LONG-TERM PERSPECTIVES 2017

Transcription

1 MACROSOLUTIONS INVEST WITH PERSPECTIVE LONG-TERM PERSPECTIVES 2017

2 MACROSOLUTIONS TEAM OPERATIONS AND DISTRIBUTION PETER BROOKE Head of MacroSolutions SATHYEN MAHABEER Chief Operating Officer MERRELYN DIALE Senior Account Manager MELANIE VOLLENHOVEN Business Development Specialist PORTFOLIO MANAGERS ALIDA JORDAAN ARTHUR KARAS DENZIL BURGER EVAN ROBINS GRAHAM TUCKER JOHN ORFORD URVESH DESAI WARREN VD WESTHUIZEN INVESTMENT AND RESEARCH ANALYSTS GARY DAVIDS ZAIN WILSON LUNGILE LUVUNO ECONOMIC RESEARCH TEAM RIAN LE ROUX JOHANN ELS TINYIKO NGWENYA MARIETJIE JOOSTE CONTACT DETAILS SATHYEN MAHABEER Chief Operating Officer E smahabeer@oldmutualinvest.com T +27 (0) C +27 (0) MERRELYN DIALE Senior Account Manager E mdiale@oldmutualinvest.com T +27 (0) C +27 (0) Passion Accountability Excellence Discipline Uniqueness

3 FOREWORD We build multi-asset class portfolios, investing across a wide spectrum of local and global asset classes. This requires an in-depth knowledge of what drives each of these asset classes, especially over the long term. This led us to creating LONG-TERM PERSPECTIVES, now in its fourth edition. Long-Term Perspectives scrutinises the performance and behaviour of select asset classes over the past 87 or more years. We use these asset classes to create the MacroSolutions a diversified portfolio that is a proxy for an average balanced fund (the main savings solution in South Africa). In the publication, we make a strong case for the undisputed benefits of diversification. We also highlight the factors investors need to consider when building a portfolio. These factors include understanding the silent killer of savings: inflation. To highlight its devastating impact, we focus on real returns (growth after inflation) rather than on nominal returns. Real returns are what our clients need and are therefore a key driver in our asset allocation process. Turn to page 37 for our current longer-term expected real returns. Another important influencer of returns is the rand. It requires particular attention as balanced funds are able to allocate a significant portion towards global assets, either directly or indirectly, through locally listed global companies. Perspective is key here as the rand is capable of being pushed and pulled by many factors. Long-Term Perspectives will help you to step away from the noise and take a broader and, more importantly, longer-term view of your investments. Yours sincerely Graham Tucker Balanced Fund Portfolio Manager at MacroSolutions FOREWORD 3

4 CONTENTS Executive Summary 5 Graham Tucker The MacroSolutions 6 Graham Tucker Long-term Lessons 9 Peter Brooke Diversification 12 Graham Tucker SA Inflation 15 Johann Els SA Equity 18 Graham Tucker SA Listed Property 21 Evan Robins SA Bonds 22 Zain Wilson SA Cash 24 John Orford Gold 26 Denzil Burger The Rand 28 Rian le Roux Global Assets 30 Urvesh Desai Global Equity 32 Urvesh Desai Global Bonds 34 Urvesh Desai Long-term Real Returns Outlook 37 Peter Brooke Asset Class Returns (Long-term Overview) 38 MacroSolutions (Returns) 39 All graphs and data compiled by Zain Wilson 4 CONTENTS

5 EXECUTIVE SUMMARY With the primary goal of investors being to save for long-term goals, the aim of this report is to draw attention to the long-term behaviour of asset classes and, in so doing, provide perspective on the shorter-term volatility. 7 lessons guide an investment plan In analysing long-term data, we uncovered profound lessons to help build a resilient investment plan. These lessons shape the key principles of our investment philosophy (see page 9). When R becomes R5 584 The first of our lessons is on an investor s worst enemy: inflation. A 6% inflation rate will almost halve the value of your money over 10 years (see Chart 11). 90 years to double your money Another risk to our future wealth is investing in cash. While there is minimal risk of losing money, you get what you pay for (read page 24). Investing in cash takes a lifetime to double the real value of your money, as opposed to 10 years in equities. SA s top asset class 41 out of 87 years To counter the effects of inflation and low-return investments, you need the higher growth potential of equities SA s winning local asset class for 47% of the time (see Chart 4). Diversification is the one free lunch While equities are often the winning asset class, it still pays to diversify. The analysis of drawdowns on page 12 shows the benefit of blending different asset classes, while on page 14 you can see the consistent, above-average returns of the MacroSolutions. CHART 1: MACROSOLUTIONS BALANCED INDEX PROVIDES CONSISTENT LONG-TERM RETURNS Annualised real returns in rand terms (December 1929 December 2016) 7.3% 7.0% 5.7% SA Equity Global Equity (R) MacroSolutions 3.5% 3.3% 1.5% 0.6% Gold Global Bonds (R) SA Bonds SA Cash The MacroSolutions delivered a negative real return of 3% in 2016 as the rand strengthened sharply, while SA equity returned -4% after inflation. Looking forward, we expect the MacroSolutions to deliver a real return of 4% annualised over the next five years (see page 37), down from the current 7.9% a year over the past five years and lower than the average 5.7% a year real return achieved since EXECUTIVE SUMMARY 5

6 MACROSOLUTIONS BALANCED INDEX a long-term picture of multi-asset class performance 75% of unit trust flows 45% of unit trust investments WHY A BALANCED INDEX IS SO USEFUL Multi-asset class portfolios such as balanced funds have accounted for 75%* of total flows into the unit trust industry over the past five years and have grown from 36% to 45%* of total assets under management. Investors favour these funds because they: 1. Provide excellent real (above inflation) returns 2. Offer diversified, risk-managed solutions 3. Comply with Regulation 28 of the Pension Funds Act 4. Qualify for a tax incentive for retirement savings. Therefore, the average SA investor s returns are best measured by how a typical balanced fund has performed and for that reason we developed our proprietary MacroSolutions. THE MACROSOLUTIONS BALANCED INDEX OVER 87 YEARS The MacroSolutions dates back to 1929 and provides a long-term total return series for an SA balanced fund. The Index has been fine-tuned over the years to reflect changes in the local investable universe (see History on page 8). This index is a valuable tool in that it provides insight into longterm structural investment trends in SA. CURRENT WEIGHTING OF BALANCED INDEX SA equity 45% Global equity 20% SA bonds 20% Global bonds 5% SA cash 7.5% Gold 2.5% CHART 2: WHOLE GREATER THAN THE SUM OF THE PARTS Growth of R1 over 87 years in real terms (December 1929 December 2016) R1 000 R100 R10 R1 R0 Long-term returns of the MacroSolutions 6 MACROSOLUTIONS BALANCED INDEX % a year nominal returns SA equity (R472) Global equity (R296) MACROSOLUTIONS BALANCED INDEX (R123) Gold (R19) Global bonds (R17) SA bonds (R4) SA cash (R2) 5.7% a year above inflation * Source: Association for Savings & Investment SA (ASISA)

7 MULTI-ASSET CLASS GROWTH OVER 87 YEARS: THE POWER OF COMPOUNDING R R191 R1 invested in MacroSolutions Balanced Index grew to R over 87 years. R1 growing at the rate of inflation would be a paltry R191! In real terms, investors money increased 123 times EXPANDING THE INVESTMENT UNIVERSE Investors have an increasing array of investment opportunities available for inclusion in their portfolios. This creates a greater opportunity set for managers to add value through actively managing portfolios across asset classes. To illustrate this, we look at the impact of including different assets to a now globally diversified MacroSolutions relative to an SA-only index (65% SA equity, 25% SA bonds, 10% SA cash). CHART 3: MORE OPTIONS, MORE OPPORTUNITIES MacroSolutions relative to an SA-only (December 1950 December 2016) 1.15 SA-only underperforms/macrosolutions Balanced outperforms 1.10 SA-only outperforms/macrosolutions Balanced underperforms Global assets introduced 1967 Gold included The chart highlights the potential value-add through active asset allocation and the risk reduction that is made possible through diversification. Adding alpha through active asset allocation is a key source of return for a multi-asset class fund. Here s why... MACROSOLUTIONS BALANCED INDEX 7

8 CHART 4: A MIXED PERFORMANCE PICTURE Each year s best performing local asset class ( ) Equity Property Bonds Cash Gold LOSER: CASH... but the best performer for 13% of the 87 years WINNER: EQUITIES... but only for 47% of the time Equity 47% Gold 16% Cash 13% Bonds 14% Property 10% ROTATING BETWEEN ASSET CLASSES CAN ADD SIGNIFICANT VALUE The greater scope in asset class choice enables managers to produce similar returns for less risk. By adding a conservative 0.25% a year to the MacroSolutions returns through active asset allocation, R1 would grow by an additional R4 809 to R THE HISTORY OF THE MACROSOLUTIONS BALANCED INDEX The Index was initially a simple equity (65%), bonds (25%) and cash (10%) allocation. Over time, the weights adjusted to reflect changes in the investable universe and regulatory environment for instance, gold was included in 1967 and global assets were introduced in The current weighting of the Index is 65% equity, 25% bonds, 7.5% cash and 2.5% gold. For details on this index, please visit select Insights. 8 MACROSOLUTIONS BALANCED INDEX

9 LONG-TERM LESSONS building the right solution Analysing long-term data is crucial to our investment process and it also teaches us some profound lessons. Understanding these lessons will help you build the right investment solution to achieve your goals. Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. Ronald Reagan LESSON 1 INFLATION IS YOUR ENEMY REALITY: Many investors suffer from inflation illusion as they don t notice how destructive inflation can be over time (see INFLATION research on page 15). INFLATION CORRODES SPENDING POWER Take a look at what a 6% inflation rate effectively does to your money: R R5 584 R3 118 LESSON: We need to look at long-term investment returns in real terms, stripping out the impact of inflation. TODAY 10 YEARS LATER 20 YEARS LATER LESSON 2 CASH IS TRASH REALITY: A bank loan exposes you to minimal risk, but there s a price to be paid for that security. TIME NEEDED TO DOUBLE YOUR MONEY Using each asset class s long-term average returns, this is how long it will take to double your REAL investment value SA EQUITIES SA BONDS SA CASH LESSON: Cash does not increase your real wealth over time. Over 92 years, cash has an after-inflation return of just 0.7% a year. It is better to own shares in the bank than to leave your money there. 10 years 41 years 90 years LONG-TERM LESSONS 9

10 LESSON 3 YOU NEED EQUITIES REALITY: Many investors will not retire with enough money. PERFORMANCE OVER 87 YEARS (nominal returns) SA EQUITY 14% a year SA BONDS 7.8% a year LESSON: We need the higher long-term returns from equities to grow our wealth. This is particularly important in a world where people are living longer. SA CASH Inflation 6.2% a year 6.9% a year LESSON 4 TIME IS YOUR FRIEND REALITY: The main reason investors prefer cash to equities is the fear of losing money. PROBABILITY OF NEGATIVE RETURNS OVER DIFFERENT TIME PERIODS 44% 43% 38% LESSON: The best way to manage the risk of losing money is to remain invested in equities for longer. As soon as you extend your holding period for more than three years, past performance shows that you wouldn t have lost money. Take what happened in 2008: after a negative 30% return, the market rebounded to deliver 14% a year over the following five years (see Chart 14). 30% 20% 6% 0% 0% 1 Day 1 Week 1 Month 1 Quarter 1 Year 3 Years 5 Years 10 Years 1 day and 1 week: Rolling total returns, June 1995 December month to 10 years: Rolling returns, January 1960 December 2016 LESSON 5 COMPOUNDING IS A POWERFUL WEALTH GENERATOR The old adage holds true: Time in the market, not timing the market. REALITY: Money needs time to benefit from the full potential of compounding growth. GROWING YOUR WEALTH OVER TIME Using the long-term nominal average return of 14% a year, look at what happens when your money is invested in SA equities over time: LESSON: Start saving as soon as you can, leave it for as long as you can, and let compounding do the work for you. And tick the dividend reinvest box on your investment application form to maximise your growth. TODAY 10 YEARS LATER 20 YEARS LATER Compounding simply means making money on your original investment as well as on the gains made in previous years (i.e. growth on growth over time). R1 000 R3 712 R LONG-TERM LESSONS

11 LESSON 6 DON T PUT ALL YOUR EGGS IN ONE BASKET REALITY: Equities may have been the best performing asset class since 1929, but cash was the best performer for 11 of those years and listed property for 9 years LESSON: Diversification is the one free lunch in investments; use it. That is because it pays to invest across different asset classes. The analysis of drawdowns on page 12 shows the benefit of blending different asset classes, while on page 14 you can see the consistent, aboveaverage returns of the MacroSolutions. PERCENTAGE OF TIME AS THE YEAR S BEST PERFORMING ASSET CLASS ( ) SA equity 47% SA property 10%* SA bonds 14% SA cash 13% Gold 16%** * since 1980 ** since 1967 LESSON 7 ASSET ALLOCATION ADDS VALUE REALITY: Asset classes have distinct secular or long-term periods of under- and outperformance. UNDERSTAND THAT MARKETS MOVE IN CYCLES LESSON: Active asset allocation is a vital tool in delivering superior returns. SA BONDS, for instance, gave a negative real return for 40 years, before delivering a great return over the last 30 years. LISTED PROPERTY went nowhere for 15 years, before becoming the best performing asset class for the next 20. WE INCORPORATE THESE LESSONS INTO THE WAY WE BUILD OUR SOLUTIONS: They all have real return targets. They all have growth assets. They are all well diversified. They all employ active asset allocation. We recommend a minimum holding period for each solution the more exposure a fund has to equities, the longer the recommended investment time. We hardcode long-term thinking into our investment process. These principles also form the basis of Old Mutual Wealth s investment philosophy, enabling them to deliver to client objectives. LONG-TERM LESSONS 11

12 DIVERSIFICATION managing drawdowns After time, diversification is the second most valuable tool you can use to manage risk as it reduces the impact that a single poorly performing asset has on your overall portfolio. Investors tend to have a low tolerance for pain, with the fear of losing money outweighing the greed for gains. This is especially true when it comes to investing in equities, due to their higher level of volatility. To better understand this volatility, we look at the drawdowns of equities and bonds in real terms (after inflation), which is a harsher light, as inflation normally softens the impact of a long-term bear market. DRAWDOWNS ARE PAINFUL AND COSTLY Market declines are measured by the amount of money lost from the peak and how long it takes to recover the losses. Both equities and bonds have exposed investors to painful periods of negative returns. EQUITY VOLATILITY 17.5% BOND VOLATILITY 6.9% VOLATILITY is the variability of an asset s returns. The higher volatility for equity means that it has a wider range of possible returns than bonds (both positive and negative). CHART 5: DRAWDOWNS OF SA EQUITY December 1924 December 2016 OUR LONGEST EQUITY BEAR MARKET* Investors who bought at the peak in 1948 lost more than half their money (-55.2%) in real terms in just over five years. 0% -10% -20% 15 years Time taken to get back to breakeven OUR MOST PAINFUL BEAR MARKET* 63.5% lost in just 2.5 years CHART 6: DRAWDOWNS OF SA BONDS December 1924 December 2016 THE TRUTH ABOUT BONDS -30% -40% -50% -60% -70% 0% Great Depression Post World War II 1969 crash Over 50 years to breakeven 1987 crash Asian crash 2008 Global Financial Crisis DIVERSIFICATION Starting in 1947, bonds lost 60.8%* of their value (in real terms) For a continuous 39 years, bonds were an extremely poor investment It would take more than 50 years to get back to breakeven -10% -20% -30% -40% -50% -60% -70% years

13 THE WAY TO MANAGE THIS RISK IS THROUGH DIVERSIFICATION A simple 50% equity : 50% bond blend dramatically improves the drawdown profile. CHART 7: DRAWDOWNS 50% SA EQUITY : 50% SA BONDS December 1924 December % WORST DRAWDOWN -10% -20% -30% -40% -50% -60% -70% CHART 8: BALANCED RETURNS DURING PERIODS OF EQUITY OR BOND DISTRESS December 1924 December % -60.8% -45.2% EQUITIES BONDS 50:50 PORTFOLIO If we expand this idea and look at the performance of the MacroSolutions during periods of turmoil, we can see that a balanced, diversified portfolio helped soften the blows during these difficult periods. 150% 100% US Fed Chairman Volcker kills inflation 84% Bond Returns Equity Returns Returns 50% 0% -50% Great Depression 17% -8% -20% 48% -17% -22% South African Debt Moratorium 14% 5% 1987 Stock Market Crash Asian Financial Crisis 3% -1% -22% -19% -31% -31% Global Financial Crisis -1% -30% -45% -100% August May 1932 July May 1981 August August 1985 August November 1987 July December 1998 October February 2009 Financial history clearly shows the truth in the old adage: Don t put all your eggs in one basket. DIVERSIFICATION 13

14 DIVERSIFICATION Our smartie box shows the performance rankings of the different asset classes over various time periods. The last five columns show just how variable the relative performance of asset classes can be from one year to the next. There are three key points arising from the table below that are discussed in LONG-TERM LESSONS (page 9). 1. Diversification: The MacroSolutions represents a typical balanced portfolio and illustrates that diversification works. The Index consistently ranks in the top half of the table, even in individual years such as 2010 and 2011, when both global and SA equities underperformed, respectively. 2. Active asset allocation: The range of returns shown in the last line demonstrates just how important it is to have the ability and agility to move between asset classes. 3. Equities for the long term: Although equities do go through periods of underperformance (refer to the drawdowns on the previous page as an example), investors are rewarded for this risk over the long term, as equities outperform inflation and less risky asset classes such as cash and bonds. 50 years 40 years 30 years 25 years 20 years 15 years 10 years 5 years HIGHEST RETURN (p.a.) SA Equity 17.0% SA Equity 19.4% SA Equity 14.8% SA Property 14.7% SA Property 18.4% SA Property 21.4% SA Property 15.8% Global Equity 23.4% Gold 27.9% Global Bonds 51.5% SA Equity 32.1% SA Property 29.6% Gold 32.9% SA Property 35.9% Global Equity 57.0% SA Property 26.6% Global Equity 34.6% SA Bonds 15.4% Global Equity 16.1% Global Equity 18.0% MacroSolutions 14.7% SA Equity 14.6% SA Equity 13.9% SA Equity 14.4% Gold 13.4% SA Property 17.3% SA Property 26.5% Gold 41.1% MacroSolutions 15.8% SA Equity 19.0% Global Bonds 30.8% SA Equity 26.7% MacroSolutions 22.2% Global Equity 16.7% Global Bonds 30.4% SA Property 10.2% MacroSolutions 15.6% MacroSolutions 17.7% Global Equity 14.7% MacroSolutions 14.4% MacroSolutions 13.7% MacroSolutions 12.8% Global Equity 11.7% MacroSolutions 13.5% SA Equity 19.2% SA Bonds 17.0% SA Property 14.1% Gold 16.1% Global Equity 15.8% Global Equity 21.3% SA Equity 21.4% MacroSolutions 11.5% Gold 17.7% SA Cash 7.4% Gold 13.7% Global Bonds 14.8% SA Property 13.7% Global Equity 14.4% SA Bonds 12.1% Gold 10.9% MacroSolutions 11.1% SA Equity 13.0% MacroSolutions 13.9% SA Cash 11.7% SA Cash 9.1% SA Bonds 15.0% SA Property 8.9% MacroSolutions 20.6% Global Bonds 17.9% Global Bonds 11.2% MacroSolutions 10.9% SA CPI 6.9% Global Bonds 13.4% Gold 13.0% SA Bonds 13.3% SA Bonds 12.9% Global Equity 12.1% SA Bonds 9.6% SA Equity 10.5% Global Bonds 10.3% SA Cash 9.4% SA CPI 10.3% SA CPI 6.3% MacroSolutions 13.3% MacroSolutions 8.9% SA Bonds 16.0% SA Property 8.4% SA Equity 10.9% SA Property 8.0% MacroSolutions 3.3% SA Cash 11.0% SA Bonds 12.8% Global Bonds 12.5% Global Bonds 12.1% Gold 11.6% SA Cash 8.0% Global Bonds 10.4% SA Bonds 7.4% SA CPI 8.6% SA Property -4.5% Global Equity 1.6% SA Cash 6.9% SA Bonds 8.8% Gold 13.8% SA CPI 5.4% Gold 10.6% SA Cash 6.5% SA Equity 2.6% SA Bonds 10.9% SA Cash 11.8% SA Cash 11.4% Gold 11.8% Global Bonds 10.1% Global Equity 7.3% SA Bonds 8.0% SA Cash 6.1% Global Bonds 7.4% MacroSolutions -6.6% Gold -0.4% SA CPI 4.2% SA CPI 6.1% Global Bonds 6.5% SA Cash 5.2% SA Bonds 10.1% SA CPI 5.2% Global Equity -4.2% SA CPI 9.1% SA CPI 9.5% Gold 10.2% SA Cash 10.4% SA Cash 9.5% SA CPI 6.1% SA Cash 7.3% SA CPI 5.7% Global Equity 7.0% Global Equity -16.6% SA Bonds -1.0% Global Equity 0.5% SA Cash 5.7% SA CPI 5.7% SA Bonds 0.6% SA Cash 5.9% SA Equity 5.1% Gold -4.6% LOWEST RETURN (p.a.) SA CPI 8.2% SA CPI 7.0% SA CPI 6.4% Global Bonds 5.9% SA CPI 6.4% Gold 4.9% SA Bonds 4.2% SA Equity -23.2% Global Bonds -18.8% Global Bonds -4.4% SA Equity 2.6% SA Cash 5.6% Gold -10.3% SA CPI 5.3% SA Bonds -3.9% Global Bonds -10.4% RANGE BETWEEN HIGHEST AND LOWEST RETURN 8.0% 9.9% 6.6% 7.7% 12.1% 15.5% 9.4% 18.6% 23.7% 74.7% 51.0% 34.0% 30.4% 30.3% 67.3% 21.3% 38.5% 25.8% Note: All are annualised nominal returns in rands. 14 DIVERSIFICATION

