Risk assets have had a difficult year to date as financial conditions have begun to tighten. The US Federal Reserve (the Fed) has started reducing its $8.9 trillion balance sheet and has increased rates by 1.5% since March 2022. The narrative has shifted to a focus on inflation, with US headline inflation numbers recently coming in at 8.6%, a 40-year high%. Historically, in risk-off environments, US bonds have been the preferred safe-haven assets. We have, however, argued for some time that these bonds offer very little protection should inflation be higher than the 10-year (pre-covid) average of below 2% in the US.
We believe the biggest risk in global markets is viewing the most recent 10 years of low inflation and interest rates as the likely outcome going forward. The world has changed significantly since March 2020, inflation has returned and is likely to remain more persistent than in the past. Multiple factors underpin our view, but some key drivers include years of underinvestment in supply chains and key commodity supply. We believe this will sustain pricing pressures and contribute to elevated commodity prices. The US consumer currently has a strong balance sheet and is likely to continue spending, and banks are well positioned for credit extension having significantly deleveraged since the global financial crisis. Unemployment rates in the US job market remain low. It will be hard to predict where inflation will eventually settle as the Fed unwinds its balance sheet, and this is likely to keep yields higher for a prolonged period.
As inflation pressures have come to bear, however, we have seen markets adjust to the current realities. Year to date we have seen a rise in yields with the 10-year and 30-year bond yields moving in excess of 1.5% higher, delivering deeply negative returns which have been devastating for investors. This is a trend we expect to continue as yields continue to shift higher to reflect current inflationary pressures. Locally however, the SA bond market has held up quite well and in contrast to the US experience. We believe SA government bonds are likely to be one of the best performing asset classes in the years ahead on a risk adjusted basis.
South Africa has not been insulated from offshore inflation pressures, despite inflation trending downward for years. The South African Reserve Bank (SARB) has recently moved to catch up by increasing the repo rate by 0.5%. We are seeing broad-based economic revisions upwards with inflation expected to average above 6% this year. Income fund investors have been well rewarded in recent years with attractive yields that outpaced inflation. We have seen significant flows into the fixed income market as a result, with large sums of assets moving into corporate bonds and low duration fixed income assets. Looking forward, outpacing inflation is likely to be a harder task and investors need to be pay careful attention to what is included in portfolios.
We believe SA fixed income investors need to be careful, rather than fearful, of SA bonds. Risk perceptions around government bonds have been elevated for some time, contributing to elevated yields, especially at higher durations. Thus, SA investors have one of the cheapest government bond markets on our doorstep, offering some of the most attractive real yields globally. However, not all income fund strategies are equal, and investors should spend more time lifting the bonnet on where their capital is exposed. Corporate bonds still offer very poor compensation for credit (default) risk and low duration bonds, that carry interest rates linked to the repo rate, require the SARB to hike interest rates aggressively to beat inflation. While we agree that interest rate hikes are needed, the SARB typically doesn’t hike aggressively enough to get ahead of inflation − implying that it will be tough earning real returns in these areas of the market.
The 10-year government bond currently yields above 10% (more than 4% above inflation). This is very attractive considering cash rates are still under 5%. We also benefit from the enormous gift of inflation-linked government bonds offering positive real yields. For context, the local 10-year inflation linked bond yields close to 4%% above inflation (and will earn whatever the prevailing inflation-rate is), compared to the US 10-year yielding only 0.6% above US inflation.
While government bonds are no longer a non-consensual trade, we believe an above average allocation to duration is appropriate right now given the wide risk premiums on offer. We have invested in government bonds since 2016 following on “Nenegate”, taking a longer-term view on attractive yields. Over the period, we have seen numerous challenges, including continued political uncertainty, fiscal deterioration, unemployment and social unrest, corporate defaults and incidents of fraud, a state-owned enterprise (SOE) sector under immense strain and facing liquidity issues, as well as Covid-19. Despite the numerous challenges, investors have been handsomely rewarded. Since 2016, government bonds have earned an inflation-beating average annual return of 5.3% above inflation. We believe this can continue.
We believe income investors have a window of opportunity to get the best out of the yields on offer without having to take on excessive volatility. Investors should be focused on funds which gravitate towards more government bonds, including a substantial allocation to inflation-linked bonds, as opposed to corporate bond-heavy funds. In our view, multi-asset income funds offer value in this changing inflation environment with the ability to actively use interest rate risk (duration that comes with government bond investing), which will be valuable in the years of higher inflation ahead.