Focus on the next decade, not the next crisis
As much as things change, so they stay the same. It has been relatively easy to get lost in the complexity of investment markets over the past year (or two, or three!). The blend of geo-political dynamics, extreme global economics, and various crises alongside individual companies which have either been long forgotten, or have disrupted the world as we know it, have made it difficult to reach a point of comfort when reviewing investment portfolios.
So where are we now on the spectrum of investment opportunity?
The past year has been one best left forgotten for many investment managers. It has been a tricky time to invest with several areas which may have led to losses:
- A significant derating in global growth shares, on average 50-60% off their peaks.
- A broad fallout in China, where a share like Naspers/Tencent is trading at its lowest valuation level in 25 years.
- Global bonds falling victim to the inevitable rise in interest rates (11% fall and counting), which is their biggest drawdown since the 1970s.
- A write-down to zero of any direct or indirect Russian exposure, including equity and bonds.
The chart below shows the largest detractors from global market returns over the past year:
Chinese equities feature prominently here (Tencent, Meituan, Alibaba), as do some ‘fallen angels’ (Intel, Shopify, Paypal). Others like Meta (Facebook) are recalibrating as their business model evolves, while the likes of Disney and Netflix fell in sympathy as subscriber growth warning signs started flashing.
And on the reverse side, there have been few ways to make good positive returns. Just 10 shares drove two-thirds of global equity returns over the past 12 months, out of the 2000 or so listed shares in the global market index:
The standouts here include Nvidia (gaming), Tesla (again) and notably two oil companies, proving that black gold still has value despite the greenwashing age of ESG.
Alongside a market environment fraught with uncertainty (is this ever not the case?), you may be forgiven for wanting to tread carefully and forego what may be quite attractive forward returns. In this case, it helps to take a look at the detail so that we can make a better-informed decision around where we are on the spectrum of opportunity.
The table below details the major equity markets we are generally considering for clients.
There are a few highlights worth noting:
- Firstly, revenue growth has grown at a decent lick over the past few years, through the period including COVID.
- This is also illustrated through profit margin levels which are at elevated levels
- PE ratios look extended, but not quite to the same extent as what we’ve seen the past year or two. With the S&P trading at 22x earnings, this is not far off its historical average. Both value and growth equities look relatively OK (for context, growth shares were easily trading at over 50x earnings a year ago).
- Emerging Markets are trading at reasonable levels for the first time in a while, where the Chinese tech sector suffered significant falls due primarily to regulation.
So, the caution sign here is on the base, not the price. What is the potential for companies to maintain or grow earnings and revenues – from relatively elevated levels – compared with the potential for earnings to fall as global financial conditions tighten in sync with global inflation?
Having tested these relative risks, valuations (and therefore prospective long-term returns) look OK, not too dissimilar to an average scenario.
However, there are a few known risks (as opposed to unknown risks, of which there are many more!) where the downside implications may be severe and give rise to short or even medium-term pressure on returns:
The potential still exists for a sharp correction in asset prices if panic sets in due to persistently high inflation, or another inflation shock. Interest rates will need to move more aggressively, and this will unsettle markets. This is what a sharp correction looks like:
- An escalation in the Russia/Ukraine conflict can spill over quite easily to Europe and the global economy, where it is relatively localised to Russia and a few commodities like wheat and oil for now.
On the stock specific side, we may not yet be done with government regulation forcing massive valuation haircuts in Chinese shares (Naspers/Meituan, Alibaba, etc), although the consensus is we are closer to the bottom than the top, some of these operators are not as well aligned to the policy of ‘common prosperity’ and may be further exposed.
With regards to local equity, South Africa continues to act in a countercyclical fashion compared to global markets. Having lagged in the last growth cycle, we are now catching up just as global growth loses momentum. This is in part due to another lucky break where our commodities retain support as Russian supplies leave a void. With Naspers trading on just over 10x earnings, there is potential significant upside there but not without its regulatory risks. And across the board, almost without exception, local fund managers are bullish on prospects for local equity returns.
We can add more detail to this assessment by looking at the various drivers of returns – like income, earnings growth and rating levels – to assess the expected ‘next decade’ return per asset class.
The chart below shows the result expected after accounting for inflation, and it is much in line with both the valuation models we run and the general views we see in the funds we are reviewing across asset classes:
- Expected capital loss in global bonds, from this point on.
- Sub-par returns in US Equity and offshore property
- Average returns from Global Equity (excl US), Emerging Markets and SA Property
- Above average returns from local equities.
Obviously, this is a scenario analysis and a lot can happen. But what we find over extended periods of time (10 years is reasonable, 30 years is where we see the real consistency) is that the various drivers of return revert to their expected levels and are a useful indicator of investment opportunity.
The chart below shows how the valuation on the S&P for example is linked to the return you receive, 10 years in the future. From this point on the outlook is pretty gloomy if you have an S&P500 ETF:
So what does this mean for us?
To us this looks like an environment for active management to win over passive. Specifically, value equities where you are not paying a premium for growth which may not materialise, and where the cost of capital puts a dampener on investment ‘hubris’. Then where there are shorter term pressures on assets, like those we have seen in growth equities and emerging markets, we can selectively allocate to make sure we achieve a good entry point to these opportunities.
Global bonds may just be something we are talking about with some interest in the next year. They have clearly been something to avoid and have been a frustrating sparring partner when looking at fund allocations, however the tide has turned here, capital has been lost and we are not done yet. Interestingly, US bonds for the first time in a long while are pricing in positive real returns, if somewhat tiny, over the next decade. They may just become useful again in diversifying portfolios. The death warrant for the “60/40” portfolio has been signed, but they may just need to reinstate it sooner than planned.
From a local investment perspective, there has been a significant change to our offshore investment limits, and the potential is there for funds to externalise significant amounts of domestic savings. While the majority of managers are holding on to their domestic exposure for now (and this is backed up by the points above which are positive on SA), there will be a point where local assets do not provide sufficient upside to justify the full exposure they currently enjoy. For now, we are very comfortable holding on to domestic exposure – equity and bonds – and hope that the consensus view is correct and investors are duly rewarded for their patience.
The Rand remains strong, and our inflation expectations remain lower than most developed markets for the meantime, which bodes well for the rand medium term. Finally, expect interest rate hikes to continue, hopefully in a measured way, into 2023 as global markets normalise. SA markets are currently pricing in around 2% in hikes over the next 12-24 months.
As always, we focus on what we can control, and diversify what we can’t. Match that with a suitably long-term horizon, and investment returns look reasonably good from this point on.