For Domestic Funds and Portfolios
We are all desperate for good news. Firstly, nearly all portfolios have recovered well since the March collapse. In most cases, our portfolios are now in positive territory for the year to date. The effect of global lockdowns, a negative input to economies and the size of fiscal stimulus in developed world (a positive input) enabled us to recover from the March devastation by exposing your portfolio, at the appropriate levels, to a number of asset classes and securities that recovered well.
Asset class and sector returns
To set the scene, we share the massive divergence in returns (in Rands) experienced between asset classes and sectors for the year to 16 July 2020:
|Money Market Index||3.02%|
|SA All Bond Index||-0.12%|
|JSE All Share Index||-0.67%|
|JSE Resources Index||11.53%|
|JSE Industrial Index||5.97%|
|JSE Financial Index||-27.62%|
|JSE SA Property Index||-33.86%|
|MSCI World Equity Index||16.24%|
|MSCI Emerging Market Equity Index||13.29%|
|USD: ZAR Movement||19.00%|
Source: Financial Express
If portfolios were fully invested in the MSCI World Equity Index or MSCI Emerging Market Index, despite both indices experiencing negative US Dollar returns for the year to date, the local currency returns would have been good. In the SA Equity environment, portfolios had to be exposed to the highly cyclical stocks in the SA Resource Index and the ‘expensive’ Industrial Index which is dominated by Naspers and Prosus exposure. The ‘avoids’ are clear: SA Financial and Listed Property stocks.
Fortunately, our portfolios were more balanced towards the winners than the losers over this period.
But, where to from here?
Past performance will not repeat itself
We find that investors find comfort in investing in previously successful strategies but this can come at a heavy price. Although investing offshore has been the successful strategy for the past 5-10 years, the chart below shows that the share prices in the S&P500 have overshot the underlying earnings of those companies.
S&P 500: Change in CY20 EPS vs Change in Price (6 months)
This leads to an expensive Forward Price Earnings Ratio for the S&P 500.
S&P 500 Forward 12-month P/E Ratio: 10 Years
This index is expensive relative to history and when considering the next 1-2 year earnings outlook in/after the COVID-19 environment. To be more objective, one must also consider that 78% of the gains over the last five years in the S&P 500 came from tech and e-commerce stocks. But valuations tell you nothing about future returns. All we know, is that some of the expensive stocks are also quality stocks and that guarantees ongoing volatility going forward.
The world and people’s behavior have changed. The return expectations of your portfolio should certainly change. This may mean that due to a potential of a weaker US Dollar, lower SA interest rates, certain JSE stocks (e.g. resources) could continue to surprise well on the upside, but more on this later in this overview.
The ‘free lunch for money market investors’ has gone – for now, at least
The SA Reserve Bank has cut rates by 3.00% during the year to date, with more cuts expected by the end of the year. Inflation for the past year is now at 2.1% and with the economy struggling the Reserve Bank has ample ammunition to reduce rates even further. This impacts the return of all conservative investors who received money market yields of 7.5% p.a. until recently. Current money market rates are now below 5% p.a. net of fees and will soon be closer to 4% p.a.
This scenario could certainly remain in place for the next year or two although it makes investing in cash or fixed interest in SA less attractive to both locals and foreigners.
The chart below indicates the rapid collapse of the SA money market rates on a one month rolling basis.
Alexander Forbes Money Market in ZAR
Source: FE 31.07.2019 – 30.06.2020
To outperform money market yields and beat inflation plus portfolio objectives means investors must accept increased volatility and risk in portfolios
Unless investors are able to reduce income withdrawals to the same extent that the yields have reduced, investors will have to accept that portfolio managers will have to assume more risk to achieve a return of 7.5% p.a. or more when money market net yields only offer just over 4.7% at present. Flexible Income Funds will find it hard to repeat their past performance unless the manager is willing to accept higher risk. The bottom-line remains, one needs to accept higher risks/volatility in a portfolio if one needs to achieve the 7.5% yield the money market offered not too long ago.
