Transitory trick or transitional treat?
The confluence of weather-related disruptions, geopolitics, and capacity constraints added fuel to the inflation fire in October. Energy prices surged with European natural gas prices and global coal prices reaching record highs, while Brent crude breached US$80/bbl. Although coal prices have subsequently moderated (in part due to price fixing in China), these developments have brought into question the transitory nature of current inflationary pressures. Even the Fed has admitted some doubt about how transient these price dynamics will be. The key concern for policy makers is whether elevated inflation outcomes will de-anchor inflation expectations and lead to a wage-price spiral.
The market does not reflect this. US 5y5y forward breakeven inflation is oscillating around 2.2%, comfortably below the 2.8% 5-year breakeven rate. Yet, demand remains sufficiently strong for supply constraints to have an outsized impact on prices. The fact that the US consumer still has excess savings to spend means that corporates are able to pass on higher input costs. With the global economy transitioning from a cyclical slowdown to re-acceleration, the demand side of the economy seems sufficiently robust to keep prices elevated.
Moving from goods to services
One mitigating factor is that the world economy will steadily transition from goods-intensive growth back to services, as leisure and tourism activities steadily normalise. This should reduce some of the bottlenecks and price pressures in the goods market. That said, many of the supply constraints we are currently facing – from energy to microchips – were in play prior to the Covid pandemic and associated lockdowns. Hence, improving weather conditions or slowing demand growth would merely mask tight underlying conditions.
Moreover, services sectors are often labour intensive, and with the world steadily running out of workers, there could be more persistent wage inflation. To be sure, Fed Chair Powell alluded to structural forces that may be dampening labour participation and reducing labour market slack. This could also signal a partial transition of pricing power from employers to employees.
High prices are a signal
It is often said the solution to high prices is high prices. That is, high prices lead to a rebalancing in demand versus supply either via substitution to cheaper goods (if able) or via enticing more supply (if willing). This has been lacking in the energy complex as shale gas operators have opted to protect profitability rather than increase output at any cost.
Another constraint on supply has been ESG and climate change policies that have reduced funding to and investment in fossil fuels. COP26 is an apt reminder that any transition has a cost, and that going green will not be easy and certainly not cheap.
Still competing for (excess) liquidity
On the central bank front, we are entering the transition from ridiculously loose to extremely accommodative monetary policy. The Fed confirmed the taper and various other developed market central banks have signalled that lift-off is drawing near. While the world will still be awash with liquidity, as the Fed’s balance sheet will continue to grow during the taper, emerging markets have to compete for this liquidity.
South Africa is a case in point. Despite numerous central banks keeping nominal rates at or below zero and c.US$14trillion worth of negative-yielding debt, the SARB was able to cut the repo rate to only 3.5%, while the 10-year yield could not sustainably move below 9.0%. This level has been an effective floor under long-term bond yields since 2016 (in the wake of Nenegate).
Coalition constraints
South African politics is also in transition. The recent local government elections are evidence of a maturing democracy, with the ruling party losing a significant share of the vote, forcing many municipalities into coalition governments. Yet it is still unclear that our politics has matured enough for coalitions to deliver services effectively.
A key risk to the fiscal anchor is that politicians start aligning the budget cycle with the electoral cycle. This would pose a notable risk to the sovereign credit rating, which remains vulnerable notwithstanding the recent tailwinds of GDP revisions and terms of trade boost.
A transition in the rating from BB to B would have significant implications for market access and the level of yields. BB still gives the prospect of returning to investment grade somewhere down the line, but single B is highly speculative with an attendant rise in risk premium.
Godongwana’s budget debut
The Medium Term Budget Policy Statement (MTBPS) would be the first gauge of Finance Minister Godongwana’s willingness to hold the line on fiscal restraint. It will not be an easy task given the escalating political pressures in the wake of the Covid crisis and local government elections. It will also be a key marker for the rating agencies to measure the minister when S&P and Moody’s opine on the sovereign rating later in November.
Market developments
During October, equities (5.2%) outperformed by a wide margin, followed by inflation-linked bonds (0.6%) and cash (0.3%). Fixed-rate bonds (-0.5%) and listed property (-1.7%) underperformed cash. The rand depreciated by 1.2% against the US dollar, which would have enhanced offshore asset returns for the month.
