Nov 18, 2020
So far, 2020 has set some interesting new records. The pandemic-induced global stock market crash in March this year was the fastest plunge in history. This was swiftly followed by the S&P 500 Index’s record-high close on 18 August, which officially ended the shortest bear market in history.1 Our markets also set some records of their own. SA bonds lost nearly 10% in March – the worst month ever. COVID-19 economic shocks and the country losing its investment-grade credit rating resulted in the nine-year bond reaching an eye-watering intra-day high of 13.25% in March. Liquidity constraints and a dysfunctional market saw the South African Reserve Bank (SARB) buying bonds to help stabilise the market. Fortunately, SA bond market yields are now back at pre-pandemic levels. But has the market returned to normal? We don’t believe this is the case, as shown in Figure 1.
Figure 1: What a year it has been
Source: Bloomberg and Ninety One as at 28 October 2020.
With inflation being firmly under control for some time already, and hovering around 3%, the SARB has had plenty of room to cut interest rates. The repo rate was 6.5% coming into the year, but after a series of cuts is down to 3.5%. The positive inflation picture and aggressive rate cuts would normally have given rise to much lower bond yields (when bond yields decline it means their prices increase). But despite these favourable factors, SA bond yields have remained stubbornly high, reflecting fiscal concerns. The grey line in Figure 1 shows the bond yields of our emerging market (EM) peers, and the dark green line, the yield on the nine-year SA government bond. The gap between South Africa’s bond yields versus those of comparable EM peers, known as the yield spread, has never been as wide as it is now. Essentially, South African bonds have never before traded at such a large discount to their EM peers.
South Africa’s higher yields (and deeper discount) should place it further up the queue to attract foreign capital than a lot of its EM peers. But over the last year, there has been a serious lack of foreign interest in our bond market. Foreign ownership of SA government bonds has declined to 2012 levels, and is sitting at approximately 29% (as at the end of October), as shown in Figure 2.
Figure 2: Foreign holdings of SA government bonds, the lowest in eight years
Source: National Treasury, as at 30 October 2020.
China’s bond market has attracted billions of dollars of inflows following its inclusion in worldwide bond indices, the Bloomberg Barclays Global Aggregate Bond Index – starting in April 2019; the FTSE Russell World Government Bond Index (WGBI) – starting in October 2021; and the JP Morgan GBI EM Global Diversified Index (GBI-EM GD) – starting in February 2020. South Africa’s bond weighting in emerging market indices such as the GBI-EM GD has been diluted as China’s weighting has steadily increased over time. This has been a headwind for our market over the last six months. However, the impact on our bond market has started to become less pronounced as China is nearing the end of its inclusion phase in the GBI-EM GD.
When South Africa lost its investment-grade credit rating in March, it resulted in the country’s exclusion from the WGBI. This meant that many large foreign funds could no longer hold our bonds and were forced sellers. South Africa experienced an outflow from the bond market of over R70bn between March and May of this year.
The fiscal deterioration in South Africa has been a big concern for investors who want to see concrete steps from government to stabilise public debt. The last three years have been very disappointing for investors, as the government has been long on promises but short on detail. While good plans are valued, all eyes are on implementation.
The COVID-19 crisis sparked a wave of global market risk reduction, with investors seeking refuge in “safe-haven” and liquid assets such as developed market (DM) government bonds. Global risk sentiment has improved in recent months. However, second wave COVID-19 outbreaks, and uncertainty over the US election and the magnitude of fiscal stimulus measures, have resulted in some investors adopting a more cautious approach.
South Africa has been spending beyond its means for several years. The COVID-19 shocks to our economy exacerbated our precarious fiscal situation. Government’s massive revenue shortfall – expected to be more than R300bn lower than originally projected – should not be seen as a temporary situation. Instead, it points to an impairment of the tax base, which will take years to recover. That is why the measures spelt out in the Medium-Term Budget Policy Statement (MTBPS) to control expenditure are so important.
Four months into the COVID-19 crisis, Finance Minister Tito Mboweni announced very ambitious spending cuts. If these cuts were implemented, the June Supplementary Budget projected that South African government debt-to-GDP would stabilise at 87.4% of GDP in 2023/24. However, in the MTBPS, overall spending cuts are now around R100bn less than was announced in June. The peak in the debt-to-GDP ratio has been pushed out to 95.3% of GDP in 2025/26. While the slippage on expenditure plans is not ideal, the spending mix is a lot better.
