SA fixed income quarterly insights

17 December 2020

Market internals show no evidence of investor preoccupation with the fraught United States (US) election nor its associated legal battles disputing the free and fairness of the elections held in early November 2020. The burden of proof currently lies with the Trump legal camp who has made allegations of voter fraud and vote rigging and the outcome of these cases will lay to rest once and for all who will be in the White House for the next four years. Aside from the Presidential race, two runoff elections in Georgia is scheduled for early January which will determine if republican control of the Senate will remain. The bigger picture may still reveal a change in the economic and investing landscapes, but markets remain forward looking and celebrating the perception of how US policy will be shaped under a Biden administration with a divided congress.

Risky assets have gained handsomely in November following the elections on the back of positive vaccine trial data. Many vaccine manufacturers have filed to be granted Emergency Use Authorisation by the Food and Drug Administration (FDA) which has inspired hope for a broadening of the economic recovery in the post Coronavirus (COVID-19) world as a mass inoculation scenario becomes possible. The stellar gains seen across markets have been particularly beneficial for EM assets displaying optimism over who will serve in top positions in cabinet following the US Presidential inauguration on 20 January 2021 and reflecting expectations of a more international relations friendly America and less fractious trade stance by the US towards China. Moreover, markets reflect rising confidence that the US would start to repair its international relations and adopt a less protectionist approach to be more pro-globalisation which can spur the recovery.

In recent days equity returns were further bolstered by news that Janet Yellen is Biden’s top pick for the position of US Treasury Secretary who inspires confidence that the Treasury/Fed relationship will function even better than before as both these bodies use their legislated powers and mandate to keep the US economy supported from the fallout caused by the virus and ensure easy-money policy remain in place. For the time being we see enough positives to benefit risk assets. In response to these developments, emerging markets (EM) as an asset class has rallied particularly hard in recent weeks with EM equities, bonds and emerging market foreign currencies (EMFX) all gaining ground.

The second wave of restrictions in Europe and other parts of the developed world in quarter four will take away some of the economic momentum seen in quarter three, but the impact is likely to be less severe than what we experienced in the spring. Governments and businesses are better prepared this time. Vaccine producers’ revelations of efficacy data of late stage clinical trials in the past two weeks have given much support to risk markets enabling some of the cyclical assets to post solid gains as we moved beyond the US elections as the rollout and administration of vaccines has brightened the 2021 global growth outlook. Central banks remain supportive of their economies and have hinted at providing even more stimulus for example, European Central Bank (ECB) increasing size and duration of its asset buying in December, while Fed officials have signalled openness to considering extending Weighted Average Maturity (WAM) purchase increase in UST buying in their monthly quantitative easing (QE) that could be supportive of the US long end e.g. US 20 year and 30 year Treasury market. This additional support will have to build a bridge to support the various economies in the absence of further fiscal stimulus measures passed in the European Union (EU) or US.

The roll off of some of the CARES Act special 13(3) Fed emergency facilities allowing amongst other things for corporate credit purchases by the Fed is due to expire at the end of December which could lead to some re-widening of investment grade (IG) credit and some high-yield (HY) spreads. While it could introduce some volatility, we do not view it as a major catalyst for large price moves and believe markets will be paying more attention to US political outcomes in December and early January in Georgia to see if key milestone dates can be passed smoothly that will pave the way for the January 2021 inauguration. These dates are 8 December (end date for certification of electors by US States), 14 December (electoral College chooses the President) and 6 January (Joint Session of Congress to confirm the winner). Should any of these dates run off the rails due to legal contestation it will introduce an unexpected new tail risk macro scenario that will bring renewed bid to USD, safe havens and pose a setback to the current EM friendly environment that are buoying portfolios. Examples of US election cases where the outcome of the elections dragged well beyond election day and led to a case where the winner was not decided by the actual votes cast in the election, nor the electoral college votes assigned to each state one can look to the elections of 1800, 1824 and 1876.  (https://www.inquirer.com/politics/election/presidential-election-history-bush-gore-hanging-chads-1876-rutherford-hayes-20201106.html)

