Ricardo Smith
ANY PORTFOLIO that seeks to grow an investor’s wealth in real terms over the long term should be reasonably correlated to listed equities.
Listed equities are expected to provide long-term returns above inflation at the cost of short-term volatility. However, looking at the five years leading up to the end of 2019, just before the coronavirus pandemic, more stable investments, such as bonds and cash, outperformed risky asset classes – questioning the value of equities.
Evidence of this is that over those five years the Top 40 Index delivered a total return of 6.2% a year, while the Short Term Fixed Interest (STeFI) Composite Index and the All Bond Index delivered total returns of 7.2% a year and 7.7% a year respectively - while exhibiting much lower levels of volatility than listed equities.
Equities have been weighed down heavily by low corporate profits, spurred on by anaemic economic growth. Meanwhile, cash and cash equivalents have benefited from a high interest rate environment. This was because of the South African Reserve Bank’s Monetary Policy Committee (MPC) keeping interest rates high despite a negative output gap, in an effort to keep consumer price inflation subdued.
On the longer end of the yield curve, a high credit default risk premium on government bonds, as they seek to attract local and foreign investors, has boded well for savers and investors, while increasing the government’s cost of servicing its debt.
More recently, however, the Covid-19 pandemic has brought about a few structural shifts in asset classes locally and globally. First and most noticeable is the acceleration of trends such as working from home and the adoption of technologies such as video-conferencing. This has shifted the focus and emphasis on asset classes such as property from location to property types, including data centres, storage and distribution facilities.
The second structural shift locally has been the unprecedented aggressive cutting of interest rates by the MPC in an attempt to limit any potential liquidity constraints. The interest rate cuts have increased the propensity for consumers to spend, through lower costs of debt, higher household disposable income and increased private credit extensions in real terms. Increased spending levels are good for the economy and corporate profitability, particularly because final household consumption expenditure accounts for more than 60% of real gross domestic product.
As a result of the strong monetary support, both locally and globally, local listed equity markets have significantly outperformed local bonds and cash over the past 17 months. Over this period, which includes the Covid-19 pandemic market crash, the Top 40 Index has delivered a total return of about 19.4%, while the STeFI Composite Index and the All Bond Index have delivered 4.9% and 9% respectively.
Looking ahead, the positive participation of equity markets in economic activity, coupled with the expected economic recovery from the Covid-19 pandemic, makes listed equity markets attractive.
However, the valuation from an earnings perspective remains of particular concern. Markets are pricing in double-digit earnings growth, which should be achievable over the short to medium term as earnings normalise. However, some strong concerns remain over the longer term. Whether this double-digit earnings growth will be sustainable remains to be seen, given some structural issues in the economy, including high levels of unemployment, difficulty in attracting and efficiently allocating capital, and the inability to adopt and deploy technology, including a stable and reliable electricity supply.
What remains clear, given the current interest rate and business cycle, is that portfolio managers and asset allocators will have to take a closer look at local listed equity markets. The low interest rate environment, which is good for borrowers, does imply that cash is unlikely to continue outperforming local listed equities for the foreseeable future, particularly as investor sentiment has turned positive.
Ricardo Smith is the head of investment strategy at Absa Global Investment Solutions.
* The views expressed here are not necessarily those of IOL or title sites.
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