Volatility sets in as growth momentum rolls over

We have recently made use of volatility in investment markets to tactically increase the equity exposure to Neutral from a one notch underweight position previously. The change in allocation was primarily driven by our belief that following recent central bank comments interest rates will be kept low for a prolonged period and continue to provide an underpin to valuations while the economic recovery takes hold. Following its latest meeting the US Fed has indicated that they expect interest rates to remain unchanged until 2023 and signalled that the tolerance to inflation has become more balanced, given their “new” 2% average inflation targeting objective accompanied by maximum employment. This view is very much supported by central banks globally. The outlook for earnings growth has also improved in line with economic fundamentals, with an expectation of a strong rebound over the next year. Although we don’t expect future returns to be in line with the expected recovery in earnings given the already strong recovery in share prices, we would expect the asset class to outperform both cash and fixed income securities over the next year.

Government and corporate bonds have been, and still are, very much supported by the aggressive buying from developed market central banks, which has in turn resulted Asset Classes Equities Neutral Fixed Income Underweight Cash Plus Overweight in much lower market interest rates and strong growth in liquidity as measured by money supply. These measures will probably continue for a while longer and have served their purpose in providing companies access to liquidity as well as lowering the cost of funding to record low levels. Although these events bode well for borrowers, that is not necessarily the case for bond investors who will be receiving unusually low to negative absolute and real yields on their capital. We are comfortable to maintain a maximum underweight position to developed markets bonds. In addition, volatility this year has afforded us an opportunity to cautiously accumulate Credit and High Yield in the fixed income strategies to enhance returns.

The neutral position in global equities and maximum underweight in fixed income have left portfolios with an overweight position in cash, which serves as a risk mitigator in portfolios. In addition, the overweight cash position will provide us with ample capital to deploy when more favourable conditions or valuations present themselves.

With the global economy unlikely to be firing on all cylinders for quite some time, a valuation premium will continue to be assigned to those companies that can sustainably grow their earnings. This is particularly the case in a world where almost every industry is being disrupted by a reshaped competitive landscape. Our investment philosophy focuses on identifying the winners.

We are mindful about the high valuations attached to quality growth stocks. Trees don’t grow to the sky, and neither do share prices. The risk of overpaying or being blindsided by the unexpected is mitigated in client portfolios through:

/ A conservative bias when making long-term earnings projections.

/ Healthy scepticism about assigning higher “it’s different this time” valuations relative to history.

/ Purposeful diversification by sector, theme and geography.

In other words, we guard against falling in love with a successful investment by constantly challenging its place in the portfolio and by incorporating a margin of safety in our analysis.

Amphenol is a recent purchase. The company manufactures connectors that are critical for ensuring power is transmitted in an electronic circuit. It is easy to see the secular growth in “connectedness” continuing for many years and decades to come as a result of the proliferation of electronics in more and more products. Crucially, it is nigh impossible to displace Amphenol’s mission-critical components once they have been designed into a product. In addition, the company is highly diversified by end markets, making it less obviously prone to rapid technological disruption. All these strengths are evidenced by a consistent and long track record of strong cash flow growth.

Economic data releases have been upbeat but past activity does not guarantee a lasting theme – at least at the current pace, which remains flattered by recoveries from down levels. The Federal Reserve recently tweaked their mandate with regards to inflation and now seek that it ‘averages 2% over time’. This has implications for the interest rate outlook, signalling that rates will remain unchanged even if faced with inflation rising above target. Near-zero interest rates and the ongoing pandemic should, in theory, add to the attractiveness of the government bond market but yields at current levels have factored much in and allow little in the way of a safety net in the event of higher inflation and an ongoing economic recovery. Vast money supply creation may contribute to higher inflation in 2021 and if vaccine hopes becomes reality, a ‘risk on’ mood should pervade. If this unfolds and the economy successfully navigates this terrible episode, then attention will quickly turn to an eventual dialling down in stimulus measures. This could be particularly damaging to government bond yields which at current levels are not priced for this scenario. As such, we remain defensively positioned with respect to duration as only marginally higher yields on longer-dated debt are not nearly enough compensation for the added risk.

In the UK, the sugar-rush from stimulus measures and easing of lockdown restrictions seems to be running out of steam. Whilst key economic data releases point to a healthy expansion, albeit from a very low base, more recent indicators for both the manufacturing and the services sectors are off the highs experienced in July. There is no doubt that the potential for the recovery to slow, or even stall, has risen following the Government’s new restrictions as COVID-19 cases again climb. The Monetary Policy Committee (MPC), continue to hold interest rates near zero, however there is increased speculation that the MPC may, at some stage, implement negative rates. We are not yet convinced, the lesson from Germany is that this highly unconventional policy can be very difficult to reverse and can quickly have diminishing positive effects. However, it appears the bond market has already made up its mind on this matter with UK Gilt yields already trading in negative territory out to seven years in maturity. Negative or not, we do know that an almost zero interest rate policy will be with us for quite some time.

