While running a persistent budget deficit averaging 4% of gross domestic product (GDP) a year since 2009, the South African government has increased debt as a percentage of GDP from 26% to 64%. The annual GDP growth rate has fortunately been positive throughout this period (other than in 2009), but growth is expected to contract by approximately 8% in 2020.
In addition to a rising debt bill, the South African government is likely to experience significant pressure on its tax revenue.
SA was already in recession at the start of the year. However, the impact of the global pandemic has substantially amplified these challenges.
SA investment case
Against this backdrop, the investment case for South African assets appears weak, especially for government bonds.
Accordingly, the market has seen an increase in supply. The country has now been downgraded by Moody’s to junk status and foreign investors have voted with their feet, reducing their South African bond holdings from 42% in 2018 to around 30% currently.
However, all may not necessarily be lost. Markets typically discount information a long time in advance, and it is fair to ask whether local bond market valuations reflect this discount.
We outline an investment case for South African bonds, despite this challenging fiscal backdrop.
Our case is largely premised on the following factors:
1. Global liquidity and accommodative monetary policy
2. Fiscal consolidation
3. Positioning and valuations
Global liquidity and monetary policy
Cash needs to find a home
In their attempts to lift economies out of pandemic-induced recessions with much-needed stimulus packages, many other countries, both developed and emerging, find themselves in a similar fiscal position to SA. The fiscal deficits of the G20 countries are expected to average over 15% this year, while the government debt-to-GDP ratios of the same group of countries are set to average around 110%.
J.P. Morgan Asset Management estimated that around $17 trillion of stimulus packages have been announced to deal with the fallout from the pandemic. The balance sheets of the G4 central banks have expanded from 35% to 47% in a space of a few months, and they have pledged to keep this liquidity in the system for longer to allow for economic repair. This cash will need to find a home earning attractive return.
One lesson from the GFC is that, like flowing water, liquidity finds a path to risky assets once the environment improves.
Interest rates: staying low for longer
Central banks globally coupled their asset purchase programmes with interest rate cuts. Most of the developed market short-term rates are either at zero or negative yields. The US Federal Reserve (Fed) recently indicated that it is comfortable keeping rates at current low levels until at least 2022. The increase in liquidity and accommodative monetary environment has improved risk sentiment and bodes well for emerging market assets like South African bonds.
Emerging market central banks followed suit by cutting rates. Unlike their developed market counterparts, they have the space to reduce rates further. The South African Reserve Bank (Sarb) has cut interest rates by a total of 300 basis points this year and provided liquidity through bond purchases.
Core and headline inflation numbers continue to trend lower in SA, suggesting further rate cuts. We expect the repo rate to be lowered to 3% over the coming months and to remain at these levels through 2021. This is very supportive for SA bonds, especially in the shorter end of the yield curve, and can be a mechanism to tame fiscal pressures.
SA inflation and repo rate trajectory
Governments have choices
Governments have several policy tools to address fiscal imbalances and create healthier balance sheets. They can choose to run higher inflation rates, which over time will help to reduce the real value of their debt. This is generally not advisable for economies like SA, given the negative impact of inflation on the livelihood of the lower-income market.
Another option is debt-monetisation, in which the central bank prints money to finance the deficit. This can also lead to inflation and currency depreciation.
Governments may also consider financial repression policies intended to keep interest rates artificially lower and reduce pressure on domestic debt. SA’s government may prescribe to pension funds and financial institutions a minimum holding of government bonds.
Lastly, governments can also choose to introduce austerity measures to reduce spending. While these measures help to bring public finances back on track, they are usually unpopular with the electorate.
SA government: choosing austerity
The South African government has chosen the austerity route. It aims to cut expenditure by R230 billion over the next two years to reach a primary surplus with debt set to stabilise around 87% of GDP by 2024. This is in addition to the ‘pencilled in’ R160 billion of expenditure cuts in the February 2020 Budget.
These are very ambitious targets and have huge implementation risks, given a poor track record of tightening spending.
However, National Treasury’s recent refusal to cave into trade unions’ demands around wage increases and decision to refuse further funding to state-owned entities like SAA, are encouraging. While full targets are unlikely to be achieved, some meaningful cuts will be positive for South African bonds and will support a flattening of the steep bond yield curves.
Positioning and valuations
Emerging market portfolio outflows during the peak of the Covid-19 market crisis in 2020, are estimated to be over $100 billion, compared with around $30 billion during the GFC.
Around the same time, SA was finally downgraded by Moody’s to sub-investment grade, which led to more selling of its government bonds. With foreign investors now holding less than 30% of SA’s debt, positioning is light. There is scope to expect an increase in inflows, especially if the fiscal picture and global risk environment improve.
A compelling investment?
Investors in our longer-term government debt instruments are currently offered a real yield of over 7%, one of the highest in the world, which contrasts with negative real bond yields in developed markets.
Furthermore, SA’s yield curve is already pricing in a worst-case scenario in terms of the fiscal position. The injected liquidity worldwide will be seeking a home once the risk environment improves and the hunt for yield resumes. Most emerging-market economies will once again become beneficiaries of these carry trades, as was the case post-GFC. SA will be on that list, given the attractive valuations it offers. But with one proviso – SA avoids a default.
Given the low growth environment locally, rotation away from growth assets by local managers who also have light bond positions will also support the bond market. A general IMF programme and a prescribed assets programme are likely to precede a default and will be supportive for South African bonds.
Sylvester Kobo is a fixed income portfolio manager at STANLIB Asset Management