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Economic and market review 30.04.2018

Economic and Market Review

Our monthly write-up of the markets.

Bond market took a well-deserved breather

Following an eventful period since December 2017, coupled with an extended run of excellent returns, the local bond market took a breather in April. The domestic market simply ran out of fresh noteworthy news flow to enable the bull rally, kicked-started by the ANC’s December Elective Conference, to maintain its positive momentum. This despite the fact that local economic data releases were actually mildly bond supportive.

Local data releases mildly bond supportive

On the inflation front, both Consumer and Producer price indices surprised with lower than expected year-on-year readings. Two other critical data releases from a bond perspective, namely monthly external trade and national budget data, also left little food for thought for the few bears around. The former showed a sizeable surplus for the month of March, while the latter pointed to a slightly better outcome for the 2017/18 fiscal year than forecast at the tabling of the budget in February. 

Attention caught by more bearish offshore developments

Instead, local bond bears were showered with negative news sourced elsewhere. This they found in sharply rising US Treasury bond yields, higher crude oil prices and threats of increased pressure on international trade. A rise in global trade protectionism is a significant threat to small, open economies like South Africa, especially considering its strong trade ties to China. In the US, the benchmark 10-year Treasury yield jumped from 2.75%, briefly breached the 3.0% level and eventually settled at 2.96% by month end. The above international developments contributed both directly and indirectly to some rand weakness, which in turn added to upside pressure on local yields.

Bond yields rose, but still well below the November 2017 weakest point

As a result, the yield of the benchmark R186 (maturity 2026) rose 17 basis points from the previous month end to close in April at 8.18%. A similar trend was observed in the inflation-linked bond market as real yields moved upwards. In the case of the latter, lower than expected inflation data and hardening views of a more benign inflation outlook in light of the sharp appreciation of the rand over the last few months caused a collapse in the demand for inflation protection.

Poor returns for April, but year-to-date nominal bond returns still spectacular

In light of the fact that both nominal and real yield curves lifted to higher levels, bond returns ended in negative territory for the first time since November last year. Total monthly returns for the All Bond Index (ALBI) and Inflation-linked Government Bond (IGOV) indices were -0.7% and -2.7% respectively. Cash managed a return of 0.5% for April, slightly lower than previous months following the last repo rate reduction. Even so, in the case of the ALBI, total return for the first four months of the year remains an impressive 7.3% and still well in excess of the IGOV and cash returns of 1.3% and 2.2% respectively.

 

SUMMARY OF MACROECONOMIC OUTLOOK, MARKET VIEW AND INVESTMENT STRATEGY 

Key macroeconomic themes

Economic growth

A moderate global economic recovery remains our base case, with a sustained, strong US economic recovery still leading the way. The significant loosening of US fiscal policy will contribute to this, although this expansionary attempt by the US government could be moderated by tightening monetary policy. Even so, we believe that the global recovery will continue to be structurally lower than in previous cycles, mainly due to lower productivity growth, ongoing broad-based balance sheet repair (deleveraging) and shifting demographics (ageing populations tend to save more and spend less).

 Locally, the biggest impediment to higher local growth remains of a structural nature. Despite the seemingly improving socio-political backdrop, without urgent macroeconomic policy reform, any short-term cyclical upswing from the primary and secondary sectors of the economy will prove inadequate in addressing South Africa’s economic growth ills. The low growth trap largely remains the result of a policy vacuum, policy uncertainty, weak consumer and investor confidence, and a rigid labour market. Recent political developments would have lifted confidence – evidenced in the BER Consumer Confidence Index rising by 36 points to an all-time high 26 index points in the first quarter - and the intent to improve policy clarity is welcomed. While acknowledging the positive steps towards improved governance marked by the reconfiguration of Eskom’s board, state-owned enterprises still largely remain a negative risk to the fiscus, and as a consequence, to economic growth.

Inflation

The synchronised rise in energy and other raw material prices in the past few months has started showing in headline inflation numbers in many economies. Although global reflation is welcomed, since this is what policy makers had aimed to achieve, the feed-through to underlying inflation remains unconvincing. Final demand is simply not yet strong enough to cause inflation in most developed economies to sustainably breach central bank targets.

Locally, the telegraphed drop in food inflation and a broadly neutral currency view result in our 2018 annual average inflation forecast of 4.5%. Recent rand strength, in response to the perceived market friendly outcome of the ANC Elective Conference, should contribute to a benign inflation outlook this year. The net impact of recent tax changes, the one percentage point VAT hike in particular, is negligible to our inflation outlook.

