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Provided by the South African National Department of Health
in a post-downgrade world
Alwyn van der Merwe
Director of Investments
May 02, 2017
After Nenegate in December 2015, investors panicked. Compared to the fallout after that ill-fated episode, however, the response to President Jacob Zuma’s midnight cabinet reshuffle and the subsequent decision by both Standard & Poor’s (S&P) and Fitch to take South Africa down a notch was almost complacent. The immediate impact was some currency depreciation and a jump in bond yields, and the local equity market has also not emerged unscathed. Despite negative investor sentiment, however, the reaction was nowhere near as dramatic as it was in the wake of Nenegate.
After the events of December 2015, government bond yields blew out to almost 10.5%. From an asset allocation perspective, we believed bonds were mispriced at the time – the rise in yields was based purely on investor irrationality. We therefore increased our exposure to local bonds, a decision vindicated when bonds proved to be the best-performing asset class for 2016 – the All Bond Index returned 15%.
Since the downgrades, bond yields have kicked higher by around 70 basis points to 9%. We’re again viewing this as market overreaction and considering it an opportunity to use some of the cash in our portfolios to increase exposure to this asset class for our clients. It may seem contrarian to buy bonds when we’re concerned about the government’s ability to service its debt and repay the capital at redemption, but we believe the potential yield is still attractive enough to compensate for the risk associated with this asset class.
Unexpected events on the political front often drive fearful investors to send their money offshore, which at a weak exchange rate is precisely what they should not be doing. Following Nenegate, the currency blew out to R16.50 against the US dollar, so we certainly didn’t recommend to our clients to take funds offshore at that stage – the currency was way too cheap. As it turned out, the rand strengthened considerably subsequently – just before the credit downgrades, it was trading at R12.50 to the US dollar.
Post-downgrade, our currency has naturally come under pressure. In our view the rand is still strong enough, however – it’s currently trading at R13.36 to the US dollar – to justify moving some funds offshore. For clients with limited international exposure, the current currency levels have opened another window of opportunity to add to their offshore assets.
Another factor we consider when looking at asset allocation from a geographical perspective is the prices of offshore equities versus those of local stocks. On average, there’s not much difference between the two currently. With the exception of the US market, offshore equity markets are priced more or less in line with local markets. We’re therefore considering increases in offshore exposure for our clients mainly from a currency perspective.
Since the start of the year – and since the downgrade announcements – the overall market has moved sideways and essentially retained its levels, propped up by a handful of rand hedge heavyweights such as Naspers, BAT and Richemont. The share prices of companies that don’t have a significant offshore component to the earnings they generate, notably the banks and retailers, have come under severe pressure, however.
In our local equity portfolios, we have substantial exposure to the ‘safe haven’ rand hedges that earn the bulk of their income outside South Africa. But since the credit downgrades, pockets of value have emerged in our market – including the banking and local IT sectors – as a result of negative investor sentiment. It’s of course challenging to get the timing on these cheap local shares just right, but in our experience, a good investment decision is always taken on price. With patience, value will almost certainly be unlocked over the long term.
In a nutshell, in a post-downgrade South Africa, our asset allocation remains as follows: we’re still marginally overweight in local equities, and within our balanced mandates we currently have virtually the maximum offshore exposure allowed in terms of Regulation 28 of the Pension Funds Act. We’re very comfortable with our decision last year to add to local bonds. Our portfolios have fair exposure to offshore equities, but it remains hard to see inspiring returns from global bonds.
The impact of investor sentiment and irrational reaction to ‘crisis’ events such as the recent credit downgrades results in an intra-day tug of war where the direction of the rand determines whether rand hedge counters or shares that derive most of their profits from the local economy will walk away as victors. We still believe, however, that fundamental principles will dictate market prices over the longer term. Our approach to actively managing portfolios therefore hasn’t changed, and we will stay true to our investment philosophy that price levels will be the most important factor driving prospective returns.
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