Doves donning hawkish feathers
The one thing markets do not like is uncertainty, or to be more precise, elevated uncertainty. The future is unknowable, so market pricing must always reflect a degree of uncertainty, and hence, a probability-weighted average of potential outcomes.
Yet, uncertainty is exceptionally high at present.
Fed credibility intact, for now
The much anticipated balance sheet run-off was confirmed in the May FOMC meeting, but it had only a muted impact at the time, as the 10-year US Treasury yield traded only briefly above 3.0%.
The resoluteness on the part of the Fed has dampened inflation concerns, as priced by breakeven inflation. However, US consumers are becoming increasingly worried about prices based on the decline in confidence and durable goods demand. To be sure, retailers in the US are sitting with ample inventory, which usually ends up being disinflationary, as they need to clear stocks.
But we are not there yet.
SARB doves tilt to the hawkish side
With the war in Ukraine intensifying and lasting far longer than anyone expected, the peak in inflation remains a moving target. This has prompted many central banks to turn even more hawkish, with the SARB MPC’s doves donning hawkish feathers in May to deliver a near-consensus 50bp increase.
In addition, the SARB has confirmed the change in the Monetary Policy Implementation Framework, from a shortage based system to a surplus reserves regime. While this is all decidedly technical, the SARB has gone to great lengths to emphasise that this will have no direct bearing on the policy stance, nor on money supply growth. I.e. the Bank will not use the new system to enable outright quantitative easing.
The new system should make it easier for the SARB to address bond market dislocations. In addition, it should lower the cost of borrowing for the government given that there would be no need to sterilise repatriated offshore funding, particularly from supra-national financing institutions, such as the IMF or World Bank.
SARB has been somewhat exceptional
The fact that the SARB has remained prudent, even throughout the pandemic, has set it apart from most of the other central banks. Money supply growth never ran away, which anchored the currency and inflation. Granted, the MPC did allow real rates to turn negative, but the differential to the US remains well-above the longer run average.
This policy prudence, alongside a bit of luck from the commodity windfall, has halted the negative trajectory in SA’s sovereign credit rating. Following Moody’s decision to move the outlook from negative to stable, S&P has become outright optimistic, changing its outlook from stable to positive. While the journey back to investment grade is usually a long protracted one, these developments should be a short-term anchor as the liquidity tide turns.
Will it last?
Food and transport costs continue to rise rapidly, putting additional strain on the consumer. CPI inflation has remained inside the 3% – 6% target range, but the next series of prints should be well-above target, despite the government opting to phase in the return of the R1.50 fuel levy. Food price inflation is being contained by a high base, but the extent of the food price shock, akin to that of 2007 – 2008, should push local food inflation towards 10% by the end of the year.
Add in rising political risks, we are in for an interesting second half of the year.
During May, inflation-linked bonds (2.0%) and fixed-rate bonds (1.0%) outperformed the other asset classes. Equities (0.5%) only marginally beat cash (0.4%), while listed property was flat for the month. The modest recovery in the rand (1.3%) would have been negative for offshore returns.
Fed’s 50s and softening growth weigh on the dollar
The DXY dollar index lost 1.2% in May due to marginally less hawkish monetary policy guidance and downside surprises in activity data. While the Fed followed through with a 50bp hike at the May FOMC meeting, it signalled that 75bp increments were unlikely at that stage. Even though this weighed on the greenback, the dollar was still up by 6.4% by the end of May.
EM FX weathered ongoing market volatility relatively well, gaining 1.2% against the dollar, on average. Commodity countries and those that have tightened monetary policy outperformed, while the laggards were generally commodity importers, which were penalised by high oil prices.
After depreciating sharply between mid-April and mid-May, the stabilisation in the Chinese yuan and modest stimulus from China’s authorities allowed the rand to recover by 1.3%. This brought USD/ZAR to 15.59 by month-end, which is broadly in line with our 15.00 – 16.00 fair-value range.
