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Strat Doc 1Q18 – Strategy and Asset Allocation

24 January 2018

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by Anchor

Here we set out the thesis for our strategy and asset allocation ahead of the first quarter of 2018.

Local equity

Equity returns were robust in 4Q17, with the Capped SWIX Index delivering an 8.4% total return. Gains were quite broad-based across sectors, but this masks the impact of Naspers, whose 18% rise alone accounted for around ¼ of the above gains at an index level. Banks were especially strong, delivering a 28% return.

At an index level, the Capped SWIX re-rated by 5% during the quarter to 13.8x on a 12-month estimated forward P/E basis. We have upgraded our exit multiple assumptions for financials and resources to account for 1) a better outlook for SA following the ANC elective conference; and 2) stronger for longer resources prices given a buoyant global economy. We expect a total return of 15% from SA equities, and maintain our neutral stance. This expectation is discussed in more detail, and at a sector level, in a thematic piece below (Domestic Equity: Politics and Corporate Governance driving outcomes in Further Detail).

Local bonds

We expect domestic bonds to perform well during the year, reflecting both a healthy starting yield, and a degree of capital appreciation. By our estimates, SA inflation will average 5.1% for 2018, whilst US inflation is likely to average 2.1% resulting in a differential of 3.0%. The SA credit premium has narrowed to 1.5% at the time of writing, however, we model with 2.0% which we think is more in line with the long-term average. As stated below, we think that a fair yield on the US 10-year bond will be around 2.75% at year-end. Adding the inflation differential (3%), the credit premium (2%) and the US yield expectation (2.75%) we get to a fair yield on the SA benchmark bond of 7.75%. We are not convinced that the bond will fully move towards these levels against the backdrop of rising rates in the rest of the world. Therefore, we are comfortable with our projected yield of 8.25%. With bonds starting the year at a yield of 8.55%, we are expecting a total return for the year of about 10% on SA bonds. The risk factor with bonds is that our view is predicated on the assumption that SA might avoid a further credit downgrade from Moody’s. However, it is not yet guaranteed that SA has indeed avoided such a downgrade and thus the high risk of a negative surprise remains.

Local property

The SA property market again produced a very good return in 2017. The performance by individual stocks shows very clearly the influence of the currency, and perceptions of its future strength or weakness, and this is becoming a more and more dominant factor. The index statistics show that the benchmark SA Listed Property Index (JSAPY) posted a 17.15% return for the year of which 9.9% was capital and 7.2% dividend. Large index stocks which are in major equity indices as well (particularly Growthpoint and Redefine) were beneficiaries of inflows post the ANC elective conference, but most of the heavy lifting for the year was done by offshore-focused stocks. These included NepiRockcastle post their mid-year merger, Greenbay, MAS Real Estate, Sirius, Fortress and Resilient. 85% of the returns generated comes from the Resilient group of companies, even though yields are only 3.5% to 4% on the aggregated assets. The growth of the offshore component of the property sector has meant that the investment decision-making process continues to change for local fund managers. New capital has been allocated to the stocks which trade at a premium to NAV and can raise equity that enhances return, creating a virtuous cycle. The JSAPY Index is therefore now over 40% comprised of companies that have offshore assets. On a full market capitalisation basis (not free-float adjusted), this moves to over 50% – the first time this has been the case in the SA property market.

Local property companies have struggled in a difficult operating environment. Consumer and business confidence has been low amidst an uncertain political landscape and credit rating downgrades from Moody’s and Fitch. Amongst the casualties this year:

Arrowhead, which is guiding to a 6.5% YoY decrease in distribution in 2018 after 5 uninterrupted years of 6%-plus YoY growth.

Accelerate Property Fund, until recently a bellwether growth story in SA property, is expecting two years of flat distributions.

Texton Property Fund. Although 40% of its properties are in the UK, the Group’s growth forecasts are being questioned by the market and the stock can be picked up at a near 17% yield.

In addition, local property stocks have not been able to tap equity capital markets based both on their higher yields and lack of appetite from investors to deploy into the sector locally. This effectively means a pause in growth unless loan-to-value ratios are very low – a position not many SA real estate investment trusts (REITs) are in.

However, due to a de-rating of the local sector over the last two years our two-factor return model is forecasting 14% return for the next year. In addition, confidence and sentiment should improve as a result of the outcome of the ANC elective conference. We therefore upgrade our position to overweight the sector.

