Executive summary
- Forward positioning – Pro select domestic equity (banks, retailers, resources), bullish emerging markets, neutral on the rand, underweight rand hedges, neutral on domestic bonds
- Market outlook – Buoyant global manufacturing, weak USD, strong EM currencies and financial assets.
- Risk to portfolio – Synchronised economic growth falters, no sustained recovery in SA consumer confidence
You beta remember it
One of the challenges of being a fund manager in any emerging market is that you have to contend with risk-off sentiment from time to time. The accompanying volatility can cast doubt among investment theses.
We are arguably in one of these periods at the moment. Investors are skittish and understandably so; a widely disbelieved bull market has just entered its 10th year. From trade and proxy wars, to sporadic signals of cooling global growth, to worries about whether tech valuations are justified, there are indeed reasons to be nervous about certain financial assets, equity being the most vulnerable.
But what if there are opportunities in your domestic universe that have palatable valuations AND will likely benefit from a continuation of the prevailing macroeconomic theme? It’s not a rhetorical question; this is the reality SA investors are currently faced with.
Years of a mismanaged economy have put the earnings of domestically exposed corporates to the sword. The market has consequently slapped a lower rating on these counters. But they may now have an opportunity to capitalise on the resurrection of consumer and business confidence under our new political leadership. Indeed, the recent rerating of all SA Inc. shares was a nod to this opportunity. But the SA psyche needs to see action before it can bury its now engrained pessimism, so a wait-and-see approach from both business and the consumer should be expected.
This makes SA Inc’s new-found valuations fragile, especially for those who were unable to fathom earnings growth when things were bad. This fragility showed in March when global equity investors took fright and a widespread sell-off ensued. The tight correlation (beta) between all spheres of equity is sometimes an uncomfortable truth, but an inescapable one. Therefore, to hold an equity-heavy portfolio, like we do, one must believe that it will remain a supported asset class on the global stage. We pen our reasoning for this stance in the following pages.
Domestics poised at average
SA domestic equity (banks, retailers, and select resource counters) has been among our favoured assets for two years. Our liking them was premised off attractive valuation, a view of falling inflation and interest rates, rising commodity prices and a supportive emerging market (EM) theme. It has been broadly the right strategy even in the face of political turmoil. When the Zuma regime was removed we further increased our stake in domestics based on the potential for an improvement in business and consumer confidence.
The broad rerating of these assets seen since late December 2017 took them to what we would deem fair value at the end of February. We were content to hold them on the belief that a supportive environment, both locally (recovering confidence) and globally (demand for EM assets), would facilitate a push through their fair values into overvalued territory. We still believe this possible despite the meaningful pullback in these counters during March.
In Chart 1, we’ve used Standard Bank (SBK) as a proxy for our bet on SA Inc; it has been a top holdings of ours since early 2016. The bold red line is what we deem to be the fair value of Standard Bank based on their rolling 12 months dividends paid, while the black line is the actual share price.
The deviation between the red and black lines is explained by the change in the rating, itself depicted by the gyrating dotted blue line. Because we’re using the dividend yield as our rating metric, a higher blue line suggests the share is cheap, while a lower one signals overvaluation. The recent sharp move downwards (of the dotted blue line) to circa the average dividend yield illustrates the re-rating that Standard Bank – along with a host of other domestic shares – has undergone. At average ratings (valuation) it’s now crucial that these domestic counters produce the better earnings that the market is expecting.
Should the likes of a Standard Bank fail to capitalise on better consumer/business confidence, or should that confidence fail to materialise, then our portfolio positioning as it stands is too heavily weighted in SA Inc.
In order for these shares to rerate above their averages into expensive territory, they must not only show better earnings trajectories; it is critical that the global risk-on mood remains in place. This leg of our investment thesis is at the mercy of strong global economic growth and its continuation.
Goes without saying
Of course, there are risks to both conditions mentioned in the last paragraph. For instance, Brazil has slashed their interests rates by far more than we have scope for, and yet their consumer confidence – and by extension their retail sales – has remained subdued. The same could happen here.
Perhaps more dangerous though is a return, with renewed determination, of risk-off sentiment before the potential increase in spending kicks in. While there are a multitude of factors that could induce investor fear, we think the most fundamental is a material slowdown in earnings.
