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A strong month for inflation-linked bonds: should we jump for joy?

31 Aug 2020

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

Economic & bond market review

Inflation is lifting its head – from a very low base

If we had to highlight a single development during this past month, it would be the jump in inflation-linked bond (ILB) returns.  Let us start at the beginning.  The year-on-year rate of increase in both the Consumer and Producer Price Indices accelerated for the first time since the end of 2019 with the July data releases.  In the case of the Consumer Price Index (CPI), the year-on-year rate of increase accelerated from 2.2% in June to 3.2% in July.  While this development made the inflation bears (and by implication the ILB bulls) jump with joy, some perspective is required. 

In the case of the CPI, the acceleration was largely due to the base effect caused by petrol price changes - more specifically, a petrol price increase of R1.63/litre in July 2020 versus a decrease of R0.95/litre twelve months earlier.  For the Producer Price Index (PPI), the year-on-year acceleration in July was 1.9% versus 0.5% the previous month.  Similarly, this was mainly the result of higher fuel prices, while the increase in the prices of electrical, machinery and communication products were also noteworthy.  Coming from such a low base, these changes were broadly aligned with general market expectations and our own.  Moreover, a detailed analysis still points to very muted underlying inflationary pressure.  Since the July data releases were aligned with our expectations, we continue to expect CPI to dip below 3% over the next few months, before rising to levels around 4.5% on a twelve- to eighteen-month horizon.  From a global perspective, it is worth noting that the US Federal Reserve’s preferred inflation measure (the PCE Deflator) also headed higher in July. 

Figure 1:  SA Consumer Price Index: Year-on-year rate of change
                 (Forecast = Dark Teal)

SA Consumer Price Index: Year-on-year rate of change
Source: Old Mutual Investment Economic Research

Higher inflation contributed to renewed interest for inflation protection

Even though the principal of inflation-linked bonds is re-priced with a three-month lag, the recent data releases more than likely prompted stronger investor demand as the July data releases signalled the bottom of the current inflation cycle.  This caused real yields across the curve to decline.  In the case of the 10-year RSA inflation-linked government bond, this is now trading below our fair value estimate.  As a result of the decline, the FTSE JSE Government Inflation-linked Index (IGOV) returned 3.95%, beating both the cash return of 0.3% and the 0.89% of the FTSE JSE All Bond Index (ALBI) by a significant margin in August (refer to Figure 2).    

Figure 2: Index returns for periods ending 31 August 2020

Index returns for periods ending 31 August 2020
Source: JSE, Futuregrowth

Some improvement in economic activity, but we are not out of the woods yet

South Africa’s leading indicator picked up in June with positive contributions from seven of the nine components.  This was confirmed by actual economic activity which continued to recover even though it remained well below pre-COVID-19 levels.  Indicators such as electricity demand, new vehicle sales and manufacturing activity all rebounded from the collapsed levels in April.  Even though this is welcome news, the sustainability of the rebound remains questionable.  One indicator calling for caution is the continued sharp slowdown in underlying corporate and household credit extension, a clear signal that both sectors are under significant duress, while lenders have also become more risk averse.  In the case of private sector credit extension growth, the year-on-year rate of increase continued to slow with the July data down to 5.1% from 5.6% the previous month.  Household credit extension remained particularly lacklustre at 3.2%.       

Another large merchandise trade surplus

Data for July showed another impressive surplus of R37 billion, only slightly lower than the June number of R47 billion.  While the collapse in economic activity caused a 19% month-on-month slowing in merchandise imports in June, this was more than reversed in July by a 22% month-on-month increase.  In light of this, the continued strong performance of some of the export categories is particularly pleasing.  This development continues to bode well for a current account surplus and might, in combination with a weaker US-dollar, lend some support to the currency. 

Latest fiscal data release confirms the fiscal slide

The July fiscal data continued to confirm the impact of the anaemic economic environment.  Revenue collections remain in the red with a cumulative year-on-year collapse of 21%, reflecting the dire economic consequences of the COVID-19 induced crisis. On the expenditure side, initial slow spending is starting to pick up once again with the relaxation of lockdown restrictions, with July year-on-year growth coming in at 14.2%. Overall, fiscal data thus far suggests that the risks to debt sustainability remains elevated, highlighting the urgent need for significant expenditure cuts and structural reforms.         

// THE TAKEOUT

Even though inflation is gaining positive momentum, an extremely low base played a significant role.  Strong disinflationary forces are still at play.  While economic activity appears to be picking up, it is still below pre-lockdown levels and, for now, at risk of staying at relatively weak levels.  This does not bode well for a fast deteriorating fiscal situation and unfortunately supports our scepticism about government’s ambitious expenditure reduction plan.   

Key economic indicators and forecasts (annual averages)

 

    2016 2017 2018 2019 2020 2021
Gobal GDP   2.5% 3.4% 3.3% 2.6% -3.8% 5.0%
SA GDP   0.4% 1.4% 0.8% 0.4% -7.6% 5.2%
SA Headline CPI   6.3% 5.3% 4.6% 4.1% 3.0% 3.9%
SA Current Account (% of GDP)   -2.9% -2.5% -3.5% -3.2% 1.5% -1.0%

Source: Old Mutual Investment Group