Real returns in the real world

By William Fraser

During the past seven years investors have experienced an extraordinary global macro and investment environment. A collapse of a major financial institution, a deep global recession, unprecedented monetary and fiscal policies by central banks, steep falls in most commodity prices, negative-yielding long bonds in a number of developed market sovereign (and even some corporate) bonds, followed by a slow but steady recovery in the driver of global economic activity, the US.

It is pretty remarkable therefore, to note that not a single asset class produced a total return below inflation during this seven-year period when measured in rands (returns since inception of the Nedgroup Investments Stable Fund also included).

The global investment environment today is part of the way through a normalisation process. Interest rates - while still very low and near zero in many developed economies – have little room to fall further. 

In the US, the Federal Reserve has indicated that interest rates in that market are likely to increase in the not too distant future. The trough in global inflation, brought about by falling demand, excess labour, and falling commodity prices – among other factors – has turned the corner. The risk of deflation has reduced significantly, but remains a tail risk should global growth falter.

Local interest rates are set to increase before the end of the third quarter. The tailwinds from falling oil prices have been wiped out, due to a partial reversal of the fall in prices, a weak domestic currency, and increases in fuel-related taxes. Additional factors causing a rapid rise in inflation towards year-end include fears of a material food inflation cycle; higher electricity tariffs and the associated cost for manufacturers, retailers and landlords; wage growth inflation not offset by productivity gains; and lastly imported inflation cost which to date has not been passed on to consumers in full. A fine balancing act is required when the MPC decides when and by how much to increase interest rates, given the very weak domestic economy. Household consumption expenditure has been the mainstay of economic activity, driven by government employment and high real wage growth. The latest Quarterly Bulletin highlights the conundrum the SARB faces: while non-durable goods growth (food and petrol) has remained positive, semi-durable and durable goods growth have turned negative. Increases in interest rates will further dampen demand in these segments. While this may be the medicine required to heal the economy, the appetite from the reserve bank and government to further dampen growth in the near term is questionable.

After 25 years of falling bond yields, we are now starting to see increases from these very low levels. Long-duration bond yields have been anchored by low (near zero) benchmark interest rates, falling inflation expectations, and more recently quantitative easing policies by central banks. The US Federal Reserve has reduced their involvement in government bond markets, only reinvesting coupons of the bonds on their balance sheet. In contrast, the European Central Bank and the Bank of Japan continue with outright purchase policies. A slow hiking cycle, still low inflation, and liquidity provided from central bank policies may cap the peak in bond yields well below previous peak levels. Faster rising real yields may ultimately have the biggest role to play in future asset class returns. While bond yields have risen, current entry levels leave little scope for error. The risk for permanent capital impairment in global bond markets remains high.

Domestic bond yields have been under pressure more recently. The changing rates outlook in the US, rising global inflation expectations, a currency under pressure, international portfolio disinvestments from local bond markets, and the local inflation and rates outlook are all contributing to the change in yields locally. Furthermore, a still wide budget deficit and rising debt/GDP ratio locally is threatening the investment grade status of SA government bonds. Near term, the outlook for yields remains negative but the uncertainty is presenting opportunities to increase the duration of the portfolio.

Global equity markets have responded to investor demand during the period of low and falling real rates. The PE multiples on many global markets have risen materially from the crisis period. Importantly, earnings growth – in particular in the US – has outpaced the growth in share prices in the last five years as is evidenced in the chart below. Fiscal policies – and QE in particular – has resulted in low volatility during this period. We expect volatility to change to more normal levels once interest rate increases become reality.

The near-term outlook for company earnings in particular in the US is turning marginally negative. The strong dollar is reducing the 40% of S&P 500 earnings earned in markets outside the US. This is important as the US is in many ways the steer for other global markets. At face value, the current market PE may therefore seem excessive, given the lack of near term earnings growth. Longer term, the prospects are much improved. US economic activity is likely to benefit from improvements in the labour market, some wage growth, a supportive housing market, low energy costs, fixed capital formation growth, and a still accommodative interest rate policy. The economic cycle is therefore likely to remain in expansionary mode for some time, in the absence of a major geopolitical event. Company earnings generally grow during expansion phases, in time leading to higher share prices – see chart on opposite page. We believe global shares are best placed to deliver returns in excess of the inflation + 4% p.a. objective of the Nedgroup Investments Stable Fund over the next three to five years.

In contrast, the ALSI appears fully valued at best. Quality companies with more visible and certain earnings are trading at premiums to the market. Earnings expectations for more cyclical companies seem elevated, despite the valuations they trade on. The risk of permanent capital impairment is lowest in quality companies – despite the current premium. We have reduced the allocation to local shares in the fund during the last 12 months, and continue to find more selling than buying opportunities.

The outlook for the local currency remains uncertain over the short term. The near-term depreciation has been steep, but by no means a ‘blow-out’. Purchasing power parity models based on CPI or PPI suggest a recovery from current levels. Models based on unit labour cost – i.e. how competitive we are with other manufacturers globally – suggest a very different result. Longer term, in the absence of further terms of trade gains, the lack of competitive labour markets may provide a sense of the future level of the currency. For this reason, we remain at the maximum offshore allocation permissible.

The current portfolio structure reflects a cautious outlook over the near term. The equity allocation of the fund is below 30% in total, while the local share position has fallen to 10%. Globally, we have a higher allocation to consumer discretionary, IT, and healthcare sectors, and less in energy, commodities and consumer staples. Domestic bonds remain a small portion of the portfolio, but the allocation is rising as yield increases provide more secure entry points. Listed property by contrast remains a very low allocation, and as a sector remains expensive. The cash position is high, and a short-term drag on performance, but does provide stability in a world where volatility is increasing, and creates optionality should individual or asset class opportunities present themselves.

We continue to warn investors to expect lower returns over the short term. The real return world highlighted at the start is not normal. Asset classes do not all move in the same direction. Expect and embrace rising volatility, as it will bring opportunities to ensure future returns in excess of the Nedgroup Investments Stable Fund’s objectives.