Is there value in the domestic bond market?
Financial markets will have to contend with more uncertainty and volatility this year, as major central banks take the lead in tightening global financial conditions to avoid falling behind the curve in their responses.
- Investors in 2022 are questioning the impact of global policy changes on risk assets such as South African bonds.
- The South African fiscus has benefited from unexpected revenue windfalls over the past year. However, as local growth slows and spending rises, the risks to fiscal consolidation are high.
- Despite increasing policy tightening and uncertainty about the future of the fiscus, domestic bond valuations continue to offer investors compelling returns.
Inflation in major economies has risen, and has proven to be more persistent than policymakers have been guiding and the markets have been discounting. As a result, developed market central banks have pivoted away from an accommodative stance to fight rampant inflation.
The most important questions for investors are how fast monetary policy will tighten this year and what impact it will have on growth and risk assets, like South African bonds.
STANLIB’s Fixed Income team believes four broad themes will drive South African bond markets this year:
- Global central banks reducing their accommodative stance
- Domestic fiscal trends that will be presented during the Budget speech
- Increases in the repo rate, and
- The huge premium in the valuation of South African bonds that has built up over the years, making them compelling compared with the debt of other emerging markets.
We still see value in South African bonds this year and expect they will deliver double-digit returns, although it will be a tough year, given the risks.
South African fiscal environment
The 2022 National Budget proved an opportunity for National Treasury (NT) will adhere to its stated fiscal discipline in the face of numerous spending pressures.
Revenue collection continued to perform better than NT expected in the November Medium-Term Budget Policy Statement (MTBPS) R1800 billion in the 2021/22 fiscal year. This will lead to better fiscal metrics for the year and, to an extent, for the next two fiscal years. It will improve the budget deficit, which will reduce borrowing requirements over the short to medium term. This presents an opportunity for NT to marginally reduce weekly issuance levels, but it is more likely to err on the side of caution by retaining current levels, given the spending risks in the medium term. The aggressive flattening of the yield curve over the past few months is evidence that the market is pricing in this scenario.
We view the major spending risks for the fiscus going forward to be:
- social support
- the wage bill and
- support for state-owned entities (SOEs).
The pandemic has exacerbated SA’s poverty and inequality levels, which were already high. Unemployment numbers are rising, especially among the youth, which can be fertile ground for instability. In our view, the current social relief of distress (SRD) grant of R350 per person per month for another year until progress is made on the wider basic income grant. While the Budget demonstrated commendable fiscal prudence, which will please the ratings agencies, on its own it will not be sufficient to accelerate the country’s growth rate to the levels needed to tackle persistent unemployment and inequality. That growth will depend on government’s implementation of other key measures.
Electricity supply, which continues to be a drag on growth, and Eskom debt are still issues for the government to resolve. In general, SOEs and some municipalities may put pressure on government debt. Although these expenses can be accommodated in the current fiscal year due to the revenue windfall, this will not be the case in future years, given the expected growth slowdown and uncertainty whether commodity prices will continue to support South African mining company revenues.
Fiscal consolidation could therefore potentially be derailed, which implies the long end yields are expensive relative to “belly” bonds, given the recent aggressive flattening. We expect the yield curve will steepen during the year.
Global and local inflation and interest rates
Inflation in the US and other major economies has proven stickier than initially thought and is currently at decade highs. In the US it appears that wage inflation pressures are also building up, raising fears that overall inflation might not ease off as quickly as previously expected and that the US Federal Reserve will need to hike interest rates more than five times this year to avoid falling behind the curve.
We expect US headline inflation will start edging lower around the middle of the year. In the longer term, US breakeven inflation is well-behaved and is not increasing in line with spot inflation, supporting the view that markets expect inflation in the longer term will return to target. The US yield curve also remains flat, which to us means the bond market is pricing in a higher probability of a growth slowdown as US financial conditions tighten later in the year. The European Central Bank was the last of the major central banks to turn hawkish in the face of increasing inflation, signalling that it will also be increasing interest rates later this year. These concerted efforts by major central banks risk slowing global economic growth later this year, which is negative for risk assets.
South African inflation is close to the top end of the South African Reserve Bank (SARB)’s target band, and we expect it will moderate as the year unfolds. Most of the increase in headline inflation can be attributed to energy and administered prices, on which monetary policy action has little impact. Demand in the system is better captured by core inflation, which is under control, sitting at the lower end of the SARB’s target band. Inflation expectations are also muted, supporting a less aggressive response by the SARB in hiking the repo rate. Economic growth over the next three years is only expected to average around 2% and, with unemployment so high, the SARB will continue to gradually normalise interest rates. We expect it will hike rates 3-4 times this year. The Forward Rate Agreement (FRA) market has priced in seven more domestic rate hikes this year, which we think is excessive and presents value in the short end of the yield curve.
The 10-year yield spread between SA and the US is still elevated, at 7%. It is almost 3% higher than in 2013 during the taper tantrum episodes. On a real yield or currency-hedged basis, SA still offers the best return prospects among its emerging market peers. This provides SA with some cushion against tighter global financial conditions and we think it has contributed to the better performance of South African bonds this year compared with most of its peers. Our fair value for the 10-year bond yield is 9.25% and in total we expect bonds to return around 15% this year.
With inflation expected to average 5%, domestic bonds make a compelling investment case, especially in view of the headwinds facing other asset classes.