Market Observations – Q4 2019

How have our views and portfolio positioning changed?
Starting with our view on offshore asset portfolios, we remain underweight global bonds and global cash, and overweight global equities, with the latter offering attractive valuations in many markets (particularly when viewed relative to bonds), and much higher potential returns over the medium term. During the quarter we reduced our overweight exposure to global equities in response to the strong market performance, and on the back of a year of high equity market returns which was not matched by the same extent of improvement in the global macroeconomic environment. However, because the global equity risk premium on offer remains substantially above both historic norms and global government bond yields, we remain overweight global equities. This view holds true in our higher return-targeting multi-asset funds, where our total offshore exposure remains at around 25%.

In global fixed income, US government bonds became somewhat cheaper during the quarter, but remain cheaper than other developed markets like the UK, EU and Japan, where a wide range of government bond yields are in negative territory. Consequently, the asset class remains unattractive versus equities. We are underweight global sovereign bonds and underweight duration, preferring to hold investment-grade US and European corporate bonds.

For global equities, we reduced our overweight position during the quarter, taking profits on the back of the strong equity rally and in light of our view that the global economic outlook is not as robust as that reflected in current equity valuations. However, we have remained overweight as a whole given the very high risk premium from equities versus global bonds. Emerging markets and currencies continue to be especially well valued on many measures, while the US market is relatively expensive - other markets offer better value.

We continue to prefer the global banking sector, which has underperformed the broader market, as well as certain developed markets where equities are undervalued but fundamentals for earnings growth remain positive, including Germany and Japan. We also find selected emerging markets attractive, including South Korea, Indonesia and China. These overweight positions are financed primarily by an underweight in global bonds, as well as US equities to a lesser extent.

Following December’s rally, South African equities became marginally more expensive during Q4 on most valuation measures: the 12-month forward P/E of the FTSE/JSE All Share Index rose from around 10.9X to 11.6X and the earnings yield fell from 8.6% to around 8.1% in December alone. However, both are still cheaper than the market’s longer-term fair value, in our view. We remain overweight SA equities in our house view portfolios like the Prudential Balanced Fund, and are comfortable with our equity allocation levels. We are cautiously optimistic regarding SA equity market returns over the next three to five years due to the prevailing excessive levels of pessimism reflected in share prices and valuations.

Our house view and real-return portfolios continue to hold resources stocks with exposure to global growth and foreign currency earnings like Anglo American, Exxaro, Sasol and Sappi, as well as global giants such as Naspers and British American Tobacco (BAT). All of these overweight positions added value to our portfolios for the quarter, with rebounds for Sasol, Sappi and Exxaro after suffering losses in Q3.

We have also maintained our overweight exposure to financial shares including Old Mutual, Investec plc, Standard Bank and Absa, which offer attractive valuations with relatively high dividend yields. While Investec added value to our house view portfolios for Q4, the latter two counters detracted from value. We believe Investec’s unbundling and separate listing of Investec Asset Management from the bank operations set for Q1 2020 should unlock value, as the asset management profits and dividends that were historically trapped in the bank will now be distributed directly to shareholders. The unbundling should leave both the UK and the South African banking operations in a well-capitalised position from which they can grow into the future. With a refreshed management team that is now prioritising returns and addressing sub-optimal businesses, we think returns on equity will improve over time. The demerger should also allow for more industry- focused boards and management teams that could unlock further value.

As long-time holders of Trencor, we believe its unbundling of global shipping container group Textainer during the quarter will unlock value -- both stocks could be substantial beneficiaries of improvements in the US-China trade war going forward. Remgro, another group in which we are overweight, also announced an unbundling of its stake in First Rand for Q1 2020. We believe this is likely to reduce the discount in the share price of the holding company going forward.

Also supporting returns was the rally in Quilter and Capital & Counties shares, thanks to the strong Brexit-related rebound in the UK market. We took some profits in these holdings in December. Later in the quarter Naspers and Prosus shares fell and then recouped some losses after Prosus failed to win a takeover bid for UK-based food delivery group Just Eat in a bidding war – this as the market had considered the bid too costly. On a net basis, our overweight Prosus positioning detracted from returns for the three months.

Meanwhile, we are still underweight retail stocks like Clicks, Mr Price, Shoprite and Truworths in our house view portfolios, given the pressure under which local consumers find themselves. Strategically, we do have a holding in Woolworths and a small exposure to Pick ‘n Pay.

In SA listed property we continue to be underweight in our house view portfolios given the higher risks to earnings going forward despite the attractive valuations prevailing in the asset class. We remain concerned about the earnings outlook for the sector, as it faces ongoing headwinds arising from pressure on landlords to reduce their rentals, particularly in the retail space where retailers are facing sluggish consumer spending. Equally, oversupply in office space is negative for listed property earnings currently. We are also underweight in our real return mandates like the Prudential Inflation Plus Fund where we hold significant listed property exposure.

We remain modestly overweight in SA nominal bonds in our house view portfolios, given the very attractive yields on offer, particularly in the longer- dated maturities above 10-years where real yields reached 4.5% during the quarter. This is very high relative to most other emerging market bonds, even those with worse credit ratings than ours. It is also well above our long-run fair value assumption of 2.5%. This part of the yield curve has not rallied as much as the R186 (due 2026), for example. We therefore kept our long portfolio duration as well. We are comfortable with the compensation bonds offer given the risk involved (such as a Moody’s credit rating downgrade).

For inflation-linked bonds, real yields remain attractive for long-dated tenors. However, we continue to be neutrally positioned in this asset class as we believe better value exists in SA equity and nominal bonds, where long-dated nominal bonds have the potential to offer more attractive value over the medium-term and are much more liquid.