The 2008/2009 Global Financial Crisis (GFC) precipitated a remarkable period in financial markets. In the decade that followed the GFC, global inflation was significantly lower and financial repression across developed markets ensured a bonanza of borrowing at some of the lowest interest rates in world history. This trend was further entrenched just over a decade later through the actions taken by global governments to drag themselves out of the Covid-induced recession. All good things in life come at a price and, after extended indulgence, the cost to the global economy manifested in a significant jump in the cost of living. Inflation has come back to bite, and central banks must choose between tightening their belts or loosening their pants. The uncertainty spawned by the rapidly changing macro variables has resulted in not only a significant increase in volatility, but also a sizeable change in asset valuation.
This year, market volatility (Volatility Index) is up c.80%, global equities (MSCI World Index) are down c.25% and global bonds (FTSE World Government Bond Index) are down c.21%. US bond yields have risen more than 300 basis points (bps) since their lows in 2020, which has led global bond yields higher. And yet, no matter how bad things are, you can always make it worse. The UK signaled a policy pivot towards a largely unfunded pro-growth policy, which saw their 30-year bond yields soar to above 5%. Amid all this volatility, SA bonds were not spared, with the FTSE/JSE All Bond Index down -2.1% in September, taking its year-to-date return to -1.34%. When translated into dollars (-13.1%), this is significantly better than global bond returns. Despite real yields ticking higher, inflation-linked bonds (ILBs) still offered some protection in the sell-off, as they were down 1% over the quarter, bringing their return over the year to 2.23%, which is still above bonds but below cash (1.35% over Q3-22 and 3.57% year to date).
The Fund returned -0.71% in September and 0.89% for Q3-22, bringing its 12-month total return to 3.34%, which is lower than cash (4.18%) and that of its benchmark (4.61%) over the same period. This return must be seen in the context of returns from the investable asset classes, which all underperformed cash except for ILBs and offshore USD cash. In the interest of prudent portfolio construction, having the entire portfolio in just these two assets would have been careless. We continue to believe that current positioning offers the best probability of achieving the cash + 2% objective over the medium to longer term. September was dominated by a slew of central bank meetings that delivered a consistently hawkish message and within developed markets uniformly raised policy rates. In the UK, financial markets descended into turmoil, following the announcement of a fiscal package that will be fully funded by additional borrowing. Overall, inflation remains high, compounded by the energy crisis in Europe. Policy settings are expected to continue to tighten in the near term.
In the US, the Federal Reserve Board (the Fed) raised interest rates by 75bps, moving the Federal Funds rate target range to 3.00%-3.25%. The Fed continued to signal higher policy rates with a decisive escalation in rate expectations at the September meeting. Policy rates are projected to peak at around 4.6% in 2023, indicating a 4.50%-4.70% range. Headline inflation slowed to 8.3% year on year (y/y) in August from 8.5% y/y in July. Turning energy prices and the stronger US dollar have helped ease headline inflation – although the pace of increase remains elevated. Core inflation increased to 6.3% y/y in August from 5.9% y/y in July. The upside increases in the core inflation number are the result of increases in used vehicle prices and high rental inflation, and remain a concern for the Fed.
In the UK, the Bank of England (BOE) raised interest rates by 50bps, moving the policy rate to 2.25% from 1.75%. The big surprise was the split in the votes, with three members voting for 75bps, five for 50bps and one for 25bps. Underlying growth momentum has weakened, and the accompanying statement suggests the UK may already be in a technical recession. The BOE was also forced to implement a GBP65 billion emergency purchasing programme after gilts sold off following the announcement of a bigger fiscal stimulus package than the market indicated by the UK’s new (albeit briefly) Finance Minister, Kwasi Kwarteng. The announcement pushed 30-year gilt yields above 5.00% - levels last seen in 2002. After the intervention of the BOE, 30-year yields decreased to 3.93%.
In emerging markets, China’s headline inflation remained muted at 2.5% y/y in August from 2.7% y/y in July. Core inflation was unchanged at 0.8% y/y. The price moderation was broad based and, while China’s inflation remains well within the 3.0% target range, room for monetary easing has opened in support of the weak economy.
The rand ended the month at R18.09/US$1. Expectations around aggressive global monetary policy normalisation weighed on risk appetite as global liquidity reduces in the face of elevated inflation. Offshore sovereign bonds have seen a significant reprice and are now closer to what we consider to be long-term fair value. Credit assets have seen a substantial drop in valuations which have made them look very attractive. The Fund has utilised a significant part of its offshore allowance to invest in these types of assets. When valuations are stretched, the Fund will hedge/unhedge portions of its exposure back into rands/dollars by selling/buying JSE-traded currency futures (US dollars, UK pounds and euros). These instruments are used to adjust the Fund’s exposure synthetically, allowing it to maintain its core holdings in offshore assets.
