South Africa Monthly Investment Insight

  • Virus containment measures restricted the economy's ability to expand in Q1
  • Stocks remain buoyed in positive territory on a quarter-to-date basis despite US inflation shock
  • In line with US Treasuries, South African bond yields trading lower in Q2

Real economy overview

As we head into the second quarter of the year, it is worth taking a look at how South Africa's economy has recovered from the economic shock of the COVID-19 pandemic. The final quarter of 2020 saw the economy expand by an annualised 6.3%, leaving output around 4.0% below its pre-pandemic levels. Since then, the recovery has lost some momentum. New economic restrictions were implemented late into 2020 and only lifted through February. These measures restricted the economy's ability to expand in Q1, and the impact will likely have spilt over into the second quarter of the year. Expectations of a third wave of infections and a slow vaccination process will have compounded this weak growth momentum.

The dashboard above gives a brief overview of how the economy has recovered, with some key indicators showing that certain sectors have, at least in nominal terms, risen above pre-pandemic levels. The most noticeable has been retail sales, with seasonally adjusted nominal sales figures exceeding those from early 2020. How long this can be sustained for is another question, with the unemployment rate at record levels and wage growth within the private sector almost non-existent.

The manufacturing sector's recovery has similarly shown signs of losing momentum, with the most recent PMI figures suggesting that new orders and business activity are slowing. Foreign demand continues to support the sector, but it can do so for so long before weak local demand begins to weigh once again. Overall, therefore, the outlook for the economy is still positive as it recovers from 2020's crash, but growth will remain well below potential in the coming months and years, with much-needed reforms still lacking and government spending being concentrated on consumption rather than investment.   

Financial Market Overview

Notwithstanding the ructions caused by the topside shock in the April US inflation print, which bolstered the reflation trade, global stocks remain buoyed in positive territory on a quarter-to-date basis. That said, it is worth noting that global stocks took a pounding in the days that followed the US CPI shock that prompted speculation that the Federal Reserve may have to unwind some of its stimulus efforts sooner than expected. The impact of the inflation shock has been highlighted in the accompanying MSCI World Index chart, which we use as a proxy for global stocks.

The Dow Jones dropped by the largest amount since January and came as a warning that the current market performance is heavily dependent on the central bank's stimulus efforts. Stronger than anticipated inflation in the US spooked investors and sent many scurrying back to the USD in the immediate aftermath of the US inflation print. The greenback has since returned to its losing ways. The combination of ultra-loose monetary policy coupled with extremely loose fiscal policy means that the balance of risks rests firmly against the USD, which ironically will only compound the inflation episode and raise the stakes in the Fed's policy stance.

While the MSCI World Index, which is heavily skewed in favour of developed market stocks, remains buoyed in positive territory in Q2, emerging market stocks have faltered as the combination of elevated US Treasury yields, renewed COVID-19 concerns and reflation fears weigh on risk appetite. At the time of writing, the MSCI Emerging Market Index had lost around 0.40% on a quarter-to-date basis, after recovering some of its losses suffered in the sessions that followed the US inflation shock.

The second quarter has been far less bruising for local stocks. In fact, the JSE All Share Index has recorded modest gains on a quarter-to-date basis. At the time of writing, the JSE All Share Index was up 1.65% since the start of Q2, underpinned by resource and property stocks.

In the fixed income market, traders remain fixated on rising inflation and the potential ramification it may have on monetary policy over the next 12-24 months. The 5yr breakeven rate, which we use as a gauge for international inflation expectations, rose to a fresh multi-year high of 277bps on Monday the 17th of May. Although global inflation has risen markedly in recent months on the back of persistent supply chain challenges and soaring commodity and food prices, policymakers the world over assess the recent episode of inflation to be transitory and as such remain committed to looser for longer monetary policy.

Notwithstanding the commitment from the Federal Reserve to its accommodative monetary policy stance, US Treasury yields remain elevated relative to levels seen at the start of the year. It is however worth noting that the topside bias in US Treasury yields has faded in Q2, with both the 2yr and 10yr yields trading marginally lower on a quarter-to-date basis.

In line with US Treasuries, South African bond yields have traded lower in Q2. Yields across the curve have fallen in recent weeks amid an improvement in global risk appetite and reassurance from major central banks that they remain committed to accommodative monetary policy. While South African bonds have traded lower in Q2, yields remain elevated compared to pre-pandemic levels, reflecting the fiscal degradation that has materialised over the past year due to increased fiscal spending to bolster the healthcare system cushion the economy from the impact of virus containment measures.

Despite the marked rise in inflation expectations, which is adding pressure on bonds on the front-end and belly of the curve, a significant degree of steepness remains baked into the South African bond curve. For context, the 10v2 bond spread has widened by almost 200bps from pre-crisis levels to sit just below the 430bps mark at the time of writing.

