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2019 Investment Views

A glass half-full

28 November 2018
Authors: Peter KentCo-Head of SA & Africa Fixed Income, Malcolm CharlesPortfolio Manager

Peter Kent and Malcolm Charles give their views on Fixed Income in 2019.

Transcription

Malcolm: So, Pete, 2018 has been quite a tough year for us. Emerging markets have been like that and I think global has been the big negative driver for us. What do you think is going to happen in the year ahead?

Peter: Thanks, Malc. Yeah, it has been a pretty interesting year from an offshore perspective this year. It started off fantastically well and then it shifted very hostile towards the end of the year as the Fed’s hike started to bite and the dollar started to rally.

So looking at 2019, I have actually brought an object here today which I think summarises it perfectly and this is a glass with water halfway and some people can view it has half-full and half-empty. There are two competing narratives out there when you think about offshore. You have got a situation where the US is doing fantastically well and the Fed is tightening, which is a good sign of their economy, and you have a camp which thinks this quantitative tightening is going to result in a popping of the bubble of everything. So, you know, the last 10 years the Fed and central banks have goosed asset prices and, now that quantitative tightening is setting in, those asset prices are vulnerable.

That is the one camp and then the other camp is, well, the growth situation across the globe is still good, led by the US. It has been sort of tapering off a little bit in Europe of late due to temporary factors but the growth story is still good. That is still going to drive corporate profitability. Asset prices are going to be supported by that, whether they are equities, whether they are credit. So there is a distinctly positive view out there, which is driven by a positive growth story and a profit story, and the negative take on that is well, the Fed is going to have to tighten, the dollar is going to have to rally, treasuries are going to have to go up in yield and the bubble is going to be popped.

We are of the view of a half-full glass. I am a firm believer that the Fed will tighten and won’t have to tighten too much. I don’t think inflation is going to run out of control. I don’t think the Fed is going to be forced into a corner of hiking. They ultimately want to ease financial conditions. We have seen that over the last couple of weeks. We have seen equities reprice. So financial conditions in the US have started to react to the Fed. So the Fed ultimately is in control here and if things start to get a little bit hairy in the asset markets as a result of their tightening, I think they can quite easily dial it back and that would provide stability.

So I am a firm believer that the growth picture remains strong in the US. I don’t think we are very close to recession. Recession is something we will probably need to start worrying about towards the end of next year, not through the midst of it, and, as a result of that, we think emerging market cyclical assets should benefit from that. They have revalued considerably over the last 5 or 6 months, so they start the year on a much more solid footing from a valuation perspective, and then the Fed tightening ultimately can be digested by the market: (a) because the market is pricing it; and (b) if it does start to rattle asset markets too much, the Fed can always dial it back.

So we definitely view it from the half-full perspective going into next year but I think one thing for certain, the volatility we have seen over the last few months is here to stay while the Fed is hiking. What do you think – you know, how do you think the South African bond market is going to cater for that?

Malcolm: I think if that sort of plays out, the EM debt in general will get a little bit of a bid. As we know, foreigners have sold billions and billions of rands worth of our bonds throughout 2018 and it has just been a steady – you know, from Q2 onwards where they were very aggressive and then it was just a steady continuation of that trend.

I think if that starts dissipating, which it seems to get the feeling that it is, it has been well-supported by the locals but we need the foreigners to turn. So if that half-full sort of scenario plays out, I think you will start seeing some support from foreigners but the valuation is there and, more importantly, I think the momentum from the political aspect has come through.

Peter: I was going to ask you that. So does something like Tito’s appointment – helluva credible guy, got a track record of being tough at a time where the fiscus needs it – do you think Tito’s appointment helps us navigate the volatility?

Malcolm: I think it is one of the best appointments we have had. I think the criticism – if we look back, so yes, the Zuma years were absolutely crazy and stupid and regrettable but, equally, the Finance Ministers over that time weren’t that fiscally tight.

