Bonds are currently “incredibly attractive” as market prices seem to price in a worst-case scenario for SA, says Nolan Wapenaar, co-chief investment officer and fixed income expert at fund managers Anchor Capital.
Wapenaar says SA bonds are cheap, with some maturing within four years and offering investors up to 8.6% per annum.
“We are at a pricing point in the bond market that offers an incredible opportunity,” he says, basically making the point that, globally, bond markets initially ignored bad news and then overreacted to it.
“We are seeing a slowdown in economic activity globally, from the US and Europe to China. We are seeing the first signs of inflation coming down, but bonds yields are not reflecting this yet.”
Wapenaar says the world was in denial about accelerating inflation when economies started to rebound after Covid-19 lockdowns and large stimulus initiatives. “Inflation did come through. US inflation increased from the low levels of between 1% and 2% in 2021 – it is now sitting at above 8%.
“Everybody was in denial about inflation. The world realised inflation is increasing only in September last year,” says Wapenaar.
Interest rates followed. Within months, interest rate expectations in the US increased from close to zero to expectations that the US Federal Reserve would increase interest rates aggressively.
The US increased its Fed Funds Rate by 50 basis points at its March policy meeting, from 0.5% to 1% amid expectations that interest rates are set to rise to between 2.75% and 3% at the end of 2022.
“The rising trend in interest rates [was] ignored,” says Wapenaar.
“People were denying that it would have an impact on the economy. It became the narrative. But then the penny dropped. Over time, people realised that interest rates are going to hit economic growth. There is a limit to how high interest rates can go given the realisation of lower economic growth.”
Recent data proved him correct.
Traders on the US futures market changed their expectations, according to a report by MarketWatch at the end of May. “Fed-funds futures traders are pulling back on their outlook for continued rate hikes as revised data released on Thursday [26 May] shows the US economy contracted by a deeper-than-expected 1.5% annual pace.
“After the data release, traders placed a 60% chance on the fed-funds rate target getting between 2.5% and 2.75% by December, up from 35% a week ago,” according to the CME FedWatch Tool.
“The likelihood that policy makers would get to a target between 2.75% and 3% by year-end, from a current level between 0.75% and 1%, dropped to 27% from 51% on May 19.
“Accompanying the drop in first-quarter GDP was the first decline in corporate profits in five quarters – which analysts saw as a sign that the economic contraction was more real than first thought after being chalked up to a record trade deficit,” according to MarketWatch.
Anchor Capital believes that inflation expectations will moderate too. “Inflation is starting to come down. We definitely see inflation starting to track sideways,” says Wapenaar, describing this as a global trend.
He says commodity prices are moving sideways and, even if still at the higher levels, the absence of further price increases reduces the inflationary impact.
The pressure on interest rates will decrease as inflation falls and bonds benefit.
“The economic scenario is more supportive for bonds and the current pricing point offers an opportunity,” says Wapenaar.
Remarks by Casey Delport, Anchor’s fixed income analyst, suggests that bonds yields in SA might have increased too much.
“We tend to focus too much on the negative in SA, such as the high petrol price, increasing food prices, interest rates and load shedding.
“Sometimes it is difficult to see the positives, but there are positives. The economy is starting to heal after the Covid-19 pandemic, the trade balance has been positive since 2020 and SA debt forecasts are much lower than previous forecasts,” says Delport.
A positive trade balance – on the back of higher export earnings due to rocketing commodity prices – is a big positive for the economy. In essence, net export earnings boost the economy as a positive injection.
Meanwhile, government debt levels have decreased in comparison to the size of the (recovering) economy.
At the time of the 2019 mid-term budget, government debt to GDP was expected to increase to 94%. This figure dropped to 70% at the time of the 2022 budget speech.
“The debt level is much more comfortable and sustainable.
“Economic policy is also moving in the right direction, if slowly,” says Delport.
She mentions several examples – such as actions against corruption, with arrests and the removal of those implicated in investigations from posts in government and state-owned companies, as well as moves to improve Eskom, the rail network and other infrastructure in partnership with the private sector.
Wapenaar notes that the “sensible policy discussions” are gathering momentum.
“The economic cycle and prospects are not negative for bonds any more. Market consensus is that the repo rate will increase to 6.5% over the next year, currently at 4.75%.
“That the market is pricing in very steep hikes over the next 12 months indicates that the market is pricing in the worst-case scenario. The current rate on a 10-year bond is above 10% notwithstanding a more positive scenario,” says Wapenaar.
He predicts that bond and income funds are set to perform well.