At MitonOptimal we take asset allocation (AA) very seriously, taking into consideration both Strategic AA (5-7 years) and Tactical AA within the various asset classes. In that context, this quarterly piece provides insight into our short-term tactical calls on a 12-month view (reviewed quarterly) and as such may diverge from our long-term strategic AA views. We review our strategic AA annually at the beginning of each year as we believe this is prudent practice, in a world dominated by debt de-leveraging, central bank and political interference.
Looking back at 2018 for the year as a whole, the only words we can use to describe it are ‘annus horribilis’, for it was a year in which only one asset class reigned supreme and that was US$ cash which achieved a positive return of 1.7%. To be fair, global bonds (largely due to US treasuries) eked out a return of 0.1%, but this is hardly something that investors would hang their hats on. Looking at the negative returns for all other asset classes, it reads like something out of a horror movie – these are the returns for major assets classes (all in Dollars) from the worst to the “best“:
|Emerging Markets||MSCI (ex US)||Commodities||US Small Caps||REITs||US Large Caps|
2018 was essentially a year of three parts, starting with the melt up phase in the 1st quarter as investors embraced synchronized global growth, US tax cuts and fiscal spending. This was followed by weakness in the second half of year as global trade wars; a tighter US Fed and a stronger Dollar saw investors flee emerging markets (EM’s) (and to a lesser extent Europe). Finally, US stocks capitulated in the 4th quarter of the year, wiping out all the gains for the year as investors finally realized that a more hawkish Fed; concerns over global growth (thanks to trade wars) and an inverted yield curve on the short end would not lead to US earnings being unscathed.
In terms of equity market movements, the headline-grabbing number from the last quarter is the fact the US market suffered its worst December since the Great Depression in 1931. The S&P 500 Index (which didn’t actually exist in 1931; the Dow Jones Industrial Average was the bellwether market index back then) dropped 15.74% from peak to trough before ending the month down 9.18%. An intra-quarter fall of 19.63%, meanwhile, took it within a whisker of the 20% threshold that signifies an official bear market – notable other prominent benchmarks such as the Russell 2000, -27.22%, and Nasdaq Composite, -23.03%, broke through that barrier. Elsewhere, this move was replicated on a currency adjusted basis throughout the major markets, with, in order of capitalisation, Japan Topix -19.68%, UK FTSE All Share -15.58%, France CAC 40 -17.57%, Canada TSX -19.45% and Germany’s DAX -16.57% in USD terms within the quarter.
Against this backdrop, the performance of EM’s was notable, in that the broad MSCI EM Index fell significantly less both within and over the quarter, having avoided much of the damage seen elsewhere during the latter stages. The reality is that EM assets had taken the brunt of the pain in previous quarters and like any good value investment had less to fall when US markets finally reacted to the negative news flow.
So having highlighted the painful year that was 2018 for global investors, the commentary below unpacks the major asset classes for our South African portfolios and where we are currently positioned.
SA Equities: underweight – moving to neutral
Investors can be forgiven for wanting to throw in the towel on SA equities, for it has been a thankless task, as witnessed by the fact that over the last four and a half years the JSE All Share Index has basically been flat, eking out an equivalent return of just under 1% per annum before dividends and 4% after dividends, which is below the average inflation rate.
It is not much comfort that the same South African equity market over the last 50 years has been one of the best-performing markets in the world, delivering a return of 15.4% per annum in nominal ZAR terms. When inflation is considered, the market has returned a real return of 5.9%. But at the same time, it does show you the power of long term investing and if one is a believer in mean reversion, the next few years’ returns should be a lot better to get us back to long term averages.
As we mentioned in our last quarterly commentary, a lot of the weakness we have seen in the JSE has not merely been a function of poor South African economic data or political nervousness, but the reality is that as a small open economy, sentiment towards EM’s affects our markets, irrespective of our own internal issues. Plus, and more importantly, the Rand hedge stocks now constitute 60% of the JSE, which means they are the dominant drivers of the returns of the JSE and those returns and earnings have very little to do with South African domestic issues.
So having said all that, after a dreadful year for EM assets as a group, thanks to a strong Dollar and trade wars, sentiment seemed to swing more favourably toward this asset class during the fourth quarter of 2018 and the JSE benefited slightly from this improving backdrop. Equities were actually positive in Rand terms in the last month of 2018, thanks to a weaker Rand, but also due to the fact that in Dollar terms EM assets were rather contained, despite the fallout in global markets.
