Trade war between China and the US intensified

The backdrop for emerging markets (EM) deteriorated sharply during the past quarter as the global super powers (China and the US) continue to wage ‘war’ on the trade front. President Trump imposed import tariffs on another $200 billion worth of Chinese goods, to which China promptly responded with its own tariffs on $60 billion of US made goods. The Chinese Renminbi lost almost 4% against the US Dollar as the US imposed the new round of tariffs. China did not defend its currency as it usually does.

The Turkish Lira and Argentinian Peso were the worst performing currencies against the Dollar, declining by about 40%. Turkey has been in a diplomatic standoff with the US over the incarceration of an American citizen. In Argentina, investors are worried that the country may soon default on debt. The Rand traded to a low of R15.58 against the US Dollar before recovering to R14.12 as South Africa is seen by some investors as having similar vulnerabilities as Turkey, namely current deficits and a large external financing requirement.
Bond Market Review
The US economy continued to outpace other developed markets (DM), growing by 4.2% in the second quarter. By comparison the Eurozone grew by 2.1%. US unemployment was at a low 3.7% in September and core inflation of 2% was in line with the US Federal Reserve (Fed)’s target. As a result, the Federal Open Market Committee raised the federal funds rate by 0.25% in September and signalled that the current policy stance is still accommodative.
US 10-year bond yields rose from 2.95% to 3.06% leading to a sell-off in other DM bond yields. In Germany and Britain 10-year bond yields rose 17 basis points (bps), while Japanese benchmark 10-year yields rose 9 bps. Bond yields in the US were pressured by increased supply and chances of more rate hikes.

In South Africa the sharp fall of the Rand and the rise in oil prices resulted in a deterioration of the inflation outlook. However, the SA Reserve Bank (SARB) decided not to increase the repo rate at the September meeting given the -0.7% GDP outcome for the second quarter and the lower than expected 4.9% CPI for August. The yield on the benchmark R186 bond rose 11 bps during the quarter from 8.88% to 8.99%. However, the FTSE/JSE All Bond Index managed to return a positive 0.78% for the quarter as short-dated bonds offset the capital losses on longdated bonds. We think South African bonds offer value when the 10-year bond yield is between 8.25% and 8.50%. Credit spreads continued to compress as demand outstripped supply. Bond Market Outlook The outlook for DM bonds remains poor given a combination of lower liquidity as central banks buy less government bonds, increasing inflation and larger deficits in the US.

We think yields in the US will end 2018 closer to 3%, perhaps even a little higher. However, guidance from the European Central Bank to keep rates on hold until the end of summer 2019 will have a dampening effect on yields in Europe.

The trade war between China and the US is leading to risk aversion and capital flight toward developed markets. Oil prices have risen further and pose a threat to our constructive view on bonds.

In October the Minister of Finance will deliver the Medium Term Budget Policy Statement (MTBPS). The market will be looking for continued commitment to the expenditure ceiling and for bond issuance to remain unchanged. Government has already committed to a R50 billion stimulus package, to be announced at the MTBPS. Should this stimulus package not be financed within the expenditure framework previously announced, this would be negative. We expect the SARB to raise the repo rate by 0.25% at the November Monetary Policy Committee.

Those of us who are car fanatics or simply Toyota fans will remember the long running jingle “Everything keeps going right, Toyota” which was introduced in 1973 and ran until 2004. Since the election of Cyril Ramaphosa as ANC President in December 2017, everything has gone right for the South Africa bond market. The political risk premium has been unwound. After much political manoeuvring Jacob Zuma finally resigned as President of the Republic clearing the way for Cyril to ascend to the highest office in the land. The State of the Nation address was well received as the President committed to take tough decisions to close the fiscal gap, stabilise debt and restore our State-owned Enterprises (SoEs) to health. The President also reshuffled cabinet bringing back the much respected Nhlanhla Nene as finance minister and putting Pravin Gordhan in charge of public enterprises.

Minister Gigaba delivered the February budget which promised significant debt consolidation relative to the October Medium Term Policy Statement. The centre piece of the budget was an increase in the VAT rate by 1% to 15% and a reduction in spending of some R85bil over the medium term. The various tax increases and spending reductions will result in government debt stabilising at 56% of GDP compared to previous projections of 60%. The VAT increase was well received by the markets because it showed commitment to fiscal sustainability and the ability to take tough, unpopular decisions ahead of an election year. However as in recent budgets there were few growth enhancing measures and the reduction in spending is coming almost entirely from lower capital expenditure.

