On balance, things are looking good, says Old Mutual Wealth

Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr

February may be the shortest month of the year, but it’s not short on events. The clouds are starting to part, with almost 200 million people worldwide now vaccinated against the coronavirus, including 67 000 South Africans. There is still much uncertainty over the effectiveness of the vaccines against new variants, causing South Africa to switch vaccines at the last minute, but on balance, things are looking good.

Too good?

In fact, some worry that things look too good. In particular, US president Joe Biden looks set to get much more of the $1.9 trillion fiscal package he asked for than initially thought, perhaps even all of it.

Given that the US economy is already recovering, this massive injection from March should push it back to pre-pandemic activity levels before the end of the year. While this headline improvement hides a huge dispersion among the winners and losers (across households, individual firms and sectors), it is leading to a massive repricing of growth, interest rate and inflation expectations in the bond market. Bond yields have increased sharply across the developed world. In the case of the US, the 10-year Treasury yield increased from 0.9% at the start of the year to 1.5%. While still low in absolute terms, it is a rapid move in a short space of time.

Chart 1: Developed market 10-year bond yields %

Source: Refinitiv Datastream

Predictably, the bond sell-off (bond yields and prices move in opposite directions) had a knock-on effect on the equity market. Many shares, particularly the expensive technology shares, rely on low bond yields to justify their valuations.

The equity market wobble was somewhat halted by scheduled testimony to Congress by Federal Reserve Chair Jerome Powell. He reiterated that the central bank was still a long way off from meeting its twin inflation and employment objectives. More specifically, inflation is still too low and unemployment too high to even contemplate thinking about hiking rates. Inflation will only be tackled if it becomes a problem, and not pre-emptively.

The big lesson from the post-financial crisis era was that monetary and particularly fiscal policy was withdrawn too soon in fear of debt and inflation. This led to a slow recovery, rising inequality and a turn to political populism. Policymakers are determined to avoid a repeat. Without saying so explicitly, Powell implied that the bond market was getting ahead of itself. The President of the ECB, Christine Lagarde, also expressed concern over the increase in bond yields, while the Reserve Bank of Australia went beyond jawboning by stepping up purchases of bonds to cap the rise in yields.

The more the bond yield rise, the more nervous equity investors (or at least investors in certain key sectors) could become. It is a sign of these strange times that equity investors are worried about an economy heating up. Usually, the biggest risk is an economic slowdown. Bear markets have always been caused by recessions, not by accelerating economic growth. Therefore, the most likely scenario based on what we currently know is a continued rotation out of the areas of the market that depended on low yields (such as technology) and into those sectors that benefit from stronger growth and by implication, higher yields. This rotation will not necessarily be a smooth ride, as we saw last week.

Still, global equities were positive dollars in February, while the local FTSE/JSE All Share returned a robust 4%. That is a year’s worth of cash returns from local equities in a single month. As investors worry about rising inflation, they are also increasingly hedging themselves by buying commodities. Oil and industrial metals prices rose sharply in February, but gold was weaker as it tends to move inversely to bond yields. While the oil price increase is unwelcome for local motorists, the overall rise in commodity prices is a substantial shot in the arm for the local economy, the JSE, the rand and the fiscus.

Budget backdrop

This is the backdrop against which the annual Budget Speech took place last week. It is therefore tricky to tease out the market response to the Budget from everything else that was going on. South African bonds initially strengthened, but then sold off along with global bonds. Overall, the Budget was well received and can be characterised as politically courageous, as it pushes ahead spending reductions. This is not something you would expect in an election year in many countries.

While the headline Budget numbers were all pretty horrific given the damage Covid-19 did to our economy, there are some positives. Firstly, as noted above, the global environment is still favourable, particularly as it supports commodity prices.  Secondly, tax revenues rebounded from a lockdown-induced plunge faster than anticipated, partly due to mining companies returning to profitability. Thirdly, there is modest progress on structural reforms to raise the country’s long-term economic growth rate. This is crucial to making the budget numbers work over time.

Growth assumptions

National Treasury’s projections of revenue, spending and borrowing for the next three years contained in the Budget are based on assumptions of economic growth and inflation. These need to be broadly accurate. They obviously weren’t a year ago, since no-one foresaw the pandemic. In previous years Treasury overestimated both inflation and real growth by some margin. This year the forecasts seem reasonable based on what we currently know about the world. They might even be a touch too conservative. Treasury expects real economic growth of 3.3% this year, 2.2% next year and 1.6% in 2022. This follows the historically large 2020 contraction, estimated at -7.2%. After such a historic collapse the economic rebound can easily surprise on the upside.

Chart 2: Real Economic Growth, % actual and forecast

Source: National Treasury

The current fiscal year is almost over, and Treasury estimates it will have collected R1.362 trillion in tax revenue. This amounts to a record shortfall of R213 billion against the pre-pandemic forecasts, but is R99 billion more than what was pencilled in in the October Medium Term Budget. As the economy recovers and SARS rebuilds capacity, tax revenues will gradually rise too. Therefore, there are no significant tax rate increases included in the Budget, apart from the usual fuel levies and sin tax hikes and a renewed focus on addressing tax avoidance among the wealthy. In fact, there is a proposal to ease corporate tax rates in 2022. There will also be a modest R2.2 billion relief for fiscal drag (also known as bracket creep) in the new tax year, which will benefit low to middle-income earners.

