STANLIB Balanced Fund update: finding opportunity in our SA exposure
We are now almost six months into this global recession with most countries are slowly seeing normality returning, although with a healthy dose of scepticism. SA is no exception. Along with countries such as Brazil, India and Indonesia, SA is among the worst-affected emerging markets.
At the same time as the South African government has unwound its lockdown regulations, its monetary response has been to announce a cumulative 275 bps of cuts in the repo rate to a historically low level. This has certain implications that reach beyond reducing the cost of borrowing and debt servicing.
A more profound change has been the South African Reserve Bank’s move away from maintaining high reactive real rates to protect the currency, to inviting short-dated deposits from foreign investors. This policy attracted investors to the money market and short-dated income funds. The prevailing money market rates and benign low inflation expectations have left these investors with a limited real yield uplift.
So where do investors currently find opportunities for their SA portfolio allocation while navigating this market backdrop?
The medium-term consequence of the current low-interest environment is that hoarding cash remains at best inflation-neutral, with no real yield pick-up or a substantial negative real return after tax.
The STANLIB Multi-Asset team, having experienced several market crises, have held to their approach of applying unique and in-depth analysis of the business cycle to inform their asset class views and strengthen their conviction. The funds have weathered the storm relatively well in 2020.
Since 2017, when as a business we made significant changes to turn around investment performance through simplifying our equity and balanced offerings within a single team, our funds have achieved consistent top-quartile performance.
Focusing on local exposure, which accounts for more than 70% of our portfolio, we share our current view on key SA asset classes and how we are interpreting the opportunities.
SA Bond view
We currently favour the South African sovereign bond market for the following reasons:
- Valuation. The real yield for SA 10-year bonds is approaching 6%, which was traditionally the equity risk premium. In other words, SA bonds are currently offering a level of return previously only available to equity investors.
- Break-even yield. The prevailing break-even levels of holding a bond instrument, relative to an investment in a 12-month NCD, are now approaching 100 bps in most cases, as shown in Chart 1 below:
Chart 1: Break-even yield: bond instrument vs 12-month NCD
- Carry cost. Over time, foreigners have been large investors in SA bonds, as they have sought to diversify their portfolios away from ultra-low developed market yields. The current carry cost for foreigners to hedge the rand is at an all-time low of 4%, as shown in Chart 2 below.
The carry cost is calculated by using the implied three-month rate differential. This makes it easier for foreign investors to capture the real yield without incurring currency exposure.
Chart 2: SA/US three-month Implied Rate Differential
SA equity view
The current investment case for South African equities is challenging, especially since the severe economic impact of profound lockdown regulations has become evident in the past six months.
Recent data shows that SA’s GDP declined by 17.2% in the second quarter of 2020 against the same quarter in 2019, which means that in the first half of 2020 the South African economy declined 8.7% y/y. The expected annual growth rate for the remainder of the year remains negative and only in 2021 do we expect to see growth pick up again.
Although the headline numbers are a concern, we have modelled the prevailing economic scenario (Chart 3) and our growth expectations to gain a full understanding of the impact on the equity sub-sectors of the JSE.
Chart 3: Real GDP recovery path
From our data we have been able to simulate expected earnings recovery scenarios relative to our 2019 actual base case. We have essentially sub-divided the shape of earnings recovery:
- V- Shaped – minimal impact and 2021 earnings are ahead of 2019 earnings
- U- Shaped – earnings decline in 2021 and then recover in 2022 to levels ahead of 2019
- L- Shaped – earnings decline in subsequent years and do not recover before 2022 to levels attained in 2019.
This process allows clear categorisation of the recovery momentum in each sub-sector and the impact on individual company business models. For example, the banking sector has provided for a significant proportion of non-performing loans and it will take time to potentially realise the potential losses relative to the prudency applied.
From our analysis it is clear that recovery for the technology, telecommunications and pharmaceutical sectors will be V-shaped, so we see earnings recover quite swiftly on an annualised basis.
Chart 4: Sectors experiencing a V-shaped recovery
Sectors that show a U- shaped recovery are food and drug retailers, insurance and hospitals, which makes these our preferred equity sectors.
Chart 5: Sectors experiencing a U-shaped recovery
Our analysis makes it quite clear that the general retail, diversified industrial, and banking sectors will be affected the most and face some difficult years.
Chart 6: Sectors experiencing an L-shaped recovery
Applying our thinking
Our balanced portfolios currently hold significant exposure to South African government bonds. We find the asymmetric upside in returns to be compelling compared with holding cash and equity, especially considering the risk/reward expectation and real yield on offer.
From a South African stock selection perspective, we are invested in Dischem and NuClicks in the food and drug sector, where we expect a continued U-shaped recovery.
We also hold significant exposure to Prosus, Naspers and telecommunications companies, as they remain resilient through the current crisis and show strong growth characteristics. The insurance sector remains interesting and our current overweight position to this sector is mainly in Sanlam and Old Mutual.
Looking forward, we recognise that the full impact of the pandemic on SA and the world will continue to unfold. SA’s fiscal data is likely to deteriorate as the macro-economic backdrop stays challenging.
Companies are undertaking “self-help” actions to survive, leading to shifting business models, while consumers’ spending habits continue to change, some permanently. We cannot stand still: as portfolio managers, we remain agile in this shifting environment, while staying committed to delivering optimal client outcomes in our balanced funds.