Even if one is not a believer in mean reversion, one thing is clear from the various managers we speak to is that valuations are cheap and now is not the time to be selling JSE equities, but the big question is, do we buy more?
See the table below, in which Coronation give their expectation of upside to fair value on the shares in their Top 20 fund, as written about at the end of December of 2018.
Despite what investors might be told, valuations in and of themselves don’t lead to markets rallying, what we need to see is a catalyst to unlock that value. Looking back at our commentary at the end of September we listed the following as reasons to become bullish and our comments below are how we see the investment landscape currently.
We view the following as potential catalysts that will prompt us to increase our exposure to the JSE:
- A US economic slowdown or the Fed pausing in hiking interest rates causing a weaker Dollar
It is early days, but the data from the fourth quarter of 2018 certainly indicated that growth is slowing in the US, though still not recessionary and the Federal Reserve seems less hawkish than they have been for a while. This should cause the Dollar to fall, not stop appreciating, which is a bullish signal for EM assets. As this commentary is being written, the Dollar index is weaker in 2019.
- Accelerating inflation in the Eurozone and a hawkish European Central Bank (ECB)
This has not come to pass, in fact, European growth has decelerated and inflation along with it, so the ECB remains between a rock and hard place, needing to normalise interest rates, but knowing that liquidity still needs to be plentiful. So, on this score, this is less positive for EM assets.
- No escalation of the US-China trade war or more China stimulus through the fiscal rather than monetary/currency channel
When it comes to Trump this remains very difficult to call, but it does appear that relations between China and the US are improving with US companies starting to feel the pain of slowing Chinese growth due to trade wars, it is now more in the US’s best interests to come to a trade deal, sooner rather than later. Chinese growth continues to surprise to the downside, but China has made a lot of positive noises recently, be it in the reduction in reserve ratios in order to create more liquidity in the banks, or in cutting taxes for small business, so on balance this does imply more bullish sentiment for EM assets.
- Key technical levels breaking to the upside
Medium term technical indicators for MSCI EM stocks have broken up and are starting to look quite positive. We still have not seen that for the JSE itself, as foreigners keep selling (keeping a lid on gains), but it is hard to see them continuing to sell if EM as a basket keeps rallying.
Summarizing all these views, a number of the catalysts we were looking for have come to pass and when you couple that with cheap valuations, we are starting to increase our exposure to SA equities moving from underweight to neutral. Suddenly everyone is bullish EM, but that can change very quickly as it did in the first quarter of 2018. We need to see a proper ceasefire to the hostilities of trade wars before we can turn very bullish on the JSE, plus a more sustained downward leg in the Dollar.
We also have an election in SA in the second quarter of 2019 and there is bound to be a lot of volatility in the run-up to this event, which could impact on consumer confidence and SA incorporated shares. Not to mention what this could do to the Rand, but as South Africa has shown in the past, the Rand tends to move with EM currencies, so if the risk on environment continues then the Rand could surprise to the upside, even as political headlines, Eskom load shedding and the debt issue scare local investors.
So the bottom line is we remain cautious, whilst slowly increasing our exposure, given very attractive valuations.
SA Bonds: overweight – moving to underweight
Having been upbeat on bonds for most of 2018 (which luckily proved to be the correct call as bonds outperformed both cash and equities in 2018), we have been selling bonds in the fourth quarter of 2018 and the early part of 2019.
We have been selling in order to bank profits, especially after the recent rally which was led US treasuries moving from 3.2% to 2.7% and which led to SA bond yields falling. We are also selling as short-term paper is now returning similar yields to longer-term bonds and has less duration risk.
Another one of our concerns for the SA bond market is a downgrade from Moody’s this year. First, a potential change in outlook to that of ‘negative watch’ and then a potential downgrade at the year-end from investment grade to junk shows bonds are not without risk and right now yields don’t seem high enough to compensate investors.
It worth repeating what Moody’s are worried about – the following comes from their recent commentaries:
“South Africa, we project real GDP growth will accelerate to 1.3% in 2019 from an estimated 0.5% in 2018, as agricultural output recovers and a more stable political environment leads to higher investment. Growth will continue to be hampered by rigidities in the labour market and insufficient and unstable power supply.”
Eskom and its debts woes (underwritten by government) and its inability to provide consistent power are clearly something that the rating agencies are keeping their eye on and in that vein the future does not look promising. Rolling blackouts are predicted to start again at the beginning of February and if Nersa approves their 15% electricity tariff increase (which in the past they have been loathed to do), higher electricity prices (way in excess of inflation) will lead to slowing SA growth and ultimately less revenue for Eskom, as those that can, go off grid.
