The massive disruption wrought on the world by Covid-19 has faded into a vivid dream and, while new variants are emerging, its effect on everyday life is greatly diminished. The world now faces a new, covert predicament - the effect of soaring inflationary pressures on the cost of living. A perfect storm of the liberal application of fiscal stimulus to keep consumers afloat during the pandemic, supply chain bottlenecks and sanctions on Russian exports have combined to create the largest, synchronised uptick in global inflation in over 50 years. Global central banks were initially dismissive of the sustainability of the inflation uptick, but the last few months has seen an appreciable increase in anxiety, which has led to considerable action to limit the fallout. This more aggressive action has taken the form of many central banks looking to hike interest rates to levels that are well above neutral in a very short period to slow overheating economies. Markets have reacted by pricing a recession as the only viable means of arresting inflation, which has injected significant volatility into both developed and risky asset markets.

During the first quarter of this year, South African (SA) markets stood out for their resilience among the global turmoil, but succumbed to the pressure from global markets in the second quarter. Inflation-linked bonds (ILBs) were the only safe place within local fixed income markets as they registered a return of 2.95% for the quarter, bringing their year-to-date and one-year returns to 3.26% and 10.72%, respectively. They were buoyed by an increase in inflation expectations following an upside surprise in May’s inflation number and an upcoming period where inflation will remain above implied breakeven inflation levels. Nominal bonds followed global bond trends as yields kicked up almost 100 basis points (bps) since the previous quarter as risk sentiment soured. Despite losing almost 2% so far in 2022, the performance of SA bonds remains significantly better than that of global bond markets, which are down almost 15% in US dollars this year (as measured by the FTSE World Government Bond Index (WGBI)).

SA headline inflation surprised significantly to the upside in May, printing 6.5% versus market expectations of 6.1%. Food was the most significant upside surprise, suggesting that second round effects might prove worrisome. Our expectations are for CPI to continue its upward trajectory, breaching 8% and staying above the top end of the inflation band (6%) for at least the next 12 months. We now expect the South African Reserve Bank (SARB) to continue hiking rates in 50bps increments for the next two meetings before reverting to 25bps, taking the repo rate to 6.75% (previous 6.5%). Our expectations are for CPI to average 5.3% in 2023 and 4.5% in 2024; however, the risks remain to the upside. Current market pricing already encapsulates a significant inflation premium, suggesting a repo rate of between 7.5% and 8% by end-2023. This would imply a real repo rate, based on current inflation expectations, of 3% higher than the SARB’s own 2.1% and our expectation of real repo at 1.5% to 2%.

Fiscally, SA is on a much better footing. However, many of the tailwinds that were providing support are expected to fade and the recent intensification of the energy crisis highlights the need for further support for ailing State-owned enterprises (SOEs). The three main risks for the fiscus are a higher-than-budgeted wage bill, an extension of the social relief of distress grant into a permanent basic income grant, and further support being needed by SOEs, specifically Eskom. It is our expectation that much of the tax overrun for this year will be diverted to these three areas as opposed to reducing the borrowing requirement. While this can be easily digested over the current fiscal year, going forward, the only way these can be less onerous is with 2.5% to 3% growth.

The main impediments to growth are well known, with energy supply being top of the list. Operation Vulindlela has been fast-tracking projects, so that investment is targeted into the key growth areas. This should help the growth profile over the next two to three years, but the elephant in the room remains the energy sector and steps taken to liberalise entry into that sector. The October Medium-Term Budget Policy Statement is expected to pave the way to this through a debt plan for Eskom, which should help eliminate the largest risk for the fiscus and help accelerate the path to separation. However, until there is more clarity on this plan and its impact, SA will remain a sub-2% growth economy. On the funding side, National Treasury (the Treasury) finally came to market with a floating rate note to reduce their current cost of funding. However, at this point, the instrument is not being used as a substitute for fixed rate funding and, thus, there has been no reduction in fixed rate issuance. In the next few quarters, the Treasury should use the opportunity for lower funding costs and demand for floating rate instruments to reduce their reliance on fixed rate funding and release some of the issuance premium (which forms part of the fiscal premium) currently encapsulated in SA government bonds (SAGBs). This, once again, points to things moving in the right direction, but at a very glacial pace.

