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Investor fear:

is it justified?

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SPW Contributors

Sanlam Private Wealth

2018 was a particularly turbulent year for financial markets, and concerned investors are questioning the traditional risk-return relationship associated with shares and property. Is this justified – given worrying trends such as waning global growth, trade wars and Brexit wrangling? To what extent should investors be concerned about South Africa’s seeming inability to escape the low-growth trap? In a series of client events held across the country, we tackled these and other concerns raised by our clients. Here we unpack the most pressing issues that emerged during the lively discussions at these sessions.

What are the major forces currently shaping the global economy, and how are they expected to play out? To what extent do they pose a risk to South African investors – do we need to take them seriously?

Arthur Kamp, Investment Economist at Sanlam Investment Group: The economic risks that stalked emerging market economies for most of 2018, including tightening global financial conditions, had eased up notably by early 2019. At the time of its policy rate hike in December last year, the US Federal Reserve was still signalling material further interest rate hikes in 2019 and 2020. However, in January 2019 the Fed indicated its intention to press the pause button in its interest rate hiking cycle. By March, the Fed’s economic projections suggested no interest rate hikes in 2019, followed by only one hike in 2020.

Meanwhile, as the first quarter of 2019 wore on, it seemed the latest round of trade negotiations between China and the US, which began in early December 2018, could lead to a lasting truce, which is good news for trade activity and growth – although uncertainty remains and Europe is understandably jittery about the lingering potential for US tariff increases on auto imports.

In addition, the Fed announced in March it will stop reducing its balance-sheet assets by September this year. For South African investors, this is important since global interest rates, which benchmark off US interest rates, are used in valuations of assets, and South Africa also benchmarks off them. In general, the more dovish the Fed’s stance, the more the pressure is taken off the global economy, given the implied easing in financial conditions. This has filtered through to emerging market currencies and asset prices, including our own.

Another major risk to the global economy is of course the seemingly endless drama around Brexit. If the UK crashes out of the European Union with no deal, the picture won’t be pretty – the UK may well go into a recession, with the expected decline in confidence impacting investment spend adversely. However, the current six-month extension has placed this risk on the back-burner, for now at least.

While macro conditions appear to have taken a turn for the better, South Africans are still faced with a low-growth environment back home. What’s it going to take to fix our moribund economy?

Arthur: Most commentators agree on the long-term solutions to our low-growth trap: telecommunications reform, removing barriers to entry for small businesses, improved investor confidence, transport reform and skills development. Importantly, we need to upskill our workforce to make South Africa more attractive to investors – including services, one of the fastest-growing sectors in the global economy.

In the near term, one low-hanging fruit for South Africa – to which our president referred in his State of the Nation (SONA) address – is making it easier to do business in this country. The World Bank’s 2018 Doing Business Report placed South Africa 82nd out of 190 economies (compared to a ranking of 32nd in 2010). Improving on our performance in terms of the criteria used by the World Bank for the score – including starting a business, dealing with permits, getting credit, enforcing contracts and paying taxes – is surely within our reach over the short term.

The key issue impacting our prospects for economic growth, however, is our unsustainable fiscal policy, which has resulted in a gradual deterioration of the public sector’s net worth as it accumulates more debt. What we urgently need is fiscal consolidation – cutting expenditure relative to GDP. We’re not doing this – our national debt continues to increase, with our debt-to GDP ratio now at 56.2%. What’s more, we’re spending on the wrong things – such as government consumption, not capital expenditure. If we’re going to go into debt as a country, we must at least make sure we’re acquiring assets.

Another concern is that while there’s a strong focus on the government’s debt numbers, liabilities have been building off-balance sheet. We’ve been building up large contingent liabilities, and this year, the chickens have come home to roost. Our biggest contingent liability – otherwise known as Eskom – now has to be bailed out to the amount of R69 billion over the next three years, as set out in Budget 2019. At least there’s at last a credible plan on the table for the turnaround of the beleaguered state-owned enterprise.

If this all sounds rather negative, it should be noted that our country’s economic prospects shouldn’t be viewed as a binary outcome – either fantastic or a complete disaster. It’s not often that economies work in this way. In my view, South Africa will over the next few years probably carry on doing what it does best: going two steps forward and one step back, but in the end, muddling through.

