Asset Class Views

Maitse Motsoane, Portfolio Manager & Analyst at Prescient Investment Management

Market participants will need to navigate what might prove to be a treacherous path ahead given the elevated economic and market risks. The US administration’s aggressive trade policy at a time when global growth is slowing has certainly thrown a spanner in the works. This uncertainty may very well cripple business investment as global PMIs continue to roll-over. While US consumer confidence remains robust, if the US administration pushes through the final tranche of tariffs on China’s remaining USD300 billion of US exports, consumer confidence will likely follow the downward trend already seen in PMIs. Furthermore, the breaking down of global supply chains - as result of the tariffs and other restrictions - could lead to tighter corporate profit margins.

However, we believe trying to predict when trade tensions (or other geopolitical issues) will flare up again is almost a futile exercise. Instead, we focus on interrogating global economic data, valuations, monetary policy and sentiment when forming our views around different asset classes. As things stand, leading indicators are signaling softer global growth over the short- to medium-term, sentiment remains fragile and risk premia have been eroded. Although we expect monetary policy response from key central banks, it remains to be seen whether that will be enough to reflate the global economy given the low level of interest rates. Taken together, our indicators suggest that we should start thinking about establishing defensive positioning in their portfolios.

Developed Markets and Emerging Markets equities:
The US economy should continue to outperform Europe, but the fiscal stimulus that was delivered by the current administration is expected to wear-off at a time where consumer confidence is at risk of being stifled by tariffs. Our preference lies in European equities as opposed to US equities. Valuations are less stretched, and the weaker currency has partially softened the economic slowdown. The European consumer is still well supported and recent economic data has surprised on the upside.

On the emerging market front, we are neutral SA and broader EM equities. We think emerging market economies may struggle to cope with slowing global growth and, given the fact that these are the highest beta of the major equity markets, some caution is warranted at this stage of the cycle. Further to this, China’s economy is slowing, and even though policymakers are providing stimulus in response, the approach will likely be measured, aimed at softening the blow of a slowdown rather than re-steepening of the growth trajectory.

Developed Markets and Emerging Markets bonds:
It has never been straightforward to make a call on EM rates, with numerous idiosyncratic factors to take into consideration. But with central banks now lining up to ease policy, the likelihood of a cyclical shift towards carry and duration is increasing by the day. For this reason, we favour EM bonds over their developed market counterparts. Even though global liquidity conditions remain supportive of risk assets, we continue to monitor leading indicators and high-frequency data for clues as to how future economic growth will look like. Admittedly, current global growth dynamics do not inspire much confidence in allocating capital to emerging markets. However, EM bonds trade at healthy risk premia and, as such, investors are fairly compensated for the risks that they are taking.

As for developed market bonds, intensifying fears of a recession has resulted in them rallying over the half of 2019, supported by a safe-haven bid. With benchmark US treasuries now hovering around the 2% handle and German Bund yields venturing further into negative territory, we believe valuations are fairly rich, with limited scope on the downside for yields.

Global investment grade and high-yield credit:
Credit spreads have tightened significantly since the beginning of the year. Currently, investment-grade and high-yield spreads trade at levels lower than their long-term average. This seems unattractive, particularly if one looks at it through the lens of declining corporate profit margins. While the number of companies filing for bankruptcy might seem low at the moment, we posit that this may just be a reflection of excess supply of capital as opposed to productive use of capital. As such, we are underweight global credit as an asset class.

SA preference shares, ILBs and property
Property must be one of the most unloved asset classes in South Africa, with JSE listed property index shedding around 20% of its value since the beginning of 2018. Understandably, anemic domestic growth and several industry-specific factors such as cannibalization of retail space has led to this decline. But, with a positive regime change, if one takes a view that SA’s economy will improve the next 5 years, this might prove to be an opportune time to establish a position in an asset class that is geared to economic growth at attractive valuations.

Turning our attention to inflation-linked bonds, the market implied five-year inflation expectations (break-even inflation) is currently below 5%. This is low relative to where 5-year break-evens have traded in the past – an indication that ILBs should be preferred over nominal bonds. However, caution is warranted given the fact that the SARB is effectively targeting 4.5% inflation – which suggests to us that break-evens may trade structurally tighter going forward. And with SARB’s credibility intact, making a call on ILBs based on where break-evens are trading relative to history may be misleading. Having said that, we believe there is scope for an uplift in inflation over the next 12 – 18 months. Even though domestic demand is weak, administered prices will continue to exert upward pressure on CPI, food inflation has bottomed, and it is hard to see retailers continuing to absorb higher costs of production in a bid to protect market share. Although we don’t forecast CPI, current market dynamics lead us to believe that CPI, over medium-term, will be higher than where we’ve seen it over the recent past. Consequently, we have a tactical overweight position in ILBs.

Finally, we like SA preference shares because of their diversification benefits in a low-growth environment, where ordinary equities are unlikely to deliver exceptional returns. Despite the asset class’ strong performance over the past 18 months, dividend yields relative to cash rates and bond yields are still somewhat elevated. We are therefore moderately positive on the asset class.