Current context

Lately, the macroeconomic environment in South Africa has been relatively tricky to navigate. On the one side, we have falling inflation, which should be positive for the real disposable incomes of South African consumers. Lower food price inflation will relieve pressure on lower income earners in particular, given the higher weighting of food in average monthly household spend. Optimistically, we could expect this to spur consumption and demand - and therefore GDP. However, the other side of the coin is that South Africa entered a technical recession (two consecutive quarters of negative real GDP growth) at the end of the first quarter. This followed a protracted decline in the automotive, manufacturing and mining industries; all key sectors to economic growth in South Africa. As a result - and added to unemployment of 27.7% and low levels of credit extension - the average consumer will likely be unable to take advantage of falling prices.

This is the South Africa Reserve Bank’s dilemma, with it having held the repo rate at 7% since March 2017. Clouded by political and rating downgrade narratives, it’s also a question on most investors’ minds: should the repo rate be cut to support real GDP growth, or is it appropriate to remain at 7% to protect the rand? We believe that this uncertainty has kept money market rates elevated at attractive levels for our investors.

Our perspective

Core to our fixed income philosophy is that our investment process focuses on the information we have available, avoiding the tendency to forecast. While political and economic uncertainty remains entrenched in investors’ minds, our portfolio positioning reflects that we do not know how specific events will turn out, or what the subsequent market reaction will be. This drives the need to ensure we diversify the fund appropriately, and position it to benefit from a range of possible outcomes.

While we do believe that recent data point to lower inflation and steadier interest rates going forward, we are also aware that event risk is considered higher. We therefore believe that it is important to maintain a sufficient weighting in floating rate instruments (roughly 40% of the fund as at quarter end). This gives us comfort that we are positioned to take advantage of a potential turn in the interest rate cycle, but also have insurance against a sudden increase in interest rates.

Portfolio positioning

As mentioned in previous commentaries, we look to extend fund duration through a bigger position in fixed rate instruments. These instruments are expected to perform better over the near term, with the interest rate cycle largely understood to be at a peak of 7%. We have favoured the longer end of the negotiable certificate of deposit curve, as we believe that rates of greater than 8% for a one-year term are attractive, offering a potential real yield of more than 2%. Despite the shortage in issuance of commercial paper (corporate lending in the money market space), we have been able to add exposure where we have found mispricing in issuers we are comfortable with. The fund continues to have exposures diversified across the South African banks, with an allocation to treasury bills. This ensures that we are comfortable with overall fund liquidity.

Focus on the investment principles underlying our processes

The current macroeconomic environment presents a fluid political landscape, creating significant fear in the market. This is where we believe it is important as an investor to focus on the purpose of an investment in the fund. Specifically, the objective is to preserve capital while earning a steady income yield (ideally above inflation) and maintaining a high level of liquidity. This is where the year-on-year consistency of our investment process allows us to focus despite the noise, and exploit any opportunities which have arisen.

Why we still see value in the bank short-term funding curve

We believe interest rates in South Africa are still at high levels, relative to the prevailing economic fundamentals of lower growth and a likely sanguine outlook for headline inflation over the medium term. Without any significant surprises, we consider the pressure on the South African Reserve Bank (SARB) to continue hiking interest rates to be lower going
forward. As such, we believe there remains sufficient margin of safety in current money market rates as well as the opportunity to lock in real yields (yields above the long-term inflation rate of 6%) to achieve our clients’ investment objectives.

A key area where we have found significant value has been at the longer end of the negotiable certificate of deposit (NCD) curve. As a reminder, these rates are offered by South African banks for wholesale investors as a funding source for the banks, and are highly tradable instruments. We are currently able to purchase 6-month instruments at rates above 7.9% and 1-year instruments at close to 8.5%, i.e. at a buffer above the current repo rate of 7.0%. These are considered very attractive rates with real yields ranging from 2.0% to 2.5%. While it is currently noisy in the market, this in our opinion presents a sufficient buffer, should interest rates surprise on the upside.

How we are positioned

The fund has a significant holding in fixed rate NCDs across the major South African banks, but continue to hold a mix of floating-rate instruments for further diversification. Given the high level of tradability in NCDs, we are comfortable with the overall level of liquidity in the fund, an aspect which adds to the overall investor margin of safety. We will continue to
look for mispriced corporate credit which meets our investment hurdles. These attractive opportunities usually present themselves if you can remain calm and focus on the investment objective, while other market participants are fearful.

2016 was a reminder of the risks of forecasting in financial market

2016 can best be described as driven by negative sentiment relating to heightened political uncertainty (locally and abroad). Globally, there has been a sharp focus on the potential unwinding of low (to negative) global yields, and the impact this would have on emerging markets. Our local rates were impacted by the significant surprises of Brexit and a Trump presidential victory in the US. Against a backdrop of questions around the strength of the South African economy, independence of National Treasury and fears of a downgrade to below investment grade credit rating, local interest rates were higher for much of the year.

At the outset of the year, amidst political fears, it was difficult to ignore the negative sentiment which gripped local markets. Forecasters and market pundits painted a grim outlook for the year and it would have been very hard to find an economist or any conversation suggesting positives for the future of the South African economy. It was widely predicted that we would again replace our finance minister (Minister Pravin Gordhan), be unable to produce a credible fiscal budget and would face an imminent downgrade to below investment grade. The rand was predicted to spike to R20/$, inflation to rise sharply above the 6% target and the South Africa Reserve Bank (SARB) to be forced to hike interest rates significantly - a very unfriendly environment for local fixed income markets.

At the time of writing, this picture appears to be unfolding very differently. The rand/$ exchange rate instead of weakening, had strengthened 12% over the 2016 year and inflation expectations have significantly reduced as food inflation worked itself out of the system. The market is now starting to look towards inflation falling below the 6% target of the SARB. South Africa, albeit it in a fluid situation, has managed to avoid a downgrade to below investment grade status, whilst ensuring the independence of National Treasury. This year has therefore taught lessons about the risk of forecasting based on binary events, and the implications of positioning portfolios for a one-sided outcome.

Opportunities were presented through focused and fundamental research

As an investor in money markets, the fruition of the above forecast would have resulted in significant losses for investors. It was therefore more important than ever to remain focused on the fundamental drivers of local rates, specifically the outlook for inflation. This allowed us to see the opportunity presented in the NCD (Negotiable Certificate of Deposit) market, a compelling opportunity for the Money Market fund where we have been able to take advantage of the negative sentiment and forecasts of excessive inflation. With rating agency decisions scheduled for December 2016, NCD rates remained elevated throughout the year, offering in excess of 2% real yields at current headline inflation of 6.6% (November 2016).

While we believe that certain risks mentioned above still remain, we prefer not to focus on predicting the outcomes of rating agencies and political events, instead focusing our attention on better understanding the pressures on inflation and growth into 2017. We therefore look to position the portfolio for a range of outcomes, but towards a greater position in fixed rate exposure (this would benefit investors should inflation expectations normalize). Headline inflation pressures eased with a stronger rand, improved wage negotiations and lower food inflation expected going forward. There is reasonable basis to believe that inflation should be more comfortable for the SARB going into 2017, a very positive outcome with real yields in excess of 2% already locked in for our investors looking for real income growth capital preservation over the short term.