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Local assets still coming out tops in terms of valuation

Global bonds have once again deteriorated.
SA assets are offering better value, writes the author. Picture: Moneyweb

The global macroeconomic environment is treacherous at the moment. The shift to populism and the resultant risks have brought politics front and centre. This is inherently unpredictable. At the same time, extreme monetary policy action has de-emphasised the standard cycle. In this world, it is prudent to focus more on valuation (price) and to hold macro views lightly, while focusing on building portfolios that are well diversified.

Themes suffer in the wake of uncertainty – a heavier weighting on price

As part of our investment process, we develop a set of evolving themes that take the macroeconomic environment into consideration. The theme that influenced our latest portfolio construction is that the US will underperform and, as such, our portfolios are underweight US equities. This is based off very high profits, high valuations and a strong US dollar, making it difficult for things to improve. Globally, we expect a low return world, which will force money to search for yield in an environment of ultra-low global interest rates. This has the potential to support SA assets, which are offering better value.

SA expected to fare better

In terms of SA, we maintain our ‘winds of change’ theme. This theme recognises that things are by no means easy, but at the margin we expect improvement – with lower interest rates and faster economic growth. The risk to this is that Government does not act decisively on the parastatals, particularly Eskom. There is no time to waste. If Government does not take swift corrective action, we will be downgraded to junk status and the resultant loss in confidence will mean us navigating through a path where even the welcomed winds of change turns into a storm.

Local assets to yield a better return

Our expected returns across SA assets have generally been revised up, while global bonds have once again deteriorated and are now expensive. On a relative basis, the investment case is pushing harder towards SA and away from global assets. SA assets have de-rated; in other words, they’ve become cheaper and are now offering better value. To this end, we have increased our longer-term expected returns for SA equity and property and have maintained our outlook for SA bonds, which are particularly attractive in a global context.

An important change to our outlook is that SA cash will fall. Cash has offered tremendous ‘competition’ for investments and that’s because we’ve had very high real rates in SA. Now with the first rate cut, with more expected to come, those real returns are starting to drop. Therefore, on a relative basis, SA assets are now more attractive than global assets and SA yield assets (property and bonds) are more attractive relative to cash. We see this trend of global assets becoming a little more expensive and local assets getting cheaper as an ongoing theme. SA markets are starting to show decent value for the first time since 2011. If we sum this all up into a Balanced Fund, our expected real return is 4.6% a year over the next five years – only slightly higher than six months ago at 4.5%, but much better than the low point of 3.5% in 2015 when markets were expensive and our theme was that of a low return world.

Unpacking asset class expectations

SA Equity

We have increased our expected real (after inflation) returns for SA equity by 50 basis points (bps) to 6% a year over the next five years, up from 5.5% in January and 5% this time last year. This is driven off a 4.3% forward dividend yield and a relatively depressed earnings base, which provides a good platform for better growth into the future. However, this improved outlook will require a turnaround in the local economy.

SA property

Our expected real return has increased by 50 bps to a mouth-watering 7% a year, up from 6.5% six months ago. This is backed by a very high dividend yield, despite a negative expectation on growth. We remain pessimistic about the trading outlook for these companies, but with such high yields we cannot ignore the value.

SA bonds

Local bonds continue to offer high real returns and are very attractive in a global context. While, over the long term, we expect SA to be downgraded to junk status, we are comfortable investing in the bonds because they have been priced for this. Our five-year real return outlook for local bonds remains 4% a year.

SA cash

A big change in our asset class outlook is that interest rates in SA are now falling and we expect cash to deliver a real return of just 1.5% a year going forward. With the economy on its knees and no underlying inflation, we think further interest rate cuts from the South African Reserve Bank (SARB) are appropriate. With cash yields falling, it forces investors to look at other assets.

Global equity

The global equity market is schizophrenic, with the US equity market and growth shares expensive, while the rest of the world and value stocks are cheap. Longer term, there is no alternative to equity, but we are concerned about profits as we expect them to fall. As a result, we are cautiously positioned on global equity and have revised our five-year real return outlook down to 5%.

Global bonds

Following a stellar six-month period, global bonds are once again priced to give negative real returns. In fact, the whole of the German bond curve now offers negative yields! Our five-year outlook on global bonds has further deteriorated to -1% a year.

Global cash

We also expect global cash to deliver negative returns going forward. To combat the trade war induced global slow down, central banks have swung to easier monetary policy. We hope they are successful, but monetary policy is starting to run into its limits.

Peter Brooke is the head of MacroSolutions at Old Mutual Investment Group.

The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.

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Even if these extremely optimistic projections come to pass, benchmarking your returns against the SA CPI is not doing yourself any favors. One needs to be growing your assets in real returns against real currencies to preserve your spending power. Getting an inflation beating return in Zimbabwe ain’t gonna get you very far. Don’t make the same mistake here.

I agree wholeheartedly with… “One needs to be growing your assets in real returns against real currencies to preserve your spending power”. Ideally it would be responsible for all fund manager’s to report their performance on a US$ basis! Anything less is lah lah land!

“One needs to be growing your assets in real returns against real currencies to preserve your spending power.” Agreed totally!
Responsible SA Fund Managers should start stating their performances in USD terms. Anything less is lah lah land….

On the equity side.

I wonder if the figures were adjusted for risk. Does SA Inc ever produce a competitive risk adjusted return? What premium should one expect investing in SA Inc.

Recently the JSE has been holding up mostly due to resource sector performance having the advantage of higher commodity prices.

Should things slowdown globally will commodity prices not drop and have an adverse effect on resource counters locally? What would support SA Inc then?

