Watching the curve
Stagflation remains the key macro theme for market participants, despite the improving economic surprises across the world. Even in South Africa, the data has been better than expected, with rising PMIs, stronger retail sales growth, and contained inflation.
Stagflation fears intensify
Stagflation is usually defined as high and rising inflation against a backdrop of rising unemployment.
In many countries, we can tick the first box, as supply-side price pressures are intensifying. Yet, labour markets continue to recover, most notably in the US where the unemployment rate has fallen to 3.6%, one tenth away from the pre-Covid low. This improvement has been in the face of rising labour force participation. High wage growth – on some measures the highest since the early-2000s – has not perturbed hiring, with most labour market measures pointing to an overheating economy.
Unfortunately, South Africa does not have this luxury, as the reopening has been more than offset by the persistent impact of previous lockdowns, as well as the social unrest in July last year. The net effect has been a steady incline in the unemployment rate, to 35.3% in 4Q21.
Yet meaningful inflationary pressure remains absent, with CPI inflation steady, albeit marginally below the 6.0% upper limit. Granted there are mounting input cost pressures that are set to lift headline inflation to above 6.0% in the coming quarters.
Temporary reprieve for SA consumers, but be careful
For now, this target breach has been temporarily delayed by the reprieve in the fuel tax. The Finance Minister announced a temporary reduction of R1.50/litre in the fuel tax for April and May. This would delay the target breach until June, if food prices do not escalate too sharply and if the government reinstates the full fuel tax. This could prove to be challenging, much like the inability to end the Special Relief of Distress Grant.
While a fundamental overhaul of the fuel pricing mechanism is still pending, it could be dangerous from a fiscal and signalling perspective to move closer to price controls. South Africa has generally opted for flexible policy and pricing – ranging from the fuel price to the floating exchange rate. This has meant that the fiscus was not hampered by rising oil prices and attendant burgeoning subsidies.
The current “subsidy” will cost the government R6bn, which will be offset by an equivalent sale of the state’s strategic oil reserves. Yet this cannot go on indefinitely. On an annualised basis, the cost to the fiscus is R36bn, which is close to the R40bn needed for 12 months’ worth of Covid grants. This gives some perspective to the wide-ranging demands on the government’s purse.
Pending inflation target breach makes for a much more hawkish SARB
Factoring in the higher oil price and reacceleration in food price inflation, CPI is most likely to average 6.0% (or slightly higher) in 2022, with a plausible multi-quarter breach of 6%. While this is largely exogenous, the SARB has noted its concern about potential rand depreciation given recent appreciation and sensitivity to commodity prices, as well as the risk of second-round effects in expectations and wage growth.
While the SARB is certainly not behind the curve, it is surely watching other central banks trying to “out-hawk” each other.
We are all Fed watchers now
While the SARB does not follow the Fed in lockstep during monetary policy cycles, it is very difficult to ignore the global monetary policy maker. To be sure, the start of the normalisation cycle in November was at least partly due to the expectation that the Fed would be hiking rates in 2022.
While the SARB does not necessarily want a wider SA/US real rate differential, it wants to ensure that the buffer remains adequate to stabilise the rand and limit upside inflation risks. This differential is currently at a substantial 550bp. Based on consensus inflation forecasts and the markets’ pricing of monetary policy, this gap is set to fall to 150bp over the next two years. While notably lower, it would be broadly in line with the historical average and would provide an adequate buffer for the rand.
However, the SARB will be cognisant of the more hawkish bias coming from various FOMC members. Chairman Powell has already signalled possible 50bp hikes in the coming meetings. We cannot rule this out, as there were instances in the 1990s when the Fed hiked by 75bp at some meetings.
QT an active tool
In addition, balance sheet run-off or quantitative tightening (QT) will tighten financial conditions, which would be akin to interest rate hikes. It is difficult to see how the Fed will be able to run QT on autopilot in the background. Surely, if quantitative easing (QE) was an active policy tool, then so too will be QT.
The market has been fretting about the flattening in the yield curve as a signal that the Fed will not be able to hike by much. Similarly, it sees that potential steepening from QT will give the Fed more room to hike. We disagree with this view. Rather, the combination of rate hikes and QT will tighten financial conditions in a bid to rein in inflation.
SARB wants to stay ahead of the curve
SA’s inflation dynamics have been notably different to the rest of the world, with the wide output gap, resilient rand, and constrained wage growth limiting inflation pressures. However, this will not carry on indefinitely.
The SARB continued the normalisation process in March, hiking the repo rate by 25bp to 4.25%. Yet the outcome was more hawkish than expected given the cautious statement and the fact that two of the five MPC members voted for a 50bp hike in a bid to stay ahead of the inflation curve.
