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Bond Market Vigilantes.
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Global Report: Bond Market Vigilantes
By Nick Downing
A bond vigilante is a bond trader who threatens to sell, or actually sells, a large amount of bonds to protest or signal distaste with policies of the issuer. US Treasury bonds are under siege from bond vigilantes. When bond prices drop the yield goes up. The 10-year US Treasury bond yield, the benchmark for the global cost of capital and the basis for valuing all financial assets, has surged over the past quarter, touching 4.87% on Friday 6th October from 3.84% on 30th June. Rising bond yields increase the required rate of return from equities, putting pressure on share prices. As well as placing downward pressure on the pricing of global assets, rising Treasury bond yields also sap global liquidity. Global liquidity is crucial to keeping financial assets buoyant.
What are the bond vigilantes so uptight about? The US federal budget deficit has risen to almost 6% of GDP, which is not unprecedented, but it is normally elevated during recessions, not when the economy is robust as it is currently. Among major economies, the US budget deficit is exceeded only by Japan. According to the Congressional Budget Office (CBO), the federal budget deficit could hit 10% of GDP by 2053 if current revenue and expenditure trajectories are maintained. Deficits need to be funded with debt. The CBO projects the debt/GDP ratio will double by 2053 to 180%. Net issuance of new Treasury bonds year-to-date already marks the second highest year on record after 2020 when the Covid pandemic fiscal rescue package was launched. Treasury issuance is expected to rise by over 20% in 2024. Fitch rating agency downgraded US sovereign credit risk on 1st August.
With all the talk of bond vigilantes, the main reason for the spike in Treasury bond yields is Federal Reserve policy. At the Fed’s last policy meeting, which concluded on 20th September, the chairperson Jerome Powell acknowledged that interest rate hikes had not slowed the economy as much as anticipated in order to bring down inflation. The Fed signalled one more rate hike to come and only two rate cuts in 2024, versus four cuts that it had previously indicated. In other words, the Fed cautioned that interest rates would stay higher for longer. The 10-year yield rose sharply over the following fortnight from 4.34% on 20 September to 4.87%, causing apprehension in global financial markets. G7 sovereign bond yields increased in unison. Some fear that having failed to predict the surge in inflation, the Fed is intent on restoring its credibility and will be too restrictive in its policy.
There are contrasting views. On the one hand, some economists championed by former Treasury Secretary Larry Summers believe interest rates are still not high enough to threaten economic expansion and so bring inflation back down to the Fed’s 2% target. According to independent research company MRB Partners “Long-term bond yields across the major economies have not yet reached a level that will trigger a recession…. Continued economic expansion points to further upside for the US 10-year Treasury yield.” Other economists believe that due to the lag time between interest rate hikes and economic slowdown, it is only a matter of time before the US enters recession. Another independent research company, Capital Economics says that “monetary lags are famously long and variable, and we estimate that around half of the impact of central bank tightening in this cycle has yet to be felt in the real economy. The next show to drop will be a rise in debt servicing costs on existing debt as fixed rate loans taken out in recent years expire and borrowers are forced to refinance at higher rates.” The average rate on new 30-year fixed rate mortgages in the US has already climbed to 7.8% from 3.1% at the end of 2021.
The debate centres around where the neutral fed funds rate lies. The neutral rate is the real fed funds rate (the nominal rate minus the inflation rate) which neither restricts nor stimulates economic growth. In the 15 years following the 2008/09 Global Financial Crisis (GFC), the neutral rate fell compared with previous years due to widespread deleveraging in the private sector. Although a subjective reading, the Fed set the neutral level at 0.6%. Some argue that the neutral rate has increased due to the post-GFC deleveraging and repaired private sector balance sheets. If US CPI settles at 2.3% as indicated by the Treasury Inflation Protected Bond 10-year breakeven rate, the real fed funds rate is currently 3% (the 5.25-5.50% nominal rate minus 2.3%). This is significantly above the longstanding neutral rate of 0.6% and even allowing for some upward revision to the neutral rate, suggests the Fed is already highly restrictive in its monetary policy.
