Worsening budget dynamics, foreign investors go on selling spree, bearish yield curve steepening
Failed economic recovery and accelerating fiscal slippage
The two main drivers of our current investment theme (“When low economic growth becomes bond bearish”), slipped further during the last quarter of 2019. In terms of economic growth, actual activity data failed to deliver good news, while the outlook certainly darkened in part due to severe supply disruptions to the national electricity grid. On the fiscal side, the delivery of the 2019 Medium Term Budget Policy Statement (MTBPS) in October spooked financial markets in a similar vein to 2017. Against a much weaker macroeconomic backdrop than anticipated earlier this year, tax revenue collections kept underperforming, while an earlier call for mandatory expenditure cuts was abandoned. Moreover, underperforming state-owned enterprises (SOEs) once again took a bigger slice of the budget than earmarked earlier this year.
// THE TAKEOUT
WORSENING BUDGET DYNAMICS
The main budget deficit for the 2019/20 fiscal year is now estimated to widen to 6.2% of GDP, compared to the original target of 4.7% of GDP set in the 2019 February budget. With nowhere to hide, government is once again forced to turn to financial markets with a higher borrowing requirement. The bulk of this is to be funded in the local market, leading to an acceleration in new issuance of both nominal and inflation-linked bonds (ILB). Ultimately, the worsening budget dynamics make it impossible for the debt-to-GDP ratio to stabilise over the forecast horizon.
Figure 1: Debt-to GDP ratio: Heading higher…and at an accelerating pace
Source: National Treasury, Futuregrowth
Moody’s rating agency painted into a corner
The significant worsening of the fiscal outlook left Moody’s rating agency, the only agency with an investment grade rating for the country, with no choice but to change the sovereign rating outlook from stable to negative. This opens the door for a rating downgrade to sub-investment in 2020, which would result in the exclusion of the country from the FTSE World Government Bond Index. In turn, this will force index tracking investors to reduce their exposure to South African (SA) local currency bonds, and unless matched by demand from index unconstrained investors, will cause bond yields to rise.
// THE TAKEOUT
FOREIGN INVESTORS GO ON SELLING SPREE
It comes as no surprise then, that foreign investors sold R33bn of local currency RSA government bonds on a net basis for the 2019 calendar year. Of this, 85% comprised of nominal bonds. This still leaves about 37% of government bonds in the hands of non-resident investors, down from the peak of 43% we saw in March 2018. There’s therefore still plenty of RSA government bonds to go around if they collectively decide to sell more.
Figure 2: Moody’s is lagging the market…SA is already priced as a sub-investment sovereign borrower
Source: Bloomberg, Futuregrowth
Positive developments elsewhere drowned-out
Inflation, both at consumer and producer levels, continued to reflect relatively subdued price pressure. With both headline and core annual inflation rates hovering around the mid-point of the central bank’s 3% to 6% target range, stability at the front end of the yield curve still seems like the most realistic outcome for the immediate future.
Another snippet of positive news originated from the external trade account, where recent monthly trade balances remained in positive territory, mainly as a result of a sharp drop in merchandise imports.
Nominal bond yield curve bear steepened as long dated yields increased most
As would be expected, both nominal and ILB yields spiked in response to the worse than expected 2019 MTBPS. With the short end of the yield curve anchored by a benign inflation outlook, as well as, a reasonable expectation of a stable repo rate path, it was up to the back end of the yield curve to adjust higher.
In terms of the 10-year point, the yield of the R2030 initially increased sharply from 9.00% at the end of September to 9.27% in response to the MTBPS, but managed to claw back losses to close the quarter at 9.02%. In contrast, the yield of the 30-year point (R2048) jumped by 37 basis points (bps) steady disinflation growth and afrom the September close of 9.93%, the highest since October 2017, before recovering some lost ground to end the quarter at 10.06%.
Developed market bond yields stabilised and even rose in some cases
The local market cannot function in complete isolation. A tidal wave of negative-yielding debt, estimated to have peaked at US$17 trillion in the third quarter, lost some momentum as yields backed away from historically low levels during the last quarter of the year. In the case of the United States (US) Treasury market, the yield of the 10-year bond increased by a significant 43bps from the 2019 low of 1.47% to close the quarter at 1.92%.
The ILB market remains under pressure
The local ILB market had to deal with both rising primary issuance following the weaker fiscal situation and stronger than expected disinflationary forces. While the latter erodes the inflation carry component of ILB return, it also reduces the demand for inflation protection, in turn worsening the supply/demand imbalance.
// THE TAKEOUT
CONTINUED PRESSURE ON REAL YIELDS
In the case of the 10-year point (I2029), the real yield closed the quarter at 3.70%. This was 29bps higher than the level at the end of September and well above the 2019 low of 2.90%, recorded in May.
// THE BOND MARKET RECAP
NOMINAL BONDS TOOK PODIUM POSITION - AGAIN
JSE All Bond Index (ALBI): A strong finish for nominal bonds helped ALBI record a total return of 1.7% for the fourth quarter, with bonds in the 3-to 7-year maturity band rendering the highest return.
JSE Inflation-linked Government Bond Index (IGOV): Rising real yields and a weaker inflation adjustment turned out to be the downfall for the IGOV as it disappointed with a -1.0% total return for the quarter, well below the cash return of 1.5%.
For the 2019 calendar year, the importance of accrual or carry, was highlighted by the fact that the ALBI rendered a great performance, especially considering the headwinds described above – a classical example of “bad news is already reflected in the price of nominal bonds”. For the year, the ALBI returned an inflation-beating 10.6%, way ahead of the IGOVs 2.4%. Cash rendered a return of 6.6%.
*See the PDF version for the overview of our Macroeconomic outlook, investment view and strategy, economic indicators and forecasts.
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 - or even a recession. Even so, we are of the view that authorities have, and still are prepared to, adjust relatively quickly to avoid a broad-based collapse in economic growth. In this sense, the recent tick-up in global bond yields seems most appropriate, especially in light of our earlier call that yields have gone too low. However, given the level of uncertainty about the growth outlook, and especially the role that international trade friction plays, developed market government bond yields may remain trapped at these somewhat higher levels for a while.
Locally, our main concern regarding the bond market remains the strong link between lacklustre economic growth and the lack of fiscal consolidation. More specifically, this points to the rising debt burden of the state, which arises 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 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, we also noted slow progress at rehabilitating institutions like the SA Revenue Services. In the midst of despair, as a responsible investor, we are also keenly keeping on the look-out for any green shoots, specifically with regards to efforts to fix broken institutions.
We maintain our view of a stable policy path from here on. That said, 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 with regards to sector allocation.
// INVESTOR TAKEOUT
With the above in mind, 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 consider the fact that long-dated nominal bonds are currently trading at an attractive real yield of around 5% to 6%, depending 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 one where we would utilise bouts of market weakness to add to those stocks that offer the best balance in terms of base accrual and limiting capital loss.
In the case of our Core Bond Composite (benchmarked against the ALBI), our view is expressed as follows: