South African interest rate trajectory over the course of 2020, Ameer Amod, Head of Absolute and Fixed Interest

This year, interest rates in most developed economies fell to zero, and in some cases, below zero. In this Market Matters Podcast, Ameer Amod, Head of Absolute and Fixed Interest at Old Mutual Multi-Managers, discusses the interest rate trajectory over the course of 2020 and how this has affected the bond market. He also looks at why it's imperative to take a long-term view when it comes to investing and what the outlook for the future could be. For more information visit www.ommultimanagers.co.za

Transcript

Ian Fraser  00:01

This year is definitely one for the record books. 2020 has indeed been a turbulent time on many fronts, given Brexit, the COVID-19 pandemic, and the US elections, to name a few. As we approach the end of a year marked with many challenges and uncertainties, there might be a widespread reluctance to make firm plans for 2021. 

In this Market Matters podcast series, we explore the most prominent economic themes with investment analysts from Old Mutual Multi-Managers. They help us make sense of the equity, property, and fixed interest markets, and also share insights on how diversification could be the key to survive next year and beyond. 

Ian Fraser  00:43

Let's talk to Ameer Amod, who is the Head of Absolute and Fixed Interest. Ameer began his financial career in financial services back in 1998. That seems like an age ago, Ameer, my goodness. He also has extensive industry experience as a Portfolio Manager, a Head of Quantitative Research and the Quantitative Analysis as well, amongst other things. You're also a bit of a writer Ameer, obviously, you present at investment conferences and to all sorts of clients, and write about the markets, etc. 

Welcome to the podcast, it's great to have somebody who is up to speed with all of these things. I'm looking forward to our chat.

Ameer Amod  01:22

Thank you, Ian, and appreciate your kind words of introduction. Yes, likewise, looking forward to our discussion this morning.

Ian Fraser  01:29

So, Ameer, let's start with a global view of what you do, so that anyone listening can really get a sense of what it is that we're going to be chatting about.

Ameer Amod  01:37

So, I think when you speak about fixed income, it's always good to look at it initially from a global perspective as to what's happening globally. And I think the main concerns that we generally hear in global markets, as well as the local market, is what is the part of expected inflation and interest rates. And I think I want to cement that very quickly in saying that, if you look at the next 18-24 months, inflation is likely to remain subdued. 

But with the renewed lockdown that we are seeing... a few days ago, I had a chat with a friend of mine who works in a Canadian asset management company. And he said that - this was on Tuesday - and he said, "Yeah, we're actually back into lockdown". So, these renewed lockdowns, second, third, fourth waves that we are seeing locally and globally as well, these actually present downside risks to inflation. 

What we've also seen globally, Ian, is that savings rates have picked up, you know, and the velocity of money in some of your major economies have actually fallen. So, the point here is that they are still very strong deflationary forces at play. So, as a result, we can expect inflation to be muted or subdued over the next - over the short- to medium-term.

Ian Fraser  02:44

You're saying 18-24 months? Is that kind of the timeframe that you're playing with at the moment?

Ameer Amod  02:49

I think it's a reasonable timeframe to look at. I mean, if you look at longer-term, you know, they are equally compelling arguments for and against high inflation. But I think if you look at the short- to medium-term, it's not much of a concern from both local and global fund managers that we speak to in the fixed income space.

Ian Fraser  03:07

So, let's talk about the path then of the interest rates up to now really. I mean, the bloodbath has happened. And as you say, the second, third, fourth, waves, please not second, third, fourth, but it might happen. It is happening overseas in the global areas. 

How have those rate cuts affected the bond performance?

Ameer Amod  03:22

Okay, so let me start with once again going back to the global picture, and then I will move on to South Africa. If you look at global bond yields, firstly, I think there's really little risk of yields rising. In other words, you know, moving from - they're currently at the 0% level, so moving from 0 to 1 or 2%, etc. Because if you look at global economies, they're actually operating well below normal, so that in itself deflationary. 

