- Global uncertainties and geo-political risks continue to abound, but global central banks are cutting interest rates and applying monetary stimulus that should be supportive of markets in 2020.
- Equity valuations outside the USA are not demanding. The SA Equity market is cheap by historic standards.
- Improved global returns in the latter half of 2019 reflects optimism that the soft patch in US economic growth this year and the ongoing slowdown in Chinese growth could be nearing an end.
- Economic commentary about South Africa tend to focus excessively on the negative and ignore the structural positives: a credible SA Reserve Bank, strong National Treasury, inflation that is under control, a healthy and world class banking system, a healthy government debt maturity profile and limited foreign debt that limits our risk.
- Talk of an IMF bailout might be misplaced – South Africa has a number of distinct positives that count in its favour that may stave off the need for an IMF bailout: a liquid and floating currency that acts as a shock absorber, low foreign net debt levels, a strong (long maturities) debt profile and a deep and liquid domestic debt market.
- The market already views SA bonds as non-investment grade. This is reflected in our attractive real yields, which are in many cases, higher than those of other countries already branded junk.
- Brazilian bonds returned spectacular capital returns AFTER being downgraded to junk status, due to the removal of uncertainties and compressing inflation. Once SA is downgraded, investors will likely look at the fundamental investment case for our bonds and find it difficult to ignore – we offer very attractive yields in absolute terms and on a risk-return trade-off basis.
- South African economic and business confidence is at cyclical lows and should improve as the global backdrop turns more supportive.
- Market timing (e.g. between being in the market or in cash) is extremely difficult and should best be avoided in favour of a strategy of disciplined investing in an appropriate portfolio according to one’s risk profile.
Elaborating on the detail…
Investment markets continued to represent challenges in 2019. Investment managers and investors alike were faced with the dichotomies of, on the one hand, an increasingly erratic US President Donald Trump, the threats of global trade wars, political and economic instability in the middle east, and continued pressure on emerging market assets and currencies. On the other hand, the US stock market and currency continued to outperform, even in the face of slowing US and global economic growth. The South African market continued to suffer under the weight of concerns about slow economic growth, Eskom and the risk of a downgrade of our sovereign debt rating to junk status. On the upside, and looking into the future, we believe that the anemic local stock market performance of the past number of years has opened up significant investment opportunities for patient investors as asset valuations dramatically improve. We elaborate on this topic below.
South African cautious and balanced investment mandates, which represent the investments of the majority of South African long-term savers and investors, entered their fifth year of underperforming money market investments. The equity market — as represented by the JSE All Share Index — has struggled to outperform the money market over this time. This is indeed a bitter pill to swallow for investors who feel unrewarded for the additional market risk and volatility assumed with their investments in recent years. However, as disappointing as the recent past has been, we believe investors should focus on the future and the opportunities that it may present.
South Africa and the spectre of a sovereign debt downgrade and even potential IMF bailout
Investors are rightly concerned about the potential impact of a sovereign debt downgrade to “junk status” by Moody’s, the international credit rating agency, about the country’s overall fiscal health and about the prospect of an eventual IMF bailout should things get worse. Asset prices, both bonds and equity, as well as the general business and consumer sentiment in the country reflect these realities. But could it be that these are overdone?
News headlines almost always focus on the negatives:
- Increasing debt levels
- Failing municipalities
- Low confidence
- No growth
But, hardly ever are the positives highlighted:
- A credible SA Reserve Bank
- Inflation under control
- Strong National Treasury
- Healthy and world class banking system
- Healthy government debt maturity profile
- Limited foreign debt
Asset prices and general sentiment suggest there is no balance between the above lists.
An IMF bailout might not be a foregone conclusion…
As the graphic below – a potential “road map” to an IMF bailout – suggests, South Africa has a number of distinct positives that count in its favour, that may stave off the need for a bailout:
- A floating currency that acts as a shock absorber
- Low foreign net debt levels
- A strong (long maturities) debt profile
- Deep and liquid domestic debt market
South Africa’s foreign denominated debt is relatively low and not out of line with peers…
Source: Institute of International Finance
We are not Argentina, but we might be Brazil…
The uncertainty of what will happen when Moody’s downgrade us to junk status is stopping investors from buying South African bonds, and more generally from investing in South Africa. After Brazil was moved to junk, their bond yields fell (bond prices rose) dramatically on the back of more certainty and compressing inflation. Once SA is downgraded, investors will look at the fundamental investment case for our bonds and find it difficult to ignore – we offer very attractive yields in absolute terms and on a risk-return trade-off basis:
The Brazilian analogy… curtesy of excellent research by Obsidian Capital
Being junk in the collective mind of the market, but not on paper, is undesirable because it creates uncertainty about what is priced in and what is not. Brazil was downgraded to junk by all three rating agencies within the space of 6 months, beginning in September 2015. Since then, their bond yields have fallen from a peak of 16.8% down to a recent November 2019 low of 6.4%. Remember that a falling yield means that bond prices are rising, a clear sign that there were plenty of eager investors to pick up the extra supply of bonds.
