Commitment to fiscal consolidation comes with significant execution risk
In his 2021 budget speech, the Minister of Finance demonstrated that this administration is serious about its intention to turn the fiscal ship away from the proverbial cliff. The deceleration of debt accumulation by means of higher-than-expected tax revenue collection and focus on expenditure reduction rather than simply raising taxes is encouraging. Having said that, the commitment still carries significant execution risk, particularly when it comes to the intended reduction of the enormous and unsustainable wage bill. Although the debt to Gross Domestic Product (GDP) ratio is now estimated to peak at a lower level of 88.9% (vs the medium term estimate of 95.1%), it is still extremely high and unsustainable for a number of reasons, especially in light of our (and National Treasury’s) economic growth outlook. We also remain concerned about the more bullish revenue estimates in the fiscal years beyond 2020/21, given that these are not backed by significantly higher real GDP growth, improved tax buoyancy or any additional tax measures.
Figure 1: Nominal Bond Yield Curve changes during January 2021
Source: National Treasury, Futuregrowth
Foreign investor sentiment turned sour
Even though we remain concerned about execution risk regarding the government’s encouraging commitment to fiscal consolidation, bond market bulls could not have wished for better budget news in our current dire macro circumstances. This was reflected by an initial bullish market response to the budget announcement. However, the market euphoria turned out to be a mere blip, as the local market succumbed to strong risk-off global sentiment. A spectacular meltdown in global risk appetite gained momentum towards month end, as inflation fears and expectations of monetary policy tightening took a firm hold across global bond markets and more risky asset classes. Despite assurance to the contrary from the Federal Reserve chairman, the US 10-year Treasury yield reached a one year high of 1.6%, a notable jump when compared to the one-year low of 0.5% - and in the process, dragged the global bond market with it. Locally, indiscriminate foreign selling of rand-denominated government bonds totalled a whopping R29 billion during February, with about 90% of this concentrated in the 3- to 10-year maturity band. With local buying interest focused on the 15- to 20-year maturity band, the supply/demand mismatch at the shorter area of the yield curve caused a sharp rise in shorter-dated bond yields relative to longer-dated bond yields.
Nominal bond returns took a turn for the worse, while inflation-linked bonds put in a star performance
In stark contrast to previous months, the bear flattening of the nominal bond yield curve caused a significant underperformance of shorter-dated nominal bonds relative to ultra-long-dated nominal bonds, inflation-linked bonds and cash. On a net basis, the FTSE JSE All Bond Index (ALBI) rendered a return of 0.06% for the month. The biggest negative contributor was from bonds in the 3- to 7-year maturity band, which returned -2.23%.
In contrast, inflation-linked bonds rallied across the real yield curve owing to stronger inflation-hedging demand, which in turn caused the real yield curve to bull flatten. As a result, the FTSE JSE Government Inflation-linked Index (IGOV) rendered a very strong return of 1.92%. The combination of reasonable valuation and expectations of higher inflation in the near term, which will boost the inflation carry offered by these bonds, served as catalysts for renewed interest in this asset class. This performance was well in excess of the 0.27% rendered by cash for the month.
Figure 2: Bond market returns (periods ending 31 January 2021)
Source: JSE, Futuregrowth
The market now more bearish on the local monetary policy outlook
Forward rate expectations have recently become more bearish. This could be ascribed to widely held expectations that the rate of inflation will accelerate over the next few months, while economic activity is slowly gaining upward momentum, albeit from an extremely low base. This is also somewhat linked to the recent global bond correction, which is reflective of the so-called reflation trade.
Otherwise, the local rate of inflation at both consumer and producer levels remained relatively benign in January. The Headline Consumer Price Index (CPI) accelerated by 3.2% year on year, a touch higher than the previous month’s 3.1%, while Core CPI remained stable at 3.3%. Data for January revealed that the Producer Price Index (PPI) is gaining upward momentum, accelerating at a higher than expected 3.5% from 3.0% in December. In addition, South African household credit growth continues to reflect a slowdown and more recently slipped to an even lower 2.5% year-on-year rate of increase. This is one of a number of indicators pointing to a consumer under severe financial pressure - not an ideal environment for passing on large and sustained price increases.
Similarly, the balance of payments still reflects the strongest position in years. Although data for January revealed a decrease in the merchandise trade surplus to R11.8 billion, the external account remains at its strongest level in many years, thereby not exerting undue pressure on the exchange rate of the rand.
Figure 3: Forward rate expectations turned bearish
Source: Bloomberg, Futuregrowth
// THE TAKEOUT
Government should be applauded for its insistence on fiscal consolidation and its carefully laid-out plan to attain this highly desirable objective. However, this is fraught with challenges and thus execution risk, and did not quell jittery global sentiment, which is currently focused on the risk of higher inflation and possible policy tightening on a global scale. The bout of global risk aversion spilled over into our market, which contributed to significant bear flattening of the nominal bond curve. Similarly, the local forward rate market is persistently pricing a higher repo rate in the medium term. We disagree with this pricing as we regard sustained weak economic growth and a relatively benign inflation outlook as supportive of stable monetary policy until at least sometime next year.