We at MitonOptimal take asset allocation (AA) very seriously, taking into consideration both Strategic AA (5-7 years) and Tactical AA within the various assets 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.
In reviewing the quarter that has just been, it was almost the mirror image of the 4th quarter of 2018, with the rally that began on Christmas Eve of 2018 leading to one of the strongest quarters for the markets in years. The mood in equity and credit markets was boosted by the perceived benefits of a softening in the Federal Reserve’s (Fed) and European Central Bank’s (ECB) interest rate and quantitative tightening narrative. Core sovereign bonds reacted instead to the cause of that policy shift i.e. slowing global growth and rallied hard towards the period-end.
Recession? What recession?! Dovish Central Bank rhetoric, signs of improving US/China trade relations and positive corporate news flow saw equity markets start the year with a pronounced spring in their step. Led by the US, the MSCI World (developed markets) Index posted its largest January increase since 1987 and the best calendar month for more than seven years. The positive momentum continued into February, with the aforementioned benchmark making further gains and, while the rate of progress slowed during March, the rally extended further towards the quarter-end. Emerging Markets (EM) were similarly buoyant, albeit that their returns were not as significant in historical terms: after an even stronger start to the period, the MSCI EM Index lagged its developed counterpart during the latter stages to record marginally lower, but equally welcome, gains.
All told, global stocks would close out 2019 with their best annual returns ever if they kept rising at their current pace, according to Bank of America analysis. Still, investors are trying to square their big returns with the fact that they have arrived while the global economic outlook has grown progressively dimmer. Fund managers also have increasingly questioned whether the Fed’s pivot from raising rates to holding them steady reflects economic weakness that will ultimately derail the market’s rally.
The International Monetary Fund (IMF) in April cut its outlook for global growth in 2019 to 3.3% from estimates of 3.5% in January and 3.7% in October, warning that trade tensions and declining business confidence were weighing on nearly all countries around the world. The IMF isn’t alone. The Fed and ECB have also trimmed growth forecasts in recent months. In China, officials have ramped up spending and cut taxes to try to boost a slowing economy. But for the quarter, as a whole, the Fed coming to the rescue was ultimately what drove returns, despite some questioning why they had changed their tune. Liquidity trumps fundamentals once again!
SA Equities: remaining underweight
In reviewing our last quarter’s commentary, we said that we were moving to neutral relative to our benchmark weightings and yet we are here a quarter later and we are still underweight and one has to question why that is the case, especially after the strong first quarter we have just experienced for local equity markets.
The reason for being underweight is simply because we have upped our benchmark neutral weights across our risk rated portfolios, given that after the last 5 years of dire returns from the JSE, we would expect the next 5 years returns to be substantially better, especially against cash. See the chart below, which illustrates the performance of local equities vs cash, post the under-performance we have recently witnessed.
Periods of underperformance for SA equities relative to cash (1900-2018)
Source: Global Investment Returns Sourcebook 2013, Credit Suissee; IRESS
Previously we had forecast 7% annualized returns for the JSE for the next 3-7 year and now we are forecasting 8% for the ensuing period, which has had the impact of increasing our equity neutrals across our portfolios, with the biggest impact being in our higher risk and return portfolios. To give one example of this, in our CPI +6 portfolio we have moved up from 40% equities to 60% and hence we did not feel comfortable moving the portfolios that aggressively. Long story short, relative to last quarter, we did increase our equity weighting in our portfolios, but relative to our benchmarks we remain for now, underweight.
SA Equity Market Forward PE ex Naspers
Source: IRESS, Truffle
The JSE, as many of you will be aware is a two-tier market, driven by offshore markets and the rand on the one hand and then also driven by local fundamentals on the other hand, hence when one is commenting on the local equities, the drivers of performance are very different. 60 percent of our market is now comprised of rand hedges, with the remainder being domestic stocks. It is the domestic side of the stock market where valuations are very compelling, however earnings do come with some forecast risk, especially for 2020. We remain cautious domestic stocks in our portfolios in the short term, despite the valuation underpin as there still remains a large amount of risk in the South African economy, especially with the election looming on the 8th May.
