This article first appeared in Personal Finance Magazine 4th quarter 2017
Alf James asked a handful of asset managers for their outlook on the South African and global financial markets and where they saw investment opportunities going into 2018.
Where do you currently see the best opportunities for real investment returns in listed equity markets in South Africa and internationally, and why?
Grant Pitt, the joint head of institutional client services at Allan Gray, says sentiment towards South Africa generally, and the equity markets, in particular, are sinking steadily lower.
“Economic growth has slowed with the end of the commodity boom, and government policy uncertainty is discouraging local and foreign investors. The local equity market has remained basically unchanged over the past three years, as earnings have generally undershot expectations. But, for the first time in many years, we are beginning to find opportunities in certain domestic consumer businesses outside financial services.
“Globally, one of the few sectors that looks reasonably valued is the resources sector, and we have started to invest in certain mining companies. The risk in this sector is that Chinese demand plateaus or declines. Fortunately, the underlying commodity prices are, in many cases, not particularly high, and the company valuations are pricing in further commodity price declines,” Pitt says.
David Galloway and Mark Phillips of the Sanlam Multi-Manager market research unit, say that, because implied earnings growth priced into the local equity market is well in excess of earnings estimates, the risk of a market correction has increased in the near term.
It is worth noting, however, that the high price-to-earnings ratio for the market is a result of stretched valuations on mostly rand-hedge industrial shares such as Naspers, which, if stripped out of the index, produces a far more attractive valuation. This suggests that shares dependent on the domestic economy are attractively priced, reflecting, no doubt, the weak economic fundamentals.
John Orford, a fund manager at the MacroSolutions boutique at Old Mutual Investment Group, believes global equities offer the best risk-adjusted returns across the main asset classes.
He says the world economy is enjoying relatively robust and synchronised economic growth, and this is underpinning solid corporate earnings growth. Although some regional equity markets, such as the United States, are quite expensive, others, including emerging markets, Europe and Japan, continue to offer some value.
“Developed equity markets also continue to look attractive relative to developed market bonds, with the dividend yield on equities in developed markets higher than the equivalent bond yield.
“The South African equity market has moved sideways for almost three years now and, in inflation-adjusted terms, has moved down. Consequently, we see better value in local equities than we did two years ago. Lower interest rates and some recovery in domestic growth should also support local equities. However, the lack of growth in the domestic market is a concern for local equities,” says Orford.
What do you believe will drive markets and asset prices for the rest of 2017 and 2018, and where do you see value and opportunities?
Offshore expert Kokkie Kooyman, the head of the Denker Capital global financials unit, says that, throughout 2016, we saw the rise of populism, which resulted in the Brexit vote in the United Kingdom in May, Donald Trump’s election in the US in November, and the resignation of Italian Prime Minister Matteo Renzi in December.
“There has been a carry-over of this uncertainty into 2017 as well. Issues such as the effect of Brexit on the UK and EU markets and the longer-term impact of Trump’s presidency on the economy and share markets, despite his policies delivering a boost to the US share market initially, together with slow global growth in 2016, may have left many investors wondering where they should be investing in 2017 and beyond.”
However, Kooyman says the trends in Germany, Holland, Ireland, Czech Republic and others are of increased business confidence and falling inflation. So, despite all the political uncertainty, the many years of low interest rates are finally having an effect, and these countries are finally following the US.
“If this continues (and we believe the probability is high that it will), we might be heading into a gradual (and sustainable) global upswing, which, in turn, would bring with it a slow normalisation in global interest rates to higher levels, which would be very good for the financial sector.”
Two “spring tides” will affect markets in 2017 and for a few years thereafter, according to Kooyman.
He says the “reflation tide” has just started, which will bring stronger growth and higher interest rates globally. This tide started before Trump was elected, but, as with the “reverse excessive regulation tide”, his presidency will act like a full moon, giving the tides more power. Financials globally will be major beneficiaries of this tide.
The second tide is the “value tide”, Kooyman says. The average value rally over the past 40 years has lasted 24 months with 27-percent outperformance. The current "value": rally is just under 12 months old and has to date [August 2017] outperformed eight percent.
