Bond markets: A licence to yield

Jeremy: Fixed income is often regarded as a key component of the investment portfolio. After years of inflation shocks, aggressive rate moves, and repeated geopolitical disruption, bond markets are entering a different phase. The question now is what comes next: can global growth hold up while inflation continues to ease?

Can central banks start cutting rates without reigniting price pressures? And if yields stay relatively high, are bonds becoming more compelling as a source of income, not just protection? For South African investors, the picture has another layer: the rand, fiscal consolidation, inflation, and the durability of the local bond rally.

Hi, I'm Jeremy Maggs, and this is No Ordinary Wednesday, Investec's fortnightly podcast on the forces shaping economies and the financial markets. Today, we're going to discuss the outlook for global and South African fixed income and where the opportunity may be over the next few months.

Joining me are Annelise Peers, Investec Bank Switzerland Chief Investment Officer, and Awongiwe Booi, Investec Wealth and Investment fixed income analyst in South Africa.

Annelise, Awongiwe, a very warm welcome to No Ordinary Wednesday.

Jeremy: So Annelise, let me start with the global picture. Can fiscal support and AI-led investment translate into productivity before the costs show up in inflation, debt and risk premia? Why does that matter for the bond investor right now?

Annelise: Yes, it is a good question, particularly because we've seen that growth has been below trend in the US. So when I talk about trend, it is the trend pre-COVID for a while now, and inflation has been far higher than trend, and that's cost-push inflation. So what we're hoping is that all the CapEx that the big companies have put in comes through in productivity growth, and productivity growth then boosts growth.

And once that boosts growth, we can actually address America's very high debt-to-GDP ratio. Productivity helps growth, and then hopefully inflation could come down if you have stronger growth, and we can grow out of what is the problem right now. We've had quite a lot of high inflation, so it's still a bit of a stagflationary environment that we've seen up to now in the States and the rest of the world.

So we need to see inflation coming down and growth picking up for us to go back into a good space.

Jeremy: So Awongiwe, if that's the global view, I want to bring it home now. South African fixed income had strong support from the rand, from fiscal consolidation and easier monetary policy. All well and good, but how much of that case do you think still holds, and where, perhaps more importantly, do you think the risks are right now?

[00:02:50] Awongiwe: I would say the core investment case for South Africa still largely holds, but I would say the drivers have essentially evolved. So if we think about what has transpired in the last 18 months, South Africa has benefited from falling inflation. If we look at February before the oil shock, inflation was about 3% year on year.

If you look at fiscal consolidation, we're likely to peak at the end of this financial year., we've seen a pretty substantial primary surplus and a resilient rand. So while the easy gains, I would say, from the rally are largely behind us, I think South Africa enters a period of a stronger starting point.

And like I said before, the primary surplus, the improving debt dynamics, the stronger commodity support,, these are the key things that we're looking out for. What I think is being mispriced in the market right now is reform, which is largely our view in terms of where we think growth can be supported by.

So I think if we look at what I've previously said, resilient rand, or rather I would say inflation prints, that could probably go down at this point if the oil shock largely subsides. I think there's a lot of benefit from Operation Vulindlela, and largely I think those three points could hold that SA is still going in the right direction, I would say.

Jeremy: So Annelise, on a broader canvas then, could the next inflation risk come from stronger consumer demand rather than supply pressure? And what might that mean then for bond markets?

Annelise: The bond market at the moment is pricing in a risk that inflation will come through from consumer demand. We've seen some good unemployment numbers, so unemployment in the US is still quite low at 4.2%.

So it means that the jobs are still fairly plentiful in America. However, consumer confidence has been very low because of the high inflation. So the inflation that we've seen has been coming through PPI, driven by supply shocks. We have to bear in mind that we had a COVID shock, we've had the Ukraine war shock, we've had the Iranian war shock.

So those have all come through on producer prices, and that has pushed up inflation. It hasn't come from higher consumer demand. Even though the job market is looking good, unemployment is low, we see that consumer confidence is lower than it actually was during the COVID period, and it is because inflation has been hurting the consumer.

Now, where the risk lies for the bond market is if consumers suddenly start asking for salary increases and those increases are granted, then you can see consumer price inflation increase from the demand side and not from production side, and that would be a risk for the bond market. So the market is pricing it in at the moment.

