The expected turn in interest rate cycle
Across the globe, markets are anticipating a turn in the interest rate cycle. This should be positive for financial markets, as we see in the US and EU where equity markets are pricing in rate cuts more aggressively than bond markets. By contrast, this is not taking place in South Africa with its unique confluence of risks, including political tension and an upcoming election, logistical constraints, collapsing SOEs and load shedding, fiscal challenges, as well as climate change. These threats have led to rand depreciation and financial markets which have yet to find stimulus from the prospect of lower rates. We will focus on interest rates in this issue, as a key driver of markets, and highlight how sensitive interest rate markets presently are to data points.
US soft landing will still be cyclically positive for financial markets and specifically EM Bonds
Our macro narrative since August 2023 has been that, while South Africa faces structural risks which are likely to lead to a downgrade to single B over the long run, the global monetary policy pivot is bond positive, and specifically emerging market (EM) bond positive. This narrative was supported by the US Federal Reserve’s (Fed’s) hitting the brakes on interest rate increases in November and the sustained inversion of global developed market yield curves.
However, economies don’t move through turning points smoothly, and mixed signals from recent US data releases have seen EM asset prices oscillate between expecting a shallow rate cutting cycle and an increasing possibility of the next move by the Fed being a hike. US interest rate derivatives are priced for between 75 basis points (bp) and 100bp of cuts by year-end, this after having priced up to 160bp of cuts at the start of the year. Clearly the market is uncertain.
US data and the Fed and market reaction
While US inflation is slowing, it remains above target and growth appears to be relatively resilient in the face of restrictive real interest rates, indicating that a soft landing and shallow rate cutting cycle is most likely. The US Treasury (UST) 2-year bond, which is most correlated with the Fed policy rate, is currently at 4.6%. Under this scenario, discount rates should stabilise at levels that are more in line with pre-global financial crisis equilibrium levels, which should still be net positive for EM bonds.
Apart from lower global real rates, under a soft-landing scenario the US avoids a recession, which should be supportive of risk appetite and reflected in equity markets.
According to US Fed chair Jerome Powell’s testimony on Thursday March 7, rate cuts can and will begin in 2024. We expect the Fed took comfort from the steep and persistent decline in Supercore Personal Consumption Expenditure (PCE) inflation (Services PCE less Energy and Housing), which slowed in February to 3.08% from 3.5% in January. Supercore PCE is key with respect to the Fed’s rate decision as it leads earnings (wage) inflation by three quarters.
While Powell’s comments provided much-needed guidance the market did not react as expected. This is due to conflicting data coming out of the economy. By way of example, post the release of higher-than-expected PPI inflation data, (1.6% y/y), and lower than expected jobless claims later in the month, the UST 2-year yield rose almost 20bp.
US National Financial Conditions Index
An index that the market is hanging its hat on is the National Financial Conditions Index (FCI) which the Chicago Fed releases monthly. It comprises 105 variables and accounts for conditions in financial markets. According to this index, financial conditions loosened in February and have been on a loosening trend since March 2023. The fact that it is loose indicates less rate cutting. However, if US rate cuts do not materialise, financial markets are likely to be disappointed, and bond and equity markets will need to weaken from current levels.
While the Fed has stated that it will cut rates later this year, markets are aware that it faces a dilemma: although real interest rates are historically high, data releases indicate that the US consumer remains resilient. This dichotomy has seen analysts turn their attention to understanding the financial conditions that US consumers face.
Despite a significant increase in the policy rate, US financial conditions remain loose. What does this mean with respect to the Federal Open Market Committee’s (FOMC’s) reaction function i.e. will the FOMC only cut rates once financial conditions tighten? Secondly, if high real rates can coexist with loose financial conditions on a sustained basis, how effective is the monetary policy transmission mechanism?
US consumer still strong
Post COVID, US consumers had the benefit of low historical rates that enabled them to save more and deleverage on debt while also locking in low fixed mortgage rates. This complicates the interest rate policy transmission mechanism since high rates have less of an impact on consumer spending. Contradicting this is the rise in credit card spend (debt) as shown in figure 1 below. Credit card debt is rising, and the real average credit card interest rate has risen from a low of 6.5% in May 2022 to 18.4% in February 2024.