“We’ve been hard at work identifying companies with excellent track records that are currently mispriced. Operationally they’ll do well in any case, but the reflation tide will be a boost, and the low valuations mean that the probability is high that they’ll surprise positively.”
Kooyman contends that, relative to the technology sector, financials have never been this undervalued and unloved. He says the normalisation in interest rates would benefit financials as an asset class most, because they have suffered the most from low inflation and low interest rates. In addition they have spent the past eight years cleaning up their balance sheets and incurring costs and re-capitalising to meet the new regulatory standards.
“We believe any pick-up in growth and interest margins will ‘fall straight to the bottom-line’ and increase return on capital. At the same time, a normalised world with higher interest rates would affect tech shares (which are on excessively high valuations) negatively.
“Geographically, Europe and the euro are attractive compared with the UK, which could find Brexit negotiations traumatic, with initially more downside than upside. The US continues its slow grind despite Trump, and emerging markets will benefit from stronger global growth in exports and also, most probably, higher resource prices.
“But as always, valuations in the long run are the most important determinant of investment returns; hence we’re still most positive on emerging markets, Europe and, within those regions, financials as a sector particularly. There are some really attractive stock-picking opportunities in Norway, Russia and Turkey, and also Brazil and Peru.”
Kooyman advises not to ignore the macro and simply invest in the cheapest shares.
He says the lessons are:
- Bad-news headlines are often already priced in by the time the average investor reads them;
- Good companies can and do overcome bad environments (obviously, they’ll do even better in good environments); and
- Don’t let your emotions play a role when good companies are trading at discounts to historical valuations.
Maarten Ackerman, the chief economist and advisory partner at Citadel, says that, since the start of this year, the global economy has shown signs of more robust and sustainable growth, with most countries experiencing synchronised growth for the first time in many years. In such an environment, we can expect the world economy to grow in excess of three percent a year over the next 18 months, and this should support company performance and profitability.
“While there has been talk of removing the current monetary stimulatory packages in play globally, we do not view this as necessarily negative to global growth. Any adjustment to the packages is likely to be a reduction, rather than a removal, of them. In other words, we still see some level of stimulation remaining in place, even if at a lower level. This could mean modest interest rate hikes, but despite this, the central banks will remain in an expansionary phase, which should further support growth and company profitability."
Ackerman says although South Africa derives much of its economic performance from the global economy, we are in a structurally low-growth environment and have been decoupled from global growth since about 2011. Business and consumer confidence are at decade-low levels, having been negatively affected by the credit-rating downgrades, the cabinet reshuffle and the fact that South Africa dipped into a technical recession earlier this year.
“In such a situation, people don’t spend, companies don’t invest and the economy grinds to a halt. Confidence is a leading indicator of economic performance and for it to turn – and thus for the economy to recover – requires policy stability and certainty.
“Over the coming 18 months, we still prefer global equities as the preferred asset class to generate inflation-beating returns. The current economic backdrop globally should underpin company profitability and support markets at current levels. Stock valuations remain reasonable and there is still good value to be found, especially relative to other asset classes.
“The JSE is under pressure given the weak local economic environment. However, many of the dual-listed and rand-hedge stocks are mostly immune against the difficult trading environment. These companies are rather reflecting global economic developments and should benefit from stronger global growth.
“In the event of further credit downgrades, the rand is likely to depreciate significantly, which should support these companies at the same time. However, local-only companies are likely to remain under pressure until the economy and confidence start to turn; as a result, and given current valuations we are underweight South African stocks in favour of global stocks.”
Pitt says the currency is an obvious catalyst, which could influence asset prices over the short term, with the outcome of the ruling party’s succession plan in December potentially resulting in a binary outcome for domestic equities.
A compelling and firm commitment to economic growth and fiscal prudence should be positive for sentiment and beneficial to many domestic-focused shares, which currently trade on relatively low valuation multiples. Anything less than a persuasive plan, however, suggests continued economic stagnation, further ratings downgrades and currency depreciation, which could see several of the rand-hedge stocks rallying.
