Guiding our perception of risk is crucial to achieving our financial goals

Like a pen and paper, soap and water and salt and pepper, so too risk (and reward) goes with all investments. Carl Richards points out in his blog – “Risk is what’s left over after you think you’ve thought of everything”. He goes on to explain that investors are good at managing and dealing with risk by looking backward and preparing themselves to deal with a situation they have already seen, only better this time. But we’re not good at preparing for something we can’t imagine.

If we could count on riskier investments to produce higher returns, would that not mean that it would not be risky in the first place?

Consider this example: If you buy something for R10 and sell it a year later at R20. Was it risky or not? Some might argue that the profit you made proves it was safe, while the academics would say it was clearly risky since the only way to make a lot of money (100% in this case) is to take a lot of risks. Both sides of the coin could be true – it could either have been a very safe investment that was sure to double or a very risky lottery bet.

We all have to deal with the fact that we just don’t know how the future will play out, especially when it comes to financial markets. All investments have risk but these risks come in many shapes and forms, and guiding our perception of risk when it comes to investing is crucial to achieving our financial goals.  

What is risk?

“Investment risk is the possibility that an investment’s actual return won’t match its expected return.” Risk means different things to different people. Some investors could see risk as a drawdown, as we saw in March 2020. For others, risk could be underperforming the index or even underperforming a peer group average. Investors also have different levels of risk tolerance.

The most common definitions of investment risk are rooted in uncertainty. What is the likelihood of the returns on my investment deviating from the expected returns, and by how much? There are a variety of ways to measure this likelihood, the most common measure being volatility or the standard deviation of returns.

Volatility (standard deviation) helps investors understand how extensively returns could fluctuate from their average. It is a metric that is simple, widely accepted—but not helpful at all.

Standard deviation falls short in several ways –

• It treats downside risk (the bad kind) and upside risk (the good kind) as equals.
• Standard deviation doesn’t measure the shape of the distribution of returns. Meaning, if we look at all the return observations of a certain asset and/or asset class, how frequent are these return observations positive and/or negative
• It does not directly size the magnitude of unexpected events—those episodes that result in the greatest euphoria or fear.

There are a host of other definitions of risk that are far more important when we want to achieve our financial goals, let’s unpack some of these below.

1. The risk of opportunity cost

Opportunity cost creates the possibility that the return on a selected investment is lower than the return on an investment not chosen.

The below graph illustrates –

• • A hypothetical stock/bond portfolio, with different asset allocation weightings, over the past 20 years
  • For example, the 80-20 portfolio indicates an 80% investment in equity (FTSE/JSE All Share Index) and a 20% investment in bonds (FTSE/JSE All Bond Index).
  • The blue bar showcases the returns
  • The red bar showcases the volatility
  • The grey line illustrates the risk-reward ratio. The lower this ratio – the less volatile a portfolio has been in comparison to the return generated from the portfolio.

A couple of observations:

• • An all-stock portfolio has the highest risk/reward ratio but also produces the highest annualised return over the 20-year horizon.
  • The 60/40 and 40/60 portfolios have a very similar risk/reward ratio.
  • The risk/reward ratio increases as you move to an all-bond portfolio.
  • An investor would have benefitted from having at least 40 – 60% in equities as opposed to having no exposure to equities.

Although equities introduce volatility to a portfolio they also bring additional returns which is needed when there is a target to outperform inflation over time. The risk of not having enough risk in a portfolio can be detrimental to a long-term financial plan.

2. Concentration risk

This is likely where the phrase “don’t put all your eggs in one basket” is most appropriate – due to concentration risk in investments. No asset class has a perfect strike rate and performs well all the time. It is also very unlikely that every asset class will perform well at the same time. It is for this exact reason that diversification within a portfolio is key.  

The most important rule of trying to manage risk is to have different assets and/or asset classes that are drivers of return in an investment portfolio at different times and in different market environments. This strategy is designed to capture opportunities in strong market environments and provide downside protection in weaker ones (in other words, when one asset under[1]performs, returns are protected and achieved by other asset classes that perform well when others might not).

The graph below shows asset class returns on a calendar year basis, and it is evident by looking at this chart that it is very difficult to predict which asset classes will outperform each year. Let’s use the first asset class “Global bonds” as an example – it most certainly wasn’t a sure bet and a fairly bumpy ride.

Similarly, when we look at managers within an investment portfolio it is very important to have different styles and managers who perform differently. As with asset classes, no manager has a perfect strike rate.

The below graph shows the top four performing general equity managers for 2022 (excluding FoF’s) ranked by year-to-date returns. It then shows the four bottom-performing general equity managers (excluding FoF’s) ranked by year-to-date returns. In addition, it also indicates their corresponding rank in the last six calendar years.

Let’s put these rankings into context.

• • Within the ASISA Equity General category, there are 101 funds.
  • If we look at Fund B as an example,

− This fund is the second-best-performing equity fund in 2022 and 2016. It was the fourth-best-performing fund in 2021.

− It was one of the worst-performing funds in 2020 and 2019.

• • Similarly, when we look at Fund F,

− This fund was the best performer in both 2016 and 2019 and the third best in 2021.

− It was also the worst-performing in 2017 and the third-worst in 2022.  

Blending managers with diverse styles who perform differently over time, rather than trying to pick the best-performing manager each year adds a lot of value to client portfolios.

3. The risk of falling short

The last risk is the one investors should be most concerned with because the risk of not reaching your financial goals has a much larger impact on your life and well-being than the volatility (standard deviation) of your returns ever could.  

High risk, high reward is a widely used phrase when it comes to investing. To be able to generate higher returns you need to be able to accept higher risk. The risk of falling short of your financial objectives is real and this can get amplified by investors being in the wrong strategy over their investment horizon.

Consider the example of an investor that has been invested in the wrong strategy for a long period of time.

The table below shows –

• • An investor who contributed R1 000 per annum for 30 years in different strategies.
  • These strategies range from targeting inflation (assumed to be 4,5% for this example) to inflation + 5% (your typical balanced portfolio strategy).
  • A very simple calculation will show you that over a period of 30 years –

− If you underperform by 1% – you end up with 17% less retirement capital.

− Increasing that to 3% (i.e. achieving inflation +2% rather than inflation +5%) equates to 43% less retirement capital. A more practical example would be the difference between investing in a cautious portfolio and being invested in a balanced portfolio.

− Ultimately, the proof is illustrated in the numbers – as can be seen in the bottom row.

Key takeaways

When thinking about risk you want to identify the thing that worries you and demands the most compensation for bearing and/or beating it.

What we know to be true is that:

1. 1. Risk in financial markets is unavoidable
   2. Having equity in a portfolio brings about volatility
   3. Having only cash brings about the risk of opportunity cost and not managing to keep up with inflation
   4. Being in the wrong strategy out of fear brings about the risk of falling short of your financial goals.

Don’t think about risk as something to be avoided altogether. A fundamental premise of investment theory is that to get returns beyond the risk-free rate, we must embrace some level of risk. A longer time horizon does not excuse us from the shorter-term volatility we experience over time but, riding out shorter-term volatility will give you a greater chance of overcoming your biggest risk which is not meeting your goals.

Raoul Gordon

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Market volatility and how to train your brain

The pilot’s famous answer, when asked about his job, is, “Hours of boredom punctuated by brief moments of terror”. This applies perfectly to investing, with the brief moments of terror being the rise and fall of markets. We could argue that we have just lived through one of the worst nine-month periods in history, not only for stocks but also for bonds and even more so for the much-loved 60/40 (60% equities, 40% bonds) portfolio.

