As we open the new chapter of 2018, we reflect on some of the events that shaped SA’s fixed-income environment last year, keeping market participants on their toes. 2017 was characterised by a number of risk factors from the outset which, in one way or another, transpired as the year progressed. The most notable of these included the technical recession which occurred in 1Q17, the cabinet reshuffle that led to the sacking of then-finance minister Pravin Gordhan and his deputy, an attempted vote of no confidence against the president and the move by credit rating agencies that left the country’s sovereign debt rating at speculative grade (junk status). These factors led to increased volatility in the market (see Figure 1 below), particularly within the fixed-income space.
The first major spike in the bond market (see Figure 2) during 1Q17 occurred after the cabinet reshuffle that led to the sacking of Gordhan. This caused a sell-off in bonds with the SA 10-year benchmark yields moving from 8.32% to 8.80%. Following news of the cabinet reshuffle, rating agencies Standard & Poor’s and Fitch downgraded the country’s sovereign debt to sub-investment grade with both agencies citing political instability and the poor growth trajectory as reasons.
The second spike in our bond market came as a result of the Moody’s downgrade towards the end of June 2017. Prior to the Moody’s downgrade, we saw bonds rallying back to levels seen before the cabinet reshuffle. This rally was largely in response to positive global sentiment towards EMs as the US dollar – in particular – came under immense pressure during this period. Following the Moody’s downgrade, we saw yet another sell-off which was short lived, as the rally continued and bonds recovered again.
It is worth highlighting that during the first three quarters of 2017, there was at most one risk event that took place in each quarter. More importantly, following each spike in bond yields, bonds recovered all their losses back towards where they had started (as shown by the red arrows in Figure 2 above).
However, in 4Q17, the number of expected risk events increased relative to the previous three quarters and were stacked closer to each other. This explains the persistent sell-off trend observed in 4Q17 leading up to the ANC elective conference. As seen post the ANC elective conference, bonds yet again rallied to end the year stronger than where they started.
Post the Medium-Term Budget Policy Statement (MTBPS) speech, bonds sold-off quite significantly with the 10-year benchmark breaking the 8.40%–8.80% range and moving as high as 9.50%. This came on the back of fears and concerns that SA would have been downgraded by Moody’s and Standard & Poor’s yet again leading to a removal from the World Government Bond Index (WGBI). However, as it turned out, only Standard & Poor’s downgraded SA’s local currency to junk status (BB+), while Moody’s kept SA’s local currency one notch above sub-investment grade (junk status).
In the midst of all these headwinds, SA bonds have produced positive returns for 2017, with the All Bond Index returning 10.19%.
Perhaps the greatest of outcomes in 2017 for the bond market came from the positive news during the December ANC elective conference. After the Ramaphosa victory announcement, bonds strengthened by over 65bps and the strengthening trend continued thereafter. This recovered the losses incurred during the period following the MTBPS.
It was clear in the first three quarters of 2017 that global events and sentiment towards EMs prevailed over SA-specific events. Thus, on a long-term basis, the evolution of the global environment will play a key role for SA fixed income. We believe that the global investment environment has entered (and continues within) a transitionary state that is different to what has been seen in the past decade.
In principle, any change that will set a new sustainable course does not happen abruptly, but occurs in a very slow manner. What we have seen in the past two years points to this form of transition. Most notably, the occurrence of Brexit in 2016, the push for tax reform in the US, convergence in interest rate policies by major central banks, attempts to normalise balance sheets by central banks, the increased geopolitical tensions that have shifted regions more toward protectionism etc.
Given the above, the appetite for SA bonds will continue as long as the carry and risk premium for holding SA bonds remains attractive. This is clearly seen by the strong rally in SA bonds since Nenegate, which led to the spread between SA bonds and US bonds significantly deviating from its long run average (Figure 3). This further illustrates why SA bonds have had such a strong resilience on the back of every negative local event. That is, on a global scale, SA bonds have been relatively cheap and have been on a correcting trend since the Nenegate saga.
Furthermore, the spreads between SA interest rates and US interest rates have moved significantly away from their long-run average (see Figure 4). We further expect that mean reversion will occur through global yields moving higher, with SA yields decreasing slightly.
In Figure 4 above, we see the dilemma that the US Fed is heading towards. That is, given where long rates are, the Fed appears to be overly hawkish in its hiking cycle. We are currently penciling three more rate hikes before volatility and risk premia start repricing higher, potentially derailing support for SA bonds.
However, we also note that the Fed has typically stopped hiking each time the 2-year bond yield has been in-line with that of the 10-year bond. Again, we are three hikes away from that point. This forms the basis of our view of higher global rates in the current year, with SA bonds remaining attractive for investors.
Thus, in summary, whilst global interest rates are likely to continue to drift a little higher during 2018, we think that SA bonds are fundamentally cheap and will see some capital gains over the year.