David Knee, Chief Investment Officer, M&G Investments
Despite the unexpectedly challenging year 2023 has proved to be so far for South African assets, investment managers have not gone rushing for the exits to seek “safety” offshore. Many view local assets as clearly still offering better prospective returns for the risks involved over the next three to five years than their global counterparts offer.
This view would explain why some managers’ multi-asset portfolios favour South African equities and bonds over their global counterparts. Although select global equities and bonds are also attractive, and these offshore assets play critical roles as diversifiers in investment portfolios.
Global equities vs SA equities
One of the most compelling reasons for this positioning is the differential between the valuations of global and South African equities. In aggregate, global equities are trading slightly cheaply compared to their long run fair value, which is reflecting the cheapness of many global equity markets offset by the relative expensiveness of the US market, which, with a 12-month forward P/E ratio of 19.4X, has pushed the MSCI ACWI P/E ratio to 16.2X as of mid-August.
Because there are still unresolved questions around downside risks to global earnings going forward, and combined with the lack of a strong valuation signal, managers may be comfortable maintaining a neutral position in global equities and remain selective: continuing to be underweight US equities, as well as Canada and Australia. We prefer the UK, Japan, China and certain other emerging markets that are relatively cheap.
Meanwhile, SA equity valuations (FTSE/JSE Capped SWIX Index 12-month forward P/E ratio) were trading at 10.6X at the end of July, broadly reflecting concerns around future earnings sustainability and higher “risk free” interest rate hurdles. This presents real opportunities for the careful investor. Analysis shows that current market pricing implies SA equities have a prospective real return of 9.0% p.a. over the next five years, compared to global equities at 6.0% p.a. and US equities at only 5.0% p.a. This is well above the local market’s long term fair value of around 7.0% p.a.
We recommend that portfolios include a well considered mix of rand-hedge “SA Inc” defensive and attractively valued shares, with names like BAT, Richemont, Textainer, Reinet and a collective overweight exposure to SA banks.
Global bonds vs SA bonds
A look at Graph 1 shows how the real yield on South Africa’s 10-year government bonds, at well over 5%, is far more attractive than that of 10-year US Treasuries at just over 1%. In fact, SA real bond yields are more attractive than those of most other countries and are elevated relative to their history. At current market valuations, our view is that SA nominal bonds offer far better prospects of delivering positive real returns than global bonds where higher for longer inflation outcomes remain a risk.
While we acknowledge that SA bond risks are more elevated than they were at the start of the year, they are certainly not higher than during the GFC or Nenegate. Yet yields now far exceed those seen during both crises.
Current yields are pricing in an unlikely scenario of local inflation remaining well above the SA Reserve Bank’s 3-6% target range indefinitely – despite June CPI having already fallen back to 5.4% y/y, expectations of further declines in the months ahead, and the SARB’s strong track record combatting inflation. At the same time, South Africa has a long history of repaying its debt and is not on the brink of defaulting. In our view, current yields more than compensate investors for the associated risks and patient investors will be well rewarded.
Meanwhile, it is worth owning global bonds in portfolios, given that they are offering fair real yields and serve as solid diversifiers for South African equity risk. As in global equities, investors may wish to remain neutrally positioned due to the risks associated with global inflation and interest rates, and prefer 30-year Treasuries and 30-year UK gilts, as well as selected sovereign emerging market bonds where the real yields are high and the currency trading at fair-to-cheap levels.
Looking ahead, there are many factors that can provide tailwinds for SA equities and bonds. These include falling inflation, a shift to expansionary monetary policy/interest rate cuts both globally and locally, private sector contributions to new sources of power supply and improving infrastructure, and the government’s acknowledgement of the urgent need to improve its service delivery.
Current sentiment may favour the seemingly “safer” global options. In these conditions, our investment process indicates that the “safest” way to deliver excellent returns is to remain overweight in cheaper South African assets and selectively pick global assets when building an optimal portfolio.