The US 10-year bond has rallied from levels of just above 2% to 1.7% over the course of the quarter, for several reasons. The escalation of tension in the US/China trade relationship has dented global confidence, which has led to a material slowdown in the global capex cycle. This has coincided with a slowing in US and global growth. Central banks have been quick to step in and engineer a softer growth landing, with the US reducing interest rates 0.5% this year and the European Central Bank (ECB) moving deposit rates further into negative territory, accompanied with a restart of their bond purchase programme. Current data emerging from Europe points to growth slowing to 1% with inflation of 1.5%, which suggests, at a bare minimum, a continuation of accommodative monetary policy in the EU. US data, more specifically the US labor market, has proved more resilient despite recent cracks starting to appear. The US Federal Reserve Board (the Fed) has adopted a wait-and-see approach to further rate easing, which is much more restrained that the market’s current pricing of interest rate cuts. We are still quite far away from seeing a restart of the US quantitative easing (QE) programme, given the room to move lower on policy rates. The hope is that recent measures implemented by global central banks are enough to mitigate an aggressive growth slowdown in the months to come.

On the local front, we remain in limbo as we await the Medium-Term Budget Policy Statement at the end of October and further details on the turnaround for Eskom. Inflation continues to be well behaved and expectations are for it to average 5% over the next two to three years. Growth expectations have been continually revised down, with current expectations for a marginal pick up to 1.5% over the next two to three years. Structural reforms have been much talked about, especially in the new National Treasury economic strategy plan released by Finance Minister Tito Mboweni towards the end of the third quarter. Unfortunately, time is running out, and what’s needed now is an accelerated implementation of these initiatives in order to bring back confidence and investment into the local economy.

Government finances continue to weigh heavily on the local outlook, with the fiscal deficit expected to breach -6% this year and debt/GDP to push above 60%. The major culprit of this deterioration has been the continued support needed by ailing stateowned entities (SOE’s), most specifically Eskom. Without a credible plan to turn around the entity, more money will need to be poured in to allow it to meet its obligations. Herein lies the major risk for the local economy, and, while there has been an acknowledgement of the problems by government, there has been a lack of urgency in putting a credible plan in place to halt Eskom’s deterioration, let alone turn the entity around. Moody’s is still the only rating agency that rates SA as an investment-grade country and has provided the country with a tremendous amount of leeway over the last 12 months. Their recent statements suggest that they will continue to do so, given the reform intent of government. However, given what is currently known about the trajectory of further deterioration, if there are no substantial efforts to fix the problems the country faces, it is very likely that SA is assigned a negative outlook on our investment-grade rating by November 2019 and that SA is downgraded to subinvestment grade territory by the third quarter of 2020.

The deterioration in SA’s fundamentals have been well flagged, which has allowed a risk premium to be built into SA government bonds (SAGBs), both in terms of absolute yields and the steepness of the yield curve. SA’s credit spread (represented alongside by SA credit default spread) already trades at levels that are consistent with a subinvestment peer group. In addition, 10-year SAGBs trades at a spread of 7.3% over US 10-year yields, which is well above the long-term average and close to the widest levels it has been in ten years. These measures suggest a decent amount of the bad news is already being priced in by markets.

Furthermore, SAGBs look quite cheap when compared to the EM universe. We show the nominal yields of various EM bond markets and their implied real yields (the return one would get if we strip out the effects of inflation over the next year). SA not only sits well above the EM average but also at the top of the ranking table when it comes to the relative cheapness of nominal and real yields. In a world of very-low to zero yields, SA bonds look fantastically attractive and relatively cheap to dollar-based investors.

