SAs GNU can turn out to be a fruitful arranged marriage

As far as market sentiment is concerned, the negotiations around SA’s new Government of National Unity (GNU) have been like an arranged marriage between two middle-aged people who need to start a family soon, suggests Sylvester Kobo, STANLIB’s Deputy Head of Fixed Income.

“Imagine that after lengthy negotiations, the couple agree to marry,” he said. “This is greeted by a big party, ululating and champagne. When the married couple moved in together to start a family, there is more celebration.”

SA’s financial markets celebrated the formation of the GNU with a 110 bps rally in bonds. The JSE’s All-Share Index gained almost 5% in June and the rand strengthened by about 3% against the dollar.

“When the kids are born – by which I mean growth, employment, better lives for all and service delivery –companies will regain confidence, invest in the economy and create jobs,” Kobo said. “As GNU moves in the right direction, foreign investors will gain more confidence and there will be a gradual return to SA.”

STANLIB’s Fixed Income team believes that if the GNU shows it can work together effectively, a structural shift will occur in the South African economy which will be positive for asset classes across the board. But getting to that point will not be easy. Inevitably, there will be posturing and negotiations before the parties in the GNU find a middle path.

A comparison of credit default swap (CDS) spreads in SA, Mexico, Brazil and Turkey shows that in May 2023 (when SA was facing the Lady R accusations and Eskom’s load shedding was at its height) SA’s CDS spread decoupled from Brazil’s. (A CDS reflects the cost of insuring government against debt default). While SA still has some way to go revert to its previous position, it is likely to re-align with its peers as the GNU delivers economic growth, which will give bonds and other asset classes a tailwind, Kobo said.

Analysts are beginning to price in two interest rate cuts by the South African Reserve Bank (SARB) before year-end. STANLIB’s Fixed Income team concurs, but is more bullish: where the market expects a total of only 75 bps of cuts by end-2025, the team is pencilling in 125 bps, based on the view that by the end of 2024 inflation will move closer to 4% and will average around 4.5% in 2025, which is the midpoint of the SARB’s target band.

“Clearly South African inflation is contained and there is no need to keep interest rates at this level,” he said. “The neutral rate (neither restricting nor stimulating the economy) is around 2.7% real – at present, it is restrictive at a real rate of about 3.36%, and the economy is struggling to gain momentum. We are confident that the rate will move to neutral – and it should even be accommodative now.”

Globally, inflation has retreated and significant central banks such as the European Central Bank (ECB) and the Bank of Canada have cut rates. The UK is expected to follow in Q3 2024. This should revive the carry trade (borrowing funds in low-interest markets to invest in higher-interest markets), which benefits SA’s bond market.

Currently, the US real yield is around 1%, which is significantly less attractive than the real yield in emerging markets. As major central banks cut interest rates, investors will chase yields, and SA is relatively attractive. While Brazil also presents opportunities, its central bank has already cut rates and the market is pricing in hikes in the future while SA is expected to start with interest rate cuts, which might lead to reallocation away from Brazil to SA.

One of the factors that could make the SARB cautious is that if SA cuts its interest rates ahead of the Fed, it could cause the rand to weaken. Kobo said rand strength so far this year reflects market excitement about a structural shift in the South African economy. If the GNU functions well and risks unwind, then the SARB need not worry about the interest rate differential because a lot of negatives are already priced into the rand (the credit rating downgrade, greylisting and load shedding). But SA has made some gains already: well into winter, there has been no load shedding; results of Operation Vulindlela are starting to materialise; and the country has achieved a primary budget surplus for the first time in 15 years.

“It is impossible to predict how far the rand can go. But I believe if political risks settle, it will strengthen from here,” Kobo said.

He said the positives are not yet fully priced into SA’s equities, bonds and the rand.

“We expect interest rates will go even lower than the market is pricing in. Only 2-3 years ago 10-year bond yields were about 9% and pre-Covid they were around 7-8%. Our fair value for 10-year bonds over the next 6-12 months is 10.75% from just over 11.5% now. If we see tangible proof that politics will settle, the yield could go below 10%. From a capital appreciation point of view, that will be beneficial. You want to be in the market before that happens.”