All of this suggests that the Fed is unlikely to hike further and that it is already past the peak in the rate hiking cycle. If so, the 10-year yield, notwithstanding the bond vigilantes, will come down once it becomes clear that the Fed has pivoted towards an easing in monetary policy. Over the past eight Fed monetary tightening cycles, the 10-year yield fell by an average 130 basis points in the six months following the last interest rate hike. If the latest rate hike in July turns out to have been the last, as seems increasingly likely, we should expect a retreat in bond yields soon, which would support equity markets. Largely rising Treasury bond yields are doing the Fed’s job for it, which explains the drop in probability, since yields spiked higher, ascribed to a further rate hike. Fed funds futures are now ascribing a 10% probability to a further rate hike before year-end, down from 50% two weeks ago. San Franciso Fed president Mary Daly said that “If financial conditions, which have tightened considerably in the past 90 days (higher bond yields), remain tight, the need for us to take further action is diminished.”
Local Report: Local Market Prospects
By Nick Downing
Local equity markets gave back their second quarter (Q2) returns in Q3. While the economy continued to narrowly avoid recession, printing a surprising 0.6% quarter-on-quarter GDP growth in Q2, most recent data suggest a mild contraction is likely. Consumers, under tremendous pressure from high interest rates and the rising cost of living, are likely to cut back on expenditure. On the production side, weakening export demand combined with infrastructure constraints, most notably caused by Eskom and Transnet, are impacting output. The JSE All Share index lost 4.70% in Q3 cutting its earlier year-to-date YTD) gain to a slight loss of 0.91%. The Resources 20 index fared worst due to falling global commodity prices and the impact of power outages and transport bottlenecks, with Q3 and YTD losses of 7.16% and 18.71%. The Industrial 25 index, helped by the heavy weighting of multinationals and rand hedge stocks, lost 7.62% in Q3 in line with weakness in global markets, but held onto a solid YTD gain of 8.86%. The Financial 15 index, helped by the endowment effect of rising interest rates, eked out a narrow Q3 gain of 0.49% but managed a YTD return of just 3.93% due to tepid credit extension. In line with rising global bond yields and the SA Reserve Bank’s (SARB) monetary tightening, the SA 10-year Government Bond yield increased over the quarter from 10.51% to 10.81%, compared with 10.18% at the end of 2022. Weakening export demand and the deteriorating current account balance combined with persistent selling by foreigners of local assets, caused the rand to continue depreciating against the US dollar. The rand fell from R/$17.02 at the end of December 2022 to R18.76 at the end of June and R18.91 at the end of September, amounting to Q3 and YTD losses of 0.76% and 11.1%.
GDP defied expectations and registered positive Q2 growth, up 0.6% quarter-on-quarter, an improvement on the 0.4% increase in Q1 and the 1.1% contraction in Q4 2022, while base effects improved the year-on-year growth rate from 0.2% in Q1 to 1.6% in Q2. Contributors in Q2 included agriculture with 4.2% q/q growth, manufacturing, and mining, with q/q growth of 2.2% and 1.3% respectively, and finance & business services, the largest industry in the economy with growth of 0.7%. The main detractor was transportation & communication with a q/q decline of 1.9%, led by declines in land freight and road passenger transport.
Although the GDP data provided a positive surprise, there is little confidence that there will be a pick-up in growth. BER consumer confidence, amid ongoing load shedding, elevated inflation, and high interest rates, remained in negative territory in Q3 at -16, although a slight improvement on the Q2 score of -25. Consumer confidence can vary between -100 and +100, where negative readings indicate a lack of confidence. Business confidence rose slightly from 27 to 33 in Q3 but continues to be underwhelming. Business confidence can vary between 0 and 100, where 0 indicates an extreme lack of confidence, 50 neutrality and 100, extreme confidence. The Absa Manufacturing Purchasing Managers’ Index sank deeper into negative territory below the neutral 50 mark in September, falling from 49.7 to 45.4, attributed to intensifying energy outages, the rising fuel price and sagging demand from key export markets. After contributing to positive GDP growth in Q2, the PMI suggests manufacturing may detract from GDP in Q3 and over coming months.