On the 23rd of March Moody’s released their much anticipated rating assessment for South Africa. The rating agency decided to keep South Africa’s rating at Baa3 (BBBequivalent) and crucially changed the outlook from negative to stable. In addition to fiscal consolidation, Cyril’s government has also taken steps to restore institutional strength. The Board of Eskom has been replaced with a more competent and less compromised Board and Tom Moyane has been suspended as Commissioner of SARS. The decision by Moody’s keeps South African debt eligible for inclusion in the Citi Bank World Government Bond index, thus removing a major risk to the bond market.

Bond Market Review

Bond yields in developed markets (DM) rose sharply in January and February before falling back in March. The yields on the US 10-year bond rose 30bps and 16bps in January and February respectively and fell 12bps in March to end the quarter at 2.74%. In January the markets were concerned that inflation was accelerating after Average Hourly Earnings rose by 2.9% y-o-y; the fastest pace since 2009. The market also started to price a higher chance of 4 rate hikes in 2018, one more than the Fed “dot plot” had previously indicated. Inflation fears subsided somewhat as the February jobs report showed an increase of 2.6% in AHE. The equity markets were rocked by increasing signs of trade protectionism as the US and China sparred on trade tariffs. In January the Trump administration announced tariffs of as much as 50% on washing machines and 30% on solar panels. This was tariffs of as much as 50% on washing machines and 30% on solar panels. This was followed by tariffs on steel and aluminium of 25% and 10% respectively in March. The Trump administration has pledged to impose tariffs on a further $100billion worth of trade with China. Investors sought the relative safety of bonds and equity market volatility increased.

Emerging market (EM) local currency bonds largely ignored the increase in DM yields because the dollar was weakening and global growth projections were being revised higher. Stronger EM currencies also led to lower inflation in EM economies. South African bonds outperformed their EM counterparts as political risks waned and the Rand strengthened more than other currencies. The ALBI returned 8.06% in Q1 and the benchmark R186 yield fell to 7.99% from 8.64%.

The SARB cut the repo rate to 6.5% at its Monetary Policy Committee meeting of the 28th of March. The move was widely expected as the stronger Rand and Moody’s decision to keep the rating unchanged had reduced risks to the inflation outlook despite the VAT increase.

Credit spreads continued to compress as demand outstripped supply. However credit underperformed the ALBI owing to its lower duration. In February Steinhoff settled all the JSE listed bonds early after selling most of its equity stakes in PSG and KAP.

Bond Market Outlook.

The outlook for (DM) bonds remains poor given a combination of lower liquidity as central banks buy less government bonds, increasing inflation and larger deficits in the US. We think yields in the US will end 2018 closer to 3% perhaps even a little higher. For emerging markets, firmer commodity prices are a positive and coupled with stronger global growth, which leads us to expect continued capital inflows and firmer currencies in EM. However given the outperformance by the Rand and SA bonds over other EMs in the 1st quarter, the outlook for South African bonds is less positive.

Our forecast for inflation is somewhat more bearish than the market. We think CPI will print closer to 5.6% by July from 4% currently and end the year near 5.5%. We do not expect the SARB to cut rates again this year. The decision to cut at the previous meeting was opposed by 3 out of 7 members and also the SARB believes that in order to achieve 4.5% inflation in the long term real repo needs to be 2%.

The risks to our view is that the anticipated growth rebound does not materialise and inflation is softer than current projections which would lead to a more accommodative stance from the SARB.

Developments in the fourth quarter (Q4) were dominated by the Medium-term Budget Policy Statement (MTBPS) delivered by the minister of finance on 25 October 2017. We stated previously that the market was looking to the minister to adjust spending to take account of lower revenue growth and that there would be little tolerance for much wider deficits than those tabled in February. Deficits approaching 4% would likely hasten ratings downgrades. Indeed the MTBPS deeply disappointed as it projected deficits of more than 4% for the current fiscal year due to revenue shortfall and increased spending in support of the SAA, South African Post Office and other state-owned entities (SOEs). The minister also projected spending of R3 billion in excess of the expenditure ceiling, thus going against an earlier undertaking to keep support for SOEs “budget neutral”. The MTBPS also projected much wider deficits over the forecast horizon and a deterioration in the net debt to GDP ratio to 60.8% from about 52.3% by 2022. Failure to stick to the previously outlined fiscal consolidation path was the main reason why S&P downgraded South Africa further into junk territory on 24 November. On the same day Moody’s placed South Africa on review for a downgrade, which must be resolved within 90 days. In Moody’s judgement the election outcome of the ANC president could have a material effect on the policy direction of the ruling party and the country, and as a result they decided to delay the rating action.

