Between sky-high valuations globally, Donald Trump’s unpredictable actions in the US and Jacob Zuma’s disastrous leadership resulting in political and economic crises in South Africa, it is probably fair ?to say that the rest of 2017 holds significant risk ?for investors.
Increased risk and heightened uncertainty now come standard with any investment decision, and the ability of fund managers to adapt to these conditions for long-term gain is arguably untested.
Many fund managers continue to advise investors to block out the prevailing “noise” and stick to long-term targets. Unfortunately, the outcome of this advice will only be evident in the future.
But despite the turmoil, equity markets remain buoyant and economic growth and corporate earnings, particularly in developed markets, are on the rise.
Sitting in SA, it is hard to see through the noise, which is made all the more deafening by our escalating home-grown challenges, which means any uptick elsewhere is only felt partially.
Equities remain relatively robust, but corporate earnings in certain sectors are under unprecedented pressure, and the economy is, well, just about growing.
Global equity markets are up with the S&P 500 reaching record highs in September, driven largely by better economic growth prospects and investor confidence, specifically in fast-growing companies like Facebook and Amazon and the rise of biotech and other disruptive businesses.
The sustained bull run has given rise to skittish investors fearing and anticipating the bursting of what some perceive to be a bubble. The Financial Times, among others, reports that fund managers ?are hoarding cash and trying to hedge against possible crashes.
It must be said, however, that fear of a crash and increasing share prices have been sitting comfortably side by side for a number of years. Investor confidence has won out, but that does not mean the risks are ?not formidable.
What are the risks?
- Equity valuations are high. As Ashburton and FNB Securities point out, the S&P 500 reached “a new peak for the five-year long equity bull market”.
The bull market has, they say, coincided with the rise of the FANG (Facebook, Amazon, Netflix, and Google) stocks, which have been the market leaders so far this year, with Facebook up 48% by the end of August, Amazon 29%, Netflix 41%, and Alphabet 19%, against the S&P 500’s 10% rise.
- The US Federal Reserve is ending quantitative easing, introduced through the acquisition of $4.5tr of bonds and assets to stimulate the US economy following the global financial crisis nearly a decade ago – a move aimed at lowering long-term interest rates and boosting the economy and investment.
Although it has not bought assets since 2014, it will now begin to unwind them, paving the way for further interest rate hikes, including one anticipated in December.
The Fed’s actions may lead to some pressure on the US economy, company profits, bond yields and investor sentiment in the US and, by default, similar repercussions in other markets.
- North Korea’s testing of nuclear weapons and escalating tension between it and the US is just one example of rising tensions globally, including the effect of Brexit on the EU.
Within some countries tensions are rising on the back of debt crises, rising poverty levels, fear for jobs in the future, the effect of immigration and challenges of infrastructure and sustainable resources.
The spat between North Korea and the US caused a momentary blip in equity markets, and various reports suggested that investors either expect a rational and benign outcome, or equity markets to just march ahead, no matter what.
Michele Santangelo, portfolio manager at Independent Securities, says with elevated valuations in the US at the moment, any cracks in outlook there will result in a correction in US markets, which will have a ripple effect across the globe, although this does not look likely at the very moment.
The ending of quantitative easing and the process whereby the Fed will reduce the size of its balance sheet also poses a risk, where historically equity market returns have been correlated to the change in size of the Fed's balance sheet, Santangelo says.
According to Market Watch, the global equity rally has been driven by corporate earnings rather than central banks, indicating that a revision of quantitative easing may not have a significant effect on the market.
“The case for further rate hikes in the US is looking stronger and this could put a damper on US growth prospects,” Santangelo says. “North Korea could be one of those unknown potential problems which can cause market jitters and any escalations in the conflict between the US and North Korea could quickly put markets in a risk off mode.”
Given all of the risks, commentators say fund managers are hoarding cash and looking at hedging against turbulence and they warn that a major correction could be overdue.
George Cipolloni, a senior portfolio manager at Chartwell Investment Partners in the US and Nedgroup Investments Global Cautious Fund sub-investment manager, says volatility and unrest in markets create opportunities to find value, and that “good companies, or improving companies with good future prospects, should be able to perform well in any conditions”.
Cipolloni says equities reacted positively to Trump’s election, while the US Treasury market did not, and bond yields spiked. Trump’s proposed corporate tax cuts would be good for companies, he says. High valuations mean it is increasingly difficult to find value – “but that doesn’t mean it’s not there”.
Franklin Templeton Global Equity Group’s Cindy Sweeting and Antonio Docal say markets are showing “a somewhat cautious, if not uncomfortable, optimism”.
