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Exciting prospects in both equities and bonds, despite negative sentiment

29 July 2019 Greg Hopkins, Chief Investment Officer at PSG Asset Management

A prolonged period of poor performance from the local equity market has left many investors anxious and frustrated. While most understand the importance of taking a long-term view, it’s usually more difficult than anticipated to put this into practice. When the values of investments fall, investors’ gut instinct is to put a stop to it.

The easiest way to do so often seems to be switching your investments into cash; but this holds a high risk of impeding your investment outcome. On the contrary, PSG Asset Management is reducing the cash holdings in its funds and buying attractively priced securities.

“We’re finding exciting opportunities for long-term returns across global markets, with South Africa looking particularly attractive given the starting valuations,” says Chief Investment Officer Greg Hopkins.

Starting valuations are key to successful investing, Hopkins says. “In a world of startlingly different valuation levels we believe that superior long-term returns will be derived from investing in attractively priced companies in out-of-favour geographies and sectors.”

He says the investment team is very positive on the long-term returns on offer in global markets but is cautious of the return prospects for well-owned stocks, particularly in the US. Accordingly, they’ve been recycling capital away from more expensive to cheap, unloved shares.

“This strategy of buying stocks where share prices are falling can weigh on short-term performance, but the ability to buy at times when others are fearful is a very important factor in achieving good long-term outcomes at appropriate levels of risk.”

In terms of debt markets, South African bonds have performed well over the year to 30 June, with bond yields falling further from their 2018 highs. Much of this can be attributed to the high starting yields (cheap valuations) of last year.

“Investment markets have become more volatile and event-driven compared to last year,” Hopkins says. US bond yields have moved sharply downwards in response to expected rate cuts by the US Federal Reserve, with the 10-year bond yield falling to levels last seen in 2016. In addition, the US yield curve has flattened and the indication from the US bond market is that US growth and inflation are likely to be lower going forward.

Over the past two years South Africa has experienced consistently lower inflation outcomes, often below market expectations. In addition, growth has disappointed, signalling the need for significant economic support. “Following the release of inflation data in May, with headline CPI at 4.5% and core CPI at 4.1%, it’s not surprising that the South African Reserve Bank has chosen to cut rates by 0.25%.”

From highs of around 9.5%, five-year negotiable certificates of deposit (NCDs) are now yielding around 8.3%. “Given that rates are highly correlated across the local market, we’ve seen a similar trend in corporate credit spreads, shorter-dated nominal and inflation-linked bonds, and general money market rates,” says Hopkins.

As yields fall, security prices rise, implying that the shorter-term instruments held in the manager’s funds offer significant embedded value. “However, consistent with our approach, lower real yields have made us more cautious and have prompted us to look for opportunities to switch to higher-yielding instruments where we think the risk-adjusted returns are more attractive.”

Overall, the SA bond yield curve steepened significantly over the second quarter of this year, as shorter rates fell due to rate cut expectations and longer rates rose due to poor global sentiment. For the most part the curve was the steepest it has been in recent years.

“We have therefore increased our conviction in sovereign nominal bonds and have used this opportunity to add to these holdings and move exposures further out on the yield curve to higher-duration bonds.

“With the fall in bank NCD rates and credit spread tightening, we’ve been selective sellers. We continue to hold credit where we see low probability of default risk and where spreads are above our estimates of fair value,” Hopkins concludes.

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