Although this overview is aimed to communicate our asset class views and positioning, we cannot ignore the importance of the challenge and grief we all deal with at present due to the COVID-19 pandemic.
Extraordinary times indeed
The COVID-19 pandemic has now left almost no South African unscathed, be it directly or via friends and family. Although the SA economy is on track for recovery, parts of it, especially the service sector, will once again struggle. We sincerely hope that the vaccine rollouts improve to bring SA vaccination rates in line with the rest of the world at the very least. Tragically, the human cost to this pandemic could get worse in the short term. We sincerely hope that you and your families are managing through these unprecedented times.
Factors that influence market behavior
Global factors
The current global Covid scenario can be described as a ‘global war experience’. What we mean is that people’s lives, health and psychology are being challenged while many suffer economically as well – i.e. pretty much the same effect that a war would have on people and their economies. The aftermath of a ‘war’ is normally associated with economic stimulus to kick-start the economy and create job opportunities (a war would imply widespread construction activity too). Over the past year developed market central banks and politicians certainly reacted in a similar ‘war-like’ fashion by introducing loose monetary policies and unprecedented fiscal stimulus. Unfortunately, the fiscal stimulus – that basically pays citizens massive grants to survive – was more prevalent in developed markets like the US, UK, Europe, Japan and larger emerging markets like China. Africa and Latin American economies were not stimulated in the same way or in similar proportion. That put these economies at a great disadvantage relative to developed economies. Vaccination relief was first centered around the named developed and emerging countries and in many cases more than 70% of the population has been vaccinated. This will kick-start these economies faster relative to most other emerging economies.
In short, the following factors will influence market behavior and cause upside and downside volatility as we approach the end of 2021:
- The success of the vaccine roll-out, especially in emerging economies and most definitely South Africa.
- How long and how low interest and bond rates will remain.
- The speed of economic recovery in developed and emerging economies.
- The Inflation debate – especially in the US – will it simply be transitory or will it persist due to supply bottlenecks or demand growth due to fiscal stimulus and a ‘party’ atmosphere as consumers celebrate the ability to live normally again.
- The high government debt levels of especially developed economies and emerging economies with structural headwinds (again SA comes to mind) – the trajectory of debt levels will influence market behavior in the next 2-3 years – especially interest rates and bond yields.
- Elevated valuations in certain asset classes. Here we refer to low bond yields that effectively can only go up from here over the next 2-5 years. Also, certain growth stocks in the US trade at elevated levels and will be under pressure to repeat the earnings windfalls caused by Covid -19, fiscal stimulus implications.
- Bubble areas in the market. Here we see signs of cryptocurrency price collapse and many more fraudulent activities in ‘false’ cryptocurrencies. A continued collapse in crypto prices may eventually have a negative ‘wealth’ effect or influence market behavior in the short term.
- Reflation trade or back to a stronger USD? The US Dollar price relative to other currencies always influences market and asset class/sector behavior. In this case, the argument for value vs. growth stocks will also be an important source of returns in the short term.
- The timing of tapering – tapering by central banks will have to be implemented as it is not feasible for the US & Europe to continue the frequency and size of bond purchases to perform monetary stimulus for ever and a day. Markets will have to adjust to this fact and announcements in this regard will create volatility in both equity and bond markets.
- Developed Market stimulus in 2021 appears to be moving toward US$ 4-5 Trillion. A very positive factor as broad-based developed market GDP YOY growth could increase to 6.1% according to the IMF and may stimulate company earnings growth even further.
- Companies have managed costs well over the last year and this plus improved economic activity have led to better than expected company earnings growth in 2021.
- Infrastructure plans are also moving forward in the US & China. This could further stimulate demand for commodities which will certainly benefit the SA commodity stocks again.
SA Factors
- In South Africa we are experiencing groundbreaking (in terms of democracy) political rhetoric with the arrest of ex-president Jacob Zuma. The reaction to his arrest is now spreading beyond KwaZulu-Natal and pressure mounts on government to take control of the situation, despite President Ramaphosa’s firm approach to address the violence and looting. The next few months will indicate the political will of the ruling ANC party and government. We are optimistic due to the progress made in the judicial process and hope and trust more progress will be evident. At present the political events hardly move the needle in terms of market behavior with special reference to the SA Rand and foreign investor interest. We think the foreigners have a ‘wait and see’ attitude.
