Peeking at the peak
China’s accelerated reopening and potential for broader policy support, warmer European weather and falling gas prices, and the pending Fed pivot culminated in a strong risk-on backdrop for financial markets heading into 2023. With the peak in inflation behind us, markets were able to contemplate the peak in policy rates and potential for rate cuts.
Eurozone resilience and China’s rebound boosted the euro and yuan and put downward pressure on the dollar, despite ongoing data resilience in the US. To be sure, expectations of rapid disinflation pulled back recession odds, giving way to a soft landing becoming the market’s base case.
Recession risks recede
We are not as convinced. Earnings will likely remain under pressure in the absence of broader job cuts, while many leading indicators in the US still point to a recession. Granted, it is likely to be a mild or “textbook” recession rather than a systemic crisis, but risk assets are not pricing in a US recession. This is in contrast to the US yield curve, which remains firmly inverted. Unfortunately timing a recession is always tricky.
Where there may be some incongruence is in greater odds for a soft landing, or even no landing based on some optimistic commentators, and rate cuts from the Fed. Given the strong labour market, the Fed may be comfortable to keep policy relatively tight until it is certain inflation has been slayed.
But inflation fears resurface
Yet on the prices front we face potential crosswinds. Leading price indicators and easing supply chain strain point to sharp disinflation, but excess savings and a recovery in China could keep broader demand elevated.
Following a series of downside surprise in US inflation releases since October last year, the January price reports came in above consensus expectations for CPI and PPI. Moreover, these follow a robust payroll report even when adjusted for favourable seasonals, warm weather, and the return of striking workers.
The data has triggered a rethink in rates markets, with the peak policy rate shifting to almost 5.50% from 5.00% in mid-January. In addition, rate cuts have been pushed outwards to 1Q24, in keeping with Fed Chair Powell’s signal that they may have to maintain a tight stance for a prolonged period.
SARB not quite done
Upside inflation risk and the Fed’s data dependence will very likely keep the SARB in hawkish mode. We believe the MPC has retained enough optionality to keep the March meeting live for a final 25bp hike in the event of further Fed funds hikes, potentially higher inflation expectations, and rand weakness (as we are currently witnessing). Despite a very bearish growth outlook, the bank opted to hike in January, even if the quantum undershot consensus expectations.
Load shedding remains the primary risk to the SA outlook given the negative impact on business revenues and fiscal tax receipts, the potential for larger Eskom bailouts, as well as the inflationary effects of higher input costs (buying generators and diesel and paying workers overtime) and supply disruptions (particularly in the food value chain). Add in the fact that we are heading towards a national election, populist spending pressures may mount.
Event risk runs high in February, with the Budget statement on the 22nd and the announcement on SA’s Grey listing by the Financial Action Task Force (FATF) on the 24th.
Following a challenging December, global risk appetite rebounded to support EM asset prices. SA equities (7.0%) took the lead in January, followed by fixed-rate bonds (2.9%) and cash (0.6%). However, inflation-linked bonds (-1.0%) lagged due to bear-steepening in the real yield curve, while listed property (-1.0%) showed moderate weakness across roughly two thirds of constituents, likely due to load shedding and expectations of dampened demand. The rand lost 2.3% against the dollar, which would have been only marginally accretive to offshore returns.
Dollar starts the year on the back foot
The dollar faced moderate headwinds heading into 2023, with the anticipated Fed pivot, rebound in China and Europe, and improving risk appetite. The DXY dollar index lost 1.4% in January, which provided an additional lift to commodity prices and EM FX (up 2.2% on average).
The theme of China reopening and commodity demand was evident in EM FX outperformers such as the Chilean peso (6.7%), Russian ruble (5.7%), Thai baht (5.4%), and Brazilian real (4.1%).
So does the rand
The rand was a relative underperformer, losing 2.3% against the greenback amid residual political risk and, importantly, the negative impact of intensified load shedding. With net exports already constrained by rail challenges, the electricity shortage has exacerbated production and export limitations. As a result, the likely deterioration in the current account deficit added to the risk premium embedded in the rand.
