SA Fixed Income Insights – June 2019

Markets were jolted in May following tweets by President Donald Trump that the much-anticipated trade deal between the US and China reached an impasse after several months of negotiation. In recent weeks, it has become apparent that talks advanced to reach a stage of contention between United States (US) and China trade negotiators on various points. Certain issues remain unresolved and resulted in a re-escalation of US-Sino trade tensions.

Since the surprise disappointment around US-China trade talks in early May, EM risk markets (spreads and currencies) have weakened, but not that much so far - and not uniformly. The rand and South African Government Bonds (SAGBs) performance have been relatively resilient to this perceived negative news when judged within its peer-group (measured in US dollar terms). This resulted in the imposition of an additional tariff on $200 billion Chinese goods imported by the US (raised from 10% to 25%) while China acted to impose tariffs on $60 billion of US imports. The Trump administration accused China of having reneged on promises to make structural economic changes during months of trade talks. The US is seeking sweeping changes, including an end to forced technology transfers and theft of US trade secrets. It also wants to curb subsidies for Chinese state-owned enterprises and better access for US firms in Chinese markets.

Investors continue to grapple with the rapid evolution and uncertainty of US trade policy and the US-China trade spat has escalated in the past few weeks in the press. In addition, action has been taken by the US to ban activities and severing Huawei from its American suppliers.  It is becoming clear that trade frictions pose risk to global supply chains and may lead to a reconfiguration of these across different industries. This could add further pressure to slowing global growth.
Ultimately, this could lead to central banks having to take further action to ease monetary policy and/or expand balance sheets again should a breakdown of talks lead to economic disruption. Indeed, while large-cap US equity market indices have only come of slightly from the recent highs, the fixed income markets have been telling a far clearer picture of economic downturn as two epic bull markets duel over the fate of global growth.

The US yield curve has inverted when looking at UST 10-year yields vs 3-month rates, while US 2-year yield (1.87%) is now sitting a stunning 51 basis points below the Fed funds policy rate (2.38%) signalling the market is already pricing in a substantial Fed easing by way of rate cuts. The OIS market is one of the cleanest ways to look at the amount of Fed rate cuts priced in the short end of the US curve. The US 1-month OIS rate 1-year forward vs the current level of 1-month US OIS rate spread is -83 basis points, signalling that the market expects more than 3 rate cuts of 25 basis points each to materialise over the coming year.
The fixed income markets are signalling that the Fed is behind the curve given the degree of cuts priced in and the swift repricing of the future Fed rate path over recent weeks. Markets are now pricing an almost 80% probability of a 25 basis points cut by the Fed at its July policy meeting. With the fed still signalling patience at their last policy meeting with no preference for cutting or hiking and open to review data one must acknowledge the huge disconnect between the Fed’s communication and the market pricing. This becomes even more apparent and even contradictory to consider Fed cutting rates (easing policy) while they are still also conducting balance sheet run-off (Quantitative Tightening) policy said to continue until September 2019.

We have observed an interesting phenomenon in US rate markets. The US 10-year vs 3-month rate spread is inverted, yet the slope of the US 2-year/10-year spread is positive. This hints at the enduring belief among market participants that the Fed easing cycle will be sufficiently shallow and pro-active to provide the needed easing to prevent a full-blown recession. We are closing in on the longest streak on record in which the 3m10y is inverted, while the 2y10y remains positive. By the time the 3m2y was this inverted in 2006, 2s10s was also sub-zero, pointing to a period of prolonged accommodation. In other words the interest rate market is currently saying that they think the Fed will have enough policy room and firepower to act swiftly and decisively to address any economic fallout from matters spanning as wide as tariff and trade uncertainty with China, threats of higher inflation as a result of additional tariffs on Chinese and/or Mexican imports, the waning fiscal stimulus and any drag from, the delayed impact of the Fed monetary policy tightening during 2017 and 2018. It remains to be seen if the bond market message that the Fed can cut a few times which enables the economy to stabilise near trend growth of 2% to avoid a deep recession is prescient.
It indeed feels as if the room for Fed policy mistake is small given the uncertain environment about how the trade conflict will play out, the timing of further tariffs and inflationary and growth risks they pose. We expect a stirring debate over whether Fed rate cuts happen in the July Federal Open Market Committee (FOMC), if the cutting cycle will be pre-emptive/precautionary to avoid recession or the opposite where Fed cuts (when they happen) come too late and are labelled as recessionary (Fed waited too long).

