The recent turmoil in financial markets has not been confined to equities. Bonds have been the worst-performing asset class for two years running, returning a dismal 4,2% in 2007. Does this mean the tide is ready to turn, that it can’t get any worse and that investors should pile back into bonds again after two really bad years?
Many commentators are calling this the year for bonds, but it’s not quite that simple. Markets don’t work according to calendar months, and in our view there are still far more headwinds than tailwinds facing the domestic bond market.
The factors driving the poor performance of bonds relative to cash have not yet dissipated. For too long, risk internationally had been mispriced; our relatively higher rates meant that we benefited from the carry trade, which pulled South African bond yields down to unsustainably low levels. Suddenly, the world worked out that risk is, after all, a four-letter word; risk premiums spiked and with that, South Africa — in line with other emerging markets — sold off.
In addition, we are faced with rising inflation in South Africa and, unlike the previous cycle, it is not only being driven by the pass-through effect of a weakening rand. This time around, we are faced with a barrage of higher food prices, higher fuel prices, higher municipal rates and Eskom’s 14% to 20% (or more) tariff increases — for the next three years! What’s worse, these are all feeding through at the same time. And where we had the counter-effect of the deflation in imported clothing helping in the past, we are now faced with the treat of some inflation out of China.
All of this just means that inflation is going to be sticky for much longer. Inflation is likely to peak over the next three to four months, but instead of coming down in a straight line, it is going to struggle to get below 6%. This is going to make the South African Reserve Bank governor’s job very difficult, particularly if faced with the “worst-case scenario” risk of a blow-off in the rand.
Meanwhile, the economy is clearly showing signs of a slowdown — not least of which the roughly 0,5% that Eskom’s problems are estimated to have shaved off GDP growth. Retail sales, car sales, manufacturing production and credit growth have all slowed down dramatically; the latter is now below 20%.
But getting back to the bond market: Is it offering value? The Benchmark R157 is trading at about 8,7%, yet cash gives you 11,75%, so there is huge negative carry in the bond market. Over the next three to six months, we expect bonds to continue underperforming cash.
Also, bear in mind that Eskom’s funding requirements will result in many bonds coming to the market. In addition, the minister of finance will have to do something to help Eskom, whether it is recapitalising it, guaranteeing its bonds or issuing on its behalf, which once again means more bonds coming to the market. Typically, that means bond yields rise. All this will have to be digested in the near future.
Our advice is to wait for the sell-off, then buy. When bond yields are giving you 9% to 9,5%, you can justify a greater exposure to the asset class.
Malcolm Charles is a portfolio manager at Investec Asset Management