Focus on the right factors when navigating a stormy investment environment - Angles & Perspectives Q2 2023

Focus on the right factors when navigating a stormy investment environment

Sovereign debt represents a sizeable portion of the investable universe for local fixed income investors. Therefore, it should not be surprising that debates about the South African fixed income sector can be considered a reflection on SA as an investment destination as a whole. And for many, it feels as if Investment SA has been trapped in something of a perfect storm. How are investors to navigate the investment environment when it is clear that conditions are far from ideal, and could, conceivably, be viewed as being plainly hostile?

Not so shipshape

It seems that positive headlines touching the South African economy have been hard to come by recently. The plethora of ailments mean that our ‘economic vessel’ doesn’t seem very seaworthy, to both local and foreign investors: foreigners have been net sellers of local assets for a prolonged period of time.

The litany of ailments is long and well known: load shedding and the toll it takes on economic growth, the spectre of grid failure, failing infrastructure, inflation, a high repo rate and distressed consumers are just some of the factors causing investor concern. However, we have often argued in the past that when issues are known, they can be priced for – and that with a sufficiently large discount to fair value, risks become skewed to the upside and therefore a lot more palatable.

What would it take for the ship to run aground?

With such strong headwinds (and emotions) to contend with, the margin of safety argument can still be a tough nut for investors to swallow. Can a margin of safety ever adequately compensate an investor when the risks seem to be so extreme? At PSG Asset Management, we find sketching out the scenarios that would result in a catastrophic loss of investor capital a useful exercise. In identifying each factor that could contribute to this scenario for SA soberly, and by assessing where the country is relative to these measures, we are able to more accurately gauge the risk to investor capital. After all, there are many local companies that have proven their ability to generate exceptional returns, despite the tough local economic conditions. Tough market conditions do not automatically equate to low or negative investor returns.

Taking a macro view, we believe the factors that would cause bond investors to lose large amounts of capital centre on the ‘failed state’ narrative. While the term is bandied about frequently in popular media, and is often linked to the spectre of grid collapse, the failure of one key piece of infrastructure (to which we do not assign a high probability) does not automatically make for a failed state. However, we closely watch the following key indicators, as we believe investors would be likely to suffer large losses should these be realised.

How the factors SA has firmly in its control mitigate against the permanent loss of capital

We believe there are real reasons for concern about the country’s trajectory. However, at the moment, these do not yet point to a permanent loss of capital.

• SA’s fiscal metrics. Our long-term debt maturity profile and minimal amount of foreign currency debt have long been hailed as a positive in terms of South Africa’s creditworthiness. Low near-term refinancing needs give South Africa ample space to increase government debt, especially in comparison with the AAA-rated United States. We estimate that South Africa only needs to refinance 2% of existing debt every year to the 2027 fiscal year. Redemptions peak at 4% of existing debt in the 2030 fiscal year, which we believe the market (even starved of foreign investment) could easily absorb.

• Inflation. The South African Reserve Bank (SARB) has a long and credible track record of addressing inflation. Despite the recent uptick in inflation, we have seen strong evidence that the SARB has succeeded in bringing inflation under control.

• Private/public sector partnerships that aim to address infrastructural issues like electricity and transport infrastructure. We see the growing realisation that Government is unable to go it alone as a positive and are encouraged by recent changes in regulation easing the way for private sector participation.
• Fiscal discipline. The Minister of Finance, Enoch Godongwana, has demonstrated his commitment to maintaining fiscal discipline and has repeatedly highlighted the need for trade-offs in terms of the National Budget.

Turning our sails to catch the wind

We believe the crucial advantage our process offers is identifying and pricing risks correctly. We understand that opportunities arise from the market’s tendency to price based on sentiment, which allows for wide deviations from fair value. Consequently, we often find excellent risk-adjusted opportunities during challenging markets, where we can exploit deviations from fair value, and focus on buying quality assets below what they are worth. Ironically, we find that the best opportunities often arise precisely when negative sentiment drives most investors out of the market, leaving diligent and patient investors spoilt for choice.

We are confident we can navigate our path to investment success

PSG was named as the South African Manager of the Year at the Raging Bull Awards. In addition, several of our funds earned individual accolades, including two of our fixed income funds. This is illustrative of our long-term success and ability to help our clients grow their wealth in the long run. While it is easy to be blown off course by the headwinds of a volatile macro environment and negative sentiment, we believe there are always opportunities within a globally integrated process like ours, provided you know where to look and focus on pricing risk correctly. We are committed to reducing risk when the market price does not compensate our investors sufficiently, but also to extracting the maximum benefit from opportunities when they are available, while remaining focused on the long-term rewards that accrue to patient investors.