The financial markets were good to investors in the third quarter, with the JSE reaching new highs, largely on the back of buoyant markets globally. However, conditions are still far from normal, with ongoing stimulus by central banks, geopolitical tensions and high share valuations fuelling concerns that the markets are overheated and due for a correction.
In the October Fundamentals newsletter of the Old Mutual Investment Group, strategist Rian le Roux comments that September was a very good month for global equity markets. “The US S&P 500 Index rose 1.9% and closed the month at a new record level. The German Dax fared even better, surging 6.5%, almost fully reversing a similar-sized decline over the previous two months.”
Le Roux says this good performance came in spite of a number of developments that one would normally expect to cause concern among investors, including worries about the tensions between the United States and North Korea, indications of “policy normalisation” by central banks (by, for instance, upping interest rates) and some signs of an economic slowdown in China.
“The fundamental reasons for the strong equity-market performance are likely threefold.
“The first is the growing confidence that the global economic recovery not only remains on track, but is spreading around the world.
“The second is that investors see central banks’ willingness to push on with policy normalisation as a sign of growing confidence that the global recovery is becoming self-sustaining.
"The third is that it appears there is renewed hope that the postponed tax reform and fiscal stimulus in the US is back on the agenda,” Le Roux says.
But he says that you should never lose sight of the risks that still exist. “The most important is that investors may be too complacent about the extent of central bank policy tightening.”
If the central banks increase interest rates too quickly, it will negatively affect the markets. However, they are unlikely to make any unexpected moves, and those they are expected to make are probably already reflected in asset prices.
“The next few months will tell whether the markets have priced in too much good news. In the meantime, we remain positive on the outlook for the world economy, as we have been for some time, with no serious headwind in sight that could derail this outlook,” Le Roux says.
Nick Curtin, the head of business development at Foord Asset Management, is very aware of the risks in the markets and stresses the need for capital preservation and cautious portfolio positioning.
“There are mounting risks and distortions in global financial markets resulting from a decade of post-crisis experimental monetary policy. Interest rates are still at record lows, central bank balance sheets remain massively swollen and the global debt problem has not diminished. How and when do these abnormalities unwind? And what impact will this have on financial markets?
“At the same time, markets continue to reach new highs, and volatility levels reach new lows. These are not healthy investment conditions. Include the numerous and escalating geopolitical risks and it becomes clear that the current risk environment is elevated,” Curtin says.
In South Africa, despite assurances from Finance Minister Malusi Gigaba in his mid-term budget speech this week that the government is serious about getting the country growing again, many commentators are gloomy about short-term prospects.
“The South African economy remains constrained. Its political environment will get worse before it gets better and near-recessionary conditions are likely to extend for longer than most expect,” Curtin says.
Madalet Sessions, the co-portfolio manager of the Denker SCI Balanced and Denker SCI Stable funds, points to the difference in the growth of the South African economy before and after the 2008 financial crisis.
“Between 2000 and 2008, South Africa’s economic growth tended to exceed the market’s expectations. This meant that R100 invested in a South African portfolio in 2000 would have grown to R330 by the end of 2008. In the years after the financial crisis, however, the returns generated offshore exceeded those from domestic assets. Over this period, R100 invested in an offshore portfolio would have grown to R343, outperforming a portfolio tilted towards the South African economy (R290).”
Sessions says that if the government engages in pro-market reforms, it is very likely that economic growth will accelerate. “Much of the population would benefit from income gains, which means more income will be saved and more wealth created. This is what transpired in the early 2000s as the economy grew more rapidly than expected and the value of stocks and bonds rose.
“There is some hope for growth,” Sessions says, “but we cannot say with any certainty if and when this potential growth will take place, or what the scope and speed of a recovery will be.”
What are managers doing?
Because of the uncertainties, both locally and globally, Curtin says that, for a professional investor, a defensive and cautious portfolio positioning is a good starting point. But what does this strategy entail?
“Importantly, it should not mean that investors should give up on returns in a high-risk, low-return environment or batten down the hatches to await a market crash. It does mean, though, that we must be even more attuned to the consequences of bad investment decisions than we normally would be, given the low margin for error,” Curtin says.
Sessions says you should ask how the portfolio you are invested in generates returns – does it rely on a certain outcome for a specific economy or macroeconomic event? “There is a trade-off between potentially high returns and protecting what you have. An investor who invests for the highest possible returns is likely to rely on a specific macroeconomic outcome – even where there is no evidence to support this outcome – with the risk of underperformance or capital loss if their view turns out to be wrong.”
She is in favour of what is often referred to as an “all-weather” portfolio: one that is diversified enough, with a substantial exposure to offshore assets, to ensure returns no matter what the future holds. “The investment managers of these portfolios manage assets for any macroeconomic outcome and balance the portfolio accordingly. The objective is to earn returns and avoid losing clients’ money, rather than to be the top performer,” Sessions says.
Frederick White, the co-manager of the Sanlam Investment Management Balanced Fund, says that, whereas in the 20th century, globally, equities beat inflation by 5% to 6% a year on average over the long term, these returns are unlikely to be repeated in the next decade or perhaps even in the next two decades.
“The unprecedented lowering of interest rates in the wake of the global financial crisis has led to a change in the pricing of all assets. This being said, equities is still the asset class that is most likely to produce inflation-beating returns over the long term, going forward,” he says.
But he also sees the need for protection against a market crash, and for this reason has a significant portion of his fund’s equity exposure protected through derivative structures.
“We effectively follow an approach of investing in the most likely growth opportunity and putting in place ‘calamity insurance’. We therefore continue to give investors good exposure to growth assets – making it more likely for them to reach their investment goals even in a low-return environment – while reducing the risk of large drawdowns,” White says.