Perhaps, but I do not believe they make those promises, not on final delivery. If they did I would not touch them.

My error. I am replying to The Hun, below.

If you could define, let alone accurately adjust for risk…

More braai logic.

This analysis appears to ignore the effect of the ZAR exchange rate on the net return yielded by Global bonds and equities from the perspective of a local investor.

…and totally ignores new asset classes which are outperforming all traditional asset classes.

Such as?

CryptoAssets over 4 years: BTC up over 6700%; ETH up over 2700%.
ZAR down 33% over 4 years.

I’m always intrigued when people say that central banks are out of ammo, or that monetary policy has run its limits when it’s clear that money can be printed to infinity.

The limits, I think, is the point where it starts to be ineffective – ie, detrimental to economic growth – and it does seem that these limits have been hit.

But that doesn’t mean we’ll stop printing because it’s our only option to repay the mountain of debt.

Agreed with your last sentence particularly. Now imagine the tightrope for the owners of SA debt. Threatening to go to junk, ANC still destroying the economy further with NHI, no Eskom capacity to actually grow anything,threatening EWC then borrowing more and more cash to pay salaries of thieving and incompetent cadres. Meanwhile money from pensions etc keeps flooding in constrained into SA by regulation. A bubble just waiting to burst?

What else would you expect from any large local company wanting your hard earned cash? If a “normal” company offering a product at a certain price at a certain delivery date does not fulfil the contract the customer has the right to sue for damages. Trying to sue insurance and investment companies for not delivering on promises has no chance of even getting to court.

…agree, it won’t stand up in court, thanks to the “fine print” (T&C’s) when you sign (or click) which mentions words like “your investment may go up or down”, and “past performance is not an indicator of future performance”. No guarantees.

The fund “aim to achieve” to beat (or track) the relevant benchmark.

Of course you are 100% right. My problem is that I do not know any other product or service which can claim so much and get away with providing nothing thanks to the “small print” in the contract. Could you imagine a bank account having a clause “we might not give you any interest or even your capital might be reduced”. Or buying a tv set and in the purchase agreement you find the small print “the set might not work as promised”.

This is where it gets interesting. When we want to determine which jurisdictions will offer the best returns under the circumstances of a global financial contraction, we simply have to ascertain which jurisdictions have the power to create the largest amount of new currency “ex nihilo”.

I am afraid that “value” is of little value these days. Returns are driven by the Cantillon Effect and currency devaluation. Traditional value metrics play less of a role in this deflationary spiral. What offers great value today, will offer even more value tomorrow. This is deflation. We all agree that value offers a degree of safety, but the problem is that value does not promise to produce a return under these circumstances.

It s clear that it is basically only the US market that has been in an uptrend over the past 5 years. The US market is driven by share-buybacks that are financed at record-low interest rates, cheap credit and Quantitative Easing. These factors come down to currency devaluation on a massive scale. The industries and markets that are first in line to receive the newly-created currency enjoy its full purchasing power, while those who stand last in line to receive the newly-created currency will suffer from the inflationary effect as the devaluation causes input costs to rise. This phenomenon is known as the Cantillion Effect and this effect drives the relative outperformance of the Ameican Indexes.

We will soon see a massive new round of Quantitative Easing from the Fed, on top of the old rounds of Quantitative Easing. The devaluation of the dollar hides the “real” deflation and ensures that US companies enjoy higher profit margins. In South Africa, we are far removed from the dollar printing presses, so our cost structures increase in real terms while the depressed sales volumes and selling prices put profit margins under enormous pressure. We are basically importing American deflation. The Cantillon Effect has been overruling the value metrics over the past decade.

Another driver of US equities could possibly also be the large tax reductions Trump brought in?

Nah. He just has to tweet and the market moves.

and everyone points fingers at SA analysts…investing offshore now is just as bad…not the best of returns including the US…where and in what to invest is a problem but with extreme low yields offshore I will take a bet foreigners will invest in emerging markets including SA…downgraded or not

How does one determine value when Germany’s 30-year is at minus 0.22%, Japan’s 40-year at 0.19%, Britain’s 50-year at 0.94% and Austria’s century bond at a mere 1.1%. These bonds yield less than inflation. The yield in negative in real terms. That means that money has no value and that credit is for free. The time value of money turned negative.

This scenario implies that companies that pay a negative dividend may still show capital appreciation. The abundance of cheap credit finances share buybacks that enable loss-making companies in the USA to drive the value of their shares higher.

If we use the following formula to calculate value:
Present value of stock = (dividend per share) / (discount rate – growth rate)
Then, if the discount rate is negative, the present value is also negative. The only way to get a positive Present value when the discount rate is negative is by making the value of the dividend negative. If the company pays a negative dividend, in other words, we pay the company a dividend, then the company has value. ☺

The whole world of finance is upside down when interest rates are negative.

Nice article. There is actionable information, although one does not have to agree with it.

Peter Brooke is a joke

Rational argument. Good points there.


…and conversely, US Equities must rank BOTTOM based on (current) asset valuations.

(It’s because it had a healthy bull run few other regions can match).

Let’s not worry too much about valuations….as “returns” (for investors) are the proof in the pudding.

Returns reflect past price performance and the US has been the place to be. What will returns be over the next 10 years is the question. Historically, valuations at these levels result in a 0.5% p/a return over the following 10 years. It will be different this time?

The exchange rate and its impact on inflation must be considered. History shows that when the U.S. lowers interest rates by 1% (expected over the next year), the Rand weakens by 30%. Therefore expect the Rand USD to be at 20 next year.

End of comments.





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