The grass isn’t always greener outside SA: why we like local more than offshore
The increase in offshore investment limits to 45% for Regulation 28 funds not only provides a larger opportunity set for South African fund managers, but also serves to lower volatility, thereby improving risk-adjusted returns. As a global manager with more than 250 investment professionals covering the globe, we believe Ninety One is well placed to tap into this increased opportunity set. Of equal importance is that we look at our portfolios holistically, ensuring that our offshore assets complement our SA holdings. Part of this process is assessing how offshore investment ideas stack up against SA opportunities.
While we welcome the greater flexibility that the further relaxation of exchange control brings, it is unlikely to result in immediate changes to the offshore allocation of our Global Balanced Strategy for SA pension fund investors. At present, we have a more favourable view on domestic assets. The Global Balanced Strategy is currently positioned below the previous maximum 30% offshore limit as we are finding more attractive bottom-up opportunities in the local market.
While both local and global stock markets are facing a rising interest rate environment, we have a preference for SA equities. Valuations are rich in many areas of global equity markets – earnings revisions have peaked and are losing momentum. In our view, the SA equity market enjoys valuation support, coupled with decent earnings revisions and growth over the next 12-18 months. While the FTSE/JSE All Share Index (ALSI) has started to outperform global equity markets, i.e. the MSCI All Country World Index (MSCI ACWI), our market is still trading at a 35% discount to that index and offers decent value.
Relative valuations - SA equities relative to global equities, comparing 12-month forward PE ratios
Source: Ninety One, Bloomberg. Weekly data over the last 15 years to 11 March 2022.
Better return opportunities in SA
Within SA equities, we like cyclical companies that generate global earnings such as the diversified miners, platinum group metal miners and Sappi. These companies, which are typically geared to the global economic cycle and inflation, should continuing to enjoy favourable earnings revisions. Tight commodity markets and low inventory levels across many supply chains are supporting many global cyclical companies. For example, Impala Platinum and Anglo American Platinum are expected to benefit from the step-up in auto production, given low inventory levels and strong global demand.
We still favour select ‘SA Inc’ counters – companies that are geared to domestic economic activity – and we have a healthy allocation to South African banks. Despite material upgrades over the last few months, we see further upside to banks’ earnings. The COVID economic shocks meant that SA banks had to make substantial provisions for bad debts, and we believe many of those provisions were overly conservative. Banks are experiencing fewer non-performing loans than anticipated. Non-interest income and transactional activity have also exceeded expectations, while net interest income will be supported by the rising interest rate environment. Valuations remain attractive.
The South African consumer has proven to be more resilient than the market had feared, but caution is warranted as there is a lack of momentum in the SA jobs market and inflation concerns are rising.
Given the inflationary pressures, we prefer the food retailers to food producers. Retailers can pass on higher food prices to consumers, whereas producers generally have to absorb higher input costs. We have increased our exposure to Shoprite. The group continues to take meaningful market share through its Checkers brand. Management also seems to be allocating their capital smartly, which bodes well for future returns. Other defensive local businesses that we like include MTN Group and Life Healthcare.
SA bonds more attractive than global bonds
We continue to maintain a material allocation to local sovereign bonds. South African bond yields are much higher than what is on offer on the global front. Even though we face a rising interest rate environment, SA bond holders enjoy a high yield, helping to bolster total returns. Currently, the spread between our ten-year government bond yields and US ten-year government bond yields is over 800 basis points, i.e. investors receive 8% more when investing in SA bonds compared to those who invest in US bonds. We believe high SA bond yields will continue to buffer the asset class during periods of global market volatility. While higher commodity and oil prices provide some upside risks to domestic inflation, our terms of trade should still be supportive of the rand. Overall, we expect this to be a favourable environment for domestic investments.
Global equities remain the preferred offshore asset class
We expect global bonds to continue to weaken from here as yields rise across the curve. While real yields are expected to increase as inflation starts to moderate during the latter part of the year, volatility in bond markets is likely to continue. We have almost no exposure to this asset class as we prefer equities from a growth perspective and domestic bonds on a relative yield perspective.
Within offshore equities, we have balanced exposure across cyclicals, quality compounders and growth companies. Our cyclical exposure includes companies where earnings are recovering and valuations are reasonable. For example, semi-conductor companies across the supply chain are still seeing upgrades to forecasts as the economic recovery continues to play out. Our exposure to financials is benefiting from the rising interest rate environment, while their strong balance sheets with excess capital should provide good returns to shareholders via dividends and share buybacks. We also have exposure to high-quality, attractively valued companies with an improving operating performance, predominantly in the healthcare sector. We have steered away from having any exposure to companies that are not generating earnings and profits today, i.e. ‘long duration’ businesses, where the rising interest rate environment is resulting in a big derating headwind for these businesses.
Regionally, we have a positive skew towards Asia. Chinese markets continue to exhibit reasonable valuations after the high-risk premium embedded in the stocks following last year’s regulatory crackdown. In our view, earnings have substantial upside over the medium term. In contrast to the US and Europe, the Chinese government policy is on an easing path which should provide support.
Over the long term, we believe the increased offshore allocation opportunity should enhance the return profile of South African pension fund investors. At the appropriate time, we will not hesitate to take full advantage of this opportunity for our investors.