Differentiating between the winners and the losers

Differentiating between the winners and the losers

By Clyde Rossouw, portfolio manager of the Investec Opportunity Fund and Absolute Balanced Fund

Local and international stock markets have rallied strongly. Many investors are wondering whether this is going to be sustainable or whether equity markets will plunge again. What’s most encouraging for us as long-term investors is that we still see many good opportunities locally and globally, which we are exploiting. The recovery in the equity markets does not signify the start of a long-term sustainable bull market, but there is an opportunity to make money from deeply discounted levels on really good shares. As an investor this is a fantastic time to be sowing rather than to be looking to reap. The time for reaping will come later; investors just need to be patient.

Global stock markets bottomed in March and that changed the direction of world equity market returns. Once the bottoming-out process was confirmed, investors were prepared to start taking on a lot more risk. We have seen emerging market currencies appreciating and the rand in particular has strengthened substantially – even reaching a level of below eight rand to the dollar.

Where is the recovery coming from?
There have been massive stimulus packages around the world and investors are starting to realise that the world is not going to come to an end. Emerging markets are generally in better shape than the developed world. The Chinese government has embarked on a huge spending programme to support its economy and we are starting to see more favourable economic data from China. Steel and iron ore production is increasing and China’s purchasing managers’ index (PMI) remained above the critical 50-point level in May. The Chinese stock market has done very well over the last six months, together with India, Brazil and Russia. The South Africa stock market also enjoyed excellent returns, and support from foreign investors has largely contributed to rand strength. Rising dollar prices for commodities such as copper, platinum, gold and oil signify that the world is on a recovery path and emerging markets are benefiting from this trend.

The era of a commodities super-cycle is over
The uptick in commodities has resulted in local resources shares outperforming the general market. There are a number of opportunities within the resources space, but some companies still look very risky. It is unlikely that we will ever experience a commodities super-cycle again. The super-cycle commodities trend reminds one of previous market themes such as the “new economy versus the old economy” and the “tech boom” – which are now dead and buried. When the technology bubble burst, many of the tech companies ceased to exist, but the stronger companies survived. The same scenario is likely to play out in the resources space. Some of the more marginal companies will underperform or go bust, while quality companies will power ahead. It is clear that the performance of commodities versus commodity producers will be divergent going forward.

The current environment presents many challenges, but offers good rewards for those portfolio managers who make prudent stock selections. In a bull market when a theme is strong, investors just need to ensure that they are part of that theme and ride the wave. This luxury does not exist under current market conditions. The market is going to be much more cynical and will do its homework properly in terms of differentiating between the winners and the losers.

Physical gold is more attractive than gold companies
Gold shares have been very volatile – we saw a sharp drop in April and a strong recovery in May. Gold producers’ earnings benefited from the weak rand in the first quarter, but the strength in the rand will mean that companies’ earnings will pull back again. The strength in gold shares does not seem sustainable. Since 1970 the rand gold price has outperformed gold shares. Gold production has been declining since the 1970s and it continues to bleed every year. Last year South Africa was down to 226 tons of gold from 1,000 in 1970. The gold companies are all trying to expand internationally, but their long-term health will still largely depend on the quality of reserves.

Developed market government bonds are looking very risky
The Unites States government and the US Federal Reserve (the Fed) have been on a spending spree over the last few months in a bid to support the ailing US economy. The US government has been issuing trillions of dollars worth of US treasuries (long-term government debt) to fund the fiscal stimulus packages. China has supported the US government by buying up a great deal of these government bonds that have flooded the market, together with other central banks and private investors. The Fed has also been mopping up the excess supply of bonds. Essentially, the Fed buys these government bonds by printing more money; this is known as quantitative easing. When risk aversion peaked, many investors piled into US treasuries as it was perceived to be risk-free. Consequently, US treasury yields remained very low. (When bond yields decline, bond prices increase and vice versa).

The strength in government bonds could simply not be sustained. Since March US Treasury yields have been rising, and in the last week of May the ten-year Treasury yield reached a six-month high. The weaker government bond market reflects investors’ concerns regarding the continued oversupply of bonds. More government bond auctions are on the way and with appetite for government bonds waning, the Fed will have to keep on propping the market up. The dollar has been losing value and inflationary fears have also driven Treasury yields up.

A key question is how long the Federal Reserve will be forced to support the government bond market and whether its actions will not have serious implications for inflation over the longer term? Essentially, money is being created out of nothing. This is not money that was created from people actually doing some work, performing a service or producing goods. Money has been printed without any economic activity taking place. Economics 101 would suggest that if you have more money chasing the same amount of goods, services or assets, ultimately you will have inflation.

The upside is that higher inflation could result in an improvement in company profits, which means better cash flows, enabling companies to pay off their debts. In turn, the risk of companies defaulting on their debt obligations would decrease, resulting in corporate bond yields coming down. (As corporate bond yields decline, corporate bond prices rise).

Local bonds are still pricing in risk, but listed property looks vulnerable
Local bond yields are still higher than international bond yields and because of this spread our market enjoys some protection against a sharp sell-off in international bonds. However, the local market may be too optimistic about a meaningful decline in inflation. Consumer inflation is currently running at 8% and the bond market expects this to slow to 6%. There is a risk that inflation may remain above the upper band of the Reserve Bank’s inflation target. The international environment for bonds will be one to watch closely over the next few months. Listed property would be the most at risk from a rising bond trend. The differential between the yields of listed property and government bonds in South Africa is too low, whereas in the developed world the spread is much wider. Investors are not adequately compensated for the risk of holding SA listed property.

There are many attractively valued equities available in global and local stock markets that should give strong real returns for investors with a horizon of more than three years. Some of these opportunities include MTN, which has attracted corporate buying interest and Afrox, where the market has assumed its business franchise has been decimated. We are still not finding reasonable risk-adjusted returns from either bonds or listed property, and continue to largely avoid these asset classes. Despite tough conditions, there are opportunities to outperform the market and we are confident of producing inflation-beating returns over the long term.


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