SA Fixed Income Insights - Core views based on December insights

In November last year, we highlighted that attractive valuations in emerging markets (EM) debt markets could allow one to harvest above trend returns in South African Government Bonds (SAGBs) over the coming 12 months. We cited factors such as a Federal Reserve (Fed) dovish tilt or rate hike pause in the cycle and/or thawing in US/China trade tension, as two of the likely catalysts that could be responsible for engineering a more positive return outcome this year compared to poor returns seen in 2018.

From our December Insights: “Any early signs of a Fed pause, even if distant, are likely to be a key relief for EM rates as attractive valuations for many become the most dominant feature. Thus far, our strategy to look for spikes and blow-off phases in yields to increase duration (only into weakness) has paid off. Part of this remains tactical but a core long duration view remains warranted. We expect that a shift in the Fed language this year and/or a China fiscal policy response will provide positive catalysts that can benefit EM local currency bonds. This should help to generate strong 1-year performance… In the near term from mid-December to second week in January, we are likely to see a hiatus in fresh bonds supply from primary issuance as weekly auctions are scrapped. The supply/demand equation is further improved by a slew of coupons totaling 16.2 billion of SAGBs coupons through December. The bulk of this relates to a R186 coupon of R11.4 billion on 21 December. This is followed by an additional R4.8 billion of coupons from the ILBs (R197s, R202s, I2050s).”

Since turning more constructive on South African (SA) rates late last year, when advocating to add duration at or above 9.20 on R186 (near 9.50 on SA 10 -year) we have been rewarded with bond yields declining some 47 basis points to reach our 8.73 objective in early 2019, aided by a sharp United States (US) Treasury rally spurred by risk aversion. In December, US recession fears truly emerged as witnessed by a freefall in US equities, widening credit spreads and the US 1-year-10-year treasury curve, 2-year/3-year treasury curve and USD 3m Libor/UST 10-year curve inversions all colliding in recent weeks.

From December Insights: “We are targeting 8.70 - 8.74 area on benchmark R186 by the end of the fourth quarter of 2018/early first quarter  2019 from 8.93 at the time of writing (December 2). This extends our long view from our initial recommendation when we turned positive in October with a view to begin to unwind underweight (UW) duration and move tactically long (fading into sell-offs) since October which occurred in the 9.20 - 9.30 range on R186 benchmark bond.”

Key risk events include events such as the Trump-Xi G20 meeting, US elections and the December Federal Open Market Committee (FOMC) meeting that occurred in a heightened volatility environment for global financial markets. Fears over the ability of a 90-day trade truce to yield positive results started to bite. Worries emerged over waning US and global growth as registered by regional economic surveys and manufacturing Purchasing Managers’ Index (PMI) data that rolled over in September/October 2018, accelerating further to the downside in December. Economic weakness as also reflected in various global economic surprise indices despite labour markets remaining resilient in the US and improving in Europe. The US equities December massacre saw it post its worst monthly  performance for December since 1931, as the prior mentioned concerns conspired together with the fear of a Fed Policy error - fear that it would not acknowledge asset price, maintain its hiking path and balance sheet reduction, further choking off growth in a backdrop of tightening financial conditions. The Fed communication also sent the signal that there would be no Powell Put.

Fixed Income view and this month’s revisions:

In recent days, however, the Fed Chair has pivoted from a hawkish bias to a more flexible stance where he, as well as Fed reginal chiefs, indicated that they are paying attention to signals from markets. The December dot plot shows the median Fed expectation for 2019 to be two rate increases in the year ahead. This followed after the weakening in US services and manufacturing PMIs for December and the equity market slump. The Eurodollar futures market is showing the market pricing in no hikes by the Fed for the entire 2019 (after briefly pricing in as much as 18 basis points of cuts on 3 January 2019). This contrasts with 20 basis points of hikes priced by the market at the start of December.

For 2020, the market is now expecting Fed easing of 12 basis points. Should markets be correct, this suggests that the economic expansion is likely to end in 2019 with the Fed having to reduce rates and end its balance sheet reduction programme during the course of this year.

Our base case is that US growth is likely to slow in 2019 but remain positive rather than turn negative. We expect that equity and fixed income markets will display higher volatility in 2019 compared to 2018 as the market oscillates between the scenario of pricing in recessionary conditions where equities and risk assets sell off, sub IG and EM spreads widen and safe havens such as USTs, bunds and gold all rally; versus the alternative scenario of late cycle expansion where growth slows but stays positive, buoyed by central bank policy action and fiscal and monetary policy stimulus in China that relies on local authorities infrastructure spending.

