The bull case for SA equities
The 54% return generated by SA listed equities over the 12 months to March 2021 illustrates the risk to investors of hasty stock market exits or extended periods sheltering in low risk asset classes. Nowhere is this danger better illustrated than in a study of returns from the US S&P 500 index, conducted by JP Morgan Asset Management. Investors who remained fully invested for two decades, to end-December 2018, achieved an average annual return of 5.62% compared to those who missed the 10 best trading days, with a mere 2.01%. David Knee, CIO at Prudential Asset Management, says that investors have to be “circumspect and patient” in building their asset allocations to ensure optimal investing outcomes.
An irrational flight to safety
An overview of cash flows between asset classes in the South African collective investment industry gives conclusive proof that local investors are favouring the safety of fixed income over higher but more volatile returns on offer from equities. “The bulk of the R213 billion that flowed into South Africa’s unit trust industry over the past 12 months [to 31 March 2021]went to lower risk fixed income funds, mostly in cash and bonds,” said Rushil Jaga, Investment Specialist at Prudential. He joined Knee for a fast-paced question and answer session to determine which asset classes still had ‘legs’ following the stellar 12-month performance from SA and global equities and SA bonds.
“We are emerging from an extraordinary period,” said Knee. “In my three decades in financial markets I have never seen anything like 2020.” He described an SA equity market that plummeted 25% in the year ending 31 March 2020, only to rebound 54% in the following 12-month period. This stellar turnaround took place in the context of the deepest global economic contraction since World War II. Knee explained that the timing of flows of domestic investor capital to fixed income was unfortunate, but not unexpected. Investors were shell-shocked by the extent and speed of the March/April 2020 collapse and had low confidence in a financial market recovery, especially given the poor return experience from domestic equities over the five years preceding the pandemic.
Can local shares deliver more in 2021/2?
The same investors, quite frustrated by missing out on the first phase of an incredible equity market rebound, are keen to know whether the JSE has more to give. More importantly, they want to know which asset classes will deliver the best return over the coming five years as the global economy enters the second stage of its post-pandemic recovery. “Is there more in the bag after a 50% return from South African equities?” asked Knee. Prudential’s analysis suggests that local equities should give close to double-digit real returns in the coming 12 months.
One of the most important lessons from the March 2020 market correction is to stick with your fund mandate or investment strategy. Prudential’s Balanced and Inflation Plus funds were overweight bonds and equities as prices plummeted; but resisted the temptation to reduce portfolio exposure to these asset classes. “Our investment process had highlighted that these asset classes were looking cheaper than before, so we worked hard to maintain and add to our weight, especially in equities,” explained Knee. He said that the active asset allocation decisions taken around that time included adding to SA equities, slightly reducing offshore equity exposure and moving out of SA property into SA bonds. Both funds were fully invested in equities per their respective mandates at the time of the collapse; but the Balanced Fund has since reduced equity total exposure to around 65%.
Valuation should guid offshore / onshore equity split
The offshore versus onshore equity debate is slightly trickier. Prudential explained that its equity strategy is rooted in valuation, before noting that the price-to-book ratio for SA equities was 1.7 times versus 4.4 times for the US-based S&P 500. The last time there was such a high value misalignment between the two markets was in the early 1990s, during the emerging markets crisis. “And South Africa’s price-to-book was cheaper at the end of March 2020 than during the Global Financial Crisis (GFC),” said Knee, before reminding the audience that SA equities rallied 200-300% between 2010 and 2014. “We do not know what is going to happen in next five years; but we can say that SA equities, even at a price-to-book of 1.7 times, are 20% lower than their historic average,” he said. The conclusion: It would be risky to offshore your equity exposure at this point!
The SA Property asset class is more difficult to navigate. Jaga asked Knee to explain the asset manager’s decision to cut domestic property exposure to just 2% in its Balanced fund and 5% in its Inflation Plus fund. “The asset allocation discussion is about the best risk-adjusted return and, unfortunately, the SA property class presents big challenges at present,” said Knee. He mentioned uncertainty about when post-pandemic income distributions would recover and what the long term growth rate of these distributions might be. Another concern is that property firms are struggling to capture rent in the office and retail segments. Under these conditions the asset manager prefers the almost certain 11% nominal yield on offer from government bonds.
Selected opportunities will present
The bleak outlook for listed property does not mean that there are no opportunities in the space, and asset managers are still adding well-managed listed property counters to their specialist equity funds. However, much of South Africa’s bond, equity and property performance will depend on the post-pandemic economic recovery and government’s ability to manage its fiscal crisis. “We saw five disappointing years pre-pandemic, so it is reasonable to ask what the country’s long term economic growth is going to be like,” said Knee. “The South African Reserve Bank has indicated that the country needs supply side reforms and we are hopeful that the new infrastructure fund and push into renewable energy will unlock potential growth”.
Macroeconomic factors are notoriously difficult to forecast; but there are some positives for South Africa, including a GDP growth forecast of 3.5% for 2021 and better-than-forecast tax revenue collections. One of the concerns is that it will take until 2023 for the current economic growth trajectory to return South Africa Inc to its pre-pandemic level of output. “The country’s future is in the hands of the politicians in terms of freeing up the economy and putting some real effort and initiative into the liberalisation of the supply side,” concluded Knee. “It is worth noting that SA Inc companies and SA bonds have some very poor macroeconomic outcomes priced in”.
Writer’s thoughts:
Prudential’s presentation did not dwell on the offshore versus onshore topic; but it was interesting to note the value misalignment between SA and US equities. It seems there is a strong argument in support of local equities outperforming global equities, in rand, over the coming few years. In this context, are you comfortable with investing your clients’ discretionary funds in SA equity funds? Or are you still advising them to err on the side of caution in fixed income funds? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
