Equities still in favour, but with great caution

Equities remain a preferred asset class to generate inflation-beating returns in the medium-term. This is with a definite preference for quality global assets, which can be acquired at fair value and with an optional weakening in what has been a strongly performing rand. With the global re-rating behind us, opportunities are nevertheless significantly fewer than they were during 2009.

This is according to PSG Fund Management subsidiary, Alphen Asset Management’s investment outlook for 2010.

Alphen Asset Management CEO, Adrian Clayton, said they are cautiously optimistic that through good stock picking equity opportunities could be identified to match investment criteria of owning stocks trading at reasonable valuation levels. There are, however, risks globally and domestically that should not be ignored.

After the massive 2009 rally in risky assets, Alphen currently finds itself favouring a more cautious approach to investing. The opportunities for returns are still there, but they are significantly fewer, will require very careful selection from both the asset classes and within the stocks that are a lot less “juicy”.

Notwithstanding a word of caution, the broader environment remains equity friendly. Monetary policy remains very loose and interest rate yields remain relatively unattractive to investors. We also find ourselves on the cusp of a very strong rebound in company profits.

The market has become increasingly comfortable with a accommodative monetary policy and extraordinary levels of government stimulus have put the global economy back on a sustainable growth path.

Yet, the final outcome of these efforts to re-flate economies around the world is unknown. With investor confidence currently sky-high, markets are vulnerable to deterioration in sentiment. Increasing levels of uncertainty and swings in investor sentiment are likely to result in greater market volatility

In an environment of a potentially fragile economic recovery, Alphen have a strong preference for quality franchises that offer good medium-term value. These are typically companies that generate strong cash flows and have defensive and growing profit streams. As at January 2009, these stock picks included British American Tobacco, MTN, Bidvest, Tiger Brands and Steinhoff.

Investors should currently be particularly cautious of stocks that are factoring in a strong cyclical recovery in earnings that may or may not be forthcoming. Also be cautious of many of the domestic resource companies that have seen their share prices more than double in a year without a concomitant improvement in rand earnings.

Regarding 2010, global markets will be closely watched for indications of governments starting to withdraw stimulus or central banks beginning to normalise monetary policy. The likely scenario is that authorities will prefer to err on the side of caution and will loathe withdrawing their support too early, but this is a space which bears watching.

The global recovery is predicated upon a relatively low cost of borrowing in the bond market. Given the massive expansion in G7 government bond issuance, we will be watching closely for indications that the investment market is starting to demand higher yields on their bond investments, as this will impact negatively on risk premiums for all asset classes.

The recovery in asset prices requires that appetite for risk and investor confidence remains healthy. With 2008 still fresh in investor’ minds, another shock to the psyche could have a meaningful impact.

The global economic recovery, and most commodity prices, requires Chinese demand to remain strong for recent trends to continue. A weakening in Chinese demand will be a flag for caution.

Domestically, government economic policy will need to be closely watched. We will be particularly watchful for indications that policy is increasingly pandering to The Left and hence becoming less market-friendly. At home we will also be on the look-out for any changes to the current inflation-targeting mandate of the Reserve Bank. Any changes in monetary policy implementation would undoubtedly create ripples through all domestic asset markets.

The company’s asset allocation view consists of on-weight in domestic equity, but underweight in domestic bonds and domestic listed property. Bonds are considered fairly priced given the current level of interest rates in South Africa, but are unattractive relative to cash when one factors in the risks of rising global bond yields, high levels of issuance and the likely normalisation of domestic interest rates over the next two years.

Property is generally unattractive in the environment of fully priced bonds, declining growth in income distributions and rising vacancies. Some property stocks offer some value, but careful selection will be required.

Offshore assets receive maximum weight. Investors should take advantage of a relatively strong rand to efficiently diversify their portfolios into top quality global assets. The rand has been a major beneficiary of increased risk appetite and remains vulnerable to exogenous shocks.

Alphen’s view is that many quality offshore equities are favourably priced relative to their South African counterparts. By default, they are overweight in cash. They will look to deploy this cash into opportunities that result from the volatility that we expect over the next year or two.