High yields lure buyers back despite persistent negative news flow
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In our March market commentary, we argued that the sharp intra-month rise in market yields had gone too far. Although the investment theme deteriorated in a significant way, it appeared that the market, at that point, had discounted a lot of the negative news flow.
Our argument turned out to be correct. During April, the majority of the RSA Government nominal fixed-rate and inflation-linked bonds ended the month at lower yields. In the nominal bond market, the pull-back in yields was more prevalent at the shorter end of the yield curve, while yields at the back end actually closed the month slightly higher. More specifically, the 10-year SA Treasury nominal bond ended April at 10.28%, 67 basis points (bps) below the previous month’s close. This is also almost 200bps lower than the March intra-month yield peak. In contrast, the yield of the 28-year SA Treasury bond ended April at a yield of 11.80%, or 5bps higher than the March closing yield.
Figure 1: South African nominal bond yield curve changes
Source: Bloomberg, Futuregrowth
The textbook example of yield curve bull steepening in Figure 1 above was the result of strongly opposing forces. The South African Reserve Bank (SARB) responded to the sharp drop in economic activity and the significant downside risks to an already benign inflation outlook by aggressively reducing the repo rate by a further 100bps. This followed the 100bps cut in March, and dragged down yields at the short end of the curve. At the back end of the curve, investors are more sensitive to the implications of a fast-deteriorating fiscal situation and, ultimately, the future ability of government to service the ballooning debt load. This well-founded concern impacted investor appetite for long-dated bonds, even at the elevated yields.
Inflation-linked bond yields across the curve moved in tandem with the nominal bull rally. The yield of the 10-year SA inflation-linked treasury bond (I2029) declined from the March close of 4.7% to 4.3%, a level well below the March intra-month weakest point of 5.5%. The relief rally was in defiance of the significant downside risk to inflation in the short term, as well as the very vulnerable fiscal backdrop.
Figure 2: Nominal RSA government bond market: Stock returns for periods ending 30 April 2020
Source: I-Net, Futuregrowth
As illustrated in Figure 2 above, although the April relief rally caused cash returns to drop to the last position in the short term, Nominal RSA government bonds remained the best performing asset class over all other periods.
Although both the JSE All Bond Index (ALBI) and JSE Inflation-linked Government Index (IGOV) delivered strong total returns in April, the March market weakness was devastating enough to leave both indices short of a cash return for the year-to-date and twelve-month periods, as can be seen in Figure 3 below.
Figure 3: Total index returns for periods ending April 2020
Source: I-Net, Futuregrowth
The collapse in economic activity resulting from the national lockdown dominates the real economy
Although the spread of the pandemic appears to be flattening in certain parts of the world, the outcome of this crisis is still largely uncertain. The extent of this uncertainty is demonstrated by a persistent stream of GDP downward forecast revisions. At the same time, the debate around the various shapes that the economic recovery might take fluctuates mostly between a hopeful V and a more realistic U, with other more dreaded possibilities like the L-shape also receiving some air time. What appears clear is that the global economy will experience a significant recession in the first half of 2020. This is likely to be worse than the economic meltdown that followed the global financial crisis (GFC) in 2007/08. Compared to a month ago, the exacerbated impact of the crisis on the world’s largest economy, the USA, has been a particular concern.
The vulnerable South African economy is dragged downstream
The combination of the dire outlook for global growth, the extended national lockdown and the slow pace of economic activity normalisation could not have happened at a worse time for South Africa. Not only are we experiencing the longest sustained weak economic growth path since 1945, but our very vulnerable fiscal situation is in stark contrast to the much healthier position in the period preceding the GFC. All this not only contributed to the much-anticipated Moody’s downgrade of South Africa’s only remaining investment grade rating to Ba1, but also forced deeper cuts into sub-investment territory by rating agencies Fitch and Standard & Poor’s during April.
The Moody’s rating action forced the country’s exclusion from the World Government Bond Index (WGBI) at the end of April, which in turn forced the selling of rand-denominated RSA government bonds by WGBI tracking passive managers. As could be expected, much of this well-telegraphed event had been anticipated by active managers. This is demonstrated by the net selling by foreign investors, which now totals around R68 billion for the first four months of the year. About R16 billion of the net sales figure was recorded in April. As a result, the share of foreign investor holdings of RSA rand denominated government bonds, has decreased to 33%, as can be seen in Figure 4 below. This is already well below the peak of 42% recorded almost two years ago, and is fast heading to the percentage held prior to SA’s inclusion in this and other indices in 2012.
Figure 4: Foreign ownership of RSA Government bonds (percentage of nominal and inflation-linked bonds)
Source: JSE, Futuregrowth
Meanwhile, more supportive policy measures have been announced
Over the past month, global measures in response to the economic fallout kept rising as the crisis deepened. South Africa followed suit and released additional supportive measures to the initial response. On the monetary side, the SARB cut the repo rate by a further 100bps, while announcing other measures, including the buying of RSA government bonds in the open market, as a counter measure to the worsening liquidity conditions. Despite a vulnerable fiscal situation, the South African government firmed up on a R500 billion support package. While part of this will be a re-prioritisation of existing government expenditure, National Treasury will also seek funding from several multi-national organisations.
The fiscal outlook worsens by the day
The undeniably strong link between economic activity and the ability of the state to collect tax revenue has been confirmed in a stark manner. Forecasts of economic growth and the fiscal deficit have been moving more deeply into the red, and this is now being demonstrated by the actual data. Monthly budget data for the month of March showed a disappointing shortfall of R51.2 billion. As a result, the main budget deficit for the fiscal year 2019/20 slipped to 6.8% of GDP, worse than the revised estimate of 6.5% as tabled in the February budget. With pressure on economic activity, and tax revenue collection far from flattening out, initial attempts to extrapolate make for dismal reading. Our own attempts at getting a handle on the fiscal deficit and the level of outstanding debt continue to show significant downside.
A few short-term gains
The country has been hamstrung by the so-called twin (national budget and current account) deficit phenomenon for a number of years. While the former is worsening in an exponential manner, pressure on the external account has eased in a significant way, admittedly mostly due to the COVID-19 induced crisis. A record merchandise trade surplus of R24.3 billion was recorded for March. This followed closely on a R13.7 billion surplus in February. The dramatic collapse in crude oil prices (which make up about 12% of the import bill) and a contraction of imports of other goods owing to the stalled economy contributed to a significant overall contraction in imports. This, coupled with stronger exports (mainly precious metals) led to the surplus. This is expected to significantly improve the current account balance - possibly forcing it back into a small surplus. However, the jury is still out on the sustainability of the improvement, especially once local and global economic conditions start to normalise.
On the inflation front, relative price stability remains the story of the hour. The latest available Consumer Price Index (CPI) data confirms a very muted underlying inflation picture with no evidence of pass through from a significantly weaker rand, admittedly at this very early stage. In March, a slower than expected rate of increase of 4.1%, mainly due to lower education and health inflation, compares well to the 4.6% recorded in February. In the short term, the rate of inflation as measured by CPI might still fall sharply, perhaps to as low as 2%.
These developments will allow the SARB to ease monetary policy over the next few months in an effort to contain some of the economic fallout from the significant drop in economic activity.
// THE TAKEOUT
During April the market managed to regain some of its horrendous March losses. Low inflation and a collapse in economic activity enabled the central bank to reduce the repo rate, and the yields of shorter-dated bonds moved in tandem with this. In contrast, the worsening fiscal situation caused the yields of long-dated bonds to remain trapped at relatively higher levels. The combination of these opposing forces led to yield curve bull steepening. This curve adjustment was aligned with our expectation of near-term yield curve changes.