If the Fed starts moving in increments of 50bp, alongside QT, then the SARB may feel more pressure to front-load normalisation. Hence, we cannot rule out a 50bp hike at the May or July MPC meetings.
Yet we are nearing the tipping point in global liquidity, global growth, and asset prices. If the economic cycle shifts downwards, then it is unlikely that central banks will remain as hawkish following partial normalisation. The inflection point in monetary policy pricing will accompany the slowdown, which may very well be reflected in risk assets first.
Moody’s less moody on SA
To end off on a positive note, it is worth highlighting that Moody’s changed the outlook on SA’s sovereign credit rating from negative to stable at its 1 April review. All three of the main credit rating agencies now have SA in BB-band with a stable outlook. While it will take many years to regain investment grade status, SA should be able to avoid slipping into the single-B band if it implements reform to accelerate growth.
A stabilisation in the credit rating could result in some of the excess risk premium embedded in the local yield being priced out. Moreover, lessening fiscal risk will give the SARB more policy freedom in the medium term. But for now, the focus is firmly on inflation.
Market developments
During March, listed property (5.1%) rebounded strongly, followed by equities (1.5%). Fixed-rate bonds (0.5%) marginally beat cash (0.4%), while inflation-linked bonds (-0.7%) underperformed. The rand gained 5.5% against the dollar, which would have been dilutive for offshore returns.
Equities (6.7%) outperformed the other asset classes by a wide margin during 1Q22, while fixed-rate bonds (1.9%) managed to outperform cash (1.0%). Inflation-linked bonds (0.3%) and listed property (-1.3%) underperformed.
Ruble recovers, rand robust
The dollar index (DXY) rallied by 1.7% in March, taking the Q1 gains to 2.8%. The combination of hawkish monetary policy expectations and safe haven demand following the invasion of Ukraine boosted the greenback against other G10 currencies.
DXY at almost 100 is at a similar level to 2Q20 when Covid lockdowns and heightened uncertainty also boosted safe haven demand. With the US economy better able to absorb global headwinds and policy tightening, growth differentials will likely keep the dollar firm in the short term, which will be a headwind to EM growth.
EM FX gained 2.3% against the dollar, on average, with EMEA (5.2%) and LatAM (2.9%) doing well relative to Asia (-0.6%). The Russian ruble recovered sharply in March (+29.6%), leaving the unit only 7.5% weaker for 1Q22. Commodity currencies generally performed well, as revealed in the Brazilian real (8.7%), Colombian peso (4.5%), and Mexican peso (3.1%) appreciation. At the other end of the spectrum, oil importers suffered with the Turkish lira (-5.6%), Argentine peso (-3.2%), and the Thai baht (-1.8%) underperforming.
The rand remained resilient in March, with the unit gaining 5.5% against the US dollar, which took the Q1 appreciation to 8.9%. The rand is trading at the strong end of our 14.50 – 15.50 fair-value range for USD/ZAR.
Stronger local anchors for the rand
Tightening global financial conditions pose a risk to the unit, but fundamentals are currently more supportive than during the previous Fed hiking cycle. Favourable dynamics include negative SA/US inflation differentials, contained money supply differentials, elevated commodity prices, and a robust current account surplus. These should ensure a better supply/demand balance for the currency and buttress the rand against portfolio flow volatility. To be sure, many market participants have referred to the rand as the “Swiss franc of EM” during the geopolitical turmoil.
Importantly, the stabilisation in the credit rating outlook, alongside prudent monetary policy, should also lower the required risk premium in the rand. The net effect is a reduced vulnerability and probability of a blowout in the unit.
US yield curve bear flattens, fear of a slowdown intensifies
DM bond yields sold off sharply in March, led by the US market. The 50bp increase in the US 10-year yield was due to both a higher TIPS yield and wider breakeven inflation. This brought the Q1 increase to almost 100bp, taking the 10-year yield to almost 2.5%.
TIPS yields had a volatile quarter with the 10-year real yield selling off from -1.1% to -0.40% in late-February. There was an inflation-induced rally back to -1.1%, but this proved short-lived as a more hawkish Fed lifted the real rate to -0.50% by end-March.
Concerns over a Fed policy error intensified as the 2v10 yield curve flattened persistently over the course of Q1, culminating in marginal inversion at month-end. The US yield curve has historically been a reasonably reliable indicator of a growth slowdown and this time should be no different.
That said, the Fed’s aggressive QE during the Covid pandemic has surely distorted price discovery, as the Fed is a price-insensitive buyer of bonds. If this holds during the balance sheet run-off, then there is a risk that the curve could steepen to tighten financial conditions. This means that bond yields could do some of the heavy lifting for monetary policy.
