Currencies, bonds and beating inflation: What can investors expect?
This Q&A is based on a conversation that Anil Jugmohan, Senior Investment Analyst had with Dave
Foord and Rashaad Tayob of Foord Asset Management.
AJ: Dave, what are your thoughts on currencies and beating inflation at the moment?
DF: The Dollar has been strong, but interestingly the Rand has been relatively firm versus the Dollar compared to other currencies. We expect that the Rand should come back to about R16 to the Dollar. If the Dollar weakens by 10%, this will have a significant impact on inflation. As we always say, inflation is the enemy for investors. The Nedgroup Investments Stable Fund targets inflation + 4%, while the rest of category targets inflation + 3%. So we have to work a bit harder but we think we can do it. Inflation beating returns are still achievable in this environment. Not necessarily this week or next week - but it will come.
AJ: And what about using the bond market to beat inflation, anything interesting happening there?
DF: South African government 10-year bonds are offering 11% currently. If South African inflation goes above 7% over the ten-year forward period, then we can’t get inflation + 4% from this asset class so we would need to look elsewhere. At the moment, we have lower inflation than the United States, but this won’t last. Where inflation is going, ultimately depends on quite a few factors. There are some fat tails in the scenarios we look at, and we have to consider the volatile rand and commodity prices too.
AJ: Is there any comparison globally to what we could experience here in South Africa?
DF: The Rand could blow out, like Zimbabwe, Sri Lanka, Egypt, Turkey and Columbia. There are lots of other examples where the government has handed out money but couldn’t pay it back. However, South Africa is in a stronger position because we borrow very little in Dollars and most of our borrowing is mainly in ZAR. Furthermore, we have a relatively well funded government pension fund, which helps too. So inflation will probably not run away, but if government spending in South Africa increases dramatically then we will have a problem on our hands.
AJ: What about what we’ve been seeing in the UK?
DF: The UK and EU are prime examples where the taxpayer is already stretched and now there are even more demands on them. Those governments are giving away money like South American governments, so it wouldn’t be a surprise if the same thing happens to their currencies.
AJ: Rashaad, continuing the analogy to the UK, how does South Africa fare?
RT: When the conservatives are fighting over how much money to spend in the UK then you know the policy framework has shifted. Usually it’s the labour government wanting to spend. The South African government got quite lucky. Our policy framework was not right and we were taking on a load of debt just to maintain a growth level which turned out to be quite low. We were not controlling spending but still had too low growth.
AJ: So what’s changed in South Africa then?
RT: In this respect, nothing has really changed in South Africa, although we still need proper policy to get the economy kick started again. Interestingly, it’s actually similar in other countries too, so we’re relatively fortunate that their deficit spending and money printing is bailing us out. We also got the commodity windfall of about R100bn but a lot of that will get spent fairly soon. Globally, the system is a mess, but in South Africa we’re actually ok.
AJ: Ok, changing focus a little bit, what are your thoughts on the Fed?
RT: The Fed is reacting quite late to US inflation. They were still increasing their balance sheet even when inflation was at 6-7%. Then to catch up, they went pretty extreme in the opposite direction and raised rates dramatically to counter rising inflation. During the last 20 years, they had not done more than a 25bps hike each time, but as we’ve seen now it has been hikes of 75bps each, which shows how aggressive they have been.
AJ: And what is the market pricing in?
RT: The market is pricing in 4% rates in the United States now. That puts pressure on Emerging Markets, the UK, Europe and Japan. We are seeing aggressive currency wars versus the United States, where inflation will probably remain sticky above the 2% level. Breakeven inflation expectations are at about 2.4% over 5 and 10 years. This seems like the market is being naïve and assuming a return to normality. But if you look at more realistic indicators of the economy it doesn’t seem like we will go back to normal.
AJ: How has this shown up in asset prices?
RT: Stock markets have fallen, and credit spreads have widened significantly, especially high yield. Mortgage rates have gone up from 3% to 6% and now no one is buying houses in the United States anymore. We have seen a significant slowdown. The consumer is still cash flush from all of the Covid-period handouts, but the labour market is starting to struggling, with, for example, full time employment starting to fall. So the situation remains difficult.
AJ: What about the situation here in South Africa?
RT: The SARB took rates down to 3.5% during Covid to boost the economy and were only raising quite slowly initially but more recently have realised that we are actually an emerging market so also stepped up to 75bps hikes. We’re now at 5,5%, with the market pricing rates at up to 8%.
AJ: What impact does this have on inflation and bond yields?
RT: Inflation should come down to more normal levels in South Africa by Q2 next year. But at 7 – 7,5% it is in line with where we are as an emerging market. We can expect more rate hikes to come. Bond yields are already at 11%, but there is still some value in the bond market and also potentially in the shorter end of the curve too where you can get 8,5 – 9%, which is good compared to what we had during the financial repression of the past two years where rates were extremely low.
AJ: Ok last question for you, what has been the impact on global asset prices through all of this?
RT: Asset prices have come down, bond prices have come down, risk premia have widened so globally credit spreads are wider, so there is a lot more value, but we are in an environment where things are messy and we’re fighting the Fed. Until you see signs of where United States inflation can be better controlled, the Fed will continue to be aggressive. So while there is good value out there, we may need to wait 3-6 months before the Fed becomes less aggressive in their approach. However, given what’s happening in Europe that may actually happen sooner. This will lead to better value in the various asset classes once again.