January 2021 Update
Making the News
In January, President Biden announced a $1.9 trillion economic stimulus plan, although it has not yet been introduced in Congress. The impact of a stimulus package of this magnitude could be US Dollar weakness and increased inflation.
Since the November meeting of the Monetary Policy Committee (MPC), a second wave of Covid-19 infections has peaked in South Africa and in many other countries. It is expected that these waves of infection will continue until vaccine distribution is widespread and populations develop sufficient immunity to curb virus transmission.
Against this backdrop, the MPC decided to keep rates unchanged at 3.5% per annum. Two members of the Committee preferred a 25-basis point cut and three preferred to hold rates at the current level. The MPC expects GDP to grow by 3.6% in 2021, 2.4% in 2022 and 2.5% in 2023.
Interesting news in the US, an epic short squeeze in GameStop highlighted social discord, and simmering unhappiness with the narrow financial market gains post the Global Financial Crisis (and especially post Covid-19).
Markets in the Month
The FTSE/JSE All Share Index ended 5.2% up for the month which pushed its one-year return to +14.5%. The gain achieved during the month was largely due to the contribution from Naspers, which returned +15.2%. In the offshore space, following Q4 2020, one of its best quarters for equity markets in almost a decade, Emerging Markets (+5.6%) continued its relative outperformance over Developed Markets (+1.5%) in January.
The FTSE/JSE All Bond Index returned +0.7% in January. Domestic bond yields have largely settled into a range, whilst waiting for the greatly anticipated annual budget later this month.
The Rand weakened against the Dollar by 3.9% in January. Over the last year, the rand has weakened by 2.6% against the US dollar, which is less than the weakness experienced in the Australian dollar (c.10%) and the British pound (c.4%). The rand’s performance also compares favourably to the Brazilian real (c.21%) and Turkish lira (c.20%) over a one-year period.
Impact on Our Portfolios
Core Wealth model portfolios were up strongly over the last three months (November, December and January) given how strong equity markets were over the period. On a five-year basis, most of the models have outperformed inflation apart from CWM RI-Growth falling marginally short on the back of a more aggressive allocation to growth assets. Given the current economic backdrop and the performance of ASISA peer group categories which our models fall in, we think the performance across our model portfolio range is reasonable but expect the next 5 years to be stronger as tailwinds from Q4 2020 persist.
Clients may notice that underlying fund switches took place across our model portfolios. The rationale across the switches implemented was to increase diversification within the models and in doing so, increase the likelihood of stronger returns at a lower level of risk going forward.
The first two themes highlighted in the news section of this monthly wrap up (US Stimulus Package and Vaccine Distribution) provides context for how major currencies and asset classes are expected to perform in 2021.
To start, the future performance of the rand against the US dollar is a function of both the strength of the dollar as a currency and the strength of the rand. Looking ahead to 2021, we expect to see structural US dollar weakness. The three factors that are perceived as most likely to weaken the US dollar are:
- a broad-based global economic recovery after the rollout of vaccines. This will see a cyclical upturn in markets of which EM is likely to be a beneficiary,
- stimulus packages, which are generally negative for one’s own currency, particularly monetary stimulus, thus by prolonging existing programmes or increasing US stimulus measures may result in the greenback coming under pressure; and
- stock markets outside of the US are currently preferred, as US equities are arguably expensive, which means that we may see investment flows away from the US towards other, cheaper markets.
To understand how expensive the US market is currently, we look at historical data of the S&P 500’s Cyclically Adjusted Price-to-Earnings ratio (also known as the Shiller PE). The ratio is calculated by dividing a company’s stock price by the average of the company’s earnings for the last ten years, adjusted for inflation.
In layman’s terms, the higher the ratio, the more “expensive or overvalued” the asset class and therefore the lower the ratio, the more “cheaper or undervalued” the asset class. History dictates that buying undervalued shares (i.e. more attractively priced companies) has generated stronger subsequent returns than the subsequent returns from buying expensive shares.
The table below shows the various bucket ranges of starting PE multiples. According to data from Research Affiliates, the S&P500 currently trades at a 33.5x PE multiple which places the index into the 11th bucket range.
