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Economic and market review 30.06.2018

Economic and Market Review

Our monthly write-up of the markets.

Global markets have caught the jitters

The second quarter of 2018 saw global investors hurriedly taking risk off the table. The about turn in global risk appetite had been the result of a confluence of factors. This ranged from idiosyncratic issues to forces of a more globalised nature. Emerging markets had an important role to play, but so did the developed world. Both Argentina and Turkey were forced to play the policy rate card in an effort to stabilise their respective currencies following significant net capital outflows as weak fundamentals could no longer be overlooked. Argentina in particular had to bear the brunt of the investor fall-out as its economic and financial market fragility relative to its emerging market peer group, mostly pertaining to the country’s endemic inflation rate and wide twin deficits, simply could not be ignored. Elsewhere, Italian politics spooked markets while an escalation of trade tensions between the USA and some of its main trading partners, inclusive of Canada, the UK, the Eurozone and China, reached a new worrying level. All of this played out against a backdrop where the US Federal Reserve stuck to its well telegraphed intention to gradually increase its key policy rate. Even the European Central Bank confirmed plans to begin with the unwinding of its net purchase of bonds in the secondary market.

South Africa got helplessly dragged along in the global mud slide

In light of the events described above, South Africa’s status as a small, open economy with strong Euro zone and Chinese trade links, once again exposed its vulnerability to global risk-off investment strategies. This, apart from a strong US-dollar, which tends to do well in periods of global risk aversion, caused the South African currency to lose some ground and bond bears to gain confidence. The risk of a large foreign holding of local bonds was once again clearly demonstrated, as net selling amounting to circa R40bn during the first half of this year had been one of the main drivers of the recent surge in bond yields. That said, while there are similarities with problem-child Argentina, one very distinct difference is the fact that South Africa’s foreign currency denominated government debt amounts to 5% of GDP, well below Argentina’s 22%. Equally important is the gulf in monetary policy management – wherein South Africa ranks favourably relative to economies like Argentina and Turkey. As a result, the weakening pressure on the local currency and bond markets was relatively contained in comparison to some of the other emerging markets.

Disappointing local data releases offer no reprieve as reality starts to bite

In addition to an overwhelmingly unsupportive global backdrop, local data releases offered little respite to the few bond bulls around. This was crowned by a sharp seasonally adjusted and annualised GDP contraction of 2.2% (quarter-on-quarter) for the first quarter of the year. To make matters worse, the current account deficit widened more than expected in the first quarter of this year, from -2.9% in the fourth quarter of 2017 to a massive -4.8%, partly in response to the sharp appreciation of the rand since late last year. The rate of inflation at both consumer and producer levels started its much anticipated steady acceleration, confirming our view that both the inflation and interest rate cycles have troughed. In the case of the Consumer Price Index, the year-on-year rate accelerated to 4.4% in May, compared to the cycle trough of 3.8% recorded two months earlier. So far, national revenue and expenditure trends have largely been in line with expectations, but it is too early in the fiscal year to draw any conclusions on the outlook given that we have only had two months of national financing data. Given its strong link to economic growth and sovereign risk, fiscal execution risk remains a key watch point. Against this backdrop, it comes as little surprise that the initial exuberant euphoria following the election and appointment of President Ramaphosa has lost significant momentum. The reality of the enormous challenge ahead has finally dawned.

The South African central bank has no choice but to sound the hawkish alarm bell

With uncertainty mounting, both domestically and abroad, the South African Reserve Bank appropriately opted to keep the repo rate unchanged at its May monetary policy committee meeting. Most encouraging to fixed income managers like ourselves who fear inflation almost as much as borrowers who default on their obligations, is that the Committee sounded the hawkish alarm bell regarding future inflation risks. In light of the developments described above, it also comes as little surprise that market interest rate expectations have shifted from a mild bullish state a mere few weeks ago. While the forward rate market now expects rates to trend higher in the near term, we would caution against getting too bearish on monetary policy. Yes, we most certainly see no room for more rate cuts, but we also see no urgent need for rates to be ratcheted higher any time soon. For one, the growth outlook remains shaky, while the free floating exchange rate regime is designed to allow for a quick monetary adjustment. This is one of the fundamental contrasts to a country like Argentina where direct policy intervention takes centre stage in periods of crisis.

