There’s certainly no shortage of things to worry about at the moment – and, as with all things unknown and uncertain, it’s human nature to speculate on how things will unfold.
Although we have no real control over the outcome, being mentally prepared for a certain outcome brings a kind of comfort, especially when it comes to our investments. Predicting outcomes for life is one thing, but humans are notoriously bad at correctly predicting markets and the impact subsequent events might have on their money.
In the words of Warren Buffett: “Forecasts can tell you a lot about the forecaster; they tell you nothing about the future.
The mathematical equation for the forecast is actually quite simple and consists of only two factors. The big trick in this seemingly simple test is that you need to have both factors correct, and both predictions correct, to succeed and capitalize on the situation:
- First, you need to predict the event itself;
- Second, you need to predict how the market will react following the event and what effect it will have on your money/investments.
Let’s say you are exceptionally good at predicting and succeed 70% of the time – the odds are still the same as if you tossed a coin, as shown in the equation below:
Probability of correctly predicting the event
x probability of correctly predicting market reaction
= 70% x 70%
= 49% (same probability as tossing a coin)
Statistically, the likelihood of you getting the right answer from speculation and prediction (even if you’re pretty good at it) is very low, 25% in fact.
At Morningstar, we pay little attention to forecasts. We don’t try to predict outcomes – instead we focus on the facts, assess assets to understand their value and price (and hope there’s a lag), then build protection into our portfolios by additional precautionary measure.
Let’s take a look at some factors that investors in South Africa might find themselves speculating on lately…
Is the local lekker or not?
In our opinion, the local is very lekker at the moment. Even amid factors such as Russia’s invasion of Ukraine, US inflation above 8% and the possibility of a global recession, things are looking up for South African assets. .
- Let’s start with the economy – are we sinking or swimming?
At the end of 2019, a big concern for markets and investors was whether South Africa would be downgraded to junk status by all major rating agencies in 2020. As you may recall, soon after At the start of 2020, South Africa was downgraded to junk status by the last of the major ratings agencies, Moody’s, with further downgrades to below investment grade territory occurring thereafter.
Over the past two years, we have seen some improvements – for example, last month Moody’s revised our outlook from “negative” to “stable”, noting that South Africa’s fiscal position had “significantly rectified”.
Factors that contributed to the change in sentiment and improved outlook for South Africa were largely driven by the amount of tax revenue collected due to high commodity prices and increased demand for resources (including we have a lot).
In fact, the South African Revenue Service (Sars) broke a revenue record last year and collected over R1.5 trillion in net tax revenue in 2021/22. This is an increase of 25.1% over the previous year.
Sars delivers impressive results for 2021/2022
Improved tax revenue supports South Africa’s recovery and growth
South Africa is a net exporter of commodities and precious metals and has been a net beneficiary of supply shortages suffered due to the current sanctions imposed on Russia. The demand for what we produce has increased and the supply has been reduced, which means that prices have increased to reach this new equilibrium.
In March, we saw manufacturing sentiment hit its highest level in almost 23 years and hit the highest monthly reading since record keeping began in 1999.
- What about South African asset classes?
In the first three months of the year, we have seen global equities fall 13% in rand (5% in USD) versus South African equities, which are up 4% in rand.
This represents a performance gap of 17% in rand terms in just three months. While some of the easy money may have already been earned, we still see good value in certain stocks and market segments, and this is reflected in our clients’ portfolios.
Read: Morningstar expects SA stocks to excel
South African bonds are an asset class we’ve been talking about for some time. Our government bonds offer investors a yield of around 9.5%. Compare that to cash, where you can get 4% in the bank, and inflation, which is currently 5.7% (and rising). Simply put, you are being offered a real return of over 3.5% on South African government bonds versus a near negative 2% real return on cash.
Yes, government bonds are more volatile than money market instruments when viewed in isolation, however, when held in a portfolio of foreign equity and assets, South African government bonds offer a healthy yield and the potential for capital gains if yields fall.
Then there is the rand. For most South Africans, this is a one-sided bet and a slippery downward slope for the South African currency against major developed market currencies.
It is hard to imagine that 11 years ago (April 2011) the rand was 6.11 rand to $1.
Given the war in (Eastern) Europe, high geopolitical risk, rising interest rates and a possible recession, it’s safe to say that most South Africans would probably have bet on the weakening of the rand.
Well, the first quarter of 2022 saw the rand strengthen by 8% against the US dollar. In fact, 2022 has been the best start to the year for the rand since 1993.
We expect that over the long term, relative purchasing power parity (inflation differentials) will boost the rand and based on the fact that we have structurally higher inflation than most developed economies, the rand should weaken in the long term.
Medium-term moves are largely determined by our terms of trade; in other words, how much we export to the world compared to the world’s import. Right now, given the demand for commodities and rising prices, the terms of trade are in our favor and support a stronger rand. Short-term valuation will be determined by politics and sentiment. The sentiment is unstable, and when it comes to our politics – well, everyone guesses that.
- Not everything can be good news – what’s the problem?
Despite the good news on the ground in South Africa, we are certainly not immune to what is happening globally. The first obvious impact is the rise in the price of oil and its effect on consumer pockets and inflation.
As an emerging economy, we are very dependent on oil and it makes up a large part of the consumer price index (CPI) basket.
Over the past two years, we have experienced record high interest rates and inflation. As energy prices soar, we see this trickling down to inflation and, in South Africa, eating away at consumers’ pockets through higher transport costs, higher food costs and higher electricity.
Unlike interest rates which can have a lagged impact on consumers, the price of oil has a direct and immediate impact on consumers’ pockets.
If it’s costing you an extra R500 to fill up your car per month, it’s coming straight out of your pocket.
The pass-through effect of higher oil prices on food and transport will mean that inflation is expected to peak at over 6% this year.
We know that higher inflation will mean the South African Reserve Bank will likely raise interest rates, putting further pressure on an already strained consumer. Add shedding to the mix and there are real headwinds threatening the good news listed above.
- What do higher inflation and interest rates mean for your investments?
When inflation is high, real assets such as commodities, materials, gold, and inflation-linked bonds tend to do well.
Profitable businesses that generate good free cash flow also do well in this environment; unlike growth companies whose cash flows are highly dependent on uncertain future results.
While we cannot predict where the price of oil will stabilize and how these events will unfold, what we can do is build hedges and inflation protection into our portfolios. We did this through several channels.
First, we have significant exposure to commodities and real assets which tend to do well in times of rising inflation. We have a large overweight allocation to South African government bonds, which offer investors real yields of over 3% and nominal yields of over 9%, protecting investors against adverse capital flows.
Additionally, we have exposure to inflation-linked bonds in our more conservative portfolios which perform well in times of rising inflation.
Investors should remember that returns do not occur in a straight line and rarely occur when expected. Separating emotion/sentiment from an investment portfolio is essential.
Oftentimes, the most beleaguered investments turn out to be a great opportunity for future returns, as investors can access these investments at a good price.
Volatility creates opportunity, and short-term underperformance can translate into a solid longer-term upside.
A well-diversified portfolio designed to achieve your investment goals while staying within your risk tolerance is a much better solution, and far more likely to result in long-term investment success than trying to buy the yesterday’s winners.
Investing is a marathon, not a sprint. If you have a 10-year investment horizon, remember to keep a long-term view – don’t worry too much about your returns for the first three to five years. When it comes to investing, patience pays off.
* Victoria Reuvers is Managing Director of Morningstar Investment Management SA.