In the first scenario, global growth continues to slow down and tightening monetary conditions, downward earning revisions/outlooks by companies in the fourth quarter earnings season, liquidity withdrawal from the European Central Bank quantitative easing -end and Fed’s quantitative tightening, and a strong US dollar dominate.

In the second scenario (which is our current base case), China’s gross domestic product (GDP) growth deceleration finds a bottom in quarter one and displays signs of improving as a result of recent and forthcoming policy measures announced and implemented before and after the Chinese New Year in February. United States growth slows from well above trend closer to the 1-2% range, escaping recession but importantly persuades the Fed to “pause” in its “pragmatic” hiking cycle as hinted by Chairman Powell at his recent panel interview with Ben Bernanke and Janet Yellen. This Fed “pause” which we first considered in our November Insights piece appears to have arrived sooner than we envisaged. We now expect the Fed may stay on hold in its cycle until at least the US summer.

While there is an increased probability that December was the last hike in the current Fed cycle, we would prefer to wait to see the incoming data and policymaker responses and the March Fed dot plot before drawing fresh conclusions about a potential looming US recession.

United States’ third quarter 2018 GDP growth registered 3.4% growth. This is expected to slow with the New York Fed GDP Nowcast forecast latest read at +2.5% and the ST Louis Fed quarter four 2018 GDP Nowcast at +2.6%. Looking into early 2019, the NY Fed GDP Nowcast forecast is sitting at +2.1% signalling a slowdown rather than a recession being on the cards.

With bond yields having reached our objective of 8.73% on R186, we are naturally inclined to reduce our overweight bond duration to lock in gains over December. Our view that the dollar may suffer on a variety of factors such as the dovish Fed pivot and shrinking US-RoW growth differentials as US growth slows as Trump Fiscal Stimulus measures begin to wear off getting into quarter two of 2019.

More importantly, with Democrats now in control of the House, it carries with it negative implications for the dollar, as it boosts the likelihood of a surge in US excess liquidity because of the debt ceiling coming into force on 1 March 2019 (Chart 1). Fitch even warned that bipartisan contention over the US debt ceiling may have negative implications. A meaningful deal around the lingering US/China trade conflict that has plagued markets and economies since 2018 may find a temporary resolve which may see the USD safe haven premium being priced out. The Chinese yuan is already responding favourably to trade headlines and as Chinese capital markets benefit from reserve manager buying of CNY government bonds on Barclays Global Aggregate Index inclusion and supportive dynamics such as falling Consumer Price Index, Producer Price Index and additional monetary policy easing expectations. Morgan Stanley expects $90 billion of inflows as a result of index inclusion into China government bonds in 2019 which we recommend to funds that can access this asset class.

Chart 1 = A substantial drawdown in Treasury Cash Balance ahead of 1 March Debt Ceiling likely to weigh on Libor/OIS spread and US dollar

Chart 1 Fixed income insights 2019 01
Source: Macrobond and Nordea

United States outperformance was a key theme of 2018, which fuelled global growth de-synchronisation and dollarstrength. This should also shift in 2019, as RoW growth rebounds while US growth slows. Annualised quarterly growth in the US is likely to slow from 4.2% in quarter two of  2018 to 1% in quarter thee of  2019 (or even in negative territory in the bear case). The weaker US growth outlook should serve as a headwind to firm revenue growth, while margins are likely to become increasingly compressed as rising rates, wages and input costs from tariffs take their toll.

This combination of factors – a weaker US economic and asset outlook, reduced net global savings, and central bank hawkishness – bodes poorly for currencies of countries reliant on foreign capital flows. The US is vulnerable in this regard – a significant portion of its financial assets are foreign-owned and an increasing share of flows into the US in 2018 have been into money markets, suggesting increased investor caution about the US outlook. The dollar should weaken against capital exporters like the euro and yen, but it should also weaken against a good number of EM currencies too. Cheap valuations, better fundamentals, and the positive sentiment impact of a weaker dollar may keep EMs supported into 2019.

