Be careful what you wish for
The relative stability of January gave way to volatility in February. This time, interest rates led the way with a shift from reflation hopes to inflation fears. Breakeven inflation across most tenors reached post-GFC highs, with front-end expectations at 2.5%.
While higher inflation should be welcomed as a way of managing exorbitant debt levels, it will not fully succeed if borrowing costs also adjust meaningfully higher. In this regard, the substantial steepening in the US yield curve, jump in nominal yields, and the turning point in TIPS yields is noteworthy. The message from the market could be that the Fed risks losing control of inflation and long-end bond yields. Yet this should have capped the rise in real yields given the inflation-hedge properties. Alternatively, the market may be pricing in a pending taper by the Fed, which means less demand for US Treasuries in the face of rising supply. This will lead to a rise in the real cost for loanable funds to entice investors into the bond market. Another narrative is that rising real yields reflect the expectation of sustained stronger growth once the vaccine rollout matures. It is probably a bit of everything.
On the inflation front, the jury is still out. Until recently, the base effect run-up in inflation in 2Q21 was widely anticipated, and that this would be followed by cyclical disinflation in 2H21. Yet the $1.9trillion stimulus bill may just have been the tipping point for an economy that is set to close its output gap this year. The consensus forecast for US growth has increased from 4.0% to 5.5%, while high-frequency GDP trackers sit at 8.5% – that’s in real terms. The conundrum for the Fed is that it is set to succeed under its recently adopted flexible average inflation-targeting regime, but may be forced to extend QE or do Twist 2.0 if the yields sell-off leads to an equity market rout. There is nothing worse for a DM central banker than a slump in the equity market.
The messaging from US rates that the Fed is behind the curve has been permeating EM markets and finally hit SA shores in February. Markets are discounting 400bp in rate hikes in Brazil, 100bp in India, 85bp in Russia, and now 100bp in SA. While many attempt to frame rate hikes in SA as a domestic inflation story, it is difficult to square higher core inflation with a substantial output gap and significant fiscal tightening over the coming year. Importantly, the weak private sector labour market and proposed wage restraint in the public sector should limit the upside to unit labour cost growth – a key driver of longer-term inflation. Rather, it is the spillover from higher core rates that has led to the renewed risk premium in the front end of the SA rates curve. With the repricing in risk making for a more balanced outlook, the rand, as always, could be the spanner in the works. Strong global growth and rising commodity prices should cap rand weakness, but a notable risk off and capital outflows could increase the risk premium in the currency to vindicate expectations of more aggressive SARB rate hikes. This would be despite some progress on the fiscal side.
The Budget committed to “growth friendly” consolidation by cutting current expenditure – notably on wages – while maintaining allocations to capex. The front-loading of expenditure cuts and the pending reduction in issuance in FY22 lowers the debt-to-GDP profile by c. 5ppt across the medium term. While this should limit the upside to local yields from fiscal risk and stabilise the sovereign credit rating in the short term, it by no means guarantees that the government is out of the fiscal woods. If the bond vigilantes are truly back, then SA should tread carefully.
Market developments
Listed property (8.6%) was in pole position in February, beating the solid performance from equities (5.9%). Inflation-linked bonds (1.9%) outperformed cash (0.3%), but fixed-rate bonds (0.1%) were basically flat. The marginal appreciation in the rand (0.3%) would have been neutral for offshore and dollar commodity exposure.
The US dollar was torn between excess liquidity amid ongoing Fed balance sheet expansion, and rising US nominal and real yields due to fiscal stimulus and mounting inflation fears. In the end, the latter won the day, with the dollar index up 0.3% for February. This proved to be more of a headwind for EM currencies, than for high-beta DM currencies, as the antipodean units gained during the month. Elevated commodity prices also helped the rand, which was a relative outperformer with a 0.3% appreciation versus the greenback. Fiscal and political concerns weighed on the rand’s peers, with the Brazilian real (-2.4%), Turkish lira (-1.6%), and the Mexican peso (-1.4%) all weaker during the month. USD/ZAR traded in a broad 14.45/15.10 range during February, which is overvalued compared to our 15.50 – 16.50 broad fair-value range. While high commodity prices have buoyed the rand, portfolio flows turned more volatile during the month, making the rand’s resilience contrary to fundamentals. A potential support was the expectation of a positive budget, which did indeed materialise. In addition, elevated implied rates relative to interbank money market rates may also have buttressed the currency. These, however, seem to be turning, which could weigh on the rand alongside greater risk discrimination by investors.
The benign increase in breakeven inflation turned somewhat malign over the course of the month as real yields start moving upwards alongside nominal yields. While some inflation is good for risk assets via a weaker dollar and improving pricing power, rising real funding costs are a headwind to flows. The 10-year US yield rose by 34bp in February, breaching 1.5%, with the bulk of the move due to higher real yields as TIPS increased by 29bp. Breakeven inflation increased across the board, with 2-year above 2.5% (the highest in the post GFC period), 5-year at almost 2.5%, and 10-year at 2.2%. While the absolute yield levels in DM are still low, the increases have been a headwind to EM bond markets – the EMBI lost 2.6% while the GBI-EM declined by 2.4%. EM local 10-year yields rose by an average 36bp, leaving SA’s 32bp rise in the middle of the pack. Similar to the FX dynamics, SA’s peers underperformed notably because of risk discrimination, with Brazilian and Mexican yields 90bp and 60bp higher, respectively. According to JSE data, non-residents sold a net R29bn worth of SA bonds in February, in sharp contrast to Treasury data that showed a net inflow of c.R16bn. At 9.25%, the SA 10-year yield has cheapened moderately given the outlook for fiscal prudence and a likely issuance cut.
Notwithstanding rising interest rate volatility in February, global equity markets generally performed well amid excess liquidity and rising inflation expectations. Towards the end of the month, higher US yields started to test the resilience in equities. After falling to 20, the VIX rose back to 30, but this is contained versus the peaks over the past 12 months. The S&P reached a record high mid-month, with earnings growth picking up and ratings remaining elevated. The MSCI World Index gained 2.6% (total return), beating the MSCI EM Index performance of only 0.8% as FX weakness weighed on dollar returns. The SA MSCI index was a relative outperformer with a total return of 2.9%. The ALSI and SWIX gained 5.9% and 4.6% respectively. According to JSE statistics, non-residents sold net R15.5bn of SA equities. Sectoral performance remains uneven. Basic materials (11.5%) led the performance as higher commodity prices benefited platinum (19.2%), mining (11.6%), and chemicals (12.8%). Gold mining (-16.3%) was a notable underperformer because of the lower dollar gold price (down 6.2% m/m). Telecommunications (10.5%) performed well on positive trading updates, while financials (4.8%) and industrials (4.0%) performed more in line with the overall market. Consumer services (2.7%) and technology (1.2%) lagged, while health care (-1.5%) posted an outright loss. Earnings revisions have turned even more positive over the past month, but the valuations remain cheap, at a c.11 times forward PE ratio, a substantial discount relative to EM, which is sitting at around 16 times.