15 SA INFLATION public enemy #1 SA s inflation followed the rest of the world higher during the 1970s, on the back of the first oil crisis, while local factors kept our inflation rate high during the 1980s. These included rocketing wage growth, as remuneration per worker topped growth of 20% in the 1970s and early 1980s, and the negative impact of economic isolation during the sanction years of the mid-1980s. Nearly a decade after US Federal Reserve Board (Fed) Chairman Paul Volcker broke the back of US inflation, Dr Chris Stals played a similar role after becoming Governor of the South African Reserve Bank (SARB) in A combination of high real interest rates, a fairly lengthy recession and the opening of the economy in 1994 led to lower inflation. The introduction of inflation targets also played a big role in anchoring inflation expectations. The result is that inflation has averaged 6.3% over the last decade. Inflation is the biggest enemy of savers as it erodes their spending power. This is why we look at our long-term investment returns in real terms (which strips out the impact of inflation). In SA, this is particularly pertinent as inflation has averaged 5.6% over the past 105 years (see Chart 9). This compares unfavourably to the average 4.3% in the UK and 3.5% in the US. CHART 9: INFLATION TARGET ANCHORS EXPECTATIONS SA inflation as measured by the consumer price index (CPI) (December 1911 December 2016) 30% 20% 10% 0% -10% -20% -30% SA CPI Average Source: StatsSA FIVE-YEAR OUTLOOK We expect inflation to average 5.5% over the next five years, which is within the SARB s target range of 3% to 6%. The risk, though, remains to the upside despite our expectations that inflation could fall towards 5% in the first half of As we are a small and an open economy, SA inflation will always be subject to big global cycles as the currency and, consequently, food and petrol prices play havoc with price changes. SA s inflation rate unsurprisingly is more aligned to those of other emerging economies than those of developed economies. For instance, in 2016 our average inflation was 6.7%, compared with those of our BRICS counterparts (Brazil at 8.8%, Russia 7.1%, China 2.0% and India at 4.8%), and higher than that of the US (1.3%) and the euro area (0.2%). SA INFLATION 15

16 THE IMPACT OF INFLATION ON OUR EVERYDAY LIVES 1. What will it cost? The variability of inflation is a huge challenge for budgeting. Despite the fact that SA s inflation measurement and calculation is among the best in the world, it is an average of all the consumers in the country. If your expenditure is more skewed towards components in the basket of goods with very high inflation rates (for instance, education and healthcare), you will experience a much higher personal inflation rate than the country average. In this case you will need to save more for future expenses R Mid-sized family sedan (1600cc engine) at 5.8% vehicle inflation rate (average since 1990) +10 YEARS R YEARS R R One year s tuition and boarding at top Cape Town private school at 9.2% education inflation rate +10 YEARS R YEARS R R Private hospital kidney dialysis costs for a year at 10.1% medical inflation rate (average since 1990) +10 YEARS R YEARS R How much have prices gone up? We can look back in time to see how much some South African favourites cost compared with today s prices. R R72.90 R81.99 R0.30 R0.50 R0.25 R0.10 R s s s s 2016 Spur burger Cheddamelt steak Ricoffy 750g Nestlé condensed milk 16 SA INFLATION

17 Similarly, 10 years ago you would have paid almost half of what it costs today for a basket of consumer goods. Twenty years ago it would have cost R292 to fill your trolley, compared with the mere R5 of 80 years ago. CHART 10: VALUE OF BASKET OF GOODS THAT COSTS R1 000 TODAY R1 000 R758 R538 R410 R292 R94 R4 R5 R13 R years ago 80 years ago 50 years ago 40 years ago 30 years ago 20 years ago 15 years ago 10 years ago 5 years ago NOW 3. Did I save enough? If your retirement income does not at least grow in line with inflation, you will either experience a decline in your standard of living or you will run out of money. At a 6% inflation rate, a fixed monthly retirement income of R a month today will decline in real terms to about R1 700 a month after 30 years. Chart 11 shows your purchasing power is even worse at a higher inflation rate. This highlights how important it is to plan carefully and ensure that you invest to achieve inflation-beating returns in the long run. CHART 11: IMPACT OF INFLATION ON RETIREMENT INCOME OF R OVER TIME R R % inflation 6% inflation 9% inflation R8 000 R6 000 R4 000 R4 120 R2 000 R1 741 R754 R years +20 years +30 years SA INFLATION 17

18 SA EQUITY valuations determine subsequent returns Over the past 90 years, the SA equity market has swung between cheap and expensive relative to trend (as per the grey trend line in Chart 12). This movement from low to high and vice versa is known as reflexivity was another difficult year for the SA equity market as a whole, but the market is now in line with the long-term trend. Just a few short years ago our market was trading at one standard deviation above trend, which suggested that the balance of risks was shifting to the downside. The performance observed in 2015 and now in 2016 means that the market is more finely balanced. REAL RETURNS +7.9% a year since 1925 NOMINAL RETURNS +14.3% a year since % HIGHEST annual return (1979) -26.4% LOWEST annual return (1970) CHART 12: UPWARD TREND, DESPITE VOLATILITY SA equities in real terms (December 1924 December 2016) 2.0 standard deviation 1.0 standard deviation SA EQUITY -1.0 standard deviation -2.0 standard deviation Trend (6.9%) REFLEXIVITY IN PLAY Low to a high in just 5 years (2000s bull market) Followed by a sharp move lower (Global Financial Crisis 2007/08) THE INSIGHT OF VALUATIONS While Chart 12 shows the real price of the equity market relative to its history, to determine if a market offers value, an important consideration is the price one is paying relative to the profits the company is generating, that is, the price-to-earnings ratio (PE ratio). Chart 13 plots the average five-year real return for the equity market based on the PE ratio quintile at the beginning of that period. When viewed in this way, there is a clear relationship between the attractiveness of the market from a valuation perspective and the subsequent returns. 18 SA EQUITY

19 CHART 13: IS THE MARKET EXPENSIVE OR OFFERING VALUE? Historic PE ratio of JSE vs subsequent five-year real return ( ) The more expensive the market (i.e. higher historic PE ratio), the lower the subsequent five-year return, and vice versa. 35% THE MARKET IS EXPENSIVE This means that returns will most likely be lower than the real return of 6.9% a year we ve seen over the past five years. If history is any guide (which we firmly believe it is), the current PE, which is in the most-expensive fifth quintile, suggests that the lean years aren t entirely behind us, at least at a broad market level. Subsequent 5-year SA Equity total real return 25% 15% 5% Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Average of respective quintiles -5% -15% Historic price-to-earnings ratio TAKING A POSITIVE VIEW ON NEGATIVE RETURNS Although the long-term equity market trend is up, in nearly one out of every three years investors have lost money in real terms, as we ve seen in 2015 and While painful, these periods of significant negative returns can be opportunities, as can be seen in Chart 14, which shows the Sandton skyline of annual real returns for the local equity market. CHART 14: OPPORTUNITIES IN TIMES OF CRISIS SA equities real return (December 1924 December 2016) 2008 was one of the worst years for our market (-30.4%), but look at the performance in subsequent years (see grey boxes) % -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% SA EQUITY 19

