Normalisation
The global economy continued the slow but steady process of normalisation as the developed world reopened further. Yet, the growth performance across countries remained rather mixed – a function of restrictions, stimulus, and vaccine deployment. Markets reflected this varied activity, as some commodities – such as energy and agriculture – climbed further, while others – such as platinum and rhodium – took a breather after a robust performance heading into May.
Activity nearing normal, policy and markets not
Central Bank tapering, tightening credit conditions in China, and vaccine supply constraints are potential headwinds to growth. Until recently, these have not perturbed markets, as equities remain elevated, thanks to highly accommodative monetary policy and generous fiscal stimulus. This begs the question of how policy and markets will adjust once real activity fully normalises.
With direct fiscal support to US households expected to end during 3Q21, the employment data could recover quite sharply, leading to a reassessment of quantitative easing and forward guidance. The pace of the taper would have to be co-ordinated with the pace of issuance so as not to be overly disruptive to financial markets.
What is normal?
The purpose of the Fed’s average inflation targeting framework is to enable the price level to normalise. This requires that the inflation rate run above target to compensate for multi-year misses to the downside. Yet the inflation debate continues as to what is “normal”. Based on the very long-run history, inflation would “normally” oscillate around 0% with inflationary episodes during wartime and subsequent deflation.
This pattern held in the first half of the 1900s (World War I and II), but in the 1970s the culmination of the oil embargo, lax monetary policy, and unanchored inflation expectations led to sustained high inflation. Since then, inflation underwent a great moderation amid declining unionisation, globalisation, technological/productivity developments, and the broadening adoption of inflation targeting. Whether we are now facing the end of the great moderation is still unclear.
Inflation normalisation tipping SARB towards hikes
Locally, the ongoing pandemic has not limited mobility, with SA a mere 5% short of baseline activity levels. While much of this is the rebound off a low base, the positive terms of trade could make the growth spurt a bit stronger. The durability will depend on the fixed investment recovery, which is a function of confidence in the government and in consumers’ willingness and ability to spend. On the former, the short-term fiscal position has improved, but the reform agenda still faces opposition from various corners. On the latter, the Q1 employment data showed a notable post-Covid jobs shortfall, while credit growth remains lacklustre, despite record-low short-term interest rates.
Alongside normalising activity, the inflation cycle has turned, with CPI expected to oscillate around 4.5% – the effective target. Given this outlook, the SARB has signalled its willingness to start the process of normalisation. Yet the rand’s resilience and contained core inflation have prevented the market and analysts from bringing forward the timing of the first hike. Following the May MPC meeting, the FRA market and the SARB’s Quarterly Projection Model were broadly aligned on a gradual (25bp per quarter) hiking cycle. The Fed’s much-discussed taper may accelerate the undertaking of repo rate normalisation. The debate is whether this comes as early as 2H21, or whether the Fed will stay pat on its asset purchases and policy rate until well after the unemployment gap has closed.
When structural change is temporary
In the meantime, inflation fears are percolating. Much of the recent run-up in inflation has been due to the confluence of base effects and supply disruptions. The latter resulted partly from the (now incorrect) belief that the Covid-19 pandemic and attendant policy measures, such as lockdowns, would cause significant structural changes in the economy. As a result, producers and retailers cancelled orders and reduced capacity, only to face a v-shaped recovery in the demand for goods – a case of demand normalising (and then some) but supply lagging.
While inflationary pressures from supply shortages are usually transitory, these could prove more durable if policy remains excessively loose and/or inflation expectations pick up meaningfully. This durability is the current source of market and policy uncertainty.
Market pricing suggests there is no concern about runaway inflation such as in the 1970s. Yet we must be cognisant of the fact that the Fed has become the US bond buyer of last resort and that this may be distorting price discovery. The commodity spectrum is telling us something about inflation expectations, being an input into the inflation process, as well as an inflation hedge. There are many circularities, feedback loops, and spillovers to consider in the coming months.
Market developments
During May, fixed-rate bonds (3.7%), inflation-linked bonds (3.4%), and equities (1.6%) beat cash, while listed property (-2.9%) fell well short of cash returns following a robust performance in April. The 5.5% appreciation in the rand versus the US dollar was dilutive for offshore asset returns.
Perplexing rand strength
Dollar weakness continued in May, with the dollar index losing 1.6%. Negative real yields, a dovish Fed, and the petering out of US exceptionalism weighed on the greenback. Confirmation of the risk-on environment was evident in the 0.2% decline in the Japanese yen, but the performance was rather mixed among EM FX. The Hungarian forint and the rand were the outperformers, gaining in excess of 5%, while the Turkish lira and the Chilean peso were the laggards, losing around 2%. The rand benefited from the robust terms of trade and receding local fiscal and political risks. This was in contrast to intensifying political uncertainty in many of SA’s peers.
USD/ZAR traded as low as 13.76 in May, despite softening commodity prices, finding support from other factors. The trade balance remains in surplus, funding spreads are still relatively high, bond yields are attractive, and SA’s mobility has normalised faster that in many other EMs. FX valuation is usually contentious, but we maintain that a rand below 14.00 to the dollar is overvalued. Admittedly, this overvaluation may persist, particularly in a pro-growth/weak-dollar policy environment. On a purchasing power parity basis the rand may still be modestly undervalued, but on the SARB’s metric, the rand is no longer cheap.
Steady US yields supportive of bond portfolio flows
Following the recovery in US bonds in April, nominal and real yields tracked sideways in May as employment data fell far short of expectations and Fed officials downplayed taper and inflation risks. The positive surprise bias in the US started to wane while the global recovery remained uneven, anchoring other core rates. US breakeven inflation is pricing in a multi-year overshoot of the Fed’s target, albeit not at rampant inflation levels. Excess liquidity capped DM bond yields, which boded well for EM bonds. The EMBI gained 1.1% while the GBI-EM index rose by 2.5%. The underlying local market performance was a mixed bag. Hungary sold off by 17bp, in contrast to the currency, while Peru rallied by 62bp. SA was a relative outperformer with the 10-year yield falling by 45bp.
While the market is still screening cheap based on our fair-value models, lower issuance and steady US yields are already partially priced, limiting the extent of further gains. Non-residents were active in the local market in May, with net buying of R24bn effectively taking up the entire new issuance during the month. Banks increased their holdings by only R3.7bn, switching out of the short end into long-dated bonds. Unit trusts were net sellers totalling R14bn, with disinvestment spread across the curve.
Earnings revisions losing some steam
Equity markets were a mixed bag in May, despite what should have been healthy risk appetite. Low yields, easy policy, and reopening did not sustain the record high in the S&P500, which eked out a 0.5% gain. Emerging markets outperformed developed markets, with EMEA benefiting from FX gains. The MSCI World Index total return of 1.4% was eclipsed by the 2.3% return on the MSCI Emerging Market Index. The MSCI South Africa posted a respectable 7.2%, even if much of this was thanks to the rand.
The ALSI gained 1.6%, while the SWIX rose by 1.3%. SA Inc. did particularly well in May, supported by the stronger rand, rally in yields, and positive data surprises. Consumer Discretionary (12.0%), Financials (9.3%), and Telco’s (8.3%) were the standout performers. Consumer Staples (4.1%), Health Care (3.3%), and Industrials (2.6%) beat the overall index, which was weighed down by Technology (-7.9%) and Basic Materials (-1.3%) – the former reflected the ongoing pressure on Naspers and Prosus and the latter was encumbered by lower rand commodity prices. Overall, the market is trading at a c.20% discount to its long-run average. However, there has been a waning in this upgrade momentum as certain commodities consolidate.
