South Africa Fixed Income quarterly insights

08 December 2021

Emerging markets (EM) enjoyed a honeymoon at the end of 2020 post the Blue Sweep in the United States (US) presidential elections that sparked an influx back into the asset class as a result of asset rotation facilitated by the USD weakness. This positive sentiment lasted into the early weeks of this year before the reflation theme unleashed a steady climb in Treasury Inflation-Protected Securities (TIPS) and Treasury yields. This also filtered through to weigh on EMs, reaching a crescendo at the end of quarter one on fears of a change in Supplementary Leverage Ratio (SLR) regulation for Globally Systemically important banks (G-SIBs). The market feared this would lead to banks having to cut their existing holdings of US stock of high-quality liquid assets (HQLA) paper such as US Treasury (USTs) at quarter-end.

Somewhat surprisingly the steady ascent in yields petered, leading to a quarter two relief-rally which extended to late August. This was a boon for EM bonds as US real yields continued to grind lower in concert with a weak USD. At the same time US growth started to ease from the peak post-COVID-19 growth in March/April and the Federal Reserve (Fed) continued to remain dovish in their policy setting and signalled patience in their guidance to announce their tapering plans.

As we transitioned into September the markets faced an inflection point when Fed, at their September Federal Open Market Committee (FOMC) meeting, released a more hawkish dot plot forecast, indicating that the hiking cycle was to kick-off next year. The dot plot forecasts that will be updated at the December FOMC with the latest views showed the median survey dot for one rate hike next year in 2022 followed by three hikes in 2023 and another three hikes in 2024. This development was followed in October by evidence of US data weakness troughing as the US economic surprise index turned higher and started improving in conjunction with the Fed indicating they see their conditions met for announcing their balance sheet taper at their next meeting. This hawkish pivot by the Fed from September into December re-asserted a trend of USD strength and led to liquidations in EM funds.  There was also a broader trend of outflows from EM local and hard currency debt funds coinciding with significant depreciation across the emerging market foreign currencies (EMFX) universe.  Much of this was in response to a bear flattening US rate curve as US short rates rose to star to reflect the risk of earlier and more pronounced Fed rate hikes.

Chart 1 – Yield curves in the US have already started flattening aggressively with 10s30s starting months before tapering was announced formally. These flattening moves have been a replay of similar curve behaviour during the 2014 taper. Inversion of curves could send message of a severe economic slowdown and Fed policy error. Surprisingly, we have already witnessed the inversion of the US 20s30s curve.

Source: Bloomberg

In the past two weeks the Fed chair retired the word “transitory” that has dominated his inflation narrative since middle 2021 and also signalled together with other regional Fed presidents an openness to consider an even faster tapering of current pace of monthly quantitative easing (QE) (UST and Mortgage-backed securities (MBS) purchases on Fed balance sheet). The November meeting communication from the Fed was that it would proceed with its reduction in purchased (tapering) by $15billion per month. This would result in QE ending by June 2022. Recent Federal Reserve official speeches, including that of the Fed Chair, has created some market unease in that in all likelihood the Fed would proceed with speeding up its taper to conclude earlier than was previously guided with the possibility of this being announced on 15 December at its final FOMC meeting for 2021. The release of the latest US labour data on 3 December showed some further labour market tightening, which together with the statements that the Fed’s decision could see a faster taper, resulted in a sharp bond rally in 10-year and longer US bonds leading to further curve flattening. The USD has received a renewed interest, creating further unease in EMs despite the attractive valuations of EM local currency bonds in real yield terms - and for emerging market foreign currencies (EMFX) trading at Real Effective Exchange Rate (REER) levels that is a far cry below their five-year averages.