20 While Chart 14 shows that there are years in which equities have lost a significant portion of their value, it is important to remember that investing is a long-term endeavour, and Chart 15 demonstrates the benefits of being patient. This time funnel shows the range of the annualised real returns investors would have achieved over various periods (listed on the horizontal axis). The funnel narrows from both the top and bottom as you increase the length of time invested, showing that time softens the impact of large positive or negative periods. CHART 15: OVER TIME RETURNS BECOME LESS VOLATILE Range of annualised real returns from SA equities (December 1924 December 2016) 31% High Current 21% Average 16% Low 13% 11% 11% 10% 10% 7% 8% 8% 4% 8% 7% 7% 7% 7% 7% 7% 6% 2% 2% 2% 7% 7% 4% 4% 9% 7% -1% -6% -14% 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Although losses can be experienced over shorter periods, history proves that long-term investors have been rewarded with positive real returns. This will have contributed significantly to meeting their investment objectives. FIVE-YEAR OUTLOOK It s easy to lose faith in the equity market when returns are low. However, this is an important characteristic of the market, as we tried to highlight at the start of the chapter when we discussed reflexivity. While some value has returned to the market, it s by no means cheap and our view is that earnings growth will be key going forward. We would expect equities to deliver a real return of 5% over the medium to long term. This is below the long-term trend of 6.9%, but we believe that there will be opportunities to enhance that return, given divergences at the sector and industry level. 20 SA EQUITY

21 SA LISTED PROPERTY the once-tiny sector is an important asset class today At MacroSolutions, we have long considered this once-tiny sector an important and a separate asset class in its own right. Consider the following performance statistics: NOMINAL RETURNS +14.0% a year since % highest annual return -26% lowest annual return R2 955 What R100 invested in LISTED PROPERTY grew to over the past 20 years CHART 16: LISTED PROPERTY TURNAROUND R1 invested in SA Property Index in real terms (January 1980 December 2016) R 6.00 R 5.00 A DRAMATIC RECOVERY 2002 to 2016: 15.1% a year real returns R 4.00 R 3.00 R 2.00 PERIOD OF DEEPLY NEGATIVE RETURNS 1983 to 1998: -7.8% a year real returns R 1.00 R THE STRONG PERFORMANCE OF LISTED PROPERTY Listed property is like a hybrid of equities and bonds, offering both capital growth and a stable and growing rental income component. Since 2002, dividends and reinvested dividends have accounted for 67% of the total return. The remaining 33% was capital return, driven by earnings growth, declining bond yields (see page 22 for more on bond yields) and improved ratings. Property fundamentals recovered from difficult conditions office vacancies, for instance, peaked at 24% in 2002 causing distress then, but benefited later as the voids were filled when a buoyant SA consumer boosted shopping centres. This combination allowed for a growth in dividends, which have more than doubled since FIVE-YEAR OUTLOOK Over the next five years, we expect property to deliver a solid 5.5% real return. This is based on the current forward yield of the sector (which is above inflation), dividend growth broadly in line with inflation, and the possibility of derating (as the pace of distribution growth declines from historical high levels and property portfolios age). This expectation does not incorporate the positive or negative capital impact of movements in bond yields or distribution growth continuing to surprise positively. Note: All performance figures are from January 1980 to December 2016, unless otherwise stated. SA LISTED PROPERTY 21

22 SA BONDS real returns in a world without inflation Bond market returns are particularly sensitive to event and policy risk and can be broken up into distinct periods driven by structural macroeconomic and socio-political forces. Seeing the impact of these forces on returns reinforces why a long-term macro perspective is so critical. REAL RETURNS +1.6% a year since 1925 NOMINAL RETURNS +7.7% a year since % HIGHEST annual return (1986) -9% LOWEST annual return (1994) CHART 17: BOND MARKET REACTION TO ECONOMIC AND POLITICAL EVENTS SA bonds in real terms (December 1924 December 2016) BULL MARKET Annualised real total return: 4.5% BEAR MARKET Annualised real total return: -2.3% BULL MARKET 1986 to date Annualised real total return: 4.9% 2.6 Global Financial Crisis Great Depression WWII capital controls Post-war recovery Sharpeville massacre Rubicon speech Oil crises 1973 and 1979 Volcker ups US rates New SA Inflation targeting Rand crises 1998 and Bretton Woods ends fixed exchange rates s: THE LOST DECADE While the US bond bull market began in the early 1980s (see GLOBAL BONDS on page 34), SA bonds continued to suffer from a combination of weakening currency, structurally high inflation and political and economic isolation. The broad strength of the US dollar, driven by aggressive US interest rate hikes, along with a weak gold price (SA s primary export at the time) exacerbated the financial pressures exerted on the economy by international sanctions. The consequences of trade restrictions increased as the strong external reserves position (which had protected SA in the early stages of sanctions) deteriorated and eventually led to a group of foreign creditors refusing to refinance their debt to domestic banks. This ultimately ended in the SA government imposing a debt moratorium on private sector debt. While national debt was unaffected, as it was primarily denominated in rands and continued to be serviced, the currency acted as the pressure valve for the external trade and funding pressures facing the domestic economy. The rand weakened against foreign currencies, entrenching higher and less stable inflation, and with it higher bond yields and poor real bond returns. 22 SA BONDS

23 : ABOVE-AVERAGE RETURNS 12.6% nominal returns a year (over 20 years) 5.9% real returns a year In the two decades that followed we saw many of these pressures reverse: the US dollar peaked and was followed by a period of falling US interest rates and easier global financial conditions. SA s political and economic transition enabled the domestic bond market to re-sync with the global bond bull market at a time when global inflation had begun its almost three decade-long structural decline. At the same time, the strength of domestic institutions actions added stability and reduced vulnerabilities in the SA economy, providing a pull factor to complement the push that was generally easier global liquidity. SA bonds benefited from both global and domestic forces: Signing of the Plaza Accord in 1985, which paved the way for a period of a weaker US dollar and lower global interest rates More credible monetary policy as the SARB adopted inflation targeting in 2000 and began accumulating more foreign exchange reserves National Treasury reduced public debt to below 30% of GDP by 2008 More recently, a deteriorating domestic environment and a trough in global bond yields have seen SA 10-year nominal bond yields rise from a multi-decade low of 6.3% in April 2013 to a high of 10.8% in December 2015, before eventually settling at 8.9% in December One consequence of an open economy and a more globalised financial market is the high level of foreign ownership of our bonds. Weak domestic savings, evidenced by SA running large and persistent twin deficits (current account and budget deficits), has left us somewhat vulnerable and reliant on foreign capital to fill the savings gap. The flame that ignited the tinderbox sparking a massive sell-off in December 2015 was Nenegate and fears of a political shift away from the hardearned credibility and frugality of the prior two decades. Although the outlook for domestic political and economic conditions have subsequently eased, where yields eventually settle will continue to be driven by the forces that have done so over the past 100 years. YIELDS PROVIDE A CRYSTAL BALL While market volatility influences the performance of bonds in the short run, as we expand our horizon we see that yield proves to be the best predictor of nominal returns. Chart 18 shows the relationship between any given level of yield and returns, over different time horizons. As your time horizon lengthens, your starting bond yield is increasingly better at telling you what your returns could be. CHART 18: BOND YIELDS ARE THE BEST PREDICTOR OF FUTURE RETURNS SA 10-year bond yield versus subsequent nominal returns STRONG RELATIONSHIP NO RELATIONSHIP Time horizon (in months) FIVE-YEAR OUTLOOK With evidence of our economy starting to re-balance and our expectations of contained global and domestic inflation over the medium term, SA bonds continue to look attractive in real terms offering a positive real yield of about 3% compared with an average real return of 1.7% since While rising global yields and the end of ultra-easy monetary policy present a threat to the relative attractiveness of SA bonds, secular forces of aging populations and high levels of global debt limit the pace and extent to which global conditions can tighten and act as headwinds to returns. This provides a firm underpin to the attractiveness of SA bonds. Inflation-linked bonds will likely deliver a 2% real return over the next decade not far off the average that investors have received since the 1920s. SA BONDS 23

