While these favourable conditions would usually be quite suitable for an offensive strategy, we believe certain areas of the market seem to be getting ahead of itself. We believe many have ignored the potential tail risks we are likely to face over the next few months as we continue to recover from the devasting impacts of the pandemic. The era of free money has led to some elements of speculative behaviour. This is evidenced by increased retail interest, notably from Reddit members, and the popularity of app-based low-commission stockbrokers such as Robinhood.  We have seen a growing disconnect between Wall Street and Main Street as markets continue to rally in the face of the significant economic damage caused by Covid-19.  The fear of missing out has caused some to abandon any defence in their portfolios and risk potentially scoring a few own goals in the process. 

While some investors might want to be more defensive given elevated risks, the income desert both locally and globally has meant that hiding in cash is no longer viable in the pursuit of inflation-beating returns.  In our opinion, the current environment requires investors to have a balance between offence and defence when constructing portfolios.

The below chart highlights the expected annual returns for our current holdings over five years:

Global equity

The most hotly debated view currently is that high-quality global equities are expensive. Some believe that we have seen the start of a multi-year rotation to more cyclical stocks, which supposedly are more attractively priced. We, in contrast, remain optimistic on the prospects for the concentrated selection of high-quality global stocks we own in the portfolios. We believe the market has consistently under-priced these quality companies and their ability to compound over time. In our view, many of these cyclical shares are not as “cheap” as many believe and certainly carry a greater degree of forecast risk given the reliance of macroeconomic drivers. The rotation to more cyclical stocks over the last six months, which have largely been funded by selling the high-quality businesses we own, has also resulted in more attractive valuations in our quality universe. 

SA nominal bonds

The best local opportunity remains government bonds which provide a real return in excess of 5%, which is attractive relative to historical real return expectation for bonds of 2-3%. Local bonds also provide a natural hedge against the volatility of the South African Rand and bring stability to the portfolio given our exposure to offshore equities.SA 

Inflation-linked bonds (ILBs)

We believe ILBs with short durations (less than 10 years) are particularly attractive given the muted inflation expectations priced into shorter dated maturities, relative to our base case inflation forecasts, and that these should form part of a diversified portfolio. The risk of short-term real yields rising is offset by the very low duration and, to a lesser extent, the coupon.  For longer dated maturities (greater than 10 years), we prefer nominal bonds.

SA equity

Our Quality team has been quite bearish on the outlook for local equities for some time. While valuations are more attractive, the prospects for many ‘SA Inc’ businesses are still dependent on a local economic recovery. Unfortunately, the timing of this recovery is incredibly difficult to forecast given the ongoing uncertainty around Eskom, continued job losses, regulatory uncertainty and low business and consumer confidence. 

Current valuations of many of these businesses incorporate some level of recovery and if the expected recovery does not happen, we believe investors will once again likely be disappointed with returns. Based on our scenario analysis the range of future expectations is quite wide and thus we have lower conviction in the asset class given the elevated risk. It is therefore important to be selective and disciplined around security selection on local growth assets based on valuations. If our more optimistic scenario plays out, we will prove to have been too defensively positioned. 

SA cash

Over the last 5 years investors could hide in the safety of cash and earn real returns in excess of 2%, which is high by historical standards. The prospects for cash have deteriorated significantly given the 300bps cut in interest rates during 2020. With cash rates at 3.5%, we do not believe cash will deliver real returns for investors over the next five years, based on our inflation outlook of 4-5%.

SA property

The returns from the local property sector have been abysmal over the last few years as expensive valuations, excessive gearing and unsustainable dividends have finally made investors realise that property is not a one-way bet. We believe the prospects for local property are too binary given our bottom-up forecasts and do not believe they offer attractive risk adjusted returns. 

Global bonds

We do not believe global bonds offer any value given record-low interest rates and unattractive global yields, which in our view do not offer downside protection in the event of interest rate normalization. 

Conclusion

In terms of outlook for the year ahead, we continue to focus on the highest quality opportunities. In the context of South African assets, this means government bonds, which will generate income for the portfolio. We balance this with growth in the form of high-quality global equities with low leverage, low economic sensitivity and exposure to growth vectors unavailable to us in South Africa. We reiterate that a balance between offence and defence is required to navigate through the expected volatility in the year ahead. BM

This article was written by Duane Cable, Head of SA Quality, Ninety One 

For more insights from Ninety One’s team of investment specialists, please visit https://ninetyone.com/en/south-africa/how-we-think/insights.