An eventful quarter closes off a harrowing year
Blips aplenty on the financial market radar screen
The last quarter of the year, which will most likely be remembered for misery and hardship, was action-packed. Unfortunately, the COVID-19 pandemic remained prominent, and turned into a rollercoaster ride as sentiment alternated between vaccine-related euphoria and renewed despair caused by second and third waves of infection. While the globe continued to battle the human tragedy and economic ruin caused by the pandemic, financial markets had lots to process, including the surreal events surrounding the US presidential election.
SA government confirms commitment to fiscal consolidation
Locally, the dire fiscal situation remains one of the main concerns. The Medium Term Budget Policy Statement (MTBPS) tabled on 28 October reiterated the commitment to fiscal consolidation initially outlined in the June Supplementary Budget. Compared to the Supplementary Budget, the MTBPS appeared to be more credible in terms of the size of the proposed expenditure reduction and the more likely public sector debt path. In essence, the focus remains (as it should, in light of the country’s low growth trap) on expenditure management as opposed to higher tax revenue collection. The lower but more realistic cumulative expenditure cut for the fiscal years 2021/22 and 2022/23 of R139 billion, compared to the estimate of R230 billion tabled in June, is also closer to our more conservative estimate of R115 billion.
That said, in terms of implementation risk, our biggest concern remains the pencilling of a reduction of the public sector wage bill. Although this is welcomed, execution risk is very high in light of the fact that negotiations on the upcoming wage cycle starting in the 2021/22 fiscal year between government and organised labour are yet to start. We also fear that the MTBPS underestimates the size of financial support to state-owned enterprises (SOEs) and other spheres of government, including a growing number of financially distressed municipalities. Even if these risks do not crystalise, the latest consolidated budget deficits still range between a high of 15.7% for the current fiscal year and a low of 7.3% for 2023/24, in turn calling for a large borrowing requirement. As a result, the public sector debt ratio is only expected to peak in 2025/26 at 95.3%, around 8% higher and two years later than the June supplementary budget estimates.
Figure 1: Consolidated public sector debt and weekly bond issuance
Source: National Treasury, Futuregrowth
International rating agencies forced to realign with reality
The tabling of a more realistic MTBPS did not prevent Fitch and Moody’s credit rating agencies from downgrading their South African sovereign credit ratings by one notch to BB- and Ba2 respectively. Both agencies retained a negative outlook. Unsurprisingly, none of the reasons backing the downgrades were newsworthy. Sustained low trend growth, exacerbated by the COVID-19 pandemic, significant implementation risk around fiscal consolidation and structural reform plans, the fast-rising debt burden and, more specifically, the unaffordability thereof are all well telegraphed. Rigid labour market conditions - especially in light of plans to reduce the unsustainable size of the public sector wage bill - received specific mention, and for good reason. In contrast, Standard & Poor’s (S&P), which had already downgraded the country to BB- in April, opted to affirm its rating, but with a stable outlook.
Rating action had very little, if any, negative impact on market yields
Even though few market analysts expected actual downgrades by any of the rating agencies as soon as November, the more important matter is that the downgrades were already baked into market pricing. This is demonstrated by basic market valuation indicators, of which the level of credit default swap spreads relative to the S&P sovereign credit rating is but one. As demonstrated by Figure 2 below, the market once again seems to be streets ahead of rating agencies. That said, the graph below also clearly suggests that a further slippage down the ratings scale is not priced.
Figure 2: Credit Default Swap spreads: Recent downgrades to BB- are priced
Source: Bloomberg, Futuregrowth
Bout of risk-seeking by unconstrained foreign bond investors
The rating downgrades and sober news around the national budget did little to discourage renewed foreign interest in local bonds. In stark contrast to much of 2020, which saw foreign investors aggressively reducing their RSA government bond exposure, some buying interest resurfaced the last two months of the year. The combination of a USA presidential victory for Joe Biden, promising news on COVID-19 vaccines and indications of some economic recovery served as a catalyst for a global relief rally. This jump in global risk appetite spilled over to the South African bond market as those foreign bond investors who are indifferent to sovereign credit ratings took their cue from the relatively high level of local bond yields as well as an undervalued local currency. As a result, net foreign buying of nominal bonds totalled a hefty R33 billion during November and December. Even so, foreign investor holdings of RSA government bonds are still R60 billion lower compared to the end of 2019 and well below the peak recorded in May 2018.
The central bank again opts to keep the repo rate unchanged
At the November Monetary Policy Committee meeting, the South African Reserve Bank opted to keep the repo rate unchanged, with two of the five committee members voting in favour of a 25 basis points rate cut. Concern about the poor fiscal backdrop once again played a role in the decision to keep monetary policy stimulus unchanged, although the bank did not turn a blind eye to some improvement in economic activity or some upside risk to inflation in the medium term.
Strong rebound in economic data supports central bank caution
Following the severe lockdown-induced economic growth slump in the second quarter, economic activity rebounded strongly in the third quarter as, unsurprisingly, all sectors expanded following the sharp and broad-based contraction the preceding quarter. While the economy expanded at a seasonally adjusted annualised rate of 66% during the third quarter, the depth of lost output in the preceding quarter caused overall GDP to still be down by 6.0% relative to the same period a year ago. Also noteworthy is the very strong balance of payments rebound as the South African current account recorded a surplus of 5.9% of GDP in the third quarter, a significant swing from a 2.9% deficit the previous period. This follows a 31.8% quarter-on-quarter surge in export volumes, while stagnant imports and a decrease in net income outflows also contributed to deliver the largest quarterly current account surplus since the late 1980’s. On the inflation front, the current situation remains fairly benign as the Headline Consumer Price Index (CPI) for the month of November eased to 3.2% year-on-year despite higher than expected food inflation.
A strong quarter for both nominal and inflation-linked bonds
As a result of strong foreign demand, nominal bond yields decreased, with longer-dated bonds gaining most from a capital gain perspective. As a result, the FTSE JSE All Bond Index (ALBI) rendered a strong return of 6.76%, with the ALBI 12+ year maturity band the star performer as it returned 8.97% following yield curve flattening. Likewise, inflation-linked bonds also outperformed cash handsomely, even without support from foreign investors. The FTSE JSE Government Inflation-linked Index (IGOV) returned a strong 5.48% as real yields decreased. Although lower than the return offered by nominal bonds, it also outperformed cash (0.86%) hands down. For the 2020 calendar year, the ALBI ended in first place with a return of 8.65%, well above that of cash (4.52%). Even though it made up significant lost ground following a very poor prior twelve months, the IGOV remained in last place with a return of 3.94%.
Figure 3: Bond market returns (periods ending 31 December 2020)
Source: JSE, Futuregrowth
// THE TAKEOUT
Although inflation is slowly regaining positive momentum, strong disinflationary forces are still at play. Even so, a cautious central bank opted to keep the repo rate unchanged at the most recent November MPC meeting, following a series of unprecedented cuts earlier this year that left the repo rate at an all-time low of 3.50%. While economic activity appears to be picking up following the devastating impact of the national lockdown in the second quarter, economic activity over an extended period remains relatively subdued. This does not bode well for a fiscal situation that is already at its most fragile in many years, and unfortunately supports our scepticism about government’s ambitious expenditure reduction plan. The recent bout of sovereign rating downgrades simply serves as confirmation. The combination of stable monetary policy and an increasingly slippery fiscal path implies an anchored short end, but upside risks to the yields of longer-dated nominal and inflation-linked instruments.