They're keeping a very close eye on it. We have CPI numbers coming out this week that will be very important. The fact that we had softer payrolls data last week has put the Fed a little bit at ease to say that they don't have to hike interest rates because inflation is still coming down from those very high levels because of the PPI inflation.

But as I say, if it now comes from the consumer side, it could tilt the risk against the bond markets.

Jeremy: And Awongiwe, back to you, and that distinction, I would contend, matters in South Africa as well. So how then do fixed income investors distinguish temporary imported inflation from more persistent pressure that could force the SARB to tighten?

Awongiwe: So not all inflation is equal, right? So if we think about imported inflation, which comes from oil or currency weakness, that can create a temporary shock, which I would say the SARB can look through. However, if you have persistent inflation that becomes problematic, which affects inflation expectations, wage growth, and service inflation, that's when the SARB cannot look through.

So the SARB would monitor inflation expectations, service inflation, and wage settlements, and we've seen obviously from the hike that happened in May that the SARB took the role of maintaining credibility. And we've seen from last year when they decided to change the inflation target to 3%, credibility is very much something that, one, the market supports, but two, that the SARB really wants to hold controlling inflation, controlling the currency.

So when inflation becomes something it can't look through, that's when the SARB will make a decision. So at this point in time, we saw, I think, two weeks ago that the SARB decided not to hike. However, if we do see persistent inflation expectations starting to rise, we will likely see another hike going into September.

Jeremy: So, Annelise, let's look now at what bond prices themselves are telling us. With US rates still high and the 10-year Treasury near 4.7%, are investors being paid to wait or are bonds signalling deeper inflation and fiscal risk? And what would make you lock in longer-dated yields?

Annelise: Yes, as we've said before, the 10-year Treasury actually affects most global bond yields, so Europe looks similar to that.

What we've seen in that 4.7% up to now was the Trump risk premium, so Trump spending that we've seen in the last two terms under Donald Trump, that has increased the budget deficit quite a lot. The oil risk premium and the Warsh premium. So Kevin Warsh is the new Fed chair. There was a premium in there because people were really worried that Warsh will be a Trump lackey and that he would cut interest rates even in the face of persistent current inflation rates.

If I look at the risk premium right now that's in there, for me, the Trump risk is starting to fall out because we have the midterm elections that will contain Trump's ability to spend. The oil markets are starting to slow down. They are not as worried about supply constraints, even though we will probably face some supply constraints in the future.

And the Warsh premium, I think, is pretty much out of the market. So if I look at all the risk premia in the bond market that is being priced in, the surprises could come on the other side. If inflation surprises on the downside, the premium that you are being paid for getting 4.7% for 10 years guaranteed is not a bad option compared with trying to find the right equity right now at the high valuations that we see in the equity market.

So I do think a good part of your portfolio should start looking at locking in some of this 4.7%. And if yields were to spike temporarily, I would buy even more.

Jeremy: So Awongiwe, back to you then. You've singled out the rand as one of the most important variables for South African bonds. So what then do you think has underpinned that resilience, and what would be the early warning signs that the currency is beginning to work against rather than in favour of local fixed income?

Awongiwe: I think the rand's resilience has largely been underpinned by three factors. The first is the commodity exports, PGMs and gold in the last year and a half have rallied quite significantly, and we've seen that the South African balance sheet has benefited from that. We've also seen attractive real yields.

So if we look at even our EM counterparts in a risk-on environment, we've seen a lot of offshore investors coming back into the market, capturing some carry on that side, and then of course improving fiscal credibility. I think investors will watch out for, I think going into Q3, persistently high oil prices.

I think there's still a lot of uncertainty that's been sort of priced into the market regarding the oil shock. I think also another thing we need to look at is the US. Annelise has talked about it quite significantly but the rising US real yields, deteriorating current account, which obviously would impact the SA side.

So I think what we have to look to in H2 is basically what's happening with the US. Will US sentiment deteriorate? Will growth numbers likely deteriorate? That would probably impact, South African bond yields.

Jeremy: We're going to continue this conversation in just a moment with a closer look at what all of this means for portfolio allocation, government debt, and where the opportunity may lie in global and South African bonds.