I think Tito showed when he was at the Reserve Bank, he was a lot more hawkish than the market anticipated at his appointment. I think (and we got a sense of it from National Treasury themselves) that he is going to be fiscally hawkish and then I think it’s the soft issues. I think if you look at – he’s on the NEC. I think he is number 10 or 11 on the NEC so he is a very senior ANC member. He can shift the debate whichever way he wants to do it within the ANC as well as within Treasury and I think he can sort of build the credibility that we haven’t really seen from National Treasury since the Trevor Manuel days.

So I think you have got a President that is absolutely committed to get the economy right and he has given his endorsement to a very strong Finance Minister and I think that combination is almost the perfect combination for the position that we are in at the moment. I think you are going to see – in a year or two’s time, I don’t think you are going to recognise the budgets that we get. they are not going to be these continuous slippage budgets that we have had for about (what?) 7 years.

So, you know, I think that is a sound fiscus but, on the flipside, SARB has done a fantastic job through these crazy Zuma years. What do you think Lesetja is going to do now? You know, there’s a slight shift in the dynamics within the MPC with Brian Kahn having resigned. What do you think the path of interest rates has in store for us for 2019?

Peter: Yeah, Malc, I mean, as you know, one of our highest conviction calls this year has been the disinflation theme in South Africa. You know, due to lack of demand, there has just been no pass-through of rand weakness, oil prices and inflation has been very well-behaved and we have seen it.

We have seen very, very well-contained inflation [prints] and we have stuck to our guns this year that the SARB would be easing in the beginning of the year and, through the rand weakness over the last few months, we have stuck to our guns that the SARB wouldn’t be hiking but I think we have finally had to change that view: (a) because the Reserve Bank is now telling us pretty explicitly and they have just lost Brian Kahn. He has just retired so the Reserve Bank goes down to 6 people. The last meeting was barely voted through as unchanged and, with Brian going and the Governor with a casting vote, there is every chance it goes 3-3 for a hike and then the Governor voting for a hike would apply the casting vote and it would be a hike as a result.

So I think there is every chance that they hike now in November and there is every chance that they hike one more time in Q1 next year. Why? Why should they be doing that with inflation in the high 4’s? You know, I tend to agree with it. I think it is tough medicine but, ultimately, there is a lot of uncertainty in the globe. The Fed is hiking. The Fed has hiked a lot. Other emerging markets are hiking and I think, from a policy perspective, if you recognise that the South African economy is not doing fantastically well and you want to be as gentle as possible as a central banker, if you don’t want to be doing emergency moves, big moves, lots of moves, if you want to try and do slow, steady, as small as possible, you have got to start hiking early.

So whilst I would love to sit here and say that they shouldn’t be hiking or they won’t be hiking, I think, in terms of the best, most sort of risk-adjusted monetary policy, they should be hiking rates and, hopefully, if they hike now in November, that means that they only have to do one or two and then the impact to the economy and to the consumer is really not that hard.

So, unfortunately, I think rate hikes are in the offing despite the positive inflation story that we have had this year. At the end of the day, the oil price and the rand have just been too much and the fact that the Fed is moving so much as well means, to sort of attract capital, our rates need to be going up. So, unfortunately, I think that is coming.

One thing I would be interested in is you have had a fantastic call this year to be underweight listed property. It has really underperformed bonds. As you know, we sort of use it as a vehicle, as an alternative to bonds. So you have had this underweight call. With a glass half-full next year, with fiscal that looks like it is going to become incredible, with an exceptionally orthodox and credible monetary policy, like when do you think you are going to – when do you think the stars will align to reduce that underweight and possibly go overweight? And do you mind if I have a sip of my object? (Laughter)…

Malcolm: Look, I think listed property has rerated a little bit as an asset class. The earnings outlook, due to the recession and the just generally very weak retail part of the economy out there, earnings are probably down a percent or 2 from what we have got used to. So I think there is still a bit of bad news baked into the numbers and I think they are vulnerable to I think your point that we are probably going to 1 or 2 rate hikes.