Earlier this year when the Fed first announced its taper plans, the market reaction was muted. But perhaps a market flare-up similar to the 2013 taper reaction – when Treasury yields, duration spreads and the dollar soared while emerging markets melted – has only been delayed not averted. Given the risk of a faster tapering and recent curve flattening and the US 20/30 curve inversion we are concerned about the risk of a market tantrum in the coming weeks especially if the Fed continues to downplay concerns around downside economic risks posed by risk of the emerging new COVI-19 variant that could lead to mobility or other restrictions imposed. In recent days, the markets have turned more volatile and rate volatility has increased across developed markets (DM) and EM. This leads us to take a more defensive view in our portfolios into year end and as we enter the new year. This include allowing coupons or maturities in portfolios to run up to result in running of higher cash levels to enable us to take advantage of any capitulation move in either rates or Foreign Exchange (FX).

In terms of the Fed policy reaction function, the situation has now changed with the Fed hinting it wants to accelerate its taper plans. This effectively re-ties tapering to the timing of the interest rate hiking cycle. The tie-up should have been a long time coming with the Fed telegraphing its disquiet over inflation for weeks. When the New York Fed released a blog post in September defending Fed zero rate policy under the premise that long-term inflation expectations were still well-anchored – you knew they were worried. The reality is that consumers’ medium-term inflation expectations were rising substantially. And that put long-term expectations – a key variable in the Fed’s reaction function – at risk. This was the tell that the Fed was suddenly more concerned about inflation than employment. The confluence of higher inflation, a robust economy and a tightening Fed should mean curve steepening in the US. This was the case initially because the growth outlook was (and in many ways still is) favourable.

However, as consumer confidence eroded and Fed peak has become increasingly inflation-focused, the potential for demand destruction or over-tightening has increased. In this regard we see the risk of a Fed policy error has increased and will be watching for further signs of market stress in equities and lower bond yields and potential curve inversions that signal market concerns about tightening financial conditions.

Chart 2 - DM and EM inflation likely to continue to climb in the next few months but disinflation from quarter two of 2022 is projected

Source: Bloomberg, Goldman Sachs, Ashburton Investments

A month ago, we wrote that this should be a “big flashing red warning sign for bond markets” - and indeed, it has been. The MOVE index is at its highest since the lockdowns in March 2020. Last month saw high yield outflows and its biggest losses since September 2020. And now taper tantrum risks are growing, not waning. Even doves at the Fed want to tackle inflation aggressively. 

For investors, the environment where the macro backdrop is challenging given the Fed policy shift. A lower (but above trend) global growth outlook in 2022 versus 2021, rising inflationary pressure that is yet to abate and the fact that the China growth picture is still uncertain. They also lack clarity on where the Chinese policy put is. It is prudent to position cautiously or conservatively until we have some signals of the shifts we are looking for to provide us with conviction to take advantage of an improved 2022 outlook.

We see the environment and landscape shifting more favourably next year after the current risks and headwinds potentially abate from quarter one of 2022 onwards. These include signals of a policy put exercised in China and recovering growth with either targeted measures and/or a Reserve Ratio Requirement (RRR) cut being exercised among others. A pivot back to a dovish outlook if the market enacts sufficient pressure on the Fed. This could result in a re-flippening of the policy outlook, including delaying or slowing the taper and/or pushing out the Fed rate hiking cycle. This could occur if the disinflationary cycle of inflation moderation does occur. In accordance with projections of US economists (Chart 3) at Morgan Stanley global inflation is close to peaking and should recede in varying degrees next year against slower (but still well above potential) global gross domestic product (GDP). Forecasts are showing DM inflation rolling over and closing 2022 near 2%, which if realised, would represent more than halving from its current levels. This would represent a significant boon in our view for bond markets that is currently being ignored.

