Most asset managers would agree that the most important way to add significant value to investment portfolios is to get asset allocation just right. We certainly subscribe to this view, and through a meticulous process of analysing each asset class in terms of its relative price levels, as well as the macro factors that drive financial markets, our team of analysts decides on the most appropriate asset class composition for our clients’ portfolios.
There are times, however, when not a single asset class looks likely to shoot the lights out, and lamentably, this is one of those times. There’s of course a traditional pecking order in terms of long-term asset class returns, with equities leading the pack, followed by bonds and cash. Property lies somewhere in between.
As every investor knows, higher returns mean more risk – but investors in South African listed assets have over the past five years unfortunately not been rewarded for the risk of investing in them. Equities marginally underperformed both cash and local bonds over the period.
Internationally, investor experience was a bit different. Global equities, as measured by the MSCI World Index, outperformed bonds and cash. However, with the exception of US equities, the overall picture was similar to that of South Africa. These performances aren’t in line with the traditional financial laws investors have always relied on, which hold that investors in risky asset classes such as equities should expect outperformance as a reward for incorporating extra risk in their portfolios.
PRICES OUT OF KILTER
So what’s going on? In our view, the root of the problem is that global interest rates are artificially low, as inflation appears to be under control. As other asset classes price off interest rates, the entire financial pricing system appears out of kilter. To illustrate the ‘abnormality’: investors can currently buy a 10-year government bond in Germany and, if it’s held until maturity, they’ll be guaranteed a negative return of around 0.3% per annum.
The question is, with such abysmal return prospects, who in their right mind would opt for global bonds? Well, investors are indeed buying them, and the only way to explain this is that they’re now questioning the traditional risk-reward relationship associated with growth assets such as equities and listed property. Purchasing bonds implies that they’re more fearful of the risk or probability of losing money on equities and property than they are of a guaranteed negative return of 0.3% per year!
A ROCK AND A HARD PLACE
This is the dilemma we face: investors seeking out the most optimal asset allocation in their portfolios really are caught between a rock (bonds) and a hard place (equities and listed property). Over the longer term, equity returns will always trump those of bonds. However, recent history suggests the opposite, and when one considers that global economic growth momentum is showing clear signs of slowing down, an argument in favour of traditional financial laws becomes more challenging.
In South Africa, from a ‘top-down’ or macro-economic perspective, equity valuations in fact appear to be quite rational – and indeed more palatable than those of offshore equities. But looking at individual local shares, especially the so-called SA Inc companies – those that generate most of their earnings within our borders – it’s difficult to see significant earnings growth in our current economic environment, and therefore material share price upside, over the short term.
While opportunities are starting to open up in listed property as an asset class, particularly in South Africa, we remain cautious on the sector against a tough economic backdrop. Both here and abroad, the risk remains that rental income growth rates will come under pressure.
This leaves us with government bonds – the one asset class that has traditionally been viewed as a shock absorber providing protection against equity market shocks resulting in sell-offs. But as we’ve seen, investors buying this protection are guaranteed to lose money, and it’s hard to see bond yields declining materially from these levels (remember, when bond yields fall, bond prices appreciate).
POSITIONING OUR PORTFOLIOS
Investors therefore have a tough call to make in an environment in which nothing stands out. In our view, the best course of action is to ensure a sensible blend of assets – taking into account both the macro-economic risks as well as the current asset class pricing dilemma.
In this unusual environment we don’t believe it’s wise or rational to employ aggressive asset allocation calls in our multi-asset portfolios. We still express our views on the margin, however. We’re now underweight in both global and local bonds – but we do still hold some bonds for their ‘buffer’ role in a portfolio in times of uncertainty.
It’s our view that financial markets currently dictate a more conservative cash position, so the cash portion in our portfolios is significant. Cash provides security, but it also offers optionality – to take advantage of opportunities that may arise in either the property or equity markets.
Taking a longer-term view, we’ll be looking to increase the offshore equity exposure in our multi-asset class portfolios, taking into account currency considerations as well as equity valuations. We’ll consider it prudent to migrate a portion of assets offshore at an exchange rate lower than R14 to the US dollar – and then only if equity prices are such that we see decent prospective investment outcomes for our clients.
SAME APPROACH, BUT MORE ACTIVE
It’s important to note that we won’t be changing our proven long-term approach when it comes to asset allocation. This approach has always been rooted in a solid base of research, insight and patience, seeking superior returns over the long term and avoiding the distraction of quick and perhaps unsustainable wins.
However, the aggressive movements in the prices of the various asset classes we’re currently experiencing do require us to be nimble – without sacrificing our long-term value considerations. We’ll therefore make use of these short-term opportunities – if the price is compelling – and carefully adjust our clients’ portfolios for better investment returns over the long term.
