Coronation Strategic Income Fund - October 2020
The Coronation Strategic Income Fund, our managed income fund aimed at investors with a time horizon between one and three years, returned 1% during the third quarter of the year (Q3-20) and 5.8% over the past six months. Over one year, the Fund returned 3.5%, which is 1.9% behind cash (measured using the STeFI 3-month Index) and over three years it returned 6.6% p.a., which is 0.4% p.a. ahead of cash.
September was filled with central bank meetings, and most policymakers voted to keep policy interest rates unchanged. Asset purchasing programmes were maintained, and the focus at the meetings was on providing market guidance with medium-term policy statements. Inflation pressures should remain subdued until the end of the year, and monetary policy interventions are expected to remain in place for a considerable period.
In the US, the Federal Reserve Board (the Fed) left the target interest rate range unchanged at 0.00% to -0.25%. The Fed forecasts suggest policy rates will remain on hold until at least 2023 while it implements an average inflation strategy, which suggests some tolerance for inflation to overshoot the 2% target. US headline inflation increased to 1.3% year on year (y/y) in August from 1.0% y/y in July. Rising vehicle prices contributed to the inflation uptick. Food prices remained stable and the cost of medical care services declined slightly.
In emerging markets, China’s headline inflation slowed to 2.4% y/y in August from 2.7% y/y in July, with food prices driving the decline. Elsewhere, the impact of Covid-19 on growth continues to evolve, with many countries still battling rising infection rates and relatively stringent lockdown restrictions.
The Fund maintains exposure to offshore assets and, when valuations are stretched, 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.
The South African Reserve Bank (SARB) met in September and kept the repo rate unchanged at 3.5%. The vote was split, with three members calling for a hold and two members opting for a 25-basis point cut. The SARB also revised its growth assumptions for the year because of weaker-than-expected second-quarter GDP growth. The central bank is expecting the economy to contract by 8.2% in 2020 from a previous forecast of 7.3%. The SARB sees inflation risks as ‘balanced’ and average headline inflation is expected to be 3.3% for 2020.
Headline inflation for August was 3.1% y/y versus July’s 3.2% y/y. Food inflation, rentals (both actual and owners’ equivalent rent) and goods price inflation remain contained in the current weak demand environment. However, administered and regulated prices, as well as pressure from imported goods – notably vehicles – are increasingly an upside risk to future inflation.
GDP contracted by an annualised -51.0% quarter on quarter (q/q) seasonally adjusted average (saa) in Q2-20, following a revised -1.8% q/q saa in the first quarter of 2020 (-2.0% q/q saa previously). The biggest detractors were the contraction in activity in the primary and secondary sectors of the economy, which faced the hardest shutdowns, while trade sectors fared a little better. Mining, manufacturing and construction output fell by more than 70% q/q saa. The services sector saw output fall by 40% q/q saa, with the trade sector down by 67.6% q/q saa and transport down by 67.9% q/q saa. Financial and business services fell less than other services, down by 28.9% q/q saa. On the expenditure side, household spending was down 49.8% q/q saa. The collapse in personal consumption expenditure far outweighed the decline in compensation, in part owing to mobility restrictions, which should improve in Q3-20. Gross fixed capital formation contracted by 59.9% q/q saa. Net exports contributed negatively to growth as exports fell by 72.9% q/q saa, while imports fell by 54.2% q/q saa. The Q2-20 shock was, on balance, worse than expected, and it extends the recession to three consecutive quarters.
Despite the weak growth outlook, we expect the repo rate of 3.5% to remain unchanged for a sustained period, as the SARB monitors the impact of a cumulative 300bps in easing year to date and while fiscal risk remains elevated.
At the end of August, shorter-dated fixed-rate negotiable certificates of deposit (NCDs) traded at 4.58% (three-year) and 5.76% (five-year), much lower than the previous month. Shorter-dated NCDs have pulled lower due to the significant interest rate cuts, recovery in bond yields and tightening of credit spreads. Short-dated fixed-rate NCDs continue to hold appeal due to the inherent protection offered by their yields. NCDs have the added benefit of being liquid, thus aligning the liquidity profile of the Fund with the needs of its investors. The Fund continues to hold decent exposure to these instruments (less floating than fixed) and we will remain cautious and selective when increasing exposure.
Inflation-linked bonds (ILBs) have performed poorly at index level as the ILB bond curve is weighted heavily towards longer-dated bonds. However, ILBs out to seven years have produced decent returns relative to cash over the past year, offer an attractive pick-up to their nominal bond counterparts, and still provide inherent protection against higher inflation. Furthermore, the one-year forward real policy rate (the difference between the repo rate and one-year forward inflation) sits at -1%, which acts as a very strong anchor for short-dated real yields. The risk, which we believe to be negligible at this point, is that the SARB moves the real policy rate into a marginally positive area.
CONSERVATIVE ON LISTED CREDIT
The listed credit market was not spared during the Covid-19 selloff. However, the subsequent recovery in listed credit spreads has far exceeded the improvement in the quality of the underlying fundamentals. This market is suffering from a supply/demand imbalance, as primary supply has dried up from most of the bond issuers. Since the SARB relaxed prudential capital buffers for banks, they can now afford to refinance upcoming debt maturities for corporates without relying on the capital markets. At the same time, the risk/return characteristics of other yielding asset classes have turned less favourable, making listed credit, with its optically lower return volatility, a seemingly attractive opportunity. Unlike investing in an equity, where one can double or triple one’s initial investment, when one invests in a credit, the best one can hope for is to receive one’s coupon payments on time and one’s capital back at the end. The return profile is therefore discrete; that is, one continues to earn a steady interest rate (coupon) until maturity or default. Even though underlying fundamentals might be deteriorating, the return of the South African corporate credit market has remained steady, predominantly because individual issues are tightly held by a small number of institutions, hence limiting secondary market activity and price discovery. This reduced observed volatility hides the underlying risk within the sector, in our view. In addition, structured products can also be used to reduce the observed volatility of returns of the underlying credit exposures due to inefficiencies in the mark-to-market process for these products. We remain conservative in our credit allocations.
PROPERTY UNDER PRESSURE
The local listed property sector remains under pressure and was the largest detractor from Fund performance over the past year. Share prices are weak as a result of a general rise in balance-sheet risk across the sector. The current crisis reduced rental income, put pressure on asset values, increased the cost of borrowing for lower-quality businesses and tested inexperienced management teams. It is entirely possible that many property companies will require additional capital and that dividends are suspended to preserve capital. While historical yields are attractive, we remain cautious not to take these at face value and understand how the key issues mentioned above may affect prospective yields. We believe there are a few select large-cap counters that satisfy our stringent conditionality.
We remain vigilant of the risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the local economy. However, we believe that the Fund’s current positioning correctly reflects appropriate levels of caution. The Fund’s yield of 5.3% (net of fees) 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.