February 12, 2018
Using fixed income to add stability to investors’ portfolios
There are always a number of key variables the bond market focuses on, and at the start of 2018 that remains the case. But in light of the specific circumstances we find ourselves in right now, we are giving a greater weighting to three specific variables.
The most imminent is a decision by ratings agency Moody’s in March on whether to downgrade South Africa’s credit rating from Baa3 investment grade to sub-investment grade. Moody’s made it clear in its 24 November 2017 statement what factors it would be monitoring. At that time, it held SA’s credit rating unchanged but with a negative outlook.
SA’s government must show it is implementing the necessary economic reforms; and that it is willing and able to respond to rising economic and fiscal pressure. It must also demonstrate it is able to implement growth-supportive fiscal adjustments, raise revenues and contain expenditure.
Cyril Ramaphosa taking over as ANC president in December is a significant step towards instilling the right kind of policies and confidence to drive many of these things and lead to domestic growth.
Worth highlighting are the positives that Moody’s identified alongside its concerns. This included SA’s deep domestic financial markets and well-capitalised banking sector, its well-developed macroeconomic framework and low foreign currency debt. Other supporting factors are the continued adherence to the constitution and rule of law as a pillar of strength for institutions. These all count in the country’s favour.
Right now the country – and most pertinently for the bond market – needs to control the country’s budget deficit of 4.3% of GDP. Demonstrating the sustainability of government’s debt-to-GDP ratio, now around 51.6% and last forecast to reach 60% over the medium-term, is one of the most pressing issues. This is where the Budget speech scheduled for 21 February is going to be critical to communicating policy certainty and outlining how government plans to deal decisively with state-owned entities (SOEs).
Our second area of focus is South Africa’s inflation outlook. A benign inflation environment is positive for bonds. In 2017, inflation averaged 5.6%. At the start of 2018, inflation has remained under control due in part to the rand’s strength. Broadly, we expect inflation to average around 4.5% this year with perhaps two interest rate cuts during the year. This provides a positive backdrop for bonds in 2018.
US interest rates are another key focus area and potential risk for SA bonds. The US Federal Reserve, under newly-appointed chairman Jerome Powell, is broadly expected to increase US interest rates three times from 1.25% currently to around 1.75% or 2% during 2018. If for any reason the Federal Reserve increases interest rates at a quicker pace, this poses a risk for emerging market bonds as foreign investors could find greater value in developed market bonds. What could cause a quicker pace of interest rate increases? One significant factor would be the US economy becoming “overheated”. In other words, growth pushing higher to the point that the Federal Reserve believes more interest rate increases are necessary.
Overall, we are positive about the outlook for bond markets in 2018 and expect a good year ahead, notwithstanding some of the key risks we have highlighted. With inflation expected to average around 4.5% in SA, we expect our fixed income fund to deliver around 8% to investors.
Diversifying investment portfolios is paramount. For investors wanting to allocate capital in the conservative portion of their portfolio or with capital in money market or cash, we believe our low-risk income fund is much better suited to provide a real return of over 3% on a low-risk basis.
Much like businesses, investors thrive on confidence, clarity and clear communication. As we move through the first few months of 2018 we are seeing positive signs that gives us a confident outlook for markets this year.
By Victor Mphaphuli, Co-head of STANLIB Fixed Income