The Fourth Wave Remains

The past few years have created more investment angst than usual, and it has been difficult at times to make sense of return prospects across asset classes. The collision between investments, economics, politics, and social issues has undermined the ability to gain comfort in the direction of markets and investor outcomes.

So, we won’t complicate it any further. In simple terms, asset class valuations continue to normalise locally and offshore, creating decent return potential for portfolios looking ahead. That’s it. Moving towards calmer waters in investment markets may seem like a less exciting place to be headed, but relative to the past few years, a return to normalcy may be a welcome surprise.

How do we get to this conclusion? “We’ll all celebrate when the US jobs report comes out very negative”. Charles de Kock made this comment to us recently and it reminds us that investment returns are often quite far removed from news flow, sentiment, and risk perceptions. At the point of maximum stress, forward-looking returns tend to be getting better, not worse.

With mean reversion taking place across equities, bonds and cash markets, the distortions created by the GFC, QE, COVID and others are washing out of the system.

But we are not there yet. We have spoken over the past year about the four waves we have seen since the start of 2022:

• 1st Wave: Inflation is real
• 2nd Wave: Russia / Ukraine Crisis (which also fueled the first wave)
• 3rd Wave: Pricing for Recession – as we saw a broad swathe of financial assets sold down

This leaves us with the 4th wave: the reality check on company earnings. The chart below highlights how broad global markets benefitted from the huge stimulus provided after the onset of COVID-19:

While high-level valuations across markets appear to be more reasonable, even good value, it helps to dig a little deeper. The high earnings base in conjunction with extended profit margins provides significant room to take strain should economic conditions recede. And strain they might. The real impact of inflation is yet to be felt in many industries, and while some companies have started with widespread layoffs, there is still potential for the trend to snowball. The earnings base above has some way to fall if a recession
takes hold, which it appears likely to do.

An additional consideration is the impact of the US Dollar which has been extremely strong in 2021/2022 as investors deserted uncertainty and headed for sharply rising interest rates in the US. When viewed through this lens the earnings trend looks somewhat different:

While Japan has shown the strongest earnings in Yen over the past decade, its weak currency has offset much of this benefit when measured in dollars. China lags behind the globe albeit from a high base in the mid-2010’s so is somewhat out of sync with the western economies. Locally the resources sector has contributed materially to a large recovery in local equity earnings, matching and beating other emerging markets and only marginally lagging world markets excluding the US.

While inflation was expected at some point and could be mitigated, the Russia/Ukraine impact on markets – emerging markets in particular – and the Chinese zero-COVID policy forcing strict lockdowns, were surprises for most. The irony here is that investors avoiding the ‘obvious’ risk of inflation got caught up in the ‘surprise risks’ owing to Russia/Ukraine and China. There was little place to hide in 2022.

So, in a global marketplace where growth is slowing, how do you mitigate the headwinds to returns? We see three broad approaches:

• Find the growth! While broad markets and economies can take strain, individual companies can still deliver, or “power their way through a recession”, particularly where they have strong cash on balance sheet.
• Buy cheap. In this instance, a broad basket of companies is trading cheaply relative to even muted expected economic growth.
• Avoid assets where the trade-off may not be what it seems. The obvious place to consider here is where investors have overpaid for safety in a volatile market, and have not fully considered the reality check risk.

In the conservative assets space, the fact that inflation appears to have peaked locally and in the US, speaks to an improving outlook for cash and bonds in those markets. We can see a decent real return by holding cash just 12 months out, compared with the deeply negative levels over the past 12 months.

Domestic bonds offering yields above 10% remain attractive, despite persistent problems at home such as load shedding. The sentiment in SA is weighing on equity valuations, which are at their 4th lowest point in the past two decades. Over 40% of the market is trading below a 10x PE ratio, and if you had held equity at these points in the past you would have done very well in the years that followed (post-tech bubble recession; GFC; COVID). The economic outlook in SA is not strong but given the starting point you are paying for assets, there is money to be made.

This culminates in a set of investment opportunities summarised below:

Now back to our original point: investment markets have been complex and stressful, and it is somewhat of a fool’s errand trying to forecast how each may react to a global environment resetting itself. Our advice here is to simplify the equation by looking at the valuations. And if you do this exercise, as we have shown above, the future looks OK. The big risks are smaller now, and the opportunities are more diverse than they have been for some time. We are getting closer to the point where prices fully reflect reality, and when this does happen, we need to be alert to the opportunities which arise.

Once the 4th wave settles, and hopefully, it is not a big one, we see a ‘normalised’ investment environment where the usual rules of the game should apply. Cost of capital back to normal levels (i.e., not zero!), the gap between financial and real assets closing, economic gains made through hard work and perseverance (rather than buying meme stocks and crypto). We have not seen this for many years, and it will be a welcome relief when we do.

Asset Class Outlook

 

Below we highlight the main asset class prospects: