The market reacts to a surprising US election. Is more growth expected in the US consistent with less growth in emerging economies? Perhaps not.
Donald Trump’s ascension to the White House surprised the financial markets. The bond markets have recorded the largest surprises. A heavy dose of shock and awe was registered in the Treasury bond market and the shock waves were also felt in emerging bond markets, including the market for RSA bonds. US 10 year Treasury yields ended last week over 30bps higher (as we write on Monday 14 November, the yield is 2.21% p.a). The RSA 10 year also ended the week higher at 9.11% p.a (now 9.17%) or 44bps higher, meaning a slightly wider SA risk spread of 6.95% p.a. – equivalent to the average rate the rand is expected to depreciate against the US dollar over the next 10 years.
The higher rates in the US were not confined to vanilla bonds. Inflation linked yields (TIPS) also moved higher on Wednesday 9 November, revealing that the Trump presidency was expected by market participants to not only bring more inflation but also faster growth; faster growth that was expected to increase the competition for capital, so making capital more expensive in real terms.
RSA yields indicated that more SA inflation came to be expected as real bond yields remained largely unchanged through the week. This indicated that little change in the SA growth outlook was expected. The wider spread between nominal and real RSA bond yields indicated more inflation expected that was consistent with the faster rate at which the rand was expected to weaken. More rand weakness, other things equal, means higher rates of inflation in SA (See figures 1-4 below).
Higher bond yields were also registered in Europe. German 10 year Bund yields that had been negative in October increased from 0.08% p. a. on the Monday to 0.235% by the Friday close, but not by enough to prevent the spread Vs US Treasuries from widening in favour of the US dollar, which made gains against the euro and much more significant gains vs emerging market currencies.
The rand was an underperformer within the world of weaker emerging market currencies. R13.35 bought a dollar on the Monday, but by Friday the USD/ZAR was R14.29, a decline of 6.8% (now R14.39) compared to our equally weighted basket of 11 other EM currencies that declined by a mere 3.8%. The currency market would appear to be pricing in additional SA-specific risks, perhaps associated with Zuma resilience revealed in the no-confidence in the President motion in the SA Parliament that failed on the Thursday.
Other signs that US growth assumptions were being revised upwards came from the market in high yield or junk bonds. These yields remained largely unchanged as the high risk spread narrowed even as Treasury yields rose. Faster growth reduces the risk of credit defaults and the market in high yield credit appeared to be drawing this conclusion.
Other signs of faster growth expected came from the metals market. While the gold and oil prices expressed in the stronger US dollar fell away, the CRB Index of Industrial Metals in US dollar increased by about 5% in the week while the weaker rand compensated to some extent for lower US dollar prices.
The stock markets also told the story of faster growth expected in the US and slower growth expected in emerging economies. The SA component of the emerging market equity benchmark lost over 6% in the week compared to the MSCI EM that ended the week 3.5% weaker. The large cap US S&P 500 Index gained 3.8% while the small cap index did significantly better, gaining over 7%. This move too could be regarded as supportive of faster growth that improves the prospects for riskier small companies.
The best performing sectors on the S&P 500 and the JSE in the week of 7 to 11 November proved to be the highly cyclical plays. Materials and resource companies did much better than the consumer-facing companies that had offered predictable dividend yields, yields and dividend growth that had compared well with what had been very low interest rates. The same direction could be seen on the JSE with the Global Consumer Plays, despite the weaker rand, proving distinct underperformers.
It is however not at all obvious why faster US growth should be associated with less growth expected fromemerging market economies; nor why strength in metal prices should be associated with a deteriorating outlook for emerging economies, including the SA economy. The opposite conclusion might have been drawn as appears to be the case for the Australian economy, which is highly dependent on metal exports.
The growth prospects for the SA economy would not have been improved by the changed outlook for short term interest rates. As we show below, the short term yield curve, as reflected in the Forward Rate Agreements (FRAs) offered by the banks, moved sharply higher last week. The money market, having much reduced the chances of higher short term rates earlier, has reversed course. The market is now expecting a further 75bp increase in the Reserve Bank repo rate. Such increases, where they to be imposed on the already hard-pressed SA economy, would eliminate almost any possibility of a recovery in household spending, a necessary condition for a cyclical recovery. The bond market is expecting more inflation to come and the weaker rand expected is consistent with such a view.
Yet the USD/ZAR, while now weaker, is stronger than it was in early 2016, indicating stable import prices. Furthermore the outlook for much lower food price inflation should see headline inflation and Reserve Bank forecasts of inflation recede well below the upper band of the inflation target in 2017. The case for higher policy-determined interest rates, given a further slowdown in the economy, is even weaker than it has been, even though the market may now believe otherwise of the Reserve Bank.
Lower inflation, should it materialise, will lead inflation expected in the same lower direction. The causation runs from inflation to inflation expected and not the other way round as the Reserve Bank has argued. Inflation takes its cue from the exchange rate and is much affected by the weather and the actions of the President. These are forces over which interest rates and the Reserve Bank have no predictable influence. The Reserve Bank should concentrate on what it can do to assist the growth prospects of the economy and that is to lower interest rates. Inflation is beyond its control; a fact of economic life in SA that is overdue official recognition but may yet receive it. 15 November 2016