As a dollar-based investor, when one invests into a local currency bond market, there are two major risks that one takes. Firstly, you take the risk that the yield at which you are investing does not offer a sufficient margin of safety in the event of further local fundamental deterioration, and secondly you are taking the risk that the currency depreciates to such an extent that it wipes all the yield from the bonds. The first risk is something that we have discussed at length in the past. We construct a fair value for 10-year SAGBs, using the expected global risk-free rate (US 10-year), expected US/SA inflation differentials and SA credit spread. We use values of 2% (Normal US 10-year rate), 3.8% (5.3%-1.5%) [SA 10-year breakeven - US 10-year breakeven] and 3.2% (SA EMBI Plus Sovereign Spread) to arrive at a fair value of 9.03%, which is not far from current levels of 8.9%. This suggests that SAGBs trade pretty much at fair value, implying not much room in the case of further fundamental deterioration.

Dollar-based investors have the option of buying 10-year SA bonds issued in dollars, currently trading at 4.9% with no currency risk or buying a 10-year SAGB issued in rands trading at 8.9%. If you do not expect the currency to move, then it’s a no-brainer to buy the bond issued in rand due to the higher yield on offer. Over the last 20 years, the rand has depreciated by an annualised rate of 4.5%. The annual depreciation would comprise inflation differentials and risk premium. Since SA runs a higher inflation rate that the US, the rand has to deteriorate by a minimum of the inflation differential in order for purchasing power between the two countries to remain unchanged. The more unpredictable part is the risk premium that needs to be priced due to the risk of deterioration in other local factors. Over the last 20 years, inflation differentials between SA and the US has been 3.4% (5.6%-2.2%: actual inflation outcomes), suggesting the risk premium should be 1% (4.4%-3.4%). Current inflation differentials sit at 3.8%, which makes the 20-year annualised depreciation of 4.4% look reasonable, as we assume a reduced risk premium going forward. This implies that a dollar-based investor can expect a return in dollars of 4.5% (8.9%-4.4%). Compared to the actual SA 10-year dollar bond, this is not that attractive, unless one has a materially positive view on the currency. It would also explain why the local SA bond market has experienced outflows this last year of approximately R8 billion. This is a big turnaround from the R20 billion of inflows we were sitting with at the end of the first quarter of 2019.

SA inflation will remain benign and growth subdued, which would, at worse, allow policy rates to remain on hold. However, persistently low growth and the need for further support of SOEs will weigh heavily on government finances, resulting in wider budget deficits and a significant increase in the debt burden. The global environment remains supportive for EM and SA, especially given the renewed monetary policy easing embarked on by global central banks. However, SAGBs trade at fair value at best and have a very limited margin of safety against a turn in global sentiment or a worsening in local economic conditions. Therefore, it is prudent to maintain a neutral to slightly underweight allocation to SAGBs at current levels.

The All Bond Index (ALBI) returned 3.8% over the last quarter, bringing its return over the last 12 months to 3.5%. Inflation-linked bonds continued to lag nominal bond performance, producing 0.6% over the last quarter and -3.1% over the last 12 months. In dollars over the quarter, South African bonds returned 2.8%, in line with the 2.9% returned by other emerging markets (as measured by the JP Morgan Government Bond Index - Emerging Markets Global Diversified Composite). However, they remain quite a laggard over 12 months (-15.6% versus -7.5%). The 10-year benchmark bond traded in quite a narrow range over the quarter (9.47% to 9.08%) before breaking lower to sub-9.0% after the end of the quarter, following rating agency Moody’s decision to keep South Africa’s credit rating stable at investment grade.

The sustainability of South Africa’s investment grade rating will remain a key concern. Credible monetary policy has caused inflation and inflation expectations to gravitate towards the midpoint of the band (4.5%), yet it remains adequately accommodative given the subdued growth profile. Growth, or the lack thereof, remains at the core of South Africa’s structural problems. Cyclically, growth should pick up to approximately 1.3% in 2019 and 1.8% in 2020. However, the risk to this outcome is to the downside, given the threat of load shedding, the effect it has on business and consumer confidence, and how rising electricity-related costs affect corporate profitability. The burden of low growth and state-owned enterprise (SOE) support weighs heavily on fiscal policy. Until more concrete structural reforms are put through, it is up to fiscal policy to provide a supportive growth environment and support for SOEs in a manner that does not widen the fiscal deficit or increase South Africa’s debt burden. Up to now, this has been well managed, as is evident in the February budget, where despite the R23 billion per year capital injection for Eskom, National Treasury still managed to limit fiscal slippage by cutting expenditure, primarily through a reduction in the wage bill. Unfortunately, given Eskom’s precarious financial and operational position, the SOE still poses immense risk to both the fiscus and the economy.