24 SA CASH you get what you pay for Cash is a poor long-term investment because you get what you pay for you can t expect a high return for a short-term loan with minimal risk. It is not optimal to grow long-term savings by making shortterm investments. Instead, you need a time and liquidity premium. In other words, you need to be rewarded for taking on risk, which is not something you can expect from cash. 90 YEARS to double your real wealth NOMINAL RETURNS +6.7% a year since % LOWEST annual return (1938) +21.7% HIGHEST annual return (1985) VICTIM TO INFLATION AND POLICY Inflation is a real threat to cash and returns can be adversely affected in times when it may suit monetary authorities to keep interest rates artificially low (as has been the case in many developed countries in recent years) or to inflate away debt ( theft by stealth ). The long-term real return of 0.7% a year from SA cash, masks long periods of negative real returns. Cash delivered a negative real return for 23 years from 1932 and for another 16 years from 1972, highlighting how monetary policy can adversely impact savers. This was reversed by the very high real yields under the Stals/Mboweni regime to crush inflation. Many investors today have an artificial perspective of the real returns available from cash because of the excellent 5.5% delivered in the 1990s. Since 2010, average annual real returns from cash have been below their long-term average, with negative real returns in 2011, 2012 and Since then, however, rising interest rates have resulted in positive real returns. Cash returns stacked up well in 2016, beating global asset and local equity returns and justifying a higher than average weighting in investors portfolios. In 2016, cash delivered a nominal return of 7.4% compared to inflation of 6.8%. REAL RETURNS +0.7% a year since 1925 NEGATIVE REAL RETURNS FOR: 23 years from years from 1972 Returns would be even worse when adjusted for fees and tax. WHEN CASH IS KING A benefit that cash does offer is opportunity value it preserves its nominal value while other assets are falling and enables investors to buy those assets at a cheaper price. Cash has been the best performing asset class for 11 years out of the past 87 years. In 100% of these instances, the JSE was actually down, including the 1932 Great Depression, the post-wwii bear market and the 1998 emerging market crisis. That said, it is important to remember that cash is not a long-term investment. Over all 10-year time periods, cash has been the worst performer 35% of the time. INTERNATIONAL EXPERIENCE Cash has been trash in a global context over the long term. The long-term work from the Triumph of the Optimists shows the average return on cash has been a negative 0.3% 1 in real terms. This is skewed by the high inflation and volatile economic conditions in those countries that lost in WWII. However, in every country equities and bonds beat the return from cash. The term premium 2 for investing in longer-dated bonds was just over 1%, while the equity risk premium 3 was a material 3.6%. The lesson is clear: Cash is not a viable long-term investment option, although it does remain a hedge against short-term downside risk in alternative asset classes. FIVE-YEAR OUTLOOK In 2016, cash outperformed local equities and major global assets, justifying a higher than average allocation in investment portfolios. However, local inflation and interest rates have likely peaked and, while cash will deliver positive real returns over the next five years, it is unlikely to beat either bonds or equities over that period. We expect cash to deliver an annual real return of 1.5% a year over the next five years. 1. Credit Suisse Global Investment Returns Yearbook Term premium the extra annual return the market demands for buying a bond that matures further in the future. 3. Equity risk premium the extra annual return the market demands for investing in more risky equity rather than less risky bonds. 24 SA CASH

25 25

26 GOLD low correlation to other asset classes Gold has been part of the global financial system for centuries, having been adopted as a peg for currencies such as the UK pound since The end of the Bretton Woods system of fixed exchange rates in 1971 saw the move to broadly floating exchange rates. GOLD AS AN INVESTMENT Gold s value has been seen as a hedge against inflation and protection against economic turmoil. The investment case cited against gold is that the metal has virtually no fundamental intrinsic value and does not produce cash flows. South African investors, in particular, have a long history of investing in gold, no doubt influenced by the historical importance of gold in the South African economy. GOLD PRODUCTION AND THE SA ECONOMY % of GDP % of GDP Despite its dwindled significance in SA s economy, gold has remained a useful investment alternative with significant returns recorded in periods, especially in times of elevated uncertainty. Source: StatsSA Investors who find the ability to own physical gold appealing have been able to invest in Krugerrand coins since We added gold to the MacroSolutions at a 2.5% weight, and it has delivered a return of 14% a year since A large component of this return has been driven by currency weakness as the annual US dollar return has been 6.7% a year. This is clearly shown in Chart 19 where the gold price has gone from R25/oz to R15 670/oz, while in dollars it has gone from US$36/oz to US$1 146/oz. NOMINAL RETURNS +14% a year since 1967 REAL RETURNS +4.4% a year since 1967 BEST PERFORMING LOCAL ASSET CLASS 14 TIMES CHART 19: RAND DEPRECIATION OFFSETS EROSION IN US DOLLAR GOLD PRICE Nominal gold price/oz in rands and US dollars ( ) Gold price in rand/oz Gold price in US dollar/oz GOLD

27 GOLD S ROLE IN A DIVERSIFIED PORTFOLIO Our optimisation work shows that, historically, the price of gold has a very low correlation to the various mainstream asset classes. The tendency for gold to move independently from other markets helps to smooth out the overall volatility of a diversified investment portfolio. From 2004, gold became even easier to access, especially for retirement funds, via the popular NewGold Exchange Traded Fund (ETF). Some R17.3 billion of this ETF has been issued by the end of GOLD UNDER PRESSURE Some reversion from elevated levels towards the long-term trend, together with a recovery in the value of the US dollar, has seen an erosion of the dollar gold price over recent years (see Chart 20). A rally in the gold price over the first half of 2016 fizzled out towards the end of the year, as US Federal Reserve rate hikes came back on the table and US dollar strength resumed. Combined with a firming of the South African currency through 2016, this resulted in gold s rand return for local investors being negative for the year. CHART 20: US DOLLAR CONTRIBUTES MATERIALLY TO GOLD S PERFORMANCE Nominal gold price/oz in US dollars and the trade weighted US dollar (December December 2016) Gold price (US$) $2 000 Trade-weighted US dollar Index $1 900 Gold price in US dollars $115 $1 800 $1 700 $1 600 $1 500 $105 $1 400 $1 300 $1 200 $95 $1 100 $1 000 $900 $85 $800 $700 $600 $75 $500 $400 $300 $200 $ Trade-weighted US$ Index CHART 21: GOLD REMAINS PRECIOUS Real gold price in US dollars ( ) $18 $16 $14 $12 $10 $9.25 $8 $6 $4 $2 $ FIVE-YEAR OUTLOOK From a valuation perspective, the price of gold remains fairly elevated in real terms compared with its long-term history. It is accordingly difficult to motivate good returns for this asset class over the next few years off this relatively high base, especially if the US dollar were to remain firm. Having said that, a major reason for holding gold in a portfolio is to diversify risk and it is easier to argue that the level of uncertainty on, inter alia, the political front both locally and globally has increased. There will almost inevitably be times when holding gold will be beneficial to investment portfolios over the coming years. GOLD 27

