As the second quarter of 2020 closed, global policymakers still found themselves in the throes of dealing with high or rising infection rates in many regions - facing a challenging task of gradual reopening of their economies in a post-lockdown paradigm. Governments have opted for fiscal support, running war-like deficits while most central banks relaxed banking sector regulations and capital requirements. They have also reduced policy rates sharply and resorted to both newly crafted and unorthodox policy tools to provide the necessary support to their economies. To act as boldly as possible within their mandates. This follows the healthcare and lockdown interventions required since the Coronavirus (COVID-19) emerged as a global pandemic to curb the spread of the virus. The implications of dealing with the pandemic come with severe economic repercussions such as rising unemployment, pressure on corporate profitability, higher bankruptcy filings and larger fiscal deficits (Chart 1).
Similar to the Lehman crisis, the COVID-19 crisis is causing a steep increase in the amount of debt in the financial system.
The need to replace lost income is introducing more debt creation by both the private sector, i.e. households and non-financial corporations, but also by the government sector, which, via stimulus programmes, aims at smoothing private sector's income disruption.
Chart 1 – Large fiscal response to COVID-19
Source: IMF Fiscal Monitor, J.P. Morgan Asset Management. Fiscal measures are estimates from the IMF’s Monitor Database from June 2020 Guide to the Markets – U.S. Data are as of June 30, 2020
According to the International Monetary Fund (IMF), the global fiscal support in response to the crisis stands at around
$9 trillion or 12% of global gross domestic product (GDP) ($76 trillion at end-2019 exchange rates), half of which is via direct budget support and the other half in the form of additional public sector loans and equity injections, guarantees, and other quasi-fiscal operations. This implies that, at a global level, after also factoring in a decline in GDP by 5% this year, the government debt-to-GDP ratio would increase from around 88% at the end of 2019 to 105% by the end of this year. Private sector indebtedness is also seeing a sharp increase. When looking at all economic agents, the IMF sees $16 trillion of additional debt in 2020 raising the total debt in the world, private and government debt, to a new record high $200 trillion. Factoring in the GDP decline, total debt-to-GDP for the world as a whole increases by around 35%, from 243% at the end of 2019 to 278% by the end of this year. This 35% of GDP increase in global indebtedness is even bigger than the 20% of GDP increase seen in the year after the Lehman crisis.
We see three main implications from the big increase in global indebtedness. First, the private sector would likely be inclined to save more in the future, sustaining the persistently high savings rates seen in the decade after the Lehman crisis. In turn, persistently high private sector savings rates would keep economic growth and inflation low and make it even more difficult for debt levels to decline versus incomes in the future.
Second, very accommodative central bank policy policies and low interest rates are likely to continue for a very long time to make it possible for both the government sector and the private sector to sustain their much higher debt levels. Indeed, the last few years there has been an inverse relationship between debt levels and interest rates.
The third implication is more liquidity. More credit and more monetary stimulus in the form of quantitative easing (QE), both imply more liquidity, i.e. extra money supply and cash balances, which in turn would result in more asset reflation. If current policies endure with large developed markets (DM) central banks leading the charge, backed by fiscal support and continuing boost to liquidity, we anticipate that this would ultimately lead to a trickle-down effect from risky assets such as DM equities, DM investment grade (IG) and high yield (HY) asset markets that are enjoying direct and indirect policy support towards portfolio flows into emerging markets (EM) debt and EM equity markets.
On this score South Africa (SA) still enjoys membership in EM bond benchmarks, such as JPMorgan Government Bond Index-Emerging Markets (JPM GBI-EM), despite having lost its coveted membership in World Government Bond Index (WGBI) in April this year. After initial outflows during the market mayhem in March and pending WGBI exclusion, SA has seen persistent large selling pressure abate from its bond market and liquidity and market functioning restored. Subsequently, portfolio flows have been mixed. South Africa has a much larger financing need now post the Special Adjustment Budget tabled on June 24, so international financial institutions (World Bank, IMF, New Development Bank) will play a key role in helping fund the higher borrowing requirement. South Africa will need to illustrate that it has the ability to steady its fiscal balances in order to continue to compete for EM flows. Since late quarter one of 2020, SA Government bond issuance has been largely absorbed by local banks and savings institutions.