We see the local fundamental picture as constructive as SA domestic economic growth finds firmer footing, and optimism that negative Moody’s rating action will be averted in March. Our stance on inflation is for it to remain anchored in the 4.6% - 4.9% area for headline CPI in the near term and hence we remain constructive on local bonds. While valuations are less compelling compared to end November and early December, we still see risks skewed towards yields moving lower rather than higher in the medium term. We therefore recommend an overall mildly overweight SAGBs duration stance as we enter the first quarter. We expect headline risk and economic data risks as relatively high and anticipate that yields will over time grind lower in an environment where risk-off episodes will present themselves that allow investors to enter tactical long positions in the 8.83 to 8.92 area on R186 or SAGB curve equivalent. To the downside, we expect the 8.66 area to act as a strong floor of resistance but targeting the 8.53/47 area in the medium term at or below which we are more inclined to move to neutral or underweight duration.

Risks to our view is that US 1, 2 and 3year recession probabilities continue to rise resulting in widening of credit spreads and global risk position reduction and fleeing of EM assets into USD. US one-year recession probability based on all near term and background risk indicators as measured by JP Morgan Models has risen to 40%. This is the highest level in the current economic expansion over the past 10 years. This is only the 12th occasion that this level was triggered from below since 1955 and of these 12 events it preceded US recessions in nine of the previous 11 cases, hence only two early or false signals.

Given US 1-year recession probability we need to be ready to adjust position sizes and risk budgets to smaller portions in the event of policymakers being unable to use their limited firepower to avert a global and US recession. This could easily transition into a recession scenario where deleveraging is a key feature of correcting the imbalances of the ZIRP central bank policy era rather than slower-growth late cycle economic expansion scenario. We therefore like to have some tail hedges in portfolios that can have diversified assets such as long gold exposure where the asset benefits from lower US real yields if the Fed pauses hiking and US growth slows, and also benefits from dollar weakness and has safe haven characteristics in times of market panic.

In December we indicated a preference for owning long and ultra-long dated bonds as opposed to the belly of the SAGBs curve. From our December Insights, “National Treasury communicated it will issue across the curve, but with a preference to 5-10-year sector of the curve, we opt to have a duration overweight bias in the ultra-long end bonds as the short end of the curve is already trading quite rich given it has been pulled lower by extensive switch auction activity. More switch auction activity is to be expected but we think that with weekly issuance already raised by over 400m/week most of this is already reflected in long end yields.”

This view has played out well, adding alpha to portfolios as R2048/R186 spreads have flattened over the past month from north of 104 basis points to near 97 basis points recently. We expect further flattening to near 92 basis points (1-year average) and in a full-fledged return of carry and search for yield in a goldilocks environment it could tighten towards 82 basis points which is the 5-year mean if we see a return of foreign EM and cross-asset demand.

Working on current ALBI modified duration and projecting 12-month SA 10-year constant maturity exit yield near 9.05, which is close to our latest team consensus median survey, suggests a 1-year expected all-in return for the ALBI index of 11.2% one month ago. The recent decline in local yields has reached the 9.05 level on constant maturity SA 10-year bond. If this exit yield is used it suggests a newly revised 1-year total return of 9.5%. This projected return is 120 basis points higher than 1-yeaer negotiable certificate of deposit (NCD) paper yielding 8.30%, and about 20 basis points higher than the cycle average compound annual returns posted by the ALBI index of 9.3% since its inception in 2001. With our expectation of lower yields in the medium term, we think we can add tactically at levels at or above 8.83 on R186 for a target of 8.66 or 8.53/47 area in late quarter one. This R186 level corresponds with just below 8.8% on SA constant maturity 10-year bond yield. Note that we will start reducing duration to neutral to underweight near or below these targeted levels if achieved.

A decline to near 8.52% (once 8.66 support is breached) could lift the ALBI 1-year expected return from 9.5% (using 10-year 12-month exit yield (Jan 2020) of 9.05) to a 1-year expected return of 11.4%. For readers who do not subscribe to our positive China policy action thesis coupled with dovish Fed and soft US dollar outcome to conspire to boost demand (and returns) for EM assets including rand and SAGBs in the first half of 2019, should look to high quality short dated credit and FRNs or safety of other money market instruments or high quality bank variable rate preference shares.


2019 – A year that can usher in US dollar weakness and benefit the rand:

After the worst December for US equity markets in 50 years, January is delivering tentative stability across risky markets, supported by a strong US payrolls report and dovish Powell remarks. Most failed to anticipate December's global data downdraft, US policy disarray and broad market declines - those moves were so large that they evoked recession-like conditions at odds with the global economy's likely path in 2019.

As a reminder of how extreme pessimism had become, equity (S&P500) 12-month forward price earnings (PEs) typically de-rate by about three points, for equity volatility to spike above 20% and for spreads to widen by some 30 basis points from their cycle lows by the time a recession begins. Since these thresholds had already been breached by end-2018 when the US economy was still expanding at an above-trend 2.5% pace, some strange dynamics must be in play.

