Risk-off climate ‘will see yields on SA bonds rise’
“Now we also face an immediate crisis. In the past week, Covid-19 has started behaving a lot like the once-in-a-century pathogen we’ve been worried about. I hope it’s not that bad, but we should assume it will be until we know otherwise.” - Bill Gates, February 28.
What impact would this have on the economy? A slowdown in trade and economic activity and market action in response to the virus fear.
Slowdown in economic activity
Global growth and trade forecasts will be revised down sharply and central bankers are responding by cutting interest rates and adding liquidity. The injection of liquidity will help to support the financial markets.
For South Africa, at risk of a downgrade, the combination of rising debt levels and union resistance to pronounced labour cuts to help alleviate this, together with a lower growth outlook, will hasten Moody’s day of reckoning.
Moody’s is concerned about South Africa’s vulnerability to external shocks. The stabilisation of South African public debt, a shock to domestic growth in an economy laden with rising public debt and a 0percent savings rate, will give them cause for concern.
The question remains, to what extent is the downgrade priced into the market? In terms of the credit default swop spreads, default risk on local debt is priced at similar levels to Brazil - that is, junk. We don’t expect this risk premium to widen further relative to emerging-market peers on a downgrade announcement.
However, what we have noticed over the past year is a widening in the South African currency risk premium as investors demand higher yields for South African currency risk (5 percent).
This is the excess yield global investors’ demand for rand currency risk. It is difficult to know where this could go, but if foreigners sell bonds on a downgrade, and growth and South Africa’s fundamentals continue to deteriorate, it is possible that this premium will widen further.
Foreigners are not net buyers of South African bonds this year, indicating that, at current levels, they do not yet see compensation for the risk they are taking.
The consequence of easy money conditions globally has been an increase in leverage in the financial system. When panic sets in as the world sneezes, traders face margin calls, cut positions and markets implode. Market movements are exacerbated beyond what the fundamentals tell us about potential shocks to earnings.
The 15 percent fall from the recent high is the fastest 15 percent from a high in the history of the US equity market. During the pandemonium, the gold price fell close to $70 at a point of flight to safety.
It seems the major reason for this was that traders, faced with margin calls on equity positions, were forced to cut winning trades to meet margin. Now, as equity markets have recovered, gold is rising again. The high level of leverage in the system has unforeseen consequences and risk is rising.
What does the market risk-off selling mean for South African bond markets? The flight to quality away from risk assets saw South African bond yields rise sharply in early March and further risk-off activity will likely see South African bond yields rise further.
The combination of a weaker economy, rising national debt and a government that is unable to contain the deficit, combined with a general global risk-off environment, are all negative for South African bonds.
Having said that, real yields are historically high and further sell-offs in the market will provide an opportunity to purchase bonds as real yields rise further.