Staying stable amidst uncertainty
With contributions from Dave Foord on the current positioning of the Nedgroup Investments Stable Fund
How do we deal with the uncertainty in the world today? We diversify.
In the Nedgroup Investments Stable Fund we’re trying to achieve inflation + 4% over rolling 3-year periods. We have been able to achieve more than that in the past and we still expect to get that in future. For example, ILBs are offering just about 4% real currently, so in theory we could have just loaded up the portfolio with those - but we’re not doing that because we think we can do much better than 4% real with other assets.
The SA 10-year bond is at 11%. Therefore, as long as inflation does not go above 7% on average for the next ten years, we will do better than 4% real. We don’t think that inflation will go above 7%. So that gives us a margin of safety, but we’re also not piling everything into the 10-year bond either. We have about 36% of the portfolio in SA bonds, of which about half is in the 10-year area and half is in shorter duration (around 4 years) earning 9%. Our plan is to switch the shorter duration bonds at the right time into longer dated bonds as we believe that there is still more momentum in rising rates and yields. Eventually about a third of the fund that will be positioned like that.
We have a 36% exposure to equities in the fund. The US market is still not cheap, even though it is less expensive than it used to be and we believe it should get cheaper. In the South African market, on a 3-year view, we can get 14 PE’s currently, which results in about a 20% p.a. return. But there will be differences between industrials and resources, for example, so the key is in stock-picking, and it will be path dependent. If the US market falls, South Africa will get cheaper as well. Our aim is to focus on the stocks which will deliver the returns at lower risk to the investor. The South African is market looking attractive, but we also consider other scenarios – for example, if earnings growth does not materialise are we protected? Also, if the PE is lower in 3 years’ time than we expect, what does that mean for returns? We should be able to comfortably achieve the inflation + 4%, and probably a bit more too.
The returns cycle
The important thing to note is that returns don’t come in a straight line. If you’re expecting 12% for the year, as an example, you’re definitely not going to get 1% per month. It doesn’t work like that. There will also be years when you get close to zero, and of course one of the key objectives of the Stable Fund is to protect against and minimise drawdowns as well as to ensure that there aren’t long periods where you are not getting your CPI + 4% returns. These things go in cycles. We’ve been through a down cycle recently but things catch up over time. So we try to be a bit clever on our entry points but we won’t get it right all the time. We also have a bit of dry powder in terms of potential equity exposure waiting to be deployed into better opportunities. Half of our equities are offshore and half in South Africa. Half of our South African exposure is in rand hedge stocks and the other half is in SA Inc. The SA Inc. stocks will do well as long as inflation does not blow out and the currency doesn’t weaken significantly.
Gold has been a problem for the portfolio. With inflation where it is, Gold should have been much higher, which would have been fantastic for the fund returns. This has been a disappointment. We have about 6% of the fund in Gold and gold related instruments. Gold is now under pressure because of high interest rates but is being buoyed by inflation.
Inflation in the US should settle at around 5% in the medium term, currently a bit higher, but we’re happy that we have Gold as insurance in the portfolio. If inflation goes back down to 2% then our gold position is probably going to hurt. But for now, we’re still very happy to have it.
Regarding offshore credit, which is yielding 6-7% in USD, we have about a 6% allocation in the fund. Using the Sasol USD bond as an example, if the ZAR weakens by 4%, we’re getting 10% there in a good short duration asset, and we’re not taking much credit risk in Sasol near term as we should be getting our capital back in 18 months’ time.
Property in South Africa and globally has headwinds with lots of structural change happening. We prefer logistics and storage for example. In South Africa, gearing has been overused and has been a disaster for many of the property counters. This will be a headwind for their distribution growth as and when yields rise. For this reason, we are staying low weight to property at around 4% and half of that is outside South Africa.
Overall, we’re confident that we are going to get CPI + 4% from here, but not this week. These views need some time to play out.