Edition: Dec 2013- Feb 2014

Offshore Equity returns are more attractive in a 4 year view

As any investor worth his salt will tell you, it’s the long-term focus that is most important. To quote Ben Graham, popularised by Warren Buffett, “In the short run the market is a voting machine but in the long term it is a weighing machine”. In other words, you need to look through the short term noise and figure out the long-term trends.

This article will set out our view of the medium term (four years) outlook for asset class performance, based on our view of the global and local economic environment.

Putting Things in Perspective

The single most useful indicator of market returns is the US 10-year Treasury yield. The graph below shows its long term track record since the start of the previous century. From this, we see that this yield has been declining for the past 30 years. This is indicative of a reduction in the global cost of capital and has had large implications on market returns for 30 years.

For most market participants, their entire career has been characterised by this trend. To them this is “normal”. In truth, this is only one half of a longer 60-year cycle, which appears to now be reversing, with yields set to expand again.


The second point in setting investor’s perspective is the recent (up to end of August 2013) 10-year real compound annual growth rate (CAGR) of the primary asset classes in SA, both relative to their history and relative to their US equivalents. Having done this comparison, we can highlight the following points:

Equity: The US real return over 10 years was 5.1% CAGR (in US$) and was below the 20-year average of 6%. In SA equities return was 12.7% (in Rand terms) and well above the 20-year average of 9%. South African equities have therefore had an excellent run over the past decade.

Bond: As shown in the chart above, the 30-year bond bull run has been driven by the reducing US 10-year treasury yields from 14% in the 1980’s to the recent low of 2%. US Bond returns in real terms averaged 4.2% p.a. in the past 10 years, in line with their long run average. However, SA bonds delivered 5.3% p.a. against their long run average (53 years) of 1.3%. SA Bonds have also had an excellent decade.

Cash: In South Africa, this asset class delivered a 2.6% real CAGR over the recent 10 years, against its long run average of 1.1%.

Listed Property: This asset class does not have a very long returns history, and therefore a meaningful comparison was impossible.

From this simple analysis it is easy to see that SA assets have enjoyed very strong performance relative to their own averages and their US peers over the past 10 years. So as SA emerges from a “good” 10 years of returns, the opposite is true for the US. This is an important consideration which informs the starting point for our analysis.

The Economic Environment Forecast

The next step in our asset class returns forecast is to try to set the macroeconomic backdrop to the market performance. In the US, we expect the GDP growth rate to climb up to 3% within four years. With the economy slowly improving, we expect the US Federal Reserve (FED) to start tapering its quantitative easing programme in 2014, with the FED funds rate of 3.25% in year four of our forecast. The Euro-Area is expected to recover and trend slightly higher over the four year period, while the Japanese quantitative easing is predicted to continue.

In contrast, the Emerging Markets GDP growth rates are expected to grow at 5.25%, which is weaker than historical figures but still supportive of global growth. The combined result is for the world growth to continue recovering but at a below trend trajectory, with Emerging Markets slowing relative to recent history.

Base case economic assumption in 4 years Base
US continues to recover at a modest pace, but trends higher. Growth struggles to break above long term average (3.1%) GDP growth in 4 years 3.0%
Fed starts to taper in late 2013/early 2014, but rates remains on-hold until mid-2015 Fed rate in 4 years 3.25%
Euro-area slowly improves in 2014 to +0.8%. Trends slightly higher over 4 years GDP growth 1.5%
Japan QE continues. The Government debt issue still a concern. Growth improves GDP growth 2.2%
Emerging market growth moderates. Slows to 4.5% in next year, but then improves. GDP growth 5.25%
World growth improves moderately in 2014. Trends higher over 4 years GDP growth 3.75%


Domestically, we forecast a slowly improving GDP growth rate to 3.2% at the end of the four-year forecast period, with Infrastructure spending gaining traction and the recovering global environment assisting our GDP through increased exports. We expect monetary policy to remain on hold to 2015, while consumer inflation is to remain controlled but trend towards the upper end of the 3-6% band. The Budget and Current Account deficits are set to remain, with tax hikes expected, in our view, to close the fiscal gap.

SA Base case economic assumption in 4 years Base
SA growth remains range-bound at 3% to 3.5%. Infrastructure spending slowly gains some traction into 2015. GDP growth in 4 years 3.2%
Monetary policy targets the upper-end of the inflation range. SA interest rates remain onhold until late 2014 or early 2015. Repo rate in 4 years: 7.50%
Consumer inflation remains acceptable, but with risk to the upside Inflation ave 5.80%
SA Government finances struggle to cope with a revenue shortfall Budget deficit -4.2%
Ratings downgrade (by S&P) would lift bond yields S&P rating BBB
Current account deficit remains under pressure (higher growth implies more imports, but better world growth implies increased exports) Current a/c -5.3%


Our Resultant Forecasts

We used a primary valuation methodology utilising trailing multiples, adjusted for the economic and macro environment, accompanied by explicit forecasts for earnings and dividends.

To double check ourselves, we compared the primary results with an outcome of an economic risk rating method to ensure sensibility of forecasts.

Our return forecasts for the four year period, annualised, therefore are:

Summary of four-year annualised projected returns

4 Year IRRs Base Base (Real returns)
US Equity 15.1% (10.1% US$) 7.1% US$
US Bonds 5.5% (0.5% US$) -1.5% US$
SA Equity 9.8% 4%
SA Bonds 7.3% 1.5%
SA Property 9.3% 3.5%
SA Cash 7.5% 1.7%


These point estimates are an indication only. We do not expect each asset class to return exactly this forecast percentage over the four-year period.

It is also just as important to remember that models are just that – models of the real world – and at all times keep in mind the inputs used to create these outputs. If any of the inputs change substantially to what we have assumed, their results would need to be re-worked to adjust for these changes.

What is more important are the relative returns between the asset classes, rather than the absolute point estimates. Our models indicate that US Equity should provide the best returns over the medium term, followed by SA Equities and SA Listed Property. US Bonds are set to offer the least value, in line with our assumption of increasing yields.

Risks to our view

Of course, as with any forecasts, there are associated risks. The assumptions set out above might not fully play out, which would affect the final outcome. The timing of the emergence of these forecasts is also an uncertainty.

Among others, some key risks to our forecasts are that the SA rand does not depreciate at our assumed rate of 5% p.a., the US economic and consumer recovery is not as robust as we believe and finally, that our SA GDP assumption proves too optimistic.