National Treasury acknowledges that local savings cannot be relied upon as the only source of funding given increased auction supply announced post June 24 budget. South African Government Bonds (SAGBs) weekly auction size was increased in conjunction with Inflation linked bonds (ILBs) by a collective R1.1 billion per week. In order to attract enough foreign portfolio to fund the deficit at lower borrowing costs, SA policymakers will need to ensure they are able to illustrate a clear an evidence-based approach that they are able to deliver on its ambitious fiscal consolidation measures tabled.
The latter part of quarter one of 2020 and the early part of quarter two were characterised by risk deleveraging leading to major market dislocations. Safe havens outperformed as one would expect but also with extreme associated volatility. Unprecedented policy support taken by the Fed to cut rates aggressively to near zero, liquify markets through increased repo market intervention, re-engaging in UST, Agency MBS asset purchases and a plethora of special lending programmes together with over $3 trillion in Fiscal stimulus from Washington lawmakers were successful in providing a backstop to the financial market mauling.
Chart 2 – Equity correlation (measured by level of S&P 500 (SPX) and growth in large DM central bank balance sheets expansion since peak of the COVID-19 market correction in mid-March when latest episode of aggressive central bank policy intervention commenced. Central bank balance sheet growth advancement correlates with higher equity prices, lower credit spreads, falling equity market and other asset class implied volatility plus cheaper option skew. CITI expected path of central bank balance sheet growth suggests SPX between 3500-3700 by end quarter four 2020.
These bold actions taken have sown the seeds of a recovery leg in asset markets to build a bridge to bolster capital that will hopefully help engineer a similar pickup in the real economy. Perhaps the largest policy surprise came when the Fed crossed red lines, as Fed Chair admitted it in a recent statement to Senators, by intervening directly in the United States (US) credit markets buying IG debt and certain fallen angels directly and via credit Exchange Traded Funds (ETFs). Credit purchases have been actioned with the help of BlackRock by an exclusive arrangement with the Fed, using special purpose vehicles (SPVs) falling under the US Treasury. As a result of such policy support, a sharp relief rally followed with asset markets enjoying direct central bank intervention retracing losses faster and these moves gained further traction throughout quarter two.
As we transition into the US summer, the concern for markets is increasingly turning to the risk of a lingering second wave of resurgence of the spread of the virus and apprehension over the scope for extension of stimulus from fiscal support programmes such as Paycheck Protection Program (PPP) and current unemployment benefit checks running out by August. Certain US states such as California and Florida are registering new highs in positive infection cases which hamper a synchronised re-opening of the US economy to achieve full escape velocity and can heighten market fragility especially if the central bank balance sheet expansion plateaus. Looking longer-term investors have valid concerns regarding the continuous need for life support from central banks to keep markets buoyant.
We have seen sufficient evidence that supports the view that strong causal linkages exist between the pace of G4 central bank expansion and asset class returns. Most notably price levels and performance of equity indices such as S&P500 Index correlate particularly well with central bank balance sheet growth (Chart 2). On this score we do not foresee the Fed stepping back or altering the pace of its asset purchases and liquidity provision until at least the September Federal Open Market Committee (FOMC) meeting.
The evolution of and the rate of change of the Fed balance sheet together with the run-up to and outcome of the US November Presidential elections will play a vital role in the investment landscape in the coming months. Using Citibank projection for the quantum of G4 central bank expansion that commenced from the market turmoil in March until the end of this year signals that S&P500 is likely to rise to between 3500 and 3700 using historic correlations.
Markets have entered a new regime where there are more fluctuations between phases of market wariness over a second wave of the COVID-19 infections that are sometimes flipping to optimism from a loosening of local lockdown restrictions and improving activity data and upside momentum in economic surprise indicators. Periodically markets have also enjoyed spurts of bullishness from headlines suggesting progress in the development or testing of vaccines against COVID-19. All of these factors, however, have been of secondary importance given the potency of monetary policy and adoption of loose fiscal policies across the globe.
