Rate cuts come to those who wait…

The South African Reserve Bank (SARB) is likely to take its cue from the United States Federal Reserve (US Fed) in making its all-important first interest rate cutting decision this year. “One of our core views on South Africa is that the central bank will act after the US Fed, and the pace of subsequent interest rate cuts will be slower than the US Fed too,” said Bradley Preston, Chief Investment Officer at Mergence Investment Managers.

Narrowing the SA-US yield gap

In discussion with FAnews midway through January 2024, Preston noted that the differential between real interest rates in South Africa versus the US had narrowed significantly over the past 12-months, and that the local central bank was keen to see that gap widen. For this to happen, domestic inflation would have to fall faster than inflation in the US, or declines in South African interest rates would have to lag those in the world’s largest economy. 

US inflation is easing with economists and other market analysts expecting it to trend towards 2.3% by end-2025. There was, however, mixed news for domestic financial advisers and their clients. On the plus side, Mergence expected the US Fed to begin cutting rates as early as March; on the minus side, the investment manager reckoned there would be four rather than six interest rate cuts over the full year. “The latest market data out of the US suggests that a soft landing is more and more likely; in this scenario, the US Fed does not have to cut interest rates aggressively,” Preston said. 

Mergence has three core focuses anchored by its actively managed, benchmark-cognisant, core domestic general equity offering. “We manage these funds using a bottom-up, discretionary, fundamental approach that is mainly run on a quality and value methodology,” said Preston. The second and third ‘legs’ of the business include a stable of multi-asset products and a private market business mainly involved in infrastructure-focused private equity and private debt. 

Fiercely independent and ‘hawkish’

FAnews asked whether the ANC government might try to force the central bank governor’s hand to score ‘points’ ahead of the 2024 National Elections; but the CIO refused to take the bait. He noted that in his experience the SARB governor was “fiercely independent” and “quite hawkish”. Courtesy Investopedia.com, a hawkish policymaker is defined as someone “who is predominantly concerned with the potential impact of interest rates as they relate to monetary policy”. These ‘hawks’ are typically prepared to increase interest rates to combat inflation even if this impacts the economic growth outlook. 

The monetary policy committee (MPC) of the SARB has a long track record of making interest rate decisions entirely based on its mandate, which centres around maintaining inflation in a 3% to 6% ‘band’. In the November 2023 MPC Statement they wrote: “The policy stance aims to anchor inflation expectations more firmly around the midpoint of the target band and to increase confidence of attaining the inflation target sustainably over time”. At the time, market-based expectations for inflation in 2023 stood at 5.8% while “medium and longer-term market expectations for inflation remained elevated”. Moments before this newsletter published, the January 2024 MPC confirmed that the Repo rate would remain unchanged at 8.25%. 

At this juncture, the discussion shifted to how asset managers and investors should position their portfolios for the predicted interest rate environment. According to Preston, the asset allocation signals emerging from a cross-asset valuation exercise occasionally conflicted with the macroeconomic environment. “If we view things on a valuation basis, we want to be very overweight South African assets,” he said. “But when we consider some of the challenges in the global macro environment, and take SA-specific issues into account as well, you end up wanting to add a lot of offshore assets”. The trick is to balance these conflicting views with other factors such as the outlook for the rand. 

Pro-rand developments unlikely

The discussion revealed three scenarios that could have a positive influence on the rand during 2024. First, aggressive interest rate cuts from the US Fed; second, a strong China and commodity price recovery; and third a sensible outcome from the 2024 National Elections. This writer reckons the first two scenarios are unlikely, and the third, rather hopeful. 

“If you balance these things together you probably want to be neutral in terms of how much you invest locally versus offshore,” Preston said. He added that Mergence was neutral SA equity and overweight SA nominal bonds: “in a world where we see inflation and interest rates trending lower, SA bonds look very cheap relative to history”. As for international equities, the investment manager suggests overweight Japan; slightly overweight the United Kingdom; and neutral on the US due to high stock valuations. 

“All of our approaches suggest that US equity is expensive; it was expensive [entering 2023] and has continued to get more expensive,” Preston said. This does not mean that those predicting further gains in US equity markets can be ignored. A few points worth considering include the hype around artificial intelligence (AI); the fact that investors struggle to get access to AI growth ex-US; and the staggering sums of capital that are still being pumped into US indices by the likes of Blackrock and Vanguard each month, irrespective of valuations. The key outtake here was that there is a wall of passive investor capital to counter your market overvaluation view. 

On YouTube and US commercial property

One of the interesting diversions during the discussion stemmed from a recent YouTube documentary on risk to the US commercial property market. FAnews asked Preston whether a combination of falling commercial building leases and higher refinancing charges might contribute to a financial system shock in that country. He responded that this was among the risk that large multinational allocators of capital were concerned over. “Commercial real estate is a sector that that we are cautious about; the rising interest rate burden is going to hit earnings in this sector,” he said. 

The lacklustre outlook for commercial property impacts on private markets too. For context, the aforementioned YouTube documentary spoke of a building owner who was offered USD80 million for his property pre-pandemic, and eventually accepted less than USD40 million in 2023. “This example is relevant in the private equity and private debt space,” Preston said. “There are still a lot of miss-marked private assets; they are still being priced at lower interest rates and there is a lot of pressure that must still come through”. 

Another interesting snippet to emerge from the conversation was the need for investment managers to start viewing large independent financial adviser (IFA) practices and discretionary fund managers (DFMs) in a similar vein to their institutional clients. This makes sense given the significant chunks of capital that these financial institutions invest and manage on behalf of clients nowadays. Non-institutional investors are no doubt drooling at the prospect of being treated like investment royalty at some point in the near future. 

Accommodating hard or soft landing

In closing, Preston advocated for a cautious approach to financial markets. “We remain somewhat risk off and are aiming for a balanced asset allocation to try and keep appropriate exposures in the event we see a hard landing in the US,” he said. “Some asset classes will perform well in the hard landing scenarios, while others will fare better if the US Fed successfully engineers a soft landing”. The ‘soft landing’ scenario will suit FAnews readers just fine because it translates as no recession and the return of lower interest rates. 

Writer’s thoughts:

On 25 January 2024, the Monetary Policy Committee of the South African Reserve Bank announced that the Repo rate would remain unchanged at 8.25%. Was this the correct decision, or did the central bank miss a trick to bail out struggling consumers and reignite economic growth? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.