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.

 It’s an investment that will always ensure the best return – for you. 

Households across the globe are increasingly expected to be responsible for more financial decisions, such as determining how much to save for retirement, how to invest savings, how to be tax-savvy and when to retire. It’s a tricky one – especially, if no one in your household is a trained financial planner and/or adviser. 

Within that reasoning, you might as well also be in charge of doing the plumbing and electrical installation for your home. While you might be able to fix a simple leak – it’s not as easy when your geyser bursts and floods your entire house. Ironically, it’s for this exact reason that you are also expected to have the correct financial planning and insurance in place. So, why is everyone expected to plan their finances when it is such a specialised task? 

It’s actually scary how underrated, misunderstood and undervalued the value of quality financial advice is. Just because we’re taught basic math at school, it most certainly doesn’t mean everyone can understand, manage and maintain their own financial planning needs. Maybe that’s why so many people are hesitant to seek financial advice – because the assumption is that everyone should know how to do it. 

The fact is – long term financial planning and investing is much more than a mathematical analysis of risk and return. It’s a struggle with ourselves – to tune out irrelevant information, to have the strength to stick to the plan and to resist the urge to follow the herd. This is undoubtedly the most important role and value add of quality financial advice. 

The industry consensus on why financial advice is valuable is different than it used to be. While an advisor’s worth used to be simply based on the advisor’s ability to beat a benchmark, it’s now understood that an advisor’s value is far better measured by the impact that their services can have on investors’ financial outcomes. 

New metrics and research findings show that the interpersonal aspect of advice have more impact on a person’s finances than anything else. This outlook favours services like behavioural coaching — helping clients mitigate their biases and stay the course — and personalised advice versus traditional selling points like maximising returns and asset allocation. 

When it comes to generating positive investment returns, investors arguably spend the most time and effort on selecting “good” investment funds/managers — the so-called alpha¹ decision — as well as the asset allocation, or beta², decision. However, alpha and beta are just two elements of a myriad of important financial planning decisions for the average investor, many of which can have a far more significant impact on your investment return.

Gamma³, a metric introduced by Morningstar’s David Blanchett and Paul Kaplan, measures the additional expected retirement income achieved through wise financial-planning decisions, and many of these decisions are made with an advisor’s assistance. Morningstar’s Gamma research demonstrates that making sound financial planning decisions in five areas — asset allocation, withdrawal strategy, guaranteed income products, tax-efficient allocation, and portfolio optimisation — can generate 29% more income on average for a retiree. 

Vanguard’s Advisor’s Alpha⁴ is similar. It measures the value added, in basis points, by seven best practices in wealth management: asset allocation, cost-effective implementation, rebalancing, behavioural coaching, asset allocation, spending strategy, and total-return investing versus income investing. This research suggests that behavioural coaching is the single most impactful thing an advisor can do, adding, on average, 150 basis points. 

In the past, the financial industry’s tendency was to over-emphasize returns and benchmark relative performance. However, research shows that the interpersonal side of advice, which includes personalisation and behavioural coaching, can be the most valuable aspect of professional advice, and the industry needs to better articulate that. 

As investors, emotions can be our own worst enemy. The best advice as we embark on 2022, is to ensure that you partner with a good financial adviser to ensure you stay the course, and rest assured knowing that your long-term financial plan is being implemented and on track. Returns aren’t the end-all, be-all — modern advice is more coaching than stock-picking, and the short-term returns are only part of the picture. 

Most of all – never take for granted the power and value of good financial advice. 

1 Source: https://www.morningstar.com/invglossary/beta.aspx
2 Source: https://www.morningstar.com/invglossary/alpha.aspx
3 Source: https://www.morningstar.com/content/dam/marketing/shared/research/foundational/677796-AlphaBetaGamma.pdf
4 Source: Kinniry, Francis M., Jaconetti, Colleen M., DiJoseph, Michael A., and Zilbering, Yan. “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha.” The Vanguard Group, 2014.

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.

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.

Investment Process: Any description or information regarding investment process or strategies is provided for illustrative purposes only, may not be fully indicative of any present or future investments and may be changed at the discretion of the manager without notice. References to specific investments, strategies or investment vehicles are for illustrative purposes only and should not be relied upon as a recommendation to purchase or sell such investments or to engage in any particular strategy. Portfolio data is expected to change and there is no assurance that the actual portfolio will remain as described herein. There is no assurance that the investments presented will be available in the future at the levels presented, with the same characteristics or be available at all. Past performance is no guarantee of future results and has no bearing upon the ability of Manager to construct the illustrative portfolio and implement its investment strategy or investment objective.

Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable. MSCI data is sourced from MSCI Inc. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

This document is the copyright of Ninety One and its contents may not be re-used without Ninety One’s prior permission.
Ninety One Investment Platform (Pty) Ltd and Ninety One SA (Pty) Ltd are authorised financial services providers.

Could our current status quo be déjà vu? Have we been here before? The answer is no. Since the formation of our democracy, we have not seen violence, looting and riots of this nature. While it’s impossible to comprehend and rationalise what we are going through as families, communities and as a country, one thing that we know to be true, that we will survive this and we will rebuild this nation.

When the dust settles and we sit at home and reflect, we find ourselves wondering about the future and we worry. We worry about when/how life will ever return to ‘normal’. We worry about the health of our family, friends, and colleagues. We worry about the economy and work. We worry about money and our savings. While we are not able to provide guidance on all these worries, we can provide more context around money, savings, and investments.

Markets keep moving up and down, and so too do investor’s emotions. This is understandable – it is, after all, our hard-earned money we’re talking about. It’s only natural that many investors have now grown tired of stomaching this unpredictable rollercoaster ride and would much rather prefer to place their feet on solid ground. In the world of investments, the rollercoaster ride is equities and cash is often seen as the solid ground.

How will the latest unrest in the country affect my investments?

The big question across the country is around the issue of the medium-term economic impact and where to from here? We have seen the Rand weaken against major currencies as the market pulls away from South Africa in times like this. It is too early to assess if the current events will have a long-lasting negative impact on the South African economy, but we believe immediate evidence points to a short-term impact (assuming officials are successful at containing the situation).

The reality is that, in times of stress and uncertainty, markets and currencies can move sharply. Even so, these types of events create uncertainty and often leave investors with the urge to do something.

The below graph shows the 15 worst days on the JSE (the red bars) since the end of June 1995 and how the local market reacted after the drawdown. The blue bars show the 12-month returns investors experienced after the worst day and the green bars show the five-year annualised returns after the drawdown.

As an example, during the 2008 global financial crisis on 06/10/2008, there was a loss of -7.12% for the day but the subsequent one-year return amounted to 22.41% and the annualised five-year return was 19.24%.

Despite the current negativity and volatility, investors who are in Equities are advised to retain their exposure to this asset class since this is likely an unplanned short-term phenomenon that should not detract from the long-term value of equities.

If the impact is short-term, price declines may produce buying opportunities. Warren Buffett, chairman and CEO of Berkshire Hathaway, said “you don’t buy or sell a business based on today’s headlines. If the market gives you a chance to buy something you like and you can buy it even cheaper, then it’s your good luck.”

Current portfolio positioning

Current events and the possible volatility that might be experienced in the coming weeks once again highlights the importance of effective portfolio management, asset class diversification and pricing in risk to protect capital.

Client portfolios managed by Morningstar Investment Management are well diversified between strategies and asset classes and we are confident in our current positioning. Your portfolios are well diversified against SA specific risks.

Morningstar is keeping a close eye on all the above and actively managing your money. Our investment team has built portfolios that we believe are designed to not only protect investor capital in tough periods but more importantly to provide long term growth of investor capital.

This means that short-term market moves and doom and gloom media headlines, rarely (if ever) rattle our cages and we focus our energy on areas where we can add value.

What should investors do? Remain calm. Remember: time in the market is superior to timing the market.

At this stage, the best thing investors can do is to remain patient. Investing in the equity market is a long-term pursuit and is best used to reach long-term goals such as retirement. As the saying goes – a river cuts through a rock, not because of its power, but its persistence.

While noise and speculation can act as an emotional rollercoaster, your goals are unlikely to have materially changed and, therefore, your plan shouldn’t either. This is where we need to be balanced. A big part of wealth creation is avoiding the biggest mistakes and disinvesting into cash now is one of the most well-known actions to avoid.

While the consideration to grab the closest cash lifejacket, jump ship and move all your assets to cash is an understandable response to recession fears, it is unlikely to be in investors best interests.

In closing

As investors, we too often redirect our 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, lockdown or speculation around government policies or trying to predict what is next, always remember what is in your control and what is not.

The habit of investing is one of the best habits you have within your control. Doing nothing and staying the course is still a decision. 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.

Providence Wealth would like to send thoughts of strength and support to those who need it now.

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.

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.

