Since 1870, global bond markets have moved in 20- to 40-year cycles. More recently, the period of 1950 to 1980 saw a prolonged and steady sell-off in US Treasuries while the 40 years thereafter saw a major bull market of declining bond yields and rising prices. If the history of debt markets repeats itself, we are now in year three of a new multi-decade bear market for bonds. Much of this weakness can be explained by unprecedented levels of global inflation. While US consumer prices disinflated for much of this year given the high base in oil prices created in 2022, there are signs of a rebound in energy prices. To combat this, over the last three years the US released almost half of its strategic petroleum reserves into the markets in an attempt to keep energy prices low. Such actions were to little avail, with crude oil prices again rebounding in the third quarter of 2023 to US$90 a barrel.
Apart from OPEC supply cuts, many large US oil production companies remain in capital discipline mode, with capital infrastructure investment sitting roughly 40% below what was being spent by the US oil sector in 2018. US shale producers are uneasy to overextend their balance sheets against the backdrop of an unfriendly fossil fuel rhetoric emanating from global politicians. What makes this problematic for energy supply and security is that a question mark hangs over the realistic timeline for the ambitious transition to renewables. Large-scale unbudgeted investment into aged transmission grids will be needed to accommodate this shift, as well as overcoming a potential global shortage of copper, nickel and other battery metals that are needed to meet battery electric vehicle production targets.
The recent rise in global wages also has the potential to reignite services inflation and lead to second-round price spirals. In the US, wages have grown in excess of current inflation for much of the year. Worker bargaining power is not weak – while there are only six million unemployed Americans, US job listings in August rose above nine million. While many jobs have been filled in leisure and hospitality in the last two years, the number of new listings in the professional services and healthcare sector has been rising. Personal savings have been drawn down since 2021 due to high inflation, and workers are now fighting for better incomes, with strike action at a multi-decade high. It is easy to call into question the “looming recession” narrative given that US household leverage remains low versus history, bank non-performing loans sit at 2016 to 2019 lows, and bankruptcy filings are also at multi-decade lows. While the raising of interest rates by the Federal Reserve has led new credit activity to materially decline, the prevalence of long-term debt that was fixed at low rates for corporates and household mortgages has cushioned the blow that should have been dealt by these higher rates.
In an environment of resilient US consumers and corporates, combined with second-round inflation shocks, it is appropriate for the Federal Reserve to keep interest rates higher for longer. This is an uncomfortable truth for the US bond and equity markets, both of which took a large knock in the third quarter of this year. Another realisation that the market might finally be awakening to is that government spending is imprudently high and shows no signs of declining. In the US, enormous healthcare expenditure, military defence spending and recent manufacturing subsidies have broken through the debt ceiling once again. By the Federal Reserve’s own estimates, this US government debt might be virtually unserviceable in the coming decades, which played a role in their recent credit rating downgrade below AAA by Fitch. Such reckless spending and globally elevated government deficits take monetary policy hostage as interest rates must be kept high to keep the inflationary effects of excessive expenditure at bay.
South Africa’s deteriorating fiscal trajectory
A similar market realisation is dawning in South Africa, although with the government’s large interest service burden threatening to derail the fiscus on a far shorter timeline. The South African Budget tabled in February greatly overestimated corporate income tax collection, which has subsequently been decimated by a decline in commodity export prices and the severe cost of loadshedding. The Budget also pencilled in far lower public sector wage increases than those ultimately agreed to with striking unions. Against such a backdrop, we have already seen National Treasury raise their weekly issuance of short-dated Treasury bills from R12.4bn per week to R14.8bn per week.
There are serious fiscal implications for the South African government when issuing long bonds at a 12% to 13% rate of interest while nominal economic growth is climbing at less than half of that, or 6%. In this situation, the government’s interest expense grows and compounds at a much faster rate than tax revenue growth, requiring cost-cutting measures to offset growth in the unfunded interest bill. Using theoretical estimates, if nominal GDP grows at 6.5% per annum for the next seven years while government’s cost of interest remains at 12% then, even if we manage to run a neutral primary balance every year (i.e. government revenue equals to government spending, ignoring the interest bill), by 2030 we could easily be in a situation where debt is close to 100% of GDP and where approximately 40 cents on every tax rand that is raised goes towards servicing interest on old debt.
The only way to neutralise the fiscal deterioration from such a growing debt burden is to embark on fiscal austerity and put aside large primary surpluses in the Budget every year. A version of such an approach has been proposed by National Treasury and our Finance Minister, Enoch Godongwana, although with some resistance from government and unions. This is perhaps understandable when one questions the appropriateness of austerity in a country with such devastating levels of social inequality, poverty and unemployment. The challenge will be to cut spending in areas where it is wasteful and keep the taps open where it is being routed to social welfare and critical infrastructure. Treasury argues for a restructuring of the public sector by closing redundant government departments and reducing headcount, as well as scrapping a host of smaller spending programmes that are seen as non-critical.
In a scenario where fiscal austerity cannot be achieved, any move to raise the issuance of longer-dated South African government bonds will put pressure on yields beyond the 13% level at which they recently traded, which will also have knock-on impacts into the cost of borrowing for the broader economy and for corporates who have not maintained healthy balance sheets. This is a risk of which we are vigilant when constructing the asset allocation of our portfolios.