All about the delta, and the dots
Global risk appetite started the month on a positive note, supported by lessening lockdown restrictions in the US, UK, and Europe, as well as robust global trade activity – evident in still-elevated PMI readings. This changed quite quickly mid-month following the June FOMC statement, updated forecasts, and post-meeting press briefing. Risk appetite moderated and volatility rose, most notably in EM FX and fixed income markets.
What a difference a dot makes
The market’s interpretation of the June FOMC meeting was that it underwent a “hawkish pivot”. The 2023 median dot jumped from no hikes to two hikes, the Q&A session confirmed that the Fed is “talking about talking about tapering” and that it has become less certain on the transitory nature of the current inflation surge. That the median rise in an anonymous survey of projections triggered a bout of market volatility highlights the reliance on easy policy to prop up valuations. It also highlights the sensitivity of markets to central bank communication, as noted by Jeremy Stein in 2014 speech:
“There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating.”
Governor Jeremy C. Stein, 6 May 2014, Challenges for Monetary Policy Communication
One of the fundamental concerns is that short-term supply-driven inflation will lead to long-term stagflation because of overly stimulatory monetary and fiscal policy amid excessively high debt levels. Markets are not yet pricing such an inflation scenario. US nominal and real yields remain low, breakeven inflation has narrowed somewhat, and equity markets have risen on a solid earnings rebound. The longer-term outlook for asset markets will depend on the momentum in liquidity. On this front, the rate of change – the delta – has started to moderate, not only in China – where the credit impulse has turned negative – but also in the Fed’s balance sheet expansion.
Covid concerns trigger tighter restrictions
Towards the end of the month, Covid jitters increased amid the broadening prevalence of the Delta variant. This more contagious version of the Covid-19 virus has come at a time when the vaccine rollout in the developed world has lost pace, with levels still short of ensuring herd immunity. EMs are notably worse off, with many of the middle to lower income countries having vaccinated less than 10% of their populations.
SA is case in point where the vaccine rollout has been disappointing, reflecting distributional capacity constraints, rather than limitations on supply or funding. Encouragingly, registrations for younger cohorts will open early in 2H21 and surveys of the willingness to vaccinate are surprisingly high.
While SA has moved to lockdown level 4 amid the rampant spread of the Delta variant, particularly in Gauteng, the economy continues to benefit from the cyclical breather provided by the positive terms of trade. GDP and the current account beat expectations for Q1 and tax revenues continue to recover. Following the better than expected data, consensus forecasts for 2021 GDP growth has climbed to above 4.0% and the budget deficit is projected to be comfortably below 8%/GDP. At this stage, the impact on productive sectors should be minimal, with the curtailments focused on the hospitality (restaurants), entertainment, and alcoholic beverage industries. This poses modest downside risk to Q3 GDP growth, depending on the duration of restrictions.
SARB still talking about normalisation
While CPI inflation breached 5% in May, it should have been temporary as the base effects start to reverse from June onwards. The key upside risks to inflation are the higher oil price and elevated food price inflation, as these could test inflation expectations. Rising inflation expectations would signal the emergence of second round effects, which would probably prompt the SARB to remove some policy accommodation.
In the absence of clear inflationary pressures and/or rand weakness, communicating the start of a modest hiking cycle is likely to be challenging for the Bank given that there are no obvious macro imbalances stemming from the monetary policy stance. Consistent with the rhetoric since the March MPC meeting, the SARB has continued to signal that policy normalisation is in the pipeline. Yet there is still no explicit guidance on what would prompt normalisation, even as the committee emphasises the data dependence amid elevated uncertainty. Faster tightening from the Fed and negative spillovers to local inflation via the currency could trigger earlier rate hikes by the SARB. With USD/ZAR having moved back above 14.00, the FRA curve has brought forward the timing of tightening, with the market fully discounting a hike by September and a cumulative three hikes by January.
While the SARB celebrated its centenary on 30 June 2021, President Ramaphosa’s reform and clean-up agenda received much-needed impetus. SAA was partially privatised, even if funding is yet to be finalised, and the president increased the threshold on embedded generation to 100MW.
