Allan Gray Income Fund

One of the most frequently asked questions we get about our new interest-bearing funds is how they will perform through a rate-cutting cycle. On the day before South Africa’s September 2024 rate cut was announced, the Fund’s weighted average yield gross of fees was 10.06%. It subsequently declined by 15 basis points (bps) following the 25 bps rate cut to reach a yield of 9.91%. This was still higher than the FTSE/JSE All Bond Index (ALBI) yield of 9.77% on the same day. What is important to keep in mind when performing point-in-time yield comparisons is that a low duration and predominantly floating-rate or “cash-plus” fund will naturally offer lower yields as rates decline, whereas one can expect a long-dated fixed-rate bond, such as that found in the ALBI, to already price for rate cuts via the forward curve. The good news for savers is that the current expected terminal repo rate at the end of the cutting cycle is still projected to be higher than its pre-COVID level. Thus, if an investor felt it was attractive to be in an income fund back then, the environment going forward should be at least as attractive as it was, and likely slightly more.

In September, the South African Reserve Bank (SARB) cut interest rates for the first time in four years – lowering the overnight rate of interest from 8.25% to 8.00% in a unanimous vote. The SARB outlined the case for caution when lowering rates and cited risks to inflation via potential offshore trade tariffs which raise the price of imported goods. In this regard, the outcome of the US election in November has the potential to rock the trade tariff boat with Republican presidential candidate Donald Trump proposing a blanket increase in import tariffs to 10%, and a more punitive 60% applied to Chinese goods, if he were to be elected.

Much of the disinflationary trend of the decade preceding the COVID-19 pandemic was undoubtedly aided by the flood of cheap Chinese goods into international markets, with many countries now complaining that Chinese overproduction and dumping practices make it tough for local industry to compete in a wide range of sectors, including car and steel production. As a general observation, the US invents, China builds and the EU regulates. For example, China’s bloated industrial base, fuelled by ultracheap government financing and subsidies, produces more solar panels than the world can absorb. Such production continues to take place even when goods are ultimately dumped into international markets at loss-making sale prices that require these producers to later be bailed out by the Chinese state.

The SARB also touched on global risks to inflation via renewed supply chain disruptions that could result from escalating geopolitical tension and war, as we are seeing in the Middle East at present. When debating local risks to the inflation outlook, the SARB lamented that the stronger rand, lower oil prices and well-behaved South African food price inflation might be partially offset by higher local administered, municipal and electricity prices. Earlier in the year, a leaked document showed that Eskom planned to apply to increase the electricity tariffs it charges municipalities by up to 44% in 2025. Rising electricity and water tariffs naturally bleed into the cost of production and raise the prices of local goods and services.

Despite all these risks, South Africa’s current inflation prints have been coming down, with a stronger rand allowing August’s CPI print to moderate to 4.4% and the SARB modelling for sub-4% throughout the first half of 2025. Given that inflation is by nature a year-on-year calculation and can almost always be expected to disinflate in the short term when base prices are high, the SARB has stated that it will “look through” a temporary inflation breach on the downside of its target. Although the SARB’s quarterly projection model is just a loose policy guide and is not strictly implemented, the model currently suggests that the appropriate terminal rate of interest at the end of the South African rate-cutting cycle is an overnight rate of 7%, which implies a further 1% worth of rate cuts.

In the last quarter, the Fund lowered its modified duration by reducing exposure to five-year fixed-rate instruments as the market rallied following the formation of South Africa’s government of national unity, the anticipation of a global rate-cutting cycle and the monetisation of R100bn from South Africa’s Gold and Foreign Exchange Contingency Reserve Account (GFECRA). Monetising the GFECRA has to some degree bailed out the fiscus such that bond auction sizes can remain unchanged.

Most of the Fund has exposure to floating-rate instruments that return cash rates plus a spread and have low modified duration. At the end of September, the lowest yielding of these floating-rate notes held in the Fund was earning cash plus 1.3%, and the highest yielding was earning cash plus 3.5%. While the future remains uncertain, we aim to construct portfolios that can do well across a range of possible scenarios. In the event of rate cuts, the Fund’s weighted average yield (gross of fees) of 9.9% as at 30 September 2024 should further decline but still offers a rate of interest that is 1.9% higher than that of overnight cash.

Commentary contributed by Thalia Petousis