This article was written on 12 June 2021
The combined effects of the powerful cocktail of fiscal and monetary stimulus adopted globally amid the epicentre of the Coronavirus (COVID-19) pandemic fallout in March 2020 is still reverberating through financial markets. The global economy is 14 months into recovery mode while liquidity in the system appears to be exorbitant considering various metrics. For starters, the rate of central bank balance sheet growth (~$350 billion/monthly pace of quantitative easing (QE) by large developed markets (DM) central banks) appears extreme. Secondly, the rapid asset price inflation on display entails nose-bleed valuations versus current and future fundamentals. Lastly, a more recent emerging signal is the all-time record daily United States (US) reverse repo operations (RRP) where banks are using this facility to place excess cash back with the Federal Reserve System (Fed) approaching a breath-taking and almost inconceivable $1 trillion.
The powerful central bank monetary policy easing and fiscal impulses has led to the proclamation and embrace of the reflation narrative as the primary investment thesis for positioning portfolios. This finds its expression in many forms from being long inflation breakeven wideners, engaging in curve steepeners, overweighting commodities and cyclicals and shorting bond duration to name but a few. Reflation is a fiscal and/or monetary policy designed to expand output, stimulate spending, and curb the effects of deflation, which usually occurs after a period of economic uncertainty or a recession. The term may also be used to describe the first phase of economic recovery after a period of contraction. Inflation is what we blame when a dollar buys less today than it did yesterday, which can result in a reduced standard of living or purchasing power. On the other hand, reflation can be good for wages, profits, and risk assets, as demand drives prices and profits higher.
Reflation is generally driven by single period drivers, (usually fiscal and monetary stimulus post-crisis) with finite horizon and decaying impact. According to Goldman Sachs research, the most recent historical reflation peaks in US were in March 2003 and August 2011. Inflation on the other hand is usually driven by sustained multi-period drivers, which can be either fiscal or quasi-fiscal deficits or more often private sector financial cycles, which can create endogenously sustained acceleration loops unless offset by policy tightening.
Reflation can transition into inflation if the fiscal transfer from the public to the private sector is leveraged up by a well-capitalised banking system which is open for business or if supply constraints persist for longer than expected and feed into a wage-price loop. We currently see some elements of the second scenario in the economic data. Hence monitoring wage growth, commodity prices and the credit cycle as the Coronavirus (COVID-19) related fiscal impulse fades into quarter one of 2022 are the metrics that could define a transition from reflation to inflation in the 2023-2025 policy horizon. This would also imply that over the next 12 months inflation may be “transitory” as many anomalies and base effects drop off the dataset but pose a risk further out in the cycle. The more powerful the inflationary forces the greater the need for Fed QE taper to commence, which we see as a 2022 story. Eventually Fed policy tightening can kick-off in 2023 once tapering concludes, to serve as dampener of inflationary forces.
Chart 1 - Global liquidity and growth cycle at a glance
Source: Ashburton Investments
Recent communication underscores that central banks across the globe begin to recognise that the actions taken last year are bearing fruit. Progress is being made to support the recovery due to their aggressive policy choices adopted last year. In certain economies, we have started to see the signs of inflation and sufficient confidence emerging in the durability of the recovery. Certain central banks are signalling that they are ready to start removing some of their current accommodation. Examples include the Bank of Canada that has commenced tapering some of their QE. Also, the Hungarian central bank became the first country in European Union (EU) region to hike rates due to inflationary forces pushing headline inflation to levels outside their inflation target band. In recent weeks we have seen certain Fed officials, such as Kaplan, breaking ranks to suggest that the time has come to start debating if it is appropriate to embark on tapering of the Fed’s current rate of monthly QE. Fed QE runs at the tune of $120 billion per month (before accounting for coupons and reinvestments that results in a significantly larger number). In early June, the Fed made the unexpected announcement that it has decided to start unwinding some of its emergency credit facility purchases of credit Exchange Traded Funds (ETFs) and other credit securities purchased during the height of the 2020 market fallout. Albeit a tiny fraction of the Fed balance sheet (a mere $13 billion of $7.9 trillion), it nevertheless signals clearly that we are now in the nascency of Fed’s accommodation reduction and have officially passed peak Fed stimulus.
