The expression ‘hindsight is 20/20’ means it is easy to know the right thing to do after something has happened. Predicting the future is a lot harder. Enter 2020, and the saying has never been truer in the area of investments.
It’s no secret that the past few years have been hard on South African investors. Looking ahead to this year, there are some noticeable dark clouds looming on the horizon and many are wary. Should investors be preparing for a light drizzle or a full-on storm?
Last year was a relatively bumpy year for equities but the asset class still managed to deliver solid inflation-beating returns. Unfortunately, the rand remains weak and a Moody’s downgrade remains likely. On the global front, the trade war between the world’s two largest economies continues and the US will soon be gearing up for its next presidential election.
Key hindsight lessons to take into 2020
- Separate bad news and emotions from investing
Every year brings bad news, dramatic headlines, and things to worry about. It is safe to assume that 2020 will be no different. When investors are faced with negative news or sensationalist views, it’s hard not to worry or react. While acting on these calls to action may give investors a sense of control in the short term, it is the surest way to destroy wealth in the long term. It would serve investors to remember that concerns and uncertainties surrounding the future are most likely already priced into any associated assets.
- Steer clear of regret and envy
There have been many quick-win strategies and ‘hot tips’ over the years and this will likely continue. As a long-term investor, Morningstar prefers to remain focused on fundamentals and stay true to our long-term view, even if doing so may mean missing out on the occasional quick win.
There will always be some person, some fund, some share or some investment strategy that did a lot better than yours – whether through luck or skill – and you may regret missing out. However, fear and panic can force investors to make mistakes with their money.
What would a downgrade mean for SA?
A downgrade to sub-investment grade from Moody’s would result in South Africa losing its place in the Citigroup World Government Bond Index (WGBI). This could translate into a forced selling of South African bonds by international investors that are mandated to only hold investment-grade bonds. The rand could potentially weaken against the US dollar due to foreigners selling local bonds.
That said, this is not the only government bond index. Should SA fall out of the WGBI, it would be included in several other global indices that only include countries that are sub-investment grade. As some investors may be selling South African bonds, a host of foreign investors will be buying local bonds.
At a portfolio level, there may be a short-term movement in the currency, and bond yields might spike, but over the medium term this would settle and the current yields will have more than priced in this risk. In so doing, investors will be compensated for an overly pessimistic outcome.
If a downgrade will have such an impact, should I sell?
Market pricing suggests that a downgrade has already been priced into SA bonds (given that they are offering investors a real yield of close to 4%). It is possible that yields creep higher on the day of the downgrade, along with a weaker rand. Remember, if bond yields rise, it results in capital losses for bond holders, however, investors are being paid roughly 9% a year in yield to compensate for this potential risk. Rising yields could also create buying opportunities for investors.
Times of panic and stress often present golden opportunities to enhance returns if one can price risk appropriately.
Moreover, should SA be downgraded, those who invest in sub-investment grade options will start allocating to SA bonds. This, combined with the fact that nearly 60% of European debt is yielding negative returns, would be a great opportunity for foreign investors.
Morningstar is seeing good value in SA government bonds as well as select SA equities, which appear to have the pessimism and bad news already priced in.
For the past three years I have been told not to move to cash, where I could have achieved 7% per annum. So why should I remain invested and not move to cash now?
Having a portion of your investments allocated to a cash component is part of a well-diversified portfolio. During turbulent times, people tend to seek safety and surety, which cash investments offer. Investors should consider the cost they would be paying to switch their investments to cash and the risk associated with holding too much cash.
Over the long term, equities continue to outperform cash. Cash may provide security in the short term, but it also has its risks.
Cash is subject to inflation risk, and if the value of your investments does not keep up with inflation, you will lose value and purchasing power.
Conservative investors in a cash-plus or a cautious portfolio still have to manage growth assets and ensure that the yield of the total portfolio is in line with that of a money market. If an investor has longer than a 12-month horizon, they are likely to get capital growth from the underlying assets.
The graph below illustrates the rolling five-year return of the JSE relative to the rolling five-year return of cash. It highlights how unique the last few years have been, with cash outperforming equities for a sustained period. However, it is clear that equities deliver more substantial returns over the long term.
While no one can predict the outcome of whatever transpires in the coming year, the best thing investors can do is remain disciplined, stay focused on valuations, and identify opportunities in unloved, well-priced asset classes. In this context, volatility in market prices should be welcomed. A drop in price can create opportunities for managers who hold cash to buy assets that are significantly under-priced relative to their long-term fair values, thereby sowing the seeds for future returns.
That said, the biggest worry at the moment is the impact that trade wars are having on global growth.
This remains a severe area of concern as global world trade accounts for roughly a third of the global GDP. A slowdown in world trade will impact global growth, which will affect all countries and economies.
Currently, large cap US equities are looking expensive (earnings have not been able to keep up with the prices they are currently trading at), so Morningstar has been building exposure to unloved areas of the market such as UK equities, and Japanese and US cash.
A tried-and-tested philosophy of not overpaying for assets that people have fallen in love with (as a result of sensationalism) has rewarded investors handsomely in the past. Keep an eye on the fundamentals – often bad news is in the price, offering an attractive entry point for long term investors. This is, however, easier said than done.
It is much easier to buy something that makes you feel good, even if it is expensive and unlikely to repeat its returns.
When thinking about the valuation opportunity in select South African equities that have been battered over the past five years, it is impossible to predict when unloved areas of the market will turn around and deliver returns – nobody rang a bell on March 9, 2009 and said ‘ The crisis is over, let’s go markets!’
The coming decade
President Cyril Ramaphosa’s investment drive to pull $100 billion worth of investments into South Africa continues to be keenly watched by South African market participants and businesses. At the 2019 Africa Investment Forum, 56 deals worth $67.6 billion made it to boardroom discussions at the forum.
According to the Africa Investment Forum statement, this is an increase of 44% compared to last year. Of the 56, 52 made it to approval. The deals secured investor interest worth $40.1 billion. Rectifying the economic decay and low confidence that has built up over the past decade will take time. Make no mistake, this will be a multi-year process, but it has started.
Portfolio construction and investments should always be approached keeping an investor’s time horizon and risk tolerance in mind.
Morningstar’s portfolios have exposure to areas of the market where we have high conviction, but we also remain diversified. While diversification may feel silly in the short term, the reality is that it does pay off in the long term.
‘Best chance’ recommendation
In our view, a diversified portfolio tilted towards asset classes with higher expected returns – within appropriate risk constraints – provides the best chance of reaching our investors’ return objectives. We do not try to predict the future; instead we focus on finding asset classes and opportunities that are undervalued.
While market conditions are both challenging and uncomfortable, it is exactly at times like this that investors should be encouraged to stop, pause, and use evidence and perspective as their guide.
As counterintuitive as it may feel, sitting on one’s hands and doing nothing really is the best action one can take at the moment.
The above factors once again emphasise the need for investors to remain patient, stay the course and avoid making investment decisions in a panic.
It is during these challenging investment times that investors should remove emotions from the investment decision-making process and focus on the fundamentals.
Victoria Reuvers is director and senior portfolio manager at Morningstar Investment Management South Africa