July 24, 2018
In a mere matter of days in mid-June, Ramaphoria was wiped off the face of the rand. Between end-February and mid-June, the rand lost 20% against the dollar to return to the levels last seen just before the ANC elective conference in December.
These trends are less about South Africa than emerging market trends in general and the direction of US inflation and global interest rates. Taking a longer-term view, there are positive undercurrents for local fixed interest markets.
Various economic indicators are signalling that US inflation is creeping upwards and the market expects the US Federal Reserve will respond by raising interest rates more aggressively than previously expected.
The Fed indicated after its most recent meeting that it will hike rates four times this year rather than the three previously communicated. That is negative for emerging markets, including SA, because it draws global investors’ money back to the US.
We are seeing a change in the language of the US Fed’s communications. Under the chairmanship of Janet Yellen, the Fed’s stance was dovish – or pro-market. Her successor, Jerome Powell, took over in February, at a time when the US government’s tax cuts coincided with a growing US economy, following one of the longest economic upturns in history based on various economic measures. The combination of stimulus and growth is pushing US inflation over 2%, encouraging the Fed to adopt a more hawkish, or interest-rate tightening, policy.
That is the major fear that is driving an emerging market sell-off. If there is a co-ordinated withdrawal of liquidity from the market – not just from the US Fed but other central bankers in developed markets – it means the surplus funds that have lifted emerging markets in the last few years will be withdrawn.
Of course central banks are not expected to tighten rates to the point where it will stifle economic growth. The US Fed has indicated it intends to stay behind the curve, and allow some inflation. If it does that, it limits the potential for a melt-down in riskier emerging market assets.
Another factor spooking emerging markets is the trade war between the US and China. It will particularly affect emerging markets such as SA that are heavily reliant on commodity exports, and that are suffering from fiscal imbalances.
The European Central Bank (ECB) is also reducing the size of its balance sheet which, over time, will have an impact on emerging markets. At some point in the future, if inflation starts to rise, additional pressure will become evident.
Some emerging markets such as Indonesia, Turkey and Argentina are responding to this challenge and protecting their currencies by hiking domestic interest rates. SA moved in the opposite direction, with a 0.25% cut in the repo rate to 6.5% in March, which has driven recent rand depreciation.
The exit of foreign investors is reflected in bond market yields. The benchmark ten-year bond yield has risen 1.3%, from about 7.9% to 9.2%, and the longer-dated bond yields have moved into double digits, as the currency has slid from R11.50/$ to around R14/$. Rising bond yields mean capital loss.
At a certain point markets can be seen to have overreacted to these trends, creating a disconnect between current yields and fair value. If you look through the cycle, our market is looking attractive at a fundamental level. One of the biggest drivers of the bond market is inflation expectations and SA’s inflation rate is still relatively low. The latest CPI showed inflation at 4.4%, less than the 4.6% the market was expecting, which is well controlled.
Earlier in 2018 the expectation was that the SARB might cut rates to stimulate a struggling SA economy. However, in the current environment, the SARB is hinting it may have to hike rates to contain inflation resulting from more costly imports. It creates a dilemma for the SARB because higher rates can stifle economic growth. But interest rates are not the only driver of economic growth. Government also needs to create policy certainty and restructure the economy, which is not a one-day event.
Since the change of leadership in government, the SA economy is experiencing tailwinds, but some of them take time to become evident. For example, there are steps to address government and state-owned enterprise borrowings and create much needed confidence in them, which is being recognised by the ratings agencies. S&P and Fitch have not downgraded SA further and Moody’s has retained us at investment grade. This gives the government breathing space without facing higher borrowing costs.
It is vital that the SA economy should grow because it will help with addressing issues such as low tax collection and unemployment. Failure to achieve that will lead to an unsustainable debt path which can over time threaten ratings again.
In this environment of high volatility, an income fund is a relevant inclusion in any portfolio. Income funds are largely exposed to the shorter end of the fixed-interest market, which reduces their volatility and provides income protection. They are offering annualised yields of about 9% gross. Bond funds, which have greater exposure to medium and long-term debt, are showing some losses, but it makes sense to buy into a bond fund when yields have risen beyond fair value.