Last year was a bruising year for investors, with negative returns across a broad set of markets and asset classes. Developed market equities, emerging market equities, commodities and global credit, to mention a few, generated negative US dollar returns. Back home, we had to contend with yet another year of disappointing equity returns, with only cash and bonds providing positive returns.
In an interview with Deputy Managing Director Sangeeth Sewnath, Co-Head of Quality, Clyde Rossouw, reflects on the sustainability of returns for the SA bond market given that it has run hard, and whether there is still opportunity offshore.
During 2018, we expressed our concerns about the lack of liquidity. It was a difficult year for markets due to a challenging geopolitical environment in which politics took centre stage, and tighter monetary policy put pressure on liquidity.
While it is heartening to think that a new year brings a new market direction, it’s important for investors to recognise that when you are investing for the longer term there will always be asset classes and opportunities that can be exploited. So, for us, if you look at the Investec Opportunity Fund, we still believe that the growth drivers for our portfolio for the next 2-5 years will come from global equities. We have already seen a rebound occurring in January, particularly in the offshore markets. Looking at fixed income, SA bonds had a reasonably good year in 2018. We believe there is more upside as disinflation takes hold in 2019.
So, we would encourage long-term investors not to become despondent. I know we have had three years of very muted returns and investors may be tempted to turn to cash. We believe it is a good time to sow the seeds for future returns from growth assets.
It’s important to understand the context of those real returns. SA growth has decelerated significantly over the past year and the retail trading updates show the sector is under pressure. Across the board, there has been a massive slowdown in December, which will only feed through to the GDP numbers that will be released in February/March. Typically, in the six months leading up to an election, people tend to put off any big spending decisions and businesses tend to pull back on capital expenditure, due to political uncertainty. We believe sluggish growth will move the Reserve Bank to cut rates.
Cash is unlikely to give you the same level of return as last year. Depending on how the year unfolds from a liquidity perspective, cash could be a lot more disappointing compared to other asset classes. In SA, listed property, bonds and equities, both the locally-oriented and the rand-hedge shares, are now starting to offer some material value.
Our holdings in SA bonds reflect our view that significant real value exists, particularly at the long end of the curve. You have a 9% yield in an environment where inflation has peaked at 4.5% and is on a downward trajectory, so that is a substantial real return in anyone’s books. Last year, bonds gave us a high single-digit return from the long end of the curve, while SA equities were strongly negative. That tells us that we need a reset to occur in financial markets.
We believe that without a significant rally in bonds, the SA equity market is not going to perform because there is no strong driver of earnings in the near term. Both locally-oriented and internationally-oriented equities are struggling to grow their earnings.
Without a re-rating that comes from lower interest rates, we are not going to get massive returns from stock markets, particularly on the domestic front.
So, we’d first need to see lower bond yields fuelled by lower inflation. Of course, there are fiscal and political dynamics at play, which could have an impact on the valuations of bonds. But these factors should ebb during 2019, potentially offering an opportunity to switch some of our bond holdings into equities.
We’ve had very little exposure to listed property, and some of the concerns we had about the sector have played out. For the first time again in many years, the absolute dividend yields in the property sector are now starting to get closer to the levels offered by the long end of the bond market.
While the relative value has started to improve, investors need to bear in mind that the guaranteed rental growth rate that everyone has been banking on is no longer there. We see distribution growth probably around the 3% mark for the sector this year, with some companies producing sub-zero growth. In other words, the distributions will go backwards, and I think that is important to bear in mind.
Another key consideration is that the dividend yields in the property sector are in many cases supported by continuous issuance, either companies tapping into the bond market or, issuing units by virtue of scrip dividends or placements. So, while the true dividend yield is becoming more attractive, you cannot take it at face value. Adjusting for the underlying free cash flows, we still think a 100-basis point increase is needed to attract more investment into listed property. So, 2019 could see us increasing our weightings to the sector, subject to bonds re-rating and listed property yields offering an additional 1%.
Our high-quality offshore equities again did well for us last year, providing attractive returns. Rand depreciation over the course of 2018 further bolstered returns for SA rand investors. We are not expecting much action from the currency in terms of driving returns in 2019, but we believe our offshore equities are still priced to deliver attractive returns. There has been a significant reset in offshore equity prices and the valuations of our offshore equities have improved substantially. The business fundamentals remain positive and corporate earnings still appear to be strong.
The global quality equities in our portfolio are typically priced for outperformance because of their superior earnings growth. Their outperformance in 2018 can largely be attributed to better drawdown-risk characteristics than the broader market. Our stocks are less exposed to economic cycles, so their better earnings dynamics in a slowing growth environment have also been favourable for investors. We believe our stocks remain attractively priced, given their potential to outperform the market over the medium term in terms of earnings growth and free cash-flow growth.
Across the board, a lot of stocks are now trading on high single-digit multiples, which is a refreshing change from where we were a couple of years ago. We started voicing our valuation concerns in 2014/2015, warning investors of the high likelihood of low single-digit returns from the equity market based on the starting valuation levels. This has now played out. The valuations are looking much better. Overall, the FTSE/JSE All Share Index is now trading at around 12.5x this year’s earnings, which is lower than its long-term average; so that is encouraging.
We have a very low weighting in financial and domestic industrial stocks, some exposure to resources and no holdings in retailers. Unfavourable trading conditions have resulted in retailers performing poorly. We saw large downward movements in their share prices in December and January as the market reset its expectations. We are getting closer to the point where we can consider sowing seeds for future growth.
Equity opportunities will emerge this year, but we are not going to jump in and ‘catch the falling knives’. Should earnings reach a trough within the first half of 2019, and we have a positive interest rate environment, we could see a re-rating in stocks. Hence, we anticipate that in a few months’ time the environment may be more favourable to proactively allocate capital to companies that are offering good value.
While the Investec Opportunity Fund’s relative performance was gratifying, the absolute performance was slightly negative. Nevertheless, we were pleased with our capital preservation efforts given the broad-based market sell-off. The Investec Opportunity Fund preserved more capital than the average fund in its sector, validating our investment approach. What’s encouraging for us is that the investment environment has become more favourable to pursue attractive real returns over the long term. To summarise: we still like SA bonds; we’re seeing much better value in local equities; and we expect continued growth opportunities offshore. So, from an asset allocation perspective, we have identified several drivers of returns that should help us to deliver inflation-beating returns over the long term.