Where to find real returns in increasingly tricky conditions
As 2016 draws to a close, a look at asset valuations across the globe tells us that, going forward into the new year, returns that substantially beat inflation are likely to be harder to come by for South African investors than they have been in the past few years. Not only is global growth slow, but many assets are expensive compared to their long-term histories. This means that investment managers like Prudential will have to search even harder for attractive sources of real returns, while being ever-vigilant of the risk involved.
So how are we positioning our multi-asset funds to earn the best possible returns over the medium term? From a global perspective, we believe that South African bonds are cheap compared to their long-term fair value, and offer good prospective returns. This follows their weakness stemming from elevated political risk (incidents such as “Nenegate” and threats to the Finance Minister’s position), as well as the risk of a credit rating downgrade, both being priced into yields. Relatively high yields of around 8.7% (for the 10-year government bond) offer attractive real returns on a risk/reward basis. The easing of inflation and diminished likelihood of further interest rate hikes have improved – to an extent – the outlook for interest-rate-sensitive assets like bonds and listed property, despite very slow economic growth.
Local listed property, with a forward distribution yield of over 7% and (conservative) long-term potential distribution growth of over 5%, is priced to deliver low-double-digit returns in the region of 12% in the medium term (in the absence of a market de-rating). This is well above inflation, and we consider it attractively priced relative to inflation-linked bonds (ILBs). As such, we are modestly overweight both SA bonds and listed property (to a lesser extent) in the Prudential Inflation Plus and Balanced Funds.
South African equities, meanwhile, have been trading at levels near (or slightly higher than) their long-term fair value. As such, we are neutrally weighted in SA equities in our multi-asset portfolios currently. We are underweight expensive global heavyweights like Aspen and Steinhoff. By contrast, British American Tobacco is one of our top overweights as a solid defensive stock. We also retain our defensive positioning in Resources, being underweight specialised miners like Anglogold and Implats, while preferring diversified miners (like Anglo American) and non-mining shares like Sappi. We are also overweight financial stocks, including Old Mutual and Barclays Group Africa, whose share prices have come under pressure.
For global equities, our portfolios are currently neutrally weighted generally and compared to SA equities. This follows a run-up in global share prices in the latter part of this year even as company earnings growth has been virtually flat, resulting in a deterioration in global equity valuations. More global investors have been seeking higher returns from the US and other developed equity markets, forced to take higher risk in the face of record-low yields from global sovereign bond and money market instruments. Some European markets do offer value, where concerns over growth have kept share prices under pressure. At the same time, certain emerging market equities are also valued attractively, but we are very selective in our exposure as many also come with relatively high risks. India is a market that we like. In the Prudential Balanced Fund we are near the 25% maximum exposure allowed for offshore equity.
With many developed economies offering negative or record-low yields on their government bonds, we are avoiding these assets, preferring to hold both investment-grade and high-yield corporate bonds which have offered solid returns so far this year. Despite the recent rally in corporate bond yield spreads versus US Treasuries, they remain around their long-term historic averages and therefore close to fair value. At the same time, our portfolios are underweight duration and overweight cash to protect against the increasing risk of interest rate hikes.
In conclusion, we would caution investors to expect continued volatility in financial markets in the new year as the US continues on its interest rate hiking path and other factors like Brexit and slow growth in major economies (and in South Africa) continue to weigh on sentiment. With many asset values elevated compared to their long-term histories it will be difficult for returns – especially from global bonds which have rallied to unsustainable levels -- to measure up to their longer-term performance.
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