SA bonds offer value, while global rates shift lower
The global monetary policy cycle is bullish for bonds, as evidenced by central banks keeping policy rates on hold in October. The US Federal Reserve Bank (Fed) kept the policy rate at 5.5% where it has been since July’s meeting, as did the European Central Bank (ECB) (4.50%) and the Bank of England (BoE) (5.25%). Against the global monetary policy cycle backdrop, we see value in SA bonds at current levels.
Over the longer term i.e., the next five to ten years, we are concerned about SA’s rising sovereign risk. With SA GDP growth capped at 1.0% due to structural constraints, and structurally higher global real rates, SA’s fiscal outlook could result in a sovereign downgrade to a single B by 2028. We note that according to JP Morgan’s indices, single B rated sovereign bonds trade in the region of 250 basis points (bp) above BB rated bonds. Over time, if growth remains below 1.0% in real terms, sovereign bonds will need to offer an increasing return for escalating default risk. We estimate that SAGBs offer 100bp of risk premium, which compensates for our assessment of current fiscal uncertainty.
SA’s MTBPS saw bond issuance unchanged
The November Medium Term Budget Policy Statement (MTBPS) provided no negative surprises and kept bond issuance unchanged. The market reacted positively post the release and continued to strengthen, supported by a dovish Federal Open Market Committee (FOMC) meeting and weak US non-farm jobs data, indicating a softening in the US labor market. US Treasury (UST) yields have shifted downwards, taking EM bond yields with them.
The MTBPS expects debt-to-GDP to stabilise at 77.7% in 2025/26, up from February’s 73.6%. This more realistic assessment is still optimistic. Firstly, it requires non-interest government expenditure to contract this year by 0.7% (in nominal terms), despite the wage bill growing 5.1%. Secondly, the wage bill over the three-year Medium-Term Expenditure Framework (MTEF) is budgeted to average 3.6% per annum, or -2.0% per annum in real terms, despite the wage agreement being set at CPI in 2024/25, plus 1.5% pay progression. Thirdly, social support services and grants will need to be cut from the current 68% of revenue to 63%. These are political decisions over which the Treasury has little control.
On the revenue side, private sector wages are budgeted to average 7.8% per annum over the MTEF and household consumption 6.4% per annum, to support average personal income tax (PIT) and VAT growth of 7.9% and 6.1% per annum. These growth rates seem incongruent with SA’s 4.5% year-on-year (y/y) inflation target and growth constraints.
To reduce the cost of debt, the MTBPS shows that where possible Treasury is shifting its debt profile away from instruments with long-dated maturities towards those with shorter-dated maturities that are cheaper, such as T-bills, Floating Rate Notes (with three- and five-year maturities), and a newly announced local Shari ’ah product, Sukuk. Over the budget period SAGB and inflation-linked bond (ILB) issuance may need to increase, as the total debt stock is set to increase by R1.3 trillion. We do expect that there will be additional, more creative sources of revenue and concessional foreign funding than has previously been the case, reducing the negative impact on SAGBs and ILBs. This includes drawing down on the GFECRA (Gold and Foreign Exchange Contingency Reserve Account), which is estimated at R450bn.
South Africa’s rand-denominated redemptions have averaged R33bn per annum over the past 5 years; however, over the next five years it will average R130bn per annum. And, five years after that, out to 2031, the amount of local currency debt maturing will rise to R250bn per annum. This is cause for concern, considering SA runs a budget deficit of between R300bn and R400bn, which means not only do we need to raise debt to pay down maturing debt, but SA also needs to raise debt to pay its annual bills.
In addition, because the country’s credit worthiness has deteriorated in the eyes of investors, debt that was issued in the past at par i.e., for every R1 of debt NT incurred R1 was received in cash, SA now issues at a discount of around 83 cents i.e., for every R1 of debt incurred only get 83 cents is received. This runaway train is accelerating exponentially and unfortunately our National Treasury has less and less control over the budget.
On a positive note, Eskom announced the successful reactivation of an additional unit at the Kusile Power Station, contributing 800MW to the grid. This follows the return of unit 3 at the end of September, leaving only unit 2 to be restored. Unit 2 is expected to return during November 2023, while Unit 5 is scheduled to be commissioned in December 2023.
US Treasury yields fall post jobs and CPI data, as the probability of the US economy reflating fades
US yield curve inversion, which widened to -175bp in May (3-mth T-bill versus UST 10-yr), unwound to -53bp in October as markets positioned for either a soft landing or reflation, pricing out a hard landing and rate cuts in the front end of the curve. However, post October’s weaker-than-expected CPI and jobs data, the probability of recession increased, and bonds strengthened as yields shifted lower across the curve. Curve inversion intensified back to -90bp as the UST 10-yr yield fell 45bp to 4.5% and UST 2-yr fell 20bp. Treasury Inflation-Indexes Securities (TIPS) (real 10-yr US rates) fell 28bp, to 2.2%, reflecting a moderation in 10-yr inflation expectations to 2.3%. Driven by USTs, SAGBs strengthened across the curve, falling 60bp over October and November.
UST curve alternates between bull and bear steepening
Curves can dis-invert either via bear curve steepening – which indicates that reflation is at hand, or bull curve steepening – indicating a “landing”, either soft or hard. Ordinarily yield curves invert in response to an expectation that a downward phase of the business cycle is imminent i.e., growth will slow because of rate hikes.
Since May this year, the UST market has been characterised by massive uncertainty about the US economic outlook, causing the yield curve to vacillate between bear and bull steepening. The curve bear steepened between May and October, but month-to-date bull flattened. If data releases continue to be soft, the curve should bull steepen on average as the front prices Fed rate cuts. The forward rate agreement (FRA) curve has already moved from pricing for 100bp of cuts to 150bp of cuts since the start of the month.
In this context we note that historically, back to 1981, it would be unprecedented for the US inflation cycle to turn and for the yield curve to remain inverted. It would also be highly unusual for steepening to be driven on average by bear steepening as opposed to bull steepening.
SA bonds offer value
Looking ahead, we expect the recent trend will continue on average and the US curve will shift lower. The front end will do most of the heaving lifting. If a hard landing were to materialise, we should see a more aggressive fall in both the long- and the short-end yields. SA bonds will be driven by price action in USTs.
Potential benefits for SA bonds will be constrained by the structural sovereign risks as outlined above and the extent to which domestic monetary policy can be accommodative. As an inflation targeting central bank, the SARB is required to keep policy rates restrictive to ensure that CPI, which peaked at 7.8% in July 2022, returns to average 4.5% y/y on a sustained basis. The latest data for September surprised to the downside at 5.4% y/y. A real policy rate around 3.0% is highly restrictive relative to real growth below 1.0% adding to the cyclically bullish argument for SA fixed income assets.