The view in the market remains that the ANC will win the elections, but what is not clear is how a big a percentage that will achieve and this is hugely important if Cyril Ramaphosa is to enact proper change in SA. If his mandate is weak (the ANC gets less than 60%), we can expect many more years of low growth in this country, increased emigration, and rolling blackouts as some of the ANC politicians that we have come to witness continue to mismanage this country. However should the ANC achieve a decent showing in the elections (greater than 60%), thereby giving CR a strong mandate, the future trajectory of this country could be very different. CR would be able to make some positive changes, send corrupt politicians to jail, encourage SA corporations to invest their substantial cash pile and we could see a slowdown in our brain drain and this would ultimately lead to stronger GDP growth going forward. But the outcome is very binary and that is why for now, we prefer to err on the side of caution and not be too aggressive on our domestic holdings within our equity portfolios. If we do see a re-rating in SA incorporated stocks, as we witnessed post CR taking over the presidency of the ANC, we would probably sell, as for now structural concerns in the SA economy worry us if valuations should become stretched again.
Education in SA remains our largest worry in the long run, with 24% of grade 4 in this country not able to read properly; only 37% of kids that start school graduate 12 years later with matric and absenteeism by school teachers (especially on Monday and Fridays) is at 13% of all teachers! How are we possibly going to compete in the upcoming 4th Industrial Revolution and this assumes the lights stay on!
But on the bright side, as investors in SA, there is still money to be made investing in some world class rand hedges that make up 60% of our market. In the last 10 years, Naspers and Richemont have outperformed the MSCI World Index and with the continued rise of China, as in our base case scenario planning outlook, there is every reason to believe that these companies could do the same in the future. Michael Power, investment strategist at Investec, recently highlighted that the middle class in Asia could grow by 2.1billion people in the next 15 years, which can only be good news for SA companies that derive their growth from China.
But, when it comes to resources (the other rand hedge component of the JSE) we are less optimistic, as we believe future growth in China is going to be more consumer led and less producer led. We believe, based on extensive research, that China’s growth going forward will be a lot less bricks and mortar based and more on the services side of the economy, as China tries to move its economy up the value chain and become more concentrated in technology. In the short term, resource shares have had a good run, largely on the back of less capex and reduced supply, but this is not a longer-term growth story and ultimately, we favour mangers who trade resources, as opposed to buy and hold investing.
So overall, we are currently underweight SA equities (largely due to a large up weight in our long term strategic AA weightings to local equities), preferring the relative safety of rand hedges, but equally are not making massive bets against the rand, as bullish sentiment around the election could see the rand rallying to 13 to the dollar and this will hurt the rand hedge component of our market. This is mitigated, somewhat, by current bullish sentiment towards EM equities, which could see the likes of Naspers, which makes up a large portion of the MSCI EM ETF’s rally even in the case of a stronger rand . Now the Fed seems to be firmly in pause mode, with the view that dollar rates could even be cut in 2020, we could see sentiment towards EM stay bullish for a while and this will help underpin the JSE.
SA Fixed Interest: overweight
Our fixed interest component of our portfolios is made up of traditional bonds, flexible income mangers and floating rate notes. Combining these all together, we are currently overweight fixed interest relative to our neutral, but remain underweight long duration bonds, as we mentioned in our previous commentary.
During the quarter, Moody’s surprised the market by not changing it’s outlook to that of negative watch, so one of the fears that we have for SA bonds did not materialize and post the announcement (or should we say lack of announcement), we bought back into SA bonds and reduced our underweight bond duration call a little.
We do, however, continue to believe that unless CR and his cabinet start making some concrete changes to Eskom, it will only be a matter of time before Moody’s do indeed downgrade our rating to junk status. Currently Eskom is keeping the lights on by burning diesel as the plants are not coping with current demand (and that is with a moribund economy), but this is very expensive and post elections is unlikely to continue. Rating agencies worry about growth in SA and if we have rolling blackouts post the election, this will impact with the SARB recently estimating zero growth for 2019 if rolling blackouts start again.
Despite the risks of a downgrade, SA bonds still warrant a place in our portfolios, for the simple reason that with inflation at 4% and possibly moving to 5%, real rates of 4-5% are still incredibly attractive in order to match client’s assets to future liabilities. Our view on inflation is that it has probably bottomed for now, sitting at 4.1% in February and will probably trend higher due to higher fuel prices and administered prices, but we don’t expect inflation to go above the 6% target any time soon, as demand pressures are non-existent in the SA economy, due to the economy having excess labour and factory capacity.