Secondly, I think declines in interest rates are also unlikely, because central banks have cut rates basically to the zero bound. And they have thrown ample liquidity into the system, which has resulted in significant compression of global bond yields. So, if you look at some of the global bonds, Ian, if you look at Germany, if you look at - I mean, you're getting negative real rates. In other words, if you put R100 into a bond, you're getting R99 back. I'm just using hypothetical numbers here to speak about negative real rates globally. The local picture certainly is subdued. 

But Ian, I must just draw your attention to two recent events that have happened in the local economy. Okay, before I even get there, let me put it this way: COVID has actually exacerbated an already weak economy in SA. We've got deep structural problems. Those things existed before COVID and has been exacerbated post-COVID. 

But the two most recent events, which you're probably familiar with, is that rating agencies have recently downgraded us. This was last week Friday. So, Moody's and Fitch have downgraded us further into the sub-investment grade category and the S&P maintain their sub-investment grade position. Also, the second event is the sub decision actually kept rates on hold. So, the first, about the rating agencies, if you actually followed the bond market last week, it was a non-event, you know. And I don't want to sound dismissive, but effectively, I think that this has been largely priced in. We've been talking about downgrades for the last two years, it happened earlier. And the bond market is adjusted to that. 

So, a lot of this negativity or talk of downgrade has been largely patched into the bond market. So, it's not a new phenomenon, and ultimately, we could form the holdings of South African bonds to around the 29% mark, anyway. I think what's important from the message of rating agencies is that they are basically very doubtful of government's ability to implement fiscal consolidation. And the decision by the Reserve Bank to have kept rates on hold, it basically vindicates the recent caution about fiscal risks in the economy. 

So, although the decision to have kept rates on hold was not unanimous, I think the bank is unlikely to cut rates during this cycle again. Because if you look at - we speak of forward rates, in other words, what the market expects on a forward looking basis, in terms of interest rate expectations, in terms of increasing rates or decreasing rates, the money market curve is no longer discounting any further rate cuts. 

Ian Fraser  06:18

Right. 

Ameer Amod  06:19

So, that's the position in terms of the part of interest rates within the local and global economy.

Ian Fraser  06:24

You paint a rather sketchy picture at the moment, it's not seeming incredibly positive. Let's stay on this line of chatting for a second here and talk about the risks then in the bond market, because really, I suppose there are plenty. I'd love you to unpack that for us, just so that we can get an idea specifically in the South African market.

Ian Fraser  06:44

Ja. So, that certainly has been a very worrying feature of the local economy and investors in particular. But I think what I find interesting about the bond market is that it's the place where interest rate risk is basically priced. So, if I put it very simply, if you are not credit worthy, on demand higher compensation from by lending your money, and if I find that your credit worthy, I will demand his compensation. And that compensation is reflected in the level of interest rates. 

So, I think, firstly, if you look at our current money market rates, you know, they're around the 5% mark. So, you're not 4 or 5% mark, and looking forward for money markets, you could probably expect rates less than inflation going forward. So, two or three years ago, you could easily get inflation plus 2 or 3% by being exposed to the money market. 

Ian Fraser  07:32

Okay. 

Ameer Amod  07:32

But that advantage has not dissipated. But, ja, so, I think what's important is, it sounds a bit negative. But if you look at the yield curve, now the yield curve is it basically gives you an indication of rates, one year, two years, three years, 10 years, 20/30 years out in terms of rate expectations. If you look at what we speak of the 10 plus area of the yield curve, at the belly to the long end of the yield curve, your rates are quite high, so they around 9% plus.

So, the compensation that we are getting for the risks that we will speak of, we've actually compensated for the risks in the in the South African market. And I shall, I'll just unpack some of those risks very quickly. 

Ian Fraser  08:12

I'd love that, ja.

