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After the unusually high returns from SA equities (and even local bonds) that investors enjoyed in 2021, some may be expecting lower results in the next few years. After all, some headwinds to growth are presenting themselves in the form of rising inflation, higher global and local interest rates, the potential of new Covid strains, geopolitical tensions, and political concerns both locally and abroad, all arising from the interconnected world we live in. Also, importantly, starting valuations for both SA equities and bonds are now more expensive than they were at the beginning of last year.

However, at M&G Investments we still see many good opportunities for excellent investment returns across most SA asset classes over the medium term. This view is based predominantly on the fact that, even though our asset valuations did rise last year, this was off a very cheap base and those gains lagged many other markets in terms of both their absolute level and re-rating. Negative investor sentiment has weighed heavily on our local assets, and this presents opportunities for further strong potential returns going forward. By contrast, global developed equity and bond markets are relatively expensive. 

So what do we believe are the returns on offer for investors, and will they reward investors adequately for the prevailing risks?  Our valuations analysis shows that SA equities are priced to deliver an after-inflation return of nearly 9.0% p.a. over the next 3-5 years, well above their fair value of around 7.0% p.a. This compares to global equities’ prospective real return of less than 6.0% p.a., which is why on an overall level we prefer SA equities to global equities in our multi-asset funds like the M&G Balanced and Inflation Plus Funds. In our view, the market is overly pessimistic about SA companies’ expected performances – there are many excellent businesses in South Africa like banks, retailers and miners that have demonstrated solid long-term profitability, and we believe many have the potential to deliver strong results going forward, with earnings and dividends showing a robust return to growth over the medium term.

Many mining companies continue to experience elevated earnings as the prices of commodities remain at high levels, at least over the near-term, helping them strengthen their balance sheets as well and enabling large dividend payments to shareholders. These high commodity prices are supportive not only for the companies mining them, but also for the wider South African economy via growth, higher tax revenues and added consumer spending.  

We are particularly excited about the return potential from SA banks: Standard Bank, Absa and Investec are among the top 10 equity holdings in the M&G Balanced and Inflation Plus Funds. Banks can benefit from a rising interest rate cycle as long as its pace and extent remain relatively moderate – as we currently expect from the South African Reserve Bank (SARB). By contrast, we are underweight insurers, where Covid-related claims and business disruption remain a risk.   

We prefer SA equities to property counters in our portfolios due to the continued structural challenges the listed property sector faces, such as oversupply in the office space, rising interest rates and negative rental reversions. There are numerous attractive options in other sectors, including small- and medium-cap shares. In fact, we are currently holding a higher weighting of small- and medium-cap shares in our portfolios than average, reflecting the wider-than-usual dispersion of attractive dividend yields on offer. 

Meanwhile, we believe local nominal bonds present investors with an opportunity to earn lucrative returns over time. Despite last year’s strong total return, the yield on the 20-year government bond remains well over 10%, near its highest level since 2001. In fact, our valuation of the government bond market as a whole shows a potential real return of around 5.0% p.a. over the medium term, compared to a fair value of around 3.5% p.a. We believe current yields are still pricing in overly negative market sentiment regarding prospective inflation and other risks. SA inflation expectations remain relatively subdued compared to many other countries, and within the SARB’s 3-6% inflation target band. 

Global sovereign bonds are still offering investors negative real yields as a result of the historically deep interest rate cuts made by global central banks during the pandemic. We have reduced our global bond position further in favour of SA nominal bonds in the M&G Balanced and Inflation Plus Funds. We also hold more SA government bonds and fewer corporate bonds than usual, given that there’s little need for us to take on the additional credit risk at the current elevated yields on offer. We prefer longer-dated bonds due to the extra yield they offer as a result of the steepness of the local yield curve.  We believe investors are adequately compensated for the extra risk associated with the longer duration.  

Finally, SA cash continues to be an unattractive investment option for now. This is because of the very low base from which our rates are rising and the unusually wide gap between local cash and bond yields – leaving potential cash returns much lower than those from SA bonds and equities. Based on the SARB’s latest projections, it will take time before it becomes a viable option for longer-term investors. Given the large shift of local investors into cash over the past 3-5 years, investors will need to reassess their cash holdings very carefully. 

In conclusion, despite the risks – both known and unknown – presenting themselves in 2022, we believe SA equity and bond valuations remain attractive, and have the potential to deliver strong returns over the medium term. Although we don’t know how or when these will be delivered, South African investors have an opportunity to continue to reap the benefits of well-priced assets across a variety of asset classes. This makes multi-asset funds a particularly appealing option in the current environment, especially given their broad diversification which helps to mitigate downside risks when important assets like global equities and bonds are at relatively expensive levels. DM/BM

Author: Leonard Krüger, Equity and Multi-Asset Portfolio Manager at M&G Investments

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