Focus on the fundamentals, remove the emotion and trust the process

By Victoria Reuvers, Managing Director, Morningstar Investment Management

“Isn’t it funny how day by day nothing changes, but when you look back, everything is different“  a quote by CS Lewis and one I thought was fitting to close out this year.

Looking back at the year

If we cast our mind back to this time last year, it’s hard to imagine that we were in a fundamentally different place with real worries. Globally interest rates and inflation were at multi-year highs, and the concern for investors was that inflation could remain structurally high and that monetary policy (i.e. the hiking of rates to curb inflation) was not working.

Turning to South Africa, our days were dark, literally. There were 250 days of load shedding in 2023. That’s almost 70% of the year with interrupted and limited energy and the estimated impact on GDP that was erased due to load-shedding was close to 2%.

We were added to the Financial Action Task Force’s grey list of countries, which is not good company to keep and had many ramifications. Adding to this was the negative foreign sentiment towards South African assets resulting in foreign ownership of our equity market being at levels last seen in 1998 and close to no appetite for allocations to our bond market. The Rand was trading around R19.30, and given that we import most of our inflation, a weak rand had a direct impact on us as consumers.

And after a prolonged period of poor economic growth, a weak rand, higher than usual inflation and a rising interest rate environment, the cost of living crisis for South Africans was real.

Change can happen quickly

But as we enter the final month of 2024 things look remarkably different. Inflation globally appears to be under control, and we have seen central banks around the world (South Africa included) start to cut interest rates. Lower interest rates are good for equity markets and bond markets but more importantly, they are good for every South African, as lower interest rates and lower inflation help to ease the cost of living crisis.

At the time of writing this, we have not had load-shedding since the 25^th of March this year and it’s incredible to see the impact this has had on both productivity and sentiment. This improvement in load-shedding has not even filtered through to business earnings yet but should we remain in an environment of no load-shedding, you are likely to see an uptick in both company earnings and GDP growth which will ultimately be favourable for our local market.

The Rand is trading around R17.5/$1 and inflation is well below the 6% level and around 3,8% with the last inflation print, close to the bottom of the SARB’s target range for inflation. This means an environment of lower interest rates which ultimately benefits us as consumers.

Our general elections were not only fair but accepted, with a peaceful transition of power from a ruling party that has had the majority for 30 years to a Government of National Unity (GNU) that appears to be working (long may it last). We have also seen a colossal effort from the FIC and FSCA to ensure processes and procedures are in place to hopefully get us removed from the grey list in 2025.

And all of the above have been drivers of the rally we have seen in domestic assets over the past 6 months.

Where to from here?

Now given the changes mentioned above, where are we seeing opportunities on the investment front and how have we positioned our portfolios?

We continue to see good opportunity in domestic equities, and we favour companies that are geared to the South African economy, we like to call these “SA Inc” companies.  It’s been incredibly tough to do business in South Africa over the past decade. Any South African focused business that has managed to survive has not only demonstrated resilience, but also a business model that can be sustained in an environment of low growth and real headwinds. As we see the environment shift and become more favourable, we believe this area of the market is poised to capitalise on these changes and generate good returns for investors.

Despite the rally in local bonds, we continue to favour this asset-class across portfolios holding a dedicated position to local bonds. With inflation around 3.8% and bond yields around 9.4%, the asset class is offering real returns after inflation of 5%, and in a rate cutting environment, investors will be rewarded not only with higher yields but also possible capital gains.

We remain on weight with regards to our global exposure in our multi-asset regulation 28 compliant portfolios.  While the Rand may be relatively stronger against the US dollar today than a year ago, we try not to time the exchange rate. Our research has shown that over time, the returns from underlying global investment opportunities have outweighed the rand contribution to performance.

It is good to remind ourselves that we are less than 1% of global GDP and so it makes sense that we have a healthy exposure to industries and investments outside of South Africa over time.

Let’s unpack our global ideas in a bit more detail

Emerging markets are a relatively diverse group of countries and regions, and we are seeing a fair amount of dispersion across the opportunity set. Chinese and Korean equities stand out as two investable opportunities that we have added to our more aggressive portfolios.

Chinese equity markets have recently benefitted from increased government stimulus to support the slowing economy. While the government can wave its proverbial magic wand to give stocks a jolt, for the rally to have meaningful staying power, it must be accompanied by earnings growth. However, earnings growth has not been a relevant topic for Chinese equities for some time, as real annual earnings growth has been negative over the past decade.

The Morningstar view is twofold: First, we expect Chinese companies to deliver moderate earnings growth over the next decade—a shift from the past—which supports our position in investor portfolios. Second, as with any asset class we invest in, quality matters! There are several vibrant sectors, especially the technology sector, that offer significant growth potential and according to Morningstar's wide moat methodology, screen as very attractive.

And the good news? You don’t have to pay an arm and a leg to own them. For example, Alibaba was trading at a single-digit PE ratio at the end of August and, as a reflection of quality, had nearly 30% of its market capitalisation in cash.

Lastly turning to the US, an expensive market just became more expensive thanks to the Trump rally. However, within the US market there are some great pockets of opportunity that we have tactically allocated exposure to. These include the more defensive Healthcare, Financials and Consumer Staples sectors, as well as more opportunistic Telecoms exposure where Meta and Alphabet are large index constituents. More recently we have also added positions to US Small Caps that are trading at multi-decade lows relative to their large-cap peers and have historically benefitted from a falling interest rate environment.

A year full of lessons:

So, as we end this year feeling more optimistic than we did a year ago, the lesson is that extrapolating our current situation and emotions into our future investments is a strategy that seldom works. Focus on the fundamentals, remove the emotion and trust the process. We have been doing this for 40 years at Morningstar and while it never gets easier, it’s a proven recipe for long-term satisfaction..