The month that was would surely be better placed in the cinema, with trade tensions, cold wars, electioneering, politically motivated murder, sanctions, currency manipulation, the new NAFTA that has a hard to pronounce acronym of USMCA, Fed fears, Brazil’s pending rebirth, Brexit, Italexit, German electoral gyrations, and South Africa’s pending reform and non-stimulus stimulus.
It is now a case of the hunt for returns after red October. On this score, November is off to a promising start.
The toxic mix of a strong US dollar, high oil price, rising US yields, and China’s growth slowdown was always going to be a major test for emerging markets. Add in the correction in the US equity market from early-October as quantitative tightening overwhelmed growth and risk aversion broadened rapidly. Concerns about slower growth alongside waivers for sanctions on Iran shifted the supply/demand balance in the oil market quite sharply. Brent has now dropped towards US$70/bbl. Valuation extremes cushioned some markets, such as Argentina and Turkey, while the market-friendly political outcome bailed out asset prices in Brazil.
Throughout the market turmoil Fed officials have signalled ongoing gradual rate hikes, remaining unperturbed by non-US developments. It is still a case of “our dollar, your problem”. Add in political strife in Europe (Italy, Germany’s regional elections, and the end of the Merkel era) and downside surprise in economic activity, it becomes doubtful whether the ECB will be able to lift rates next year. And so the euro faces renewed pressure, the large current account surplus notwithstanding.
Other than US yields, SA’s biggest global concern is the pace of the slowdown in China. So far China’s policy easing has been modest and targeted (reserve requirement ratio and tax cuts), but there are growing expectations of more aggressive stimulus down the line that does not necessarily exclude exchange depreciation. Yet with China being monitored as a potential currency manipulator (never mind Switzerland and Taiwan), officials will for the time being stem FX weakness rather than encourage it. Unofficial indicators suggest that growth has already slowed to well below the 6.5% official target. After all, China’s statistics are “man-made” because in the Chinese political economy “statistics make the man”.
On the local front the output gap remains large based on the unemployment figures and contained inflation. Rental inflation was subdued in September, indicating that the supply/demand balance in housing has severely curtailed pricing power in the rental market. Confidence indices have weakened as current conditions and expectations have moved from Ramaphoria to Ramarealism. This in itself gives scope for some upside surprise down the line, but until there is policy clarity, particularly on Section 25 and expropriation without compensation, meaningful expansion will be side-lined. Yes, the Investment Conference has tallied up more pledges, but so far the scope, scale and timing are yet to be revealed.
In keeping with volatility, the 2018 Medium Term Budget Policy Statement (MTBPS) was delivered by SA’s sixth finance minister in half as many years – Tito Mboweni. His appointment caused a market rally, only for his budget statement to trigger a sharp sell-off – it was seen as Gigaba 2.0. The headline numbers were bad – no fiscal consolidation – but the detail was more nuanced – much-needed VAT refunds and no further direct tax rate hikes. There is some risk that SA is losing its hard-won fiscal credibility, which puts the onus of orthodoxy on the SARB.
The MPC faces a stagflation-lite outlook of rising inflation and weak growth. Given lower exchange rate pass-through, inflation is unlikely to meaningfully and sustainably breach the 6% upper end of the target range. This should negate the need for significant policy tightening. Even so, we cannot ignore that the Fed is set to carry on hiking rates and that South Africa’s twin deficit position will require a higher risk premium in interest rates. It is probably a case of when, not if, the SARB will raise rates. From a macro perspective there is little difference between hiking in November or waiting another two months. But from the markets’ perspective there could be a wide range of outcomes. Given the polarisation on the MPC, November’s decision will be a very close call even if the more benign rand/oil nexus has given the Bank some breathing room.
Market developments
Inflation-linked bonds (0.8%) was the only SA asset class to beat cash (0.6%) in October, while fixed (0.2%) and floating rate credit (0.2%) delivered only marginal positive returns. Equities (-5.8%) underperformed sharply, while property and bonds lost 1.7% each.
The dollar surged in October (up 2.1%) amid strong US growth data, rising yields, hawkish Fed rhetoric, and higher risk aversion. The latter was evident in the yen being the only currency to gain against the greenback. EM FX weakened by 1.4%, on average, but underlying performance was wide-ranging: from a 15% and 9% gain in the Argentine peso and the Brazilian real, respectively, to an 8% decline in the Mexican peso. The rand was relatively weak, losing 4.3% against the dollar. The bulk of this was due to general risk-off dynamics, but the disappointing MTBPS also weighed on the unit. With the uncertainty of the US midterm elections removed, USD/ZAR is testing the bottom end of its recent 14.00 – 15.00 range and of our 14.00 -14.50 fair-value estimate.
The jump in the US 10-year yield from 3.00% to 3.20% in the first week in October was the proximate trigger for the correction in US and global equity markets, despite the still robust US growth and earnings outlook. The sell-off in rates was real, as TIPS yields overtook the nominal sell-off in the latter part of the month (reaching 1.15%). This reflects the combination of strong growth and rising budget deficit in the US. That breakeven inflation has declined is not surprising given the sharp drop in the oil price (-19% from the peak on WTI).
The higher global risk-free rate, thanks to the hawkish Fed and persistently strong US growth, caused credit spreads to widen somewhat, but resulted in a mixed local currency performance. Valuation and country-specific factors were also important. Cheapness aided Turkey bonds, while the market-friendly outcome in the Brazilian elections boosted local asset prices there. In contrast, the SA market was hit with a large switch auction followed by a negative surprise in the MTBPS. Rates sold off by around 40bp, but the 10-year yield has edged back into our revised (on account of renewed fiscal risks) 9.00% – 9.50% fair-value range thanks to the risk-on post the mid-terms. Non-residents sold R9.2bn of local bonds in October, bringing the year-to-date sales to R68bn according to the JSE flow data.
The global equities rout matched the February sell-off in extent but took longer to unfold. Rising rates triggered valuation adjustments despite strong earnings growth. The combination of trade tensions, the high oil price and the surging dollar also weighed on risk assets. The S&P500 lost 6.9%, the UK FTSE100 was down by 5.1%, the Nikkei slumped 9.1% and the Shanghai dropped by 7.7%. Of the EM majors, only the Brazilian Bovespa gained (10%), while the Saudi main bourse was flat. The MSCI EM index underperformed the DM index (-8.8% versus -7.4%). Performance in dollar terms ranged from +17.8% for the Brazil to -17.4% for Mexico, while SA was a relative laggard with -11.1%. The FTSE/JSE ALSI lost 5.8%, while the SWIX declined by 6.1%. The local market weakness was broadly based: sharp underperformers were household goods (-22%), media (-15%) and chemicals (-11%); notable gains were limited to gold mining (17%). Foreigners sold a net R7.6bn in October, bringing the year-to-date sales to R21bn.