At this point in the market, investors may feel the need to understand every headline and the immediate impact it can have on their investments. And as we devour every article and/or watch every daily, weekly and monthly drop and rise in our investment portfolio, it becomes extremely important to know and acknowledge our behavioural biases.

What is worse – action or inaction?

Our minds take shortcuts every day when we make decisions. Like deciding to stick to a more familiar brand when buying an item. Usually, these shortcuts are for the better, they help us react quickly and help us manage the thousands of decisions we have to make every day.

There are times, however, when mental shortcuts are not helpful and tend to lead us astray, and that’s when they become biases. What is a bias? Behavioural biases are irrational beliefs or behaviours that can unconsciously influence our decision-making process.

Markets have been brutal and it might feel like they are only going one way, and that is down. Taking action seems like the only rational decision to make. A common bias is called the Action Bias, and is best explained by the sentiment of “well, at least I tried.” This common consolation can be comforting and justified in many decisions, but not in all circumstances.

In some situations, it can be better to do nothing. The chart below shows the effect of moving to cash during a market downturn, using the Global Financial Crisis as an example.

• An investor who capitulated and moved to cash during the Global Financial Crisis would have ended with an investment portfolio of $160 096
• An investor who stayed the course would have ended with an investment portfolio worth $523 740 The difference equates to $363 644.

In our minds, it hurts less to try something and lose, compared with doing nothing and losing anyway. During times of market volatility, if investors don’t calmly think about the appropriate course of action and give in to action bias, it can make losses objectively worse despite feeling subjectively better. It is important to acknowledge that inaction is also an active decision.

Investors are inherently loss averse, meaning we hate losses more than we love gains.

One of the most well-known and often-cited behavioural biases is “Loss Aversion”, and it too can be especially prevalent during market volatility. A 20% portfolio loss feels a lot more intense than a 20% gain for many investors and experiencing a loss generally feels twice as bad as gaining the same amount feels good.

This strong emotional reaction to losses and the need to “do something” can cloud our judgment during times of volatility and it is critical to acknowledge that losses are a part of a well-functioning market. If markets never experienced losses, they wouldn’t be risky, if they weren’t risky, they would get really expensive, when they get really expensive, they experience losses.

Learn to accept constant and guaranteed turbulence

Over the last 20 years, the average return for the S&P 500 and the All Share Index has been about 11% and 15% in rand terms. Investing our hard-earned money in the stock market would be a lot simpler if we could rely on earning 11-15% every year without any volatility. But that is not the reality, throughout our investment horizon we will have to endure constant and guaranteed volatility.

Historically in both local and global markets, every year has had a “moment of terror” or drawdown and the chart below looks at the S&P 500 annual returns in the blue bars and the maximum drawdown of each year in the red dot. The maximum drawdown shows the movement from the highest peak of the market in that year to the lowest point. This chart shows that every single year of the 35 years had a maximum drawdown, while only 10 of the 35 years ended the year in negative territory.

The four most expensive words in investing are likely to be “this time it’s different”

During a boom, greed dominates. After the crash, the residual emotion is fear. If we look back to March 2020 it was the most volatile month since the Great Depression. An overwhelming amount of headlines read, “this time it is different”, this was a pandemic, unprecedented times, markets would take years to recover, if they would ever recover. But, it was the fastest recovery we saw in stock market history.

During the sell-off in 2020, we reached a bottom in the market on the 23rd of March 2020. Historically it has taken the market about two years to recover from a drawdown of this magnitude. This time it happened in 149 days and at the end of August 2020, the market had already reached new highs.

Now that we look back, it seems obvious that the market would recover.

Hindsight is 20/20

Many events seem obvious in hindsight, this is called Hindsight Bias. This bias tends to occur in situations where we believe (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact the event could not have been reasonably predicted. Identifying when things really are different and when the collective madness of the crowd is in full force is the difference between sitting out a market rally or participating in it.

In an article by Morgan Housel, he speaks about how important it is to remember that most of our lifetime investment returns will be determined by decisions that take place during a small minority of the time. Most of these periods come when everything we thought we knew about investing is thrown out of the window.

We all know to expect things like market volatility and inflation, but the emotions we feel while they occur can be even more dangerous than the market movements themselves.

Carefully consider both sides of the argument

Learning to embrace the downturns is easier said than done. We tend to seek out information that supports our beliefs, such as that the stock market will never recover, rather than seek information to the contrary. This is Confirmation Bias in action.

Let’s consider an investment example of confirmation bias. It is December 2015 in the midst of Nenegate, the finance minister had just been fired, the 10-year bond yield had just hit a record high of 10,4% causing a sell-off in the bond market and the rand depreciated to more than R16/$.

You feel strongly that South-African bonds are set to experience significant losses, and the rand will continue to weaken, the economy is on the brink of collapse. You seek out every news headline and/or research that confirms your belief and you plan to move your fixed-income holdings to cash as a result.

Right before you make the change, your financial adviser shows you the probability distribution of historical bond yields and points out that South-African government bonds are offering attractive value at this point in time. When presented with this data, you say to yourself, “This is crazy. This would never happen” and you move ahead with changing your portfolio.

What happened in the next two years, between January 2016 and March 2018? South-African government bonds returned 15,23% annualised while cash returned 7,45% annualised over this period.

Remember to consider both sides of the market noise and movements when reading the news or looking at your investments. It might seem like the only decision is to move to cash during times of market volatility, but as we’ve shown above, the other side of the argument proves much more prudent.

Switch on autopilot and sit tight

For investors, it is critical to acknowledge these biases and make good decisions in volatile times. Making big changes when there has been no change in your time horizon, circumstances or needs can be detrimental to your long-term financial plan. Stay on autopilot during the turbulence.

When stress and anxiety are high, it’s easy to give in to our biases and let them cloud our better judgments. Research shows that understanding our biases can help us spot them in our decisions which can add immense value to our financial plan over time.

When you find yourself questioning your investments, and being down and out about the market, set up some time to speak to your financial adviser, who will be best placed to paint a realistic picture for you of what is really transpiring in markets and what action – or rather inaction – would be best suited to your unique investment needs.

Raoul Gordon

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

There’s an old saying in the world of fitness – “summer bodies are made in winter”, meaning that, although it is common for us to let our fitness regime slip in winter, it is actually the season we should be using to get our bodies in shape for summer. If one had to apply the same logic to finance, it could be something like Oscar Wilde’s quote – “when I was young, I thought that money was the most important thing in life; now that I am old, I know that it is.”

Now and then we all get a little complacent with life. Sometimes we exercise less during the cold winter months, and we eat a little more comfort food. The best of us sometimes lose sight of our goals (whether it is health, career or finance related) or maybe we get lazy with things like budgeting and saving. In South Africa, 1 September is known as Spring Day, signaling the approaching change in season from winter to summer. This time of year is known to act as a trigger for people to tackle their annual “spring cleaning” ritual – they get rid of old or unused items, deep clean the house, and do some general reorganizing. It is also a time when people start questioning their fitness routine, spending more time outdoors and unpacking and trying on those summer clothes again. I would like to suggest that we all start the habit of using Spring Day, as a day to trigger the reassessment of our savings as well.

