As­set Man­ager Re­view

The Star Late Edition - - COMPANIES -

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? Pa­trice Ras­sou, head of eq­ui­ties at SANLAM IN­VEST­MENTS says Pres­i­dent Trump’s vi­sion to “make Amer­i­can Great Again” has been com­pared to that of Franklin D Roo­sevelt who boldly said that “the re­ward for a day's work will have to be greater, on av­er­age, than it has been, and the re­ward to cap­i­tal, es­pe­cially cap­i­tal which is spec­u­la­tive, will have to be less”.

How­ever we are cur­rently a mil­lion miles away from the mid2000s, when Chair­man Ben Ber­nanke ob­served that we are in an era of great mod­er­a­tion, laud­ing new found eco­nomic flex­i­bil­ity and re­silience, while prais­ing cen­tral bankers’ steer­ing the world eco­nomic around ma­jor eco­nomic shocks.

While Pres­i­dent Trump may not be the next FDR, the fu­ture is likely to be very dif­fer­ent from what we have ex­pe­ri­enced since the naugh­ties dur­ing which fi­nan­cial re­turns were boosted by record low in­ter­est rates.

Maybe to echo the words of the FDR, we are about to en­ter an era where other fac­tors of pro­duc­tion – es­pe­cially labour – will de­mand their fair share and in­fla­tion may rear its head again.

This would equate to lower re­turns on cap­i­tal and greater eco­nomic un­cer­tainty – both of which would lead to lower in­vest­ment re­turns. Sa­man­tha Har­tard & Chris Fre­und, port­fo­lio man­agers at IN­VESTEC AS­SET MAN­AGE­MENT say the com­bi­na­tion of lower real eco­nomic growth rates and low in­fla­tion is con­se­quently hav­ing the ef­fect of low­er­ing nom­i­nal in­vest­ment re­turns across the globe.

How­ever, there are def­i­nite cycli­cal op­por­tu­ni­ties that pe­ri­od­i­cally present them­selves to greatly en­hance re­turns.

We con­sider that such an op­por­tu­nity cur­rently ex­ists; in the last six months global eco­nomic growth has seen a clear cycli­cal ac­cel­er­a­tion at a time that the world’s cen­tral bankers have yet to mean­ing­fully ap­ply the brakes.

Over a short term pe­riod the cor­re­la­tion be­tween cor­po­rate earn­ings and share prices di­verge greatly as mar­kets try to an­tic­i­pate earn­ings growth.

Although there are these pe­ri­ods where eq­uity mar­kets lag or over­re­act, over the long run eq­uity mar­kets rise in line with cor­po­rate earn­ings growth, not GDP growth.

Com­pa­nies are not im­mune to the en­vi­ron­ment, so it does in­deed stand to rea­son that (ex­clud­ing pe­ri­odic cycli­cal fire­works) we should pre­pare our­selves for con­tin­ued lower nom­i­nal eq­uity re­turns.

What wor­ries us more are the cur­rent ul­tra-low global short and long term in­ter­est rates.

The re­sult of be­ing at the tail end of a 35 year bond bull mar­ket means that de­vel­oped mar­ket fixed in­come cash and bond re­turns are very likely to dis­ap­point in the fu­ture, as mar­kets give back some of these re­turns that have been bor­rowed from the fu­ture. Jay Vo­macka, se­nior port­fo­lio man­ager at AEON IN­VEST­MENT MAN­AGE­MENT says over time, the com­pany has no­ticed a trend that the for­ward-look­ing na­ture of the eq­uity mar­ket has in­creased.

This has led to an in­crease in the dis­lo­ca­tion be­tween eco­nomic growth and in­vest­ment mar­ket re­turns in a sin­gle cross sec­tional view.

In­vest­ment re­turns are linked to eco­nomic growth but only on a time hor­i­zon­tal for­ward look­ing ba­sis and so it is get­ting harder to see the cor­re­la­tion at any spe­cific time due to chang­ing look-back pe­ri­ods.

Cur­rently, growth is start­ing to pick up glob­ally, al­beit at a lack­lus­tre pace but eq­uity mar­kets con­tinue to see through the slow re­cov­ery.

Cer­tain mar­kets, like in the US and Eu­ro­zone, are mak­ing new highs be­fore be­ing con­firmed by in­creas­ing earn­ings, stretch­ing val­u­a­tions.

This shows the in­tense for­ward-look­ing na­ture of mar­kets. An­drew Vint­cent, eq­uity and bal­anced fund port­fo­lio man­ager at CLUCASGRAY AS­SET MAN­AGE­MENT agrees with the as­ser­tion that in­vestors are en­ter­ing a pe­riod of low in­vest­ment re­turns.

Cur­rent val­u­a­tions on Eq­uity Indices, cou­pled with multi-gen­er­a­tional low global Bond yields lead us to be cau­tious on the abil­ity of both ma­jor as­set classes to gen­er­ate de­cent nom­i­nal re­turns.

“We do, how­ever, be­lieve we are en­ter­ing a pe­riod of im­prov­ing global eco­nomic growth, cou­pled with moder­ately ris­ing in­fla­tion.

