David Knee, Chief Investment Officer, Prudential Investment Managers, says investors have reason to be more optimistic about medium-term returns than the headlines would suggest.

In recent times, South African investor confidence has been undermined by the news spotlight on the country’s higher political and economic uncertainty following government cabinet reshuffles, the sovereign credit rating downgrades and various government corruption scandals. This has been compounded by poor returns from local equities, which have underperformed money market returns over the past three years and not beaten inflation in the past two years (to 31 May 2017). These conditions, in turn, have pushed investors to sell their local equity holdings and other risk assets, and move more into cash. Yet this is a mistake – a look at current valuations dictates that investors should be buying equities, listed property and bonds, not selling, in order to generate solid inflation-beating returns. Some short-term courage is required to profit in the longer term.

Taking advantage of Nenegate – buying, not selling

A recent example of market turbulence and mispricing investors could have exploited was that caused by the dismissal of Finance Minister Nene, or “Nenegate”, in December 2015 after which government bonds sold off sharply: amid market fear, the 10-year government bond yield jumped from around 8.5% to nearly 10.5%. Although this reflected legitimate investor concerns that government bonds were now more risky amid higher fiscal uncertainty, the market overreacted. Valuations were cheap compared to Prudential’s view of their long-term fair value: a 10.5% yield was ample compensation for the extra risk involved going forward, particularly when long-term inflation is expected to be less than 6%.

Subsequent market performance proved that anyone who had simply kept their bonds, or been brave and bought more, rather than moving into cash or offshore equities, would have come out on top. Bonds have been the best-performing local asset class since Nenegate, regaining all their losses and returning a cumulative 18% from end December 2015 to 31 May 2017. This includes the weakness resulting from the April-May 2017 dismissal of Finance Minister Pravin Gordhan and credit rating downgrades. Investors who switched into cash following Nenegate would have missed out with an 11% cumulative return, while anyone who decided to move to offshore equities has actually experienced a loss: global equities returned -2% in rand terms (on an aggregate basis) due to the approximate 20% appreciation of the local currency versus the US dollar over the period.

Investors should be buying more risk assets

What about current valuations? The local equity market is currently trading just below its long-term fair value. As the graph indicates, it is priced to deliver an estimated return of 12.8% p.a. over the next three to five years, the highest among the major asset classes, including international assets. Listed property is priced to produce a slightly lower return of 12.6% p.a. over the same period, making these risk assets the most attractive among those analysed.

For fixed income assets, South African government bonds are currently slightly cheap compared to their long-term fair value level, and are priced to return around 9.2% p.a. over the next three to five years, more than 3 percentage points above inflation. The valuation of inflation-linked bonds (ILBs), meanwhile, indicates a return of approximately 8.5% p.a. over the medium term, and short-term cash only 7.5% p.a.

International asset returns, meanwhile, are partly dependent on the vagaries of the rand exchange rate. With the rand just less than 10% undervalued, it may have a tendency to strengthen more over the medium term. This would offset gains in the underlying offshore assets. However, the direction of the rand is exceedingly difficult to predict, and this variable shouldn’t be used in determining offshore exposure - a focus on asset valuations is key. Looking at those valuations, while global government bonds are still expensive, offering very low yields compared to their history, foreign equity valuations (on an aggregate basis) are somewhat cheap compared to their long-term fair value. Allowing for the rand to move in line with Purchasing Power Parity, global bonds are priced to return approximately 2.7% p.a., foreign listed property around 6.3% p.a. and foreign equity 8.0% p.a. (all in rand terms) over the next three to five years.

Multi-asset funds should comfortably beat inflation

Based on the above valuations, we would expect that over the next three to five years returns from multi-asset high-equity or “balanced” funds should continue to beat inflation, as in the past. For example, considering its positioning the Prudential Balanced Fund could deliver an approximate return of around 11.4% p.a., while more conservative low-equity funds like the Prudential Inflation Plus Fund would produce around 10.4% p.a. These are both significantly above inflation, and meaningfully more than the estimated 7.5% p.a. investors would receive in cash assets like money market funds. While this difference may not seem like a lot, an extra 3.5% p.a. in returns over 20 years gives an investor double their money at the end of the period.

This gives investors a reason to be more positive about the investment environment than the prevailing news headlines would indicate. Certainly, the road to realising these higher returns is a rougher one than cash since they are delivered unevenly over time; it does take courage to be overweight risk assets in a difficult and uncertain environment. However, being brave and staying the course over the medium- to longer-term will prove to be invaluable down the road.

If you'd like to learn more about risk assets, you can watch Part 2 of our Guide to Investing video series. Alternatively, contact your financial adviser or our Client Services Team on 0860 105 775 or at query@prudential.co.za