Since last quarter’s commentary, global central banks have stepped up their measures to stimulate the world economy against a backdrop of declining inflation, increased trade tensions, a reduced level of exports and belowexpectation growth figures.

In China, this stimulus took the form of a cut in the reserve requirement ratio, a metric that determines how much excess cash banks are forced to hold. A lower ratio should inject cash into the financial sector and redirect lending to businesses and households. The European Central Bank cut its overnight deposit rate to an absolute rate of -0.5%, announced a new round of debt purchases and implemented a host of monetary tools to encourage banks to increase their lending. Similarly, in the United States, the Federal Reserve has cut rates twice in the last quarter.

What does this mean for fixed interest markets? In the developed world, around 40% of governments now issue 10-year debt at negative yields (the lowest yielding are Swiss 10-year bonds at -0.9%, and German 10-year bonds at -0.6%). In such an environment, one would expect South Africa’s government bond markets, in which 10-year debt currently yields around 9%, to be attracting significant foreign investor interest. Unfortunately, this has not transpired – with foreigners being net sellers of several billion rand in SA debt year to date.

Fears of collateral damage arising from US President Donald Trump’s trade war are partially to blame for this negative sentiment towards emerging markets. Arguably, even more to blame would be South Africa’s fiscal risks, the “Eskom problem” and a government spending deficit estimated by some analysts to rise to about 6% of GDP, or approximately R300bn. Certainly, the South African Reserve Bank is cognisant of these risks – with all committee members unanimously deciding to keep our interest rates unchanged at the September monetary policy meeting. The current committee’s preference for caution and prudence when setting interest rates in a “persistently uncertain environment”, should continue to keep South Africa’s fixed interest yields elevated versus country peers.

One-year bank funding levels have dipped from 8.30% to 7.60% year to date. This decrease partly reflects the market’s forward expectations of interest rate cuts. As a result of this decline, the Fund has had to reinvest cash at falling yields, which has lowered the return for investors in line with lower benchmark rates. That said, returns remain well in excess of inflation of 4.3%. Over the quarter, the Fund favoured fixed-rate opportunities in the belly area of the yield curve given a flattened risk-return profile. This allows us to defensively reinvest cash at higher yields in the shorter term should market risk sentiment turn further negative towards South Africa.

Commentary contributed by Thalia Petousis

In last quarter’s Fund commentary, we discussed our view that money market yields were unusually attractive due to high interest rates combined with low inflation. We didn’t expect this to last. The decline started this quarter as the market started to price in future interest rate cuts, meaning the Fund is reinvesting cash at lower yields than recent years. We expect future Fund returns to drop but remain attractive relative to 4.5% inflation.

South Africa needs higher economic growth to move forward. Lower rates are often cited as the easiest solution, in the hope that this encourages borrowing and injects money into the economy. We agree that real rates are too high in South Africa and believe that rates will be cut by more than the market expects. There are few signs of global inflation, with global bonds signalling the opposite as developed market yields fall back towards zero. Local inflation remains similarly benign, despite external volatility caused by input prices and the exchange rate. This, plus growth challenges, suggests increasing pressure on the Reserve Bank to lower rates.

Unfortunately, we doubt that lower rates will have a meaningful impact on growth, even if we are right about aggressive rate cuts. A more lasting solution is to correct the structural deficiencies plaguing the economy. However, such actions are unpopular since they require a short-term cost to pay for long-term gain. Allan Gray’s philosophy of prioritising the long term over the short term applies to economic policies as well as investing, meaning we strongly favour a focus on improving the supply side of the economy despite the short-term pain. We are not policy nor macroeconomic experts, but there is sufficient low-hanging fruit among the country’s many challenges to have a meaningful impact.

Over the quarter, the Fund favoured fixed-rate and longer-maturity instruments that should delay the impact of lower rates.

South Africa’s economy has performed poorly over recent years. Five years ago, at the end of 2013:
-The South African government had R1.6tn gross loan debt or 44% of GDP, and Eskom had around R250bn gross debt. Government debt has since grown to R2.7tn (as of September 2018), substantially faster than GDP has grown. Eskom gross debt has grown even quicker to R420bn, or 16% of GDP.
-Nominal GDP was growing at 8.8% per year. This growth rate has since dropped to 7.9%, despite much of the increase in government debt being used to fund ‘counter-cyclical fiscal policy.’
-The rand/dollar exchange rate was R10.35/US$ and the 10-year government bond yield was 8.0%. Exchange rates and bond yields are reliable indicators of risk for a small, open country such as South Africa. Both have increased materially over the last five years, the rand/dollar to R14.38 and the government bond yield to 9.2%, highlighting South Africa’s economic decline.

In US dollar terms, the FTSE/JSE All Share Index (ALSI) has fallen 3.2% over five years while the FTSE World Index has increased by 26.8%. Share prices do not always represent underlying realities, but this seems a fair indication of South Africa’s decline relative to the rest of the world.

In light of the above, low risk assets such as cash have been among the best performing South African investments over recent time periods. The outperformance of cash over one year is notable, generating 7% return compared to -9% from the ALSI. Investors who have sat on the sidelines have been rewarded for doing so. This is unlikely to continue forever but until hard choices are made to correct South Africa’s deficiencies, money market investments offer attractive returns higher than inflation with minimal volatility.

A steep money market curve and a high supply of treasury bills offered attractive investments for the Fund. Purchases this quarter were concentrated in one-year bank instruments and six-month treasury bills, at 8% or higher yield.

Commentary contributed by Mark Dunley-Owen