It’s been an extremely challenging decade for many South Africans, and it is okay to feel exhausted, emotionally, and physically. It is okay to feel a little run down and behind in your goals. The wonderful thing about spring is, that it reminds us that life continues. New flowers will soon bloom, the sun will shine a little longer as each day goes by, and the temperature will start to rise. Seasons do change, and so can we. Spring is the perfect time to dust off your financial plan and re-assess whether it requires some tidying-up. Now more than ever is important to get back into financial shape. 

Back to the basics

A good starting point to get back into financial shape is to take stock of where you are. Make a list of all your assets, liabilities, monthly income, and monthly expenses. This will give you a good indication of what your financial position looks like and it is important to be honest with yourself here.

• Assets refer to anything that you own, for example, property, investments in shares, unit trusts, money that is owed to you, and cash in the bank.
• Liabilities refer to your debt, outstanding payments and loans – for example, your home loan/bond, car loans, student loans, credit card debt, etc.
• Income can include your salary, rental income, interest, and dividends earned.
• Expenses include all your fixed expenses – for example insurance payments, levies, medical aid, as well as variable expenses (like groceries and electricity).

Start with the end in mind

When you know what your goal looks like, it is much easier to visualize and plan how to achieve it. Make sure your goal is well-defined, obtainable, and realistic. For example, if you want to lose 10 kilograms over the next couple of months, your plan will look very different to that of someone whose goal is to run a marathon. Although being fit and healthy are the ‘means’, the end is very different. Know what you want your end to look like.

Perhaps it is a comfortable retirement, perhaps it is saving enough to start your own business. Whatever it looks like, it’s important to establish clear goals so that you know exactly what you are working toward and what you need to do to get there.

Budget, budget, budget

You can’t identify your healthy (and unhealthy) financial patterns until you put a budget in place. Your budget is essentially a plan for how to spend your money each month. Look at your spending over the last few months (or compare the same month with that of a year ago) to get an indication of what you usually spend in each category. There are many budgeting templates available online if you get stuck.

In the wise words of James W. Frick – “Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.”

The key to setting up a successful budget – even for a beginner – is that you must monitor how far you are sticking to or deviating from your budget. Keeping track of your monthly income and expenses against your budget will give you a much better view of where your money is going, show you where you are overspending and/or where you are saving. That brings me to the next point.

Spend what is left after saving – pay yourself first

Saving should be part of your budget. The easiest way to prevent yourself from spending what you should be saving is to set up a monthly debit order and let it do the work for you. Warren Buffett’s words will always ring true – “Don’t save what is left after spending but spend what is left after saving”.

You can use your annual tax-free savings contribution allowance of R36,000 (that’s up to R3,000 per month), increase your retirement annuity contribution and/or save by using other products available at your disposal, such as unit trust investments.

It is important to note that, it’s the habit of saving that matters most, and less so the actual amount. Of course, the more you save the better, but getting into the habit can be the hardest part. You will be surprised how rewarding it is to see how quickly you can build up a nest egg and the incredible power of compounding.

Have you invested appropriately for your risk profile?

As we enter new or different phases in our lives, our risk profiles can change. It is a good idea to take stock of all your investments and do an asset allocation check on an annual basis. Have you invested appropriately for your risk tolerance, time horizon, age, and financial circumstances? Do you have enough offshore exposure? Perhaps you have been de-risking too much or taking too much risk.

Tax

A small word that often evokes big emotions is ‘tax’. Whether we choose to talk about it or not, the reality is that tax is inevitable. What you can do as part of your spring-cleaning exercise is to get a professional to assess whether your financial plan is structured in the most tax-efficient way possible.

In addition, tax return season is open – SARS has announced that their filing season will run from July 1 to October 24 for individual taxpayers, so get those tax returns filed nice and early.

Insurance and risk policies

Perhaps part of reviewing your financial plan should be to do a check to ensure that all your short-term insurance, medical aid, and other policies (for instance life cover, disability cover, severe illness, etc.) are still relevant and accurately reflect details about your circumstances and beneficiaries. Consider if it is time to add or remove policies. 

Will

As part of cleaning up your act and getting back into shape, consider having a look at your will. Do you have one? Is the information, assets, beneficiaries, etc. still relevant and applicable? What can you remove and what should you add?

Consider your emotional well-being as well

Most definitions of financial health are very one-sided. It often focuses only on economic or financial stability. Ignoring your emotional well-being could be a recipe for disaster.

Being financially healthy is not just about having enough money to cover your expenses—it’s also about feeling emotionally at ease with your finances. People who feel empowered in their financial lives also experience more joy, peace, satisfaction, and pride concerning their finances.

Conclusion

Getting back into shape can be a daunting task, so take it one step at a time. It is recommended that you review your financial plan at least once a year (barring any life-changing events that might take place in between, such as getting married, having a child, losing your job, etc.). If you haven’t done so in a while, don’t lean into the temptation to bury your head in the sand and ignore the issues that might exist – the solution is often more achievable than you think.

The key to being successful is to stay motivated throughout the process. Now and then you are going to have a setback. You are going to give in and eat that decadent slice of chocolate cake and/or dread your next workout. And that is okay. As long as you keep doing your best and get back on track as soon as possible.

Share your goals with your financial adviser and family to keep yourself accountable, break down your goals into smaller steps, and reward yourself when you hit major milestones. With patience and commitment, you can improve your financial situation and rest easier about your future.

Raoul Gordon

Raoul Gordon

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

It’s been an interesting year for investors. Given the state of the global economic outlook, there has been a lot of talk of an impending recession, or even that we’re already in one. Understandably, this may leave you feeling nervous. Recessions may elicit fear in us, as we might expect a slower economy to affect both our portfolios (through lower investment values) and broader lives (through less income or a job loss). The implications of a recession tend to play games with our emotions and often drive us to make bad decisions.

What exactly is a recession? The technical definition is two quarters (six months) of negative economic growth, measured by a declining gross domestic product, or GDP. GDP is the total market value of the new goods and services produced during a specified period. More simply, a recession describes a shrinking economy rather than a growing one.

As counterintuitive as it may sound, recessions can be a great time for investors, because prices can become lower than they normally are. That gives your investment manager an opportunity to buy assets more cheaply and, in so doing, sow the seeds of future growth. The problem is that recessions create uncertainty around the future and thus it does not feel like a great time to invest, so some investors are tempted to pull money from their portfolios. This typically leads to selling at depressed prices, locking in losses.

The best thing we can do is to be prepared, should we find ourselves in a recession, by having a few rules in place to help us make better decisions and know what to do. Here are a few habits that can help protect your savings in a slowing economic environment.

1. Take some time to make sure your financial position is secure. In a recessionary market, it’s a good rule of thumb to make sure you have a cash buffer and that your portfolio includes exposure to assets that can thrive in a depressed environment. If you are unsure about this, take some time to check in with me to make sure your total financial position is still appropriate for your goals.
2. Remember the rules of wealth attainment. Namely, save early and often, and invest your savings in a portfolio that reflects your risk tolerance. Then let the power of compounding grow your wealth faster than inflation. In a recession, fear may drive some people to stop saving and/or choose a more cautious portfolio. But, as we’ve said, some of the best returns historically have been recorded during rebounds from recessions. Taking a break from markets can mean missing out.

Given the current environment, staying invested can be easier said than done. I encourage you to give me a ring if you have any concerns, or if your financial situation has changed and you think that warrants a rethinking of your investments. Regardless, save every little bit you can, as we’ve discussed.