- A positive SA trade balance and improved tax collection due to massive taxable profits in SA mining companies has stabilized the SA Rand.
- The success of a SA vaccination roll-out is fast becoming an important factor in determining the ability of the SA Economy to normalize – especially the service and tourism sectors. Without discussing the appropriateness/success of vaccinations, facts do indicate that developed markets like the US, Europe and the UK have ‘normalised’ in terms of hospitalization and death rates, post vaccinating more than 70% of their population. This has already improved tourism activity in Europe and our observation is that improved SA vaccination success will change the impact of SA economic recovery materially.
- A global shift towards decarbonization is also pushing up demand for PGMs and other precious and industrial metals, specifically Copper. Although we are seeing signs of growth in demand factors already, we consider this to only play out over a longer term.
- Investors were surprised as better than expected earnings results generated a positive re-rating for the majority of JSE Equities.
- Our SA Government bond real yields remain attractive and only a handful of offshore investors have re-invested back into our bonds since their exodus over the past 4 years.
- The JSE All Share Index excluding Naspers/Prosus is trading at massive 30-40% discount to peers. If our economic activity can improve due to positive political rhetoric, successful management of our fiscus/vaccinations and improved business confidence, foreign investors may seek to invest in our SA equities and bonds.
All of the above factors lead us to state that our highest conviction action in portfolios is to embrace a diversity of asset classes in different geographies at present. Diversification remains the free lunch to provide protection and optionality in portfolios. There is no need to pay for ‘insurance’ in portfolios.
Introduction to Asset Class Overview
We at MitonOptimal take asset allocation (AA) very seriously, taking into consideration both Strategic AA (3-7 years) and Tactical AA within the various asset classes. In that context, this quarterly piece provides insight into our short-term tactical calls on a 12-month view (reviewed quarterly) and as such may diverge from our long-term strategic AA views. We review our strategic AA annually at the beginning of each year as we believe this is prudent practice, in a world dominated by debt de-leveraging, central bank and political interference.
Herewith the summary of our views (relative to our long-term strategic asset allocation plan and the past quarter):
Global Equities (Marginally Underweight)
In our Discretionary portfolios we prefer global equities relative to SA equities for long term investors due to the larger opportunity set available in markets outside SA. We are underweight relative to our long-term neutral allocation at present, mainly due to higher valuations in developed market growth stocks and due to improved earnings upside visibility in SA equities. In our Regulation 28 portfolios we are underweight (as we cannot be overweight) in most moderate portfolios as we believe that the long-term neutral asset allocation to global equities must be at the maximum permitted allocation of 30%.
The world economy continues to accelerate with global growth lifting from an already strong 5.9% to 6.1% according to the IMF. Led again by the US with President Biden’s infrastructure program making progress, but also by strong numbers out of Europe as tourism begins to reopen at last.
Central banks have also been successful as they manage to regain credibility and bring back their interest rate forecast to 2023 for the first rate rises. Better than expected US and other developed market company earnings and vaccination success make us more optimistic to favour developed market equity exposure above emerging market equity exposure in the short term.
The GDP growth trajectory is improving faster in the US relative to China and other emerging markets. Fiscal stimulus and improved economic activity to support risk assets, despite slowing global liquidity in the short term. We prefer to respect both Growth and Value stock exposure in all our portfolios. The current data, our own in-house interpretations and a wide consideration of market opinions indicate that our current position is prudent. We are ready to make changes should a different trend emerge.
Year-on-year M2 money supply growth
Source: Refinitiv, Investec Wealth & Investment 23.03.2021
With the increase in earnings estimates outpacing global benchmark gains and bond yields having retreated from their March-end highs, broad market valuations, though far from cheap, certainly appear more reasonable than has been the case for some time. Indeed, it could be argued that a prospective PEG (price/earnings to growth) ratio of 1.0 puts the current rating fairly and squarely in “fair value” territory. While it would be fair to say that the discomfort over market pricing that we have referred to in recent commentaries has given way to a more constructive view of risk assets, we have not yet been persuaded to add to equity weightings. Like many market participants, we would rather wait for at least some clarity over the path of inflation and associated data and the resulting implications for interest rates before committing further risk capital to the markets. In the meantime, we remain happy with the blend of investment styles, strategies and areas of specialization provided by the current mix of active managers and index/thematic exposure within portfolios.