Most developed world equity markets are trading on demanding valuations when considering the underlying earnings picture and economic outlook. However, at the moment markets are flooded with liquidity stemming from aggressive central bank balance sheet expansion which is set to continue with no terminal date communicated by the Fed to slow down or stop its balance sheet expansion. The European Central Bank (ECB) has recently announced a larger Pandemic Emergency Purchase Programme that will reinvest maturing bonds and continue to buy European sovereign bonds through rest of this year and 2021. Many strategists currently expect a phase of USD weakness to set in as a result of Fed money expansion, large twin deficits and lower USD interest rate differentials with Rest of World. There are also growing consensus that central bank and fiscal policies are delivering a reflationary environment in which the rest of world growth will catch-up and outpace that of the US that tends to be a negative for the USD.
We remain cautious on this view due to the view that the ECB balance sheet expansion will likely overrun that of the US from quarter three onwards and into 2021 (Chart 3). Moreover, a fiscal union in Europe is far from assured and Italy’s budget shortfalls are likely to rear its ugly head again post the summer. This makes the window of USD weakness small and likely more temporary in duration. The USD has also showed a strong correlation to the presidential popularity of Donald Trump. Under the assumption that the political race for the White House will be a closer race than polls currently predict we can anticipate that we may see renewed USD strength in the lead-up to the November elections (Chart 4).
Chart 3 – Delta of ECB balance sheet growth have started to dominate balance sheet expansion of BoE, Fed and BoJ
For now, the buying power provided by central bank support is continuing to propel markets higher and remains the dominant force where liquidity trumps all other fundamental drivers.
The Fed – From Doves and Hawks to Peregrines
"The quality of decision is like the well-timed swoop of a falcon which enables it to strike and destroy its victim." - Sun Tzu
Peregrines are the fastest bird on the planet. Not to mention, they prey on other birds. We think that is a more suitable description of the fostering sentiment that has prevailed within the Fed since the arrival of COVID-19 spread to the West and the raging internal debate on how to best set policy within this uncertain setting. Enter 2020, doves and hawks are now on the verge of extinction.
If a "dovish" Fed is one that is leaning toward accommodation and a "hawkish" Fed one that is leaning toward tightening, a "peregrine" Fed is one that simply dive bombs toward liquidity and accommodation and embraces broadening its existing toolkit, reaching to deploy even more stimulus measures. Fully prepared to cross the Rubicon to act as powerfully and swiftly as possible. It leaves the others behind as policy implementation has to speed up to keep up with policy decision-making efforts. The Fed becoming a Peregrine is a new paradigm of sorts. To be clear, a dovish Fed is being accommodative. A Peregrine Fed is both aggressive and proactive. There is no denial that the speed at which the Fed acted to adjust policy once it became apparent that COVID-19 poses a threat of economic shutdowns, causing global economic disruptions vastly outpaced policy action and implementation of the Bernanke Fed during the 2008/2009 Global Financial Crisis (GFC) period.
Chart 4 – Trump popularity polling has lead US Dollar Index performance (DXY) since 2016
Source: Macrobond, Nordea Markets
The Fed July FOMC meeting outcome was yet another stake in the ground befitting of this description. Its updated DOT-plot shows it dive bombed to zero percent rates for at least a couple years, reinforcing the market expectations for a zero interest rate policy (ZIRP) setting far beyond 2020 and 2021. Importantly, the Fed did not "cry wolf". It held up its end of the bargain to signal low rates should not be bet against using calendar-based guidance for rates to remain near zero until at least the end of 2022.
Besides Chair Powell specifically not taking Yield Curve Control/Yield Cap Targets (YCC/YCT) off the table as a tool, there were a couple of other comments worth noting. Instead of talking about the headline unemployment rate, Powell called out the "U-6" measure of unemployment. Why does that matter? A couple of reasons. Primarily, it is a very broad measure for unemployment that includes people who want full-time but only have part-time work and hence a far broader measure of unemployment. That is the measure of unemployment Powell was steering people to look at for understanding the Fed's policy decisions moving forward – rather than the headline. Should U-6 be the "new" unemployment metric for the Fed, that means "capped lower for longer" should have been "capped much lower, for much longer."
