Structurally bearish, cyclically bullish bonds
Global interest rate normalisation continued in 2Q23 as proxies for global risk free rate rates moved into positive territory for the first time since the 2008 GFC. Long term expectations of real policy rates rose in the US, from -2.5% in late 2021 to 2.46% in June 2023, and in the EU from -2.9% to 0.83%. Markets expect another hike from the Fed (July) and two hikes from the ECB (July and September). The structural shift in global risk-free rates has seen the SARB and other emerging market central banks being forced to hike, to protect the value of their currencies and continue to attract capital inflows. However, SA’s real rate differential with the US is lower than that of its peers, leaving the rand vulnerable to depreciation. SA’s equivalent measure of long-term real policy rate expectations has risen from a cyclical low of -1.7% in June 2022 to 3.25% in June 2023, bringing the differential with the US to 80bp, below its post GFC average of 150bp. In addition to global monetary policy normalisation, domestic dynamics have raised the sovereign risk premium. These two structural factors saw the USDZAR fall 5.9% YTD while EM currencies on average appreciated 0.3%. SA Government bonds returned 1.75% in ZAR and -9.1% in USD.
The SARB hiked the policy rate by another 50bp in May to 8.25% and markets are priced for another 25bp hike in July. While higher interest rates usually protect the value of the rand via the FX basis (or carry trade), there comes a tipping point where the effect of higher rates on GDP growth starts to impact the currency negatively via the anticipated deterioration of fiscal metrics. This has started to play out and we have seen increased volatility in bond portfolio inflows as risks rise and real money investors’ appetites for both bonds and equities reduce. Capital outflows by domestic and foreign investors are feeding back into a weaker currency. The SARB faces a dilemma about how high to hike the policy rate as loadshedding exacerbates stagflation. Fortunately, SA inflation slowed more meaningfully in 2Q23, from 7.1% to 6.3%, and we expect it will continue to fall on average over the remainder of the year.
Foreign holdings of SA bonds continued to decline in the second quarter. According to monthly data released by National Treasury, the percentage of SAGBs held by foreigners fell to 25.1% in May from 28.1% in May 2022. The dramatic sell-off in the currency in May is likely to have been aggravated by offshore investors selling R14bn worth of SA government bonds.
Domestic fund managers have also reduced exposure to SA bonds and equities. In February 2022, a change in pension fund regulation allowed local SA funds to increase their offshore allocation from 30% to 45%. Offshore allocations have risen from 29.8% in 1Q22 to 36.7% in 1Q23 and an estimated 38.7% in 2Q23.
With respect to domestic dynamics, SA’s sovereign risk premium is structurally higher due to loadshedding and fiscal deterioration. If the US and EU impose sanctions on South Africa as a consequence of the ruling party’s perceived alliance with Russia, this would also see an additional shift higher in the country’s risk premium. As things stand, accusations made in May by the US that SA supplied arms to Russia in December led to one of the most significant sell-offs of South African assets in recent years. While much of that has now been reversed, risks remain as the BRIC’s Summit draws near. Factors which raise SA’s cyclical risk premium are a deterioration in the outlook for the trade balance, an impending recession and national elections in the first half of 2024.
Structural and cyclical risks intensified in April and May such that financial asset prices fell to reflect the increased sovereign risk associated with SA. June saw some correction in financial asset prices, as global and local inflation slowed, and markets began to anticipate the end of the interest rate hiking cycle. An end to the policy rate hiking cycle would provide a cyclical reprieve for bonds.
In 2Q23, the SA interest rate market underperformed cash (+1.9%), JSE All Share equities (+0.7%) and listed property (+0.7%). Fixed-rate bonds measured by the ALBI (-1.5%) underperformed inflation-linked bonds (-0.7%). The 5.9% fall in the rand versus the dollar would have been positive for offshore returns.
Total returns for the month of June differ markedly from 2Q23 performance and are indicative of the perception that a turning point had been reached in inflation and the monetary policy cycle, as well an improvement at the margin in load shedding and geopolitical risk as the SA government made an attempt at damage-control. Markets started to factor in disinflation and contemplate the timing of potential future rate cuts. Fixed-rate bonds (+4.6%) was the best performing SA asset class, followed by SA equities (+1.4%) and inflation-linked bonds (+1.2%). The interest rate market outperformed cash (+0.6%) and listed property (+0.9%).
The US Fed kept the policy rate on hold in June while the ECB raised rates by 25bp. This saw the dollar weaken; the dollar DXY index lost 1.4% in June but managed to hold its value over the quarter.
EM FX lost 1.1%, on average in June and 3.4% over the quarter. Meaningful declines in commodity prices did nothing to help the rand which is spite of a recovery of 4.6% in June, still lost 5.9% over the quarter.
The US banking crisis triggered a substantial reassessment of monetary policy, with US nominal and real yields falling sharply. The 10-year US Treasury yield declined by 45bp, to 3.5%, broadly matching the 40bp decline in the 10-year TIPS yield, to 1.15%.
US growth resilience and advances in the tech sector countered banking sector woes with the S&P500 gaining 8.3% as large cap tech drove the market higher on growing AI optimism. The Eurostoxx Index underperformed for the quarter, being up 1.9%. The FTSE 100 Index lost 1.3% while the Shanghai Composite declined by 2.2%. EM equities were broadly flat in dollar terms. The MSCI World Total Return Index rose by 5.6%. The MSCI South Africa Index posted a total return of -5.2% in US dollar terms.
The relatively muted changes at an overall SA equity index level belie the significant volatility experienced in the quarter. Most notable was the significant drop in financial and industrial “SA Inc” names in May on rising load shedding and geopolitical concerns, only for these moves to reverse in June as fears receded. Resource sectors were equally volatile, holding up relatively well in May as the Rand weakness offset hard currency declines, and then falling sharply in June as a strengthening Rand amplified further falls as pessimism grew around China’s lacklustre reopening. The overall market ended up (Capped SWIX +1.1%) in local currency for the quarter, with financials the largest contributor and resources the largest detractor.