In a similar vein to most of the year, the fourth quarter of 2016 proved to be a volatile period as returns varied from month to month. The initial gains achieved in October were quickly reversed in November as the ‘Trump reflation trade’ sparked a sell-off in global bonds. However, local yield-oriented assets strengthened into year-end as South Africa maintained its investment-grade status and the local political risk premium declined. This backdrop saw bonds (JSE ASSA All Bond Index +0.3%) and listed property (FTSE/JSE SA Listed Property Index +1.3%) ride choppy seas to end the period on a firmer footing.
The fourth quarter of 2016 was chequered with political developments at home and abroad. At the centre of this was the US presidential election which sent jitters across global markets given the uncertain outcome. Soon after the election of Donald Trump, developed market equities rallied and the US dollar strengthened, while global bond yields shot upwards and emerging market stocks fell, as investors began to price in pro-growth and reflationary US policies. The ‘Trump reflation trade’ weighed heavily on global bonds as the asset class had its worst month on record, with the Barclays Global Bond Aggregate Index declining 4.0% in US dollars.
On the local front, Finance Minister Pravin Gordhan faced fraud charges in October, but the charges were later withdrawn. Amid this political noise, Gordhan delivered a pragmatic medium-term budget policy statement with conservative growth and revenue forecasts, and significant consolidation from lower expenditure and higher taxes over the next two to three years.
The spotlight shifted to the latest round of sovereign credit rating reviews in the final two months of 2016. While the country managed to avoid its sovereign debt being downgraded to junk (below investment grade), we are not out of the woods yet. By and large, all the rating agencies outlined similar conditions that could lead to rating downgrades in the future: the absence of a recovery in growth; an increase in government debt and contingent liabilities relative to GDP; and/or political instability prohibiting structural reform or leading to weaker institutions.
The uncertain global backdrop continues to be a prevalent theme in 2017. The election of Trump as US president has provided few clues about the path of US policy (fiscal, monetary and trade). Meanwhile, the US Federal Reserve’s projection of three rate hikes in 2017 appears to be hawkish — we expect two US rate increases at present. In Europe, political uncertainty will likely persist for the better part of the current year given the busy election calendar. All these factors pose a threat to emerging markets, albeit to varying degrees, i.e. rising risk premiums in emerging market fixed income assets.
Locally, the political environment remains fluid and we could see succession dynamics within the ruling party – African National Congress – become more of a talking point. While South Africa has achieved a reprieve from a sovereign credit rating downgrade, government officials still have a considerable job on their hands to stabilise the country’s rating by way of fiscal consolidation and structural reform which will be needed to encourage private sector investment and economic growth. Thus, the risk of a downgrade will linger until the next round of reviews in June and we believe the path ahead will most likely continue to be volatile.
Inflation rose again in December and we expect it to peak at the current level, before returning back within the SARB’s target band of 3-6% in the second half of the year. In our view, aggregate inflation should moderate towards an average of 5.9% for the year. We believe the central bank is likely to keep rates on hold for now, while standing ready to act on any negative influences should the need arise, particularly a materially weaker rand. The bar for rate cuts remains high and will likely only be reached if inflation is sustainably well within the SARB’s target range.
In terms of positioning, we have maintained our cautious stance towards nominal bonds. In our view, the more pro-cyclical global environment is positive for emerging market risk and inflows into the local market. This, combined with a favourable inflation outlook, should be supportive of domestic bonds. Developed market bond yields will remain elevated, which reduces the attractiveness of our bonds somewhat. While we are convinced that bonds offer good value, both outright and relative to cash and other asset classes, we remain more circumspect on longer-dated bonds given the uncertain political environment — e.g. the ANC consultative and elective conferences could unsettle markets. As such, we will look to use bouts of volatility to pick up exposure at more attractive levels. We also believe our bond options will provide some protection against the ever-present political and global risks.
Currently, we do not find inflation-linked bonds very attractive given the improving local inflation outlook. However, we do have a moderate allocation to the shorter-dated instruments as they should provide us with some safeguard against a weaker rand in the event that the political situation unhinges. In 2016, the listed property sector was adversely impacted by the strengthening of the rand, given numerous companies having offshore operational exposure, general global uneasiness towards equities as well as the derating of local stocks. In our view, relative valuations have improved and we have some exposure to the sector. Moreover, rebounding local growth, a positive inflation profile and a stable domestic interest rate environment should be supportive.
We trimmed our exposure to preference shares following a strong performance last year. Additionally, this asset class could come under pressure if the National Treasury decides to implement more punitive taxes on the instruments in the coming fiscal year. Investment-grade credit remains a key component of our strategy and we have increased our allocation, while remaining selective in terms of sectors and issuers given the weak local economic outlook. We perceive the asset class as being attractively valued. Our investments remain focused on defensive sectors with strong bottom-up fundamentals. Bank, insurance and real estate names have attracted the bulk of our liquidity. Our top-down view on commodities has become more constructive and, as we see more evidence of this trend persisting, we will look to rotate into more cyclical sectors.
While we are confident the rand will behave more consistently in the near term, we think it is prudent to retain our offshore exposure from a portfolio construction perspective to balance local interest rate-sensitive risks. Within this component, we have diversified away from the US dollar as we perceive it as expensive and reallocated the proceeds in favour of the Australian dollar and euro.
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