Kyle Hulett, CFA, FFA (UK)Deputy CIO and Head of Multi Asset ClassB Bus Sc (Actuarial Science) UCTFellow of the Faculty of Actuaries (FFA), UK

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The reflation trade is strongMacro-economic momentum continues to exceed expectations, leading to another upgrade to global growth. Although it has taken some time for the reflation trade to take a firm hold of markets, it is in full swing now. Earnings are driving the latest bounce as well as the rise in the price-earnings ratios of reflation stocks. Global growth indicators such as PMIs are at multi-year highs and bond yields are rising. The start of a rise in bond yields is good for equities, as it reflects resilient growth. Furthermore, economic data remains supportive of a reflation environment, with both global unemployment and global real policy rates at near 30-year lows (as shown in Chart 1).

The unwinding of quantitative easing (QE) is not a riskDespite the Fed continuing to raise rates and having started to unwind its unconventional monetary policy, equity markets have risen over the past quarter. The European Central Bank (ECB) also announced its plans to ‘taper’ its asset purchases in 2018, and the Bank of England is likely to lift its base rate for the first time in a decade. Overall, net asset purchases by major central banks will come to an end by late 2018 (as shown in Chart 2). However, this is well-telegraphed in the markets, which seem to be weathering the news of lower liquidity thanks to stronger-than-expected growth. As a result, the ECB’s decision to reduce its bond purchases to €30 billion per month did not rattle markets, neither did the replacement of Fed Chair Janet Yellen with a more hawkish Fed member. In fact, the market is pricing in another rate hike in December. If the Fed raises rates in December, the Bank of Japan will be the only major advanced-economy central bank to keep its policy unchanged for the foreseeable future. Nevertheless, overall markets seem to be taking this in their stride thanks to strong growth and supportive commodity prices.

In South Africa, political risk is mostly priced inAfter the Medium Term Budget Speech (MTBS) last week, the odds of a downgrade of South Africa’s sovereign debt has increased. Both S&P and Moody’s will release their views on 24 November. The market was expecting them to wait until after the ANC National Conference in December, which would have meant a March 2018 review. However, the MTBS has brought that risk forward. Fitch’s comment on the MTBS was as follows: ‘The change in direction of policy-making, away from a focus on fiscal consolidation that we anticipated as a consequence of March’s cabinet reshuffle, is under way and occurring faster than we had expected.’ S&P stated that ‘politics will probably trump the near-term macro-economic performance in South Africa, particularly for the local currency rating’. A downgrade of South Africa’s local sovereign debt to sub investment grade would result in South Africa leaving the World Government Bond Index, which would lead to the potential liquidation of R140 billion worth of local government bonds. This possibility triggered a significant rise in local government bond yields, with yields rising above Brazil’s for the first time since 2010 (as shown in Chart 3). Despite the recent sell-off by foreigners, foreigners are still net buyers of South African bonds year to date (YTD), thanks to the general support for emerging markets. However, foreigners have been avoiding the South African equity market, with the biggest outflows since the great financial crisis. As a result, despite South African equities rallying 17% YTD, 12% of this is driven by Naspers alone (up nearly 70%), with the rest of the market combined accounting for only 5% of the rise. With bond yields higher and local equities not rallying with the rest of the world, a lot of the political risk is therefore priced in.

So what… The reflation rally still has more room to continue. Global GDP is synchronised for the first time in a decade (as shown in Chart 4), and the structural impediments support lower-for-longer bond yields in the developed world. This combination of strong growth and low rates (along with seasonal factors) will support the equity market into year-end. The global backdrop will keep emerging market bond yields low and their currencies well bid. In South Africa, the markets are likely to wait until after the rating agency reviews in November and the ANC National Conference in December. And with GDP for the third and fourth quarters likely to be better than expected because of seasonal adjustments, South African markets could do very well once the event risks have passed. We are taking a bullish stance – despite some short-term volatility, we don’t expect a major derailment from QE unwinding or local politics for the remainder of the year.

THE REFLATION THEME CONTINUES

CATCH UP WITH KYLE 1 November 2017

BEYOND THE BENCHMARK

Chart 1: Unemployment and real rates are at 30-year lows

Source: J.P. Morgan

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2017

Source: J.P. Morgan

10%

9%

8%

7%

6%

5%

DM unemployment rate (LHS)

-2%

-1%

0%

1%

2%

3%

4%

DM real policy rate (RHS)

12%

7%

2%

-3%

-8%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

World

Sources: Thomson Reuters, Datastream, HSBC

Real

GD

P gr

owth

(% y

oy)

12%

7%

2%

-3%

-8%

Real

GD

P gr

owth

(% y

oy)

Western Europe EM Asia North America CEEMEA LatAm

Source: HSBC

Chart 4: GDP is synchronised across the world

AAA AA AA- A+ A- BBB+ BBB BBB- BB+ BB

1 000%

800%

600%

400%

200%

0%

-200%

-400%

Source: Morgan Stanley

S&P debt rating

Spre

ad o

ver U

ST

Better relative value

1 000%

800%

600%

400%

200%

0%

-200%

-400%

Spre

ad o

ver U

ST

AUSCAN

GER

SWI

KOR

UK

FRA

CZKTAI IRE

JAP

CHLMAL

POL

THASPA

HUNPORITA

PHI

MEXCOL

IDOIND

RUS

SAF BRA

TUR

Less relative value

Source: Morgan Stanley

Chart 3: South African bonds attractive even after a downgrade

Chart 2: Net quantitative easing by the major central banks

Source: Capital Economics

2009 2011 2013 2015 2017 2019

350

300

250

200

150

100

50

0

-50

Source: Capital Economics

350

300

250

200

150

100

50

0

-50

CEForecasts

Fed BoE ECB BoJ Total

Converted at prevailing exchange rates

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