The Fed statement and Powell did not explicitly state that YCC was coming - but it did lay the groundwork. That should not be underestimated. Certainly, YCC is not imminent, but it remains a policy option on the table.
The Fed is now a Peregrine. It will dive bomb issues it sees. If the Fed decides to move with force, it is likely to go with YCC. That may already be in the works given the ongoing debate within the Fed and mention of its study of the effects of YCC that was recently adopted by Reserve Bank of Australia. Fed policy is not going to be tied to prior accustomed metrics. U-6 unemployment is an indication and markets would be expecting some tweaks to current Fed policy later this year once the Fed has concluded all the public comments submitted during the 2019 ‘Fed Listens’ events held across the US. Another overhaul of Fed policy is likely to include the adoption of new measure of inflation using an averaging-based approach. This may allow the Fed to run inflation a little hotter than in the past allowing for overshoots of its near 2% inflation target.
Powell has downplayed any Fed concerns about risks of blowing potential asset bubbles. The Fed is "focused on the real economy goals" and not overly worried about asset bubbles or injecting too much liquidity and has communicated its priorities is addressing the need for dealing with the crisis first before worrying about withdrawal of stimulus and reducing the size of its balance sheet at a later point in the cycle.
The prolonged Peregrine Fed is watching out below for anything interfering with the recovery. And it is willing to dive bomb any of them it regards as a threat to the recovery. Instead of losing its credibility, the Fed is wielding its power over markets with vigour.
The release of the June minutes reported that the FOMC discussed forward guidance, asset purchases, and yield caps or targets (YCT) extensively, with the intention of providing greater clarity “in coming months.” Many participants thought the completion of the framework review would help to clarify the Committee’s policy intentions. Participants supported outcome-based forward guidance and agreed that asset purchases could help promote accommodative conditions. Of the various YCT policy options, participants were most sympathetic to the Australian version, which targets three-year yields, but many were doubtful that YCT would be needed if the forward guidance remained credible. We now expect the FOMC to conclude its framework review at the July meeting and announce changes to its forward guidance and asset purchase programme at the September meeting. We do not currently expect the FOMC to introduce YCT alongside its policy changes in September.
South Africa – The dilemma of prudent monetary policy with ballooning fiscal deficits
It would be amiss of us if this article didn't discuss our views of the Special Adjustment Budget that was delivered on 24 June. One of the big announcements in the budget was that National Treasury has decided to finally draw down on its rainy day funds which are its cash reserves. Most of these sits as sterilisation deposits in both rand and US dollars with the South African Reserve Bank (SARB). We will go from a place where at prior fiscal deficits and issuance pace National Treasury had enough of a cash buffer to allow it to pause on issuing any government paper for up to a year if required. With the planned drawdown ahead, we anticipate this buffer will drop to only about two to three months’ worth of issuance in cash reserves. This will raise the degree of fragility if we were to encounter any scenario where auctions cannot be held in future due to unforeseen emergencies.
The implication of the National Treasury drawing down on these cash balances at the SARB is an important factor as it is likely to create a lot of additional excess reserves in the banking system. This could lead to the interbank funding system, which has been operating at a structural money market deficit that has to be funded at the SARB via weekly repo auctions, to a structural money market surplus where the SARB has to take action to drain surplus liquidity from the banking sector. Hence the SARB will have to switch from providing liquidity to the banks and earning interest on this activity, to mopping up surplus liquidity and having to operate with a floor system where they bid for funds from the banks. This is likely to have an additional cost to the SARB with some estimating that it could run at a cost of near R3 billon per year which if estimated correctly would wipe the banks margin of profitability. Moreover, such a new regime would have a lot of impact on the dynamics of the front end of the yield curve such as Treasury Bills (T-Bills), Foreign Exchange (FX) Swaps and interbank rates. The management of these new developments will need to be carefully monitored. The SARB may opt to increase reserve requirements to the banks (currently at 2.5%) but would probably need to at least double this to mop up all the liquidity that is likely to be created.