With no further official talks scheduled until the Trump-Xi meeting at the G20 at the end of June in Osaka, the markets will remain cautious on what is likely a ‘techonomic war’ as much as a battle involving cross-border trade of goods. The gloves are also coming off in the propaganda front being waged by the respective countries to their own constituencies. Our base case is for the current discussions to not break down completely but see a low probability of a compromise and resolution before or at the upcoming G20 meeting. This will likely lead for further tariffs which will be deemed growth negative, EM rates supportive as bond yields dip further, but negative for EM currencies. (Chart 1). This holds for the SAGB curve broadly too, but we think G20 outcome matters more than the Fed at this stage given the degree of rate cuts already priced (over 80 basis points rate cuts priced in the coming 12 months). Importantly, we expect that the Eskom results and clarity of additional fiscal support needed from National Treasury in July and the guidance on operational and restructuring plans and Eskom leadership (new CEO and CRO appointments) to matter even more than the two afore mentioned global macro events.  In the long term there is also a threat that the global auto industry can be caught in the crosshairs with USTR Section 232 investigation report and a tariff decision looming on the Eurozone and Japanese economies that could further sour the increasingly fragile environment.

Chart 1 -  3 Main scenarios for G20 and Fed we are considering with the first scenario considered highest probability to us

Scenario
Source: Citi Research

The JPM GBI-EM Index has returned +2.1% year-to-date in US dollar terms, comprised of local duration and carry returns of +3.3% and -1.2% FX returns. For South Africa, as index component the return contribution to the index has been among the top five performing countries, returning +5.2% (+5.9% from local currency duration and carry and -0.6% on FX) (Chart 2).

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The recent general election results have pleased markets given the share of ANC votes at national level (57%), fuelling market hopes that the result provides a sufficiently strong mandate to Cyril Ramaphosa to assert his political and economic aspirations and embark on much needed reforms. Investors are hopeful that his new term will involve removal of some policy impediments that can improve business confidence, investment, employment and support faltering economic growth that threatens a 
sub-investment grade debt rating for South Africa in absence of any strong policy responses and initiatives such as the Investment Summit that can attract foreign capital. They also looking for steps to tackle corruption and renewed focus on rebuilding institutional strength. We have seen some rand weakness in recent weeks associated with pressure on EM currencies emanating from the ongoing US-China trade tensions, US dollar strength and fears of a depreciation in the Chinese yuan as either a negotiation tool or to cushion the impact on US tariffs, coupled with concerns over a possible fallout of an unresolved Brexit scenario. Since the inception of US/China trade tiff, the average tariff escalation on Chinese imports rose by an average of around 11%, which almost completely coincides with the degree of Chinese Yuan depreciation over the period. Additional tariff hikes by the Trump administration post the G20 meeting would therefore imply that we should expect yuan depreciation beyond the 7 to US dollar threshold that has been considered tacitly sacrosanct.

Chart 2 -  EM FX weakness has not been uniform across currencies, with rand weakness buttressed by election optimism

Chart 2 EM FX markets
Source:

The benchmark R186 has spurned rand weakness however, piercing the floor on 8.40% as US Treasury yields fell to their lowest levels since 2017 amid expectations that the Fed would cut rates sooner than expected, not least on poor data outcomes but as US inflation and inflation expectations deviate further from the Fed’s target of 2%. The benchmark yield should re-attach to the rand once US Treasury yields stabilise and local idiosyncratic factors dominate the investment landscape. Despite the announcement of a smaller and more credible cabinet, SA’s political risk premium remains elevated based on our fair-value models.

