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South African bonds offer opportunities relative to their peers

SIMON BROWN: I’m talking now with Daniel King, head of fixed income at Counterpoint Asset Management. Daniel, I appreciate the early hour. You put a note last week around our bonds, and you point out that South African bonds are – we’ll get to the vigilance part in a moment – ​​cheap, especially relative to their peers, providing opportunities here.

DANIEL KING: Yeah. Thank you, Simon, thank you for having me. I think the fixed income space globally is actually a pretty tricky space right now because there are risks everywhere with inflation and rates moving everywhere. But in terms of order of preference, we generally prefer emerging market bonds to developed market bonds right now, because we have this heritage in the developed market universe of massive central bank involvement in bonds of state. While we don’t necessarily know the exact magnitude of the impact of this on yields, it does raise a question mark as to the appropriateness of pricing these bonds. In emerging markets, we don’t have this problem, so we think the market is at least free to properly price risk. Although the risks are of a different nature, they are free to assess the risks that exist and compensate us for them.

South Africa is in this space. And so, in particular, our government bonds are actually one of the cheapest outliers on the valuation spectrum, offering yields of up to 10.6% right now – which, if you use the historical inflation rates, could be a real return of up to 5%.

It is plausible that if the inflation target is lowered to peer level over the next decade, it could reach 6%/7% real at some point in the future. This is simply unprecedented in the developed markets space, where the real interactions are mostly still negative. So yes, we are generally quite overweight in South African bonds, but we are also quite sensitive to the risk involved, as we pointed out in the note that we published. This is why we are always careful to diversify these exposures to a reasonable extent; and the situation may change. If that changes, we will have to change our minds, but for now we are overweight.

SIMON BROWN: I will take this point. It’s fluid and things can change quickly. But you also make the point [that they are] obviously attractive, not without risk. There will always be risks, especially when we are cheap. Turkey is an example. I guess the fact is that we are not Turkey. In South Africa, you can lay a lot of blame on our doorstep, [but] being Turkey is not one of them. We have, at least, a very independent central bank.

DANIEL KING: Exactly. I think so. So that’s very important when you think about the fundamental pillars of a well-functioning government bond market. The first is monetary integrity and the second is fiscal integrity. We think South Africa ranks quite well when it comes to monetary integrity.

We have arguably more central bank independence than even the [US] The Fed or the ECB, which have arguably become quite politicized in a way.

The core mandate of our central bank, which is to maintain the monetary integrity of the country, is actually enshrined in the Constitution, which requires a two-thirds majority in parliament to change. So I think we definitely have that going for us, but perhaps the biggest and most imminent risk, in our case at least, is the fiscal side.

There are scenarios in which GDP growth continues to be weak, fiscal momentum declines, and spending discipline is undermined. These are not necessarily beautiful scenarios for us. A lack of growth, I think in particular, could usher in unhealthy macro politics over time, and those are the kinds of structural changes that create the negative feedback group psyche, like the one you’re seeing in Turkey right now. This is something to be aware of.

But, having said that, in our current baseline scenarios – and this is true for the Treasury and also true for the IMF – the public debt-to-GDP ratio should stabilize over the next five years, and obviously the market is wise at these risks. Our point is actually that it’s a good price. So we’re actually more comfortable taking well-priced risk in an emerging market environment, being one in the DM space, which we’re not necessarily compensated for.

SIMON BROWN: I take this point. The actions of central bankers in developed markets distort this price. But also, while you were saying that, a thought came to me. They become almost beholden to the markets rather than some kind of good old-fashioned economic policy. I’m thinking about that tantrum of 2014. We’ll see what happens this week with the selling we see.

Daniel King, Head of Fixed Income at Counterpoint, I appreciate the early morning.