Lower returns in 2013 favour equities and stockpicking

Although global macroeconomic risks are receding somewhat from the high levels of 2012, the new year is not necessarily going to be a better one for investors, according to Peter Brooke, head of MacroSolutions at Old Mutual Investment Group SA (OMIGSA).

Speaking at a press conference in Johannesburg today, Brooke said he expected lower returns in 2013 across most asset classes versus the surprisingly high levels of 2012, as most good news had already been priced into both global and local equity markets, and bond yields had very little room to fall further from their historic lows.

“The extreme policy response that central banks undertook in 2012 (by cutting interest rates and buying bonds) to avoid a renewed global financial crisis lowered the cost of capital and resulted in record-low global bond yields and higher prices of local assets as well,” explained Brooke. “Essentially, all of the bad news last year gave rise to market-boosting policies that, in the end, gave investors higher-than-expected returns. For example, the 50 basis point rate cut by the SA Reserve Bank (SARB) helped produce stellar returns from listed property (35.9%) and bonds (16.0%), with the SA government 10-year bond yield reaching 6.7% - a level not seen since 1970.”

Equities, he said, had also re-rated, with the FTSE/JSE SWIX index returning 29.1% last year from a combination of dividend growth (15%), strong earnings growth (50%) and higher price-earnings (P/E) ratios (35%). Forward P/E’s moved higher following lower earnings expectations.

“So in 2013, with the global macroeconomic outlook expected to improve as China and the US both recover to an extent and worries over a Euro break-up recede, we expect policymakers to have a quieter year as they maintain their current policies. This means the global cost of capital should stabilise – in fact, global bond yields are likely to have bottomed last year,” observed Brooke. “So we can’t see good real returns from global cash and bonds in 2013 – we are forecasting -1.5% and -1.0% p.a., respectively (in US dollars), over the next five years.”

Therefore global equities still offer the best return prospects among offshore assets, primarily due to their higher yields relative to bonds and cash, Brooke said. He is forecasting a real return of 6.0% p.a. (in US dollars) over the next five years from this asset class. Investors should consider adding global equities to their portfolios in 2013 for their valuable diversification benefits, regardless of rand moves over the year.

“We are also taking advantage of the pockets of higher yield to be found in emerging market debt, international property and higher-yielding international shares to enhance returns in our funds,” revealed Brooke.

Turning to South African assets, Brooke points out that the surprise SARB rate cut left cash investments delivering a below-inflation return of 5.6% in 2012. “Looking forward, investors would be lucky to beat inflation over the medium term – we are expecting no real returns from cash over the next five years.”

And after producing surprisingly strong returns in 2012, South African bonds and listed property are not likely to maintain this performance in 2013, he believes, largely since local interest rates are likely to remain o­n hold. He has lowered his five-year real return forecast for both by 50 basis points – for bonds to 1.5% p.a. and for listed property to 4.5% p.a.. “This does enhance our investment theme of a low-return world, and investors should temper their expectations for these asset classes in 2013,” he stated.

The good news, he says, is that these conditions should be positive for equity returns, as investors continue to be forced to avoid negative real returns and chase the higher returns they offer. “We expect the local equity market to grind higher in the absence of any exceptionally positive or negative global news. Our forecast is for a real return of 6.5% p.a. over the next five years. Although valuations are getting expensive, SA equities do offer the best absolute return. Plus, positive economic surprises – such as faster-than-expected growth in China and the US – have the potential to lead to a broad investor rotation out of bonds and into equities, so it is important for investors to maintain their equity exposure.”

Brooke also believes that active equity managers should have an easier time in 2013 than last year. “Both globally and locally, active managers struggled to outperform equity indices in 2012 due to the investor flight to safety – this created high correlations and momentum-driven markets as those shares that did well kept doing well, and those counters that did poorly continued to do poorly. Valuations played little role in share price moves, meaning active investors were unable to outperform the index.

“The improved global outlook creates the potential for higher risk appetite among investors, so we expect some reversal of this trend. Stockpickers should be able to add more value under these conditions. Following from this, within international equity we are overweight in emerging markets (due to their higher growth prospects) and have a tactical overweight in Japan (to take advantage of the benefits of economic reflation in that country). Within South Africa equity we are underweight the expensive industrial shares and overweight selected resources and financial shares.”

In summary, noted Brooke, improving global macroeconomic conditions, ample liquidity and attractive relative valuations should be positive for equity investments in 2013. A lack of inflation-beating alternatives also favours equities, as does the potential for a broad rotation back into equities from bonds should any positive surprises materialise. These factors all suggest that investors should maintain their equity exposure this year, while continuing to diversify to both reduce risk and take advantage of select higher-yielding opportunities such as international property and emerging market debt.

“Ironically, investors shouldn’t take it for granted that the improved economic conditions expected in 2013 will be good news for investors, especially for bond and property investments. Returns are likely to be lower across all asset classes in the absence of further policy stimulation. Equities have more upside potential, but with company earnings growth likely to be lower than 2012, the chances of repeating last year’s good equity returns are slim,” Brooke concludes.