The current spike in inflation and rising global interest rate environment requires us to revisit our expectations around i) implied inflation between SA and the US; ii) expectations around fair value for US 10-year yields; and iii) the current measure for risk sentiment priced into risky assets.

Since the start of inflation targeting in SA, SA inflation has trended lower, but, more importantly, our differential to the US has also trended lower. Historically, SA inflation was expected to average between 5.5% and 6% while US inflation expectations were steady between 1.5% and 2%, leading to an inflation differential of ~4%. However, in the last five years, this has changed considerably, with the differential retreating to between 2% and 3% and, more recently, US inflation exceeding SA inflation by 2%!

Longer-term expectations for US inflation are around 2%, however, market pricing suggests something in the range of 2.5% to 3%, which is above the Federal Reserve Board’s (the Fed) average target of 2%. SA inflation is expected to be high over the short term but settle around 5% to 5.5% over the longer term, suggesting an inflation differential of 2% to 3%. Longer-term real rates have proven to be a strong driver of emerging market bond yields and risk sentiment over time. The recent repricing has been more violent and larger than in the taper tantrum of 2013, putting levels well above the post-Global Financial Crisis (GFC) average of 0.15%. The current level of 0.75% is much higher than that but still lower than the pre-GFC average of 2%. However, real GDP growth in the 2003 to 2007 period averaged 3%, compared to the post-GFC average of 2%. In addition, the debt load that the US carries now is significantly higher, with current interest payments consuming 9% of revenue, which would increase to well above 20% if the US funding rates (bond yields) move to 4.5%, which would be unsustainable. As such, with an expectation of US inflation to settle in the 2.5% to 3% range, it is likely that US real rates stay contained in the current range of 0.5% to 1%. This implies a fair value for the US 10-year rate of around 3% to 4%.

Risk sentiment has deteriorated considerably as can been seen in the performance of the BB Index, of which SA is a component. Spreads have only been wider during the GFC and the Covid- 19 crisis. The implication of this is that the market has already priced in a decent expectation of a recession, as credit quality/worthiness generally deteriorates during such periods. If the recession does not materialise or proves to be short lived, then it is likely that these spreads will return very quickly to their longer-term average of around 350bps to 400bps, or even lower, depending on the growth dynamics. In large part, the most recent sell-off of SAGBs can be seen as a reflection of the deterioration in recent risk sentiment.

The fair value for the SA 10-year bond is made up of expectations for the global risk-free rate (US 10-year bonds), SA’s inflation differential to the US and a measure of credit worthiness of the SA sovereign. In the previous paragraphs, we ascertained a fair value for the US 10-year bond was 3% to 4%, the inflation differential between SA and the US should be 2% to 3% and SA’s credit spread should be in the 3.5% to 4% range. Taken together, this puts the fair value of the 10-year SAGB at between 9% to 9.5%, which is still well below current market pricing of 11%, which continues to suggest considerable longer-term value in the SA 10-year bond.

ILBs have had a great run over the last two quarters. Despite good outperformance, we still find value in the shorter-dated ILBs, given their real yields are more than 2% and the implied break-even inflation for these instruments still sits at 5% versus our expectations for inflation of above 6% for the next year. This implies a minimum expected total return of 8.6% (2.6% + 6%) for an instrument with a maturity in 2025, which is 2% above expected cash rates and close to what can only be achieved by investing in a nominal bond of longer maturity (2026). We still believe that longer-dated ILBs, given their higher modified duration and significantly higher implied breakeven inflation, do not offer as much value as their equivalent nominal bonds and we would thus avoid these for a bond fund.