Will President Cyril Ramaphosa have the necessary mandate after next month’s elections to implement the necessary reforms to kick-start our economy?

Arthur: Speculation about what constitutes a mandate for our president – in terms of levels of support within the ANC – is in my view, unhelpful. I’d rather be on the lookout for more concrete signs that we’re on the road to economic reform. Two are particularly important: as mentioned above, increased ease of doing business in South Africa; and addressing one of the key risks in our economy – Eskom’s operational capacity. If we can successfully implement the proposals put forward in the SONA to fix our ailing power utility, including splitting the enterprise into three separate units; and if we focus on purchasing cheaper electricity from independent power producers, we’ll be making significant progress.

President Ramaphosa has announced that the South African Reserve Bank (SARB) is to be nationalised. What are the implications of such a move?

Arthur: It’s important not to confuse ownership of the SARB with the independence of the institution. There are in fact very few central banks globally that are owned by the private sector. It wouldn’t make too much difference if the SARB is nationalised, although the current private shareholders must be compensated.

The critical issues are the continued independence of our central bank, and allowing it to implement its mandate. As far as monetary policy is concerned, the mandate of maintaining stable inflation in the interest of balanced and sustainable economic growth is protected by the Constitution. There is, however, leeway in interpreting the mandate and what stable inflation means. Currently, the mandate is given ‘teeth’ by the National Treasury, which sets an inflation target at a relatively low level for the SARB to pursue. To change the mandate, you’d need to amend the Constitution, which would require a two-thirds majority in Parliament. Even so, implementation of the mandate requires Reserve Bank independence to be maintained. Current indications are that the SARB’s independence will remain intact.

The negative news in South Africa is sometimes overwhelming, with land reform, state capture and commissions of enquiry dominating the news headlines. How do we ignore all the noise? And after a tumultuous 2018 on the local equity market, isn’t it a bit naive to want to remain invested in this asset class?

Alwyn van der Merwe, Director of Investments: 2018 was indeed a challenging year for many investors, with just about all major asset classes ending in the red. With local equities losing 21% in US dollar terms, there was nowhere to hide. The only asset that generated a meagre positive US dollar return was cash, which gained just over 1.8%.

However, it’s not uncommon for South African equities to generate a negative return over a 12-month period. In fact, over the past 50 years, it’s happened on 10 occasions. This is why equities are a risky investment – you may well lose money over short periods of time. But over the long term, there’s no asset class that can beat the returns of the equity markets. And if you’re not invested in equities when the action happens, you’ll miss out on huge opportunities. Periods of market turmoil are often followed by periods of strong performance – and the fact is that since 1960, there has never been a rolling five- or 10-year period in which South African equities delivered a negative return.

The five most dangerous words in investments are ‘this time it’s different’. Of course, there’s always the risk that this time it is indeed different, and that we’re being naive in not recognising this. However, throughout the history of financial markets, whenever the news flow is negative, investors have tended to extrapolate this narrative into perpetuity, and overreact. There’s no reason why tried-and-tested financial laws that have held sway for decades should now suddenly be invalid. The news flow might be dismal and the story might change, but the laws generally don’t. We therefore still hold the view that patient investors in equities will be justly rewarded through an investment cycle for the risk they take in investing in the asset class.

In simple terms, if we continue to buy decent-quality companies at a reasonable price, it would be fair to expect that the return on investment will beat cash over the longer term. The results of this approach speak for themselves. Over periods of one, three and 10 years, our house view equity portfolio has outperformed not only its benchmark, the JSE All Share Index (ALSI), but also the average competitor:

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Several former stock market darlings have over the past few years seen dramatic share price declines. Companies such as Aspen, Mediclinic and Resilient – whose share prices more than halved – were all investor favourites. What caused their fall from grace?

See the separate article by David Lerche, Senior Investment Analyst, on this subject.

What about British American Tobacco, which declined by 40% during 2018? Why is Sanlam Private Wealth still holding this share?

