The global economic climate has left the markets facing uncertainty and there has been a clear downturn in the Western world, with the United States heading towards recession.
In addition to the slowdown in the developed world growth, commodity prices, especially food and oil, are on the rise, impacting on inflation around the world.
In South Africa, the policy response by the Reserve Bank has been to fight inflation aggressively by hiking interest rates, whereas the US is battling recession and has slashed its interest rate sharply.
January saw the worst ever start to a year on world equity markets, with developed markets off 8% and emerging markets down 12% in US dollar terms.
The sub-prime crisis represents the greatest credit excess in US financial history. The result is unwarranted risk-taking and inflated asset prices with housing markets leading the charge.
Cannon Asset Managers chief investment officer Adrian Saville says the value lost during the January equity market sell-off was equivalent to 40% of the US economy — or almost 20 times South Africa’s GDP.
There have been a few places to hide — investors have run for cover, switching assets into bonds or hedge funds, says Saville.
But the Hedge Fund Return Index lost 2% in January and a further 2,5% in March. The panic has seen US treasury yields driven down to just 1,6% (with price inflation at 4%) as investors have rushed for the safety of government bonds.
After five years of rampant equity markets, the JSE, along with world markets, has experienced a very volatile first quarter. The majorityof this volatility was driven by problems far beyond South Africa’s shores and a natural reaction for investors in this situation is to want to sell out completely.
But Jeremy Gardiner, director of Investment Asset Management, warns against this instinct.
”In 2001, equity markets were overpriced and earnings collapsed, leading to a multi-year bear market. The current scenario sees equities reasonably priced and earnings that will slow, but because of the influence of Asia, will not collapse,” says Gardiner.
The current situation is very different to 2001. This is not the beginning of a multi-year bear market. Sanlam Investment Management managing director Armien Tyer says the sub-prime, banking and financial market crises have not played out in respect of real economy and regulations will have to change to avert such crises in the future.
The leading emerging market countries such as Brazil, Russia, India and China are continuing to grow despite the slowdown in the US and European economies. This is creating a dislocation in the commodity cycle.
Saville says central banks have been pumping liquidity into the system by slashing interest rates.
”Sadly, this liquidity has not reached its intended targets, but has rather been pouring into commodity markets, with the result that prices of both hard and soft commodities have scaled new heights in 2008. Commodity fund inflows this year have already exceeded the flows seen from 2003 to 2005,” says Saville.
This has led to immense speculation and volatility in commodity markets, which has impacted on equity markets. Markets have overreacted to the gloom, but this is excellent for asset managers. It means there are some outstanding investment opportunities available.
On the global front, the 20% slump in equity values has resulted in US large-cap stocks being cheaper now than at any point in the past 70 years.
Locally, we are seeing a similar trend. By stripping emotion out of the investment decision, Cannon Asset Managers is taking advantage of exceptional opportunities that are on offer, says Saville.
What is the most sensible investment strategy under these conditions?
Saville says the best way for investors to protect themselves would be to go back to the principles of successful portfolio management.
Diversify your portfolio
This means diversifying geographically in terms of currency as well as in terms of economic exposure. It also means building exposure to different asset classes. Sensible diversification will add stability to a portfolio.
Recognise the overreaction
Remember that markets always overreact and the ability to time an entry or exit is poor. If an investor is unable to get out of the market at the right time, timing a re-entry will be equally challenging.
Take into account the costs involved in moving in and out, including transaction costs, taxation impact and opportunity costs. Because markets overreact, some of the most depressed stocks are now also the cheapest.
Stick with your long-term asset allocation
Success in timing the market is likely to be more as a result of luck than skill. Paul Hansen, director of retail investing at Stanlib, says an element of risk-taking has come back into the markets.
”Until March, investors were very cautious, but they’ve started to venture out a bit and have been buying shares offshore. They’ve also been looking at riskier currencies like ours,” he says.
Hansen says resources have been performing phenomenally well.
”On the commodity front, it’s been Anglo, Billiton and all the platinum shares. Although gold shares have been dismal, resources have been doing really well.
”Financials and retailing are very depressed after the sharp rise in the interest rates. I think the fear in March about the credit crisis in the US has just reached its crescendo. All the banks are taking big losses and property prices are tumbling in the US. That has all led to very depressed conditions,” he says.
But he adds that there is some good news as the credit crisis does appear to be coming to an end: ”There is a feeling they have written off everything that looked a bit offish and that we’ve seen the worst of the storm.”
Outlook for the next three to five years
Hansen says there has been a five-year bull market for financials and industrials have been in a bull market for the past four-and-a-half years. Financials and resources should see a 10% to 15% return with some short-term risk, but resources are more difficult to predict.
”A lot of people said copper would fall by 20%, but it has gone up by 20%. So you can’t forecast those. From this point on, it’s impossible to say what resources will do,” he says.