28 THE RAND greatly impacting investment returns The exchange rate has a profound effect on investors as it is used to translate the returns of the 25% exposure to global assets that is currently permitted in funds that we manage into local currency returns. Local companies with global operations and exposure also have a significant impact on the JSE s earnings. SA CURRENCY TIMELINE 1922 SARB issues SA pound denominated banknotes, which trade on par with GB Pre Commercial banks issue SA pound notes, convertible into gold 1920 South African Reserve Bank (SARB) established 1932 SA exits gold standard (currency no longer convertible) 1944 Bretton Woods system of fixed exchange rates: SA /GB pegged at US$ onwards ZAR free floating (subject to periodic SARB intervention) Bretton Woods system ends Range of exchange rate regimes used (e.g. managed floats, fixed rates vs US$ or GB ). ZAR drops to R1 = US$ April: IMF agrees countries have free choice between fixed or floating currencies 1961 Zuid-Afrikaanse rand (ZAR) introduced. Exchange rates R1 = GB 0.50 and R1 = US$1.40 Over the past 16 years, the rand has suffered three major bouts of weakness. Twice it recovered to pre-fall levels, but after the latest bout of weakness, it has only partially recovered A surging US dollar, falling commodity prices and capital flight from SA sunk the rand to more than R13/US$ The currency then recovered to an average of about R6.50/US$, driven largely by surging commodity prices and strong capital inflows The currency started weakening again, initially on account of a sharply widening current account deficit, but eventually slumping, with other emerging market currencies, to over R11/US$ during the Global Financial Crisis in The rand recovered to below R7/US$ by the first half of 2011, this time driven by a renewed rise in commodity prices and a surge in capital inflows The rand depreciated steeply and by the start of 2016 had declined to new all-time lows of almost R16.86/US$, almost R24.50/GB and more than R18.30/. It has since partially recovered, ending 2016 at R13.68/US$, R14.44/ and R16.70/GB. 28 THE RAND

29 The correct perspective, when looking at currencies, is to use a basket of currencies and adjust for inflation. We have used data from 1978, which is when the rand became a floating currency. On this basis, the rand has depreciated by 0.5% a year in real terms. CHART 22: RAND CONTINUES TO WEAKEN RELATIVE TO SA s MAIN TRADING PARTNERS December 1920 December 2016 Rand per UK pound R17.82 Rand per US dollar R16.70/GB R13.68/US$ R6.85 R2.64 R1.01 R0.39 R CHART 23: THE REAL RAND EXCHANGE RATE December 1977 December Source: INET OUTLOOK A difficult global economic environment, a large current account deficit, deteriorating local macroeconomic fundamentals, little progress with introducing growth-enhancing economic reforms, and a firming US dollar have sharply weakened the rand since mid The rand remains the key adjustment mechanism for when South Africa has to adjust to more difficult global and/or local economic conditions. With global conditions having improved through 2016, the rand responded positively, as has been the case historically. Looking forward, global economic conditions are expected to be broadly rand supportive in 2017, but local economic and political developments hold downside risks to the currency. THE RAND 29

30 GLOBAL ASSETS expanding investment opportunities The ability to include global assets in a portfolio increases the opportunity set for portfolio managers. This was not always possible and, before 1995, SA investors could not invest outside our borders because of exchange controls (see timeline below). RELAXATION OF EXCHANGE CONTROLS TIMELINE Exchange controls prohibited investments outside our borders Asset swap limit increased to 15% AUM Investment managers had their limits increased to 25% Retirement funds had their offshore limit increased to 25% (plus an extra 5% in Africa) % of AUM via asset swaps Asset swap limit increased to 10% AUM Collective investment schemes allowed 20% offshore Retirement funds allowed to increase their global investments to 20% Last year we spoke about the diversification benefits of global assets and the significant benefit one gains from diversifying away from the rand over time. This diversification detracted from performance in While returns on global equity were reasonable in US dollar terms, the strength of the rand meant you lost money in rand terms. However, in keeping with the purpose of this publication to focus on the longer term, we note that it has now been 10 years since the start of the Global Financial Crisis. While financial and banking crises are significant events and have a significant impact on markets, many would have laughed off the thought that the crisis would result in significantly lower returns in the future especially as we saw equity markets rebound since the crisis. But now, with the benefit of hindsight, we can see that the return on global equities (in US dollars) has been just 3.6% a year over the past 10 years. This is less than half the 7.6% a year return from the previous 10-year period ( ). In fact, for the first five years after the crisis, returns were negative. Only over the past five years have returns on equities been reasonable (10.4% a year). The heart of the poor returns on equities has been the poor earnings growth generated by companies. This was as expected. In an environment where corporates are deleveraging, earnings will come under pressure. For the last decade, global equity earnings growth has come in at -1% a year. The point here is that over the long term, relationships are much more stable and effects more predictable. One of the notable stable/ predictable long-term relationships is valuation, namely price to earnings (PE). Buying when valuations are high delivers poor returns, and buying when valuations are low delivers better returns. This is especially useful over periods of 10 years. On an aggregate basis, valuations (on a PE basis) are currently towards the high end. What this means is that for equities to continue to do well, it is critical that earnings growth should pick up. Globally, margins have been squeezed and there is limited gain to be had from further leverage. The top line sales must improve. There have been tentative signs of global economies emerging out of a growth quagmire. For now, global markets seem to have taken heart from the election of Trump as US president and the Republican controlled Congress indicated that corporate taxes will be cut in the US, forcing earnings growth higher at least for GLOBAL ASSETS

31 CHART 24: A WORLD OF CHOICE Global returns to December YEAR 5 YEARS 10 YEARS SINCE 1995 Equity Indices USD ZAR USD ZAR USD ZAR USD ZAR MSCI World 8.2% -4.6% 11.0% 23.4% 4.4% 11.6% 6.6% 13.5% MSCI All Country World 8.5% -4.3% 10.0% 22.2% 4.1% 11.3% 6.5% 13.4% MSCI Emerging Markets 11.6% -1.5% 1.6% 12.9% 2.2% 9.2% 5.7% 12.6% MSCI BRIC 12.4% -0.8% 1.1% 12.3% 1.2% 8.1% 8.8% 15.9% Developed Equity Indices MSCI US 11.6% -1.5% 14.6% 27.3% 7.0% 14.3% 8.4% 15.4% MSCI UK 0.0% -11.8% 4.0% 15.6% 0.4% 7.2% 5.5% 12.3% MSCI Japan 2.7% -9.3% 8.4% 20.5% 0.7% 7.6% 0.6% 7.2% MSCI Australia 11.7% -1.4% 4.5% 16.1% 3.9% 11.0% 8.7% 15.7% MSCI Europe 0.2% -11.6% 6.9% 18.8% 1.0% 7.9% 6.5% 13.4% Emerging Equity Indices MSCI Brazil 66.7% 47.2% -6.5% 3.9% 0.8% 7.7% 9.5% 16.7% MSCI China 1.1% -10.8% 5.3% 17.0% 4.0% 11.1% 3.0% 9.7% MSCI India -1.4% -13.0% 6.8% 18.7% 2.7% 9.8% 9.2% 16.3% MSCI Russia 55.9% 37.6% 0.5% 11.7% -4.0% 2.5% 13.1% 20.5% MSCI South Africa 18.4% 4.5% 1.0% 12.2% 3.4% 10.5% 6.1% 12.9% FTSE/JSE All Share 16.3% 2.6% 1.7% 13.0% 3.4% 10.5% 7.3% 14.3% Global Bond Indices JP Morgan Global Bond 1.6% -10.4% -0.7% 10.3% 3.3% 10.4% 4.3% 11.1% Barclays ex Treasuries 2.6% -9.5% 1.7% 13.0% Barclays Global Aggregate Corporates 4.3% -8.0% 3.0% 14.4% 4.0% 11.2% - - Barclays Global High Yield 14.3% 0.8% 7.4% 19.3% 7.3% 14.7% 8.3% 15.4% JP Morgan Global Bond - EM 9.9% -3.0% -1.3% 9.7% 3.8% 10.9% - - GLOBAL ASSETS 31

