Worsening budget dynamics, foreign investors go on selling spree, bearish yield curve steepening
SARB surprises on the timing of the recent repo rate reduction
The South African central bank surprised most analysts at the January Monetary Policy Committee (MPC) meeting when it decided to reduce the repo rate by 25 basis points (bps) to a level of 6.25%, the lowest in four years.
How much does this really matter? From our perspective, not that much. Even though we, like most others, did not expect policy action this soon, our investment strategy had partly been based on front-end stability, with a risk of a lower as opposed to a higher policy rate. As a result, the policy action boosted returns, particularly for those lower- risk funds with a higher holding in short/medium-dated fixed rate instruments.
Negative fiscal news keeps flowing, but it may not be as bad as it seems
For the first time since 2004, National Treasury reported a negative monthly budget balance for December. More specifically, corporate income tax (CIT) underwhelmed relative to expectations and, in the process, buckled a very strong seasonal trend (on which at least some of these expectations were built) with cumulative year-on-year growth of 2.4%, below the Medium Term Budget Policy Statement (MTBPS) targeted growth of 3.3%.
Our analysis points to a nine-month lagged positive correlation between CIT collections and gross domestic production (GDP) data. With this in mind, the December CIT collection disappointment is not a complete surprise, considering the exceptionally weak first quarter GDP data for 2019. Moreover, VAT also disappointed, which was unanticipated considering that we have seen a normalisation in VAT refunds. That said, we do notice some light down the dark fiscal tunnel. Based on historical trends, the cumulative budget deficit is still slightly ahead of the full fiscal year target of 6.2% for the fiscal year 2019/20. In addition, we are cautious about basing trends on monthly data releases, considering potential timing issues with regards to both month-end receipts and payments.
Figure 1: The forward rate market is priced for more repo rate cuts…not our base case view, but a strong possibility nonetheless.
Source: Bloomberg, Futuregrowth
Even though the latest rates of consumer and producer inflation accelerated, the outlook remains relatively subdued
Data released for the December readings of both the consumer price index (CPI) and producer price index (PPI) confirmed expectations of an acceleration in the annual rate of inflation, as measured by the respective price indices. In the case of CPI, the rate of inflation accelerated from the previous month’s 3.6% to 4.0%, which is still well within the 3.0% to 6.0% target band as well as being below the mid-point of this range. The inflation rate at the producer level jumped from 2.3% to 3.4%, with base effects being an important contributor. Although the most recent data points to the start of an upward trend, the near-term inflation outlook nonetheless remains relatively benign and well within the expected forecast range. This partly explains why the SARB opted to ease monetary policy at its last meeting.
Foreign investors are back…for now
Even though very little has changed with regards to both the investment backdrop and market valuation, foreign investor demand for South African local rand denominated bonds has picked up considerably in the first month of the new year. The net purchase number of just short of R8bn is not insignificant. One possible explanation could be the sharp yield decline in many of the larger developed bond markets, most notably the US where the yield of the 10-year Treasury bond ended the month a very significant 40 basis points (bps) lower at 1.52%.
The most recent bout of renewed foreign investor demand is even more striking considering the extent of rand weakness over the same period. The rand lost around 7% against the greenback, partly owing to some global risk aversion. In turn, this is partly in response to negative news flow related to sustained soggy global growth, concerns related to the outbreak of the Coronavirus epidemic, and little sight of an improvement in terms of the many local hurdles to higher economic growth. This includes renewed disruptive electricity load shedding by Eskom.
On the positive side, this may also be an indication of the weight of relative value in a global context, especially among the group of benchmark unconstrained investors to whom a widely expected imminent Moody’s sovereign ratings downgrade is of little significance.
Figure 2: We believe that inflation breakeven yields are still too high relative to our inflation forecast and that this favours nominal as opposed to inflation-linked bonds.
Source: Bloomberg, Futuregrowth
The nominal bond yield slope steepened in response to the repo rate reduction
The short end of the nominal bond yield curve responded in tandem to the repo rate reduction of 25bps. The yield of the R208 (maturity 2021) and that of the R186 (maturity 2026) ended the month 22bps and 23bps lower, respectively. Further out on the yield curve, the direct impact of the rate cut decreased in proportion to the term to maturity. For instance, the yield of the 10-year bond only decreased by 5bps during the month, while the yield of the longest dated bond, the R2048 (maturity 2048), increased by 2bps to close the month at 10.10%. The yield curve adjustment makes sense in light of the combination of sustained weak economic growth, a benign inflation outlook and an appropriate monetary policy response on the one hand - and a very poor and worsening fiscal backdrop with negative consequences to the last remaining sovereign investment rating on the other.