Cash is king in the short term, he says. In the current climate, bonds are losing money and property shares are losing value. This makes cash a powerful factor to have — especially for pension funds.
Investors could go for whichever asset classes seem popular at the time — such as gold — but although these asset classes may be perceived to be defensive and to prosper when times are tough, they can weaken just as quickly.
Although Asian demand (primarily from China and India) for resources will continue for the next 10 to 15, possibly even 20, years, investors must avoid allowing these returns to seduce them into overweighting their portfolios too heavily in favour of resources, says Gardiner. ”At some stage, whether driven by a global slowdown or by infrastructure collapse in countries such as India and China, demand will slow, which will lead to an immediate correction in commodities that could last for a few years. So by all means ensure that commodities play a relevant role in your investment portfolio, but don’t forget the risk,” Gardiner says.
World markets remain in negative territory for the year as the sub-prime and resultant credit crisis work their way through the system. South African equities are therefore looking very reasonably priced, although stock and sector selection are going to be vital.
The South African consumer is under severe pressure and with higher interest rates it looks as though things might get worse before improving.
Gardiner says commodities look set to continue outperforming, but at some stage financials and industrials will get the rerating they deserve.
”Financials won’t get the rerating until the sub-prime crisis is over and for industrials that rely heavily on consumers, the environment remains tough.
”The best advice is not to react during times of market turmoil, but rather when markets are calm. Create your perfect portfolio and stick with it,” he says.
Metropolitan Asset Management says the April monetary policy committee (MPC) rate hike is another reason to expect the rand to weaken further or at the very least stay weak.
The company points out that emerging markets are more risky than their developed counterparts; investors expect to get compensated for taking this risk through higher returns, which is a function of higher economic growth. Higher interest rates impact negatively on growth. Conventional wisdom, which states that higher interest rates attract capital which results in a strengthening currency, applies mainly to developed countries — not to emerging countries.
The consensus among asset managers is that hiking rates is unlikely to address the inflationary problems in the economy, as the drivers of inflation do not react to higher interest rates.
Therefore the unintended consequence of this policy will be to keep the rand weak, which tends to be inflationary. The rand has already weakened by about 16% on a trade-weighted basis since the beginning of the year.
The Metropolitan group of asset managers say, in their experience from other periods of rand weakness, investors tend to underestimate the impact of a sharply weaker rand on inflation.
”We therefore think that most investors are behind the curve when it comes to their estimates of inflation for the next 12 to 18 months and this has implications for our portfolio positioning. Metropolitan is of the view that the MPC should stop hiking the interest rate.”
But it concedes that asset prices are driven by what the MPC will do.
”Even if the MPC does not hike rates any further, given concerns about inflation we think it highly unlikely that there will be any rate cuts before the middle of 2009, which again have implications for the way in which asset managers position their portfolios.”
Asset managers have largely started to reduce their exposure to some of the interest rate-sensitive shares and increased exposure to more defensive sectors such as food retailers and construction.
They have also increased their exposure to resources, consistent with their view of higher dollar commodity prices and a weaker rand.
Metropolitan asset managers has chosen to remain overweight in South African equities, underweight in South African bonds, neutral in foreign assets and overweight on cash.
It says it has increased its earnings expectations for most of the resource shares. In fact, its sense is that the sales side (that is the brokers) is behind the curve as far as its earnings numbers for resource shares are concerned.
”This means we should continue to see upgrades to their earnings numbers as they start using the higher commodity prices in their earnings calculations. This should provide further momentum to the price performance of resource shares,” Metropolitan says.
Equally, given the change in the growth prospects of the local economy (growth of between 3% and 3,5% for the year is now expected) on the back of power-related problems, high inflation and higher interest rates, it warns that the earnings of some financial and industrial companies (particularly those exposed to the consumer) are at risk of being revised downwards over time.
This should provide headwinds to the performance of shares exposed to the consumer. Taking all these factors into account, we now expect earnings growth of 22% for the SWIX over the next year — compared to 16% at the end of the previous quarter.
Given the inflation concerns, Metropolitan has increased its exit yield on the R157 bond to 8,8% — compared to 8% previously.
Other than interest rates, the Eskom debacle has led to higher inflation and lower growth expectations. Private sector investment spending plans are also being re-assessed.
Coronation Investment strategist Charles de Kock says investors should not bet the farm in any one area, because outcomes are pretty unpredictable. He says in most developed markets equities offer good value following the sharp downturn in prices since last October.
”Unless one is sure of a deep and long-lasting global recession, global bonds do not offer good value,” he says. Domestically, the Reserve Bank makes it difficult for the consumer and therefore it is no surprise that consumer-related stocks are out of favour.
”The shrewd investor with a longer-term horizon will, however, look to add good-quality companies at current prices to his/her portfolio, even though the near-term outlook does not look rosy. If the price is cheap enough, buy it,” says De Kock.