So I don’t think this is the time to rush into increasing exposure to listed property, I think for the simple reason, you know, it is a substitute for us. I think government bonds and corporate bonds are actually much better instruments and much better priced and offer a better yield definitely for the next 6 months or so. So I think you are going to do better in a bond portfolio than adding listed property for now.

Just out of interest’s sake, what do you think the rate hikes do to credit spreads and what is the vulnerability to credit spreads to a hiking cycle because we have had a nice flat to [easing] cycle for a long time and credit has done very well for our portfolio?

Peter: Yeah. I mean investment grade credit has been one of our high conviction calls over the last 18 months. It has done exceptionally well. You know, at the beginning of 2017, the fiscus – well, I mean it still looks in trouble now but the fiscus was in real trouble then without the prospect of political change. So you had a situation where investment grade credit was pricing in like really recessionary, poor balance sheet conditions when the average corporate was actually looking in pretty good shape and, ironically, if there is no opportunity in the markets, you know no growth opportunities in markets, banks don’t need to expand their balance sheets and they don’t need to issue paper.

So, as you know, we took a maximum overweight position in investment grade credit at the beginning of 2017 and we have seen spreads grind tighter since then. You know [they] have had real momentum this year. Bank spreads have tightened 30, 40 bps, so that position has worked exceptionally well for us.

The interesting thing about a credit portfolio is it comes back at you quite quickly, as you know. You have to keep on topping it up as things mature. So we have used that opportunity this year of the book coming back at us to go from overweight to neutral so we are a little bit more neutral as a result now and happy with that. You know spreads have tightened. I think we want to be a little bit more neutral.

I think the prospect of spreads continuing to tighten, I think you can build a case either way for a marginal tightening or a marginal widening. What you do tend to see in this economy is, as rates do go up, you do see spreads tending to tighten. There is a relationship between the repo rate and credit spreads that suggest that perhaps the tightening is now done but, very happily, as that credit portfolio reduces in maturity, it rolls down. So you know 5 year credit becomes 4 year credit and the spread rolls down, so you have always got that roll-down as protection and you have always got that carry. It is still earning 130 bps above cash so, even if there is a mild widening, it represents value and also bear in mind spreads have been quite a lot tighter than where they are right now. In 2013, we got to 70 [over] on bank paper, so this is certainly not the tightest we have been.

So this is not an environment necessarily where you sit there and you go wow, you know, investment grade credit is a dripping roast but there is certainly value in there and in a world with volatility being managed I think is a real virtue. You know, we have said it a few times – I think managing volatility is going to be perhaps more important than managing direction, certainly with the Fed tightening and the possible scenarios next year. Investment grade credit does give you that nice steady alternative, providing you are not overpaying for it and I am pretty confident that we are not overpaying for it, so very happy with the position that is neutral to marginally overweight at the moment.

Malcolm: Now just to look forward, I mean we haven’t got too much FX in the portfolio. You, about a month ago, thankfully, sold virtually all our dollars as you felt that the dollar boom market had come to an end. What do you think going into 2019? I mean are there more legs on the dollar? Is the rand going to pull back?

Peter: I mean the way we use FX, it is as much a portfolio decision as it is an active play. It can be either, right. So in 2015, you know we had a very, very bullish dollar call so we had a very active dollar position in there that was not designed as a hedge. It was designed as a sort of return generator. For much of this year, we have been using a dollar position as a hedge to our positive duration view in South Africa, understanding that locally valuations look fantastic but the external environment is moving a little bit hostile.

You know what got me thinking about the dollar and perhaps that it had peaked was ultimately Fed pricing. When you look at Fed pricing right now, this morning, despite the midterms, which were meant to offer significant relief to fixed income, you know a split house was meant to offer significant relief to fixed income because there wasn’t going to be massive fiscal expansion, even after that kind of result, Fed repricing hasn’t really changed this morning. We have still got a December hike pretty much priced and we have got close to 3 hikes priced next year.

I think that is about right, to be honest. I think the Fed can hike in December and then, at most, hike another 4 next year. So 1 priced for now and 3 priced for next year looks pretty full to me from a Fed perspective. So the dollar, in my opinion, wasn’t really going to get much more impetus from a Fed repricing. Ultimately, inflation is at the upper end. It is sort of getting close to the Fed target. The Fed is not going to have to do more than that, in my opinion, and, as a result of that, the dollar run that we have seen since March I think ran out.