3. Don’t sell out. We all know the old adage, “Buy low, sell high”. Yet, when fear drives you to move to a more conservative portfolio, you sell stocks low (again, locking in losses) and buy bonds high (increasing the chance that they’ll return less or even lose money over the long run). The start of a recession is not the time to liquidate your investments. Depending on your time horizon, you most likely have enough time to ride out short-term stock price drops if you stay focused on the long term.

A recessionary environment could even be a time to increase your contributions to your portfolio. By saving when the market is down, you’ll likely buy low. This brings me to my next point.

4. Stay the course by averaging in. With uncertainty in the air, holding together your finances can be tough. Therefore, it’s a good idea to set accounts on autopilot to avoid the temptation of hoarding cash under your mattress. Automated savings plans take the guesswork and hesitation out of your present self and help attain your financial goals.
5. Think long-term and keep concentrating on your goals. It’s important at all stages of the market cycle to think about the goal of your investment portfolio. Ignore short-term performance in favour of your progress toward your goals. If you do that consistently, it’s really going to help you to continue investing through this or any recession.

Above all, let’s remain focused on the long term and avoid being spooked by the “R word”. We should all expect at least one recession over our investment horizon (likely many more) so we should try to make the most of it.

As always, please let me know if you would like to discuss this or anything else in more detail.

Raoul Gordon

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

On 23 February 2022, Finance Minister Enoch Godongwana delivered the annual budget speech, providing an update on South Africa’s finances. 

Low economic growth, vast unemployment, increasing debt levels, coupled with South Africa still being in a state of disaster two years since the start of the Covid-19 pandemic, all contributed to a complicated juggling act for the Minister of Finance. 

Given the unrest witnessed in 2021 along with weak foreign investment, the 2022 budget had to be geared not only to curb unemployment and to stimulate economic growth, but to also give assurance to foreign investors. 

In the words of Minister Godongwana “we need to strike a critical balance between saving lives and livelihoods, while supporting inclusive growth. This budget presents this balance”. 

 Some key aspects to consider that has affected spending potential and therefore, economic growth: 

• An already high unemployment rate that was exasperated by Covid-19. 
• A lot of companies had to implement retrenchments and/or salary cuts, leading to lower household income and therefore lower spending. 
• Lower income levels also directly impact the amount of personal income tax and VAT that is gathered. 
• Inflation has increased to 5.7% – placing increased pressure on low-income bracket tax earners. 
• The emigration of highly skilled workers has increased. 
• Higher commodity prices, which supported the economic recovery, slowed in the second half of 2021. 
• Industrial action in the manufacturing sector, and the re-emergence of loadshedding, also slowed the pace of the recovery. 
• Continued requests for financial support from financially distressed state-owned companies. 

According to Minister Godongwana, “only through sustained economic growth can South Africa create enough jobs to reduce poverty and inequality; enabling us to reach our goal of a better life for all.” 

 Revenue, deficits, and debt to GDP according to the 2022 budget: 

• Tax revenue for 2021/22 is estimated to be R1.55 trillion, exceeding the original budget estimate by about R182 billion. 
• Higher income levels have been primarily driven by the resources sector due to increases in commodity prices. 
• The budget saw higher revenue from other sectors and other tax instruments, such as personal income tax, value-added tax followed by corporate income tax. 
• Government debt has reached R4.3 trillion and is projected to rise to R5.4 trillion over the medium-term. 
• The consolidated budget deficit is projected to narrow from 5.7% of GDP in 2021/22, to 4.2% of GDP by 2024/25. 
• The debt ratio will stabilise at 75.1% of GDP by 2024/25 (which is 3% lower than projected in the MTBPS). 

Below is a quick overview of some of the key updates announced in the budget speech: 

Tax credits and rebates: 

Levies, duties, and charges: 

Other areas of tax collection that were introduced and/or increased for the first time in a while: 

Disclosure of wealth will be required to assist with the detection of fraud 

To assist with the detection of non-compliance or fraud through the existence of unexplained wealth, it is proposed that all provisional taxpayers with assets above R50 million be required to declare specified assets and liabilities at market values in their 2023 tax returns.¹ 

Retirement fund taxation and reform on the cards 

Changes have been proposed to allow for greater investments into infrastructure funds by Regulation 28 compliant funds. Amendments to Regulation 28 are expected to be gazetted in March 2022. 

There are proposals to allow members access to one-third of their retirement fund savings while the two-thirds balance must be preserved for retirement. The tax consequences of these changes are still being considered. The draft legislation on these amendments will be published for comment in the middle of the year. 

In conclusion 

Given the endless stream of hardships that South Africans have had to face since the outbreak of Covid-19 and its devastating aftermath, the 2022 budget was expected to be consumer-orientated, and it has delivered on expectation. Given the fragile state of the economy and the country’s growing debt burden, National Treasury faced a difficult balancing act between providing the necessary relief to consumers and businesses while also taking steps to improve the country’s fiscal metrics. 

Minister Godongwana shared this view and stated, “…in these trying times and without compromising our ability to collect revenue, we have managed, through these tax proposals, to keep money in the pockets of South Africans, and to create conditions for greater investment in the economy”. 

According to Treasury, if the personal income tax brackets were not adjusted, revenue would have increased by R13.5 billion. This relief is mainly targeted at individuals in the middle-income group. 

The government’s main task will remain to create jobs, to ensure that we continue to grow and stimulate the South African economy and to keep government spending low. 

Perhaps the most crucial element of the budget was the continued commitment to the fiscal stabilisation programme, with the restriction on increases in public sector wages being a vital component. As we have seen from previous budgets, implementation risk is high, given the politically unpopular move of restricting wage increases. This restriction is likely to continue to be contested by labour unions. Fiscal prudence going forward will be essential if South Africa is to avoid a debt trap in the medium term. 

Useful links and resources: 

• Budget 2022 Highlights 
• Budget 2022 Tax Guide 
• 2022 Peoples Guide (English) 

1 Source: http://www.treasury.gov.za/documents/national%20budget/2022/review/Chapter%204.pdf

 Michael Kruger

Investment Analyst
Morningstar Investment Management
South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

At face value, it appears as though markets have performed well, however, broadly speaking there have been some landmines that simply could not have been avoided by all investors. 2021 was also by no means a dull year – global bonds bottomed out, the Evergrande debacle, Chinese tech stocks slumped and the contagion of it all to emerging markets. 

 If we look at the various asset classes across the calendar year, the first point that stands out is the broad positive returns across all the nine asset classes in 2021 (as can be seen in the chart below). The second is the rotation in the ranking, highlighting the importance of diversification.

 Looking at local markets in 2021 

•  S.A. Equities are making a comeback
  After a seven-year drought of returns for domestic equities, the past 18 months have seen a strong rebound in S.A. equities with broad-based returns across the sectors. While 2020 saw resource shares (mainly platinum and diversified miners) performing well, 2021 saw a rotation into more unloved areas of the market. Looking back at 2021, the strongest performing areas were what we would term “S.A. Inc.” shares, namely banks, retailers and select industrial shares. 

  What caught many investors by surprise in 2021, was the sharp fall in the Naspers and Prosus share price. Market darling Naspers, combined with Prosus (its European listed counterpart) account for almost 20% of the All-Share Index. A combination of concerns regarding the Chinese government’s interference in their market with regards to the new regulation for select tech companies alongside the disappointment surrounding the Naspers Prosus share swap and/or company restructure has proved to be strong headwinds for these shares.

