Sanlam Select Bond Plus comment - Mar 17
Taking into account all of the volatility we have seen over the last quarter it is quite remarkable that the rand is trading where we ended 2016 - 13.65 against the US dollar at the time of writing. Similarly, the benchmark R186 bond is trading at a yield of 8.90%, the close we saw in December. Based on prior market episodes and the reaction to news of this extent many of us would have expected much weaker levels.
We did see a sell-off in the rand of roughly 11% from the lows seen merely two weeks ago and yields retracted from a low of 8.30 to their current levels but if things are really as bad going forward as some commentators lead us to believe then there could be room for more movement/weakness. Overnight we all became experts on how things work in the ANC, and we are dreaming of a ..no confidence...... impeachment and resignations. What has come to the fore, though, is that things do not move that quickly in the ANC and the individuals that spoke out against president Zuma have within days apologised to a certain extent for what they had said. All is not doom and gloom, though.
Local assets have actually held up remarkably well. This is mainly due to the renewed appetite for emerging market (EM) assets with the Fed less hawkish and Trump clearly not being able to push his campaign promises through, specifically a Middle Eastern travel ban that was blocked by the courts together with a failed repeal of Obamacare that was withdrawn by a house vote thanks to lack of support. We have seen foreign inflows of roughly R20 billion over the last quarter. Foreign investors clearly still see value in our local bonds. The downgrade by S&P puts our local debt one notch above junk status. For South Africa to be kicked out of offshore investment grade indices that track EM fixed income assets we need to be rated sub-investment grade, i.e. junk, by two rating agencies. Initial estimates are that if this were to happen, offshore investors will be forced sellers of roughly 7 billion dollars. This will put significant pressure on local bonds and the currency. S&P did downgrade South African foreign debt to junk status but this has less of an impact than the local debt rating. They have kept us on negative outlook, meaning any rating announcement is live from a further downgrade perspective.
On 15 March the US Federal Reserve raised interest rates by 0.25% in a well anticipated move. This is only the third time since the global financial crisis that the Fed hiked interest rates, once in 2015 and once in 2016. Members of the Fed have indicated that the pace of rate hikes will pick up with another two hikes expected by the end of the year. This interest rate hike was justified based on mainly unemployment and not the actual strength of the economy. US unemployment has fallen to 4.7% with the US adding jobs for the last 77 months. Fixed income markets in the US sold off leading up to the meeting date on expectation of the hike but also more to come. The US 10-year bond traded as high as 2.60 shortly before the meeting but retraced to the lows of the year and currently trades at 2.32%. Contrary to expectations, the US dollar has also not rallied much against peers with specifically EM currency baskets benefitting over the quarter. Furthermore, the market is not agreeing with the rate hike expectations and is pricing in only one further hike in the US in 2017. In 2015 and 2016 the market was correct.
Locally we remain constructive on inflation in South Africa based mainly on expected food price deflation with record crops expected after the decent rains in the northern parts of South Africa. Hard data are showing a struggling consumer with local GDP expectations continuing to be lowered. The market correctly anticipated the monetary policy response to inflation and growth and started to price in multiple rate cuts over the forecast period. To explain the possibility of rate cuts: the rand has (even at current levels) appreciated against the US dollar by 9% over the last 12 months, stemming fears of a foreing exchange pass-through into inflation. A rand that stays stable at these levels or stronger could actually lead to further deflation on imported goods. Our expectation is for local inflation to dip well below the 6% upper limit of the target band and we estimate that inflation could be at 5% with an exchange rate of 14 against the US dollar. Were we to see the rand at 13 against the US dollar, inflation could trough as low as 4.5%. The recent Monetary Policy Committee meeting on the day of the cabinet reshuffle confirmed our views with one member actually voting for a cut in rates at that meeting. The market was also agreeing with this view on 22 March with the 12-month forward rate agreement (FRA) then pricing in an 80% probability of a 50 basis point cut. At present the forward market is pricing in no rate cuts with slight rate increases in three to four years time.
If one looks at the South African credit default swap (CDS), the shape of the yield curve, as well as the spread between bond and swap yields (asset pack), you can clearly see the risk that the market is pricing in to the credibility of National Treasury at present. The South African CDS traded from a low of 182 in middle March to 220 basis points at the time of writing of. This is much less than the levels we saw during December 2015 when we went all the way up to 380. The market was either better positioned for the news that came out or it..s again, as mentioned, complacent at present. The foreign demand mentioned before is mainly in the most liquid 10-year area of the curve. Local investors correctly reduced duration during March at the lows of the market, selling mainly longer-term bonds, i.e. greater than 10 year. This, combined with the additional risk premium priced in by the market, has caused the yield curve to steepen over the quarter. The spread between bonds and swaps (asset pack) is also higher, further showing the distress in the local bond market with the bond curve steepening and the swap curve remaining stable.
We have been marginally underweight duration throughout the quarter amidst the volatility experienced. We favour the 7-12 year area of the curve, as well as oneyear NCDs, and have underweights in the 3-7 year and 12+ year area of the curve. We are cautious at present regarding the full impact of the changes we have seen in the cabinet and how that will play out, especially at National Treasury. Investing in projects or infrastructure that is not required will cause an escalation of our overall debt and if that debt comes at a much higher cost we are in for tough times ahead.