What made us reduce global equities and buy SA bonds in Q4, 2021?


Global diversification can open up opportunities and ameliorates risks. However, the price paid is the most important determinant of future returns, making it critical to avoid one-dimensional strategies and myopic linear thinking. We unpack the warning signs we saw in global equities and opportunities in SA bonds that led to NorthStar taking a position in opposition to the herd.

Northstar believes firmly in diversifying capital globally, particularly accounting for the sizable opportunity set and risk ameliorating benefits that accrue through this approach.

Notwithstanding this however, our investment philosophy and process pivot off mispricing opportunities, both in terms of capitalising on undervalued securities but equally so, circumventing overpriced assets.

With this in mind, our asset allocation framework (constructed from our bottom-up return matrix for all asset classes) instructed a meaningful adjustment in Q4, 2021, to reduce global equities and purchase South African bonds. This article does not explore Northstar’s bottom-up research inputs, but instead depicts some higher-level linkages that we believe, rationalise this action.

This is of course a two-sided discussion – we will start by showing the risk indicators that were flashing red for global equities and then demonstrate the opportunity that presented for domestic bonds late last year.

Dow Jones dividend yield turns negative in real terms

We understand that Covid prevented many corporations from paying dividends and in 2022, companies that did not pay dividends in 2021, could do so going forward if we exit the pandemic. This does distort the picture that follows. But the facts remain, the real dividend yield on the Dow Jones at the end of Q3 2021 was -4.48%. Only twice over 50 years, both of which occurred in the 1970’s has the yield been this low – a period characterised by a sideways moving market for a decade.

Chart 1: Dow Jones real dividend yield (1970 to 2022)

Source: Bloomberg, Iress & Northstar (Date: 31 Jan 2022)

In our second chart, we compare the total returns from the Dow Jones versus a strategy where an investor exits the market when the real yield drops below -1% and enters the market when it heads higher than -1%. The total annualised return of the Dow Jones since October 1970 to the end of October 2021 is 11.2%, with a standard deviation of 15.1%. For the dividend yield strategy described above, the annualised return is 13.5% with a standard deviation of 11.3%.

Chart 2: Dow Jones total return index vs. strategy incorporating switching to cash when real DY falls below -1%

Source: Bloomberg, Iress & Northstar (Date: 31 Jan 2022)

S&P forward P/E against prospective market returns

Our third chart compares the forward P/E (including market’s earnings for the following 12 months) against prospective returns. The current forward P/E of the S&P 500 is 20.6 times, historically, off this forward P/E the market generated returns on a 10 year basis of 4.4% annualized. Even assuming 2% inflation, a real return of 2.4% annualized does not compare favourably to long-term real returns from the S&P over the same period (1990 to present), of 8.7%.

Chart 3: Forward P/E and subsequent 10-year annualised returns S&P 500 Total Return Index

Source: Bloomberg & Northstar (Date: 2 Feb 2022)

Our fourth chart on US market valuation compares the earnings yield of the market against inflation. Historically, as inflation rose, the earnings yield rose in sympathy, in so doing, compensating investors through a higher inflation-adjusted yield. Presently, the earnings yield is negative in real terms to the tune of 4.1%. The market has to believe that inflation is dropping to justify this situation, alternatively earnings must rise rapidly or stock prices must adjust lower. It is probable that a combination of all of these outcomes is likely.

Chart 4: Earnings yield follows inflation

Source: Iress & Northstar (Date: 31 Jan 2022)

SA Bonds

We now switch to the opportunity that presented itself during Q3 2021 – SA bonds.

The R2030 that matures on 31 January 2030 was yielding 9.63% at the time and by our estimates, offered a 1-year return of between 11%, under a bear case scenario, to 17.5%, our base case scenario and 24%, being our bull case – these projections incorporated 75bps of SARB hikes over a year.

Chart 5: SA Government yield curve

Source: JSE & Northstar (Date: 29 Oct 2021)


We conclude with the message that one dimensional strategies and myopic linear thinking propels herd mentality. The perceived safety of offshore investing by South Africans has to some degree ignored the key principle that the price you pay is the most important determinant of future returns.

Juxtaposed against this, high yields and a marginally better fiscal position than most of us had imagined during the height of Covid meant that SA bonds offered abnormally high returns for the risks being taken.