What do foreigners see that local investors don’t?

Since Nenegate South Africans have had to digest a series of rather unpalatable political events. This year alone there have been the surprise Cabinet reshuffle, the so-called continued ‘state capture’ and the release of a Mining Charter draft so punitive and unreasonable that it’s highly unlikely to ever be implemented in its current format.

In addition, there’s the economy’s entry into a so-called ‘technical’ recession, an unemployment rate of close to 28%, more downgrades looming and little on the horizon to signal an economic lift-off and an improvement in the fiscal budget anytime soon. So, it’s not surprising that SA investors have a gloomy view of local assets, including SA bonds and cash. Cash is currently giving you just under 6% and historically has given returns between 5% and 12%. SA equity has offered investors a wide range of returns between a staggering -38% and 70%.

Local investors’ perception of SA assets stands in sharp contrast to foreign sentiment: despite all the uncertainty facing South Africa, foreign investors are grabbing the yields on offer from SA fixed income assets with both hands. According to the Institute of International Finance, foreign inflows into emerging debt markets surpassed $100bn in the first half of 2017 and according to Deutsche Bank have reached an all-time high of $700bn. SA received its fair share – inflows totalled R30bn in the second quarter of 2017 and almost R45bn year to date!

What do foreigners see that local investors don’t? Du Plessis confirms that, despite the uncertainty in South Africa – or perhaps because of it – his team sees value in local fixed interest and credit markets.

The hunt for value offshore

For disgruntled South Africans the only way out appears to be offshore – for any spare capital they may have. But one of the principles of value investing is to buy low and sell high – or if you have to invest now and can’t find assets at a discount, at least don’t pay a premium. This begs the question, where would SA investors currently find fair value offshore?

Most developed market cash accounts now offer between 0% and 1% – hardly the type of returns that create long-term wealth. On the equity side, the majority of global equity indices have hit record-highs in the past quarter and according to Sanlam Investment Management (SIM)’s calculations US markets have only been more expensive during the internet bubble of the 90s and the run-up to the US stock market crash of 1929.

It is normally towards income-yielding portfolios that more conservative investors turn and here the picture is not very promising either. Nearly a decade of quantitative easing and asset purchase programmes have sent global bond yields to all-time lows (and consequently developed market bond prices sky high.) There’s most likely only one way global bond prices could go from here.

Says Melville du Plessis, portfolio manager at SIM, ‘The fiscal and monetary policy responses to the 2007 to 2008 global financial crisis were on an unprecedented scale, with fiscal stimulus and budget deficits leading to an increase in debt levels worldwide. Interest rates are still at their lowest levels in history and quantitative easing has led to massive expansions of central bank balance sheets.’

The central bank ‘bubble’ appears to have spilled over to other assets, leading to record-high asset prices across most asset classes in developed markets. Undervalued assets offshore have become a scarce commodity.

Exactly how big is the central bank bubble?

The world’s largest central bank, the US Fed, currently has more than $4.5 trillion on its balance sheet, composed primarily of bonds that it purchased in response to the great financial crisis. The programme, also known as quantitative easing, was pursued to inject money into the economy and encourage risk-taking. As a result, the Fed’s balance sheet is now big enough to buy the 10 largest companies on the S&P 500, including Amazon, Apple and Exxon.

It’s not only the absolute size of these debt numbers but also the rise in negative-yielding debt that is noteworthy. Says Du Plessis, ‘We have reached a point in history where some debt instruments even carry negative interest rates. You actually have to pay someone to lend them money! During the last few years the amount of negative yielding debt increased significantly with the total amount peaking at around $13 trillion during the second half of 2016. It is a staggering amount.’

It is clear that the debt dynamics in the world are not on a sustainable path, but how will central banks shrink their balance sheets and what will be the consequences?

How to shrink the world’s largest balance sheet

The Fed has already started raising interest rates, but it has not yet started the second part of the journey: unloading its balance sheet. The Fed has two choices: It can simply allow the bonds to run off naturally when they mature, or it can actively sell them back into the market before maturity. If the Fed gets its tapering process wrong, possible consequences include a sharp decline in equity and other asset prices.

In comparison, SA bonds look attractive

The good news is that unlike the US and the rest of the developed world, South Africa hasn’t seen yields moving lower. In spite of the economic and political uncertainty, South Africa still offers good quality credit plus a margin of safety. Investors are actually being compensated with a healthy premium for the level of risk taken (currently around a 8.5-9% nominal yield for SA 10-year bonds). The type of yields on fixed interest and credit assets that we currently see in South Africa are actually quite rare in the global context.

In fact, SA long bonds are still offering among the highest local currency real yields in emerging markets. ‘Even if inflation settles at the top end of the 3% to 6% inflation target, a real return of 3% is still on offer from vanilla government bonds, and that’s before one starts investing across high quality companies and credits where you get an additional 1.5% to 2% above that,’ says Du Plessis. This is particularly attractive given the low real returns available in global bond and equity markets.

In addition, SA inflation is currently trending downwards, while inflation in developed market countries are picking up. South Africans could therefore see more rate cuts over the next year, which would be a boost to SA bond prices.

What happens to SA bonds if they’re downgraded further?

If or when SA debt will be downgraded further should not be the main focus point. At the moment SA’s credit default swap spread is already similar to non-investment grade countries and a large and sustained drop in asset prices is not necessarily expected, and very dependent on the global backdrop and specific local factors at play should further downgrades transpire. The SA government should theoretically always be able to service its own currency debt (as it’s in control of the money printing press). But there are risks. The mismanagement of an economy can manifest itself in rising inflation, which could halt the decreasing interest rate cycle that the Reserve Bank signalled recently with its first interest rate cut in five years during July this year.

SIM, however, expects inflation to trend lower and trough below 5.0% by the end of 2017 before picking up again. Upside risks stem from the potential for higher electricity tariffs next year, as well as unfavourable political outcomes, which could lead to a weaker rand.

The sleep-easy option

Fixed income performs an important role in helping investors preserve capital and generate a more stable level of income. In this category, Du Plessis manages the Sanlam Investment Management (SIM) Active Income Fund, which aims to add outperformance to its cash plus 1% benchmark by tactical asset allocation between fixed income yielding asset classes across the entire duration and credit spectrum. Although its unit trust category allows for offshore investment, the SIM Active Income Fund focuses only on local asset classes and as such doesn’t hold any offshore assets. We believe this makes it a valuable local building block for investors, and allows investors to sleep easy – they have no exposure to the risks looming over global bonds currently.

At an individual stock selection level, the Fund actively pursues high quality bonds – all within the security net of the SIM credit concentration risk management framework. The overall Fund position is relatively cautious and conservative – even by its own historic standards – given the combination of continued market strength, political uncertainty and fundamental weaknesses in the local economy with the market not necessarily reflecting the fundamentals.

This approach to adding value has served conservative investors well over the long term:

*An annualised return is the weighted average compound growth over the period measured.

Du Plessis concludes, ‘We believe SA fixed-income assets are still attractive within the global context of a low-yielding environment. Locally, we see real yields of between 2% and 3% on offer against a backdrop of declining inflation.’