The fast view
- The macroeconomic backdrop of the past 18 months has taken a heavy toll on fixed income markets, with persistently high inflation and aggressive interest rate hiking acting as major headwinds.
- Homegrown challenges – including crippling loadshedding and heightened geopolitical tensions – exacerbated the situation to weigh heavily on the rand and South African rates.
- On all fronts, the clouds seem to be starting to clear: inflation is starting to moderate; an end to Fed rate hikes is near and the SARB has paused hiking; geopolitical tensions are abating; and headwinds from loadshedding are weakening.
- Risks remain, but at current market valuations, investors are getting well compensated for these.
- Given the more constructive outlook – especially for SA rates – we believe it is time for investors to take a less cautious stance in portfolio positioning.
Reflections on a perfect storm
It has been a tumultuous 18 months for fixed income, and South African fixed income certainly did not escape the broader bear market. Driving this was a combination of stubbornly rising inflation, aggressive monetary policy tightening, and souring sentiment among investors – all coupled with some homegrown challenges.
Inflation remained frustratingly high – dashing hopes of it being a ‘transitory’ phenomenon – and Russia’s invasion of Ukraine exacerbated this: food, grain and fuel prices all spiked, pushing Europe into an energy crisis. In addition, ongoing COVID-related disruptions – especially relating to China’s zero COVID policy – weighed on global supply chains. As a result, inflation became the main focus of central banks globally. The US Federal Reserve (Fed) raised rates by over 400 basis points (bps) during 2022, with other major central banks also tightening monetary policy considerably and playing catch up with emerging market (EM) central banks in this regard.
Turning to homegrown challenges, the South African Reserve Bank (SARB) slashed its GDP forecasts in the wake of the intensified power cuts early this year, estimating that loadshedding would shave a full two percentage points off this year’s annual growth rate. Loadshedding has also weighed on the country’s inflation dynamics, with food price inflation still at elevated levels – largely as a direct result of the added cost of diesel for generators used in food production and storage.
This year began on a positive note, as China finally reopened from its COVID lockdown and US inflation appeared to be slowing. But market sentiment subsequently soured as a combination of resilient economic data in Europe, robust US labour market data, and stubborn core inflation in the US caused investors to anticipate tighter monetary policy. Rates volatility remained for the rest of the period, not helped by negative headlines from the banking sector (in the US and Europe) and concerns around US debt ceiling negotiations.
Against this backdrop, the SA rates market came under pressure and the rand suffered as a result of a strengthening US dollar and heightened geopolitical tensions – relating to allegations over links with Russia and concerns around a potential visit by President Putin. The move by the Financial Action Task Force (FATF) to greylist the country earlier in the year was a further headwind.
Figure 1: The rand underperformed relative to expectations driven by a flurry of headwinds
Source: Ninety One, Bloomberg, 8 August 2023.
The skies are starting to clear
Fortunately, there have been recent signs of storm clouds beginning to clear. Although by no means a case of uninterrupted sunshine, the risk of unexpected showers has diminished, for a variety of reasons as we explore below.
First to inflation. After proving stubbornly sticky, inflation in South Africa seems to have finally peaked, allowing the SARB to pause its hiking cycle. We are of the opinion that inflation will continue to fall within the SARB’s 3-6% target band in the second half of the year.
Figure 2: The SARB has finally paused
Source: Ninety One, August 2023.
The Fed may not be far behind
July saw the Fed raise the target range for the federal funds rate by 25bps, in line with consensus and bringing borrowing costs to their highest levels since 2001. However, the tone from the central bank was less hawkish, causing investors to speculate that the end of the hiking cycle could be near. Support for this theme came in the form of softer inflation prints for June, with both headline (3.0% vs 4.1%) and core (4.8% vs 5.3%) inflation printing lower month-on-month, tracking closer towards the Fed’s 2.0% target. In July, US headline inflation rose slightly to 3.2%, while core inflation decelerated to 4.7%. The increase in the headline figure was a result of base effects and was below market expectations – further bolstering speculations of a pause at the next Federal Open Market Committee (FOMC) meeting.
Figure 3: Fed hiking and US rates
Source: Bloomberg and Ninety One, 8 August 2023.
In a further positive shift, recent economic data fuelled increasing optimism that the Fed could bring inflation under control without driving the US economy into a recession. Other positive dynamics for the global economy include the recent pledge of support by officials in China to lift the country’s economy and support the struggling property sector, although concrete measures of support have so far disappointed market participants.
Domestically, we have seen encouraging signs of a turnaround at Eskom, which should help draw a line under the loadshedding that has weighed heavily on the economy. Although it’s still early days for Eskom to steady the ship, the state-owned power utility continues to receive much-needed help from private sector investment, providing some cause of optimism. In addition to the improving energy sector backdrop, geopolitical risks receded after South Africa clarified its neutral stance on the Russia/Ukraine war. President Ramaphosa has since undertaken efforts to broker peace negotiations and has engaged with a variety of global leaders. Furthermore, he has also reached an agreement with Russian President, Vladimir Putin, which means Putin will no longer attend the upcoming BRICS summit in person – this is set to be hosted by South Africa in August. These measures have helped reduce some of the risk premium embedded in the rand and local fixed income assets.
But beware of lingering clouds
Despite the various improvements to the macro environment, there are still some headwinds facing fixed income markets. In South Africa, fixed income is particularly sensitive to volatility in developed markets, especially monetary policy adjustments by the Fed. The good news is that the Fed may be nearing the end of its interest rate hiking cycle (as noted above), bringing some stability to local fixed income assets. In addition, fiscal challenges relating to lower commodity prices and ongoing loadshedding could make fiscal consolidation challenging.
Figure 4: National Treasury facing some challenges due to lower commodity prices and loadshedding
Source: National Treasury and Ninety One, August 2023.
What this backdrop means for investors
Despite the current headwinds facing the asset class, investors are being more than adequately compensated for the associated risks. Investors are currently being offered very attractive yields, with the yield on the 10-year South African government bond currently exceeding 10% - well above inflation and cash.
Figure 5: SA valuations are particularly attractive
Source: Bloomberg and Ninety One, 26 July 2023.
How to position portfolios?
The current high yields on local government bonds bode well for the fixed income return outlook, with income being an important driver of rates market returns, as shown in the figure below.
Figure 6: ALBI returns for the last 6 years
Source: Bloomberg and Ninety One, 26 July 2023.
Our current portfolio positioning is constructive and we added some risk by adding duration and increasing exposure to listed property, where mandates allow. We have concentrated our buying activity in the belly and long end of the curve and remain underweight the ultra-long end of the curve as a hedge against the deteriorating fiscal picture. We have also maintained some exposure to inflation-linked bonds as a hedge against rand weakness.
Figure 7: Current positioning
Figure 8: Asset allocation
Source: Ninety One, 16 August 2023.
Although, now is not a time for over-exuberance, there are rays of light that warrant a less cautious top-down positioning.
Conclusion
As global inflation continues to moderate, we can expect central bankers to start pausing the aggressive hiking cycle that has been a headwind for global fixed income markets. With the prospect of interest rates stabilising and economic growth showing more resilience than expected, we expect global investors to become more comfortable investing in emerging markets again. Domestically, the country has seemingly turned the corner in terms of the intense levels of loadshedding that have weighed on the economy, with GDP forecasts now starting to see some upward revisions. At the same time, the SARB paused its policy-tightening measures at the most-recent MPC meeting, signalling that the end of its rate hikes could also be near. As these headwinds continue to dissipate, we think South African government bonds remain very attractive, once again offering investors the opportunity to earn returns well ahead of inflation.