There is no such thing as a ‘guarantee’
We still find investors seeking ‘guaranteed’ investments or results. Even if a local institution is providing you with an income or capital guarantee, the security of that guarantee is only as good as the soundness of the institution.
BACKGROUND TO OUR PORTFOLIO POSITIONING IN A COVID-19 ENVIRONMENT
We have been responsible for many of our existing investors investments for more than 15 years. Our philosophy of diversifying between asset classes and investment talent served us well during the Global Financial Crisis (GFC) in 2008/9 as well as in the current crisis. We have no reason to reconsider this investment strategy. What has changed, and will continue to change, is the type of asset class, sector, security and currency exposure we have. It will look decidedly different from what we have had over any time over the past 5, 10 or 15 years.
A perfect storm for technology and healthcare stocks
Since lockdowns were enforced by governments, we realized that holding the appropriate asset class, sector and security was prudent when economies come to a halt. No surprise that technology and global health care stocks earnings and price growth outperformed other sectors as the COVID-19 and lockdown environment remains a good environment for these business models. Quality companies with limited gearing and healthy balance sheets recovered well, while on the JSE, the Resource Sector (due to supply constraints and healthy balance sheets) and gold stocks (due to the appreciation of the gold price) rallied hard since March 2020.
For example the chart below shows that 78% of the gains over the last five years in the S&P 500 came from tech and e-commerce stocks.
S&P 500 return attribution over the past 5 years
Source: BofA Research Investment Committee, Bloomberg
There is no doubt that some global technology, gold, resource and health care stocks are expensive and some analysts expect a short-term pull-back in prices. While the current environment continues and considering many institutional investors missed out on the recovery rally, any pull-back could lead to investors buying the dips in the equity market as global interest rates and bond yields remain unattractive.
Attractive Global Equity risk premium
Global interest rates have been slashed to near all time lows as Central Bankers do their part to ensure a quick economic recovery after lockdowns. One can expect global interest rates and developed market bond yields to remain low for longer as governments and economies will be ill-served by a quick turn-around to higher interest rates. This makes the equity risk premium* attractive to investors.
*Equity risk premium refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing.
Unfortunately, the suppression of global interest rates globally has created the TINA effect (There Is No Alternative) where investors are being obliged to invest further out on the risk spectrum in the search for higher returns.
The TINA effect will also increase short term volatility as prices will re-rate as economic prospects and fiscal stimulus improve market sentiment, while any negative earnings growth sentiment or results will pull back markets aggressively at times.
Percentage of S&P 500 companies paying dividends greater than the 10-year treasury yield
Source: BofA Research Investment Committee, Bloomberg
What about global inflationary effects due to fiscal stimulus?
The potential for higher global inflation is growing as Central Bankers are trying their very best to avoid economic collapse by providing liquidity injections, eased monetary policy and fiscal stimulus.
The biggest fear of a Central Banker is inflation. The only measure to combat inflation is to hike interest rates – an action that no economy can afford since lockdowns have derailed short-term economic activity.
We do understand that despite all the monetary stimulus (known as QE for Quantitative Easing) since the GFC, developed market inflation has been under control, but this time is different. Post GFC central banks had to guard against a collapse in the banking system, which meant that QE saved the system and did not reach the real economy at the time. This time the real economy needs monetary and fiscal stimulus and it will stimulate the developed market consumer base. We do not think certain emerging market consumers, for example SA consumers, will experience the same stimulus in their household income, but inflation could increase due to the global factors as transport and food prices may increase due to supply constraints globally and affect us in SA.
Moving away from developed market dynamics we note from reports that China credit growth remains strong which bodes well for the global industrial cycle. Chinese credit leads domestic capital expenditure and imports. Real Estate loans in China are accelerating which supports housing prices and construction activity. All these elements can increase demand for machinery and commodities.