32 GLOBAL EQUITY alternative source of growth to more risky SA equity Over the past 90 years, global equities have delivered inflation-adjusted returns of 5.4% in US dollar terms and 7.2% in rand terms. The SA equity market, on the other hand, has delivered a real return of 7.7% over this period outperforming global equity, as you would expect, due to higher risk factors. This is confirmed by independent studies showing that the SA equity market has been one of the best investments since The past few years have seen a partial reversal of this as the resources sector has come under significant pressure. CHART 25: GLOBAL EQUITY RETURNS LOOK MORE PROMISING Global equities in real US dollar terms (January 1925 December 2016) 2.0 standard deviation 1.0 standard deviation Global Equity (US$) -1.0 standard deviation -2.0 standard deviation Trend (5.1%) Comparing global equity to local equity, you can see some major differences in drawdowns: The 1929 Wall Street Crash and the resultant Great Depression affected global markets more than the SA market. WWII was good for export industries and SA was generally more insulated from the conflict. In the aftermath that saw a building boom and recovery in Germany and Japan, SA entered a major bear market. CHART 26: DRAWDOWNS OF GLOBAL EQUITY (US$) AND SA EQUITY (RANDS) December 1924 December % -10% -20% -30% -63.6% GLOBAL Worst drawdown (1929 crash*) -40% -50% -60% -70% SA bear market Global markets 1929 crash Great Depression *and recover 1969 crash * SA Equity (rands) Global Equity (US$) % SA Worst drawdown (1969 crash*) The market drawdowns in Chart 26 show how important it is to have a global perspective when managing assets and, particularly, understanding risk. From the high correlation of global equity markets during and immediately following the 2008 Global Financial Crisis, country level correlations are now breaking down. 32 GLOBAL EQUITY

33 RANGE OF GLOBAL EQUITY RETURNS WORST YEAR US$ -40% in 2008 RANDS -42% in 2002 BEST YEAR US$ +66% in 1933 RANDS +101% in 1985 Investing globally remains a powerful source of diversification and risk reduction. An example of this is the very strong return from this asset class in 1985, as that was the year South Africa defaulted on its debt obligations. In addition, as we showed in SA EQUITY (page 18), time is your friend. Chart 27, when compared to the SA market (Chart 15), has almost identical ranges between high and low across all periods. This clearly proves that time in the market as a means of reducing risk is a global phenomenon. Note that this graph is in real terms and in nominal terms the numbers would look much better, as inflation provides a cushion to returns. CHART 27: OVER TIME RETURNS BECOME LESS VOLATILE Range of annualised real returns for global equities (December 1924 December 2016) 31% High Current Average 17% 14% 12% 11% 10% 8% 8% 9% 7% 5% 5% 5% 6% 6% 6% 6% 6% 6% 5% 5% 4% 4% 3% 4% 3% 3% 2% Low -1% -2% -5% -13% 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years FIVE-YEAR OUTLOOK The world has shifted. There is a move away from monetary policy stimulus to using fiscal stimulus to revive economic growth. Monetary policy (specifically low interest rates and quantitative easing) has gone as far as it can go in its effectiveness in boosting growth. The next step is fiscal stimulus increasing government spending and/or lowering taxes to stimulate demand. A more expansionary fiscal programme in the US will support growth and should result in global earnings going up in That is good for equities relative to bonds and within equities, it is good for value-style investing over growth-oriented shares and for cyclicals over defensive shares. Despite the reasonably high valuations, we re optimistic that global equity will have a decent This will be driven by the improved macroeconomic environment flowing through into company earnings, especially where margins are depressed. GLOBAL EQUITY 33

34 GLOBAL BONDS low correlation to equities enhances global diversification Given their diversification benefits relative to equity risk, developed market global government bonds are an important asset class. Their correlation to SA equities in calendar year returns (in rands) is effectively 0%, while their correlation to global equities (in US dollars) is 28%. CURRENCY ENHANCES RETURNS MORE THAN INFLATION In line with economic theory, most of the difference in US dollar and SA rand returns can be explained by the real depreciation of the currency over and above the inflation differential. As with SA bonds, the returns on global bonds have gone through very long cycles. The secular pattern of the global bond market can easily be seen by looking at Chart 28, which shows the benchmark UK and US 10-year bond yields since 1703 and 1871, respectively. At the time of the peak in the US 10-year bond yield, the Federal Funds rate came close to 20%, as Chairman Paul Volcker sought to end the decade-long stagflation (high inflation and low growth/high unemployment) that the US had gone through after the post- WWII boom of the 1950s and 1960s. This arguably sowed the seeds for the phenomenal returns delivered by global bonds over the next 30 years, as inflation and interest rates dropped. Similarly, arguments have been made that the actions of Alan Greenspan and Ben Bernanke, the US Federal Reserve Chairmen for much of the past 20 years, laid the ground for the next 30-year bond bear market by cutting interest rates to all-time lows. It is also worthwhile noting that the UK base rate, at present 0.5%, is the lowest ever according to available records dating back to The much awaited lift-off of the US Fed s target rate from its zero interest rate policy finally happened in December While US economic data has proved to be quite resilient and seemingly warranted increasing rates for some time now, there is significant uncertainty as to how much higher US rates will go given the global economic malaise and a slowing Chinese economy. NOMINAL AND REAL RETURNS SINCE 1930 NOMINAL in US dollars +4.6% a year +35.9% HIGHEST annual return (1933) -24.9% LOWEST annual return REAL (US inflation) +1.4% a year NOMINAL in rands +10% a year % HIGHEST annual return (1933) -24.9% LOWEST annual return REAL (SA inflation) +3.6% a year 34 GLOBAL BONDS

35 CHART 28: SECULAR CYCLES OF DEVELOPED MARKET BOND YIELDS UK & US 10-year government bond yields ( ) 18% 16% 14% 12% 10% 8% 6% 4% 2% US 10-year yield (2.46%) UK 10-year yield (1.24%) 0% The Barclays Global Aggregate Bond Index comprises more than just government bonds. The Index increasingly includes other significant asset classes, such as global corporate bonds, high-yield debt and emerging market debt, which have benefited from an environment of low global interest rates. Over the past 10 years, global government bonds have returned 3.3% a year in US dollar terms. Comparatively, global corporate bonds have only offered a small premium (total return of 4.0% a year in US dollars) to this for, at times, significantly more risk. The greatest beneficiaries of the low interest rate environment have been high-yield debt and emerging market local currency debt. However, recent years have seen both these fixed income asset classes sustain significant losses, especially emerging markets, as the values of their currencies have been seriously eroded. Over the past 10 years, high-yield debt has returned in excess of 7.3% a year and emerging market local currency debt has returned in excess of 4% a year may finally be the year that marked the end of the 30-year secular bond bull market. The US Federal Reserve target rate (the rate the world s bond markets are priced off) was finally increased again in December 2016, confirming that the December 2015 hike was not an error. More importantly, it seems likely that the Federal Reserve will continue to hike throughout this year, with three hikes predicted for While the long-term impact of Trump s US presidential election win is less certain for equities, the impact on US bonds is clearer. The US is very likely to implement expansionary fiscal policy (tax cuts and possibly increased spending). This means monetary policy stimulus can be reduced (and that means interest rate hikes are much more likely). FIVE-YEAR OUTLOOK The US economy continues to improve and unemployment is lower. As such, we expect the US Federal Reserve (the Fed) to be more active in raising interest rates. We also think that the world economy looks healthier and there should be some growth in All of this is bad for global bonds. Higher short-term interest rates (and thus bond yields) and improving growth mean we re starting to move into the later stages of the interest rate cycle. As a result, the big bond bull market has come to an end and that means that Governments and corporates will incur a higher cost of capital. We have lowered our longer-term expectations for global bonds to a -1.5% real return over the next five years (in US dollars). GLOBAL BONDS 35

36 36