In this piece we will discuss the updated outlook with a focus more on the coming two months into end of January also known as the lame-duck session in the US plus where we have more clarity or conviction may opine over the medium-term outlook. Critically important for markets is signalling by the Fed, ECB, Bank of Japan (BoJ), Bank of England (BoE) that there will be continued central bank support via QE that is increased in magnitude and/or extended in its duration that can provide a continuing supportive risk backdrop into Q1 2021. The upcoming ECB and Fed meeting will be closely watched to deliver additional easing via QE extension in Europe and Fed to continue its current purchases at similar pace with the possibility of weighted average maturity (WAM) of purchases being increased. As things stand, we do not anticipate a steep and lasting global market correction while government and central banks are taking steps to inject further stimulus. We see the risk of central bank guiding peak stimulus and gradual QE tapering unlikely before the second half of 2021 with our current base case being that QE is likely to run at a reduced pace and end during 2022 that could lead to market pricing of start of a hiking cycle in the second half of 2023. Our expectations are that as we enter the second half of quarter two of 2021 that the risks of a tapering of Fed QE becomes a more material risk once vaccines are more widely available and rolled out in advanced economies and the economic recovery upswing has reached even firmer footing while inflation rises, but view this risk becoming more important for investment time horizons exceeding one year.

SAGBs view and curve

Most of our views since our last update have transpired broadly as envisaged and our more cautious bear steepened stance into Medium-Term Budget Policy Statement (MTBPS) in quarter three was well rewarded, allowing us to cover our underweight  ultra-long end South African Government Bonds (SAGB) duration ahead of the MTBPS to lengthen duration in portfolios. This allowed us to participate in the recent rally which has again allowed us to trim some of our overweight duration exposure. Our preferred R186 and R197 long ideas expressed in the prior Fixed Income Insights piece have performed exceptionally well with R197 returning +4.0% over three months until 8 December and R186 returning a striking +14.8% over the same three-month period which compares to a 4.2% positive return on All Government Bond Index (ALBI) during the same period. We have turned neutral on R186 at a yield of 6.80% (preferring to express longs on further dated bonds e.g. ultras as R2044/2048). Importantly we still remain bullish R197, seeing a lot of room for real yield compression in the first half of 2021 supported by South Africa real policy rates moving negative, wider inflation breakevens and demand driving real and nominal yields lower as its nominal companion bond the R2023s features as the source bond in switch auctions whilst policy rates remain anchored.

Post US elections and looking ahead into the turn of year and early 2021 we turned constructive on long-end SAGBs duration for various technical factors. We are also seeing early signs that flows into EM local currency debt which could benefit SAGBs curve flattening after the severe 2020 outflows. If one thinks about the debate between value and growth in the equity space in 2020 with stark outperformance of growth and renewed debate over rotation into value from vaccine developments, we have seen a similar dynamic play out inside the EM debt space. This year with Chinese Government Bonds (CGBs) experiencing a phased in approach in GBI-EM Global Diversified Index, we have witnessed most EM debt flows being channelled into China and to lesser degree Korea at the expense of the rest of EM.

In recent weeks we have seen some green shoots in terms of data of flows of EM hard and local currency debt ex-China which we read as a harbinger of asset allocators deciding to start re-allocating back into rest of EM (ex-China) ahead of turn of year into 2021 and also we are seeing rotation now starting to occur as asset allocators and fund managers move further down the risk spectrum into local currency debt which has been lagging hard currency debt since the dark days of March when the market convulsion from COVID-induced deleveraging reached a crescendo.

Latest high frequency data shows EM bond fund inflow momentum surged to the highest level since 19 February ($3.5 billion for the week, from $3.2 billion prior week); inflows have averaged +$3.1 billion over the past three weeks into early December. Inflows were elevated across both hard currency bond funds (+$1.5 billion) and local currency bond funds (+$2.0 billion). Year-to-date flows to EM bonds and equities are now +$7.8 billion and -$22.4 billion, respectively. Within EM debt we see that year-to-date EM hard currency debt has now registered inflows year-to-date, whereas local currency debt has still registered outflows. Year-to-date returns stand at 3.32% and 0.14% for hard currency and local currency, respectively, while year-to-date flows stand at +US$10.25 billion and -US$14.35 billion for hard currency and local currency, respectively as of early December.