The latest SARB Monetary Policy Committee meeting statement (May) outcome had dovish undertones versus market expectations. The SARB lowered their inflation expectations seeing inflation average 5.1% in 2020, 4.6% in 2021. 
They lowered their gross domestic product (GDP) growth outlook for SA to 1% (1.3% previously) for 2019. Three of the five MPC committee members favoured to keep rates unchanged, while the remaining two favoured a 25 basis points cut. The QPM of the bank is forecasting a policy rate that is lower than the current repo rate of 6.75% by the end of the forecast period using its latest assumptions. More specifically the model now indicates a cut could happen in the first quarter of 2020. Given a sharp quarter-on-quarter SAAR GDP slump in quarter one (-3.2%) and falling inflation expectations we think the door is open to consider reducing rates as soon as the next (July MPC meeting) which is also our house view. The fiscal deficit numbers are suggesting fiscal slippage which does concern us and requires close monitoring in the next few months but given that tax receipts data will provide more clarity into quarter three of 2019, we do not see the fiscal slippage concerns or threats of Moody’s credit rating outlook change later in the year influencing the SARB’s decision-making until later in 2019.

After this SARB meeting we have seen very weak quarter one SA GDP print as many sectors showed economic contraction on a quarter on quarter basis which implies that even if growth rebounds in quarter two through to quarter four of this year, that the SARB GDP growth estimates will be lowered at the next meeting. If we assume GDP growth this year of 0.5% and we assume an elasticity of 0.98% (i.e. just below 1.0) then the fiscal deficit will be 5.8% (vs 4.5 deficit projected for 2019/20 in February) and debt to GDP will be 59.1% in 2019/20. Note this does not account for State-Owned Enterprise (SOE) bailouts beyond the 
R23 billion balance sheet support earmarked in the February budget to Eskom.

Including Eskom debt, debt to GDP in 2019/20 may be 64.9%. For Moody’s to downgrade SA the fiscal strength, score needs to move down two notches from M+ (current score) to M- according to Moody’s ratings methodology. At 64.9% SA’s 2019/20 debt level will almost breach the 60% -65% range. A ratio of 60% -65% corresponds with an M and 65% – 70% is M-. Moody’s will only incorporate the 2019/20 fiscal metrics in June/July 2020. Hence, the impact of our assessment of this year’s fiscal deterioration will only be used in the rating methodology in the middle of next year. This leads us to conclude that the risk Moody’s downgrade that will lead to WGBI Index exclusion is likely to be more of a factor for bond investors in the second half of 2020.

Turning to the global economy, cracks are spreading across markets' cheery the first quarter facade, but it is vital to note that it doesn't all come down to trade war headline risks. At the start of the year, the consensus narrative was that growth was 
well-oriented and risks were limited despite the threat of trade war and sluggish global trade overall. Many analysts still consider growth to hold up, citing solid quarter one GDP growth in several key major economies. Looking at the US and Japan, however, growth is not as resilient as it seems. In both countries, the strong first quarter figures were mainly driven by an increase in stockpiling, which is less encouraging.

Growth may come under further pressure if we consider and analyse the recent fall in credit impulse. Economists used to refer to the stock of credit to understand the business cycle, but academic research mentioned by Saxobank since the great financial crisis (Biggs, Calvo, Ermisoglu) pointed out that the flow of new credit – what we call credit impulse – is a better method of assessing where the economy is heading. Credit impulse leads the real economy by nine to 12 months with a correlation of 60%.

Based on Saxobank’s latest estimates, global credit impulse is falling again and now stands at -1.8% of global GDP (Chart 3). 
The amplitude of the contraction is similar to that seen in quarter four ‘15. That year, the decrease in credit impulse led to the lowest global growth level seen in the current cycle, with global GDP growth reaching just 3.09% in 2016. We have not yet reached that point, but recent developments on the trade war front urge caution on growth forecasts. So far, half of the countries in their sample are in contraction and the other half, excepting certain emerging market countries like India and Russia, are experiencing a deceleration in the flow of new credit in the economy. In developed countries, the trend is most concerning in the US. The US credit impulse is running at -2.2% of GDP, the lowest level since 2009. 

The US Composite Leading Indicator, watched by asset managers all around the world, is also confirming this negative signal with the index now at its lowest point since Autumn 2009; the year-on-year rate has fallen from 0.68% to -1.65% over the past 12 months. Such levels are usually consistent with the risk of recession. The Chicago Fed National Activity Index, which gives a broad overview of the state of the economy, is back to where it was in Spring 2016 if we look at its 3-month moving average. 
With the US economy no longer supported by massive tax cuts and facing the negative economic consequences of the trade war, particularly those felt by US consumers, the outlook may continue to wane in the months ahead. This reinforces our view that the current business cycle, especially in the US, may be more fragile than the current consensus view or Atlanta Fed Nowcast barometer is signalling.

