SA Fixed Income Insights – October 2019

The third quarter was significant in that it marked the first occasion since the global financial crisis of 2008/2009 that the Federal Reserve (Fed) moved to lower interest rates. Central banks more broadly have acted in concert across emerging markets (EM) and developed markets (DM), showing an inclination to monetary policy easing - cutting rates and adjusting forward guidance in order to help lend support to consumer and business confidence, inject liquidity and lower borrowing costs to boost the economic outlook and aim to prolong the business cycle. Global growth readings, many forward-looking indicators and forecasts and activity data continue to point to a slowdown across most parts of the world during the quarter. This softness in growth trends have been felt in Asian economies, China and Eurozone and has been more pronounced in manufacturing sectors with many G20 readings in contraction. Labour markets globally, consumer confidence and spending has been more resilient, while service sectors of most economies are still in expansion which has helped to counter a more widespread outright bearish sentiment in financial markets fanned in part by lingering trade tension between the United States (US) and China.

While inflation readings have remaining subdued and growth risks remains, fixed income markets have performed better on average than equities in DM, while EM assets have encountered headwinds due to higher sensitivity as a high beta play on global growth dynamics.

For the US case, the Fed Chair termed its July rate cut to be a “mid-cycle adjustment” to provide communication to the market that the Fed is not on a pre-set course for an extensive easing cycle and that the Fed remains data dependent. The South African Reserve Bank (SARB) followed suit in July to cut the repo rate by 25 basis points due to a rising real policy rate and improving inflation outlook against a backdrop of contained FX pass-through and upside oil price risks.

An episode of escalation and de-escalation in the US-China trade war in July and further tariff threats unnerved markets in August. Many US curves inverted in August which has added to market concerns about late cycle and future recession risks leading to reduction of EM exposures. This was also felt in South Africa where we saw net foreign selling in SA stocks and bonds during most of the quarter. An increase in South African Government Bonds (SAGBs) issuance in weekly auction sizes after tabling of Eskom Appropriations Bill resulted in bear flattening in July/August. National Treasury indicated no further switch auctions to be conducted in the FY2019/2020 fiscal year which has helped prevent the yield curve from steepening further after significant steepening in the first six months of 2019.

South African fixed income assets appear to be pricing in a lot of risk around a lower Moody’s rating’s action, uncertainty surrounding the Eskom White Paper on debt restructuring and business turnaround and a disappointing Medium-Term Budget Policy Statement (MTBPS) which is offering fundamental value to us in light of more SARB rate cuts to be delivered in quarter four of 2019 or possibly 2020 quarter one. Waning of US dollar strength is possible if Fed balance sheet expansion gains pace which could pave the way for a more favourable backdrop for EM in 2020 if the Fed is able to act to sustain the economic cycle and inject enough additional USD liquidity to quell tightness that can tame USD strength and reverse the dollar direction. We are closely watching the October Federal Open Market Committee (FOMC) meeting communication, European Central Bank (ECB) quantitative easing 2 (QE2) restart (1 November 2019) and Fed open market operations in repo and T-Bill markets for evidence that the tide in USD may be turning.

During quarter three (Q3), all SA assets underperformed cash (1.83%). Equities posted a decline of 4.57%, while listed property registered negative returns of 4.44%. Inflation linked bonds were almost flat (0.25%) with nominal bonds performing the best among the asset classes with 0.78% gain over the period. Year-to-date bonds have generated 8.44% followed by 7.08% return from equities. Cash has delivered 5.45% with inflation linked bonds coming in with 3.53% return. Listed property continues to experience challenging conditions due to concerns over high leverage, sluggish economic expansion and uncertainty over durability of distribution growth, posting year-to-date returns of 1.34%.

As we move into the middle of quarter four (Q4) the market will be facing some significant event risks that will help shape the outcome of the return profile for emerging markets and SA assets. We think the final week of October and first week of November holds significance with seven major events over three days from 30 October onwards: MTBPS, Eskom White Paper, Eurozone Gross Domestic Product (GDP), US GDP, Brexit deadline, Fed October meeting, US non-farm payrolls, and Moody’s decision on SA credit rating. News should be a mixture of good and bad. We expect the mid-term budget may be disappointing due to its degree of fiscal slippage which risks SA to be placed on negative sovereign ratings outlook on Friday, 1 November 2019, by Moody’s.

