David joined Prudential Portfolio Managers SA, as Head of Fixed Income in January 2009. Prior to Prudential, he was the senior fixed interest portfolio manager in the London office of M&G Investments. David worked at Prudential in South Africa in 1999 and 2000, and was responsible for establishing our current fixed interest process. Before joining M&G, David worked for Hill Samuel Asset Management as a fixed income fund manager, managing both life and pension funds for a variety of clients. David graduated from the London School of Economics with a BSc in Economics and from Birkbeck College with an MSc in Economics. He is an Associate of the Institute of Investment Management and Research.
Roshen Harry is a Portfolio Manager at Prudential Investment Managers, with 10 years’ experience. Having joined the group in May 2006, he is co-Portfolio Manager of Prudential’s Enhanced Income Fund, High Interest Fund and Money Market Fund.
Prudential Enhanced Income comment - Mar 19
After the sharp losses suffered at the end of 2018, investors were able to take heart in the first quarter (Q1) of 2019 with markets rebounding as a few negative factors appeared to reverse themselves. Although evidence of slowing global growth continued to mount, global equities and bonds rallied strongly after the US Federal Reserve announced a substantial change of view and decided to pause (and perhaps even end) its interest rate hiking cycle. At the same time, other developed market central banks undertook more growth-supportive moves, and considerable progress was reportedly made in resolving the US-China trade dispute. On the negative side, an even more chaotic Brexit environment and the uncertainty engendered by Trump's unpredictability remained bearish factors for markets. Emerging markets also benefitted from the more bullish sentiment and the Fed's rate pause, but some like Turkey and Venezuela faced idiosyncratic challenges. However, for South African investors, local equities and bonds posted respectable gains in rand terms thanks to several positive developments.
In the US, it was the Fed's more dovish rate stance that proved to be the key for turning last year's losses into this quarter's gains. The Bank emphasized that it would be 'patient' when it came to further raising interest rates, given that the case for hiking had weakened in the face of slowing global and US growth. This eased fears that inexorably higher rates could choke off growth. US GDP growth for Q4 2018 was revised down to 2.2% (q/q annualised) from 2.6% previously, sharply lower than the 3.4% in Q3 2018. Dismal US retail sales data were a key highlight. Not only did the Fed opt to keep rates on hold at its January and March FOMC meetings, but on 20 March its 'dot plot' showed it had slashed its own interest rate expectations from two 25bp rate hikes in 2019 to zero, and only one 25bp hike in 2020. This was very positive for equities, and also helped push longer-dated US Treasury bond yields lower, such that the yield curve 'inverted' for the first time since 2007 (where 3-month interest rates were higher than those for 10-year bonds). Some interpreted this as a sign of a looming recession.
Adding to the general positive news was the end of the 35-day US government shutdown in January, and that good progress was reportedly being made in the US-China trade negotiations to avert higher tariffs and a full-blown trade war. This was particularly beneficial for the global growth outlook, especially for trade-dependent countries like China, Japan and South Korea, and helped push the US dollar stronger for the quarter against most other currencies (although not the yen).
In the UK, agreement was reached with the EU to extend the Brexit deadline into April, and PM Theresa May effectively lost control over determining a way forward, forced to hand over to Parliament. However, MPs rejected every possible option for structuring the future relationship, worsening the chaos within government. Meanwhile, UK GDP growth slowed to 1.4% (q/q annualised) in Q4 2018 from 1.6% previously, with the EU area equally pedestrian at 1.4% for the quarter. This deteriorating growth was a factor in keeping interest rates on hold across both regions, as well as in the US Fed's interest rate view. The European Central Bank even introduced a new cheap long-term loan plan for banks to help avoid further deceleration, as Germany's manufacturing data was negative for three months in a row.
During the quarter it was revealed that the Japanese economy returned to growth in Q4 2018 after a contraction in Q3, although exports remained sluggish amid trade uncertainty and the slowdown in Chinese growth. Japanese GDP is forecast to reach around 1.0% in 2019, supported by the Bank of Japan's ongoing easy monetary policy, but expected to be hit by a new consumption tax on spending and consumer prices to take effect later in 2019. In China, meanwhile, 2018 GDP growth came in at 6.6%, its weakest in 28 years but meeting consensus expectations. The government's new 2019 growth target is even lower at 6.0%-6.5%. There was, however, renewed optimism amid the positive US-China trade news; government pro-growth measures, including easier bank credit, took effect; and manufacturing activity accelerated - China's PMI recorded its highest rise since 2012.
South African assets were boosted over the quarter primarily by the easier global monetary outlook, recording gains across all asset classes. This mixed with some still-gloomy sentiment locally. The economy emerged with growth of 0.8% in 2018, slightly above expectations. Still, this was a very weak absolute growth level, and the SARB is now projecting only 1.3% GDP growth for 2019 (down from 1.7% previously), not including the negative impact of any ongoing electricity cuts. In some growth-positive news, retail sales growth recovered somewhat to 1.2% y/y in January from the shocking -1.6% y/y in December.
Apart from the Fed's rate pause, which bolstered bond markets around the world, SA bonds rallied on several local factors, as the BEASSA All Bond Index delivered 3.8% for Q1: the yield on the benchmark R186 bond (due 2032) fell from around 8.9% at the start of the quarter to end at around 8.6%. These supportive factors included good investor demand, subdued inflation (February CPI at 4.1% y/y, below the SARB's 4.5% midpoint target) and the SARB's decision to keep interest rates on hold at both its January and March MPC meetings. The SARB's latest interest rate projection model showed only one 25bp rate hike this year. Also importantly, Finance Minister Tito Mboweni's February Budget was greeted favourably by most analysts, reinforcing the government's commitment to reining in the budget deficit and cutting spending, while also reforming and reducing wastage at the parastatals.
