Wealth Intelligence Weekly 28 Oct 2019
Don't let the gloom get your portfolio down
The mood in the country is still very gloomy, despite the best efforts of the Springboks. The economy is under pressure, corruption seemingly continues to go unpunished and loadshedding has made an unwelcome comeback. The large political parties all appear divided.
This week's Medium Term Budget Policy Statement (MTBPS) will likely land another body blow. Due to a tax revenue shortfall and parastatal bailouts, the Finance Minister is expected to announce that the expected budget defi cit (the shortfall of tax revenue relative to government spending) for the current and next fi scal year has ballooned to between 5% and 6% of national income.
This gap has to be plugged with borrowing, which will add to the government's debt pile. And since the government is paying a relatively high interest rate (it is currently borrowing at 9% for ten years), the cost of servicing this debt is crowding out other pressing spending needs. While debt levels are not at a crisis point yet, this trajectory is not sustainable and investors and taxpayers alike will be scrutinising the Minister's plans to put state fi nances on a sounder footing. There are no easy and politically popular steps to get us out of this situation. It will involve some combination of cutting spending allocations to departments, reducing the government's wage bill, raising tax rates and selling off assets. And above all, we need faster economic growth. The good news is that it appears that a consensus is starting to develop within the ruling party to implement most of the economic reforms that have been proposed by National Treasury. The bad news is that these will take time to increase economic activity on the streets, factories and mines of South Africa.
To top it all, investment returns from traditional balanced funds have been disappointing, largely since they tend to heavily invest in South African equities. The return from the FTSE/JSE All Share over the past fi ve years is only 5% per year. This is not a catastrophic collapse (Argentina and Turkey's markets halved over this period) and returns have kept pace with infl ation, but it was much less than what investors expected.
Not all asset classes have struggled. Global equities delivered 13% annualised return in rand over the fi ve years to end September, local bonds 8% per year and cash 7%. Predictably, there has been a big shift from retail investors into either global equities or local income funds.
Within global equities, there has been a big divergence. The US market delivered 19% annualised in rand, while the rest (the MSCI All Countries ex US Index) returned 11%. Of this, 5% per year was due to rand depreciation. In other words, if you could ignore the impact of the weaker rand, local equities would have performed in line with other non-US markets. Most of the rand weakness occurred early on in this fi ve-year period (i.e. 2014 and 2015). The rand has basically been fl at over the past four years (and has appreciated recently). Also remember that over the previous fi ve years (2009 to 2014), local shares outperformed.
Looking more closely at the local market, it is no surprise that South African-focused shares have struggled given the sustained weakness of the domestic economy. What is more puzzling and disappointing is how global shares (rand hedges) listed on the JSE have struggled, despite the weaker rand. The JSE share price of Richemont only increased 4% per year over the past fi ve years, while British American Tobacco lost 2% per year. AB Inbev is below its 2016 listing price. The mining heavyweights BHP and Anglo American have gained 4% and 7% annualised respectively. None of these shares have been victims of the domestic economic and political headwinds of the past few years, nor the negative sentiment towards South Africa since their prices are set in their home markets. Notably, these home markets are in Europe and not the US. These shares can do well irrespective of local conditions.
There has also been the fl ood of investments by local companies abroad, mostly with disastrous results. The four poster children, Woolworths, Sasol, Aspen and Mediclinic, lost an average of 50% over the past fi ve years as a result of troubled overseas acquisitions. In other words, global is not necessarily better.
If local conditions improve, as we expect them to do gradually, the domestically focused shares can perform well from current cheap valuations. In other words, there is upside to JSE-listed equities. People who think the current situation is unique in South Africa's history have short memories. Political uncertainty and economic instability, punctuated by periods of calm and rising prosperity, have long been features of our collective experience. It is the country where neither the best nor the worst ever happens, as Jan Smuts famously said. The JSE has operated through much turmoil since 1887 but South African equities have always paid off for long-term investors. However, returns have always been cyclical. Just looking at the modern period in Chart 2 we can see the cyclical nature of rolling fi veyear returns. The most recent period, as disappointing as it has been, is not a complete aberration.
