While 2023 was ultimately a good year overall for local and global bond market returns, the ride was anything but smooth for investors. Uncertainty about the direction of global inflation and growth kept market volatility elevated. Stubbornly high inflation against resilient growth forced the US Federal Reserve (Fed) to keep hiking rates. Locally, we had the impact of load-shedding on growth and an aggressive rate-hiking cycle.
Global market sentiment improved in the last few months of last year. With global inflation retreating and dovish noises from the Fed, market expectations shifted from interest rates staying higher for longer to rate cuts on the horizon. Increased risk appetite towards the end of the year sparked a rally in global markets, also benefitting our bond market. What will this year bring?
The global inflation picture continues to moderate overall. Recent data releases have led markets to become increasingly more confident of a soft landing (rather than recession) for economies, especially the US. They have priced in the end of the rate-hiking cycle and are now grappling with how quickly rates will come down and the extent of the growth slowdown. Whether the Fed starts cutting in March or delays the first cut, is largely data dependent. With economic activity remaining resilient, policy decisions around rate cuts will largely be focused on how inflation is behaving. The good news is that inflation in the US, UK and EU are heading towards central bank targets. Rate cuts this year will be a huge relief for consumers and businesses, bolstering economic activity and underpinning markets.
Figure 1: Inflation is providing the policy space to cut rates – activity remains resilient
Six-month annualised core inflation
Source: Bloomberg and Ninety One, 31 December 2023.
Inflation in South Africa has slowed but not as quickly as in many other countries. Cost pressures rather than demand pressures have been driving inflation. Rising costs associated with electricity supply and transport/logistics issues still present upside risks to inflation. Last year, food inflation remained stubbornly high. This year, we anticipate service sector inflation to be sticky, with school fees and medical scheme costs remaining elevated. Housing costs, although low, are beginning to normalise.
We see headline inflation averaging 5% in 2024 and core inflation averaging 4.6%. Food inflation will likely decelerate in the first half of the year as the near-term risks from vegetable shortages and bird flu dissipate. Despite El Niño risks, global soft commodity prices remain well behaved. This, we believe, is driven by the high global stock levels.
We have penciled in US$84 a barrel in our inflation numbers for this year. There are, however, downside inflation risks if oil prices return to levels below US$80 a barrel. In recent days, developments in the Middle East have raised the risk premium on oil prices but could decline in the event of a cease fire in Gaza, and a cessation of attacks on shipping in the Red Sea.
With the SA inflation picture improving, we expect 50-75 basis points of interest rate cuts this year. Our view is that the South African Reserve Bank (SARB) will likely start cutting rates only in the second half of the year. The SARB is expected to remain focused on getting inflation close to the 4.5% mid-point of the target range and is unlikely to begin the cutting cycle before the Monetary Policy Committee assesses inflation to be sustainably at or close to the mid-point.
Figure 2: SA inflation has peaked but remains sticky
Source: Ninety One, December 2023.
We expect the SARB to be more hawkish relative to many other central banks, adopting a measured approach to cutting rates. This should help to underpin the value of the rand. The global environment should also be positive for emerging market (EM) currencies. Our currency underperformed its EM peers last year, largely as a result of load-shedding and domestic political factors. We think there is a lot of bad news priced in. Of course, the rand faces some downside risks, which include political volatility around SA’s upcoming elections (more about this later), a faster-than-expected slowdown in global growth and a deterioration in our terms of trade. The valuation buffer that rand weakness has created provides some insurance against a significant further slide.1 Rate cuts should bolster economic activity in South Africa, but growth is expected to remain sluggish this year.
More than 60 countries are holding elections (including South Africa), representing over half the world’s population. Elections in the US, UK, EU (European parliament), India, Indonesia, Mexico, South Korea, Iran, Russia, South Africa and Venezuela are particularly significant. This is against a backdrop of Europe’s Russia-Ukraine war, the Middle East’s Israel-Hamas war and tensions in the Indo-Pacific region. Amid geopolitical risks, this election-packed year will add an extra layer of uncertainty to markets.
The outcome of the US election is going to be key for global policy and could have a material impact on markets and economies. A Trump win will likely lead to a stronger dollar and higher yields through expansionary fiscal policy.