We also know National Treasury would prefer to lower the high asset swap (ASW) rates at which it has to raise funding with TB’s ASW near 70 basis points and nominal bonds near 250 basis points. Since banks have played a key role to absorb the burden of additional government issuance with foreigners being less active, the SARB may opt to leave some higher degree of excess reserve in the system than has been the recent norm. This surplus liquidity becoming structural would need to be very finely managed as the new regime will also exert downward pressure in FX implied yields which could lead to an aggressive weakening in the currency due to erosion of carry appeal. A similar case study was found in Russia in 2015/2016 when a similar interbank regime shift happened leading to lower front end rates and a bias for Russian Rouble (RUB) depreciation. We therefore like doing tactical hedges on swap receiver plays or front-end plays. We also maintain our bias for fixed rather than floating rate exposure where possible due to a view that front end rates on the curve is likely to continue to see downward pressure due to these floor system developments and lower inflation outcomes that could lead to repo rates being cut further by the SARB. For multi-asset portfolios we advise having an active tilt toward FX-sensitive assets that would benefit from ZAR weakness on a three-month view entering in the USDZAR 16:50-17.00 area. We expect levels north of 18 more likely to be reclaimed during quarter four of 2020.
The Special Adjustment Budget clarified the state of public finances in the current 2020/21 fiscal year. The budget projected a deficit of 15.7% of GDP in 2020/21 fiscal year, taking public debt above 80% of GDP. From 2021/22 fiscal year the budget outlines consolidation programme driven primarily by aggressive expenditure reduction, targeting a positive primary balance by 2023/24 fiscal year (meaning revenue exceeding non-interest expenditure) with peak debt near 87.4%. Details of how this will be achieved was mostly deferred to Med-Term Budget Policy Statement (MTBPS) in October. While we view the announcement as positive, its political and economic credibility will rest heavily on specific announcements made in October.
The budget outlines two scenarios, namely a passive scenario where status quo is pursued leading to a fiscal crisis by 2024, versus an active scenario which has been endorsed by cabinet. To achieve these goals spending reductions and revenue adjustments amounting to R250 billion over the next two years will need to be achieved of which R230 billion relates to expenditure that will be achieved using a zero-based budgeting procedure. Importantly to note these targeted expenditure reductions are in addition to the R160 billion in wage bill reductions already announced in the February budget. This effectively amounts to a nominal freeze in total expenditure and amounts to almost 5% of GDP.
It will be challenging for SA to credibly project debt stabilisation within the next five to eight years. Crowding out of social spending is becoming an increasing concern with debt service costs estimated to take up 22% of revenue in fiscal year 2021/22, up from 12% in 2015. Estimates indicate a 1.5%-2% of GDP primary surplus is required to stabilise the debt ratio, yet the primary deficit may stand at only 3% in fiscal year 2022 in optimistic scenarios. Even with an optimistic annual fiscal savings of 1% of GDP, debt stabilisation is unlikely before 2026/7 on the current trajectory. Alternative scenarios (infrastructure, Regulation 28, debt monetisation and higher inflation) would likely create a moderately more favourable near-term debt profile and a worse longer-term outlook with debt ratios rising beyond 100% eventually if markets allow it.
In light of National Treasury's “passive scenario” showing unsustainable debt, there has been questions on SAGB relative value in a run-up to possible default. In a 'standard' sovereign restructuring, typically involving large principal haircuts, one would prefer to be in longer duration, lower priced bonds. In SA's case, any potential restructuring could be quite different from the standard. This is the case since SA's problem is large interest payment burdens. Hence in SA a coupon haircut may be a part of any restructuring, perhaps to be combined with principal haircuts for shorter dated bonds to ease near term repayment risks. Interestingly, this outcome would favour longer dated bonds. While there are many other scenarios that could alter bonds RV, in principle low coupon or low dollar price bonds should trade a bit “rich” in a run-up to a possible default for better properties in a restructuring. The fragility of SA fiscal position that has been amplified and exposed by the COVID-19 crisis has also led to the discussion around fiscal dominance in South Africa.
