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ASSET ALLOCATION:
TIME TO REDUCE RISK?
After the dramatic plunge in global equity prices in response to the impact of COVID-19 during March, the recovery has been nothing short of spectacular. Markets have rebounded with a rapidity and aggression seldom matched in history – producing in 2.5 months returns usually expected over a six-year period. At Sanlam Private Wealth, we used the opportunity directly after the sell-off to acquire quality assets at material discounts. The momentous recovery since then, however, has resulted in a ‘disconnect’ between market activity and economic reality, and we’ve therefore now reduced exposure to global equities for our clients with multi-asset mandates.
Read more below or listen to Alwyn's views here:
After first ignoring the news around the COVID-19 pandemic, financial markets plummeted as the crisis escalated globally. From their peak in mid-February, the S&P 500 and the Nasdaq declined by 30% and 34% respectively, and the MSCI World Index by around 30%.
The largely indiscriminate sell-off in both global and local financial assets suggests that fear and panic drove investor behaviour – it was, in our view, an overreaction reflecting desperate actions by market participants. We argued at the time that macro events, even ones as severe and scary as this one, don’t usually have a material long-term impact on the true value of high-quality companies, provided that economic activity returns to normalcy after a year or two. We saw the extreme price movements as an opportunity to take on more risk and selectively increase exposure to attractively priced local equities in our clients’ portfolios.
Investors have certainly been rewarded by the global market rally since the end of March – and we believe our decision to buy deeply discounted assets at the time was correct. It should be said, however, that this market recovery has been unlike anything we’ve ever seen in a bear market. The S&P 500 and the Nasdaq have recovered by 46% and 42% respectively.
To put this dramatic upswing into perspective: since 1900, equities have on average typically produced real returns of 5% per annum. If one assumes an inflation rate of 2%, it implies a nominal return of 7%. We’ve therefore witnessed over the past 2.5 months what we normally see happening in financial markets over a period of around six years!
An important driver of the surprising bounce in global equity markets has been the aggressive measures taken by monetary and other economic authorities to mitigate the effect of the virus – by providing economic stimulus to counter its dire impact on economic activity. The resulting flood of liquidity has created a natural demand for financial assets, pushing up equity prices in particular.
There’s no denying, however, that despite these measures, the world has entered a severe economic slump amid COVID-19, and the near-term prospects for the global economy are looking decidedly downbeat. Put differently, the economic outlook and business conditions are still clouded by material uncertainty. In addition, the two main tail risks that dictated market direction last year – the US-China trade conflicts and Brexit – haven’t gone away and are likely to return to centre stage over the next few months.
In South Africa, the risks are even more pronounced as our economy limped into the economic fallout and it may be some while yet before we can start to claw our way out of the current meltdown. Finance Minister Tito Mboweni said during his Supplementary Budget Speech this week the local economy is expected to contract by 7.2% in 2020 – the biggest contraction in 90 years. The economic outlook is further dampened by uncertainty over when activity will be able to resume fully post-lockdown, an unreliable energy supply, and fiscal drag should the path of proposed fiscal consolidation become reality.
What we’re seeing is a major ‘disconnect’ between surging global financial markets and share valuations on the one hand, and gloomy ‘real-world’ economic prospects and concomitant decreased company earnings on the other. It’s almost as if the markets are completely at odds with the extreme economic and business uncertainty – a state of affairs which, in our view, is ultimately unsustainable.
What’s also concerning is the rating of equity markets, traditionally expressed as their price-earnings (P/E) multiple. At the start of the year, the MSCI World Index was trading at a multiple of around 21 times. As share prices collapsed, this figure fell to a level of 14 times but now, 2.5 months later, it’s back even higher at 22 times. So if we were edging into dangerous territory in terms of valuations before the current crisis, the situation is even more troubling now.
It’s for these reasons that we at Sanlam Private Wealth have decided to reduce risk in our clients’ multi-asset portfolios and trim our holdings in global equities – keeping the resultant cash offshore to make the best use of opportunities when they arise. In our view, the prospective returns currently offered by global equities generally don’t provide enough upside to justify the risk associated with the asset class.
One would be naïve to think that the local equity market will appreciate significantly if global equity markets are under pressure. From a valuation perspective, however, South African equities are looking more attractive than their global counterparts. Excluding Naspers, the forward P/E multiple of the JSE All Share Index (ALSI) is only 10.8 times (with a historic dividend yield of around 5.4%).
So, although the economic outlook for South Africa is sombre, there is still value to be found in our markets. Despite operating in a decidedly tough macro environment, many SA Inc companies (those that generate most of their earnings within our borders) are still high-quality businesses with good long-term prospects, and we’ve therefore not trimmed any SA Inc shares in our portfolios.
Local bond yields blew out late in March in a knee-jerk response to the downgrade by Moody’s of South Africa’s sovereign credit rating to junk. We viewed this as market overreaction and considered it an opportunity to use some of the cash in our portfolios to increase the bond holdings in some of our multi-asset portfolios where we held an underweight position. Since then, bond yields have fallen or prices have strengthened.
Despite the local bond market continuing to offer attractive returns – the 10-year bond yield is currently at around 9.3% – we won’t be adding to this asset class. Our main concern is the untenable fiscal position of our government, which has deteriorated significantly over the past decade – this was highlighted again by Minister Mboweni in his speech this week. You can read commentary on this by Investment Economist Arthur Kamp here.
Global bonds are not in our view a viable long-term investment option at present. The 10-year US and German government bond yields are now at around 0.7% and -0.4% respectively. Bonds have, however, traditionally acted as shock absorbers in multi-asset class portfolios – they do provide protection against equity market sell-offs. Despite low prospective returns, we do therefore have some exposure to global bonds in our clients’ portfolios.
Based on historic dividend payments, valuations of local property shares look attractive. However, many listed entities have already passed their dividend payments – historic dividend yield is therefore not a good measure of the value of the sector. The local economic fallout and the dim outlook for consumer spending and stressed balanced sheets have dampened the prospects for the sector and we therefore think it’s too early to consider adding to this asset class.
While the sharp fall in equity markets with the advent of COVID-19 provided an opportunity to buy cheap assets to enhance the growth potential in our clients’ portfolios, the subsequent rapid and aggressive market rise is in our view out of kilter with the realities of rebuilding the global economy after the pandemic lockdowns are lifted. For now, we deem it prudent to reduce risk by selling off around 5% of our global equity exposure in our multi-asset portfolios. While we are long-term investors – not traders – the current valuations are simply too rich.
We’ll maintain the cash proceeds of reducing our holding in global equities in the asset class. The cash will be used to acquire cheaper equities offshore should an overvalued equity market lead to lower future prices.
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