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Are real returns beyond the passport gates

The end of cheap money

After more than a decade of artificially low rates across the US and other developed markets, prospective real returns beyond Emerging Market (EM) shores are looking more attractive to bond investors. An end to Quantitative Easing (QE) and two years of an aggressive rate hiking cycle, means global risk-free rates are now in-line with longer term levels.

Strategically the 10-year return assumptions across major Developed and Emerging Markets (as shown in the chart above) provide a good foundation for prospective returns and indicate that DM bonds compare well with EM counterparts over the long term, building the case for a globally diverse bond portfolio. Historically low to zero rates across DM regions meant EM compared more favourably from a long-term return perspective. However, given the long term and non-linear nature of these assumptions, short-term and tactical opportunities can be found to earn excess returns above these strategic expectations.

The promised lands

We believe the current rate hiking cycle has reached its peak, and that EM’s are set to benefit when rates are eventually cut – the timing of these cuts remaining uncertain. Emerging Markets in this environment provide:

  • attractive starting yields that protect against downside,
  • moderating inflation – eroding less of your returns,
  • good growth prospects, and
  • cheap currency valuations versus an expensive US Dollar.

Tactically, it makes sense to include EM bonds in a fixed income portfolio.

While Emerging Market players share similar characteristics and in aggregate should benefit from the cutting cycle, we acknowledge that not all ships will rise with the tide and local idiosyncratic challenges mean risks will differ across each region, building the case for diversification.

2024 and beyond brings many challenges and uncertainties including global elections. Half the world is heading to the polls amidst a more polarised environment lifting the risk of extremist views that could drive significant change. Due to the extent of globalisation, outcomes of elections will have far reaching effects.

South Africa is a case in point. Our ruling party is aiming to extend their term, however current data indicates a real possibility that a coalition will be required for the ANC to hold the reigns. This is unchartered territory and the tail risks for investors are increasing. We need to consider tactical or short-term opportunities to mitigate risk and protect downside.

The only free lunch is diversification

It is difficult to predict the timing of a rate cut with any conviction, especially as the market is already guilty of raising expectations, only to be disappointed. As fixed income investors we’re taking a measured approach to incrementally increase exposure to the assets we believe will benefit from peak rates or a cutting cycle.

“If it doesn’t happen imminently, we earn attractive yields while we wait.”

The significant idiosyncratic uncertainty in each region worldwide, warrants introspection into any concentration risk. South African bonds offer compelling real returns over the long-term, while familiarity with and a deep understanding of the local risks and economic environment provides local investor comfort. However, being mindful of “home bias” * we believe it is currently prudent to take the “free lunch” in the form of diversifying our Emerging Market exposure beyond local shores. Fortunately, rising global rates provide a reasonable entry point into diversified global income, without sacrificing real returns.  EM bonds are also typically perceived as riskier than reality given their geographic categorisation. Its therefore important to consider the specific characteristics of each EM bond.

Nobel laureate, Harry Markowitz, claims diversification is “the only free lunch in finance.” As local elections draw nearer and the sustainable health of our fiscus hangs in balance it can only make sense to diversify our bond and fixed income holdings into other Emerging Markets ensuring we increase the probability of participating positively when rates are eventually cut.

Footnote

* Home Bias:
The term home bias refers to the tendency for investors to invest most of their portfolio in domestic equities, ignoring the benefits of diversifying into foreign equities. This bias was originally believed to have arisen because of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs. Other investors may simply exhibit home bias due to a preference for investing in what they are already familiar with rather than moving into the unknown.
https://www.investopedia.com/terms/h/homebias.asp

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