David Lerche, Senior Investment Analyst: British American Tobacco (BAT) has in fact gone up again by about 23% since the start of the year. There are a few things worth noting about BAT. Even though consumers are smoking less than a decade ago, use of the product remains quite predictable. Consumers are also used to price increases, which they’re prepared to pay – both as a result of the addictive nature of the product and because advertising bans prevent new competitors from entering the traditional market. At Sanlam Private Wealth we’re satisfied that a company that has a fair amount of predictability associated with its earnings growth in pounds and a high payout ratio justifies a holding in client portfolios.

The market became concerned last year following the finalisation in late 2017 of the buyout of US cigarette maker Reynolds American. This business generates more than enough cash to handle the debt it has accumulated and to reduce this to comfortable levels over the next few years. We’ve valued the share at around R760 (around £40).

2018 was a tough year for the retail sector. What are Sanlam Private Wealth’s views on Shoprite? Is the share becoming a buy?

Alwyn: With consumers under immense pressure in a struggling economy, we could never quite understand why investors rated the retail sector so highly in the current investment cycle. Shoprite, for instance, traded for long periods at a price-earnings (P/E) multiple of 20 times and occasionally above a multiple of 30 times. The share price went up to R270 in March last year, but is currently trading at around R170. Initially the market evidently gave Shoprite the benefit of the doubt – justifiably believing it to be a well-run South African company with a sizeable footprint in Africa to grow its business.

Despite these credentials, however, it became clear that Shoprite could not escape the realities of a very tough business environment. The company’s growth rate was slowing, and its African operations were struggling due to currency devaluations impacting its cross-border revenue. Shoprite’s interim results for the six months ending in December 2018 were below expectations, and the market is now more realistic about the company’s prospects.

We’re still of the view that Shoprite is a good company. For us, it’s about buying the share at the right price. Our valuation is currently at R130 per share. If the price doesn’t reach this level, we’ll instead be looking at other assets that provide similar upside but less risk from a pricing perspective.

We’ve also seen huge losses in the property sector – listed property was the worst performing asset class over the past five years. But whereas average yields were around 5% four years ago, they’re now up to 10% in some cases. Is it time to start increasing exposure to the sector in clients’ portfolios?

Alwyn: Yes, we are in fact selectively starting to accumulate listed property shares in our portfolios again. However, the entire property landscape is under pressure. If we just take the retail sector, for instance, the rental income of retail property owners over the short term will probably not meet market expectations. This is likely to put further pressure on listed property share prices, at which point we may take a slightly more aggressive stance in this sector.

Richard Colburn, Investment Analyst: The different property sectors – office space, retail and industrial – each face multiple headwinds. However, some shares are starting to look interesting from a valuation perspective, and we’re slowly edging towards putting our buying caps on. We may not time the bottom of the cycle perfectly, but we’ll buy when we feel comfortable that we’re able to do so with a margin of safety. Paying the correct price is critical.

The companies we currently have in the portfolios include the likes of Stor-Age and Equites Property Fund. Equites owns industrial property in South Africa and the UK, while Stor-Age also has assets both locally and in the UK. Our view is that these companies are able to extract value from their existing tenant base. Equites has strong assets in great locations and long leases to expiry – which is desirable in a tough operating environment. Stor-Age manages between 20 000 and 30 000 tenants – these numbers increase diversification and reduce tenant failure. Although tenant churn is high, the company has operating systems in place to capitalise on this and push through favourable pricing, given location and convenience of assets.

Amid all the uncertainty, both globally and closer to home, what’s the most important message for Sanlam Private Wealth clients?

Alwyn: Towards the end of last year, many of our clients were highly negative about the continued case for equities as an asset class. Fortunately, most decided not to jump ship at the time – if they had, they’d have lost out on the almost 10% the local equity market has gained since then. It’s human nature to get excited about short-term gains and losses on the stock market, and it’s sometimes difficult not to get caught up in the ‘noise’ impacting the market. As professional investment managers, we need to focus on the facts, however, and the most important is this: over the long term – and by this we mean at least 10 years – both global and local equities have significantly outperformed every other asset class. Taking a long-term view, nothing trumps shares when it comes to inflation-beating returns.

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