One possibility is that markets are correctly anticipating the inevitable end to the second-longest expansion in history, yet doing so earlier to avoid the complacency that defined the pre-Lehman years. A second possibility is that markets are overreacting to inflection points in the US/global economy and corporate earnings, as they did in 2015-2016. This implies that the quarter four earning season that kicks off in coming days will be crucial for market performance after the recent oversold rebound from Christmas Eve lows. A third possibility is that lower liquidity across markets post the global financial crisis is exacerbating the price impact of minor macroeconomic events, and thus price levels and volatility reflect a liquidity premium as much as a recession premium.

Since November, a risk-off tone, some disappointing US housing data and wider concerns about a slowing global economy have led to markets re-evaluating Fed policy. The front-end of US curves are now judging that the next move for the Fed will be a cut rather than a hike. However, there appears to be a divergence between how macro markets have priced in this change in Fed expectations, with the biggest divergence being between FX and fixed income markets.

A synthetic spread using the weights of the DXY Index (Dollar Index) using different fixed income instruments – 5-year govvies, 10-year govvies and 2-year swap spreads would all suggest that the DXY Index should be trading around 93 (current price 95.4) based on the relationship over the past year. There are three potential reasons for this: either fixed income markets have exaggerated their expectations of Fed cuts, other developed market rates should have flatter curves and be less aggressive in expecting policy normalisation in the rest of the world, or the dollar should be trading at a lower level. We suspect that the market will correct through a combination of all three of these factors converging.

Furthermore, a comparison of the DXY Index to a synthetic spread of 6th generic money market futures indicates that the DXY Index should be trading even lower, around 91. As this rate it is also misaligned relative to other fixed income markets, it shows that the moves in US Eurodollar futures have been even more aggressive than other fixed income markets. Again, this suggests that either Eurodollar futures are leading the market and will eventually correct or govvie and swap markets are behind the curve and the dollar should be even lower. These valuation metrics is not dollar supportive and we expect that if our central scenario plays out we should see dollar softening which will help the erandand SAGBs.

The Bloomberg model of sovereign risk using variables such as political risk score, economic growth, FX reserves, short-term and long-term external debt, external debt due in 12 months as a percentage of GDP and Non-Performing Loans (NPLs). The 5-year Model CDS for SA hard currency bonds (SOAFs) is indicated closer to 170 basis points with GDP growth of 1.3% vs. actual market level of 215 basis points. Bearing in mind that the CDS has been the component of SA bond yields decomposition that has deteriorated in recent times as opposed to US Treasury 10-year that has fallen and SA currency risk premium that has also fallen. It suggests that once the market is more comfortable with SA’s fiscal metrics post the February National Budget speech, that bond yields have room to move lower should SA GDP growth indeed improve in quarter one versus a soft fourth quarter.

As far as South Africa is concerned we think that a trend of weaker dollar will aid the high beta currencies such as the rand. We note that SA’s terms of trade is likely to get a boost from Chinese infrastructure spending and yuan stability and can further be bolstered by improving risk-on sentiment if a US/China trade deal sticks. Note that since October, SA’s terms of trade has improved substantially and it suggests to us that USDZAR range that is no longer lagging this trade improvement but more consistent with a higher terms-of-trade is in the 13.00-13.50 range (Chart 2). If recent foreign bond buying as witnessed since late December is any guide, EM debt inflows can help the rand regain a firmer footing after is depreciation period post the Ramaphoria era that was characterised by deteriorating US-Sino relationship and dollar repatriation by US multinationals since the second quarter of last year.

Chart 2 = USDZAR (yellow - inverted) lagging the significant improvement in SA terms-of-trade (white) that started in October, suggesting lower USDZAR levels possible in the coming weeks

Chart 2 Fixed income insights 2019 01
Source: Bloomberg

Chart 3: It could be a temporary game changer for the USD, if debt ceiling stand-off increases USD liquidity

Chart 3 Fixed income insights 2019 01 01
Source: Macrobond and Nordea

Finally, as can be seen in Chart 1 and Chart 3, the dynamics around US Treasury using existing cash balances to draw down ahead of the anticipated debt ceiling deadline as has been historically the case could inject dollar liquidity into the market.