The budget states rather plainly that without significant and urgent policy action, the economy is too weak and the stock of debt is too high for GDP growth and revenue to recover enough to stabilise the debt-to-GDP trajectory. Stabilising the trajectory, i.e. National Treasury’s active scenario, (Chart 5) requires reduced spending, higher growth and state owned enterprise (SOE) reforms to reduce their reliance on public funds. Our base case projection for debt-to-GDP is that it follows their passive path, rising to 81.4% this year, 88% in fiscal year 2021/22 and 94% in fiscal year 2022/23. Under this scenario, bond yields become increasingly unsustainable, with the generic 10-year rising to 12% according to RMB’s outputs of fair value analysis approach implementing an IMF valuation model for EM debt in times of crisis (Chart 6). The fair values for end 2020 and end 2021 depict the urgency at which fiscal reforms and active scenario needs to be implemented to avert borrowing costs rising to unaffordable levels, which if realised would start crowding out non-interest Government expenditure as debt service costs is projected to reach 31% of gross government revenue by 2025 and 40% by end of decade. As things stand debt service costs already exceeds healthcare spending in 2021 and could exceed basic education spending by 2022.
Chart 5 – Debt/GDP scenarios presented in June Special Adjustment Budget
Source: National Treasury
Fiscal dominance occurs when the fiscal authority is so profligate that a conscientious monetary authority is forced to accommodate the profligacy—that is, the monetary authority prints gobs of money to fund endless deficits. The SARB Governor recently delivered a key speech on this topic making very clear the risks and arguments for SARB limits in terms of size of its asset purchases and we do not see this as a risk for South Africa in the near to medium term. However, if fiscal levers are not exercised to avoid heading towards a potential sovereign debt crisis by middle of this decade, undesirable policy options will increasingly be turned to meaning this scenario cannot be ruled out entirely.
Chart 6 – SAGBs ZAR Yield Curve – current and future fair values using IMF EM debt valuation model approach
Source: RMB Global Markets
Higher auction supply, inflation linked markets may turn interesting in the weeks ahead
The budget also contained a number of adjustments to the financing strategy in the current fiscal year. A total of R776 billion in financing is required which is up by R344 billion since February. Domestic bond issuance is set to rise to R462.5 billion with a temporary focus on shorter dated issuance (reducing the weighted average maturity from 15 years to seven years). Treasury will also increase TB issuance from ZAR 48bn planned in Feb to ZAR 148bn which is a prudent strategy given ample TB demand to absorb increased TB supply and lower funding costs in TBs versus ILBs or SAGBs.
National treasury announced an increase in weekly government bond auctions (SAGBs form R6.1 billion to R6.6 billion) and surprised by also increasing inflation linked auctions by R600 million (from R1.4 billion to R2 billion per week) on Friday the 26 June. This announcement served to stall the positive momentum of a bull flattener relief rally post the Special Adjustment Budget and both the linker and nominal bond yield curves have subsequently steepened.
The market struggled to absorb R6.1 billion and another increment step-up of R500 billion within the space of two months did cause an adverse market reaction as was to be expected but very few were expecting National Treasury to increase weekly auction sizes so close to its prior announcement.
To be clear, in order for bonds to meaningfully rally, you need to see buyers to the tune of around R13.2 billion a week which may prove challenging for the market to absorb, especially if meaningful support is lacking from foreign buyers. To put that in context, National Treasury is selling approximately $750 million of local currency debt each week in the primary market, which is only a smidge less than the entire net foreign inflows seen in January/February period when the market was in the midst of a more constructive risk on backdrop for both SAGBs and EM local currency debt. Until these foreign flows shift again into more favourable direction, indigestion will continue to be a story which will pose a headwind for yields to move back to its best levels we saw in early June (Chart 7).
The latest SAGB holdings data published on the Treasury website shows a further decline in non-resident ownership to 30.6% in June from 31.5% in May with holdings declining by R8.2 billion. Over the first six months of the year, non-resident holdings have dropped by R86.6 billion ($5.2 billion) from close to 37.3% ownership near the start of the year.
