Aug 12, 2020
What a tumultuous year 2020 has been so far! Bond investors experienced a harrowing first quarter, where SA bonds lost nearly 10% in March – the worst month ever. Not only have investors had to contend with the market fall-out from the COVID-19 pandemic, but also the credit downgrade to junk from Moody’s.
The South African Reserve Bank (SARB) has been cutting rates aggressively this year in response to the economic devastation caused by measures to contain the spread of the virus. Falling inflation and poor demand have given the SARB room to cut rates by a staggering 300 basis points this year. This brings the repo rate to 3.5%, the lowest rate since the system was introduced in 1998. These rate cuts, coupled with the benign inflation outlook and local and global stimulus measures, have helped to bolster SA bonds. We’ve seen a strong rebound over the second quarter, with the SA market returning almost 10%.
There’s no doubt that on the global front there is going to be stiff competition for capital over the next few years. The borrowing needs of governments across the world are increasing at unprecedented rates due to fiscal stimulus measures to bolster their economies. Developed markets have the luxury of not really having to queue for capital, given their central banks’ ability to monetise those borrowings in a non-inflationary way. But as this approach poses a significant currency risk for emerging markets (EMs) such as South Africa,1 we will have to join the long emerging market capital queue – with the relative attractiveness of our bonds and currency moving us up and down it.
Over the first half of the year, the rand took a huge knock, losing close to a quarter of its value against the dollar. A risk-off global environment, substantial foreign outflows from our bond market, SA’s fiscal deterioration, and aggressive domestic rate cuts, have all contributed to rand weakness. High real rates had previously helped to anchor the rand and protect the capital account as they enticed yield-seeking foreign investors to invest in our bond market. The SA government has relied heavily on foreign bond investors to help fund its ballooning budget deficit. While foreign capital outflows have been a concern, the weaker dollar environment may give National Treasury some breathing room to address public finances.
The unprecedented policy action from governments globally to cushion the virus impact has led to significant extra debt being added to already high levels. Global stimulus amounts to more than US$15 trillion, 2 which far exceeds support measures following the Global Financial Crisis. The US Federal Reserve (the Fed) is keeping the liquidity taps open, ensuring that dollar funding will remain readily available to foreign central banks until March 2021. Its emergency lending programmes will also run until the end of this year. Besides the Fed expanding its balance sheet aggressively, it’s also deeply committed to keeping interest rates rock bottom for the foreseeable future. While the Fed is pulling out all stops to save the global economy and keep financial markets going, the dollar has come under pressure.
With nominal interest rates pinned at zero and inflation pressures allowed to build, the Fed is hoping to engineer negative real interest rates for the next few years at least. As a consequence, the US could see capital outflows as investors seek positive real yields elsewhere. Such a move could see capital flow to Europe, Japan and China, and high-yielding emerging markets. Ironically, places like Japan and Europe that have traditional low carry currencies with negative nominal rates, could be considered “higher carry” than the dollar, given higher realised inflation in the US and the Fed’s ability to therefore engineer more negative real rates.
With fiscal and monetary policy measures in overdrive, US consumer spending could pick up and add fuel to the potential oversupply of dollars. Ultimately, very loose monetary policy in the US could put pressure on the country’s current and capital accounts, which in turn would keep the dollar on a downward path.
Over the last few weeks, the rand’s fortunes have been buoyed by the relatively weak dollar environment. Looking forward, the value of our currency can be thought of as a battle between the capital and current account, with the dollar environment and global sentiment being key considerations in attracting capital and foreign flows.
Figure 1: The rand – a battle between current and capital accounts
Source: Bloomberg, data as at 27 July 2020
One of the key factors in the health of our current account is our terms of trade – it serves as a proxy for our ability to generate foreign income through trading with the rest of the world. South Africa’s terms of trade have been improving because our exports have been bolstered by rising commodity prices, such as iron ore and gold. At the same time, the value of our imports has fallen, largely because of the sharp decline in the oil price but also weak overall demand due to the lockdown and the severe economic contraction.
