It’s not the world’s best-kept secret that SA is teetering off a fiscal cliff.
The economy is barely growing, more credit rating downgrades might be on the cards, state-owned-enterprises have been engulfed in corruption scandals, and large investment decisions by companies have been put on hold pending the outcome of the ANC’s succession battle in December.
And yet foreign investors are not running for the exit. According to JSE data, foreigners bought a net R69.5 billion of South African bonds (mainly the key R186 ten-year government bond) in the year to end of September 2017.
Foreigners appetite for local bonds is in line with the inflows of R68.7 billion recorded in the year to the end of September 2016, which was significantly higher than the R8 billion in 2015 and R2.1 billion in 2014 over the same comparable period.
Although the wave of bad news continues apace in SA, the global search for an attractive yield by cash-flush foreigners has intensified, pointing them to the local bond market.
“Foreigners take a different view on emerging markets risk than people living in emerging markets do. Foreigners are used to political turmoil, junk status downgrades, and uncertainty. It’s not news to them,” said Wayne McCurrie, senior portfolio manager at Ashburton Investments.
SA’s current ten-year bond yield at 8.6% (the interest rate that investors would receive on loans to the government) is more attractive than emerging market peers including Russia, India, and Indonesia, which are offering a yield of 7.5%, 6.7% and 6.5% respectively. This is the reason why foreign inflows have continued, coupled with SA’s bond market that is exceptionally liquid and sophisticated, allowing investors to get out quickly.
“No matter what the politics are in SA, our government is not about to renege on its debt. We are still a mile away from that and foreigners believe that they will get paid,” said McCurrie.
It’s important to note that the foreign inflows don’t necessarily mean that investors are comfortable with SA’s economic fundamentals and political uncertainty. “Those concerns are all there, but that is not the main driver when it comes to their investments. SA is attracting a lot of money but we remain vulnerable because the fundamentals are weak and not good,” said Kevin Lings, the chief economist at Stanlib.
SA bonds are receiving a fair share of inflows in the wake of an improved sentiment towards emerging markets.
Emerging markets inflows have been under pressure since 2015 as concerns mounted about China’s economic slowdown deepening, and Brazil and Russia sinking into a recession. Worsening these concerns was the possibility that the US Federal Reserve would hike interest rates, ending a sustained period of low interest rates. However, China’s economy grew, Brazil and Russia came out of a recession and the US Fed now expects a gradual rise in interest rates. This re-energised investment flows into emerging markets.
Although SA’s prospects remain precarious, the rand has remained resilient, trading in a narrow range of R12.50/$ to R13.50/$ so far this year. At current levels (R13.63/$ at the time of writing), market watchers consider the rand to be undervalued, which has made local bonds attractive for foreigners.
To underscore the undervalued rand, it would be useful to use The Economist’s Big Mac index. The index is centered on the theory of purchasing-power parity (PPP), which examines the divergence in the value of currencies between countries and their “correct” level. The index is a lighthearted guide to explain PPP and was never intended as a precise gauge of currency misalignment.
For example, the average price of a Big Mac burger in the US in July 2017 was $5.30. In SA, it was $2.26 at an exchange rate of R13.27 at the time or R31.52 for a burger. So the “raw” Big Mac index suggests that the rand was 57.3% undervalued against the US dollar using the PPP theory. The rand is the fourth most undervalued currency against the US dollar among 44 countries in the index, after Malaysia (62.2%), Egypt (66.9%) and Ukraine (68%).
George Glynnos, the chief economist at ETM Analytics, expects the rand to retreat back to R12.50/$ to R13/$ as he doesn’t believe that the weakness in the local unit – by more than 7% so far this year – is the start of a big reversal for a rand that has remained remarkably resilient. McCurrie has put a fair value of R12 to the rand by end of year depending on commodity prices, which the local currency generally takes cues from.
The Big Mac Index- July 2017. Sources: McDonald’s; Thomson Reuters; IMF; The Economist.
Bond buying opportunity?
So, are bonds now a buying opportunity given the attractive yield and undervalued rand?
In the short term (next three months) Stanlib’s Lings agrees as inflation has been kept in check and the search for yield is still strong. “Beyond that, we are flagging that there is too much uncertainty that we don’t fully appreciate relating to politics and credit ratings.”
In April, S&P Global Ratings cut SA’s foreign currency credit rating to sub-investment grade (or junk) while Fitch cut both foreign and local currency credit rating. Moody’s cut SA’s sovereign credit rating one notch above junk, with a negative outlook. A downgrade to junk of SA’s local currency credit by S&P and Moody’s in early December would be catastrophic, as the country could lose its spot in Citigroup’s World Government Bond Index.
South African government bonds became the first African government bonds to be included in the index in October 2012. If excluded from the index, many foreign asset managers with investment grade mandates would dump SA bonds.
This would put the rand at more risk, said Lings.
Another risk is the normalisation of US interests; if they rise rapidly SA bond yields would become less attractive. SA is dependant on inflows to prop up government spending, whereas other emerging markets like India and China offer foreign investors bond yields and economic growth.
“We can’t offer foreigners that [yields and economic growth]. If you are offering foreign investors only the search for yield trade, then that is the main basis on which you are attracting foreign investment. You become somewhat vulnerable. What happens if the search for yield is not as intense as it was?” said Lings.
Another risk to bond yields is the ANC leadership elective conference outcome in December. Said Ashburton Investments’ McCurrie: “If there is a truly positive political outcome, bonds would rally by 50 basis points and maybe even a full percent.”
Right now, it’s anybody’s guess what a positive political outcome might be.
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