Sanlam Select Bond Plus comment - Jun 19
It has been an erratic three months for equity markets. The S&P 500 Index was Goldilocks in April (+3.9%), but lost it all and then some in May (-6.8%) due to Trump's tariff tweets, only to rebound strongly in June (+7.2%) on the expectation of US Federal Reserve (Fed) easing, and to make a record high in the first week of July on a renewed trade truce. Notwithstanding the ongoing damage to the global economy from existing trade tariffs and persistent uncertainty, the equity market is signalling strong growth ahead. Admittedly, the sharp fall in bond yields has assisted valuations.
The slump in developed market bond yields is telling a different story - it signals concern about growth, evident in lower real yields, as well as deflation fears. The first half of 2019 repricing in monetary policy expectations has seen a scramble by some analysts to revise forecasts to Fed cuts. While few are projecting a US recession, some expect insurance cuts to offset the impact from trade wars and the waning impact of prior fiscal stimulus.
It is not obvious that the Fed should be cutting rates based on the performance in equities and US GDP. Yet the expectation of Fed stimulus has contributed to the easing in financial conditions, with the market pricing in at least 25 basis points for the July meeting. Hence, the Fed would have to explain a pause carefully to prevent a sharp sell-off in rates and risk assets.
The Fed's dovish pivot has given emerging market central banks room to manoeuvre. The SA market reflects this, with the forward rate agreement curve fully priced for a 25-basis point rate cut in July. SA is a more obvious candidate for substantial central bank easing, but fiscal risks and capital flow volatility have so far prevented an easing cycle. With only five Monetary Policy Committee members contributing to the July meeting, the divisions within the committee make the repo rate outcome a much closer call than what the market is reflecting.
A more dovish Fed and hopes of a trade truce left local equities (4.8%) in the lead for June. Bonds (2.2%), listed property (2.2%) and fixed-rate credit (2%) beat cash (0.6%), while floating-rate credit (0.5%) and inflation-linked bonds (0.3%) underperformed. For 2Q19 all the asset categories beat cash (1.8%), with listed property taking a surprising lead (4.5%), followed by fixed-rate credit (4.2%), equities (3.9%), bonds (3.7%), inflation-linked bonds (2.8%) and floating-rate credit (2.6%).
The lower Fed dot plot and US yields left the Dollar 1.6% weaker in June and emerging market FX 2.5% stronger. The Rand rallied 3.5%, taking the USD/ZAR to the low 14.00s. At 14.10, the Rand is neutral on our short-term 14.00-14.50 fairvalue range, but potentially expensive on a medium-term view given the weak growth trajectory and potential for credit rating downgrades.
Developed market bond yields plummeted in June with the German 10-year Bund falling deeper into negative territory (-0.4%) and the US 10-year bond moving sub-2% for the first time since the 2016 US elections. Expectations of Fed rate cuts and European Central Bank President Draghi's 'whatever it takes 2.0' boosted global bond markets. SA lagged the global rally due to the negative impact of the first-quarter GDP data, political news flow, and fiscal fears. Even so, the 10-year yield fell by 30 basis points in June, to 8.70%, which is at the lower end of our 8.60- 9.10% fair-value range.
Falling yields contributed to the surge in equities in June, with the S&P 500 Index rebounding by 6.9%. The MSCI World Index gained 6.5%, marginally beating the MSCI Emerging Markets Index's 5.7% gain. SA was a relative outperformer, in part due to FX appreciation, with the MSCI SA Index up by 6.2%. The FTSE/JSE All Share Index gained 4.8% and the FTSE/JSE Shareholder Weighted All Share Index 3.1%. The underlying performances were wide-ranging: resources outperformed (8.9%), in particular gold mining (+24.5%) stood out, followed closely by consumer goods (8.4%), while industrials (-4.1%) and health care (-0.5%) declined outright. Financials (1.3%) and consumer services (0.6%) underperformed, while technology (4.4%) and telecommunications (4.1%) outperformed modestly. The rally brought valuations closer to fair value with the market now trading on a forward price-toearnings ratio of 13.5.
Portfolio performance and positioning We maintained a neutral-duration stance in June given our view that the rally in global and local rates was becoming extended. Fiscal risks have escalated based on the government's commitment to front-load support to Eskom. Taking into account weak real and nominal GDP growth, tax revenue is very likely to fall far short of the Budget estimates. These factors point to further increases in weekly issuance, which should put a floor under the level of yields in the medium term.
The rally in the bond market has pushed the 10-year yield towards the bottom end of our 8.60-9.10% fair-value range. At this juncture, it is a trade-off between further downside in global bond yields as the European Central Bank implements QE II and as quantitative tightening in the US stops, and the local fiscal position and mounting funding requirement. Cyclically, global conditions should dominate, which should anchor SA yields at these lower levels for the time being. As such, we maintain a neutral-duration stance rather than moving underweight. The curve remains relatively steep, with long-dated bonds providing attractive carry. We reflect this view in our overweight stance in cash, the 1-3-year area, and the 12+ year area of the curve. We are underweight the 7-12-year area, but neutral the 3-7-year area of the curve.