Fund review

The fund returned 5.38% for Q3 2019 (YTD: 10.24%) compared with the benchmark return of 7.77% (YTD: 11.61%). The portfolio’s weak performance during the third quarter was almost entirely due to the currency contribution. Duration provided significant absolute returns and came both from holdings of Treasuries as well as from emerging market bonds, with Mexican and Brazilian bonds powering the gains. The rand ended the quarter weaker at R15.17/$ after trading at R14.08/$ at the end of June 2019. The rand remains volatile due to economic uncertainty and a low growth environment in SA. The fund grew in market value from R953 million at the end of June 2019 to R993 million at the end of September 2019.

Market overview

Yields fell across the curve, as the 10-year Treasury posted its largest quarterly decline in several years, and the 30-year bond yield hit a record low in August. This drop in global rates sent investors searching for yield during the quarter, and emerging market debt generally rallied modestly.

As for the substantial negative drag from currency contribution, the portfolio is underweight US dollars, yet the dollar rose steadily throughout the quarter against almost all currencies. The sustainability of this trend is the key issue for positioning going forward. An underweighting in the euro and lack of exposure to the yen were positive exceptions, but exposure to a basket of foreign currencies was detrimental in the strong US dollar environment.

There was very little change in the portfolio positioning during the third quarter. In terms of duration, the portfolio largely sustains its barbell profile: duration in US Treasuries counterweighted by duration in the emerging world, with particular emphasis on Mexican sovereign bonds. The barbell structure makes sense from a risk management perspective, given the global crossroads macro theme moving forward. However, this structure was not a result of implementation around that macro uncertainty. Instead, the duration allocation arose out of a normal price discovery process and where we believe value resides in the global fixed income market.

The fund is overweight emerging market bonds, which paid off during the third quarter. Despite dollar strength and emerging market currency weakness, local currency bonds across the emerging world continued to rally in step with developed country markets. The breadth of the rally attests to the deflationary forces at play in the global economy.

A sizeable position was committed to US Treasury duration in the fourth quarter of 2018. The rally in bond prices since then has dramatically reduced the price opportunity to such an extent that this position was reduced during the most recent quarter. Upside in Treasury prices from here seems limited, unless the world economy goes off the rails.

The extraordinary gains in the dollar during the third quarter do not seem sustainable. A gradual decline in the dollar is expected due to it being expensive, improvement in the trade standoff, an expansionist Fed and economic stabilization in China, all of which is dollar negative.

There is a small but growing possibility of some form of intervention to contain the dollar’s strength. President Trump has been critical of the Fed for helping to support the dollar at a time when balance of payments factors argue that the euro is structurally very cheap. The weakness in the renminbi that largely corresponded to the increase in US tariffs on China was not lost on the President either, as he declared China to be a currency manipulator.

Looking ahead

The big move in bond prices is probably nearing an end in most of the developed world. However, that is not the case in emerging markets. More interest rate cuts are in the pipeline, both in the US and abroad. The engine for return in the portfolio will be dollar depreciation in response to the three crucial variables of the dollar noted above. We believe the Fed will cut interest rates by another 50 bps, the Chinese will continue to stimulate and, most importantly, the trade negotiations will be driven by political and economic self-preservation.