As investors, we recognise that while we see markets behaving consistent with the reflation narrative, we argue that the recent data and asset price behaviour suggests to us that we are in the process of transitioning fully into a Goldilocks environment (see Chart 1). Characteristics of Goldilocks include the economy strengthening, inflation rising towards the central bank targets, amid ultra-easy financial conditions that prevail. United States bond yields have risen from near 0.5% in the summer of 2020 to 1.60% currently. Credit spreads have tightened to record lows. During this phase of the cycle we expect to see a transitioning to the point where central banks indicate that they are ready to commence tightening of monetary policy again. We also anticipate that the Fed will transition their language to pave the way for a formal policy pivot in the second half of 2021. Among the major developed world central banks, the Bank of England (BoE) and Fed is expected to lead this hawkish policy pivot.
We believe that the market is still in the early phase of Goldilocks which is likely to last a few quarters but remain sensitive to policy choices and policy guidance. The risk to this view is inflation overshooting and make a more permanent step-change resulting in a Fed policy error. We do, however, expect that in quarter three and quarter four of 2021 we will remain in the Goldilocks phase of the investment thesis. We do expect to see bouts of volatility and bumpiness as markets digest the communication and actions from the Fed and other central banks. We view such bouts as opportunities to re-enter or add to local bond market bullish tactical rate positioning (ahead of Fed taper). Central banks will be committed to pull off the delicate task to guide markets and commence to remove some accommodation without triggering a violent market tantrum that occurred during the 2013 cycle. The challenge is to tighten financial conditions gradually but not to the extent that it results in asset price collapse that causes a negative wealth effect and/or economic growth peaking as fiscal and monetary stimulus recedes. Hence they will aim to keep supporting the business cycle without allowing runaway inflation that risks them having to frontload tightening to prevent overheating. (Chart 2)
In terms of policy response, we think that Flexible Average Inflation Targeting (FAIT) helps central banks avoid premature tightening related to reflation that can amplify cyclical volatility. However, it doesn’t change the reaction function in respect to inflation. It risks acting more rapidly if inflation overshoots in the medium term, together with overshoot of full unemployment goal since they won’t be hiking until the economy reaches full employment by Fed’s standards. This also leads us to have conviction that the terminal policy rate for the Fed might be above 2.5% currently indicated in their dot plot. As a result, fixed income hedges against risky asset portfolio longs and emerging market (EM) exposures for us looks compelling to sell EDZ4 or EDZ5 (December 24 and December 25 Eurodollar futures) which we consider attractive portfolio additions as the market is pricing closer to 2%, less than the Fed’s terminal rate.
United States economic data momentum is enough to keep the Fed on-track to ramp up the tapering discussion with signs of some dissention emerging within the Fed. But the latest labour data for the US was not a blow-out hiring number that could have driven consensus around a more rapid progression toward taper, which is consistent with our view for taper communication to happen in late summer at the Jackson Hole Symposium.
Chart 2 - JSE All Bond index performance displays high correlation to Bloomberg Barclays Local Currency Bond TR index and GS US Financial Conditions.
In the current phase of the cycle with rapid economic recovery, coupled with bottlenecks in certain supply chains against a backdrop of easy policy, a weak USD has all benefitted commodities. A strong cycle of commodity price gains occurred over the past 12 months. Price gains in the commodity sector has accelerated in the past few months which has benefitted the commodity sensitive EM and DM exporters.
This trend has been accentuated by some stockpiling in China and more structural forces associated with many years of under investment and low capex across a wide range of commodities has also resulted in constraining the supply side.
