Current context
South African rates markets have delivered solid returns for the year to date. Investment markets generally continue to be event-driven, with trade wars and related global growth concerns driving rate cuts by the US Federal Reserve. This has led to a sharp downward move in US bond yields and, for the first time since 2007, an inversion of the US yield curve (with 2-year bonds trading at a higher yield than 10-year bonds) in August 2019. The clear indication from the US bond market is that US growth and inflation are expected to be lower going forward. Locally, after a disappointing first-quarter GDP decline of 3.1% and stable inflation, markets were pricing in rate cuts of 0.5% over the next six to twelve months in late June 2019. The South African Reserve Bank cut rates by 0.25% in July 2019. Despite a 3.1% rebound in GDP in the second quarter of the year, a further 0.25% cut is still being priced in by the markets. Over the past quarter, the rand weakened by 7.5% against the US dollar. While a weak currency has historically been a precursor to higher inflation and higher money market rates, this is no longer a foregone conclusion.

Our perspective
The extreme divergences we are currently seeing in the valuations of popular securities compared to those investors are shying away from are rare, and present risks as well as opportunities. Investors seeking a smoother ride by switching to cash or buying high-quality counters at any cost may find that this ‘fail safe’ proves to be the opposite over the longer term. Missing out on the gains from a market recovery can dramatically erode an investment outcome. Similarly, buying securities at lofty valuations underpinned by high growth expectations may result in losses if expectations prove to be unsustainable.

In contrast, areas in which valuations have been driven lower due to fear and uncertainty present the potential for mispricing. Where prices fall across the board – an entire sector or geography, for example – quality securities become available cheaply, along with the rest. Tainted by pessimism, their earnings potential is easily overlooked. While it may take time for the market to realise mispriced value, investors who can ride out the storm stand to generate outsized returns from such attractive entry points.

Portfolio positioning
Real yields in the local money market have been very attractive. The fund has therefore consistently had a bias for fixedrate paper. From highs of around 9.5%, five-year negotiable certificates of deposit (NCDs) are now yielding around 8.1%. The fund has therefore benefited from locking in the higher rates on offer earlier this year. Credit spreads have also continued to contract as market participants search for yield. We prefer to avoid tighter credit spreads in the commercial paper market and are comfortable that the fund holds assets with low credit risk. The fund remains highly liquid.

Current context
Negotiable certificate of deposit (NCD) rates fell over the quarter: 6-month NCDs are now yielding 7.63% (down 7.5 basis points) while 1-year rates are 8.10% (down 17.5 basis points). Inflation remains comfortably within the South African Reserve Bank’s (SARB’s) 3% to 6% target band, printing at 4.1% as at end February. The SARB expects inflation to average just below 5% for the period to 2021. However, growth continues to disappoint. The outlook from both the World Bank and the SARB is for a slow economic recovery locally, with the SARB expecting South Africa to reach 2% real GDP growth by 2021. The rand continues to be volatile over the short term, starting the quarter off at R14.35 to the US dollar and trading all the way down to R13.20 at the end of January, before ending March at R14.60.
Our perspective

As we have noted for some time, there is pervasive fear in certain parts of investment markets. In local fixed income, we are finding opportunities to earn attractive risk-adjusted returns.

The SARB continues to revise growth and inflation expectations downwards. Historically, such low inflation prints and growth expectations would likely have given rise to a rate cut. However, the SARB has kept the repurchase (repo) rate unchanged at 6.75% (equating to a real rate of over 2.50%), as it looks to anchor inflation closer to 4.50% (the middle of the target band) over the long term. The SARB’s view remains that without policy reform, interest rates alone cannot stimulate growth. For investors looking to protect capital and earn a steady income yield, the real rates currently on offer are very compelling.

Portfolio positioning
In December 2018, we noted increased exposure to RSA Treasury Bills, which were for a short period yielding above-NCD rates. This exposure has declined as treasury bill rates have fallen, generating attractive returns for the fund. The fund continues to buy on the longer end of the fixed NCD curve (6 and 12-month notes), where we see the most value.