The case for diversification has never been stronger
Vanessa Mabophe, Quantitative Analyst at Prescient Investment Management
In the latest Federal Reserve’s Monetary Policy Setting meeting, the Federal Open Market Committee (FOMC) chair, Jerome Powell, noted that these are extraordinarily unusual times, and not a time to reach hard conclusions.
At Prescient, we couldn’t agree more. The plethora of uncertainties resulting from COVID-19 is well-known, especially in the developing market space – where vaccine roll-outs are drastically lagging those in developed markets. This is exacerbated by the fact that with every new variant of the virus, the efficacy of vaccines come into question. It signals that the rocky road is far from over and our investment decisions should therefore reflect such sentiments. The best way to do this is to exploit the ever-relevant notion of diversification.
Diversification rests on the ability to minimise overall risk towards portfolio returns by combining a set of assets that interact with each other in an opposing manner. For example, we’d combine assets that thrive in a growth environment like emerging market equities and those that have defensive capabilities in times of heightened uncertainty like developed market bonds. This characteristic becomes vital when things go haywire, because the resistance of the defensive assets would, to a certain degree, offset the losses introduced by cyclical assets and smooth out the journey.
Effective diversification thrives in an abundant set of available investable assets. Being able to invest in local offerings such as South African equities and bonds, as well as offshore offerings like developed market bonds and emerging market equities, allows investors to get closer to this diversification objective. The various asset classes not only offer interesting interactions, but the distinct fundamentals prevalent in the various regions also have a unique effect on the performance of the various asset classes, thereby enhancing the effectiveness of diversification efforts.
For Prescient’s Multi-Asset Funds, diversification means both allocating towards different asset classes and offering diverse views on those asset classes. Over the short to medium term, uncertainties are likely to persist and as a result, investors should position their portfolios for an ever-changing environment. Prescient’s in-house models currently point towards improving local economic fundamentals – albeit off a low base. For instance, the Citigroup Economic Surprise Index for Emerging Markets remains elevated, while profit margins have had a recent rebound. Added to this, financial conditions remain easy – credit spreads are still narrowed while funding pressure between banks remains lower than the historic median. These are supportive of risk-seeking behaviour and point towards risky assets delivering in the short-to-medium term.
Though valuations and sentiment remain muted, the improving economic fundamentals and easy financial conditions lead to a positive investment case for South African equities and are often seen as precursors to growth. South African bonds continue to offer a good value case. Not only are they attractive from a real yield perspective, but they also offer good value from a relative perspective; given that the relative yield of South African bonds in relation to United States bonds remains attractive. It therefore means that carry trade premia can be attained with limited duration and credit risk.
Similarly, developed markets are also enjoying improving economic fundamentals and fairly easy financial conditions. Though equity valuations are fairly stressed in this region, the other factors Prescient considers (i.e. economics, financial conditions and sentiment) more than compensate for the valuation dilemma and lead to a cautiously bullish stance. This was especially pertinent in the second half of 2020, when global equities continued to rally despite being conventionally “expensive”.
Of course, on the flipside, such fundamentals are generally not supportive of safe-haven assets, and they put Prescient on a strong underweight towards United States government bonds. This is exacerbated by US 10-year government bonds sitting at the lowest real yields (-2.4%) since 1974. Real assets in both the local and developed market space currently offer a strong value thesis and an inflationary hedge, should inflation remain here to stay rather than being transitory. We’re therefore strong overweight South African inflation-linked bonds, South African preference shares and developed market property.
It’s clear that numerous assets offer a great overall value proposition over the short to medium term. In these uncertain times, it’s best to stick to the basics and apply methods that have been tested over years to offer value in tough conditions. Portfolio diversification across asset classes is one of those methods and a diversification of investment theses is another. Combining these two sources of diversification ensures that we don’t reach hard conclusions and run portfolios with a balanced mix of assets. When applied correctly, it has proven to be a veritable gold mine through both the worst and the best of times.