   

• Fixed Income, wasn’t so ‘fixed’
  Fixed income managers did not have an easy year, with 2021 not being the year for income assets. What had appeared to be a stable (and dare I say “boring” asset class) was no more, as 2021 saw fixed income assets experience a lot of volatility.

   

• S.A. Government bonds bamboozled
  S.A. Government bonds remain perplexing. We are seeing good value in this asset class, with S.A. government bonds offering a yield of around 9.5%. This is almost 5% ahead of cash and 4% ahead of inflation, which is unheard of in global markets. Yet despite this attractive yield, foreigners have not been investing in our bond market to the levels they have previously. As a result, this asset class is generating a decent yield for investors but has been subject to market volatility this year due to the lack of foreign support.
   

• Cash is still out in the cold
  We see little room for holding cash in portfolios. Not only is the nominal yield low (around 4%), it is in fact offering a negative real yield, given that inflation is close to 5%. 

Turning to global markets, it seems nothing could stop this bull. 

While value shares and unloved sectors (such as energy and UK equities) certainly rallied and were solid contributors to portfolio performance, the tech stocks in the US reached stratospheric levels (both in terms of performance and in price). 

In our opinion, this sector is starting to carry a striking resemblance to the tech bubble of the late 90s. Firstly, the market is trading at extreme valuations and is experiencing new IPO’s (stock listings) in the magnitude last seen in the late 1990s. (If it walks like a duck and talks like a duck…) We prefer to be cautious at this point. We remain materially underweight US large-cap tech shares. 

Despite emerging markets selling off sharply on the back of the Chinese government’s interference in capital markets and the restrictions and regulations placed on their tech companies, we are seeing good pockets of opportunity in emerging markets. 

It was not only S.A. fixed income managers that had a tough time in 2021; global fixed income managers had it even worse. Global bonds were one of the worst performers in 2021. With starting yields at low levels and bond yields rising throughout the year, this led to bondholders experiencing meaningful capital losses. 

How have we positioned Morningstar portfolios? 

Our Morningstar capital markets work guided us to have meaningful exposure to domestic equities, with an overweight allocation to the S.A. Inc. shares (which benefitted portfolios). We have always had an implied 10% cap exposure to Naspers and Prosus combined, which also helped limit drawdowns as this share fell. I have to say that for the years that this share drove returns, the implied cap we held in portfolios resulted in a contained drag on performance. Nevertheless, risk mitigation is key. We are prepared to forego some upside in order to protect on the downside. 

We have remained fully invested offshore with the majority of this allocation being held in global equities. This allocation has been a solid contributor to performance as we have captured the returns from global equities markets, despite the rand zigzagging between R14.50/$1 – R16,50/$1. We have a healthy exposure to emerging markets which detracted marginally from performance; however, this remains a high conviction allocation looking forward. 

Our meaningful exposure to S.A. government bonds has not provided the returns we had envisaged, however, when compared to cash, it has been the right decision. We remain confident in this holding as we expect interest rates to rise in 2022 (albeit in small increments) and this should be beneficial for long-dated government bonds. 

Looking forward – onwards and upwards into 2022 

Overwhelmingly, the so-called “TINA Theory” narrative from 2021 is still alive and well as we enter 2022. For a while now, the TINA – “There Is No Alternative” – Theory, has been used as the reason or basis for why the current bull market simply won’t quit. 

The fact that we have very low cash yields and very low global bond yields has pushed investors towards riskier assets such as stocks, which seemingly continue to go up (and up, and up). Let’s not forget that equity markets looked fairly expensive going into 2021—and many key markets are again looking expensive going into 2022. 

In the wise words of Warren Buffett – “Be fearful when others are greedy and greedy when others are fearful”. There is much exuberance, easy money and excitement in certain areas of the market. This level of optimism and crowding makes us “fearful”. 

There will be good news stories for companies and sectors that will be extrapolated into the future with investors prepared to pay extreme prices just to own these golden companies. Remember that “Price is what you pay, but value is what you get” – another valuable lesson shared by Mr Buffett. Now is the time to be vigilant and to ensure that you are getting value for what you buy. 

At Morningstar, we are certainly seeing attractive opportunities in select areas of the market. While we have a healthy exposure to select equities (both domestic and global) we also retain our holding in S.A. government bonds in favour of cash and global bonds. As a result, our portfolios are constructed to invest in areas where we see good long-term upside but also to ensure that risk is considered and there is a balanced exposure to both growth and income assets. 

You may not know if you should choose heads or tails, but at least you have the coin. 

You may hear some commentators saying that “markets are expensive and now is not the time to be invested” whereas others say that “things will just keep going up”. To this we would say there is never a “right time” to invest, the key is just to be invested and to remain invested. 

To quote Morgan Hounsel “Compounding works best when you can give a plan years or decades to grow. This is true for not only savings but careers and relationships. Endurance is key. 

And when you consider our tendency to change who we are over time, balance at every point in your life becomes a strategy to avoid future regret and encourage endurance. “ 

As you reflect on the year that was, you can be pleased knowing that you remained invested and that you now have more wealth than you did this time last year. The seasons will inevitably keep changing, and so too the seasons for asset classes. This is exactly why your portfolios are being actively managed to ensure that as markets change, your investment changes to take advantage of the next cycle. All you need to do is stay invested and let the magic of compounding do its work. 

Victoria Reuvers

Managing Director
Morningstar Investment Management
South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

I have a confession to make.

I just can’t get myself worked up this Evergrande story.

Some markets people are comparing this Chinese property developer to Lehman Brothers or Bear Stearns.¹

But if we’re being honest here 99.9% of investors had never heard of this company before they showed up in the headlines last week. And how many investors actually understand how the Chinese government is likely to handle all of the debt on this company’s books?

You can read all of the stories and listen to all of the podcast explainers but is it really going to help you become a better investor? Is this company really going to impact your ability to reach your financial goals?

Maybe I’m just over the fact that we’ve been swatting away potential canaries in coalmines for years now when the majority of them simply haven’t mattered.

Or maybe it’s just that I’ve resigned myself to the fact that market corrections can and will happen and the reason is mostly irrelevant.

If you’ve been reading this blog for an extended period of time you’ve read all of my market correction stats.

• The average peak-to-trough drawdown for the S&P 500 in a given calendar year since 1928 is around -16%.
• There have been 53 double-digit drawdowns overall in this time frame.
• The average loss for those corrections is -23%, lasting more than 200 days from peak to trough.
• Over the past 93 years the U.S. stock market has fallen 20% or worse on 21 different occasions.² That’s once every 4-and-a-half years.
• It’s fallen 30% or worse 13 times or one out of every 7 years.

Of course, there’s a big difference between averages and reality.

The stock market fell 50% from 2000-2002. It repeated that feat just 6 short years later.

From 1940-1968, there wasn’t a single bear market in excess of 30%. Then over the next 6 years it happened twice.

There are also some years in which there are no corrections. In 34 out of the past 93 years, there was no peak-to-trough drawdown that reached double-digit levels in a calendar year period (it hasn’t come close this year just yet).

On 7 different occasions, there wasn’t even a 5% correction in a given year (most recently in 2017).

From 2007-2011, the average peak-to-trough drawdown in the S&P 500 each year was -24%. Then from 2012-2017, it was just -8%.

There are ebbs and flows to these things.

It’s also true that each time there is a correction there is a different reason.

Sometimes it’s macro-related. Sometimes it has to do with market fundamentals. Sometimes it’s geopolitical in nature. Sometimes investors are simply looking for an excuse to sell after experiencing large gains. Sometimes the downturns feel completely random.