“Experimental central bank monetary policy across the globe has fuelled global stock price appreciation, but a dangerous dependency on stimulus to generate ever-higher market returns is a possible side effect.
“This could present challenges for future equity market performance as major central banks gradually move to normalise extraordinarily supportive policy measures.”
Franklin Templeton raised some concerns for the rest of the year, including diminishing investor confidence in Trump’s ability to enact pro-business policies and it is not sure that his plans to lower taxes or boost infrastructure spending will materialise in legislation.
European markets, however, have benefitted from “positive economic growth, supportive monetary policy and market-friendly election results,” European GDP growth has outpaced that of the US over the past year and corporate profits have been accelerating.
Franklin Templeton said that “corporate earnings and cash flow generation will matter most for equity returns going forward”, although central bank policy will continue to demand market attention in the second half of the year.
Emerging markets have shown strong returns in 2017, and UBS Wealth Management cited China, Indonesia, Russia, Thailand and Turkey as investment options but snubbed SA due to expensive valuations, low earnings and political infighting.
“Our trajectory for investment is veering from other emerging markets and for South African investors, the local risks add another layer of risk which are not encouraging.
“Locally it is all a political story,” says Santangelo.
- The ANC elective conference in December could be a turning point for investment, but this is unlikely given the ANC’s inability to act against Zuma.
If deputy president Cyril Ramaphosa edges in, there could be a more investor-friendly environment, but the odds are stacked in favour of continued poor management of the economy, increasing poverty and unemployment as well as higher levels of corruption and wasteful expenditure, all of which scupper economic growth and increased investment potential.
- Further rating agency downgrades still loom large for South Africa. Moody’s, which has a sovereign credit rating of one notch above junk status for the country after a downgrade in June, is expected to give its next credit assessment in November.
It has indicated that it is not seeing positive signs and commented specifically on radical economic transformation and its risks to growth and the undermining of investor confidence.
Moody’s said that in the run-up to the elections “the commitment to difficult (and hence less popular) reforms aimed at promoting growth and consolidating government finances has been weakening, such as the much talked about reform of state-owned enterprises which has stalled”.
- SA may have come out of recession, but there is little prospect of economic growth. The Reserve Bank has forecast GDP growth of just 0.6% for 2017 and 1.2% in 2018. At these levels, investors would be silly not to look elsewhere for decent returns.
Differences over whether local companies are or aren’t hoarding cash do little to hide the fact that SA is not seeing meaningful inward investment, nor are most of its companies investing locally.
The fact that over 60% of JSE-listed company earnings are derived offshore indicates the sea change in investment decisions over the past decade.
For individual investors, the story is no different. “Given all the risks, it is good to have a decent percentage of your portfolio offshore,” says Santangelo. Despite some renewed interest in emerging markets, “South Africa’s idiosyncratic issues suppressed investor appetite”.
“The biggest risk in the short term is the potential downgrade by Moody’s in November,” comments Santangelo. “If we see a downgrade of local debt, investors won’t be able to invest in the local bond market and local bonds won’t be able to be included in indices.”
Moody’s would be watching the Medium-Term Budget Policy Statement, out towards the end of October, carefully, “but it would have to be robust and market-friendly to attract investment and it is likely not going to be, especially with talk of the nuclear deal coming back”, he says. “It will be difficult for Treasury to sway investor sentiment.”
How to invest given the risk outlook
Fund managers continue to encourage South African investors to invest globally.
For local investors, there are a lot more opportunity sets offshore, says Santangelo. “There are a lot of strong-performing emerging markets to invest in as well as investment themes globally which are not available in South Africa, like robotics and the Internet of Things.
“There is the opportunity to invest in growth themes, whereas locally investors are going to struggle to get returns,” he explains.
There are some opportunities for investment in some good local mid-cap stocks, which have been hammered lately and are set to recover.
Lester Davids, trading desk analyst at Unum Capital, says he favours Coronation Fund Managers, a former JSE high-flyer that has lagged the market over the past few years because of its exposure to resources and slower growth in assets under management off an increasingly high base.
But the resources sector is recovering, and Coronation indicated that it had re-opened some of its institutional funds, which “should re-accelerate inflows going forward”.
Unum Capital also holds a number of other mid-caps including Blue Label, Clicks Group, Impala Platinum, Pioneer Foods and Sygnia, and has both Distell and Coronation on its radar.
Meanwhile, BlackRock recently said it remains neutral on US stocks and overweight on emerging market equities, favouring Asian stocks.