The Bond market gave up most of its excess returns for the first six months of the year

Against this background, the path of least resistance for bond yields had been upwards. The yield of the benchmark R186 (maturity 2026) increased sharply by 117 basis points from 7.99% at the end of March to a weakest point of 9.16% around mid-June, before settling slightly lower at 8.84% on 29 June. More telling is that the slope of the yield curve steepened as long-dated bond yields rose by more than those of shorter-dated bonds. As a result, the total return of the All Bond Index slumped to a quarterly return of -3.8%, well below the cash return of 1.6% over the same period. Even so, the extent of the bull rally during the first three months of the year was big enough for the All Bond Index (+4.0%) to remain slightly ahead of cash (+3.3%) for the first half of 2018.

Inflation-linked bonds failed to offer any protection against capital losses

Returns in the inflation-linked bond market also disappointed in the second quarter. Real yields drifted higher in tandem with nominal bond yields even as the inflation outlook worsened, which usually tends to support the demand for inflation protection. Moreover, the real yield curve steepened slightly with long-dated inflation-linked bond yields rising more than those of short-dated bonds. As a result, the Inflation-Linked Government Bond Index returned -4.6% for the quarter, well below cash and slightly worse than nominal bonds.

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 positively contribute to growth, 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). In the short term, we expect the tension pertaining to international trade protectionism to escalate. Compromised global trade relations, coupled with higher crude oil prices, could potentially become a larger drag on the global growth outlook.

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, low levels of fixed capital investment, and a rigid labour market. While acknowledging the positive steps towards improved governance, marked by the reconfiguration of Eskom’s and Transnet’s boards, state-owned enterprises still largely remain a negative risk to the fiscus, and as a consequence, to economic growth.

Inflation

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 positively contribute to growth, 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). In the short term, we expect the tension pertaining to international trade protectionism to escalate. Compromised global trade relations, coupled with higher crude oil prices, could potentially become a larger drag on the global growth outlook.

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, low levels of fixed capital investment, and a rigid labour market. While acknowledging the positive steps towards improved governance, marked by the reconfiguration of Eskom’s and Transnet’s boards, state-owned enterprises still largely remain a negative risk to the fiscus, and as a consequence, to economic growth.

Balance
of
payments 

Strong rand appreciation in December 2017 and the first three months of 2018 and a loss of competitiveness relative to peers is undoing some of the previous 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 -3.2% in 2018 and -3.5% 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. Rising international trade tension and the sharp increase in crude oil prices are cumulatively negative developments for a small, open economy like South Africa, with strong Euro zone and Chinese trade links.

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 now officially below 4% and inflation pressures gradually building in the US, we believe that the Federal Reserve should continue with its interest rate normalisation process. 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 50 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, which is already visible - especially if the economic recovery continues to gather 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.

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. Of course, in the case of the Euro zone, political instability in the periphery may stall the process of normalisation.

The South African Reserve Bank is expected to maintain its more cautious stance, which we fully support. Factors in this regard include: renewed pressure on the balance of payments; the fact that actual inflation is back above the mid-point of the target range (which the SARB has well telegraphed as the desired target point); inflation expectations are still closer to the top end of the target band; and indirect support from very loose global monetary policy is waning. The current tide of global risk aversion also offers a reason for caution in the short term.   

Fiscal 
policy

Following the tabling of a less alarming national budget in February, National Treasury is still confronted by a very challenging fiscal path. 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. National financing data for the first two months of the current fiscal year disappointed with a wider than expected deficit. Although not ideal, it is probably still too early to draw firm conclusions from year-to-date fiscal data.

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. We believe that the Federal Reserve is in a position to lift its policy rate by at least another 50 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 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 went some way to reducing some of the concerns we previously had. However, it would be irresponsible to ignore fiscal execution risk. The structural nature and extent of the country’s macroeconomic ills requires significant policy adjustment, time and effort to resolve.

Our long held view pertaining to no more interest rate cuts in this cycle and the risk of global risk aversion to local market stability, especially considering the size of foreign bond holdings, is busy playing out. The current account deficit is still deemed at risk of widening as a result of rising international trade tension, a relatively stronger rand and a higher oil price compared to levels prior to December 2017, and leakage from net negative interest and dividend payments.

While the observable investment theme and real time developments related to it mostly have negative consequences for the local bond market, it is important to note that current market valuation is reflective of this. We were defensively positioned prior to the recent correction and have managed to limit the drawdown of the negative market movements on our portfolios. Cheaper market valuations are affording us an opportunity to cautiously increase risk by selectively buying bonds into bouts of market weakness.

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% 3.4% 3.2%
SA GDP   1.5% 1.3% 0.3% 1.3% 1.8% 2.2%
SA Headline CPI   6.1% 4.6% 6.3% 5.3% 4.7% 5.0%
SA Current Account (% of GDP)   -5.4% -4.4% -3.3% -2.0% -3.2% -3.5%

Source: Old Mutual Investment Group

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