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Economic and market review 31.07.2018

31 Jul 2018






Economic and Market Review

Our monthly write-up of the markets.

Nominal bonds performance picked up in July

Following a weak second quarter, the local bond market got a new lease on life during July. Nominal bond yields drifted lower as risk appetite, especially from jittery foreign investors, recovered somewhat. The yield of the benchmark R186 (maturity 2026) decreased by 30 basis points to close the month at 8.58%. In contrast and despite a broad-based expectation of higher future inflation, inflation-linked bond yields continued their gradual rise to higher levels. At month-end, the yield of the benchmark R197 (maturity 2023) closed at 2.75%, well above the March 2018 low of 1.89%. 

Nominal bonds retain its top podium position 

As a result of these yield movements, the All Bond Index (ALBI) rendered a strong return of 2.4% in July, well ahead of both cash (0.5%) and the Inflation-linked Government Bond Index (0.3%). The strong nominal bond performance helped to consolidate the ALBI’s relative outperformance over the first seven months of this year. Over this period the ALBI returned 6.5%, compared to cash (3.8%) and inflation-linked bonds (-0.5%). 

Foreign bond buying resumed following improved risk appetite 

Earlier in July, this positive outcome did not seem likely. At the time emerging markets still faced a four-pronged assault, from uncertainty about the impact of potential international trade disruptions as spearheaded by Trump, a strong US-dollar, lower commodity prices (with the exception of crude oil), and concerns about a Chinese economic growth slowdown. This formed the basis for a significant reduction in global risk appetite, and as a result triggered capital outflows from emerging markets from May to early July. The portfolio outflows abated somewhat in recent weeks in response to some improvement in investor sentiment. The fact that local market valuation improved in light of the second quarter sell-off, and thus reflective of at least some of the negative developments listed above, goes some way towards explaining renewed buying interest. South Africa gained from the sentiment improvement as foreign investors added a net R5bn of local currency bonds in July. This despite global bond yields continuing to drift upwards as evidence is piling up in support of a broadening of tighter monetary policy in developed markets.

Risk to fiscal consolidation remains

The combination of a lower than expected Consumer Price Index reading and hawkishness from the South African Reserve Bank also helped stabilise demand for local long-dated government bonds. This coincided with a recovery in the external value of the rand over the past few weeks, particularly against the US dollar. Moreover, both monthly government financing and international trade data releases managed to ease investor concerns with regards to the twin deficits, despite our and the market’s concerns about the quality of tax revenue collections. The higher than expected reading of the Producer Price Index had little bearing on market sentiment, partly due to the fact that the spike had mainly been the result of higher petrol and diesel prices.  



Key macroeconomic themes

Economic growth

A moderate global economic recovery remains our base case, with a sustained, strong US economic recovery still leading the way. The significant loosening of US fiscal policy will continue to positively contribute to growth, although this expansionary attempt by the US government could be moderated by tightening monetary policy. Even so, we believe that the global recovery will continue to be structurally lower than in previous cycles, mainly due to lower productivity growth, ongoing broad-based balance sheet repair (deleveraging), and shifting demographics (ageing populations tend to save more and spend less). In the short term, we expect the tension pertaining to international trade protectionism to escalate. Compromised global trade relations, coupled with higher crude oil prices, could potentially become a larger drag on the global growth outlook.

Locally, the biggest impediment to higher local growth remains of a structural nature. Despite the seemingly improving socio-political backdrop, without urgent macroeconomic policy reform, any short-term cyclical upswing from the primary and secondary sectors of the economy will prove inadequate in addressing South Africa’s economic growth ills. The low growth trap largely remains the result of a policy vacuum, policy uncertainty, low levels of fixed capital investment, and a rigid labour market. While acknowledging the positive steps towards improved governance, marked by the reconfiguration of Eskom’s and Transnet’s boards, State Owned Enterprises still largely remain a negative risk to the fiscus, and as a consequence, to economic growth.


The US remains at the forefront of the global reflation effort, with a decade of ultra-easy monetary policy and recent fiscal stimulus yielding satisfactory inflationary effects. Progress towards European reflation is also highlighted by the recent announcement of asset purchase tapering by the European Central Bank. Although global reflation is welcomed, since this is what policy makers had aimed to achieve, the feed-through to underlying inflation remains contained. Final demand is not yet strong enough to cause core inflation rates in most developed economies to sustainably breach central bank targets.

Locally, the telegraphed drop in food inflation and a broadly neutral currency view result in our 2018 annual average inflation forecast of 4.7%. Although the net impact of recent tax changes, the one percentage point VAT hike in particular, is negligible to our inflation outlook, the sharp increase in the rand oil price as well as the threat of renewed currency weakness will contribute to upside inflation risk over the medium term. Even so, the pass-through of rand weakness to inflation still appears to be relatively weak, supporting the view that the near term acceleration in the rate of inflation may still turn out to be relatively benign.


Strong rand appreciation in December 2017 and the first three months of 2018, and a loss of competitiveness relative to peers, is undoing some of the previous benefit of rand weakness to the overall balance of payments. As a result, we expect a marginal widening of the current account balance from an annual average of -2.5% of GDP in 2017, to -3.5% in 2018 and -3.7% in 2019. The unfavourable income account deficit (primarily due to the large net dividend and interest payments to foreigners) remains a considerable drag on a sustained and meaningful balance of payments correction. Rising international trade tension and the sharp increase in crude oil prices are cumulatively negative developments that will adversely impact the balance of payments, especially for a small open economy like South Africa with strong Euro zone and Chinese trade links.


