Our Investment Theme Keeps Darkening

Investor Sentiment Dips to New Lows

Intensified loadshedding has been ongoing for several months. While this arduous experience has become part of the average South African’s daily routine, investor concerns about the negative impact on economic growth prospects and inflation continued to increase over the period. Amongst foreign investors in particular, the disturbing possibility of a grid collapse and its devastating consequences finally proved too much to stomach. This was evident in an accelerated reduction of exposure to South African financial assets, including government bonds. Foreign shareholding of SA government bonds has now reached the lowest levels in more than twelve years.

Not only did net foreign selling impact bond valuation directly as sellers outnumbered willing buyers, but bond yields across the yield curve moved in tandem with the weakening rand as it reached a new weakest level of R19.86 against the US-dollar. 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 fall-out from an international trade perspective reduced confidence further.

While unsettling offshore developments such as the US debt ceiling soap opera 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.

The South African reserve Bank (SARB) Keeps a Firm Foot on the Tightening Pedal

The combination of sticky inflation at elevated levels (specifically relative to the official 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 SARB Monetary Policy Committee to vote for a 50 basis points (bps) repo rate increase at the May meeting. The latest increase took the repo rate to 8.25%, the highest since 2009. This increase, in combination with the deceleration of the rate of inflation to 6.8% from 7.0% the previous month, allowed the real repo rate to shift further into positive and thus restrictive territory. The repo rate is now well past the 7% peak we predicted earlier this year.

Producer Price Inflation Continues to Decelerate from a High Base

Understandably, significant focus remains on the speed of consumer price increases. Encouragingly, Headline CPI data for April slowed to 6.8% year-on-year from 7.1% the previous month. While Core CPI disappointed with a marginal acceleration from 5.2% year-on-year in March to 5.3% in April, the latest developments at the producer level continue to support our view of a more prominent disinflation trend in the next few months. The April PPI data release showed that final manufactured goods prices at the producer level had increased at a rate of 8.6% year-on-year from 10.6% the previous month. An even more pronounced price deceleration was recorded for intermediate goods and agriculture, which slowed to 4.6% and 3.7% year-on-year, respectively. The latter represents the lowest rate of increase since mid-2020. While producer food prices at 11.1% for April are still very high, base effects are expected to support the continuation of the recent sharp deceleration in the rate of increase.

We Have a Discouraging Start to Fiscal Year 2023/24

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. 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 state of 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. Data for the month of April confirmed our long-held and rising concerns about the knock-on effect of intensifying 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 an 8.8% year-on-year shrinkage in tax revenue receipts, which included a 10.1% decrease in VAT receipts. While one should refrain from drawing longer-term conclusions from one month of data, the exceptionally weak start to the fiscal year is particularly worrying and unfortunately serves as a timely reminder of the risks that weak economic growth pose to domestic fiscal sustainability.

The External Trade Account Continues to Weaken

Like most market analysts, we never expected the large surplus on the external trade account that South Africa has enjoyed in recent times (partly due to the fall-out from the Russia/Ukraine conflict that started more than a year ago) to be maintained indefinitely.  However, the April data release was the latest data point to confirm the view of a narrowing surplus and thus an overall weaker balance of payments position. The smaller April trade surplus of R3.5 billion, from R6.3 billion the previous month, was partly the result of a sharp drop in merchandise exports, mainly due to lower gold and platinum exports.    

While the Blow-Out in Bond Yields is Abysmal, Cash Comes to the Fore

Higher developed-market bond yields, sustained and significant rand weakness, aggressive monetary policy tightening by the SARB and growing evidence of a very vulnerable fiscal backdrop led to a mini exodus by foreign market participants in both the nominal and inflation-linked bond markets. We sense that the weakness experienced in the past two months is an indication of a confidence loss in the credibility of the South African government. In May, bonds in the 7- to 12- and 12+ maturity bands rendered the weakest returns of 5.33% and 5.77% respectively, as the yield curve bear steepened. The FTSE JSE All Bond Index (ALBI) rendered an overall return of -4.79%, significantly worse than the -1.11% recorded the previous month. The inflation-linked bond market (ILB) did not manage to completely escape the investor flight out of RSA Government bonds, despite sticky consumer inflation data. The negative capital impact of rising real yields more than offset the buffer from a decent inflation carry, causing the FTSE JSE Government Inflation-linked Bond Index (IGOV) to render a return of -2.40%. As a result, cash managed to handsomely outperform both nominal and inflation-linked bonds with a return of 0.63%.

The market weakness since April had been significant enough to drag both the ALBI and IGOV down to levels well below those of cash for the first five months of this year. The former returned a dismal -2.65%, followed by the IGOV return of -1.18%. In contrast, cash managed to return 2.95%. While yielding a significant positive return relative to both nominal and inflation-linked bonds, the return offered by cash still lagged consumer inflation over the period.

//The Takeout

While the rate of inflation (both at consumer and producer levels) slowly subsided, investors turned their focus to the devastating impact of power infrastructure decay on South African economic growth, price pressures, the weakening balance of payments and the impact on an increasingly vulnerable fiscal situation. Apart from the continued weakening of the structural backdrop, at least in part due to poor macroeconomic management, the political fall-out from the South African/Russian romance also contributed to a sharply weakening currency. Concern about the impact of sustained intensified loadshedding on costs and a sharply weaker rand forced the SARB to increase the repo rate by another 50bps to 8.25%. While the US deficit ceiling saga played a role, sharply worsened investor appetite for all South African financial assets caused a significant jump in both nominal and inflation-linked bond yields. As a result, the ALBI returned a disappointing -4.79% in April, followed by the -2.40% rendered by the IGOV.