Ameer Amod  08:13

Firstly, I think what we appreciate, Ian, is that the cost of capital in South Africa is very high. You know, for the government to borrow at 9 or 10%, it's actually significant high, which makes the cost of capital for businesses' functionaries in this economy quite high. And I think what's scary is that, Ian, one out of every R5 basically goes to servicing our debt. You know, so that is worrying. And I think we need to do the right things now, it's become non-negotiable. 

Ian Fraser  08:40

Right.

Ameer Amod  08:41

So, a lot of the risks that we speak about in the bond market, the major concern is fiscal risks. A decade ago, South Africa's debt to GDP was around 25%. And our projections are, you know, it could approach the 90% level, etc. So, there's been concern about fiscal consolidation, prescription default, the state of the SOEs, etc. And certainly, these are things that we have to think about very seriously, you know, because the implication of this is certainly higher interest rates for the high cost of capital in SA. 

But let's just talk about the issue about default. Firstly, I mean, we have exited the Big B because we are sub-investment grade, okay, that happened a while back. But domestic fund managers are already holding about 20% of SA bonds and foreigners around the 29% level as well. And I think this fear of default has led to the yield curve in South Africa being very steep. And when we speak of a steeper yield curve, we mean that your long-term rates are very high, relative to short-term rates. So, if you look at the long end of the yield curve, for simplicity, I just want to round of numbers here, it's about 10%, and the short tail around 3.5%. 

So, there's a significant gap. And that's the steepening, the spread between the long end and the short end, that results in the steepness of the yield curve. So, what it's effectively telling us is all these risks that I mentioned, about fiscal consolidation, state of the SOEs, issues like prescription, has largely been this premium between the long rate and short rate, significantly embeds some of the distance we are concerned about. So, what I'm effectively trying to say is that we are being compensated for the risks that are already priced into the market. 

So, I think if you look at the yield curve, you're getting rates about 6% above inflation. So, that long end of the yield curve is compensating us handsomely for this fear of default. And speaking on the subject of default, I mean, that being said, South Africa is not a classic case of default. Firstly, these countries can operate with a very high debt to GDP. And secondly, most defaults happen with the inability to service dollar denominated debt. If you look at our debt, it is mostly land-based, not dollar denominated. And if I look at our external debt to GDP, it's probably less than 10%. Foreigners are holding about 30% of bonds, banks holding 23%, pension funds are holding about the same amount, around 20% of local bonds. 

So, effectively, if there is a default, the whole system will collapse. So, oxygen masks will be released, you know, so I'm not sure to what extent we will be resuscitated in that environment, because, you know, it has a contingent effect on other asset classes. 

Ian Fraser  09:01

Of course, it does, yeah. 

Ameer Amod  11:19

And so, the point is that, historically, the bond market has given you 2% above inflation, currently it's offering about six or 7% above inflation. And that compensation is basically embedding this risk that we speak of. And the other issue that comes to mind is prescription. Firstly, SA managed to only hold 20% of the bond market, a bit more than 20% on average. I mean, there's no need to actually force pension funds to actually buy SA government bonds. I mean, they see the value in government bonds, and they've allocated a significant portion to these government bonds. I think more importantly, it looks like the ANC appears to have accepted the arguments against prescription. So, that's a positive thing. 

But in South Africa, Ian, capital is not the problem. It's the capacity to deliver which is the issue.

Ian Fraser  12:09

And you mentioned the SOEs. Those state-owned enterprises are going through a very, very torrid time at the moment, aren't they? I mean, there's very little light in the end of the tunnel.

Ameer Amod  12:22

Sure, yes, it's been a challenge. You know, I think largely there's been obviously elements of corruption, which have resulted in mismanagement within SOEs. But the other issue, Ian, is that certainly, if you look at what COVID has done, it has certainly also had a significant impact on SOEs. Like, if you look at AXA, for example, you know, it's an entity with, you know, it has high operating costs, high operating leverage, etc. But it's an entity that is actually critical to the country's transport infrastructure. And we know that with the impact that COVID has had on tourism, you can see the impact this would have had on access cash flow, as an example. 

