Q Going into 2019, the SA Fixed Income investment team was bullish about the domestic fixed income space. How has this view panned out?
Our assessment was based on a positive inflation outlook and attractive South African bond valuations – relative to emerging market peers and inflation. This view turned out to be correct. Inflation has remained contained around the South African Reserve Bank’s (SARB’s) mid-point target of 4.5%, averaging 4.3% over the year. Government bonds have provided a generous yield well ahead of inflation (around 9% annualised) and a capital uplift of close to 1%, year to date. Investment-grade credit has yielded a significant amount above cash (approximately 1.5-2%). These yields should be seen against a backdrop of inflation at 4.3%.
Q What does 2020 hold for the South African fixed income market?
Bond yields and valuations are still attractive. While there are local and global risks, we believe the South African fixed income environment will remain favourable for investors seeking an income. Why do we think the income environment will continue to be rewarding?
The mid-term budget once again highlighted the South African government’s propensity to spend more than it earns as a percentage of GDP. Currently, our budget deficit hovers around 5% of GDP. On top of that, our current account, which records South Africa’s transactions with the rest of the world, shows that we are running a deficit of approximately 3-4% of GDP. Essentially, as the value of our imports exceeds the value of our exports, more money is flowing from South Africa to our trading partners than the other way round.
The two deficits are related, meaning the overspend by the government needs to be financed from offshore sources. South Africa therefore needs enticing real interest rates to attract foreign investors into our government bond market. To maintain this fragile equilibrium, the SARB has to keep real interest rates higher than it otherwise would have done. Sustaining this delicate balance has kept the rand from unhinging and inflation under control.
This fiscal predicament is unlikely to be resolved any time soon and therefore these higher real interest rates and the positive income environment of the last two years, will remain in place. However, this is not without its risks.
Q What are the major risks and how are they influencing your portfolio positioning?
Key domestic risks are the state of the fiscus, progress of essential economic reforms, and Moody’s downgrading South Africa’s sovereign debt to below investment grade. This would trigger foreign capital outflows, which could lead to bond market weakness and rand depreciation.
Growth in South Africa is too low. If these economic reforms are not successful, and growth and tax revenues continue to disappoint, South Africa could find itself in a classic debt trap.
Given the credibility of the SARB and weak domestic demand, we are still convinced that inflation will remain under control and stay close to the mid-point of the target band. However, it is possible that if some of these risks are realised, a weak rand could lead to higher inflation.
Key global risks are the US-China trade war and the possibility of a global recession.
Risks and uncertainties abound, but due to the inflation-beating income environment, we believe SA fixed income still offers very attractive opportunities. We have a balance of exposures to provide some protection against the multitude of risks locally and globally. While we are positioned to take advantage of appealing real bond yields, our offshore exposure acts as a buffer should any of these risks arise. This investment strategy has worked well for us during periods where we have experienced bond market volatility or rand weakness.
All investments carry the risk of capital loss.