Figure 1: Real value of credit card debt per capita ($000’s)
Source: Bloomberg, Matrix
EU rate cuts sooner than US
Meanwhile across the pond in the EU, analysts have taken comments made at the European Central Bank’s (ECB’s) March meeting to mean that cuts will begin in June after the ECB slashed its inflation forecast for 2024 to 2.3% from a prior 2.7% in December. Economic growth in the EU is fading after the post-pandemic spurt, but there’s still a glimmer of hope. Despite tight financing and lingering consumer jitters, declining inflation and healthy wage growth are boosting purchasing power.
SA rates to follow global rates but local risks add a premium and a delay
As opposed to global markets South Africa’s interest rate derivative market implies the first rate cut may only materialise at the November MPC meeting, with a cut of 25bp in September seen as a lower probability, at the time of writing. This delay will be less stimulative for the local economy, reflected in domestic equity and fixed income market pricing and resulting performance of local indices.
Key real risks facing South Africa include:
- Political tensions ahead of the 29 May election: not only is there serious in-fighting within the governing ANC, but the lead up to the May elections has potential for political instability and possible civil unrest. The riots and civil unrest in July 2021, centred in KwaZulu-Natal, exacted a heavy toll on the economy – estimated at between R50bn and R75bn with 2 million jobs being lost or affected – and remain fresh in our memories.
- Potential election results: the elections are predicted to be a watershed event, at both national and provincial level, with the likelihood of coalition governments being formed. This will be a significant change to our political landscape, with potential instability in subsequent administrations.
- Constrained transport and logistics: Transnet, the operator of SA’s rail and port network has proven to be woefully inept with persistent delays and backlogs in our major ports including Durban, Richards Bay and Cape Town. This has led to plummeting exports and losses running into billions. The SOE has not fared better in its management of rail with equipment shortages and maintenance backlogs after years of under-investment compounded by rampant cable theft and vandalism.
On a positive note, Transnet has released a draft Network Statement aimed at preparing the logistics provider for “privatisation” – or rather to offer third-party access to the rail network. However, the statement has been met with a tepid response as it seems that Transnet remains intent on retaining its monopolistic control of rail while also pointing to tariffs that could show dramatic increases. Those who are disappointed should be reminded that it was as recently as October 2023 when the Presidency insisted that Transnet is a key national asset “that will remain in public ownership.”
- Collapsing SOEs: from Eskom with its load shedding to the bulk water suppliers, critical services are failing and the government and municipalities are battling to provide delivery of basic utilities on an ongoing basis. Not just inflationary, but a severe constraint on production, the lack of infrastructure and basic services is a significant drag on the economy. While many businesses now generate their own backup power, this is more challenging in the case of water.
Residents and businesses are increasingly taking action to find solutions and in the instance of the Makana Municipality (formerly Grahamstown), the city council was dissolved through court action and placed under administration for failing to provide basic services to the community.
- Fiscal challenges: although the use of foreign exchange reserve gains, as announced in the 2024 Budget Speech, will reduce South Africa’s borrowing requirements in the near term, the country remains in a tight fiscal position with an expected deficit of 4.9% of GDP for the 2024/25 year and the debt-to-GDP ratio peaking at 75.3% of GDP in 2025/26. With low growth negatively impacting tax revenue forecasts, the limited ability of the government to rein in its spending considering significant expenditure requirements, not least on welfare and infrastructure, means that we are not out of the woods yet.
- Climate change: extreme weather events of intensifying severity may be a risk facing all countries. South Africa has witnessed the devastation that can result from the extremes of both drought and storms and the extent to which the country is ill-prepared to deal with them. Businesses need to be aware of and manage several risks associated with climate change: the physical risk to assets and the business interruption from the extreme event; the transition-related risk as the business seeks more sustainable solutions; and the financial and reputational risks from losses arising from damage and litigation due to climate related disruption.
