Stay diversified and think long term
David Crosoer, Executive: Research and Investments at PPS Investments.
Despite the Federal Reserve (Fed) leaving US interest rates unchanged this week, there is still a possibility it could raise rates later this year. Whatever the outcome over the next few months, it is important for investors to diversify their portfolios to withstand an increasing interest rate environment when this eventuality materialises.
The United States is ahead of most other countries in contemplating normalising their record low interest rates. While the Fed did not raise rates at its June meeting, Yellen confirmed expectations that the Fed still intends to raise rates twice this year. In anticipation of this, and because of a deteriorating local inflation outlook, the South African Reserve Bank (SARB) also intends to raise interest rates. Over the next 18 months, the market is now expecting a further 1.75% increase in interest rates from the South African Reserve Bank (the SARB has already raised rates by 0.75% since January last year).
South Africa is raising interest rates despite meagre global growth, because we still experience inflation (CPI came out at 4.6% year-on-year in May, up from its low 3.9% year-on-year in February, and is expecting to be close to 6% by the end of the year) and are heavily reliant on attracting foreign capital inflows.
Given weak global growth outside the US, and other central banks (like Australia and China) still cutting interest rates, there remains the possibility that the US will delay raising rates.
Yellen has been at pains to point out that the Fed’s decision to raise rates is data dependent, and she has introduced the term gradual to describe how the tightening cycle will unfold. If the economy turns out weaker than expected, the Fed could delay raising rates.
Regardless of Yellen’s caution, many asset managers say that if you use a normal interest rate (rather than the current low interest rate) to discount earnings, then stocks look expensive.
We would typically not justify buying an expensive asset class on the basis that that interest rates will stay artificially lower for longer than expected. Instead, we would try to construct portfolios that are relatively robust to an increasing interest rate environment. Consequently, our portfolios are all overweight South African cash at this point in the cycle, and the managers we use are mostly underweight property and parts of the equity market that appear particularly expensive.
The world economy still looks far off from recovering from the global financial crisis. Economic growth continues to disappoint on the downside, and consumers and governments are still saddled with excess debt. Despite this, investors will only realise the economic is recovering strongly once it has already happened. The risk is that the Fed could also be behind the curve, given its current caution, and start raising rates too late. Then, the market will be very quick to re-price financial instruments off higher anticipated interest rates.
How then should investors construct portfolios in this environment? We believe the appropriate strategy is firstly not to take on too extreme a position in expensive shares and secondly to lower one’s future return expectation given the current valuation starting point.
We encourage investors to have a sober discussion with their financial adviser and if necessary, look at increasing their savings so as to make up any shortfall in their retirement or financial planning to cover likely reduced earnings in future. We understand this is a difficult conversation, but investors need to diversify the risk that returns will be insufficient to meet their needs. Better forsake some consumption now for capital later, than find out later you don’t have enough capital.
For the investor, a multi-manager approach can take away some of those risks because it means investing in multiple managers who have different styles and philosophies each of which are appropriate to a different stage in the investment cycle.