Looking forward, given the fiscal degradation that has occurred as a result of the pandemic, we expect that traders will continue to demand a substantial premium for holding longer-dated South African government bonds. As such, a significant degree of steepness is expected to remain baked into SA's government bond curve. While some emerging market central banks have begun hiking rates, the South African Reserve Bank is expected to keep rates on hold in the coming months, keeping yields on the front-end of the curve relatively anchored.

Investment Strategy

GENERAL: The COVID-19 virus threat is starting to abate as many developed-market nations have begun massive vaccination programmes and have reopened their economies even further. The US economy will receive a massive boost from stimulus measures, adding trillions of dollars to the already significant amount of savings that were built up during the pandemic. The global economy is, therefore, on its way to a strong recovery this year. Longer-term, however, questions remain over how this can be sustained, given the massive build-up of debt accumulated by governments the world over. The US and China are expected to be the outperformers through 2021, with Europe lagging due to a slow initial roll-out of vaccines. Asia, meanwhile, is still struggling to bring the pandemic under control, with the likes of India facing a resurgence in infections. For South Africa, the global economic rebound will support the local economy through export-reliant sectors such as mining. Structural constraints, however, will limit the extent to which the economy can recover, keeping output below potential.

The global recovery does, however, bring with it the problem of higher inflation. Demand has surged, but supply constraints have not been fully rectified, driving up prices of almost every commodity. Inflation expectations have reached multi-year highs and higher price growth will certainly be a feature of the global investment space through the months ahead. Higher price growth will become a feature of South Africa's economy, but not to the extent seen in many of its peers, given expectations of persistently weak demand against a backdrop of relatively tight monetary conditions.    

FOREIGN EXCHANGE: The Rand has performed well through Q2 of this year so far, gaining over 5.00% as the dollar has resumed its bearish trend and higher-risk assets have become favoured once again. Quantitative models suggest that there is still room for further appreciation, but the window in which it can do so and to what extent has narrowed as a result of a continued deterioration in South Africa's fiscal situation. South Africa's current account and trade surpluses cannot be sustained at current levels, and once the global and local economies normalise, these surpluses will swing back into deficit positions. South Africa will once again require external funding, which will ultimately weigh on the resilience of the Rand. A tactical bullish bet on the Rand is, therefore, warranted at current levels, but the longer-term outlook remains Rand bearish.   

EQUITIES: Building on the recovery seen at the backend of last year, the JSE ALSI has extended its ascent in 2021, with the index climbing to fresh record highs. The strong rally for the JSE has been supported by the massive liquidity injections by global central banks, stimulus expectations out of the US and optimism concerning the global vaccine roll-out. While many in the market have utilised the repricing of SA stocks as an opportunity to buy, the local equity market faces severe headwinds over the longer term against a very weak macroeconomic backdrop. This has been evident in recent weeks, with the ALSI failing to break through the 68,500-point mark despite global equity markets reaching new records. The repricing of South African equities through the pandemic presented an attractive entry point, but how much additional alpha can be extracted now is questionable given the country's weak economic outlook.

BONDS & CASH: Expectations for 2021 are that developed market central banks continue to deploy all their ammunition as powerfully and frequently as needed to ensure that the global economy reflates. This has been confirmed by the Fed, who have looked past recent bouts of higher inflation to affirm that policy will remain loose until a full recovery has been completed. Global economic activity is rebounding and this has brought with it the threat of higher inflation, which has recently weighed on developed-market bonds. Downside risks to bonds have risen significantly as a result, but it is unlikely that we will see central banks allow borrowing costs to rise and bring into question the sustainability of the current economic recovery.

Persistently low yields within the developed-market world will continue to bolster the appeal of South African bonds through the rest of 2021. However, fiscal risks still feature prominently, highlighted by the recent record budget deficit numbers. The February budget served as a sobering reminder as to just how severe SA's fiscal challenges are, while the state wage negotiations have shown no signs of making any progress. Unless progress is made in the government's spending consolidation efforts, South Africa will be downgraded further by credit rating agencies. The risk of this may not yet be fully reflected in the prices of South Africa's bonds, which are still finding support from the global environment. Therefore, the bias of risks for South Africa bonds remains tilted towards the downside.  

REPO: The SARB has kept the benchmark repo rate unchanged at 3.50% through 2021 so far, and will likely continue to do so until the end of the year, or for as long as the ZAR maintains its composure. The risk of fiscal crisis has reduced any further rate cut potential. It is also questionable whether or not any further rate cuts will have a significant impact. Whether one looks at very restrictive labour market policies or the disfunction of SOEs, the government has much that it needs to urgently address if it is to make lasting progress in returning SA to sustainability. On the other side of the equation, lacklustre local inflation pressures will limit the need for rate hikes.

PROPERTY: The view remains that a meaningful and sustained rebound for the property sector will be difficult to achieve in a weak economy where more rental space is coming online. Recent surveys have shown that vacancy rates in business nodes are rising, presenting another challenging environment for the property sector for the year ahead. The reality is that yields are likely to remain relatively suppressed and fail to live up to the returns on property that investors have gotten used to.

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