Orford sees two key drivers for markets globally. The first is stronger earnings growth as the global economy continues to recover. This should underpin global equities. The second driver is likely to be a gradual increase in central bank policy rates led by the US Federal Reserve Bank. This is likely to result in gradual increases in global bond yields. This expected rise in global bond yields is indicative of a stronger, more normal global economy and, consequently, should coincide with reasonable equity market returns.
“Investors in global bonds, however, are likely to see negative returns given relatively low starting bond yields. Locally, lower interest rates and a modest recovery in the domestic economy should underpin the performance of local equities.
“However, earnings delivery remains a key risk to local equities given the muted medium-term growth outlook. Low growth, political uncertainty and the potential for capital flight if South Africa’s sovereign credit rating is downgraded further will also likely weigh on local assets, including the rand and bonds, over the medium term,” Orford says.
Have we entered an era of low growth and low investment returns – what are your views on this?
Galloway and Phillips say the global recovery has been “too slow and too low, for too long”. Growth in global trade and industrial production remain at levels well above 2015/16 rates despite retreating from the very strong pace registered in late 2016 and early this year. Expectations signal sustained strength ahead in both manufacturing and the services sectors, however, with some moderation in downside risk from political uncertainty. The International Monetary Fund’s global growth estimates are expected to rise from 3.2 percent in 2016 to 3.5 percent in 2017 and 3.6 percent in 2018.
Orford says investment returns have been low for some time. For example, the median returns for high-equity balanced funds to July 2017 over the past one, two and three years have been below cash returns, and have been below inflation for the past two years. The median balanced fund has returned 5.9 percent per year over the past three years, which is almost half the 11 percent per year returned over the past five years. We do indeed live in a world of lower returns.
Pitt says the fundamentals of the South African economy have continued to deteriorate and, in the absence of decisive action from government, growth is likely to be modest over the medium term.
“Fortunately, there does not appear to be any correlation between economic growth and investment returns, the most important determinant of the latter being the price you pay at the start.
“The South African equity market has outperformed inflation by only about one percent over the past three years, with Naspers now accounting for 18 percent of the total market, growing by 30 percent a year over that period. It stands to reason that a number of shares have clearly not performed well and have, in fact, declined over the period. We have therefore found more exciting investment opportunities recently, certainly more than was the case a few years ago. We believe this should provide a positive underpin for attractive real returns for clients,” Pitt says.
How do you rate the attractiveness of other asset classes such as local bonds, the listed property sector, global bonds, alternatives and the rand?
Orford says that, at yields of about 8.5 percent, local bonds are relatively attractive given expected medium- term inflation of 5.5 percent. However, low growth and political uncertainty mean that South Africa is quite likely to have its sovereign credit rating downgraded over the next 12 to 18 months, which could see a further rise in bond yields. The relatively attractive yield, therefore, needs to be balanced against the potential for volatility in the near term.
“Local property, particularly locally focused property companies, offer an attractive yield and should be able to grow dividends over time. This should provide a reasonably attractive real return to long-term investors.
“At current levels, the rand appears fairly valued. In the short term, continued improvement in the global economy and a further narrowing in South Africa’s current account deficit could see the rand strengthen, but, over the longer term, South Africa’s weak growth and higher credit risk are headwinds for the currency. South Africa would need to see structural reforms and improved productivity to support a medium-term appreciation of the currency. This appears unlikely in the current political environment.
“Global bonds are broadly speaking unattractive given still very low yields, a firming global economy and an expected gradual rise in core inflation in developed economies. There are pockets of value in emerging-market bonds, although rising US bond yields pose some risks for emerging market bonds,” Orford says.
Pitt says the South African listed property sector has outperformed local equities by eight percent a year over the past 15 years. This has changed over the past couple of years, with both property and equities generating more modest returns than investors have become accustomed to. Deteriorating business conditions suggest increasing pressure on vacancies, particularly in an oversupplied office sector, and a general difficulty to increase rentals.
“We remain cautious on the outlook for the property sector in general as future distribution growth moderates.
