Navigating the headwinds
Financial conditions are set in the West, while real conditions are made in the East – usually the former dominates. As such, the re-emergence of US exceptionalism put pressure on EM financial markets in March.
The global risk-free rate – the US 10-year yield – has increased by 83bp year-to-date, split almost equally between the real component and inflation expectations. Nascent inflationary pressures, revealed in commodity prices and industry surveys, have pulled forward the timing of Fed lift-off from 2023 to 2022, despite the Fed reiterating its dovish stance. US data surprises have remained positive, payroll reports have been robust, and US growth forecasts have been revised up sharply, narrowing the differential with China. In contrast, Europe has re-entered lockdown, while the vaccine rollout has faltered amid fears of adverse effects from the AstraZeneca Covid-19 vaccine. The ECB has turned more dovish in signalling a higher pace of asset purchases.
In the East, China has turned more cautious on loan growth, which means the credit impulse will very likely wane over the course of the year. Moreover, the trade rebound is set to hand over to the services recovery during 2H21, which could dampen commodity prices. Some markets, notably EM FX, have pre-priced the potential tightening in external monetary and real conditions, which has also led to pre-emptive policy rate increases. Central Banks in Brazil and Russia surprised the markets with earlier and/or more aggressive rate hikes, while Turkey is suffering the fall-out from another governor being fired for doing what he should – hiking rates to stabilise the currency, domestic inflation, and financial conditions.
This brings the focus to South Africa. Real conditions warrant highly accommodative monetary policy given the high unemployment rate and tepid credit growth. In contrast, the FRA market and yield curve are telling the SARB it is supposedly behind the curve. Even so, financial conditions do not reveal the need for tightening. Inflationary pressures are muted based on headline CPI, core CPI, and the latest BER inflation expectations survey. The rand has shown remarkable resilience, being in disinflationary territory. There are no obvious signs of imbalances from overly accommodative monetary policy. The current account was in surplus in 2020, and is likely to remain so in the short-term.
The biggest macro risk to SA is the fiscal position, yet even on this front the news has improved. Following a market-friendly budget, SARS confirmed a further R38bn revenue overrun, which could shave a further 0.8%/GDP off the budget deficit. Treasury has lowered the weekly auction size by more than expected, which will ease some of the indigestion in the bond market. Importantly, the government has held firm on wage restraint, but this contestation is set to heat up in the coming months. Load shedding is an ongoing constraint on investment, even if consumers and producers have managed to adapt to life with intermittent power cuts.
With SA being a small open economy, it is a price taker on financial conditions from the West. If we add in the base-effect driven spike in inflation and the risk of a third wave, then Q2 could be a bumpy one for SA markets.
SA’s asset class performance was rather modest in March, with equities (1.6%) taking the lead, followed by property (1.2%), and inflation-linked bonds (0.6%). Fixed-rate bonds (-2.5%) underperformed cash (0.3%), while the rally in the rand (2.4%) would have diluted offshore returns. For 1Q21, equities (13.1%) posted a robust performance, followed by property (6.4%) and inflation-linked bonds (4.6%). Fixed-rate bonds (-1.7%) fell short of cash (0.9%), while the rand was marginally weaker for the quarter (-0.6% q/q).
After the cyclical low in early January, the dollar index gained 4.2% by the end of 1Q21, with more than half the performance (2.6%) coming in March alone. Higher US yields, stronger US macro data, and upward revisions to US GDP growth forecasts supported the greenback. The headwinds posed by the stronger dollar, lower commodity prices, and more volatile portfolio flows triggered a 1.8% decline in EM FX, on average, during March. The Turkish lira (-10%) and Polish zloty (-5.0%) were the worst performers, while the rand (2.4%) and the Mexican peso (2.0%) bucked the weakening trend. At 14.50, USD/ZAR is around 7% overvalued based on our estimates. While we cannot rule out an overshoot, the terms of trade seem to be stabilising and the trade surplus is likely to decline in the medium term amid the recovery in domestic demand.
The US 10-year yield rose further in March, to peak at 1.74% by month-end. The increase was mostly due to widening breakeven inflation, which reached 2.37% (a near 8-year high), as the TIPS yield declined back to below -0.6%. Even so, EM yields rose on higher US nominal yields and weaker EM FX. The EMBI lost 4.5% in Q1 and 1.0% in March, while the GBI-EM index declined by 6.7% during the quarter and 3.1% in March. SA’s 10-year yield has risen by 74bp since the start of the year, with more than half (44bp) coming in March. SA bond weakness has been in contrast to rand appreciation, but SAGBs have nevertheless outperformed the peer group (Russia, Mexico, Brazil, and Turkey). SA’s bonds have cheapened notably, with 10-year breakeven inflation widening to over 6% versus the effective 4.5% inflation target and the 2.9% latest CPI print.
The persistent weakness in bonds during March was contrary to supportive domestic fundamentals: the rand appreciated in the face of dollar strength; inflation surprised to the downside; National Treasury lowered the non-comp allocation from 100% to 50% and announced a 27% reduction in the weekly auction size; SARS confirmed a further R38bn tax revenue overrun; the SARB MPC was dovish, but still prudent in the March meeting; and the political dynamics turned in favour of the Ramaphosa faction.
Non-residents sold a net R14bn worth of fixed-rate bonds market during March. Even so, year-to-date net inflows totalled R21bn on a nominal basis. Whereas domestic banks had previously absorbed foreign selling and additional issuance, the official National Treasury statistics showed that this reversed sharply in March with the monetary sector disinvesting across the yield curve. Excess HQLA holdings, de-risking, and the reduction in the non-comp allocation could have contributed to the net sales by the banking sector, but the magnitude of selling across the curve is perplexing. Other financial institutions, largely the unit trust industry, were reportedly the offsetting buyers to foreigners and banks, but at substantially more attractive clearing yields.
Equity market performance was mixed during March, with Mexico and Chile outperforming, while Peru and Turkey underperformed sharply. In general, DM bourses did well, with the S&P500 reaching a record high in March, being up 4.2% for the month. The MSCI World Index gained 3.3% (total return), outperforming the 1.5% loss on the MSCI EM Index. South Africa was a notable outperformer, posting a total return of 6.1% in dollar terms. The de-rating in domestic equities continued as consensus earnings estimates were revised upwards yet again. As a result, the 12-month forward PE multiple is now at a 20% discount versus its long-run history.
Despite reaching a record high during March, the ALSI’s 1.6% gain was short of the 3.2% rise in the SWIX. Telcos (13.0%), consumer services (6.7%), and industrials (4.6%) were outperformers, while Technology (-0.2%) and consumer goods (-0.8%) were the laggards. Financials (1.7%), healthcare (1.6%) and basic materials (1.3%) posted pedestrian performances, with the latter masking sharp divergence within the sector. Chemicals (11.5%), gold mining (12.6%), and platinum mining (8.8%) posted solid returns, while industrial metals (-3.8%) and mining (0%) reflected the waning momentum in a wide range of commodity prices.