Feb 12, 2020
Bad news on the domestic front continues to trouble investors: load shedding, woeful economic growth, a further deterioration in government finances, policy inertia and the threat of a Moody’s downgrade – to name a few. It’s not surprising that the most common question we get from clients is: Why are the SA bond market and the rand holding up so well? The rand strengthened against the dollar while the bond market returned a solid 10% last year. We think the answer lies in defence. Much like the Springboks showed impressive defensive characteristics in winning the 2019 World Cup, so too do the rand and the SA bond market have two key defensive advantages, which help explain their expectation-beating performance in 2019.
The SA government is spending more than it earns, running a budget deficit of more than 6% of GDP. In monetary terms, this overspend translates into nearly R300bn annually. As a result, government debt to GDP has hit 60% – and is climbing even higher. Interest payments are now close to two-thirds of the government’s budget deficit. Given the magnitude of these numbers, the government relies heavily on foreign bond investors to help fund the overspend. Foreign ownership of SA government bonds amounts to 37%.1
We are seeing the effect of this foreign ownership on our current account. South Africa is running a current account deficit of 3-4% of GDP, which means that from an income perspective, more money flows out of our country than into it. Over the last five years, the interest paid to foreign debt holders has grown substantially. These foreign income payments are one of the biggest contributors to our current account deficit.
The two deficits are related, meaning the overspend by the government needs to be financed from offshore sources. South Africa therefore needs enticing real interest rates to attract foreign investors into our government bond market. To maintain this fragile equilibrium, the South African Reserve Bank (SARB) has little choice but to keep real interest rates higher than it otherwise would have done.
Figure 1: SA has to offer foreign investors enticing rates to keep the rand stable
Source: Ninety One SA (Pty) Ltd and Bloomberg, as at December 2019, and 2020 forecast, as at January 2020.
Figure 1 shows how maintaining this delicate balance has kept inflation under control and the rand relatively stable, despite the marked fiscal deterioration. Inflation has realised close to 4.5% over the last few years and cash rates have been 2-3% above that. Such real rates are very attractive in relation to what you can get globally. As a result, foreign investors have been enticed to allocate capital to the SA bond market, keeping the rand and yields relatively steady.
Global recession fears over the past two years have seen yields in developed markets (DMs) decline. With bond yields low to negative in DMs, investors are increasingly seeking higher yield opportunities in emerging markets (EMs). But how does the SA bond market stack up against EM peers?
Figure 2: The bond market’s defence – a lot of bad news is priced in
SA 9-year bond yield vs. EM spread
Source: Bloomberg, as at 10.01.2020.
As can be seen from Figure 2, which shows what SA government bonds yield over their EM peers, pre-2015 SA had a yield spread of approximately 1-1.5%. This has widened to a premium of over 3.5% above EM peers – a level that is even higher than when we were heading into the ANC Elective Conference at the end of 2017 (bond prices fall when yields rise – so this amounts to a significant price discount). Many would argue (as we do) that SA is in a far better place politically than it was in 2017, so we believe these higher relative yields mean a credit rating downgrade is largely priced in.
Moody’s next rating review is scheduled for March this year, after February’s budget. We would need to see a significant attempt to consolidate SA’s debt trajectory for Moody’s not to downgrade, and that consolidation would likely have to come from the government wage bill. Given that the quantum of savings required is a minimum of R150bn over three years, and considering how politically sensitive such a move would be, we think a resounding fiscal response (whilst not impossible) is unlikely.
We do not expect the government’s fiscal predicament to be resolved any time soon, and therefore, these higher real interest rates and the positive income environment will likely persist.
With inflation firmly under control around the SARB’s mid-point target range and demand so weak, there is room for another rate cut or two this year. However, with the obvious fiscal risks and the need to offer enticing real interest rates, the scope for material cuts (in excess of 1%) is limited. We would need to see the fiscal risk premium reduce before such a prospect becomes feasible. Uncertainty over Eskom and precarious government finances are constraining economic growth. Further governance and economic reforms are crucial to restore confidence and jumpstart the economy.
The rand and SA bonds have also held up because the global environment has become more supportive. The US Federal Reserve started cutting rates last year and has also employed other monetary stimulus measures, which have bolstered risk assets. The US-China ‘phase one’ trade deal has lifted markets too. Our bond market and the rand have also benefited from these initiatives. Because of our dependence on foreign investors, we would argue that the global environment is as important as the local environment for SA fixed income assets.
But we would be naïve not to recognise that risks and uncertainties abound – both on the local and global front. It remains to be seen whether Eskom can arrest its decline and if February’s budget will offer concrete measures to address government debt and allay Moody’s concerns. We expect global growth to continue to stabilise this year, but recession fears are never far away.
From a Diversified Income portfolio perspective, how do we deal with what is a fantastic inflation-beating income environment amid the obvious local and global risks? We believe SA fixed income still offers very attractive valuation opportunities, and we have a balance of exposures to provide some protection. Whilst we are positioned to take advantage of appealing real bond yields, our offshore exposure acts as a buffer, should any of these risks arise. This investment strategy has worked well for us during periods where we have experienced bond market volatility or rand weakness.