Considering the impact of rising interest rates on our portfolios
We f i nd ourselves i n extraordinary times. Ninety percent of the industrialised global economy is subject to near-zero interest rate policy, and central banks have adopted extremely accommodative monetary policy to counter the effects of the global f inancial crisis and the unwinding of a debt ‘super-cycle’. As a result of these interventions, we find most interest rates in developed markets, both short and long term, at multi-generational, or, in some cases, all-time lows.
The consequence of very compressed yields on cash, government bills, treasuries and investment grade credit is that investors requiring income from their investment portfolio have been forced further out on the risk curve, into things like property, high yield credit, equities and emerging markets. To maintain yields, investors have had to move into riskier assets and securities.
The key question that investors should be asking themselves today is: am I being compensated for the risk that I am taking? In other words, am I being compensated via current yield and sustainable future growth thereof for the risk that, at some stage, the world economy reverts to looking more normal?
Remember that in this world of ultralow yields, a small positive increase in inf lation expectations could have a pronounced impact on asset prices in some areas. For example, Should G7 bond yields revert to their 10-year average, investors in those bonds, typically the lowest risk investors, would suffer an 18% loss. If the price-to-earnings (P/E) ratio of the FTSE/JSE INDI 25 Index were to revert to its 10-year average, the capital loss would be in the order of 33%. The list goes on. (Sources: Bloomberg, I-Net, PSG Asset Management.)
Our portfolios are constructed in a bottom-up fashion. We carefully analyse all the securities across the yield spectrum (from cash to high risk equities) and decide whether the specific securities meet our required rate of return, given our view on the underlying risk of the security. We like to invest with a margin of safety and are happy to walk away from investment opportunities where we think that it is possible that our clients could lose money. Our summation of the current conditions on financial markets is that an investment into some of the traditionally lower risk asset classes (government bonds, property and low beta equities) carries a high likelihood of capital loss and most of these assets are overpriced. Accordingly, we do not own government bonds, property and bond-like equities.
Within equities, we have been finding significantly fewer opportunities to invest
FUND MANAGER, PSG ASSET MANAGEMENT in higher quality businesses at reasonable valuations on the JSE. As a result, our portfolios are not fully invested in domestic equities. Our domestic funds have utilised the full extent of their mandates to buy attractively priced global businesses with quality franchises.
The result of having very l imited exposure to duration assets and being less than fully invested in equities is that our multi-asset portfolios sit with relatively high levels of cash, which would become larger contributors to portfolio returns as interest rates rise. Cash also provides f irepower to be employed if valuations normalise and opportunities arise to buy attractively priced higher duration assets. We think the value of cash at this stage of the investment cycle is both attractive and underappreciated.
Now i s t he t i me f or i nvestors to consider whether they are being compensated for the risk they are taking in their portfolios. We are comfortable that we are not putting our clients’ capital at risk by chasing overpriced assets and securities. We take f urther comfort from the fact that we can still find good opportunities in very specific assets and securities both at home and abroad.