The upcoming budget in February will also be a risk for bond markets, especially if debt to GDP ratios have deteriorated, which is highly possible given weak South African growth and what’s more, what if we see some electioneering expenses in the budget to try and sway voters to vote ANC, this too adds risks to bonds.
The latest ANC manifesto has also led to risks in SA bonds, in which they propose investigating the concept of prescribed assets. Clearly given the perilous state of the SOEs, this was just a matter of time, and if Eskom does fail, the whole country fails, but it’s not good news if pension funds are forced to allocate capital to poorly performing assets and foreigners will not like seeing the savings industry being meddled with, so this is yet another short-term concern.
But by the far biggest risk the SA bond market, is a resumption in US treasury yields upwards, if investors continue with their risk on environment and sell bonds to buy equities. Or if we get an agreement on the trade wars and global growth concerns reduce and investors sell their bond insurance. Don’t forget there is also a lot of treasury paper coming to this market this year, at the same time the US Fed is reducing its balance sheet – all of which should lead to bond yields rising.
At the same time, bullish trade talks and less worries about global growth are bullish for EM debt, so you could see continued tightening in EM credit spreads and this is entirely possible, but for now, the valuations of SA bonds relative to shorter bank paper don’t warrant the risk.
Should we see a sell-off in SA debt, on the back of the downgrade in Moody’s outlook or a poor budget, we would probably look to buy back again, because as we have said before, inflation in SA is expected to remain contained, given weak SA consumer demand. The SA economy might be recovering, but still has plenty of slack and if inflation does not blow out (which is not our base case), then real yields on SA bonds are very attractive at higher bond yields. We need to see the R186 above 9% again to be a buyer of longer duration bonds.
SA Listed Property: neutral to underweight
Off the back of our reduction to bonds, we have been reducing property back to underweight. Property might look very attractive from a yield perspective, but there remains a huge amount of risk in the sector and news that Edgars (the largest retail tenant in the country) could have solvency issues (not confirmed) has also led us to be more circumspect on property.
SA landlords have become accustomed to upward rental reviews, but with the pressure from Edcon to renegotiate leases downwards, coupled with a difficult retail environment which might encourage others to do the same, forward dividend yields are certainly not a given. For now, we are selective on our property holdings and are only buying the bluest of blue-chip investments. UK property, listed on the JSE is looking interesting and could be something on our radar screen, should we get some good news on Brexit. For now, how Brexit plays out is anyone’s guess, but the odds are 50-50 between a hard Brexit and no Brexit.
SA Cash: remaining underweight
Cash is still generating attractive yields, but for now, we prefer to be underweight and have instead invested money with flexible bond managers that are buying very liquid bank paper, which offers similar yields to bonds (above money market rates) and have far less duration risk.
Global Equities: neutral – moving to overweight on both DM and EM
According to the revered investor Sir John Templeton, “Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria”. Whereas it can be argued that we have witnessed a localized “melt-up” in US and Chinese internet stocks (the “FAANG” and “BAT”s), that final – euphoric -phase of the cycle has been notably absent from the broader equity market picture. It’s therefore entirely possible that we haven’t yet seen the end of the market cycle. Indeed, we’d go as far as to say that if the risk of a recession that has spooked markets doesn’t materialize, you can swap the “possible” in the previous sentence to “likely”.
Despite tales of doom and gloom, the reality is that global growth still remains robust, though a little way off recent peaks. Important indicators such as Purchasing Managers Indices (PMIs) in the major economies remain comfortably above the 50 level which signals the divide between expansion and contraction. The latest composite numbers (combining the manufacturing and service sectors) for the US, EU and China at 54.7,54.4 and 52.0 respectively. The World Bank did downgrade growth recently, but it is still expecting growth of 2.9% from 3%.
Does that mean that we are aggressively buying stock after such a sizeable correction in markets? After all, as a consequence of the adjustment brought about by the last quarter’s movements, even after allowing for a (prudent) downgrade in earnings expectations, the broad market is trading on the cheapest price/earnings rating since 2012, with other valuation metrics not far behind. Well, no, not exactly. As the foregoing comments suggest, while our considered view is that those recessionary fears are unfounded, it is an outcome – with perhaps a 35% or even 40% possibility – that cannot be entirely ruled out, particularly if the Sino / US trade situation worsens or policy error becomes more likely.
