Edition: February/April 2018
What do foreign investors see that we don’t?
For fiduciaries, the ongoing search for yield may be closer to h ome than you might think, says Melville du Plessis, fixed-interest portfolio manager at Sanlam Investment Management (SIM).
Investment decisions are frequently made in the face of uncertainty, in some instances more than others. Current times are no exception.
The global investment landscape is in constant flux due to geopolitical risk, radical technological change and heightened complexity. Locally too, fiduciaries and other allocators of capital have had to digest a series of rather unpalatable political events. This year alone we saw a surprise Cabinet reshuffle, the so-called continued ‘state capture’, release of a Mining Charter draft which was particularly punitive, and more recently the release of Budget policy statement which helped pushed credit-rating agencies further down the downgrade path.
Add to these the economy’s entry into a so-called ‘technical’ recession, an unemployment rate of close to 28%, more downgrades looming and little on the horizon to signal an economic lift-off or improvement in the fiscal budget anytime soon. It’s not surprising that SA investors have a less-than-rosy outlook on local assets. Cash is currently yielding a return of around 6% and historically has rendered returns between 5% and 12%. SA equity has historically given investors a wide range of returns between a staggering -38% and 70%.
Poor sentiment towards domestic assets stands in sharp contrast to foreign sentiment: despite all the uncertainty facing SA, during 2017 foreign investors have been grabbing the yields on offer from SA fixed-income assets. According to the Institute of International Finance, foreign inflows into emerging debt markets exceeded $100bn in the first half of 2017 and, according to Deutsche Bank, reached an all-time high above $700bn. SA received its fair share, with inflows totalling roughly R70 billion for the year.
So what do foreigners see that local investors don’t?
Search for yield offshore
Despite the uncertainties in SA, there is still value to be found in our local fixed-interest and credit markets. For many disgruntled SA investors, the desperate search for yield may have driven them offshore. But this begs the question: can SA investors still find fair value offshore?
The risks associated with exposure to low-yielding offshore debt are significant as investors are faced with the ‘double whammy’ of both the lower yields of the countries invested in and the deteriorating quality of the assets invested in. Nearly a decade of quantitative easing and asset purchase programmes have sent global bond yields to all-time lows (and consequently developed market bond prices sky high). The majority of remaining global bonds are simply not looking attractive.
Heading for a central bank bubble?
The world’s largest central bank, the US Fed, currently has more than $4,5tr on its balance sheet, made up primarily of bonds that it purchased in response to the global financial crisis. Its quantitative easing programme was originally designed to inject money into the economy and encourage risktaking, but there were a number of unintended consequences.
Massive expansion of central bank balance sheets and the US Fed’s zero interest-rate policy served to inflate the price of US government bonds, while keeping yields artificially low. The Fed’s balance sheet is now big enough to buy 10 of the largest companies on the S&P 500 (including Amazon, Apple and Exxon Mobil).
Interest rates are still at their lowest-ever levels and the concern is that these low interest-rate policies may also have spilled into other asset classes, leading to overinflated asset prices elsewhere. Undervalued assets offshore have become scarce.
Negative-yielding debt on the increase
It’s not only the size of governments’ debt but also the rise in negative-yielding debt that is so remarkable. Some debt instruments even carry negative interest rates. You actually have to pay someone to lend them money! During the past few years the amount of negative-yielding debt increased significantly with the total amount peaking at around $13tr during the second half of 2016 and currently still around $8tr. It’s a staggering amount.
Debt dynamics in the world are not on a sustainable path. How will central banks shrink their balance sheets and what will be the consequences of quantitative tightening?
Clearly, there are no simple capital-allocation decisions in today’s markets. And while everyone in SA may be in a hurry to send money offshore, positive real yields aren’t necessarily going to come from the same place. For investors looking to achieve a sustainable and relatively diversified yield, the answer might be close to home.
The good news
Unlike the US and the rest of the developed world, SA hasn’t seen yields move lower. In spite of the economic and political uncertainties, SA still offers good-quality credit plus a margin of safety. Investors are actually being compensated with a healthy premium for the level of risk taken (currently above 9% nominal yield for SA bonds). Real yields higher than 3% (as we currently have in SA) are extremely rare.
In fact, SA long bonds are still offering among the highest local currency real yields in emerging markets. Even if inflation settles at the top end of the 3% to 6% inflation target, a real return of 3% is still on offer from vanilla government bonds even before one starts investing across the more broader range of higher quality companies and credits where you also get an additional 1,5% to 2%. This is particularly attractive given the low real returns available in global bond and equity markets.
After the most recent S&P downgrade?
Bond yields are likely to rise further as investment-grade investors exit the domestic bond market. As yields rise, however, other bond investors could enter the market given the ongoing search for yield globally. With the yield on the ALBI currently touching 10%, an estimated through-the-cycle 4% real yield makes bonds look attractively priced.
From a tactical point of view, investors should consider taking on bond exposure following further downgrades. But sizing positions will matter considerably, also taking into account the uncertainty around the ANC’s elective conference, Nersa’s electricity tariff hike for Eskom and the National Budget to be tabled in February.
The SA government will always be able to service its own currency debt (as it’s in control of the money printing press). But there are risks. Inappropriate economic policies can manifest themselves in rising inflation, which could result in interest rate hikes.
SIM expects inflation to trend lower and trough below 5,0% in the first quarter of 2018 before picking up again. Upside risks stem from the potential for higher electricity tariffs this year, as well as unfavourable political outcomes which could lead to a weaker rand.
Fixed-income building blocks have an important role in helping investors preserve capital and generate a stable level of income or a more appropriate overall return and risk profile. These building blocks are valuable for institutional investors and allows them to sleep easier, knowing they don’t have direct exposure to the risks looming over global bonds.
SA fixed-income assets are still attractive within the global context of a low-yielding environment. Locally, we see real yields of between 2% and 3% on offer against a backdrop of declining inflation.