Granate SCI Uncnstrnd Fxd Interest Comment - Sep19
The Granate SCI Unconstrained Fixed Interest Fund is a domestic fixed interest portfolio which seeks to provide investors with exposure to the fixed interest market and aims to offer maximum returns by actively extracting value from various sources within the fixed interest universe. The portfolio uses strategic asset allocation, aggressive duration (ranging between the duration typical of a money market fund and the longest maturity South African government bond), yield curve positioning, switches, stock selection as well as derivative and other yield enhancement strategies, including exposure to foreign currency to maximize returns. The objective of the portfolio is to maximize both income and capital over a long-term investment horizon. Given that the portfolio aims to maximize total return (which includes capital) it is expected to be more volatile than a traditional income fund with the possibility of negative monthly returns. The portfolio is managed in accordance with regulations governing pension funds and CISCA. Economic overview Further deterioration in many of the economic indicators in major economies and the ongoing concerns around trade wars have resulted in increasing risk of a US economic recession with broader implications for global growth. 2019 global growth forecasts have been revised lower – the 5th consecutive quarter of downward forecast revision, while EM growth is expected to accelerate into 2020, it too has been revised lower. The softer economic outlook prompted the US Federal Reserve to cut its key lending rate for the first time since the Great Financial Crisis twice during the quarter despite what appears to be a very strong labour market.
Domestic economic growth in 2Q19 (released in September) recovered strongly from the awful 1st quarter as key sectors such as manufacturing and mining benefited from an uninterrupted power supply and, somewhat surprisingly, the services sector (finance, insurance and real estate) recorded strong gains.
Incoming monthly data for 3Q19 has been mixed. Leading indicators and confidence surveys are painting a rather grim picture going forward. Business sentiment measured by the BER recorded its lowest level since 1999. With more than 2 quarters of economic data available it appears that growth should meet its 2019 consensus forecast of 0.6%. The focus is now moving to 2020/21 which is likely to be revised lower unless we see a significant turn in policy delivery and a better business and consumer confidence.
The Monetary Policy Committee (MPC) of the Reserve Bank met twice during the 3rd quarter and after cutting the repo rate by 25 basis points in July, kept it unchanged at 6.5% in its September meeting. The decision to keep the rate unchanged was unanimous which could be considered as somewhat of a surprise given the weak state of the economy, low domestic inflation and the fact that the global policy “tone” is generally dovish as evident by the fact that 22 central banks cut their policy rate over the last quarter at least once.
The SARB’s inflation forecast was lowered for the next three quarters due to the lower than expected print in July, but the outer forecast period was revised upwards. Economic growth, however, was revised downward suggesting that the net impact of the revisions should have provided for a more dovish (or at least a split) decision.
It appears therefore, that a large consideration was given to the risks associated with the MTBPS (now delayed to the 30th of October) and the Moody’s review which is expected shortly afterwards.
As was the case in the previous meeting, the MPC saw the risks to the inflation outlook as being “largely balanced” and risk to the growth forecast to be balanced in the near term but remains concerned about medium term growth and weak employment prospects.
We maintain our view that the SARB will cut the repo rate in its November meeting, although an unfavourable MTBPS does make this a close call. Market overview After 2 consecutive quarters of strong performance of most global asset classes, the last quarter was more mixed with global equities (emerging markets in particular) taking a breather while bond markets - both developed and emerging, performing strongly.
Locally, however, markets performed poorly in a quarter where the rand was particularly volatile shedding 7% of its value. Money market (1.8%) was the best performing asset class with the listed property sector (-4.4%) just managing to beat equities (-4.6%) which saw all major sectors losing ground.
Interest rate cuts and slowing global growth drove investors into safe haven bonds such as US Treasuries, Japanese bonds, and German bunds pulling other bond market yields lower with them and resulting in a WGBI return of 2.8%. South African bonds, however, were left behind with the yield on the All Bond Index rising by 14 basis points and the sector returning only 0.7% as the rand came under pressure and the market continued to adjust to the reality of more SOE bailouts.
Inflation-linked bonds continue their dismal run (0.3%) as investors have had little appetite for the long end of the curve due to more attractive valuations for long dated nominal bonds. While the 4th quarter is unlikely to have as high a carry as the 3rd, the carry for the remainder of the year is still positive. Expected lower inflation adjusted policy rates make the shorter end of the ILB yield curve particularly attractive and with yields close to 3.5% the long end is also looking attractive on an absolute basis, although still expensive compared with nominal bonds. Portfolio activity We increased the portfolio’s exposure to local currency fixed rate bonds materially during the quarter and continued to increase the interest rate risk in the fund in anticipation of a repo rate cut and better risk compensation on fixed rate bonds.
We were also active in the currency market – hedging the funds USD position (due to USD bonds held in the fund) back into rand when our currency valuation model suggested that the rand was significantly undervalued.
The portfolio’s exposure to the listed property sector was increased very slightly during the quarter to 1.8% (significantly underweight its strategic asset allocation). The sector continues to suffer from very weak economic growth as well as a material build-up of rental space over the last few years that has outstripped demand.
In line with our view that ILB’s in the short end of the yield curve offer better risk compensation than nominal bonds with similar maturities we increased the portfolio’s holding of these bonds during the quarter. Most of the ILB’s held in the fund are Government bonds and are usually purchased in the weekly auction. Portfolio positioning Our bond valuation models point to a similar level of positive risk compensation for domestic bonds compared with the beginning of the 3rd quarter after improving materially in August. Inflation adjusted long bonds are more than 1 standard deviation above their long-term average, and the highest since 2004. This makes the long end of the curve attractive, although there are material short and medium-term risks which will result in heightened volatility. In particular, we expect further deterioration of the fiscal outlook and Moody’s to move the SA’s credit rating outlook to negative in November, much of which is already priced in bond yields.
We are therefore keeping the portfolio’s exposure to long dated bonds relatively high while maintaining a healthy amount of liquidity in the event of a poor MTBPS at the end of October.
Exposure to credit bonds in the portfolio has been slowly rolling off and we have elected, in most cases, not to reinvest into this asset class. Credit bond spreads have continued to narrow as investors look for floating rate instruments to minimise interest rate risk in portfolios. This drive to lower interest rate risk, however, means that investors are accepting a credit risk for which they are not sufficiently compensated. While the financial health of major SOE’s remains fragile, the risk of default is low due to government’s continued bailouts. However, poor governance, while being addressed, remains problematic precluding us for including these assets in our funds.
While valuations of the listed property sector appear most compelling, we maintain our cautious stance on the asset class as weak fundamentals and poor growth weighs on a potential re-rating. We will look to increase exposure to this asset class slowly over the coming quarters.
The fund remains highly liquid with well diversified exposure to high quality credit.
The Visio BCI Unconstrained Fixed Interest Fund is a domestic fixed interest portfolio which seeks to provide investors with exposure to the fixed interest market and aims to offer maximum returns by actively extracting value from various sources within the fixed interest universe. The portfolio uses strategic asset allocation, aggressive duration (ranging between the duration typical of a money market fund and the longest maturity South African government bond), yield curve positioning, switches, stock selection as well as derivative and other yield enhancement strategies, including exposure to foreign currency to maximize returns. The objective of the portfolio is to maximize both income and capital over a long-term investment horizon. Given that the portfolio aims to maximize total return (which includes capital) it is expected to be more volatile than a traditional income fund with the possibility of negative monthly returns. The portfolio is managed in accordance with regulations governing pension funds and CISCA.