On Tuesday, Stats SA announced that the country’s GDP had fallen by 51% in the second quarter of this year. This was slightly below expectations and for many would have confirmed the consensus view that investors need to be highly aware of, and insure their portfolios against, significant local risks.
Greg Hopkins, the CIO at PSG Asset Management, pointed out that typically that is happening in three ways at the moment.
‘People are buying a lot of local cash,’ he said. ‘We have seen a large move from risky assets into local cash.
‘Offshore technology is another example. People think that there are better growth prospects there and are trying to hedge against the rand. And gold is another one that has made its way into many portfolios.’
This shows that the risks that investors are clearly focusing on are poor government execution on a recovery strategy, the low-growth environment, and rand weakness.
Risks being ignored
‘However, what’s interesting to us,’ said Hopkins, ‘is that there are risks that the market is not trying to insure against. Those are that there is some chance that the government might execute on some of its policies, that the South African economy might recover, or that the rand might be a little stronger than the consensus view is.’
This is reflected in investors crowding into local rand hedges, and the beaten-up nature of SA Inc. counters.
‘The way that local stocks are currently priced, the market is giving an almost zero chance that the government will execute on its policies in the future,’ said Hopkins. ‘When we take a step back, we don’t know what the odds are of government execution, we don’t know whether they will or they won’t and over what time frame, but we don’t think the odds are zero.
‘And what’s interesting here is there is a group of SA Inc. shares which would provide very cheap insurance against this happening.’
Currently 39% of the PSG Equity fund is held in SA Inc. stocks. Significant holdings include AECI, Discovery, the JSE, Shoprite and Remgro. As Hopkins pointed out, these are quality companies with historical return-on-equity well above the market average.
This, he argued, makes them cheap insurance against risks to the upside in South Africa. And there are reasons to believe that these should not be discounted.
‘Interest rates are currently at 55-year lows,’ said Hopkins. ‘This is something that sometimes the market misses. In the past, at this point in a crisis, our central bank would typically be raising rates because they would be protecting the rand and future inflation. These low rates, we think, could set the foundation for future growth in the economy.
‘The yield curve on government bonds is also very steep. Generally, when you see a steep yield curve it precedes economic growth. Now, we don’t know what the precise odds are of economic growth in South Africa improving in the future, but we certainly don’t think it’s zero.’
Commodity prices have also been improving, which means that South Africa’s terms of trade have benefited.
‘This could also provide the foundations for rand strength in the future,’ said Hopkins. ‘We don’t know what the odds are with any precision for what the rand will do in the future, but the chances of it strengthening are certainly not zero.’
Companies have also had the opportunity in the Covid-19 crisis to right-size and restructure their assets and operations. This restructuring creates the opportunity for future earnings growth.
‘We don’t know with any precision, once again, what the odds are of significant earnings growth in the future,’ said Hopkins. ‘But the possibility is certainly not zero.’
Finally, there is the possibility of investment returning to emerging markets.
‘Capital outflows form emerging markets in the first quarter of this year were the highest we’ve seen on record,’ said Hopkins. ‘There is a chance that the herd could come back. The weakness in the dollar and recent strength in emerging market currencies could be a harbinger of some of this money returning.
‘If it does, it generally lifts local asset prices and improves the currency. Once again, we don’t know what the odds are with any precision, but we don’t think that they are zero.’
This informs PSG Asset Management’s view that there is value in insuring against the possibility of the South African economy, the rand, and local company earnings surprising to the upside.
‘There is a very strong consensus view in the country that we should be sitting anywhere other than SA Inc.,’ said Hopkins. ‘And there could be a lot of pain if South Africa is a little less bad than we expect, and if government just executes a little on its policies. And, right now, you can get cheap insurance against that outcome.’