Local inflation and interest rates have peaked in the current cycle and South Africa had its first interest rate cut in five years during the quarter. While borrowers welcome lower interest rates, savers, like clients in the Allan Gray Stable Fund, will receive lower investment returns from holdings in interest bearing investments such as bonds or money market equivalent instruments.
At a time of significantly increased political and policy uncertainty, combined with greater credit risk due to the recessionary economic environment, lower prospective returns are not particularly appetising for savers. By way of comparison, investing in the JSE All Bond Index today compared to the start of 2016, investors are required to assume additional duration risk for 0.8% less yield in return.
Conversely, following three years of lacklustre returns amid falling company profits, the local equity market is offering attractive opportunities. Investing in shares of a business with a strong asset or competitive advantage underpin at current levels, should deliver inflation beating returns over the longer term. Whereas the average expected total return from local equities was below 10% three years ago, expected returns are now above 10%.
Viewed from an asset allocation perspective, the risk/return profile of choosing equities ahead of interest bearing investments is thus a lot more compelling today compared to previous years.
During the quarter, the overall asset allocation of the Fund remained broadly unchanged. Locally, the Fund increased its exposure to Naspers while reducing the size of holdings in British American Tobacco, Remgro and the local banks. From a bond and cash perspective, the Fund maintained its very limited exposure to long duration instruments given the risks discussed above and retained ample available liquidity resources. Offshore, the Fund increased its US dollar exposure at the expense of the euro and increased the hedged component of the gross foreign equity exposure.