As for income funds, they obviously serve an important purpose and South African investors are lucky to have high real interest rates in their investment toolbox, something that cannot be said in many parts of the world. Of course, borrowers do not feel similarly lucky, and high real interest rates are one of the reasons why the economy is struggling. But remember that income funds are for income, and interest rates won't necessarily always be high. (There was a time when cash was considered trash.) Long-term growth requires investing in businesses that can capture infl ation and earn a profi t above that. The share prices of these companies are volatile, unfortunately, and the fundamental trade-off between risk and return never goes away for too long. How much return an individual investor or pension fund member needs and how much they are prepared to take is for them and their advisers to determine. Fund managers cannot make that call, and therefore a traditional balanced fund will almost always have a large exposure to equities. A signifi cant portion of the total returns from equities over time is made in the early months of a recovery and funds cannot afford to miss those gains. Nobody can predict turning points with any accuracy, therefore you have to stay invested to benefit.
Given this growth requirement and the regulatory constraint of a maximum of 30% offshore exposure, balanced funds usually have higher local equity than global equity exposure. The underperformance of local equities against global equities over the past fi ve years has therefore cost pension fund investors returns. Investors who are considering exiting such funds to go fully offshore should weigh up the tax advantage of a retirement vehicle against the limitations on asset allocation. They should also be wary of closing the stable doors after the horse has bolted. Projecting the most recent experience forward is a very human tendency, but markets are cyclical and the next fi ve years are unlikely to look like the previous fi ve. Finally, beware of a currency mismatch where assets are all in dollars (or pounds or euros) and liabilities are all in rand, since exchange rate movements can hurt. We do expect the rand to weaken over time against hard currencies, but it can appreciate for painfully long periods, especially from oversold levels.
One of the reasons why local companies have struggled and government's tax revenues have missed expectations year after year is the decline in domestic infl ation. The government has persistently overestimated infl ation in setting its budget targets. High infl ation implies rising incomes for businesses and households (though not necessarily rising purchasing power) of which the government can take a share as taxes. Chart 3 shows the consumer infl ation rate and broader GDP defl ator (the difference between real and nominal economic growth) which captures production, consumption and trade prices. The decline has been striking, especially since early 2017.
And it is not just the government. Over the past fi ve years, private sector economists have also persistently overestimated infl ation in their forecasts. Last week's latest infl ation update from Stats SA was another example. The consensus expectation was a 4.2% rise in the consumer price index in the year to September, while the actual reported number was 4.1%. Core infl ation, which excludes volatile food, fuel and energy prices, was 4%. Excluding administered prices (prices not directly determined in a competitive market such as electricity tariffs and other municipal charges), it was only 3.8%.
Over the long term, low and stable (but positive) infl ation will be benefi cial. However, the sudden and somewhat unexpected decline in infl ation requires a rather painful adjustment not only for government coffers, but also for business revenues. And though consumers benefi t from lower infl ation, income growth for households has slowed as well. Businesses will have to adapt and become even more effi cient. A good example is Pick n Pay, who last week reported top-line growth of 6.5% from its local stores with infl ation of only 2.2%. But it managed to grow the bottom line by 10.7%, which the market cheered.
With inflation remaining below the midpoint of the Reserve Bank's 3% to 6% target range, and economic growth still weak, further rate cuts are on the cards. The immediate hurdle will be whether there is a negative market reaction to the MTBPS or Moody's announcement a few days later. With so much disappointment already priced into the rand and the local bond market, a severe sell-off is unlikely, opening the door to a repo rate cut on 21 November, an early Christmas present from the Reserve Bank.
Legendary investment writer Peter Bernstein once noted that diversifi cation is "the only rational deployment of our ignorance". In other words, we don't know what the future holds, and we need to position portfolios for good times and bad. We are so used to asking what could go wrong in this country. Diversifi cation means one also has to ponder what could go right. That doesn't mean wearing rose-tinted spectacles or sticking it out with local assets out of a misguided sense of patriotism. The challenges facing South Africa are numerous and serious, but they are already largely refl ected in local bond and equity prices. While a healthy exposure to global assets is appropriate, we should be prepared for all possibilities and use valuations, not emotions, as a guide.