The recovery in Investment Grade (IG) and High Yield (HY) corporate bond markets has been dramatic following severe capital declines in March and spreads are edging closer to pre-COVID levels which certainly doesn’t appear to make them look cheap. However, the environment for both taking risk and yield hunting remains supportive. Central bank initiatives have increased the allure of riskier fixed income assets and those that can pay an income stream above government debt are greatly benefitting as the world remains starved of yield. One could argue that the global marketplace’s reliance and in many respects complacency towards central bank support is possibly creating a bigger issue down the road, and this is entirely plausible. However, the past six months has clearly demonstrated the pitfalls of being too risk averse in an environment where the central bank ‘has your back’. We continue to hold IG debt with a smaller allocation to HY in our fixed income strategies and any upcoming weakness may persuade us to increase weightings to both.

RECOMMENDATION - INTEREST RATES

The US dollar has posted a negative quarter with virtually all of the downside attributed to the month of July. Ultimately, the currency was due a period of consolidation but where do we see direction from here? Firstly, it is important to appreciate that the currency, in general terms, is only down approximately 2.5% year-to-date and in fact, the relative outperformance of the US bond market versus the German bond market (as an example) has more than compensated for the currency’s depreciation against the Euro. Without doubt, the outlook for the US dollar is negative if other developed economies (Eurozone, UK etc.) enjoy periods of economic ‘catch-up’ but we are not currently seeing enough evidence of this. The US still enjoys a solid advantage in this arena and is backed up by a central bank that seems willing to pull out all the stops to stimulate growth. The US dollar has defied the ‘demise of the dollar’ story time and again, and whilst it may well be different this time, it will not be a one-way street. It is crucial to remember both the performance and yield (often negative) of the asset class underlying each respective alternative currency – we remain overweight for now.

Sterling has been somewhat resilient over the quarter gaining approximately 4% against the US dollar, although more recently has given up some ground from the September high of $1.34. Sterling strength has been more attributed to US dollar weakness rather than broader support for the currency as it struggled to rise against other currencies, especially the Euro. We have commented for some time that Sterling is undervalued on a purchasing parity basis and over the long-haul, should regain some footing. However, current headwinds from the resurgence of BREXIT uncertainties, particularly with a year-end deadline fast approaching and still no deal in sight, combined with heightened restrictions to control the increasing spread of COVID -19 is likely to keep volatility elevated. Our Sterling International fixed income strategies remain moderately overweight base currency, but it is still too soon to exit the foreign currency exposure which sits as a hedge against potential shorter-term weakness.

as at September 2020

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South African investment markets have been treading water since June and domestic equities are back into negative territory on a year-to-date basis after the correction in September. An increase in COVID-19 related cases and weak economic news flow in South Africa are largely to blame. Domestic- orientated stocks such as financials and retailers have borne the brunt of the pain of this year’s crisis, whereas precious metals, and the likes of Naspers and other rand hedge counters, have provided some support to the local bourse.

Offshore assets have performed strongly in Rand terms and provided much needed impetus to the performance of domestic portfolios – again illustrating the importance of regional and sectoral diversification. Regardless of the underlying value that exists, South African assets are expected to take their cue from global events such as the developments surrounding COVID-19, the US presidential elections and Brexit for the remainder of the year.

South Africa has reached level 1 status of the government’s COVID-19 containment programme, which has allowed the economy to recover from a period of extreme pain in which more than 2 million people lost their jobs, while the full effects from the crisis will only be revealed in time. Although it will likely take the economy another two to three years to fully recover at least, the worst appears to be behind us as economic activity starts to gather pace again.

Low interest rates supported by low inflation will support the economy at the margin, but as SA Reserve Bank Governor Lesetja Kganyago indicated at the latest Monetary Policy Committee meeting, this won’t be enough to sustain growth in the long run. In the statement following the meeting, Governor Kganyago stated, “monetary policy however cannot on its own improve the potential growth rate of the economy or reduce fiscal risks. These should be addressed by implementing prudent macroeconomic policies and structural reforms that lower costs generally, and increase investment opportunities, potential growth and job creation. Such steps will enhance the effectiveness of monetary policy and its transmission to the broader economy.”

Leading economic indicators have changed direction and we expect that the manufacturing sector will recover first before the services sector starts contributing more meaningfully, in the same vein as the global trend. Pent up demand, low interest rates and inventory rebuilding will support manufacturing activity, while the services sector is expected to be hamstrung by a change in consumer behaviour and spending patterns. Tourism and leisure will continue to be affected by international travel restrictions.

On a separate and positive note, the corruption eradication drive, led by the National Prosecuting Authority, is starting to gain momentum. Several high-profile arrests have been made in recent weeks and more are sure to follow in the coming weeks ahead.