The unstable world due to the wider societal impact of Covid-19 of empty sports stadiums and travel restrictions despite the misstep in the markets has allowed some sectors to thrive sooner than expected and changed the landscape of investing in others, says Luigi Marinus, Portfolio Manager PPS Investments.
So what has changed and how does this influence investment prospects in the future? From the perspective of South African investors, the two main considerations to be discussed are cash and equities; and from a global perspective, US inflation is at the top of the list.
Is cash still an attractive asset class?
From 2016 to the first quarter of 2020, the repo rate fluctuated between 6.25% and 7%. The last breach of the high end of the inflation target range was in the first quarter of 2017, and inflation has moderated since then.
This means that for three years, cash generated an annual return above 7%, or about 2-3% above inflation, which, on a risk-adjusted basis, argued in favor of a high allocation to cash during this period.
When the foreclosure was introduced, the South African Reserve Bank implemented a reduction cycle reducing the repo rate from 6.25% (end of February 2020) to 3.5% (end of July 2020) in five months, resulting in lower cash yields and a reduction in the inflation differential. . At current returns, the case for liquidity is less convincing and asset class allocation has been reduced in PPS funds.
What are the alternatives for fixed interest investors, especially those who have relied on the above inflation returns to generate income? The most appropriate alternative would be domestic bonds, although this carries some risk.
On the positive side, the yield on 10-year government bonds is currently 9.5%, more than 6% above inflation and the steepness of the government yield curve highlights the yield. additional to cash on all maturities.
Bond duration makes the asset class sensitive to changes in interest rates and bond yields respond to adjustments in economic expectations.
Overall, an appropriate allocation between cash and bonds can provide a return similar to what cash previously offered, but the potential volatility could increase. Liquidity is significantly less attractive as a stand-alone asset class, but by including an allocation to bonds aligned with investment or needs and risk profiles, an appropriate risk-return trade-off can be achieved.
Stocks – Is it too late to enter or too early to exit?
There are many ways to assess the relative attractiveness of stocks as an asset class. At PPS, we focus on three factors: valuation, macroeconomic framework and dynamics, with the ranking of the importance of these factors varying as market conditions change.
In the local context, the macroeconomic framework contributes the most to informing the neutral allocation of national actions through PPS funds. Uncertainties over vaccine deployment and the impact that a possible third wave could have on the economy tempers the more aggressive allocation, if only valuation and momentum were to be considered.
In addition, GDP growth has disappointed relative to global GDP growth and emerging market GDP growth expectations.
In a global context, the macroeconomic framework appears more favorable to equities, which results in a maximum overweighting of global equities. Money yields have remained close to zero in developed markets, while; Quantitative easing and stimulus packages in the United States, as well as in Europe, have had a positive effect on stock prices.
GDP growth forecasts have been adjusted upward as vaccine deployments have steadily improved in developed markets. Valuations have become more expensive in sectors that have benefited from lockdowns, but there are areas of the market that remain higher priced.
Trying to time entry and exit points with stocks shouldn’t be a question of whether an investor should have high exposure or no exposure. Likewise, considering whether it is too late to get into stocks or too early to sell stocks implies a significant change in allocation.
The recent performance of equities is only one aspect taken into account in deciding the allocation to the asset class. Being too late or exiting too early is not the important consideration, as evaluating current conditions and what that means for the future provides the framework for adjusting or not adjusting equity exposure.
Should the world be worried about US inflation?
The last time US inflation exceeded 3% was in the last quarter of 2011, but that doesn’t mean it can be ignored. To a large extent, low interest rates in the United States have been a catalyst for rising asset prices and inflation has remained low, even though quantitative easing provided liquidity.
Rising inflation is moderated by rising interest rates; but rising interest rates have a negative effect on stock returns. It always has been, so why these seemingly sudden inflation concerns?
Quantitative Easing has ensured market liquidity since the financial recession, but much of it has remained within the formal financial economy. The recent stimulus packages announced by the US government are placing checks directly in people’s hands in the hope that they will be spent on goods and services, not investment products.
The US Federal Reserve has said that if this were to be inflationary, it is unlikely to raise interest rates for the next 18 months, assuming, however, that the rate of inflation is stable.
Even in a volatile world, two things are clear: All investment decisions are relative and maintaining an investment process makes investing in tough times manageable. A decision to reduce exposure to cash cannot be taken in isolation, in the same way that the trajectory of US inflation must be considered before an allocation to equities can be decided.
Following a process reduces the effect of emotions and prejudices and inevitably leads to a deeper and more thoughtful outcome. Therefore, making sense of an unstable world is possible. At PPS Investments, we aim to build sensibly diversified portfolios where components are poised to perform well through different market cycles.
- By Luigi Marinus, portfolio manager of PPS Investments
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