Inflation is gradually easing as would be expected amid weak domestic demand. In August headline consumer price inflation (CPI) registered 4.8% year-on-year, up slightly from 4.7% in July but down significantly from the recent high of 7.1% in March. Core CPI, which excludes fuel and food prices, also eased to 4.7% compared with a recent peak of 5.3% in April, while producer price inflation fell sharply from a peak of 12.7% in January to 4.3% in August. With CPI closing-in on the mid-point of the SARB’s 3-6% target range the Reserve Bank paused its rate hiking cycle. The benchmark repo rate remained steady at 8.25%, where it has been since the 26th May following a rate hike of 50 basis points. However, SARB governor Lesetja Kganyago refused to rule out further rate hikes. While keenly aware that the economy is teetering on the brink of recession, he made it clear that inflation will continue to be the key driver of interest rate decisions. Inflation risks are heightened by the combination of loadshedding, chronic underperformance of key State-Owned Enterprises, looser fiscal discipline ahead of the 2024 general election, a rising budget deficit, and a weakening rand.
The sharp improvement in South Africa’s budget in recent years has started to reverse, as revenues have fallen short of expectations due to falling commodity prices and falling company tax receipts. At the same time government expenditure is rising faster than projected in February’s Budget projections. The public sector wage bill increase had been budgeted at 1.6% but ended up at a much higher 7.5%. The Social Relief of Distress Grant (SRD Grant), introduced as a temporary measure during Covid lockdowns, was extended in the February 2023 budget up to March 2024, but will very likely be extended for another year. After widening in the midst of the Covid pandemic to more than 10% of GDP, the budget deficit narrowed to around 4.5% of GDP at the last budget but was already back to 5% by June. Budget concerns have caused foreigners to continue selling their holdings of local bonds, reducing their holding from just over 40% to 25% over the past 5 years. The rand may also come under pressure from volatile trade data. Slower export activity has reduced the accumulated trade surplus for the year to end August to R32.95 billion compared with a trade surplus for 2022 of R193.65 billion. The current account deficit widened from 0.9% of GDP in Q1 to a deficit of 2.3% in Q2. As well as being net sellers of bonds, foreign investors were net sellers of South African shares in the year to end September to the tune of R117 billion. A volatile and depreciating rand would lead to imported inflation.
The BRICS summit, hosted in Johannesburg in August and chaired by President Ramaphosa was a historic occasion as it concluded with the expansion of membership to six more countries, leading to a name change to BRICS+. The event was successful and combined with a state visit by China’s President Xi Jinping. At the same time South Africa mended its relations with the US, reducing the risk of being ejected from the AGOA Act. President Ramaphosa emphasised South Africa’s commitment to non-alignment.
Loadshedding continued to be a way of life. However, since February’s Budget, which gave tax allowances for solar panels, there has been a surge in private investment in energy solutions. Figures from Eskom show that installed capacity from rooftop solar panels stands at 4.4GW, quadruple their level a year ago, and equal to a tenth of Eskom’s total available capacity. There has been progress with hiving off an independent National Transmission Company from Eskom with the recent approval by NERSA of two key licenses. Meanwhile, Transnet announced that global port management company, International Container Terminal Services Inc, headquartered in the Philippines, would enter a joint venture to upgrade Durban’s port terminals.
In August, seven political parties, including the DA, IFP and Action SA agreed on a coalition charter to collectively challenge the ANC in next year’s general election. The Multi-Party Charter is expected to gain between 30-35% of the vote, which may not be sufficient to unseat the ANC or prevent an ANC-led coalition at national level, but raises the opposition’s profile and could help increase voter turnout, which would be to the detriment of the ANC.
The JSE All Share index price-to-earnings multiple increased over the quarter to 10.2x from 9.5x at the end of Q2. The rating gain came despite falling markets over the period due to an aggregate earnings decline. Earnings will remain under pressure due to the poor economic outlook. Manufacturing and mining earnings will be constrained by weak domestic and export demand, infrastructure bottlenecks and load shedding. Household spending will be subdued due to high borrowing rates and stagnating personal income growth. Upside risks to inflation will prevent the SARB from providing interest rate relief. Meanwhile, foreign selling of local assets will likely continue until after the general election, by which time there will be greater certainty over government policy direction. According to the IEC the election needs to be held between May and August next year. Based on historic precedent, the most likely month is May.
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Reference: Capital Economics – Historical bond and equity return data.
The Bottom Line: Innovation and the Magic of Compounding
By Carel La Cock
The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.
Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.
After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.
Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.
As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.
Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.
Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.
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