The case for spot commodity and resources
- In March 2020, the Bloomberg Commodity Index reached a 14-year low. It has since recovered mildly in line with other global risk assets, but it remains ‘early days’
- The Bloomberg Agriculture Index now trades at the same level as in 1970 – a 50-year low
- Gold as an asset class? Gold’s bluntness as a tool makes it useful. It offers broad insurance against the unknown and/or Central Bank Policy errors. Gold correlates to the greatest fear in the financial markets at the time. And while global developed market bond yields trade near zero, it makes gold attractive as no central banker can print gold.
- COVID-linked supply side issues in South America, falling stockpiles and recovering Chinese demand lifted copper prices recently. If COVID-19 infections continue into 2021, supply-side issues in many commodities will rear their heads as demand due to the speed of economic recovery in the East and China could increase the demand for many commodities.
- In SA, infections are increasing and could further limit platinum/rhodium and palladium production (we produce more than 50% of these commodities globally). However, COVID-19 infections are not the only issue in SA mines. Long-term power supply constraints continue to be a threat as Eskom cannot keep the lights on during the current lockdown. All of the above could lead to higher prices of these commodities.
- Many other potential possibilities exist to increase demand for commodities such as the potential that the developed market consumer will use less public transport going forward and will consider buying a car to travel to work, increasing demand for palladium and platinum.
- Over the past number of years, the US Dollar traded as the strongest currency globally. One reason for this outperformance was the improved interest rate yield relative to the Euro, Yen and other developed market currencies. After the Fed cut interest rates (10-year US bond yield trading near 0.6% p.a. at present), the US Dollar yield premium benefit has disappeared. This has led to a weaker US Dollar over the past 2-3 months and it may continue to weaken from here as the mountain of debt created by the US Central Bank and Government can be well served with a weaker US Dollar. Traditionally a weaker US Dollar is positive for commodity prices and emerging market currencies. The SA Rand is undervalued relative to emerging market currencies (see chart below). This is validated due to our structural headwinds, but if emerging market currencies appreciate vs the US Dollar, they will take the Rand with them, even if it does not correlate at the same pace, but the Rand could appreciate vs the US Dollar.
Rand vs Emerging Market currencies
Source: Visio Asset Management
PORTFOLIO CONSTRUCTION OBSERVATIONS
The biggest challenge for the SA investor is to realise that when investing in the JSE, it does not necessarily mean that you invest in the SA consumer and economy. Just Naspers, Prosus and all the Resource Stocks available on the JSE make up over 62% of the All Share Index and have little or nothing to do with the SA economy and consumer.
SA Incorporated stocks – could remain a ‘value trap’
The ‘Achilles Heel’ of the JSE remains the SA Listed Property, Retail and Financial Sectors – we refer to these sectors as ‘SA Incorporated’. Although these sectors appear ‘cheap’ relative to history we make the following observations:
- These SA Incorporated companies are experiencing a much more difficult operating environment. Mean reversion in earnings and price growth of these sectors may not happen and investors considering these stocks simply due to the ‘lower’ prices could continue to be disappointed
- The ability of SA Incorporated stocks to grow earnings is impaired as many experience negative operating leverage (e.g. Property companies and companies with high debt levels) as their cost base is inflated higher relative to their income.
- We expect many more companies to reduce their cost base by reducing office space and effecting staff reductions in the SA Incorporated environment.
One could expect these sectors to rally positively from time to time as collapses in share prices get oversold, which may then lead to short term rallies. We prefer to only hold quality SA Incorporated companies with healthy balance sheets that will outclass competitors over time as many smaller companies will not be able to survive against strong competition.
Despite our careful approach in SA incorporated stocks, it is fair to project that the better-quality stocks in the SA economy will grow earnings far beyond 4% p.a. and could easily outperform money market yields in the next 2-3 years.
Good stock picking will be important, but will come at a cost
Stock picking has been important in the year to date. We think it will be even more important going forward and prefer to invest with fund managers who are willing to trade the SA and global equity market volatility as part of their investment thesis. Indexation solutions and larger asset managers can continue to be successful but will find it harder to compete against smaller funds that successfully trade the equity market based on sound momentum philosophies.