We are very vigilant that we may be in the very early stages of this move. Further analysis reveal that if you plot the global credit impulse against the Chinese credit impulse, which roughly represents a third of the global growth pulse, it tends to lead the global credit impulse by one year. As long as the Chinese credit impulse does not return to positive territory, we expect the global credit impulse to move downward in the coming quarters leading to lower-than-expected growth. As Chinese trade war rhetoric becomes more strident the odds of a detente being reached at the upcoming G20 Summit in Osaka have shrunk to less than 50%. There is currently a deafening silence from Beijing as the US waits upon China to continue the trade talks, yet China is holding off waiting on US to put on hold or discuss removing the ban on Huawei. This is now an integral part of the negotiations. The upshot may be Fed policy moves in the US and infrastructure development programmes in China to help offset the negative drag on the global economy that stems from lower business confidence, lack of visibility both of which can weigh on capital investment.

We have noted that there has been an uptick in hardening of rhetoric in Chinese within the media fostering a sense of nationalism and recent interviews suggests China if provoked (e.g. Hauwei brought to its knees) it will be forced to harden its stance may take action to target not US goods but US services sector.

Chart 3 –The aggregate credit impulse across 5 major economic regions are currently negative

Credit impulse
Source: Macrobond, Saxo Bank Research & Strategy

The response of financial markets to this latest escalation of trade tensions is broadly in keeping with the initial skirmishes between the US and China last year (Chart 4). 
The scale of equity market declines through May (as at start of June) pretty much matches the 5-6% drawdowns seen last September when 10% tariffs were first implemented. But in some important instances including the US bond market, JPY and CHF, the escalation of tensions with China and the threatened deployment of tariffs against Mexico has been much more pronounced. The disproportionate slide in yields and the outsize appreciation in safe-haven currencies other than the US dollar suggests that after one year into trade tensions, investors have not become habituated to tariffs. Instead they are becoming more sensitive to the ratcheting up of trade measures.

Chart 4 –The market reaction to the latest round of tariffs is broadly in keeping with the onset of trade conflict last year, albeit US yields and non-USD safe-haven currencies are moving much more sharply

JP Morgan Colour bar table
Source: JP Morgan; Note: business days: G10 High Beta is average TWI's of AUD, CAD, NZD, and NOKs

We are therefore on guard to conclude that tariffs be regarded as business-as-usual from either an economic or market perspective. JP Morgan found that the opposite in fact hold. The economic damage from tariff escalation is liable to be cumulative (as observed in the disturbingly weak trend in global capex) and so there is a risk that even minor incremental measures could at some stage tip economies and markets over the edge into a non-linear environment, i.e. a recession. 
We’re not there yet, but the skittish behaviour of US yields and non-dollar safe-haven currencies bears watching as a barometer of the market’s anxiety that the global expansion may be nearing the end of the line due to missteps on industrial and trade policy. Even if this latest cyclical stumble does not end in recession, the global economic environment is liable to deteriorate before it can stabilise. In other words, the subjective probability of recession is liable to rise, and currencies will trade off this in coming weeks and months. A defensive environment is set to get even more defensive, we suspect, and our macro portfolio is well positioned for this through a suite of long positions in USD, JPY and CHF and being underweight or hedged on high beta currencies.

An update of our tactical and strategic views

Uncertainty surrounding timing and progress or lack thereof of a US/China trade deal at the Osaka G20 meeting on June 28/29 and whether additional tariffs will be imposed by the US on Chinese imports we remain cautious on being overexposed on bond duration. High coupon flows in June and August and supportive valuations of local bonds relative to UST yields screen as attractive for local bond when hedged back into USD for USD investors. When we look at the data, we are less constructive as we identified a falling wedge pattern on R186 yields suggests to us that bond yields in the belly of our curve may ultimately break out to the topside, once the bull campaign that started last November in EM reaches a level of exhaustion.