But first, a quick reminder to follow Investec Focus Radio SA wherever you get your podcasts or subscribe on YouTube. A new episode of No Ordinary Wednesday drops every fortnight, bringing you analysis from Investec experts on the economic and market developments affecting investors and businesses. Now let's get back to our conversation.

All right, Annelise, back to you now. With equity valuations elevated, is fixed income now a return asset rather than just a hedge? And where do you see the best income for the risk?

Annelise: Absolutely Jeremy. As previously said, the yields at 4.7% for the next 10 years is a nice return, and in America that is, they even have some tax breaks on it, so that makes sense.

However, you will take some dollar risk. In Germany you can earn 3.2%. Even Switzerland is paying you a positive interest rate on the 10-year bonds of 0.38%.

And remember that the last 10 years you have not been able to buy a Swiss bond with a positive return. And in pounds, you can buy 4.98%. Now, the US dollar, I think we probably have a view on that, that it, in the next few years we will probably see dollar weakness just because of the fiscal position and the fact that America has to have an equity market that stays robust in order to attract dollars.

But the euro, the Swiss franc, and the pound seem fairly valued, and I think if you just take the currency combined with the yield that you earn in these countries, you can get good diversification by having a nice suite of bonds in your portfolio, and that can actually give you guaranteed income for the next 10 years at these levels.

Jeremy: So Awongiwe then, where do you think the strongest opportunity in South African fixed income is today? Is it cash, longer-dated government bonds or credit? And what is the key risk in taking more duration, do you think?

Awongiwe: How I would think about opportunities within the fixed income market is what has been priced in and what has not been priced in.

And if we look at the yield curve, at this point in time, it's still pricing in a 1% to, let's say, 1.5% growth year on year. And we're seeing a lot of dislocation between what the market is pricing and what we're seeing on the ground. So what I mentioned earlier on was we're seeing a lot of impact that's happening within the reform agenda.

So think logistics, think energy., the fact that we have an EIF been consistent for the last year at about 60%, which means there's no longer a constraint on growth. If we look at logistics and what's been happening on the ground with Operation Vulindlela, we've seen the beginning phase of private-sector participation.

And if you recall, we see that there is a direct correlation between the gross fixed capital formation and forward-looking P/Es. And we see the fact that because the market's not pricing in the potential of growth reaching 2% year on year for the first time since 2008, and the fact that the banks, for example, have not re-rated as a result, we see that if you do take on longer duration, so think the belly of the curve, the long end of the curve, you can capture cheap valuations.

You can also capture the fact that the market hasn't priced in the reform agenda that's happening. And we see that that is probably the opportunity going forward is that we can see yields in the next year, or let's say two years, going from about 8.5% to about 7%. Also, the fact that you've got the inflation target that's gone back to 3%.

in the next two to three years, potentially we could see the back end of the yield curve also flattening. What I would say at this point in time, again, is the oil shock, which is something that potentially the market can't look through because South Africa is an oil importer. And so we have to monitor inflation expectations, because if those do rise, then obviously we have an exposure to inflation or, rather, potentially a steepening of the yield curve.

So I would say the risk of taking on more duration is the fact that inflation expectations start to increase because of the uncertainty of inflation. However, we see the opportunity with the fact that the market is mispricing what we're seeing from a growth potential rather than what's currently what the market is kind of factoring in.

Jeremy: So Annelise, let me throw it back to you. Could long-term bond yields stay high even as central banks cut rates, and does that weaken the case then for long-duration bonds?

Annelise: Absolutely. If there's any whiff of the US Federal Reserve cutting interest rates because of pressure from the president, the long bonds will blow out.

Now, that in itself will be a big problem for America, and I think the risk of that is quite limited because at the moment they already have a $2 trillion deficit, and just the interest on that deficit is a trillion dollars per year, and that is at current interest rates.

So if the interest rates were to go higher, you suddenly will have the interest bill that is already double the size of what America's spending on defence would be a constraint.

However, if the markets feel that Warsh is cutting interest rates before inflation expectations and inflation comes down, we will see a reaction in the bond market, and that will weaken the case, as you say, for long-duration bonds.

On the flip side, though, is if we see, Warsh standing pat in the face of inflation or even hiking interest rates in September, the market can then relax to say that there is a Federal Reserve that is worried about inflation and the market doesn't have to do the job for the central bank.

