Major market inflection points: Thinking about portfolios for the next decade - Angles & Perspectives

Major market inflection points: Thinking about portfolios for the next decade

Conditions have changed substantially over the past 18 months, and we believe the weight of the evidence suggests that the market has probably reached an inflection point. In our view, the probability has shifted towards a more reflationary global backdrop, which the market is not yet pricing in. This is likely to have wide implications when considering asset classes that performed well over the last decade, and those that can be expected to deliver real returns at appropriate levels of risk over the next decade. Accordingly, fixed income investors need to review their strategy and explore the benefits of multi-asset income funds for generating real returns at low levels of risk.

Where we have come from
It is useful to reflect on history, and how it has shaped investment portfolio construction choices until now. Inflation has been on a steady downward trend in the US averaging roughly 4% since the 1970s. However, despite significant monetary policy stimulus by the US Federal Reserve following the Global Financial Crisis (GFC), the inflation rate has disappointed, only averaging 1.87% over the past decade (as at August 2021). Considering this, it is understandable that investors have become accustomed to persistently low inflation and interest rates in developed markets, having benefited from steadily falling bond yields and the rise in prices of stocks which have high growth expectations, and long-term cash flow payback profiles.

Contrast this to South Africa’s inflation targeting journey. Since inflation targeting was implemented in the early 2000s, inflation has averaged close to 6%. Measured monthly, however, inflation has been above 6% roughly 46% of the time – proving that it has been very hard for the South African Reserve Bank (SARB) to steady inflation until recently. For markets, this volatility around targets made it difficult to determine the appropriate premium above expected inflation for investing in long-dated bonds. Over the last decade, however, the SARB has credibly managed to reduce both the average inflation rate to 5% and the volatility of inflation. Observing this process, it is clear how hard it has been for market participants to adjust expectations lower from 6%, despite a very credible SARB showing commitment to achieving a lower inflation outlook.

The current inflation reality
Developed market fiscal and monetary policy has seen dramatic changes over the past 18 months, particularly in the US. The Covid-19 crisis showed governments that they could run much higher budget deficits than historically considered prudent alongside extremely accommodative monetary policy. Current and projected fiscal spending at levels previously only seen in wartime, is now considered acceptable policy.

In South Africa, inflation is likely to remain subdued and within the target band, with the usual factors (electricity, wages and food price inflation) unlikely at present to force the SARB into hiking rates quickly. Further, with low demand resulting in lower imported inflation pressures (through a weak rand), it is also likely that inflation will be less volatile around the 4.5% mid-point of the SARB’s target. Lower volatility is typically good for bond investors.

Consequently, as we look at evidence on the likely path of the macroeconomic environment in years ahead, the probability has grown that the investment landscape will be unlike what markets have been used to, namely low inflation in the developed world and high inflation in South Africa.

What this means for income investing in South Africa
Low and stable inflation is good for the general health of the economy, providing stability for businesses in terms of input costs and cost of funding, and being supportive of real growth in general, as it allows for lower and narrower moves in interest rates. Commodities make up a large share of SA’s exports and have provided much-needed support for the country’s high debt levels. In a reflationary developed world, SA would continue to benefit directly, as well as through second-round effects, from greater spend locally. Currently, valuations imply an extremely low probability of positive economic surprises in SA continuing for a longer period. Forecasts for real GDP growth next year are potentially too low, reverting to what we have been used to for years. This is not inconsistent with this year, where expectations have been significantly below outcomes.

For income investors, a lower repo rate path implies a few key things:

• Investments into cash, money markets and other shorter-dated (low duration) instruments would continue to generate low yields for a sustained period.
• Investors need to consider longer-dated bond yields which offer attractive real yields and stand to benefit from the shift in macroeconomic conditions, off very low expectations.
• Investors need to consider using multi-asset income funds which are able to fully exploit the current government bond opportunity, as well as use a broader suite of asset classes to bridge the gap to client income requirements.