But there are SOEs like the Development Bank, STB SA, as well as IDC, they have strong balance sheets, and also their debt profile is longer term. I think Land Bank have some issues, but they have recently, from what I understand, have resumed interest rate payments, and are getting some support from National Treasury as well. But certainly, as I said, Ian, these can be fixed, firstly. And I think we're at a point where it's non-negotiable anymore. You know, we need to reduce this cost of capital and funding in South Africa.

Ian Fraser  13:37

It's exactly right. I think you've hit the nail on the head, it is non-negotiable. We're at that precipice now, where if we don't start to make a plan, we are going to fall off the cliff. Which leads me nicely on to my next question, from a high-level point of view. Let's just go over a default. You mentioned oxygen masks coming out and, you know, having to be resuscitated, etc. 

What are some examples of economies that have defaulted on loans? Have you got any on the top of your head, and what has been the outcome?

Ameer Amod  14:03

Firstly, I think most have defaulted on dollar denominated debt. So, in other words, they have borrowed externally quite heavily. 

Ian Fraser  14:09

Right. 

Ameer Amod  14:11

We don't have that problem in SA. Ja, and if we see structural reforms within South Africa, it'll certainly lower the cost of capital. And what's more important, Ian, we need this economy to grow. If you have growth in the economy, then it certainly restores confidence to local and global investors. And at the same time, it reduces the cost of capital and reduces the risk of default. So, I mean, if you look at the last 10 odd years, our growth has been very anemic in South Africa. 

I think, and I stand corrected, I think Venezuela was the only country that has defaulted on local currency debt. 

Ian Fraser  14:47

Right. 

Ameer Amod  14:48

But most, from some of the research I've come across, where - and this goes back to I think the 1800s and is a list of many emerging market countries - I mean, Russia is a prime example as well, where defaults have happened, is mostly dollar denominated debt. So effectively, what happens, Ian, is that your currency weakens. And it becomes very expensive to finance dollar type debt. 

So, I don't think - I think that fear of default has led to our cost of capital being high, apart from other structural issues within the SA economy. But I think it's also probably a bit overplayed, we are getting compensated. If as those fears of default dissipate, we will certainly see some strengthening in the bond market, which will be positive for the local economy.

Ian Fraser  15:30

Ameer, I love your positive lining of all of this conversation. It's quite inspirational, actually. I want to talk particularly about investment and the returns that we can expect going forward. I'd love to find out what those expectations are. Because, you know, as you say, there has been some green shoots, some new sort of opportunities that might have shown their head. What can we expect?

Ameer Amod  15:56

Ian, the first thing we'll speak about, is people always look at cash as a safe asset class. But I think as investors, it's really imperative that we take a long-term view when it comes to investing. And if you look at cash currently, like you alluded to earlier on, on a forward-looking basis, I like to get returns which are less inflation. Now, if you actually protect the purchasing power of your money, you need to have returns above inflation. Cash is not going to give you that over the shorter term, because rates are historically low now in South Africa. So, be invested in cash. 

I think that's an opportunity cost, you know, and we know that two/three years ago, fund managers were heavily invested in cash, because as I mentioned earlier, you could get the inflation plus 2 or 3% quite easily. That advantage has now dissipated. But if you look at the view, the yield curve, and this is where our managers and our position has been in the funds that we offer, we are basically positioned in that belly to long end of the yield curve, where you're getting a return 6 or 7% above inflation. Two important things to note here, we know in the bond market, we talk about yields weakening and strengthening. And I'll use very simple examples just to illustrate my point. 

Ian Fraser  17:08

Yes. 

Ameer Amod  17:09

If yields weaken, in other words, move from say 10 to 11%. Because effectively investors are now demanding higher compensation-

Ian Fraser  17:16

Okay. 

Ameer Amod  17:17

-by asking for more. If yields weaken, the bond market works in a funny way, you immediately take a capital loss. So, your overall return with the short term would effectively be very similar to cash. But the point is, you're getting a positive return in the end. But if yields strengthen, in other words, move from 13-11, or from 10-9%, we speak about strengthening of yields, that's very positive for the bond market, and you get a strong capital injection. 

