There has been a mixed bag of developments for the domestic market since the elections in early May. Some stability emerged after the official election outcome was announced, but the new administration has not yet been able to provide convincing evidence that the current trajectory of the domestic economy is going to change. At the same time, global growth concerns are mounting and an ongoing maturation of the dollar liquidity cycle is expected to precipitate an increasingly fragile EM FX environment. Add to this renewed fiscal fears stemming from the dwindling local growth outlook, raising concerns about SOEs and renewed uncertainty related to the SARB’s independence, and local bonds are assessed as becoming increasingly vulnerable. On the interest rate front, the market has turned very aggressive in positioning for dovish risks over the short to medium-term. While domestic growth is soft and inflation risks are muted, the ZAR is fragile for the reasons mentioned above, and the local currency has been subject to an increase in volatility of late. It, therefore, remains to be seen whether the SARB will feel comfortable to lower interest rates at the July meeting, especially if ZAR volatility remains elevated in the weeks leading up to this meeting. If they do assess the environment as appropriate for lowering rates, the view is that there will potentially only be one interest rate cut (rather than the numerous cuts that the market is pricing in at the moment).
GLOBAL BUSINESS CYCLE MATURING
Emerging markets got off to a rosy start in 2019 as the market became more optimistic of a possible trade deal between the US and China, while at the same time, major central banks such as the Fed, ECB, BoE, and BoJ shifted to more dovish rhetoric. Since early in Q2, developments on the geopolitical and global trade front have resulted in a marked deterioration in global risk appetite, weighing heavily on perceived riskier EM assets. Although international investors have adopted a more cautious tone recently given the multitude of geopolitical and other risk events that are present, they have been reluctant to fully rotate out of the EM space given the attractive returns offered by these assets. This is captured in a gradual increase in foreign ownership of domestic bonds since the beginning of the year, with combined vanilla and inflation-linked bonds owned by non-residents rising to 39.2% (or R 767.87bn) from a recent low of 37.7% back in December. When stripping out just vanilla bonds, this proportion increases to 47.3%, or R 761.06bn of the total R1.61trn in total vanilla bonds in issuance by the end of April.
Note, though, the latest available figures from NT only covers movements up to the end of April, and the latest portfolio flows data suggests that foreigners were, in fact, net sellers of domestic bonds in May. While there appears to have been a shift in sentiment once again at the start of June as the Fed has offered a more dovish bias on policy risks, these market movements, as always, should be viewed in the context of the global business cycle dynamics.
It is therefore instructive to note that while the Fed has adopted a more dovish leaning policy stance, the global business cycle is still maturing and this is captured in the USD liquidity measure which has trended lower in recent quarters. The tightening of the USD liquidity cycle, as seen in the accompanying chart, raises red flags for risk assets over the medium term. Once a point is reached where USD liquidity has tightened sufficiently (as demonstrated by prior toughs), we tend to see riskier investment destinations, including EMs, experience significant sell-offs. Furthermore, note that many EM crises over the past couple of decades have coincided with the USD liquidity cycle troughs.
DOVISH SARB EXPECTATIONS GROWING
As expected, the SARB kept its benchmark repo rate unchanged at 6.75% for a third consecutive meeting in May, although the decision wasn’t unanimous this time around as two MPC members voted for 25bps cuts. The central bank came out notably more dovish than in the recent past, with the quarterly projection model (QPM) now signaling a rate cut by the end of 2021. Recall that at the March meeting, the model was projecting one 25bps interest rate hike by the end of 2019. Since the May meeting, the market has ramped up dovish SARB bets, and the abysmal Q1 GDP data released early in June in conjunction with a more dovish policy bias by the Fed have emboldened the doves. Add to this the latest collapse in the oil price, and interest rate reductions in the near future seem like a no-brainer.