The bond rally also occurred against the backdrop of the expected 29 March Moody's sovereign credit rating report. While many were pessimistic, Moody's final decision not to review the rating and leave it at investment grade with a stable outlook granted the country a big reprieve on the final trading day of the quarter, with the R186 rallying 10bps on the day. Further bond gains were, however, only reflected after quarter-end.
However, the SARB remains concerned about future inflationary pressures arising from the weaker rand, as well as higher costs from fuel and electricity, among other sources. SA inflation-linked bonds, meanwhile, again performed rather poorly in the low-inflation environment, returning 0.5% over the three months, while cash (as measured by the STeFI Composite) delivered 1.8%. Despite US dollar strength, the rand lost only 0.5% versus the greenback, but 2.1% against the UK pound sterling, while gaining 1.3% against the euro, which was hit by growth concerns and more dovish interest rate expectations.
Other worries remained Eskom's generation capacity and the negative impact of load-shedding on growth in 2019, the land expropriation debate, nationalisation of the SARB, and last but not least, the upcoming May elections.
PERFORMANCE The fund returned 2.3% (net of fees) for the first quarter of 2019, outperforming its benchmark by 0.5%. For the 12-month period ending 31 March 2019, the fund returned 5.9% (net of fees), underperforming its benchmark by -1.4%. Investments in international assets, floating-rate notes, fixed-rate and inflation-linked bonds contributed positively to overall fund returns for the quarter, with SA Property also providing a modest contribution. As the rand weakened to R14.50 to the US dollar, we hedged about a third of the fund's offshore exposure using listed currency options. This was to protect some of the currency gains made in the portfolio from its offshore assets due to a weakening rand.
STRATEGY AND POSITIONING
In global fixed income, despite the rally over the quarter, US government bonds are still trading at slightly expensive levels, but are less expensive than other developed markets like the UK, EU and Japan, where government bond yields remain at exceptionally low levels. We do not own global sovereign bonds and prefer to hold investment-grade US corporate bonds. These assets are slightly cheap and have the potential for stronger returns going forward now that the US interest rate hiking cycle is on hold.
In SA listed property we are neutral and note the higher risks to earnings going forward compared the attractive valuations prevailing in the sector. We remain concerned around the quality of earnings and possibility of further downward revisions to earnings forecasts for listed property. The sector faces headwinds arising from pressure on landlords to reduce their rentals, particularly in the retail space where retailers are facing sluggish consumer spending. Equally, oversupply in office space is negative for listed property earnings currently.
In SA nominal bonds, valuations still remained cheap over the quarter compared to their longer-term fair value; however, we hold modest exposure to longer-dated government bonds and prefer to own floating-rate instruments issued by high-quality corporates and the big local banks. We consider the credit spreads being offered as attractive and adequately compensating investors for the risks being taken on. These instruments by construction have very little interest rate risk and suits the risk profile of the fund.
For SA inflation-linked bonds, following the quarter's return of 0.5%, the real yield remains very attractive, having risen to 3.3%. Given the significant sensitivity of the asset's price to modest changes in real yields were have limited our exposure to about 9% of the fund.
The Prudential Enhanced Income Fund is a varied specialist fixed income portfolio.
The objective of the Prudential Enhanced Income Fund is to maximise total returns in excess of the benchmark, the BEASSA ALBI 1-3 year Total Return index, over a rolling 36-month period, whilst seeking to preserve capital and reduce volatility through active asset management.
In order to achieve the portfolio's investment objectives, the securities to be acquired for the Prudential Enhanced Income Fund will consist of a mix of high yielding securities, including equity, listed property instruments, bonds, preference shares and assets in liquid form, both locally and abroad, thereby generating both tax free and taxable income, whilst preserving capital. The portfolio may include non-equity securities where the instrument or issuer has been assigned a rating or any other form of measurement approved in terms of prevailing statutory limitations. The Portfolio may also include participatory interests or any other form of participation in portfolios of collective investment schemes or other similar schemes registered in the Republic of South Africa, or of participatory interests or any other form of participation in portfolios of collective investment schemes or other similar schemes operated in territories other than South Africa, with a regulatory environment which is to the satisfaction of the manager and the trustee of a sufficient standard to provide investors protection at least equivalent to that in South Africa and which is consistent with the portfolio's primary objective. The use of derivative strategies may be pursued and will only be limited by the prevailing statutory limitations placed on the inclusion of such financial instruments in the portfolio.
Nothing in this supplemental deed shall preclude the Manager from varying the ratios of securities, to maximise capital growth and investment potential in changing economic environments or market conditions or to meet the requirements, if applicable, of any exchange as defined in terms of legislation and from retaining cash or placing cash on deposit in terms of the deed and this supplemental deed; provided that the Manager shall ensure that the aggregate value of the assets comprising the portfolio shall consist of securities and assets in liquid form of the aggregate value required from time to time by the Act.
No direct physical property holding will be made by the portfolio.
For the purpose of this portfolio, the manager shall reserve the right to close the portfolio to new investors on a date determined by the manager. This will be done in order to manage the portfolio in accordance with its mandate. The manager may, once the portfolio has been closed, open the portfolio again to new investors on a date determined by the manager.
The portfolio will comply with regulations controlling retirement funds or such other applicable legislation as may be determined for retirement funds.
The portfolio investment in listed equity instruments will be limited to 10% of the total portfolio value,
The trustees will ensure that the portfolio meets the investment policy requirements as stated in the supplemental trust deed.