Most of the risks investors worry about don’t occur. And even if they do occur, they don’t match up with the time frame you’re worried about them occurring.

Markets are hard.

Now, just because this Evergrande story will likely never morph into another Lehman or Bear Stearns moment doesn’t mean it won’t impact certain investors or investments. It still might lead to some damage.

The question is: Does it matter?

If you measure your time horizon in years and decades, you’re going to be dealing with many more corrections along the way. At times, a large portion of your portfolio will seemingly vanish (for a time at least).

I suppose you could try to predict every geopolitical, macro and fundamental story in the years ahead to figure out how it will impact the market. But the odds show even if you could predict the headlines, you’ll never be able to predict how investors will react to those headlines.

And even if you could predict the direction of the markets over the short-term, you’ll never be able to predict the magnitude or length of those moves.

And even if you happen to nail the timing on the next correction, you’ll likely never be able to do it again.

My point here is market corrections are going to happen whether you know the reason or not. It’s not an if, but a when.

And since no one can figure out the when with consistency, the only thing you can do is recalibrate your portfolio or expectations ahead of time.

Either you learn to live with volatility or make your portfolio durable enough to better withstand the bursts of volatility.

This is true if we’re living through the next Lehman moment or a minor dip we all forget about in 3 months.

¹There have been dozens and dozens of “Is this the next Lehman?” stories since 2008.

²It is worth noting the S&P 500 has fallen 19% and change on 5 different occasions since 1928. Oh so close to a bear market but not quite.

Source: https://awealthofcommonsense.com/2021/09/the-consequences-of-a-market-correction/

Ben Carlson

Director of Institutional Asset Management at Ritholtz Wealth Management

In August we addressed four key questions raised by financial advisors and their clients: What are the alternatives to cash? How much should you invest offshore? Is it too late to invest in South African equities? Are we seeing a change in investment style leadership?¹ The article raised several additional questions from advisors, which we discuss briefly below. Please note that we have addressed each question independently, and not with a subsequent answer building on the prior question.

1. Can you do both good (make an impact) and well (generate investment returns)?

In short, yes. But why, and how?

There is growing consensus that the world needs to urgently address climate change, and that accelerated investment is needed to ensure global temperature increases stay within two degrees Celsius. Unfortunately, even a two-degree increase will have a massive impact on our planet. For example, coral reefs will be almost entirely wiped out; people will be exposed to more extreme weather (heat waves, droughts, floods, and tropical cyclones); mountains will lose their glaciers and be more susceptible to landslides; more than 70% of the earth’s coastlines will see sea levels rise greater than 0.2 metres; and certain islands will become uninhabitable.

There is an approximate 90% correlation between carbonisation and economic growth, and therefore we need to change the way the economy works. As a result, the world will need to invest between $2.4 trillion and $4 trillion per annum in areas such as wind and solar capacity, electric vehicles, and battery production over the coming decades to meet this objective. And yet we are currently only investing in the region of $700 billion per annum. This transition has barely begun.

It is fair to say that we all know what the problem is, but what are the catalysts for change? We have identified three key drivers:

1. Regulation: Countries around the globe are signing up to the net zero carbon pledge.² The year 2020 saw new policy announcements across Asia and the US, and stronger commitments from Europe. In fact, 64% of global emissions are now covered by “net zero” announcements.
2. Technology: Costs have fallen materially as technologies have improved in areas such as wind and solar energy generation, and battery pack production which has, for example, resulted in an exponential increase in electric vehicle sales over the past decade.
3. Consumer behaviour: Surveys suggest consumers are concerned about climate change and, as a result, are increasingly comfortable that their investment solutions include a portion that is environmentally focused.

The Ninety One Global Environment Fund seeks to benefit from the new structural growth themes of renewable energy (solar, wind, clean power utilities, etc.), electrification (electric vehicles, hydrogen economy, heating and cooling, etc.) and resource efficiency (waste management, agriculture, factories, etc.). Our specialist knowledge and proprietary research help us identify the most attractive opportunities within the complex environmental sector. This approach has been rewarding for our investors, with the fund outperforming the traditional global equity benchmark, the MSCI All Country World Index (ACWI), by more than 16% per annum since launch in February 2019.³

The fund’s differentiated strategy means that it serves as a great diversifier to traditional global equity portfolios, including the Ninety One Global Franchise Fund, which has attractive ESG credentials given the types of companies in which it invests.

2. If SA cash is trash, what can be said of offshore cash?

Well, offshore cash is even trashier. For several years now, offshore dollar, sterling and euro cash investments or money market funds have delivered zero (or marginally negative after fees) returns. While offshore money market returns might improve at the margin should the US Federal Reserve and other central banks start to raise rates, they are unlikely to do so materially in the short to medium term. Investors need to look beyond the perceived safety of these offshore cash funds to earn attractive hard currency real returns.

Conservative investors should therefore take a slightly longer-term view and consider funds such as the Ninety One Global Multi-Asset Income Fund. The fund targets an attractive, resilient yield of around 4% per annum, as a significant part of the overall return. This higher yield reduces the dependency of returns on generating large capital gains, and the associated volatility. The defensive income anchor has also meant that since inception in July 2013, the fund has not delivered a negative calendar year return.

In an article,⁴ co-portfolio managers John Stopford and Jason Borbora-Sheen said: “Given the importance of income [as a dominant driver of most asset class returns over the long run], the decline in yields, [as evidenced in Figure 1], on most asset classes since the Global Financial Crisis, and the further fall during the COVID-19 crisis, appears to bode ill for conservative investors.” The good news, however, is that the managers are still finding attractive opportunities across a range of asset markets and securities.

Source: Bloomberg, BofAML, yields as at 31 August 2011 and 31 August 2021. 1 month deposit rates for cash; 10yr Government bonds – generic sovereign yields; investment grade bonds: BofAML Sterling Corporate & Collateralised All Stocks Index; BofAML US Corporate Index; BofAML Euro Corporate & Pfandbrief Index; BofAML Japan Corporate Index; High yield bonds: BofAML Asian Dollar High Yield Corporate Index; BofAML US High Yield Index; BofAML Sterling High Yield Index; BofAML Euro High Yield Index; Emerging market bonds: JP Morgan GBI-EM Global Diversified Index; JP Morgan EMBI Global Diversified Blended Index; JP Morgan CEMBI Diversified Broad Composite Index; equity indices as stated. For further information on indices, please see the Important Information section.

It is these attractive opportunities that make their way into the fund. The managers are, however, selective in what to own and what to avoid, as the highest-yielding assets are often compromised and can deliver disappointing returns with significant risks. Better returns for less risk can generally be found in moderately high-yielding securities, where the yields are properly underpinned by resilient excess cash flows.

3. Global equity markets have run hard, now what?

While global equity markets appear expensive when looking at broad market indices, we believe that there are still unique opportunities for active stock pickers, as captured in the Ninety One Global Franchise Fund.

