In light of the weakness across most global financial markets – and our own – in January, as well as the SA Reserve Bank’s surprise interest rate hike on 29 January, we thought it important to share with you our views on these developments and the approach we are taking in managing our client portfolios.
In summary, although the SARB rate hike was a surprise, our three-year view has not changed: we still believe South Africa will experience lower rates for longer, compared to the period before the global financial crisis. As a result, we are maintaining our portfolio positioning as it was before the rate hike.
First of all, although the SARB’s rate hike did take the market by surprise, in that it came much sooner than everyone had expected, it was still in line with our view that SA interest rates would be gradually increasing over the next two to three years, in line with the gradual normalisation of interest rates around the world. In raising the repo rate by 50 basis points (bps), SARB Governor Gill Marcus has acted to try to keep inflation expectations anchored within the Bank’s 4%-6% inflation target band, having seen that their inflation forecasts had worsened significantly as a result of the sharply weaker rand exchange rate.
The acceleration in rand weakness in January can be attributed to a number of factors, including contagion from wider emerging market asset sales that have arisen from deteriorating conditions in Turkey, Argentina, India and Brazil (among others). On top of this, US Federal Reserve tapering of its supportive monetary policy has led investors to switch out of riskier emerging market investments back to US assets in anticipation of higher US interest rates. Some emerging market weakness and volatility was expected (and is likely to continue) as a result of the Fed’s policy shift, since it can be seen as the start of a return by investors to “more normal” risk appetite levels after years of zero interest rate policy in developed countries.
Despite the SARB’s pre-emptive rate move and unexpected rand depreciation, we have not changed our medium-term (three-year) view: that South Africa will still likely experience a rising interest rate cycle that is shallower and more gradual than previous cycles, so that our interest rates should stay lower for longer.
As we’ve said previously, global growth rates on average are likely to stay below trend over this time, given the lingering impact of the financial crisis on developed markets and slower growth in emerging markets. The result: interest rates and average real rates of return on cash and fixed income assets will be lower than those seen before the financial crisis. We are very sceptical that South Africa will experience a rapid rise in interest rates in 2014 (given the sluggish economy, high unemployment and large output gap), although the market (looking at current FRA rates) appears to think so, currently expecting another 50bp hike in three months’ time and continuing apace thereafter to reach 8% by the end of 2015.
ASSET CLASS VIEWS
On a broad investment view over the next three years, we are confident that our positioning and individual holdings in our real return (inflation-targeted) and balanced mandates are such that our portfolios will continue to deliver real returns above cash. Cash will still deliver very low real returns over the next 2-3 years. However, as mentioned above, bond returns will remain under some pressure from global conditions in the short term, so those investors concerned about returns over the next six to 12 months would be best placed in cash or near-cash assets.
Looking at bonds generally, our positioning overweight long-dated nominal bonds across our funds has helped insulate them to a certain extent from the sharp selling of SA bonds sparked by the SARB’s rate hike, and should also cushion losses going forward. We saw medium-dated bonds (2-15 years) lose the most ground, while those under 2-years and above 15-years were less hard-hit. As a consequence, although the ALBI was down 3.2% in January, our more conservative Enhanced Income Fund produced a total return of -0.8%, while our Inflation Plus Fund returned -1.6%. Following January’s bond sell-off, bonds are now priced to deliver a real (above inflation) return of approximately 3% per annum on a three-year view, with longer dated bonds likely to do better than this.
SA Corporate Credit/ILBs
Despite some weakness in corporate bonds on the back of foreign selling in January, we remain overweight these assets given the relatively attractive yields on offer. Inflation-linked bond (ILB) yields rose following the SARB’s rate hike, in step with the rise in real cash rates. We still view these as somewhat expensive, building in very high inflation expectations, whereas in our view the rise in inflation is likely to be temporary in nature given the sizeable output gap in South Africa.
Listed property was also dented by the rate hike, as rising bond yields impact negatively on property assets. The listed property sector returned -7.1% in January. We remain broadly neutral on this asset class in our portfolios. The universe of SA REITs currently offers a relatively attractive forward distribution yield of 8.2%, and combined with expected robust distribution growth, is priced to deliver a real return of over 5% per year under our lower-for-longer rates scenario. This makes it likely to outperform both cash and bonds over the medium term.
Local equities were also hit in January by broader emerging market selling amid a general global correction in equity markets following last year’s strong gains. The FTSE/JSE All Share Index lost 2.4% in January, with the SARB rate hike seen as generally negative for equities given its drag on economic growth, the higher cost of capital and investing, and higher costs for indebted consumers. We remain neutral on local equities, with current valuations now more attractive. South African equities are still priced to deliver a real return of around 7% per year on a three-year view.
Prices of most offshore assets, both equities and bonds, fell in January, making them more attractive on a valuation basis. Emerging market equities look particularly attractive now, although sentiment is still very negative on these markets as investors worry about longer-term growth prospects. In rand terms, rand depreciation over the period has offset losses in funds holding these assets. We remain overweight offshore equities, and our holdings of global high yield bonds should continue to add attractive yield to our funds.
MULTI-ASSET PORTFOLIO VIEWS
Despite 2013 being a generally poor year for bond returns, the fund’s real returns outperformed cash by approximately 100bps after fees (and about 200bps before fees). We are confident that our overweight exposure to higher-yielding long bonds (20 years-plus term to maturity) will help cushion losses going forward as well. With about 50% of the fund invested in cash assets, the rise in interest rates should boost real returns from these assets going forward, and are still confident that the portfolio will continue to outperform cash on a real return basis over the next three years.
We believe our diversified mix of asset classes and our long bond positioning will mitigate possible bond weakness going forward. Losses in bond and equity holdings in January were partially offset by foreign holdings. Looking forward over the medium to long term, the sell-off in risk assets has resulted in improved real return prospects compared to those prevailing at the end of last year. We are still confident that, with a three-year view, the portfolio will outperform cash on a real return basis.
The higher equity holdings and offshore assets, combined with the relatively low bond holdings, should help cushion any losses from bond weakness over the medium-term.