Betting on the US

In his most recent letter to Berkshire Hathaway shareholders, Warren Buffett made a telling statement about the US economy. While many commentators have been concerned about the country's recovery and future growth outlook, Buffett stated his belief that there is still no better place to invest.

“For 240 years it's been a terrible mistake to bet against America, and now is not the time to start,” he wrote. “America's golden goose of commerce and innovation will continue to lay more and larger eggs.”

It was a significant statement to make in the context of an economy that is still struggling to shrug off the effects of the 2008 financial crisis. The bout of market volatility at the start of 2016 showed that investors are still worried about the prospects for global growth, and by extension what will happen in the US.

However, recent data has eased some of these concerns. Investec economist, Chris Hare, believes that the country is now on a solid, if not spectacular course that will see the economy continuing to strengthen over the next few years. The labour market is tightening and the prospects are that inflation will start rising as wage growth also improves.

Nonfarm payroll employment in the States has grown ahead of expectations for four of the last five months. The figures for February also showed that average hourly earnings had risen by 2.2% year on year. Ultimately these improvements will have a positive impact on US equity markets as growth will lift investor sentiment.

“I would expect the US market to be one of the star performers in terms of developed economies over the next few years,” says Hare. “Given that there are quite a lot of risks to the global economy and emerging markets, I think the US will continue to be some sort of safe haven in an uncertain world.”

This is an important consideration for investors in emerging markets like South Africa. It is important to diversify into developed markets that are more stable, and the US offers the best prospects in this regard.

The question, however, is what is the best way for local investors to gain exposure to this market in a way that can maximise gains in US Dollars and limit risks? Even though the outlook for US equities is reasonably positive, there are still concerns. Uncertainty around China’s fundamentals, the Federal Reserve’s monetary policy outlook and the Donald Trump factor, all weigh in on what should be an interesting next 5 years for the US.

This is what makes the use of structured products a compelling option. These investments are able to offer both the prospect of equity-like returns, as well as a degree of capital protection.

“Structured products bring a level of certainty from a payoff perspective, which investors appreciate, especially when dealing with foreign markets,” says Ryan Sydow, head of retail distribution at Absa Corporate and Investment Bank. “Particularly having local providers offering dollar solutions also brings a level of familiarity.”

Two products currently available to South Africans that provide exposure to the US market are the Discovery Dollar Capital Plus Fund, which closes in April, and the Investec US$ Digital+ product, which closes in May. Both have similar return profiles and both employ what is referred to as digital gearing, where any gains are amplified to a stipulated level.

Discovery's product has a five year term, and is based on a global portfolio comprising of 30% S&P 500 and 70% Eurostoxx 50 indices. It will give a minimum return in US dollars of 40% if this portfolio is flat or positive over the term, and will also give any upside above 40%.

In addition, it provides full capital protection as long as the portfolio does not fall by more than 30% at any stage. In that scenario, investors will receive the negative US dollar return.

The Investec offering is linked entirely to the performance of the S&P 500, and has a 3.5 year term. It provides a minimum US dollar return of 25% should the index end positive, as well as 100% of any upside beyond that. Capital in this product is also protected provided the index does not fall by more than 30% at any time.

The significant benefits to both of these products are that they will provide good returns even if markets are only marginally positive, and deep capital protection if they are negative. In an uncertain environment, that gives investors a great deal of comfort, specifically where exposure is to the US, with growth more likely to be stable than in Europe.

The Investec structured products team tested 15 760 different investment periods from 1950 to analyse how the product is likely to perform, and their study showed that it would have delivered positive returns 84% of the time. Just 3% of the time investors would have had their original capital returned to them, and 13% of the time returns would have been negative.

The average return was 35.89% in US dollars, which is 9.16% annualised.

Brian McMillan, Investec’s Structured Products head of retail sales, explains that the digital component refers to the fact that through the use of bonds and derivatives investors are able to receive a binary pay-off profile. “Simply put, this means that the underlying index only needs to click into the positive for the investor to get a very attractive minimum payoff.”

While structured products are not risk free, they do offer an appealing risk-reward profile. And for South African investors looking for foreign market exposure in the current environment, they come with the potential for amplified returns in foreign currency.