Current context
Fixed income markets started the period with a continuation of the positive sentiment we saw in the final quarter of 2020, but faced a difficult and volatile ending to the first quarter of 2021. Local fixed rate and inflation-linked bond yields continued to benefit from inflows
into emerging market bonds during the months of January and February. Higher expected global growth following on vaccine rollouts and the opening of economies, maintained expectations of higher global inflation (at more normalised levels). Locally, the fiscus received a much needed positive growth surprise in the fourth quarter of 2020, marginally closing the year- on- year GDP contraction for 2020. This spurred positive sentiment, but most importantly, implied that National Treasury was under less pressure to borrow through the issuance of additional bonds the local fixed income market. Towards mid-February, the 10-year bond yield reached its lowest level in a year at 8.5%.

The second half of the quarter, however, saw a swift change in global sentiment. Markets began to fear that higher than expected growth, significant fiscal stimulus and accommodative global monetary policy would lead to the risk of soaring inflation. Rising inflation by its nature is one of the biggest risks to fixed-rate bond returns, eroding value over time. The result was that the US 10-year bond yield rose sharply to reflect the expected higher issuance and inflation expectations (from 0.79% in December 2020 to 1.7% at quarter end) in the US. US breakeven rates (the market-implied inflation rate) rose above the Federal Reserve’s long-term target of 2%. The 10-year South African government bond followed suit as global bond yields rose in sync, yielding 9.5% at the end of March and reversing earlier gains. The February budget was considered relatively growth positive, however, as in 2020, the global backdrop was overwhelmingly difficult for SA bond investors. The result was a negative -1.74% return for the Albi for the period. Conversely, as fears of inflation rose, South African inflation-linked bonds had a strong performance delivering roughly 4.5% for the period. Cash returned 0.9% for quarter, reflecting the low rate environment. Global equities continued displaying strong positive momentum since markets reached a low in March 2020. By the end of the first quarter of 2021, the MSCI World Index had recovered 79% from its March 2020 low and returned 5% during the quarter under review (in US dollar, including dividends). On the domestic front, the JSE All Share Index (ALSI) finally broke through its pre-pandemic record high set in 2018 and delivered its strongest first quarter performance in 15 years, posting a quarterly total return of 13.2% in rand. Given the recovery of the local currency over the past year, which as recently as in April 2020 traded above R19 per US dollar, ALSI total returns of 79% in rand since the March 2020 lows translate to an impressive 115% when measured in US dollar. The property market continued its recovery, with a return of 6.4% for period.

Our perspective
Given the significant shift in global fiscal and monetary policy in 2020 and, the extreme divergences in bond markets, the excesses of last year were bound to unwind somewhat as investors grapple with the level of real yields available in developed markets and particularly in the US. While the absolute level of the US 10-year bond remains low relative to history, the sell-off shows a pricing-in of higher than targeted near-term inflation and sends a clear message from the bond market that security selection needs to consider a higher inflation
environment. Importantly for investors in SA fixed-rate (nominal) bonds, rising US bond yields do not imply a permanent impairment to valuations. South Africa’s local fixed-rate bonds currently trade at roughly 7.5% above the US equivalent bond (nearly 2% higher than the long-term average premium, which both accounts for credit risk inherent in SA bonds and any additional inflation protection required). Therefore, we believe the current move upward in yield is rather transitory for local bonds and present a compelling buying opportunity. SA inflation will likely rise in the years ahead, but in our view, this move is unlikely to be significant given the credibility of the SARB and the low inflation impulse in SA. It is important to contextualise the market backdrop we have seen over the period. Sovereign fiscal stimulus both during 2020 and expectations for the current year, remain sizable relative to history and the resultant borrowing requirements in fixed income markets are significant. Considering where developed market bond yields trade, investors are required to fund this massively increased supply at yields below that of expected inflation, at negative real yields. In contrast, emerging markets, and South Africa in particular, remain among the few sovereigns offering a high real yield for investors.

Portfolio performance and positioning
We believe the market (as communicated previously) will remain volatile as the US bond market finds a level of confidence in where the 10-year bond yield should trade. We have been able to add to areas of conviction in South Africa’s bond curves where we believe the
yields available are compensating well for both local and global risks. We believe it is appropriate to think alternatively about protection against inflation surprises ahead and as such have increased holdings in preference shares and a selection of local listed property names meeting our 3M process. In addition, the fund continues to make use of our local and global equity buy lists where we believe we both enhance the ability to generate through the cycle real returns for clients, but also add much needed diversification of future return sources in deeply undervalued securities. We continue to hold direct offshore cash, local cash and floating-rate exposure where spreads areattractive to balance risks in the fund.
Over the quarter the PSG Diversified Income Fund and the benchmark both returned 1.44%. The contributors over this period were equity (0.90%), cash (0.79%) and local government bonds (0.34%). Over a 1-year period the fund delivered a return of 13.05% versus the
benchmark return of 3.87%, despite the tough market environment. There has been a marginal increase in preference share and local property holdings during the period, where we believe there aremispricing’s to be exploited. In addition, these instruments provide protection against rising inflation. The fund has increased exposure and duration within nominal (fixed rate bonds) where we believe the valuations have become cheaper as global bonds have sold off.