Personal Trust Income comment - May 16
The second quarter of 2016 was characterised by international markets initially rallying, as any imminent rate hiking actions emanating from the Federal Reserve were priced out to 2017; the quarter ended with markets actually pricing an extremely high likelihood of either a June or July +25bp rate hike from the Fed. In a similar vein, we saw a spectacular reversal in fortunes for the commodities complex, and many battered commodity counters saw unheard of rallies in both equity and bond prices. However, the euphoria there also seems to have petered out towards the end of the quarter, and a great deal of uncertainty now prevails as we look forward to continued gloomy prospects for China, Japan and Europe. In addition, there appears to have been a rise in geopolitical risks, and this culminated with a historic visit by US President Barak Obama to Hiroshima in Japan, and a telling snub of the G7 by China. As a result we saw a return of dollar strength and emerging currency weakness, and we are now closely watching the global risk indicators for signs of either a rapid escalation of risk-off sentiment, or a return to the usual risk suppression, aided and abetted by Central Bankers and their printing presses. In South Africa, fixed interest markets spent most of the quarter rebuilding confidence post the trauma of Nenegate in December 2015. CPI prints showed a marked recovery from the local high of 7%, declining to a deceptively low level of 6.2% for the April 2016 print, tantalizingly close to the upper end of the target band of 6%. This was chiefly due to the technical statistical impact of the #FeesMustFall campaign and Statistics South Africa’s survey of education costs occurring in April. However, our models, in sympathy with those of the SARB, still see a significant inflationary impulse to occur in Q3 and Q4 of 2016, with CPI expected to peak somewhere between 7.7% and 8.0%. The quarter drew to an end with revelations that the Finance Minister was facing charges and an investigation by the Hawks, combined with various negative developments on the parastatal front (as far as financial impropriety is concerned), Guptagate and State Capture. The general simmering political tensions between those classified as the 'Forces of Good' (from a bond holder perspective read pro-Pravin Gordhan and fiscal prudence) and the 'Forces of Evil' (from a bond holder perspective, read those benefitting from and actively promoting 'State Capture') served to undermine any positive sentiment that might have caused market participants to take bond yields to lower yields than those that applied before Nenegate. This is best reflected by the 8.80% yield level on the R186. The mid-April low in yields of 8.84% was followed be a vicious sell-off that took the R186 all the way back to 9.50%. The CAM Fixed Interest Team correctly called the March repo rate hike by the SARB of +25bp, and after rigorous internal debate, we adopted the position that the SARB would pause in May, to take advantage of the temporary respite in CPI, as well as the general perception that the SARB is finally ahead of the curve. However, more heavy lifting is still required and our current view is that the Repo Rate will top out at 8.25%. If some of the global risks we consider materialize, our risk view is that the SARB might get away with a much reduced hiking cycle terminating at 7.75%, but this is not our core view. The South African economy now needs to negotiate the treacherous Rating Agency calendar, with S&P expected to downgrade South Africa’s foreign currency rating to sub-investment grade in the first week of June, and Fitch opining one week later. This will have spill-over effects on the local currency rating, and if foreign capital chooses to flee, could mean a vicious spiral of currency sell-off, combined with further rate hikes, and further outflows. It will be difficult to generate the growth required to maintain our rating with the other Rating Agencies in such an environment. The only silver lining in this gloomy tale is that the South African Credit Default Swap (CDS) Spread already prices South African debt at junk, and some argue that the downgrade is already in the price, an argument with which we concur. The duration positioning remains low, and we will only consider increasing duration once we have comfort that South Africa is not at risk of rising yields due to political factors influencing prudent fiscal policies. If South Africa avoid the ratings downgrades, we will extend duration further. In an environment where sovereign credit spreads widen, we have chosen to reduce exposure to credit, as ceteris paribus, credit spreads tend to widen far further when sovereign Spreads rise. However, where specific factors have given us comfort on certain credit names, and where there is abnormally large yield compensation for the risk being taken, we have been able to add yield enhancement to the portfolio without undue additional risk.
We have mainly focused on using bank NCDs and have continued to benefit from the wide funding spreads in this sector. As they mature, we will place shorter, or focus on floating rate notes. Our property exposure has been completely reduced, and we will only return to property once the peak of the rate cycle has been put in place. We remain focused on the fund objective of achieving an enhanced yield for our investors over the long term, with minimal volatility. Prescient Commentary
In South Africa, all eyes will be on ratings agencies S&P and Fitch, which will decide on South Africa’s sovereign credit ratings on 3 June. Fitch, which is no longer bound to a fixed review cycle but is nonetheless expected to announce its decision this week, said that South Africa should not attempt to rely on quick fixes and populist measures such as the minimum wage in the run-up to local government elections on 3 August. While Fitch, which rates South Africa’s foreign-currency debt at BBB- and its local-currency debt at BBB, is unlikely to downgrade South Africa, it may elect to change the outlook from Stable to Negative. Moody’s 6 May decision, against market expectations, to keep its rating unchanged was announced before news broke of disconcerting comments from President Zuma on state-owned enterprises such as SAA and of Finance Minister Gordhan’s possible arrest. If Finance Minister Gordhan is removed from office, it is believed that the rating agencies’ confidence in SA’s fiscal situation would fall and negative rating actions could follow. However, for now, expectations are for S&P to keep its BBB- foreign-currency and BBB+ local-currency ratings with a Negative Outlook unchanged when it releases its decision after business hours on Friday, 3 June. The MPC hiked interest rates by an unexpected 25 bps in March which took the repo rate up to 7%, but kept the repo rate flat in May. It was a close decision with the committee being split evenly between those in favour of a hike and those in favour of leaving rates unchanged. Inflation was once again the culprit as a weaker currency and higher local food and international oil prices would result in cost-push inflationary pressures. Rating agencies have expressed concern about the low growth environment and relatively large budget/current account deficits. These structural headwinds do not play favourably in the eyes of the ratings agencies.
3 month Jibar ticked up over the quarter from 7% to 7.32%, on the back of the rate hike in March. The FRA ended the quarter flat with the market currently pricing in 90bps worth of rate hikes in 12 months’ time. We have seen some widening in credit and funding spreads over the month. 3 year fixed rates ticked up around 30bps over the month and we used this as an opportunity to increase duration. We maintained the position in short dated inflation linkers due to the high expected inflation carry over the coming months.
At the end of May, the Fund held a mix of yield enhancing assets comprised of bank floating-rate notes, credit-linked notes, corporate paper, fixed, floating and inflation linked bonds, preference share, property and some fixed rate swap exposure. The duration of the Fund is just over 1 year, which is about 0.6yrs shorter than the ALBI 1-3 year index. Credit exposure remains conservative, primarily with the big banks, State Owned Corporations and large corporates. The Fund is currently yielding 10.18% versus 3m Jibar at 7.32%. The Fund outperformed both cash and the ALBI 1-3 year over the quarter.
Contributor to performance
The main contributor to performance was the high credit and funding spread in the fund.
Detractor from performance
The fund had fixed rate swap exposure that detracted from performance on the back of rising rates. However, we used this as an opportunity to lock into these higher rates and increase duration. We sold out the Anglo American exposure post the client instruction, which also detracted from performance.
Fund Objective - To manage the interest rate cycle to obtain the highest possible yield whilst ensuring the security of the capital invested.
*Managed by Prescient & Cadiz
*Suitable for investors with a low risk profile who are seeking managed exposure to income generating investments
*Tactically managed to secure an attractive return while protecting capital
*Recommended investment period is 12 months or longer.