Prevention is better than cure
After a relatively benign second quarter, risks escalated during the third quarter. China’s regulatory tightening turned more aggressive, while last year’s “three red-lines” for developers came home to roost in the threat of an Evergrande default. The US debt ceiling deadline loomed increasingly large, while the Fed moved the dot plot higher and confirmed a more rapid pace of tapering in the September FOMC meeting.
The confluence of policy uncertainty, slowing cyclical growth, and commodity price volatility required a greater focus on risk management. Risk management not only entails the identification of risks, but also action to protect against the potential crystallisation of the risks. The attendant pre-emptive action is a case of “prevention is better than cure”, as it is challenging to recoup losses after a large drawdown.
Challenging trade-offs for central banks
Yet for many developed economy central banks, risk management runs in reverse. I.e. the view for some time has been that it is better to deal with the aftermath of an asset price bubble than to try to manage or deflate it. Similarly, there was limited pre-emptive bipartisan action in the US to deal with the debt ceiling and the risk of a government shutdown and technical default.
The surge in US inflation is another challenge for the Fed. While it is correct to look through the first-round effects of a supply shock, there is a risk that a wage-price spiral could ensue. This would make the cure – substantially tighter monetary policy – difficult to implement in light of elevated debt levels and heightened asset price sensitivity to low rates. Stagflation risks tend to result in higher interest rates, as we are very well aware in South Africa.
SARB back in hawkish mode
The SARB shifted to risk management mode in March this year, with a temporary dovish tilt in July following the social unrest. The rhetoric following the September MPC meeting signalled that the start of policy normalisation is nearing and that there is a strong view that it is better to do a little bit (of hikes) sooner than being forced to do a lot (of hikes) later.
Under orthodox monetary policy implementation, pre-emptive normalisation would anchor inflation expectations, contain wage inflation, and stabilise the real exchange rate. Yet being too pre-emptive could have negative consequences via slower cyclical growth and lower confidence. The SARB seems willing to run this risk, particularly given existing binding constraints on structural growth that do not relate to the level of the policy rate.
Heightened event risk in the final quarter
The November MPC meeting will follow the local government elections, the Medium Term Budget Policy Statement, and the Fed FOMC. That is a lot of event risk to digest. The hurdle for a structural improvement in the fiscal outlook remains high, given renewed support, wage increases, and socio-economic pressures.
The Fed is expected to confirm the timing and pace of the taper and although this is now partially priced, the flow effect may still be negative for the rand and SA rates. With a surging oil price, the SARB is set to up the ante on pre-emption to avoid the potential cure of a substantially higher policy rate, as is currently priced by the market.
Market developments
During September, inflation-linked bonds (0.3%) were the only major asset class to meet the return on cash (0.3%). Listed property (-0.8%), fixed-rate bonds (-2.1%), and equities (-3.1%) underperformed sharply. The rand lost 4.0% against the US dollar, which would have been accretive to offshore asset.
For 3Q21, listed property (5.9%) and inflation-linked bonds (2.0%) beat cash (1.0%), while fixed-rate bonds (0.4%) and equities (-0.8%) underperformed. The rand depreciated by 5.3% against the US dollar, which would have enhanced offshore asset returns for the quarter.
Dollar demand on riskier backdrop
The dollar gained 1.7% in September, which took the DXY to a year-to-date high and a similar level to a year ago. While the greenback was range bound earlier on in Q3, Delta fears and a dovish Fed gave way to risk off and renewed hawkishness. Concerns about China’s property sector and the US debt ceiling boosted safe-haven demand for the dollar. The hawkish dot plot and stronger taper talk from the September FOMC meeting, alongside inflation persistence lifted US yields quite sharply in the final week of the quarter, further benefiting the US dollar.
The stronger dollar and risk aversion hit EM FX hard in September, with average depreciation of 2.5% month-on-month. The underlying performance was wide-ranging with the Turkish lira down 6.6% as the central bank surprised the market with a 100bp rate cut, while the Russian rouble gained 0.7% amid the surge in the oil price. The rand lost 4.0% against the dollar, with USD/ZAR back above 15.00 by month-end, screening marginally cheap versus our 14.50 – 15.00 short-term fair-value range. Since then the rand has recovered, but still neutrally valued.
Core rates higher on hawkish rhetoric
After moving broadly sideways in July and August, US yields sold off sharply in the final week of September on the confluence of a hawkish Fed and inflation fears. The move was parallel, with the shape of the nominal, TIPS, and breakeven inflation curves unchanged month-on-month. Higher nominal yields were more a function of rising TIPS yields, with only modestly wider breakeven inflation.
Other core rates also sold off due to more hawkish monetary policy rhetoric. The BOE turned more hawkish, signalling the potential for a hike before the end of the year, while the Norges Bank was the first of the G10 central banks to lift off the Covid lows.
Lower commodity prices, outside of the energy complex, and moderating global growth were exacerbated by the rise in real US yields to push EM local bond yields sharply higher by the end of the quarter. EM yields rose by 36bp, on average, with Philippines yields unchanged at the low end and Turkish yields 135bp higher on the top end. The SA 10-year yield was almost 50bp higher by month end, leaving the market outright cheap versus our fair-value estimates.
Equities end on a low note amid headwinds
Equity markets had a tough end to Q3 with intensifying risk aversion from China’s property sector concerns, the US debt ceiling, inflation fears, and tighter monetary policy conditions weighing on risk assets in September. While the S&P500 reached a record high in early September, the index lost 4.8% for the month.
The MSCI World Index lost 4.2%, marginally underperforming the 4.0% drop in the MSCI Emerging Markets Index. Notable gains were limited to Russia (6.3%) and Norway (4.1%), where the rising oil price provided a buffer. Brazil (-13.0%) and Turkey (-12.4%) fared the worst in the risk off, while South Africa lost a middling 4.8%.
The ALSI declined by 3.1%, while the SWIX lost 1.4%. At a sector level, healthcare (16.4%), telco’s (4.7%), and financials (1.7%) ended in the black, while consumer staples (-1.0%), technology (-2.2%), consumer discretionary (-2.6%), and industrials (-2.8%) ended in the red. Basic materials (-9.8%) was a notable laggard amid falling commodity prices, except for chemicals (25.4%) where the surging oil price (in dollar and rand terms) boosted returns.
