Insights

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Global central bank policy divergence becomes more pronounced

30 Jun 2021

Wikus Furstenberg, Refilwe Rakale, Yunus January, Daphne Botha, Aidan Kilian / Interest Rate Team

Economic & bond market review

Inflation approached peak territory

Without exception, developed and emerging economies around the globe had to process the significance of inflation spikes over the past few months. In South Africa, the May year-on-year rate of increase for the Headline Consumer Price Index (CPI) and Producer Price Index (PPI) for final manufactured goods surged by 5.2% and 7.4% respectively. In our view, these are the likely peaks in the current inflation cycle. Price increases are still not broad-based, with large year-on-year increases limited to individual categories such as “Oils and fats”, “Vehicles” and “Petrol”.

As widely expected, a common denominator across the globe is the influence of base effects one year after a dramatic crude oil price collapse, accentuated by the strong crude oil and general commodity price rebound since then. A similar trend played out in food prices, with pandemic-induced supply-bottleneck price increases added to the mix. While the inflation surge in recent months was well telegraphed and thus widely expected, headline inflation data generally still managed to surprise on the upside. This tested the nerves of investors and central bankers alike. In contrast, measures of core inflation remained relatively well contained in the majority of cases, supporting the view that headline data distortions caused by the pandemic in the past twelve months are most likely transitory. In the case of South-Africa, the transitory view is supported by the small 0.1% month-on-month Headline CPI increase in May.

Figure 1: SA Headline CPI has likely peaked and is expected to stabilise at lower levels in the months ahead


Source: OMIG, Futuregrowth

Economic growth surprised on the upside

Global economic activity continued to broadly gain traction, even though progress remains uneven across regions. In the case of South Africa, the economy grew at a quarter-on-quarter seasonally-adjusted and annualised rate (SAAR) of 4.6% in the first quarter of this year, beating the consensus estimate of 3.2% by a significant margin. On the production side, the mining sector recorded a mammoth 18.1% growth (quarter-on-quarter, SAAR), reflecting the direct benefit of a strong global commodity cycle on our largely resource-based economy. While the latest data release confirms our expectation for a strong growth rebound this year, the economy still contracted by 3.2% year-on-year following the 2020 pandemic-induced growth collapse. The recent shift to adjusted Level 4 countrywide restrictions in an attempt to control the spread of the surge in COVID-19 cases does pose a risk should it be extended for longer than the anticipated two weeks.        

Central banks become increasingly cautious

The improvement in economic activity combined with higher (albeit transitory) inflation brought about a stronger monetary policy response divergence among global central banks. While several central banks have started expressing more caution about the path of future monetary policy measures, some emerging market central banks have actually started hiking policy rates. The most prominent central bank in the world, the US Federal Reserve, indicated that it has officially started talk about the possible near-term tapering of its current USD120 billion monthly bond purchase programme. This is despite its firmly held view that the current inflation surge is merely transitory. A growing number of its Monetary Policy Committee members have also brought forward their rate increase expectations, but with the first hike at earliest still only forecast in 2022.

Locally, the South African Reserve Bank (SARB) repeatedly expressed the view that the recent surge in inflation was widely expected and can be mainly attributed to technical causes. More specifically, the SARB maintains the view that the current surge is not a threat to longer-term inflation stability (especially considering the persistent wide negative output gap) even though it did acknowledge upside risks to the short-term outlook. The announcement of a two-week escalation in lockdown restrictions as COVID-19 infections continued to rise is more than likely to support policy inaction for now.

Figure 2: SA terms of trade are still strong, but expected to roll over in the second half of this year


Source: Bloomberg, Futuregrowth

Surging metal prices continue to provide broad based macroeconomic relief

One of the main developments in the past few months has been the positive impact of the strong global commodity cycle on the South African economy. On the external side, a much-improved terms of trade (where the prices of our main exports rose faster than the prices of those imported) bolstered the current account balance to its largest surplus in decades. This contributed to a more resilient currency, allowing the rand to gain more ground in the quarter, admittedly also with some assistance from a weaker US dollar. Moreover, the significant direct impact on economic activity via the very strong mining sector performance continued to bolster tax revenue receipts, which in turn supported fiscal consolidation efforts.        

