Will it be a ‘sweeter 16’ for investors?

PF 16Jan pg1 updateIOL PF Illustration: Colin Daniel

The year began with a steep decline in global financial markets, the rand suffered a flash crash and the outlook for the local economy has been labelled “bleak”.

But if you are a long-term investor, you should not let this depressing news get you down too much, because if you are invested with a good asset management company, its fund managers are likely to see opportunities in the short-term market falls.

One manager has gone as far as to predict the year will turn out to be a “sweeter 16” on global financial markets, but most are warning it will be a year of volatility, and diverging monetary policies will create a greater disparity in the returns from different markets, requiring their careful navigation.

Old Mutual Investment Group (Omig) says that, after the Chinese market fell seven percent and closed for two days, there was a sharp decline of global stock markets in the first week of the year. It was the worst start to the year for the United States market in the past three decades, while the JSE had its worst start to the year in at least two decades.

However, Ed Perks, the chief investment officer of Franklin Templeton Equity, believes that, despite the volatile start to the year, global equity markets could be poised for a “sweeter 16”.

Perks says the markets were weighed down last year by sputtering growth in developed economies, slumping emerging markets and collapsing commodity prices.

But Franklin Templeton is generally optimistic about the prospects for global equities because there have been further declines in unemployment in key regions, the wage outlook for the broader global economy is improving and corporate profits are proving resilient.

Sanisha Packirisamy, an economist, and Herman van Papendorp, the head of macro research, at MMI Holdings, say they believe investors should have maximum exposure to offshore assets this year and within global asset classes they prefer equities to fixed-income instruments.

They say the global recovery will be shallow and uneven, with 2016 characterised by further desynchronisation among the major economies in economic growth and monetary policy.

A sturdy growth outlook and stable inflation expectations are expected to prompt central banks in the US and United Kingdom to nudge interest rates higher from ultra-low levels. On the other hand, weaker conditions and fragile growth trajectories in Europe and Japan are likely to see the European Central Bank and the Bank of Japan maintaining easier monetary policies for some time to come, Packirisamy and Van Papendorp say.

With US unemployment dropping, a consumption-led recovery is expected to leave the world’s largest economy as the relative bright spot globally, they say. This is in spite of sluggish global demand and a firm US dollar holding back faster acceleration in exports and investment growth.

Packirisamy and Van Papendorp expect domestic demand will result in mild economic growth in the Eurozone this year, as low oil prices, a slow recovery in credit growth and an easy monetary policy – which may need to be extended – boost consumption spending. Public spending in response to the rising number of asylum seekers could also benefit growth, they say.

Perks says Franklin Templeton is comfortable that, provided there isn’t a substantial escalation in geopolitical tensions, markets will eventually look beyond the short-term issues and return their primary focus to the merits of individual shares or bonds.

In the meantime, however, the over-reaction by financial markets to short-term negative news has created attractive investment opportunities for disciplined long-term investors, Perks says.

He says a key feature for 2016 is that company profit levels are high, giving companies the flexibility to implement measures such as mergers and acquisitions, increased investment and capital expenditure, balance-sheet enhancement, dividend growth and share buy-backs.

In addition, he says, many companies have shed non-core assets and reprioritised investment opportunities to improve returns.

Low energy costs and prices for many commodities, moderate wage price pressures and low interest costs on borrowing are likely to continue to help improve company profits, Perks says.

While many investors are concerned about the impact of higher interest costs on corporate profits and, ultimately, share prices, Franklin Templeton believes other factors, including lower debt-to-capital levels, need to be considered.

Perks says that despite uncertainty about global economic growth, numerous growth themes remain, offering investors many opportunities. Examples are the rising fortunes of the middle class and the increasing reach of mobile technology, he says.

The Investment Institute of the world’s largest asset manager, BlackRock, says the business, credit and valuation cycles will be crucial for further gains in equities and property this year, now that the impact of the easy monetary policy cycle is fading.

