The Cost of unsustainable Fiscal Policy
South Africa’s fiscal deterioration has resulted in a series of sovereign downgrades, from BBB+ in 2015 to BB- in 2020. And, if the current growth trajectory persists over the longer term, South Africa will likely be downgraded again, to a single B. Considering the implication of such a downgrade for SA bonds we note that the average spread of JP Morgan’s Index of BB rated sovereign bonds over UST’s is 635bp (post 2008) while the spread over UST’s of those rated BBB is 351bp a difference of 284bp. Since the February 2023 budget we note that, SA’s sovereign spread is already trading around 40bp above the BB average.
As highlighted in our July monthly “Structurally bearish, cyclically bullish bonds”, the shift in SA’s sovereign spread from the BB average is indicative of SA’s rising sovereign risks and unsustainable fiscal trajectory under current growth scenarios and argues for a structurally bearish outlook for SA fixed income.
However, cyclically, global and local monetary policy remains positive for bonds. The UST 10-yr yield rose 15bp in August to 4.10% and TIPS (real 10-yr US rates) rose 28bp, to 1.87%, reflecting a slight moderation in longer term inflation expectations. US yield curve inversion, which widened to -175bp in May (3-m t-bill versus UST 10-yr), unwound to -133bp in August as markets started positioning for a soft landing in the US, pricing out rate cuts in the front end of the curve. Simultaneously US CPI has fallen, from 9.1% y/y in June 2022 to 3.2% in August. Historically, back to 1981, it would be unprecedented for the US inflation cycle to turn and for the yield curve to remain inverted and in this context, we note that the spread between the 3-mth t-bill and US 10-yr has averaged +170bp since 1981. A dis-inversion of the curve would see the entire curve shift lower; in a soft landing the front end will do the majority of the heaving lifting, while if a hard landing were to play out we would see a more aggressive fall in both the long and the short end yields.
While there should be a significant correction in local bond prices as the global risk-free curve bull steepens, potential benefits for SA bonds will be constrained by the structural sovereign risks as outlined above and the extent to which domestic monetary policy can be accommodative. As an inflation targeting central bank, the SARB is required to keep policy rates restrictive to ensure that CPI, which peaked at 7.8% in July 2022, returns to average 4.5% y/y on a sustained basis. Fortunately, the latest data for July surprised to the downside at 4.7% y/y versus an expected 4.9% y/y, raising the real policy rate to 3.55%, which is highly restrictive relative to real growth of 0.5%, and adding to the cyclically bullish argument for SA FI assets.
From a political perspective, heading into South Africa’s MTBP (medium term budget policy) we note that the extent to which South Africa’s monetary policy remains restrictive relative to potential growth is bound to heighten the natural tension between fiscal and monetary policy, especially when fiscal policy is under immense strain, and requires higher rates of nominal GDP growth to be sustainable.
Against this backdrop, the SARB hosted its biennial conference on Thursday, 31 August and Friday, 1 September allowing academics, policy makers and market agents from across the globe to thrash out these and other conundrums in the safety of the Cape Town Convention Centre. In summary, this tension was acknowledged by the SARB Governor who went as far as to say that coordinating monetary and fiscal policy was akin the central bankers swimming with crocodiles.
Market performance: Assets reprice for a US soft landing in August
Only cash provided a positive rand denominated return in August, of 0.7%, while SA’s fixed rate bonds returned -0.23% and inflation-linked bonds -0.7%. Equities at -4.8% were the worst performing asset class over the month. Listed property provided some relief giving a positive return of 0.9%. The 6.2% fall in the rand versus the dollar would have been positive for domestic investors’ offshore returns. Year-to-date, domestic cash has outperformed versus other S.A. asset classes with a total return of 5.2%. Equities have returned +4.9%, bonds +3.9% and property is down 1.3%.
Emerging market assets were negatively affected by the rise in US rates as well as increased concern over China’s recovery. The rise in the global risk-free rate was driven by the expectation of fewer cuts priced by the US yield curve, as economic data indicated a higher probability of a soft landing. The World Government Bond Index (WGBI) lost 1.4% in USD, driven in part by an estimated 1.5% depreciation across an index of EM currencies, as the dollar appreciated 1.7% against a weighted index of its major trading partners. Foreign investors were net sellers of SA bonds with the value of offshore holdings of SA fixed rate government bonds falling R9.4bn, to R853bn. Global equity (both EM and DM) also responded negatively, falling 3.0% on expectations that DM rates would remain higher for longer, and Chinese economic growth may not compensate for a slowdown in the EU and US. This saw industrial metals prices fall over 4.0. %.
The US Fed (5.5%), BoJ (-0.07) and ECB (4.25%) all saw policy rates remain unchanged over the month, while the BoE hiked 25bp to 5.25%.
In developed markets we saw mild risk off as the S&P500 fell 1.8%, broadly correlating to the further leg up in US yields. Energy outperformed as oil prices continued to grind higher on ongoing supply curtailment out of OPEC+. The US nevertheless continued to outperform as European equities fell 3.9% and Hong Kong reversed most of its prior two-month bounce, sinking 8.5% as China negativity reasserted itself.
Much of the extra weakness in EM markets stemmed from the broad China/commodity nexus. South Africa was no different as resources fell 10%, while financials relatively outperformed, declining only 2%. Hardest hit were the precious metals counters, with the combined gold and PGM sector declining 15.7% as the dollar rebounded and real yields spiked. In the plus column was mostly rand hedge industrials, while domestic industrials fared somewhat worse, with telcos down 12% as MTN reversed recent gains as the market processed the implications of the Naira’s devaluation, and general retailers fell 6.5%, reversing some of their recent gains as the Rand weakened.