MELVILLE DU PLESSIS: Fixed-income funds are on track for another bumper year

The outlook for global and local inflation as well as interest rates remains favourable and should continue to provide support to fixed-income funds, which have delivered exceptional returns lately.

The performance has been supported on the back of global and local interest rate increases pretty much across the board. Entering 2024, bond yields were at some of their highest levels since the early 2000s, with both floating-rate assets and fixed-rate bonds offering attractive yields.

As such, there are good reasons to suggest fixed-income funds will repeat some of the above-average returns seen over the past year. Yield levels remain high and offer a direct benefit to the aggregate fund-level outlooks.

The returns in 2023 were delivered despite record levels of financial market uncertainty, particularly in the fixed-interest markets. Market volatility remains high, and a disproportionate level of uncertainty is set to reign for the foreseeable future. But investors are being well compensated for this, with running yields across fixed-income portfolios exceptionally high, which would act as a tailwind going forward.

In our view, the current forward-looking return prospects considered in the context of the positioning of portfolios across the fixed-income offering remain extremely attractive.

This does not mean portfolios will be totally insulated from the potential economic, geopolitical and political risk events on the horizon. There are countless examples of these risks, including that half the world’s population will be affected by elections this year; the ongoing Hamas-Israel and Russia-Ukraine conflicts; the long-standing threat of US recession; and strained US-China relations.

To inform our future expectations for fixed-income securities we must consider offshore inflation and interest rates. Starting with the US as a proxy for global developed markets, it is worth noting that financial market analysts and economists have been forecasting a recession in that country over the past 12-18 months. Most expected a contraction over the third and fourth quarters of 2023. Instead, US GDP growth powered ahead, prompting the label “the most anticipated recession that never happened”.

Be warned though, the recession threat has not dissipated, nor uncertainty about whether US or global inflation has truly been whipped. The past two years have witnessed global interest rates increase at the fastest pace on record, starting from zero in the case of US dollar assets and even in negative territory in Europe and Japan.

The rapid increases have shone the spotlight on the importance of discount rates when it comes to the valuation of asset classes on the one hand, and dashed the “Tina” (there is no alternative) narrative on the other. Global investors can now finally generate more meaningful returns in something other than “risk-on” assets, enabling better allocation of capital to global cash and bonds for pretty much the first time in 14 years.

Granted, US equities had a strong 2023, but the bulk of market returns came in November and December and the total return was dominated by the so-called Magnificent Seven technology shares. Strip these shares out and the performance of the S&P 493 was somewhat lacklustre.

Overall, US financial markets will be dominated by two concerns in the coming year. First, whether US inflation is truly under control, giving the Fed the peace of mind to start cutting rates. And second, how wide the gap is between the rate cuts the US financial markets have priced in versus what the Fed actually delivers. The Fed says it will cut rates by 75 basis points in the coming year, but the market is pricing for more aggressive action.

Locally, the SA Reserve Bank’s monetary policy committee was expected to adopt a hawkish stance going into 2024, though is likely to delay interest rate cuts until after the Fed acts. This is despite a fairly benign inflation outlook, with the December 2023 print of 5.1% nicely within the Bank’s 3%-6% target range. On Wednesday, the Bank left interest rates unchanged, but hinted at cuts later in the year.

Currency exposure

The rand has been volatile against the dollar of late and enters 2024 at a deep discount to fair value on a purchasing price parity basis. The Sanlam Investment Management fixed-income team is not banking on a short-term rand recovery, and believes it is appropriate to hedge its foreign currency exposure accordingly.

The yield curve on SA nominal bonds remains incredibly steep, offering significant “pickup” from moving further out on the nominal bond curve. It is also worth noting that SA government bond yields are trading at exceptionally high levels relative to US treasuries while SA cash rates are not as high, relatively speaking.

This implies that an attractive overall portfolio outcome can be achieved by taking advantage of higher offshore cash rates, and offsetting that with local duration-carrying bond exposure. Overall, bonds remain more attractive than cash, with double-digit yields still on offer in the “belly” of our nominal bond curve.

SA equities appear cheap too, with our local equity market having looked this cheap only a handful of times so far this century. This contrasts interestingly with the local credit market, which, despite looking quite strong from a fundamental perspective, is pricing on the expensive side given the strong demand for paper from the local investor base. Demand for assets in this space outstrip supply, and selectiveness is key when aiming to take advantage of any opportunities if and when they arise.

As we near the end of the first quarter of 2024 we can confidently say that we have rarely had such a constructive outlook, despite the prevailing uncertainties and risks. Investors in the local fixed-income space should not take for granted that SA has some of the better forward-looking return prospects on the table. Indeed, some of the valuations and opportunities have not been seen in decades.

There are no guarantees and no free lunches, it is often said, so caution and a close eye on the risks are key. We believe ultimately investors are being well compensated for the underlying fundamentals, and a constructive approach is warranted.

• Du Plessis is portfolio manager at Sanlam Investment Management Fixed Income Funds.