Economy’s recovery phase bodes well for equities and multi-asset investments
Investment managers at Prudential believe there is genuine potential for an improvement in GDP growth and recovery in equity returns if even a subset of the government’s plans come to fruition
Investor patience has been sorely tested in the last few years: the local equity market has put in one of its worst five-year return performances in history.
Yet in these testing times we would all do well to remember Warren Buffett’s comment on such matters: “The stock market is a device for transferring money from the patient to the impatient”. Buffet is 10% behind the S&P over the last decade, so his own investors are also exercising patience, remembering that over the past 30 years Berkshire Hathaway has tripled investors’ money relative to the return from the S&P 500.
At Prudential we believe there’s good reason to be patient with the SA equity market, as importantly it’s representing excellent value at current levels (as at the end of October 2018), and the economic cycle appears to be in the early recovery phase. We believe there is genuine potential for an improvement in GDP growth and a concomitant recovery in equity returns if even a subset of the government’s plans come to fruition.
Key valuation measures also indicate that SA equity is priced to deliver healthy returns over the longer term.
So what is the potential for equity returns going forward? We looked at the historic business cycle, plus different valuation measures for guidance. Our comparative analysis of the past 25 years of asset performance through all four phases of the business cycle (contraction, recovery, expansion and slowdown) shows that equity is the worst performer in the contraction and recovery phases, taking time to improve as lower interest rates and other growth-supportive policies slowly feed through into the broader economy and company balance sheets.
However, as economic growth then accelerates into the expansion phase, equity returns significantly outstrip those from bonds and cash, as well as through the slowdown phase, thanks to strong momentum. Our study shows that in the expansion phase, equity produced an average real (above-inflation) return of 12.1% per year, while bonds produced 8.3% a year and cash was the laggard with 2.3% a year.
Even though data indicates that GDP growth troughed at the end of 2016, SA has failed to gain much traction since then, as 10 years of deteriorating governance and a worsening fiscal position undermined consumers and business.
The hollowing-out of vital institutions such as the National Prosecuting Authority, the looting at state-owned enterprises and the failure to reform the supply side of the economy all conspired to constrain growth at a time when the global economy was accelerating. We now observe the green shoots of improvement pushing through, with President Cyril Ramaphosa co-ordinating a strategy to reverse and remove these economic roadblocks. Investor patience will be rewarded as economic growth accelerates, and with it equity returns.
Key valuation measures also indicate that SA equity is priced to deliver healthy returns over the longer term. Prudential’s valuation, based on long-term fair value, points to a prospective real return from equity of more than 7% a year over the next five years, an attractive level relative to cash and other local opportunities.
If we interrogate exactly how much we’re now paying for assets on company balance sheets as measured by the market’s price-to-book value ratio (P/B), relative to history this is cheap at 1.7x. And historically when the equity market P/B has been trading at 1.7x, it has subsequently produced a five-year nominal return of close to 20% a year (the probability distribution midpoint statistically). Clearly inflation was higher in the past — so we don’t expect returns at this level —but low double digits are definitely achievable if growth can rise even modestly.
We also observe that following the collapse in local company earnings resulting from the global financial crisis in 2008/2009, the subsequent recovery has still left earnings well below their long-term trends. This suggests there is upside potential here that would be amplified if the economy begins to recover.
Bolstered by improving equities, the disappointing returns from multi-asset (MA) funds should also be much higher going forward. Assuming asset valuations normalise over the next five years (and SA avoids a recession or a visit from the IMF), then ball-park returns using the average asset allocation in the Association for Savings and Investment SA (Asisa) MA high-equity, low-equity and income categories, high-equity funds are poised to deliver about 12% a year, low-equity funds 11% a year and income funds 9% a year (in nominal terms) over the next five years (gross of fees). All returns compare well against long-term inflation, which is expected to be about 5%-5.5% year on year.
Finally, real returns on cash are expected to deteriorate going forward, as a result of a pick-up in inflation from the rates of the last couple of years where rand strength post Nene-gate depressed the prices of food and imported goods.
This is no unwinding. Cash can still place a positive but low real return in investors’ pockets, but it will, in our view, compare poorly to its multi-asset alternatives.
• Knee is the chief investment officer at Prudential Investment Managers.