Risk-on not helping EM FX
The dollar index (DXY) lost a mere 0.1% in October, but this belies notable weakness against riskier G10 currencies, such as the Australian dollar, the New Zealand dollar, and the Norwegian krona. The Japanese yen lost 2.2% against the greenback, confirming the risk-on backdrop. Relative monetary policy developments were the main drivers of FX performance, as other DM central banks turned more hawkish to catch up to the Fed.
The risk-on backdrop should have favoured EM FX, but the asset class posted a mixed performance due to idiosyncratic fiscal risks, differential sensitivities to commodity prices, and disparate monetary policy movements. The Peruvian sol (3.6%) and Russian rouble (2.6%) outperformed amid rate hikes and commodity prices rises (notably copper and oil). At the other end of the spectrum, the weakness in the Turkish lira (-7.4%) stood out as central bank rate cuts pushed the real rate deeper into negative territory. The Brazilian real (-3.4%) suffered from sharply higher inflation, as well as a renewed focus on fiscal risks.
Despite higher volatility, USD/ZAR depreciation has been modest, with the unit trading in line with our 14.50 – 15.50 medium-term fair-value range.
Behind the curve (flattening)
The sell-off in US yields that started in September continued well into October, with the 10-year yield peaking at 1.70%, close to the mini-tantrum level in March this year. Higher nominal yields were driven entirely by widening breakeven inflation, with the 10-year TIPS yield falling by 14bp compared to the 7bp increase in the nominal yield. While 5-year breakeven inflation reached a record high of 3.0%, the 5y5y forward breakeven inflation rate – a generally accepted measure of long-term inflation expectations – moved sideways around 2.2%. This is in line with the Fed’s inflation target, indicating that the market is not (yet) concerned about a sustained inflationary spiral. Similarly, the US nominal yield curve flattened, leading to concerns that pre-emptive tightening could lead to a sharper slowdown in growth in the medium term.
Inflation fears spilled over to EM sovereign bonds and short-end monetary policy expectations. EM bonds rose by an average of 41bp in October, led by Turkey (150bp) and Brazil (110bp), with Peru (-61bp) at the other end of the range. SA’s 10-year yield sold off by 59bp as contained inflation and a better cyclical fiscal position buttressed the market. This left the market outright cheap relative to fair-value estimates and fundamentals.
Real rates treading (under) water
The sharp move in EM rates reflected the repricing in monetary policy expectations, rather than a fundamental deterioration in creditworthiness. EM yield curves flattened almost across the board, with Russia and Brazil inverting. The general theme in EM was a substantial reset in the market pricing of monetary policy, as central banks have tried to keep pace with rapidly rising inflation. While nominal policy rates have risen sharply in Russia, Brazil, Mexico, CEE, and other LatAm countries, the adjustments still fall short of the rise in consumer price inflation. As a result, real policy rates have merely stabilised in negative territory.
The absence of real tightening has left EM exchange rates vulnerable, supporting the view that central banks are falling behind the curve. Even the SARB has highlighted a scenario where a delay in policy normalisation would lift longer-term inflation projections.
Equities benefiting from demand for inflation protection
Following a tough September, global equity markets rebounded in October, benefiting from the confluence of reopening, falling real rates, and inflation-hedge properties. Rising consumer price inflation is signalling some degree of pricing power. The S&P500 gained 6.9% m/m, reaching a record high, while the Eurostoxx rose by 4.0%. The MSCI World Index gained 5.7%, comfortably outperforming the MSCI EM Index’s measly gain of 1.0%.
Similar to FX and bonds, Peru was the top performer, gaining 13.4%, while Brazil was the laggard with a 9.0% loss. The MSCI South Africa Index dipped 0.1%, in part due to exchange rate depreciation. The ALSI gained 5.2%, while the SWIX posted a more modest total return of 2.7%.
The sector performances were wide ranging. Consumer Discretionary (15.8%) outperformed, driven by Travel and Leisure (32.2%) against a backdrop of faster global reopening and the move to alert level 1 lockdown. Basic Materials (8.7%) also stood out, benefiting from higher commodity prices, barring coal, while Technology (7.0%) was aided by a rebound in Prosus. Telco’s (-1.9%), Health Care (-2.6%), and Financials (-2.9%) took a breather after a solid performance in September.
The local bourse continues to trade cheap, even as the forward PE ratio has ticked upwards towards 10 times. The discount is largely driven by the resources sector, with industrial and financial ratings close to their long-run averages.