If our observations are correct, the successful fund or fund manager may produce higher fees as their trading costs will influence higher total expense ratios.
High SA government bond yields – ‘attractive for a reason’
Our 10-year government bond yield trades near 9.4% p.a. at the time of writing. Keep in mind that this yield is already one of the highest in the Emerging Market Bond market due to the perceived credit risk of the SA Government. There is no evidence of the SA Government affecting tough austerity measures to reduce government spending. If we continue on the current path, the debt to GDP ratio will exceed 100% within the next 3 years and may keep foreigners’ interest in our SA Bonds at bay. To attract foreign investors, the yield will need to spike up with negative consequences to the capital price for SA bondholders. This was evident in March and investors must realise that unless the SA Government curbs expenditure and implements positive economic reform soon, we will potentially face a Sovereign Debt crisis in the next 3-4 years. Be careful of holding a high yield instrument – it is high for a reason.
We realise that the asset classes and sectors that may outperform in the short and medium term are very volatile in nature. Gold and resource stocks are highly volatile and there will be times to take profit and reduce exposure. A similar trend exists with global technology stocks in the Nasdaq and Emerging Markets. This means that we favour funds and managers that have proved themselves over the short and long term by actively rotating their portfolios to manage these trends. We also respect funds and managers that focus on quality companies or a valuation based approach at a reasonable price.
We do think that – despite SA economic and political risks – the Rand may strengthen further mainly due to potential US Dollar weakness. We do not think it will be an aggressive appreciation as our high economic, sovereign debt and political risk premium will put a floor to major rand appreciation. The Rand will weaken in periods of global risk-aversion which – as explained – will happen from time to time.
Despite potential SA Rand strength, we prefer global emerging market equity exposure relative to SA Incorporated exposure and therefore prefer funds and solutions that invest in China and East Asia as an investment theme. We continue to favour Global Technology as a long-term investment theme but are wary of a potential pull-back in prices in the short term. The TINA affect should continue to underpin global equity market prices in the next year until inflation rears its head and bond prices or expectations of central bank interest rate hikes may curtail an equity bull run. This situation explains why gold is the insurance in portfolios, while – as explained – many spot commodities prices and resource companies can benefit in the short and medium term, as long as all the fiscal stimulus does reach the developed market consumer. Generally, SA and global equity prices are trading at much more attractive levels than in 2014 when the JSE traded at its all time high. One can therefore expect higher returns from growth portfolios relative to the past 5-6 years, but it will require accepting a big volatility premium.
If the pandemic continues to repeat itself in a third, fourth wave all bets are off and we will have to hide in cash instruments until the economic affects are clear.
Importantly, volatility creates opportunity…and we will manage it.
ASSET ALLOCATION VIEWS
We take into consideration both strategic and tactical decisions (overweight/neutral or underweight) within various asset classes in each of our multi-asset funds/portfolios, according to an optimized portfolio profile per risk profile and investment horizon of each mandate. In that context, this table reflects our views on our short-term tactical calls; which may differ from our long-term strategic views. We believe this is prudent practice, in a world dominated by debt deleveraging, massive developed market fiscal stimulus and political interference. We think ‘buy and hold’ and static asset allocation approaches carry risks in an era of such extreme global volatility.
|Consumer Services Sector||x|
SA Fixed Interest
|Fixed Rate Government Bonds||x|
|Inflation Linked Bonds||x|
|Floating Rate Notes||x|
SA Money Market
Global Listed Property
|Developed Market Equity||x|
|Emerging Market Equity||x|
|Developed Market Bonds||x|
|Emerging Market Bonds||x|
The content of this content is for information purposes only and does not constitute an offer or invitation to any person. The opinions expressed are subject to change and are not to be interpreted as investment advice. You should consult an adviser who will be able to provide appropriate advice that is based on your specific needs and circumstances. The information and opinions contained herein have been compiled or arrived at from sources believed to be reliable and given in good faith, but no representation is made as to their accuracy, completeness or correctness.