These factors will likely continue to support commodity prices in the months ahead. We do expect to see new order activity slow down and China credit impulse rolling over which is expected to slow the price gains in commodities and likely result in an early cycle pullback in commodity prices (Chart 3).
We expect this to only start becoming more evident in quarter three and quarter four of 2021. Recent warnings and steps taken by Chinese authorities to encourage heads of commodity companies in China such as steel mills to curtail purchases at current price levels, discourage stockpiling behaviour and price speculation, and raise exchange margin requirements are all signs that investors may need to be more conservative and cautious regarding the medium term commodity outlook. We remain constructive on commodity price cycle but would be cautious of a positioning unwind and market psyche readjustment of overexuberance following the recent strong price gains with probability of a price correction increasing in our view in second half of June and beyond. The recent sharp non-commercial speculative positioning in LME Copper can be a posterchild for this playing out more broadly in various commodities.
Chart 3 – China credit impulse momentum has shifted suggesting second half of 2021 may temper commodity price gains
Source: Ashburton Investments, Bloomberg
The direction and vibrancy of demand in commodity prices and commodity markets are of particular importance for South Africa (SA). Recent price gains have been a huge boon for SA Terms of Trade (ToT) resulting in improvement. The durability of this improvement could result in the present state of SA current account surplus that has developed after more than a decade (from previously a structural deficit) persisting for longer (beyond 2022). This could result in rand price appreciation becoming more entrenched. The emerging market foreign currencies (EMFX) narrative has shifted from ZAR being an underperformer in the EM universe in 2020 to consensus now seeing it make further headway as rand benefits from the commodity cycle, high carry and portfolio inflows into EM. In addition, we now observe a structural glut of USD in the local banking system that has been sterilised using FX swaps as a result of IMF, RFI and BRICS bank loans amounting to $5.3 billion which pushed one year rand basis up over 1.2% above the repo policy rate – Chart 4B.
While being cognisant of the above commodity risks and the potential instability that (Chart 2) a Fed QE tapering announcement could have on EM assets such as local currency bonds (when tapering results in tightening of financial conditions), we remain constructive on the SA investment outlook for fixed income investors for the remainder of quarter two and into early quarter three. We anticipate scope exists to deliver above cash returns in local SA Government Bonds (SAGBs) (measured in rand) for local investors. Our current best assessment is that the Fed will delay debating the need to embark on tapering with urgency and only see the debate intensifying around Jackson Hole Symposium that will be held in late August. The lower fragility on EM external balances across many EMs including SA that used to be a factor during the 2013 taper tantrum is no longer applicable and the Fed intends telegraphing their tapering plans extensively to prepare the market for this policy move.
The June and July inflation, manufacturing and services activity reading, wage and employment data trends will be vital to shape the timing of when the Fed debate. Strong data could start either bringing it forward to the upcoming Federal Open Market Committee (FOMC) meeting in July or postpone it to late summer or even as late as the fall post-US Labour Day. The current forecasts for the pace of improvement in US employment against the backdrop of continuing US economic expansion and the approval of a new US infrastructure programme being passed later this year can help be accretive to US growth in 2022 and beyond. This should give the Fed the green light to reduce its monthly QE size from $120 billion per month by roughly $15 billion increments starting 31 January 2022 and end tapering by January 2023 (pic.twitter.com/KfscXQsDz2). The speed towards meeting these objectives in US personal consumption expenditures (PCE) inflation above 2% and move toward full employment will inform the timing of the announcement and actual implementation of Fed tapering. We expect an announcement in quarter four of 2021 followed by tapering in early 2022.
