While we continually review markets and update our views throughout the year, the quieter time at year end allows us to take a deeper dive into global and local economies, markets, and expectations for asset class returns. It is also the time when we can stress test our assumptions, and assign probabilities on certain scenarios playing out.
During our review process in late 2014 we came to the conclusion that, with a relatively high degree of certainty, domestic asset class returns were likely to produce pedestrian nominal and real returns while offshore equities were best placed to deliver rand returns in excess of domestic inflation. Given these assumptions, our expectation was for forward returns - for the Nedgroup Investments Stable Fund - well below what has been achieved in the past, and in all probability include a period within investors’ investment horizon where returns may even be below the stated fund objective. Capital preservation and a conservative portfolio positioning took centre stage. Investors should therefore be delighted with the returns achieved for 2015, once again exceeding the investment objective of CPI + 4%.
However, closer inspection of the sources of returns highlights how tough a year it really was. The dramatic fall in the oil price and poor consumer demand environment meant that inflation (5.2%) came in lower than expectations, with correspondingly lower local cash returns (5.8%). Domestic equity market returns (5.1%) were concentrated in a handful of businesses with predominantly global sources of revenue, while bond market returns (-3.9%) disappointed following a fall in prices subsequent to the debacle surrounding the replacement of our ministers of finance in December. These events further dented investor confidence and increased South Africa’s risk premium, contributing to the 25.3% decline in the rand against the dollar. Few global equity indices produced positive dollar returns. Offshore translation gains therefore contributed significantly to the outcome for investors, as the fund held well in excess of 25% in offshore investments through the year.
Moving forward one year, and our most recent deeper dive largely reconfirmed our prior year views and forecasts. In some cases, our conviction has grown, while in others we are now less certain. Future return expectations have been adjusted, both in nominal and real terms, reflecting changes in growth rates, the outlook for interest rates, valuations as well as concerns about the future path of inflation.
The events which unfolded in early December 2015, when then Finance Minister Nene was fired, is of great significance to all of us. And while we may have our own personal views on what this means and how it plays out, international market participants have already made up their minds. The fact that the spread for South African government debt has increased to a premium relative to the emerging market index (EMBI) for the first time since 1994 has far reaching consequences for all the role players in the country’s economy, and is significant because investors now demand a sufficiently high rate of return before investing in South African assets. The cost of capital is increasing for government, which is running a 4% deficit to GDP. Government bonds, now yielding 10% on the R186, is not that sure a ‘bet’ anymore. The probability of a foreign currency sovereign debt downgrade to junk has increased significantly, but seems to be largely priced in given the spreads now equal those of BB rated countries Brazil and Russia. Consequently the allocation to domestic bonds in the portfolio has increased, but remains low, given the tail risk of much higher domestic inflation compared to our base case scenario.
Domestic shares remain a low conviction position in the fund, based on valuation concerns and the eventual consequences for investors from higher interest rates. SA Inc. in particular is facing another bleak year. GDP growth forecasts of 1% seems optimistic, threatened by much higher food inflation due to the drought and import requirements, and subsequently higher interest rates. A lack of confidence in the private sector and the need to cut expenditure by government will affect fixed asset investment. The consumer, the ‘bright’ spot in the economy, may finally surrender. The result is a possible earnings recession for locally focused businesses, and a resulting derating in the multiple of these companies. We continue to prefer non-resource rand hedge businesses, where the offshore earnings is diversified and stable. The stability in the earnings from these companies is likely to play a significant role in anchoring the returns of the fund.
Local interest rates are increasing into a weakening economy. Growth rates have been well below potential output and falling, while inflation expectations are rising due to the weaker currency and risks posed by food price inflation. Domestic rates are therefore rising in response to the weakening of the domestic currency against those of our major trading partners, and the fear the currency weakness poses to future inflation and inflation expectations. The MPC expects a more stable currency due to higher short-term rates, while acknowledging the risks to growth. The alternative of unchanged rates in a rising Fed cycle may exacerbate the weakening trend of the rand and fuel inflation through higher wage costs.
While the increases in rates in the USA are likely to be at a slow pace, the incremental increase will have some effect on asset classes and valuations.
- After many years of stagnant or falling incomes, investors in cash instruments will start to see incomes rise, albeit at a very slow pace.
- Banks are likely to become more wary to whom they lend, tightening their lending standards.
- Heavily indebted individuals may struggle to repay interest or capital repayments, in particular in an economy like SA where wage growth lags increases in interest rates.
- Government and company revenues come under pressure due to slower economic growth, which result in higher interest cost on new bonds they issue.
- The growth in asset prices slow down or reverse (for individuals most notably house prices and investments in shares and bonds in investment portfolios).
- Corporate profit growth slows down, with a concomitant decline in the P/E rating of shares.
- Private sector investment may fall, given the decline in consumption growth and higher investment hurdles.
- Ultimately, when interest rates rise too far, it results in a redistribution of wealth from debtors to lenders.
The various factors mentioned above therefore increases the likelihood of poor returns from domestic asset classes. The Nedgroup Investments Stable Fund has accumulated cash in the local asset component, and will hence benefit from rising short rates. More importantly, our cash position allows the portfolio managers to take advantage of investment opportunities which may arise from changes in investor sentiment in the short term.
2016 is therefore a year of continued consolidation. It is likely to be another very difficult year to make money, and once again the investment risk has increased significantly. It is therefore still prudent to retain the offshore allocation in the fund, despite the significant depreciation experienced in the last 18 months. Capital preservation is foremost in our minds in the current environment.