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INVESTING IN A LOW RETURN ENVIRONMENT - THE CASE FOR OFFSHORE PROPERTY“AFTER MORE THAN FOUR YEARS OF SUBPAR GROWTH, GLOBAL GDP HINGES ON THE RESILIENCE OF DOMESTIC DEMAND IN DEVELOPED NATIONS, THE OUTLOOK FOR CHINA AND THE IMPACT OF US MONETARY TIGHTENING ON EMERGING MARKETS.” This view from Morgan Stanley economists and strategists from December 2015 highlights the challenges facing investors in the search for yield in a low return environment.

For South African investors, the search for yield is just as difficult. The SA Equity market for example saw the All Share Index return 14% per annum (total return basis) over the past five years, which is well below the long-term average.

This return was impacted by the rand which weakened from R6.80/US$ to R15.69/US$ over the period supporting earnings of the index, where more than 60% of the earnings come from outside of South Africa. Without this earnings tailwind, the All Share Index would have been much weaker and would have reflected the slowing economy more closely.

Most asset classes are expected to return single digits in the medium-term and as a result, risk mitigation is key.

The graph below shows that in the past investors were being rewarded for taking on more risk by achieving higher returns.

The expected return environment going forward is one where investors will not be rewarded for taking risk. The return profile is much flatter than it has been in the past. For the same level of volatility, investors should expect much lower returns. At the same time, the rand is a structurally weak currency.

A POORER RISK-RETURN OUTLOOK

RETU

RN

VOLATILITY

Source: Andrew Sheets (Andrew.sheets@morganstanley.com) /Morgan Stanley cross strategy team; Monack Advisors.Note: efficient frontier based on four assets: US Stocks, 10 year Treasuries, investment grade and high yield bonds. Markers show points with highest Sharpe ratios (ratio of return to volatility).

Best Return/Vol:5.8%/3.1%

2010 - 2015

1990 - 2009

EXPECTED RETURN

Best Return/Vol:5.3%/4.3%

Best Return/Vol:2.2%/3.5%

14%

14% 16%

12%

12%

10%

10%

8%

8%

6%

6%

4%

4%

2%

2%0%

0%

US efficient investment frontier

BY VAUGHN HENKEL, INVESTMENT STRATEGIST, STANLIB

SA REAL EFFECTIVE (TRADE-WEIGHTED) EXCHANGE RATE

60

70

80

90

100

110

120

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Fair value = 100

Over-valued

Under-valued

SINCE 2000 THE RAND HAS BEEN AT FAIR VALUE OR STRONGER ONLY 11.2% OF THE TIME

The rand is currently 27% under-valued on a trade-weighted basis

Source: STANLIB

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STANLIB is an Authorised Financial Services Provider

The number one point to remember is that investors need to beat inflation. After everything is said and done, the investor who beats inflation is the investor who has protected the purchasing power of their capital.

The graph shows that the rand has only been above fair value 11% of the time in the past 15 years. As a general rule for investors, this means that the rand is most often going to be weaker than the fundamental calculation of where it should be (according to classic economic theory).

So, the rand is structurally weak, which means investors want increased exposure to offshore assets to improve their rand-based investment return and they need to look for low risk assets that provide diversification.

THE CASE FOR OFFSHORE PROPERTY Relative to international bonds, the valuations of offshore property are cheap. An investor could borrow money for 2% offshore and can get a yield in offshore property of 4%. In South Africa, an investor would borrow at a rate of 10% and earn property yields of around 6%.Occupancy rates of offshore property are high. Vacancy rates and bad debts are low so the likelihood of continued rental growth is high. Over the long-term, property provides beneficial diversification in terms of overall asset classes. Over the past 15 years, a 15% allocation to property would have added 1% compound annual growth rate (CAGR) to the return experienced

of an investor in a balanced mandate.

CASH AND PROPERTY On a relative return basis for now, domestic cash and offshore property are where the opportunities lie for investors.

The number one point to remember is that investors need to beat inflation. After everything is said and done, the investor who beats inflation is the investor who has protected the purchasing power of their capital.

Inflation is around 6% currently. Investors can earn just under 8% in cash right now. This means investors are earning almost 2% in real terms risk-free, for being invested in cash and near cash assets.

At the same time, offshore listed property offers a return of 5-7% per annum. While the rand is now trading at largely fair value, the structurally weak nature of the rand should support all offshore assets in the medium to long-term. Furthermore, the risk scenarios tend to result in a sharp weakening of the rand, and this exposure provides risk-adjusted protection.

At this point in time, our view is that investors should be looking at cash and offshore property.

ON A RELATIVE RETURN BASIS FOR NOW, DOMESTIC CASH AND OFFSHORE PROPERTY ARE WHERE THE OPPORTUNITIES LIE FOR INVESTORS