The Bloomberg Commodity Spot Index is up 12% since start of the second quarter. The drivers for the surge remain solid. Broad global demand is being fed by the recovery from the pandemic, with a dash of extra spice due to moves to re-engineer toward a greener future. Supply remains tight thanks to virus-era disruptions and years of under-investment. For now, we see few signs that China’s latest efforts to cool down price speculation of raw materials will derail the positive story for commodities and we view it more likely to have a dampening effect rather than cause a shift in trend without additional forces playing a role to alter the current fundamental backdrop. We would, however, be surprised to see a complete break of the historic relationship with a Chinese credit impulse (Chart 3) that is fading which for us provides a guide that commodity price strength will start to recede in the second half of 2021.
Chart 4A – USDZAR has deviated in the short term from its Terms of Trade (ToT) which suggest to us it is more of a positioning and momentum driven trade currently suggesting ZAR overvaluation of 3% (14.01 vs 13.56). We see USDZAR technical supports at 13.23, 13.06 with possibility of overshoot to 12.71 area if current account surplus conditions prove stickier for longer. We consider levels below 13.30 as demanding from fundamental standpoint (Chart 5) and see the currency returning into the 13.84-14.42 zone in quarter three as market focus shifts from the pro-cyclical commodities trade toward gradual reduction of monthly QE liquidity additions as Fed moves closer to commencing QE tapering.
Source: Ashburton Investments, Bloomberg
The matrix below (Chart 5) summarises three separate scenarios as inputs to an econometric model. It shows three fair value outcomes for USDZAR based on which scenario one believes is the most likely outcome given one’s outlook for the commodity cycle that impacts on the SA Terms of Trade and the degree to which higher revenues will budget deficit assumptions.
It is a multi-variate regression model and other fundamentals in this regression model, includes inflation, growth, interest rates and unit labour cost differentials between SA and US. When keeping these variables static and shifting various scenarios term of trade and budget deficit outcomes yielded a USDZAR fair value of 13.30 under the most optimistic scenario. Since we assign low probability of that scenario being realised, we consider any further ZAR appreciation to sub 13.30 as levels that should be faded or levels where currency hedges should be initiated over a 6-12-month timeframe. All factors considered suggests to us that USDZAR is stretched near current levels unless one extrapolates the current supportive commodity prices for the remainder of the fiscal year. Slow vaccine rollout, new virus strains and risks of tighter curbs taken in the domestic economy could add to ZAR depreciation risks.
Chart 4B – USDZAR one-year basis swap (in basis points) and USDZAR
Source: Ashburton Investments
South African rand one-year basis swap (a proxy for rand carry measured as pickup over the policy rate which is repo rate at 3.5%) has also declined below 100 basis points from a peak of 120 basis points to near 93 basis points. The short-term correlation since the eye of the COVID-19 market storm in March 2020 of this metric and $/rand suggests USDZAR should trade north of 14. Also, of note is that South African Reserve Bank (SARB) Deputy Governor Fundi Tshazibana warned of SA increased reliance on imported refined petroleum product which has increased with two local refineries currently offline. This makes SA ToT more vulnerable for deterioration should we encounter oil price and/or refinery margin shocks as we see continued energy demand pickup or US hurricane season disruptions.
In terms of the broad dollar, we think as we move into the second half of 2021 there is risk that the US inflation breakeven starts to roll over. Commodity price pull back and higher US real yields can help support the USD. Positioning shows well subscribed view that most real money managers already positioned short USD and asset manager client conversations reflect that. In US real rate, we see asymmetry now as it skews in favour of higher real rates rather than lower real rates. Let’s assume US month-on-month inflation comes in higher than expected it may lead to higher US real rates even if breakeven rates rise as the market will expect earlier end to Fed accommodation due to higher inflation. In the case of a Consumer Price Index (CPI) downside surprise in coming months we see TIPS positioning heavily skewed towards long exposure that can unwind and send yields higher especially since we have likely surpassed the point of peak Fed dovishness.