Source: Obsidian Capital / IRESS
Brazil is a commodity exporting country like us. They run punchy budget deficits, like us. Their debt-to-GDP is 77%, worse than us, and government corruption is rife. Our fundamental economic similarities are such that our currencies, inflation and bonds tend to track each other quite closely over time.
As the graph above shows, despite being downgraded to junk, Brazil’s bond yields have compressed aggressively. Why/How did this happen? Because Brazilian inflation (blue line in the graph above) has collapsed. Inflation is one of the fundamental drivers of bond yields, and this doesn’t seem to change when a country loses its investment grade rating.
South African inflation has also eased (from 7% to 4%), and yet our bond yields have drifted sideways, with an upward bias. The point being that despite falling inflation our yields are staying high because of the uncertainty that a pending downgrade by Moody’s is casting into the minds of potential investors.
Given that the real yield on our 10-year government bonds, at roughly 4.9%, is already higher than that of Brazil at 4.3% (already in junk status), it seems that the downgrade is already reflected in South African bonds. It might just be that if Moody’s officially downgrades us, removing the uncertainty, global bond investors will pounce on our attractive yields.
In conclusion – the market already views SA bonds as non-investment grade. This is reflected in our attractive real yields, which are in many cases, higher than those of other countries already branded junk. SA’s attractive yields should have already compressed because of our falling inflation, but rating uncertainty prevented that. There are real benefits to be had (capital gains on bonds) should our yields compress.
What about South African growth, confidence and the prospects for equities?
South African confidence is at 40-year lows and asset prices (and equity returns of the past 5-6 years) reflect that:
Confidence = at a low…
Returns = have been anaemic….
Source: Investec AM
Valuations = at a low…
The SA market = one of the cheapest globally (% of companies in a bear market)
Source: Bloomberg, PSGAM
Global growth has slowed this year. Geo-political risks are omnipresent. In South Africa low growth and structural problems persist, HOWEVER:
- The global picture is changing: The US Fed and other central banks are stimulating anew (cutting rates), this will be supportive for markets; growth is expected to stabilise and company earnings expected to improve in 2020.
- The global backdrop will therefore be more supportive of Emerging Markets, including South Africa.
- Many markets (especially outside the USA) offer appealing valuations. South Africa is one of the cheapest.
- Inflation globally is low. So too in South Africa.
- As the US Fed and others reduce interest rates, there is scope for the South African Reserve Bank to cut rates further too.
The depressed levels of confidence as well as valuations, combined with the potential effect implied by renewed global stimulus, can be viewed akin to a compressed spring – offering from current levels, potentially much more upside than downside:
What about Market Timing?
In short, attempting to time the period one spends exposed to the market in a binary fashion or timing the entry and exit points is extremely difficult. This is especially difficult on a consistent basis and should best be avoided in favour of a strategy of disciplined investing in an appropriate portfolio according to one’s risk profile.
Research conducted by Prudential Asset Management illustrates that missing out on even just the best 5 weeks of market performance in the past two decades would have delivered a return below cash returns to a SA investor. Although this is clearly an extreme theoretical and hypothetical example, it illustrates the risks associated with “Market Timing”.
The effect of missing out on the best 5 weeks of ALSI returns since 2000:
Source: Prudential AM
Well-diversified portfolios continue to be the best approach to follow for achieving long term investment goals. Cornerstone will endeavour to actively managed your portfolio in response to market prospects and conditions. Therefore, investors can rest assured that their investments are being prudently managed with an eye on the long term.
Acknowledgement – this newsletter has partly drawn on research and insights published by PSG Asset Management, Boutique Investment Partners and Obsidian Capital, which we acknowledge with thanks.