Allan Gray backs the Reserve Bank to crack the inflation code

The Reserve Bank has a difficult task on its hands in managing the inflationary shock from rising petrol and diesel prices in South Africa. 

While the bank is set to respond by potentially hiking rates at its next two meetings, it can actually do very little about the root cause of the inflation. 

The Reserve Bank cannot drill new oil wells, improve South Africa’s refining capacity, or bring peace to the Middle East, but it is expected to manage inflation all the same. 

This will be done through interest rate hikes to rein in inflation and slow price increases by limiting demand growth in South Africa. 

These hikes will come at the cost of faster economic growth in South Africa, which has been driven by consumer spending as disposable income was freed up by lower inflation and falling interest rates. 

The most important factor to consider amidst the inflationary shock is the Reserve Bank’s credibility, with its new target being less than a year old. 

This is the first major test for the Reserve Bank’s Monetary Policy Committee with regard to ensuring inflation is sustainably kept at around 3%. 

Allan Gray’s Sean Munsie explained that the Reserve Bank has a long history of strong inflation-fighting credentials. 

The firm is investing on the back of this belief, with it using the sharp selloff in local government bonds following the US-Israeli strikes on Iran to snap up assets at a low entry point.

“We have been using this selloff to add some longer-dated bonds to our portfolios,” Munsie explained at Allan Gray’s The Times roadshow. 

“We went into the massive rally with a slightly lower duration than where all the bond indices were sitting and have now extended that duration.” 

He noted that the Reserve Bank has shown a strong willingness to return inflation towards the 3% target once the current inflationary shock dissipates.

“There are credible reasons why we could probably get in and around the mid-3% to high-3% range in time once the dust settles,” Munsie said. 

“If you think at this point you can buy the 10-year note with a yield of around 9% now on an inflation outlook of 4%, a 5% real return is very attractive.” 

Munsie said the Allan Gray Balanced Fund has allocated around 10% of its assets towards local bonds. 

Not the worst-case scenario

Allan Gray’s positive outlook on South African bonds is informed by the strong run these assets have had over the past 18 months. 

This strong run was driven by a series of positive improvements in South Africa’s economic and financial landscape, particularly the formal shift to a lower inflation target. 

Munsie explained this as the second of a series of tailwinds for financial markets, with it being part of a broader shift away from the dollar and towards emerging market assets. 

Pointing to the 20-year South African government bond yield, Munsie said the string of positive news drove one of the most rapid swings ever seen in local fixed-income markets. 

“From a fixed-income perspective, a 400 basis point move over 18 months is very significant,” Munsie said.

“That is a sort of 40% capital gain, and clearly, while the emerging market story helped, we have had a lot of things work in our favour.” 

This includes the formation of a Government of National Unity (GNU), the use of gold and foreign exchange reserves to bolster state finances, and surging precious metals prices. 

However, the most important factor was the announcement of a lower inflation target of 3% that would bring South Africa more closely in line with developed markets.

Munsie also pointed out that the strong positive momentum regarding South African fixed-income assets means that the current shock is not as severe as many think. 

While bond yields have surged since the conflict in the Middle East kicked off, they are still well below the peaks seen at the beginning of 2024. 

Despite this, Allan Gray is not completely convinced about South Africa’s economic revival, with low levels of fixed investment indicating that long-term economic growth will remain relatively low. 

The emerging market average for Gross Fixed Capital Formation (GFCF) as a share of GDP is between 25% and 30%, with the average economic growth being 4.5%. 

In contrast, South Africa’s GFCF as a share of GDP is between 12% and 14%, with economic growth floundering at 1% per annum.