Michael Kruger, Senior Investment Analyst, Morningstar Investment Management South Africa

A strong period of performance for South African asset classes

South African (SA) assets are currently in vogue. I doubt that many investors would have forecast that outcome 12 months or even 6 months ago, as the country faced multiple headwinds from political uncertainty, persistent load shedding, high inflation and interest rates, low business and consumer confidence as well as tepid economic growth. However, here we stand at the beginning of November, and South African assets have outstripped the performance of many global bond and equity markets on both a year-to-date and a 1-year basis in rand terms to the end of September 2024. Perhaps the most surprising outcome is the performance of SA bonds, with the asset class outperforming both SA equities and global equities in rand terms on a year to-date and 1-year basis.

Source: Morningstar Direct. Data as at 30 September 2024. Past performance is not a reliable guide to future performance. For illustrative purposes only and not indicative of any investment. Returns of SA asset classes have been proxied as follows: SA Equities (FTSE/JSE All Share Index), SA Bonds(FTSE/JSE All Bond Index), SA Listed Property (FTSE/JSE SA Listed Property Index), SA Cash (STeFI Composite Index). Returns of global asset classeshave been proxied as follows: Global Equities (MSCI World Index), US Equities (S&P 500 Index), Emerging Markets Equities (MSCI Emerging Markets Index), Global Bonds (Bloomberg Global Aggregate Index), Global Property (FTSE EPRA Nareit Developed Rental Index).

Opportunities in unloved assets?

While these are both short-term investment horizons and need to be approached with a healthy dose of skepticism, it is clear that a positive sentiment shift towards South Africa (rather than actual fundamentals) has been a large contributor to the sudden surge in the performance of South African assets. The lesson here is that often the pendulum swings too far in one direction in financial markets, which can lead to assets pricing in too much optimism or pessimism. At Morningstar, as valuation-driven investors, we often find investment opportunities in areas of the market that are unloved or have experienced a period of poor performance, resulting in the asset trading below our assessment of fair value.

We have written previously about the SA fixed income positioning in our local rand denominated portfolios as well as our views on South African government bonds. We have maintained overweight positions to SA bonds this year based on our fundamental work on the asset class, a somewhat contrarian investment position, given that a large number of prominent SA managers have been vocal about their negativity towards the asset class. This has resulted in a strong performance contribution from this position over the past 12 months, which has significantly benefitted the investors in our portfolios.

Morningstar’s overall conviction on SA government bonds from H1 2024

At Morningstar, when we assess the attractiveness of different asset classes, we look at four different areas or pillars. Absolute Valuation assesses whether the asset is cheap or expensive relative to its history. Relative Valuation assesses whether the asset is cheap or expensive compared with similar assets. Contrarian Indicators look at evidence of extreme investor optimism or pessimism based on areas including expectations, positioning and sentiment. Lastly, Fundamental Risk considers what potential there is for a permanent loss of capital for the asset. Our capital markets work on SA bonds from the first half of 2024 led to an overall conviction of Medium to High, with the Absolute and Relative Valuation pillars scoring High, which was offset slightly by a Low to Medium score for Fundamental Risk and a Medium score for Contrarian Indicators. In our view, the market pricing justified overweight positions in SA bonds across our portfolios.

Still value in SA bonds after the recent rally?

Following the recent period of strong performance, the question many investors will be asking is whether there is still value in SA bonds and other South African asset classes? Or have they run ahead of fundamentals, to the extent that they are now too expensive? Our asset class work suggests that the recent rally in South African asset classes may have more room to run. As the below chart illustrates, following strong performance from South African asset classes over the past 12 months, the future return expectations for SA bonds, SA equities and SA property have all decreased. This is evident from the downward trending lines for forward looking expected real (after inflation) valuation implied returns (VIR’s), indicating that return expectations have diminished slightly from a year ago. What is apparent, however, is that SA bonds and SA equities are still priced at real return expectations of between 5-6%, despite the recent rally in both asset classes.

Source: Morningstar Investment Management South Africa. Data as at 30 September 2024. Past performance is not a reliable guide to future performance. For illustrative purposes only and not indicative of any investment.

In conclusion – how has the recent rally in SA assets impacted our positioning?

Despite the recent rally in SA assets, we have maintained our overweight position in SA bonds, as we still believe that the asset class is attractively valued relative to our assessment of fair value. We have also maintained our on-weight position in SA equities, which balances the attractive valuations with potential short-term outcomes influenced by idiosyncratic and global risk factors. SA property is an asset class where we did decide to take profits earlier in 2024 in more aggressive portfolios, as the rally led to the asset class trading at levels above our assessment of fair value. Given the performance of SA assets versus global assets in 2024, the level of portfolio drift or deviations from our target weights reached levels which in our view required action across our Regulation 28 range of portfolios (outside of SA Multi Asset Income). We have used this opportunity to rebalance all portfolios in this range during October to reduce SA equity and SA bond allocations and top up global exposure at a more attractive entry point, given the recent strong moves in the rand. We are optimistic that these portfolio decisions will be beneficial for the future return prospects of client portfolios.

ENDS