The MSCI Emerging Markets Index’s rise of close to 30% this year has been fuelled by the performance of companies like Samsung, Alibaba and Tencent.
Ashburton Investments portfolio manager Jan Botha and investment analyst at FNB Wealth Chantal Marx said there is a growing interest in disruptive technology underpinned by strong cash flows and good profitability.
Comparing new technology companies to those in the dot-com bubble at the turn of the century, FANG balance sheets are more robust with large amounts of cash on hand, free cash flow margins are better and – most importantly – they are profitable and trading at reasonable multiples relative to growth.
They said Facebook beat earnings expectations in the second quarter with revenue growth of 45% and profit growth of 71% and progress with Instagram, which was expanding rapidly, expectations that WhatsApp and Messenger will monetise in 2018 and the integration of AI.
Amazon grew revenue 26% and, despite its size, there are significant growth opportunities. They said sales growth is anticipated to remain robust and it has recognised the constraints of online grocery shopping by investing in a brick-and-mortar footprint.
Amazon Prime is expected to continue growing top-line and the type of income it provides (subscription based/annuity) is attractive, they said. The Whole Foods acquisition offers distribution capability for Amazon’s other businesses.
“Virtual and augmented reality could be a game-changer for online retail, especially in clothing,” they said, and it could have a strong impact on purchase rates and lower return rates. They warn, however, that ongoing investments in fulfilment and new business lines will be at the expense of near-term margins.
Netflix grew revenue 32.3% as it added 5.2m subscribers, 2m more than expected.
The entertainment company may be losing content from its most important supplier in Disney, but its strategy to pivot to originals, build its own global content brand (30% of total spend), and vertically integrate into self-production mitigate this loss. This loss of Disney-branded films will not impact the service until the second half of 2019.
Alphabet revenue was up 21% and is in a market-leading position in search and video, although it is trading at an all-time high and has struggled to break into social media and messaging.
They expect that over the next 12 months Facebook would grow earnings by 48%, Amazon’s earnings would drop 22%, while Netflix would grow 166% and Alphabet 9%.
This was against expectations of a 16% growth in the JSE All Share Index and 6% in the S&P 500. At forward price-to-earnings multiples (P/Es) of 24.4, 60.9, 70.6 and 20.3 respectively, their valuations are rich, but “top-line growth is expected to remain robust and over time the investment in revenue will filter through to the companies’ respective bottom lines”.
Chartwell looks for businesses that “are trading at a discount, but have improving return on capital, healthy balance sheets, strong competitive positions and (new) management teams with good track records of turning companies around”.
These companies can do well under any conditions, says Cipolloni, who likes Nintendo, Nokia and Ericsson.
Orbis Investments director Dan Brocklebank says this is a good time to be investing in stocks “that are being shunned due to prevailing market sentiment”.
“We invest where the biggest discounts to intrinsic value lie. Sometimes whole industries are cheap and sometimes just a few companies.
“In general we find that there are interesting valuation discrepancies in most industries at the moment, resulting in a number of idiosyncratic investment opportunities,” he says. Globally, Orbis likes JD.com in China and MercadoLibre in Latin America.
Franklin Templeton says it is avoiding the banking sector, state-owned enterprises and industrials and prefers companies in healthcare, insurance and information technology.
According to Franklin Templeton, the UK has had a tougher time than broader Europe but it remains a relatively attractive equity market. The FTSE 100 Index offers the highest dividend yield of any major region (measured by the MSCI World Index), it said.
Old Mutual Edge28 Fund co-manager Arthur Karas says his fund is positioned for rate cuts, with increased holdings “in SA bonds, SA listed property, SA banks and credit sensitive retailers while reducing cash exposure”.
“Any investment decision with a long-term investment horizon becomes challenging when focused on a potentially binary political outcome.
“Our discussions with domestic banks confirm that both large corporates, smaller businesses and individuals are all behaving in a similar fashion, curtailing new capital investment, hoarding cash or investing offshore,” he explains.
This environment is not encouraging for future profit growth, he adds. “Combined with other dubious policies, such as a Mining Charter that is very discouraging of new mining investment, it’s hardly surprising that foreigners have been selling South African shares.”
The South African bond market, on the other hand, has seen steady inflows. “Yield-hungry global investors seek to exploit the large spread between SA bonds and sovereign yields available elsewhere. These investors must believe that our political and economic woes are sufficiently discounted into our 8.5% yields.”
This is a shortened version of the cover story that originally appeared in the 5 October edition of finweek. Buy and download the magazine here.
Source : http://www.fin24.com/Finweek/Investment/investing-in-turbulent-times-20171012