Central banks globally have started down a path of rapid monetary policy normalisation in the wake of much higher and persistent inflation. In many cases, policy rates are expected to move into restrictive territory, which carries the risk of sending the global economy into recession. There has been a profound impact on global risk sentiment and expectations are for emerging market central banks to adopt a similar stance. In SA, the market has priced a much more aggressive monetary policy normalisation cycle, despite a more gradual rise in local inflation. Bond yields have widened in line with the deterioration in global risk sentiment and repricing in global bond yields, but still encapsulate a significant risk premium. We continue to believe that bond yields in the 10-year area of the curve still offer significant value for bond portfolios, and allocations to ILBs should still be maintained but focused in the shorter end of the yield curve.

The first quarter of 2022 (Q1-22) saw a significant increase in financial market volatility. Global inflation expectations for this year have more than doubled from a year ago (5.1% currently from 2.1% previously), while expectations for growth have moderated (4% current from 4.6% previously). Russia’s invasion of Ukraine has placed risk on tenterhooks, while fanning concerns about global stagflation on the back of the resultant surging oil and other commodity prices. The hangover from Covid-19 and its many variants had already rendered economic outcomes relatively uncertain, and current geopolitical dynamics have only served to further muddy the outlook and perplex investors.

South Africa (SA) has proved to be the prettiest among its ugly siblings. In Q1-22, the rand has appreciated 9.15% against the US dollar (only outdone by the Brazilian real), ending the quarter at R14.61/$1. The terms of trade boost (higher export prices relative to import prices) on the back of higher commodity prices has been the primary driver of the rand’s outperformance. SA government bonds (SAGBs) returned 1.86% over the quarter (as measured by the ALBI), ahead of cash and inflation-linked bonds (ILBs), which returned 0.93% and 0.31%, respectively. Over the last 12 months, SAGBs have returned an impressive 12.37%, well ahead of cash (3.64%) and ILBs (10.76%). This outperformance has been driven by a flattening of the yield curve, that saw bonds with a maturity of 12 years returning 17.77% over the last year. The combination of rand appreciation and bond returns has made SAGBs the best performer in the global bond universe, well ahead of global bond indices, which have been dragged into negative territory due to the sell-off in US bond yields.

SAGB investors are still faced with assets that trade at historically and comparatively high yields, suggesting a significant embedded risk premium. However, considering recent global gyrations, a reassessment of the risks and repercussions thereof is warranted. Locally, fiscal and inflation risks must be reevaluated considering recent commodity price moves, while from a global perspective the impact of stressed US bond yields needs to be factored into current valuations.

SA’s inflation was expected to average 5.5% in 2022 and 4.6% in 2023 prior to the move in commodity prices. Consequently, the South African Reserve Bank (SARB) was expected to continue the normalisation of interest rates at a very gradual pace taking the nominal repo rate to between 6% and 6.5% by the beginning of 2024, hence maintaining the real repo rate within the 1.5% to 2% range. However, things have changed significantly since the start of the year, with white maize and oil prices higher by 12% and 42%, respectively. Despite the poor demand backdrop in SA, given that a large part of the inflation basket is comprised of food and fuel related items, the longer these prices stay high, the stickier inflation becomes at higher levels and the more likely it becomes that this elevates other prices in the basket (second round effects of higher food and fuel prices). Inflation is now expected to average over 6% for 2022 (peaking above 6.5%) before coming down to an average above 5% in 2023. The risks, however, are very much tilted to the upside and surveyed expectations for longer term inflation are now at 5.5% (up from 4.8%). Therefore, it is highly likely that the SARB will accelerate the path to reaching a nominal repo rate of between 6% and 6.5% in the first quarter of 2023. This would help to anchor inflation expectations at a lower level and keep pace with the expected path of global monetary policy normalisation.

