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It was a Friday afternoon when the news that South Africa had been put on the Financial Action Task Force’s (FATFs) grey list didn’t necessarily surprise financial markets. Yet, it was a disappointing moment for us. Initially, market participants dismissed the announcement: the rand, our bond market, and equities did not react at all. Then by Monday, the news had already been priced into the market.

At Prescient, we cautiously monitor economic themes, inflation dynamics, labour market trends and market behaviour based on our deep and point-in-time analysis of massive data sets. These direct us to what we believe to be the most scientifically correct conclusions. We’re hesitant to simply accept the “it’s all in the price already” argument without seeing the evidence that is the case. So, we’d rather dig deeper. If we find it hasn’t been incorporated into the price of assets, we question whether we should have expected a bigger move. The answer to this question in this situation might surprise you since we think it’s a: “No, it wouldn’t have mattered that much either way.”

It has been our longstanding claim that South African markets are driven mainly by external factors. We are by no means dismissive of the fact that a greylisting, ongoing stage 6 load shedding and an eroding belief in our political governance are all structurally damaging to the South African economy and materially impact asset class returns. In fact, we think this is already happening, which is highly problematic, and we urgently need to see profound change before we can turn the story around. Yet, we do think that most of the short-term moves in South African bond yields, the rand and even our equities are usually driven by entirely different sources, and these are primarily external and not linked to South Africa at all. 

To get a more scientific explanation of which factors have driven our local bond yields, we did a mathematical exercise that interpolated South African five-year constant maturity bond yields and regressed these against 11 variables. We aim to analyse the impact of certain global and local factors on the yield compensation investors require to hold SA local currency sovereign bonds. We conduct a monthly analysis based on data from end-December 2007 until today. The chart below shows the weighted explanatory power of the variables in our analysis through time.

Figure 1: Historical Explanatory Power 

Source: Prescient Investment Management, Bloomberg as at 03 March 2023

 

It is evident that the explanatory power of exchange rate factors increased in the post-taper-tantrum period and then jumped even further during the post-covid episode. Global determinants like the rand forward (a good proxy for the carry trade), the South African credit default swap spread, the rand option volatility, the US term premium, and emerging market bond spreads explained most of the change in bond yields. Factors like local GDP and even local CPI play a small role. The Budget forecast matters to a certain degree.

Hence, we also incorporate these factors into our view on our local bond market – and intentionally ignore the negative South African headlines. These insights are a testament to our data-driven, evidence-based investment approach.

So, if global factors drive bond yields, are these global factors affecting other emerging economies to the same extent? We try to answer this question while searching for more statistical evidence to support our hypothesis. The chart below compares the monthly returns of the US dollar-rand exchange rate to a broad-based basket of emerging market currencies. The co-movement is astounding; in fact, 65% of the variance in the rand’s return is perfectly explained by simply looking at a broad basket of emerging market currencies.

 Figure 2: Foreign Exchange Returns

 


Source: Prescient Investment Management, Bloomberg as at 03 March 2023

The above analysis leaves very little room for the residual to be SA-specific, or, in other words, the portion of the movement not explained by emerging market factors is more likely to be just statistical noise than a result of factors like load shedding, the greylisting, or domestic politics. This confirms how important it is for us, as investors, to cut through the noise, ignore the headlines, and focus on the facts.

So, what has happened to our markets and other emerging markets over the last few weeks? And why were they so weak, seemingly selling off similarly to some of 2022’s painful sell-offs? The answer once again lies in looking abroad: global monetary policy has become more hawkish again on the back of a stickier inflation print than anticipated by market participants. Thus, once again, the repricing of the Fed Fund Futures led to emerging markets’ underperformance.

The chart below visually represents this, with the red line showing the current Fed Funds rate and the yellow dots showing the Fed’s own interest rate prediction. The turquoise line shows where markets expected the Fed to move a month ago, while the blue line showcases how markets have repriced. We can see that market participants had to reprice upwards to a higher terminal interest rate, a higher peak in rates, and a shallower path for rates to come down again. This higher for longer interest rate outlook, which is a global driver, was thus the primary contributor to the aggressive sell-off in emerging markets across the globe.

Figure 3: US Market Pricing: Effective Federal Funds Rate vs Fed Fund Futures

Source: Prescient Investment Management, Bloomberg as at 03 March 2023

 

At Prescient, we are data-based and evidence-driven. However, we are also human beings, and being an optimist is often not a bad thing. We acknowledge the need for South Africa to do its homework, fix load shedding, get off the grey list, and halt any decline in institutional governance. We believe this is still possible and advocate ignoring the negative headlines more often.

Asset class returns are driven by more than headlines or gut feel hunches. Behavioural biases are important to consider when calculating expected returns, but hard data and facts should take centre stage. Markets are efficient, and our point-in-time, data-driven approach helps us identify and process information in the timeliest fashion. That gives us an information advantage, enabling us to adapt quickly and remain well-positioned for whatever challenges the future holds. DM/BM

Author: Bastian Teichgreeber, Chief Investment Officer at Prescient Investment Management 

Disclaimer: 

  • Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612).
  • The value of investments may go up as well as down, and past performance is not necessarily a guide to future performance.
  • There are risks involved in buying or selling a financial product.
  • This document is for information purposes only and does not constitute or form part of any offer to issue or sell or any solicitation of any offer to subscribe for or purchase any particular investments. Opinions expressed in this document may be changed without notice at any time after publication. We therefore disclaim any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable directly or indirectly to the use of or reliance upon the information.
  • The forecasts are based on reasonable assumptions, are not guaranteed to occur and are provided for illustrative purposes only.

 

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