National Treasury withdrawing/postponing the switch auction in late November certainly caught the market off guard. As a result, those who had been positioning to get some back-end stocks in via switch participation were left clamouring for the stock and the flattening of the curve was pronounced with reduced supply now in the back end. We believe the current strategy to steer away from auctioning ultras and only one more auction left this year where one can find paper in the primary market before periodic liquidity black hole through the end of December where auction supply taps are turned off until 12 January. This can enable the SAGBs long end to consolidate recent gains. We expect some further bull flattening by mid to late January and think there is a window of opportunity for ultra-long end to outperform the rest of the curve until mid to late January.

National Treasury has communicated it is not cancelling the switch programme and intend to resume it in 2021. Next date is in the calendar for 29 January which coincides with lumpy coupon payments of R2030, R2037 and R2044 which can provide support for the success of the auction. We still anticipate R2023 to be the primary source bond but as started in our quarter three Insights article we assign increased probability of R197 making it onto the switch auction source bond list sometime next year which we believe will provide an opportunity to reap outsized returns having some R197 exposure over the next six months.

One potential negative for the very long end of the bond curve would be if Government loses the case against unions surrounding Government’s announcement not to honour the final year of the three-year wage deal awarding civil service wage increases. If the National Treasury is successful in the court case this could translate into a R37 billion saving on expenditure. Last week some unconfirmed news swirled that an out of court settlement proposal was made involving a pension contribution holiday for a year for government workers with a rumoured cost of R27 billion. Hence a failure to enforce its decision to curtail runaway wage bill growth could result in an additional need to raise circa R37 billion with a three month deadline in a year where government is trying to shore up finances against an anaemic economic backdrop. Where will this money come from? Funding reshuffle? Auction issuance? Pressure on spending is likely to come back into focus in 2021 in our view. Expenditure on COVID-19 Vaccine Global Access (COVAX) payments for vaccine procurement and a new border control agency at a cost exceeding R30 billion and other factors such as local elections in 2021 are all able to complicate National Treasury’s strategy to hold the line on expenditure.

Having flagged these risks we are prepared in the near term to play tactical longs on the ultra-long end, looking for further yield compression on the long end of the curve from near 11% at the time of writing to closer to 10.65 due to technical factors and positive EM sentiment. A study of SA EM local 10 year FX-hedged yield using 3m USDZAR FX forward implies a yield of 4.6% versus South African USD-denominated government bonds (SOAF) 2030 (SA 10-year Hard currency bonds) yielding 4.18%. Since March these two metrics have traded largely in line suggesting to us that there is scope for as much as 40 basis points compression around the 10-year point of SAGBs curve in absence of any global macro shocks.

Currently our 2021 market outlook reflects a broadening and deepening global economic recovery that should lead to EM outperformance given higher cyclical sensitivity of EM assets and pockets of undervaluation.

With a resurgence of COVID-19 cases in quarter four, economic growth forecasts have the flavour of 'less now, more later'. However, with the uncertainty of the US election now largely behind us, and the potential for more positive vaccine news ahead, markets are likely to take credit for the economic recovery we forecast earlier, and defer difficult questions around vaccine production and distribution for later. We recommend investors move into pro-cyclical positions heading into year-end instead of waiting for economic data to turn more meaningfully.