All risks weighed, we think that the local market pricing in context of benign inflation, efforts to implement ongoing reforms, improved portfolio flows into EM, scope for further SARB and/or the Fed, additional central bank liquidity provision by Fed, ECB, Bank of Japan (BoJ) among other catalyst tilts risk-reward in favour of owning SA duration into quarter one (Q1) of 2020. We therefore aim to face any significant sell-offs due to political or fiscal events that may arise between now and mid Q4 to participate in what we expect to be a better turnout by end of the year.

We prefer to add overweight  duration in ultra-long end of the curve to overweight ALBI04 with preference for R2037, R2040 and R2044 for three-month investment horizon to end January. We are targeting 4.5% investment return vs projected cash return of 1.7% over same period to add significant alpha. This assumes a 25-30 basis points rally in back end yields over the time horizon as well as carry.

We remain cognisant of risks surrounding the global and local growth outlook. While reforms have been somewhat sluggish to gain traction, we believe dimmed prospects are likely to revive. Secondary concerns are fiscal stability, though this appears a necessary though insufficient condition to alleviate investor concerns.

The MTBPS is due on 30 October 2019 and the Investment Summit is planned to happen in November 2019. Latest news regarding the lifting of a moratorium on State Owned Enterprise (SOE)/public land has now been approved. This entails criteria to start disbursing public owned land for human settlements - the first leg of land reform. Cabinet backed proposals on 167 000 portions of land measuring 14 105 hectares of land held by the Department of Public Works and Infrastructure to be released for human settlement purposes. Secondly, the Integrated Resource Plan was announced last week and is expected to provide a lot of clarity to the energy sector and is said to be gazetted. Thirdly, spectrum licensing is going ahead this month (to be completed first quarter 2021). Lastly, unabridged birth certificates for foreign tourists travelling with children is planned to be scrapped, visa applications process set to be simplified for skilled foreign workers and e-visa programme is expected to provide a boost to the tourism industry.

Tolerance for another economic growth plan has faded amongst many foreign SA bond investors, yet South Africa still has enough institutional strength to keep fixed income investors interested in observing the near-term evolution of Treasury’s Economic Policy Paper. The reworked version of the paper due end of October is therefore critical also to inform Moody’s rating decision.

Chart 1 - SA Fiscal Metrics have been deteriorating and Finance Minister Tito Mboweni is under pressure to put the country back onto a sustainable fiscal path and deliver a credible budget that illustrates a plan of how fiscal consolidation can be achieved.

SA budget deficit
Source: National Treasury, Bloomberg

Even if the MTBPS macroeconomic assumptions are not based on the actual reform plans, budget forecasts are naturally more credible because of an economic plan. Most economists expect SA nominal GDP growth forecasts to range between 5 - 5.5% over the next three years before considering any reforms that could lift growth. Treasury might be able to credibly assume 6 - 6.5% nominal GDP growth forecasts over a similar period, allowing for smaller revenue shortfalls.

It was also acknowledged that expenditure reduction plans would be a positive signal, especially for those expenditure items where multipliers are weak (as this would surely not impede on economic growth). There was interest in the fact that Treasury’s June Medium-Term Expenditure Framework ‘MTEF technical guidelines 2020’ has proposed a scenario for more expenditure reduction than any guideline this decade. This, together with the Finance Minister’s frequent public commentary on the need to reprioritise and reduce expenditure, keeps investors interested in the prospect that expenditure growth may well be reduced. There is, however, also the understanding that any major expenditure reduction plan can only occur materially in the February 2020 Budget, due to budgetary and parliamentary processes. However, there is some hope that some expenditure efficiencies may emerge in the MTBPS.

The consolidated budget deficit to GDP ratio range of expectations for MTBPS for FY2019/2020 appears to be in the 6 - 6.5% range. Our view is that the Finance Ministry can better this consensus expectation slightly with a bit of fiscal effort (a mix of spending efficiencies and somewhat stronger and credible nominal GDP growth estimates) which would mean Treasury presenting a deficit ratio at or just below 6%, with some consolidation over the outer years. The fiscal position between February and now still deteriorates materially, but probably beats market expectations.

As the bellwether of the economy, Eskom was an understandable area of interest, however, our answers were also then understandably vague given lacking information until the White Paper, IRP, CRO restructuring plan and CEO are known. Above all, mere clarity of what’s planned for Eskom will be a relief for investors. To be clear, sustainable and affordable operational restructuring is seen as the most pressing issue and there was broad consensus that a direct transfer of Eskom debt onto government’s balance sheet should be expected, with a likelihood of a potential debt-equity swap.

Regarding Moody’s, the general expectation is that the agency either skips its review or places the sovereign rating on a negative outlook. But there are many nuances.