Still no relief for the beleaguered inflation-linked bond market
The local inflation-linked bond (ILB) market continues to battle the lethal combination of rising primary issuance as a result of a weaker fiscal situation and stronger than expected disinflationary forces. While the latter erodes the inflation carry component of ILB returns, it also reduces the demand for inflation protection. This, in turn, worsens the supply/demand imbalance, as the state is issuing more bonds to fund the widening budget deficit. In the case of the I2029 bond, the real yield closed the month at 3.78%. This was 9bps higher than the level at the end of December 2019 and well above the 2019 low of 2.90%, recorded in May.
Nominal bonds continue to be the top performing sub-interest rate bearing asset class
The January repo rate reduction and resulting yield curve steepening, as well as the strong demand from foreign investors, contributed to a strong month for nominal bonds. As a result, the ALBI recorded a total return of 1.2% for the month (with bonds in the 3-to 7-year maturity band rendering the highest return of 1.9%) as it benefitted most from the repo rate reduction and the resultant “roll down” the steeply sloped yield curve. The worst performing maturity bands were the 1- to 3-year and 12+year sectors. Rising real yields and a weaker inflation adjustment turned out to be the downfall for the JSE Inflation-linked Government Bond Index (IGOV), leading to a disappointing return of -0.1% for the month of January, well below both that of nominal bonds and the cash return of 0.5%.
// THE TAKEOUT
The period is characterised by the continuation of a failed economic recovery; belated monetary policy easing; and yield curve steepening through the continued fiscal slippage. In spite of this, we do notice a flicker of light down the dark fiscal tunnel.
Our investment view and strategy
At a global level, the shift from quantitative easing to tightening has stalled - and in some cases even reversed - due to a heightened fear of a global growth slowdown. Even so, we consider that authorities have adjusted, and are still prepared to adjust, relatively quickly to avoid a broad-based collapse in economic growth. Given the level of uncertainty about the growth outlook, and especially the role that international trade friction and sustained strong disinflationary forces play, developed market government bond yields may remain trapped at the lower levels for a while.
Locally, our main concern regarding the bond market remains the strong link between lacklustre economic growth and a weakening fiscal position. More specifically, this points to the rising debt burden of the state, as a consequence of the lack of fiscal consolidation. This continues to threaten the country’s sovereign risk profile and places pressure on domestic funding costs. The financial burden of poorly managed SOEs on state finances has reached a point where the delivery of a credible national budget is nearly impossible, especially in the absence of substantial remedial action for the unfolding financial disaster. The proverbial chickens, mainly in the form of Eskom, have come home to roost, and this requires more than the usual liquidity provision. Addressing solvency is an entirely different matter, requiring more than simply kicking the can down the road via more liquidity bail-outs. The presentation of the 2019 MTBPS in October confirmed our worst fears. That said, while it is hard to quantify, we did note slow progress at rehabilitating institutions like the South African Revenue Services. As a responsible investor, we pay attention to possible green shoots amidst the despair - particularly any efforts to fix broken state institutions.
We maintain our view of a stable monetary policy path from here on. Nonetheless, we acknowledge the risk of more easing in light of weak economic growth and strong disinflationary forces. From a yield curve perspective, the important point is that the short end remains well anchored, with a negligible possibility of monetary policy tightening in the near term. This remains a crucial pointer to our investment strategy, specifically for sector allocation.
// INVESTOR TAKEOUT
We continue to endeavour to strike a balance between avoiding capital loss in the case of a market sell-off, and not losing out on the accrual offered by a steeply sloped yield curve. We also note that long-dated nominal bonds are currently trading at an attractive real yield of around 5% to 6%, depending on what point on the yield curve is used as reference. Therefore, while our broad interest rate investment strategy remains defensive, the neutral modified duration position acknowledges reasonable valuation, which partly offsets the relatively poor investment theme. For this reason, our investment strategy remains to use bouts of market weakness to add to the stocks that offer the best balance of base accrual and limitation of capital loss.
In the case of our Core Bond Composite (benchmarked against the ALBI), our view is expressed as follows: