The second quarter got off to a bad start as the South African bond market was still reeling from the cabinet reshuffle that cost Pravin Gordhan the post of Finance Minister. This event served as the catalyst for sovereign credit rating downgrades by both S&P Global and Moody's. In the case of the former, its foreign currency rating is now aligned with the Fitch non-investment grade category ratings. In light of the low economic growth trap in which the country finds itself and heightened concerns about policy stability, both S&P and Moody's retained a negative outlook on the respective foreign and local currency ratings. This means that the next ratings action is either a change to a stable outlook or for all ratings to become non-investment grade. We believe circumstances favour the latter.

In support of this view, the release of first quarter GDP data confirmed that the country officially entered a technical recession (negative rates of growth for two consecutive quarters). This served to exacerbate concerns about persistent sub-par economic growth, with an array of implications for the creditworthiness of the country in the long run. In the short term, sustained weak economic growth will negatively impact plans to consolidate the fiscal situation as low growth limits tax collection. The impact of the worsening, already weak, growth backdrop partly offset the good news that the current account deficit had narrowed further. In the meantime, the rate of inflation kept grinding lower in response to lower food prices, a stronger rand compared to a year ago and weak consumer demand. This combination of weak growth and lower inflation spurs speculation of possible repo rate reductions by the South African Reserve Bank (SARB) before the end of this year.

After ending the first quarter at a yield of 8.84%, the benchmark R186 government bond weakened to 9.0% in early April, at which point the global reach for yield, once again, came to the rescue. Other external developments helped, namely a weaker US dollar and sharply falling US Treasury yields, which, in turn, were the result of fading optimism about the strength of the US economic recovery and its implications for the path of official interest rates. Global bond bulls also received support from sticky inflation at relatively low levels in most of the developed world. Against this backdrop, yield-seeking foreign investors brushed aside local political developments and the sovereign rating downgrades. This demand drove local bond yields sharply lower and the R186 yield reached an intra-quarter low of 8.39% by the middle of June.

The latest non-resident bond buying spree saw the foreign ownership of total outstanding rand-denominated South African government bonds, which includes both nominal and inflation-linked bonds, reach an all-time high of almost 40%. In the case of nominal fixed rate RSA government bonds, the foreign share is now a whopping 48%, well above the 20% held by local pension funds. To us, this large foreign holding endangers future market stability, considering the weak local fundamental situation, negative ratings momentum and its impact on global index changes. Moreover, a future correction to extremely loose global monetary policy still holds a significant risk to overvalued bond markets in general.

This risk came to the fore in the last week of June when influential central banks, including the European Central Bank and the Bank of England, suggested that the extent of monetary policy accommodation requires reconsideration. This forced bond holders to rethink and lighten up on exposure. The rise in global bond yields as well as unwelcome speculation about possible changes to the SARB's mandate caused a wave of bond selling late in the quarter. As a result, the R186 yield retraced to 8.78%, just 6 basis points lower than the closing yield at the end of March. More importantly, the slope of the bond yield curve steepened as long-dated bond yields rose by more than short-dated bonds. Nonetheless, the ASSA JSE All Bond Index still managed to render a positive return of 1.5% for the quarter, the result of fairly stable returns offered by short-dated nominal bonds. Even so, cash delivered a slightly better return of 1.7%.

The re-pricing of inflation-linked bonds gained momentum on the back of lower inflation during the second quarter. Reduced demand for inflation protection and the weekly primary issuance of inflation-linked bonds, as part of the financing of the national budget deficit, pushed real yields higher. As a result, the ASSA JSE Government Inflation-linked Bond Index only managed to eke out a return of 0.9%. In an environment of lower inflation and rising concern about a possible future higher national government financing requirement, the relatively poor performance of this asset class makes perfectly sense.

The cabinet reshuffle at the end of March and South Africa’s sovereign credit ratings downgrade by Standard & Poor’s global rating agency in early April overshadowed all other happenings during the first three months of the year. These two closely linked events forced interest rate bulls into hiding, as the rand and bond yields raced to weaker levels.

Prior to the disastrous political event, the general market trend had been for rand strength and falling bond yields. The yield on the benchmark R186 (maturity 2026) government bond drifted down to a closing level of 8.31% on 23 March, the lowest level since November 2015. This was 65 basis points below the closing level on 31 December 2016. At that point, the All Bond Index total return had increased to 5.9% for the year to date, well above a cash return of 1.6%. But then disaster struck, causing yields to spike and wiping out all the gains made up to that point in a matter of five days. As a result of the sharp rise in yields across the entire yield curve, the All Bond Index ended the quarter with a significantly lower 2.5% total return, still slightly higher than cash, which returned 1.7%. The nominal bond sell-off also sparked an upward movement in inflationlinked bond yields, resulting in a quarterly return of 0.6% for the Inflation-linked Government Bond Index.

The downtrend in bond yields for most of the quarter was mainly backed by a fall in core and headline consumer price inflation, better than expected external trade data and a reasonable National Budget considering the very difficult circumstances. A much stronger rand against most other currencies and good rains in the central and northern parts of the country also contributed to expectations of a further improvement in the inflation outlook.

The decision by the US Federal Reserve to raise its policy rate for the first time in months was well anticipated, even welcomed by financial markets. Locally, the last meeting of the South African Reserve Bank’s Monetary Policy Committee, mere days before the unfortunate cabinet reshuffle, caused market sentiment to change to reflect an expectation of possible rate cuts later this year. This eventuality was quickly priced out during the last week of March. The fund underperformed its benchmark for the 12-month period ending March 2017. This was the result of the large underweight position in long-dated nominal bonds as well as fund modified duration. The fund is conservatively positioned with a large underweight modified duration position and some cash. This in turn is the result of the underweight holding to nominal bonds with a term to maturity longer than 10 years.