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Economic and market review 31.08.2018

Economic and Market Review

Our monthly write-up of the markets.

Another cruel month for emerging markets

August was particularly cruel for emerging markets following another barrage of negative news flow from Turkey and Argentina. This was in addition to existing headwinds like the escalating risk of more international trade restrictions between the US and key trading partners. As market sentiment once again turned sour, foreign investors predictably responded by becoming large scale sellers of local currency emerging market bonds and currencies. Although dwarfed by the excessively sharp depreciation of the Turkish New Lira and Argentine Peso, the rand, like most other emerging market currencies, failed to escape the carnage as it depreciated by around 11% against the US dollar. In the process, the local currency reached its weakest level against the greenback since November last year. The sharp weakening of the rand contributed to heightened market fears of additional future inflationary pressure and a possible South African Reserve Bank repo rate increase.       

Large scale foreign selling contributed to negative bond returns

The sharp depreciation of the local currency and net sales of local currency bonds by foreign investors to the value of R20bn forced bond yields across the yield curve to higher levels. For instance, the yield of the benchmark R186 (maturity 2026) government bond jumped by 39bps to 8.97%, contributing to a disappointing All Bond Index return of -1.7% for the month. The inflation-linked bond market was also impacted by negative market sentiment, although with an index return of -0.2%, it was fairly muted in comparison to the nominal bond market. The relative safety of cash offered a return of +0.5% in August. Rising expectations of a hawkish monetary policy response to rand weakness were reflected in the spot and forward money market curves as both curves steepened significantly.

Local data releases largely played into the hands of the bears

While negative international developments had been prominent, disappointing local data releases for the month of July also contributed to negative market sentiment. Although broadly expected, the rate of inflation at both consumer and producer levels continued to tick higher, with the latter now at the top end of the inflation target range. Rather disappointingly, South Africa posted a merchandise trade deficit due to a surge in imports, in turn partly reflecting higher crude oil prices. On the fiscal side, the release of main budget fiscal data for July showed a significant deficit of R96bn. Although the large deficit is aligned with seasonal patterns in government expenditure payment flows and tax revenue receipts, it managed to raise unease about risks to desperately needed fiscal consolidation, especially in light of the rising possibility of a failed economic recovery.

Stronger US Treasury market reflects broader risk aversion

The emerging market volatility seems even more extreme when considering the relative calm in developed bond markets. In the USA, the yield of the 10-year US Treasury bond actually declined by almost 10 basis points to 2.86%, despite firm evidence of sustained strong economic activity, which should allow the US Federal Reserve to increase its key policy rate again at its next policy meeting. In the past, the negative correlation has been a clear sign of risk-aversion, as sellers of higher yielding assets turn to the relative safety of developed markets.

 

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 continue to contribute positively 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 mainly on the back of a worsening China-US trade dispute, with no resolution in sight. Compromised global trade relations, coupled with higher crude oil prices, could potentially become a larger drag on the global growth outlook than initially anticipated.

Locally, the biggest impediment to higher local growth remains of a structural nature. 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. For now, the risk of a failed economic recovery remains the biggest threat to our current investment theme.

Inflation

The US remains at the forefront of the global reflation effort, with a decade of ultra-easy monetary policy and recent fiscal stimulus yielding satisfactory inflationary effects. Progress towards European reflation is also highlighted by the recent announcement of asset purchase tapering by the European Central Bank. Although global reflation is welcomed, since this is what policy makers had aimed to achieve, it is important that the feed-through to underlying inflation remains contained. It is noteworthy, however, that final demand is not yet strong enough to cause core inflation rates 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%. 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 as well as the threat of renewed currency weakness will contribute to upside inflation risk over the medium term. Even so, the pass-through of rand weakness to inflation still appears to be relatively weak, supporting the view that the near term acceleration in the rate of inflation may still turn out to be relatively benign, and thus remaining within the SARB’s target range.

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 -2.5% of GDP in 2017, to -3.5% in 2018 and -3.7% in 2019. The unfavourable income account deficit (primarily due to the large 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 that will adversely impact the balance of payments, especially for a small open economy like South Africa, with strong Euro zone and Chinese trade links.

Monetary
policy

With the unemployment rate in the US now officially below 4% and inflation pressures gradually building, we believe that the Federal Reserve should continue with its interest rate normalisation process. 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 - with the 10 year Treasury bond reaching the 3% mark several times - 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. 

The current trend of global monetary policy divergence is slowly changing from an overall quantitative easing stance to moderate tightening - with more policy tightening in the US on the cards, and the European Central Bank (ECB) confirming that it will continue to taper its bond buying programme. All told, we expect central bank hawks to slowly gain some ground over the next few months.

The South African Reserve Bank is expected to maintain its more cautious stance, which we fully support. Factors contributing to this stance 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 remaining stubbornly close to the top end of the target band; and the waning support provided by a decade of ultra-loose global monetary policy. The risk to the stable repo rate outlook is skewed to the upside, mostly due to upside risks to the current inflation outlook. Even so, the central bank is not prone to respond in a panicked manner to shocks such as the recent emerging market sell-off.  

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 four months of the 2018/19 fiscal year is tracking the budget estimate closely following sound fiscal performance in June. Even so, we remain concerned about the sustainability of fiscal consolidation due to the weak growth backdrop and the quality of tax revenue collections, specifically Personal Income Tax and Corporate Income Tax, which have historically contributed on average 37% and 17% respectively to total revenue collected.

Investment view and strategy 

The recent, more sustained pick-up in global bond yields notwithstanding, our view remains that most developed bond markets are still not appropriately priced. In the case of the US, the strong pace of economic growth, the low level of unemployment, and evidence of sustained higher inflation support further US monetary policy tightening. We believe that the Federal Reserve is in a position to lift its policy rate by at least another 25bps this year. More importantly, at a global level, the trend continues to gradually shift from quantitative easing to quantitative tightening.

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, which arises as a consequence of a lack of fiscal consolidation and therefore continues to threaten the country’s sovereign risk profile. The risk of a failed economic recovery has risen following a slew of disappointing data releases the last few weeks. This makes us question the quality of tax revenue collections, which in turn keeps the risk of a budget deficit overrun at elevated levels.  

On the monetary policy front, we maintain our view that the central bank will remain hostage to the opposite forces of a lacklustre economic growth outlook and upside risks to inflation. For now, this, to us, suggests a stable policy path. The risk to this view is skewed in favour of some upside risk to inflation and thus interest rates.

While the observable investment theme and related real time developments mostly have negative consequences for the local bond market, it is important to note that current market valuation is largely reflective of this. Cheaper market valuations following the sell-off during the second quarter afforded us an opportunity to cautiously increase risk by selectively buying bonds. We shall continue to look for opportunities to increase bond market exposure, but only into bouts of weakness, considering the level of uncertainty discussed above.

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% 3.3% 3.2%
SA GDP   1.5% 1.3% 0.3% 1.3% 0.8% 2.0%
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% -3.5% -3.7%

Source: Old Mutual Investment Group