Should this occur it will provide more favourable levels to re-enter duration and we prefer to take a slightly tactical underweight (or do option overlay hedges) or at best neutral SA duration position at current levels with R186 yields below 8.30 and the R2030 (10-year benchmark) near 9%. Moving beyond R2035 on the curve towards the ultra-long bonds the curve has steepened significantly fuelled by deteriorating fiscal metrics which include weaker than expected GDP growth and high-level CEO resignations at key SOEs like Eskom and SAA at the end of May. This presents a major challenge to Ramaphosa’s reform campaign as momentum is thwarted and lack of political will to make business decisions that achieves reform objectives become apparent. Inability to make headway on the implementation of the Ramaphosa administration goals will lead to give back of the political dividend received in the post-Zuma handover. This adds to our conviction to remain neutral to defensively positioned due to idiosyncratic risks but will use any selloffs over the G20 or US summer to increase duration focussing on R2030 to R2035 part of the curve where carry and rolldown is high. We dislike the short end of the curve which is expensive given rate cut receiving interest that has collapsed the 5-year part of the swap curve spilling over to bonds. We also feel ultra-long end bonds are exposed to fiscal disappointment into October MTBPS.

Chart 5 –R186 yields (6-year) picture shows R186 yields in a falling wedge pattern as it approaches trendline support from higher yield lows extending back to the pre-taper tantrum era in early 2013

R186 yiels 6 yr
Source: Bloomberg

The major rally in US Treasuries since early May has been a major supportive factor anchoring EM yields in an otherwise hostile macro environment for EM where the US dollar displayed strength against EM currencies. The US 10-year Treasuries touched the key 2.06 level in recent days. This marks the 61.8% Fibonacci retracement level of the 2016 yield lows near 1.32% and the recent yield highs in late 2018 near 2.75%. From here we expect yields to find a challenge to build on its rally. A correction higher in US yields (within a structural bull market) could also lead to an uptick in EM yields in the coming weeks if correlations hold. 
The UST yields do not bottom ahead of the first US rate cut in cutting cycles. Chart 6 reveals how UST 10-year has performed in prior Fed cutting cycles and hence we anticipate that over time UST 10-year yields will end up below 2% once the cutting cycle is underway and will act as a supportive anchor for EM yields. Please see our summary below of views on segments of the curve.

Chart 6 – Bond market reaction to Fed cuts : It’s the economy again. The grey line represents the current cycle and assumes the Fed cuts rates at the July 31 meeting after using the June meeting to announce them ending their QT with balance sheet run-off in June rather than end of September as communicated previously

FED Rate cuts
Source: Pictet WM  - CIO Office, Fed, Bloomberg

We expect the SAGBs yield curve to remain steep given the fiscal risks posed in the leadup to the October MTBPS, risks of further fiscal slippage and market uncertainty over the quantum of additional funds that will be required from the fiscus as additional support. At this juncture, based on conversations we have had we are expecting that the $23 billion additional support earmarked for Eskom as financial support by National Treasury will be insufficient and may very well be closer to the 50 billion mark for the current fiscal year supports our view that the curve may remain structurally steep. We do, however, expect that the Eskom financial results due in early July may provide the market with more clarity on how much additional support Eskom requires and what steps will be taken to make its debt more manageable, a new CEO appointment as well as who will be the appointed Chief Restructuring Offer for Eskom.

This leads us to keep a mildly constructive stance on local bond yields medium term based on a combination of factors such as lumpy June coupons that is paid to SAGBs investors, downside risks to growth and global bond yields coupled with increased scope of an MPC rate cut down the road coming into play outweighing negatives such as headwinds to EM from US dollar strength and a depreciating Chinese yuan feeding through to Chinese and commodity sensitive currencies such as the rand. Timing will be important, and we would use strength from current levels to fade the rally yet use any negative news that results in sell-offs to add back duration in the R2030 to R2035 area.

Summary of our directional views:

Exchange rate: Domestic exporters should repatriate, and foreign investors should reduce FX overlays. Barring a very negative G20 outcome that is severely EM negative, we expect dollar/rand to retrace losses from its recent high near 15.17 and stabilise in the 14.50-15.00 zone.

Nominal bonds: Underweight 3-to-7-year, neutral 7-to-12-year, and overweight +12-year bucket. The back end is very steep and could retrace some losses as some spreads are at record highs or elevated levels last seen during Malusi Gigaba’s tenure as Finance Minister.

IR Derivatives: Short 5-year swap. Foreigners have been adding a lot of receivers on the 5-year point of the local swap curve. 
We expect this to be priced out when it becomes more apparent that the SARB is unlikely to engage in a rate cutting cycle.