With valuations no longer cheap and corporate profit margins under pressure in many markets, economic growth is needed to boost revenues, and BlackRock expects only muted gains for most equity markets in 2016.

“Careful navigating” will be critical in 2016 because … valuations appear to have leapt ahead of the business cycle in many markets, especially in the US. We have essentially been borrowing returns from the future,” the institute says.

Most equity markets were “running on empty” in 2015, the institute notes, with multiple expansion (rising price-to-earnings ratios) and dividends hiding “sins” such as flat or falling profits.

However, the institute is predicting a modest pick-up in global economic growth.

LOCAL MARKET DISAPPOINTS

The local equity market returned just over five percent last year and only 0.2 percent in after-inflation (real) terms (go to link, below).

The outlook for the local economy is bleak and, to complicate matters, rand-hedge shares that are likely to benefit from rand weakness are trading at high prices.

Peter Brooke, the head of Omig’s MacroSolutions boutique, says the the implications of the global financial market sell-off early this year for South Africa include a weaker rand, more inflation, additional rate hikes, fiscal tightening and weaker economic growth. However, he says, it is difficult to gauge the extent to which the local economic environment will deteriorate this year.

The bleak economic outlook for South Africa has asset managers banking on rand-hedge shares that earn a good portion of their earnings offshore, rather than the so-called “SA Inc” shares that earn most of their profits locally.

But rand-hedge shares are now starting to look expensive relative to SA Inc shares. Renier de Bruyn, an investment analyst at Sanlam Private Wealth, says that over the past five years, SA Inc shares have under-performed and they are now trading on lower valuations (prices relative to earnings) than rand-hedge shares.

De Bruyn expects SA Inc shares to out-perform should the rand strengthen, but cautions that it is notoriously difficult to predict movements in the rand. The rand is vulnerable to negative investor sentiment towards South Africa and emerging markets in general, which is arising from fears of a slowdown in China, low commodity prices, and the economic recovery and rising interest rates in the US.

De Bruyn says these considerations have led Sanlam Private Wealth to conclude that it is too early to shift its portfolio away from rand-hedge shares.

INVESTING OFFSHORE IN THE FACE OF A FALLING RAND

Fund managers are still betting on offshore equity markets to provide the best returns in the year ahead, but when the rand is weak relative to the major currencies, as it currently is, it is expensive for local investors to invest offshore.

You should invest in line with a plan that includes a level of offshore investments suited to your goals, stick to it and don’t try to time the rand, Izak Odendaal, an investment analyst at Old Mutual Wealth, says.

If you try to time the valuation of the currency, you are likely to get it wrong, he says. There are many reasons the rand could either strengthen |or weaken, so you need to have a long-term view of your offshore investments, rather than respond in a knee-jerk manner to any rise or fall in the rand.

If you are investing monthly and continue to do so despite the movements of the rand, the ups and downs in the rand values at which you invest will even out over the long term, Odendaal says.

If you are saving into a South African multi-asset fund that has offshore exposure, the fund manager will make the decisions about investing offshore for you. Because the offshore exposure of South African funds is capped at 25 percent, if the rand drops in value, the manager may be forced to sell some offshore investments and rebalance into local shares, Odendaal says.

He says if you are saving in a retirement annuity and have reached your maximum offshore exposure, you should not worry too much, because investments on the JSE give you a lot of exposure to rand-hedge shares, which earn a large portion of their earnings outside South Africa. Almost half of the earnings of the FTSE/JSE All Share Index come from outside South Africa, Odendaal says.

It is trickier to decide on a lump-sum investment into foreign markets when the rand is so weak, but if you keep your money in cash and phase it into the market over several months, the lower cash returns can be a drag on the overall returns you earn, he says.

The uncertainty about the rand is an argument for diversifying across asset classes, Odendaal says. If the rand strengthens, property and bonds will do better, but if it weakens, offshore investments and rand-hedge shares will do better.

Asset class returns on local investments since 1925

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