Factors that are candidates for potential development of left return distribution tail risks include slower rollout/adoption or efficacy in the global CV19 vaccine distribution and stretched fiscal and monetary positions after 2020 that pose a risk of waning positive fiscal impulse in 2021. But while there are always left tail risks when it comes to EM assets, 2021 could be the year when it may be equally important to look at the possibility of the right tail of the return distribution. Across global markets, EM assets embed most tangibly a combination of (i) cyclicality, (ii) commodity exposure, (iii) China sensitivity and (iv) pockets of deep value, all of which could be in favour through the course of the year. If these tailwinds come together all at once and given low positioning and a friendlier US attitude towards global trade, EM outperformance may be more sustained through the year. As we enter quarter one 2021 we will continue to monitor Chinese Credit Impulse which is a key leading indicator for EM asset returns. China's credit expansion could be approaching its peak in quarter one of 2021 and if so would send a key signal to reduce EM exposure. With growth to return to its pre-COVID-19 path, policymakers in China are ready to tighten counter-cyclically in 2021 to rein in leverage and financial risks, similar to 2017, amid a global demand and domestic consumption recovery.

With monetary policy headwinds mostly behind us, we think investors can combine value, cyclical beta and high carry with MXN, ZAR and INR longs vs USD. Commodity price appreciation, large trade surpluses and strong carry and portfolio inflows are all factors pointing to ZAR building on recent gains which may be compounded by seasonal ZAR strength in second half of December. This sole risk to this trade in our view would be unexpected US political risk that creates a global risk off move or alternatively a trigger that results in paring of enormous USD short positioning amassed by asset managers.

Source: Bloomberg

The US dollar index (DXY) has now fallen below the key 100 month moving average level of 92 and managed to close below this level on a monthly closing basis. From a technical perspective we see a break below 91.75 opening an increased possibility of a test of the 88 area on DXY. An absence of USD demand near 92 in the coming days post Federal Open Market Committee (FOMC) December meeting would likely allow for a further leg in DM and particular EM currencies to post additional gains against the USD. Considering a lingering broad soft USD backdrop, one has to be optimistic for scope for USDZAR to move into the 14.45 -15.08 range when taking into account additional factors. These include the improving trade surplus, high FX basis swap pricing on USDZAR making short ZAR bets expensive and increased offshore inflows seen for SAGBs and SA equities post US elections. Moreover, the anticipated deal flow from Prosus doing a buyback of Naspers shares that could involve as much as $3.6 billion flow and year end illiquidity that typically sees less importer demand in December are all supportive of ZAR to extend gains.

Emerging market high yielders should outperform EM low yielders next year, given relatively attractive valuations and risk premia. Inflation uncertainty is likely to stay elevated, and primary supply to remain a headwind for bonds, but pockets of value argue for taking exposure to select fiscal risks in the short term (SAGBs, IGBs, front-end BRL rates screen attractive). United States 10-year yields upward grind appear to capture market attention this week with auction supply and talk about a new fiscal stimulus bill, but there are a number of reasons why EM investors need not fear a repeat of the 2013 taper tantrum.

First of all, the Fed is likely to have learned from its 2013 forward guidance. Furthermore, the next policy move is more likely to be further loosening via an increase in the average maturity of asset purchases. In contrast, 2013 involved a planned reduction in total purchases.

Secondly, EM conditions are generally more favourable:

• The median trailing one-year current-account deficit for a large sample of EMs (excluding China) is +0.2% of gross domestic product (GDP). Prior to the 2013 tantrum it was -1.8%.
• Emerging market positioning is much lighter. Back in April 2013, debt inflows had a Z-score of +1.1 for 12-month flows relative to their five-year average (versus -0.6 today). In equity markets it was +0.6 (compared with -1.3 today).
• Emerging market real yields are higher than in 2013. Despite current nominal yields being ~50 basis points lower on average than April 2013, forecast inflation is more than 150 basis points lower.

We expect EM assets are positioned to ride out higher US yields this time, despite occasional rumblings about other metrics such as large fiscal deficits and growing debt to GDP ratios that are less favourable than those cited above. We would however use sharp rallies in local assets to reduce tactical bull flattener positions and see value emerging in the one-year point where fixed rate negotiable certificates of deposits (NCDs) have backed up over 75 basis points in yield since early November and would look to that as a viable option for redeploying capital or carry gains. 12x15 FAR rates are also starting to appear attractive receivers to us as they are now pricing in 37 basis points worth of hikes out to December 2021 which may be lofty given current SARB guidance and inflation profile in 2021.