World Economic Outlook

Bond Markets

When assessing bond markets, it is important to make the distinction between government (safest) and corporate/high yield (riskier). As their opposing risk characteristics suggest, one should be cheap, the other shouldn’t, but in the current abnormal environment that isn’t the case – they both appear expensive. The reason for this is fairly simple; risk free interest rates are as good as zero or indeed increasingly turning negative and if central banks keep manipulating yields lower surely that’s an almost riskless trade investors want to be part of? Well, the answer was a firm yes in 2020 but looking forward we have our reservations concerning the sustainability of both government yields and corporate credit spreads to remain at such low and outright expensive levels. It would be fair to say we are more concerned with the very low level of perceived safe-haven government yields than we are with narrow corporate spreads, although even the latter now seems somewhat out of sync with economic reality. Central banks have become the biggest buyers of their own bonds, by far, thanks to quantitative easing and this has been a key factor in driving yields to abnormally low levels.

The result is that we now have many bond markets trading as pure ‘capital’ plays with little, and quite often negative, yield protection. Consequently, the smallest move in yields can equate to large capital swings and the danger here is that it has (almost) been a one-way street in recent years and the onset of the pandemic has only served to drive yields even lower. Sure, in a low growth and inflation environment this can continue for a while longer, but if either surprise on the upside there could be a rush for the exit door. Investment grade and high yield corporate debt is perhaps a little easier to understand as the ongoing global ‘search for yield’ has found itself with increasingly fewer places to look and these markets tap into that desire. However, participation in crowded trades can often blind investors to the fundamentals and therefore one should never forget to ask ‘am I being paid for the risk?’. We don’t believe corporate bond markets are yet pushing the risk/return boundaries but there is no doubt that the asset class is on the expensive side and as such dissuading us from aggressively adding to current weightings.

US Election

It is now official - Joe Biden will be inaugurated as the 46th president of the United States on January the 20th with the Democrats controlling both the White House and Congress for the first time since the first half of President Obama’s first term. This will open the door for additional fiscal stimulus and provide an underpin to the growth outlook in the US. President Trump’s desperate attempt to upset the voting process turned out in absolute mayhem in Washington DC as some of his most staunch supporters stormed and broke into the Capitol building - indeed a very unfortunate event that will surely one day be recorded in the history journals.

In Biden’s latest speech, he said it’s “time to turn the page” after his election victory was confirmed. A clear affirmation that despite the domestic political turmoil and divisions inside the US, Biden is first and foremost a pragmatist. After 48 years in government, since he was first elected to the US Senate for the state of Delaware, his campaign and administration will expectedly focus on themes of unification, bipartisanship and his ability to collaborate with moderate Republicans; moderates form most of the Republican representation in the Senate.

Biden is expected to focus on key legislation, such as infrastructure, environment, green energy, and improvements to the Affordable Healthcare Act (Obamacare).

What we as investors will concentrate our minds upon is the Biden initiative to rejoin the Paris Climate Agreement, thus committing to cut US greenhouse gases by up to 25% by 2025. This is highly positive for investment and companies embracing environmental, social and governance initiatives so our Melville Douglas philosophy of allocating only to companies that can display strong corporate and social disciplines look well positioned. Additionally, appointing Pete Buttigieg to transport secretary is a clear indication of the want for a sweeping infrastructure bill that will increase the potential for cyclical companies to progress as the 2021 economic recovery takes hold. Biden’s values of multilateralism and engagement on the world’s stage has not changed so a reversal of Trump’s isolationist view is very much on the cards. Reaching out to NATO allies to repair divisions will allow the formation of international coalitions centered around democracy to fight China’s trade practices, instead of the current combative unilateral trade tariffs. One should also not disregard the enthusiasm that the new President will bring to healthcare and cancer research given that Biden’s son Bo died of cancer in 2015.

Finally, many of us have grown accustomed to hearing the President’s thoughts and feelings broadcast to his 60 million Twitter followers; an insight into a President’s mind we have not previously been privileged to. Biden’s decisions will be behind closed doors for the most part. On a positive note – we no longer need worry about Presidential ‘tweets’ that can alarmingly move financial markets on a whim!

Signs That Reforms Are Gathering Momentum.

Structural reforms are slowly being implemented. More companies can generate electricity for own consumption, significant capital has been invested in alternative and more environmentally friendly sources of electricity such as solar and wind, while high profile arrests within the public sector provide hope that government is serious about eradicating the corruption which has become so ingrained in the system and plagued the economy for years.

The misallocation of taxpayers’ money has been very costly and an improvement on this front will hopefully pave the way for improved service delivery and ultimately economic prosperity for all, something that is desperately needed in an economy that has not been able to grow GDP per capita over the last 5 to 6 years. Government’s recent victory over public sector wage increases for 2020/2021 also provides hope that there exists enough political will within government ranks to follow through on fiscal consolidation. This will please ratings agencies and bond investors alike, especially after the recent downgrades to the country’s credit rating. Of course, much more change is still required to sustainably lift South Africa’s growth trajectory and deal with the country’s massive unemployment and social challenges. The reality is that it will take time and a concerted effort from all stakeholders in the economy, as well as a much closer working relationship between government departments and the private sector.

