How to invest during geopolitical and inflation insanity

Asset managers presenting their 2022 ‘market wraps’ and 2023 ‘market outlooks’ during the final quarter of 2022 had no shortage of ‘doom and gloom’ domestic and global events to provide context for asset allocation decisions and projected portfolio returns. At a recent Allan Gray and Orbis Investment update, Saleem Sonday, Head of Retail Distribution at Allan Gray, singled out bond and equity market volatility; South Africa’s load shedding debacle; global energy shortages; and the fragmented geopolitical environment as ‘food for thought’ for the ensuing discussion. The asset manager’s update was delivered in two parts, with some comment on balanced funds and performance fees followed by an investment outlook. This newsletter dwells on the latter.

Positioning portfolios for the trend shift

The audience of financial advisers and retail investors did not have to wait long for the first ‘returns are under fire’ warning. “There is a reasonable probability that the investing landscape is going to look pretty different over the next 10 to 15 years than it has in the decade since the 2008-9 Great Financial Crisis (GFC),” said Duncan Artus, Chief Investment Officer at Allan Gray. “And that means that what worked [in asset allocation and portfolio construction] between 2009 and 2022 might not be what works into the future”. Fund managers that follow bottom-up investment methodologies are paying close attention to the unfolding trend shift and are positioning their portfolios both to benefit from the change and protect investors from the risks accompanying it. 

Artus’ view is largely informed by a more inflationary world. “We are not talking about the seven, eight or higher percent coming out of the United Kingdom (UK) and United States (US) presently; because inflation settling at between four and five percent creates a very different outlook for those who live in the developed world,” he said. In addition to inflation, global economies look certain to face energy supply constraints and increased geopolitical tensions in the near term, and certainly through 2023. The rapid rise in developed market inflation has caused money to re-price quickly and violently, as illustrate by significant hikes in developed market central bank interest rates. It is worth noting that one of the big ‘unwinds’ taking place in global markets at the moment is that interest rates, which were kept artificially low for years, are returning to more sensible levels. 

Inflation, shifting from equity markets to consumers

“The US Federal Reserve raising rates from near-to-zero to 4% makes for a very different world; you can now achieve 4% yield lending to the US government without any duration risk,” said Artus. It turns out that inflation was present in equity prices long before it trickled into the consumer space. Developed market shares went on a decade-long tear following the GFC thanks to record liquidity provided by fiscal and monetary policy stimulus, especially in the US. “What we expect to happen now, as consumer price inflation emerges and central banks raise interest rates, is for banks to start shrinking their balance sheets,” he said. This signals an about turn from an environment in which banks were pumping money into economies, to one in which they tighten money supply. The result, big Chinese and US tech stocks that were in favour until late 2021 have plummeted in value. 

The geopolitical tensions mentioned in the opening paragraphs centre around the Russia-Ukraine war, China’s ongoing sabre-rattling over Taiwan and North Korea’s continuing development of long-range missile technology. “The world is kind of splitting in two at the moment: those who support the US and the West, and those who align with China, Russia and various other countries,” commented Artus. Local investors should be particularly concerned about the battle between the world’s largest and second largest economies due to the JSE’s significant exposure to China. The South African stock market is extremely exposed to Chinese risk, with much of the market valuation in a single share, Naspers. Just imagine, dear reader, what happens to Naspers shares should China decided to annex Taiwan! 

Too much China could be risky

The close connection between South African equities and China extends to a number of heavyweight top-40 shares that generate much of their revenue from that economy. For example, luxury goods firm Richemont generates over 40% of its sales from Chinese customers; while big mining companies like Anglo American, BHP Billiton, Glencore and Kumba rely on the Chinese economy firing on all cylinders too. “China is basically 60% of seaborne demand for most commodities, and [this exposure is] something we look to manage in the balanced and stable funds,” said Artus, who singled out shares such as British American Tobacco and AB InBev as being far less exposed to the Chinese economy, and therefore worth considering. 

The energy price crisis that played out during 2022 bears further exploring. According to Artus, the world is ‘short energy’ due to not having invested enough in energy infrastructure. “No matter what your philosophical view is on energy [you have to appreciate that] energy and fossil fuels go into making fertiliser, food, fuel and the manufacture of all sorts of items in daily use,” he said. The global focus on reducing greenhouse gas emissions and achieving net-zero by 2050 has created an unnatural situation in energy markets, with new investments by gas and oil firms at all-time lows despite oil prices being historically high. “What normally happens is when commodity prices are high, there are more profits for the commodity companies, offering an incentive to expand supply; but that has not happened this time around, partly due to government policy,” Artus explained. 

Having handled the three major risks facing global financial markets, the discussion turned to South Africa, where risks were said to be compounding over time. Artus offered two examples of domestic risks, beginning with the July 2021 rioting that afflicted areas of Gauteng and KwaZulu-Natal. The point being that the impact of inequality and poverty must be factored in when evaluating the long-term prospects of South African consumer shares. The second risk is the apparent ineffectiveness of coalition politics, with growing concerns about the impact of political posturing on service delivery. Of course, these issues go hand-in-hand with growing concerns over the ability of critical state-owned enterprises (SOEs) such as Eskom and Transnet to deliver on their mandates. 

Striving for the highest risk-adjusted returns

The balance between offshore and onshore assets is among the important considerations when managing the various risks identified in today’s newsletter. At present, the Allan Gray Balanced Fund is invested about 34% offshore with the remainder in South Africa. “We do not sit and rebalance to 60-40 all the time; but rather apply our minds to how bonds stack up to equities, equities to cash and South African asset classes to offshore asset classes,” said Artus, who summed up by saying that it was important to be on the right side of long-term trends, especially when those trends were likely to persist for 10 or 15 years. 

Through 2023, investors will have to look out for more inflation; energy being in short supply, globally; and new geopolitical conflict. Asset allocation decisions will, therefore, have to reflect the multi-years secular trends that emerge from the interplay of energy, inflation, interest rates and geopolitical instability. “We do not only aim to get the highest return; we aim to get the highest risk adjusted return,” Artus concluded. 

Writer’s thoughts:
 Following Russia’s incursion into Ukraine, shares on that market plummeted by as much as 95%. Allan Gray’s update presentation warns that if China invades Taiwan, a similar market shock might follow, placing huge pressure on many locally listed shares. Are you concerned about the impact China’s actions may have on your clients’ portfolios, especially given their exposure to Naspers, which is heavily invested in Tencent? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.