Lesson on forecasting from SA’s 2024 elections and what this means for US market predictions

Lyle Sankar

There is immense value in understanding the limitations and risks of predictions around events. The recent South African elections presented a major risk event for clients, and in many ways it proved to be a pivotal moment for South Africa’s economic outlook.

There are important learnings from this event. Firstly, forecasting is inherently flawed, and using predictions to guide decisions ahead of major events carries significant risk. Before the elections, many expected the ANC's support to dip below 50%, yet few predicted it would approach the 40% mark.

Secondly, the consensus market view is typically already reflected in the price or yields, and therefore presents risk if it proves to be incorrect. We believed that the market consensus was that the ANC would receive around 45% of the vote, which was seen as being a market-friendly outcome which markets already began to price in. Some of the key questions we asked ourselves in the run up to the elections were: “What happens to markets if the view is wrong? Is the probability of this outcome really 80%? Has the market already fully priced in this specific outcome?”

At PSG Asset Management we believe it is possible to make significantly better decisions when we focus on the probabilities of various scenarios, rather than trying to predict exact outcomes.

We recognised the risks tied to a market-unfriendly election outcome and assessed the potential fallout. Given the uncertainty and the potential for significant downside in an unfriendly market outcome, it was prudent to proactively manage risk by adding protection within our funds ahead of the elections. This strategy, we believe, effectively safeguarded our clients’ interests.

Applying these learnings to US inflation predictions and global fixed income markets

Looking at international markets, there’s a broad consensus on the future path of inflation, but it deserves closer examination. Most market participants expect US inflation to remain contained and are betting with near certainty on a rate-cutting cycle starting in September 2024. With US growth slowing, the expectation is for a deep and fast cutting cycle in the next six months, and US bonds are already factoring in a softer inflation and growth environment.

However, we would caution against assuming inflation is destined to fall from current levels of around 3% to within the 2% target range for an extended period. In our view, the impact of longer-term inflation dynamics and drivers of inflation are being underestimated by the market, even if the economy seems to be cooling in the short term.

U.S. inflation has averaged 3% to 4% over the past 18 months, driven by persistent core services inflation, largely fuelled by elevated wages. With wage growth stubbornly above the Fed's 2% target, bringing inflation under control without a significant rise in unemployment is challenging. Historically, after periods of entrenched inflation, a return to target levels is protracted. Consequently, we expect inflation to remain elevated and volatile in the near term, defying market expectations.

US elections are likely to drive further inflationary pressures

While US election outcomes need to be considered when trying to understand the likely direction of underlying inflation pressures in the US, US inflationary pressures will probably persist regardless of the outcome of the election. This will be driven by ongoing deficit spending amidst the tightest labour market in history and continued wage growth.

We also think that US government spending is likely to remain elevated and therefore believe that the prevailing consensus on low inflation is increasingly precarious, and may not materialise as expected.

Despite this, we expect that the Fed will cut rates even though we do not think inflation is under control.

A key reason is that the Fed is aware of the impact of elevated interest rates on the existing US debt burden, debt servicing costs and on the amount of debt that the US treasury needs to issue to market. The US continues to spend significantly more than it earns, and its interest payment bill has ballooned by more than 75% over two years.

We estimate that over the next three years, the US will issue more than $20 trillion of debt to refinance maturing bonds and sustain current budget deficits. While it is not the Fed’s primary mandate, one way to control this dynamic is to lower the cost of debt.

However, cutting rates without inflation being under control has negative implications for the US dollar, the attractiveness of their debt instruments, and how the interest rate cycle progresses from this point forward.

Although the US dollar has been on a 15-year upward cycle, there is a distinct possibility that it will weaken from here, marking an inflection in the current cycle. This gives rise to typically attractive environments for emerging market assets.

South African assets offer investors attractive opportunities
Against this backdrop, we believe the local environment has grown increasingly favorable for South African assets to outperform.

There is greater political certainty and forward momentum on the much-needed reform agenda. There has also been no load shedding for more than [five] months, with energy supply outstripping demand. In addition, we think that the anticipated rate cutting cycle could be deeper than many expect.

This means that the probability has shifted towards the bull case of equity-like returns at bond-like levels of risk for bond investors.

As we look ahead, South African bonds present a compelling opportunity for investors to secure attractive real yields at the peak of the interest rate cycle. However, this advantageous window won't last forever. We are strategically positioning our funds to leverage the current market conditions for our clients' benefit, while remaining vigilant capital preservation, which remains paramount for fixed-income investors.