Just under two weeks ago, we noted that 2016 has proven to be a very good year for investors in RSA (government) bonds (see Special focus). We revisit and update the topic in the light of recent events.
Bonds have outperformed equities and cash by a large margin this year. By 28 October, the All Bond Index (ALBI) had delivered a total return (including interest reinvested) year-to-date of 14.2%, compared to 2.7% provided by the All Share Index (ALSI) of the JSE. The inflation-linked RSA Bond Index (ILBI) had returned 8.1% by 28 October, while the money market would have returned 6.2% over the period (though it should be appreciated that bond yields had weakened sharply in December 2015 as had the rand in response to the President Zuma-inspired turmoil in the Ministry of Finance). On a 12 month view to 28 October 2016 – from 1 November 2015 the ALBI had returned 5.5% and the ILBI 7%; while R100 invested in the JSE ALSI on 1 November would have lost value and have been worth (with dividends reinvested ) R97.2 on 28 October 2016.
The JSE, when measured in US dollars, has performed very strongly this year, increasing some 14% this year (to 28 October), in line with a similar increase in the MSCI EM Index and well ahead of the S&P 500 Index, which is up by about 4% this year (see figure 2 below).
The strength in emerging market equities has given impetus to emerging market currencies, including the rand, as more capital flowed towards emerging markets and their currencies. Less global risk aversion and the capital flows that drive the MSCI EM Index higher are generally helpful for the rand as well as for the US dollar value of the ALSI. SA-specific forces acting on the rand can be identified by the ratio of the USD/ZAR exchange rate to the USD/EM basket exchange rate as we do below. A weaker rand relative to other emerging market currencies, indicated by an increase in the ratio of the foreign exchange value of rand to other emerging market currencies, represents extra SA risks and a lower ratio, less the SA risk that is priced into the exchange value of the rand.
The performance of the rand and other emerging market currencies is shown below, as is the relative performance of the rand. All emerging market currencies weakened against the US dollar between 2012 and 2015, though rand weakness was especially pronounced by year-end 2015. The rand not only strengthened in 2016 in line with other emerging market exchange rates, but has recovered some of this relative weakness vs the emerging market basket after mid-year. As may be seen in figure 3, the ratio of the rand to the equally weighted EM currency basket declined from 1.25 at the 2015 year-end to the current ratio (31 October) of 1.1 This indicates generally less SA-specific risk in 2016 – helpful to the bond market also, as expectations of inflation recede somewhat with rand strength and long term interest rates accordingly decline.
Recent interest rate trends are shown in the figure below. Long term interest rates in SA are significantly lower than they were in January – though are still above the lows of mid-August 2016. Hence the good returns realised in the bond market to date (though it should also be appreciated that the SA risk spread, being the difference between 10 year RSA Bond yields and the US Treasury 10 year yields, rose significantly in 2015 and spiked in December when President Zuma replaced his Minister of Finance. The spread is still significantly wider than it was in 2014 and before).
This spread is now 7.01% p.a. and is also by definition the expected depreciation of the rand over the 10 year period. In other words, the rand is expected to weaken on average by 7% p.a. over the 10 years. Any greater or lesser premium in the cost of buying dollars for delivery in 10 years would provide an opportunity for riskless profits – for borrowing dollars and lending rands, or vice versa – while securing the dollars or rands for future delivery at a known exchange rate, which eliminates the risk of the exchange rate depreciating or appreciating excessively . This spread is known as the interest carry, though it is one that can only be earned or helpful to borrowers taken on debt at lower rates, when taking on exchange rate risk. If this exchange rate risk is not accepted and the currency risk is fully hedged, the cost of borrowing or lending in the one or other currency will be approximately the same.
Such a relationship is not intuitively obvious. Why would more weakness in an exchange rate today be associated with still more weakness tomorrow? It might be thought that a lower price (exchange rate) today would improve the prospects of a higher price tomorrow rather than weaken its prospects? For the developed market currencies a wider spread would ordinarily be associated with improved prospects for a currency under pressure and lead to currency strength rather than weakness.
Irrespective of the forces driving exchange rate expectations, more exchange rate weakness would surely be associated with more inflation to come and the reverse: a stronger rand today associated with less inflation to come. In figure 7 below we show the strong and understandable link between the risk spread, or the expected depreciation of the rand, with inflation compensation offered in the RSA bond market. Inflation compensation is the difference between the yield on a vanilla bond and the real yield provided by an inflation-linked RSA bond of the same duration, and is a very good proxy for inflation expected in the market place.
The rand has strengthened this year in line with other emerging market currencies and has also benefitted, as we have indicated, from improved sentiment about SA political trends in recent months. The decision today to withdraw fraud charges against Minister of Finance Gordhan has added further to rand strength relative to the other emerging market currencies. Accordingly, the outlook for inflation in SA will have improved. The outlook for lower interest rates therefore will also have improved, to the advantage of JSE-listed companies with full exposure to the SA economy, that stands to benefit from lower interest rates. RSA bonds clearly also have this character.
The chances of a cyclical recovery rest with the behaviour of the rand, with inflation and inflation expected and with the interest rate responses of the SA Reserve Bank. The recent news flow has clearly improved the prospects for less inflation and faster growth for SA. These improved prospects are helpful for investors in conventional bonds and for SA economy plays, like banks and retailers that benefit from lower inflation and lower interest rates as are revealed on the JSE. Rand (SA economy) plays do well with (unexpected) rand strength. They do even better in a relative sense when rand strength can be attributed to less SA specific risk. 1 November 2016
One issue we can never turn a blind eye to is the fact that exogenous forces have severe impact on the inflation/currency and therefore interest rates. As the US economy heats up, a lot of pressure is going to come down south, forcing the SARB to hike. I think is something we cannot ignore lest the FED tightens come their December meeting. What are the odds?