High-quality global equities and local bonds are good prospects
Muted returns generated by the JSE all share index over the past few years are hard to stomach, but markets work in cycles
Last year proved to be the antithesis of 2017. Whereas in 2017 almost every asset class globally generated a positive return, 2018 ended with almost every asset class in the red.
Other than cash, there was nowhere to hide: developed market equities, emerging market equities, commodities and global credit, to mention a few, generated negative US-dollar-returns. It was the first negative year for global equity markets since the financial crisis, despite the fiscal stimulus in the US.
The muted returns generated by the JSE all share index over the past few years, although not altogether surprising given the stretched valuations at the beginning of this period, are hard to stomach.
Over the past three years to the end of December, the total return from the all share was a mere 4.3%; over five years, the total return was only 5.8%. Equities are commonly referred to as “real” assets, meaning they are supposed to provide an inflation-beating return and are the main weapon in the arsenal of an investor seeking growth in excess of inflation. How are investors supposed to beat inflation if equities are not up for the job?
The answer lies in remembering that equity returns do not come in a straight line. Markets follow cycles. The strong double-digit returns that investors had come to expect from the all share were never sustainable in perpetuity. Valuations had become stretched and lower returns were inevitable.
However, there is a silver lining to this cloud. The subdued returns from the all share over the past few years have resulted in more attractive valuations for many all share-listed stocks and buying opportunities are emerging.
The strong double-digit returns that investors had come to expect from the all share were never sustainable in perpetuity.
However, while we acknowledge that equity markets are at their lowest levels in years, this alone does not merit an increase in equity exposure. Equity markets are not cheap in absolute terms (they are still trading above their long-term averages).
Furthermore, expectations of earnings growth are still high and appear somewhat disconnected from the economic reality that we are experiencing. Combined with an environment of tightening liquidity, slowing growth and multiple risk events, individual stock selection becomes paramount.
The best opportunity, in our view, remains high-quality, global equities that are generating high and sustainable returns on invested capital.
In terms of individual stocks, we have sought a balance between old-economy staples and newer, higher-growth opportunities. What these businesses have in common, apart from their prodigious cash generation and exceptional returns on capital, is an ability to grow with a lower dependence on the economic cycle than the average business.
Given their prospects, these businesses also continue to trade cheaper than the market and have proven far more resilient over 2018. In a similar vein, we have sought out locally listed global businesses with little dependence on a weak South African economy.
Locally, the best opportunity in our view remains South African government bonds, offering more attractive risk-adjusted returns than SA equities. At yields above 9%, these instruments offer far higher risk-adjusted return potential than the retail, banking and property sectors.
On a 10-year basis, SA government bonds are offering an expected 4% real yield to patient investors. Our bond exposure remains prudent: lower duration, higher quality instruments, with exposure balanced against offshore holdings to limit the potential for loss (SA bonds and the dollar-rand exchange rate are negatively correlated).
We therefore maintain a balance of exposures in our portfolios, which offers protection against a range of potential outcomes. With risk at the fore and liquidity being drained away, we do not believe that it is appropriate to position our portfolios for a particular outcome.
As always, we remain unwavering in our commitment to growing capital in a judicious and discriminate manner.
• Chetty is a portfolio manager, and Jocum an analyst, at Investec Asset Management