Global monetary policy has again turned accommodative. Following the US’s about-turn on monetary policy, the European Central Bank followed suit a few weeks later. Global bond yields have plummeted, with the US 10-year Treasury Note continuing to rally to below 2.4%. An amazing 20% ($10.3 trillion) of all issued government bonds now trade with yields below zero. In previous periods, this proved to be quite supportive for emerging market government bonds; however, this time around, given the inversion of the US yield curve (10-year rates trading below cash rates), more caution has been exercised. An inverted US yield curve has been a successful predictor of all recessions over the last 30 years; however, the period between curve inversion and the onset of recession varies between 12 and 24 months. Therefore, over the short term, we might see this ‘goldilocks’ period for emerging markets continue, supporting their currencies and bond yields. Over the longer term, we still see fair value for US bond yields being above 3%. Growth in the US has come off in the shorter term due to the government shutdown at the beginning of the year and the tax cuts of 2018 coming out of the base, but is still expected at 2.5% for 2019 and 2.0% in 2020. Furthermore, wage inflation has continued to prove quite sticky, which should keep headline inflation close to the 2.0% level. Market expectations of interest rate cuts in the US seem premature at this stage, with the economy growing at 2.5% and inflation at 2%. A 1.0% real policy rate still seems appropriate given the prevailing conditions, which suggests a 3.0% nominal long bond rate at the minimum (2.0% inflation plus 1.0% real policy rate). The risks posed to global bond yields are therefore to the upside.

The key consideration for a South African bond investor is whether the yield on offer by South African government bonds compensates them for the underlying risks that the economy faces. The main areas of concern are the effect of South Africa losing its investment grade rating, the impact of higher global yields on South African bond yields and how South African bonds fare relative to their emerging market peers. South Africa’s credit rating has and continues to trade at subinvestment level. The graphs below show the South African credit spread relative to the BB Spread Index (the index representing the credit spread of the first rung of subinvestment grade) and then the BB Spread Index (right) over a long period of time. The graph on the left shows that South Africa trades in line with the subinvestment grade index (10 basis points [bps] more expensive than current index levels), while the graph on the right shows that the subinvestment grade index trades pretty much at its long-term average. Both metrics suggest that South Africa, even if Moody’s were to move the country to subinvestment grade, at worst could see a widening of between 10 bps and 20 bps.

Once again, South Africa features as quite attractive relative to its peers, especially considering that Brazil has yet to pass a massively unpopular pension reform initiative to reduce its debt to GDP ratio from 80%, while Mexico’s largest SOE (petroleum company Pemex) is in dire need of further financial support that will weigh on the Mexican fiscus and, hence, credit worthiness.

If we construct a fair value for South African 10-year bonds using the global risk-free rate (US 10-year yields), the expected inflation differential (between South Africa and the US) and South Africa’s credit premium, the result is 8.92% (3.0% + (5%-2%) + 2.92%). Current levels of 9.0% on South Africa’s 10-year government bond therefore compare quite favourably to our fair value estimate. Given the long-term risks the local economy faces, predominantly from a further deterioration in Eskom, one would look to move from a neutral to slightly underweight allocation to South African government bonds, as levels move through our fair value estimate.

Chronic load shedding and poor local sentiment will continue to weigh on South Africa’s growth outcomes. Inflation should remain under control, allowing policy rates in South Africa to, at worse, remain stable. Global monetary policy has once again turned more supportive for risk sentiment, which should help buoy emerging market valuations over the shorter term. At current levels, South African government bonds trade cheap to fair value estimates. However, given the longer-term risks posed to the economy from further SOE deterioration, allocations should be kept at a neutral level.