Amid all the risks facing our fixed income market, it may be hard for investors to see a silver lining. While the risks are well documented – Eskom, a Moody’s credit rating downgrade, a deterioration in the fiscus and politicians tinkering with property rights – low inflation has been a welcome fillip. In this article, we explore why we believe fixed income could be the best place to be.
As had been widely anticipated by the market, the South African Reserve Bank (SARB) cut interest rates by 25 basis points in July. This is in line with our long-held view that the South African economy is experiencing sustained disinflation, driven by the lack of demand in the economy and the SARB’s determination to get inflation to the middle of the target band at 4.5%.
Indeed, the cyclical elements of inflation – traditionally a function of supply and demand – are running very low at closer to 2-3%. The only drivers of inflation in the economy are administered prices (such as electricity tariffs and tax hikes), combined with periods of higher oil prices and episodes of rand depreciation.
The SARB has long maintained that the impediments to growth are structural rather than cyclical, and that South Africa needs reforms rather than rate cuts. While this view holds true, it appears that the Bank is finally acknowledging that there may be a cyclical element to the growth slowdown too, and has accordingly responded by easing policy.
SARB reluctant to cut aggressively, despite poor growth prospects
There’s no denying that the growth picture in South Africa is ugly, with commentators bemoaning the lack of investment in the economy. But a recent research note from the SARB makes the point that for the period 2010-2016, “South Africa’s investment rate has actually remained above its long-term average.”1 What has happened is that the public sector has been crowding out the private sector, with state-owned enterprises (SOEs) becoming a much bigger investor in the economy. It is not surprising that from 2010 onwards, capital spending has become less productive. For every rand that has been invested in the economy, we are not getting the kind of return that is needed. Eskom’s two new power stations, Kusile and Medupi, are key examples of this kind of unproductive investing. In the same research note, the Bank makes the point that the “misallocation of capital” flowing from “patronage spending” and “self-enrichment” has contributed to the drop-off in investment efficiency, which in turn has curtailed “the country’s long-term growth potential.”
The SARB cut its forecast for GDP growth in 2019 from 1% to 0.6%. We believe the Bank’s growth forecast for 2020 and 2021, is still too optimistic. There is a strong argument from a cyclical perspective to cut interest rates further. However, South Africa’s structural problems mean that the extent to which the SARB can ease has a floor – in our view at between 50 and 75 basis points overall. More than that would require a meaningful improvement in the structural impediments to growth. For now, we are simply too dependent on foreign capital to fund our fiscal and current account deficits.
Investors well rewarded for taking on risk
While the SARB has welcomed the continued downward trend in inflation, it is concerned that the financing needs of SOEs could impact the value of the rand and push long-term interest rates higher. The Bank’s strong focus on anchoring “inflation expectations near the mid-point of the inflation target range”, has meant that fixed income investors have been well rewarded for taking on South African bond market risk. While bond yields have risen to reflect heightened risks, the SARB’s cautious stance on rate cuts and sustained disinflation have provided investors with attractive real (above inflation) yields. These are much needed in an environment where South Africans’ incomes have been eroded by ever-increasing taxes, and higher electricity and water tariffs.
Investec Diversified Income – where to from here?
Domestic bonds have had an exceptional – if bumpy – 12 months, with the All Bond Index returning almost 11.5% to the end of June. We have participated in this upside and continue to have a constructive view on domestic bonds, as we believe they are a better expression of this disinflation theme than listed property. With our portfolio yielding above 8.5% and inflation running at 4.5%, fixed income provides a meaningful real return. In addition, we believe there is further capital uplift to come from bonds.
We maintain a prudent allocation to government bonds, taking advantage of disinflation, high real yields and attractive valuations. The portfolio also has a meaningful exposure to investment-grade corporate bonds. This has been a high-conviction call over the last two years and the portfolio benefited from it materially. The yields are still good but not as compelling as they have been in the past.
The global environment has become more supportive of emerging markets such as South Africa. Uncertainty sparked by President Trump’s trade policies and global growth concerns moved the US Federal Reserve to cut the federal funds rate at the end of July. The European Central Bank will likely ease key interest rates in September and introduce other support measures, given persistently low inflation in the euro zone and a gloomy growth outlook.
While the global environment has provided some breathing room for South African markets, we remain mindful of the risks, outlined above. There has been constant negative news flow about a potential credit rating downgrade by Moody’s. A close examination of the methodology that Moody’s uses to assess and rate the quality of a country’s sovereign debt, leads us to believe that a rating downgrade in November is unlikely. But without targeted government intervention to stabilise Eskom and our fiscal situation, we could see the ratings agency move the outlook to negative.
Risks and uncertainties abound, but on a risk-adjusted basis we believe fixed income could be the best place to be. Valuations, together with our offshore allocation, provide some protection against the multitude of risks locally and globally.
1 South African Reserve Bank, Occasional Bulletin of Economic Notes, July 2019, What happened to the cycle? Reflection on a perennial negative output gap, Theo Janse van Rensburg, David Fowkes and Erik Visser.