A pivot or a pumpkin?
Risk appetite improved modestly in October on market expectations for a Fed pivot that would entail a clear signal of a step down in the size of the hikes. While the FOMC’s rhetoric remained explicitly hawkish, other major central banks did indicate a slower pace of hiking or less hawkish rhetoric.
Not all tightening is equal
The ability of central banks to move to slow the speed of tightening depends on the transmission mechanism from monetary policy to the real economy. This is partly via the credit channel and wealth effect, particularly the housing market. Here the mechanisms are uneven between the major economies, given the different types of mortgage financing structures.
In the US, the bulk of mortgage loans are at a fixed rate and have an average maturity of around 22 years. This implies much lower direct sensitivity to higher mortgage rates for existing borrowers. In the UK, the average maturity of fixed-rate mortgages is closer to two years, which implies a greater sensitivity to higher mortgage rates over time, while a greater proportion of borrowing is done on a floating-rate basis.
The larger the share of floating-rate debt and/or the shorter the period to fix, the stronger the transmission from rate hikes to the economy. This implies that the UK economy would have a more pronounced and quicker response to monetary policy tightening than would the US economy.
Hence, the market pricing for the BOE’s terminal rate may be too high, while the market pricing for the Fed’s terminal rate might be too low due to the dampened transmission mechanism.
Broad based tightening partially undone
That said, the Fed does not have to rely only on the policy rate. Most shadow rates suggest that the effective tightening has been more extensive than the rise in the Fed funds rate once taking financial conditions and quantitative tightening into account.
On this front, the UK faced notable market-induced tightening as Kwasi Kwarteng’s fiscal experiment resulted in a sharp sell-off in yields in September, a slump in pound sterling, and the market pricing in a terminal rate of 6% for the BOE. The bond market recovery has come at the expense of yet another Prime Minister as Sunak replaced Truss after only 44 days.
The markets may be undoing some of the Fed’s work following the release of the October CPI and PPI inflation reports. The notable downside surprises have reduced the expected peak for the Fed Funds rate, enabling a rally in stocks and bonds alongside a sharp drop in the dollar.
Yet this perceived pivot may again be premature given the strength of the labour market, elevated wage growth, and broad-based inflationary pressures. The Atlanta Fed GDPNow estimate for US growth in Q4 is at a whopping 4.4% q/q seasonally adjusted and annualised, which is well above the 2010 – 2019 average of 2.3%.
While a wage/price spiral remains unlikely given low unionisation rates, a more globally integrated labour force, and still anchored long-term inflation expectations, this Fed is fighting this inflation. As such, there is still a chance that market hopes for a proper pivot may be disappointed.
Nevertheless, short-term risk appetite has been supported by the market pricing in a 50bp rather than a 75bp hike for the December FOMC meeting. In addition, most investors expect the Fed to be reactionary to a recession and cut rates rapidly. This outcome is being partially priced by the inverted Fed funds futures curve. The ability and the willingness of the Fed to ease will depend on how far and how sustainably inflation declines.
Zero-Covid masking tight supplies
As the war in Ukraine dragged on, geopolitical attention shifted to the 20th Communist Party of China (CPC) Congress. The most surprising part of the outcome was the extent to which Xi was able to stack the Politburo with loyalists, seemingly side lining other factions within the party. The small hope the market had for a shift away from the zero-Covid policy was dashed (even as speculation of an announcement has persisted). In addition, the strengthening grip of the CPC and the concentration of Xi’s power put regulatory risk and geopolitical concerns back into focus.
Alongside moderating global growth, China’s lockdowns have helped to dampen commodity prices. However, the supply situation across many markets remains tight, as borne out by the recovery in the oil price following the announcement of the OPEC+ production cut.
The commodity price outlook is crucial for the evolution of producer price and headline inflation across the globe, as it will influence how quickly and intensely disinflation will give central banks breathing room.
Some caution is warranted on the scope for disinflation/deflation in the event of a sharp slowdown, as commodities may not fall as far as in prior recessions. Moreover, the tightness in supplies could result in a sharper rebound in commodity prices when global growth recovers.
The oil and gas industry is a great example where companies have prioritised shareholders over new investment. While this is warranted based on the urgency of the energy transition, the short- to medium-term reliance on fossil fuels in the face of limited investment implies an upside bias to prices.
A double-edged sword
For South Africa, fuel and food prices are keeping headline inflation elevated. At the same time, steady export commodity prices are supporting the fiscal position. Lower commodity prices will notably ease the first-round inflation fears, but would pose downside risk to tax revenues and the ability of the government to lower the debt ratio.
The Medium Term Budget Policy Statement (MTBPS) delivered a very positive, dare we say optimistic, outlook for the medium-term fiscal position. Not only does the headline deficit fall to 3.2% of GDP, but the primary balance also moves into a growing surplus from next year. The debt ratio is projected to decline from the current c.70%/GDP.