We could then see the bonds actually doing quite well.

Jeremy: So Awongiwe, I guess that brings us directly to South Africa's fiscal position. What would convince bond investors that the country's fiscal consolidation is durable, and how would stronger credibility then affect yields and also bond returns?

Awongiwe: I would say the market at this point in time is looking for credibility rather than promises.

Which is why, again from the previous question you'd asked me why we're currently seeing the market still asking for a show-me story, so the market is still pricing in a 1% growth versus where we think the potential could be 2 to 3%. So I think if we see a continued primary surplus declining debt-to-GDP ratio, I think the number that's been thrown in the market is that the debt to GDP will peak at around 78%.

I think also if we see discipline from National Treasury, we see government spending being decreased, I think that would allow for more confidence in the market. I think at the same time, if we look at where the South African risk premium is, before the GNU coalition, we had seen that the risk premium was sitting around 200 to 300 basis points.

At this point in time, it's about 130 basis points. So the market is already pricing the fact that it trusts the SARB and National Treasury to take fiscal consolidation seriously. But again, I think what we're kind of looking for is the fact that fiscal discipline is maintained. We're looking for the fact going forward,, what wage negotiations will look like over the next two to three years.

Obviously, those will be anchored towards the 3% inflation target, which the market obviously likes. And again, I think we should benefit still from commodity terms of trade where we could potentially see a lower primary deficit.

Jeremy: All right. I want to start wrapping up the conversation. And Annelise, to you first of all, what three indicators will tell us whether we're moving towards a Goldilocks scenario of resilient growth, easing inflation, and lower rates?

Annelise: So the first indicator I'm watching is CPI. I think that's more important at the moment than PPI. So the next two months, month-on-month number, if that comes in at about 0.2%, that would be very good because that shows that inflation from the consumer side is contained while we're having strong growth.

So very excited if we see those numbers. And then inflation expectations. The University of Michigan has two indicators: They've got a one-year and five-year inflation expectations series, and they've been trending down. So the one-year inflation expectations are currently at 4.2. That has come down from nearly 6.7% last year this time.

And the five-year inflation expectations has been quite well contained even through all this uptick that we've had in the last year, and that's running at 3.3. So if we see inflation expectations coming down, I think those would be really important indicators to show that growth can pick up. It's doing well because of the CapEx, because jobs are plentiful, consumers are feeling better, but inflation is contained.

Jeremy: And Awongiwe, let me finish then with the South African investor. What three indicators should they be watching through to the end of the year?

Awongiwe: How I would answer that would be how we look at the yield curve and what sort of proxies we use to measure fair value of the SA bond market. So I guess those three factors would be the risk-free rate, which we proxy through the US.

So what is happening regarding US sentiment, what is happening regarding the fact that Warsh has come in will he continue to be hawkish? Does that mean that there could potentially be hikes in the US? I think the second factor would also be inflation expectations. Obviously, we still have this uncertainty or this dark cloud of the oil shock still hovering around us, where we still don't know when it will end.

So inflation expectations, if we continue to see those rise, we could potentially see hikes, which would obviously affect the bond market. And, of course, I think the last thing would be the SA fiscal condition.

So again, South Africa was on the right trajectory. We're on the the right side of the bond market, where we had seen the rand being resilient, inflation had gone down, fiscal consolidation was improving, commodity terms of trade were good.

I think what's important is, will the fiscal consolidation peak within the 2026 financial year? We largely think that is going to be the case. And if we do see the benefits of PGMs and gold continuing to rally potentially as safe havens, then we could see a primary surplus continue to improve.

And then, of course, we would see the budget deficit narrow going forward. So I think those would be the three factors that we would look at.

Jeremy: And that's where we are going to leave it.

Annelise Peers in Switzerland, Awongiwe Booi in South Africa. To both of you, thank you so much for joining me on this episode of No Ordinary Wednesday.

And thank you for listening. To ensure that you don't miss an episode, follow Investec Focus Radio SA wherever you get your podcasts, or subscribe to the Investec channel on YouTube. If you value these conversations, please take a moment to rate the podcast. It helps more listeners find the programme.

We'll be back in a fortnight with more analysis on the economic and market trends shaping investment decisions.

Until next time, goodbye from me, Jeremy Maggs, and the entire Focus Radio team.

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