A third of 2019 is basically over and returns have been good for local investors so far this year. This is largely because of strong gains in global equities. With the rand flat against the dollar year to date, local investors have enjoyed the full benefit of global returns.
The local equity market has also improved this year and April has been a very good month for the JSE, despite a local economy that continues to be buffeted by bad news and uncertainty ahead of next week’s general elections. The global backdrop remains broadly supportive for equity markets. China’s economy appears to be stabilising as stimulus measures take effect.
The US economy is still very healthy, growing by 3.2% in the first quarter, according to data released on Friday. There are still question marks over Europe, but at least things don’t seem to be getting worse there. Meanwhile, major central banks, notably the US Federal Reserve, have shifted their policy stance from hiking to keeping rates unchanged (a few are even adding stimulus).
This is not to say everything is plain sailing. Some of the optimism baked into markets reflects the view that a trade deal between the US and China will be signed soon. By implication, it also assumes President Trump will not open up a new front in his trade wars. The other risk is that the oil price keeps marching higher. Oil jumped to a six-month high after the US revoked waivers to imposing sanctions on Iran granted to a few countries. This could significantly reduce Iranian oil exports. Higher oil prices do not pose much inflationary risk, here or abroad. Although it does act like a tax, reducing the disposable income of consumers, it only leads to inflation if firms can pass on higher input costs to their customers by raising selling prices. Most firms don’t have the pricing power to do so.
Dealing with disappointment
With April almost over, the year-to-date returns for the major markets (in local currency) are 17% for the US, 16% for Germany, 10% for the UK, 24% for China and 13% for South Africa.
Chart 1: Major global equity indices in 2019, rebased to 100
Despite the 2019 rally, the FTSE/JSE All Share Index is still below its 2018 record level and not much above where it traded four years ago. This disappointing period, while the US markets have raced ahead, coupled with the general sense of gloom around domestic economic prospects and the uncertain political environment, has led to a widespread view that South African investments are inherently inferior to global. Taking this argument to its extreme, some commentators have argued that local investors should take all their assets offshore, even their retirement funds.
Retirement funds have tax advantages, but regulations limit the offshore exposure, as well as total exposure to equities. These ‘prudential guidelines’ serve as soft capital controls and prevent excessive risk in portfolios. The government has gradually increased the limit to 30% and is likely to continue doing so over time as it phases out exchange controls. The regulations don’t apply to discretionary investments (such as stockbroker portfolios) or living annuities.
This view is problematic on five fronts. Firstly if your assets are mostly in one currency and your liabilities in another, exchange rate volatility can cause havoc. In simple terms, if investors take all their assets overseas but need to live locally in rand, a period of rand strength can be very painful. The period of the early 2000s stands out here. Many investors took money offshore as global markets surged higher in the late nineties, while the rand slumped (especially in 2000 and 2001).
However, from 2002 the rand strengthened against the US dollar for three consecutive years – by 50% in total. Over time the rand should weaken against the dollar since South Africa’s inflation rate is higher and hence balanced global exposure makes sense. But there will also be periods of appreciation. To put all eggs in one basket risks a currency mismatch omelette.
Secondly, though it is easy to blame the underperformance of local equities on politics, the fact is that the JSE has performed in line with other non-US markets. The outlier over the past decade has been the US and not South Africa.
To use one example, the FTSE 100 first peaked at 6 930 index points in December 1999 at the height of the dotcom boom. It had to wait until October 2007 to regain this level. After the financial crisis, it finally hit a new record in April 2014. The index slumped back to 6 585 points at the end of last year, a 19-year low. Similarly, the FTSEurofirst Index of the top 300 European companies has not beaten its 20-year record.
Chart 2: The US versus the rest and South Africa in US dollar
There are good reasons why the US equity market performed better over the past decade, notably a relentless focus by company management on shareholder returns, higher levels of innovation and a stronger economy compared to other developed markets. But this does not necessarily mean that the US will outperform over the next 10 years.
History on your side
Thirdly, while South African equities lagged global and US equities in recent years, they have outperformed over other periods. Indeed over the longest period for which data is available (since 1900), the JSE has beaten other major markets according to the landmark study by London Business School professors Dimson, Staunton and Marsh. This outperformance came mostly in three spurts, the 1930s Depression era, the late 1970s (when the JSE was boosted by the surging gold price) and the commodity boom in the 2000s. There were also long periods of underperformance, including the most recent. It would therefore also be a mistake to assume that local markets will always outperform or underperform. Simple extrapolation is always dangerous.
The global local market
Fourthly, the JSE has become increasingly international, partly due to the secondary listing on the JSE of big global consumer companies (Richemont, AB InBev, BAT) but also because local companies have diversified abroad (Naspers, MTN, Woolworths). Mining companies have always been international as their output is priced in dollars. This is another reason to believe that the JSE’s performance relative to global markets will not be as pronounced in the future, since the price of a large component of the local index is set directly in global markets, with no reference to local political or economic developments.
However, locally focused shares are also influenced by global market conditions, partly because of the large foreign ownership.
Simply put, local investors get plenty of global exposure on the JSE.
This, by the way, is increasingly the case for most major markets: the benchmark index is not the same as the domestic economy. Just as the JSE does not reflect the SA economy, with more than half of its revenues generated overseas, so is this the case for other countries.
For the London Stock Exchange’s FTSE 100, three quarters of revenues come from outside the UK. For the US S&P 500, the number is around 40% and the recent surge in the dollar is therefore largely unwelcome.
Regulations currently allow 30% offshore exposure in balanced funds, which, together with the global nature of local equities, limits the need to take additional money offshore. The exposure to global economic activity in most balanced funds is therefore much more than half.
Finally, while most of the discussion above has centred on equities, balanced funds invest in interest-bearing assets too, and on this front local assets – from short-term cash to long-term government bonds and a lot of things in between – offer yields that investors in developed markets can only dream of. This is especially true once inflation is accounted for. The German 10-year government bond yield is negative in real and nominal terms, compared to 8.5% for South Africa. The rand would have to depreciate by more than 8% against the euro every year for the next decade – double the inflation differential – for the former to generate a better return than the latter.
Chart 3: 10-year government bond yields minus core inflation %, local currency
Diversify to avoid the extremes
The bottom line in all of this is not to get carried away by good news or scare stories. Extreme positions in your portfolio imply perfect foresight, while in reality no one knows exactly how the future will play out. For most South African investors, the ideal portfolio is neither completely offshore nor completely domestic; the appropriate long-term asset allocation to achieve investment goals is likely to combine both. The exact mix will depend on the investor’s goals and risk appetite. In the short to medium term, valuations should dictate tactical shifts in asset allocation, and current valuations also don’t support an all-or-nothing view.
Dave Mohr is chief investment strategist and Izak Odendaal an investment strategist at Old Mutual Multi-Managers.