This means that an investor willing to buy into the S&P500 would pay 33.5 times the earnings of the aggregated companies in the index. The graph below shows the expected real returns over the next 10 years from starting PE ratios. The green dot indicates the highest real return that the S&P 500 delivered based on the PE range bucket it occupies. Conversely, the red dot indicates the lowest return generated historically based on its starting PE bucket range and the purple bar shows the average return one can expect at these multiples.
From this graph, a key take-away is that there is a significant risk to investing in the S&P 500 at these current multiples as real returns from here are expected to be mediocre, if not negative over the next 10 years. Put differently, this graph also shows how important starting valuations are and how buying assets that are attractively priced, like bucket 1 for example, can deliver robust real returns for the foreseeable future.
2020 has created a significant divergence between winning companies and losing companies in the financial markets. This resulted in the winners being overvalued and losers being undervalued. Undervalued shares of sound companies offer long-term investors a great opportunity to buy in and to generate inflation beating returns. We see this below in a graph from GMO showing that across the offshore asset classes, only emerging market value shares offer the prospect of positive real returns over the coming seven years (expected to deliver inflation +5.6%), whereas other markets are not expected to outperform inflation at all.
Moving over to fixed income, it is important to note that global yields are currently at low levels. To illustrate this, the chart below, from PSG, shows the yield on the US 10-year government bond (which can be used as a proxy for developed market risk-free bonds) overtime and indicates that the yield is currently at the lowest point it has ever been over the last 220 years.
Fixed income investors require attractive yields to generate returns and with developed market yields at its lowest point over the last two centuries, investors must find opportunities elsewhere. Given that most other developed markets offer similar/lower yields on their bonds, the logical market to look to would be emerging markets. The graph below from Anchor Capitak, summarises the real yields on offer in emerging market countries.
Traditionally, these markets are perceived to be riskier than developed markets and therefore need to compensate investors with higher yields. As one can see by this graph, countries such as Zambia, Uganda and Ghana for instance offer much higher real yields than the rest but this also comes at a significantly higher risk given that these countries are rated sub-investment grade by the rating agencies. On the other hand, South African bond yields are an interesting investment case as they trade above Brazil, a country with more fiscal and monetary concerns.
It would be naïve to think that investing in South African government bonds would be without risk, however we believe that most of the risk is priced in at these yields. SA finds itself at a fiscal crossroads, and bond investors need to see decisive commitment and action from authorities this year on both fiscal consolidations, as well as growth reforms, to address debt sustainability risks. Investors will be looking to the Budget for further guidance on the fiscal consolidation outlook, particularly pertaining to updated forecasts for the public sector wage bill.
To conclude, we look at local listed property, an asset class that has been under pressure since the start of 2018. In our model portfolios, we have a key allocation to Sesfikile Capital, a manager which solely specialises in property, both locally and globally. In their quarter four update on the outlook for local listed property, the investment team have provided their overall return expectation for 2021, shown in the graph below.
To keep it simple, we focus on the two main components which make up most of the total return estimate (+23%) for local listed property in 2021. From an income perspective, the 10% is the actual distribution paid after companies retain earnings. In terms of the earnings growth forecast (+11%), at first glance this seems optimistic considering the weaker fundamentals, however listed property is coming off a significantly deflated base where rental collections were at historical lows, the costs of restructuring some balance sheets proved costly to earnings and many of the listed holdings withheld distributions. All assumptions were performed on a stock-by-stock basis and barring any significant unforeseen headwinds, the Sesfikile investment team believes this is fair.
As with any investment there is a risk-reward payoff and we are by no means ignoring the headwinds faced in the sector, especially the impact of Covid-19. Taking all this into account as ‘known risks’ that by Sesfikile’s estimates are priced in, we still see attractive upside for the year ahead.
Tax year end
In order to maximise your tax deductions before the end of the tax year please speak to your advisor regarding your Retirement annuity contributions, investment into Tax Free Savings Accounts and investments into Section 12J companies for the larger lumpsum tax relief.