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LDI specific measures

Liability

General

Longer-dated nominal bond yields fell during the fourth quarter of 2022. The unfolding history of these yields influence liability-driven investment (LDI) performance over time. More detail on specific yield curve movements is listed in their dedicated sections.

The key news items over the quarter are as follows:

The global Covid pandemic

• The pandemic, particularly its various waves and cycles, strongly drove movements in investment markets in the period from the first quarter of 2020. Globally, deaths from Covid and Covid-related government restrictions are declining, except for China and some of its neighbours.

• Locally, the fifth wave of Covid-19 in South Africa ended in the second quarter of 2022. Considering the change of pandemicrelated circumstances, this commentary will no longer include Covid case numbers each quarter. If the pandemic returns with widespread effects, or if any relevant economies again impose restrictions, the reporting will resume.

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Portfolio as a percentage of liability shows the size of the assets managed by the manager relative to the size of the liability the manager is mandated to hedge.

The

Tracking error shows the dispersion of portfolio returns relative to the investor’s liability.

The risk adjusted outperformance shows the extent to which managers outperform liabilities, adjusted for the tracking error or risk they have introduced.

• As mentioned, China and select neighbours are the exception to the declining global Covid risks. The severe wave of cases in China resulted in restrictions for people travelling from China and some of its neighbours. Most restrictions require negative tests before travel or upon arrival, but Morocco proposed a ban on travel from China, Hong Kong, or Macau.

• In China, protestors against the zeroCovid policies took to the streets from late November. The resulting pressure forced government officials to act by reducing Covidrelated restrictions, softening zero-Covid goals and allowing freer movement. Case numbers increased in the short term because of reduced restrictions, with cases still rising towards the end of December 2022. The continual changes to the status quo in China, from Covid-related policies to interest rates, will affect emerging markets this year.

• Attention among investors will shift towards global inflation and changing interest rates with the Covid pandemic no longer being the singular dominant driving force of global economies.

Inflation

• Inflation continued to be a major concern for global economies, including South Africa. The South African Reserve Bank’s (SARB’s) main target was to keep local inflation between 3% and 6%. South African inflation was high during 2022.

• South African consumer price inflation (CPI inflation) was 7.2% over 2022. This is higher than the 5.9% observed over 2021 according to Stats SA.

• Consumer price inflation in the USA (US inflation) was 6.5% over 2022, which is less than the 7.0% observed in 2021. However, both are at high levels relative to the 10-year average inflation over the past 10 years, which is 2.8%, including the high levels in 2021 and 2022.

Changing interest rates

• The SARB increased the local interest (repo) rate again this quarter. The repo rate, which was 3.75% at the beginning of the year, increased again in Q4 2022. The increases in the first three quarters of the year brought the rate to 6.25%. From 1 November 2022 the SARB raised the repo rate by a further 0.75%, bringing it to 7.00% at the end of the year.

• This is a continued response to rising inflation and inflation expectations, where the tighter monetary policy intends to reduce future inflation and current inflation expectations. Many economists expect further increases in 2023, but at reduced rates due to the recent tapering down of inflation prints.

• The US Fed announced an interest rate hike in Q4 2022. The Fed Funds rate was 0.00% in January 2022 and seven increases over the year upped the rate to 4.00%. This has been the highest repo rate since before the global financial crisis of 2008.

• Consumer price inflation (CPI) in the European Union (EU inflation) was 9.2% over 2022 and CPI in the United Kingdom (UK inflation) was 10.5%. These are increases over their respective 2021 inflation rates of 5.0% and 5.4% respectively.

• Similar to the US Fed, the European Central Bank and Bank of England have each raised interest rates this quarter to their highest levels since before the global financial crisis of 2008. The EU Central Bank raised their rate to 2.50% from 0.00%. In January the Bank of England raised theirs to 3.50% from the January starting point of 0.25%.

• Contrasting the local and global hawkishness, the People’s Bank of China maintained its lowered interest rate of 3.65%, with looser monetary policy intended to help ease various short-term pressures in the local market caused by zero-Covid-related lockdowns. In the longer term, the government’s plan to achieve “common prosperity” may affect economic growth and markets.

Market performance

• Despite a muted recovery in most international equity markets in Q4 of 2022, the overall market performance for the year was mostly negative. The MSCI All-Country World and MSCI World indices each lost over 12.00% in rands over 2022, while MSCI Emerging Markets struggled even more with a loss of 14.55%. South African markets bucked this trend with the JSE All-Share index returning a positive 3.58% in rands over 2022.

• The continued military conflict in Ukraine involving Russia and Ukraine may continue to influence markets over 2023.

• Bond managers continue to face the challenges of a volatile market, where developed nation bonds have low-to-negative yields and emerging market bonds have high risks.

• The local equity market rose steadily in 2021, and this continued in 2022, despite global challenges. The Capped SWIX index returned 4.41% over 2022. This positive performance is expected to have favourable effects for LDI hedging strategies since many defined benefit funds have elected to combine interest- and inflation-hedging with growth assets (like SA equities). Liabilities and their immunising bond (LDI) portfolios have performed similarly over the quarter, so the rising values of growth assets would, generally, lift funding levels, depending on the relative level of de-risking.

Inflation-linked bond section

Real yields (Bond I2046) in the long end decreased by 9 basis points from around 4.58% at the end of the last quarter (September) to 4.49% at the end of Q4 2022 (December).

High real yields present an opportunity for funds to hedge real liabilities, including those that have not been able to do so in the past. It may be worth revisiting this topic if you are a decision-making agent for an entity with defined liabilities (such as a defined benefit retirement fund or an insurer) without existing LDI assets.

However, this opportunity would need to contrast against the potential loss of higher expected returns (due to reduced allocations to growth assets like equities and property). We recommend discussing this with an LDI expert or your valuator.

Higher yields also benefit funds transitioning unhedged active members into a hedged pensioner pool, as the transfer (and subsequent expansion of the LDI hedge) may occur at a higher yield than was previously possible.

Nominal bond section

Long-dated nominal bond yields (bond R2040) decreased over the quarter. Longer-dated nominal bond yields increased by 34 basis points from 11.89% at the end of last quarter (September) to 11.55% at the end of this quarter (December).

Looking at the 2030 maturity (bond R2030), we see that yields in the medium end of the curve also decreased. The decrease of 70 basis points from 10.87% at the end of September to 10.17% at the end of December combines with the longer-dated decreases above, and shorter-dated increases, to create a flatter yield curve.

Manager returns were diverse over the quarter

Given the broad range of characteristics seen in the participants’ composites, this is as expected. For example, the levels of allocations to credit and the benchmark durations vary notably.

Participating managers broadly coped well with a challenging and volatile environment, with most delivering positive (or zero) outperformance. However, one can only draw limited conclusions from the small sample of participating LDI managers in the survey, and we recommend caution when analysing these managers. Investors should seek bespoke advice when considering LDI.

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