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Risk assets have had a tough time over the past three years. Notwithstanding 2017’s recovery, returns generated by risk assets have been fairly benign and have only moderately outpaced domestic inflation. Sluggish global growth, elevated valuations, concerns about the end of quantitative easing and geopolitical tensions are but a few of the reasons put forward for this sub-par performance.
Domestically, the perceived instability of the Jacob Zuma administration, which included several cabinet reshuffles; the deterioration of the government’s finances; weak economic growth; corruption and the ANC’s internal power struggle manifested in downgrades; rand weakness; sharply higher inflation and severely depressed investor confidence.
Domestic assets sold off aggressively in the first 11 months of 2017. Banks and retailers lagged the All Share by 14% and 9%, respectively, while the yield on the 10-year government bond (R186) reached 9.5%, placing it among the cheapest assets globally. In December 2017, “Ramaphoria” delivered a much-needed adrenalin shot to domestic risk assets. South African banks, retailers and the bond market rebounded sharply. The rand strengthened by nearly 20% in the following months, which reflected the positive sentiment of global investors. As a result, inflation fell and interest rates have even been cut. This rebound has been very good news for investors, but the key issue now is the sustainability thereof. Is this a structural shift or merely a cyclical rebound from very depressed levels, and where are the opportunities for investors?
The efforts of the new government, albeit in the right direction, will take years to manifest into higher growth. Major challenges such as education, land reform, social inequality, infrastructure, parastatal corruption and government inefficiencies will take time to right. GDP growth should improve back to trend of around 2% this year, but is unlikely to shift into the much-needed higher gear until the structural issues are resolved. In this light, domestic asset prices have run too far ahead of the economic fundamentals. As we know, investment returns are heavily influenced by the price you pay. At these levels, prospective returns are likely to be low, and even prone to cyclical downside.
While domestic assets have been in a bull market since Ramaphosa’s election, global assets and rand hedges have been hurt by the relative strength of the rand. Stalwart rand hedges such as British American Tobacco, Anheuser Busch and Naspers* are all down more than 20% from their peak levels in December 2017. Selective rand hedges with strong balance sheets and a good dividend underpin look a lot more attractive than the domestic counters. These shares are not without risk though.
Global markets are facing increasing challenges. After a near decade-long bull market, valuations are well-above trend; the Federal Reserve is raising interest rates and shrinking its balance sheet; the European Central Bank will begin tapering later this year and China has been reducing monetary stimulus for some time now. Liquidity is systematically being withdrawn and historically that has not been good for returns generated by risk assets. Rising geopolitical tensions and the threat of a trade war have done little to calm the market. Volatility has risen sharply since January and points to an environment of very low, or possibly negative, returns from global markets for the foreseeable future.
As a small open economy, South Africa will remain vulnerable to any global shocks. With 60% of the JSE All Share market cap comprising dual-listed and rand-hedge shares, South African markets will struggle to decouple from the global markets despite the positive effects of political change.
Given this somewhat bearish outlook, where should investors look for returns? At this late point in the global market upswing, it makes sense to adopt a defensive stance. Higher-than-average cash levels and maximum offshore exposure make sense in a South African investment context.
High cash levels protect capital and provide optionality when the market sells down. The cash-rich patient investor will reap the benefits of attractive entry points to high-quality stocks that invariably get caught up in the panic.
The rand is among the most volatile currencies in the world. Maximising offshore exposure is a worthy consideration, particularly after a significant bout of rand strength as we have just experienced. This makes the entry point into global assets more attractive in dollar terms and coincides with the recent increase in the offshore allowance. Due to the myriad of opportunities globally, foreign exposure adds diversity and growth to portfolios, while also enhancing the ability to protect the rand value of capital.
The risk is that we still remain exposed to a global market sell-off. Typically, when markets panic, there is a scurry for safe-haven assets such as US Treasuries and gold. Emerging market currencies and assets tend to perform very poorly in this environment. Rand weakness, therefore, offers a natural buffer by softening the impact of the sell-off. Also, the huge diversity of opportunities means that global managers can protect and grow your assets by focusing on attractively priced long-term opportunities. Foreign assets also help protect the purchasing power of rand savings, which are eroded by inflationary spikes from dollar-denominated fuel and food prices.
In conclusion, South Africa is in a much better space now than it was just a year ago, but a structural uplift in economic and domestic earnings growth will take many years to be realised. The domestic bond and equity prices have, however, discounted a very large part of this expected improvement. From this point on, returns are likely to prove disappointing, even if there is no global market shake-out. Maximising foreign exposure and increasing cash levels therefore make a lot of sense. The recent rand strength and increased foreign allowances offer the ideal opportunity to execute on this strategy.
*finweek is a publication of Media24, a subsidiary of Naspers.
