Luigi Marinus, PPS Investments Portfolio Manager
The unsettled world as a result of Covid-19’s broader societal impact of empty sports stadiums and travel restrictions notwithstanding the whipsaw in markets has provided opportunities for certain sectors to thrive sooner than previously expected and has changed the investment landscape in others. So, what has changed and how does this influence investment prospects going forward? From a South African investor perspective, the two main considerations to be discussed are cash and equities; and from a global perspective, US inflation is top of the list.
Is cash still an attractive asset class?
From 2016 until the first quarter of 2020, the repo rate has hovered between 6.25% and 7%. The last breach of the top end of the inflation target band was in the first quarter of 2017, and inflation has moderated since then. This meant that for three years, cash delivered an annual return greater than 7%, around 2% to 3% above inflation which, on a risk-adjusted basis, made a compelling case for a high allocation to cash during this period.
When the lockdown was introduced, the South African Reserve Bank implemented a cutting cycle reducing the repo rate from 6.25% (end February 2020) to 3.5% (end July2020) in five months, which resulted in cash yields declining and the inflation differential reducing. At current yields, the case for cash is less compelling and the allocation to the asset class has been reduced across PPS funds.
What are the alternatives for fixed interest investors, in particularly, those who have relied on the above inflation returns of cash to generate an income? The most suitable alternative would be domestic bonds, although this comes with some risk. On the plus side, the 10- year government bond yield is currently at 9.5%, which is more than 6% above inflation and the steepness of the government yield curve highlights the additional yield above cash across maturities. Bond duration does make the asset class sensitive to interest rate changes and bond yields react to adjustments in economic expectations.
On balance, an appropriate allocation between cash and bonds may provide a yield similar to what cash has previously offered, but the potential volatility could increase. Cash is significantly less attractive as a stand-alone asset class, but by including an allocation to bonds aligned to investment or needs and risk profiles, a suitable risk-return compromise can be attained.
Equities – Is it too late to get in or too early to get out?
There are many ways to assess the relative attractiveness of equities as an asset class. At PPS, we focus on three factors: Valuation, Macroeconomic framework and Momentum, with the ranking of importance of these factors varying as market conditions change.
In the local context, the macroeconomic framework contributes most to informing the neutral domestic equity allocation across the PPS funds. Uncertainties with regard to the roll-out of vaccines, and the impact a possible third wave may have on the economy, tempers the more aggressive allocation, should only valuation and momentum be considered. In addition, GDP growth has disappointed when compared to global GDP growth and emerging market GDP growth expectations.
From a global context, the macroeconomic framework appears more favourable to equities resulting in the maximum overweight allocation to global equities. Cash yields have remained close to zero in developed markets, while; quantitative easing and stimulus packages in the US, as well as Europe, have had a positive effect on equity prices. GDP growth expectations have been upwardly adjusted as vaccine roll-outs have consistently improved in developed markets. Valuations have become more expensive in the sectors that have benefitted from lockdowns, but there are areas of the market that remain better priced.
Trying to time the entry and exit points with equities should not be a question of whether an investor should have high exposure or no exposure. In the same way, asking whether it is too late to get into equities or too early to sell out of equities assumes a significant change to the allocation. The recent performance of equities is only one aspect that is considered when deciding on the allocation to the asset class. Being too late or exiting too early is not the important consideration, as the assessment of current conditions and what that implies going forward provides the framework of whether or not to adjust the exposure to equities.
Should the world be concerned about US inflation?
The last time US inflation was above 3% was in the last quarter of 2011, but that does not mean it can be ignored. To a large extent low interest rates in the US has been a catalyst to increasing asset prices and inflation has remained low, even as quantitative easing has provided liquidity. Increasing inflation is moderated by increasing interest rates; but increasing interest rates have a negative effect on equity returns. This has always been the case, so why the seemingly sudden inflation concerns?
Quantitative easing has provided market liquidity since the financial recession, but this has largely remained within the formal financial economy. The recent stimulus packages announced by the US government put cheques directly in the hands of people with the expectation that this will be spent on goods and services and not investment products. The US Federal Reserve has commented that, should this be inflationary, they are unlikely to increase interest rates in the next 18 months, however, assuming that the rate of the inflation increase is stable.
Even in an unsettled world, two things are clear: all investment decisions are relative and maintaining an investment process makes investing through difficult periods manageable. A decision to reduce a cash exposure cannot be done in isolation, in the same way the trajectory of US inflation needs to be considered before an equity allocation can be decided. Following a process reduces the effect of emotion and bias and inevitably leads to a more thorough and considered outcome. Therefore, making sense of an unsettled world is possible. At PPS Investments, we aim to construct sensibly diversified portfolios where components are poised to perform well through different market cycles.