There is one caveat, however, which is, of course, the ZAR. Although the dollar’s bull run has been brought to a halt, providing a boost to emerging market currencies, the ZAR has suffered a significant blow as the combined news of a collapse in GDP, and an ongoing fight for the SARB’s independence sent ripples across the domestic FX market. When pulling back the lens, there appears to be a decoupling of the relationship between the USD and emerging market currencies and investors are focusing more closely on idiosyncratic dynamics instead. ZAR internals has turned increasingly less supportive as both fundamentals, and fiscal dynamics have continued deteriorating.
As the ZAR internals deteriorate, the currency becomes increasingly vulnerable to external shocks, and the SARB will be cognizant of this. On balance, given the collapse in the oil price,
the extremely poor Q1 GDP number and the associated output gap, coupled with moderating inflation expectations have arguably built enough justification for the SARB to act at the next meeting and cut. Whether another cut beyond that is justified is debatable. Recent weakness in the ZAR will be seriously testing the view that the SARB must cut and more than once.
Moreover, ETM’s Inflation Risk Indicator points to limited room for
interest rates to be lowered over the next year. SA’s fragility does
not lend itself to more than possibly one interest rate cut, and
even that should not be treated as a foregone conclusion. The
SARB itself will likely be surprised in how quickly the market has
moved to price in cuts, and while one cut at the next meeting is
possible, two cuts before year-end with a currency behaving like
it is, feels like a stretch.
BUT ALAS, FISCAL RISKS CONTINUE MOUNTING
South Africa’s SOEs remain in full-blown crisis mode. Various resignations from CEOs at high-profile state companies are symptomatic of this and understanding the reasons behind the resignations of some key SOE CEOs recently is sobering. It also continues a worrying trend where some of these SOEs are without a permanent CEO. Eskom, Transnet, PRASA, and SAA are all searching for permanent CEOs with the Eskom and SAA CEO resignations materializing in just the past two months. The theme that runs across all of them is the alleged political meddling and blurring of jurisdictional lines between the CEO, the board and the minister which has resulted in the company’s decision-making agility being lost, leaving these companies with an incoherent turnaround plan. In both Eskom and SAA’s cases, decisions being taken to satisfy the short-term objectives of keeping the companies functional are undermining the longer-term turnaround objectives with the consequence being a steady build-up in their respective debt piles. As if the debt accumulation was not already desperate at both Eskom and SAA, such developments render any turnaround plans unachievable and the CEOs have clearly lost their confidence in being able to implement an action plan.
While one can lament the lack of progress made, there are practical issues that cannot be wished away, and they relate to the rate of increase in the interest on debt line items on these companies’ income statements that render them defunct. It is now also clear that without a major debt roll-up on to the government balance sheet, that these companies will never be able to recover. The amount of money now needed to stabilize these companies is gargantuan and rising by the day. Conservatively speaking, debt in excess of R400bn could be rolled up to help alleviate the interest on debt burden on cashflows, but the problem runs far deeper than just that. These companies are massively inefficient and so bailing them out now, only risks having to repeat the process in the next decade. Furthermore, and lest we forget, the government is currently sustaining a budget deficit in excess of 4.5% of GDP, a figure that is likely underestimated. SA’s debt trajectory has been steadily rising for a decade and looks set to rise further. A debt roll-up which is looking increasingly inevitable would not only place another massive burden on a shrinking tax base, but would be a very credit negative development if not accompanied by the means to turn these SOEs efficient and profitable. It means that the “developmental” objectives of some of these SOEs will need to be reassessed, that they no longer be used as employment vehicles and that the state finally considers the option of partial privatization as they did with the likes of Telkom. Anything short of this will likely perpetuate the slide and render these companies even greater burdens. For the bond market, it implies that a healthy risk premium needs to be reflected in yields. The idiosyncratic risks that are permeating the domestic market will likely prevent domestic bonds from fully capitalizing on the renewed appetite for yield across global markets that has been brought about by the dovish shift at the Fed.
Published by ETM Analytics (Pty) Ltd for the Phoenix Group