In South Africa (SA), the economy contracted by 0.7% quarter on quarter (q/q) in Q2-22, from a revised growth of 1.7% q/q in Q1-22. Growth in Q2-22 was affected by floods in KwaZulu-Natal that hampered production, strike activity in the mining sector, and ongoing bursts of loadshedding. Despite these challenges, fixed capital investments made a positive contribution to growth and household spending remained resilient.
The South African Reserve Bank (SARB) increased the repo rate by 75bps in September, moving the policy rate from 5.5%to 6.25%. The vote was split with a hawkish bias, as three members voted for 75bps and two for 100bps. Despite a moderation in SARB inflation forecasts over the forecast horizon, mostly reflecting lower fuel and food forecasts, the Monetary Policy Committee (MPC) nonetheless sees inflation risk to the upside and remains particularly concerned about the impact of tightening global monetary conditions amidst slower growth on the exchange rate. The ongoing pressure on the currency is likely to reinforce the MPC’s hawkish bias and see ongoing hiking into year end.
Headline inflation moderated to 7.6% y/y in August from 7.8% y/y in July. Core inflation also came in lower at 4.4% y/y in August from 4.6% y/y in July. The cause of the moderation was mostly due to lower transport costs, but this was partly offset by a strong rise in food prices. Food inflation continues to surprise on the upside and is largely driven by bread, cereal, oil, and fats prices. We see some ongoing upside from food inflation in coming months, but for now see July as the peak in headline inflation in this cycle. More challengingly, we expect core inflation to continue to accelerate in coming months, albeit at a relatively moderate rate.
At the end of September, shorter-dated fixed-rate negotiable certificates of deposit (NCDs) traded at 9.33% (three-year) and 9.97% (five-year), significantly higher than the close at the end of August. The recent move is due to a repricing in bond yields in the local market. Our inflation expectations suggest that the current pricing of these instruments remains attractive due to their lower modified duration and, hence, high breakeven relative to cash. In addition, NCDs have the added benefit of being liquid, thus aligning the Fund's liquidity with the needs of its investors. The Fund continues to hold decent exposure to these instruments (fewer floating than fixed), but we will remain cautious and selective when increasing exposure.
ILBs have had a decent run and their outperformance relative to nominal bonds requires us to relook valuation. The table below looks at the various ILBs, their real yields and what their implied nominal yields would be at 6% inflation and compares them to the equivalent nominal bond of the same maturity. In addition, we show the modified duration of both the ILBs and the nominal bonds for the various maturities. Even though real yields remain quite elevated in the longer end (>10 years), one would still need inflation in excess of 6% for ILBs to outperform their nominal equivalents. When taking into consideration that the risk (relative modified duration to nominals) carried by ILBs are multiples of their nominal counterparts, it makes sense that one should instead own nominal bonds in that area of the curve. The shorter end of the curve offers a much better risk/return profile with a marginally higher duration risk, which is amply compensated for by better return prospects than those of their nominal bond counterparts. As such, we continue to advocate shorter-dated ILB positions for bond portfolios.
Global monetary policy normalisation has gathered pace to combat the highest inflation in decades. Central banks are willing to sacrifice growth by taking policy rates into restrictive territory, to ensure inflation does not get disorderly. This has pushed global bond yields to levels that have not been seen since before the GFC. Risk sentiment has soured as volatility has soared and asset prices have tumbled. SA bonds have fallen victim to this global fallout but still embed a significant buffer both from an inflation and risk premium perspective. The uncertainty around global inflationary outcomes will ensure that volatility remains elevated, but, over the longer term, valuations of SA bonds should provide a reasonable buffer, as they have already, since they trade at significant discount to fair value. We continue to advocate an overweight position in SA bonds and believe short-dated ILBs still warrant a place in portfolios.
The local listed property sector was down 6.5% over the month, bringing its 12-month return to -10%. The balance sheet concerns in the sector have subsided, as companies have managed to introduce dividend payout ratios (with some withholding dividends entirely) and selling off assets in order to recapitalise themselves. Going forward, operational performance will remain in the spotlight as an indicator of the pace and depth of the sector’s recovery. We believe that one must remain cautious due to the high levels of uncertainty around the strength and durability of the local recovery. However, certain counters are showing value, given their unique capital structures and earnings potential. These counters remain a core holding within the Fund. We remain vigilant of the risks emanating from the dislocations between stretched valuations and the local economy's underlying fundamentals. However, we believe that the Fund’s current positioning correctly reflects appropriate levels of caution. The Fund’s yield of 9.61% remains attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected Fund performance over the next 12 months.
As is evident, we remain cautious in our management of the Fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium to limit investor downside and enhance yield.
Please note that the commentary is for the retail class of the Fund. View the Strategic Income Fund