Figure 3: The Rand is better aligned with our estimate of fair value following recent strong appreciation (USD/ZAR exchange rate versus its estimated purchasing power parity)


Source: Bloomberg, Futuregrowth

Recent developments may have bought SA Inc some time

In addition to the good news regarding the improvement in economic growth, the balance of payments, and of course the fiscal situation, government came to the proverbial party with long-awaited announcements. In an effort to resolve the persistent dire energy generation dilemma, a significant increase in the independent energy producer limit from 1MW to 100MW was proposed. At a more structural level, more detail regarding the planned unbundling of Eskom and Transnet were announced. The Department of Public Enterprises also announced a possible South African Airways privatisation deal, the details of which were still lacking at the time of writing. Even so, the intention to enhance growth-enabling conditions and address the level of contingency risk to the fiscus is welcomed.

Even so, we are not out of the woods yet

Prior to these announcements, international rating agencies Moody’s, Fitch, and Standard & Poor released their latest South African sovereign credit rating reviews. The central message was largely aligned. In summary, the broad-based benefits from higher commodity prices as discussed above contributed to staving off further negative rating action for now. The agencies nonetheless expressed concern about our ability to return to a higher, sustainable economic growth path in light of structural hurdles and to continue on our fiscal consolidation path. Unsurprisingly, execution risk related to the intention to reduce the size of the bloated public sector wage bill was, once again, specifically flagged, given the recent strong stance by organised labour regarding the expectation of above-inflation increases. The alarming state of local government finances - where only 27 of the country’s 257 municipalities recorded clean audits - remains one of a number of concerns. In essence, the jury is still out on the outlook in the longer term, with attention already nervously turning to the next scheduled round of rating reviews in November this year. Another round of rating downgrades will take South Africa into the B-band (speculative rating band), something the market is not priced for at current yields. 

Figure 4: South Africa is not priced for another round of rating downgrades (Sovereign credit default spreads versus Standard and Poor’s sovereign ratings)


Source: Bloomberg, Futuregrowth

The nominal bond market regained some lost ground following a weak start to 2021

The developments described above, as well as the reduction in the size of primary government bond issuance at the weekly auctions by National Treasury, created room for nominal bond yields to drift lower, more so at the back end of the yield curve. In the process, the market regained some of the lost ground caused by the global mini-taper tantrum earlier this year. As a result, the FTSE JSE All Bond Index (ALBI) rendered a strong return of 6.86% during the quarter. The biggest positive contribution of 10.09% was from the 12+ year maturity band, as a result of bullish yield curve flattening.

Inflation-linked bond yields also ended the quarter lower, although inflation-hedging demand faded significantly towards the back end of the quarter. Even so, the FTSE JSE Government Inflation-linked Index (IGOV) still rendered a reasonable return of 2.95%. The performances rendered by both nominal and inflation-linked bonds were well above the 0.86% offered by cash during this period.

Figure 5: Bond market index returns (periods ending 30 June 2021)


Source: Bloomberg, Futuregrowth

// THE TAKEOUT

The sharp yield increase in major global bond markets (particularly the US) in the first quarter was backed by improved economic growth prospects, fears of higher inflation, and, by implication, future monetary policy tightening. This overdue sharp upward correction in developed market bond yields lost momentum in April and May as inflation concerns were played down by monetary policymakers, including the US Federal Reserve. Locally, extremely bearish rate expectations were also tempered by a strong, consistent message by the SARB, insisting that the upcoming inflation spikes are deemed transitory, which, together with a sustained negative output gap, imply no immediate impact on its policy rate. Some improvement in economic growth, the external account, and particularly the fiscal situation, convinced international rating agencies to hold back on rating action even though all expressed concern about the longer-term outlook. Improved risk appetite supported local markets for the second consecutive month. As a result, nominal and inflation-linked bond returns outperformed cash by a significant margin in May.

Key economic indicators and forecasts (annual averages)

 

    2017 2018 2019 2020 2021 2022
Gobal GDP   3.4% 3.3% 2.6% -3.6% 6.7% 4.6%
SA GDP   1.4% 0.8% 0.4% -7.0% 5.5% 2.0%
SA Headline CPI   5.3% 4.6% 4.1% 3.3% 4.1% 4.5%
SA Current Account (% of GDP)   -2.5% -3.5% -3.2% 2.2% 2.0% -0.5%

Source: Old Mutual Investment Group