Unprecedented levels of inflation in the developed world sparked a robust monetary policy response that heavily impacted asset returns in 2022. The US Federal Reserve (the Fed) raised its policy rate by 4.25% and embarked on balance sheet reduction with much of the rest of the world following suit. Investors experienced one of the worst years in history for US fixed income assets in 2022. We saw 10-year US Treasury yields rise from 1.5% at the start of 2022 to end the year at 3.9% (when yields rise bond prices decline). US equities retreated 18% and the US dollar appreciated 8.2% against a basket of its major trading partners.
Investors have endured two very challenging years in the US bond market. As Figure 1 shows, the last time investors experienced 2 negative years in a row for US Treasuries was in the 1950s!
Figure 1: The US bond bloodbath
10 Year Treasury Bond: Total Return 1928 - 2022 | |||||||||
---|---|---|---|---|---|---|---|---|---|
Year | Return | Year | Return | Year | Return | Year | Return | Year | Return |
1928 | 0.8% | 1947 | 0.9% | 1966 | 2.9% | 1985 | 25.7% | 2004 | 4.5% |
1929 | 4.2% | 1948 | 2.0% | 1967 | -1.6% | 1986 | 24.3% | 2005 | 2.9% |
1930 | 4.5% | 1949 | 4.7% | 1968 | 3.3% | 1987 | -5.0% | 2006 | 2.0% |
1931 | -2.6% | 1950 | 0.4% | 1969 | -5.0% | 1988 | 8.2% | 2007 | 10.2% |
1932 | 8.8% | 1951 | -0.3% | 1970 | 16.8% | 1989 | 17.7% | 2008 | 20.1% |
1933 | 1.9% | 1952 | 2.3% | 1971 | 9.8% | 1990 | 6.2% | 2009 | -11.1% |
1934 | 8.0% | 1953 | 4.1% | 1972 | 2.8% | 1991 | 15.0% | 2010 | 8.5% |
1935 | 4.5% | 1954 | 3.3% | 1973 | 3.7% | 1992 | 9.4% | 2011 | 16.0% |
1936 | 5.0% | 1955 | -1.3% | 1974 | 2.0% | 1993 | 14.2% | 2012 | 3.0% |
1937 | 1.4% | 1956 | -2.3% | 1975 | 3.6% | 1994 | -8.0% | 2013 | -9.1% |
1938 | 4.2% | 1957 | 6.8% | 1976 | 16.0% | 1995 | 23.5% | 2014 | 10.8% |
1939 | 4.4% | 1958 | -2.1% | 1977 | 1.3% | 1996 | 1.4% | 2015 | 1.3% |
1940 | 5.4% | 1959 | -2.7% | 1978 | -0.8%; | 1997 | 9.9% | 2016 | 0.7% |
1941 | -2.0% | 1960 | 11.6% | 1979 | 0.7% | 1998 | 14.9% | 2017 | 2.8%; |
1942 | 2.3% | 1961 | 2.1%; | 1980 | -3.0% | 1999 | -8.3% | 2018 | 0.0% |
1943 | 2.5% | 1962 | 5.7% | 1981 | 8.2% | 2000 | 16.7% | 2019 | 9.6% |
1944 | 2.6% | 1963 | 1.7% | 1982 | 32.8% | 2001 | 5.6% | 2020 | 11.3% |
1945 | 3.8% | 1964 | 3.7% | 1983 | 3.2% | 2002 | 15.1% | 2021 | -4.4% |
1946 | 3.1% | 1965 | 0.7% | 1984 | 13.7% | 2003 | 0.4% | 2022 | -17.8% |
Source: NYU Stern School of Business.
The Chinese economy remained in lockdown for much of last year and global food prices spiked, impacted by the war in Ukraine. All of these factors created a very hostile environment for emerging markets (EMs).
Surprisingly, South African assets fared reasonably well in this environment. Despite a depreciation in the rand of 6.9% against the US dollar and the repo rate going higher by 3.25%, the JSE All Share Index returned 3.6% over the year. This can largely be attributed to strong commodity and financial sector returns. On a trade-weighted basis, the rand performed significantly better depreciating only 0.04% against our trading partners.
South African government bonds returned 4.3%, marginally behind cash, in the worst global bond bear market we have experienced in recent history. Despite yields on the 10-year benchmark bond rising 1.1% (lowering their price) over 2022, the income protection inherent in the asset class shielded investors. South African government bond yields rose 0.3% less than their EM peers over the year. This is a significant outperformance, given the 1.4% rise in EM yields.
An income return of 9.7% over the period provided South African government bonds with a significant buffer against a 5.5% loss of capital, leaving a combined return of 4.2%.
