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Economic and market review 31.05.2018

Economic and Market Review

Our monthly write-up of the markets.

Local bond market dragged along by strong global tides

During May South Africa’s currency and bond market were dragged along by strong global tides which caused investor risk sentiment to turn for the worse. Argentina and Turkey once again rocked the emerging market boat, while rudderless Italy also had a role to play in the latest bout of investor unease. Persistent threats of a global trade war and the sharp increase in crude oil prices also continued to fray market nerves, particularly with regards to the implications for global growth.

Foreign investors continue selling local bonds

In light of the events described above, South Africa’s status as a small, open economy with its strong trade links with the Euro zone and China, once again exposed its vulnerability to global risk-off investment strategies. In the case of the bond market, this was demonstrated by significant net selling amounting to circa R33bn of local currency bonds by foreign investors. 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, which in turn caused bond bears to gain confidence

Local data releases also play into the hands of the bears

In addition to an unsupportive global backdrop, local data releases, crowned by a quarterly contraction in GDP for the first quarter of the year, also offered little respite to the few bond bulls around. The rate of inflation at both consumer and producer levels for the month of April accelerated by a faster pace than expected. This confirmed that the inflation cycle trough is now visibly in the rear-view mirror. While the external trade account recorded a small surplus, early indications are that the current account deficit has widened further in the first quarter of this year. Although one month’s data is inadequate to conclude a trend, the April monthly national financing data nonetheless reflected a worrisome picture.  Against this backdrop, it comes as little surprise that the initial euphoria following the election of President Ramaphosa lost more momentum during May as the reality of the enormous challenge ahead started to dawn.

The hawkish central bank stands its ground

With uncertainty mounting 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 who fear inflation, is that the Committee once again sounded the hawkish alarm bell regarding future inflation risks.

Poor returns for May, but year-to-date nominal bond returns still noteworthy

Against this background, the path of least resistance for bond yields had been upwards. The yield of the benchmark R186 (maturity 2026) increased 36 basis points to close the month of May at 8.54%. As long-dated bond yields rose by more than those of shorter-dated bonds, this caused the yield curve slope to steepen. This in turn resulted in a slump in the All Bond Index with a monthly return to -2.0%; below the cash return of 0.5%. Even so, the extent of the bull rally during the first three months of the year was big enough for the All Bond Index (+5.2%) to remain well ahead of cash (+2.7%) for the calendar year ending May. The real yield curve steepened slightly with long-dated inflation-linked bond yields increasing faster than those of short-dated bonds, resulting in the Inflation-Linked Government Bond Index also returning less than cash at -0.2% for the month of May.

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 restrictions 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. Recent political developments 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, but both business and consumers will now seek tangible reform going forward. While acknowledging the positive steps towards improved governance marked by the reconfiguration of the Eskom and Transnet boards, state-owned enterprises still largely remain a 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 4.7%. Rand strength relative to levels prior to the market friendly outcome of the ANC Elective Conference, should contribute to a relatively benign inflation outlook this year. Although the net impact of recent tax changes, the one percentage point VAT hike in particular, is negligible to our inflation outlook, the sharp increase in the rand oil price will contribute to upside inflation risk over the medium term.  

Balance
of
payments 

Significant rand appreciation in the first half of the year 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. Rising international trade tension and the sharp increase in crude oil prices are cumulatively negative developments for a small, open economy 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. 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, which is already visible - 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. 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. We fully support this defensive stance. Factors in support 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 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. 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. National financing data for the first month 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 one month’s 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. In our view, the Federal Reserve is in a position to lift its policy rate by at least another 75 basis points this year, with the next increase possibly as soon as this month. 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 most certainly went some way to reduce some of the concerns we previously had. However, it would also be irresponsible to ignore execution risk. The structural nature and extent of the country’s macroeconomic ills will require 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 also 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% -2.7% -3.2%

Source: Old Mutual Investment Group