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Cough up… Why your clients owe Treasury 7000 Big Macs, each

18 June 2021 Gareth Stokes

The growing disconnect between asset prices and personal incomes is testing fund managers’ resolve insofar sticking with their medium- to long-term asset allocation strategies. Jacques Plaut, a portfolio manager and equity analyst at Allan Gray, recently described the difficulty in remaining invested in the sweet spot of financial markets against a backdrop of investor exuberance and irrationality. By way of example, had you or your clients asked Google the leading question: ‘Should I invest in…’ early in 2021, the search engine would have auto-filled your query with suggestions like Bitcoin, Ripple and Ethereum more readily than equities like Amazon or Woolworths.

From zero to $74 billion and most of the way back

Retail investors, flush with cash following record levels of pandemic-related fiscal stimulus, especially in the US, are chasing returns in extremely risky propositions. “The total crypto market capitalisation is now north of US$1.7 trillion; you could pay off South Africa’s national debt five times with this amount of money,” said Plaut. He also lamented the pump-and-dump that took place in shares in US-listed Game Stop, an out-of-favour computer / console game retailer that rebounded from near bankruptcy to a market valuation of around US$74 billion at the height of a retail investor buying frenzy. “The general theme here, is of a disconnect between asset prices on the one hand, and incomes, on the other,” he said. “It is not just shares: house prices and commodity prices are also increasing way faster than incomes”. 

The Allan Gray and Orbis Investment Roadshow, held virtually on 19 May 2021, warned that the only way for the current disconnect to resolve itself was through higher inflation. The fund managers pointed out that investors’ fear of inflation was in plain view in the bond market. “Interest rates go up with this fear, because it is not such a good idea to lend out money at 1% if inflation is going to average 4%,” noted Plaut. “If inflation picks up a lot, then interest rates will have to follow … and retail investors will begin dumping their cryptocurrencies, $1.8 million Nike sneakers and higher risk equities for the relative safety of government bonds”. The message to retail investors, your clients, is clear… Inflationary pressures in the US will eventually force the Federal Reserve to hike rates, at which time US equities and other stretched alternative asset classes might find the wind knocked from their proverbial sales. 

Governments are constrained by soaring fiscal debt

The Allan Gray Balanced Fund must make its asset allocation decisions in a South African economic context. As such, the discussion inevitably turns to national debt. Concerns over the country’s expanding debt-to-GDP and worrying budget deficit mean that local borrowers must pay a much higher real interest rate than they would in any other country, if you exclude the proper basket cases. Plaut used some helpful imagery to illustrate South Africa’s debt burden, starting with the observation that each of your clients would have to pay an additional once-off tax of R230 000 to settle the country’s debt… This assumes we settle the debt across all employed taxpayers. He went a step further by using the ultimate measure of Purchasing Power Parity (PPP) to illustrate the impact of government debt per employed citizen in SA, the UK and the US. 

If we convert the ‘per employed person’ share of country debt to Big Macs, it would ‘cost’ South Africans the equivalent of 7000 Big Macs, bought locally in rand, to settle the country’s debt compared to 25 000 Big Macs, bought in that country in dollars, in the United States… The UK falls somewhere in the middle. “Given this illustration, it is a bit strange that South Africa’s creditors are so worried and US creditors are so relaxed,” said Plaut. Returning to the serious matter at hand, the portfolio manager observed that the best way to tackle fiscal debt was to encourage economic growth by investing in the economy; focusing on education and skills development; and implementing sensible business-friendly policies. South Africa has, regrettably, disappointed against each of these measures over multiple years. 

Commodities are booming; but not clear for how long

It is common knowledge that a resurgence in commodity prices saved National Treasury’s bacon in the 2020/21 tax year as various base and precious metals shot higher, adding to mining sector profits and taxes. Rhodium traded up to five times higher than its March 2020 price while copper and iron ore more than doubled over the year to end-May 2021. Allan Gray noted that commodities, with the exception of gold and nickel, were close to their all-time highs. “As a consequence, the rand has strengthened considerably, outperforming most emerging market currencies since March last year,” said Plaut. He added that Allan Gray’s strategy lent towards “calling the rand right at the extremes”. At current levels the rand is not considered extremely valued against the US dollar; but there is risk to the downside. 

The Allan Gray Equity, Balanced and Stable funds delivered positive returns over the prior 12 months, with 30%, 20% and 14% respectively; but the Stable fund was the only fund to outperform its benchmark. It was possible to pin much of the equity underperformance on a single share, with British American Tobacco (BAT) described as a cheap share that went down further during the period under review. “We were buying loads of cheap shares a year ago; but with the benefit of hindsight we were too focused on companies with limited downside potential and should have been buying riskier shares,” concluded Plaut. “The fact that we have had low exposure to US shares, which we think are expensive, has also hurt us”. Another drag on equity returns came courtesy the so-called South Africa Inc shares that performed poorly, including KAP, Life Healthcare, Old Mutual and Remgro. 

It takes time for long-term strategies to bed down

The good news for investors is that Allan Gray remains confident in the equities in its various portfolios and expects their decisions to prove correct over time. As for asset allocation, it appears your clients are still best served in equities with maximum offshore exposure. At May 2021, the Allan Gray Balanced Fund was at 71% equity exposure and close to its maximum offshore exposure. Around 51% of the fund is in SA equities of which 23% are considered SA Inc shares. The Allan Gray Stable Fund had 36% equity exposure and just under 30% off shore. 

Writer’s thoughts:
We were surprised that Allan Gray offered an apology to investors for underperforming against its Equity and Balanced Fund benchmarks. It seemed counter intuitive that an asset manager might be poorly judged despite delivering 20%-plus returns in one of the most turbulent trading years on record… How do you manage client expectations when their preferred asset managers’ funds fail to deliver to benchmark? Do you advise them to stay put; or do you consider changing to another brand? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

Comments

Added by cynical simon, 18 Jun 2021
The name of the game is "uncertainty"
,,the particular moves are "risky" and the strategy is called "volatility whilst the game plan is "kneejerk, violent reaction.
Bye bye "Peace of mind..
.
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