The main net buyers during the month were once again banks (including the SARB) with holdings rising by R45.6 billion and taking their share of overall bond ownership to 22.1% in June from 20.6% a month earlier and well below 20% in quarter four of 2019. Banks have bought a net R158.8 billion since the start of the year. The natural concern for the issuer and market participants are that there is likely to be a natural ceiling where local institutions will be disinclined to further accumulate SAGBs. While we have not reached these levels by any means this need to be considered and once it is reached it will be crucial to be able to have new supply also absorbed by foreign investors. Using the SARBs Institutional sector classification codes: Monetary authorities (Banks, SARB and its subsidiary) owned 22.90% of nominal bonds at the end of June versus 21.47% at the end of May. Insures, Pension Funds, CISs holdings decreased to 40.52% at the end of June versus 40.78% at the end of May.
Chart 7 – Cumulative non-resident flows into EM local bonds over the past three months
Source: JP Morgan
Looking at the real yield curve bear steepening following the first higher duration auction we see that I2029s have risen from 4.24 (pre-increase announcement) to 4.31 (post auction). I2038s have moved from 4.55 to 4.76 and I2036 have moved from 4.60 to 4.82 with an under-allocated auction seeing R1.565 billion placed. With markets needing time to adjust to higher issuance, low liquidity and relatively high break-evens along the curve versus current inflation backdrop, we anticipate further bear steepening ahead in the coming weeks on ILBs.
From an investor standpoint, with long-term real exposure, and purely the need to achieve that, it is hard to beat the long duration real yields of a low coupon 30 -real bond. Relative to nominals if you just want outperformance, and no worries about matching future liabilities, then the nominals currently make sense, with the option to switch when you want to if stagflationary conditions warrant it.
Linkers in our view can be a good hedge in a multi-asset portfolio in the medium term if weakness plays out in our currency (e.g. policymakers or market inflates debt burden away to a more manageable level), then the linkers are likely to outperform nominal counterparts, for a) they're protected, and b) their underlying investors are 98% local and hence won't be forced sellers on a debt restructuring event. In absence of fiscal consolidation SA will likely find itself in a true dilemma to have to continue to face debt service costs in excess of 5% real if economic real growth languishes near the zero line. While long end linkers yields look too low when considering breakeven inflation, these real rates look far less demanding when one considers a fixed rate asset swap which is yielding around 10.50% (I2046), which compares more favourably with ultra-long nominal SAGBs trading near 11.5%. We like considering a strategic long in Namibian sovereign linkers trading at 6.8% real yield with Namibian currency pegged to the rand and more favourable sovereign indebtedness.
When purely considering expected inflation over next two years SAGBs look more compelling from real yield perspective versus long end linkers. However, the linker investor base is prepared to pay a small premium (earning lower real yield for now) versus higher perceived real yields of nominals to have long term inflation protection that could stem from currency weakness and owning high duration assets for a potential stagflationary regime in the medium term and are relatively speaking less prone to market price volatility from foreign portfolio flows.
With National Treasury new issuance strategy focused on the 7-year to 10-year part of the curve rather than the 15-year part of the curve, it would favour some flattening of R2035s and longer versus R186 and R2030. Keep in mind that the nominal curve is steep out to the R2030 point so there is more benefit from carry and rolldown perspective to be in the R186 and R2030 part of the curve vis-à-vis the longer bonds.
We remain cautiously optimistic on SAGBs in the near-term seeing opportunities in the recent post-Special Adjustment Budget sell-off, but maintain realist tendencies on ability of Government to improve the fiscal picture and achieve debt sustainability in the medium term. Clearly delineated plans and proof of implementation that illustrate politicians are able to stick to the narrow path is still lacking at this point. We like being overweight the R186 and R2030 part of the curve and extending duration with R2032s and R2035s. For now, we avoid unhedged exposure to ultra long bonds until we see better fiscal dynamics.
On the growth front SA quarter one current account turning to a surplus for the first time since 2003 on the back of fast contracting imports. The important test for SA monetary policy is markets willingness to go along with SARBs balance sheet expansion and secondly the sustainability of closing of the current account deficit. If both fronts remain constructive this would support a lower policy rate regime without any risk of material rand weakness. In addition, if these trends remain in place together with lower outcomes in inflation path it can ultimately lead to lower term premium in SA bond and swap curves. On this score we are more constructive on playing the term premium in the two to three year part of the swap curve where forward rates are more consistent with the rate regime of pre-COVID-19 crisis policy rates in 3 years’ time compared to current record low SA policy rates with repo rate at 3.75% and possibly being reduced further at the Monetary Policy Committee (MPC) meeting later this month.