Yields trading the growth/inflation trade-off
US yields faced a tug of war between elevated CPI inflation and slowing growth momentum. Nominal yields fell as the curve steepened marginally, while TIPS yields rose to flatten the real yield curve. The net effect was a sharp decline in breakeven inflation. Hawkish Fed rhetoric and the pending start of the balance sheet run-off likely contained the market’s inflation concerns.
The stabilisation in US yields and hawkish shift from the ECB allowed bund yields to steady around 1.0% during the month. Breakeven inflation in Europe widened sharply following the invasion of Ukraine, but slumped in May, from 3.0% to 2.3% despite accelerating inflation.
EM bonds were a mixed bag in May, with the Philippines’s 10-year yield up by 75bp, as the central bank turned hawkish and hiked rates amid mounting inflation risks. In contrast, Mexico’s yields rallied by almost 50bp as global risk appetite stabilised.
Local bond market lacks a positive catalyst
SA’s market recovered modestly, with a 10bp rally in the benchmark yield. At 10.25%, SA’s yields are trading cheap on a long-term fair value, but tactically neutral given global inflation risks and uncertainty around the impact of quantitative tightening. The spread of 740bp over USTs is wider compared to the previous period of QT and suggests that there is ample risk premium embedded in the SA curve.
According to National Treasury, non-residents sold a net R2.4bn worth of bonds in May, which is modest in the context of heightened global uncertainty. Banks also lightened their exposure to the sovereign, selling a net R7.1bn. The unit trust industry bought R27.1bn, effectively taking up the entire net issuance during May, with pension funds buying a further R9.9bn.
At 28.1%, foreign ownership of the local market is at its lowest share since mid-2011, which highlights that positioning in the market is relatively light. Yet dedicated EM investors remain overweight South Africa, given attractive yields and a constructive macro story, relatively speaking.
For the local market to rally on a more sustained basis, the pace of reforms must accelerate sharply, or EM bonds must again become a favoured asset class. Both are tall orders at this juncture.
Bear market rally in equities
Equity markets remained under pressure in May, with a modest but temporary rebound towards the end of the month. Hawkish central bank rhetoric and high food and transport inflation are weighing on consumer sentiment, driving recession risks higher.
The S&P500 was flat in May, while the Eurostoxx declined by a modest 0.7%. The MSCI All World Index ticked 0.1% higher, but marginally underperformed the 0.4% gain in the MSCI Emerging Market Index. Elevated commodity prices and stabilising risk appetite boosted commodity exporters, with Chile (18.4%), Colombia (13.4%), and Brazil (8.4%) outperforming. Receding political risks may have contributed to stronger markets in this region. Hungary (-13.7%), Turkey (-6.6%), and India (-5.8%) underperformed on the back of worsening terms of trade amid the ongoing war in Ukraine.
SA equities cheap, with some earnings resilience
SA equities cheapened further, with the MSCI SA Index trading at a near 30% discount to EM and its own historical rating. Sectors with high quality earnings – such as banks – are trading on sub-10 multiples, while basic materials are not discounting sustained higher commodity prices. The renewed impetus to the recovery from elevated commodity prices, alongside the rebound in tourism and upside to infrastructure spend should mitigate downside risks to earnings growth.
The MSCI South Africa Index rose by 1.1%, which largely reflects the appreciation in the rand. The ALSI fell by 0.4%, while the SWIX rose by 0.6%.
The underlying sector performance was skewed to the downside, as only technology (5.5%) and financials (3.0%) printed in the black, benefiting from China’s reopening and support in the former and local earnings resilience and rate hikes in the latter. Consumer discretionary (-6.7%) and health care (-4.6%) were the clear laggards amid the trade-off between ongoing reopening and a muted Covid wave and growing consumer strain amid high fuel and food prices. Consumer staples (-1.2%), industrials (-0.6%), and telco’s (-0.3%) also printed in the red in May.
While banks benefited from improving activity and positive earnings revisions, retail came under pressure as a result of higher interest rates and mounting inflation fears. Despite negative earnings revisions for Naspers, the share price turned a corner on the back of China’s steady reopening, renewed focus on growth supporting measures, and ongoing comments from officials suggesting that the regulatory focus on tech may be nearing its end.