We believe that our Quality capability’s purist approach to quality investing is well suited to current conditions and for the uncertain times ahead. The team is solely focused on identifying attractively valued best-of-breed “franchise” companies with the following key attributes:

• Hard-to-replicate enduring competitive advantages, for example, ASML (EUV lithography, DUV lithography)
• Dominant market positions in stable growing industries, for example, Estée Lauder (brands include Estée Lauder, Bobbi Brown, Clinique and MAC)
• Low sensitivity to the economic and market cycles, for example, Nestlé (brands include Gerber, Nescafé, Maggi, Nespresso, Purina)
• Healthy balance sheets and low capital intensity, for example, Verisign (.com, .net)
• Sustainable cash generation and effective capital allocation, for example, Visa

The result is a high conviction, concentrated portfolio of currently only 27 stocks. There is also very little overlap with the Top 50 MSCI ACWI stocks – only eight are included in Global Franchise and only two of these are in in the top ten holdings (Microsoft and Johnson & Johnson). In fact, the fund’s active share⁵ is 93%, meaning that the fund is highly differentiated from the MSCI ACWI and so is likely to also be very different from many other global funds, especially passive index funds.

Importantly, the companies in the Ninety One Global Franchise Fund are still generating far superior returns on capital, but are valued at a discount to the broader market.

Source: FactSet, Ninety One, 31 August 2021. *Index: MSCI AC World NDR (pre Oct-11, MSCI World NDR). The portfolio may change significantly over a short period of time. The above reflects the portfolio characteristics reweighted excluding cash and cash equivalents. Inception date: 30 April 2007. For further information on indices, please see the Important Information section.

Conclusion

Investors faced with one or more of the issues raised above may best be served by seeking professional financial advice, tailored to their individual circumstances.

Paul Hutchinson

Sales Manager

1. What’s on investors’ minds? This is the copyright of Ninety One and its contents may not be re-used without Ninety One’s prior permission.

2. Net zero refers to the balance between the amount of greenhouse gas the world produces and the amount removed from the atmosphere. Net zero is achieved when the amount produced is no more than the amount taken away. Reaching net zero is vital to avert the extremes of harmful global warming.

3. Source: Morningstar, 30 June 2021. Performance is net of fees (NAV based, including ongoing charges, excluding initial charges), gross income reinvested, in US dollars. Highest annualised return since its launch: 88.1% (31.03.21), A Acc USD. Lowest annualised return since launch: -7.3% (31.03.20), A Acc USD.

4. Thriving in an income desert, July 2020.

5. Active share is a measure of the percentage of stock holdings in a manager’s portfolio that differs from the benchmark index.

Important information
All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium- to longterm investments and the manager, Ninety One Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class.

Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.ninetyone.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, RMB, 3 Merchant Place, Ground Floor, Cnr. Fredman and Gwen Streets, Sandton, 2196, tel. (011) 301 6335. The fund is a sub-fund in the Ninety One Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act. Ninety One SA (Pty) Ltd is an authorized financial services provider and a member of the Association for Savings and Investment SA (ASISA).

Investment Team: There is no assurance that the persons referenced herein will continue to be involved with investing for this Fund, or that other persons not identified herein will become involved with investing assets for the Manager or assets of the Fund at any time without notice.

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It’s interesting how the value of the rand can influence our perception of the value of our country. A strong rand, when compared to the dollar, often makes us feel better about the state of affairs in South Africa. When the value of the rand climbs, so does our optimism about the growth and recovery of the country, while a weak currency fires up all the negative sentiment we read about in the press.

With that said, it’s not all doom and gloom and South Africans can find some reprieve in knowing that the value of our currency is only partially affected by South African specific factors. In the following article, we discuss the different factors that can influence the value of our local currency.

In recent years, the South African rand has been on the back foot against major currencies, with investors being extra cautious due to the many headwinds and political infighting that frequently dominates news headlines. Investors simply can’t ignore that the country has subdued growth, a weak fiscal outlook, rising industrial and social tensions, and external vulnerabilities associated with the current account deficit, all of which support a weaker currency.¹

A research report² was written by the International Monetary Fund (IMF) wherein it looked at the main drivers that impact the Rand/Dollar exchange rate since the onset of the global financial crisis and the results are very interesting.

Rand volatility could be attributed to global macro-economic factors

The IMF’s research showed that the main driver behind the movement of the rand relates to global factors and macro-economic events in the U.S. In other words, the level/value of the rand is often influenced and determined by dollar movement (strength and/or weakness). Roughly 30% of all rand volatility could be attributed to global macro-economic factors which influenced the US dollar and hence the rand.

As a small, open, emerging market that makes up less than 1% of the world economy, we are more likely to be affected by what is happening globally rather than in our own country. This is further exacerbated by the fact that the rand is one of the most liquid and tradeable currencies when compared to other emerging market currencies globally. Often when there is global risk aversion (better known as a “risk-off trade”) and investors flock to safe-haven assets, the rand acts as a proxy for all assets perceived to be risky by global investors. This can often lead to the rand depreciating.

1 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
2 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.

Commodity price volatility is a key factor

A second finding was that commodity price volatility was a key factor that influenced rand/dollar volatility. Roughly 30% of the volatility of our currency was a result of commodity price volatility. Over the past year, we have seen a sharp rise in commodity prices of which South Africa has been a beneficiary.

South Africa is a net exporter of resources, and local exporters benefit from the rand weakness in that it makes the goods and services that we produce cheaper for foreigners and more attractive when compared to the goods and services available in other markets.

South Africa also imported a lot less in 2020, which has impacted our current account balance positively which, in turn, has been a factor causing the recent Rand strength.

Impact of domestic factors on the rand

The IMF’s research also looked at the impact of domestic factors on the currency. They found that neither domestic macro-economic surprises nor those originating from other emerging markets are statistically related to rand volatility. However, they did find that local political uncertainty is positively associated with rand volatility.

Purchasing Power Parity’s part

Of the many metrics used to determine the valuation of the rand against other major currencies, is the Purchasing Power Parity Index (PPP). PPP is an economic theory that compares the different currencies from countries across the globe through a “basket of goods” approach.

In 1986, The Economist created the Big Mac Index ³ to create a lighthearted way of showing PPP and whether currencies were cheap or expensive. The Big Mac Index uses a price of a Big Mac burger in the US (as a base) and then compares the price of a Big Mac burger in every other country (in its native currency) and then looks at the price differential.

According to the latest Big Mac Index data, the rand is very cheap compared to the US dollar. A Big Mac costs R33.50 rand in South Africa and US$5.66 in the United States. The implied exchange rate is 5.92. The difference between this and the actual exchange rate, 15.52, which suggests the South African rand is 61.9% undervalued.⁴

With that being said – it should also be pointed out that we do not believe the Rand to be 62% undervalued – this is merely a fun way of looking at relative currency strength or weakness versus the US dollar.

3 https://www.economist.com/big-mac-index
4 https://www.economist.com/big-mac-index

So, how should we go about working out a fair value for the rand?

Currencies can deviate significantly from fair value over time, however, over the long term, movements between currencies should reflect inflation differentials between two countries. Due to the relatively higher inflation environment in South Africa (especially compared to most developed markets), we would expect the rand to depreciate against most developed currencies in the long term.

Currencies can frequently deviate from purchasing power parity over time. Extreme examples include the height of the commodities boom in 2005 and 2006 when the rand reached R6 to the US dollar. Following the removal of previous Finance Minister Nhlanhla Nene (in late 2015 and early 2016) the rand reached around R17 to the US dollar.

What should be apparent, however, is the movement in the exchange rate following these events. In almost all cases, the exchange rate moved back to a value that would be regarded as fair when judged according to PPP. That is not to say that currencies do not stay cheap or expensive for long periods of time. Idiosyncratic events may cause currencies to deviate from fair value for extended periods, however, currencies tend to move back to levels reflective of inflation differentials in the long term.

