Asset Manager Review
Some are saying that we have entered an era of low growth and low investment returns – although the link between economic growth and investment market returns is often disputed. What are your views on this? Natalie Phillips, head of institutional at INVESTEC ASSET MANAGEMENT says the IMF has forecast that global growth will recover in 2017 to 3.4 percent and average 3.6 percent between 2017 and 2021.
While this would be better than 2016’s estimated 3.1 percent growth rate and is not the secular stagnation that some economists have warned about, it remains below the average of the last 20 years of 3.8 percent.
The reason for lower growth is a combination of high debt levels, deteriorating demographics and declining productivity. Izak Odendaal, investment strategist at OLD MUTUAL MULTI-MANAGERS says After the 2008-crisis, a “new normal” period of low returns was predicted.
While interest rates have been stuck at or close to record lows, some asset classes have done well. US returned 16 percent annualised returns from March 2009 to January 2017. Local equities did well initially, though not so much over the past three years.
The FTSE/JSE All Share Index also returned around 16 percent annualised since March 2009 in rand (the dollar return was much lower but still respectable at 11 percent per year).
The surging US dollar since 2011 means that dollar returns from outside the US look poor across the board.
Studies show that rapid economic growth over the long term does not necessarily lead to fantastic long-term equity returns. Share prices follow earnings, so what counts is whether faster economic growth can be transformed into profits.
It depends whether companies can capture reasonable share of economic growth (as opposed to labour and government) and whether shareholders get a de- cent share in turn (as opposed to management and investment bankers).
Economic growth has indeed disappointed since 2009, but global growth has been more or less in line with the long-term trend.
The disappointment stemmed from the fact that one would expect above-trend growth following the deep global recession.
Several major economies experienced recessions since 2009 (Europe, Japan, Russia and Brazil), contributing to poor investment returns from these regions as recessions tend to cause profits to decline or turn into outright losses.
Part of the problem with the “new normal” thinking is that it assumes that the commodity supercycle and credit-fuelled boom of 2003-2008 was the “old normal”.
But it is probably more correct to view that period as the outlier. The crash and immediate aftermath saw the pendulum swinging violently the other way.
Now normality appears to be slowly returning after years of deleveraging. Global economic activity appears to be picking up and the deflation fears of the past two years are passing.
This has driven market higher with a bit of help from President Trump’s expected (but not yet delivered) policies.
Ultimately, the starting valuation is a crucial determinant of returns. The likelihood of a good return is much higher when an asset is bought cheaply.
Valuations can swing around with shifts in sentiment, especially in the short term. In 2009, equity markets were extremely cheap on depressed sentiment and offered a once-in-a-generation buying opportunity.
However, now headline equity valuations are average for most major markets, perhaps slightly above average (with interest rates well below average) pointing to moderate returns below the longterm norm going forward. Kent Grobbelaar, Head of Portfolio Management at STANLIB MULTI-MANAGER says the company’s view is that we don’t understand why there’s a dispute.
We believe the reason there’s confusion, is because a key variable (valuation) is often not included in the debate. The level of the market is determined by both earnings and valuation.
Therefore strong economic growth can result in good earnings growth, which in theory should drive markets higher.
The problem is, if Mr Market has already factored in the aforementioned, then there clearly won’t be any link.
“We concur with the view that we’re in an era of low growth and low investment returns largely because expectations baked into markets, and especially the US, are high leaving room for disappointment.
“In addition, the structural problems of low productivity, bad demographics and significant debt, haven’t gone away and could well be headwinds for the global economy.
“A flatter frontier would be our base case,” says Grobbelaar. Neville Chester, senior portfolio manager at CORONATION FUND MANAGERS says the statement that the linkage between economic growth and asset returns is weak is correct.
“We have been through a period post the financial crisis where economic growth was weak but asset returns were generally good due to central bank interventions and quantitative easing.
“To assess what future returns will look like one has to assess what base we are coming off.
“In South Africa, you can currently buy a 10-year government bond yielding 8.8%, or you could buy the majority of the mid-cap listed property stocks with yields in excess of 8%.
“Given that we expect inflation to average below 6% for this year, there is immediately the potential for positive real returns, assuming a stable political environment. Similarly, the JSE has been flat for close to two-and-a-half years.
“If you exclude a couple of specific heavyweight stocks that have outperformed, the index would be down over this period.
