Richard Farber & Reezwana Sumad from Nedbank CIB examine the resilience of the South African financial system and how it reacted to the recent financial crisis. They also discuss the inflationary risks that seem to be increasing in global markets.
What does the Quarterly Projection Model (QPM) suggest for the interest rate outlook and do you agree with it?
The SARB’s QPM is currently forecasting just over 10 hikes of 25 basis points each to the Repo rate by the end of 2023. The QPM is forecasting a Repo rate of around 5% by the end of 2022 and just above 6% by the end of 2023. Our forecast shows that the ideal time to hike interest rates to reduce future inflation and future inflation expectations is when inflation and inflation expectations are low and when growth and the credibility of the central bank is high. In this type of environment, the negative impact of higher interest rates or the negative impact on growth will be felt immediately over the next two quarters. The cost or impact on growth will decline sharply thereafter. A real GDP growth for this year is expected to have recovered quite sharply from last year with growth expected to well above 4%. Inflation and inflation forecasts are close to 4.5% with inflation expectations close to multi-year lows. We think that the base case is for the Repo rate to be hiked in the first quarter of 2022. If we are wrong, then we will probably see a hiking cycle sooner rather than later. The SARB could end up hiking rates sooner and hike less rather than waiting well into 2022 and possibly having to hike by more. Bloomberg’s consensus is a much more tepid or drawn-out hiking cycle in 2022. Our base case is for hikes of between 75 and 100bps until the end of 2022.
What is the FRA market pricing in and do you agree with that?
The FRAs are pricing in 100bps of hikes over the next 12 months. At the last MPC, the SARB suggested they would be comfortable with negative real rates for a period of time as long as inflation remained contained, so could delay hiking interest rates for as long as possible. If there is continued resilience in the currency, there will be continued strength in commodity prices and accommodative monetary policy, not only from the US Fed, but from other developed markets central banks. We think there will be pent-up demand for high-yielding assets that perversely will keep the Rand at a fair level and will keep our bond yields lower. Given the structural impediments that the country faces, the SARB will not hike if they don't have to. We think it’s going to be lower for longer.
How was National Treasury able to reduce the issuance of nominal and inflation-linked bonds so aggressively?
Revenue collection in April was about R38 billion higher than expected and we've had very strong demand in the primary auctions. The non-competitive bond auction was raised by national treasury to 100% allowance. This has now dropped back to 50%. Overall demand in our primary auctions has been quite strong. As a result, national treasury and the government ended up raising their cash balance by over 100 billion. In February, National Treasury was forecasting a R52 billion increase in cash for the last fiscal year. This amounts to almost R50 billion more through better tax revenue collection and demand for bonds. Given the substantial rise in cash, it would make sense to use a bigger portion of cash to fund part of its budget deficit for this year. National treasury is forecasting 8.8% nominal GDP growth for the 2021/22 fiscal year but think this will be revised to at least 9.2%. With better GDP growth, revenue collection will tick up. With high commodity prices, tax revenue from some of the mining companies will probably surprise to the upside as well. Early estimates indicate that VAT collection and excise duties are also higher. We are forecasting at least a R34 billion revenue overshoot for the current fiscal year, which could higher if these trends persist. As a result, National Treasury has reduced the issuance profile. If the revenue overshoot is much higher than our forecast, then debt issuance could reduce further by around R800 million per week.
What has the smaller supply of debt in the weekly auctions done to the bond curve?
The bond curve has flattened in stages. The initial reduction in the weekly issuance was telegraphed when the budget was announced. The market had anticipated that there would be a reduction in the issuance of both nominal and inflation linked bonds. As a result, the flattening happened, but it wasn't as aggressive as anticipated. We then started to see the curve steepen. This coincided with a time when the US Treasuries were under significant pressure and people were talking about the reflation trade and the potential for Treasury to move north of 2%. What caught the market offside though and caused significant flattening, which has remained, was the second reduction in issuance. The market rallied and the curve has flattened. Longer dated bonds have significantly outperformed front-end bonds. The curve has flattened against the 10-year bond, which reduces our financing and borrowing costs quite substantially. This may not be felt in consumers’ hands now, but it has been a massive boom of around 80bps for the 2048's. We've got a fair value of between 8.50 and 9% for the 10-year and between 10.50 and 11% for the third year.
What could derail the revenue and growth forecasts for South Africa over the next year?
If South Africa experiences a severe third wave wither higher lockdown levels, which constrains physical and economic activity further, this will obviously limit upside to growth and potentially reduce growth estimates. South Africa has been lifted by global recovery. If we were to see an abrupt end to the global commodities boom or if the global recovery were hampered by resurgent waves or Covid variants that would impact not just us but other emerging markets. Any negative political developments could impact growth and confidence levels. Over the next six months we will benefit from this global uptick and better revenue collection.
How did clients behave regarding your portfolio during the pandemic?
From March to July, liquidity was key for clients. They were looking to place large amounts of cash and our cash balances went up by 20 to 30 billion over that period although clients wanted reassurance of liquidity. The pricing of TVs went up significantly because some banks, particularly international banks were declining deposits, so we had to look for alternative sources. TVs were a great source; yields were picking up and some TVs were paying higher than the banks. There was a lot of cash in the system, which worked well for us. I do think that's going to reverse and companies will revert to infrastructural spending.