DAVID KNEE: Investors can find ‘safety’ in SA asset valuations

Despite how unexpectedly challenging the year has been so far for SA assets, we have not gone rushing for the exits to seek “safety” offshore. In our view local assets are still clearly offering better prospective returns for the risks involved over the next three to five years than their global counterparts.

This means our multi-asset portfolios, such as the M&G Balanced and Inflation Plus funds, favour SA equities and bonds over their global counterparts, though select global equities and bonds are also attractive, and these offshore assets play critical roles as diversifiers in our portfolios.

Global equities vs SA equities 

One of the most compelling reasons for our positioning is the differential between the valuations of global and SA equities. In aggregate, global equities are trading slightly cheaply than their long-run fair value, which is reflecting the cheapness of many global equity markets, offset by the relative expensiveness of the US market, which with a 12-month forward price-earnings ratio of 19.4 times pushed the MSCI ACWI PE ratio to 16.2 times by mid-August. 

Because there are still unresolved questions about downside risks to global earnings going forward, and combined with the lack of a strong valuation signal, we are comfortable maintaining a neutral position in global equities and remain selective: we continue to be underweight US equities, as well as Canada and Australia. We prefer the UK, Japan, China and certain other emerging markets that are relatively cheap. 

Meanwhile, SA equity valuations (FTSE/JSE Capped Swix index 12-month forward PE ratio) were trading at 10.6 times at the end of July, broadly reflecting concerns over future earnings sustainability and higher “risk free” interest rate hurdles. We believe this presents real opportunities for careful investors.

Our analysis shows that current market pricing implies SA equities have a prospective real return of 9% a year for the next five years, compared with global equities at 6% a year and US equities at only 5% a year. This is well above the local market’s long-term fair value of about 7% a year. 

Our portfolios include a well-considered mix of rand-hedge, “SA Inc”, defensive and attractively valued shares, with names like BAT, Richemont, Textainer, Reinet and a collective overweight exposure to SA banks. 

Global bonds vs SA bonds

The graph shows how the real yield on SA’s 10-year government bonds, at well over 5%, is far more attractive than that of 10-year US Treasuries at just over 1%. In fact, SA real bond yields are more attractive than those of most other countries and are elevated relative to their history. At current market valuations our view is that SA nominal bonds offer far better prospects of delivering positive real returns than global bonds, where higher for longer inflation outcomes remain a risk.

While we acknowledge that SA bond risks are more elevated than they were at the start of the year, they are certainly not higher than during the global financial crisis or Nenegate. Yet yields now far exceed those seen during both crises.

Current yields are pricing in an unlikely scenario of local inflation remaining well above the SA Reserve Bank’s 3%-6% target range indefinitely — despite the June consumer price index having already fallen back to 5.4% year on year, expectations of further drops in coming months, and the SA Reserve Bank’s strong track record combating inflation.

At the same time, SA has a long history of repaying its debt and is not on the brink of defaulting. In our view, current yields more than compensate investors for the associated risks, and patient investors will be well rewarded.

Meanwhile, we also own global bonds in our portfolios, given that they are offering fair real yields and serve as solid diversifiers for SA equity risk. As in global equities we are neutrally positioned due to the risks associated with global inflation and interest rates, and prefer 30-year Treasuries and 30-year UK gilts, as well as selected sovereign emerging market bonds where the real yields are high and the currency is trading at fair-to-cheap levels.

Looking ahead, there are some factors that can provide tailwinds for SA equities and bonds, including falling inflation, a shift to expansionary monetary policy/interest rate cuts both globally and locally, private sector contributions to new sources of power supply and improving infrastructure, and the government’s acknowledgment of the urgent need to improve its service delivery.

Sentiment may favour the seemingly “safer” global options. In these conditions our long-proven investment process indicates that the “safest” way to deliver excellent returns is to remain overweight in cheaper SA assets, and to selectively pick global assets when building an optimal portfolio.

• Knee is CIO at M&G Investments.