MALCOLM CHARLES AND ADAM FURLAN: Storm clouds start to clear in fixed-income markets

It has been a tumultuous 18 months for fixed income, and SA fixed income certainly did not escape the broader bear market. Driving this was a combination of stubbornly rising inflation, aggressive monetary policy tightening and souring sentiment among investors — all coupled with some home-grown challenges.

Though 2023 began on a positive note, market sentiment subsequently soured as a combination of resilient economic data in Europe, robust US labour market data and stubborn core inflation in the US caused investors to anticipate tighter monetary policy. Rates volatility remained for the rest of the period, not helped by negative headlines from the banking sector in the US and Europe, and concerns about US debt ceiling negotiations.

Against this backdrop the SA rates market came under pressure, and the rand suffered as a result of a strengthening US dollar and heightened geopolitical tensions relating to allegations about links with Russia and concern about the possibility of Russian President Vladimir Putin visiting SA. Another headwind was the move by the Financial Action Task Force to greylist the country earlier in the year.

Fortunately, there have been recent signs of storm clouds beginning to clear. Though by no means a case of uninterrupted sunshine, the risk of unexpected showers has diminished, for a variety of reasons.

First, inflation. After proving stubbornly sticky, inflation in SA seems to have finally peaked, allowing the SA Reserve Bank to pause its hiking cycle. We believe inflation will continue to fall and remain within the Bank’s 3%-6% target band in the second half of the year.

The Federal Reserve (Fed) may not be far behind. July saw the Fed raise the target range for the federal funds rate by 25 basis points, in line with the consensus, bringing borrowing costs to their highest levels since 2001. However, the tone from the central bank was less hawkish, causing investors to speculate that the end of the hiking cycle could be near.

Support for this theme came in the form of softer inflation prints for June, with headline (3.0% vs 4.1%) and core (4.8% vs 5.3%) inflation printing lower month on month, tracking closer to the Fed’s 2.0% target. In July US headline inflation rose slightly to 3.2%, while core inflation decelerated to 4.7%. The increase in the headline figure was a result of base effects and was below market expectations — further bolstering speculations of a pause at the next Federal Open Market Committee (FOMC) meeting.

In a further positive shift, recent economic data fuelled increasing optimism that the Fed could bring inflation under control without driving the US economy into recession. Other positive dynamics for the global economy include the recent pledge of support by officials in China to lift the country’s economy and support the struggling property sector, though concrete measures of support have so far disappointed market participants.

With the prospect of interest rates stabilising and economic growth more resilient than expected, we expect global investors to become more comfortable investing in emerging markets again.

Domestically, there are encouraging signs of a turnaround at Eskom, which should help draw a line under the load-shedding that has weighed so heavily on the economy. Though it’s still early days, the state-owned power utility continues to receive much-needed help from private sector investment. In addition to the improving energy sector backdrop, geopolitical risks receded after SA clarified its neutral stance on the Russia/Ukraine war.

Risks

Despite the various improvements to the macro environment, there are still risks facing fixed income markets. In SA, fixed income is particularly sensitive to volatility in developed markets, especially monetary policy adjustments by the US Federal Reserve. In addition, fiscal challenges relating to lower commodity prices and ongoing load-shedding could make fiscal consolidation challenging.

Despite these headwinds, investors are being more than adequately compensated for the associated risks. The 10-year SA government bond now yields in excess of 10% — well above inflation and cash.

The high yields on local government bonds bode well for the fixed-income return outlook, with income being an important driver of rates market returns. Our portfolio positioning is constructive, and we have added some risk by adding duration and increasing exposure to listed property.

We have concentrated our buying activity in the belly and long end of the curve and remain underweight the ultra-long end of the curve as a hedge against the deteriorating fiscal picture. We have also maintained some exposure to inflation-linked bonds as a hedge against rand weakness.

• The authors are portfolio managers at Ninety One.