Lara Dalmeyer of Abax Investments, the managers of the Nedgroup Investments Opportunity Fund, provides an overview of the Fund’s performance for the last quarter and how it is positioned going forward.
The Fund is a multi-asset flexible income fund that looks to outperform 110% of STeFI with a focus on capital preservation over rolling 6-months. The last quarter was definitely one of the most difficult that we’ve experienced and was one of the first drawdowns over any 3-month period for the Fund since its inception in April 2004. Given how fixed income securities across the board responded to the market correction in March, this was not unexpected and we managed to claw back those returns nicely in Q2, posting a Q2 performance of 3.94% compared to the benchmark performance of 1.23%.
Q2 has seen the global and local markets rebound from the lows of Q1, where local bond yields were hit hard with the local 10-year trading as high as 13.4%. Q2 saw local government bonds rebound back to pre-COVID levels. Our R2030 allocation was a nice contributor to our Q2 returns. Our allocation to inflation-linked bonds, which we are currently building, our floating rate assets (34.4%) as well as our small allocation to property (1.6%) and preference shares (2.4%) were all contributing factors to the return over the last quarter.
Asset classes worldwide rallied in Q2 and the local market was no exception. Property was up 18.7%, preference shares were up 13%, the ALBI was up 10% and inflation-linked bonds up close to 18% for the quarter. The Rand strengthened on back of a recovery to global investor sentiment, although it is probably the one asset class that is still lagging pre-COVID levels.
The global outlook
Developed markets are essentially no longer offering any yield. Global central banks have, in response to the pandemic, provided unprecedented support in terms of monetary policy with the Fed taking the lead cutting interest rates to practically zero (negative in real terms) and engaging in quantitative easing (QE) like we’ve never seen before. The Fed has purchased about $1.7 trillion of treasuries, promised to buy up to $750 billion in corporate bonds and $500 billion support in municipal and local government bonds. They’ve provided liquidity support to money market funds, commercial paper markets and opened swap lines with central banks around the world. Pre-COVID, the Fed’s balance sheet was at $4.2 trillion and is now just over $7 trillion. While we’ve seen signs of economic recovery, the signs are mild. The rally in asset prices was certainly attributable to central bank policy and not to the fundamentals of the economy or corporates.
While this kind of monetary policy and level of liquidity injection affects the market’s ability to allocate capital efficiently, you are at risk of creating zombie markets where investors believe that it’s a win-win situation where either fundamentals improve and asset prices will run or central banks are there to support asset prices as they continue to run. Another potential consequence is the impact on currency values. Will the value of the Dollar hold and will all the monetary easing eventually be inflationary? What we can say for sure is that the risks around inflation and a weaker Dollar have increased, which has global ramifications.
QE is never a good strategy for emerging markets (EMs) as investors generally lose faith in the value of the currency as EMs attempt to devalue their debt by inflating it away. Although it was never a standard policy for EMs, this crisis has allowed them to perform QE and the market hasn’t seemed to mind. They’ve also cut interest rates to levels we wouldn’t think is prudent.
Since January, the South African Central Bank (SARB) has cut interest rates from 6.5% to 3.75%. This was prompted by the lowering of global rates by various central banks and the subdued inflation that we’ve seen as a result of the pandemic. The moves have been rapid and aggressive , but this stimulus was necessary given just how depressed our economic activity is. The SARB and Treasury GDP estimates for 2020 are around -7%, while others predict levels closer to -9% or -10%. The market believes that the central bank will cut interest rate by another 25bps to 50bps. Rates also need to stay sufficiently high to keep capital in South Africa and to compensate investors for keeping their capital here. Should the compensation rate become too low, it would certainly make the Rand vulnerable in terms of capital flight. We believe they will be prudent and rather move in smaller steps from here on.
While our Repo rate is low, there is still yield in South Africa. There is, however, a massive discrepancy between our 10-year yield and the Repo rate, which implies that the South African yield curves is one of the steepest in the world. This is because investors in South Africa are pricing in a significantly higher sovereign risk. The creditworthiness of South Africa has come into question over the last few years and the longer end debt has increased substantially. Another factor is the issuance of these bonds whose prices have gone down significantly because the market has been flooded. In April 2019, R3.3 billion of bonds were being issued each week. In March 2020, that increased to R4.5 billion and today is at R6.6 billion. Naturally, our longer end yields aren’t following this decrease in the lower end interest rates.
Solvency risks in South Africa have never been higher. In February, the debt outlook for the 2020/1 fiscal year was 6.8%, which has been adjusted to 15.5%. Our debt-to-GDP ratio for the current fiscal year is now 82%. If you add the government guaranteed SOE debt, this ratio increases to 87%. If you add all SOE debt, our ratio is higher than 100%. These levels are completely unsustainable, especially given that 22% of our budget is allocated to servicing this debt. The revenue shortfall is around R300 billion and will need to implement some very serious reforms in order to avoid a debt trap.
Inflation-linked bonds are attractive
Where we do see value, and have been adding exposure, is in inflation linkers, which we’re able to add at yields close to 4%. We’ve added the I2025’s, which expire in January 2025 so we’re still on the shorter end of the curve and were able to pick them up at close to 4%. Should inflation return to 4.5%, we’ll generate an 8.8% yield. We also like them because we think there’s a real possibility that South Africa will be forced to run higher inflation as a tactic to deflate their debt position.
Our money market and floating rate bonds are high quality corporate bonds . We have about 6% in fixed rate government bonds in the R2030, the 10-year bond giving the Fund. We’ve increased our inflation-linked bonds to about 12.7% bringing our local duration to about 0.8. We still like our convertible bond position in Royal Bafokeng although the issuance locally is not very big. We’ve got 2.4% in preference shares, which have done very well for us. We have low exposure to local property (1.6%) and are still negative on the sector. We’ve got a good selection of offshore bonds, mostly South African names. The yield on the portfolio is sitting at about 6.8% and the total duration is 1.2, which includes our offshore duration. We continue to take advantage of opportunities as they arise.