LYLE SANKAR: Fixed-income investors should review strategy as market shifts

Conditions have changed substantially over the past 18 months and we believe the weight of the evidence suggests that the market has probably reached an inflection point. The probability has shifted towards a more reflationary global backdrop, which the market is not yet pricing in. This is likely to have wide implications when considering asset classes that performed well over the past decade, and those that can be expected to deliver real returns at appropriate levels of risk over the next decade. Accordingly, fixed income investors need to review their strategy and explore the benefits of multi-asset income funds for generating real returns at low levels of risk.

It is useful to reflect on history, and how it has shaped investment portfolio construction choices until now. Inflation has been on a steady downward trend in the US, averaging about 4% since the 1970s. However, despite significant monetary policy stimulus by the Federal Reserve after the global financial crisis (GFC), the inflation rate has disappointed, only averaging 1.87% over the past decade (as at August 2021). Considering this, it is understandable that investors have become accustomed to persistently low inflation and interest rates in developed markets, having benefited from steadily falling bond yields and the rise in prices of stocks that have high growth expectations, and long-term cash flow payback profiles.

Contrast this to SA’s inflation-targeting journey. Since inflation targeting was implemented in the early 2000s, inflation has averaged almost 6%. Measured monthly, inflation has been above 6% about 46% of the time — proving that it has been very hard for the Reserve Bank to steady inflation until recently. For markets, this volatility around targets made it difficult to determine the appropriate premium above expected inflation for investing in long-dated bonds. Over the past decade the Bank has credibly managed to reduce the average inflation rate to 5% and the volatility of inflation. It has been clear how hard it has been for market participants to adjust expectations lower from 6%, despite a very credible Bank showing commitment to achieving a lower inflation outlook.

Developed market fiscal and monetary policy has changed dramatically over the past 18 months, particularly in the US. The Covid-19 crisis showed governments that they could run much higher budget deficits than historically considered prudent alongside extremely accommodative monetary policy. Current and projected fiscal spending at levels previously only seen in wartime, is now considered acceptable policy.

In SA, inflation is likely to remain subdued and within the target band with the usual factors (electricity, wages and food prices inflation) unlikely at present to force the Bank into hiking rates quickly. Further, with low demand resulting in lower imported inflation pressures (through a weak rand), it is also likely that inflation will be less volatile around the 4.5% midpoint of the Bank’s target. Lower volatility is typically good for bond investors.

Consequently, considering the evidence on the likely path of the macroeconomic environment in years ahead — the probability has grown that the investment landscape is unlike what markets have been used to, being low inflation in the developed world and high inflation in SA.

Low and stable inflation is good for the general health of the economy providing stability for businesses on input costs and cost of funding, and is supportive in general of real growth as it allows for lower and narrower moves in interest rates. Commodities make up a large share of SA’s exports and has provided much-needed support for SA’s high debt levels. In a reflationary developed world, SA would continue to benefit directly, as well as through second round effects, from greater spend in SA. Valuations imply an extremely low probability of positive economic surprises in SA continuing for a longer period. Forecasts for real GDP growth next year are potentially too low, reverting to what we have been used to for years. This is not inconsistent with this year in which expectations have been significantly below outcomes.

For income investors this implies the following:

• Investments into cash, money markets and other shorter-dated (low duration) instruments will continue to generate low yields for a sustained period.
• Investors should consider longer-dated bond yields that offer attractive real yields and stand to benefit from the shift in macroeconomic conditions, off very low expectations.

Expecting a quick return to a repo rate of 7%, as in 2018, appears less likely with comfortable inflation at present.

We see government bonds offering value both in a subdued SA inflation environment and yielding a sufficient margin of safety to offset potential inflation shocks. These bonds offer real yields above 3% at the five-year point, and more than 5% real yields from the 10-year bond onwards, potentially without the historic inflation volatility ahead. This is extremely attractive for income investors and we believe government bonds will be a vital tool for generating real yields where shorter-duration assets could underperform. We do not believe SA is likely to experience a debt trap in the near term and therefore these valuations are deemed very cheap (yields are too high) relative to our expectations of inflation and a less extreme fiscal path.

We believe that these shifts in the macroeconomic environment are significant and are likely to alter risk-return outcomes, and therefore necessitate serious consideration of asset class allocations within a fixed income portfolio. While we believe a higher-than-average duration is appropriate, an investor need not be all-in by investing only in the longest and highest-yielding bonds, with sufficient risk-adjusted opportunities across the government bond curve.

• Sankar is Fund Manager at PSG Asset Management