SA bonds rally 5% post May’s election as EM peers experience negative returns
SA’s Government of National Unity (GNU) now comprises 72% of the seats in parliament and excluding the DA it is one seat short of a majority. This has reduced the Democratic Alliance’s (DA’s) negotiating power, leaving the party threatening to resign from the GNU after being offered fewer cabinet seats than desired. We view this as being part of an ongoing negotiating process and that markets will be left in relative limbo while provincial and national coalition trade-offs are made.
Against this backdrop, we consider the outlook for South African bonds and the currency, noting unsynchronised emerging market monetary policy cycles, the global backdrop and reduced risks to domestic inflation.
SA tailwinds are gathering momentum …
Things are looking up for SA. Firstly, US real yields are moderating, with 10-year Treasury Inflation-Protected Securities (TIPS) trading at 1.97%, down 20bp from May and a peak of 2.5% in October last year. Further moderation in developed market interest rates should render emerging market yields more attractive. Secondly, loadshedding has miraculously evaporated which, combined with national elections surpassing all expectations in terms of a market positive outcome, has raised growth expectations. And lastly, South Africa’s inflation rate has been marginally slower than expected year-to-date and economists are revising their forecasts lower for the remainder of 2024 and 2025 on the back of a stronger rand.
… creating room for rate cuts
Analysts are starting to feel more hopeful about the country’s growth outlook, and although this will take some time to come to fruition, business and consumer confidence should pick up more immediately. The country’s sovereign risk premium has consequently compressed year-to-date, from an average of 320bp between January and April to 280bp currently. This combination of positive factors has reduced the term risk premium priced into SA bonds, equities and the rand.
The reduction in sovereign risk premia, priced by bonds and the currency, reduces upside risks to inflation and provides space for the SA Reserve Bank (SARB) to cut rates, creating a virtuous circle. Consumer Price Inflation (CPI) is expected to meet the current 4.5% target over the next 12 months and the market expects cuts of between 75 basis points (bp) and 100bp, taking the real policy rate to 2.75% by May 2025. However, if longer-term potential growth improves, the room for cuts should widen further.
The extent of rate cuts will also be a function of the currency. Our USD/ZAR fair value estimate based on expectations for the SA/US inflation differential as well as commodity prices, is currently 15.60. Accounting for South Africa’s structural growth and political risks raises fair value to 19.30. This framework helps to measure the sovereign risk premium priced by the currency, which we estimate at around R3.80. Post elections, the currency has rallied by about R1.00, from 19.00 to 18.00. We think the initial rally is largely over and expect the rand will trade around a midpoint of 18.00 (between 17.50 and 18.50) to year end. If South Africa’s growth outlook starts to improve, the currency’s sovereign risk premium could narrow structurally, and settle around 17.00. However, that will require time and empirical evidence. Exogenously, a weaker dollar could also see a further structural rand decline below 17.50.
SA 10-year bond yield now at fair value
Assessing bond performance, we note that South Africa’s generic 10-year bond yield is trading at our estimated fair value i.e. 11.09% (Figure 1), having rallied 100bp post elections from May’s 12.04%. Historically, comparing our fair value bond model against actual yields shows South Africa’s generic 10-yr bond tends to price an additional 50bp of term premium during times of elevated uncertainty (e.g. Covid and elections). It also shows that bond yields can rally 50bp below fair value, which would take the 10-year to 10.60%, all else being equal (Figure 2).
It is useful to differentiate the extent to which sovereign bonds are determined by exogenous factors, and with this in mind we put SA bond performance into a global perspective. We compare SA to the JP Morgan Government Bond Index (GBI) EM index (Figures 5 & 6) and to Brazil – considering Brazil is also a BB rated country which competes with SA for foreign investor funds (Figures 3 & 4).
Figure 1: Fair value versus Actual 10-year generic bond yield
Figure 2: 10-yr generic bond yield, actual minus fitted
Source: Bloomberg, Matrix
Since Covid, emerging market local bonds have returned -10%, according to JPM’s GBI EM index (Figure 5). Against this, SA’s All Bond Index (ALBI) has returned +42% (Figure 5). Similarly, Brazil experienced a 600bp rise in its bond yields since Covid, versus SA’s 200bp, despite Brazil having cut its policy rate by 250bp since the start of 2023, whereas SA is yet to start its cutting cycle.
Prior to Covid, SA’s 10-year generic bond yield traded on average at 300bp below Brazil’s equivalent bond (Figure 4). From 2016, Brazil’s bond yields fell considerably on domestic fundamentals, narrowing the spread over SA to 200bp into Covid. Post 2020, and SA’s downgrade to BB, the spread settled at a structurally narrower 150bp. Post Lady R in 2023, SA’s geopolitical risk premium saw SA’s bond yields move structurally higher yet again; SA’s 10-yr spread/premium? rose above Brazil’s, peaking at 100bp before falling back to 50bp. SA yields rose again to 100bp above Brazil leading up to the country’s May election.
Interestingly, this 50bp premium aligns with what is implied by our fair value model in times of stress. Post elections, as political risk has dissipated, SA’s 10-yr has fallen 100bp, to 60bp below Brazil’s 10-yr. Looking at returns against the GBI EM local currency index, SA’s ALBI post elections has provided a phenomenal return of 5.07% month-on-month (m/m) decoupling from the EM bond index which provided a total return of -1.08%.
Figure 3: SA bonds have deteriorated vs Brazil
Figure 4 : Brazil 10-yr minus SA 10-yr bond yield
Source: Bloomberg, Matrix
Is the SA bond rally over?
Using these benchmarks, we try to assess whether the rally is over and make sense of how SA bonds could perform considering unsynchronised monetary policy. With countries in emerging markets such as Brazil having already cut interest rates, investors are finding the double-digit yields in other emerging markets attractive.
SA’s spread over Brazil implies that the election risk premium is now priced out of SA’s 10-yr bond. A further fall in yields – to spreads prior to March 2023 – would require a structural shift lower, possibly due to an improvement in SA’s fiscal and/or geopolitical risks.
Indexing the ALBI and EM GBI index to January 2023 shows SA underperformed consistently from the start of 2023 and we think the post-election rally is unlikely to be replicated in the near term. However, SA may outperform if it cuts rates while other EMs are hiking. In addition, what is evident from SA’s positive total return despite yields rising 60bp over the period, is that SA’s high yields have more than compensated for losses through capital gains. As the US starts to cut interest rates, and funds flow into EMs, SA’s high yields and capital gains from rate cuts should see the ALBI outperform, especially against markets that are starting to consider hiking rates.
Figure 5: ALBI versus Global EM Local Currency total returns, Indexed to January 2020
Figure 6: ALBI versus Global EM Local Currency total returns, Indexed to January 2023
Source: Bloomberg, Matrix
Inflation will determine how shallow the cutting cycle will be
The outlook for SA rates is highly dependent on domestic inflation. Matrix notes that consensus forecasts expect food inflation to remain sticky until September and then moderate substantially in the second half of 2024. We see risks to this view from maize and wheat prices and caution that the food component may surprise to the upside from September 2024 to mid-2025. We expect there is room for a cumulative adjustment of 100bp and that it could start in September 2024. This would see the real policy rate averaging 2.8% over the next 18 months, with a terminal rate of 2.5%.
Of course, all of the above is subject to how the GNU plays out. Currently markets are relatively sanguine, and tail risks are not priced.