EM bonds were under pressure from the combination of higher US yields and the spillovers of the Russia/Ukraine war. In the absence of trading in Russian bonds, Turkey stood out as the underperformer, with the benchmark bond yield rising by 130bp in March amid consumer price inflation breaching 60% y/y. Contagion from the conflict was evident in higher yields in Poland (111bp), Hungary (62bp) and Czech Republic (62bp). Elevated commodity prices and FX resilience limited the weakness in some EM bond markets, with Brazil only 5bp weaker and SA’s benchmark yield only 13bp higher.
The aggressive sanctions have ignited fears of a Russian debt default, evident in the 5-year CDS spread trading close to 4000bp in March. Subsequent intensification of sanctions in April have resulted in the spread blowing out to 13000bp. Turkey’s CDS spread remains elevated, trading around 600bp, while SA is aligned with its commodity-producing peers (Brazil and Colombia), which are trading close to 200bp.
The EMBI composite lost 10% in Q1, but traded sideways in March as the pace of outflows from EM hard currency debt slowed. The GBI-EM outperformed the EMBI, falling by 6.5% in Q1 as portfolio outflows were not as severe during the quarter, thanks in part to relatively light positioning ahead of the invasion of Ukraine.
SA bonds lack foreign sponsorship
SA’s benchmark 10-year yield ended the month at 9.90%, which was moderately cheap versus our 9.00% – 9.50% fair-value range. However, a prudent budget and unchanged issuance was not enough to steady the market, as the war-induced sell-off intensified in March. Yields peaked at 10.70% – the highest level since the market dislocations in 2020.
The headline bond portfolio data showed net foreign selling of R66bn in March, but this seemed excessive relative to the market’s performance during the month. The adjusted JSE data showed more muted disinvestment of around R18bn, which would have almost fully offset net foreign buying earlier in the year in anticipation of a positive budget outcome. The official National Treasury data showed a more benign R9bn of outflows, which was absorbed broadly across the domestic savings pool.
A tough quarter, but equities shake off tightening financial conditions in March
Following a 12% correction in the S&P500 since the start of the year, the market rebounded by almost 11% in the second half of March to leave the Q1 return at -4.9%. While most DM equity bourses recovered in March – the S&P500 was up by 3.6% – Europe bucked the trend with the Eurostoxx losing 0.4% to take the Q1 loss to -9.2%.
With improved valuations, the US market shook off the war, tightening financial conditions, and the hawkish Fed, despite the rising share of downside surprises in earnings. This reflects the tech stock rebound and improved activity data – evident in upside economic surprises.
Interestingly, the correlation between the S&P500 and the 10-year TIPS yield turned positive during February and March, but has since reverted to the norm with higher real yields putting downward pressure on stocks.
The MSCI World Index (2.7%) outperformed the MSCI EM Index (-2.3%), as the latter was dragged down by China (-8.0%). Ongoing regulatory constraints, fears of broadening sanction, and harsh Covid lockdowns triggered a severe mid-March slump in Chinese equities. Outside of select Asian markets, EM equities generally did well in March, with Argentina (15.5%), Brazil (14.9%), and Colombia (14.8%) leading the pack.
Domestic earnings resilience still somewhat undervalued
The MSCI South Africa Index posted a respectable 7.6% return in March and 20.3% in 1Q22, but a notable portion of the gains came from the stronger rand. The ongoing slide in Naspers and Prosus weighed on the market throughout Q1, while falling resources shares added to the pressure.
The ALSI was flat for the month, while the SWIX gained 1.4%. Technology (-13.8%), consumer discretionary (-5.2%), and industrials (-3.4%) were the notable laggards. Basic materials (-1.5%) came under pressure as precious metals and mining sold off amid a reversal in platinum and palladium prices. In addition, the gold price was hampered by higher real yields. Consumer stables (-0.2%) were marginally lower in March. Health care (1.8%) and telco’s (2.7%) outperformed, but the standout was financials (10.9%), which was underpinned by solid results from the banking sector.
With modest price gains and upward revisions to earnings expectations (that were broadly based), the rating on the SA market remained at just below 11 times on a forward basis. The moderation in earnings growth has seemingly stalled, with renewed upside to momentum thanks to elevated commodity prices and the ongoing normalisation in the local economy. Despite relative resilience in the rand, improving earnings momentum, and prudent macro policy, SA continues to trade a discount of around 20% versus its historical rating as well as the EM average.
Following sequential quarterly non-resident disinvestment from the local market, foreigners have turned more constructive. Based on the JSE data, non-residents bought a net R30bn of local equities during 1Q22.