It is hard to imagine that only a year ago, markets hit rock bottom and investors were worried about how the rest of 2020 would pan out. Across the globe, investors were faced with questions such as – will valuations decline even further? How and when will markets recover? Is it perhaps time to deploy cash into the market? Should we disinvest and wait for better days? Should we sit on our hands and do nothing?

Today we are facing a different dilemma. Markets are at an all-time high. In a short space of time, everything has changed. The rollout of Covid-19 vaccines and associated hopes for imminent economic recovery, along with unprecedented fiscal and monetary support from governments and central banks around the world, has driven equity markets beyond or close to record highs of late. With stock market valuations at historically high levels speculation about a market bubble has been rekindled.

The Price-to-Earnings (P/E) ratio as a measure of valuation

Investors often look at a valuation in its most traditional form, also known as the P/E multiple. A P/E multiple (price to earnings ratio) gives investors an indication of what the market is willing to pay for every R1 of earnings generated. Setting aside the impact of short-term changes to profit, a high P/E ratio typically indicates the expectation and/or perception that a company could/would have good growth prospects, or less risk to profits, than the average company. Thus, a company with a proven long-term track record of growing profits would normally trade at a high P/E ratio and a company with low growth, or a patchy profit history, would trade at a lower P/E ratio.

While P/E is an incredibly good starting point to assess the valuation of a company or a market, many investors fail to look deeper.

Delving deeper into markets

The P/E ratio of the S&P 500 is trading at near-record highs. One could argue that it is, perhaps, a very blunt way to look at the world. It is important to unpack what drove the performance of the S&P 500 to these levels.

When analyzing the data depicted in the below two graphs, it is clear that most of the performance of the S&P 500 came from large FAANG stocks. [FAANG is an acronym referring to the stocks of the five most popular and best-performing American technology companies: Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google)].

Exhibit 1 depicts the cyclically adjusted P/E ratio for the US market.

There is no doubt that most of the large tech giants are good companies, with robust business models and incredible management teams. However, one must keep in mind the two tailwinds that existed – the first being record low interest rates for a prolonged period of time and the second being that most of these FAANG stocks were direct beneficiaries of lockdowns worldwide. Therefore, caution should be applied when assessing if they will continue to generate such exceptional performance indefinitely.

Looking at the opposite side of the coin – what about the other sectors that have not enjoyed such lucrative returns over the last number of years? Could the grass be greener on the other side but investors are not seeing it?

Is local still lekker?

On the local front, investors have enjoyed good returns from the JSE All Share index over the last few months. The question remains – will this continue or are we due for a correction? The truth is that nobody knows how long a rally can and/or will continue.

What we do know is that emerging markets have been severely out of favour for the last decade or so. Within the emerging markets group, South Africa has been out of favour for such an extended period that both local and foreign investors seem to have lost hope.

The recent rally could be the market playing catch up coupled with a positive global backdrop for South African equities. The domestic economy may well continue to face structural headwinds going forward but could also recover from depressed levels gradually as activity normalises and accommodative interest rates stimulate incremental demand.

While we contemplate whether this partial recovery will be enough to generate satisfactory returns from domestic shares (from current price levels), there is the possibility for a more pronounced and sustained recovery in activity and sentiment as the global economy reflates and South Africa receives a natural slice of emerging market flows.

At Morningstar, we believe some areas in the domestic market still offer a very good opportunity and has lagged in the recent recovery. Financials are a good example of such an area.

What is the alternative?

A few years ago, South African investors could generate a real return (a return over and above inflation) of about 3%, by simply remaining in cash. It was an easy choice for those that did not want to expose themselves to equity market risk. Today, this picture is quite different. Cash rates are at historic lows with returns from money market funds sitting at about 4% and there is not much yield either if you look at developed markets.

Long dated South African Government bonds on the other hand still offer very attractive yields and continue to make up an overweight percentage within the Morningstar Portfolios. As far as equity risk is concerned, we continue to assess all individual opportunities through a valuation lens as well as the fundamental risk associated with each asset class. We continue to find value in areas of the market like UK Equities, European Equities, S.A. Financials, Energy etc.

Getting back to the question, are markets in a bubble at the moment?

At Morningstar, we believe a blunt expression like this one is probably foolish. The truth is there is always a bubble somewhere, whether it is Tesla, Bitcoin or the FAANGs. The best you can do is to continue to assess opportunities as they arise and patiently allocate money to the areas that will best serve your investment goals.

Although the obvious opportunity set has declined in equity markets over the last couple of months, there is still ample opportunity for investors who are willing to look a little deeper.

Debra Slabber, CFA®

Portfolio Specialist

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.