The 2019 first quarter market action may look reminiscent of the 2017 first quarter, when the US Treasury also held a large cash buffer heading into a debt ceiling suspension deadline. In 2017, LIBOR-OIS tightened (as a result of less bill issuance) and the USD weakened as a consequence. We would not be surprised to see something similar happening this year.

More on trade, China policy action that has occurred and expected to come through pre-and post Chinese New Year:

The PBoC announced two 50 basis points broad-based RRR cuts for 15 January  and 25 January, which will release in the order of Rmb1.5 trillion of liquidity into the Chinese economy. The reserve ratio requirement easing will also be broadened in scope to include the larger part of the banking sector.

Policymakers announced the introduction of medium-term lending facility (TMLF), which is a new tool under which the government will provide long-term, low-cost financing to financial institutions to increase lending to private businesses. This will be implemented for the first time in the second half of January. After replacing the maturing MLF in quarter one1 (Rmb1.2 trillion) and including the upcoming injection from TMLF and looser rules for targeted RRR (Jan. 2), the PBoC estimates this could release Rmb800bn long-term liquidity on a net basis to the market.

The latest RRR cut boosted sentiment for risk assets and took place right after China's Premier's pledge to step up counter-cyclical efforts and make full use of broad-based RRR cuts, suggesting policymakers are viewing growth as the top priority for the new year and affirming our view that CEWC pledged more policy easing. Economists expect between 150-300 basis points more RRR cuts this year to accommodate fiscal easing. Policymakers will likely front-load local government bond issuance from this month and implement a 2-3% VAT cut on the 16% bracket in the next 2-3 months.

Further monetary and fiscal easing is expected to lift broad credit growth to 12.5% from 10.6% currently, and the cumulative fiscal easing could result in a 1.5% of GDP increase in the augmented fiscal deficit. We expect that China’s economic growth rate could bottom in the first quarter of  2019 near 6.1%, with recent policy easing fully kicking in by March.

Easing measures have been aimed at encouraging private sector spending, but weak private sector sentiment (dampened further by trade tensions) has prevented spending from picking up. Premier Li Keqiang held a roundtable with the big three banks at the CBIRC, urging lenders to take advantage of RRR cuts to support private companies and SMEs. He said China will strengthen the scale of its counter-cyclical adjustments of macro policies and further cut taxes. 

In a sign of the scale of investment to come, China Railway Corp said it would construct 6,800 kilometers of new railway lines in 2019, almost 50% more than last year, including 3,200 kilometers of high-speed track. China has approved new rail projects worth more than $125 billion in the past month as it steps up fiscal spending to counteract a slowdown in its economy. The investment drive and recent policy measures highlights Beijing’s fears about slowing growth. However, it  also signals its readiness of policymakers to act to stop its emphasis on deleveraging by expanding credit growth and placing reliance on infrastructure spending as one of the key drivers and pillars of support to ensure that China’s 2019 GDP growth rate that has been on a declining trend can be stabilised in the vicinity of 6.2-6.3% for calendar 2019.

In a recent interview with senior Chinese Government Economist Zhu, he said China will authorise higher local government borrowing to pay for increased infrastructure spending including a major railway expansion in 2019, as officials seek to keep economic growth to at least 6.2% despite both a trade dispute with the US and slowing domestic demand. Infrastructure investment will be the main buffer for stabilising the economy this year, as exports, consumption and property investment will all soften. He added that export weakness could drag the rate of expansion of GDP as low as 6% in the first quarter of this year and said that there is still space for infrastructure investment to expand in the short term. Such spending would not only boost the economy, but also improve worrying levels of unemployment in rural areas.

To fund increased spending, local governments will be allowed to sell more than last year's CNY2.18 trillion in bonds, Zhu said. Much of this issuance will come in the form of special bonds, which are not included in the headline national budget figures and so will not endanger the government's preferred fiscal deficit ceiling of 3% of GDP. Local government special bond issuance totalled CNY1.35 trillion last year.

He recommended to policymakers that to meet the demand for infrastructure, issuance of both special and general bonds needs to be increased. The exact quota will be announced during the two sessions of the Communist Party in March and will be bigger than what the State Council approved in late 2018 when the State Council authorised new local government bond issuance of CNY1.39 trillion. This included CNY810 billion of special bonds, enabling local authorities to start issuing debt from January, ahead of the usual schedule.

