Policy uncertainty upends markets in February

MAGA BUOYS EUROPEAN GROWTH PROSPECTS

We had outlined heading into 2025 that politics would have an outsized influence on financial market returns and volatility in the years ahead – and so it’s proving to be.

The Trump administration has swiftly pursued its Make America Great Again (MAGA) objectives, which centre on creating a “golden age” of elevated, non-inflationary economic growth by protecting American industry via trade tariffs. This will be achieved while deporting millions of migrants, easing tax policy, and halving the fiscal deficit.

Emboldened by a sweeping Republican electoral victory, these incompatible electoral promises have morphed into a deluge of executive orders and policy directives, which have so far only served to sap US financial markets and economic participants of confidence and certainty – the illusionary bedrocks of spending and investing. This has dented the “US exceptionalism” narrative, and rather than providing a boost to the US and global growth outlook, as many had expected, the US now poses near-term downside risk. This uncertainty has contributed to a dovish pivot in the forward rate market, which is now almost fully priced for three Federal Funds Rate cuts by year-end, despite the trade war risk.

In Europe, the broad trends from the “Year of Democracy” continued in the German national elections in February, with incumbents and the political centre losing ground. High voter turnout and pivot to the extremes of the political spectrum reflect a disillusioned electorate, frustrated by high inflation and economic stagnation. Ironically, the isolationist MAGA policies, which include restraining US North Atlantic Treaty Organization (NATO) contributions and military support for European allies, have laid the grounds for increased fiscal expenditure on state security and infrastructure in Germany and the broader Euro area. This has strengthened medium-term growth prospects and buoyed European financial markets.

In the East, China is battling to avoid the “Japanification” of its economy - marked by deflation and stagnation. While there are parallels between present-day China and Japan in the 1990s (including demographics and an overleveraged real estate market), there are also key differences, such as China’s lower GDP per capita and the seemingly sufficient macro policy room to stimulate the economy. The Japanification of the Chinese economy is avoidable, but a laboured macro policy response raises uncertainty. Until then, South Africa and China’s major trading partners will continue to enjoy the strong disinflationary impulses from that economy.

GNU optimism yet to translate to tangible economic gains

Domestically, headline consumer price inflation increased by 3.2% year-on-year in January from 3.0% in December. This is the first print from the recently reweighted basket of consumer goods, reflecting updated consumption patterns across South African households. While we expect consumer prices to rise in 2025, inflation expectations remain well-anchored towards the South African Reserve Bank’s (SARB) 4.5% inflation target. In the near term, the benign inflation outlook will be supported by threats to global growth and easing energy prices. Beyond this, escalating trade tensions risk disrupting supply lines and threaten long-term producer and consumer price stability.

This backdrop will challenge the SARB’s conservative monetary policy management in this interest rate cycle, with elevated real interest rates limiting cyclical growth potential. However, it’s important to differentiate between the potential cyclical growth upside from lower interest rates and the significantly higher structural growth needed to address South Africa's fiscal and socio-economic challenges. The responsibility for the latter falls on the other organs of state – and will serve as the ultimate measure of success of the Government of National Unity (GNU). While the GNU has buoyed investor and consumer confidence, often reliable leading indicators for aggregate economic growth, there’s currently little feed-through, judging by the underwhelming 0.6% quarter-on-quarter real growth rate in the fourth quarter of 2024. Alongside stable electricity production, we expect improvements in port and rail logistics in the coming months and years to help remove a key constraint to higher structural growth outcomes.

The fiscal estimates tabled in the medium-term budget are pragmatic and credible. They strike a suitable balance between a continued commitment to debt containment, social security, and growth-enhancing capital formation. We believe the fiscal path committed to by National Treasury is attainable. However, fiscal flexibility remains a constraint for government finances in the medium term as evidenced by the need to increase the VAT rate by a cumulative 1% to alleviate expenditure pressures. This also reflects the political will to adopt unpopular measures in the interest of fiscal responsibility. That said, as a small, open economy, South Africa remains significantly exposed to exogenous shocks, with little room to effect meaningful counter-cyclical fiscal measures in the event of an economic downturn. This is particularly relevant in an increasingly hostile global environment.

Inflation-Linked Bonds outperform in the interest-bearing asset class

The domestic nominal yield curve shifted higher during the month. The ALBI 1-3 years was the best-performing segment of the nominal bond curve, returning 0.50% in February, relative to the ALBI total return of 0.07%. Cash, represented by the STeFI Call Deposit Index, returned 0.56% in February, while the IGOV Index, comprised of sovereign-issued local currency inflation-linked bonds (ILBs), led the interest-bearing asset class with a return of 0.99%.

Figure 1: Bond market index returns (periods ending February 2025)

Source: Futuregrowth

THE TAKEOUT: The Trump administration has hit the ground running in pursuit of its incompatible MAGA objectives, hampering investor and consumer confidence and heightening market volatility. This has dented the “US exceptionalism” narrative, and far from offering a tailwind to the global growth outlook at the onset of the year, the US now poses near-term downside risk. Domestically, while we expect consumer prices to rise in 2025, inflation expectations remain well-anchored towards the SARB’s 4.5% inflation target. This will challenge the South African Reserve Bank’s (SARB) conservative monetary policy management in this interest rate cycle, with elevated real interest rates unduly throttling cyclical growth upside.

Our investment view and strategy 

Politics will play a major role in the performance of financial market assets in the months and years ahead as the Trump administration pursues its “Make America Great Again” agenda. So far, this policy path has only served to undermine investor and consumer confidence – the bedrocks of spending and investing. Heightened market uncertainty will spill over into weaker macroeconomic growth outcomes in the near term and renew expectations for Federal Reserve rate cuts. This backdrop also supports the case for domestic monetary policy easing, given modest economic growth conditions and stable inflation expectations.

Locally, government finances show nascent signs of stabilisation but will remain an important watchpoint in our management of local currency bonds due to the strong link between macroeconomic conditions and government finances.

The confluence of a seemingly stabilising fiscal position and an easing monetary policy cycle provides a favourable backdrop for nominal interest rate risk. However, the strong market response since the national elections in May 2024 has compressed the risk premium in domestic nominal bonds, opening the door to potential near-term return reversion. Our yield curve position across nominal bond funds aims to strike a balance between the carry and roll-down potential offered by medium-dated bonds in this phase of the interest rate cycle. Additionally, the sovereign risk premium and inflation carry in ILBs remain attractive, offering tactical trading opportunities relative to cash and nominal bonds in the coming months.

THE TAKEOUT: Our investment strategy aims to strike a balance between: 1) capitalising on the base accrual (carry) on offer, especially relative to cash;

2) participating in the roll-down potential offered by short-dated bonds; and

3) active modified duration management, seeking to maximise capital gain opportunities.

We marginally favour ILBs over fixed rate nominal bonds in the near term, guided by the favourable capital return potential offered by the asset class.

Table 1: Key economic indicators and forecasts (annual averages)