By: Michele van der Berg, Portfolio Manager & Analyst, Prescient
Do you believe the SA Reserve Bank’s repo rate is appropriate at its current level? Why?
The SA Reserve Bank (SARB) cut the repurchase rate by a further 25 bps in July, which takes monetary policy easing to 300 bps year to date. The Bank front-loaded its monetary policy response to the COVID-19 crisis by cutting rates aggressively sooner than other emerging market central banks when the pandemic struck. In so doing, the Reserve Bank was proactive in providing monetary policy stimulus and relief to indebted households in turn.
What are your expectations for the repo rate going forward? Why? Rates should remain on hold over the near to medium term as reflected in the Reserve Bank’s quarterly projection model, which indicated a 3.48% repo rate by the fourth quarter of 2020, in line with the current repo rate.
The Reserve Bank forecast inflation at 4.3% for both 2021 and 2022 – close to the midpoint of the inflation target range – but there are upside risks that can be attributed to administered prices. The petrol price component, in particular, could be inflationary as a result of a recovery in the oil prices.
With huge uncertainty on how quickly, or when, there will be an economic turnaround after the COVID-19 crisis, inflation could well surprise on the downside over the next few months due to weak demand and higher expected unemployment. As such, the Reserve Bank could have additional room to reduce the repo rate should inflation expectations fall further.
QPM Repo Rate Forecast (end of period)
Why are real interest rates at their current levels? Are they too high? Cash has offered high real rates over the past three years as a result of the central bank’s generally hawkish stance during the period. Even with inflation within the target range of 3% to 6%, the repo rate did not move much over the period.
After the recent reduction in rates, real interest rates have moved lower, but are still not at the lowest points reached over the past 20 years. On more than one occasion, South Africa experienced negative real interest rates, including during the great financial crisis in 2008 and 2014.
What impact are they likely to have on fixed interest assets over the next year? Based on the SARB’s 2021 inflation forecast, the real repo rate could move negative, but money market could still deliver 1% real returns off current 12-month rates. Pricing further out on the bond curve, five-year breakeven inflation, the rate the market expects inflation to average over the term, is close to the bottom of the target range of 3%, indicating that the market is pricing in lower inflation for longer.
South African bonds offer attractive real yields, with a very steep yield curve. With cash rates low, investors will need to look further out the curve to achieve a positive real return.
QPM Headline CPI Forecast
How is South Africa positioned relative to other emerging markets and do you think we will see inflows or outflows over the next year? South Africa has seen significant foreign selling of local bonds since March and were net sellers from January to end- June, with ownership dropping from nearly 37% close to 30% of the domestic bonds in issue.
Sales of emerging markets bonds were attributed to the risk-off sentiment that took hold at the start of the COVID-19 crisis. South Africa experienced added selling pressure due to Moody’s downgrading our sovereign credit rating.
Many developed markets’ central banks have announced response measures to current market conditions. Resulting in compressed developed market bond yields. Should foreigners start to search for higher yields, we will start seeing an uptick in bond purchases in emerging markets.
How do all of these factors influence the way you manage your portfolio? With interest rates expected to remain relatively flat for the remainder of 2020, Money Market funds are still likely to deliver inflation-beating returns close to 1% for the rest of the year. Credit spreads have widened in part due to liquidity constraints experienced in the debt market since March. With weak economic growth expected, this has raised concerns about corporates’ ability to refinance their debt. Prescient’s enhanced cash portfolio comprises of high-quality assets, and its short average term-to-maturity is positioned to take advantage of any credit spread widening in the current cycle.