Fixed income funds: Looking ahead into 2022
South African bonds remain relatively compelling, Victor Mphaphuli, STANLIB’s Head of Fixed Income
Asset managers navigated a tough environment over the last two years as the pandemic led to worldwide economic shutdowns and the market grappled with inflationary pressure which prompted interest rate hikes in a few regions, including SA.
Fortunately, unprecedented funding support from central banks quickly alleviated the resulting liquidity challenges.
In early 2022, more uncertainty prevailed in financial markets. In this environment, it is critical to remain agile and active to achieve inflation-beating returns while protecting against the risk of losing capital.
STANLIB’s Fixed Income team considers four broad themes that will drive valuations and opportunities in the South African market this year.
1. US Federal Reserve (Fed) actions: Reducing balance sheet debt and managing inflation
Sustained higher inflation in the US and the tightening labour markets have raised a strong case to increase interest rates and implement quantitative tightening. Although we expect that interest rates in the US will move higher from March this year, we expect the Fed will be measured and adjust its policy stance according to prevailing economic conditions. We expect to see four rate hikes this year from the Fed and the announcement of balance sheet reduction from the middle of the year. This will lead to tighter financial conditions globally and poses some risks to assets like South African bonds. The wider spread between US and SA bond yields provides some valuation cushion for domestic bonds, so we do not expect to see a major sell-off in local bond yields as a result.
2. South Africa’s financial well-being
The health of SA’s fiscus is critical when driving economic growth and attracting foreign investment. The future of local markets depends on whether government can deliver a sustainable debt path. It is imperative that National Treasury sticks to fiscal prudence in its upcoming February Budget. There are some risks on the expenditure side of the Budget but at the same time we expect revenue will surprise further to the upside. National Treasury will need to strike a good balance between providing social support and charting a sustainable fiscal path for SA. Positively, in December, Fitch revised its outlook on SA’s BB- sovereign credit rating from negative to stable. Fitch justified the move by referring to “the faster than expected economic recovery, the surprisingly strong fiscal performance this year and significant improvements to key GDP-based credit metrics following the re-basing of national accounts”. The only rating agency to watch closely is Moody’s, which maintains the country on a negative outlook, but with recent developments leading to an improved fiscal position it is quite possible that the trough has been reached.
3. Local interest rate hikes
The decision to raise interest rates as soon as November 2021 was probably influenced by the vulnerability of the rand, underscored by recent developments in global financial markets. With upside risk to the South African Reserve Bank (SARB)’s inflation outlook, and a negative policy rate adjusted for forward-looking inflation, the SARB faced the risk of falling behind the curve. Further inflationary pressure in 2022 provides a strong case for increasing local rates further, also in a quest to pre-empt the Fed’s tightening. Markets are expecting aggressive rate hikes through the year, as evident in the FRA curve, which indicates 190 bps of increases over the course of 2022. STANLIB’s Fixed Income team expects there will be rate increases over the coming months, however, we recognise that in a low growth environment and with inflation and inflation expectations still contained these hikes will not be as aggressive as market expectations.
4. Attractiveness of South African bonds
Given these factors, we consider South African bonds remain a compelling investment, particularly compared with other emerging markets. While the US may raise interest rates, there remains a significant premium for investing in SA. We remain constructive on domestic bonds. Our fair value for the 10-year bond yield is 9.25%.
If the Fed raises interest rates at a faster pace than expected, this poses a risk to domestic bond yields and valuations. Our fiscal health poses a further risk and, while tax revenues have been boosted by recent commodity price increases, we will look for government spending to be appropriately allocated to drive growth and improve the debt trajectory.
In 2022, market uncertainties prevail with the direction of inflation and timing of interest rates likely to change as economies shift. We expect policy tightening across all markets. We have reduced risk in the portfolio and continued to decrease modified duration across the spectrum of fixed income funds we manage. In our view, local fixed income assets currently offer better return prospects and we expect South African bonds will deliver a total return of 15% for 2022 and inflation-linked bonds around 9%.
It remains critical to constantly monitor for changes in sentiment and be agile in portfolio management and asset allocation in a continued uncertain and volatile environment. Most of the volatility this year will be driven by central bank actions.