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Economic and market review 31.01.2018

Economic and Market Review

Our monthly write-up of the markets.

Another good month for nominal bonds due to the Ramaphosa “dividend”

The South African bond market consolidated its late 2017 gains during the first month of 2018. The euphoria surrounding the election of Mr Ramaphosa as the ANC president still reverberated, although the impact on investor sentiment, in particular, started waning as the reality of the difficult task of correcting years of mismanagement moved to the fore. Even so, the JSE All Bond Index still managed to deliver a very strong return of 1.9% for the month as yields across the yield curve declined to lower levels. This compares very well against the cash return of 0.6%. The inflation-linked bond market suffered from falling inflation expectations, partly due to rand appreciation. Lower inflation expectations reduced the demand for inflation protection, which, in turn, caused real yields to rise. As a result, the Inflation-linked Government Bond Index rendered a negative return of 1.3% for the month.

Local data releases lend support to interest rate bulls

The nominal bond market also received support from benign inflation data and another strong external trade surplus. The latest monthly government financing data also pointed to the possibility that the budget deficit for the current fiscal year may at least not be worse than the bearish October 2017 estimate. Reduced inflation expectations boosted the prospect of repo rate reductions later this year. Decisive action in response to Eskom’s governance concerns also contributed to reducing investor concern about an imminent Moody’s downgrade post the tabling of the national budget on 21 February.

Developed bond markets remain under pressure

While local bond market sentiment remained relatively buoyant, it is worth noting that the same could not be said of most developed bond markets. In the US, the largest global government bond market, bond yields continued their march to higher levels. The correction is the combined result of the strong economy at or very close to full employment, the gradual unwinding of the Federal Reserve’s large balance sheet, as well as its well-telegraphed intent to raise its policy rate further this year. A sustained strong economic performance in the Eurozone also led to rising bond yields in the region, although in this case the European Central Bank is still in no hurry to raise interest rates.

 

​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 relatively strong US economy still leading the way. Although improving, 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).

Most emerging market economies are caught between an improved outlook for the developed world, the implication of structurally lower Chinese economic growth on commodity demand, and the US Federal Reserve’s intent to normalise monetary policy. Therefore, commodity producers with external imbalances, such as SA, remain vulnerable.

Locally, the biggest impediment to higher local growth remains of a structural nature. 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 serious policy vacuum, policy uncertainty and unpredictability, weak consumer and investor confidence and a rigid labour market. While acknowledging the positive steps towards improved governance with the reconfiguration of Eskom’s board, state-owned enterprises remain a negative risk to the fiscus, and economic growth, as a consequence.

Although the election of a new ANC leader has been well received by financial markets, the jury is still out on the planned course and efficacy of corrective policy action. Given the tight margin of victory, as well as the fact that the ANC NEC is relatively evenly split between two factions, the road to reform may yet prove to be a bumpy one. That said, the determination shown in picking low hanging fruit such as the very meaningful changes at Eskom, is an excellent start to a long and arduous recovery process.

Locally, the biggest impediment to higher local growth remains of a more structural nature. 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 serious policy vacuum, policy uncertainty and unpredictability, weak consumer and investor confidence and a rigid labour market. Poorly managed state-owned enterprises also remain a negative contributor. Although a new ANC leader has been well received by financial markets in particular, the jury is still out on the planned course and efficacy of corrective policy action. Given the tight margin of victory, as well as the fact that the NEC is relatively evenly split between the two factions, the road to reform may yet prove to be a bumpy one

Inflation

The strong rise in energy and other raw material prices in the past few months has started showing in headline inflation numbers in many economies. The sharp rise in crude oil prices is particularly worth noting, especially on the local front. 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 4.6%. Recent rand strength in response to the perceived market friendly outcome of the ANC Elective Conference, as well as NERSA’s decision to only allow Eskom a 5.2% tariff increase as opposed to the requested 19.9%, should contribute to a more benign inflation outlook for this year.

