The Slow Rotation

Old Mutual Investment Group’s quarterly press conference, Johannesburg, 23 July 2013: According to Peter Brooke, who heads up MacroSolutions, the multi-asset class manager at Old Mutual Investment Group, markets reached a critical turning point in the fir

‘Many commentators believe that this is the start of the Great Rotation as the world moves away from an era of financial repression. The Great Rotation is synonymous with better growth, higher bond yields and money flowing out of bond funds into equity funds. Our view is that the global cost of capital did bottom, but the process will take time, and we have dubbed it the “Slow Rotation”’, says Brooke.

He explains that recovery will be led out of the US, but that structural constraints in Europe and the decline in China’s secular growth rate means that it will be a “bumpy grind higher rather than lift off”. In the medium term he says that this will provide powerful headwinds to fixed income assets and he still expects negative real returns from international bonds. Despite the improvement in growth, short-term rates will be kept at abnormally low levels, which means o¬ngoing negative real returns from offshore cash (-1%).

‘With growing supply and changing demand dynamics as China shifts from investment to consumption, it is hard to see commodities prospering, particularly if the US$ moves stronger o¬n the back of better relative growth. By default this leaves equities as the o¬nly game in town due to the unattractive outlook for bonds, cash and commodities’, he continues. ‘Dividend yield will replace the ‘Quest for yield’ which has pushed investors into the more risky extremes of the fixed income world. However, equity multiples have risen and we have cut our long-term forecast of expected real returns from SA equities from 6.5% to 6.0%. This is based o¬n lower growth expectations o¬n the back of slower trend GDP and lower commodity prices and margins depressing return o¬n equity.

‘Another technical factor is lower retained earnings will reduce future growth potential. Our preferred asset class remains international equity, our outlook for which remains pegged at 6.0% real over the medium term.’

However, he points out that with the rand having weakened substantially, potential returns for local investors are much reduced. This re-enforces the theme of a ‘low return world’.

Brooke says that the shift to higher global cost of capital is bad for South Africa as the local economy and market have been the beneficiaries of the secular decline in global bonds which enabled the authorities to fund the current account deficit. ‘The country has also benefited from the rise of China, the resultant commodity super cycle, and the rise of emerging markets as an asset class, and will suffer o¬n the reversal of these secular trends, and we will simply have to save more and consume less to balance our economy. We are walking a tightrope with risks to the east and the west – the Chinese recession and the higher cost of capital associated with the global rotation both spell potential danger,’ he expands.

As a result, at MacroSolutions, they maintain maximum international exposure in their funds and recognise a much more risky environment for SA assets.

Brooke underscores the importance of maintaining a well-diversified portfolio, ‘Diversification remains crucial and the tactical value of cash has increased. Avoiding losers is important and we remain cautious o¬n the short-term outlook for consumer shares. A small bright spot is the recent sell-off in local bonds has resulted in better yields, helping future savers. This is particularly valuable for older investors who require a higher income component.

However, in a low return world investors have no other option but to save more.’