Articles

Nominal bonds remain our preferred asset class in South Africa (SA). That said, where we ranked the expected return of cash already ahead of most asset classes for the last quarter, cash’s expected return is now also closing gap with bonds. This comes as higher domestic real yields weigh not only on growth, but also on asset valuations. In short, higher real yields imply higher real risk, which results in investors wanting to pay less than before for the same earnings. Our analysis suggests that nominal bonds, on a 12-month horizon, remain likely to generate low double-digit returns, followed by cash, inflation-linked bonds (ILBs), listed property and equities.

The inflation-linked bond (ILB) curve has seen some bear steepening over the past month, with the back end of the curve moving above 5,0% last week. We maintain our view that long-dated ILB yields are still too low, and as a result, we expect further upward pressure and steepness.

This week will see the release of South Africa’s (SA’s) 2Q GDP data, which could signal a fairly resilient economy, despite the country’s ongoing load shedding (albeit at lower stages in 2Q) and multiple global headwinds present. We project growth of 0,3% q/q in 2Q23 from 0,4% in 1Q23. We project low levels of growth of c.0,2% for the whole year and 1,3% over the next two years. Risks to these estimates are marginally to the upside, especially if SA’s energy woes ease and global demand ticks up.

We estimate what to expect from spreads on the nominal curve if we are set for more dovish inflation surprises while the fiscal policy bind remains. This result is consistent with our research, which suggests that the back end of the curve remains largely irresponsive to any dovish monetary policy surprise. Fiscally induced inertia in ultra-long bonds is likely to keep the curve steep and, for the time being, we would continue to hold a bias for such an outcome should there be some bull curve flattening.

With the USDZAR at 19,00, the “weak China trade” is priced into the rand, in our view. The rand, being a commodity and emerging market (EM) currency, tracks South Africa’s commodity terms of trade closely. Focusing on the post-pandemic period, the relationship of the terms of trade with the rand suggests the currency should trade stronger rather than the 19,00 level. Where weak commodity prices have led to a weak rand, we believe the larger risk right now lies in a stronger USD in the short term.

Where nominal bonds appeared attractive across the curve for the past two months, much of the upside has compressed for now, in our view. At this point, we believe cash appears attractive relative to the front and back ends of the nominal curve. Our analysis suggests only the 7-year to 15-year bucket appears attractive and provides better expected return than cash. The same goes for inflation-linked bonds (ILBs), although we believe the curve may bear steepen somewhat and shorter maturities may provide better value in an environment where an adverse inflation impulse remains likely.

There is an unwritten rule that says one should favour bonds (or duration more broadly) whenever there is a dovish monetary policy surprise. Some call it “the Golden Rule”. In the case of South Africa (SA), this rule has been highly predictive over the past 20 years. However, fiscal dominance of ultra-long bonds has been diluting this rule, suggesting a structural bias for shorter-duration bonds in a scenario where monetary policy is a key input for one’s bond view.

Against our forecast, the SARB MPC kept the repo rate unchanged at 8,25% due to an improvement in the macro environment, downward revisions to the inflation outlook and a stronger rand exchange rate. The tone of the statement was still hawkish, and the governor indicated that interest rates have not peaked, that it is not the end of the hiking cycle and that the trajectory of monetary policy will depend on inflation outcomes. The voting pattern also shifted materially since the last meeting, to three members voting for a hold, while two voted for a 25 bps hike, compared to May, when all members voted for a 50 bps hike. Given the backdrop of sticky inflation and upside risks thereof, we cannot rule out further rate hikes in the near term. However, our base case is that the MPC could maintain the repo rate at the current level before starting an easing cycle in mid-2024, or sooner.

We expect SARB to hike the repo rate by 25 basis points (bps) this week. The hike will see a reduction of its rate-hike increment, after the last two consecutive 50 bps hikes. At the same time, we project South Africa’s (SA’s) CPI to ease further in June, to 5,6% yoy from 6,3% in May, driven predominantly by lower transport and food inflation.

Since the start of this year, South Africa’s (SA’s) ex-ante real rate has been roughly in line with the US’s. This is the longest period in which this has been the case. SA’s ex-ante real policy rate has almost always exceeded that of the US, providing an attractive real-rate pick-up for offshore investors to invest in SA. But this year, rising SA inflation expectations, slow increases in the FRA rate and expectations for an end to SARB’s hiking cycle have kept SA’s ex-ante real policy rate unattractive relative to the US’s. In contrast, US inflation expectations have fallen, while the Federal Reserve (Fed) has remained hawkish. This has shown up in a weaker currency [USDZAR -10,4% year to date (ytd)] and higher SA bond yields [(SA 10y yield up 100 basis points (bps) ytd]. Our base case remains for a correction in one or both of these rates in the coming months. SARB will likely hike by 25 bps this month, taking the repo rate to a peak of 8,50% (with upside risks to this estimate should inflation surprise to the upside). The Fed is expected to hike twice more this year, which could push out the first rate cuts by both central banks to around the middle of 2024.

Despite a volatile second quarter, when developments in the political economy dominated asset price movements, we prefer to stay the course. Our preference for domestic asset classes remains unchanged, with local-currency bonds topping the list of expected returns.

Headline inflation is expected to have eased for the second consecutive month in May, to 6,7% yoy from 6,8% in April. Despite the slow deceleration in CPI, it is still projected to remain at an elevated level of 6,4% in 2023 (annual average) before easing to 4,9% in 2024. Risks to these estimates are to the upside, particularly to the estimate for 2024.

The local markets have rallied in the past two weeks. While any strength is unlikely to be linear, we still view the rand and nominal bonds as cheap. Monetary policy will be a key focus, driving especially bond markets in the next two weeks.

South Africa’s (SA’s) GDP growth for 1Q23 will be released this week, with expectations for fractional growth just enough to stave off a technical recession; we project growth of 0,2% q/q in 1Q23. Full-year growth estimates are at risk of being revised lower, which would adversely affect revenue collection and fiscal ratios.

Our indicators suggest that from a risk/return perspective, this is the wrong time to extrapolate rand weakness. It is easy to maintain a bearish narrative, but the reality is that plenty of bad news is priced in already to the currency. For bonds, we maintain that while ILBs appear fair, nominal bonds, too, are cheap.

It appears as if inflation expectations have recently become more inelastic than before and may well remain elevated for longer. There is a further risk that expectations remain more inelastic than before as the country experiences weaker trade integration and rising public debt. On the back of a weaker rand, higher country risk and elevated inflation outcomes and inflation expectations, SARB is expected to hike by 50 basis points (bps) this week. The bias remains for further hikes at future meetings.

Uncertainty within South Africa’s political economy has increased further this week as the now widely publicised deterioration of the relationship between South Africa and the US has gathered momentum. While the rand has reached our target of R19,00 against the USD, bond yields have moved well beyond what we expected. At this point, bond yields reflect substantial fiscal risk, in our view.

Base case: S&P Global Ratings (S&P) may defer its review, given the recency of its post-budget rating action that affirmed its BB-/B ratings and led to revising its outlook to “Stable” from “Positive”.