Balance
of
payments 

An improved terms of trade position and a pick-up in global economic activity are still lending relief to the South African balance of payments position. Weaker local consumer demand also proved to be a drag on merchandise imports. As a result, we expect a narrowing of the current account balance from an annual average of -3.3% of GDP in 2016 to -2.0% in 2017, followed by a widening to -2.5% in 2018. The unfavourable income account deficit (primarily comprised of net dividend and interest payments to foreigners) remains a considerable drag on a sustained and meaningful fundamental balance of payments correction. A stronger currency may limit a significant further 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 seemingly marching to 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. While the shrinking of the Federal Reserve’s large balance sheet will be conducted in an interest rate neutral manner, this should over time contribute to a gradual lift in the ceiling for US Treasury yields, especially if the economic recovery gathers more momentum.

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 and Bank of Japan will retain their respective quantitative easing and negative interest rate policy programmes, but with some tweaks. More recently, financial markets had to absorb slightly less dovish signals from the Bank of England. We expect the central bank hawks to slowly gain some ground over the next few months.

Following the surprise repo rate reduction in July 2017, the South African Reserve Bank has since consistently remained on a more cautious path. We fully support this more defensive stance. Considering the size of the balance of payments deficit (albeit improving), the stickiness of inflation expectations (still in the upper end of the target range), higher crude oil prices and the increased risk of rand volatility (with a weakening bias), we deem a neutral policy stance the most appropriate course for monetary policy right now. That said, the risk to our view is rate cuts, a possibility that the forward rate market started pricing for at the time of writing.

Fiscal 
policy

National Treasury still confronts a challenging fiscal path, as outlined in the tabling of a disappointing Medium Term Budget. As we’ve previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the urgent 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 quickly narrows.

Addressing the contingent liability overhang to the fiscus provided by SOEs is critical to regaining fiscal prudence. The recent reconstitution of the SAA and Eskom boards is a positive development towards reigning in the SOE rot. For now, the significant financial assistance required by a growing number of badly managed SOEs and tax revenue under-collection remain the two main threats to fiscal consolidation and an improvement in the credit worthiness of the country.

Investment view and strategy 

The modest global economic recovery sets the scene for limited inflationary pressure and a steady monetary tightening cycle for the few economies that are in a position to normalise policy. In our view, the Federal Reserve is in a position to lift the policy rate by 75 to 100 basis points this year: a gradual normalisation of monetary policy. Our view remains that despite the recent pick-up in global bond yields, developed bond markets are still not appropriately priced. Considering the strong positive growth momentum and the low level of risk premia following years of aggressive central bank intervention, we expect more moderate global bond market weakness in months to come. Although the Federal Reserve is adamant that the unwinding of its balance sheet will be done in an interest rate neutral way, we believe that this will contribute to the lifting of the global bond rate ceiling.

Locally, our main concern with regards to the bond market, remains the strong link between lacklustre economic growth and tax revenue collection. This, together with macro policy uncertainty, has negative implications for fiscal consolidation and, eventually, sovereign credit rating downgrades. However, following recent political events, we have to acknowledge that the possibility of some improvement in fiscal consolidation has increased. This, and the decisive stance with respect to state owned enterprise like Eskom, has reduced the probability of a Moody’s downgrade in the near term. While the changes to the governing party’s political leadership are welcomed, the structural nature and extent of the country’s macroeconomic ills require significant policy adjustment and time to be resolved. For now, we fear that markets have gotten ahead of themselves with unrealistic expectations. South Africa is not by any means out of the woods yet.

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:

Composite tilts against the ALBI (%)

 

 

 



Key economic indicators and forecasts (annual averages)

 

    2014 2015 2016 2017 2018 2019
Gobal GDP   2.8% 2.9% 2.5% 3.2% 3.4% 3.0%
SA GDP   1.5% 1.3% 0.5% 0.8% 1.8% 2.0%
SA Headline CPI   6.1% 4.6% 6.3% 5.3% 4.6% 4.8%
SA Current Account (% of GDP)   -5.4% -4.4% -3.3% -2.2% -2.5% -3.0%

Source: Old Mutual Investment Group

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