During June, listed property (3.4%) and fixed-rate bonds (1.1%) beat cash (0.3%), while inflation-linked bonds (-1.5%) and equities (-2.4%) underperformed. The 3.8% depreciation in the rand would have been accretive to offshore asset returns. For 2Q21, listed property (12.1%) outperformed sharply, followed by fixed-rate bonds (6.9%) and inflation-linked bonds (3.0%). Low policy rates reinforced paltry returns from cash (0.9%), while equities (0.1%) were flat for the quarter. The rand gained 3.5% against the dollar, which would have detracted from offshore allocations.
Dots drive the dollar higher
The Fed’s “hawkish pivot” at the June FOMC meeting boosted the dollar, with the DXY gaining 2.9% m/m, albeit still 0.9% weaker for the quarter. EM portfolio flows moderated in the second half of June due to concerns about tightening financial conditions, pushing EM FX down by 1.5% m/m. In a reversal of fortunes from the previous month, the Hungarian forint and the South African rand suffered the most, losing 4.3% and 4.0%, respectively. The Brazilian real and Russian rouble outperformed, being the only EM majors to post monthly gains of 5.0% and 0.4%, respectively, as both currencies benefited from monetary policy tightening.
Despite recent weakness, the rand remains resilient, supported by better cyclical dynamics, the terms of trade, and elevated implied forward yields. With USD/ZAR at 14.25 (as at June month end), the rand remains moderately overvalued versus long-run fundamentals.
“Hawkish pivot” leaves US yields lower, EM yields higher
US nominal and real yields were range bound in June, with a brief spike following the FOMC meeting. The nominal, real, and breakeven curves flattened in the second half of the month as the market interpreted average inflation targeting (AIT) as not too flexible. This was partly derived from the broadly unchanged median inflation forecasts for 2022 and 2023, even though the first rate hikes were only expected in 2023. While taper talk routed markets in February and March, confirmation by the Fed that tapering is entering discussions had minimal impact this time round. The 10-year nominal yield is back at 1.45% and the TIPS equivalent is at -0.9%.
The impact of the “hawkish pivot” on EM bond yields was more acute, albeit notably less severe than the Q1 rates reset. The GBI-EM yield rose by only 4bp m/m, while the EMBI+ yield rallied by 8bp. SA yields were broadly unchanged month-on-month, but are trading 30bp above the pre-FOMC low of 9.0% on the 10-year yield. With the renewed decline in TIPS yields, compressed credit spreads, and manageable inflation, SA bonds are again screening cheap, particularly given the tactical improvement in the fiscal picture and resultant decline in net issuance.
Global equities up as SA de-rated further
Global equities again posted a varied performance in June as moderating commodity prices, the reaction to the Fed, and idiosyncratic factors, such as politics, tempered performance. The S&P500 was a relatively strong performer, rising by 2.2% m/m and 8.2% for the quarter. The return from Europe was a more pedestrian 0.8% m/m and 4.6% q/q on the Eurostroxx. The MSCI World Index total return of 1.5% eclipsed the 0.2% from the MSCI Emerging Market Index. Country returns were disparate: the MSCI Colombia Index gained 5.6% in dollar terms, while the MSCI Peru Index underperformed sharply (down 11.9%) amid elevated political uncertainty following the 6 June presidential election.
The MSCI South Africa index was also a laggard, losing 7.9% in June and 1.5% for the quarter as a whole. The ALSI lost 2.4% m/m and the SWIX declined by 2.8%. SA consumer stocks were the only bright spots in June with consumer discretionary (3.3%) and consumer staples (1.2%) posting positive returns. Industrials (-0.2%), telecommunications (-0.5%), and health care (-0.9%) posted modest losses, so too technology (-1.8%) and financials (-2.1%). The stand-out laggard was basic materials (-6.7%), which was dragged down by precious metals and mining (-13.6%) amid the ongoing decline in gold and the PGM complex. Earnings revisions have turned positive again, driven by upgrades in the energy, materials, and communications sectors. SA Equity multiples, particularly on resource and SA Inc. counters, continue to trade at a discount versus the long-run average – the overall market is screening c.25% cheap following a further derating.