Despite the market pricing in no rate hikes for 2019 and even a potential cut in 2020, for now we share the view of our local fixed income managers that a rate cut is probably not likely, in light of the fact that the SARB is hell bent on getting inflation expectations to anchor towards the midpoint of the inflation range, which is 4.5% and until such time as that is achieved, interest rates will stay higher than they should in SA.
This means there is still plenty of opportunity for flexible income managers to make money out of floating rate instruments, especially short-term paper issued by the banks. SA remains one of the few places in the world where investors are well compensated for holding short-term fixed income, especially cash.
So we still think real yields are very attractive in the fixed income space and have given most of our budgeted allocation of fixed income instruments to flexible income managers, who take advantage of duration call and attractive credit (when it is available). Should we see a sell-off in fixed income, we would look to increase our duration and lock in higher real rates further down the duration curve, but for now, investors are not being compensated enough for extra duration risk, especially given how attractive short-term paper is.
As we said in our commentary last month, one of the biggest risks to SA bonds is a resumption of yields higher in the US, but for now that risk seems quite contained. Economic data out of the US has been a lot more muted in 2019 and the US central bank seems quite sanguine about raising rates any time soon. Weakness in the rest of the world has also been given as a reason to keep rates from rising.
Longer out, if we come to some agreement on trade talks between the US and China, which if Bloomberg is to believed is any day now, that will be good for global growth and risk appetites and should see investors continue to support EM bonds, which will probably lead to spreads narrowing versus US Treasuries. Even if sovereign yields were to move up because investors have turned more bullish, spread compression could mean that EM bonds will still do well and at the same time EM currencies could be supported.
Bottom line, we think fixed income has a place in our portfolios, despite the obvious attractiveness of local equities. Real yields in SA are still very high and we do not see inflation running away and hence we remain overweight this asset class across the portfolios, especially relative to the risk.
Local Property: neutral to underweight
The property sector remains a challenging space, made all the more difficult by it’s dual characteristics, namely that property shares in SA comprise both locally and offshore situated property. This makes their earnings drivers very different and hence it’s not a one size fits all rules when it comes to JSE property sector.
In terms of locally situated property, we remain nervous, given very high vacancy rates and a dividend yield in the sector which we do not believe is sustainable. Sandton alone is experiencing its worst office vacancy level in more than 20 years, with some estimations putting vacancies as high as 21%. This is about three times the 7%-8% level that analysts consider to be healthy and highlights that rental reviews will be under some considerable pressure, all of which is not good for dividend yields.
Admittedly, not all rentals are reviewed at the same time, but we are hearing anecdotally that some landlords are reviewing their rentals prior to their rent review and moving rentals down, as they are worried that the tenant will simply leave at the next review. In another anecdotal story, second hand office furniture resellers are refusing to take on more stock, even on consignment as there is so much extra stock as company’s downside or go out of business. None of this is good news for local property stocks.
The one area of the property market that is doing very well and this is also a global trend, is storage companies, with the move towards e-commerce and some of our mangers have bought into this story, but are still being careful as valuations are on the high side.
As far as the UK property stocks are concerned, we have traded around these stocks, but clearly there is still huge uncertainty around Brexit. Brexit delay has now been pushed out to the 31st October (happy Halloween?), but it is hard to see how a delay is going to break the impasse between the Tories themselves and between Labour and the Tories. It does feel a bit like Groundhog Day and from what we are reading, most British citizens just want to get a deal done, whatever that entails. Just think how impossible it must be to run a business in the UK that exports or imports goods from the European Union with this uncertainty going on. Whilst it is true that economic data out of the UK has been better than expected for 2019, a large part of this is being blamed on stock piling in the event of a no-deal Brexit and so it is hard to get too excited about the data.
For now, despite attractive valuation in certain stocks, we are choosing to remain underweight UK property, but will look to trade, should prices on UK property stocks trade at silly valuations.
