The mid-term budget delivered by Malusi Gigaba was laced with evidence that the fiscal consolidation path trodden by his respected predecessors has been abandoned. Most concerning is his insinuation that borrowing more is the solution when it’s so obvious that doing so is incredibly dangerous for the future of our country. The deviation from the planned debt-to-GDP ratio is visible in Chart 1 below.
Chart 1 – Don’t worry, we’ll just borrow more
This proposed trajectory means more and more of the revenue collected by the government will be usurped by interest payments instead of funding the vital projects we need to prioritise in order to kick-start our economic growth, reduce unemployment, and provide a stable environment for South Africans to live in. The more indebted we become, the less chance we have of ever growing out of it; it’s the epitome of a vicious circle.
Our currency (red line) and bonds (blue line) tanked post Gigaba’s speech – evidenced in Chart 2 – and the market chatter was quick and self-assured in laying the blame at the feet of our well-heeled finance minister.
Chart 2 – Our rand and bonds, there she blows!
Source: INet, Obsidian Capital, October 2017
Time to cut and run?
As South African investors, do we then quarantine those investments sensitive to our currency (think our banks, retailers, property, and bonds) as un-investable given the rand’s seemingly inextricable link to our political mishaps?
We believe that the recent weakness in our currency (and the assets it impacts), while cheered on by our politicians, is a result of far heftier global forces. To demonstrate, consider the improbable possibility that Malusi Gigaba is moonlighting as Switzerland’s Finance Minister, responsible too, for the recent, sharp depreciation of the Swiss franc against the US dollar (blue line in Chart 3).
Chart 3 – Did Gigaba also speak in Switzerland?
Source: INet, Obsidian Capital, October 2017
We chose the Swiss currency for a reason. If there’s a store of value that should show immunity to US dollar strength, it’s the Swiss franc. But even this bastion of certainty has fallen victim to a rampant greenback. To contextualise this idea further, peruse Table 1.
Table 1 – The carry trade hurting most currencies, not just the rand
Source: Obsidian Capital, October 2017
What we’re trying to illustrate in Table 1 is that recent, meaningful kicks in US bond yields have seen the greenback strengthen across the board, country specific idiosyncrasies counting for little. The cause of the blanket depreciation against the greenback? With European and Japanese bond yields offering diddly, a rising US 10-year bond yield is attracting global investors. This phenomenon is known as the ‘carry trade’, the core topic of this piece, and the culprit responsible for the depreciation of our rand and bonds, in our opinion.
We’re not saying that politics doesn’t matter. The utterings in the recent budget speech are (another) giant leap toward a Venezuelan-type economy, and looking at the performance of the rand across the three blocks in Table 1, you could argue that the rand has become increasingly vulnerable to rising US bond yields thanks to our propensity to score own goals.
Chart 4 talks to this idea, this time in respect to our bonds, essentially showing that since global bonds rolled over in September 2017, the capital loss on our bonds (blue line) has been in the region of 0.7% more than the global bond index (red line) as a result of wayward politics.
Chart 4 – SA bonds suffering greater capital loss than global peers
Source: INet, Obsidian Capital, October 2017
However, the point is that, like the Gordan spike (also highlighted in Chart 4), these violent, short-term moves tend to fade into the bigger trends with the passage of time. Given that these political events are almost impossible to predict and have a questionable impact on asset prices, should they really play a pivotal role in your investment decision making?
Returning to our currency, and along a similar line of thought, was the 4.8% depreciation against the US dollar post the budget drama (refer to Table 1 again, far right column) out of step with how other currencies fared? We don’t believe so. Consider that the New Zealand dollar, Mexican peso, and Turkish lira were even weaker than the rand in the month of our budget speech.
But will the carry trade persist?
The carry trade doesn’t always work. But the US 10-year bond yield does seem mighty influential at the moment. Every noticeable spike is accompanied by US dollar strength against most competing currencies. A similar theme plays out in foreign bond markets, their yields tracking those of the US higher.
The magnetism of US yields could potentially be explained by the lack of yield in other developed markets. Keeping interest rates low makes sense when growth is elusive, and perhaps we can pardon Japan given their perennial dance with deflation. But why are rates still so low in Europe, and in particular, Germany? And what if those interest rates and yields began to rise?
As the next graphic (Chart 5) illustrates, Germany’s business confidence measure (red line), an indicator of economic activity, has reached all-time highs. They should already be raising interest rates (blue line) given the strength of their economy, but they haven’t even halted their bond buying program.
Chart 5 – Surely it’s time for German interest rates to rise?
Source: INet, Obsidian Capital, October 2017
Certainty is rare in the game of investing, but there are so many indicators espousing a healthy German economy that we feel its authenticity is beyond reproach. But as long as yields in Germany are supressed by the continuation of QE, US yields climbing in isolation may continue to impact global exchange rates and bond yields through the carry trade mechanism.
The dislocation between yields in the US and Europe is so profound that its sustainability – and by extension the sustainability of the carry trade – demands reflection. Chart 6 shows that the US and German 2-year bond yields have been well correlated over time, until 2013.
Chart 6 – How will US and German yields come together?
Source: INet, Obsidian Capital, October 2017
To take a stance on what happens next it’s extremely important to grasp what we feel to be the true mechanics of the carry trade. Some conclude that currency X will appreciate against currency Y because its bond yield is 5% versus a yield of 3% in Y. This is not how it works, in our opinion.
Instead, it’s the directional move in the yield differential that causes currency movements, rather than the absolute differential. Put simply, this means that if the German yields in the above chart rise faster than the US yields from today (i.e. the spread narrows), the euro should strengthen against the greenback, even though their yields are much lower on an absolute basis. Similarly, should the jaws you can see open further, the greenback will continue to strengthen.
To illustrate this important idea, let’s revisit the case of the Korean won in Table 1 (Table won, eish). After depreciating in line with the ZAR during the 100 bps kick in the US bond yield (during the Trump Tantrum in late 2016), it ignored the next two spikes, holding its ground against the greenback. So naturally we pulled up the Korean bond yield to see what was cracking. Putting the dangers of data mining aside for a second, it’s interesting to note that the Korean bond yields have risen faster than US yields since the beginning of 2017 – coincidence that their currency fought back?
The million dollar questions is as follows: What is the risk that the dislocation between US and German yields widens further, perpetuating the carry trade? Chart 7 shows the US and German 10-year bond yields on a real basis going back two decades. With both strong growth out of Germany, AND the US real yield touching its high trend line, we feel it’s more likely the yield differential narrows in favour of the Europeans.
Chart 7 – Where does the risk lie for the yield spread between the US and Germany?
Source: INet, Obsidian Capital, October 2017
Conclusion
When the market reacts violently to political news it’s tempting to extrapolate that reaction into the future, damning the affected asset classes as un-investable. This is particularly true when the intention behind the poor decision making from government is so blatantly in favour of corruption, and so vigorously pursued.
Deciding if/when South Africa transitions from an emerging market to a failed state, ala Venezuela and Zimbabwe, is a critical debate to have. There’s no doubt that Zuma’s tenure at the helm has moved us some way down this perilous road. But fortunately for us, global investors are still treating South Africa as an emerging market, albeit a low quality one. And while this remains the case, our domestically exposed asset classes will continue to be influenced by much bigger global forces, ones that we feel you can act on.
Obsidian fourth quarter commentary – 2019