Allan Gray, the asset manager that oversees the largest chunk of private capital in SA, says interest rates and inflation are likely to stay higher and stickier for longer than most people expect.
Though forward rate agreements, a type of money market futures contract used as a bellwether for future interest rate movements, are predicting at least two more 25-basis point rate hikes in the next six months, most analysts believe the rate hiking cycle has either peaked or is close to topping out.
But Allan Gray, which has about R560bn in assets under management, has positioned its fixed income portfolios on the assumption that the forward rates market is going to be proven correct in terms of where borrowing costs are heading. That would take the SA Reserve Bank’s repo rate from 7.75% currently to 8.25%, with Allan Gray’s dedicated fixed income portfolio managers Sandy McGregor and Thalia Petousis saying the forward market is pricing for at least a 50% chance of another rate hike beyond that level.
“Rates and inflation are likely to stay higher and stickier for longer than the market expects, both offshore and locally,” Petousis said in an interview.
“The market is pricing in two more 25-basis point hikes with a 50% chance of another one beyond that. It’s not to say the forward curve is always right but the forward market has been more right than not in recent times.”
Petousis and McGregor say that partially as a consequence of where they think rates may be heading, they have positioned their fixed income portfolios to be “low duration” with a reduced weighting to fixed-rate bonds relative to competitors.
With 2030 government bonds yielding around 10%, while one-year money market rates are offering about 9.4%, the fixed income duo say there is no point taking the duration risk of being locked into a fixed income instrument until 2030.
“We have been higher cash and low duration and that is because of the view we’ve had for a while that inflation will be stickier than people expect,” Petousis said. “We’ve held a lot more in cash and money market, which is providing returns in excess of inflation. The market is not paying you enough to own seven-year to 10-year bonds — not locally and certainly not offshore.”
McGregor says one of the underlying reasons Allan Gray believes inflation and interest rates will remain elevated for longer than expected is because it is largely being driven by factors that central bankers are virtually powerless to control. While raising the cost of borrowing can be highly effective in containing demand-side inflation that is being spurred by consumer spending, it is far less effective when price growth is stoked by pandemic-related supply side constraints or a spike in energy prices caused by Russia’s invasion of Ukraine.
“The ability of central banks to control inflation is actually very limited,” McGregor said. “All central banks can do is make sure money supply doesn’t cause inflation, but if there’s a drought or a pandemic or Russia invades Ukraine there’s not much they can do.”
High praise
Despite that view, both McGregor and Petousis had high praise for the Reserve Bank’s pre-emptive strike against inflation, as well as the 425 basis points in rate hikes the monetary policy committee has instituted since November 2021.
They argue that without that “orthodox” approach to hiking rates in anticipation of aggressive action by major global central banks such as the US Federal Reserve, the rand would have been far weaker than its current R18.31/$.
“Our inflation in SA isn’t a money [supply] problem,” Petousis said. “So all the Bank can do is think about the rand at this point in time. What the Bank is doing is risk management ... making sure they’re not setting up a situation where the rand goes to R25/$ because then we’d really see food and fuel prices blow up.”
As a major institutional buyer of government bonds Allan Gray also backed fellow asset manager Futuregrowth in saying Eskom would struggle to attract private investors into any of its ageing fleet of coal-fired power stations. Futuregrowth last week questioned the viability of electricity minister Kgosientsho Ramokgopa’s plan to revitalise some Eskom power plants with private sector investment, saying banks and asset managers are under too much pressure to reduce funding for fossil fuel projects.
“If you’re an institution you can’t use your client’s money to buy outdated coal-fired plants,” McGregor said. “We’re already under pressure for investments we’ve made in carbon intensive sectors in the past. The banks are also under scrutiny for funding anything linked to coal.”
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