SA Cash: underweight
Cash is still generating attractive yields, but for now we prefer to be underweight and have instead invested money with flexible bonds 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: staying overweight
Stock markets, true to form, brushed aside poor economic data over the quarter and focused instead on the expectations of better data ahead, as central banks began to pump liquidity back into the system, especially the Chinese and European central banks. With one or two exceptions (US employment figures for one) the trend in data released during January was unambiguously negative, with closely-watched indicators such as purchasing managers indices (PMIs) for manufacturing and services in the major economies not only declining in absolute terms, but also falling below consensus forecasts. Later numbers did, however, show signs of improvement, with the composite PMIs for the US, Eurozone and China all reversing direction and picking up as the quarter progressed.
Arguably the most significant and encouraging of these figures from a global perspective was the return of the Chinese manufacturing sector to a positive (i.e. above 50) reading, which suggested that the Beijing authorities efforts to stimulate activity by lowering banks’ reserve requirement ratios on two occasions either side of the (western) New Year had achieved its desired effect. Far less auspicious, on the other hand, was the sharp fall in the corresponding Eurozone Index below that crucial 50 level, particularly since this was driven by an even larger deterioration in activity (to 44.1) – within the region’s largest and most important manufacturer, Germany.
While, in normal circumstances, equity markets’ response to a dramatic slowdown in such a crucial exporting economy would be significant, the presence of one-off and temporary mitigating factors, in the form of major disruptions to the auto and chemical industries (due to the imposition of new vehicle emissions testing standards and abnormally low Rhine river levels that hindered transportation of finished goods) meant that the news was widely anticipated.
Despite having been given the benefit of the doubt in this instance, Europe remains a source of concern for many investors. Indeed, as a key component in the global industrial framework and therefore one of the most important indicators of economic health, the next set of manufacturing data will be important in setting the tone for markets’ expectations.
On the corporate front, the period under review was notable for a pick-up in M&A activity, which saw major deals announced across a number of geographies and sectors, among which, respectively, the US and healthcare / biotech were the most prominent. The final week of March also witnessed the Initial Public Offering (IPO) of on-line ride-sharing business, Lyft – the latest of the so-called “unicorns” (>$1 billion start-up companies) that are expected to list in the coming quarters.
In both respects, this signaled a welcome increase in confidence among management after a relatively fallow period in the second half of last year during which uncertainty over the direction of Sino-US trade “negotiations” has undoubtedly played a major part. Much in the same way, for a different but obvious reason, the UK market remains largely off limits to M&A specialists. Given the resilience demonstrated by both the UK economy and corporate sector in combination with a meaningful discount in valuation, however, it seems likely that, irrespective of the eventual outcome (whenever that may be!), we can probably expect a flurry of corporate activity as soon as there is any certainty on the shape of Brexit.
After recovering to within 3.5% of September’s (local currency) all-time high, markets have moved from being attractively priced at the year-end to, in our estimation, just on the right side of long-term fair value at the quarter-end, with the MSCI World Index trading on a forward price/earnings ratio of 15.6x, based on a 12-month consensus earnings growth forecast of 13.5%. This applies equally to EM, where a cheaper rating (12.4x forward P/E) is balanced by lower earnings growth estimates.
Even if, as is likely to be the case, those earnings estimates turn out to be overly optimistic, these are not demanding valuations and, absent from any unforeseen negative shocks, provides scope for further upside in markets. Moreover, as the managers, through whom we are invested, have ably demonstrated during the period covered by this commentary, increased dispersion within the market at both sector and individual stock level means that opportunities to generate excess returns through stock-picking are arguably as good as they have been for some considerable time.
One area of the market that we have turned much more bullish on during the quarter is Chinese A shares, for a whole host of reasons, but chief amongst those is the fact that when combining Chinese A share with local listed SA shares, the overall portfolio risk reduces, despite the common held belief that buying EM shares does not add diversification benefits to the portfolio. The simple reason for this, is that China A shares are hugely under-represented in the MSCI EM ETF, with the likes of Tencent, NPN, and Alibaba carrying a lot more weight. This is going to change over time as China A shares increase their weight to 16% over the next few years, but as of now, they present only 0.8%, with expectations of this moving to 3% by year end.
Chinese A equities should continue to be supported, not only because of MSCI EM inclusion, but also because of the fact that earnings have most probably bottomed and consensus forecasts for EPS growth of 15% this year, leading the market to be on forward PE of 11.7, trading at a discount to both SA and the US. Trade scuffles have also led to China embarking on structural reforms and tax cuts for SME’s, all of which should be good for future earnings in China.