The MTBPS reprioritised non-wage spending to improve service delivery, while making provision for even deeper cuts in the wage bill. In the current fiscal year, public sector wages will account for close to 60% of all taxes collected. Therefore, approximately 2.5% of the population will consume 60% of all taxes collected. It is widely recognised that the public sector wage bill is unsustainable and that is where government needs to cut. The MTBPS attempts to be realistic about the spending cuts that can be achieved while holding a tough line on wages. With that combination, we think the October mini budget is reasonable. So, it’s all about wages. If government can contain public sector wage growth, we may see some capital uplift in the bond market as investor sentiment improves.
The US dollar has weakened steadily over the last few months, largely due to the US Federal Reserve’s (the Fed’s) monetary policy measures, which include very low interest rates and bond buying to aid the US economy. A weaker dollar benefits EMs as it bolsters their currencies, supports commodity prices and promotes a more favourable environment for investing in these countries’ assets. The Fed is committed to keeping short-term borrowing costs near zero for the foreseeable future, even if unemployment falls sharply, which usually signals higher inflation. Lower interest rates for longer should remain a drag on the dollar. Besides the weaker dollar, low interest rates in DMs are a global tailwind for EMs such as South Africa. The euro area and Japan have gone a step further than the Fed, allowing interest rates to fall below zero. So, South Africa, with its high real interest rates, low inflation and stronger rand, has a window of opportunity to attract foreign capital flows into the bond market.
The Fed, which should expand its bond-buying programme towards the end of the year, has called for further fiscal stimulus measures to prop up US growth. The Republicans and Democrats failed to reach an agreement on fiscal easing before the election. Markets would like to see substantial fiscal measures soon. But a divided US government means that the magnitude and timing of the fiscal package will likely remain uncertain in the near term. A large fiscal boost would provide much-needed support to the US economy, and in turn, the global economy and markets – including EM countries. A Biden presidency should also see more stability on the geopolitical front.
Against a backdrop of intense market volatility, we’ve had a strong emphasis on protecting the capital of our investors this year and have managed to deliver returns that are comfortably above inflation and cash (12 months to end September).
Exposure to offshore assets plays an integral part as a risk mitigator in our portfolio. During the height of the market meltdown (March and April of this year), our offshore exposure helped to bolster portfolio returns when the domestic market was under severe pressure. Of course, our level of exposure varies materially depending on market conditions, our currency outlook and other potential risk factors. While our offshore exposure was as a high as 10% during the first quarter, we are currently sitting between 3 and 5%. We expect the rand to be resilient in the near term, given the weak US dollar, an improved global risk appetite and South Africa’s favourable terms of trade.
The portfolio is slightly underweight credit. Institutions are not issuing much paper, plus there is huge demand, so credit is actually quite expensive. However, we are still finding some attractive opportunities and have maintained a decent allocation to credit in the portfolio.
With cash rates at record lows, government bonds are offering the best yields. Investors can earn in excess of 9% on a ten-year government bond, which is very attractive.2 A combination of government bonds with some foreign exchange exposure to mitigate the risks, allows our investors to earn a decent yield in the portfolio. We have a reasonable allocation to inflation-linked bonds, which also helps us to manage risk in the portfolio. If the government manages to contain its wage bill and we see some concrete progress on the path to structural reforms, SA bonds could enjoy a capital uplift.
Listed property is very volatile, and we remain underweight the sector. We think there is some upside potential, but sharp daily swings mean we have to carefully manage our exposure to listed property.
We have a balance of exposures to provide some protection against the multitude of risks locally and globally. This investment strategy has worked well for us during periods where we have experienced bond market volatility or rand weakness.
1 “Say goodbye to the shortest bear market in history”, Reuters, 18 August 2020.
2 As at 11 November 2020.
COVID-19 has been a sufficiently large shock to overcome longstanding behavioural and technological barriers to working from anywhere, and it has become a consensus view that the pandemic will prompt many companies to reassess geographic footprints, normalise flexible working arrangements and shift commuting patterns. We are witnessing a major socio-technological paradigm shift – within a decade our current world of work could look unrecognisable.