Efficient, risk-adjusted positioning in the sweet spot of high yield assets

Comparing a snapshot of global macroeconomic factors midway through 2023 with one taken at the end of the year, illustrates the dynamic, fast-paced environment in which portfolio managers make their asset allocation decisions. Case in point, the significant shift in outlook for global inflation and interest rates that played out in the last quarter of 2023.

At our first half 2023 update, Sanlam Investment Management (SIM) told clients to expect further interest rate hikes from the United States (US) as the US Federal Reserve (the Fed) continued its struggle against then stubbornly high inflation. The Fed did not disappoint, hiking rates by 25 basis points in July and keeping them pegged at near-20-year highs for the remainder of the year.

At the time, our concern was that high interest rates would throttle the US economy, bringing about a recession that would filter through globally. As the team managing the SIM Inflation Plus Fund, we were cautious on return expectations from risky assets, though we indicated that the services component of the US economy seemed robust. Our asset allocation view was influenced by the attractive risk-adjusted returns on offer from global bonds and cash, while we preferred JSE-listed shares over both emerging market (EM) and developed market (DM) equities.

Inflation and interest rates remained ‘top of mind’ as we headed for our second-half 2023 update. One key development was the potential Fed ‘pivot’ at the start of the third quarter last year; they signalled that inflation was slowing and showing signs of trending towards their 2% target, opening a ‘window’ for several interest rate cuts in 2024. Risky assets performed strongly on this expected pivot, driving portfolio returns higher over November and December 2023.

The big surprise in 2023 was that the US did not enter a recession despite that country’s infallible (until now) leading indicator signalling an economic contraction. Historically, every period bar one of significant US interest rate hikes, has been followed by a recessionary period not least due to consumers and corporates incurring higher debt servicing costs and having less disposable income to buy goods and services. Entering 2024, market participants were looking for signs of whether the expected Fed rate cuts would materialise.

SIM favours in-country Purchasing Manager Indices (PMIs) as a higher-frequency, near-real-time indicator of economic health, as opposed to GDP growth figures. PMIs measure the prevailing economic trajectory of manufacturing with either a goods or services skew. Entering 2024, many countries were recording manufacturing PMIs below 50 points (a negative outcome), while several services-focused PMIs were above the key level of 50 (indicating expansion). On these measures, the US economy appeared to be moving along quite solidly, but many economies in both the DM and EM regions were taking strain.

Returning to the inflation outlook, we note that many DM inflation rates are trending down to more manageable levels. Many EM countries, however, are still grappling with high inflation, with some levels uncomfortably above 10%. South Africa’s CPI print in December 2023 however remained within the South African Reserve Bank (SARB) 3-6% target range, at 5.1%, and is expected to trend closer to the midpoint of the band by 2025.

Very high inflation is a concern for central bankers since it eventually constricts economic growth by making goods and services unaffordable, impacting corporate earnings and labour. Among DM central bankers, there is general agreement that a level of 2% inflation is desired. One would expect a level of 0% inflation would be preferred but targeting 0% introduces the risk of deflation (a general decline in the prices of goods and services), that also results in lower consumer spending, plummeting corporate profits and sluggish economic growth. Deflation however is the greater evil, since once it takes hold, it could send an economy into a deflationary spiral.

The US Fed knows all too well what happens when they get the timing of interest rate cuts wrong. In the early 1980s, then US Fed Chair, Paul Volcker, discovered that inflation can reignite with the slightest encouragement. At the time, he felt that inflation had been tamed following a number of rate hikes and started cutting rates again, only for core inflation to reaccelerate, prompting the central bank to hike interest rates once again.

Entering 2024, the US Fed will be very cautious about repeating Volcker’s timing error, meaning that portfolio managers will have to wait patiently for the US rate cutting cycle to begin. Market implied cuts are priced in around June or July of this year, if not later.

The US ‘recession or not’ debate is also worth unpacking in more detail because a slowdown in the world’s largest economy has major implications for asset allocation decisions. Historically, US recessions are bad news for risky assets, with several of the MSCI World Index’s all time negative returns occurring during these economic downturns.

One of the recession indicators the market relies on is the Sahm Rule Recession Indicator. The indicator, which is published by the Federal Reserve Bank of St Louis and others, indicates imminent recession derived from a calculation of momentum in the unemployment rate. The reason for this indicator’s popularity, was that it came very close to its trigger level earlier this year.

In relation the fund’s performance in 2023, for the 6-month to year end, was in line with the peer average, over the one- and three-year periods slightly behind, and over 5 and 10 years in line with the peer average. Importantly the fund has been able to protect client’s wealth over rolling 12-month periods, bar the COVID crash where the rolling 12 month dipped below zero but recovered to above 0% just as quickly. Our approach in managing inflation plus funds is to achieve clients’ targets by taking the least amount of risk possible, hence the tilting of our clients’ funds towards interest bearing assets given the attractive yields at present.

Overall, most of the fund’s 2023 contribution to return came from its exposure to interest-bearing assets such as enhanced cash, nominal bonds and inflation linkers, complemented with risky assets including local and offshore equities and bonds. Major detractors from performance for 2023 included MTN as it struggled, and continues to struggle, with the devaluation of the naira; Richemont which produced underwhelming returns driven not least by China ‘reopening’ story flattering to deceive; and Naspers which buckled under tough Chinese regulations to restrict spending on, and addiction to, gaming.

We maintain that the economy and markets have yet to feel the full impact of one of the swiftest hiking cycles since the 80s. US inflation in particular remains above the Fed’s 2% target, while that economy continues to ‘run hot’. We thus continue to expect rates to remain higher for longer, in particular locally. Thus, we look to take advantage of these high real yields while on offer and have tilted clients’ portfolios towards these interest-bearing assets, The overall mix remains diversified across the bond, cash and equity asset classes, both locally and offshore. In particular, high real returns on offer from SA government bonds, are second only to Brazil at present. SA nominal bonds are offering around 6% real, resulting in our preference for these over the somewhat pricier inflation linked bonds (ILBs). As for equities, our preference remains for selected South African counters over EM and DM shares.

Over the coming year, investors can rest assured that the SIM Inflation Plus Fund portfolio management team will remain consistent in achieving the most efficient risk-adjusted returns for our clients.

*Fernando Durrell is Head of Absolute Return at Sanlam Investment Management.