Balance
of
payments 

Significant recent rand strength, and a loss of competitiveness relative to peers, is undoing some of the earlier benefit of rand weakness to the overall balance of payments. As a result, we expect a marginal widening of the current account balance from an annual average of -2.0% of GDP in 2017 to -2.7% in 2018 and -3.2% in 2019. The unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners) remains a considerable drag on a sustained and meaningful balance of payments correction. A stronger currency may continue to impede a narrowing of the current account deficit over the medium term.

Monetary
policy

Now firmly down the path of monetary policy normalisation in the US, we agree with the Federal Reserve’s continued intent to follow a slow and gradual monetary policy normalisation process. With an unemployment rate gyrating around 4% and inflation pressures gradually building in the US, we believe that the Federal Reserve should continue with its interest rate normalisation process. If anything, we are of the view that it may be in a position to raise rates by more than what is currently priced by markets, i.e. by as much as another 75 basis points, this year. While the Federal Reserve intends to reduce the size of its balance sheet in an interest rate neutral manner, we are of the opinion that the sheer size of this reduction should contribute to a gradual lift in the ceiling for US Treasury yields, especially if the economic recovery continually gathers momentum. In addition, the expected widening of the Federal budget deficit for the forthcoming fiscal year on the back of strong economic growth momentum will create additional scope for monetary policy normalisation.

The current trend of global monetary policy divergence is expected to continue over the next year or so. With more policy tightening in the US on the cards, the European Central Bank (ECB) and Bank of Japan will retain their respective quantitative easing and negative interest rate policy programmes, but with some tweaks. In the case of the ECB this will continue to take the form of a slowdown in the pace of quantitative easing. All told, we expect central bank hawks to slowly gain some ground over the next few months.

Following the recent widely expected 25 basis points repo rate reduction, the South African Reserve Bank is expected to become more cautious. We fully support this defensive stance. Considering renewed (albeit relatively limited) weakening pressure on the balance of payments, the fact that actual inflation is hovering around the mid-point of the target range, which the SARB has well telegraphed as the desired target point; inflation expectations still largely stuck closer to the top end of this range and indirect support from very loose global monetary policy slowly waning, we deem a neutral policy stance the most appropriate course for local monetary policy. We therefore disagree with the forward rate market’s pricing of more repo rep rate cuts for the remainder of this year.

Fiscal 
policy

Following the tabling of a less alarming national budget in February, National Treasury is still confronted by a very challenging fiscal path. The gross debt to GDP ratio estimates for the next three years are lower compared to the October 2017 estimates, but still worse than the estimate a mere twelve months ago. As we have previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the actual delivery of fiscal and wide-ranging State Owned Enterprise (SOE) reform to reinvigorate consumer and business confidence as the scope to steer SA Inc. towards a sustainable growth path narrows.

Investment view and strategy 

Our view remains that, despite the recent pick-up in global bond yields, developed bond markets are still not appropriately priced. In our view, the Federal Reserve is in a position to lift the policy rate by another 75 basis points this year. The fact that the US has opted to loosen fiscal policy significantly at a time when positive economic growth has already gained sustainable momentum partly supports this view.

Locally, our main concern with regards to the bond market remains the strong link between lacklustre economic growth and fiscal consolidation - or more specifically, the rising debt burden of government. Recent political changes, action with regards to SOE management and the tabling of the latest budget most certainly went some way to reduce some of our previous concerns. However, it would be irresponsible to ignore fiscal execution risk. The structural nature and extent of the country’s macroeconomic ills require significant policy adjustment, time and effort to resolve.

Our view on monetary policy also remains more cautious than what has been priced by forward money market rates. We do not subscribe to a view of further interest rate cuts in this cycle. Inflation expectations are hovering closer to the top end of the 3-6 percent inflation target range, actual inflation is merely back to the middle of this range, while monetary policy tightening in some parts of the developed world should not go unnoticed. The current account deficit is at risk of widening as a result of a stronger rand, slightly stronger local economic growth and leakage from net negative interest and dividend payments. At current levels, the bond market is not priced for bad news. As a result, we would maintain our slightly defensive stance, while utilising opportunities to enhance the running yield of our funds.

As a result, our broad interest rate investment strategy remains defensive. In the case of our Core Bond Composite (benchmarked against the All Bond Index), this is expressed as follows:

 

 

Key economic indicators and forecasts (annual averages)

 

    2014 2015 2016 2017 2018 2019
Gobal GDP   2.8% 2.9% 2.5% 3.3% 3.6% 3.2%
SA GDP   1.5% 1.3% 0.3% 1.3% 2.3% 2.5%
SA Headline CPI   6.1% 4.6% 6.3% 5.3% 4.5% 5.0%
SA Current Account (% of GDP)   -5.4% -4.4% -3.3% -2.0% -2.7% -3.2%

Source: Old Mutual Investment Group

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