It is an interesting time for the global economy. Short-term economic growth is strong, inflated by fiscal stimulation in the US. Long-term prospects have been negatively impacted by political struggles, the most high profile of which is the US-China trade war. The outlook for emerging markets is uncertain, with countries ranging from Turkey to Zambia to China having too much debt and unsustainable macroeconomic policies. Against this backdrop, higher US interest rates have made holding risk-free US dollars more attractive at the expense of other currencies. Three-month treasury bills now yield more than 2%, compared to 0.02% three years ago.

We cannot reliably forecast any of the above macroeconomic factors and we don’t base our investment decisions on them. However, we can draw reasonable conclusions. A world with many uncertainties provides many potential surprises. Asset prices are closer to cyclical top than bottom, with more positive than negative news already priced in. This favours caution, with asset prices likely to react to negative rather than positive news. Within this context, South Africa faces multi-decade structural challenges but near-term risks appear contained. The challenges are well known and largely priced into South African assets. In US dollar terms, the FTSE/JSE All Share is 10% lower than it was five years ago, compared to the FTSE World Index, which is up 38% and the S&P, which is up 73% over the same period. South African government bonds yield 4% more than inflation, attracting investors looking for higher returns without the tail risks of Turkey or Argentina. Our conclusion is cautious confidence in local asset returns in the absence of global shocks.

Going into the quarter, we believed there was limited risk of a large move in South African bond yields either way. This view was tested by emerging market volatility, but the yield curve recovered and ended the quarter approximately 20 basis points higher. Fund duration was maintained around 5.8 years through the volatility, in line with our philosophy of focusing on long-term fundamentals.

There was limited Fund activity over the quarter. The most notable change was adding exposure to the Land Bank. Despite the current uncertainty around land reform, the Land Bank remains profitable with a reasonable balance sheet, and forms an integral part of South Africa’s development initiatives.

Commentary contributed by Mark Dunley-Owen

Recent times have been volatile for bond investors. The South African 10-year bond yield peaked close to 9.5% at the height of political uncertainty in late 2017, rallied to 7.9% in the optimism following Cyril Ramaphosa’s victory, and has since fallen to 8.8% due to rising global uncertainty. Investor total returns from the All Bond Index have been similarly volatile: 10.5% in the 12 months prior to the ANC elective conference in December 2017, 8.0% in the first quarter of 2018 and -4.1% in the second quarter.

We couldn’t and didn’t predict this volatility. Instead, we remained focused on long-term value based on our view of South Africa’s credit strength and inflation expectations. This value is relatively stable, allowing us to adjust the Fund’s exposure as market prices move above or below value. The Fund’s positioning has moved from being relatively aggressive in late 2017, to conservative towards the start of this year, and more recently adding duration as bond yields rose to more attractive levels. This has allowed the Fund to generate reasonable absolute returns despite the market volatility.

The recent bond sell-off appears to have been driven by global rather than South African concerns. Foreigners have sold R64.3 bn of South African bonds since March 2018, after buying R25.1 bn in the first quarter. This not only highlights South Africa’s dependency on global investment sentiment, but also the short-term nature of many investors. Changes in sentiment without similar changes in underlying fundamentals provides opportunities to investors such as ourselves that focus on long-term value. The yield on the All Bond Index is now more than double inflation. The outlook is supported by improving domestic sentiment following years of underinvestment and mismanagement. This combination suggests South African bonds are attractive at current levels.

We switched liquid money market instruments and government bonds into higher yielding corporate bonds during the first half of the quarter. As yields rose, we added duration by buying government bonds. The Fund is currently positioned at a higher average yield than the All Bond Index with shorter duration.

Commentary contributed by Mark Dunley-Owen

South African bonds performed well over the quarter following improved sentiment from the change in political leadership. The Fund delivered reasonable absolute returns over this period, although it underperformed the All Bond Index.

The Fund was relatively aggressively positioned at the start of the quarter, in line with our view that bond yields were suitably compensating investors for future uncertainty. As bonds rallied and yields dropped, Fund duration was gradually decreased to more conservative levels.

The main reason for our conservatism is the growing disparity between expectations and reality. One tends to find attractive investment value when expectations are lower than reality, as was the case in late 2017. Since then expectations have increased sharply, while reality remains concerning. Important metrics of South Africa’s health, such as government debt-to-GDP and unemployment, remain weak and the structural causes behind them have not been addressed.

At the same time, the yield curve has flattened to the extent that 10-year and 1-year instruments offer similar yields. In this scenario, one should limit duration exposure unless one believes yields will fall farther. We believe this is unlikely and prefer the safety of short duration instruments without giving up much yield. There were material flows into the Fund over the quarter. These were invested into money market instruments, thereby reducing duration. New investments were made in Eskom and Land Bank bonds.

For much of last year, governance and financial concerns prevented us from investing in many SOEs, including Eskom. Our governance concerns about Eskom have lessened following board and management changes. While we still believe Eskom faces severe financial challenges, one is able to invest in government-guaranteed Eskom bonds at a materially higher yield than similar duration government bonds. Given the guarantee, the probable justification for this yield pickup is lower liquidity of the Eskom bonds. Our long-term focus makes it attractive for us to earn this liquidity premium with the comfort of the government guarantee behind us. Furthermore, and somewhat counterintuitively, the worse Eskom’s financial situation becomes, the more likely it is that the government will have to step in. If this happens, we expect the yield spread between Eskom and government bonds to narrow.

Commentary contributed by Mark Dunley-Owen

On the face of it, 2017 was a good year for South African fixed income investments. The rand strengthened against most major currencies, inflation fell to near historic lows, the Reserve Bank lowered rates, and bond yields were relatively stable year on year. However, as any South African knows, this hides a high level of intra-year uncertainty and volatility.

Focusing on long-term fundamentals helped the Allan Gray Bond Fund deliver reasonable returns through these uncertainties. The Fund was conservatively positioned when bond yields did not reflect the underlying challenges of the local economy. Duration was increased as yields sold off to more attractive levels, but maintained below benchmark to limit risk given uncertain future scenarios. While the timing and magnitude of changes was imperfect, the Fund generated returns of 7% above inflation for the year.

Looking forward, we are hopeful that investor confidence and subsequent capital investment will improve following recent political change. However, South Africa’s structural challenges are unlikely to have quick or easy solutions. Improving the growth potential of the economy via education, productivity and employment is a slow and steady process, one that is yet to begin let alone bear fruit.

Within this environment, the Fund’s remains focused on generating absolute returns while limiting risk. To do so, the Fund holds a combination of low risk money market instruments, and higher yielding medium duration corporate bonds and long duration government bonds.
Activity
By our standards, the Fund experienced a high level of activity over the quarter. Money market exposure was switched into long duration government bonds as the yield differential between the two increased, following a more realistic medium-term budget speech and subsequent sovereign downgrade. This duration was maintained into the ANC conference as yields sufficiently discounted low expectations.

Commentary contributed by Mark Dunley-Owen