Current context
Investment markets continue to be event-driven, with trade wars and related global growth concerns driving rate cuts by the US Federal Reserve. This has led to a sharp downward move in US bond yields and, for the first time since 2007, an inversion of the US yield curve (with 2-year bonds trading at a higher yield than 10-year bonds) in August 2019. The clear indication from the US bond market is that US growth and inflation are expected to be lower going forward. Locally, after a disappointing first-quarter GDP decline of 3.1% and stable inflation, markets were pricing in rate cuts of 0.5% over the next six to twelve months in late June 2019. The South African Reserve Bank cut rates by 0.25% in July 2019. Despite a 3.1% rebound in GDP in the second quarter of the year, a further 0.25% cut is still being priced in by the markets. South African bond yields increased marginally across the curve over the quarter, but performance year-to-date remains solid, driven by declines in bond yields relative to their elevated starting yields (cheap valuations) in late 2018.

Our perspective
The extreme divergences we are currently seeing in the valuations of popular securities compared to those investors are shying away from are rare, and present risks as well as opportunities. Investors seeking a smoother ride by switching to cash or buying high-quality counters at any cost may find that this ‘fail safe’ proves to be the opposite over the longer term. Missing out on the gains from a market recovery can dramatically erode an investment outcome. Similarly, buying securities at lofty valuations underpinned by high growth expectations may result in losses if expectations prove to be unsustainable.

In contrast, areas in which valuations have been driven lower due to fear and uncertainty present the potential for mispricing. Where prices fall across the board – an entire sector or geography, for example – quality securities become available cheaply, along with the rest. Tainted by pessimism, their earnings potential is easily overlooked. While it may take time for the market to realise mispriced value, investors who can ride out the storm stand to generate outsized returns from such attractive entry points.

Portfolio positioning
We have used the opportunity presented by the steep yield curve and the high real yields available to add to bond holdings and move exposures further out on the yield curve (to higher-duration bonds).

From highs of around 9.5%, five-year negotiable certificates of deposit (NCDs) are now yielding around 8.1%. As yields fall, security prices rise, implying that the shorter-term instruments held in the funds offer significant embedded value. However, consistent with our approach, lower real yields have made us more cautious. We have been more selective in extending current positions in fixed-rate NCDs, however wider spreads in floating-rate NCDs have offered an interesting opportunity.

Credit spreads have continued to contract as market participants search for yield, and we believe many credit instruments no longer offer a sufficient margin of safety. Where we have seen credit spreads tightening, we have been selective sellers. We continue to hold credit where we see low probability of default risk and where spreads are above our estimates of fair value.

Current context
Local fixed income assets experienced some tailwinds from Moody’s decision to keep South Africa’s credit rating unchanged. This has resulted in sovereign yields reducing slightly, as local and foreign investors continue to see value in South African government bonds. Anchored inflation - well within the South African Reserve Bank’s (SARB’s) 3% to 6% target band - has further supported yields, as the SARB has taken a more neutral stance on interest rates and maintained the existing repurchase rate of 6.75%.

Our perspective
As we have noted for some time, there is pervasive fear in certain parts of investment markets. This is in complete contrast to other areas that are well owned and in which investors are inclined to be complacent. Markets therefore continue to be characterised by wide valuation divergences. We are finding far more opportunities in those parts where investors are fearful. In fact, our bottom-up analysis is indicating valuations usually seen in deep bear markets. For longer-term investors who can ride out the storm, the return profile from carefully selected securities at such low valuation levels is promising.

Local short-term interest rates have declined over the quarter, with the rate on the 1-year negotiable certificate of deposit (NCD) reducing from 8.2% to 8.1%, and the rate on the 5-year NCD reducing from 8.8% to 8.6%. This implies that the market has built in even lower interest rate increases. Fixed income yields have declined marginally, but starting yields remain high. 20-year government bonds are offering yields of around 9.5% (down from 10%) and 5-year bonds are yielding 7.6% (down from 8.1%). We expect further market noise in the run-up to the May general elections but believe that local fixed income assets present the potential for strong returns in future.

Portfolio positioning
We continue to gradually reduce exposure to expensive corporate bonds and allocate cash to longer-dated NCDs. Over the quarter, the fund reduced its exposure to shorter-dated corporate fixed-rate bonds as spreads tightened. The 5-year government bond (the reference bond for these credits) is yielding around 7.6%, while bank 5-year NCDs offer close to 8.6%.

Cash levels remain healthy, with the fund holding 76.2% in cash and NCDs. This is dry powder that we expect to employ if the opportunities we currently see in many domestic securities become more widespread.