Resorting to increased borrowing goes against the grain of the government's deleveraging campaign of recent years, which sought to wind down what officials regarded as dangerous levels of debt, accumulated especially by state-owned enterprises and local administrations during the massive stimulus which kept the Chinese economy firing on all cylinders throughout the global financial crisis. But officials are increasingly concerned about the effects of the trade dispute with Washington, which has imposed special tariffs on Chinese goods and whose effects has already been reflected in rapidly deteriorating data, including purchasing managers' index readings indicating factory output might be contracting.

The government is also known to be keen to keep growth at high levels until at least 2020, in the lead-up to the 100th anniversary of the foundation of the Chinese Communist Party. Uncertainty prompted by the trade war will remain a challenge for the world's second largest economy during all that period, pressuring employment. Zhu‘s view is that the central government could also issue special treasury bonds to support infrastructure. The country has not issued such bonds since 2007, which if used will make for further upside in infrastructure spending, commodity demand and by implication bodes well for commodity exporters such as South Africa.

What to watch out for as the quarter progresses

  • Indications that global liquidity conditions could stop tightening – this comes from central bank commentary and US IG credit spreads stopping widening.
  • Further China Stimulus including fiscal
  • Global growth conditions look better – Korean export data, global manufacturing PMIs and China's liquidity injections.
  • Cross-border investment flows – Japan's appetite for US equity and bond investment was high last year, helping to keep volatility low. There are emerging signs of repatriation back to Japan (next data point is released on January 9), a dynamic that may be repeated in other surplus regions.
  • Trade developments
  • US Government Shutdown Resolution and emergence of debt ceiling debate ahead of 1 March deadline
  • US quarter four 2018 earnings season

If 2018 began with global economic harmony, 2019 is set to start with economic discord. The global synchronised upswing at the beginning of 2018 has given way to a far more uneven and uncertain outlook that will continue well into 2019. As China, Europe and Japan as well as many EMs slipped into slowdowns in 2018 that are still underway, the US enjoyed the full fruits of its pro-cyclical fiscal stimulus. Today, US growth is as good as it gets and will soon peak, ending the country’s splendid isolation from the realities of the global economy. The higher yields and higher dollar that are the inevitable consequence of the US’s economic acceleration clog up the arteries of finance around the globe, and eventually this pain is reflected back to its source.

Global growth is set to slow in the early part of 2019 but should begin to recover as US growth begins to decelerate. This relative underperformance should lead to a weaker dollar, challenging conditions for US equities and continued elevated cross-asset volatility as markets price in this new paradigm. Recession risk in the US is rising and late cycle dynamics is expected to prevail in coming quarters.

In SA, the growth outlook looks somewhat rosier for the coming quarter after SA real GDP quarter-on-quarter SAAR in quarter four of 2017 registered 0.7%. The manufacturing PMI exceeded expectations with a rise to 50.7 in December (seasonally adjusted) from 49.5 in November. This was the first time that the index exceeded the neutral 50-threshold since May 2017 (it reached 50 fleetingly in February2018). Importantly, this was supported by improvements in the business activity and sales orders sub-indices, both of which exceeded 50 in December (at 53.8 and 54.3 respectively).

Financial markets should view this in a positive light. However, amid the headwinds from lingering pre-election policy and political uncertainty, an expected global growth slowdown and a possible resumption of electricity load-shedding, this might not be sufficient to ease concerns about the local economic growth outlook.

South Africa sovereign credit review release calendar for 2019 is for S&P to provide ratings updates on 24 May and 22 November. Moody's is scheduled to provide their ratings opinions on 29 March and 1 November. Fitch has not provided a public schedule for SA ratings in 2019. Given the expectation of persistent momentum in State Owned Entities reform embarked on since start of Cyril Ramaphosa administration, a  2019 quarter one vs 2018 quarter four SA GDP improvement from +0.3% year-on-year growth to +1.3% year-on-year GDP and a pragmatic budget next month leads us to believe that SA downgrade rating risk will be deferred until the second half of 2019.

A recent survey by Morgan Stanley showed that equity investors are rather unexcited about South African opportunities until risks around Eskom, land reform and the general elections play out. Fixed income investors are less concerned on a relative basis, particularly if SA inflation is to remain muted and print lower than South African Reserve Bank (SARB) current 2019 consensus and if the calls for SARB to maintain SA repo rate at its current level for the entire 2019 are accurate. The fiscal dynamics and the Moody's review in March are key risks to trade around. Without question, however, Eskom is seen as the most important risk event to watch in the coming months, starting with a possible return of load shedding and its much-awaited turnaround plan (hopefully at the end of January). Recent news around employment cost reductions are encouraging and if it plays out, combined with additional reforms and business turnaround, it should add favourably into the ratings picture for Moody’s not to alter its current ratings outlook in March. Should this play out, we expect SA 10-year constant maturity yields to be below current yield levels of 9.05%

