JOHANNESBURG - For South Africa's currency and government bond markets, 2018 has so far been a year of remarkable price volatility. From late 2017, we saw a euphoric market reaction to a new South African political dawn and the immediate market-friendly steps taken by the freshly shuffled government seemed to play out well for investors.
This was followed by a gradual, then powerful reversal, as weaker economic indicators and confidence levels, combined with the realities of complex economic challenges ahead, began to develop more clearly.
For the rand and South African government bonds we noticed similar weakening trends in the run-up to the ANC elective conference in mid-December last year, followed by a strong recovery all the way into the end of March 2018. March’s Monetary Policy Committee (MPC) meeting culminated in an interest rate cut as the inflation outlook was comfortably within target.
MPC comments on the currency being over-valued at this meeting seemed to stop the currency appreciation in its tracks, despite several analysts forecasting continued appreciation trends for the rest of the year.
From this pivotal point, the global and domestic picture deteriorated sharply, with global trade threats and shrinking global money supply adding to the negative outlook for the economy.
These market movements may, however, be almost entirely attributable to global developments, with limited influence from domestic factors. It is well known that South African currency and capital markets, being highly liquid, bear the burden of emerging market secular trade flows in a more pronounced and generally heavier fashion than our less liquid and less developed counterparts. This means that South Africa often feels the heat in bear markets worse than when the emerging market backdrop is supportive.
Over the elective conference, there was a 6to 7percent appreciation in the rand and government bond prices. Momentum slowed into year-end, only to resume aggressive strengthening at the beginning of 2018. The powerful foreign buying at times seemed overly optimistic, compared to historic foreign investor behaviour.
When trying to filter out the idiosyncratic moves or factors attributable only to South Africa, it is important to look at global market prices at the same time. When we overlay the dollar index, a general index of the international value of the dollar (in black) over Benchmark SA Bond yield (R186) and the rand, we can see that their behaviour has been reasonably well correlated.
Even around the December elective conference (December 16 to 20, 2017 - vertical lines on chart), the direction of the dollar index weakness coincidentally corresponded with the anticipated reaction of local markets to the elective conference outcome.
Clearly, domestic asset prices have been powerfully influenced by global developments, factors that cannot be ignored. The South African Bond market has sustained heavy foreign selling since April 2018, in excess of R50billion.
But there are idiosyncratic factors that support investment and which compel one to remain cool-headed, even as it feels increasingly difficult to do so. There have been many positive changes, and South Africa’s investment environment and trajectory has improved since the end of 2017.
From pricing in a small probability of another cut in interest rates at the time of the March MPC meeting, the market is now seeing only rate hikes over the next two years. But, on the surface, inflation has remained surprisingly low and the MPC’s ability to contain it within the target range (3 to 6percent) and slowly influence expectations towards the 4.5percent middle has shown encouraging success so far.
Foreign exchange pass through is the risk - but as demonstrated by the muted signs of the VAT hike on inflation so far - this risk is not yet to be feared.
South Africa’s longer yields have sold off, not just due to a rise in interest rate expectations, but a hefty increase in term premium as well - and currently has one of the highest term premiums in the emerging market (EM) universe, assuming the South African Reserve Bank is not likely to hike rates any time soon.
The political backdrop is reflected by the country's sub-investment grade rating - and hence the 10-year yield is not likely to dip below 8percent on a sustainable basis. Yet, from a cyclical perspective, there is no reason why bonds cannot reprice, especially taking into consideration the direction in which the country's politics has changed - albeit from a low base.
As a domestic investor with yields on long-term government debt now ranging anywhere between 8 and 10percent, against an inflation outlook that, although rising, remains forecast to be below 6percent by most analysts, there are good reasons to be a selective buyer of South African bonds.
One should not ignore the global pressures that befall our capital markets, but we also need to assess the risks pragmatically and, if the real valuations appear attractive on a longer-term outlook, the window of opportunity may be more obvious when stability returns.
As soon as global sentiment turns, South Africa's bond market is set to be one of the out-performers in the EM universe.
James Turp is the head of fixed income at Absa Asset Management.
The views expressed here are not necessarily those of Independent Media.