South African bonds: longer the better as growth questions rise

Analysts with Barclays noted in late June that offshore and local fund managers alike remained short duration in South Africa but based their valuations “on different frameworks (nominal yields and market inflows for the former, expectations of a tightening cycle and higher inflation for the latter).  Yet the somewhat swift shift in sentiment to longer duration debt (evidenced by a 22bp bull flattening in last Thursday's yield curve) is not necessarily surprising; as we noted weeks before that, South Africa's relatively muted core inflation coupled with myriad and mounting roadblocks in the ever-dithering labor sector were all in fact explicit red flags rather than herrings and screamed for continued slack in monetary accommodation.  Recent data only supports this thesis: Absa Capital reminded clients Friday, for instance, that on the heels of July's wretched PMI figures published earlier in the week “showing a massive deterioration to 44.2 (53.9 prior)”, manufacturing sector capacity utilization is up “only 0.7pp y/y . . . indicative of the still relatively subdued activity in the industry, where utilization remains below its long-term average of around 84% . . . and around 15% lower than its pre-recessionary peak . . . [a reflection of] the headwinds the sector continues to face.”  The domestic forward rate agreements (FRA) curve has also taken note, with the shorter end (December) declining steadily from its 5.9 percent peak in May indicating a widening belief that the economy's outlook is subdued and rates will stay soft at least until next January.  Yet even that take looks to be too sanguine, especially since current real GDP forecasts are built on the assumption that demand-side factors will make up for the aforementioned supply-side slump.  Because households remain leverage sticky (debt-to-disposable income remains just below 80%), banks remain spooked by credit quality concerns (the country's National Credit Regulator recently noted that accounts 3 months or more in arrears continue to rise) and core inflation remains more than a full percentage point below headline inflation (where as before the last rate hike in 2006 it sat only 0.4pp under the target) we look for continued downwards pressure on the FRA curve as longer duration bonds will continue to be the vehicle of choice.