Economy on the mend,

but side effects linger

Listen to Alwyn’s views here or read more below:

Our world entered the second year of the decade faced with a vastly different reality than it did the first. At the start of last year, we were all talking about the global economy potentially nearing the end of a very mature upcycle, how the synchronised global growth narrative was running its course, and how the decade-long equity bull market may not be repeated into 2020.

Needless to say, no one could predict the dramatic end to the cycle in late February and early March. We all know the gory details – the global economy collapsed very suddenly into a severe recession, and investors scrambled for safe havens such as gold and the sovereign bonds of developed markets as the crisis deepened and global equity markets plummeted.

Unlike during the global financial crisis of 2008/09, however, economic authorities sprang into action, pulling out all the stops to try and cure the patient. Global central banks provided extraordinary levels of monetary stimulus in the form of low interest rates and relief packages worth trillions of dollars. The extremely aggressive policy response had the desired effect – the global economy recovered well in the second half of the year.

On the financial markets, investors preferred to look forward. Despite the fact that we clearly weren’t out of the woods yet, the markets responded as if the shot in the arm by the authorities had given the patient a clean bill of health. There was a phenomenal rebound in risky assets, and equity prices ticked up markedly – in fact the NASDAQ Composite gained an astonishing 34% towards the end of the year.

In the developing world, including South Africa, financial markets followed the global trend – a sell-off, followed by a recovery, albeit not one as spectacular as that of the developed world. On the economic front, there was a similar pattern – emerging market economies rebounded, but they generally didn’t eclipse the growth story of advanced economies. The exception was China, which closed the year with a positive 2.3% growth rate in 2020 – a truly exceptional outcome against a background of severe challenges.

LINGERING SIDE EFFECTS

The positive investor sentiment has so far continued into 2021. Is the general optimism justified? Can we realistically expect the upward trend in financial markets to continue in 2021? Against the backdrop of a tumultuous 2020, we can’t ignore the lingering side effects of the consequences of the pandemic just yet. In our view, investors need to take note of four main factors likely to have an impact on financial markets this year:

• The most important ‘medicine’ to ensure the continued recovery in global economic activity will remain the rapid, widespread and efficient distribution of the various vaccines worldwide – market perception around the efficacy of the roll-out will drive investor sentiment and financial market movement over the short term. While vaccine delivery has been slower than anticipated in some parts of the world, most countries appear to at least have the right strategies in place.
• It will also be crucial that the success of the vaccine drive leads not just to a temporary rebound, but to sustained economic growth in both developed and emerging markets. The World Bank has issued a 4% global growth forecast for 2021, with China’s economy expected to expand by 7.9% this year – but policymakers will have to rotate from income support to growth-enhancing policies to ensure this recovery is sustainable over the long term.
• Why is this important? All things being equal, an improvement in economic activity is likely to filter down to continued, although uneven, recovery in corporate earnings. As we’ve said before, the performance of financial assets is simply a function of growth in income or profits and a change in investor sentiment. The recovery in equity prices in the second half of 2020 was largely based on improved investor sentiment. Now we have to witness an improvement in financial performance or profits to support these asset prices.
• A further crucial consideration for investors is valuation – across all asset classes. Investors’ upbeat view on the prospects of risky assets has led to some fairly aggressive valuations in equity markets worldwide. In terms of their own history, many companies – especially the large-cap US information technology stocks – are trading at highly elevated levels. This phenomenon doesn’t only relate to equity valuations, but is perhaps even more valid when we assess the valuations of bonds in the developed world. On a relative basis, global bonds are even more expensive than equities. European government bonds are trading at negative yields and in the US, the yield is trading at around 1%, which doesn’t leave much upside in terms of investment performance.

THE BULLS AND THE BEARS

It’s clear that the prospects for 2021 remain fraught with uncertainty – I must admit I’ve seldom seen such strong arguments for both bearish and bullish outlooks for financial markets. The bulls argue that there is sufficient global economic momentum to translate into higher earnings, and that – at least in the developed world – the vaccine roll-out and its initial results are meeting expectations. The liquidity created by central banks is looking for a home, and this has created natural demand for equities, since bonds don’t look attractive given current interest rates.

The bears, on the other hand, argue that the positive outlook regarding the roll-out and the efficacy of the vaccines is already baked into the prices of equities, so any disappointment with regard to the roll-out is likely to influence financial asset prices negatively. They also argue that although short-term economic recovery will most likely happen, the side effects of the stimulus effort have created enormous debt levels – largely at government level – that will need to be addressed in future. This expected deleveraging (reduction in debt) is likely to reduce economic growth potential. Finally, the bears correctly point to speculative behaviour, as evidenced by retail investors in the US driving selective equity prices to levels bearing no relevance to the earnings potential of companies. This behaviour can change overnight.

POSITIONING PORTFOLIOS

What are investors to make of all this, and how can they best position their portfolios in the face of such diverging viewpoints? Taking into account both the bull and the bear arguments, our view is that – given the lack of alternatives – equities remain the most promising asset class for investors this year. From a valuation perspective, we are biased towards South African equities, which are currently looking more attractive than their global counterparts as investors have taken a dim view of the local macro outlook. We’ll take a neutral stance with regards to global equities in our clients’ portfolios.

Why do we hold this view? The NASDAQ Composite and the S&P 500 indices are largely being driven by only six or seven very expensive ‘big guns’. These information technology shares had obvious advantages in a COVID-19 environment and have produced more than admirable results, but our view is that the average investor has made a common error in ‘uncommon times’ by extrapolating the current trend favouring these companies as if it will become the long-term norm. As a result, our view is that these companies – which are dominating the headline indices – are simply overpriced and caution needs to be applied when investing aggressively in these names.

Having said this, there are still many quality companies that are trading at substantially lower ratings than some of the top names driving the global indices, and we will look to include some of these in our clients’ portfolios.

What about interest-bearing assets, which tend to provide a ‘buffer’ in a portfolio in times of uncertainty? Given their low yields, global bonds don’t make much sense in a multi-asset portfolio right now, and we’ll therefore remain underweight in this asset class. Local bonds, on the other hand, are looking quite attractive. However, South Africa’s current fiscal dilemma will certainly cap the upside performance potential of this asset class. Ten-year government bonds are trading at around 9% and with inflation expected to hover at about 4%, they’ll provide a yield after inflation of around 5%. While we increased our clients’ investment in local government bonds – we bought 10-year government bonds – in the second half of last year, we’re unlikely to add to this position.

On the property front, I believe that from an operational perspective, it will be extremely tough in the current environment for property companies to grow distributions from their 2019 levels. We’ll therefore retain our current position, which is neutral. With regard to cash, given that the yield will be higher locally, we’ll retain any cash we hold in the portfolios in South Africa to make the best use of opportunities when they arise.

A LAST WORD

In general, we’re of the view that economic authorities will continue their efforts to keep global economic momentum going on a sustained basis. There’s also a new incumbent in the White House, who is likely to take a friendlier international stance, and uncertainty regarding Brexit is now over – both of which will be positive for financial markets over the short term. The key factor, however, will be the success of the global roll-out of vaccines.

Financial markets will remain highly sensitive to anything suggesting that economic activity may disappoint on the downside, and are likely to remain volatile. However, this is in our view no reason for investors to shy away from risk, and we’ll continue to apply our long-term investment principles when we construct our clients’ portfolios.