But at the same time, after the vicious falls we have seen in the 4th quarter of 2018 and with the Rand being relatively strong, increasing exposure slightly to offshore equity does seem to make sense. It is true that the JSE has a large number of offshore assets, namely the Rand hedges, but they are not terribly broad in their earnings streams and I am sure investors want a greater investment choice than Chinese tech, resources (another play on China), tobacco and luxury good companies.
Global Listed Property: remaining neutral
Global property outperformed equities over the quarter but was still in negative territory and behaved more in line with equities than bonds.
We remain neutral on global listed property given the risks of e-commerce and slowing growth rates but do think certain UK properties have been hugely oversold on Brexit concerns, but will leave the buying of where to be in the property market to our underlying managers.
Global Cash: remaining negligible overweight
Global cash rates remain unattractive and we simply use US$ allocation as a long-term risk management allocation against any unknown risk within global capital markets. Global cash, in absolute terms, is a very small weighting within our portfolios.
Global Bonds: remaining underweight
During the quarter fixed income markets provided investors with some sort of diversification benefits – if one was in sovereign bonds, with core sovereign debt prices rising and credit spreads widening. Ten-year (yr) benchmark yields for US Treasuries, German Bunds and UK Gilts declined by, respectively, 38 basis points (bps) (to 2.69%), 23bps (to 0.24%) and 30bps (to 1.28%) over the period, with the corresponding Bloomberg >1yr Government Bond Indices posting gains of 2.57%, 1.58% and 2.13% for the quarter.
As has been the case for some while, the big talking point as far as bond markets are concerned continues to be a gradual flattening US yield curve, which the textbook tells us is an indicator of a slowing economy. Moreover, that same textbook suggests that when a yield curve becomes inverted – i.e. the return from short-dated bonds exceeds those with longer maturities – it is often an indication of a forthcoming recession. It should perhaps come as no surprise, therefore, that the beginning of December’s equity market sell-off coincided exactly with the point at which the 2-yr Treasury yield fell below that of the 5-yr; nevertheless, the timing strikes us as uncanny. Cause or effect? That’s anyone’s guess…
Either way, it is worth commenting upon the predictive power of that yield curve’s inversion, since, depending upon who one listened to during the past month, one could be forgiven for thinking that a recession in the US is now a foregone conclusion. As ever, there’s a fair bit of daylight between perception and reality. Looking at the period since 1976, for example, whereas the US economy has experienced five recessionary periods, that 2yr / 5yr yield differential has been negative on 19 separate occasions, equating to a rather underwhelming 26% “success” rate. Even in the case of the more statistically reliable 2yr / 10 yr spread (which, it must be noted, despite expectations to the contrary from those of a bearish persuasion, remains stubbornly positive), that hit rate is still less than 50%, with 11 inversions during that time. Since experience suggests that bond markets tend to behave far more rationally than those of other asset classes, the yield curve movements in the US and elsewhere are certainly something to which we are paying close attention. As the foregoing figures suggest, however, even what are perceived to be the most consistent of predictive indicators aren’t necessarily as reliable as one might think.
We remain and have been underweight bonds for a long time now and still see no reason to change this view. Technical indicators for sovereign bonds might have improved in the short term, but the fundamentals for bonds remain unappealing, based on large issuance and central banks that are cutting back on their bond buying programs, as they seek to reduce their balance sheets.
It also means that we would prefer to be at the short end of the curve, as the long end has more duration risk. There will be a time when we want to buy bonds, given that yields are rising and certain bonds are becoming more attractive, but we remain underweight for now.
This view is predicated on DM sovereign bonds as EM bonds are far more attractive and have sold off aggressively and again, if we see the Dollar start to weaken, we would look to increase our exposure to EM bonds.
Investment Strategy Conclusion
One of my colleagues recently wrote a brilliant commentary on how brave one has to be to be different and he went on to argue that being contrarian in markets is one such act of bravery. In that vein, looking across our various asset classes, I hope the conclusion, you the reader, have to come to is that we are active and have begun increasing risk in our portfolios. Yes, there are risks, but valuations are giving investors a margin of safety and earnings globally are still forecast to grow. If we do see some good news emanating out of Washington and Beijing, we could see much higher global stock markets in 12 months. This should also be good news for the battle-weary JSE, for although the economy is feeling quite fraught and there doesn’t seem to be a day that goes by without some new tale on state corruption; fears over Eskom imploding; or the ever-increasing brain drain from SA, shares on the JSE are cheap. Furthermore, 60% of the JSE’s market cap is driven by news events and earnings that are not even related to SA domestic issues, so we would be remiss as guardians of your investments, not to take advantage of the valuations of equities we see before us today. Fortune favours the brave!