Wage freeze

This category will include many public servants and should help the government as it heads into negotiations with unions over a new three-year wage deal. This is crucial, since the planned fiscal consolidation comes almost entirely from keeping non-interest spending flat in rand terms (therefore declining in inflation-adjusted terms) over the three-year period. This in turn is largely achieved through a wage freeze, making this Budget a politically brave one.

Planning for the future is always dogged by a lot of uncertainty, but the biggest and most obvious risk is that public sector unions won’t agree to this. While negotiations are likely to be tough, the government is serious about sticking to its guns and probably has the weight of public opinion behind it. While the wage freeze will be hard-hitting for public sector workers, they are shielded from job losses, unlike their peers in the private sector where millions saw either job or salary cuts.

As the Budget documents show – it is no secret – South Africa spends a greater portion of national income on public sector compensation than its emerging market peers, without getting much additional benefit. Quite simply, the public sector wage bill is large and has grown at an unsustainable pace. It needs to stabilise so that government spending can increasingly be redirected to investing for the future. This is the intention in the Budget.  

The gap between tax revenue and spending (the consolidated budget deficit) amounts to 14% of GDP (or R689 billion) for the current fiscal, instead of 15.7% as projected in October. The gap is projected to narrow to 9.3% in 2021/22, 7.3% in 2022/23 and 6.3% in 2022/23. These are obviously still massive deficits that will require R1.6 trillion to be borrowed over the next three years (including bond redemptions). However, this is R226 lower than the October projection, significantly reducing pressure on weekly bond auctions. It is the first time in eight years that the profile of deficits has improved from one projection to the next. In a time of crisis, small victories count.

Chart 3: Gross government debt as % of GDP, actual and projection

Source: National Treasury

The overall debt-to-GDP ratio is projected to peak at 89% in 2025, a slightly lower level than previously thought. This is comparable to most other emerging markets with reasonable capital market access but is lower than most developed markets. The difference is that developed countries have lower interest rates and therefore spend less on interest payments. In contrast, the portion of the South African Budget that goes to servicing debt is large and growing rapidly because the government borrows at very high rates. Interest payments for the next three fiscal years will be more than R300 billion per year, averaging 20 cents out of every tax rand collected. This approaches levels last seen in the late 1990s when debt was lower but long-term interest rates averaged around 15%. 

Fiscal crisis watch

This is where the oft-mentioned fiscal crisis materialises: every cent spent on interest is not spent on delivering crucial services. This is a slow-burning crisis; a chronic but not an acute condition. It should ultimately force government to look long and hard at where and how the remaining money is spent, and as a result zero-based budgeting is already being rolled out on a trial basis in two departments.

The good news is that the interest payments mostly flow to South Africans and ultimately circulates in the economy. That is the benefit of borrowing mostly in your own market.

A fiscal crisis can manifest itself on financial markets when the market is not willing to absorb new debt or roll over maturing debt at reasonable interest rates. These episodes are acute, and often unpredictable as we saw in March of last year. Another example: the new Italian Prime Minister Mario Draghi made a name for himself eight years ago during the European fiscal crisis as European Central Bank president. Bond yields had shot up not only because of high debt levels, but in particular the fear that it would lead to a disorderly disintegration of the single currency. With long bond yields rising above 7% by mid-2012, borrowing was becoming unaffordable for Italy, the world’s third largest sovereign debtor. Greece, Portugal and Spain, were in similar positions. Draghi promised to do “whatever it takes” to prevent the euro collapsing.

It was enough to calm markets and Italy can today borrow over 10 years at 0.7%, even with a debt-to-GDP ratio of 145% and poor longer-term growth prospects. Our central bank can also, as a last resort, “do whatever it takes” to prevent the government from being shut out of markets.

Nonetheless, for as long as the government remains committed to fiscal consolidation, the biggest risk for local bond investors remains a surge in global risk aversion (as we saw last week) and not a home-grown crisis. It helps of course that South African debt is of a long maturity and mostly rand denominated. This reduces the risk of having to constantly roll maturing debt in potentially unfavourable conditions, while currency volatility also has little impact, whereas it can be devastating for many other emerging markets. This prudent debt management approach is an important hedge against a potential default scenario.

Counter the extreme pessimism

In summary, the Budget should counter some of the extreme pessimism about South Africa and its fiscal situation, though it is clear that the market wants to see the wage agreement signed and sealed before getting too excited.

To put it slightly differently, the big three risks to South African investors at the moment are probably a global Covid resurgence, a policy error by major global central banks (tightening excessively and prematurely) and runaway SA government debt. Though nothing is certain, what we can say is that for now the world is making progress in fighting the pandemic through vaccinations, central banks remaining committed to a sustained recovery and our government taking tough steps to stabilise debt.