Figure 2: The power of income
Source: Ninety One, Bloomberg, as at 31 December 2022.
With yields starting the year at 10.9%, the outlook for 2023 looks promising with significant income protection on the table.
The deceleration of inflation globally, combined with the growth impact of China reopening its economy, finds emerging markets in somewhat of a sweet spot.
Data out of the US at the start of the year showed continued gains in the labour market. However, there are also indications of some wage normalisation through a slowdown in average hourly earnings. Headline consumer price inflation (CPI) slowed to 6.5% in December, with wage-sensitive services categories more contained. This allowed the Fed to slow the pace of its tightening cycle to 0.25% at its February FOMC meeting.1 The Fed continues to signal that the federal funds rate should reach a peak slightly above 5%, while markets expect rates to top out at around 4.9%.
A relatively warm winter in Europe has softened demand for natural gas and continues to temper energy prices. The relatively benign outlook for global energy prices continues to place downward pressure on global CPI, allowing central banks to take their foot off the throttle and slow the pace of monetary policy tightening.
Late in December, China released new guidelines to significantly relax Covid controls for domestic infections and inbound travellers, which took effect in early January. The reopening of China’s economy has already improved sentiment about Chinese growth this year. This move, combined with measures to support the property sector taken in late 2022, will likely bolster commodity prices and further buoy the commodity-exporting emerging markets.
Headline inflation peaked in July 2022 at 7.8%, falling to 7.2% in December. Looking forward, we see headline inflation averaging 5.4% in 2023 owing largely to declining petrol prices and a deceleration in food inflation. The South African Reserve Bank (SARB) was proactive in managing inflation over 2022. It started hiking rates early. At 7.25% currently, the repo rate reflects a more neutral policy setting (relative to expected inflation). With the inflation picture improving and many of the upside risks abating, we expect that we are close to the end of the SARB’s hiking cycle.
Figure 3: SA inflation and repo rate outlook
Source: Ninety One, Stats SA and Bloomberg, January 2023.
The growth outlook remains difficult with consumer sentiment slowing after a year of rate increases and high inflation. We remain optimistic about private investment in the energy sector on the back of structural reform underpinning our 1% GDP forecast for 2023. As we expect commodity prices to remain elevated, we see fiscal revenues performing well. This should allow National Treasury to further consolidate the debt burden over the coming year. The economy has shown remarkable resilience to the high levels of power outages in 2022. But with load-shedding set to continue, this undoubtably places a cap on sentiment and our potential growth.
Despite extreme volatility, the Ninety One Diversified Income Fund generated an attractive return over 2022, outperforming bonds and cash while avoiding any negative quarterly returns. We often talk about how the Fund tries to “participate and protect”, and this was very much a year to protect.
For most of the year we thought SA bonds were cheap, but not riskless. So our job was to find a way to own SA bonds, earning the attractive interest on offer, but in a way where we protected the portfolio from the many developing risks.
With global risks subsiding, local inflation likely to have peaked in the third quarter of 2022 and local political risks abating post the ANC elective conference, we are optimistic on bond market returns. Hefty income on the table, combined with dynamic portfolio construction, will continue to help protect capital against global monetary policy and growth volatility, and continued load-shedding locally. We remain overweight the 10-15 year sector of the curve relative to longer-dated bonds as valuations look most attractive in this space. These shorter-dated bonds should benefit further from a slowing or pause in the monetary policy cycle over the first half of the year. With yields on credit looking relatively less attractive given where government bond yields are, we remain underweight investment-grade credit in the portfolio. However, we continue to look for yield-enhancing opportunities in high-quality counterparties.
The portfolio’s currency exposure remains underweight, given dollar momentum waning and elevated terms of trade supporting the rand. Yields on offshore credit, however, look attractive. We hold a material exposure to high‑quality SA counterparties issuing in dollars, and US investment-grade credit. This portion of the portfolio yields 6.3% in US dollars.
Turning to listed property, balance sheets are in a healthier position post Covid and the sector is paying out dividends again. We marginally increased our exposure during the fourth quarter of 2022, further reducing our underweight. As we expect a slowdown in economic growth in response to global monetary policy tightening, we remain more constructive on the prospects for SA government bonds relative to listed property.
With inflation decelerating across the world, monetary policy cycles nearing an end, and China reopening its economy, we are constructive on the outlook for EMs. We hold a similar view on monetary policy locally, and combined with continued fiscal consolidation, we expect strong returns from SA fixed income assets in 2023.
1. FOMC refers to Federal Open Market Committee. Its members determine the direction of monetary policy in the United States – Investopedia.