Matrix NCIS Balanced Comment - Sep 19
Global policy discord was the main theme in 3Q19 as political decisions hurt growth, leading to demands from politicians for monetary policy to do more.
Trump expanded tariffs on Chinese imports, although implementation will be staggered. The decline in the equity market stoked recession fears, with the US 2s/10s curve inverting. The Fed has cut rates twice since mid-2019, but the statements, minutes, and dot-plots have revealed a less dovish tone. Yet the Fed Funds futures are pricing in one more cut for 2019 and two more for 2020.
It is a case of the Fed following the market, albeit reluctantly, given that falling rates, a 50-year low in unemployment, and trend GDP growth are offsetting fiscal tightening and trade wars. The slump in the ISM manufacturing index may be an overreaction to data and politics, but the fact that the oil price has not rallied despite attacks on Saudi production facilities suggests that global growth is faltering.
The ECB has already embarked on the next round of QE with Draghi’s swansong delivering deeper negative rates and asset purchases of EUR20bn per month. Negative yields across Europe and Japan are spilling over to the US and, from there, pushing investors further out the risk frontier. This search for yield has helped mask South Africa’s deteriorating fiscal position, as local bond yields have risen only modestly in the face of higher issuance.
The government announced a second large bailout for Eskom, which will have to be funded by higher taxes or expenditure reprioritisation. Both will be a net drain on the economy, as the cash injection will go towards debt redemptions rather than infrastructure.
While we all bemoan that the SARB has not cut rates more aggressively, we must acknowledge that weak fiscal policy and lack of reform has hamstrung monetary policy. Cautious language accompanied the July MPC repo rate cut, highlighting that the SARB is cognisant of the risks. Hence, the Medium Term Budget Policy Statement will have to go beyond business-as-usual in laying out a clear and credible plan on how government will steer the fiscal ship on a more sustainable course..
During 3Q19, SA floating-rate credit (3.1%) beat cash (1.8%), while fixed-income asset classes (fixed-rate credit (1.5%), nominal bonds (0.8%), and ILBs (0.3%)) trumped property (-4.4%) and equities (-4.6%).
Relatively resilient US growth and sporadic safe-haven demand related to trade tensions, geopolitical risks, and impeachment uncertainty added impetus to the greenback. The rand lost 7.2% against the dollar in Q3, with some of the weakness reflecting hedging activity. The rand is marginally cheap versus our 14.50 – 15.00 fair value range for USD/ZAR, but weak productivity growth and a substantial fiscal funding requirement are headwinds to major gains in the local currency.
Local bond yields rose only 20bp during 3Q19, but this belies the sharp increase in SA’s risk premium versus EM. SA’s 5-year CDS spread over its peer group widened from 60bp to 90bp, while the SA/GBI-EM spread rose from 280bp to 340bp. SA-specific factors account for the underperformance, as high real yields are required to entice foreign funding. At 8.80%, the SA 10-year yield is trading 720bp above the US equivalent, but within our 8.60% - 9.10% fair-value range.
Central bank easing did not counter trade wars and Trump tweets in Q3, with the MSCI World flat for the quarter, while the MSCI EM lost 5.1% in dollar terms. The MSCI SA lost 13.2%, with the rand accounting for just over half the decline. Despite the September rebound, the SWIX lost 4.3% (total return) in Q3, with broad-based underlying weakness: telecommunications (-7.8%), financials (-6.8%), basic materials (-6.4%), consumer services (-6.2%), industrials (-3.9%), health care (-2.5%), technology (-1.1%), and consumer goods (-0.8%). Stock-specific issues and policy uncertainty constrained the local market, with gold (12.3%) and platinum (25.8%) the standout sectors thanks to the higher rand commodity prices.
Portfolio performance and positioning
The fund’s performance (-0.6%) during 3Q19 was driven by domestic equity (-2.4% contribution), which was partly countered by foreign cash (1%) and foreign equity (0.8%), due to the rand’s depreciation. Domestic cash (0.1%) was modestly accretive, while domestic bonds and property were broadly neutral in the attribution. Given the attractive valuations in fixed income and curtailed return distribution, we increased our duration position from underweight to overweight the strategic duration stance during the quarter.
Notwithstanding the 3.1% rebound in GDP in 2Q19, output in 1H19 was still 0.5% below that of 2H18. Moreover, the SARB’s leading indicator has trended downwards, Q3 business confidence slumped to 21, and the manufacturing PMI has dropped to a post-crisis low of 41.6. While the market welcomed Treasury’s growth plan as being more private sector friendly, policy uncertainty continues, particularly in the electricity sector. SOE bailouts have gathered pace, while revenues are running well short of budget estimates. SA credit and local currency risk premia are already reflecting the SA-specific weakness. The benign inflation outlook results in a real yield of over 4.0% in local fixed income. This is competitively priced versus local and peer group asset classes. Our equity positions still reflect a cautious view on global and local growth, being overweight resources and global diversifieds. With cheaper valuations in recent months, we have reduced our underweight allocations to various SA Inc sectors, including retailers.