 

SA preference shares

The 0.25% reduction in the prime interest rate in July 2017 resulted in a poor performance in the sector. The de-rating now means that yields look optically attractive. However, the sector suffers from a severe liquidity problem which means that there should be a legitimate discount on the asset class. Current yields are high (ranging from 11% to 13%) but our forecast is a return of 10%, based on two interest rate cuts (0.5%) to come in 2018, reducing the prime reference rate to 9.75%. Given the attractiveness of some of the other categories, Property in particular, and given the fact that it is difficult to forecast exactly how pref shares will react, we recommend an underweight position in SA preference shares.

Global equity

2017 was nothing short of remarkable for offshore equities. The two major equity indices, MSCI World and MSCI Emerging Markets were up 20% and 34% respectively (in US dollar terms), for the calendar year, before taking their respectable dividend yields into account.

It was perhaps even more remarkable for the consistency with which those returns were achieved. The S&P 500 Index has data back to 1928, and in the 90 years prior to 2017 the index had never experienced a year with every calendar month positive. On four prior occasions there had been only one negative month in a calendar year, but 2017 was the first year in history with no negative calendar months (on average, there have been 4 to 5 negative months a year).

In the current year, needless to say, we expect somewhat more modest returns, in the region of 7% in US dollar, and surely with a heightened degree of volatility.

Although global corporates should have another stellar year of earnings growth, somewhere in the region of 25% for CY18, this is already to a significant degree reflected in share prices. We estimate that underlying earnings growth (which strips out the effects of such commodity price swings) is still strong, in the region of 10% p.a. This will not, in our judgement, flow through into price gains as it did last year, but will be meaningfully dampened by PE compression. Hence, we have a more modest return expectation.

Perhaps the main challenge facing global equities at present stems from an environment of rising rates, associated with rising inflation. The latter could simultaneously pressure profit margins and valuation multiples. Rising rates do not affect all sectors equally, indeed some are typically positively correlated with interest rates (e.g. Banks, a sector which we are overweight), while others tend to bear a greater proportion of the burden of rising rates (e.g. Consumer Staples, which we are underweight). The latter sector is discussed further in a thematic note below. Our forecast returns for the major MSCI indices consequently assume a material compression in their respective PE multiples. In spite of this, the fundamentals still suggest a superior risk-adjusted return is on offer in the equity market during CY18. We have, therefore, retained our overweight allocation.

Offshore bonds

We expect minimal returns from offshore bonds as rising rates, albeit by a modest degree, erode bond yields. This reflects our expectation of robust US growth during 2018, which will likely give the impetus for US bond yields to rise further. We note that the US Federal Reserve (Fed) is anticipating 3 interest rate hikes of 0.25% each during the course of 2018. We concur that the economy will be resilient enough to withstand these hikes, even though inflation is not yet feeding through into the US economic system. Our regression model of the fair US 10-year bond yield is derived off the US three-month Libor rate, ISM manufacturing index, net purchases of treasuries and core inflation. We are estimating that a fair yield is 3.37% today, though we continue to hold that the effects of global stimulus will keep rates below this level. We are accordingly projecting a US 10-year rate of 2.75% at year-end.

We expect offshore investment grade corporate bonds to deliver a 1.5% return during the current year. US investment grade credit spreads averaged around 0.9% for the majority of the prior bull market and they seem to be headed back towards that level and potentially lower. This reflects the relative attractiveness of that spread in light of extremely low treasury yields. We retain our neutral allocation to corporate bonds.

Global property

As with global bonds, we expect a relatively modest starting yield to be eroded by rising rates, producing an expected total return of 2.5% in US dollar during 2018.

Distribution yields for European property stocks are at 4%, high enough that a moderate bond sell-off in Europe is unlikely to derail European REITs. The derating is more likely in the US where the indices are skewed towards retail REITs (currently struggling with oversupply) and technology REITS (which have run extremely hard and are most likely to contribute to the majority of the de-rating as incremental growth becomes more challenging).

The following table illustrates our house view on different asset classes. This view is based on our estimate of the risk and return properties of each asset class in question. As individual Anchor portfolios have specific strategies, and distinct risk profiles, they may differ from the more generic house view illustrated here.

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