July was all about stimulus, as the approval of a EUR750bn Next Generation EU/Recovery Fund boosted sentiment, while negotiations to extend fiscal support in the US were ongoing. The ECB and the Fed committed to maintain accommodative policies for as long as needed to ensure a strong and sustainable recovery. The net effect was a sharply weaker US dollar, with EUR/USD surging from 1.12 to 1.18 – the highest level in over two years.
While inflation has remained low, in part thanks to subdued energy prices, widening breakeven inflation, falling real rates, and the surge in gold and silver prices signal concern about potential inflation risks on a longer-term horizon. The market value of negative-yielding debt is back up to US$16 trillion, just a trillion shy of the record reached in August last year. In this context, investors are again showing a preference for a return of capital rather than a return on capital.
The anticipated inflation surge has seemingly little to do with the recovery in demand. As an example, the flat-lining oil price in July suggests that the support from the reopening of economies has been countered by excess inventories, which could be exacerbated by pending tapering of production cuts. Rather, the concern is about weakening fiat currencies, in particular the dollar, as the Fed floods the market with liquidity.
At the same time developed market bond yields have fallen anew, which could signal ongoing caution. In particular, the tensions between the US and China are coming back into focus, as the commitments under the Phase 1 trade deal have not been fully met. The clash of the titans has led to the closure of consulates amid Trump’s toing and froing on the potential Microsoft/TikTok deal.
At least the worst of the Covid-19 recession is behind us, as confirmed by the US and Eurozone Q2 GDP releases and recent activity data. Europe contracted by a whopping 40% while the US declined by “only” 33%. The annualisation makes it sound alarming, as activity fell by 12.1% and 9.5%, respectively when the data is not annualised. South Africa’s Q2 GDP data is due only in September. In the interim, the focus has been on how the government will fund itself and the renewed attention on Eskom in light of a resumption of load shedding.
The “good” news is that South Africa has secured a US$1bn 30-year loan from the New Development Bank and a US$4.3bn c.5-year loan from the IMF. Who would have thought the ANC government would go cap in hand to the Fund. But beggars cannot be choosers. While the conditionality is not as onerous as that of an IMF programme (and the IMF is a very different institution now than it was thirty years ago), the IMF will also be focussed on a return of its capital. Hence, the government had to make some commitment to debt stabilisation and economic reform.
With SA near or at its peak in new daily Covid-19 infections, there is some upside to sentiment should the State of Disaster conclude on 15 August and additional lockdown restrictions be lifted. Yet various surveys of employment, income, and businesses suggest that the damage done by the lockdown is deep and could be long lasting. The resulting wide output gap has dampened inflation, which allowed the SARB to cut rates by a modest 25bp at its July MPC meeting. The tone, however, suggests that elevated fiscal risk will stay the SARB’s hand, unless the data undershoots expectations, which is a plausible scenario. Hence, we would not rule out further monetary easing just yet.
Market developments
The performance range was relatively narrow in July, with equities (2.6%) taking the lead, while listed property (-3.2%) lagged. Bonds (0.6%) barely beat the return on cash (0.4%), with inflation-linked bonds (-1.1%) falling short.
The global recovery, higher commodity prices, and the weaker dollar should have been a boon for EM FX, but the performance did not fully mirror the dollar’s decline. While the DXY lost 4.2% – the largest monthly percentage fall since September 2010 – EM FX increased by only 3.0%. The underlying performance was wide-ranging, from +8.4% for the Chilean peso to -4.3% for the Russian rouble. The rand appreciated by only 1.8% m/m, but this belies substantial intra-month gains as USD/ZAR fell to a low of 16.34. USD/ZAR at 17.50 puts the rand 16% weaker year-on-year, and around 7% undervalued based on our estimates. The near-balanced current account and elevated terms of trade should mitigate risks to the rand, but sustained gains will depend on the dollar weakening further and the global growth recovery gaining more traction in light of weak growth and fiscal fundamentals domestically.
The US 10-year yield moved out of its rut, falling to 53bp by the end of July following a dovish FOMC statement and Q&A, as well as a renewed decline in German yields. The Fed’s commitment to balance sheet expansion via asset purchases has kept a lid on nominal yields. As a result, the persistent widening in break-even inflation has been a real phenomenon, with the 10-year TIPS yields falling below -1.0%. The GBI-EM yield declined by a modest 16bp to a record-low of 4.35%, with strong performances from the Brazilian and Indonesian local markets. South Africa’s 10-year yield was unchanged at month-end, but as with the exchange rate, this masked a 70bp intra-month range. While bonds screen tactically cheap, the rise in the debt ratio warrants additional fiscal risk premium. Inflation risk is adequately priced with 10-year breakeven inflation averaging 5% since May this year.
While the major DM bourses were down for the month, the US bucked the trend thanks to a strong showing from tech, evidenced by the 6.9% rise in the NASDAQ versus the 5.6% increase in the S&P500. Higher commodity prices, improving global data, and the weaker dollar supported EM equities. The MSCI EM index gained 9.1%, substantially outperforming the MSCI World index (4.8%). MSCI SA index returned 7.7% in dollar terms, while the ALSI and the SWIX rose by 2.6% and 2.4%, respectively, in rand terms. The performance was driven by basic materials (9.1%, notably gold, platinum and industrial metals), as well as telecommunications (8.2%, particularly mobile operators). Financials (0.4%) and technology (-0.2%) were flat, while consumer goods (-4.9%), industrials (-2.6%), health care (-2.1%) and consumer services (-1.6%) were the laggards.