Chart 3 - DM and EM inflation likely to continue to climb in the next few months but disinflation from quarter two of  2022 is projected

Exhibit 2: Strong global inflation now, but receding next year


Source: Morgan Stanley

In many ways 2021 has turned out to be a year that many EM investors would want to forget. This has been the central puzzle that many of us wrestle with is that 2021 should have been a fantastic year for investors in emerging markets if you consider that there was a surge in GDP growth that coincided with huge improvement in terms of trade for commodity exporters. Secondly EM economies as a whole is running some of the healthiest current account (CA) balances that they have seen for decades. The current CA surplus for EM countries are close to 1% of GDP. This is a number that was last seen pre-2005. Moreover, REER levels in EMs are now at levels well below their five-year and 10-year averages which makes entry costs much lower, and creditors also are lending to countries that has much healthier credit metrics.

To further add to the picture, central banks in EM has been embarking on a tightening policy. Hiking rates in a disciplined manner after a year when they ran large fiscal stimulus programmes, while also starting to pair back on running those crisis fiscal deficits. And finally, with US 10-year real rates at -1.1% one can argue that external funding conditions are extremely easy and have never before been as favourable.

Why has EM struggled besides the factors mentioned above? Other than Fed policy action and the market fretting over the possibility of substantially tighter financial conditions ahead, one has to acknowledge that Chinese economic growth moderation for majority of this year and a negative Chinese credit impulse and regulatory crackdown has been detracting from the positive EM conditions. In addition, if we study the EM debt flows this year, we can see that the vast majority of money that flowed into EM was destined for Chinese bonds as they sucked investor capital away from the rest of EM.

Chart 4 – EM real yields have increased as valuation buffers have increased in EM and in addition the spread differential of this to US TIPS is at a record wide. This is likely to compress next year once the external landscape turns more favourable and the market has repriced fully for Fed tightening risks. Once the inflation hump has passed and some EM central banks signal, they are done hiking we expect pockets in EM will perform very well, especially if the Fed has room to stay patient and have breathing room to delay hiking rates vs hiking rates immediately once tapering runs off

10 Year GBIEM Weighted Real Yield vs US 10 year TIPS (%)

Source: Bloomberg, Morgan Stanley

Contrary to extrapolating recent trends and consensus, we believe there is now a case for more optimism in some EM local debt markets later in 2022. Granted there are plenty of challenges in the near term, ranging from an acceleration in Fed tapering and rate hikes, to macro risks like rising inflation and COVID-19 variants. But our view is that pockets of value have emerged in some local rates markets where underlying risks are now adequately compensated. Moreover, many EM central banks have raced far ahead of developed central banks in the policy tightening cycle, and further aggressive implied tightening in forwards suggests that fixed income assets within most emerging markets are already pricing in risks of global policy normalisation. While recognising risks to remain in the early weeks and possibly months of 2022 we think weakness should be used to switch from a defensive position into a position where we expect local EM rates to outperform.

Among EM high yielders, we like Russian government bonds (OFZs) after their frontloading of policy tightening. This means the prospect of policy easing could resume earlier next year and the Ruble also appears cheap and has the added boon of benefitting from high energy prices that is supportive. In South Africa we see one of the steepest curves and highest real yields within EM (Chart 5) and quite sizeable carry even on an FX hedged basis. We think investors is well compensated for running neutral or slightly overweight duration in SA government bonds (SAGBs) (with protective option overlays that can be closed once EM headwinds fade next year).

South African government bonds are also among the most attractive bonds in Central and Eastern Europe Middle East and Africa (CEEMEA), and EM more broadly, on several other metrics (curve steepness and asset swap spread), which are not just among the highest in EM but which have also increased recently and are substantially above their own respective five-year averages and high relative to peers. This is despite some of the lowest and stable inflation in the region and a fiscal outlook having much improved in recent quarters. The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) investor positions in duration are the most underweight since 2016 when Trump won US elections and FX positioning is also very underweight which suggests that we could see this light positioning act as a positive catalyst for favourable EM repricing once investor sentiment shifts for EM next year.

