Volatile times call for long-term thinking

David Crosoer, Executive, Research and Investments at PPS Investments.

Financial markets have had a volatile and challenging start to the 21st century.

Volatile and challenging times

We witnessed the technology bubble of 2000, the global financial crisis of 2008/9, and the unprecedented monetary policy stimulus from all the major global central banks over the past seven years.

More recently the rise of populist politicians like Donald Trump in the US and the Brexit movement in the UK, and even the Economic Freedom Fighters closer to home, has increased concern that the global liberal order of free trade upon which much of the post-war economic prosperity is placed is under threat.

It is very easy to be spooked by the current economic environment. The global economy is still battling with the aftermath of the global financial crisis and is bogged down by weak growth and rising inequality. At times like these it is particularly important to take a long-term focus and invest appropriately.

An unexpected Brexit

The Brexit decision in the week leading up to the end of the second quarter is undoubtedly a shock to the global economic system. In terms of the relationship between the United Kingdom (UK) and European Union (EU), it is sim¬ply too early to say with any conviction whether authorities will be able to quickly negotiate a mutually-beneficial arrangement, although the market reaction (in both the currency and bond markets) suggests it is pricing in the risk of some unforeseen complications. We do know however that this isn’t the first time a political event has impacted financial markets and it won’t be the last time either. Often, such shocks are temporary, but occasionally they are more profound and could have a more lasting impact.

Certain thoughtful commentators have linked the Brexit decision to a potential retreat from free trade that could be felt not just in the UK and EU but also in other parts of the globe including the US. Such a retreat to protectionism will undoubtedly come at an extensive economic cost.

It’s worth stressing again that more than one third of global investment grade government bonds are trading at negative nominal yields post-Brexit. This astounding result (i.e. investors paying governments for the right to lend to it) suggests at the very least an unstable equilibrium sustained by a short-term focussed marginal investor and the highly distortionary actions of monetary authorities. While the current equilibrium of exceptionally low short-term interest rates and a heightened ‘search for yield’ theme looks unstable (by driving down government bond yields and ‘quality’ equities to very expensive levels) there is no indication what catalyst could cause it to unwind - particularly if a return to global trend growth or a normalisation of US interest rates remains on the backburner.

Rate hikes kept on hold, but hikes still expected

Both the US Federal Reserve (Fed) and the South African Reserve Bank (SARB) paused in their interest rate hiking cycle this quarter. The Fed raised interest rates in December 2015 and market expectations for further rate hikes have fallen sharply following a poor US May payroll number and the unexpected decision of the UK voters to back the decision to leave the EU. However, a case could be made for further policy tightening given that US unemployment remains below 5% and US core inflation is in excess of 2% p.a.

Locally, the SARB also kept short-term interest rates on hold at 7% at its May Monetary Policy Committee (MPC) meeting. This is despite CPI remaining outside its 3% to 6% target band, and the expectation that it will stay there for a number of quarters. Fortunately, rand strength in the subsequent period has made excessive inflation less probable and may allow the SARB to be less hawkish than previously indicated. Market expectations at quarter-end were for just one further 0.25% hike this year.

Ratings downgrade still priced in

South African bonds are still pricing in the prospect of a ratings downgrade to sub-investment grade, although this was avoided last quarter. South African government debt has ballooned to close to 50% of GDP since the global financial crisis (mainly spent on public sector wage increases). Under a low-growth scenario, this could breach 60%. The latest International Monetary Fund (IMF) forecast for SA economic growth is just 0.1% for 2016 – substantially less than that of National Treasury which has yet to adjust downwards its 0.9% forecast made in February this year.

Unless government can get a decisive handle on unnecessary state expenditure and stabilise prospects of state-owned enterprises (contingent liabilities from SOEs now account for an additional 14% of GDP), a downgrade to sub-investment grade still looks like the most likely outcome.

Muted investment returns

Global equities still look expensive given current valuations and the lack of economic growth, despite global equity returns having disappointed for more than a decade. Bond yields likewise have been driven downwards to levels not previously observed, with more than $11 trillion of government debt now trading at negative nominal yields. Cash rates have remained stubbornly low as no central bank feels sufficiently confident to assertively raise interest rates anytime soon.

When measured from the perspective of a US investor, global equities have returned just 1.6% p.a. above inflation in the 21st century so far, global bonds a staggering 4.9% p.a. and US cash an insufficient -0.4% p.a. Such returns contrast unfavourably with the very long-run returns since 1900 of these asset classes of approximately 5% p.a. for global equities, 1.8% p.a. for global bonds and 0.8% for cash1 . In contrast, South African assets (when measured in local currency, but allowing for SA inflation) have had a much better 21st century with SA equities compounding at 9% p.a., SA bonds at 4.9% p.a. and SA cash at 2.2% p.a.

For the quarter (when measured in rands) SA and global equities both returned 1.3% and lagged global bonds (up 1.6%) and SA bonds (up 4.4%). SA cash returned 1.7%. Within local equities, financials (down 6.1%) and property (down 0.4%) were both negative over the quarter, while resource stocks continued to rally (up 6.5% for the quarter and 20.5% year-to-date). The rand has weakened marginally against the US dollar over the quarter (but is up 4.9% over the past six months) and strengthened materially against the British pound over both the quarter (7.25%) and past six months (13.25%).

In these circumstances, retain a long-term perspective

The past quarter’s investment returns have an immediate impact on all of us invested in the market, but the past century’s investment returns are arguably more important in helping to frame our own investment strategy. This is because next year’s investment return is arguably the least important investment horizon for almost all of us.

No matter what our current circumstances are, most of us have a far longer investment horizon than we realise – whether we’re just starting out, are in the middle of our working careers, are approaching retirement, or are already in retirement. And the longer the investment horizon the less relevant the most recent returns are in understanding what is likely to happen next.

So while it is highly relevant for short-term returns that the equity market in aggregate still looks expensive, our economic growth outlook looks poor, and bonds and cash rates only offer a modest return above inflation, these considerations are less important the longer our investment horizon.

One could frame this point with two deceptively simple questions.

1. Do you take more notice of what investment markets returned over the past quarter or the past century?
2. When you think about future investment returns do you think more about the next year or the next 50 years?

We’d argue that the long-term historical returns of 5% p.a. in excess of inflation for equities, 2% p.a. for bonds, and around 1% p.a. for cash are the most relevant for most investors in framing their investment strategies, given these forecasts are average periods that span periods of both market elation and despondency. In the short term, however, returns could (and probably will) be quite different.

Our managers invest in attractively-priced and successful companies

As equity investors we have the opportunity to be joint owners of the companies tasked with driving economic growth in the 21st century. The managers we invest in all have the opportunity to find attractively-priced companies that they believe will successfully grow over time. Investing in the companies that will drive global capitalism forward remains, we believe, the most effective way of coping with the distortionary impact that monetary authorities are exercising by keeping short-term global interest rates at such low levels. Most importantly, we all probably have an investment horizon longer than we realise. This means most of us can afford to hold an appropriately diversified portfolio of asset classes and managers despite current market prospects. In time, we will be compensated for this.

Multi-management important in volatile times

As multi-managers our starting point is always to find and back exceptional asset managers who we believe can add value over market returns and protect in difficult times. Such a strategy looks especially important today where market returns are likely to remain subdued and economic conditions difficult.