Multi Manager Insights Webinar - The case for equities or fixed income
Anthony Sedgwick makes the case for investing in domestic equities
To watch a recording of this conversation, go to Nedgroup Investments Insights on YouTube.
The JSE is no longer a hedge against inflation
SA equities has not been a great place to be for some time. For many years, we were able to rely on using our equity exposure as a hedge against inflation by investing in businesses that were able to grow their profits in a flourishing economy. The growth of profits would result in capital appreciation and astute investment managers were able to pick the relative winners and outperform the index. The last six years have been very difficult. The JSE has lost its reputation as a hedge against inflation, having moved sideways. This has been compounded by a litany of scandals from Steinhoff to EOH and collapses in the valuation of many businesses previously considered blue chips.
Performance has been narrow and extreme
There has also been massive divergence in performance. Since 2015, the All Share Index has had an unflattering performance and there has been a massive dislocation in where those returns have come from, which has been extremely concentrated. Unless you’ve had very heavy exposure to Naspers and the mining sector and nothing else, you wouldn’t have done very well as a result of a huge drag on the market by the banks, retail and property index, all of which have been underperformers.
The JSE has less and less to do with SA
Fifteen years ago, 65% of the market cap of the JSE was made up by our domestic businesses with industrial and mining Rand hedges making up the balance. Today, this situation is reversed where only 35% of the JSE market cap has anything to do with what’s happening in our domestic economy, which we’re fortunate to have as an emerging market and as South African investors. By investing in equities, we’re not tied to the fortunes of our domestic economy, which is in a very fragile state. But, we’re becoming increasingly irrelevant in the greater scheme of things. South Africa’s weighting in the MSCI Emerging Markets Index fifteen years ago was about 15%. Today it’s 3.5% with only 1% of this having anything to do with our domestic economy. We are becoming irrelevant in the greater scheme of things and in the bigger world. This has been driven aggressively by the ascension of China, which has gone from 5% to 41% of the index market cap.
SA economic outlook – pre-Covid … now what?
In 2018/19, our debt was unsustainable and getting worse with no GDP growth or plan. There was political instability, no accountability for corruption and little economic certainty. There was no evidence of an accelerating and broad-based economic growth, no sign of a rising capital investment cycle or improving business confidence. Employment was declining and there was deteriorating consumer confidence. In 2020, we were hoping to see some impact or changes in economic policies or changes in attitudes towards corruption that had become the norm over the previous decade. We did see some small signs of political progress, corruption accountability and capital investment activity before Covid hit at the end of Q1. The difficulties we were facing in all the above areas have become worse. Both consumer and business confidence has weakened substantially as a result of Covid. It is encouraging to see the progress of the Zondo Commission, SANRAL starting to award contracts and a refreshed attitude of cooperation between the public and private sector and labour unions although the public sector wage situation has deteriorated again.
SA equity market now cheapest on record and relative to MSCI
While it does look bleak out there, there are a few things which are very supportive. The first is that SA equities are very cheap relative to our long-term history on an absolute basis. The MSCI 12-month forward P/E ratio for South Africa is down to 10 times, which is a bit overstated as it includes Naspers, which trades at much higher ratings. On a relative basis, relative to emerging markets, we are at an all-time low at 25% - 30% discount rating relative to emerging markets. Emerging markets are cheap relative to developed markets. Relative to developed markets like the US, Europe and Japan, we are again at record low levels of relative valuation. The outlook might look tough, but the valuations relatively and absolutely in the context of history, are very low.
EM are out of favour in global portfolios
The markets broadly are also not interested in emerging markets. There’s been this huge performance from US exposure and developed markets and so the relative exposure by global investors to emerging markets is also at a record low. If this starts to turn, and we’ve seen evidence of this over the last month, SA will be a natural beneficiary. Disappointingly, only 3.5% of the 100 will come here.
There is no alternative source of yield
Despite the worrying outlook, there is an even more compelling reason to invest in domestic equities on an after-tax basis. Valuations are extremely attractive and, relative to a fixed income product, the yield differential is at an all-time record low, i.e. the yield differential between putting your money in the bank versus the dividend yield that you get out of the All Share Index. The All Share Index dividend yield is currently at about 3.5%, which is about the same as leaving your money in the bank. For the first time in a very long time, despite the uncertainty and risks, the odds and price are as good as they have arguably been for a very long time. You definitely don’t want to be reducing your exposure to equities at this time, but rather increasing it.
Rashaad Tayob makes the case for investing in fixed income stocks
Money market yields are low, but bonds are still yielding
The Repo rate has been cut quite aggressively, down from 7% to 3.5% and money market yields are quite low, but you are still getting quite decent yields out of the bonds, which have barely moved. You’re getting 9%+ yields on a 10-year SA government bond, which is guaranteed, indicating that you can get decent yields out of the fixed income space. The fiscal issues in South Africa are significant. The risk is there even with that yield advantage. We’ve increased our bond exposure in the portfolio within moderation and have increased our FX exposure in order to hedge some of that downside risk. While we accept the downside risk, we believe that you can get a very attractive yield and there are mechanisms like diversification and FX exposure to control the risk.
Inflation linkers protect the real value of capital
In the fixed income space, we have the only asset in the world that guarantees the real return of your capital and that’s an inflation linked bond where we are getting yields of around 3% real, which means that your real return is guaranteed at 3%. If inflation is 4%, you’re going to get a7% return. If you have a very high inflation scenario of say 10%, you can end up with a 13% return. While equities are an inflation hedge over the longer term, there’s no guarantee of that and we’ve seen periods of high inflation where equities can underperform for a period. An inflation linked bond will protect the real value of your capital. While money market rates have decreased, if you look at where we were in terms of bonds and inflation linkers in the portfolio, at the start of the year, we were 10% combined and now we’re at 30%. There are ways to mitigate that lower yield in terms of the money market by having more real and nominal bond exposure.
Do convertible bonds offer the best of both worlds?
A convertible bond gives you a fixed return with upside participation to equities. If a convertible bond doesn’t perform, you still have a fixed yield bond giving you about a 5% return. If it does perform, you may not match the stock return, but you participate with a lot of that upside. If, for some reason there is a period of poor equity performance where the stock underperforms, you still have a fixed return to bank on. Convertible bonds give us the opportunity for the best of both worlds and is one way in which we have been allocating.
The SARB is not following the global QE playbook…yet
In terms of quantitative easing, the SARB is still playing a traditional role where they’re not printing excessive amounts of money to inflate away the debt burden. The SARB has an inflation targeting framework to protect the value of the currency. At this point they are still following this framework, which means that holding Rand denominated assets, which can give you a decent yield are still an attractive opportunity. Until that framework changes, bonds, inflation linkers and money market offer a reasonably attractive risk return proposition. Combined with a diverse portfolio, you get a reasonable fixed return with downside protection, giving you an attractive return that protects capital. When equities do dip, you will have the ammo to buy when the time is right. Fixed income is still a very necessary part of your portfolio.