year-on-year, respectively – marking the 20th consecutive month of declines for electricity production. Positively, the labour-intensive tourism sector continues to recover, with foreign tourist arrivals growing by 54.7% year-on-year in May. Freight volumes also continue to show pleasing signs of resilience to and recovery from the generally challenging macroeconomic backdrop.

Early evidence of fiscal execution risk emerges

The budget deficit for the fiscal year ending March 2023 ended at 4.7% of Gross Domestic Product (GDP), slightly wider than the 4.5% formal estimate by National Treasury. Although this marks the smallest budget deficit since 2019, the combination of elevated expenditure pressure, slowing tax revenue growth, and 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 has been followed by a challenging start to the new fiscal year. Data for the month of June, historically a crucial month for corporate income tax receipts, confirmed our concerns about the knock-on effect of structural hurdles to economic activity, falling commodity prices and weaker global growth on tax revenue collections. Specifically, year-on-year corporate income tax receipts shrunk by 22% on a fiscal year-to-date basis relative to the 1% forecast by National Treasury for the 2023/24 fiscal year. The buoyancy in personal income tax has buffered some of this underperformance, but the warning signs loom large for significant fiscal underperformance relative to estimates that National Treasury presented in the 2023 Budget.

The local bond market continues to recover some lost ground

July marked a month of improved market conditions, following a tumultuous second quarter. The improved local backdrop was jointly attributable to broad-based dollar weakness and moderately improved appetite for risk assets, the increased momentum of the local disinflation trend at both the consumer and producer level and continued evidence of a stabilisation of domestic energy availability. This forced some short covering in both the currency and bond markets and a partial pull-back in nominal bond yields. Additionally, July is a significant coupon month in the domestic bond market, with the market benefitting from a clear bidding bias into the month as investors sought to reinvest their coupon receipts.

As a result, the nominal bond curve bull steepened in July, with shorter-dated yields decreasing more than longer-dated yields. Despite the bull-flattening, the ALBI +12 year was the best performing segment of the curve, returning 2.54% for the month as it benefitted from its higher interest rate sensitivity relative to shorter maturity segments of the nominal bond curve. The ALBI Index rendered a monthly return of 2.29%, outperforming the broader interest-bearing asset class. IGOV rendered a monthly return of 1.49% and cash a comparatively modest return of 0.67% for the month.

Figure 4: Bond market index returns (periods ending 31 July 2023)

Source: IRESS, Futuregrowth

THE TAKEOUT: The domestic disinflation trend has firmly taken root, with year-on-year headline consumer price inflation back in the central banks’ inflation target band for the first time since April 2022 and producer price inflation growing at its lowest year-on-year rate since February 2021. Despite receding price pressures, and the vote to retain the repo rate at 8.25% at the July MPC, the Governor’s statement remained decidedly hawkish, warning of the upside risk to the inflation outlook and the pervasive effect of the various structural impediments on trend inflation. We share the Governor’s concerns, but the pause in the hiking cycle nonetheless heightens our conviction that the 8.25% repo rate marks the peak of the current interest rate cycle, with a prolonged pause now to follow. Alongside improved global risk appetite, this backdrop contributed to the outperformance of nominal bonds relative to cash and inflation-linked bonds for the month. The ALBI Index rendered a monthly return of 2.29%, outperforming the broader interest-bearing asset class. The IGOV rendered a monthly return of 1.49% and cash a comparatively modest return of 0.50% for the month.

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