Deputy SARB Governor Francois Groepe resigned in recent days and will be departing from the Reserve Bank at the end of this month. He was not a dove or a hawkand tended to swing depending on the data. We believe that he preferred to keep rates unchanged at the last two meetings versus SARB Governor Lesetja Kganyago, Deputy Governor Daniel Mminele and Fundi Tshazibana who comprised the hiking camp. His departure after the January Monetary Policy Committee (MPC) meeting leaves the committee with a hawkish bias with Kuben Naidoo and Rashad Cassim as the doves. The MPC has quorum if the Governor and three members are present. Mr Groepe will be moving back to the private sector. We still expect the MPC to remain on hold at the 17 January meeting. Generally, inflation remains benign and disinflationary, while food inflation is likely to tick higher this year. Falling petrol prices will become a tailwind that helps inflation to remain relatively benign in SA in 2019 and undershoot consensus CPI 2019 headline inflation which is near 5.2 or 5.3. Coupled with a stronger rand it is likely to make the SARBs task a lot easier in H1 2019 compared to the second half of 2018 when USD strength prevailed, along with a backdrop where the Fed continued to hike rates.

While the first quarter of 2019 is likely to pose challenges for South African assets, Eskom challenges, a restructuring operation at a large domestic retailer (Edcon), the National Budget speech and Moody's are near-term risks. Of course, while all this is playing out, the campaigning for the national elections will be in full force, meaning that investors will need to be nimble and prepared for heightened volatility. While we expect cross-currents from global trade headlines to be a key feature in the early phase of 2019 we look to use bond and FX weakness to increase bond exposure tactically to benefit from dollar weakness, slowing global growth, stable to improving local growth from China policy measures, EM inflows and Moody’s rating reprieve by end of quarter one.

State Owned Enterprise reform

A World Bank study in 2016 found that South African utilities pay workers more than double the norm in 35 other countries on the continent, and that Eskom is potentially 66% overstaffed. Eskom last month reduced its highest executive structure to nine positions from 21 by regrading and combining roles. The utility will extend its strategy of trimming top executive positions to include lower ranking managers and finally the general workforce as they look to cut costs. The next phase is to cut a 600-strong layer of managers -- known as E-band employees -- by at least 70%.

Reducing the bulk of this headcount is not likely to occur until after the presidential election (around May), but after that we may see Eskom’s payroll shrinking from c.48,600 to below 40,000 employees, according to a source that talked to Business Day.

Load-shedding remains a factor to watch as the systems will be constrained from the middle of the month when business returns to normal and demand increases on the old generators according to what Eskom has said. They have claimed that steady progress was made with regard to fixing coal stockpiles as 35 new coal contracts were concluded in the last year and supplies at the power stations have been replenished over the holiday season.

During quarter one of  2019 Eskom tariff determination will be an important input into its operating model going forward. All the signs are that there is a double-digit increase on the way. Public hearings on Eskom’s demand for a 15% electricity tariff increase over the next three years will start in the week of 14 January. Eskom has argued that this 15% increase is needed to ensure that it maintained its stability and growth trajectory.

The announcement of a turn-around plan for the struggling state utility has been delayed but on 14 December the President appointed a panel to advise the government on how to resolve the producer’s operational, structural and financial challenges. The plan is likely to be announced by the end of January, ahead of the annual budget speech on 20 February. The plan is likely to incorporate a combination of cost cutting, capex rationalisation, tariff hikes and possibly some form of equity injection to convince stakeholders and ratings agencies that the company is put back on a sustainable financial and operational footing for the long term.

Baseline view: Our view that Fed will pause in 2019 more evident

Two key reasons for the bear market in risk assets over 2018 have been Fed policy and the uncertainties created by global trade tensions. Both catalysts could moderate in 2019, creating better conditions for EM. Our December call for the Fed to hike at least once more (after Fed Dec-18 hike of 25 basis points) has been altered to a view where we now expect the Fed to pause until the summer before resuming rate hikes. This was triggered by the equity massacre of December that unleashed turmoil in markets and resulted in the Fed capitulating and taking note to acknowledge signals of asset markets.

A summer hike in June/July is still a possibility in our view if the shift towards tightening in monetary conditions is well absorbed by the US economy. We are concerned by rising probabilities in the 1,2,3-year models of a US recession.

