The past quarter has been quieter than the first half of the year, and investors and fund managers alike appear to be catching their breath. This also coincides with how the investment markets have behaved over the past few months, with significantly lower volatility, many asset classes trending sideways and a ‘wait and see’ approach prevailing. The interesting part however, is that we could be at significant inflection points across many local and offshore asset classes, with large relative performance moves ahead of us. So why the complacency in the market?
Given the extent of potential dislocations ahead of us, do we see fund managers positioning themselves aggressively in any particular direction? The answer is no, not really. There are two broad opposing forces in global markets: the basic maths of asset valuation, which relies on long term assumptions and things like risk free rates, risk premiums and fundamental earnings growth. Following this process leads to many negative outlooks on asset classes, as you will see in the summary table below. And then on the other side, the Fed, which is playing the backstop role and potentially ‘bluffing’ its way through by offering support to financial markets through the form of low interest rates and various stimulus packages, but actually spending a lot less than what it has committed. It seems like the Fed can simply say it will act as buyer of last resort, and that is good enough for the risk-on mindset to prevail.
So here we sit, in the middle of two warring factions. On the one side, economic reality and significant valuation risk, and on the other, financial engineering of the greatest order, propping up markets. It seems to us that the reason fund managers are not voting with their feet and selling riskier assets is that a) there is no real place to go, and b) you can lose your shirt betting against the Fed.
For the die-hard ‘say it like it is’ value managers, they are still taking most of the pain as they avoid the appealing prospect of latching onto the Fed bail out. This is a relatively unfair outcome for them to date, as underlying earnings from these shares have in many cases been quite robust.
We then overlay the consequences of the global economic shutdown, which has not been fully documented and will likely take years to properly assess. The large information gaps mean that investors seem to increasingly trade on short term news, but importantly, because the consequences are not yet fully understood, there is a disincentive to ‘bet the farm’ on a contrarian view. And there we end up – with many fund managers playing it safe, down the middle so to speak.
At points like this, when investment markets are at seeming inflection points and risks seem asymmetrical, it is always useful to remember that while the investment journey may seem uncertain and volatile right now, it is always the case and this time is not different. Secondly, capital preservation is an essential part of the investment approach at this stage of the cycle, where markets are increasingly likely to incur permanent capital losses.
We have adopted this outlook for some time, and while it is somewhat of a repeat, bears worth saying again: ensure diversification levels are high, guard against our behavioural biases which are heightened at this point, and be prepared to ride through the noise.
In South Africa, we have seen some positive news emerging over the past few weeks. With every piece of progress towards ‘structural reform’, we are one step closer to oversold domestic assets revaluing upwards. It has been a long time since investors have viewed any form of SA asset class with a positive outlook, so it is probably worth dusting off this thinking to make sure there is an objective assessment of return prospects as this trend hopefully develops further. For beaten down local investors, missing the local recovery should it happen would be a travesty.
In the summary table below we highlight the change to our investment outlook for asset classes, which this quarter is limited to a single asset class being the Euro-USD currency level. As the USD has weakened, we are now at a point of relative parity against the USD. While both economic zones have their issues, the relative underperformance of the Euro has largely been recovered.
Chart 1: Relative value of asset classes vs long term history
The table below provides a summary of where each asset class is currently positioned from a relative value perspective:
Outlook changes since 30.06.2020
EUR-USD: downgraded from (+1) to (0). As the US$ has weakened, the gap to Euro has almost closed.