“Given this de-rating, we are more optimistic on the return potential for local stocks than we have been for a number of years,” says Chester. Haakon Kavli, portfolio manager & analyst at PRESCIENT INVESTMENT MANAGEMENT says over the last five years, economists have debated the risk that we have entered a global era of “secular stagnation”, that is an era of low growth, low inflation and low returns.
“This concern may seem strange if one were to look at current global macroeconomic data.
‘For example, US unemployment is currently at 4.7 percent (down from 10 percent during the global financial crisis) and the Federal Reserve keeps policy rates near record low levels (0.5-0.75 percent).
“The combination of full employment and monetary stimulus would normally be expected to boost both growth and inflation.
“But investors have for a long time stuck to their expectations of low growth, low inflation and low returns.
“This view was most intensely priced six months ago, when bond markets reflected inflation expectations of 1.5 percent over the next 10 years in the US. Yields on US 10 year bonds were at 1.4 percent; and German and Japanese 10 year yields were negative.
“With less than 0 percent gain on a ten year investment, one can surely say expected investment returns are low.
“Surprisingly, with Trump’s victory this secular stagnation hypothesis was quickly forgotten. US bond yields jumped back above 2.5 percent and equities rallied in expectation of improved company profits.
“Inflation expectations jumped back to the Fed’s target of 2 percent. Investors who for years had thought secular stagnation was immune to policy, driven by unstoppable demographic forces, suddenly changed their minds overnight.
“Our view is that markets have overpriced the impact of a Trump presidency. Overall we see a rather robust global economy, where growth is slow but stable and expected investment returns remain low due to stretched valuations.
“Our estimates suggest this trend will continue in 2017. Asset allocation is difficult in this environment.
“Equities come with considerable risk and offer limited realistic upside. Local bonds offer some risk compensation but are exposed to political risk, rand depreciation and inflation surprises.
“In total we therefore view corporate credit to be the most attractive driver of risk adjusted returns in 2017,” says Kavli. Kyle Hulett, deputy chief investment officer and head of multi-asset class at ARGON ASSET MANAGEMENT says it is true that the link between low GDP growth and low equity investment returns is unclear.
However, it is important to understand why growth is expected to be low; and to understand the monetary policies that have been implemented to address low growth and how these affect investment returns.
“Economic growth is expected to be low due to a combination of factors that have not been seen before in Western history. Only Japan has experienced this combination of growth headwinds that include an ageing population, falling productivity and peaking debt levels.
“These forces have created a savings surplus that has pushed interest rates down to new lows. In some countries interest rates are even negative.
“This, and the quantitative easing policies that central banks have deployed to stimulate economies have in turn distorted asset class valuations.
“So, it is not only the low growth that affects investment returns, but also the historically high valuations that are a consequence of quantitative easing,” says Hulett.
“Ageing populations mean an increase in retirees, which pushes equity valuations down. Falling productivity affects company margins and therefore their earnings.
“Peak debt levels mean greater debt servicing requirements for consumers, corporates, and governments.
“These factors all decrease demand and reduce pricing power, which again affects revenues and margins.
“So, while low growth in and of itself may or may not affect investment returns directly, the current causes of low expected growth rates do affect equity investment returns negatively on their own.” Peter Brooke, Head of MacroSolutions boutique at OLD MUTUAL INVESTMENT GROUP says the firm has been proponents of a “low return world” for some time now and this remains the case, predominantly driven by valuations.
However, a ray of light comes from the local equity market which has been going sideways for the last couple of years.
This has resulted in some valuations being refreshed and we have upped our long-term real return from South African shares.
“On our five year investment time horizon, we now think it is possible to deliver a real return of 4 percent on a balanced fund. While this is lower than we have delivered historically, it is better than what has been available in the last couple of years.
“We also expect cash yields to fall, meaning savers can no longer sit on the side-lines.” Duncas Artus, portfolio manager at ALLAN GRAY says the level of returns that a portfolio can produce over time depends on the starting valuations of the assets it is invested in, rather than the level of economic growth.
There is little correlation between real equity returns and per capita GDP growth over the long term. With global interest rates still at historically low levels, one has to expect that absolute returns from fixed income will be low.
The low level of interest rates has driven some equity markets, such as the US, which has generated strong returns since the crisis. However, valuation levels now appear stretched, in our view.