Expect the political noise to increase in South Africa over the coming months as election promises ramp up. There’s much speculation that the ANC will lose its outright majority in this year’s general election. Polls are mixed on the outcome, but a coalition government at national level is a real possibility. Given an uncertain political environment, the rand could suffer from bouts of volatility. We don’t foresee a marked increase in government spending despite the election. Government has already announced the extension of the social relief of distress (SRD) grants, which was widely anticipated by markets. We don’t expect significant further fiscal pre-election spend.
Markets will closely monitor expenditure relating to the state-owned-enterprises, particularly, Transnet. National Treasury has stated that they are not looking to bail out Transnet. We expect that National Treasury will guarantee Transnet’s debt, attaching strict conditions. Transnet is still cash-generative and has the ability to service its debt. We do not anticipate Transnet to need direct cash injections from government; it should be able to obtain funding on the back of government guarantees.
The combination of lower commodity prices and continued load-shedding could create some revenue challenges for the fiscus through 2024, making fiscal consolidation more difficult than in the recent past. While developments around National Health Insurance and the potential fiscal costs thereof are a longer-term risk, we do not see it impacting the fiscus meaningfully in the short to medium term.
A key issue that is currently under discussion is whether National Treasury should tap into the gold and foreign exchange contingency reserve account (GFECRA). In terms of the SARB Act, all valuation profits and losses on gold and foreign exchange reserves are recorded in this account which the South African Reserve Bank (SARB) manages on behalf of National Treasury. The rand amount of the GFECRA has increased materially over time, as the rand has depreciated sharply against the dollar (Figure 3 – higher rand value of the GFECRA due to rand depreciation). There have been calls for the National Treasury to access some of these unrealised profits as a means to reduce pressures on the fiscus. The SARB and National Treasury are discussing the issue, and the IMF is also providing input to our government on the matter.
Figure 3: Rand value of the gold and foreign exchange contingency reserve account
Source: South African Reserve Bank, as at end 2023.
Realising GFECRA profits by selling foreign exchange reserves would reduce South Africa’s stock of gold and foreign exchange reserves which are considered by the IMF to be on the low end of their reserve adequacy metric. Conversely, using an allocation from the GFECRA to retire local or offshore debt would put National Treasury on a stronger financial footing. We would view this as a positive if done in moderation. It should improve the bond issuance outlook and the shape of the yield curve – particularly longer-dated bonds. However, the bond market would react negatively if the GFECRA is used to fund additional expenditure rather than to improve the government’s debt situation, as it could signal an unsustainable situation where there is a continual drawdown on the GFECRA. So, the GFECRA should not be seen as a ‘get out of jail free card’ to avoid budget cuts. Nor is it a ‘free lunch’, as the SARB (and ultimately National Treasury) would have to deal with the costs of sterilisation of this debt monetisation. However, as such activities will be conducted at the repo rate, it could help reduce the cost of debt servicing.
Ultimately, fiscal consolidation needs to come from expenditure cuts. However, it appears that National Treasury and the SARB intend managing the proceeds from GFECRA responsibly. While the timing is unclear, there is a possibility that details on the use of the GFECRA will be shared in the upcoming budget.
After much toing and froing between National Treasury and parliament’s finance committee, the two-pot retirement system is set to come into effect on 1 September this year. There is some concern about the practicalities around implementing this system, given the short time frame. But from a bond market point view, we are ultimately constructive on this policy.
In the short term, we could see some divestment as some retirement fund members tap into their retirement savings pot. However, it may be positive for short-duration fixed income assets as there will be a need to allocate more liquid assets to members’ retirement savings pot to make provision for potential withdrawals. Over the longer term, we believe the two-pot system should have a positive impact on the retirement funding pool, as the new system will ensure better overall preservation of retirement capital. Retirement fund members will only be permitted to tap into the retirement savings funding pot, not the retirement funding pot, before retirement age.
We remain constructive on both global and local bond market returns. With global interest rates set to decline and global inflation slowing, the environment is looking favourable for developed market and EM bonds. Domestically, a better (although still challenging) fiscal outlook, cooling inflation and the prospect of lower rates support our bond market. But as this is a big year for elections and policy, investors may have to contend with bouts of market volatility. Rising geopolitical tensions are another important consideration. While uncertainty prevails, we believe the high yields on SA bonds sufficiently protect against the risks.
1 Dollar/rand exchange rate: R18.90 as at 30 January 2024.