In Chart 2 we have the Obsidian Global Economic Indicator in red. It pulls together a variety of global manufacturing surveys that help us gauge economic activity. When it rolls over, corporate earnings usually slow, forcing investors to question whether they want equity at this hour of the party. It also signals falling demand for commodities.
Retreating earnings and falling commodity prices is the anathema of our portfolio; the former will see equity underperform versus other asset classes, the latter will put EM assets (to which our portfolio is significantly geared) under pressure.
But manufacturers only mothball their equipment when demand dries up. Our simple retort to the idea that a collapse in demand is imminent is as follows: With global interest rates still very accommodative and inflation posing no threat to the current equilibrium (even in the US!), it’s difficult to see why consumers stop spending or why corporates stop investing; rates in Europe are still basically zero for Pete’s sake! So while we wouldn’t be surprised to see some mean reversion in manufacturing data – and the volatility that goes with it – we don’t expect corporate earnings to dry up just yet. And as a result we are staying the course with equity.
Slow and steady wins the race
EM currencies have a reputation of blowing out in spectacular fashion – reference the 2011 to 2015 period. When this happens their inflation follows suit because of their dependency on imports. To slow spiralling prices, interest rates are then hiked aggressively. So when their currencies (eventually) show strength, which they inevitably will, there is scope for both inflation and interest rates to fall, sometimes precipitously.
We’ve seen this play out in Russia and in Brazil, and to a more tempered degree, it’s happening in SA. The two obvious beneficiaries in a falling inflation and interest rate environment are interest rate sensitive equity (banks and retailers) and bonds.
With an element of uncertainty around whether SA corporate earnings will rebound meaningfully – and equity valuations that are now broadly average – we continue to prize our SA Government Bond holding, one of the best performing asset classes of late. With no imminent threat of forced exclusion from world bond indices and a real yield of nearly 4% on our 10-year government bond, we believe it’s an asset class that will continue to find support in the current environment. However, as is visible in Chart 3, our inflation drivers may have bottomed and any rand weakness (not our view but always possible) could narrow that real yield.
Offshore, we still prefer emerging markets
As long as the global economy is still growing we’ll continue to favour emerging market assets over their developed market counterparts. To reiterate the reasoning behind this preference, better global growth means better global trade which in turn increases EM country export volumes causing their currencies to appreciate; in our experience, currency movement is one of the biggest drivers of offshore returns. And as such, we prefer investing in undervalued currencies where the macro is turning in their favour.
Chart 4 plots the real effective exchange rate of the Mexican peso, our favoured EM currency. While the peso has appreciated since the beginning of 2017, there is scope for further gains. Ironically, Mexican manufacturers – and eventually their currency – may benefit from the simmering trade war between the US and China as their products become more competitive by virtue of being tariff-free.
However, this would purely be the cherry on top and is not the core thesis of our investment in Mexico. Rather, we believe their inflation has peaked and that a stable to stronger currency will then allow their central bank to cut interest rates, eventually benefitting their consumers and fixed income type assets. We take note of the political turmoil, but as we have seen at home, politics is mostly a sideshow.
Our offshore thematic should ring a bell – a large portion of our foreign allocation is simply an extension of the macro thread of falling inflation and monetary easing that is weaved into our domestic portfolio. No coincidence then that our offshore holdings are concentrated in banks and retailers in select EM territories.
Just like our equity back home, the performance of these foreign equity counters is conditional on their ability to generate earnings post their broad rerating. And of course, if we needed to say it again, the continuation of strong global economic growth.
Conclusion
The global beta sell-off in March was near impossible to escape for those who still have equity as their preferred asset class. We see these dips as an inevitability given the nervousness that comes with a record-breaking bull market, elevated trade war rhetoric, and escalating tensions between the US and Russia over Syria. But as an investment manager we have a process to stick to and guessing what Trump’s next tweet will be is yet (see never) to be incorporated into our fundamental methodology.
Instead, the work we’ve done on the macroeconomic environment continues to solidify our view that global economic growth remains buoyant; that global monetary policy is still very accommodative and inflation still low; and that this is an environment in which business will continue to generate earnings. Under this scenario equity, particularly EM equity (which includes South Africa), should outperform.
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Obsidian first quarter commentary – 2018