So how do we view going forward? Ultimately, you know, South Africa and the way we construct our portfolio, we need an offshore component as a bit of a hedge, especially to try and take advantage of the local bond view and the local bond valuation. The external environment is going to remain choppy, so we will keep an offshore component in there but I think we will be viewing it from a hedge perspective and we will be oscillating between dollars and more pro-cyclical currencies like Aussie dollar and EM currencies on a more tactical basis as the volatility swings.

So I would imagine our position right now, where we have got 5% offshore, a small amount of it in dollars, the balances in EM and Aussie – I would imagine that is pretty much going to be our posture for some time. If it gets to the stage where we think the Fed has to do more next year, we will shift that higher and shift it more into dollars but for the moment that seems like the right posture, where it is offering protection to the portfolio but it is not a serious drain in the event that the rand rallies like it is today.

So, Malc, we have spoken about our views, portfolio positioning, etc. What do you think the return prospects are? You know, the fund is yielding 9% at the moment. We talk a lot about capital and income. Where do you think the return prospects outside of income are going to be coming over the next 6 months to 1 year.

Malcolm: Yeah, okay. I think 2019 is a very interesting time for an income fund in South Africa. As you say, we are starting that at a fantastic yield. It is not often that we get that sort of kick-start for a portfolio. Then, if you look into 2019, if the glass remains half-full on a global perspective, we have got elections probably around May next year on the local, there’s all the chance that Cyril gets a decent mandate and consolidates his position even further. On top of that, I would at this stage bet that Tito delivers a fantastic budget which takes the rating agencies completely out of contention to downgrade us.

In that sort of scenario, with bond yields earning you 9.5% for a 10 year bond, gee whizz, the chances of a capital gain is pretty attractive and you can add a couple of percent onto a bond return quite easily in that sort of environment.

Peter: I have to ask you one final question. You know we speak about this a lot on the desk. So the big picture politically seems to be moving in the right direction in South Africa, both on an absolute basis when you look at South Africa in isolation and when you look at what is happening globally politically. It seems to me we are one of the few countries that are heading in the right direction politically.

That is the big picture but on the ground it feels pretty tough. You know, you see it in the headlines, you see it in the unemployment numbers, you see it in the consumption numbers. SA right now on the ground is a really tough place to be. So the return outlook that you mentioned seems quite positive. We are trying to paint a picture of half-full in terms of the external environment. Do you think in South Africa, on the ground, we are through the worst?

Malcolm: Absolutely. I think the [J-curve] is a classic J-curve. I think everyone got excited when Cyril took over, expecting it would immediately tick up. I think we all underestimated how bad things were. I don’t think we were at the edge of the precipice. I think we had already fallen over the edge and I think Cyril has literally been pulling us back up the cliff for the first couple of months of his presidency and you are starting to see signs.

So all the SOE’s have got new boards and new management. We are going to get new plans in the next couple of months. You have got a Mining Charter. You have got the spectrum announcement. You have got the visa issue and the tourism, you know a lot of focus being put on the tourism because that is a great job creator. You know, just the early signs of change. Vehicle sales have ticked up for the first time. Business confidence – we have had 2 months of increases.

So it is early stages but those early indicators are there that the economy is just-just starting to turn the corner. There’s still a long way to go, a lot of work to be done but there are green shoots that we have turned the corner.

Peter: I think volatility, just like this year, is going to be key so I will participate and protect. You know, the options in our downside protection are going to be key.

Malcolm: Absolutely.

Peter: Our offshore component is going to be key but, hopefully, deliver another decent year of return despite it being a tricky environment and, hopefully, things on the ground improving.

Malcolm: Absolutely.

Peter: Great.

Peter Kent
Peter Kent Co-Head of SA & Africa Fixed Income
Malcolm Charles
Malcolm Charles Portfolio Manager

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