We like receiving ZAR 3-year/2-year forward near 6.75% which sits roughly 300 basis points above 3m Jibar and the policy rate. This level is same as the 2012/2013 period when policy rates were substantially higher under then Governor Marcus’ SARB. In the absence of financial stability risks and major rand weakness we see SA policy rates remaining lower for longer further supported by the Fed keeping rates floored near the zero lower bound until 2022 at the earliest. The Fed is also likely to pursue conditional forward guidance requiring unemployment rate declining below a certain level and inflation overshoot target above 2% in order to start hiking rates again. This dual conditionality is unlikely to be achieved in the US until 2025 in our view which provides room for term premium to compress as rates are kept at low levels for an extended period.
On 15 July, we expect the next Consumer Price Inflation (CPI) print where we see headline inflation near 2.2%. With SARB a week after where we look for another 25 to 50 basis points rate cut.
Chart 8 – Term premium of ZAR 3y2y forward swap receiver looks too extreme considering 300 basis points spread to current policy rates and with 3m Jibar sitting ~125 basis points lower than 2012/2013 policy trough during Governor Marcus SARB MPC era
Source: Bloomberg, Ashburton Investments
We also believe the term premium in the 12 to 15 years are of the SAGBs curve is elevated and can compress but have higher conviction of monetising this idea in the front end of the swap curve than in the 12 to 15 year part of the bond curve. We prefer long duration positioning in the near term as we expect IMF loan approval, SARB rate cut in July, high coupons flows in July and August together with a pro-risk backdrop to allow for an overweight duration stance to be rewarded. Our double OW established since the crisis peak yield levels seen in late March that was registered just prior to the SARB entering SAGBs secondary market with bond purchases to improve market functioning has served our investors well. We have subsequently trimmed back some of this overweight duration exposure in first part of June.
We however will continue to add portfolio hedges and capitalise on gains during periods of market strength in bonds to turn more defensive as we enter quarter four ahead of MTBPS where we still see risk of disappointment on delivering on government fiscal strategy as high. While news on savings on the wage bill can be a catalyst for positive surprise there is also a risk of political pushback to implement the degree of fiscal expenditure cuts recommended in the coming two years. Moreover, SOE’s like SANRAL and even ACSA that has been one of the best performing profitable SOEs are also finding it necessary to ask for financial support that will need to be added to the SOE provisions.
This scepticism towards achieving fiscal debt stabilisation targets announced in the Special Adjustment Budget is shared by two prominent ratings agencies including Moody’s and Fitch.
From a global macro perspective, a second COVID-19 wave that triggers lockdowns is one of five risks to manage in the second half of 2020. Others include a pullback in activity due to virus anxiety, even if no major state or country re-imposes restrictions on mobility; a mini US fiscal cliff if Congress fails to extend stimulus measures; a step-up in US-China tensions linked to developments in Hong Kong SAR; and a Democratic sweep in November that delivers higher corporate and capital gains taxes. Another potential geopolitical flashpoint could be developing between US and China in Taiwan as US is likely to move ahead with steps to cut off Huawei access to critical chip supply from its largest – Taiwan based supplier TSMC in September. Another important event that would impact on either hampering or boosting market risk-on sentiment centres around whether European Union (EU) leaders can reach political agreement this month on the bloc’s recovery fund. An agreement would be massively risk-on and would argue for more narrowing of peripheral sovereign bond spreads in Europe. Lack of an agreement could redirect spreads immediately wider, depending also on global risk sentiment. Given the correlation between EM and peripheral European spreads the spill over effect of the decision is likely to also be felt within EM debt markets.
These global factors combined with intersection of local political and fiscal risks and potential erosion of implied FX yields associated with drawdown of National Treasury sterilisation deposits at the SARB as mentioned earlier that can undermine ZAR attractiveness as a carry play leading to depreciation are all factors identified by our team that will need to be closely monitored when managing portfolio risks to be able to deliver benchmark-beating returns for our valued retail and institutional investors.