“A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterised by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.” - Investopedia
An exponential escalation of infections causes business and consumer confidence to collapse
Much has been written about the COVID-19 pandemic, forced lockdowns and the devastating effect on economic activity. The outcome of this crisis is still largely unknown, and, until the globe manages to slow the infection rate or find a vaccine, it would be foolhardy to put numbers to forecasts. What is obvious is that the global economy will experience a significant recession in the first half of 2020. This will possibly be worse than the economic meltdown that followed the global financial crisis (GFC) in 2007/08.
The dire outlook for global growth and the national lockdown 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, our very vulnerable fiscal situation is in stark contrast to the much healthier position in the period preceding the GFC. All this contributed to the Moody’s downgrade of South Africa’s only remaining investment grade rating to Ba1. Even though this was widely expected, the timing is particularly unfortunate in light of constrained domestic bond market activity, our exclusion from the World Government Bond Index (WGBI) and the enforced selling by passive managers that will come about as a result of the exclusion.
South Africa Gross Domestic Production – more downside risk to an already dark picture
Source: Bloomberg, Futuregrowth
Panic selling followed widespread risk aversion
The disruption to economic activity caused by the pandemic in most parts of the world, and the uncertainty about the near-term path, led to frantic selling across almost all asset classes. Emerging markets are particularly at risk in light of a significant global recession. In turn, this fear-fed risk aversion by foreign investors had a devastating impact on currencies and bond markets.
Locally, the rand weakened from an exchange rate of R15.65 to R17.85 against the US dollar, ignoring the benefits of the dramatic oil price collapse to a large oil importer such as South Africa. Foreign investors sold close to R50 billion of local bonds over this period. The sheer weight of local and foreign selling in combination with a dire lack of liquidity caused both nominal and inflation-linked bond yields to spike in a dramatic fashion. The lack of liquidity was worsened considerably by the decision by National Treasury in the midst of the unfolding crisis to relieve private banks (acting in the capacity of official market makers) from the requirement to make two-way prices to the market. This only served to feed seller panic, with buyers few and very far between.
The yield of the 10-year SA Treasury bond is well above our estimate of fair value following the brutal sell-off in March
Bond volatility surpassed that experienced in 2007/08
On the nominal side, the yield of the 10-year SA Treasury bond (R2030) rose from 9.07% at the end of February to over 12%, before ending the quarter at 10.95%, returning -10.74% for the month of March and -9.6% for the first quarter. This intra-month trading range (and stock returns) are unprecedented and certainly worse than experienced in any preceding crisis period. Similarly, the yield of the 30-year SA Treasury bond raced from 10.22% to levels close to 14%, before closing the month at a yield of 11.75%. The higher duration of the ultra-long dated instrument caused the return to drop by -11.68% for the month and -12.02% for the quarter. Inflation-linked bond yields moved in tandem. The yield of the 10-year SA inflation-linked treasury bond (I2029) spiked from 3.74% to around 5.55%, before settling at 4.7% by month end.
South African 10-year nominal yield relatively attractive – even after the Moody’s ratings downgrade (local currency denominated bonds)
Source: Bloomberg, Futuregrowth
Cash was the only interest rate bearing asset left standing
With both yield curves steepening, the JSE ASSA All Bond Index (ALBI) returned -9.8% for the month and -8.7% for the first quarter. Similarly, the JSE ASSA Inflation-linked Government Index (IGOV) rendered a return of -7.3% in March and -6.9% for the quarter. Cash returns at 0.6% for the month and 1.7% for the first quarter look pretty enticing relative to the March bond blood bath.
Authorities from all over rushed to the scene of the COVID-19 accident
Both monetary and fiscal authorities across many countries jumped into action during the month in a desperate effort to offset some of the COVID-19 induced destruction to consumer and business confidence. In the US, the Federal Reserve reduced its official policy rate to zero and combined that with various measures of a more quantitative nature. A number of other central banks, who as recently as a mere month or so ago would not have considered any action, were forced to reduce lending rates and announce a range of supporting measures as well. On the fiscal side, the G20 committed to $5 trillion (which includes $2 trillion from the US) in extra spending. The International Monetary Fund is also expected to double its lending facility to $2 trillion.
Locally, the South African Reserve Bank (SARB) reduced the repo rate by 1%, followed by liquidity support in the form of lower capital requirements for private sector banks, in order to boost credit extension. The central bank also announced measures to improve the lack of bond market liquidity. While the Ministry of Finance announced a number of supportive measures, which will cause the budget deficit to balloon further, the jury is out on whether any of these will prove sufficient to stem the tide.
The bond market is priced for a higher debt-to-GDP ratio (and by implication a wider budget deficit) at current levels
The month of March constituted as near a perfect storm for South Africa as one could get. From a health perspective, the national lock-down was inevitable and a critical precautionary measure. However, it will add a very significant burden to an already frail economic situation. In turn, the combination of a deeper recession and additional demands on the fiscus will drag the national budget deficit deeper into negative territory. Our current Our Investment theme: “When sustained low growth becomes bond bearish” received an unfortunate boost with any hope of an economic recovery put on the back burner.
That said, the spike in nominal and real yields and the dramatic steepening of the nominal yield curve slope in particular, reflect a significant amount of bad news. With this in mind, we have and are likely to continue to cautiously and incrementally add risk to our portfolios.