Quarterly Commentary - Q2 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

Uncertainty around global economic growth momentum, concerns relating to trade tensions and the possibility of slower global trade translated into dovish comments by both the European central bank (ECB)and the US federal reserve (FED). Both central banks referred more openly to the prospect of policy loosening if growth risks materialise and follow a wave of central banks that have either adopted or alluded to monetary policy easing.

Domestic economic growth in 1Q19 (released in June) came in a lot worse than expected at a seasonally adjusted annualised rate of -3.2%, the worst contraction since 2009. The contraction was broad based – agriculture, mining and manufacturing sectors deteriorating the most – suggesting that the cause of the slowdown is not limited to electricity outages. Leading indicators such as the PMIs and business confidence remain depressed and available data for 2Q19 continues to point to softness in the local economy as the mining and manufacturing sectors remain weak and car sales continue to decline sharply. That said, the electricity supply has stabilised, and the softness does not appear to be as severe as 1Q19. While a technical recession (which brings with it negative sentiment) will probably be avoided, the lowered GDP growth forecast for 2019 of both consensus and the SARB might be difficult to achieve.

The Monetary Policy Committee (MPC) of the Reserve Bank met once during the 2nᵈ quarter and kept the repo rate unchanged at 6.75%. However, the vote was much closer than previous meetings with two of the five members voting for a 25bp cut. The MPC revised its headline and core CPI inflation forecasts lower across the entire forecast horizon. CPI forecasts are now only slightly higher than the mid-point of the inflation target of 4.5% over most of the forecast horizon – something that the SARB has been determined to achieve. There was also further downward revision to the SARB’s growth forecast for 2019 which is now expected to average 1.0% (down from 1.3% in March) because of the larger than expected slowdown in the first quarter. The MPC now expects a materially wider output gap than previously envisaged, due to the disappointing 1Q GDP. A wider output gap and a lower inflation trajectory, which is closer to the mid-point target of 4.5%, are reasons that the Quarterly Projection Model (QPM) now embeds one 25bp cut by the end of 1Q20, as opposed to the March 2019 forecast which had one generated hike by the end of 2019. The inflation trajectory and an MPC that sees the balance of risks around its inflation projection being more or less even, provides room for a rate cut and cyclical support for growth without comprising its main objective or credibility.

We therefore believe that rate cuts are very likely in the 2nᵈ of 2019 with the risk of rates remaining flat if Eskom’s challenging financial situation (and the knock-on consequences this could have for South Africa’s fiscal position, credit rating, and exchange rate) cannot be resolved.

Market overview

Financial markets had a 2nᵈ consecutive positive quarter in 2019, buoyed mainly by dovish central banks and despite generally softer economic data in both emerging and developed markets.

Locally, all major asset classes recorded a positive return. The listed property sector (4.52%) outperformed all other domestic asset classes followed closely by equities (3.92%) and bonds (3.70%). For the 12 months to the end of June, listed property has however underperformed all other major asset classes. Despite the short-term outperformance in listed property, yields are seemingly at attractive levels. We are however wary of the risk that the oversupply and weak domestic growth poses to the sector as well as the risk inherent in the highly geared offshore investments. What is becoming more apparent is that the correlation of listed property with the equity market continues to rise as it does its volatility.

Lower growth, inflation and probability of lower policy rates have driven the US 10yr bond below 2% for the first time in almost three years. The local bond market (ALBI) ended the quarter 13 basis points lower than where it started led by the medium dated maturities of the index, despite foreign investors turning net sellers of bonds in the 2nᵈ quarter. Yields on longer dated maturities also fell, but to a lesser extent as investors remain concerned by the deteriorating fiscal outlook which means that government borrowing will increase. The fiscal deterioration worsened at the State of the Nation Address (SONA) where there was commitment by government to accelerate the timing of the fiscal support for Eskom to ensure that the utility has enough cash to meet its commitments in the short to medium term.

Inflation-linked bonds continue to perform poorly – now the only domestic asset class to record a negative real annualised return over the last five years, as investors have had little appetite for the long end of the curve due to more attractive valuations for long dated nominal bonds. Looking forward, an upward leg in the inflation cycle, real yields of 3% (and above) and potential repo rate cuts does make the asset class more attractive, but the demand for inflation protection over the medium term will likely remain subdued. The lack of demand will be compounded by the inflation carry becoming less attractive post July.

Portfolio activity

The Multi Income fund outperformed the the Stefi index for the quarter with a return of 2.40%. The fund’s duration hovered between 0.7 and 0.8 over the quarter, and was able to benefit from the strong performance in bonds. The bond swap spread narrowed over the quarter as bonds outperformed swaps which benefitted the swap overlay position that the fund had in place.

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. The majority of the fund exposure is in the 1-3 year area now as longer dated credit spreads are not compensating us for the risk in this asset class, particularly in the lower rated categories. 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.

Although listed property performed well over the quarter we slightly reduced our exposure to this asset class. We also have a very low exposure to inflation linkers, however it appears that since inflation has bottomed, inflation linkers are now offering better value than they have in the past, particularly in the short end. Although inflation linkers are generally illiquid, the shorter end government bond linkers have decent liquidity characteristics.

Portfolio positioning

After the significant rally in bonds we will be monitoring our fair value model closely to determine whether we should be reducing duration. At the moment the fair value model is indicating that the bond market is still offering value, and we cannot escape the fact that on a real yield basis government bonds appear to be offering a significantly positive risk adjusted real return. Floating rate credit appears to be getting more expensive as spreads adjust lower and issuers are using this opportunity to come to the bond market, benefitting from the significant flexibility that the corporate bond market has to offer.

In an environment where the corporate bond market is flooded with demand and spreads continue to narrow, 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 since there are now certain signs 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)