“This is likely to be sup­port­ive of an im­prov­ing cor­po­rate earn­ings pro­file, but given the high mul­ti­ples, this growth is un­likely to be suf­fi­cient to gen­er­ate high nom­i­nal re­turns from Eq­uity mar­kets,” says Vint­cent.

“South African in­vestors have be­come ac­cus­tomed to an ever weakening cur­rency to boost off­shore re­turns – we cau­tion against as­sum­ing a con­tin­u­a­tion of this trend.

“The Rand re­mains un­der­val­ued in real terms, and an en­vi­ron­ment of im­prov­ing global growth has typ­i­cally been sup­port­ive of com­mod­ity cur­ren­cies.

“South African in­vestors have the ben­e­fit of high nom­i­nal and real in­come yields from which to de­rive rea­son­able re­turns.

“The ClucasGray Equi­lib­rium Fund (Reg 28 Bal­anced) has a large al­lo­ca­tion to shorter du­ra­tion in­come as­sets. Within Eq­ui­ties, we be­lieve there are a num­ber of sec­tors that have the prospect of de­liv­er­ing good re­turns for in­vestors over the next few years.

“As a re­sult, we be­lieve that SA in­vestors are not faced with the same low return en­vi­ron­ment as is the case glob­ally.” Mark Ap­ple­ton head of multi as­set and strat­egy (SA) at ASH­BUR­TON IN­VEST­MENTS says eco­nomic ac­tiv­ity re­sults from a com­bi­na­tion of peo­ple plus pro­duc­tiv­ity.

Glob­ally long term de­mo­graphic growth has shown signs of slow­ing as have pro­duc­tiv­ity gains.

“Faced with a lack of de­mand com­pa­nies have lacked in­cen­tive to in­vest in capex and pro­duc­tiv­ity has been suf­fer­ing from a lack of this capex spend.

“Taken to­gether, this has had a con­strain­ing ef­fect on po­ten­tial global GDP growth,” says Ap­ple­ton.

“There is a nat­u­ral long term link be­tween eco­nomic growth and ag­gre­gate cor­po­rate prof­itabil­ity, although this will be in­flu­enced from time to time by the shift­ing shares of labour ver­sus cap­i­tal within the econ­omy.

“Prof­itabil­ity will nor­mally be pos­i­tively in­flu­enced by ac­cel­er­at­ing eco­nomic growth be­cause this cre­ates greater de­mand, although at the in­di­vid­ual cor­po­rate level greater com­pe­ti­tion could limit these gains some­what.

“Eq­uity in­vest­ment re­turns will be in­flu­enced both by po­ten­tial profit growth and by the cost of cap­i­tal. Ris­ing in­ter­est rates for ex­am­ple will in­crease the cost of cap­i­tal and raise the rate at which fu­ture earn­ings are dis­counted back to present val­ues.”

Go­ing for­ward into 2017, Ap­ple­ton says the global growth out­look ap­pears to be bright­en­ing some­what. Lead­ing in­di­ca­tors and Pur­chas­ing Man­ager In­dex read­ings are show­ing de­fin­i­tive signs of im­prove- ment.

He con­tends that fis­cal stim­u­lus is an emerg­ing theme which could un­leash “an­i­mal spir­its” with re­spect to cor­po­rate capex spend and this would be pos­i­tive for risk as­sets in gen­eral.

“There are, how­ever, signs that in­fla­tion may also be headed up and cen­tral banks could be­come some­what less ac­com­mo­dat­ing on the mon­e­tary pol­icy front.

“While a ris­ing in­ter­est rate en­vi­ron­ment in the de­vel­oped world will not be pos­i­tive for de­vel­oped mar­ket sov­er­eign bonds, it should not be too much of a con­strain­ing fac­tor from an eq­uity mar­ket per­spec­tive as long as the up­ward in­ter­est rate re­sponse is slow and mea­sured and re­sults from in­creased eco­nomic ac­tiv­ity (and de­mand),” says Ap­ple­ton. Nick Curtin, in­sti­tu­tional in­vestor re­la­tion­ship man­ager at FO­ORD says yields have fallen across the board over the last three decades, re­sult­ing in a steady rise in cap­i­tal val­ues across all ma­jor as­set classes. In­ter­est rates now ap­pear to be en­ter­ing a nor­mal­i­sa­tion phase, led by the Fed.

“In a nor­mal cy­cle, ris­ing rates are not nec­es­sar­ily a bad thing – they usu­ally fol­low a pe­riod of eco­nomic strength with ris­ing em- ploy­ment, wage lev­els, in­fla­tion etc. all of which are sup­port­ive of com­pany earn­ings.

“How­ever, in this in­stance, a long pe­riod of very low in­ter­est rates in many de­vel­oped economies has re­sulted in some mis­al­lo­ca­tion of cap­i­tal through cor­po­rate ac­tiv­ity funded by very cheap debt and in­vestors chas­ing yield any­where they can find it.