We do see risks in the near term of potential South African rands (ZAR) weakness and risks around the possibility of a permanent basic income grant being announced in the budget that could erode a potential cut in SAGB issuance, while risks to the government wage bill next year could also detract from what could otherwise be a positive fiscal backdrop for SAGB investors. We do see more support from inflation once we pass the quarter one peak in South African (SA) inflation profile and the possibility of the South African Reserve Bank (SARB) taking a pause in their hiking cycle after delivering another one or two hikes which could lead to SA bond returns that could meet or exceed double digit annual returns.

Into year-end we maintain the use protective option strategies to hedge against significant rand weakness by also sacrificing large rally potential where we cap upside participation in bullish cycles. We also prefer running higher cash levels in portfolios and have already made use of switching strategically from fixed to ore floating exposure in the past few months to prepare for the SARB hiking cycle. In turn we see opportunities to fade the way too aggressively priced SARB hiking cycle.

Chart 5 – South Africa’s real yields are among the highest globally

Source: HSBC, Morgan Stanley

Setting Omicron-uncertainty aside, we acknowledge that EM faces a ‘double whammy’ next year. On the one hand, risk appetite towards EM – which already seems quite weak – will be constrained by a tightening of US monetary conditions,. And meanwhile, EM growth will suffer for a variety of reasons to do with weakening external demand growth, lower global trade growth, and the effects of further domestic monetary and fiscal tightening in many countries. Having said this, we do also believe that EM has already repriced for a lot of these risks including wider credit spreads, at least two if not more Fed hikes and higher UST yields. (Chart 2). Looking at the relative performances of EM and DM (specifically US assets, it is clear that EMs have already done significant repricing for 2022 risks.

What should we expect for EM performance next year when Fed hikes commence given the performance of EM in past hiking cycles?

Emerging market local markets usually sell-off as markets price Fed hiking cycles, with EM credit typically less affected. Markets already expect the Fed will start hiking in 2022. Whether you think it is the first half or the second half of 2022, we are in a period ahead of a Fed hiking cycle and for EM local markets that is usually a period of weakness. Chart 6 shows the performance of EM assets prior and during Fed hiking cycles computed by JP Morgan.

Looking at this through timeseries analysis is not very instructive, as we only have four Fed hiking cycles since modern EM was trading. It is also useful to look at market pricing (using US one-year-one-year rates) as well as the actual hiking cycles, given the EM reaction will likely happen as US rates reprice in anticipation. The results show that:

• Emerging market FX: When the market prices a Fed hiking cycle (US one-year-one-year higher), EM currencies usually weaken. This continues during the hiking cycles (Fed funds higher). However, the 2004 hiking cycle was different – EM FX did not weaken then given EM was in a period of high China growth, EM structural reform, and a commodity super-cycle. That was enough to withstand the pricing and delivery of the Fed tightening. Also, the 2001-2008 cycle was the exception for EM, rather than the norm. Next year is unlikely to resemble 2004, given the outlook is for EM and China growth to stabilise with steady commodity prices. So, EM will not have the same supports, but early EM central bank hiking before the Fed does will provide some offset.
• Emerging market rates: These typically sell-off when the market starts to price the Fed hikes (US one-year-one-year higher) but are stable to lower in yield once the Fed starts to hike (Fed funds higher). The question for 2022, is whether we have already had the major repricing in EM rates given the 148 basis points move higher in GBI-EM yields in 2021. We believe that we have already seen the bulk of the move in EM local yields. US one-year-one-year could still have room to run which is reason for caution until it peaks at which point overweight EM local bonds could be appropriate.
• Emerging market credit: Using EM sovereign spreads, which have the longest history, there is no clear pattern for the relationship with the pricing of Fed hikes (US one-year-one-year higher). When the Fed subsequently starts to hike, more often spreads have actually tightened which suggests it would make sense if EM credit widen significantly ahead of actual Fed hikes which may even be a late 2022 or even early 2023 story rather than mid quarter two or early quarter three of 2022 story that is currently embedded in market psyche and US market pricing and may be too frontloaded in terms of what the Fed can in fact deliver.

Chart 6 – Historic performance: EM fixed income versus pre- and post-past Fed hiking cycles