In the years preceding Covid-19, the average real repo rate averaged 1.6%, which is lower than our expectations of 1.9% by end 2024. Current market pricing for the real repo rate based on our expectation for inflation, suggest a real repo rate of 4.5% by end 2024, which is almost triple what it has been historically and double our expectations. This suggests that current market pricing embeds a significant inflation premium, which translates into a high embedded inflation premium for bond yields. It is highly likely that the market expectations for inflation recede as inflation prints materialise lower, thus compressing the inflation premium in bond yields.

The flipside of higher commodity prices, specifically higher metal prices, is that the price of SA’s exported products increases relative to its imported prices. This means that SA receives more money for the same volume of exports and, of course, if volumes increase, then there is a significant multiplier effect. Tax revenue is likely to increase as company earnings increase and SA’s current account remains in surplus, reducing its reliance on portfolio flows. Fiscally this translates into a lower deficit, due to higher tax revenue that should imply a lower borrowing requirement. The precedent set in the March Budget, saw 55% of the windfall revenue used to reduce the borrowing requirement while the other 45% was spent on funding free tertiary education, along with higher municipal and healthcare wages.

Unfortunately, these do not have a significant growth dividend and are very hard to recoup, making it an unproductive recurrent expenditure. At current prices, government can expect another R100 billion in tax revenue next year, which will hopefully be spent on reducing the known risks in the economy. Namely, the Eskom debt overhang, ailing municipal and state-owned-enterprise finances, and a permanent solution to the basic income grant debate. Thankfully, SA’s starting position is better than it has been and the debt-to-GDP ratio is expected to peak at 75% in five years. This is by no means an insignificant debt load, but, relative to peers, this is no longer outrageous. This makes the prospects of SA entering a debt trap a much lower probability over a five- to 10-year horizon.

With the debt trap issue being kicked into the long grass, it is worth looking at SAGB breakeven relative to cash-based on our new expectations for the repo. On average, breakeven to cash has come down by 25 basis points (bps), but remains historically high.

In addition, the value shifts more towards the 10-year area of the curve, which is reflective of the recent risk premium compression that has occurred between the 10- and 20-year areas of the yield curve (curve flattening), which is now at historical norms. SAGBs, therefore, still embed a significant risk premium, both in terms of inflation expectations and relative to cash, with the value point now being the 10-year area of the yield curve.

The recent rise in US bond yields has raised concerns of an imminent sell off in emerging market bond yields, similar to the taper tantrum of 2013. First, it is important to point out that although the emerging market debt load has escalated, in developed markets, more specifically the US, the increase has been sharper. The weighted average maturity of US debt is just over five years, which means the cost of funding the debt load is closely connected to what happens with short-term rates. This argues for the real funding rate of US debt to remain relatively low compared to history, and for the cost of debt funding to remain below real growth. Over the decade preceding the Covid-19 crisis, the average real US 10-year yield versus realised inflation (represented by US Personal Consumption Expenditure Index) has averaged 0.77%. This implies that, going forward, this real rate should be, at most, between 0% and 0.5%, which puts the long-term US 10-year fair yield, assuming a long-term US inflation outcome of 2.5% to 3%, at 2.5% to 3.5%. In the short term, we can expect volatility in the US 10-year bond as inflation prints higher; but 2.5% to 3.5% is where US yields should settle.

The current level of the US 10-year bond remains in the range of 2.5% to 3.5% and SAGB yields are still more than 700bps above US yields. This suggests a significant risk cushion to absorb a move in the US 10-year yield to levels that would be deemed fair with longer term expectations.

Geopolitical tensions have increased the risk of higher global inflation and a faster normalisation of global monetary policy. SA has benefited from a significant term of trade boost that provides more breathing room for the fiscus, but that will place pressure on the SARB to normalise rates at a similar pace to global central banks. SAGBs still trade at historically high yields and are elevated compared to their emerging markets counterparts. The current market pricing of interest rate normalisation in SA also suggests that the embedded inflation premium in bond yields remains excessive and that yields have a significant risk buffer to absorb higher local inflation and higher US bond yields. We continue to advocate long duration positions that are focused in the 10- year area of the yield curve.