Domestic Asset Allocation

by Bernard Drotschie / Chief Investment Officer

Please note that changes were made to the equity benchmarks for global mandates which became effective on 1 January 2021. We have reduced the benchmark’s equity allocation to domestic listed companies in favour of their offshore counterparts which will now contribute approximately 40% of the equity benchmark. The primary reasons for these changes were the much larger opportunity set that is available for investors offshore and the diversification benefits of allocating a greater component of one’s investments to companies and sectors that domestic investors do not have access to on the local bourse, which has also reduced in size. The asset allocation discussion below is in relation to the new benchmarks.

Domestic Equities – Overweight. Expected returns from both a bottom up and a top down perspective remain attractive with double digit returns expected this year. This is a function of attractive valuations and a rebound in earnings from depressed levels which will further be supported by an improving global backdrop. Any tangible signs of reforms in South Africa or an improvement in the domestic growth outlook will unlock significant value for investors. A return to dividend payments by many domestic companies will also be welcomed as cash earnings improve.

Offshore Equities – Underweight. Although we expect positive returns from offshore equities over the next 12 months, we find domestic equities at current valuations more attractive. Elevated absolute valuations in offshore listed equities are however expected to be supported by very low interest rates in developed markets. Strong and positive earnings growth will continue to underpin returns but this should to some extent be hampered by the fairly rich starting valuations. In other words, a de-rating in valuations is our base case.

Domestic Fixed Income – Neutral. Income yields are attractive relative to cash and long term expected inflation, but we expect that returns from current levels will predominantly be derived from income (coupon). A deteriorating fiscus does pose some upside risk to yields (lower prices) in the medium term and the recent credit downgrades by Moody’s and Fitch have brought South Africa’s sovereign rating only one downgrade away from being rated speculative. While developed market bonds continue to trade at historically low yields, we would expect South African bonds to be well supported by an improving global backdrop, which could result in foreigners returning to our bond markets in search for yield.

Cash – Underweight. Current interest rates are unattractive.

Offshore Fixed Income – Underweight. With more than a third of global bonds trading at negative income yields, we find the asset class very unattractive in both absolute and inflation adjusted terms.

Domestic Equity

by Paolo Senatore / Head: Domestic Equity Strategy

Domestic Fixed Income

by Mzimasi Mabece / Head of Fixed Income

What a year 2020 has been! South Africa being part of this global universe was not spared the rout that befell global financial markets and economic decimation brought about by the onset of the corona virus pandemic. As a consequence of the pandemic, authorities had to respond with the South African Reserve Bank (SARB) being first off the blocks and in the course of 2020 reduced interest rates by a cumulative 300 basis points. The government, in its response to the pandemic, placed the country in a lock down under the strictest restrictions that confined citizens to their homes and virtually ground the economy to a halt in the first half of the year.

Given the SARB’s aggressive cuts in interest rates during the year, we believe that the interest rate cutting cycle has bottomed. However, given the sluggish economy, we believe that price pressures will remain subdued and as such inflation is likely to remain below the 4.5% long term target that the central bank would like to anchor inflation at and as such the SARB is under no pressure to tighten monetary policy.

The Medium-Term Budget Policy Statement (MTBPS) is always the focus in the fourth quarter and last year was no different. In the afternoon of Wednesday 28 October 2020, the Minister of Finance Mr. Tito Mboweni stood in parliament and delivered to the nation his much[1]anticipated Medium-Term Budget Policy Statement. The Minister in his address laid bare the extent of the deterioration in the country’s fiscal position. The South African Government borrows R2.2 billion per day with the national debt exceeding R4 trillion. To put this into perspective, public debt is four times bigger than the national budget and this debt trajectory is unsustainable and cannot continue unabated. What became evident from the MTBPS are the following:

/ The expected cost containment and expenditure reduction is hinged on a public wage freeze and therein lies the greatest implementation risk as public sector unions will fight tooth and nail against this proposal.

/ Debt is expected to stabilise both higher and later than previously envisaged. However, the market expected disappointment in this area as the active scenario, which predicted a peak of 87%, was viewed skeptically from the beginning. The debt stabilisation path proposed in this statement may be viewed as more realistic and achievable and this should anchor the domestic bonds and currency markets.

/ The MTBPS did not go far enough to please left leaning interests who are arguing for the government to spend its way out of trouble nor was it pleasing to conservative economists whose counter argument is for an austerity path out of our problems. In our view the Minister of Finance danced dangerously close to the cliff but managed to chart a realistic path out of our problems with political boldness required to achieve that recovery path.

We believe that as yields on developed market bonds begin to normalise to higher levels and South Africa’s fiscal position deteriorates, the domestic bond yield curve will continue to steepen. Given the above and our view that funding risks will continue to be expressed at the long end of the curve (higher yields), we prefer to be positioned along the shorter end of the yield curve where capital risk is more contained.

Domestic Market Performance % / as at December 2020