After a turbulent and volatile 2020, most role players in the financial markets have been careful to formulate strong views on the possible performance of the financial markets in 2021. In this newsletter, PBB will present its investment strategy for 2021 to clients. The investment framework in which the investment strategy will be articulated is also discussed. It will cover the following financial variables:
- Valuations of the domestic equity market and earnings growth.
- The R/$ exchange rate.
- Future interest rate levels.
- Valuations of the global equity market and earnings growth.
Valuations of the domestic equity market and earnings growth
It is clear that the market valuation of the domestic equity market is currently expensive. When the most recent P/E ratio of the All Share Index (ALSI) is studied in the graph below, it is clear that it is a very high 23.05 times one year’s headline earnings. The average P/E ratio over the long term is approximately 15.7 times one year’s headline earnings.
The high valuation of the ALSI resulted from a sharp recovery in share prices after the initial fall after the outbreak of the Coronavirus, while the earnings of companies declined sharply due to the lockdown of their businesses.
The ALSI’s earnings, as depicted by the graph below, shows us a 27.3% decline in earnings from its peak in February 2020. It is important to remember that equity markets will discount expected earnings growth at least 15 months into the future. This will explain at least a part of the recovery in share prices. However, it is PBB’s view that the current levels of the domestic equity market have been discounting an unrealistic recovery in earnings growth for the next two years.
This is unrealistic because the second wave of Coronavirus infection has already started in South Africa. Furthermore, South Africa is about six months behind the vaccination initiatives of the G7 countries without the financial capacity to roll them out meaningfully. It is unlikely that the second wave of the Coronavirus will not have a negative impact on the South African economy resulting in a more modest recovery of companies’ earnings growth. This view does not include the possibility that the government may re-introduce draconian lockdown measures.
P/E ratio of the ALSI
Earnings growth of the ALSI
The R/$ exchange rate
The approximately $7 trillion US dollars that the Fed and US Treasury have pumped into the US economy and those of their major trading partners, have increased the global supply of US dollars meaningfully.
The result of these stimulation measures has been a weakening of the US dollar against the Euro and emerging market currencies which include the rand. Thus, from April 2020 onward the South African rand has appreciated sharply against the US dollar. See the chart below for the correlation between a strengthening Euro against the US dollar and the effect on the R/$ exchange rate.
The strengthening of the rand against the US dollar is something that will not continue indefinitely. Clients who want to invest funds abroad should use the opportunity to convert rand to US dollar.
R/$ and €/$ correlation
The domestic interest rate levels
Domestic interest rates have reached their lowest levels in 55 years. See the graph below which represents the prime overdraft rate over the last 55 years. It is clear that the current 7% prime overdraft rate, was last seen in 1965.
Given the sluggish domestic economy and second wave of the Coronavirus, it is unlikely that interest rates will rise significantly over the next year. The money market deficit is still low due to weak demand for credit, the inflation rate is not a major threat and business confidence is low. Consequently, clients must consider and manage the following risks when investing in interest bearing assets:
- Be careful not to invest money in a fixed 3 to 5-year term to earn higher interest. Three to five years is a long time to be locked in a fixed interest rate structure. As mentioned in a previous newsletter, it took Zimbabwe only 3 years to create an inflation rate of over 800% per annum with resultant sharp increases in interest rates. Flexibility to move between investment opportunities is critical.
- Beware of always choosing the highest interest rate offered. A credit-worthy person or business can currently borrow funds over the long term at a prime overdraft rate of 7%. Why should certain banks and institutions pay depositors or investors a higher interest rate than the 7% to attract money? The reason is pretty simple, because the creditworthiness of those bank and/or institutions is much lower than the large banks. In other words, the possibility is greater for the depositor or investor to lose his investment capital at these banks and/or institutions.
- Given the fact that interest rates are at 55-year historical lows, care must be taken that the investor does not fix his funds for 3 to 5 years at these interest rate levels. Interest rates will normalise and steadily increase over the next 3 years.
SA prime overdraft rate – %
Valuation of the global equity market and earnings growth
PBB uses the SP 500 share index as a proxy for global equity markets. The valuation of the SP 500 as expressed by the very high P/E of 37.85 times, is much higher that the long-term average of 15.87 times. See the graph below for the expensive valuation of the SP 500 as represented by its P/E ratio. The same dynamics that have caused the high equity valuations in SA were also present in the US; a rapid recovery in share prices, whilst earnings per share declined sharply.
It is certain that earnings per share will recover in 2021. The table below gives the consensus forecast of headline earnings per share in US cents for 2020, 2021 and 2022. When the values in row 1 (headline earnings per share) are multiplied by row 2 (long-term average P/E of the SP 500) a fair value level for the SP 500 is calculated in row 3. For example, the fair value level for the SP 500 in 2021 is 2 654. However, it should be remembered that the equity market will discount the forecasted future earnings at least 12 to 15 months ahead of time. Consequently, the fair value level of the SP 500 is closer to the 2022 calculation of 3 097, which is 19% lower than the 3 700 level where the SP 500 is currently trading.
SP 500 P/E ratio
Fair value levels of the SP 500
| ROW | P/E, EARNINGS AND FAIR VALUE | 2019 | 2020 | 2021 | 2022 |
| 1 | SP 500 HEADLINE EARNINGS PER SHARE – $c | 162.97 | 135.67 | 167.24 | 195.15 |
| 2 | AVERAGE LONG-TERM P/E OF SP 500 | 15.87 | 15.87 | 15.87 | 15.87 |
| 3 | SP 500 LONG TERM FAIR VALUE LEVEL | 2 586 | 2 153 | 2 654 | 3 097 |
Investment strategy for 2021
Direct domestic investments – At present, PBB is underweight in domestic equity. PBB is looking for opportunities to increase the portfolios’ equity exposure with equities that offer value. Value can be found in banks, companies in the hospitality industry and industrial companies in the medium and small market capitalisation sectors. PBB is waiting for a decline in the value of the domestic equity market before we implement an increased exposure to equity. Given the low return in domestic equities over the last 6 years, PBB is looking at alternative investment options such as hedge funds and other emerging market funds to bolster returns. Furthermore, a reduction in exposure to government bonds is considered when capital market rates weaken. The recent strengthening of the rand against the US dollar has also created an opportunity to purchase dollar assets abroad.
- Direct foreign investments – At present, PBB is significantly underweight in global equities. PBB is looking for opportunities to increase the portfolios’ global equity exposure to exchange traded funds representing equities that have attractive valuations. A reduction in the exposure to US government bonds will occur when capital market rates decline. Clients should use the strengthening rand to invest funds directly abroad.
- Multi-management of retirement annuities, living annuities and smaller investments on the linked investment platforms – PBB is underweight the benchmarks in domestic- and global equities. The low returns that domestic equities have achieved over the past 6 years necessitates PBB to consider alternative investment options such as hedge funds and Chinese equity funds. We are currently conducting due diligence research on these two possibilities. PBB also plans to increase exposure to domestic equities and reduce exposure to government bonds when the opportunity to implement arises.
SP 500 P/E ratio