“Developed-market bonds continue to trade at extreme valuations across the globe and do not present attractive risk-reward profiles. The South African bond yield curve remains steep, as investors don’t think the current inflation rate can be maintained and our deteriorating credit metrics provide reason for concern. These factors are linked, as the credit risk will translate into a weaker rand as the government struggles to fund the deficit. Inflation-linked bonds have sold off and currently present attractive investment opportunities,” Pitt says.
Galloway and Phillips say local nominal bonds are yielding real returns of over four percent. Consequently, they are expected to outperform their inflation-linked counterparts over the short term, despite the political risks embedded in this asset class.
“These risks include the political uncertainty around the ANC succession race in December, the adoption of market-unfriendly economic policies and the high probability of further ratings downgrades.
“From a tactical point of view, domestic equities are upweighted to neutral later in the year amid expectations of rand weakness on further ratings downgrades.
“Local listed property in the near term is favoured based on distributions growth and lower bond yields, but neutral over the medium term based on rand-hedge characteristics.
“Developed- and emerging-market equities are attractive on their earnings cycle recovery and relative valuations.
“We maintain being underweight in global fixed income and global listed property, given current real yields, rising interest rates, and as central banks reduce their balance sheets.
“Also, international assets are favoured on US-dollar strength and South African currency risk premium,” say Galloway and Phillips.
Ackerman contends that, with most yields on bonds and cash remaining low, it will be hard for an investor to outperform inflation in the near to medium term. In addition, the potential for long bond yields rising as global central banks start to normalise policy implies the prospect of capital losses, which would rather be avoided.
Locally, South African bonds could come under severe pressure if we see further credit downgrades. Local long bond yields could blow out to above 10 percent, which would lead to severe capital losses.
“We believe that global listed property offers a strong opportunity to diversify a portfolio while also offering yield enhancement. Strong fundamentals are supportive of this asset class, and it will make a useful addition to a portfolio over the next 18 months.
“We prefer global listed property over local listed property given the current weak local economic environment. With the local economy and consumers under pressure, the outlook for local property is less appealing. This is already clear from the recent rise in vacancy rates across the property industry.
“Putting protection in place against downside risk to an equity portfolio is currently quite cheap, so even though we do expect good returns from equities, investors who are concerned about a potential dip in the market would be able to protect against it. Local markets, in particular, are seeing potential stresses from economic and political uncertainty, and local-only companies listed on the JSE are struggling with negative sentiment.
“In addition, there are geopolitical tensions that cannot be controlled by investors, or even most governments. Having a shock absorber in place will offer some downside protection and a good alternative relative to traditional shock absorbers, such as government bonds,” Ackerman says.
What effect do you see weak business-sector confidence having on investment opportunities?
Orford says low business-sector confidence, particularly if this is prolonged by political uncertainty, will result in lower investment by South African and foreign firms in South Africa, continued investment by South African firms outside of South Africa, and a lower rate of growth than would have been the case with higher business confidence. This, in turn, will reduce employment opportunities and continue to negatively affect domestic consumer confidence. A stagnating growth rate will make it harder for South African companies to grow their earnings locally.
“In this environment, we expect that companies that are able to either grow outside South Africa or that, through innovation or disruption, can increase market share in South Africa are likely to deliver better long-term returns.
“From a macro perspective, slower growth will continue to put pressure on the fiscal balance, with government revenue likely to be under pressure. Over time, this is likely to contribute to a downgrade in South Africa’s credit rating, which would likely see the cost of borrowing rise, further squeezing domestic growth,” Orford says.
Pitt says business conditions are improving almost everywhere. The only major countries that are not growing are Venezuela and South Africa. The former is in a state of total economic collapse, as years of misguided economic policies have taken their toll.
“It is concerning that the cause of South Africa’s malaise is also political. Following the dismissal of Finance Minister Pravin Gordhan at the end of March, and the consequent downgrade of our sovereign rating to junk by S&P and Fitch, business confidence is at an extremely low level. This is important because confidence drives investment and, without investment, there will be no sustainable growth,” Pitt says.
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