Chart 2 – The SA yield curve has pivoted around the R2030s point since late August. We continue to expect bull flattening to occur into early Q1 2020

SA yield curve
Source: Ashburton Investments

With the review scheduled for 1 November 2019, it is unknown whether Moody’s will have sufficient time to assess the many developments at month-end, from the IRP to the Eskom White Paper to the Economic Policy Paper to the MTBPS, and thus, the agency may choose to postpone its review to Q1 2020 as it has twice before. The change in the MTBPS date from 30 to 29 October may provide a bit more leeway for the agency but we know that typically, the committee makes its decision the Tuesday prior to the Friday review publication. This still makes the timeline extremely tight. There is of course just as much chance that Moody’s pushes its review out by a few days or weeks to assess the many month-end developments. In this regard, one would expect a negative outlook if the MTBPS fails to show some fiscal effort and fails to plan for more significant fiscal measures in outer years. If timing is not an issue because the agency cannot take the many month-end developments into account then a negative outlook is more likely given the extent of the deterioration in the fiscal situation and economic, however, if South Africa receives a negative outlook statement the composition of the justification is critical. Most negative outlooks end up as downgrades and thus, the statement would have to be clear that a stable outlook is likely if economic reform plans and fiscal adjustment is done quickly.

The bottom line is that investors don’t foresee even a negative outlook as a significant market event given that it is largely priced into expectations when we view widening yield spreads of actual yields vs our fair value models, rising real yields as inflation profile continues to look benign, as well as widening yields spreads relative to DM bonds and our EM peer group in the BB+ ratings category. Regarding inflation and monetary policy, most institutional investors now accept that inflation will continue to surprise to the downside and that a 4 - 4.5% handle on headline inflation is a realistic outcome over the medium-term. The question is whether our monetary policy’s inflation targeting regime is symmetric and thus, the policy rate could reduce further.

Our base case is for a 25 basis points cut by the SARB in November 2019 assuming that the midterm budget is credible and shows a path towards fiscal consolidation. The scenarios we consider are: (1) under a reform scenario where improved growth kicks in 18 - 24 months later, the SARB is able to address this low inflation by reducing rates modestly, but (2) if reform is absent, the SARB may struggle with lower-range inflation yet higher risk premium from an even-worse fiscal situation. The broadest consensus for the latter was that the SARB Monetary Policy committee (MPC) would not act, citing inflation risk, and hold steady under this scenario. Overall, the two scenarios still do not get South Africa to a deep and/or fast cutting cycle, which is seen as a positive as in the end, lower inflation expectations help in the long run. Assuming our view of November 2019 cut transpire, we remain confident that SAGBs will gravitate lower with bull flattening allowing long end of the curve to outperform.

Chart 3 – Different Policy Tools for Fed Balance Sheet Expansion

Policy tools for Fed Balance Sheet
Source: CITI

Turning for a moment more other topics on the global macro landscape that has caught our attention. On this score we believe a recent Bank for International Settlements (BIS) paper is worth noting. Also, a reminder that our long-held expectation that the ECB would announce restart of quantitative easing (QE) in September was prescient and we await the ECB’s return to bond purchases from 1 November 2019. As discussed at length in some of our previous monthly reports, the market views QE as reflationary and during implementation of QE programmes we tend to see yields rise. Interestingly, while DM yields tend to rise we tend to see EM sovereign yields fall as money allocators express more interest in carry trades and reach for yield in EM. Hence, we believe that the coming ECB QE will be a tailwind for EMFX and EM local currency debt. Finally, we also make short comments on the recent Fed announcement to start to conduct open market operations and intervene in the US repo market. The Fed has announced it will commence buying US T-Bills to the tune of $60 billion per month to help expand excess reserves in the US banking system to quell stress in USD liquidity that has been surfacing in recent weeks. We project US3m/10yr yield curve will likely steepen looking ahead and T-Bill yields will likely fall quite sharply.

We also expect that Fed balance sheet expansion has traditionally been favourable for stocks and we think that it will again be at least a mental crutch for market to hang onto. T-Bill buying (soft QE) (Chart 3) could be instrumental to help quell dollar strength and if coupled with rate cuts could make for USD weakness (Chart 5). All the above could prove to be a good mix for EM assets in the months ahead assuming global growth stabilises and starts picking up which is currently our base case scenario. (Chart 4)

Chart 4 – Post GFC World Fed Balance Sheet expansion has been positive for Equities and expected to also provide a positive boost to risky assets.

