January 31, 2018
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Adapting to a new investment environment will be key to protecting and growing investor wealth over the next 12 months
There is a saying that the “animal spirits have been brought to life” when business and consumer confidence picks up and starts to gather momentum. We certainly feel that this has been the case since mid-2016 when an economic soft-patch or mini-recession ended globally and has gathered pace since Donald Trump won the US elections in late 2017.
The animal spirits ignited by synchronised global growth, better forecasted earnings and benign inflation could however change character quickly in the near future. The economic and investment world as we have come to know it over the past decade could be facing seismic shifts. There are a number of factors that could alter what seems to be a reasonably “comforting” investment environment and rekindle a more “normal” world of volatility and hence a more schizophrenic behavioural environment from market participants.
For the most part, we believe opportunities remain for generating high quality returns for clients but the shifting sands around the world will change risk perceptions. Generating quality returns will require a flexible and dynamic investment process suited to a potential shift higher in volatility
There are always a number of key variables or signs that the market focuses on to determine the investment environment. In 2018, knowing which signs matter and which to ignore will be key to avoiding risk and identifying return opportunities.
This year we will be concentrating on some specific signs including global growth dynamics, forward earnings growth and de-regulation.
The US tax bill passed earlier this year is a major change from the world we thought we would be facing 12- to 18-months ago. This has acted as a significant catalyst for earnings growth, as analysts calculate the advantages of this tax windfall on “profits” and potentially the investment component of US economic growth.
We are also moving from an environment of significant financial regulation which has seen banks curtail their risk appetite, to one of proposed de-regulation under Trump’s administration. We believe this has the potential to underpin higher global markets, ultimately benefitting emerging markets, including South Africa, as investors’ risk appetite increases.
What does this mean for local and global valuations?
Despite equity valuations globally showing large areas of dispersion, we believe given the above supportive global growth dynamics that certain equities still offer value. In our view, emerging market equity valuations are reasonable, Europe appears 10% cheap by our calculation and locally we calculate that valuations are marginally attractive for the median number of stocks. The local index valuations however appear rich due to some of our index heavyweights.
Against the above global back drop we will also be closely monitoring a number of local variables, including consumer figures, real wages and political developments. Since mid-December, South Africans are far more optimistic, and we are seeing better consumer figures which should continue to be fuelled by higher real wages.
How we look at the world
While markets adjust to news flow and fresh data, the opportunities to generate outperformance lies in identifying what the market has not fully priced in or has possibly mispriced. Markets move faster than economic data and, in our minds often drive the economy. In every sign and indicator we monitor, we ask ourselves “has this been priced into the market?” In our view the significant change in ANC leadership has not yet been fully priced into our market.
If the new ANC leadership can put together a growth plan that businesses can embrace, then investment appetite and the real economy could improve significantly. Should we see confirmation that South Africa is trying to adopt greater policy certainty, our conviction will grow, and we will continue to see opportunities across asset classes – fixed income, currency, property and equities.
One overarching sign that we will be paying close attention to, and one that could significantly change the playing fields, is global liquidity.
There are two major changes taking place globally which could significantly alter the liquidity dynamics in all markets and economies. One is the US Federal Reserve rate hiking path and the other is the unwinding of quantitative easing.
The US Federal Reserve is on a rate hiking path and broadly communicating three hikes through the course of 2018. Given global growth dynamics, financial deregulation and a tight labour market (according to consensus), we need to be mindful of additional hikes that have not been priced by the market.
Whilst these hikes should confirm the growth cycle, we believe the cost of capital is becoming marginally restrictive (this ignores the deregulation argument) in the US and quicker hikes could bring about negative consequences to the cycle and to markets.
At the same time, the US Federal Reserve has begun its process of “normalising” its balance sheet from the extraordinary quantitative easing policies it has implemented since the global financial crisis in 2008. The European Central Bank has indicated its intention to follow suit from October 2018.
Although the market has no certainty of what the full effect of this normalisation would be, the liquidity environment has begun to change, albeit more slowly than feared given the tax cuts and deregulation, but change nonetheless.
We believe that in these uncertain times investors should be trying to maximise return opportunities while paying close attention to limiting losses when markets turn or drop. Over any time horizon the greatest risk to investors is capital loss. Portfolio losses of 20% require 25% in returns to reach break-even. A loss of 30% requires a return of 43% to break even.
Given the potential new investment environment a combination strategy of protection and growth, such as that offered by an absolute return strategy, is key to maximising client wealth.
Written by Marius Oberholzer – Head of Absolute Return