Global Cash: neutral
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: underweight
As ever, the words and deeds of central bankers remain as much of an influence on bond markets (and equities for that matter) as economic data – the two are, of course closely linked. In this respect, there was plenty for markets to digest during the period under review. After the release of minutes from the Federal Open Market Committee’s meeting in January, reiterated Chairman Powell’s comments on data dependence and “patience” in respect of future interest rate hikes, the record for February’s went a step further by indicating that the quantitative tightening program of balance sheet reduction would end “later this year”. Meanwhile, a warning from the ECB over the potential severity of the economic slowdown within the Eurozone and a statement affirming its intention to, where necessary, dust off the interventionist’s playbook added to the prevailing bullish market mood.
All of which was the catalyst for further strength in core sovereign bond markets, which, after little movement for two months, rallied strongly during March. US 10-year Treasuries ended the period 28 basis points (bps) lower at a yield of 2.41%, having touched a 15-month low, with the Bloomberg Barclays US Government (>1yr) Index posting a 2.11% gain. In Europe, the 10-year German Bund yield went negative for the first time since October 2016 and only the second time in history, falling from 0.24% to -0.02% for an index gain of 2.12% and in the UK, the equivalent Gilt moved from 1.28% to a 1.00% yield (a 21-month low), sending the corresponding Bloomberg Barclays Index up 3.49%.
The favourable combination of “risk-on” and falling sovereign yields was reflected in outsized gains across the credit spectrum. In the US, for example, investment grade corporates and high yield benchmarks recorded their largest quarterly gains – up more than 5% and between 6% to 7%, depending on the index used – since September 2009 and December 2011 respectively (European market numbers were similar). Elsewhere, there was healthy demand for EM debt of all kinds, with the JP Morgan EMBI Index up 6.59% in US Dollar terms and ending the period at an all-time high.
With the Fed and ECB’s newly-adopted dovish tilt calming fears among investors of an imminent plunge towards global recession, the shape and predictive properties of the US Treasury yield curve attracted a little less attention and generated fewer comments than previously. The movements across that curve over the period did, however, send out conflicting signals and in so doing generated plenty of food for thought. Whereas the yield differential between 2-year and 10-year benchmark bonds traded in a tight range between +20bps and +12bps, thereby ensuring that the overall maturity profile retained its (conventional) upward-sloping aspect, there was a further inversion at the short end of the curve, as the 2-year / 5-year spread moved back into red numbers, reaching a low of -8bps: a level last seen in 2007. Thus, while the long end of Treasury market points to continued growth in the US, the short end of the maturity curve suggests otherwise. So which one is right?
Over the past month or so, we have met with or engaged with, via conference call, a number of eminent bond fund managers, all of whom can claim to be among the very top performers within an asset class that experience produces some of the sharpest investment brains in our industry. What has struck us most from these numerous discussions is the broad range and polarization of views on macroeconomics, the direction of interest rates, the prospects for credit, together with pretty much every aspect of the fixed income space. That lack of consensus, which is reflected in the positioning of their funds, is rare, if not unprecedented, in our experience, and would suggest that we find ourselves at an important juncture in terms of future market direction. While it may be the case that some of the smartest managers in the business can’t make up their minds; investors appear, for the time being at least, to have put their faith in the world’s major central banks to successfully restore stability to the global economy.
However, despite Central Banks keeping the bond party alive, we prefer to allocate risk to equities and property across our portfolios, hence we remain underweight global bonds in our portfolios and where we do have exposure, we continue to lean towards EM debt. As mentioned above, German yields went negative again during the quarter and in our opinion, history will judge investors harshly if they buy into these assets, for it is mind boggling that investors would pay money to lend someone money (the ECB will have a lot to answer for in years to come, especially as they have made it near to impossible for banks to make money, given that their margins on what they sell – i.e. money, is negative!).
Lastly, we are slightly overweight global property as yields remain very low globally, but at the margin, we still prefer global equities.
Investment Strategy Conclusion
Risk came roaring back over the quarter and for now, we are overweight risk assets offshore, but preferring to keep our powder dry in the local markets, as the outcome of the SA elections remains very binary (not that dissimilar to Brexit!).