Chart 5 – USDZAR forecasts from econometric regression model based on terms of trade and budget deficit assumptions
Source: Standard Bank Research
In early May we positioned for a relative trade (ideally using total return swap (TRS) referencing ALBI total return) versus IGOV total return indices to express a preference for linkers to outperform nominals. Since this positioning on 9 May, we have seen IGOV Index outperform ALBI over 200 basis points over a three week period. This thesis is based on the cyclical bottom in CPI headline inflation that troughed at a two handle several months ago resulting in a cyclical upturn that are largely base effect driven. Based on coupon cashflows of some of the larger linker bonds over the coming month and inflation carry unlikely to fade until August due to the three-month inflation lag we maintain our view over the linker outperformance in June.
We have taken profit of half the position and look to run the balance into quarter two quarter end. This month we will see around 5.5 billion of coupons being paid on R197, R202 and I2050 that represent around 40% of the SA linker market. These coupons are typically reinvested ad equivalent of meeting around five auctions worth of fresh linker supply which will provide a bullish and supportive underdone for linkers in our view.
The boost to South Africa’s ToT this year has been underappreciated on conventional measures, with considerable implications for narrowing the budget deficit and boosting economic growth via net trade and boosting the current account surplus. While not a long-term game changer given still-formidable fiscal challenges, we think the lift from ToT puts a pause on fiscal deterioration until 2022, buying precious time and patience from offshore investors as SA investment story improves vis-a-vis our EM peers.
On macro forecasts gross domestic product (GDP) growth could be revised up from over 4% to closer to 5% in 2021 as market consensus shifts. The fiscal year 2021/22 fiscal deficit can improve from -8.7% to -7.4% with scope for an even better -7% (in the case of fiscal discipline and commodity prices maintain gains) and the current account balance to a 2.2% surplus this year. On the SARB outlook is not substantively changed amid several offsetting factors on growth, inflation and financial risks, but on the margin the SARB is likely to respond counter-cyclically to the boost in terms of trade and could hike by 25 basis points as early as November.
Chart 6 – SAGB Fair Value Matrix based on Fiscal Outcomes, Policy Rate and US 10-year Treasury Yields
Note: Fair value = α+ β1 US Treasury + β2 SA Repo rate + β3 SA budget balance + β4 SA credit rating.
Source: Bloomberg, ABSA Research
The path of travel remains lower and a flatter curve for SAGBs. Thus, we look to fade any weakness we see but unwilling to add to SAGB exposure following the strong rally with exception to six-year part of the curve where large coupon is payable on 21 June. It's worth remembering that we are heading into a heavy coupon period from late June to end September, with about 100 billion ZAR to hit the market, which will need a home. This will cushion risks from higher US yields, a stronger USD and weaker ZAR.
The analysis on Chart 6 suggests on SA 10-year priced at 9.2% suggest local and foreign investors are pricing in repo rate of 4% (50 basis points hike) with a 2% UST 10-year and a budget deficit of -8.7% based on this model. Since we see less than a 50 basis points hike, a sub 2% UST 10-year yield by year end and a budget deficit near 7% we believe local 10-year yields could trade into the 8.7-8.9% range should risk-on backdrop persist in the coupon heavy months ahead of the Fed formally announcing formal intention to QE tapering later this year. While a tapering announcement will not prove as a surprise to investors it is likely to raise volatility in markets.
Risk premium at the belly of the curve is still substantial and the underlying improvement in the macro backdrop warrants earning this risk premium but we wait for periods of weakness to extend positioning. We recognise that the potential for a reduction of fiscal issuance exists again later this year post medium-term budget policy statement (MTBPS) should combination of strong trade gains and fiscal discipline on spending result in a narrower fiscal deficit that delivers approximately 7% GDP. It will also depend on Treasury willingness to issue a new Sukuk bond and a FRN instrument to raise an additional cash buffer.
We maintain to use protective option strategies to hedge gains post meaningful yield rallies and for now prefer to focus on bolt on strategies such as positioning on a steep forward bond curve, where we can generate alpha for clients even after considering a transition from the current easy cycle into the SARB tightening cycle over the next two years.