If yields strengthen and yield will strengthen, firstly, before I go on, just prior to the US elections, our bond yields were on 920/930 level, that's the 10-year bond. And post that, and the positive sentiment that came with it, we saw a positive disposition towards emerging markets, which led to a strengthening of South African bond yields. So, they move from the 920 level to about 880/890 currently, and that was very positive for the bond market in South Africa. 

So, this strengthening of yields if we move from 10 to 9 to 8, etc., you could potentially see double digit returns, Ian, and I'm talking about probably around the... ranging from... depends which part of the yield curve you're exploiting, could be from 12% to 20%, etc. These are equity-type returns that you would get, and this is from the bond market. But Ian, it does come with one caveat, that one must expect volatility as well, you know, so it's not that these times are going to come quite easily, they will come with some level of volatility. 

But I think as a team within Old Mutual Multi-Managers, we spent a lot of time unpacking these risks in a bond market, Ian. We spoke briefly about SOEs, debt to GDP, prescription, the fear of default, we've unpacked each of these risks. And the question we ask ourselves is that are we being compensated by being exposed to, being aware of the risks? And being allocated to that long end of the yield curve where the valuation certainly is? And we believe that is the case. 

So, I think it's important that, you know, it does take about a year to see changes in asset allocation shifts. I did make a comment that managers were heavily invested in cash, and we're likely to see managers buy into the bond market, because that's where the value is, with the local fixed income. So, I think what's very important, Ian, is that when you speak of valuation, or it's important to firstly, understand why the market is cheap or expensive, and also the system assess, you know, are risks getting incrementally worse or better.

Ian Fraser  19:43

Right. 

Ameer Amod  19:43

And, ja, so we look at - basically assess both sides of the coin and make our investment decisions based on that. So, a lot of what goes into this type of research. Because at the end of the day, we want to position our portfolios to the upside, we want to buy into stuff that has, you know, worked in the short term, but have a negative effect to clients capital over the longer term.

Ian Fraser  20:05

It's interesting, I'm hearing a lot of analysts and a lot of people in the know talking about the longer terms, you know, not just rushing in and expecting things to get better in the short term. Rather, investing in the long term, watching out for it, and seeing exactly how it rolls out.

Ameer Amod  20:20

I agree with you. Because I mean, Ian, as we know, in the shorter term, there's a lot of noise, there's a lot of fluctuation, you know, the market basically leads us every day. But I think one has to see through this noise and see what the value is. I think, you know, as - there's certainly, when it comes to investing, and there are strong behavioral biases. 

And yes, I think with some of the research that we've come across, people are likely to be two times more negative than positive, you know. Some of the research done by Daniel Kahneman, etc. You know, we are emotional beings. So, at the end of the day, when we speak about default risks, we try to look for pieces of safety without actually appraising those risks. So, it's important to appraise the risks, and are we getting compensated for that. And I think we are, certainly so. 

Ian Fraser  21:08

Interesting times. Interesting times. May 2021 be a little bit less bumpy than this past year for us. I think we're all looking for a positive outlook. Ameer Amod, the Head of Absolute and Fixed Interests at Old Mutual, we really appreciate your time. Thanks for giving us an explanation. That's given me a bit of a better picture as to exactly where we sit. And I wish you a good 2021.

Ameer Amod  21:31

 Likewise, Ian, to you as well. And thank you for the opportunity, and appreciate your questions, and enjoyed having a good chat with you. Thank you very much.

Ian Fraser  21:43

Old Mutual Multi-Managers are a specialist investment boutique within the Old Mutual Group, South Africa's largest and most established financial services company. They offer affordable investments that blend together the best of South African and offshore asset managers. Old Mutual Multi-Managers is a division of Old Mutual Life Assurance Company (South Africa) Limited a licensed financial services provider and life insurer.