With an unemployment rate in the US now officially below 4% and inflation pressures gradually building, we believe that the Federal Reserve should continue with its interest rate normalisation process. We are of the view that it may be in a position to raise rates by more than what is currently priced by markets, i.e. by as much as another 50 basis points for the remainder of this year. While the Federal Reserve intends to reduce the size of its balance sheet in an interest rate neutral manner, we are of the opinion that the sheer size of this reduction should contribute to a gradual lift in the ceiling for US Treasury yields, which is already visible - with the 10 year Treasury bond reaching the 3% mark several times - especially if the economic recovery continues to gather momentum. In addition, the expected widening of the Federal budget deficit for the forthcoming fiscal year on the back of strong economic growth momentum will create additional scope for monetary policy normalisation.

The current trend of global monetary policy divergence is slowly changing from an overall quantitative easing stance to moderate tightening - with more policy tightening in the US on the cards, and the European Central Bank (ECB) confirming that it will continue to taper its bond buying programme. All told, we expect central bank hawks to slowly gain some ground over the next few months.

The South African Reserve Bank is expected to maintain its more cautious stance, which we fully support. Factors in this regard include: renewed pressure on the balance of payments; the fact that actual inflation is back above the mid-point of the target range (which the SARB has well telegraphed as the desired target point); inflation expectations remaining stubbornly close to the top end of the target band; and the waning support provided by a decade of ultra-loose global monetary policy. The risk to the stable repo rate outlook is skewed to the upside, mostly due to upside risks to the current inflation outlook.


Following the tabling of a less alarming national budget in February, National Treasury is still confronted by a very challenging fiscal path. As we have previously highlighted, structurally weak domestic growth is severely impeding the consolidation of SA’s budget balance. We now look to the actual delivery of fiscal and wide-ranging State Owned Enterprise (SOE) reform to reinvigorate consumer and business confidence as the scope to steer SA Inc. towards a sustainable growth path narrows. National financing data for the first four months of the 2018/19 fiscal year is tracking the budget estimate closely following sound fiscal performance in June. Even so, we remain concerned about the sustainability of fiscal consolidation due to the weak growth backdrop and the quality of tax revenue collections; specifically Personal Income Tax and Corporate Income Tax, which have historically contributed an average 37% and 17% to total revenue collected respectively.

Investment view and strategy 

The recently sustained pick-up in global bond yields notwithstanding, our view remains that most developed bond markets are still not appropriately priced. We believe that the Federal Reserve is in a position to lift its policy rate by at least another 50 basis points this year. In the case of the USA, the strong pace of economic growth, the low level of unemployment, and evidence of sustained higher inflation support further US monetary policy tightening. More importantly, at a global level, the trend continues to gradually shift from quantitative easing to quantitative tightening.

Locally, our main concern with regards to the bond market remains the strong link between lacklustre economic growth and fiscal consolidation - or more specifically the rising debt burden of government which continues to threaten the country’s sovereign risk profile. Recent political changes, action with regards to SOE management, and the tabling of the 2018/19 national budget went some way to reducing some of the concerns we previously had. However, it would be irresponsible to ignore heightened fiscal execution risk. The structural nature and extent of the country’s macroeconomic ills requires significant policy adjustment, which will take time and effort to resolve. In the short term, a host of soft economic data had been particularly disheartening together with its potential negative impact on fiscal consolidation. Although the latest monthly National Treasury financing data for the first three months of the 2018/19 fiscal year pointed to a deficit that is tracking the budget estimate closely, we remain concerned about the quality of tax revenue collections.

On the monetary policy front, we maintain that the central bank will remain hostage to the opposite forces of a lacklustre economic growth outlook and upside risks to inflation. For now, this to us implies a stable policy path. The risk to this view is skewed in favour of some upside risk to inflation and thus interest rates.

While the observable investment theme and real-time developments related to it mostly have negative consequences for the local bond market, it is important to note that current market valuation is reflective of this. Cheaper market valuations following the sell-off during the second quarter afforded us an opportunity to cautiously increase duration risk by selectively buying bonds, making it possible for our funds to have gained somewhat from the July bull-rally. We shall continue to look for opportunities to increase bond market exposure, but only into bouts of weakness considering the fair amount of uncertainty discussed above.

As a result, our broad interest rate investment strategy remains defensive. In the case of our Core Bond Composite (benchmarked against the All Bond Index), this is expressed as follows:



Key economic indicators and forecasts (annual averages)


    2014 2015 2016 2017 2018 2019
Gobal GDP   2.8% 2.9% 2.5% 3.3% 3.3% 3.2%
SA GDP   1.5% 1.3% 0.3% 1.3% 1.4% 2.2%
SA Headline CPI   6.1% 4.6% 6.3% 5.3% 4.7% 5.0%
SA Current Account (% of GDP)   -5.4% -4.4% -3.3% -2.0% -3.5% -3.7%

Source: Old Mutual Investment Group