While the numbers add up, we have to be mindful of the numerous spending risks: a permanent income support grant; a CPI-related wage settlement for FY24; the Eskom debt transfer (to the extent that this is indeed possible); and additional SOE support – notably for Transnet – beyond FY23.
If the Treasury does manage to follow through with the framework laid out in the MTBPS, then it would be good news for the ratings trajectory. An improvement in credit risk would lower the neutral real policy rate and give the SARB more degrees of freedom. This would ultimately be reflected in a lower and flatter bond yield curve.
Rating the rating
The pending reviews of the SA sovereign credit rate could deliver a positive surprise. Specifically, the S&P methodology points to the potential for a credit rating upgrade if the fiscal numbers from the MTBPS are included. With the outlook having moved from stable to positive in May this year, a one-notch upgrade, from BB- to BB should not be dismissed.
However, event risk looms large and prudence may result in the BB-/positive outlook being affirmed this week. An upgrade would depend on the outcomes in the ANC elective conference in December, the main budget in February, and the FATF decision on SA’s possible Greylisting.
While an S&P upgrade may have a short-term positive impact on the rand and rates, it is unlikely to move the dial meaningfully on the long-term cost of borrowing. SA remains firmly in BB-rating territory and trades in line with or slightly wider to other BB-rated credits.
Prospects for a shift from the BB-band to the BBB-band will have a much larger impact on asset prices, but will be a function of growth. The decline in per capita GDP in recent years has been a key factor that has put downward pressure on the rating directly and via fiscal fragility.
Fighting structural challenges with a cyclical tool
Until the fiscal risks are fundamentally resolved via structural reform, the SARB will have to contend with persistent stagflation risks as intense load shedding dampens growth, fixed investment, and productivity. Historically, stagflation has resulted in an elevated and sticky monetary policy rate.
Hence, the SARB may be of the view that it needs to keep policy tight even as the rest of the world starts turning a corner on the interest rate trajectory. Yet it is difficult to see how a cyclical tool – such as the monetary policy rate – can address structural constraints and uncompetitive government policies.
We will most likely have to wait for 1Q23 to see if the SARB is willing and able to decouple from the Fed.
Market developments
Listed property (11.0%) staged a robust rebound in October, taking the lead over equities (5.3%) and fixed-rate bonds (1.1%). Inflation-linked bonds (-1.3%) was the only major asset class to underperform cash (0.5%). The weaker rand (-1.5%) would have been modestly accretive to offshore returns.
Some tricks and some treats in FX in October
The dollar index declined by a modest 0.5% in October despite higher yields. Improving risk appetite, speculation of a Fed pivot, and FX intervention by China and Japan outweighed lingering concerns of a recession.
The Chinese yuan came under pressure after the outcome of the CPC Congress as investor enthusiasm was dampened by the reiterated zero-Covid policy, ongoing regulatory tightening, property market turmoil, and elevated geopolitical risk as Xi ushered in an unprecedented third term by stacking the politburo with his closest allies. CNY/USD traded to a high of 7.30 by month-end, implying a 2.6% depreciation in the yuan. While the CFETS RMB Index has held up on a relative basis, even this broad measure weakened by 1.1% in October, revealing FX strain beyond just the strong US dollar.
Despite improving risk appetite, EM FX declined by 0.4%, on average, versus the US dollar, with the bulk of the weakness coming from Asia.
LatAm and Ceemea posted wide-ranging performances. The Brazilian real gained 4.5% amid a positive view of the election outcome, followed by the Hungarian forint (4.3%), and the Polish zloty (3.8%). The Colombian peso (-6.6%) was the underperformer in October amid ongoing political uncertainty, high inflation, weak growth, and fiscal concerns. This was followed by the Argentine peso (-6.1%) and the Russian ruble (-2.9%), as lower natural gas prices and intensified geopolitical tensions weighed on the latter.
The dollar is dead, long live the dollar
While the rand lost 1.5% against the greenback, USD/ZAR traded in a broad 17.90/18.50 range for most of the month. Based on the 1.6% depreciation in the rand’s trade-weighted index, the rand’s move reflected SA-specific factors rather than the dollar. The rand continues to trade in undervalued territory.
A key consideration for EM FX and growth is whether the dollar has peaked. There is much hope that falling inflation will lead to a real Fed pivot. Less aggressive US monetary policy expectations coupled with a narrowing in the growth differential between the US and rest of the world would put downward pressure on the dollar. That said, the extent of the dollar’s decline will depend on whether and by how much the Fed will ease in the next cycle and whether the alternative majors – the euro, sterling, yen and yuan – will be able to fill the gap. This is highly debatable and a weaker dollar may not end up being very weak.
