Not much has changed over the past quarter. But a lot appears to have changed. What do we mean by this? Investing is made complex simply by the amount of information flowing around, and while it is often well intended, mostly it distracts, confuses and alarms investors, which isn’t always a productive outcome. There are too many vested interests, click-bait merchants and pseudo- science commentators to reliably draw strong conclusions from any individual source. This leaves us as allocators and investors in a vulnerable position: are we close enough to the detail to really make good decisions?
To illustrate this, below we have listed the ’hot investment themes’ in the market right now:
- The demise of Chinese tech with the socialist government stepping in to clip the wings of successful companies.
- The pending taper tantrum and how rising interest rates will destroy investor portfolios.
- Death of the 60/40 global standard for a balanced fund.
- The threat of rising inflation due to massive amounts of stimulus.
- The green wave of ESG investing.
- Evergrande default contagion into the Chinese economy.
What is interesting about this list is that they tend to have a few things in common. Mostly there is a negative perspective to start – even the go-green positivity coming from ESG investing is sourced from the depths of bad behaviour such as fossil fuels.
What is also interesting is that they are also macro-oriented in their content. None of the big themes rolling around the market today appear to be too close to where the money is actually made – being the individual companies themselves and the micro-level operations they are managing, innovating, and building towards every day.
These perspectives, between those who are close to the detail and those who are not, are structural. Unless you decide to take up a new role as a strategy consultant, line manager or stock analyst, chances are you won’t have enough objective information to weigh in on these micro level decisions, where the money is really made.
To improve your investing chances, it’s likely best to focus less on the hot investment themes, and rather assess where you can make good decisions. For us this starts with drawing a line on trying to second guess the funds we allocate to. It is tempting at times to think you know better, but experience tells us that while you can look clever for short periods of time, you tend to miss out on average. Find the good fund managers, combine them sensibly, and let them get on with it.
One of the key steps in combining funds sensibly is risk management. To us, risk management means assessing the qualitative aspects of funds, and what aggregate exposures client portfolios have, including the behavioural biases or business risks which these funds individually face.
To give this step a real-world scenario, below we show a ‘what-if’ assessment of how a change in global interest rates would impact certain types of equity funds. Note we are not forecasting interest rates, or guessing the theme, just simply testing the upside vs downside based on what we can observe today.
This what-if allows us to assess the relative risks alongside the opportunity depending on where the fund invests. Importantly, the investment opportunity – making money – is where our thinking starts. Risk management comes later.
The table below shows the impact on P/E ratios from a change in interest rates across global and local equity markets.
Interest rates are a key component of the cost of capital, and generally speaking the higher the cost of capital, the less your equity is worth. With super low interest rates today, it pays to ask the question “what if rates rise”?
The ‘Normalised’ column below shows what P/E multiples would tend to average when interest rates are at average levels. Broad US equity would tend to trade around 15.3x earnings when things are ‘average’. Currently they trade at 26x earnings where rates are roughly 2% (200 basis points) below long-term average. Assuming everything stays the same, except interest rates rise back to average levels, we could be in for a 40% haircut on equity valuations.
Its worse for Growth oriented shares, as much of their value comes later and is penalized to a greater extent. Here you could lose 60% of your value.
Table 1: Justified P/E Ratios. Basis Point change refers to the change in 10-year government bond yields for the respective market.
But there is opportunity! Global value shares are in the green with a moderate 1% rate increase. In SA, where we are currently at around the long-term average interest rate, there seems to be some pretty good upside too.
And this is what fund managers – those close to the action – are telling us: there is good opportunity in local markets, and value equities remain enticing, particularly as fund managers have been able to rotate from the riskier opportunities to higher quality, but cheap, shares.
Our risk management kicks in with the more prone growth and quality-oriented fund managers, as they stand to lose out in such a move. While rising rates are a headwind to these funds and cause us to allocate conservatively, we also need to gauge the potential for stock specific payoffs. And this is where we mustn’t get too clever, and rather leave those closer to the action to find the opportunities. This gives us the right balance of return seeking behaviour and risk management.
We have made several outlook changes (refer to Table 2 below), informed by our fund research work, and by simple valuation models which tend to be quite reliable long-term indicators.
- A more favourable outlook for local equity and bonds, driven by earnings strength as well as real yields.
- We have further reduced the Emerging Market Equity view as valuations have risen to long term average levels, and the earnings cycle looks relatively high.
- We have further reduced the outlook for holding domestic cash, given prevailing rates and inflation risks it is unlikely money market will meet any reasonable hurdle over the near term. Multi asset income funds however look like they may just make their hurdles, due in part to higher levels of government bond exposure at present.
We have been applying ourselves to the what-if scenario where global central banks like the Fed start to raise rates. This tapering can take various pathways which have quite different payoffs. While we retain a central case that ultimately the Fed will get what they want (steady normalization of rates, and good growth levels), it is likely to be a bit less controlled than what they would like, such is the level of debt which has been issued. The potential for tail risk, black swan type events is larger than ever as a result. Should you exit the market as a result? No! but it is probably sensible to build in lower return expectations, higher levels of volatility and a longer investment time horizon than usual.
Chart 2: 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:
Summary Outlook per asset class
Article Courtesy of: Fundhouse