“In many in­stances this has led to over­val­u­a­tion, which low­ers the prospec­tive fu­ture re­turns that in­vestors can ex­pect. We are in a pe­riod of low in­vest­ment re­turns, fo­cussed on cap­i­tal preser­va­tion with high liq­uid­ity lev­els to ex­ploit mar­ket volatil­ity,” says Curtin. Lis­ton Mein­t­jes, head of in­vest­ments at SASFIN WEALTH says: “In the first in­stance, I do not un­der­stand what is meant by ‘we’ as the US, as the world’s largest econ­omy is set to grow at 2.5 per­cent this year and, if Pres­i­dent Trump is suc­cess­ful in his aims, it could be higher; China, as the world’s sec­ond-largest econ­omy (ar­guably far larger than the US in steel, ce­ment) by of­fi­cial es­ti­mates is likely to grow at 6.5 per­cent; and In­dia, cur­rently only the eighth largest econ­omy is grow­ing at 7.3 per­cent”.

“Es­sen­tially what I am say­ing is that I can find no jus­ti­fi­ca­tion for a state­ment that ‘we’ have en­tered an era of low growth and low in­vest­ment re­turns.

“What we have had is a to­tally un­sus­tain­able pe­riod of low in­ter­est rates, en­gen­dered by cen­tral banks and their poli­cies in re­sponse to the GFC which was nearly ten years ago.

“It is doubt­ful that that pe­riod of ZIRP and NIRP will con­tinue un­der Pres­i­dent Trump, although of­fi­cially he has no say in mon­e­tary pol­icy and Janet Yellen’s term of of­fice is un­til 2018.

“Al­ready, in­fla­tion in the US is run­ning at more than 2 per­cent, a level that the US Fed has per­sis­tently in­di­cated as an item that would al­low a shift in their pol­icy.” David Crosoer, head of re­search and in­vest­ments at PPS IN­VEST­MENTS says it makes the­o­ret­i­cal sense that growth in stock mar­ket earn­ings and eco­nomic growth should be linked; but clearly this does not mean there will nec­es­sar­ily be a di­rect re­la­tion­ship be­tween eco­nomic growth and in­vest­ment re­turns.

This is both be­cause earn­ings growth is not the only driver of in­vest­ment re­turns (the price in­vestors are will­ing to pay for any fu­ture stream of ex­pected earn­ings can of­ten drive in­vest­ment re­turns es­pe­cially in the short-term) and also be­cause the com­pa­nies listed on the stock-mar­ket are not nec­es­sar­ily rep­re­sen­ta­tive of the broader econ­omy.

So my view is that stud­ies that dis­pute this link prob­a­bly don’t prop­erly con­trol for the noise that makes this re­la­tion­ship harder to dis­cern - it’s hard to ar­gue for in­stance that eco­nomic growth that broadly dis­ap­points should be pos­i­tive in ag­gre­gate for stock mar­kets. Anet Ah­ern, chief ex­ec­u­tive of­fi­cer at PSG AS­SET MAN­AGE­MENT be­lieves that con­struct­ing a port­fo­lio based on any eco­nomic fore­cast is fraught with fail­ure.

“Where eco­nomic fore­casts and ex­pec­ta­tions be­come very use­ful for bot­tom up in­vestors, is when ex­treme or widely pre­vail­ing views (such as the one of low eco­nomic growth men­tioned here) lead to in­vest­ment be­hav­iour which pro­vides ex­cel­lent op­por­tu­ni­ties.

“For in­stance, at present the gap be­tween the val­u­a­tions of so-called de­fen­sive com­pa­nies ver­sus com­pa­nies more re­liant on eco­nomic growth (cycli­cal com­pa­nies), is as wide as it was at the height of the dot com bub­ble.

“This means that many com­pa­nies of high qual­ity, with good busi­ness mod­els and ex­cel­lent man­age­ment track records, have be­come very cheap. In con­trast, com­pa­nies that pro­vide more cer­tainty of earn­ings have be­come very ex­pen­sive.

“These cycli­cal com­pa­nies are cheap de­spite the poor growth prospects, es­pe­cially when viewed over the long term.

“For the thor­ough, pa­tient bot­tom-up in­vestor this is a time to be ex­cited rather than con­cerned de­spite ex­ist­ing eco­nomic views, which may in iso­la­tion in­cite a much gloomier mood.” Pi­eter Hugo, MD of PRU­DEN­TIAL UNIT TRUSTS says given that the JSE de­rives over 60 per­cent of com­pany earn­ings from off­shore, the link be­tween SA eq­uity re­turns and SA eco­nomic growth is not a clear one.

“Global eco­nomic growth is im­por­tant, and in 2017 is ex­pected to ac­cel­er­ate from low 2016 lev­els as the US and EU economies gather pace, while China re­mains sta­ble.

“SA eco­nomic growth is also fore­cast to rise from very low lev­els – both of these trends should be gen­er­ally favourable for com­pany earn­ings.

“How­ever, a great deal also de­pends on the di­rec­tion of com­mod­ity prices and the rand, both very un­pre­dictable fac­tors,” says Hugo.

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