Curve inversion persists
Notwithstanding the sharp sell-off in global rates markets in September, US bonds weakened further with the 10-year yield rising by 22bp to 4.05%. In contrast, the 10-year TIPS yields declined by 14bp, to 1.54%, resulting in wider breakeven inflation. Even so, at 2.5% the market is still not discounting an inflation problem, which would be consistent with Fed credibility and the Fed funds rate peaking at around 4.5% – 5.0%.
Where the market is signalling some concern is on the growth outlook, with the 10-year/2-year yield spread still inverted, at -50bp. In addition, the 10-year/3-month yield spread inverted in October, at -11bp, and moved more negative in November. The Fed funds futures curve proxied by the 6-month/18-month spread has been negative since July and is pointing to an easing cycle commencing by the end of 2023.
Heightened uncertainty is also reflected in the higher term premium, with the long-term average short rate moving sideways around 4.3%. Relative to this long-run measure, a Fed funds rate above 5.0% would be outright restrictive and result in a tighter policy stance than in 2019 (a real rate of 1.5% versus 0.8%).
EM yields trading off the inflation peak
Country-specific factors dominated EM yield movements in October. LatAm generally outperformed with lower yields in Peru (-36bp), Chile (-19bp), and Brazil (-14bp). These economies have benefited from being early movers in monetary policy tightening, with inflation already turning the corner, most notably in Brazil. That said, Brazil has underperformed so far in November as president-elect Lula has turned lax in his fiscal comments.
On the opposite end of the spectrum, yields sold off in Poland (120bp), Czech Republic (52bp), Philippines (40bp), and Hungary (38bp). The CEE economies are still battling rising inflation and upside inflation surprises, even as some of the central banks have opted to pause in their hiking cycles.
Bullish budget not enough to price out all the risk
SA’s 10-year benchmark bond yield was unchanged month-on-month as the sell-off in yields mid-month was fully reversed by the anticipation of and follow through of a positive surprise in the MTBPS. While the size of the weekly auctions was kept unchanged, a markedly improved debt profile, prospects for a turn in the sovereign credit rating trajectory, and ongoing monetary policy prudence stabilised long-term yields in the face of rising US rates.
In addition, the 5-year CDS spread compressed by 50bp during the month, with the bulk coming through in the wake of the budget release. The recovery in the bond market has brought the benchmark 10-year yield closer to our 10.50% – 11.00% fair-value range.
Non-residents turned bearish on SA bonds in October, selling net R11bn. This took the share of holdings down to 26.2%, which is the lowest since 2Q11. Net issuance of R16.4bn was more than taken up by the domestic unit trust industry, which bought R19bn worth of bonds, while banks were net buyers of R7.6bn.
Countervailing trends in commodities
Commodity prices were a mixed bag in October. SA’s agricultural commodities rose strongly on the back of higher global prices and the weaker rand, despite solid harvest expectations. Sunflower (16.3%), soybeans (15.8%), and white maize (9.1%) posted solid gains in US dollar terms.
Brent crude recovered by 7.8% following the OPEC+ production cut, improving risk appetite, and hopes of a China reopening. Lower natural gas prices and high inventories put downward pressure on the coal price (-24.3% for Richards Bay export prices). Industrial metals were generally weaker amid slowing growth.
Gold (-1.5%) continued to face a tug of war between the strain from the stronger US dollar and high TIPS yields and the defensive properties during heightened inflation and geopolitical risks.
Broad risk-on recovery in equities, save for China
Global equities benefited from risk-on, driven by the hopes of a Fed pivot and a soft landing. Despite lower earnings expectations, forecasts are still for reasonable earnings growth in the medium term. The S&P500 rebounded by 8.0%, Eurostoxx by 7.9%, and FTSE All Share by 3.0%.
The MSCI All World Index (7.2%) outperformed the MSCI Emerging Market Index (-3.1%) by a wide margin, with the latter being dragged downwards by the MSCI China Index (-16.8%). Excluding China and India (-0.5%), EM indices ended the month in the black, ranging from the MSCI Czech Republic Index (0.6%) to the MSCI Turkey Index (23.0%).
The MSCI South Africa Index gained a modest 3.0%, with the ALSI and SWIX up by 4.9% and 5.0%, respectively. The weakness was concentrated in technology (-15.6%), where Naspers and Prosus sold off on concerns regarding China’s policy and growth trajectory following the outcome of the CPC Congress. Basic materials (4.3%), consumer discretionary (4.5%), and telco’s (5.3%) were relative laggards given downside risks to commodity prices, elevated food and transport costs, and ongoing monetary policy tightening. Consumer staples (8.5%), industrials (9.6%), health care (11.0%), and financials (12.8%) performed strongly thanks in part to defensive earnings, as well as positive spillovers from global trends.
SA equities re-rated slightly following the market rebound and negative earnings revisions. Higher ratings on financials and industrials are still being countered by depressed valuations on resources. The broadening negative earnings revisions is evidence of more widespread growth strain.