As can be seen in the below graph, the rand is currently undervalued on a Purchasing Power Parity basis.

Work done by the capital markets team at Morningstar supports the view that the Rand remains undervalued compared to the US dollar. It is also worth remembering that the rand never really trades at fair value. Historically, the rand moved in big swings from being expensive to being cheap and each time shooting through fair value.

Where does that leave us?

While the rand (at roughly R14/$) is undervalued/cheap, we don’t believe the economic data supports a materially stronger rand. Over time the inflation and growth differentials between South Africa and our developed counterparts support a depreciating currency. While the commodity cycle and US economic factors favour a firmer rand for now, we do expect that in a 10-year horizon the rand is likely to depreciate from these levels.

We are often asked the question, “Is this the time to be taking money offshore given where the Rand is?” and the best way to answer that is to quote Howard Marks who said, “This is not the time but it is a time”. The decision to invest offshore should be based on the investment opportunity. While the value of the currency does play a factor, we would encourage investors not to try to time the currency.

The above factors once again emphasise the need for investors to remain patient, stay the course and avoid making investment decisions in a panic due to gloomy news headlines. This would include articles forecasting which direction the rand is heading. Previous experience has taught us that these forecasts are seldom accurate. It is during these challenging investment times that we should remove emotions from our investment decision-making process and focus on the fundamentals.

In Conclusion

Over decades of evidence and through the investment literature there is one golden thread –time in the market remains superior to timing the market.

Ask yourself this: “Given where I am now, what actions move me closer to my long-term goals?” “Would an investment change align with the original investment plan for reaching well-defined goals?” These are different questions than, “What do I wish I had done last month?”.

We believe that investing is a long-term pursuit, patiently allocating to assets that will help you achieve your investment goals.

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

The seeming disconnect between the performance of financial markets versus that of economies across the globe has left many investors scratching their heads. We often get asked how is it possible for financial markets to increase in value, but the economy is shrinking?

It goes without saying that we live in extraordinary times. The South African economy had never faced such an abrupt cease in trade and/or economic activity as with the commencement of the nationwide lockdown on 27 March 2020. The same can be said for other economies around the globe. As economies started to reopen, many investors have been left scratching their heads – the recoil in financial markets painted a very different picture from the economic outlook.

It is not surprising that markets experienced some of the sharpest falls in asset prices during the first quarter of 2020. The JSE All Share Index lost more than 30% from the start of 2020 until 23 March 2020. What was surprising to see was the speed of the recovery hereafter – since 23 March 2020 (the bottom of the sell-off), the market is up more than 70% (as at February 2021) making COVID-19 seem like a mere short-term disruption.

The economy, however, tells a very different story, with one of the largest contractions in GDP ever recorded, coupled with sky-high unemployment numbers.

How are financial markets flourishing when economies are falling apart? Let’s have a look at financial markets in more detail, more specifically the equity market.

Equity market

The equity market is forward-looking and prices of stocks/shares/bonds (any listed liquid instrument’s) are determined by the supply and demand of investors. Investors that are buying these instruments are expecting positive outcomes looking forward. Sellers, on the other hand, expect the price of the stocks/shares/bonds to decrease in value.

So how do you know if you should be buying or selling? Ultimately, you need to consider the value of the company. The intrinsic value of a company can be estimated by taking its future expected earnings and discounting the future cash flow with an appropriate discount rate to ascertain what the value of those future earnings are worth now (or at the time one buys the listed equity).

The factor that has changed most notably in the above equation is the significant drop in interest rates – not only in South Africa but globally as well. With interest rates decreasing with 3% since the start of 2020, the discount rate being used to calculate the worth of future earnings is now significantly lower. This will result in future earnings being worth more today than before the interest rate cuts.

When the economy is slowing, the South African Reserve Bank (SARB) cuts interest rates to stimulate financial activity. This benefits businesses in that they enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, also leads to higher share prices¹. The reduced financing cost also increases future earnings figures.

Companies also have control over aspects that contribute to the current value of the company. Companies can use times of uncertainty as justification to cut their cost base and in doing so increase their bottom line/earnings. In other words, the leaner operational costs will result in higher expected future earnings.

In short, market crashes reset valuations of listed companies and provide investors with the chance to invest into opportunities that might not have been available, or an even an option previously due to prices being too high. This ‘opportunity’ buying cycle subsequently drives up market prices.

The last factor that can’t be ignored, and one that is especially important in the South African landscape, is that listed companies that sell products offshore are not reliant on how the South African economy performs. These shares are more broadly known as Rand Hedges (with the weaker Rand also working in their favour).

If one looks at every company listed on the South African stock exchange (the Johannesburg Stock Exchange or JSE), the majority of companies are not reliant on the South African economy to generate earnings. These are companies with business interests that are either predominantly outside of South Africa or entirely outside of South Africa.

In fact, 69% of the revenue generated by the top 40 companies listed on the JSE was generated from outside of South Africa for the 2019 calendar year². In essence, when you are investing in the South African equity market (as represented by the Top 40), only 31% of company revenues are reliant on the South African economy³.

This is possible due to the fact that some of the largest companies on our stock exchange are dual-listed companies. In other words, these companies are listed on more than one country’s stock exchange. For example – the BHP Group is listed on the London Stock Exchange as well as the Johannesburg Stock Exchange. While the BHP Group used to have operations in South Africa, currently the company does not generate any earnings in South Africa.

There are many similar examples on our stock market and most of these companies carry larger weightings in the index. We call these rand hedge shares. In short, if the rand weakens, it is a benefit to own these shares as they generate earnings in offshore currencies. So, as an investor, you are hedging your currency exposure even though you are investing in a South African listed equity.

Local government and economy

In contrast with forward-looking equity markets, Government GDP numbers are backwards-looking. GDP is the value of goods and services produced/rendered in a country during a certain period. It provides a snapshot of a country’s economy, and it is used to estimate the size of an economy and its growth rate.

Due to stringent lockdown rules in South Africa, several sectors came to a complete standstill and, therefore, did not contribute to growing our GDP rate. As an example, in South Africa, GDP numbers are highly dependent on mining, agriculture, manufacturing and construction (to name but a few) – most of which had to halt operations for quite some time. In addition, many of the companies that contribute to our GDP numbers are not listed entities but rather privately held and/or small business.

Unemployment is another number that has a different effect on economies when compared to listed companies. When a company retrenches employees it immediately lowers the expenses of the business and can potentially grow earnings (if income is unchanged) but the opposite is true for an economy. When someone is retrenched and they can’t find an alternative job, they move from being paid by a company to being paid by the economy and thus increasing the expenses of the government.

In closing

Investors too often redirect their attention away from the destination to the journey when faced with a lot of outside noise. Much like in other walks of life, we can lose focus, making us susceptible to capitulation or giving up at the moments when fortitude and resolve pay off most.

Patiently allocating to assets that will help you achieve your financial goals should remain key. So, if you catch yourself getting down about the state of our economy, or speculation around government policies or trying to predict what is next, always remember why you are investing in the first place.

There’s no doubt that the current market conditions are unsettling. It is at these moments that we would discourage investors from making changes that could harm their ability to reach their financial goals. It is often during these difficult times that we have the greatest opportunity to add value for our clients, acting rationally when others struggle to do so.

1 Source: https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/
2 Source: Ninety One Asset Management as at 31 May 2020
3 Source: Ninety One Asset Management as at 31 May 2020

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.