As can be seen in the chart on the left, the trade weighted rand (pink line) tracks our terms of trade (green line) reasonably well through time. It follows, therefore, that the recent improvement in our terms of trade should have supported the value of the rand. This has not happened because of the chart on the right – capital has been leaving the country in the form of bond outflows, a function of sentiment and the global competition for capital. Somewhat fortuitously, for the first time in 17 years, South Africa recorded a surplus on its current account in the first quarter of 2020. This has made the currency risks more balanced, helping to mitigate the impact from foreign portfolio outflows.
So, while dollar weakness has been good for the rand, better global risk sentiment, foreign investors searching for yield and our improving terms of trade have also underpinned it. This confusing mix of currency forces means, in our view, that the risks to the rand are a bit more balanced than what you may read in the papers. It is clear, however, that the currency does not have a strong fundamental anchor either way and is therefore likely to be buffeted by global events – rand volatility is about the only thing of which you can be assured.
It seems that the SARB is coming close to the end of its rate-cutting cycle – we expect another rate cut this year of 25 basis points. Lower interest rates should provide some relief to battered consumers and businesses. We expect GDP growth for the year to decline by more than 8%, but we should see some green shoots in 2021.
The sharp economic contraction will materially impact the government’s coffers. National Treasury is budgeting for a R305 billion plunge in tax revenues this year due to the fall in VAT and personal income taxes. The shortfall will be funded by a re-allocation in the budget, a drawdown on cash balances at the SARB, foreign loans (e.g. the New Development Bank, the IMF and the World Bank), and additional bond issuance. So, while government finances are dire, these financing measures mean government does not necessarily have a cash-flow problem. Through the “active path” in the June Supplementary Budget, there is a clear attempt to stabilise the debt profile at 87.4% of GDP by 2023/24, by significantly reducing expenditure and stimulating growth through regulatory reform. While the plan is good, the risks, as always, lie in implementation – and the bond market knows it. The market has shifted the burden of proof to National Treasury – the Medium-Term Budget Policy Statement scheduled for release in late October, will be key (along with the progress of wage bill negotiations and funding for state-owned enterprises).
The attractive yields in our bond market reflect these fiscal risks and the doubts the market has. With cash rates so low, SA investors needing a decent income from their investments, are finding attractive real yields in our bond market. If the government manages to contain its wage bill and we see some concrete progress on the path to structural reforms, South African bonds could enjoy a capital uplift.
Inflation and interest rates are the two key factors that drive bond markets. Both have retreated in South Africa, which is very supportive. On valuation grounds, South African government bonds remain attractive versus inflation, cash and EM peers. But they are by no means riskless.
The Ninety One Diversified Income Fund aims to “participate and protect”. While the harrowing first quarter for bond markets was all about protecting the downside of the fund, the second quarter gave us the opportunity to participate in the upside, with bonds giving us an attractive capital return.
We also managed to mitigate rand weakness in the first half of the year, thanks to our offshore allocation, which was higher than at any other period over the last four years. Our offshore allocation acts as a buffer against local interest rate-sensitive risks and helps to offset any inflation risks from rand weakness. While we still need to manage potential rand weakness, we think the outlook for the currency is more balanced, as outlined above. We therefore have a lower offshore allocation than we had in the first half of the year, and our foreign exchange exposure is diversified away from the dollar.
We have maintained an underweight position in listed property for some time and remain very cautious. We have gradually started to increase our allocation, focusing on the valuations of quality companies with stronger balance sheets. The portfolio has maintained a defensive investment-grade credit positioning in light of the weak local growth outlook in recent years. Security selection remains paramount and we continue to monitor the sector for opportunities to enhance yield, based on attractive risk-return dynamics.
We have built up a decent liquidity buffer to take advantage of the opportunities that will arise over the near term. With cash rates already at the 3.5%-level and potentially heading lower, our combination of bond duration and asset allocation maintains yields substantially above that. 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 “Why quantitative easing isn’t appropriate for South Africa”, Nazmeera Moola, July 2020.
2 Source: Reuters, “$15 trillion and counting: global stimulus so far”, 11 May 2020.