Further Fed policy tightening is no longer priced by the market and this should not boost the dollar materially unless US growth and economic resilience surprises to the upside. However, with GDP growth expected to slow markedly from the first quarter of 2019 towards the middle of this year the Fed has already pivoted towards a dovish turn and signalled a pause in the hiking cycle as we alluded to in our December outlook last month. Emerging markets and risk assets have benefitted with SAGB yields declining almost 50 basis points, however, the USD has remained quite resilient. The current ‘official’ Fed statement does not indicate any plan to pause the hiking cycle, so confirmation of this would be taken as a relief by markets. In recent days regional Fed chiefs have suggested that the Fed will pause to re-assess the signals sent by markets and to analyse the incoming economic data.

There is a further possibility that the Fed could announce a pause of balance sheet reduction early in 2019 (e.g. March FOMC meeting) for implementation later in 2019, which would also be a positive for risk assets and undermine dollar strength. This view is non-consensus and Morgan Stanley has recently written on this. This is a highly technical topic which we will cover briefly later in this article. It’s hard to have a high degree of conviction over how trade negotiations will evolve given a wide divide in US demands vs. China’s domestic economic policy and its aspirations around its 2025 plan which will be infringed upon if it were to concede to many of the US demands. Our base case is that as the US economy slows and US risk assets come under pressure in response to periodic bouts of escalation, there will be a greater incentive to come to a deal due to the co-dependence of these two economic superpowers as referred to by Stephen Roach, laureate economics professor at Yale University. We also expect that Trump would be eager to clinch a trade deal to bolster his claims of delivering to his electorate and boost his chances for re-election in 2020.

Talks in Beijing between US and China proceeded well, noting a commitment by China to buy more US agricultural goods, energy and manufactured items. China and the US concluded three days of talks with a cautious sense of optimism that the world’s two biggest economies might be able to reach a deal that ends their bruising trade war. We will closely watch the next round of talks that could happen later this month when a US delegation including President Donald Trump travels to Davos and may meet with Chinese trade representatives. President Trump and President Xi Jinping have given their officials until 1 March to reach an accord on “structural changes” to China’s economy on issues such as the forced transfer of American technology, intellectual-property rights, and non-tariff barriers. The USTR statement didn’t say whether progress had been achieved on its main concerns. People familiar with the discussions said positions were closer on areas including energy and agriculture but further apart on harder issues.

Is the Fed tightening too much?

A Barron's piece and CFR blog article were published in late November.  (https://www.cfr.org/blog/fed-tightening-more-it-realizes)

These articles reveal that the Fed may be underestimating the impact of its current “auto-pilot” programme of balance sheet reduction. Benn Steil and Della Rocca from the Council of Foreign Relations posit that the balance sheet reduction to date by the Fed has resulted in the 10-year Treasury yield lifting by 17 basis points. Based on historical relationships this would be associated with a 68 basis points boost in the Fed Funds rate. They stated that if the Fed were to reduce their holdings by $50 billion a month, as it has been doing since end of quarter three 2018, they estimated that monetary policy conditions would tighten by the equivalent of 220 basis points by the end of 2019. They concluded that using these relationships would result in monetary policy to start to contract US economic growth from early next year.

Note that this is a stark contrast to the Fed’s own contention that the balance sheet “normalisation” is neutral for policy. This view is not shared by the broader financial community as the Fed lowering assets may not match the rise in Fed liabilities, most notably currency in circulation. The net effect is the shrinkage of another liability, bank reserves, the raw material or money supply. This shrinkage is not just felt in the US but also abroad by European banks. Quantitative tightening (QT) can be caustic as lower liquidity can and does have consequences which may not be desirable. We anticipate that if the market gyrations in recent weeks have been any guide we can expect the impact of QT to rear its head again in 2019 and if it is deemed to be too much of a tourniquet on economic agents we could very well anticipate the Fed to act to take this programme off so called autopilot. Quantitative Tightening Tapering – QTT.

The Fed sees its current balance sheet programme as an exercise of “watching paint dry”, an “autopilot” programme which is of concern to us as we believe that this $50 billion per month liquidity withdrawal is an obtuse policy measure which is adding pressure to financial conditions and dismissed by the Fed - hence our expectations that in the course of 2019 the Fed will come to view its balance sheet policy as something that needs to be altered or ended once a determination is made over what level of the Fed balance sheet is optimal versus the amount of ample excess liquidity in the banking system. We refer readers to our December monthly insights piece for further information, available here