Rating agencies catching-up with reality
On 20 November 2020 Fitch and Moody’s rating agencies downgraded the South African sovereign credit rating 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, impact on market yields
Even though few market analysts expected actual downgrades by any of the rating agencies in November, the more important matter is that the downgrades are 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 1 below, the market once again seems to be streets ahead of rating agencies.
Figure 1: Credit Default Swap spreads: Downgrades to BB- are priced in
Source: Bloomberg, Futuregrowth
Renewed bout of risk-seeking by unconstrained foreign bond investors
In contrast to October, when local investors stepped up to the plate, it was up to foreign investors to absorb excess supply during November. The combination of a USA presidential victory for Biden and promising news on a number of COVID-19 vaccines served as catalyst for a broad-based relief rally. The 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 yields. Net foreign buying of nominal bonds totalled a hefty R13.5 billion during November, which resulted in a decline of the year-to-date net foreign sales figure to R73 billion.
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.
Despite some hefty monthly food price increases, broad inflationary pressure remains remarkably subdued
The Headline Consumer Price Index (CPI) for the month of October showed a slightly higher than expected year-on-year increase of 3.3% from 3.0% in the previous month, mainly due to higher food and non-alcoholic beverage prices. Core CPI edged up to 3.4%. Despite these positive surprises, the fact remains that both these inflation indicators are still well below the official central bank mid-point target of 4.5%, while underlying inflation remains well contained. A similar outcome unfolded at the producer level, where the year-on-year price increase for final manufactured goods accelerated by 2.7% from 2.5% in September, with much of the upward price pressure emanating from food, beverage and tobacco products.
Another strong month for nominal bonds
As a result of strong foreign demand, nominal bond yields decreased, with longer dated bonds gaining most from a capital gain perspective. On the nominal side, the FTSE JSE All Bond Index (ALBI) rendered a strong return of 3.25% for November with the ALBI 12+ year maturity band the star performer with a return of 5.33%, as the yield curve flattened from the back end. Inflation-linked bonds ended the month with a fourth straight month of positive returns. In November, the FTSE JSE Government Inflation-linked Index (IGOV) managed to eke out a return of 1.97%, well below that of the ALBI, but beating cash (0.28%) hands down. For the first eleven months of 2020, the ALBI is in first place with a return of 6.07%, well above the 4.22% return offered by cash. The IGOV remained in last place with a return of 1.65%.
Figure 2: Bond market returns (periods ending 30 November 2020)
Source: JSE, Futuregrowth
// THE TAKEOUT
Although inflation is slowly regaining positive momentum, strong disinflationary forces are undoubtedly still at play. Even so, a cautious central bank opted to keep the repo rate unchanged at the last 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, it is still well below pre-lockdown levels. 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 fixed and inflation-linked instruments.