After a disappointing 2018, the first three months of this year certainly buoyed investor sentiment: in US dollar terms, the S&P500 climbed by 13.6%, while the MSCI World Index returned 12.6%. Most European equity markets also delivered double-digit returns. On the local front, the JSE All Share Index (ALSI) finished the quarter with a gain of around 8% in rand terms.
In April and May however, it all started to go pear-shaped. The figures for May are particularly dismal: the MSCI World Index plummeted by 5.7% in dollar terms, while locally, the ALSI declined by 4.8%. After such a promising start to the year, what happened? To explain what’s behind the current volatility, we need to examine the broader context of the investment environment. In our view, there are three main issues at play:
The phase of the global economic and investment cycle. Looking at the investment environment from a top-down perspective, the stage of the financial cycle is crucial to understand the psyche of investors. Since the global equity up-cycle started back in 2009 and global economic activity levels recovered, we’re now in the 10th year – and therefore an advanced phase – of an equity bull market. In late-cycle markets investors tend to respond nervously, in other words, sell off when economic indicators suggest the cycle is rapidly losing momentum, or about to roll over into a period of sustained slowdown and possibly recession.
The stance of monetary authorities. In an advanced stage of the economic cycle, market sentiment is particularly vulnerable to two crucial factors, one of which is rising interest rates. Global equity prices came off significantly during the second half of last year after the US Federal Reserve (the Fed) hiked rates, which rattled markets. But in December, the Fed did an about-turn on its monetary policy stance, which gave investors hope that central banks would be able to engineer a soft landing in terms of the cycle. In response, equity prices rallied during the first quarter of this year.
Tail risks. If the diminished prospect of rising interest rates had somewhat settled investor nerves, the other critical factor impacting late-cycle market sentiment – so-called tail risks or exogenous shocks – had not. The major current risk is the increasing geopolitical tension resulting from global trade wars, mainly between the US and China. While at the start of the year there was optimism that the US-China spat may be resolved, there’s now less certainty of a positive outcome any time soon.
The ongoing dispute has naturally had an unfavourable impact on the operations and therefore earnings prospects of those companies directly in the firing line. But we also know the repercussions of a full-blown trade war would go beyond the direct, quantifiable impact. It’s the secondary, knock-on effects late in a cycle when confidence levels are low that are likely to concern investors.
Rubbing salt in the wound is the tedious, seemingly never-ending Brexit saga, which is already affecting trade between the UK and the rest of Europe and will continue to have a ripple effect on economic activity in Europe – the third largest economic region in the world.
Had the world been in a different phase of the global economic cycle, the trade war and Brexit tail risks may not have had such a marked impact on investor sentiment. However, because we’re in a late cycle, the market is particularly sensitive to the potential of exogenous shocks of this nature to tip the scales and derail economic growth to the point of recession.
IMPLICATIONS FOR INVESTMENTS
What are investors to do in such a volatile investment environment? At Sanlam Private Wealth we’ve always maintained that in late-cycle markets, investors should be more cautious about asset allocation. In our multi-asset portfolios, we’ve therefore taken a neutral position in terms of both global and local equity exposure over the past 18 months. Importantly, we have significant exposure to companies with earnings streams that are defensive in nature – in other words, less sensitive to changes in the economic cycle, such as British American Tobacco. Even our exposure to companies in the commodities sector is focused on those that are less cyclical, like Mondi.
Although both global and local bond yields don’t offer fair returns at the moment, global bonds have always been a good shock absorber should equity prices come under pressure. We therefore do have some exposure to global bonds to provide balance in our portfolios. We also currently have above-average dollar cash holdings where client mandates allow for it.
NO PRICE BUBBLES
It’s important to note that despite global markets being late-cycle, we don’t predict any major collapse of risk assets or equity markets. Unlike the situation in past lengthy up- cycles, where exuberance led to price bubbles, for instance the IT bubble in the late 1990s or commodity shares in the late 2000s, we haven’t seen much evidence of these in the present cycle.
Although there’s no getting away from the risks we’re now grappling with, we do believe they’ve already been largely factored into asset prices. The current uncertainties are well known and have been well documented by both investment professionals and in the financial media – a recent article titled ‘Late in the day’ in the 25 May 2019 edition of The Economist being a case in point.
SEEKING OUT OPPORTUNITIES
On the local front, the vulnerable political environment in South Africa over the past few years has contributed to valuations looking considerably more attractive than in the past –and compared to those of global markets. We’ve become used to a roller-coaster ride in our country – this year investor sentiment has been shaken by, among others, the general elections and more recently, disappointing GDP figures. It’s an unfortunate reality, however, that investors tend to extrapolate a negative narrative into perpetuity – while it’s in many cases understandable, it’s certainly not rational.
The key is to be able to spot investment opportunities when they arise. From a top-down perspective, we can certainly identify value in the South African market, which is now trading at a price-earnings multiple of about 11 times – below its long-term mean. Importantly, when we analyse individual companies, we can see quite significant upside on some of these. In our view, cautiously adding to such assets when value is apparent will – as it normally does – pay off over the longer term.