Ultimately, expecting a quick return to a repo rate of 7% (as in 2018) appears less likely with inflation contained at present.

Bonds to generate real returns
We see government bonds offering value in a subdued SA inflation environment, as well as yielding a sufficient margin of safety to offset potential inflation shocks. These bonds offer real yields above 3% at the 5-year point, and in excess of 5% from the 10-year bond onwards, with likely less than the historic inflation volatility ahead. This is extremely attractive for income investors, and we believe government bonds will be a vital tool for generating real yields where shorter duration assets could underperform. We do not believe SA is likely to experience a debt trap in the near term. Therefore, these valuations are deemed very cheap (yields are too high!) relative to our expectations of inflation and a less extreme fiscal path.

We believe that these shifts in the macroeconomic environment are significant and are likely to alter risk-return outcomes, and therefore necessitate serious consideration of asset class allocations within a fixed income portfolio. While we consider a higher than average duration very appropriate, an investor need not be all in by investing only in the longest and highest yielding bonds, with sufficient risk-adjusted opportunities across the government bond curve.

An income solution for the next decade
Real returns are central to our investment process, with each security analysed on a bottom-up basis and required to meet a real return hurdle before being included in our funds.

When considering the current landscape, we still believe that large portions of the fixed income market will remain under pressure to beat inflation for some time to come. Specifically, we refer to cash, corporate bonds and large portions of the money market universe. Conversely, as noted, we see bonds offering value both in a subdued inflation environment and at a sufficient margin of safety for any potential inflation shocks to the system. Given the major change in macroeconomic conditions and shifts in probability towards a higher inflationary world, we believe it is important to think about what your portfolio would do should the global environment play out as more inflationary.

When analysing the fixed income space, historically, a key means to supplement yield when rates have been low would be the use of local property (REITs), which historically offered inflation-linked distributions (dividend yields). Investors had become used to seeing property alongside bonds in a portfolio, seeing property largely as bond-like. This has been the traditional approach, which in recent years has disappointed tremendously given the excessive usage of debt by REIT structures to ensure dividend growth in a low growth economic environment – falling 36% in 2019 pre-Covid. We believe in a local market that is likely to have lower inflationary pressures, and a property market still highly indebted facing lower rental increases, there are selective and limited property opportunities available to apply this strategy at an appropriate level of risk.

Our process continues to benefit our investors
At PSG, we apply one investment process to all asset classes. This allows us to filter both property and preference shares through our established equity process, allowing cross comparisons of risk-reward metrics. As such, we have not been invested in property (pre-Covid) for some time and have instead largely used selected equity ideas and preference shares to supplement and in some cases lower the risk within our multi-asset portfolios. The PSG Diversified Income Fund, which falls within the ASISA multi-asset income category, has been broadening the net for some time and using all asset classes as allowed within its risk tolerance and mandate. Consequently, we have been able to diversify away some of the risk of SA fixed income where local property would not do so. We do so by allocating a small portion of the portfolio to assets at deep margins of safety, earning attractive dividend yields in both local and offshore companies we believe will compound cash flow into the future. Importantly, we believe when looking ahead, this strategy will result in a more robust, diversified portfolio than the traditional approach of relying on low-risk fixed income (expected to underperform) and property (select opportunities available, but also correlated to long bonds).

Positioning income portfolios appropriately for the challenges ahead is key
Markets appear to have reached an inflection point. In our view, the probability has shifted towards a more reflationary backdrop, which we believe the market is not yet pricing for, especially when considering the concentrated positions in assets which have benefited from low developed market yields.

We expect that these small shifts in probability are likely to shift risks in the market, as well as provide significant opportunities to generate attractive returns at a wide margin of safety in areas largely unloved by the market at present. While we believe duration is central to a local fixed income portfolio, an investor need not be all in on duration. Rather, there are attractive means to supplement income yields for clients by using all asset classes which pass through our multi-asset process.

PSG Asset Management.