World capital markets were caught unprepared for the result of the UK referendum (“Brexit”) on their EU membership. This is especially evident in the sharp decline in the Sterling currency and share prices worldwide, and the ‘flight to safety’ in government bonds.
Whilst the UK is the world’s fifth largest economy, it makes up less than 4 per cent of the world’s GDP and should not have a profound effect on global growth. The current political upheaval in one of the world’s oldest and strongest democracies has unexpectedly caused more political and economic uncertainty in wider Europe.
As a result, global bond yields have fallen further to unprecedented levels. More than 50 per cent of Europe’s government bond market is now yielding less than 0 per cent. Equity markets have swung violently and volatility is likely to remain high in the near term. These developments support our view to increasing our allocation to domestic fixed income expo-sure. As a result of the low-interest rate environment globally, foreign investors find SA bond yields attrac-tive. Domestic bond yields remain high due to political uncertainty, the potential sovereign debt downgrade as well as the risk of rising inflation expectations. We feel these risks are overstated and that SA’s potential downgrade later in 2016 is already priced into the equity and bond markets. SA’s current low/ no growth environment paralyses the South African Reserve Bank’s (SARB) ability to raise interest rates in the short-term, and we believe there are opportunities to buy mispriced fixed income securities.
Furthermore, the current state of quantitative easing in developed markets is serving as a tailwind for corporate debt (e.g. bonds sold by companies as opposed to governments to raise capital), and is aiding our disciplined approach to fundamental analysis and identify mispriced assets. It is important to avoid credit risk dominance and diversify across different companies, credit ratings and credit maturities. Short or long-term anomalies in credit markets allow us to deliver additional returns whilst minimising the risks associated with investing in single corporate names. Therefore, a long-term strategic fixed income allocation, of around 20-30 per cent of overall portfolio can help investors reach their long-term investment objectives despite the challenging investment environment.