The ANC presidential race was hotly contested between the eventual winner, Cyril Ramaphosa, and Nkosazana Dlamini-Zuma. The financial market clearly favoured Ramaphosa, because of his ties to the business community and his anti-corruption stance on the campaign trail. Dlamini-Zuma, on the other hand, led a faction that was fiercely loyal to Jacob Zuma and therefore the market perceived her to represent the status quo. In the end the ANC engineered a compromise that saw Ramaphosa win the party presidency while the Dlamini-Zuma camp took the very powerful positions of secretary general, deputy president and deputy secretary general. Analysis by political analysts revealed that even the ANC National Executive Committee (NEC), an 80 member body, is split down the middle. The conference also adopted policies that are not market friendly, namely land expropriation without compensation, free higher education and nationalisation of the South African Reserve Bank (SARB). While these are ANC policies and not government policy (yet), they serve to highlight the tensions within the ANC and the difficulties Ramaphosa will face as he tries to reform ANC and government economic policies.

The markets reacted positively to the Ramaphosa win with the rand rallying from R13.50 to the US dollar to end 2017 at R12.38, a gain of over 8%. Bonds followed the currency stronger, with the yield on the R186 benchmark bond rally from 9.20% to 8.60%, surpassing pre-MTBPS levels. Bond market review The yields on the US 10yr rose marginally from 2.33% to 2.40% over the quarter, but for a brief period when they touched 2.5%. However, the curve flattened aggressively as shorter maturities sold off in anticipation of the December rate hike and continued tightening of monetary policy by the Fed in 2018. Yields on German bonds rallied slightly from 0.46% to 0.42%. The local bond market endured a tumultuous ride and yields sold off more than a 100bps as the market anticipated a bad mini-Budget and the finance minister Gigaba revealed the extent of the fiscaldeterioration in the MTBPS. 2017 foreign inflows into the bond market reversed sharply from a high of R73bn in October to around R45bn just before the ANC conference, before recovering to R53bn on confirmation of a Ramaphosa win. In the days leading to the ANC conference our assessment was that a Ramaphosa win will lead to a rally in bonds while Dlamini-Zuma will lead to a continued sell-off. Given the binary outcome, we sought to reduce risk and position moderately short because our thinking was that the market was under-pricing the possibility of a Dlamini-Zuma victory. Indeed had the courts not disqualified some of the delegates from the Free State, North West and KZN provinces, where Dlamini-Zuma had strong support, the results could have been different. The All Bond Index returned 2.25% for the quarter, outpacing cash returns of 1.78% on the STeFI Composite. The 5.66% rally in December resulted in bond returns of 10.22% for the year. Steinhoff International shocked the market by announcing a delay in the publication of its 2017 financial results due to “accounting irregularities”. The announcement kicked off a 92% decline in the share price and a downgrade by Moody’s from BBBto CCC+. Steinhoff also announced that it will have to restate its 2016 financials. Our bond portfolios held about 1.5% exposure to Steinhoff bonds. Spreads on Steinhoff bonds issued in the local market widened, resulting in bond prices of 10% to 15% below par. While Steinhoff has not been forthcoming about the exact nature of the accounting irregularities, the company has been forced to engage with its lenders to stave off a liquidity crisis as some banks have pulled their credit lines. On 2 January 2018 Steinhoff issued a SENS announcement in which it said it does not believe that the restatement of financial reports will apply to Steinhoff Services Ltd, the issuer of listed bonds on the JSE. Bond market outlook The backdrop for developed market (DM) bonds remains poor as central banks remain on course to withdraw liquidity. The European Central Bank (ECB) will reduce its asset purchases from 60 billion euros to 30 billion euros starting in January 2018. In the US the recently passed tax reforms should lead to wider deficits and, in combination with Fed rate hikes, we think yields in the US will end 2018 closer to 3%. International oil prices have risen 20% in US dollar terms compared to January 2016 levels and they are 50% higher than June 2017 levels. Higher oil prices and low unemployment in DM will support firmer inflation. For emerging markets (EM) firmer commodity prices are a positive and coupled with strong global growth leads us to expect continued capital inflows and firmer currencies in EM. Locally, the rally at the end of 2017 has all but priced out political risk in the bond market. While we agree that political risk is now lower and, in fact, should President Jacob Zuma be recalled by the ANC, local assets could rally further given positive sentiment. The medium- and longer-term outlook are more challenging owing to the deteriorated fiscal situation. Should government implement free university education in 2018 as announced by President Zuma, budget deficits could widen by 1% to 4.9% of GDP. The National Energy Regulator of South Africa (NERSA) granted ESKOM a 5.2% tariff increase, well below the 19% increase requested by the company and our expectations of low double-digit increase. SIM’s CPI forecast for 2018 is 5.1%, with oil prices at $62 per barrel and rand dollar exchange rate of R12.6 by end of 2018. For now it seems that the lower electricity tariff increase will be offset by higher petrol prices. Therefore we see only a small probability of rate cuts in 2018. Finally, we expect Moody’s to downgrade South Africa in the first quarter of 2018. We think Moody’s will assess the political stalemate in the ANC as hindering fundamental reforms.