Strong US labour data and a repricing of the peak Fed funds rate has more recently supported the US dollar, leading to a headwind for the rand. At 18.15 on USD/ZAR, the currency is undervalued by around 10%.
Yields rally on potential pivot
Expectations of sharp disinflation and lower Fed policy rate peak led to lower US nominal yields in January. This was largely due to a decline in the real component, with breakeven inflation already relatively compressed. This spilled over to German bond yields, but ongoing speculation of the abolition of yield curve control led to a rise in real and nominal yields in Japan.
While news flow on the debt ceiling has caused some uncertainty regarding the outlook for the US bond market and the progress on quantitative tightening (QT), it has so far not disrupted markets. If anything, the cash drawdown by the federal government is set to inject modest liquidity into the system, while the unchanged issuance plans would facilitate an orderly unwind of the Fed’s balance sheet in the shorter term.
While most of the major DM central banks have already started QT or signaled to do so soon, the BoJ’s bid to anchor the 10-year yield resulted in even more aggressive QE. This has been a partial offset to moderating liquidity elsewhere and could potentially have contributed to improved global risk appetite and portfolio flows.
Boosting EM bond markets
Lower US yields, improving risk appetite, and recovering portfolio flows benefited EM bond markets, with yields declining by 27bp, on average. While Brazil (+43bp) was a relative laggard amid persistent fiscal fears and rumours of a higher inflation target, peak policy rates and disinflation benefited Hungary (-105bp) and Poland (-83bp).
SA was a moderate outperformer, as the 10-year benchmark bond yield fell by almost 50bp to 10.3%. In contrast to the currency, some of the excess risk premium was priced out, despite mounting concerns about the negative implications of load shedding for the fiscal position.
The main budget data suggests that revenue momentum has remained reasonably solid, but spending pressures could lead to unchanged, or potentially higher issuance in the coming fiscal year. This is currently not priced by the market, with bonds trading in line with our 10.50% – 11.00% fair-value range on the 10-year. That said, the steepness in the yield curve reflects ongoing uncertainty about the government’s ability to stabilise debt.
The demand for EM assets benefited SA, as non-residents bought a net R29bn nominal worth of bonds in January. The bulk of this was effectively from banks (-R24bn), with unit trusts net buyers of R13bn. The stronger foreign demand was effectively double the net issuance of R15bn during the month.
And a broad based equities rebound
Expectations of a Fed pivot, resilient US data, receding recession fears and improving risk appetite boosted global equities in January. While the S&P500 rebounded by 6.2%, this was eclipsed by the 9.2% bounce on the Eurostoxx. The MSCI Emerging Markets Index (+7.9%) pipped the MSCI World Index (+7.1%) thanks to the ongoing recovery in Chinese equities (the MSCI China Index gained 11.8%) and positive impact on the broader Asia region. Czech (17.1%) and Mexico (17.0%) outperformed amid regional growth resilience and hopes for disinflation.
SA was a relative laggard, despite the MSCI South Africa Index gaining 4.7% in dollar terms. Some of this reflects the weaker rand, based on the 8.9% jump in the ALSI and 7.2% rise in the SWIX.
Technology (18.1%) outperformed, benefiting from China’s reopening, followed by consumer discretionary (16.3%), which reflected positive earnings updates and surprising consumer resilience. Telco’s (10.6%) also did relatively well amid an improved EM outlook and rebound in Telkom. Industrials (8.7%) and basic materials (6.9%) performed broadly in line with the market as some of the impetus to the China/commodities trade started to wane, while health care (5.6%), financials (3.9%), and consumer staples (3.0%) were relative laggards despite ending the month in the black.
The recovery in SA equities in January was met with modest earnings upgrades, in large part due to the benefit to Naspers of China’s reopening. The net effect was a broadly unchanged forward PE at around nine times, which still represents a c.20% discount relative to history.