Investing with uncertainty and volatility

Gareth Stokes, FAnews Online Editor

Cast your minds back 12 to 18 months and the economists were all discussing the likely “shape” of the global economic recession. Their favourite “prop” was the alphabet, and they spent hours debating weather markets would exhibit the V-shape, U-shape or d

Although we could assign a W-shape to the JSE, we’d like to conclude that the threat of a double-dip (or W-shape) economic recession is now confined to history… But given the latest developments on the international stage such conclusion would be ill-advised. In fact, investors are possibly as nervous today as they were at the heart of the financial system meltdown. Why? David Green, Chief Investment Officer at PPS Investments discusses the main impediments to an “all clear” for the global economy in an article titled Uncertainty in Markets is Nothing New.

A grim picture…

A major concern among South African investors is the ongoing tension between the members of the Euro-zone. “The indebtedness of Greece, Ireland, Spain, Portugal and Italy, and their attendant solvency and liquidity problems, underline the fragility of the common monetary alliance,” notes Green. This is of major significance to South Africa Inc, because the Euro-zone block is among our largest international trade partners… And the world’s problems extend beyond Europe.

The world’s largest developed and emerging economies – USA and China – are beset by their own problems. “The US economy has slowed – Standard & Poor’s downgraded its coveted AAA credit rating – and government was forced to raise the nation’s debt ceiling,” he says. “Meanwhile, the Chinese government has continued to combat rising inflation by raising interest rates, reinforcing concerns about the rate of its future economic growth and consequent demand for commodities! Once again this is bad news for South Africa due to the heavy mining weighting of our JSE All Share index.

Uncertainty has positive and negative spin-offs. On the positive side the rand has remained unexpectedly strong against the currencies of our trading partners – despite being over valued by as much as 15%! AT the same time gold, the traditional bolt-hole for “nervous” investors, has surged 37.5% in US dollar over the past year, from around $1, 200 to the mid-$1, 600s per ounce.

Responding to uncertainty

How should investors respond to the challenging investment environment? Green says it’s pointless stocking up on baked beans and heading for the “bunkers”. Instead we should accept that economies and markets are always uncertain. “There is absolutely nothing unusual about this state of affairs – and there is only a tenuous relationship between economic growth and the fortunes of the world’s investment markets,” he says.

Financial advisers have an important role to play in easing their clients’ fears. Instead of obsessing over daily volatility they need to focus on the value on offer in the major asset classes from time to time… Green explains: At the moment (end August 2011) the most attractive asset classes continue to be global developed and emerging market equities, in the aggregate. And there are, of course, pockets of greater or lesser value within these broad categories.” He believes that South African equities are significantly cheaper now than for the last year-and-a-half, while cash, bonds and local listed property are more expensive asset classes.

Adapting strategy for the strong rand

How does PPS Investments carve out an investment portfolio given market uncertainty, a strong rand and the poor outlook for so-called risk-free products? We’re not surprised the fund manager holds full exposures to local and international equities, while maintaining underweight exposures to local and international fixed interest assets. “We have no deliberate exposure to local listed property as an asset class, and remain comfortable leaving the selection of individual listed property securities to our underlying asset managers,” notes Green.

The equity bias makes sense when one considers local equity market performances going back 110 years, to 1900. PPS Investments draws some powerful observations from a study of one, two and three year returns over this long period. Their first observation is that the range of possible outcomes over any one year is extremely wide, from +90% to -30%! As the investment periods get longer, so the range of possible outcomes (best to worst) gets narrower. Thus the second – and most important – observation: In investing, the longer your time horizon, the more certain you can be about the eventual outcome. “Having a longer-term and valuation-based view of the investment environment eradicates the uncertainties evidenced in our economy today,” concludes Green.