Local Fiscal Consolidation Amidst Hawkish Central Banks and Global Banking Turmoil

Global developments cause significant market volatility

During the first quarter of 2023 global financial markets were trapped by the monetary policy implications of stickier inflation on the one hand and concerns about the health of the global banking sector on the other. The latter, which was caused by the collapse of Silicon Valley Bank and Signature Bank in the USA, quickly raised contagion concerns about the financial health of Credit Suisse and several other major banks in Europe. These developments had opposing impacts on monetary policy expectations and thus market responses.

Earlier in the quarter, the more prominent global bond markets, including the US Treasury market, had to contend with a more challenging backdrop related to slower-than-expected disinflation, and more evidence that earlier recession risk had faded somewhat. This lured interest rate bears back as expectations of policy easing as early as later this year had to be 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.

During March, the unfolding banking crisis led to global risk aversion. This risk aversion turned out to be another factor allowing the US dollar to remain well bid. In the case of the US Treasury market, this short-lived flight to safety forced yields sharply lower and thus exposed investors in this market to significant volatility during the quarter. After reaching a peak of 4.06% earlier this year on the back of sticky inflation and monetary policy concerns, the yield of the 10-year US Treasury bond decreased sharply by around 50 basis points (bps) following the banking sector-induced safe-haven trade. Monetary policy expectations also caused the US Treasury curve to be particularly volatile and to end the quarter inverted. Concerns about the broader banking sector receded towards the end of March, in turn illustrated by the VIX (a measure of market fear), which pulled back from levels above 30 to 19. The return of some market calm also caused longer-dated US Treasury yields to retrace to higher levels as the earlier rush for relative safety lost momentum. 

Figure 1: Volatility in the VIX index remains elevated with the latest flareup coming as a result of the banking sector crisis

Some of the risk aversion was taken off the table as both monetary authorities and the private banking sector stepped in to stabilise matters in the global banking sector. In addition, some of the major central banks went the extra mile to reiterate their main policy objective of taming the inflation monster by tightening monetary policy further, even in the face of weak economic growth and banking sector jitters. Among the major advanced economies, the US Federal Reserve and the European Central Bank raised their policy rates by 0.25% and 0.50% respectively, citing sticky inflation at unacceptable levels relative to their respective targets. In the case of the Fed, the latest, smaller increase also served as confirmation of a slowdown in the pace of policy tightening.

Intention Confirmed 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 2022/23 fiscal year is commendable, investor focus has already turned to the 2023/24 fiscal year and beyond. The main challenge for the 2022/23 fiscal year was 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 comprehensive note on our thoughts on the Eskom debt relief proposal.

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 was 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.

From a funding perspective, National Treasury has sought to further develop the local currency nominal, inflation linked (ILB) and floating rate bond (FRN) curves with the issuance of new instruments in each of these markets. The 8-year maturity I2031 ILB was issued for the first time at the last ILB auction in March, with the first issuance of both the 30-year maturity R2053 nominal bond and 7-year maturity floating rate note scheduled for April.

Figure 2: 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, Despite a Pick-up in February

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, this trend was disrupted by the year-on-year Headline Consumer Price Index reading of 7.0%, which was slightly higher than the previous month’s reading of 6.9% and higher than market expectations at the time. Core CPI also remained sticky at 5.2%. Even so, the broader trend remains one of disinflation. This is confirmed by the latest data on the production side of the economy. While still at a high level compared to CPI, the rate of increase for final manufactured goods eased to 12.2% year-on-year in February from 13.5% in December. The deceleration in the rate of increase was across a broad range of products, including intermediate manufactured goods and agriculture inflation.

As Feared, South Africa was Greylisted

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 business confidence in the country, we maintain that the direct market impact will be limited as none of this comes as a surprise.

The SARB Maintains a Hawkish Stance

The SARB proved the market (and us) wrong by lifting the repo rate by more than we anticipated in the first quarter of this year. The combination of sticky and high inflation in many advanced economies, the slow shift to local disinflation, perceived upside risks due to renewed currency weakness, intensified loadshedding and rising inflation expectations convinced three of the five monetary policy committee members to support a larger than expected 50bps at the March meeting. The concern about risks to the inflation outlook is striking considering its downward economic growth revision to 0.2% for this year. The SARB raised the repo rate by a cumulative 75bps during the first quarter of this year to 7.75% - 1.5% above its pre-COVID level. Considering the February Headline CPI reading of 7.0%, the real repo rate is at 0.75% and is expected to increase significantly in the next few months as we continue to expect disinflation to regain momentum.

Figure 3: The South African inflation-adjusted repo rate back in positive territory and expected to rise sharply to pre-COVID levels

A Strong Quarter for Nominal Bonds Despite Recent Market Turmoil

The nominal bond market came 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 March and, in the process, detracted from the exceptionally strong performance earlier this year. Even so, the exceptionally strong January market performance allowed the FTSE JSE All Bond Index (ALBI) to render a return of 3.39% for the quarter, with bonds in the 7- to 12-year maturity band outperforming ultra-long-dated bonds as the yield curve bear steepened. In contrast, the inflation-linked bond market (ILB) managed to recover some lost ground in March following a very weak start to the year. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned 0.87% for the quarter, a significant swing from the -1.05% recorded in January. Cash rendered a return of 1.70%, slightly better than the returns offered by ILBs.

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

The Takeout

Globally, financial markets were exposed to a disruptive mixture of sticky inflation, hawkish central bank talk, a two-speed economic recovery and a banking sector scare. Intervention by central banks as well as the private banking sector brought about some sanity and calm, but only following significant market volatility, including the US Treasury considering its safe-haven status. Banking sector concerns failed to derail central bank focus on fighting sticking inflation. Locally, the Ministry of Finance managed to strike a commendable balance between an ongoing commitment to fiscal consolidation and addressing the Eskom debacle in the delivery of the annual national budget in February. While the South African disinflation trend still seems on track, the trend was disrupted by medical aid premium increases, sticky food prices and the more rand-sensitive components as the Consumer Price Index ticked slightly higher in February. A very hawkish South African Reserve Bank surprised all by adjusting the repo rate by 50bps at the March Monetary Policy Committee Meeting, for a cumulative increase of 75bps to 7.75% during the first quarter. To add insult to injury, South Africa was also grey listed by the Financial Action Task Force, although the market impact, as expected, was overshadowed by other global and local developments. Against this backdrop, nominal bonds (ALBI) lost some ground in February and the early part of March. However, the exceptionally strong start to the new year and the return of the bulls at quarter end enabled the ALBI to render a decent return of 3.4% for the first three months of 2023, outperforming both inflation-linked bonds (IGOV) and cash, which returned +0.9% and 1.7%, respectively.