2016 has proven to be a very good year for investors in RSA (government) bonds. Bonds have outperformed equities and cash by a large margin this year. By 17 October, the All Bond Index (ALBI) had delivered a total return (including interest reinvested) year-to-date of 14.2%, compared to 2.7% provided by the All Share Index (ALSI) of the JSE. The inflation-linked RSA Bond Index (ILBI) had returned close to 8% by 17 October, while the money market would have returned 6.2% over the period. By contrast, an investment in the S&P 500 would have lost ground this year as we show below.
The JSE, when measured in US dollars, has performed very strongly this year, having returned close to 10%, though these returns have trailed behind the emerging market benchmark (MSCI EM) that returned 15.5% year to date-well, ahead of the 6% return provided by the S&P 500, though much of the extra return from the MSCI EM Index came in October as the rand weakened, temporarily it would now seem, in response to the fraud charge raised against Finance Minister Gordhan (See figure 2 below).
The strength in emerging market equities has given strength to emerging market currencies, including the rand, as more capital flowed towards emerging markets and their currencies. Less global risk aversion and the capital flows that drives the MSCI EM Index higher is generally helpful for the rand as well as the US dollar value of the ALSI. SA-specific forces acting on the rand can be identified by the ratio of the USD/ZAR exchange rate to the USD/EM basket exchange rate as we do below. A weaker rand relative to other emerging market currencies, indicated by an increase in the ratio of the rand to other emerging market currencies, represents extra SA risks and a lower ratio less SA risk priced into the exchange value of the rand.
The performance of the rand and other emerging market currencies is shown below, as is the relative performance of the rand. All emerging market currencies weakened against the US between 2012 and 2015, though rand weakness was especially pronounced by year end 2015. The rand not only strengthened in 2016 in line with other emerging market exchange rates, but has recovered some of this relative weakness vs the emerging market basket after mid-year. This indicates generally less SA-specific risk in 2016 – helpful to the bond market also as expectations of inflation recede somewhat with rand strength and long term interest rates accordingly decline.
Recent interest rate trends are shown in the figure below. Long term interest rates in SA are significantly lower than they were in January – though are above the lows of mid-August. Hence the good returns realised in the bond market to date.
When the rand strengthens for SA-specific reasons (less SA risk) as has been the case since mid-year, the different sectors on the JSE will react differently. In these circumstances, the global plays listed on the JSE (companies with much of their revenue and costs located outside SA) that provide investors with a hedge against a weaker the SA economy, will tend to underperform the ALSI (and vice versa when the rand weakens in response to an increase in SA-specific risks rise as was the case for much of 2015).
We show these forces at work in the figure below. The USD/ZAR gained relative to other emerging market currencies from mid-year, indicating less SA-specific risk. The global plays, represented by an equal-weighted index of 14 such stocks we describe as global consumer plays, lost ground both absolutely and relatively to the ALSI. A strong rand, for global or SA-specific reasons, is good for the SA economy and the companies dependent on it. It means less inflation and so lower short term interest rates, which in due course can be expected to encourage extra spending and borrowing by households.
This year the rand value of the global consumer plays on the JSE has been negatively affected by both the strength of the rand and the weakness of sterling. Some of the companies we describe as global consumer plays are in fact more a play on the UK consumer, as can be observed. The global consumer plays on the JSE in 2016 performed closely in line with the S&P 500 – in rands – while lagging behind the ALBI and ALSI.
This raises the important question – under which circumstances can bonds be expected to outperform equities? The US markets over the long run provide some insights in this regard. As we show below, US Treasury Bonds consistently outperformed equities through two distinct phases, during the Great Depression (when deflation afflicted the US economy between 1929 and 1938), and more recently during the near deflation and slow growth that burdened the US economy for much of the period since 2008. It would that seem slow growth, especially when accompanied by low inflation or deflation, is good for the performance of bonds relative to equities.
JSE-listed equities have provided superior returns over bonds or cash since 2000, as we show below, as would have been expected given the greater volatility of their returns. R100 invested in early 2000 with dividends reinvested in the JSE ALSI would have increased by 10.5 times by 17 October, equivalent to an annual average return of 15.8%. The same R100 invested in the less risky bond market would have multiplied by 6.7 times if committed to the Inflation Linked Bond Index (ILBI) and by 5.3 times if invested in the ALBI. These returns are equivalent to impressive average annual returns of 12.4% for the ILBI and 11.3% for the vanilla bond index, the ALBI. This is impressive when compared to consumer prices that rose 3.7 times over the period. Measured by the standard deviation of these annual returns, that were 23% for equities and 6% and 6.5%t p.a for inflation linked and vanilla bonds respectively, the bond market in SA has clearly delivered very good risk-adjusted returns both absolutely and compared to equities.
Deflation seems a very remote possibility for the SA economy. But SA inflation rates can recede, as recent history has demonstrated. Less inflation than expected, even when inflation remains at high but generally declining rates, will bring down interest rates and increase the returns on bond portfolios as the value of bonds rise. Slower SA growth rates, independent of inflation, will also tend to improve the performance of bonds compared to equities. In other words, if past performance were to be our guide, the case for a larger weight in bonds over equities in portfolios can be made on an expected combination of less inflation with slow growth. The case for equities over bonds will be made with faster growth and less inflation.
In the figures below we compare the relative performance of equities over bonds with the phases of the SA business cycle. The ALBI significantly outperformed the All Share Index during the slow growth years between 1995 and 2003. As growth took off, because inflation came down between 2004 and 2008, equities more than made up for the earlier underperformance. During the brief recession of 2008-09, bonds again outperformed, but have since lagged behind equities. However bonds have held their own with equities since 2014, as household spending and capex by firms slowed in response to more inflation and higher short term interest rates.
The relationship between the relative performance of inflation linked bonds (only indexed since 2000) is even more closely identified with the business cycle. Inflation-linked real interest rates are strongly pro-cyclical. They rise and fall with growth rates: faster growth brings increased demands for capital and so higher real rates. As we show below, equities have outperformed inflation linkers during the expansion phases of the SA business cycle and underperformed as growth slowed. These comparative returns have level pegged since 2014.
A comparison of the performance of SA bonds and equities since 2000 leads to a similar conclusion to that drawn for the US. SA equities do best with faster growth while bonds can outperform when growth slows down. Faster growth in SA can only be anticipated when the rand stabilises (or better still, strengthens) enough to hold back inflation so that interest rates can decline to stimulate more consumption spending.
More growth with less inflation will be better for equities than bonds – especially when compared to inflation linked bonds. Less inflation expected will provide very good returns from vanilla bonds – but still better returns could be expected from equities in such highly favourable economic circumstances. It will take a combination of favourable global growth trends, and so less emerging market risk, combined with less SA specific risk, to make it all possible. 21 October 2016