During the last quarter, US equity indices reached new all-time highs as the US Federal Reserve (the Fed) commenced its rate-cutting cycle with a cut of 50 basis points (bps) in September 2024, lowering the upper target of the overnight rate from 5.50% to 5.00%. The market prices for an aggressive rate-cutting cycle to take the overnight rate to below 3.00% within a year.
Much of the deepening in US rate cut expectations has occurred since the US unemployment rate rose from 3.5% to 4.0%, which triggered the so-called Sahm Rule. The Sahm Rule identifies signals related to the start of a recession when the US unemployment rate rises by 0.5% or more over three months relative to its previous annual low. The market assumes on the basis of this recessionary indicator that the Fed will need to act with gusto to lower rates and support a weak economy. One reason why this argument may be flawed is that the Sahm Rule does not consider that US population growth has exceeded 1% per annum on average for each of the last three years – or its highest population growth rate in almost 20 years. The majority (or roughly 85%) of this increase has been due to immigration, while the rate of net new births (i.e. births less deaths) has declined to new lows. This would imply that over the last three years, roughly nine million new people arrived in the US, and yet against that statistic, there were only 7.1 million unemployed people (or a 4% unemployment rate) and 7.6 million vacant job listings as of July 2024. In short, this does not seem to imply calamity for the US economy.
Locally, the South African Reserve Bank (SARB) kicked off its rate-cutting cycle with a far more muted 25 bps cut in September – lowering the overnight rate of interest from 8.25% to 8.00% in a unanimous vote. The SARB outlined the case for caution when lowering rates and cited risks to inflation via potential offshore trade tariffs, which raise the price of imported goods. In this regard, the outcome of the US election in November has the potential to rock the trade tariff boat, with presidential candidate Donald Trump proposing a blanket increase in import tariffs to 10%, and a more punitive 60% applied to Chinese goods, if he were to be elected. Much of the disinflationary trend of the decade preceding the COVID-19 pandemic was undoubtedly aided by the flood of cheap Chinese goods into international markets, with many countries now complaining that Chinese overproduction and dumping practices make it tough for local industry to compete in a wide range of sectors including car and steel production. As a general observation, the US invents, China builds, and the EU regulates. For example, China’s bloated industrial base, fuelled by ultra-cheap government financing and subsidies, produces more solar panels than the world can absorb, even if such production takes place at loss-making sale prices that require companies to later be bailed out by the Chinese state.
Returning to local markets, the FTSE/JSE All Bond Index has returned a staggering 23.6% year-on-year to date, while the FTSE/JSE All Share Index has lagged at 17.8%. As much as the positive post-election market sentiment following the formation of the Government of National Unity (GNU) has led to this bond rally, the expectation of a pronounced US rate-cutting cycle has also played a role. Most importantly, however, the monetisation of South Africa’s Gold and Foreign Exchange Contingency Reserve Account (GFECRA) has to some degree bailed out the fiscus. Without this, or the printing of rands against the profits implied in SA’s foreign exchange reserve balances, the SA government would almost certainly have had to increase the size of its bond auctions this year. By August 2024, the SARB had created and transferred R100bn of GFECRA cash to the SA government, which subsequently ended the month with only R142bn cash. This means that without GFECRA, the SA government would be running a R7tn economy with only R42bn of spare cash – or the lowest nominal cash balance on record in over 50 years. To contextualise this, R42bn equates to six days’ worth of the SA government’s annual FY24 spending of R2.37tn. Put differently, R42bn equates to 40 days’ worth of the SA government’s debt service costs (which are estimated at R382bn for FY24).
Without GFECRA, we would have been staring into the abyss, and the supply of government debt would have needed to have materially increased. The question then remains, with only R25bn of GFECRA left to be monetised in each of 2025 and 2026, will the government be able to live within its means and implement the fiscal reform required to contain the budget deficit? It would appear that year-to-date corporate income tax collection has disappointed versus the February 2024 Budget estimates, although some of this under-collection might be offset partially by the tax levied against two-pot retirement fund realisations. We await the medium-term budget policy statement (MTBPS) for further details on this.
At the time of writing, the SA 20-year bond has rallied by a cumulative 260 bps from its year-to-date yield high of 13.3% in April, down to an intraday yield low print of 10.7% on 19 September. By perusing the JSE’s trade statistics, it appears that local investor participation in SA’s government bond auctions in the last quarter has been very low. Most of the fresh cash in the bond market appears to have come from foreigners, but they have not participated in any meaningful size in SA equities as yet. The recent yield of 10.7% on the SA 20-year bond is just 50 bps wider than the 10.2% yield recorded at end-February 2020.
One could thus argue that the bond market is now overvalued when one considers that the SA government’s debt pre-COVID was 56% of GDP versus 75% at present. In the same vein, we were spending as little as 15 cents on every tax rand towards servicing debt pre-COVID versus 21 cents now – and in fact, even higher if one includes the Eskom debt relief programme in these debt service costs. When comparing the SA 10-year bond to the US 10-year bond, the spread differential is 640 bps, which is the tightest spread on record since 2018 when the SA government’s debt burden was significantly lower than present (and lower than any year in the Budget forecast for 2025–2028).
That said, even if one buys into this argument, it is perhaps important to consider that the local bond market can trade away from fundamentals for extended periods of time and that optimism around the GNU and higher SA GDP growth may spur foreigners to sink more capital into the market regardless. Fixed capital investment in SA, which is a necessary precondition for higher growth, has been contracting for four consecutive quarters. While there are investment projects in the pipeline that should see this rise, their size and pace remain unclear and rest on the speed at which certain reforms can be put through – including those for private concessions along Transnet’s rail and the requisite tariffs and funding for renewable energy projects so that transmission lines can be built.