Quarterly Commentary - Q1 2020

Market comment

March 2020 must be one of the worst and most volatile months on record, as financial markets globally responded to the economic consequences of the COVID-19 pandemic – a simultaneous demand and supply shock of unprecedented proportions. Policy responses varied across economies, but key actions have been the same: implement a lockdown to contain the health crisis and provide fiscal and monetary stimulus to support the economy. The market sell-off was widespread, as investors moved quite rapidly to increase cash holdings at the expense of risk assets. Even ‘safe-haven’ assets such as gold sold off at the height of the panic. This was despite central banks’ decisive policy action and government announcements of some of the largest economic relief packages in history.

South African equity and fixed income markets were not spared, with foreigners rushing to sell assets. The liquidity squeeze in the fixed income market forced the South African Reserve Bank (SARB) to step in and firstly cut the repo rate by 100 basis points – a magnitude of four times more than the incremental interest rate changes in recent years – and subsequently introduce an additional set of temporary measures. This was somewhat effective in stabilising the fixed income market, despite Moody’s finally downgrading the country to below sub-investment grade. Moody’s cited the lack of concrete action around structural reforms by government and massive downward revisions to growth due to COVID-19. This combination has given rise to a significantly worse fiscal outlook for the country’s overall debt trajectory, as South Africa struggles with a concrete plan to contain its debt levels.

On the monetary front, it seems as though the SARB’s Monetary Policy Committee is primed for more cuts to the repo rate, having revised growth down by a further 2% to 4% and indicating that inflation will likely be contained within the 3% to 6% range despite the significant weakening in the currency. At quarter end the forward rate agreement (FRA) market was pricing in further cuts of almost 100 basis points in this year. A lower repo rate, couple with enormous fiscal challenges, means a steeper yield curve is likely for longer.

Portfolio activity and positioning

A crisis like the one we have been experiencing produces once-in-a-decade investment opportunities. Price moves have been dramatic. We have been taking advantage of this deliberately and slowly.

  • Government bonds, being fixed-rate in nature, offered extraordinary value compared to the equivalent floating-rate bonds (including credit), and we increased government bond exposure as these instruments sold off. This will be highly accretive to returns over time. We have 12.6% exposure, with a fund modified duration of 1.15.
  • Due to the severe disruption in markets, the local bond market underperformed significantly in March. Foreigners sold record amounts, punishing the sector for the poor growth outlook resulting from the crisis. This underperformance is unprecedented.
  • There was a window of opportunity during which inflation-linked bonds were trading at unprecedented levels, offering real yields of close to 6%. We took this opportunity buy some for the portfolio.
  • Although property has been severely punished, we have slightly upweighted our exposure from 0.3% to 0.5%. However, we are still extremely cautious about the fundamentals of this sector and are not comfortable yet to take a meaningful position. We think the risks far outweigh any potential return.
  • Our corporate credit exposure was reduced slightly as we increased liquidity in the fund. Our rigorous credit process leaves us comfortable with the current underlying credit exposures, but we are continually monitoring these for any signs of stress.
  • The fund has enough liquidity to take advantage of the opportunities we expect when credit spreads widen. We have not yet decided to increase exposure to credit, as we believe credit spreads have the potential to widen further from here.
  • We are overweight South African banks. With strong capital buffers, relatively liquid balance sheets, strong risk mitigations in place and a supportive SARB, we think they will withstand this crisis.

The decision to increase modified duration has impacted short-term performance, as yields increased across the curve and we continued to buy. It’s impossible to call the bottom of a market, so we incrementally bought into weakness. It’s important to remember that this is not permanent loss of capital. Considering the yields these bonds are producing, we see this as a down-payment for compelling future returns. The fund remains a top-quartile performer across all relevant time periods.

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Written by Bronwyn Blood

Portfolio Manager

Prior to joining Granate Asset Management in December 2015, she was the Portfolio Manager of the Flexible Fixed Interest Funds and the flagship Absolute Yield Fund at Cadiz Asset Management. When Cadiz bought African Harvest in 2006 Bronwyn took over the management of the Flexible Fixed Interest funds. Bronwyn holds a B.Comm (Honours) degree from the University of Natal.

Bronwyn Blood B.Comm (Honours)