Projection of Equity upside
Source: CITI

Emerging-market economies were highly sensitive to quantitative easing from DM central banks over the past decade, according to a BIS. That signals EM assets could turn out to be even higher beta plays on global growth.

Traditionally, investors looked to EM assets to outperform at times when global growth quickens, and to underperform when global growth slows. Quantitative easing and other unconventional monetary policy tools (UMPTs) could turbocharge that role. Central banks' balance sheet expansion has tended to provide a substantial boost to flows into EM economies (EMEs), and the unwinding of unconventional tools spurred significant outflows.

Chart 5 – Increase in excess reserves projected over the next six to nine months by delta of $400-$500 billion past experience portends to USD weakness which is likely to be reinforced by additional Fed dovishness.

DXY expected to weaken
Source: CITI

Some observers suggest that UMPTs have thus helped to amplify the financial cycle in several emerging market economies (EMEs) with reasonably open capital accounts. There is also the potential here that the ultimate impact would be to attenuate the beta to be found in EM assets. If global growth accelerates enough to spur UMPT unwinding, that could cap EM gains in such a scenario, and losses could also be limited if UMPTs are used aggressively in a downturn. The report also indicates unconventional tools are here to stay in the global monetary toolbox:

The recent spike in EM dollar-bond spreads despite increasing odds of an October 2019 US rate cut signals investors are more concerned about global growth risks than any monetary policy remedies. That suggests developing-nation equities may be primed for a correction unless more clear signs of global and or EM growth rebound materialise sooner rather than later. We have seen some early signs of leading indicators such as Fidelity Forward Leading indicator of Organisation for Economic Cooperation and Development (OECD) industrial output as well as Central bank rate cuts and China Credit Creation all suggesting that we could anticipate Global manufacturing activity and downward trajectory in global economic growth to trough in Q1 2020 and start lifting from mid-2020. JP Morgan Emerging Market team is projecting widening growth differentials of EM to DM in the coming quarters which is expected to help support flows into EM assets. If Moody’s delays its decision to pronounce on SA sovereign outlook next week (1 November 2019 scheduled date) or decide not to downgrade its ratings outlook from stable to negative, we expect SA bonds and rand to benefit from such an outcome. We have a bias to fade any sell-offs into any negative market reaction as a result of MTBPS disappointment or Moody’s action.

Eskom’s announcement ahead of the mid-term budget will be key to the ratings outcome. On this front we are awaiting the Eskom White Paper which has been promised to be released before end of October 2019. Clarity is required, but as we read things from a recent Citibank report, the current consensus amongst many surveyed real money bond investors is that a direct transfer of Eskom local debt onto government’s balance sheet should be expected, with a second possibility of a potential debt-equity swap.

Given that Moody’s will need to review the Eskom White Paper, Economic Policy Paper and MTBPS at month-end, our expectation is that the agency may either skip its review or move to negative outlook. Timing is key if they choose to skip which may lead to a postponement of its review to Q1 2020 (as it has done twice before) or out by a few days. Timing comes down to fiscal effort in the MTBPS. We assess that investors are very wary of MBTPS where projected fiscal deficit is expected to widen due to tax shortfalls and bailouts for Eskom. The SAGB yields are now the highest in emerging markets after junk-rated Lebanon, Turkey and Nigeria and we believe current yields are high enough to compensate investors for those risks.

We are looking for MTBPS to show a commitment towards fiscal consolidation. The country needs non-interest spending cuts of more than 2% of GDP to stabilise debt metrics today. Alternatively, a 0.5% reduction in spending with a solid macroeconomic plan would also likely be sufficient together with credible debt restructuring plan and business reform at Eskom could keep our Baa3 investment grade rating with Moody’s intact.

The National Treasury has asked government departments to propose how to reduce expenditure in a way that has the least impact on service delivery. It sought cuts of 5% for 2020 - 2021, and 6% and 7% for the next two years. That could be as much as $300 billion rand over three years. Failure to narrow the budget gap could raise debt, including guarantees to Eskom, to more than 70% of GDP in the medium term, said Moody’s. Fitch has issued a more disconcerting outlook in July when it said it sees state debt increasing to 68% of GDP by 2021 - 2022 from 56% now.

As the debt/GDP ratio increases, questions will remain and grow over the long-term sustainability of the country’s debt position. Also the differential between the country’s cost of borrowing (in real rate terms) versus the country’s real GDP growth rate is now contributing significantly to the deteriorating fiscal outlook. Hence in our view, the Finance Minister will need to communicate and deploy a far more stringent expenditure control to stabilise and improve the public debt dynamics.