Quarterly Commentary - Q4 2019

Fund profile

The Granate SCI Multi Income Fund is a domestic income portfolio which seeks to provide investors with consistent positive returns and minimal volatility. The objective of the portfolio is to deliver real returns in excess of money market and traditional income portfolios over the medium to longer term. Investors are primarily exposed to the fixed income and credit markets.

The portfolio aims to optimize risk-adjusted returns by strategically allocating within the various sources of the fixed interest and credit universe according to current valuations. The portfolio will optimize the yield of the portfolio whilst compensating as far as possible for the underlying risk. This is done by focusing mainly on credit and yield enhancing strategies, whilst very moderate duration strategies are employed. The portfolio is managed in accordance with regulations governing pension funds and CISCA.

Economic overview

Economic growth in most regions is expected to have peaked, and consensus forecasts are for a mild slowdown. However, leading market indicators have started pointing to an increasing risk of a slowdown and possibly a US recession this year with other large economies also slowing down. Global inflation appears to be at cyclical highs which are well below longer term averages and recent inflation data releases have, on aggregate, surprised on the downside together resulting in major central banks slowing the pace of monetary tightening and communicating a more dovish message.

Domestic economic growth in 4Q18 (released in March) slowed to 1.4% q/q seasonally adjusted annualized rate (saar) from 2.6% in 3Q18 to register a full year expansion of 0.8% (1.4% in 2017). The mining sector remained the biggest detractor in the quarter and for the year while Gross Fixed Capital Formation (Investment) fell for a fourth consecutive quarter. Available data for 1Q19 continues to point to softness in the local economy as the mining and manufacturing sectors remain weak and car sales decline. Leading indicators such as the PMI’s and business confidence are depressed. Electricity outages now pose a very significant risk to the economic growth outlook and growth for 2019 can easily be shaved by 0.5% resulting in 2019 failing to beat the weak growth registered in 2018.

The Monetary Policy Committee (MPC) of the Reserve Bank met twice during the 1st quarter kept the repo rate unchanged at 6.75% – a unanimous decision in both meetings. The decision March decision was accompanied by the most dovish statement delivered by the MPC in a while, saying that “The overall risks to the inflation outlook are assessed to be more or less evenly balanced” – the first time in 6 meetings that it does not consider the risk to be on the upside.

Both core inflation and growth forecasts were revised downwards for the next three years and inflation expectations (measured by the BER) fell meaningfully, albeit remaining above the middle of the inflation target of 4.5% – something that the SARB is determined to achieve. The downward revision to the SARB’s growth forecast was the result of the “bigger than expected slowdown in the global economy, declines in business confidence, potential supply side disruptions from load shedding and growing pressure on household disposable income”. We consider it unlikely that the SARB’s growth forecast of 1.3% for 2019 will be achieved.

The MPC considers the current policy stance to be accommodative and the SARB’s Quarterly Projection Model (QPM) is forecasting 1 rate hike in 2019. It is difficult to see the need for further monetary tightening given the weak performance of the economy. However, given the SARB’s determination to get inflation expectations down to 4.5% we believe that a rate cut is very unlikely in 2019.

Market overview

After a shaky end to 2018 financial markets recovered in the 1sᵗ quarter of 2019 with all major asset classes recording a positive return.

Locally, equities outperformed all other domestic asset classes followed by bonds which returned an inflation beating return of 3.8% as foreign investors turned net buyers in the quarter – the first in 4. The bond market (ALBI) ended the quarter 22 basis points lower than where it started led by the medium dated maturities of the index which were the biggest beneficiary of lower inflation. Yields on longer dated maturities also fell, but to a lesser extent as investors remain concerned by the deteriorating fiscal outlook which has means that Government borrowing will increase. Yields on shorter dated maturities also lagged the decline of medium maturities as it has become evident that National Treasury will slow the pace of switch auctions which will reduce speculative demand for the shorter end of the yield curve.

Inflation-linked bonds also remained out of favor underperforming all other domestic asset classes in the quarter. For the 12 months to the end of March the asset class lost 3.1% – the largest loss since ILB’s were first issued in 1999. The asset class that is supposed to protect investors from rising inflation continues to destroy value, investors in this asset class now losing approximately 7.2% in real terms over the last 12 months. Looking forward, an upward leg in the inflation cycle does make the asset class more attractive, but the demand for inflation protection will remain subdued. We expect increasing demand for ILB’s during April as the inflation carry becomes attractive from May.

The listed property sector managed to break its 4-quarter streak of negative returns and outperformed ILB’s in the quarter to avoid the wooden spoon but remains a significant underperformer. While property yields are seemingly at attractive levels, oversupply and weak domestic growth pose further risk to the sector as its ability to meet revenue growth projections remains high.

Portfolio Activity

The Multi Income fund outperformed the the Stefi index for the quarter with a return of 2.38%, with the highest duration position during the quarter being around 1, and ending the quarter at a duration of 0.8. The fund remained true to its objectives of keeping duration below 2 at all times and focusing mainly on yield enhancement. As we saw bonds moving into more expensive territory we cut our duration position in the form of a swap overlay.

Credit spreads continued to narrow during the quarter and we are finding limited value in the credit market and we have shortened our credit duration position considerably. As credit has been rolling off we have been investing in 1 year NCDs which are offering very good value, especially when compared to longer dated NCDs. We will not be reinvesting extensively until we see better value in the credit market. The fund is positioned in high quality credit with the banking sector and insurance sector still being our largest weight.

Listed property has continued to underperform and we maintain a very low weighting to this asset class. We have also reduced exposure to inflation linkers as we are not overly concerned with a material increase in inflation and are getting more attractive real yields from nominal bonds, however it appears that inflation linkers are now offering better value than they have in the past.

Portfolio Positioning

With credit spreads having narrowed and looking more expensive, we are not finding value in the credit market. There are many corporate bond issuers that are facing enormous pressure in this very low growth environment as we have seen a number of very disappointing financial results coming through, with a number of issuers facing liquidity and solvency pressures. We do not see ourselves increasing our allocation to credit in this environment but will rather manage the duration of these instruments lower as we believe credit spreads will ultimately widen. The NCD curve remains extremely flat and we continue to find value in 1 year NCDs which are now offering well in excess of 3% on a real yield basis. Inflation linkers are also looking attractive against nominals, particularly in the short end of the curve. We will be looking for opportunities to increase the inflation linked exposure in the fund without compromising on liquidity. Our property exposure will remain low until we see the fundamentals or the growth outlook for this sector improve.

In an environment where corporate defaults and restructurings are becoming more frequent, we feel very comfortable with the fund being defensively positioned. Although it is tough to optimise yield with credit spreads continuing to narrow, we would rather be cautious on our level of credit exposure than experience negative drawdowns in the fund due to corporate stress. Money market paper appears to be offering better value relative to other asset classes and we will start to add inflation linkers to the portfolio as we have more conviction that inflation has bottomed.

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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)