Global Fixed Interest – Underweight
Inflationary pressures will remain high for the next 18 months on the back of disruptions to inputs and labor supply dynamics. Base case is for inflation to run at a moderately higher pace than the post GFC era – at about 2.3%. We have a strong underweight in developed market government bonds, and where we are compelled to hold some, we are invested in short duration bonds – some economies are running ‘hot’ and it implies upside risks for yields. We also basically hold zero investment grade credit – yield spreads are narrow relative to safer, quality bonds. We continue to hold exposure to emerging market bonds, with most of the exposure in Chinese government bonds as they are in a position to cut rates further.
In certain portfolios we may be overweight relative to a close to zero neutral allocation. The reason for this may be due to underlying managers ‘buying’ some insurance due to the diversification benefits offered by foreign developed market bonds, especially in SA Rand denominated portfolios.
Global Cash and Currencies – Overweight
We will hold it for liquidity after reducing global equity exposure to enable us to buy in the dips and capitalize on corrections.
Global Property – Neutral
Real estate exposed to bricks-and-mortar retail, office space and even some industrial spaces are battling while personal storage, cloud and physical data storage – both general and logistics – have a more assured future.
We have increased our exposure to US REITs marginally during the quarter as US growth dynamics remain superior relative to the rest of the world.
SA Equities – Neutral to Underweight
Confused? Yes – our process indicates different outcomes for Regulation 28 portfolios, Discretionary portfolios, and the duration/risk appetite of our varied portfolio strategies. The most important aspect is that – unlike some of our competitors – we are constructively optimistic on SA equities due to the attractive relative valuation matrix at present. The current impacts of COVID-19 and lockdowns have caused us to back down on our SA incorporated equity sector exposure. As they say, if you own a mind, why not change it? We continue to monitor our SA macro-economic risks and can therefore change our minds when the facts change.
All that said, SA risk assets trade cheaper relative to their emerging and developed market peer groups, leading to a stronger ZAR after foreigners also started to repurchase our nominal bonds in May/June. Our equity market is still valued 20% below its long-term average and trades at a discount of between 30-40% relative to our emerging market and developed market peer groups.
Blended forward PE multiples
Source: Larium Capital
Within SA Equity we prefer an overweight to SA Resource companies relative to SA Financials/Industrials. All mainly due to an improved tailwind from a global fiscal stimulus/economic recovery perspective and improved cash flow management of these miners. We remain marginally underweight SA Incorporated stocks relative to stocks benefiting from global consumer and industrial demand despite the attractive valuation matrix.
SA Fixed Interest – Overweight
SA Bond yields remain attractive relative to cash and other emerging market peers.
The SA government fiscal risks remain, but we will continue to benefit from the global cyclical recovery and therefore improved terms of trade and tax receipts. As a result, there is less need to issue SA bonds which should keep rates stable and attractive in the short term.
SA Cash/Money Market – Overweight
Overweight exposure to SA Money Market remains a portfolio risk mitigation decision. We do expect SA rates to be adjusted higher by 0.25% in 2021 and another 0.25% rate adjustment in the next 12 months.
No significant real returns (if at all) expected from this asset class in the next 24 months.
Real yield per asset class
Source: Matrix Fund Managers
SA Property – Marginally Underweight
The variety of outcomes due to SA economic uncertainty, especially in the services and tourism sector makes this asset class risky in terms of forecasting future returns and behaviour. Balance sheet risks and capital raise attempts remain.
We remain exposed to quality counters as selected by our underlying managers. Despite all the risks in the office, retail, tourism sectors this asset class could still generate CPI +3-4% p.a. returns after its price recovery over the past 12 months.
Conclusion
At the risk of repeating ourselves, our highest conviction action in portfolios is to embrace a diversity of asset classes in different geographies at present. Diversification remains the free lunch to provide protection and optionality in portfolios. Within this we are confident that the underlying holdings are the best available opportunities the market have to offer. There is no need to pay for ‘insurance’ in portfolios.
We wish our investors peace of mind and please remain focused on protecting yourselves and your family’s health and safety.
Roeloff Horne
Director and Head of Portfolio Management
The content of this article is for information purposes only and does not constitute an offer or invitation to any person. The opinions expressed are subject to change and are not to be interpreted as investment advice. You should consult an adviser who will be able to provide appropriate advice that is based on your specific needs and circumstances. The information and opinions contained herein have been compiled or arrived at from sources believed to be reliable and given in good faith, but no representation is made as to their accuracy, completeness or correctness.