For much of the past five years, local investors have had little to rejoice about. Naspers has almost single handedly bailed out the savings industry, where lackluster economic conditions have worked against strong equity returns in the local market. While Naspers was not able to fully stem the flow of capital offshore, or limit the capital flows into income type assets (where many investors ended up, when real returns were still positive), they did keep the average retiree in the game so to speak.
Over the past few months, increasing scrutiny by the Chinese government has meant that a number of the technology focused shares based in China have come under significant pressure. Naspers owns 31% of one of the most successful Chinese internet giants in Tencent which underpins the bulk of Naspers’ equity value.
Naspers has fallen 27% from its peak in February 2021, and usually local investors would feel this sell-off directly and raise concerns around savings and wealth. Yet in this instance, we have been bailed out by the long forgotten and oversold local equity market. Domestic shares have continued in their pattern of recovery, offsetting much of the damage which has come from Naspers.
How fortunate we are! This does also provide investors with food for thought. Rarely does it make sense to write off an asset class such as the local equity market. Domestic shares, property shares and commodity shares have continued to underpin local investment returns.
Over the past few months we have reviewed a wide array of fund managers. Increasingly, the consensus view is tending towards one which is very positive on domestic equity. We have not seen this level of optimism in at least a decade. Simply put, local company management tended to make good decisions through the COVID crisis, and have performed relatively better than what was expected, yet in many instances their share prices do not reflect this.
Our outlook for local equity remains neutral, as for the most part we have a mixed market of rand hedge (less positive) and domestic (more positive). As a result, we aim to position domestic equities towards a value bias at present. This would include those managers prepared to buy deeper cycle companies, smaller oversold companies and special cases where for some reason the company has been sold down out of line with its fundamentals. Important to note here is that local economic fundamentals are not strong, so the opportunity is significant but relatively limited compared with a scenario where this was also improving.
Local property has continued to recover, being one of the better performers this year. However, the risks are real: a changing retail landscape, work from home trends, debt levels and valuations under pressure means that property still has some way to go before it trades as property should. For the past few years, property has resembled deep value equity, rather than a stable dividend paying asset. In cases like this, we would prefer equity over property, but at a future point we may yet find property an attractive asset class. For now, the outlook remains poor.
Globally, while it seems like there has been somewhat of a pause in the recovery since the first quarter, the trends and longer-term implications from the COVID crisis are starting to emerge. While governments are generally in a worse position (issuance of significant debt), consumers and companies are in a strong position (high savings levels and stimulus). This is supporting general economic demand, which in turn is passing through to company earnings and we are seeing a recovery in broad global equities. This positive environment appears to have pushed equity prices beyond long term valuation levels however, and certain segments of the market appear very expensive. Ongoing earnings growth can mitigate this, but investors will need to be selective. Our outlook for broad
market equities remains negative, yet we do retain a positive outlook on value-biased equities which benefit from the recovery continuing, as well as higher inflation (eg banks) and you are also not paying an overly demanding valuation.
Inflation is one of the divisive topics at present. While much of the discussion revolves around inflation being transitory or temporary, and inflation numbers are difficult to follow as they rebase themselves, the core inflation numbers have started to trend up quite sharply. This inflation measure excludes the volatile impacts of food and energy costs (typically around 20% of the basket). The chart below shows how the developed market levels of inflation have firstly risen beyond pre-COVID levels, and have also steepened since earlier this year.
Chart 1: Core Inflation Measure. Source: Refinitiv
As we’ve discussed before, this inflation trend is one of the single biggest determinants of investment returns in the medium term. While the trend continues to take shape, we would expect asset prices to lack direction until the evidence is clearer. Should it continue to rise in this fashion, it may start to change a number of behaviours such as the Fed’s response. To date they have been keen to anchor interest rates near zero to help stimulate growth. This has resulted in negative real interest rates, which in turn is supportive for capital allocation to emerging markets for example. A ‘taper tantrum’, where the Fed reduces their bond buying programme which provides liquidity to the investment markets, could be on the cards which would be negative for asset classes in general.
The other key risk to note is the oil price. Bottoming out at around $20 per barrel in 2020, oil is now trading at around $76 per barrel. The industry has been under pressure from the global ESG movement towards cleaner energy, the pullback in demand in 2020 and the decisions of OPEC. The subsequent recovery in demand, overlaid on an industry with a significant capital investment deficit, has helped oil trade at the highest level since 2014 which has generated exceptional returns for equity investors. Should oil continue to rise, this helps drive inflation, and we fall into the rates and inflation trap highlighted above.
Overall, we can retain a positive outlook on certain classes of equity, but remain cautious on the asset class as a whole. Most assets linked to interest rates or are vulnerable to higher inflation, are currently a no-go zone.
Emerging markets have struggled this year and lag both local and developed equity markets. Much of this is due to the scrutiny by the Chinese government, where they are wanting to ensure a greater degree of control over the large internet-based businesses. At the heart of the issue appears to be data privacy given the volumes of personal data created. In addition, companies incorporated in foreign markets (such as Tencent, which is based in the Cayman Islands), as well as those listing on foreign exchanges have sold off recently as China aims to clamp down on how these companies can operate. Didi, the Chinese equivalent to Uber, recently listed in the US, and within a matter of days needed to remove their ride hailing app from the app stores until they had met Chinese
At an asset class level, this type of incident is not unexpected, such is the nature of emerging markets. Despite this, emerging markets in general have performed strongly for some time, and as a result are trending close to a fair market value in total. Prospects remain decent, but relatively less appealing pre- the broad recovery in global risk assets.
Commodities are another asset class which has piqued investor interest lately. Strong demand for all forms of commodity exposure (including agricultural goods in SA) has meant these companies are generating significant earnings, which is also finding its way through to the local government coffers through meaningfully higher taxable incomes, and this helps strengthen the rand and support our relatively weak fiscal position. Long may it continue, but we are wary of time running out (leading indicators in China have turned negative for example. As a local recovering market which is highly dependent on commodities to support our economy, we are very exposed to a decline in global economic activity before we have really had a chance to recover.
Lastly, on the topic of government reform in SA, there have been more positive signs, the most significant of which is the proposed opening up of power generating capacity by private entities where companies can generate up to 100Mw each. This will be supportive of economic growth and will also alleviate the pressure on Eskom. As the negative events of the past decade slowly compounded, perhaps this is another example of the opposite taking place.
Chart 2: Relative value of asset classes vs long term history
The table below provides a summary of where each asset class is currently positioned from a relative value perspective:
Outlook changes since 31.03.2021
- SA Credit: downgraded from (0) to (-1). Expected forward real returns have moved below our benchmark level. Transparency in credit pricing remains a concern.
- Sterling/USD: downgrade from (2) to (1). In sync with a weaker USD and low real interest rates, and the global recovery helping the more cyclical UK economy, GBP has performed better and is now just 12% below par value.
Summary Outlook per asset class